Gripping Gaap
Gripping Gaap
Gripping Gaap
LexisNexis
DURBAN
i
Gripping GAAP First edition: 2000
Second edition: 2001
Third edition: 2002
Fourth edition: 2003
Fifth edition: 2004
Sixth edition: 2005
Seventh edition: 2006
Eighth edition: 2007
Ninth edition: 2008
Tenth edition: 2009
Eleventh edition: 2010
Twelfth edition: 2011
Thirteenth edition: 2012
Fourteenth edition: 2013
Fifteenth edition: 2014
Sixteenth edition: 2015
Seventeenth edition: 2016
Eighteenth edition: 2017
Nineteenth edition: 2018
Twentieth edition: 2019
Twenty first edition: 2020
© 2020
ISBN softcover 978 0 639 00383 2
e-book 978 0 639 00384 9
Copyright subsists in this work. No part of this work may be reproduced in any form or by any
means without the publisher’s written permission. Any unauthorised reproduction of this work will
constitute a copyright infringement and render the doer liable under both civil and criminal law.
Whilst every effort has been made to ensure that the information published in this work is
accurate, the editors, authors, publishers and printers take no responsibility for any loss or
damage suffered by any person as a result of the reliance upon the information contained therein.
Suggestions and comments are most welcome. Please address these to:
Disclaimer
This text has been meticulously prepared, but in order for it to be user-friendly, the principles,
application thereof and disclosure requirements have been summarised.
This text should therefore not be used as a substitute for studying, first-hand, the official
International Financial Reporting Standards, including their interpretations.
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Gripping GAAP
Dedication
This book is once again dedicated to my very dear family and friends!
And to my team of guardian angels who not only inspired this book but who have
provided me with the guidance and super-human strength
needed to update it each year.
And finally, I wish to dedicate this book to those for whom I wrote it: You!
I sincerely wish that my book sheds the necessary light as you
fervently study towards your ultimate goal of
joining our country’s ranks of
‘counting mutants’
Our country needs you!
iii
Gripping GAAP
Foreword
Another ‘Four Words’ to Gripping GAAP
While I dread the thought that nepotism could be considered the rationale for such
distinction (I am closely related to the authoress!) I have at least, I hope, established
my monstrous lack of appropriate credentials. However, as a fellow writer (of fiction –
and is that so very different from latter-day accounting fact?), I feel thus qualified to
commend the work for its lucid and clearly understandable (even to me!) “unpacking”
of the arcane subject of Accountancy.
A sage of old opined that “money is the root of all evil” – a maxim which, like most
others, appears to have stood the test of time. Until recently, of late it would appear
that the accounting of money (on a worldwide basis) has much to answer for.
Hitherto trustworthy multinational financial edifices have been found wanting to an
alarming degree and the tendency to indulge in “creative accounting” has been rightly
indicted.
The vigour of youth (yours) coupled with a sincere passion to put right what has gone
wrong (also yours, I trust!) is the serious need that Gripping GAAP seeks to advance.
Balzac said “Behind every great fortune there is a crime!” Was he right? Winston
Churchill said “Success is the ability to lurch from failure to failure with no loss of
enthusiasm!” Was he right? Does it matter? Perhaps it does.
Certainly my personal hope is that those who, thousands of years ago, taught us all
to read and write with such fine precision will be the inspiration for your generation of
professionals to deal with an emerging global need to account with similar exactitude.
Carpe Diem!
Dr Roger Service
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Gripping GAAP
A note to you from the author
To all you dear students, planning on joining the ranks of ‘the counting mutants’
South African accountants have done us very proud, having
South Africa was ranked the been ranked as THE WORLD LEADERS in financial reporting
WORLD LEADER in auditing and auditing for seven years in a row! This highly prestigious
and financial reporting for accolade was given by the World Economic Forum, most
SEVEN years in a row! recently in the 2016–2017 Global Competitiveness Report. So,
World Economic Forum’s 2016– before breaking the bad news, may I start by congratulating you
2017 Global Competitiveness on choosing to follow a career in which you can only flourish,
Report given that South Africa’s education and training in this
field are clearly the very best there is!
The bad news is that South Africa plummeted in the ‘2017–
2018 rankings’, to 30th in the world, and more recently in the ‘2018 rankings’, to 55th in the world. Reading
their assessment, it is clear the perception of declining investor protection, ethical behaviour, efficacy of
corporate boards and increasing evidence of corruption are the main reasons. Given the news of
corruption and scandals in 2017 and 2018, our new ranking was obviously predictable. But as IRBA CEO,
Bernard Agulhas, pointed out, we all need to “work together to regain confidence in our markets, stimulate
investment and reclaim our world class rankings”. The onus is on all accountants, including you, a budding
accountant. This is not a subject you aim to get 50% in – it is imperative you grasp as much as you can
and aim at full understanding of all principles. Our economy is desperate for growth, and for this to happen,
investor confidence is essential. Accountants and auditors play a pivotal role in generating confidence,
together, of course, with clear and sound economic policies.
So, to the matter of the subject at hand: accounting. It is one of the Please visit our Facebook!
most misunderstood disciplines that you could choose to study, with (see page ii for details)
the general public’s perception being that it is dull and yet easy
because it is simply about ‘debits and credits’. And how hard can the
principle of ‘debit-credit’ really be? Well, it is safe to say that accounting is currently one of the fastest
changing and most complex subjects and is very interesting to those ‘in the thick of it’. The International
Financial Reporting Standards are currently a few THOUSAND pages long – and get longer every year.
It is these IFRSs that Gripping GAAP hopes to simplify for you. These IFRSs regulate how we commu-
nicate financial information and are essentially the rules of accounting – and you may be interested to
learn that nowhere in the literally thousands of pages is any reference made to debits and credits!
Now, probably the most important thing I can tell you is that the clue to enjoying the study of any future
career may be summed up as follows: knowledge without understanding is much the same as a vehicle
without an engine – you just won’t be going anywhere! So, to help you understand the many principles,
I have included over 600 examples and tried my very best to make the frequently dry subject as easy to
read as possible. There are flowchart summaries and little grey boxes, which I call ‘pop-ups’
throughout the chapters. These pop-ups are designed to help
you quickly identify core definitions (look for pop-ups with a
Support lectures and tutorials picture of an apple core) and to help you find mini-summaries,
are available – please contact me showing the essence of a section, important tips or interesting
for details via Facebook facts (look for pop-ups with the picture of a happy face).
To see how you are progressing, please access the LexisNexis
portal for free online questions. For teamwork and information
sharing, there is also a Facebook page (see page ii) on which you can discuss both the IFRSs and
Gripping GAAP with other students and from which you can contact me directly with any queries or
comments. I hope to see you there! The more you visit, the
more you will all benefit!
All you need is a positive attitude,
As an optional extra, I offer skype lectures for those who would
enthusiasm, commitment,
prefer extra assistance. Please contact me if you have requests
perseverance ...
or queries in this regard by using the same Facebook page.
and Gripping GAAP!
In closing, please avoid becoming complacent. I predict that
the coming year of your studies will be dynamic and you will
probably feel as though you are not studying accounting at
all but rather a form of complex law! In a way you will be right. So, it is at this crucial start, as you
embark upon your journey into the world of ‘GAAP’, that you maintain a positive attitude and keep your
wits about you … and keep Gripping GAAP as your guide.
Bon voyage! And remember that with enthusiasm, commitment and perseverance, success will
inevitably follow. Wishing you the very best for your studies!
v
Gripping GAAP
Introduction
The ongoing international harmonisation and improvements projects have seen a
proliferation of revised and re-revised standards, interpretations and exposure drafts.
This edition has been updated for all relevant standards in issue, together with any
amendments made up to 10 December 2019.
A number of new international standards and interpretations are expected to be
issued during 2020. Please watch the Facebook page for details (see page ii).
Since Gripping GAAP has gained international attention, the text has been updated
to be more country non-specific in terms of tax legislation. In this regard, students
may assume that the business entity is subjected to the following taxes (unless other-
wise indicated):
z A tax on taxable profits at 30%, (referred to as income tax);
z An inclusion rate of 80% for entities when dealing with capital gains tax (part of
income tax);
z A transaction tax levied at 15%, (referred to as VAT or value added tax).
Gripping GAAP uses the symbol ‘C’ to denote an entity’s currency but uses the sym-
bol ‘LC’ for an entity’s ‘local currency’ in any chapter dealing with foreign currencies.
Some chapters (e.g. chapter 1 & 23) include unavoidable reference to South African
legislation. Aspects of these chapters may possibly not be relevant to some of the
countries using this book. All principles are, however, international principles.
Paedagogical philosophy
Gripping GAAP is designed for those who wish to:
z fully understand the concepts and principles of accounting
z be able to study their syllabus without the aid of daily lectures (e.g. students
studying on a distance learning basis);
z qualify as chartered accountants; and
z keep abreast of the changes to international financial reporting standards.
Gripping GAAP can be successfully used with GAAP: Graded Questions, by
C Service and D Kolitz, and Gripping Groups, by C Service and M Wichlinski.
Gripping GAAP covers an enormous volume of work and is frequently studied over a
few years. It includes material that is covered at both undergraduate level and post-
graduate level.
The text has therefore been written so as to be as easy-to-read as possible and
includes more than 600 examples as well as both mini pop-up summaries and maxi
flowchart summaries, thus making it ideal for students studying on a distance basis.
Students must be able to see the ‘big picture’ and thus the flowchart summaries are
provided at the end of each chapter. These summaries are a good place to start
before reading any chapter or in preparation for lectures and are also good to read
over after reading a chapter or after attending a lecture.
In order to help one remain focused whilst reading the chapters, which unavoidably
contain copious and complex detail, little grey pop-ups have been inserted to high-
light the relevant core definitions and the essence. These pop-ups have been pro-
vided in a bulleted format to enable quick assimilation of ‘fast-facts’. The pop-ups
with a graphic of an apple-core generally identify core definitions whereas those with
the graphic of a smiling face provide summaries of core facts, principles and tips.
vi
Gripping GAAP
Paedagogical philosophy
x Chapter 1 explains the environment within which a ‘reporting accountant’ finds himself or herself (i.e.
where an accountant is affected by the IASB and various related legislation).
x Chapter 2 explains the Conceptual Framework (CF), which is the basic logic underpinning the design
of the IFRSs. Chapter 2 covers the new CF issued in 2018 and highlights important changes from the
prior CF. The IASB has not updated the pre-existing IFRSs for the 2018 CF. In this regard, the IASB
has reminded preparers that, in case of any resulting conflict between an IFRS and the new CF,
IFRSs must always override the CF. For this reason, the remaining chapters thus focus on the
relevant IFRS and simply identify any conflict with the 2018 CF.
x Chapter 3 explains how financial statements should be presented.
x Chapters 4–6 involve revenue from customer contracts and taxes. Since tax is integral to all topics, the
chapters on tax are included early on in the book. We first look at how to account for current tax
(chapter 5) and then explain how deferred tax arises and is accounted for (chapter 6).
x Chapters 7–13 involve various assets. These chapters are covered after having grasped deferred tax
since these assets have deferred tax consequences. That said, some institutions prefer to teach the
principles involving each of the asset types without these deferred tax consequences. For this
reason, the deferred tax consequences are presented in a separate section of each of these chapters
and examples are shown with deferred tax consequences and without deferred tax consequences.
We start with non-current assets and proceed to current assets (inventory). Impairment of assets is also
included in this set of chapters: it is inserted after the chapters covering property, plant and equipment,
intangible assets and investment properties but before non-current assets held for sale and inventories.
This is because the standard on impairments applies to the former assets but not the latter assets.
There are two chapters on property, plant and equipment: the first explains the basic concepts and
the cost model. The second chapter explains the revaluation model. The first part of this chapter
is designed to explain the very basics, focusing on non-depreciable assets. It then progresses to
depreciable assets. The deferred tax and disclosure consequences for both non-depreciable and
depreciable assets are also explained.
Some institutions are de-emphasising certain topics, such as borrowing costs and government grants.
However, it is essential that students understand the basic concepts and how these can topics affect
the measurement of various assets. For this reason, these topics are included at a basic level in the
asset chapters. For a more detailed understanding, see chapters 14 and 15.
x Chapter 14–17 deal with borrowing costs, government grants and leases (lessees and lessors). These
chapters may all have an impact on the recognition and measurement of assets.
x Chapters 18–19 cover provisions, contingencies & events after the reporting period and employee
benefits. Both chapters focus largely (but not entirely) on obligations (liabilities).
x Chapter 20–24: Chapter 20 deals with foreign currency transactions, where it explains how trans-
acting in a foreign currency can affect the measurement of items.
Since foreign currency transactions frequently require hedging, chapter 22 explains hedge account-
ing, by using the example of a currency forward exchange contract so as to link back to chapter 20.
However, since forward exchange contracts are a type of financial instrument, the student should
ideally first study financial instruments. The financial instruments topic is covered in chapter 21.
Share capital involves either equity instruments or financial liabilities and is thus best covered after
having grasped the various concepts in the financial instruments chapter and thus the concept of
share capital and liabilities is contained in chapter 23. Chapter 24 covers earnings per share: this
chapter is best covered after studying share capital.
x Chapter 25: Fair value measurement affects numerous prior chapters affected by fair value measure-
ments. This chapter may be referred to whilst studying these other affected chapters.
x Chapter 26: Everything we have learned thus far involves applying policies and making estimates
(and hopefully not too many errors!). This chapter now explains how you would account for a change
in an accounting policy or estimate and how to correct errors.
x Chapter 27: Statements of cash flows is distinct from all prior chapters since it applies the cash con-
cept rather than the accrual concept and is thus the penultimate chapter.
x Chapter 28: The final chapter is financial analysis and interpretation since it does not relate to an
IFRS but simply explains how users analyse and interpret the financial statements.
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Gripping GAAP
Contents
Chp. References Title of chapter Page
23 IFRS 9 & IFRS 7, Share capital: equity instruments and financial liabilities 1113
IAS 32 & Co’s Act
viii
Gripping GAAP The reporting environment
Chapter 1
The Reporting Environment
Main references: IFRS Foundation Constitution (2018); Due Process Handbook (2016);
www.IFRS.org; Companies Act 2008; Companies Regulations, 2011; King IV (2016) and JSE
Listing Requirements (November 2017) – all latest versions as at 1 December 2019
Contents: Page
1. Introduction 3
2. A brief history of accounting 3
2.1 Accounting is a language 3
2.2 Accounting has evolved 4
2.3 The difference between the double-entry system and GAAP 4
2.4 The difference between GAAP and IFRS 5
3. GAAP and IFRSs – the process of internationalisation 6
3.1 A brief history of the internationalisation of GAAP into IFRSs 6
3.2 International Financial Reporting Standards (IFRSs) 6
3.2.1 Overview 6
3.2.2 The meaning of the term ‘IFRSs’ or ‘IFRS Standards’ 6
3.2.3 The meaning of the term ‘Standards’ 7
3.2.4 The meaning of the term ‘Interpretations’ 7
3.3 Conceptual Framework for Financial Reporting 7
3.4 Compliance with IFRSs (adoption) 7
3.4.1 What does compliance with IFRS involve? 7
3.4.2 Why would one comply with IFRS? 8
3.4.3 The extent of compliance with IFRS around the world 8
3.5 Harmonisation versus Convergence 9
3.6 Adoption versus Convergence 10
3.7 Development of IFRSs (standard-setting) 11
3.7.1 Overview 11
3.7.2 Standards developed to date 11
3.7.3 Interpretations developed to date 11
3.7.4 Due process 11
3.7.4.1 Overview 11
3.7.4.2 Principles of ‘due process’ 11
3.7.4.3 The basic ‘development cycle’ 12
3.7.4.4 Developing ‘exposure drafts’ 13
3.7.4.5 Developing ‘standards’ 13
3.7.4.6 Developing ‘interpretations’ 14
3.7.4.7 Developing ‘annual improvements’ 14
Chapter 1 1
Gripping GAAP The reporting environment
Contents continued …
3.8 The IASB and the IFRS Foundation: a look at the structure 15
3.8.1 Overview 15
3.8.2 The IFRS Foundation 15
3.8.3 The IFRS Foundation: an organogram 16
3.8.4 The Trustees 16
3.8.5 The Monitoring Board 17
3.8.6 The International Accounting Standards Board (IASB) 17
3.8.7 The IFRS Interpretations Committee (IFRSIC) 17
3.8.8 The IFRS Advisory Council (IFRSAC) 18
3.8.9 The Accounting Standards Advisory Forum (ASAF) 18
4. The ‘Companies Act’ and the related ‘Regulations’ 18
4.1 Overview 18
4.2 The different categories of companies 18
4.3 Legal backing for financial reporting standards 19
4.4 Which financial reporting standards must we use? 21
4.5 Legal backing for differential reporting 22
4.5.1 An overview 22
4.5.2 What is a small and medium-sized entity (SME)? 22
4.5.3 The history of differential reporting in South Africa 22
4.5.4 How do the IFRSs for SMEs help? 23
4.6 Does our company need an audit or independent review? 23
4.7 Company records 24
4.8 Accounting records 24
4.9 Financial year 24
4.10 Financial statements 25
4.11 Annual financial statements 25
4.11.1 Timing 25
4.11.2 Audit or independent review 25
4.11.3 Other documents included in the annual financial statements 26
4.11.4 Extra disclosure relating to directors or prescribed officers 26
4.11.5 Approval and presentation 27
5. JSE Listing Requirements 28
5.1 Overview 28
5.2 JSE on ‘continuing obligations’ 28
5.3 JSE on ‘financial information’ 28
6. King IV Report 29
6.1 Overview 29
6.2 King IV Report on remuneration 30
6.3 King IV Report on sustainability and integrated reporting 30
7. Summary 32
2 Chapter 1
Gripping GAAP The reporting environment
1. Introduction
Many people think that working as an accountant will involve being locked away – alone – in a
small dusty room, armed with a calculator and reams of paperwork. However, the modern
accountant is incredibly important to business and he/she needs to be able to contribute to the
effective functioning of all facets thereof. Thus, accountants need a wide range of skills.
This book focuses on the main compulsory skill of ‘accounting and external reporting’:
x ‘Accounting’ refers to record-keeping, in other words, the process of documenting the results
of the business activities; and
x ‘External reporting’ refers to how we convert these records into the ‘story of the business’,
where this story is then told in the financial statements to those interested parties (external
users) in a way that will help them understand what occurred in the business during the period.
Having the specific skill of ‘accounting and external reporting’ requires a thorough understanding
of many related theories, principles and rules, including, for example:
x understanding the basic rules behind the double-entry system;
x understanding the accounting and reporting rules and principles referred to as International
Financial Reporting Standards (IFRSs);
x understanding that generally accepted accounting practice (GAAP) is simply an umbrella
term that refers to the accounting and reporting rules and principles that are applied in a
country or region: South African GAAP involves the application of IFRSs, whereas another
country, instead of applying IFRSs, may apply its own unique rules, i.e. its own unique
GAAP, which is would be referred to as that country’s own national GAAP;
x understanding that IFRSs are essentially a harmonisation of the various forms of national
GAAP, and where the intention is that IFRSs will replace all remaining national GAAPs.
This textbook assumes you understand the double-entry system and assumes your business will
apply International Financial Reporting Standards (IFRSs) when preparing its financial statements.
It thus focuses solely on the application of IFRSs. Each chapter in this textbook is dedicated to an
IFRS (or group of related IFRSs). However, before we become engrossed in each of these
chapters, this chapter first explains the wider environment affecting accounting and external
reporting. The remaining sections in this chapter are structured as follows:
x Section 2: A brief history of accounting
x Section 3: GAAP and IFRSs – the process of internationalisation
x Section 4: The Companies Act and its related Regulations
x Section 5: The JSE Listing Requirements
x Section 6: The King IV Report
Chapter 1 3
Gripping GAAP The reporting environment
Accounting is just another language, one that is used Examples of typical users:
by accountants to ‘talk’ with other accountants and Shareholders: who may consider
increasing or decreasing their
interested parties (called ‘users’). Interested parties investments,
want to hear the business’s ‘story’. Thus, accountants Lenders: need to assess the risk of continuing
need to be able to document the story (by debiting to provide credit,
and crediting) and be able to tell the story (by Suppliers: who may want to assess whether or
reporting). The language we use depends on which not to continue supplying goods and services,
country we are telling the story to – some countries Customers: need to decide who best to give
need the ‘story’ told in their national GAAP, whereas their business to.
others need it in international GAAP (i.e. using IFRSs). The intention is that, in time, there will be one
accounting language – an international GAAP (IFRSs).
The evolution of accounting came about due largely to the evolution The double-entry
of business. There are many stages that have been identified in this system came about
because it:
business evolution, but two significant stages include the introduction
x gives the detail and
of (1) corporations and (2) credit. The arrival of corporations and
checks & balances
credit meant that more detail was needed to satisfy those users who
x needed for those users
were not involved in the day-to-day management of the business:
x who are not involved in
x Initially businesses involved sole proprietors and family-run ‘day-to-day management’.
businesses, where record-keeping was a relatively simple affair
because the owners also managed the business and were thus intimate with the business’s
transactions. However, as businesses grew larger and corporations began appearing on the
scene, record-keeping had to become more detailed since the owners of these corporations
were shareholders who were generally not involved in the day-to-day management of the
business. This is known as the ‘agency problem’, which fair financial reporting aims to solve.
x Initially businesses worked purely on a cash basis. However, when ‘credit’ was introduced,
money-lenders wanted information that would help assess whether it was safe to continue
providing credit. Since money-lenders were not involved in the day-to-day management of the
business, they too demanded detailed record-keeping.
In summary, unlike earlier times, users of financial information today are often not involved in
the management process and thus demand more detailed financial information.
To communicate properly in any language, we need to obey certain rules. These rules tell us
how to pronounce and spell words and how to string them together in the right order to make
a sentence that someone else will understand. Accounting is no different and thus rules on
how to ‘operate’ the double-entry system were developed.
4 Chapter 1
Gripping GAAP The reporting environment
An Italian, Luca Pacioli, who worked closely with the artist and genius,
Leonardo da Vinci, is often referred to as the ‘father of accounting’. Pacioli is
However, Luca Pacioli did not design the double-entry system (since it called:
had already been in use for roughly 200 years). He simply appeared to
x the ‘father of
be the first to document how the double-entry system worked,
accounting’, but
explaining it in his mathematics textbook (Summa de arithmetica,
x he did not design the
geometria, proportioni et proportionalità, published in Venice in 1494). double-entry system, …
Interestingly, however, it seems that there were previous books on the x he simply wrote about it!
double-entry system and that Pacioli’s book was simply more widely
distributed than these previous books.
Over time, more rules sprung up around this double-entry system. These rules became
known as generally accepted accounting practice (GAAP). Before globalisation, countries
operated very separately, each developing their own unique form of GAAP (i.e. their own
accounting language). Each country’s GAAP is referred to as that country’s national GAAP.
This increased global communication between accountants gradually led them to realise that
they were ‘not talking the same language’. In fact, the national GAAP used in one country is
sometimes so different to that used in another country that it is like comparing the languages
of French and Chinese. In other cases, the differences are so minor that it is like comparing
American English with British English, where the words are the same, but the accents differ.
However, all differences, no matter how small, will still result in miscommunication. Whilst
miscommunication at a personal level can lead to tragedies ranging from losing your keys to
divorce, miscommunication at a business level often leads to court cases, financial loss,
liquidation and sometimes even prison time for those involved.
The international communication amongst accountants has been growing exponentially over
the last few decades and eventually, in 1993, the effect of the different accounting languages
became painfully clear to the public. Let me tell you the story...
Although the gradual development of a single global GAAP had been underway for many
years, the recent and unprecedented surge in globalisation, resulting in examples such as this
‘1993 Daimler-Benz experience’, led to a renewed surge of support for the idea.
Currently, the various forms of national GAAP are in the process of being morphed into a single
global GAAP, referred to as the set of International Financial Reporting Standards (IFRSs).
These IFRSs have been developed and are regularly revised by the International Accounting
Standards Board (IASB). More about the IFRSs and the IASB can be found in section 3.
Chapter 1 5
Gripping GAAP The reporting environment
The process of distilling the world’s various national GAAPs into a single global GAAP (i.e.
IFRS) is referred to as harmonisation. This project is explained in section 3.5.
International Financial Reporting Standards (IFRSs) contain the principles that are applied by
an accountant when:
x recording transactions and other financial information (accounting); and when
x preparing financial statements for external users (external reporting).
IFRSs are issued by the International Accounting Standards Board. The development of
IFRSs is explained in section 3.7.
The term IFRSs
3.2.2 The meaning of the term ‘IFRSs’ or ‘IFRS Standards’
technically includes:
It is important to realise that the term IFRSs may be used in x Standards; AND
many ways: x Interpretations.
x It may be used in a narrow sense to refer to only those standards published by the International
Accounting Standards Board and thus prefixed with ‘IFRS’ (i.e. as opposed to standards published
by the previous International Accounting Standards Committee and thus prefixed with ‘IAS’).
x In its broader and more technical sense, the term is used to refer to the combination of all
standards and all interpretations (i.e. it would refer to all the standards, prefixed with IFRS
or IAS, and all their interpretations, prefixed with SIC or IFRIC).
6 Chapter 1
Gripping GAAP The reporting environment
However, when we declare that our financial statements comply with IFRSs (or IFRS
Standards), we are using the term in the broader more technical sense to mean that they
comply with all the standards and interpretations.
These standards are not only issued by the International Accounting Standards Board (IASB)
but are also developed by the IASB. However, the development process follows strict due
process procedures that require much collaboration with national standard-setters from
around the world and other interested parties.
Standards are defined
As explained in a previous section, the IAS Board adopted all as:
the work done by the previous IAS Committee and thus some x Standards issued by the IASB.
of the standards are still prefixed with IAS while those issued They comprise those prefixed by
by the IASB are prefixed with IFRS. IFRS and IAS.
Due Process Handbook: Glossary of terms (reworded)
It can happen that a standard has confusing principles, the application of which needs some
explanation. Where an explanation is required, the IASB issues a document called an interpretation.
Chapter 1 7
Gripping GAAP The reporting environment
Since interpretations have the same authority as standards and are thus to be read together
with the standards, when we make a statement in the financial report that the financial
statements ‘comply with the IFRSs’, we are actually saying they comply with both the:
x Standards, whether prefixed with IAS or IFRS; and
x Interpretations, whether prefixed with SIC or IFRIC.
Where the national legislation requires compliance, the answer to ‘why would one comply with
IFRS’ is obvious. However, in situations where compliance is neither required and nor
disallowed, why would entities comply with it? The answer is simply that compliance with
IFRS gives credibility to the financial statements and makes them understandable to
foreigners, thus encouraging foreign investment.
For many years, South Africa’s legislation did not require compliance with IFRSs. Despite
this, the increased credibility gained from complying with IFRSs led many South African
companies to adopt IFRSs. However, a recent revision to South Africa’s legislation now
means that certain companies must comply with IFRSs while other companies may choose to
comply. [More information about the legislation may be found in section 4]
By implication, those companies that do not comply, may not make such a declaration.
Since compliance with IFRSs lends international credibility to the financial statements, to be
able to make such a statement is desirable to most entities. [IAS 1 is covered in chapter 3.]
The term ‘International Financial Reporting Standards’ can be a bit misleading at present
since not all countries use them. In other words, these standards are technically not
‘international’ until all countries require the use thereof. The situation is currently as follows:
x At least 144 1 participating countries (as at 2 October 20191) already either permit or require
the use of IFRSs. Examples include South Africa, United Kingdom and all other member
states of the European Union, Australia, New Zealand, Canada, Saudi Arabia etc.2
x There are some countries that actually do not permit the use of IFRSs. Examples of some of
these include: Cuba, Indonesia, Iran, Mali, Senegal and Vietnam.2
x Some countries permit the use of IFRSs for some companies and disallow for others. For
example, the United States does not permit the use of IFRS by their domestic listed
companies but permits the use of IFRS by their domestic unlisted companies. 2
1 http://www.ifrs.org/use-around-the-world/use-of-ifrs-standards-by-jurisdiction/#analysis (accessed 2 October 2019)
2 https://www.iasplus.com/en/resources/ifrs-topics/use-of-ifrs (accessed 2 October 2019)
Some countries have adopted the IFRSs word-for-word as their own national GAAP. Others have
adopted IFRSs but with certain modifications that they consider necessary due to reasons that are
peculiar to that jurisdiction and which they thus believe have not been dealt with in the IFRSs.
8 Chapter 1
Gripping GAAP The reporting environment
However, there are other countries that are not adopting the
IFRSs but are choosing to converge their national GAAP with World-wide usage of IFRSs
the IFRSs instead (e.g. United States, China and India). Some countries:
x require compliance with IFRSs
Thus, some countries have adopted IFRS but with x permit compliance with IFRSs
modifications and some countries use their own national x do not allow compliance with IFRSs.
GAAP that they argue has been, or is being, converged with Sometimes countries that state they
support the use of IFRSs are using:
IFRSs. However, research has found that the difference x pure IFRSs,
between using pure IFRSs (i.e. pure adoption) versus using x modified IFRSs, or
modified IFRSs or a national GAAP that has been converged x national GAAP that has been or is
being converged with IFRSs.
with IFRSs can be significant, despite claims to the contrary.
As can be seen, the current status of the use of IFRSs is that there are still relatively divergent
practices around the world and the international harmonisation of the various national GAAP’s into a
single global GAAP (IFRSs) still has a long way to go.
The Constitution
3.5 Harmonisation versus Convergence
x refers only to convergence;
Developing global standards requires close consultation x does not refer to harmonisation!
between the IASB and the national standard-setters and
interested parties from all interested countries.
In this regard, two terms are commonly used: harmonisation and convergence.
Whereas ‘harmonisation’ was previously the buzz word, ‘convergence’ is now the new focus.
In fact, the Constitution of the IFRS Foundation refers only to the term ‘convergence’.
Ultimately, however, the purpose of both harmonisation and convergence is to create a single
set of high quality, global GAAP to be adopted world-wide.
The process of harmonisation involved the IASB and national standard-setters meeting to
analyse and compare the various principles and practices used across the world to:
x identify differences/ problems, and try to eliminate them; and
x help guide the development of the international standards (i.e. the IFRS would then
incorporate a combination of best practice and any new and improved ideas that may
have emanated from the process).
Essentially, the purpose of convergence is to try to reduce the differences between the IFRSs
(international GAAP) and the standards of that specific country (that country’s national GAAP). It
involves discussion and collaboration between that country’s standard-setters and the IASB in order
to assess the differences and reach an agreement on how to minimise these differences.
The IFRS Foundation’s
The IFRS Foundation’s constitution clarifies that the ultimate objective:
objective is adoption of IFRSs, and that convergence is simply a x is not convergence; but rather
means to achieve adoption. Convergence is simply a stepping- x is adoption.
stone due to the resistance from some countries to adopting IFRSs. Convergence is simply a means
to achieve adoption.
Although most countries (at least 144 countries at October 20191) already either permit or require
the use of IFRSs (i.e. have adopted IFRSs), some countries are still resisting adoption of the IFRSs.
The reasons these countries are resisting vary, for example:
x Some countries resist adoption of IFRSs because the differences between that country’s
national GAAP and the IFRSs are so vast that the complications and related cost of
converting to IFRSs are expected to outweigh the benefits.
x Some countries resist because they believe their national standards are superior to the IFRSs.
x The US argues that IFRSs are too principles-based and thus open to litigation as they are less
defensible than their more rules-based US GAAP. It has also been suggested that more powerful
countries are ‘less willing to surrender standard-setting authority to an international body’. 2
Where a country believes that it is unable to adopt the IFRSs, convergence is an option.
1
http://www.ifrs.org/use-around-the-world/use-of-ifrs-standards-by-jurisdiction/#analysis (accessed 2 October 2019)
2
Research: Why Do Countries Adopt International Financial Reporting Standards? (2009: Ramanna & Sletten)
Chapter 1 9
Gripping GAAP The reporting environment
Adopt or converge?
The IASB’s previous Director of International Activities (Mr Wayne Upton) explained:
‘While convergence may be the necessary preparation for some countries to adopt IFRSs, the simplest, least
costly and most straightforward approach is to adopt the complete body of IFRSs in a single step rather than
opting for long-term convergence.
Certainly, this is a significant change, but the alternatives may be more difficult and may be of less benefit to a
country in the long run.
The main reason why most companies want to use IFRSs in their financial statements is the ability to demonstrate
to the investor community that their financial statements are IFRS-compliant. For that purpose, it is not
sufficient that the standards have converged. The only way to make a valid claim is to apply all the standards as
issued by the IASB and make the compliance representation required by IAS 1.
Hence, while convergence is good, adoption is necessary to be truly able to harvest the benefits of the change.’ 1
One country resisting the adoption of IFRSs is the United States. However, although the US
was initially completely opposed to the international standard-setting process, after numerous
US corporate collapses, the US Financial Accounting Standards Board (FASB) and the
International Accounting Standards Board (IASB) agreed to a process of convergence.
Convergence between US GAAP (issued by FASB) and IFRSs (issued by IASB) is commonly
referred to as ‘the Convergence Project’. However, it is a misconception that convergence refers
only to the convergence between US GAAP and IFRSs. Other countries involved in similar
convergence projects with the IASB include, for example, China and India. However, given that
the US economy is relatively large (being the second largest in the world, with the greatest
being the European economy), the convergence project between the IASB and the US’s FASB
is ‘high profile’ and worth watching.
As mentioned, the US was initially opposed to IFRSs, but eventually, the IASB and the FASB
expressed their commitment to converge their standards. This commitment was documented in
the Norwalk Agreement of 2002. Although the convergence project between the IASB and the
FASB has a long way to go, the effects of having successfully reduced many differences
between the IASB’s IFRSs and FASB’s US GAAP have already been felt by foreign companies
listed in the US since they are no longer required to prepare the complex and time-consuming
reconciliation between their IFRS-based financial statements and the results that would have
been achieved using US GAAP.
The US Securities Exchange Commission (SEC) was to decide in 2011 whether it would allow
its domestic companies listed in the US to use IFRSs, but subsequently postponed this to 2012.
But in October 2012, the SEC announced that, due to ‘the US Presidential Elections and other
priorities in Washington, it was unlikely that the SEC would return to the topic of domestic use of
IFRSs until early 2013’.2 However, the last ‘joint IASB and FASB progress report’ was released
in 2012 (correct as at October 2019), suggesting that although further work is continuing, the
issue of domestic use of IFRSs is not high on the agenda.
Despite the difficulties in the convergence of the IASB and FASB, the top 20 economies in the
world (the G20), which includes countries such as the USA, South Africa, Australia, UK, have
given their total support to all convergence projects and called on ‘international accounting
bodies to redouble their efforts’ to achieve this objective ‘within the context of their independent
standard-setting process’. In particular, they asked the IASB and the US FASB to complete their
convergence project.3
1 https://www.scribd.com/document/155503522/Adopt-adapt-converge
2 http://www.iasplus.com/en-gb/meeting-notes/ifrs-ac/ifrs-advisory-council-meeting-2014-22-23-october-2012/comments-from-the-
representative-of-the-us-securities-and-exchange-commission (accessed 4 December 2016);
3 https://www.journalofaccountancy.com/issues/2010/aug/20103021.html
10 Chapter 1
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IFRSs (standards and interpretations) are issued by the IASB, but their development occurs
either within the IASB or the IFRS Interpretations Committee (IFRSIC). Although the IFRSs
are developed by either the IASB or the IFRSIC, the development process involves
consultation with the various national standard-setters, regulators and other interested parties
from around the world and a careful analysis of the principles and practices contained in the
world’s various national GAAPs. This ensures that the IFRSs issued by the IASB are of a high
quality. This development process follows specific procedures referred to as due process.
Due process is explained in section 3.7.4.
There are now 42
3.7.2 Standards developed to date standards:
Standards are prefixed with either IAS or IFRS depending on x 25 are referenced as IAS 1
to IAS 41 (developed by the
whether they were developed by the original International old IAS Committee) &
Accounting Standards Committee (IASC) or the current x 17 are referenced as IFRS 1
International Accounting Standards Board (IASB): to IFRS 17 (developed by
the new IAS Board).
x The original International Accounting Standards Committee
(IASC) developed 41 global accounting standards, which were called International Accounting
Standards (thus prefixed ‘IAS’), only 25 of which remain, the rest having been withdrawn;
x The new International Accounting Standards Board (IASB) adopted these remaining IAS’s
and began developing further standards. So far, the newly created IASB has developed
17 new standards, referred to as the International Financial Reporting Standards (IFRS’s).
3.7.4.1 Overview
Due process, which is set out in the Due Process Handbook, is concerned with the
development of IFRSs (standards, interpretations and improvements):
x New standards;
x Amendments to standards that are considered to be major amendments;
x Amendments to standards that are considered to be ‘minor or narrow in scope’; and
x Interpretations.
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2. Full and fair consultation: the IASB and IFRSIC solicits support from a variety of sources
including, for example:
x various national and regional networks including the Accounting Standards Advisory
Forum and the IFRS Advisory Council;
x the public, through ‘invitations to comment’, as well as public hearings; and
x individuals such as preparers, auditors or investors, whom they approach through the
process of fieldwork (e.g. one-to-one interviews and workshops) and other initiatives.
3. Accountability: in this regard, the IASB is required, for example:
x to formally consider the likely ‘effects’ (cost and benefits) of proposed new or revised
standards throughout the development process;
x to provide the Basis for Conclusions (i.e. the IASB’s reasoning behind developing or
changing a standard as well as the IASB’s responses to the comments received when
the proposals were exposed); and
x to provide Dissenting Opinions (where IASB members disagreed with a standard, they are
required to provide reasons). Diagram: Basic development cycle:
Public consultation
Before development relating to standards or
interpretations can begin, a mandatory Proposal
Exposure Draft (ED) must first be released
for public comment. [See section 3.7.4.4]
Exposure Draft (mandatory)
Importantly, public feedback is obtained at every step of the development cycle. It often
happens that, after public feedback, revised EDs, for example, may need to be issued for
further public comment before continuing with the next step.
When entities start applying new or amended Standards, practical issues in the
implementation thereof may arise that might confuse accountants and auditors. The issues
that may arise can be roughly categorised as follows:
x Minor or narrow-scope issues: these are then dealt with in the Annual Improvements; or
x Major issues: these require either a revised Standard or an Interpretation to be issued.
The IASB is responsible for issuing everything IFRS-related but it does not develop
everything. Exposure Drafts and Standards are developed by the IASB. Its sub-committee,
the IFRS Interpretations Committee (IFRSIC) is responsible for developing Interpretations.
Annual Improvements are normally developed by the IFRS Interpretations Committee but
may be developed by the IASB instead.
12 Chapter 1
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Exposure Drafts are prepared in the form of the proposed new Standard. Since Exposure Drafts are
‘the IASB’s main vehicle for consulting the public’, the published Exposure Draft always includes an
invitation to comment. The comment period is normally a minimum of:
x 120 days when exposing a Standard and
x 90 days when exposing an Interpretation,
x but with special approval, it may be reduced to 30 days.
The public comments received are then thoroughly investigated. If the issues raised are considered
significant enough, the IASB may decide to issue a revised Exposure Draft for further comment.
After the comments on the Exposure Draft have been satisfactorily resolved, development or
amendment to a Standard or Interpretation may begin.
Standards
3.7.4.5 Developing Standards
x are developed by the IASB.
Standards are defined in the Due Process Handbook as follows: x are normally exposed for
comment for 120 days.
x Standards issued by the IASB. x must be approved by a
x They are prefixed with IFRS or IAS. ‘supermajority’ of the IASB
See Due Process Handbook: Glossary of terms before being issued.
The period for public comment on an Exposure Draft of a Standard is generally a minimum of
120 days, but with special approval, this can be reduced to a minimum of 30 days.
Once the IASB has reached satisfactory conclusions on all issues arising from comments on
the Exposure Draft, the IASB votes to instruct the technical staff to draft the Standard.
Then the near-final standard is posted on the IFRS website for public scrutiny, after which the
IASB votes on the Standard before formally issuing the final version.
This final Standard must be approved by a supermajority of the IASB before being issued.
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Gripping GAAP The reporting environment
After a Standard has been issued, problems in applying it may be identified, such as errors,
ambiguities, omissions and concerns regarding the existence of, for example, too many options:
x An Interpretation may need to be developed if the problems identified relate to confusion
regarding how a Standard is to be implemented.
x A revised Standard may need to be developed if the problems identified suggest that a
major amendment/s to a Standard may be needed.
x An Annual Improvement may need to be issued if the problems identified suggest that a
minor or narrow-scope amendment/s to a Standard may be needed.
When the IFRSIC reach agreement on the matters to be addressed, the technical staff members
then present this ‘paper’ to the IASB. In the meantime, the IFRSIC decides if the staff should prepare
an Exposure Draft of an Interpretation.
If a draft Interpretation is to be prepared, the IFRSIC will be required to vote on the draft
Interpretation (no more than 4 members of this committee may disagree with the draft).
Once this draft Interpretation is passed by the IFRSIC, it is presented to the IASB. The IASB
then votes on the draft Interpretation. On condition that no more than 3 members of the IASB
disagrees with the draft, the draft Interpretation is then issued for public comment.
The period for public comment on an Exposure Draft of an Interpretation is generally 90 days,
but with special approval, this can be reduced (although it may never be shorter than 30 days.
The comments received are then considered by the IFRSIC after which the Interpretation is adjusted
for any amendments that may be necessary. If the comments are significant, it may mean that the
Interpretation needs to be re-exposed for public comment.
The final Interpretation must be approved by a supermajority of the IASB before being issued.
Abstaining would be considered as a vote against a proposal. See Due Process Handbook: Glossary of terms
14 Chapter 1
Gripping GAAP The reporting environment
The due process that applies to Annual Improvements is the same that which applies to all
other amendments to Standards. However, due to their relatively minor nature, the level of
consultation and community outreach may be limited to the request for comment letters.
The most recent publication of a set of Annual Improvements (AIs cycle 2015 - 2017)
occurred during December 2017. The next set of annual improvements (AI cycle 2018-2020)
has been released as an Exposure Draft as at October 2019.
3.8 The IASB and the IFRS Foundation: a look at the structure
3.8.1 Overview
The IFRS Foundation is the over-arching legal body which exists purely for the purpose of
enabling the IASB to function.
The IFRS Interpretations Committee (IFRSIC) assists the IASB in improving financial reporting
and is responsible for developing interpretations (which are approved and issued by the IASB).
Both the IASB and its IFRSIC are assisted by technical staff members, who are employed by
the IFRS Foundation.
The Trustees of the IFRS Foundation oversee the operations of the IASB and its IFRSIC.
The trustees report to a Monitoring Board (MB), which is constituted by various representative
public authorities.
The development of the IFRSs requires much collaboration with interested parties. In this
regard, there are two advisory bodies: the IFRS Advisory Council (IFRSAC) and the
Accounting Standards Advisory Forum (ASAF).
The IFRS Foundation exists as the legal entity under which the IASB operates. It is described
as ‘an independent, not-for-profit private organisation working in the public interest’.
The IFRS Foundation Constitution details its objectives and the objectives of each of its
bodies (IASB, IFRSIC, the IFRS Advisory Council, the Trustees and the Monitoring Board)
and how each is to operate and how each is governed.
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Gripping GAAP The reporting environment
Should be 22 trustees (there are currently 22 & IFRSIC; oversee their processes and
trustees) ensure financing. They meet at least twice a
Trustees are appointed by the Monitoring year and report to the MB. Trustees are
2. ASAF
The Constitution requires that these trustees reflect a mix of professional backgrounds (e.g.
auditors, preparers, users and academics) and geographical areas (one from Africa, six from the
Americas, six from Europe, six from the Asia/ Oceania region and three from any other area as
long as the geographical mix remains balanced). Africa is currently represented by Dr Suresh
Kana, a South African, who was appointed in December 2018.
16 Chapter 1
Gripping GAAP The reporting environment
These trustees have a committee called the Due Process Oversight Committee (DPOC). This DPOC
is responsible for ensuring that the IASB and its IFRSIC comply with due process procedures.
A further structure, the Monitoring Board, ensures that the IFRS Foundation and the IASB’s
decision-making are independent. According to both the Constitution and the Monitoring
Board’s Charter, the Monitoring Board's main responsibilities include:
x ensuring the Trustees discharge their duties as defined by the Constitution;
x approving the appointment or reappointment of Trustees;
x meeting with the Trustees at least once a year (or more often if appropriate). 1
There are 9 bodies represented on the Monitoring Board. These include the Basel Committee
on Banking Supervision as a non-voting formal observer plus 8 bodies with voting power:
x European Commission (EC),
x Japanese Financial Services Agency (JFSA),
The Monitoring Board:
x US Securities and Exchange Commission (SEC),
x Board of the International Organization of Securities x Members come from Europe, the US,
Commissions (IOSCO), Japan, Brazil, Korea and other
emerging markets.
x Growth and Emerging Markets Committee of IOSCO
x The MB effectively monitors the
x Ministry of Finance of People’s Republic of China, functioning of the Trustees.
x Brazilian Securities Commission (CVM), and
x Financial Services Commission of Korea (FSC). 2
Admitting further members to the Monitoring Board and selecting its chairman require the
consensus of these existing members. Membership of this board may only include:
x authorities responsible for setting the form and content of financial reporting in their
jurisdictions;
x those responsible for protecting and advancing public interest; and
x those who are strongly committed to the development of high quality IFRSs. 2
1 http://www.ifrs.org/groups/ifrs-foundation-monitoring-board/ (Accessed 14 October 2019)
2 Monitoring Board Charter, 2016
x developing Exposure Drafts and Standards (the Interpretations are developed by the
IFRS Interpretations Committee).
They use a team of technical staff (employed by the IFRS Foundation) to prepare the IFRSs.
The IFRS Interpretations Committee (IFRSIC) – or simply called develop the interpretations.
the Interpretations Committee – is a committee within the IASB.
In this regard, it assists the IASB in improving financial reporting by reviewing ‘on a timely basis
implementation issues that have arisen within the context of current IFRS’ and providing
‘authoritative guidance (IFRIC Interpretations) on those issues’. 1
1. https://www.ifrs.org/groups/ifrs-interpretations-committee/#about (Accessed 14 October 2019)
Chapter 1 17
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The main purpose of the ASAF is to provide technical advice and feedback to the IASB. The
reason behind this forum is that the IASB was involved with numerous bilateral
communications with each of the various national standard-setters and it became clear that
this communication would be streamlined if it could be handled via a single forum.
4.1 Overview
The Companies Act 71 of 2008 (Companies Act 2008) became effective on 1 May 2011,
replacing the Companies Act of 1973 and the Corporate Law Amendment Act of 2006. A
number of errors and anomalies were discovered in this Companies Act (2008) which were
then corrected via the Companies Amendment Act of 2011. Further amendments have been
incorporated into the recently issued Companies Amendment Bill 2018.
The Companies Act of 2008 regulates many aspects of a company’s existence and conduct.
It is separated into nine chapters and five schedules, of which, Chapter 2, Schedule 2 and
Schedule 5 are most important to accounting and financial reporting. Some of the sections
relevant to accounting from these chapters and schedules will now be discussed.
The following is a summary comparing the descriptions of all these types of companies:
Category of company: Definition and Description:
1. Profit companies Definition: A company incorporated for the purpose of financial gain for
its shareholders Companies Act: S1
1.1 A state-owned company Definition: A company is a state-owned company if it is:
(a) listed as a public entity in Schedule 2 or 3 of the Public Finance
Management Act, 1999; or
(b) owned by a municipality, as contemplated in the Local Government:
Municipal Systems Act, 2000 and similar to a public entity, as
described above. Companies Act S1
Company name: must end with ‘SOC Ltd’. Companies Act: S11(3)
Other interesting facts: All sections in the Companies Act that refer to
public companies apply equally to state-owned companies, except that the
Minister may grant exemptions from one or more provisions of the Act. S9
18 Chapter 1
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4.3 Legal backing for financial reporting standards (Companies Act: S29 and Reg. S27)
Unfortunately, the efforts of the GMP and the APB were The Companies Act states
that of a classic toothless tiger because the previous that:
Companies Act did not require companies to comply with x any person involved in the
these standards. x preparation, approval,
dissemination or publication
However, the Companies Act of 2008 (section 29) now x of any financial statements
requires compliance with financial reporting standards x will be guilty of an offence
(FRSs) (see pop-up alongside). x if those f/statements do not comply
with IFRSs when they should comply.
See Co’s Act S29
Furthermore, the related Companies Act Regulations 2011
stipulate what specific standards constitute these so-called financial reporting standards.
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The Regulations (S27) refers to four different kinds of financial reporting standards (FRSs) to
be used by companies, depending on the nature of the company:
x IFRSs: International Financial Reporting Standards;
x IFRS for SMEs: IFRSs for Small and Medium-sized Entities;
x SA GAAP Note 2; and
x Any financial reporting standard of the company’s choosing (this is only allowed for
certain companies with a public interest score of less than 100 – see section 4.5).
This means that, with the introduction of the new Companies Act, certain companies are now
legally required to comply with IFRSs. Furthermore, by requiring other companies to choose
between using either IFRS or IFRS for SMEs, the new Companies Act has effectively
provided legal backing for what is referred to as differential reporting in South Africa.
Differential reporting is explained in more detail in section 4.6.
Where the FRSs must be IFRSs, the Financial Reporting Investigation Panel (FRIP) (a joint initiative
between the SA Institute of Chartered Accountants and the JSE Securities Exchange), investigates
and advises the JSE on alleged cases of non-compliance with IFRSs. The FRIP will also pro-actively
review the financial reporting of all companies listed on the JSE at least once every 5 years.
(a) monitoring patterns of compliance with, and contraventions of, financial reporting standards; and
(b) making recommendations to the Council for amendments to financial reporting standards, to secure
better reliability and compliance. See Companies Act: S187(3)
20 Chapter 1
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4.4 Which financial reporting standards must we use? (Companies Act: S29 and Reg. S27)
The Companies Act states that companies must use Financial Reporting Standards (FRS).
The Regulations explain that the ‘FRSs’ will depend on the category of company.
Essentially, Financial Reporting Standards may refer to IFRS or IFRS for SMEs. This use of a
variation of reporting standards is referred to as differential reporting (see section 4.5).
The following table summarises which standards are to be used for which SA companies (this
table is extracted and slightly adapted from the Companies Act Regulations, section 27(4)).
Since SA GAAP (AC Standards) effectively does not exist (other than the few documents remaining
in the AC 500 series), the reference in the Regulations to SA GAAP being an option is largely
outdated. Thus, any reference to SA GAAP has been removed from this amended table.
1. Profit companies
1.1 A state-owned company IFRS, but in the case of any conflict with
any requirement in terms of the Public
Finance Management Act, the latter
prevails
1.2 Public companies listed on an exchange IFRS
1.3 Public companies not listed on an exchange One of –
(a) IFRS; or
(b) IFRS for SMEs Note 1
1.4 Profit companies, other than state-owned or public One of –
companies, whose public interest score (PIS) for the (a) IFRS; or
particular financial year is at least 350 OR who holds (b) IFRS for SMEs Note 1
assets in excess of R5m in a fiduciary capacity.
1.5 Profit companies other than state-owned or public One of –
companies, whose public interest score for the particular (a) IFRS; or
financial year is at least 100 but less than 350 (b) IFRS for SMEs Note 1
1.6 Profit companies other than a state owned or public One of –
companies, whose public interest score for the particular (a) IFRS; or
financial year is less than 100, and whose statements are (b) IFRS for SMEs Note 1
independently compiled
1.7 Profit companies other than state owned or public The Financial Reporting Standard
companies whose PIS for the particular financial year is less (FRS) as determined by the company
than 100 and whose statements are internally compiled. for as long as no FRSs are prescribed.
2. Non-profit companies
2.1 Non-profit companies that hold assets in excess of R5m in IFRS, but if the IFRS conflicts with any
a fiduciary capacity OR are state or foreign controlled OR requirement per the Public Finance
perform a statutory or regulatory function Management Act, the latter prevails
2.2 Non-profit companies other than those contemplated in the One of –
first row above whose PIS for the particular year is at least (a) IFRS; or
350 (b) IFRS for SMEs Note 1
2.3 Non-profit companies other than those contemplated in the One of –
first row above whose PIS for the particular financial year is (a) IFRS; or
at least 100 but less than 350 (b) IFRS for SMEs Note 1
2.4 Non-profit companies other than those contemplated in the One of –
first row above, whose public interest score for the (a) IFRS; or
particular financial year is less than 100, and whose (b) IFRS for SMEs Note 1
statements are independently compiled
2.5 Continued on the next page…
Chapter 1 21
Gripping GAAP The reporting environment
2.6 Non-profit companies other than those contemplated in the The Financial Reporting Standard
first row above whose PIS for the particular financial year is (FRS) as determined by the company
less than 100 and whose statements are internally compiled. for as long as no FRSs are prescribed
Note:
1 Where the use of IFRS for SMEs is presented as an option, it may only be used if the company meets the
scoping requirements outlined in the IFRS for SMEs standard. Thus, if it does not meet the scoping
requirement in the IFRS for SME standard, the company will be forced to comply with IFRS instead.
Differential reporting stems from the acceptance that the content of financial statements is
driven by the needs of the users of financial statements. IFRSs are designed primarily for
preparing the financial statements of public companies. Thus, the level of complexities in the
IFRSs are often unnecessary, irrelevant and very costly for non-public companies to
implement. This led to the development of IFRSs for Small and Medium Entities (IFRS for
SMEs), which provides a simpler set of international standards.
4.5.2 What is a small and medium-sized entity (SME)? (IFRS for SMEs)
Examples of entities that have public accountability include banks, credit unions, insurance
companies, securities brokers/dealers, mutual funds and investment banks. See IFRS for SMEs
Please note that if your entity has no public accountability but is a subsidiary:
x whose parent uses full IFRSs, or
x forms part of a consolidated group that uses full IFRSs on consolidation,
you can still choose to use IFRS for SMEs for your own entity’s financial statements.
4.5.3 The history of differential reporting in South Africa South Africa was
the first country in
Although the Companies Act of 2008 allows differential reporting, the the world to adopt
South African Accounting Practices Board (APB) had already IFRS for SMEs!
approved differential reporting in 2007.
Given the extreme pressure placed on smaller companies to comply with complex IFRSs, the APB
felt it necessary to authorise the use of the IASB’s exposure draft (i.e. before it became released as
an official IFRS), entitled IFRSs for Small and Medium-sized Entities (SMEs).
South Africa adopted this Exposure Draft verbatim and was thus the very first country in the world to
allow simpler accounting for SMEs (SAICA press release 3 October 2007). The final IFRS for SMEs
was released on 9 July 2009 (i.e. replacing the Exposure Draft) and had been subsequently
amended on 21 May 2015.
https://www.iasplus.com/en/binary/safrica/0710smepr.pdf - last accessed 4 November 2019
22 Chapter 1
Gripping GAAP The reporting environment
Small and medium sized entities (SMEs) are smaller entities that do not have the capability or
cash resources required to comply with ‘full’ IFRSs. Furthermore, their users are generally
interested in financial information that focuses on the entity’s cash flow, liquidity and solvency.
The IFRS for SMEs is thus a selection of simplified IFRSs, to be used by SMEs, which:
x provides disclosure relief (i.e. less detail needs to be provided in the financial statements);
x simplifies many recognition and measurement criteria;
x removes choices for accounting treatments;
x eliminates certain topics that are generally not relevant to SMEs; and
x is not updated as often as IFRSs are updated.
4.6 Does our company need an audit or independent review? (Co’s Act: S30; Reg: 28 - 29)
Some companies must be audited, some simply require an independent review, and some
require nothing at all.
Apart from state-owned and public companies, which must always be audited, whether an
audit or independent review is required for the remaining categories of companies depends
on that company’s public interest score (PIS) and other factors.
The table below summarises the factors that are considered when determining if a company
needs an audit, independent review or neither. Please note, however, that if the Act does not
require an audit, an audit would still be needed if a company’s Memorandum of Incorporation
states that an audit is required.
OR
have a PIS for the particular financial year of at least 350.
1.4 Profit co’s other than state-owned or public companies, whose:
PIS for the particular financial year is at least 100 but less
than 350 and:
a) AFS is internally compiled: Audit RA
b) AFS is independently compiled and company is not Independent review RA/ CA
owner-managed
c) AFS is independently compiled and company is owner- No audit or independent -
managed and can apply the S30(2A) exemption for review – just prepare the
owner-managed companies AFS
1.5 Profit co’s other than state-owned or public companies whose:
PIS for that financial year is less than 100 and:
a) is not owner-managed Independent review RA/ CA/ AO
b) is owner-managed and can apply the S30(2A) exemption No audit or independent -
for owner-managed companies review – just prepare the AFS
2. Non-profit companies
2.1 Non-profit companies that: Audit RA
hold assets in excess of R5m in a fiduciary capacity; Note 1 OR
are state or foreign-controlled; OR
perform a statutory or regulatory function; OR
have a PIS for the year of at least 350
2.2 Continued on the next page …
Chapter 1 23
Gripping GAAP The reporting environment
2.3 Non-profit co’s other than those referred to above whose: Independent review RA/ CA/ AO
PIS for the particular financial year is less than 100
Acronyms used in the table:
CA: Chartered Accountant CA(SA) RA: Registered auditor AO: Accounting officer PIS: Public interest score
Reference: A table produced by the SA Institute of Chartered Accountants; reproduced and adapted with their kind permission.
Note 1: Assets held in a fiduciary capacity must be held in the ordinary course of the company’s primary business, (not
incidental thereto), on behalf of third parties not related to the company. Fiduciary capacity implies being able to make
decisions over the use of the assets but that third parties have the right to reclaim the assets.
Section 24 deals with company records in general. Company records include accounting-
related records. The requirements specific to accounting-related records include:
x all company records (including accounting records) must be in writing or in a form that is
convertible into writing within a reasonable period of time (e.g. electronic form); and
x all company records must be kept for a period of 7 years:
Company records
- annual financial statements: for 7 years after the date
must:
of issue*;
x be in writing (or be able to
- accounting records: for the current year plus the be converted into writing)
previous 7 completed years*; and x be kept for at least 7 yrs.
- reports presented at an annual general meeting: for
7 years after the meeting*.
*: Or shorter period if the company has existed for a shorter period.
Financial statements of companies reflect the financial information arising over the course of
its financial year (also referred to as its accounting or reporting period). This financial year
(i.e. a period of 12 months) ends on the reporting date.
Each company must decide when its reporting date will be. This reporting date must be
decided upon when the company is incorporated and must be stipulated in the company’s
Notice of Incorporation.
24 Chapter 1
Gripping GAAP The reporting environment
Although it is possible to subsequently change the reporting date set out in the company’s
Notice of Incorporation, it may not be changed:
x without filing a notice of that change;
x more than once during any financial year;
x to a date that precedes the date on which the notice is filed;
x if it will result in the very next financial period being more than 15 months.
A financial year is normally 12 months, but this is not always the case.
A financial year ends
For example: in the very first year of operation, a company’s on the reporting date
accounting period starts on the date of incorporation and ends on (RD).
the reporting date set out in the company’s Notice of x Each co must state its RD in its
Incorporation. Notice of Incorporation.
In this case, unless the company’s date of incorporation is exactly x RDs may be changed.
365 days prior to the reporting date, the company’s first financial x A financial year is normally 12
months but may end up longer
year will not be a perfect 12 months. or shorter, but may never
exceed 15 months.
Another example of when a financial year will not be
12 months is if the reporting date is changed.
The financial year may, however, never exceed 15 months because a financial period of more than
15 months will delay the release of its financial statements which would disadvantage its users.
4.11 Annual financial statements (Co’s Act: S30 & Reg. 38)
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Gripping GAAP The reporting environment
Annual financial statements (as opposed to financial statements) must also include an
auditor’s report (where applicable), a directors’ report and details relating to directors or
individuals holding any prescribed office in the company.
For audited financial statements, further particulars must be disclosed where they relate to:
x directors, or
x individuals holding any prescribed office of the company:
Please note the Companies Act allows the Minister to make any office a prescribed office.
Prescribed officers are defined as having:
general executive control over and management of a significant portion of the company; or
regularly participating therein to a material degree. See Co’s Regulation 38
x payments to pension funds on behalf thereof current and past Amounts S30(4)(b)(ii)
x compensation for loss of office paid current and past Amounts S30(4)(c)
x expense allowances for which the director need not account: amount Current S30(6)(c)
x contributions to any pension scheme not otherwise needing separate Current and past S30(6)(d)
disclosure: amount
x options or rights given directly or indirectly: the value thereof Current, past, future S30(6)(e)
guarantor) and any other financial assistance: the amount being: and all relatives
- the interest deferred, waived or forgiven; or
- the difference between the:
- reasonable & market-related interest in an arm’s length transaction,
- and the interest actually charged
Acronyms used in the tables: D and PO: Directors and Prescribed Officers
Notes: Note 1: the details relating to directors and prescribed officers must be separately disclosed. S30(4)
Note 2: the remuneration and benefits must be disclosed separately for each director. S30.4(a)
Note 3: the term ‘remuneration’ includes a variety of items – these are detailed in the table above. S30(6)
The disclosure of the abovementioned remuneration and benefits paid or payable to directors or
prescribed officers of the company must include the remuneration and benefits for:
x services as director of the reporting company;
x services while being a director of the reporting company and providing:
- services as director of other companies within the group, and
- other services to the reporting company and to other group companies. S30(5)
What is interesting here is that the amount of remuneration that is recognised in a company’s
financials differs from the amount that is disclosed in the company’s financials.
26 Chapter 1
Gripping GAAP The reporting environment
For example: a director of Company A may also be involved as a director in a subsidiary company,
say Company B. This would then mean that when preparing the financial statements for Company A:
x the amount recognised as an expense in Company A’s statement of comprehensive income will
include only the amount incurred by Company A; but
x the amount disclosed as directors’ remuneration in Company A’s notes to the financial
statements will include the amount paid to the director by Company A and by Company B since
Company B is in the same group as Company A. See Companies Act: S30(5)
It is clear that the Companies Act requires disclosure of certain details relating to directors, but it is
just one of 4 documents demanding director-related disclosure:
x the Companies Act 2008: S30: explained above;
x the JSE Securities Exchange (JSE) Listing Requirements: see section 5 of this chapter;
x the King IV Report: see section 6 of this chapter; and
x IAS 24 on related parties: this standard is not covered in Gripping GAAP.
Since there are many disclosures required regarding directors, it is important to understand who
would be considered to be a director. The King IV Report defines a director by using the same
definition of director that is provided in the Companies Act:
x a member of the board of a company, as contemplated in S66 (of the Companies Act), or
x an alternate director of a company and
x includes any person occupying the position of a director or alternative director, by whatever
name designated. See King IV Glossary of Terms and Companies Act, Section 1
A more detailed discussion regarding some of the director-related disclosure requirements of the
JSE Listing Requirements and the King IV Report is included in section 5 and section 6,
respectively. However, it is interesting to compare the disclosure requirements relating to directors
at this point:
x the Companies Act 2008 requires that the disclosures relating to directors’ remuneration be
provided per director; but
x the JSE Listing Requirements takes it one step further and requires that the disclosures relating to
directors’ remuneration be provided per director, and also in aggregate, and where the company must
also distinguish between executive and non-executive directors [section 8.63(k) & section 7.B.7]. This
requirement obviously only affects those companies wishing to be listed on the JSE.
The definitions of executive and non-executive directors are provided in the JSE Listing
Requirements [section 3.84 (e)]
x executive directors are: directors that are involved in the management of the company and/or in
full-time salaried employment of the company and/or any of its subsidiaries;
x non-executive directors are: directors that are:
- not involved in the day to day management of the business; or
- not full-time salaried employees of the company and/or any of its subsidiaries.
The JSE Listing Requirements also define a third category of director (i.e. over and above executive
directors and non-executive directors). This third category, which the JSE refers to as independent
directors [section 3.84 (e) (iii)] and which King IV refers to as independent non-executive directors (see
King IV’s Glossary of Terms: ‘independence’), is a category that is not required for purposes of disclosing
the directors’ remuneration, but simply relates to the composition of the Board of Directors. See King IV Principle 7
Chapter 1 27
Gripping GAAP The reporting environment
5.1 Overview
JSE Listing requirements are very detailed and will obviously only apply to companies wishing to be
listed or remain listed on the JSE. The purpose of this section is to simply give you a general
understanding of how these requirements may affect the annual financial statements.
The objective of the JSE is to provide facilities for the listing of securities (including securities
issued by both domestic and foreign companies) and to provide the JSE users with an orderly
market place for trading in such securities and to regulate the market accordingly.
The Listing Requirements of the JSE (last updated in 2017) is made up of 22 sections containing
the rules and procedures governing new applications, all corporate actions and continuing
obligations applicable to issuers of securities (including specialist securities). Thus, they aim to
ensure that the business of the JSE is carried on with due regard to the public interest.
There are two main sections of the JSE Listing Requirements that affect our financial
statements: Section 3: Continuing obligations; and Section 8: Financial Information.
Probably the most significant to us, as financial accountants, is paragraph 3.19, which
stipulates when the financial statements are due to be published. In this regard, it states that
every issuer shall, within 4 months after each financial year-end and at least 15 business
days before the date of the company’s annual general meeting, distribute to all holders of
securities and submit to the JSE both:
x a notice of the annual general meeting; and
x the annual financial statements for the relevant financial year-end (where these financial
statements must have been reported on by the auditors of the company).
The minimum contents of annual financial statements is contained in paragraph 8.62. This
paragraph requires that:
x the annual financial statements (AFS) of a company must:
a) be drawn up in accordance with the national law applicable to a listed company;
b) be prepared in accordance with IFRS and the SAICA Financial Reporting Guides (as issued
by the Accounting Practices Committee: APC) and Financial Pronouncements (as issued
by the Financial Reporting Standards Council: FRSC);
28 Chapter 1
Gripping GAAP The reporting environment
6. King IV Report
6.1 Overview
King IV deals with:
The King IV Report on Corporate Governance (King IV) was
x Ethical culture
published on 1 November 2016, effective for all financial years x Good performance
commencing on or after 1 April 2017. This report serves as the x Effective control
benchmark for corporate governance in South Africa. While x Legitimacy
King IV replaces King III in its entirety, it is not based on a King IV:
x has no legal backing; but
completely new philosophy – instead, it has simply developed x is a JSE Listing Requirement.
and refined some of the concepts discussed in King III.
King IV has been designed in a way that enables it to be easily applied in any organisation,
regardless of the manner and form of incorporation: whether private or public, small or big,
profit or non-profit. Thus, more general terminology has been used (e.g. reference is made to
‘organisations’ and ‘governing bodies’ instead of ‘companies’ and ‘boards of directors’) and
supplementary information has also been included to assist organisations in interpreting and
applying the King IV recommendations to suit their individual circumstances.
As with the previous King Reports, there is no legal requirement forcing companies to comply,
but, since it forms part of the JSE Listing Requirements, all companies wishing to be listed on
the JSE Securities Exchange must comply with all the principles (King principles) plus certain
of the practices (King practices) outlined in this report.
King IV has been simplified from 75 principles (in King III) to only 17 principles. These
principles (King principles) provide guidance on what the organisation should strive to
achieve. King IV also includes recommended practices (King practices) to support each
principle. These King practices are intended to make the King IV Report easier to apply.
A further change is that King IV has now adopted an ‘apply and explain’ approach, whereas King
III previously used an ‘apply or explain’ approach. Thus, instead of allowing entities to choose not
to apply and to simply explain why it has not been applied, it now requires compliance and
requires entities to substantiate their claim that they have followed good governance practices.
This has a twofold effect: it allows stakeholders to make better informed decisions on an entity’s
governance; and it encourages entities to see that a more mindful approach to corporate
governance is necessary and that it should not be seen as a mere compliance burden.
Essentially, the purpose behind King IV is to achieve, through its application, four ‘governance
outcomes’: ethical culture, good performance, effective control and legitimacy.
King IV has a significant impact on the reporting by those entities that are either required (e.g.
companies listed on the JSE) or choose to comply with King IV. For example, it requires a
‘remuneration report’ and an ‘integrated report’. Each of these will now be briefly discussed.
Chapter 1 29
Gripping GAAP The reporting environment
King IV also recognises the need to address the remuneration gap between executive management
and all other employees. It therefore requires entities to disclose how they have addressed the issue
and how they have remunerated their executives in relation to overall employee remuneration.
King IV emphasises the importance of sustainability reporting but notes that a sustainability
report is ‘critical but insufficient’. It thus recommends ‘the move from siloed reporting to
integrated reporting’.
King IV defines integrated
Siloed reporting tends to result in a variety of lengthy reports reporting as:
(e.g. financial reports, sustainability reports, audit reports,
x a process founded on integrated
directors’ reports etc) that lack cohesion. Annual reports that thinking
contain ‘siloed’ information make it difficult for users to bring x that results in a periodic integrated
all the relevant information together in a way that enables report by an organisation
x about value creation over time.
them to make informed decisions, which are really only x It includes related communications
possible if one can view the company in a holistic way. x regarding aspects of value creation
Financial information presents only part of the business story whereas there are also other important
forward-looking issues regarding strategies of sustainability relating to social and environmental
issues. Thus, an integrated report better reflects the reality ‘that the resources or capitals used by
organisations constantly interconnect and interrelate’.
The integrated report is viewed by King IV as the ‘first reference point for stakeholders’ who
want to understand how the organisation creates value. It is therefore intended to be a report
that provides a holistic view of the future of the entity by bringing all the information together
into one central and primary report from which all other more detailed reports flow (e.g.
annual financial statements and sustainability reports).
30 Chapter 1
Gripping GAAP The reporting environment
A useful analogy used by SAICA in explaining the integrated report is an octopus: ‘the head is
the integrated report and each arm is a detailed report or detailed information set (e.g.
governance information).’
Whilst King III has already introduced the idea of integrated reporting, King IV has since
refined the issue, and sees it as an outcome of integrated thinking, which looks at the
interdependencies of all the factors that affect an entity’s ability to create value. There are
three concepts which stem from ‘integrated thinking’:
• the organisation operates as an integral part of society;
• stakeholder inclusivity: the interdependency between an entity’s ability to create value for
itself and value creation for others; and
• good corporate citizenship.
King IV uses the same philosophy and terminology developed internationally on integrated
reporting. In this regard, the International Integrated Reporting Council (IIRC) has developed
the International Integrated Reporting Framework (IIRF) to provide a foundation for
establishing integrated reporting.
The International Integrated Reporting Framework has provided the following guiding
principles that underpin the preparation of the integrated report:
• Strategic focus and future orientation: An integrated report should provide insight into the
organization’s strategy, and how it relates to the organisation’s ability to create value in
the short, medium and long term, and to its use of and effects on the capitals
• Connectivity of information: An integrated report should show a holistic picture of the
combination, interrelatedness and dependencies between the factors that affect the
organisation’s ability to create value over time
• Stakeholder relationships: An integrated report should provide insight into the nature and
quality of the organisation’s relationships with its key stakeholders, including how and to
what extent the organisation understands, takes into account and responds to their
legitimate needs and interests
• Materiality: An integrated report should disclose information about matters that substantively
affect the organisation’s ability to create value over the short, medium and long term
• Conciseness: An integrated report should be concise
• Reliability and completeness: An integrated report should include all material matters,
both positive and negative, in a balanced way and without material error
• Consistency and comparability: The information in an integrated report should be
presented: (a) on a basis that is consistent over time; and (b) in a way that enables
comparison with other organisations to the extent it is material to the organisation’s own
ability to create value over time.
An integrated report can either be a standalone document (remember the analogy of the octopus) or
it may be presented as a distinguishable and easily accessible part of another report.
See Principle 5: Recommended Practice 12
Although King IV refers to principles and practices that are merely recommended, the JSE
Listing Requirements requires compliance with King IV. See JSE listings requirements: 2017: paragraph 3.84
This means that, whereas in most countries, sustainability reports and integrated reports are
‘nice to have’, King IV makes these a ‘need to have’ for all South African listed companies.
Chapter 1 31
Gripping GAAP The reporting environment
7. Summary
About IFRSs
IFRSs:
x We’re moving slowly towards global GAAP:
x Include: standards & interpretations.
IFRSs x Are issued by the IASB (the IASB’s legal body
x Some countries have adopted IFRSs is the IFRS Foundation).
x Development follows strict due process.
x Some countries are resisting the adoption of Standards: developed by the IASB.
IFRSs – some of these have agreed to a Interpretations: developed by IFRSIC.
process of convergence (e.g. the US) Annual improvements: developed by either
the IASB or its IFRSIC.
Some of the big changes in the 2008 Act Certain selected sections
32 Chapter 1
Gripping GAAP The conceptual framework for financial reporting
Chapter 2
The Conceptual Framework for Financial Reporting
Reference: Conceptual Framework for Financial Reporting (2018) (including any amendments to 1 December 2019)
Contents: Page
1. Introduction 35
1.1. General overview 35
1.2. Purpose of the CF 35
1.3. The new CF and the history behind it 35
3.1. Overview 39
3.2. Financial statements versus financial reports 39
3.3. Objective of financial statements 40
3.4. Structure of financial statements 40
3.4.1 Statement of financial position 40
3.4.2 Statement of financial performance 41
3.4.3 Other statements and notes 41
3.4.4 Summary of how information is structured in financial statements 41
3.5. Summary comparison: financial statements versus financial reports 42
3.6. The reporting entity 42
3.7. The reporting period 43
3.8. The going concern assumption 44
4. Qualitative characteristics and constraints 44
4.1. Overview 44
4.2. Fundamental qualitative characteristics 44
4.2.1 Relevance (which involves materiality) 44
Worked example 1: Materiality is entity-specific (quantitative materiality) 45
4.2.2 Faithful representation 45
4.2.2.1 Complete 45
4.2.2.2 Neutral (involves prudence) 46
4.2.2.3 Free from error 46
4.2.3 Applying the fundamental qualitative characteristics 46
Worked example 2: Relevant information that is also a faithful representation 47
Worked example 3: Balancing relevance and faithful representation 47
4.3. Enhancing qualitative characteristics 47
4.3.1 Comparability 47
4.3.2 Verifiability 48
4.3.3 Timeliness 48
4.3.4 Understandability 49
4.3.5 Applying the enhancing qualitative characteristics 49
4.4. The cost constraint on useful information 49
Chapter 2 33
Gripping GAAP The conceptual framework for financial reporting
5. Elements 50
5.1. Overview 50
5.2. Asset definition 51
5.2.1 Overview 51
5.2.2 Asset definition discussed in more detail 52
Example 1: Asset – rent prepaid 53
Example 2: Asset – various 54
5.3. Liability definition 55
5.3.1 Overview 55
5.3.2 Liability definition discussed in more detail 56
Example 3: Liability – rent payable 58
Example 4: Liability – various 58
5.4. Equity definition 59
5.5. Income and expense definitions 60
Worked example 4: Income definition 61
Worked example 5: Expense definition 61
Example 5: Expense – arising from a payable 62
Worked example 6: Income and expense – part of equity reserves 62
6.1. Recognition 62
6.1.1 The meaning of the term ‘recognition’ 62
Worked example 7: Recognising an asset and a liability 63
6.1.2 Recognition criteria 63
6.1.2.1 Overview 63
6.1.2.2 Relevance 64
6.1.2.3 Faithful representation 64
6.1.2.4 The trade-off between relevance and faithful representation 64
6.1.3 When an element is not to be recognised 64
6.2. Derecognition 64
7. Measurement 65
7.1. Overview 65
7.2. Different measurement bases 65
7.2.1 Overview 65
7.2.2 Historical cost 66
7.2.3 Current value 67
7.3. Factors to consider when selecting a measurement basis 67
7.3.1 Overview 67
7.3.2 Relevance 68
7.3.3 Faithful representation 68
7.3.4 Other considerations 68
8. Unit of account 69
10.1. Capital 71
10.2. Capital maintenance and determination of profit 71
11. Summary 72
34 Chapter 2
Gripping GAAP The conceptual framework for financial reporting
Goal: General-purpose financial reports, which includes financial statements (see section 2)
Aim is to achieve the objective (foundation 1) by applying the IFRSs (foundation 3), the development of which are based on the
concepts in the CF (foundation 2).
The ‘2018 CF’ clarified certain concepts (e.g. prudence), included new concepts (e.g.
derecognition) and updated certain concepts (e.g. new asset and liability definitions and
recognition criteria). Interestingly, IFRSs issued before 2018 would have been based on either
the 1989 CF or 2010 CF, but yet these IFRSs have not been updated for the new 2018 CF. This
means the wording in the older IFRSs may conflict with the wording of the new CF (e.g. IAS 37
specifically quotes the old liability definition, thus it conflicts with the 2018 CF). In all cases, if an
IFRS conflicts with the new CF, we must use the wording of the IFRS rather than the wording of
the CF (i.e. the CF never overrides an IFRS). The IASB will gradually resolve all such conflicts.
Chapter 2 35
Gripping GAAP The conceptual framework for financial reporting
The new CF (2018) is immediately effective for the IASB (and its Interpretations Committee), and
thus all new IFRSs will be based on the new CF. However, preparers who need to create their own
accounting policies need only implement the new CF when preparing annual financial statements for
periods beginning on or after 1 January 2020 (earlier application is permitted). See IASB’s CF ‘Project Summary’
The ‘objective of general-purpose financial reporting’ is to give users information that they will
find useful in their decision making. However, this objective is not to provide all possible users
with all possible kinds of information for all possible kinds of decisions.
There are many users who may find our general-purpose The objective of ‘general-
purpose financial reporting’
financial reports (financial reports) useful, but we only is:
need to design them for 3 primary users: investors, x to provide financial information
lenders and other creditors (existing or potential). These x about the ‘reporting entity’ (RE)
primary users are those who are unable to demand that x that is useful to existing and potential
the entity ‘provide information directly to them’. Examples ‘investors, lenders & other creditors’
of other users who we do not need to consider include: x in making decisions relating to providing
resources to the entity. CF 1.2
x management (they already have access to internal This chapter will simply refer to the:
financial information); and ‘entity’, ‘users’ and ‘financial reports’.
x tax authorities (they are given other information based
on tax legislation). See CF 1.2 & 1.5 & 1.9-10 Examples of some of the
limitations of general-
As the name suggests, financial reports need only include purpose financial reporting:
financial information. Other information that our users x Only provides financial information
may need include, for example, information about the x Not designed for all users
x Not designed for all decisions
industry in which the entity operates, the political stability x Not exact information
of the country in which it operates, general economic x Only provides historic information
conditions and even climatic conditions (especially useful x Not designed to show the entity’s value!
for agricultural businesses). Users will need to find this information elsewhere. See CF 1.2 & 1.6
There are many decisions that primary users may need to make, but when preparing the
financial reports, we need only provide information that will help users make decisions about
whether to provide resources to the entity. The resources that users may consider providing
the entity with are categorised into:
x equity/ debt instruments: whether to buy them, or if they already have, whether to sell or not;
x loans/credit: whether to provide financing or, if already provided, whether to require settlement;
x management actions: whether they wish to try to influence management actions that may affect
the entity’s economic resources (e.g. a user may have the right to vote on certain management
actions and would thus need to decide whether to exercise these rights). See CF 1.2
Another important aspect of the objective of financial reports is that we are not trying to provide an
exact depiction of transactions and events. Instead, reports are filled with ‘estimates, judgements and
models’, which we base on the concepts contained in the CF (i.e. compliance with these concepts is
our goal). See CF1.11
36 Chapter 2
Gripping GAAP The conceptual framework for financial reporting
and what potential return he needs to predict. For For users to make this assessment, they
example, an investor may need to predict potential future need financial reports to contain
dividends and capital growth whereas a lender may need information about the entity’s:
x economic resources (A),
to predict the potential return of the loan principal amount
claims (L and Eq) and
plus interest income. See CF 1.3
changes in these resources & claims (I, E &
other transactions & events)
To make these predictions (of a specific potential return), x management‘s efficiency & effectiveness in
users need information. To meet these needs, financial using the entity’s resources See CF 1.3-1.4
reports must include two categories of information about the entity; namely information about its:
x economic resources, claims against the entity, and changes in those resources and claims See CF 1.4
x management’s efficiency and effectiveness in performing their responsibility to use the
entity’s economic resources. See CF 1.4
Users use the abovementioned categories of information in making two basic assessments:
x ‘the prospects for future net cash inflows to the entity’ (let’s call this ‘assessment 1’); and
x ‘management’s stewardship of the entity’s economic resources’ (this is basically how
management has cared for and handled the resources) (let’s call this ‘assessment 2’). See CF 1.3
Interestingly, one assessment may also give insight into the other assessment. For example,
information that leads a user to assess management’s stewardship as being poor (assessment 2),
may lead the user to an unfavourable assessment of the prospects of future net cash inflows
(assessment 1).
The terms economic resources, claims and changes ≠the elements (See section 5)
x ‘economic resources’ (ER) is similar to ‘assets’ (A), but not all ERs will meet the asset
definition (A).
x ‘claims against the entity’ (claims) is similar to ‘equity (Eq) and liabilities (L)’, but not all
claims will meet either the equity definition (Eq) or liability definition (L).
x ‘changes in these resources and claims’ (changes) often result in income & expenses, but,
not all such changes will meet the income definition (I) or expense definition (E).
2.3.1 Overview
As already mentioned in section 2.2, financial reports provide two types of information about an
entity. However, the information about the ‘resources, claims and changes’ therein deserves a
little more explanation. Information about ‘resources, claims and other’ will provide insight
into:
x our financial position; and also
x our financial performance and other events or transactions unrelated to financial performance.
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Considering an entity’s economic resources with the claims against it, gives a user a good
idea of what is referred to as the entity’s financial position.
When one talks about an entity’s financial position, one is referring to a variety of strengths
and weaknesses, such as the entity’s:
x liquidity (the user can look at the nature of its assets to assess the entity’s ability to
convert its assets into cash if needed);
x solvency (the entity’s ability to pay its liabilities); and
x need for financing.
When a user assesses the economic resources and claims, he will not only be interested in the
amounts thereof but will also be interested in the nature thereof. In other words, users will assess
these strengths and weaknesses by analysing:
x the nature of the specific resources (e.g. an analysis of the entity’s resources may reveal that
management has invested in assets yielding high returns or, perhaps that it has invested in
technologically obsolete equipment or slow-moving inventory); and
x the nature of the specific claims against these resources (e.g. some loans are repayable soon
and some are repayable in a few years).
The balance between these resources and claims will also be important for a user to assess (e.g.
having assets that are difficult to convert into cash while at the same time having liabilities that are
repayable soon is not a good balance).
2.3.3 Changes in resources and claims: financial performance or other (CF 1.15 – 1.21)
The changes in an entity’s ‘economic resources and claims’ are caused by a combination of:
x the entity’s financial performance, being the net effect of:
income earned, and
expenses incurred; and
x other events and transactions unrelated to financial performance:
equity contributions (e.g. issuing of equity instruments);
equity distributions (e.g. dividends declared); and
changes in assets and liabilities that did not increase or decrease equity. See CF 1.15 & 4.2
Furthermore, the user will want to know what caused the changes in these amounts.
The transactions and events that caused these changes can be categorised into (a) those
that relate to the entity’s financial performance and (b) those that having nothing to do with
financial performance. Financial performance refers to the income generated by the entity
compared with the expenses that have been incurred by the entity.
It is important for users to be able to distinguish between these two causes (financial
performance and other reasons). This is because, for example, an increase in resources (e.g.
bank) that was generated through performance (i.e. income exceeding expenses) is generally
a better indicator of the entity’s ability to generate future cash flows than an increase in
resources that was a result of securing financing (e.g. raising a loan).
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The transactions and events that make up this financial performance must be presented using
both the accrual basis of accounting and the cash basis of accounting (see section 2.3.4).
Information about the transactions and events that changed an entity’s resources and claims,
but were not caused by financial performance, must also be presented because it is useful to
users to have the complete picture of what caused all the changes. Examples of changes to
resources or claims that arise due to transactions that are not related to performance include:
x the receipt of a bank loan increases cash (resources) and increases loan liability (claims);
x an issue of ordinary shares increases cash (resources) and increases share capital (claims).
2.3.4 Presenting financial performance: accrual accounting and cash flow accounting
There are two methods of presenting financial performance: using accrual accounting and using
cash flow accounting:
x accrual accounting involves recording the effects of transactions and events in the period
in which they occur, even if the related cash flow occurs in another period: this basis of
accounting involves presenting income and expenses. See CF 1.17 – 19
x cash accounting involves recording the effects of these transactions and events in the
period in which the cash flows occur: this basis of accounting involves presenting the
cash effects from operations, investing or financing activities. See CF 1.20
Assessing past financial performance is generally useful in predicting future returns, but it is believed
that financial performance that has been depicted using The cash basis gives additional
accrual accounting is the best indicator of both past and useful information, which some
argue is essential because the
future performance. On the other hand, depicting financial
accrual system is inherently flawed in
performance using cash flow accounting continues to be that it allows for the manipulation of
useful in that it assists in assessing liquidity and solvency profits through using various accounting
and helps assess and understand the entity’s operations, policies and measurement methods.
investing and financing activities. See CF 1.17-1.20
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Thus, whereas ‘financial reports’ give information about all economic phenomena as well as
management efficiency and effectiveness, ‘financial statements’ give information about only those
economic phenomena that meet the definition of the elements: assets, liabilities, equity, income and
expenses (see section 5). See CF3.1
The CF does not dictate the title that must be used for
each or the detail to be contained in each, but the CF A set of FSs includes a:
refers to them as the:
x statement of financial position, x Statement of financial position
x statement of financial performance, x Statement of financial performance
x other statements and notes. See CF 3.3 x Other statements and notes
The statement of financial position contains information about the assets, liabilities and equity
that have been recognised. See CF 3.3 (a)
x Assets are the economic resources that meet the asset definition. Examples include
goodwill, equipment, trade receivables and cash. (See section 5.2)
x Liabilities are the claims against an entity that meet the liability definition. Examples
include borrowings, trade payables and bank overdrafts. (See section 5.3)
x Similarly, equity reflects the claims against an entity that meet the equity definition.
Examples include ordinary share capital. (See section 5.4)
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As was explained previously, users analyse the economic resources and claims to gain
valuable insight into the entity’s strengths and weaknesses such as its liquidity, solvency and
need for financing (see section 2.3.2). See CF1.13
If an economic resource meets the definition of an asset and if a claim meets either the
definition of a liability or equity, and the recognition criteria are met, it will appear in the
statement of financial position. If it meets the definitions but does not meet the recognition
criteria, but is considered to be useful information, it will be presented in the notes to the
statement of financial position (see section 3.4.3).
The statement of financial performance contains information about the income and expenses
that have been recognised. See CF 3.3 (b)
x Income reflects the changes in the resources and claims that meet the income definition.
Examples include sales, rent and interest earned. (See section 5.5)
x Expenses reflects the changes in the resources and claims that meet the expense
definition. Examples include the cost of sales, rent and interest incurred. (See section 5.5)
Although the CF refers to this as the ‘statement of financial performance’, the CF does not
stipulate that this must be the title of the statement. In fact, this statement could even be
presented as either one statement or two statements. A variety of titles are possible (e.g.
income statement, statement of profit or loss, statement of comprehensive income etc).
In this textbook, we will generally present the statement on financial performance as a single
statement and will use the title ‘statement of comprehensive income’. This is covered in more
detail in chapter 3.
We use other statements and notes to the financial statements to provide the following extra
information:
x the nature of and any risks arising from assets and liabilities that have been recognised Note 1
x the nature of and any risks arising from assets and liabilities that have not been recognised Note 1
x anything else that the IFRSs may require us to disclose regarding any of the five elements
(assets, liabilities, equity, income and expenses) that have been recognised Note 1
x how the various estimates in the financial statements were made, in other words, information
about the methods, assumptions and judgements used Note 1
x information about the cash flows Note 2
x information about the contributions from and distributions to holders of equity claims. Note 3
Notes:
1. This information will be found in the notes to the financial statements
2. This information will be found in the statement of cash flows and in the notes to the financial statements
3. This information will be found in the statement of changes in equity and in the notes to the financial
statements
Financial statements include information about the elements, where this information is
categorised into information that reflects on the entity’s:
x financial position,
x change in financial position that arose due to:
– the entity’s performance and
– other reasons.
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Element Description
Assets Economic resource that meets the definition of an asset Section 5.2 Position
Liabilities Claims that meet the definition of a liability Section 5.3 Position
Equity Claims that meet the definition of equity Section 5.4 Position
Income Changes in economic resources and claims that meet the Section 5.5 Performance
definition of income*
Expense Changes in economic resources and claims that meet the Section 5.5 Performance
definition of expense *
Other items Changes in economic resources and claims that do not meet Section 5.5 Other
the definition of income/ expense because they are:
- Contributions from holders of equity claims (e.g. an
issue of shares to ordinary shareholders)
- Distributions to holders of equity claims (e.g. dividends
declared to ordinary shareholders) *
* Notice: information relating to the ‘changes in economic resources and claims’ is presented in two separate categories – those that
arose due to performance and those that arose due to other reasons.
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If an entity is a parent in a group of entities, but it wishes to provide information about its own elements,
separately from that of the group, then it can do so in the notes to the consolidated financial statements
or it can produce an entirely separate set of financial statements about itself, in which case these ‘single-
entity’ financial statements must be called unconsolidated financial statements so as not to be confused
with its consolidated financial statements. See CF 3.11 and 3.17
Financial statements provide information about an entity for a ‘specified time-period’, called a
reporting period. The reporting period is normally one year (annual reporting) but may also be
provided for longer or shorter time-periods, such as 6-months (interim reporting). Financial
statements obviously need to clearly define the reporting period to which it relates.
Information relates to the reporting period through the presentation or disclosure about:
x assets, liabilities and equity (whether recognised or not) that:
existed at the end of the reporting period, called the reporting date (if they are
recognised, we present their closing balances as at the last day of the reporting period in
the statement of financial position and if they are not recognised, their values on this day
will be disclosed in the notes)
existed during this period (this information would appear in the reconciliations between
the opening and closing balances, disclosed in the notes)
x income and expenses for the entire time-period. See CF 3.4
Predictions:
Financial statements include historic information covering the reporting period and would only include
forward-looking information to the extent that it is useful in understanding the historic information (i.e.
assets, liabilities and equity at the reporting date, and income and expenses for the reporting period). For
example, if an asset’s balance at reporting date (a historic figure) is measured based on future cash
flows, disclosure of these future cash flows may be considered useful to the user and may thus be
included in the notes to the financial statements. However, management’s strategies and budgets for the
future are not included in the financial statements. See CF3.6
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Unless the financial statements state otherwise, users may assume the financial statements
provide information about a reporting entity that ‘is a going concern that will continue in
operations for the foreseeable future’. In other words, users may assume that the entity does
not need/intend to liquidate or cease operating. If this assumption is inappropriate, this fact
plus the basis upon which the financial statements were then prepared (e.g. measuring
assets at liquidation values instead of fair values) must be disclosed.
For financial statements to be useful to its users, it must have certain qualitative characteristics,
which the CF separates into two types:
x Fundamental qualitative characteristics: these are essential for usefulness.
x Enhancing qualitative characteristics: these improve usefulness. See CF 2.4-2.5
Let’s look at what these characteristics are, how to apply them and let’s also give some thought to
the cost constraint we would face when trying to ensure that our financial statements have them.
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Materiality is not a qualitative characteristic but is simply used in deciding what information would be
relevant to our users.
When deciding if something (in terms of its nature or magnitude, or both) is material, and thus relevant,
we ask ourselves whether it would be reasonable to expect that omitting, misstating or obscuring it
might change our primary users’ decisions.
There is no one specific materiality threshold because information that is material to one entity may not
be material to another entity and also depends on the situation: materiality is entity-specific. Clearly,
deciding whether something is material will need our professional judgement. Materiality is explained in
more detail in chapter 3. See CF 2.11 & IFRS Practice Statement 2
In order to achieve faithful representation, the financial information given to users must be complete,
neutral and free from error. See CF 2.13
Complete means depicting:
4.2.2.1 Complete (CF 2.14) x all information
x necessary for a user to
x understand the phenomenon
Financial statements must be complete. Completeness means being depicted CF 2.14
giving all information (words and numbers) that a user needs
to understand whatever phenomenon is being described. For example, if the phenomenon is an
asset, we should:
x describe the nature of the assets e.g. machines (describe nature);
x give relevant numerical information e.g. cost, depreciation etc (amounts);
x describe what the numbers mean e.g. depreciated cost (describe the information);
x explain how we got to these amounts e.g. depreciated cost is calculated at cost less
depreciation calculated using a nil residual value and a ten-year useful life (explanations).
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4.2.2.3 Free from error (CF 2.18-19) Free from error means:
x no errors/ ommissions in
x description of phenomena &
To be useful, information must be a faithful representation, and x selection & application of
to be a faithful representation means it must be ‘free from error’. processes used to
However, information that is ‘free from error’ does not mean it produce the information.
CF 2.18 (reworded)
must be 'accurate in all respects’.
Free from error ≠ perfect
Sometimes amounts in our financial statements are directly observable and thus accurate (e.g. an
investment in listed shares could be valued accurately at the share price quoted on a stock exchange).
However, in other cases, there is no directly observable price and our amounts will need to be estimated
(e.g. a provision for costs relating to a lawsuit).
Having estimates in our financial statements is entirely normal but it does introduce what is referred to as
‘measurement uncertainty’. By its very nature, at the time of making an estimate, we could never prove it
is accurate. However, even very high levels of measurement uncertainty do not necessarily mean the
information is not ‘free from error’.
‘Free from error’ simply means that there are no errors or omissions in either the description of the
phenomenon or the selection and application of the processes used to produce the information. This
means that estimated amounts in our financial information can be said to be free from error if:
x the financial information describes it as an estimate,
x the financial information describes the nature and limitations involved in making the estimate
(e.g. we explain that a provision relates to a legal claim where the court case is still in
progress and thus that we are relying on our lawyer’s estimations), and
x there are no errors in the selection and application of the process used to develop them. See CF 2.18
The information cannot be useful if it is relevant but not a faithful representation, or vice versa. It
must be both. The CF explains that the best way of achieving both is to:
Step 1 Identify the economic phenomenon that has the potential to be useful to the user.
Step 2 Identify what type of information would be most relevant.
Step 3 Determine whether the information is available and can be faithfully represented.
If the most relevant information is available and can be faithfully represented, you will have
satisfied the fundamental qualitative characteristics. If not, then identify the next most relevant
type of information and repeat the process (i.e. figure out whether this type of information is
available and then figure out whether it can be faithfully represented).See CF 2.21
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There is often a trade-off between presenting relevant information that is also a faithful
representation of the phenomenon, and vice versa. What is important is that we can conclude that
both fundamental qualitative characteristics are met.
For example, sometimes the most relevant information about a phenomenon has such a high
degree of measurement uncertainty that we must question if it is a faithful representation of its value.
x In some cases, we may still be able to conclude that it is a faithful representation by simply
highlighting that this information is an estimate and explaining all the related uncertainties.
x However, in other cases, we may need to give up on the idea of presenting that piece of
information and choose the next most relevant information that has a lower level of
measurement uncertainty and which allows us to conclude that it is a faithful representation
of the phenomenon.
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‘Consistency’ is not the same as ‘comparability’…it simply helps achieve comparability. See CF 2.26
x ‘Comparisons’ need at least two items whereas Comparability ≠ Consistency
x ‘Consistency’ refers to the same methods being applied to x Comparability is the goal;
one specific item, either: x Consistency helps achieve the
CF 2.26
in a single entity across multiple periods; or goal.
across multiple entities in a single period.
Consistency helps enable
In other words, users find information more useful if they comparisons:
can make comparisons: x across multiple entities; and
x across multiple periods.
x from one year to the next: Transactions of a similar See CF 2.26
Some information may not be verifiable (e.g. predictions and certain explanations). If information is
not verifiable, it should be clearly identified as such so that users can decide if they want to use this
information in their decision-making. See CF 2.32
Interestingly, this race against time may impair other qualities (e.g. rushing the publication of
financial statements may result in faithful representation being adversely affected).
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However, some information, by its very nature, may be difficult to understand. We may not simply
leave it out on the basis that it is not easily understandable. This is because this would mean that
the financial statements would not be complete and thus potentially misleading. Thus, if something
is difficult to understand, we simply need to take extra care in how we present it and give extra
disclosure if we believe it may improve the understandability thereof. See CF 2.35
Information that does not have the fundamental qualitative characteristics (FQCs) is not useful and
cannot be made useful simply by ensuring it has the enhancing qualitative characteristics (EQCs).
Conversely, if we have a phenomenon that we could describe in two different ways, each way being
equally relevant and faithfully represented (i.e. meeting both FQCs), we could then consider the
enhancing qualitative characteristics (EQCs) of each way to help us decide which way is ultimately a
better way of describing it.
There are often large costs involved in reporting financial information. These costs obviously
increase as one tries to achieve perfection in the financial statements. We therefore need to
be careful that the benefit justifies the cost. At the same time, however, we must also bear in
mind that if we, as the providers of financial information, do not incur these costs then our
users would bear extra costs by having to obtain missing information from elsewhere.
Financial reporting that is relevant and a faithful representation allows users to make
decisions with confidence. This in turn improves the overall economy.
When the IASB develops the various IFRSs that stipulate the information to be provided, it
carefully considers the expected costs involved in applying these standards. Thus, in general,
the cost of providing information required by IFRSs will normally be justified by the benefit.
This is, however, a subjective issue due to the peculiarities of each entity (what may be cost-
effective for a large multi-national entity may be too expensive for another smaller entity).
Professional judgement is thus necessary to decide if the benefit justifies the cost.
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5.1 Overview
Just as there are 26 letters in our alphabet, which we use to communicate all sorts of information,
there are 5 elements in our accounting system that we use to communicate financial information.
Using financial statements, we describe an entity’s:
x financial position using just 3 elements: assets, liabilities and equity.
x financial performance using just 2 elements: income and expenses.
Whereas financial reports include all the entity’s economic phenomena, the financial statements
include only those economic phenomena that meet the definition of one of these elements. If an
economic phenomenon meets the definition of one of these elements, we then need to decide
whether to recognise (i.e. journalise) it. In other words, some elements might not get recognised. An
element will only be recognised if it meets the recognition criteria (see section 6). If it is not
recognised, the element will not be included in either the statement of financial position or statement
of financial performance, but may be included in the notes to the financial statements.
The new 2018 CF has introduced new definitions for these elements. These are depicted below
Asset Liability
CF 4.3 – 4.25 CF 4.26-4.47
Equity
CF 4.63-4.67
Expense Income
CF 4.69 & 4.71-72 CF 4.68 & 4.71-72
Please note! IFRSs that were developed before the publication of the 2018 CF (i.e. pre-existing
IFRSs) have not yet been updated by the IASB for the new definitions. The reason for this is that
the IASB believes the outcome will, in most cases, be the same whether we apply the old definitions
or the new definitions. However, the IASB has stated that it will update these pre-existing IFRSs
over time, as and when conflicting outcomes are identified. The IASB has emphasized that preparers of financial
statements should continue applying these pre-existing IFRSs and that, wherever there is a conflict between the
requirements of a pre-existing IFRS and the new 2018 CF, the preparers must remember that the requirements
of an IFRS must always override the principles in the CF.
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5.2.1 Overview
The new 2018 CF has introduced a new asset definition. A comparison of the new asset
definition with the old asset definition, per the previous 2010 CF, is shown below.
For an asset to exist there must be a present economic resource (defined as ‘a right that has the
potential to produce economic benefits’) and it must be controlled by the entity as a result of past
events (in other words, the event that lead to the control must have occurred before reporting date).
The most important aspects of this asset definition are to identify: Economic resource (ER):
x whether there is an economic resource (which is a right An ER exists if there is:
that has the potential to produce economic benefits), x a right (not an object):
x whether the entity controls this right, and e.g. right to use an asset
x that the right exists at reporting date due to a past event. x that has the potential (even
if it is remote) to produce
economic benefits (EB):
The most significant change brought about by the new asset e.g. cash inflow or a reduced
definition is that, when trying to decide whether an asset exists, cash outflow
we must no longer focus on the ‘object’ but rather the ‘rights’ that it represents (because an asset is
an ‘economic resource’, which is a ‘right that has the potential to produce economic benefits’). For
example, when deciding if a particular machine is an asset, we don’t look ‘at the object’, but rather
we look ‘into the object’ to see whether we can identify any rights ‘floating around’ in it (e.g. our
machine may give us the right to make muffins) and whether any of these rights has the potential to
produce economic benefits (e.g. selling the muffins would produce a cash inflow).
A right could be many things, such as a right to receive cash (e.g. receivable), a right to receive
goods or services (e.g. prepaid electricity), a right to use an asset (e.g. a machine) or a right to sell
an asset (e.g. inventory) etc. See CF 4.6
However, for a right to be an ‘economic resource’, it must have the potential to produce economic
benefits for the entity. Depending on what the right is, this ‘potential for economic benefits’ could
come in many forms, such as the right to simply receive cash (or another economic resource),
produce a cash inflow or avoid a cash outflow etc. For example, inventory represents:
x the right to sell the asset, and
x this ‘right to sell’ has the potential to produce economic benefits, (e.g. in the form of cash), if the
entity is able to sell the inventory.
Control over the ER
Control exists if we can:
The potential to produce economic benefits does not have to be
x direct the use of the ER &
certain, probable or even likely. Thus, even if the aforesaid x obtain its benefits
inventory was unlikely to ever be sold, the entity would still Generally able to prove control
conclude that it has an asset since the right has the potential, through the ‘ability to enforce
however remote, to produce economic benefits. legal rights’
For a right to meet the definition of an asset, it must be controlled by the entity. The entity has
control over a right if it has the ‘ability to enforce legal rights’ (e.g. if the right arises through a
legal contract). However, if the entity cannot establish that it has ‘legal enforceability’ over its
right, then it will simply have to prove that it can both ‘direct the use’ of the resource (i.e. that it
has the ability to decide how it is used) and ‘can obtain the benefits’ from the resource.
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An economic resource is defined as ‘a right that has the potential to produce economic benefits’
The right:
The fact that an economic resource is a ‘right’ means it is not a physical object. The right
must have the potential to produce economic benefits for the entity in order for it to be an
‘economic resource’. For example, if we own inventory, the economic resource is not the
physical goods but rather the right to sell them. Thus, depending on the item, the right could
be many things. For example:
x Accounts receivable represents the right to receive cash
x Expenses prepaid represents a right to receive goods or services
x Intangible asset may represent a right to use a patent, or lease it or sell it etc
x Inventory represents a right to sell an object.
Interestingly, since an asset is no longer an ‘object’ but rather the ‘right’ that it represents, it
means that, whereas in the past a single object would have been identified as a single
asset, a single object that includes multiple rights (called a ‘bundle of rights’ or ‘set of rights’),
may now need to be identified as multiple assets. For example, if an entity owns a vehicle
(the ‘object’), the entity would probably have the right to use the vehicle, sell it or even lease
it to someone else. In this case, the ‘object’, which is the vehicle, could be identified as three
assets. However, the CF concedes that where a set of rights arises from ‘legal ownership’ of
an object, it will generally make sense to account for the ‘set of rights’ as one asset (i.e. as
one single ‘unit of account’). Thus, in this case, it would not make sense to identify these
rights as separate assets but to rather identify the ‘set of rights’ as the asset. Similarly, the
CF also notes that describing this ‘set of rights’ as the physical object (i.e. describing it as a
vehicle rather than as ‘the right to use a vehicle’) will ‘often provide a faithful representation
of those rights in the most concise and understandable way’. See CF 4.12
The various forms that rights might take can be categorised into those that correspond to an
obligation of another party, and those that do not:
x rights that correspond to an obligation of another party include, for example, a
right to receive cash (e.g. accounts receivable represents the right to receive cash, but
there is another party who has the obligation to pay us the cash), and the right to
receive services (e.g. electricity prepaid represents the right to receive electricity, but
there is another party who has the obligation to provide us with the electricity; and
x rights that do not correspond to an obligation of another party include, for
example, the rights involving physical or intangible objects, such as the right to use
property, plant and equipment, investment property and inventory (physical objects) or
the right to use patents, trademarks and intellectual property (intangible assets). See CF 4.6
A right may arise through any number of ways. For example, a right could arise as a result
of a contract or through legislation or could arise as a result of the entity simply creating the
right (e.g. creating a ‘secret recipe’ that the entity then has the right to use). See CF 4.7
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Importantly, this potential for economic benefits does not need to be certain or even likely –
the potential could even be just a remote possibility. Remember that, at this stage, when we
are looking at the asset definition, all we are trying to assess is whether an asset exists. If
there is a low probability of producing benefits, this would be considered when deciding:
x whether to recognise the asset (if information about this asset would still be considered
useful by our users, despite the low probability of benefits, we might still recognise it:
see section 6), and
x how it is to be measured (see section 7).
x This resource must be controlled by the entity
An entity has control if it has the present ability to both:
x direct the use of the economic resource (i.e. can the entity decide how to use the right), and
x obtain the benefits that flow from the resource (e.g. can the entity receive the benefits). See CF 4.20
Control also arises if you can prevent others from directing the use and obtaining the benefits.
The easiest way to prove control is if we have the ‘ability to enforce legal rights’. For example:
We can control a right to use an asset being leased from someone else, because of the
existence of the lease contract, which gives us the ability to enforce our legal rights.
Prepaid insurance gives us the right to receive future insurance cover (an economic
resource), which is a right that we can control because of the existence of the insurance
contract, since this contract gives us the ability to enforce our legal rights. See CF4.22
However, the ability to enforce legal rights is not necessary for there to be control. For example,
an entity may have a recipe that it has not patented (i.e. there is no legal document), but if the
entity can keep it secret and prevent others from directing the use of it and obtaining the benefits
from it, then control exists. See CF 4.20 & 4.22
x This resource must arise as a result of a past event
For a resource to be a present economic resource, it must have arisen from a past event, being
an event that occurred on or before the reporting date (last day of the reporting period).
Example 1: Asset – rent prepaid
Alpha rents office space from a landlord, at C10 000 per month. It uses this space to run
a business selling advice. At 31 December 20X4, it pays for the rent for January 20X5.
Required: From Alpha’s perspective, prove this payment is an asset at 31 December 20X4.
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(iv) Land
x The present economic resource is
- the right to direct the use of the land (e.g. we can decide when to use it and how to
use it: we could decide to use the land as a public market-place or we could
decide to use it by building a new manufacturing plant on the land)
- where the right has the potential to produce economic benefits: these benefits
could be in the form of an inflow of cash (e.g. cash inflows from the rental of
display tables, if we used it as a market-place), or it could be in the form of an
inflow of other economic resources (e.g. if we used it to construct a manufacturing
plant, the land would, together with the plant, be generating inventory, which is
another economic resource)
x It is controlled through legal ownership
x The past event is the purchasing and obtaining control of the land.
(v) Equipment
x The present economic resource is
- the right to direct the use of the equipment (e.g. we can decide when to use it and
how long to use it for – or even whether to keep it or sell it)
- where the right has the potential to produce economic benefits, which could, for
example, be in the form of an inflow of other economic resources such as
inventory (if the equipment was used to manufacture inventory) or could be in the
form of an enhancement of another economic resource (e.g. if the equipment was
used to construct another asset, such as a manufacturing plant), or it could be in
the form of a cash inflow (e.g. if the equipment was used to provide services).
x It is controlled through legal ownership
x The past event is the purchasing and obtaining control of the equipment.
(vi) Investment in shares
x The present economic resource is
- the right to hold or sell these shares
- where the right has the potential to produce economic benefits through the inflow
of dividends or capital appreciation that will be realised through sale
x It is controlled through legal ownership (the share certificates)
x The past event is the purchasing and obtaining control of the shares.
(vii) Investment property
x The present economic resource is
- the right to direct the use of the property
- where the right has the potential to produce economic benefits through the inflow
of cash when the lease rentals are paid
x It is controlled through legal ownership
x The past event is the purchasing and obtaining control of the property.
5.3.1 Overview
The new 2018 CF has introduced a new liability definition. A comparison of the new liability definition
with the old liability definition, per the previous 2010 CF, is shown below
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For a liability to exist the entity must have a present obligation to transfer an economic resource as a
result of a past event. The ‘present obligation’ is a duty or responsibility that the entity has no
practical ability of avoiding. See CF 4.26 & .29
The most significant change arising from the new liability definition is possibly the clarification of the
meaning of ‘present obligation’. The CF now emphasizes that an obligation exists if the entity has a
duty or responsibility that it has no practical ability of avoiding. In other words, if the only way to avoid
an obligation is, for example, to liquidate or cease trading, then we conclude that we do not have a
practical way of avoiding it and must accept that we have an obligation. This is in contrast with the
previous concept of an obligation, where we would conclude that an obligation did not exist if there
was, in theory, a way we could avoid it, even though we might know that avoiding it in that way (e.g.
through ceasing trade) would not be practical (See IAS 37 Provisions and contingent liabilities et al).
According to the liability definition, the obligation must involve a transfer of economic resources. The
economic resource can be a variety of things, such as the rights to cash, goods or services.
Furthermore, in terms of the liability definition, the obligation is only considered to be a present
obligation (i.e. an obligation that ‘presently’ exists as at reporting date) if there is a past event (i.e. an
event that has occurred on or before reporting date). However, unlike the asset definition, the liability
definition provides criteria that must be met before we conclude that a past event has occurred. We
could describe these criteria as the ‘cause and effect’ criteria. These criteria are:
x the entity must have either obtained a benefit or taken an action (i.e. the entity has received
something or done something – the cause), and that
x as a result, the entity may have to transfer an economic resource that it would otherwise not
have had to transfer (i.e. as a result, the entity may have to give up an asset – the effect).
Obligations always involve a duty or responsibility that is owed to a third party, though it is not
necessary to know who this party is.
x The obligation must have the potential to require a transfer of an economic resource
The obligation must have the potential to require the entity to transfer an economic resource.
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Notice that the term ‘economic resource’ is part of the definition of an ‘asset’ (a right that has the
potential to produce economic benefits). So basically, the liability definition is saying that, for us
to conclude that there is a liability, we will have to prove that the obligation has the potential to
require the entity to transfer an asset. For example:
in the case of ‘accounts payable’, there is an obligation to transfer cash;
in the case of ‘income received in advance’, there is an obligation to deliver inventory or
services … or even just to return the cash (remember that, in both examples, we are
referring to the transfer of the rights inherent in these ‘objects’).
The potential transfer of economic resources does not have to be certain or even probable – the
potential could even be just a remote possibility. A low probability of a transfer of resources
being required is not a consideration when deciding if the item meets the liability definition.
This is the same principle that we apply when identifying whether an item meets the asset
definition (see section 5.2).
For an obligation to be a present obligation, it must have arisen from a past event. In the case of
the liability definition (unlike the asset definition), there are criteria that need to be met before we
can conclude that there has been a past event:
x The entity must have already either:
obtained an economic benefit, or
taken an action, and
x As a result, the entity will, or may, have to transfer an economic resource* that it would
otherwise not have had to transfer.
*: As explained previously, the term ‘economic resource’ refers to ‘a right that has the potential
to produce economic benefits’ (i.e. it is part of the definition of an asset). Therefore, for us to
conclude that a past event has occurred, the entity must have entered into an exchange
contract whereby it obtained some kind of benefit, or took some kind of action, and as a
result, the entity may potentially have to transfer an ‘asset’.
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c) Bank overdraft
x The entity has a present obligation, because:
- the entity has the duty to pay the bank
- the entity has no practical ability of avoiding the duty due to the legal nature of
overdrafts/credit granted
x The obligation has the potential to result in a transfer of an economic resource: in this
case the obligation requires the entity to transfer cash
x There is a past event because the potential transfer of economic resources is as a result
of the entity having either obtained an economic benefit or taken an action (i.e. there is
cause and effect): in this case, the potential transfer of economic resources is because
the entity has obtained an economic benefit by using the overdraft facility.
The equity definition in the 2018 CF is the same definition that existed in the 2010 CF.
When we look at an entity’s financial position, we are comparing its total assets with its total liabilities.
If the total assets exceed the total liabilities (i.e. it has net assets), the entity has equity (positive
equity). If the total liabilities exceed its assets (i.e. it has net liabilities), the financial position is very
unhealthy, and we say it has negative equity. The equity is often called the entity’s ‘net wealth’.
The entity’s total equity, total assets and total liabilities all appear in the statement of financial
position, using the following two headings: ‘assets’ and ‘equity and liabilities’.
Entity name
Statement of financial position 20X2 20X1
As at 31 December 20X2 C’000’s C’000’s
In the above statement of financial position, the entity’s equity was C70 000 at the end of
20X1 and this grew to C100 000 at the end of 20X2. This total equity, in terms of the equity
definition, is:
x End of 20X1 = Assets: 90 000 – Liabilities: 20 000 = Equity: C70 000
x End of 20X2 = Assets: 140 000 – Liabilities: 40 000 = Equity: C100 000
Although this equity represents the entity’s ‘net assets’, it also represents the total of the
entity’s ‘issued share capital and reserves’. Using the same example above, let us assume
that 20X1 was its first year of operations and that, during this year, the entity issued ordinary
share capital of C50 000 and that it earned profits of C20 000 (these profits are included as a
retained earnings reserve within equity). During 20X2, the entity did not issue any further
shares and made a further profit of C30 000. Thus, the total equity, at the end of each year
will be broken down, in the statement of financial position, as follows:
Entity name
Statement of financial position 20X2 20X1
As at 31 December 20X2 C’000’s C’000’s
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Another way of looking at the entity’s financial position, is that the entity’s assets (economic resources),
have been funded:
x through liabilities (obligations) and
x through equity (which does not involve any obligations).
To illustrate this point, let us look at 20X1 again. Let us assume that the entity had raised a loan of
C20 000, on the last day of 20X1. This is reflected on the statement of financial position as the total
liabilities of C20 000. The receipt of the funds from this loan, will have led to the recognition of:
x an asset, due to the receipt of the loan increasing the entity’s economic resource (the cash in its
bank account), and also
x a liability, due to the fact that there will be a legal loan agreement, which means that the entity has
an obligation to repay this cash.
Since both the asset and the liability increase, we say that there is no equity involved in this transaction
(debit bank (asset) with C20 000, and credit loan liability (liability) with C20 000).
By contrast, the share capital of C50 000 that was issued during 20X1, does involve equity. This is
because entities have no obligation to repay cash that is received in exchange for ordinary shares. Since
this transaction increases the entity’s economic resources (cash in bank) but does not increase its
liabilities, we say that the transaction has resulted in the recognition of equity (debit bank (asset) with
C50 000, and credit ordinary share capital (equity) with C50 000)
A transaction involving the issue of ordinary shares, is called an equity claim. These ordinary
shareholders (who have contributed C50 000 to the entity) are referred to as ‘holders of equity claims’.
The entity’s receipt of cash from the issue of ordinary shares is thus referred to as a ‘contribution from
holders of equity claims’ and dividends paid to them are called ‘distributions to holders of equity claims’.
An equity claim is not the same as equity: an equity claim is ‘a claim on the residual interest in the
entity’s assets after deducting its liabilities’ whereas equity is the ‘residual interest in the assets after
deducting its liabilities’. The term ‘equity claims’ is also described as ‘the claims against the entity that do
not meet the definition of a liability’ (i.e. a claim that does not involve an obligation). To illustrate the
difference, look at the above example:… At the end of 20X1, we have economic resources (assets) of
C90 000, of which C20 000 will eventually be transferred to third parties due to the obligations (liabilities).
x Thus, the equity is C70 000 (Equity = Assets: 90 000 – Liabilities: 20 000)
x However, the equity claim at 31 December, based on the share issue transaction is C50 000.
Different classes of equity claims are possible, such as ordinary and preference shares, depending on
the rights attached to them (e.g. rights to dividends, profit-sharing and liquidation rights).
An entity can also generate economic resources by making its own profits. These profits are also
part of total equity. Whether we have made a profit depends on the definitions of income and
expenses (profit = income - expenses). This is explained in the next section.
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There are no significant changes in the essence of these definitions other than now referring to ‘holders
of equity claims’ instead of ‘equity participants. The new definitions have simply become a lot clearer:
x Income arises from increases in equity (increases in assets or decreases in liabilities) that do not
result from contributions from holders of equity claims.
x Expenses arises from decreases in equity (decreases in assets or increases in liabilities) that do not
result from distributions to holders of equity claims.
If this increase in equity represents a contribution from a holder of an equity claim (e.g. if the cash was from the
issue of shares to ordinary shareholders), then it is excluded from the definition of income and would be
journalised as follows (see section 5.4)
Debit Credit
Bank (Asset) 100
Issued share capital (Equity) 100
Receipt of proceeds from a share issue (equity – not income!)
However, if this increase in equity does not represent a contribution from a holder of an equity claim, then the
transaction meets the definition of income. Examples of income include sales, interest earned or rent earned. If
the income was rent income, the journal would be as follows:
Debit Credit
Bank (Asset) 100
Rent income (Income) 100
Receipt of proceeds from a sale (income!)
If this decrease in equity represents a ‘distribution to a holder of an equity claim’ (e.g. if the cash outflow is a
dividend payment), then it is excluded from the expense definition and is journalised as follows (see section 5.4)
Debit Credit
Dividends declared (Equity distribution) xxx
Bank xxx
Payment of a dividend (equity distribution – not expense!)
However, if this decrease in equity does not represent a ‘distribution to a holder of an equity claim’, then the
transaction meets the definition of an expense. Examples of expenses include cost of sales, interest incurred or
rent incurred. If the expense was a rent expense, the journal is as follows:
Debit Credit
Rent expense (Expense) 100
Bank 100
Receipt of proceeds from a sale (income!)
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Remember, income and expenses are accumulated together to reflect the profit or loss for the
period (although some income and expenses are excluded from ‘profit or loss’ and are
included in ‘other comprehensive income’ instead – see chapter 3 for more detail).
This profit or loss will then be transferred to retained earnings. Retained earnings is a reserve
account within equity (i.e. the total equity on the statement of financial position would reflect
the total of the ‘issued share capital’ plus the ‘reserves’ (see section 5.4).
Recognise = Journalise
6.1 Recognition (CF 5.1 – 5.25)
An element may only be
6.1.1 The meaning of the term ‘recognition’ recognised if it meets both the:
x Element definitions; and
x Recognition criteria.
To recognise an item involves the process of:
x capturing in the financial statements, (specifically either the statement of financial position
or statement of financial performance),
x an item that meets the definition of an element
x in such a way that:
it is depicted in both words and amount (either alone or in aggregation with other
items); and that
this amount is included in one or more totals in the specific financial statement
(position or performance). See CF 5.1
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Since financial statements (statement of position and performance) are essentially a summary of
the balances in the ledger, and since the ledger balances result from the various journals that are
processed, the question of whether to recognise an element essentially means whether to actually
process the journal entry to record the effects of the transaction or event.
6.1.2.1 Overview
Before recognising a transaction or event, we first identify the elements and check they meet the
definitions thereof (see section 5), and then secondly, we ensure they meet the recognition criteria.
In this regard, the new 2018 CF has introduced new recognition criteria. A comparison of the new
recognition criteria with the recognition criteria per the previous 2010 CF, is shown below.
OLD 2010 CF NEW 2018 CF
Recognition criteria were: Recognition criteria are:
At item that meets the definition of an element Assets and liabilities, and any resulting income,
should be recognised if: expenses or changes in equity, must only be
x The future economic benefits are probable recognised if the user would find this information
x The item has a cost or value that is reliably useful, i.e. we only recognise the elements if it
means we are providing information that is:
measurable.
x relevant; and
x a faithful representation. See CF 5.7
Meeting the recognition criteria means making sure that, by recognising an element, we will be
providing the user with useful information, in other words:
x relevant information about the asset or liability, and any resulting income, expenses or
changes in equity; and a
x faithful representation of the asset or liability, and any resulting income, expenses or changes
in equity. See CF 5.7
We must also consider the effects of the cost of recognising the element versus the benefits of
providing the information (the benefits must outweigh the costs).
The most significant change from the 2010 CF is that we no longer have to achieve what was
referred to as a ‘probability’ threshold or ‘reliable measure’ threshold. Instead, we now focus on
whether the information will be useful.
The recognition of elements is thus based on achieving the two fundamental qualitative
characteristics: relevance and faithful representation (see section 4.2).
The issues of uncertainty that were ignored when we assessed whether an item met the definition
of an element, are now taken into account when we decide whether that element should be
recognised. For example: we ignored, in the case of an asset, the fact that the potential to produce
economic benefits may be very remote (often referred to as ‘outcome uncertainty’). The
uncertainties that we consider when deciding whether an element should be recognised, can be
summarised as follows:
x Outcome uncertainty
x Measurement uncertainty
x Existence uncertainty.
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6.1.2.2 Relevance
Recognition criteria:
The relevance of information is affected by: The information recognised
must be
x existence uncertainty (e.g. the existence of an x relevant; and
obligation may be the content of a legal dispute); and x a faithful representation.
See CF 5.7
x outcome uncertainty (e.g. we may be certain the
element exists, but the probability of the flow of economic benefits may be low or even remote
– outcome uncertainty relates to the amount or timing of the flow of economic benefits).
Both types of uncertainty, (i.e. where we may be unsure of whether the element exists, or if it
does, whether there will be a flow of economic benefits), may result in us concluding that the
user would find the information irrelevant.
Measurement uncertainty arises when the amounts presented in the financial statements cannot
be observed directly and must be estimated. However, most amounts in the financial statements
actually involve some degree of estimation and this does not mean that the information is not
useful. What is important is that, when we recognise information, the level of measurement
uncertainty must be considered to be acceptable.
The level of measurement uncertainty not only affects whether we believe the information is a
faithful representation of the transaction or event, but it has a knock-on effect on relevance. For
example, it can happen that the most relevant information that a user would want, has an
unacceptable level of measurement uncertainty and thus we conclude that it would be better to
provide the user with the information that is slightly less relevant but a more faithful representation.
An example of this might be land (an asset), where the user may ideally want to see the fair value
(most relevant information), but where the measurement uncertainty involved in measuring fair
value might be so high that we conclude that information about the fair value would not be a
faithful representation of the land. In this case, we might conclude that we will simply have to
provide the user with information about the land’s cost instead. In this case, although information
about the land’s cost is less relevant to the user, because it is the only information that is able to
be measured with an acceptable level of measurement uncertainty, it is the only information that is
a faithful representation of the land. See section 4.2 for more examples.
Elements that do not meet the relevant definitions and recognition criteria in full may not be
recognised in the financial statements. Information about them may, however, still be
considered ‘useful’ to the user, in which case they should still be disclosed in the notes.
An element that fails to be recognised because the recognition criteria are not met may be
recognised in a subsequent period if the recognition criteria are then subsequently met.
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In the case of an asset, this normally happens ‘when the entity loses control’ over the asset
(or part thereof). In the case of a liability, this normally happens ‘when the entity no longer has
a present obligation for all or part of the recognised liability’. See CF 5.26
If part of the asset or liability remains, we must take care to faithfully represent both:
x The assets and liabilities that remain; and
x The change in the assets and liabilities that result from the transaction or event that
caused the derecognition. See CF 5.27
7.1 Overview
Financial statements present information about the entity’s financial position and performance:
x The financial position reflects the elements: assets, liabilities and equity;
x The financial performance reflects the elements: income and expenses.
All five elements are ‘quantified in monetary terms’. To quantify an element means to
measure the element. There are many measurement bases possible. In order to assist in this
process, the CF has introduced a new section on measurement, which:
x Describes various different measurement bases; and
x Provides factors to consider when selecting a measurement basis.
Our focus when choosing a measurement basis is to ensure that the information provided will
be useful (i.e. the information must be relevant and a faithful representation). However, other
factors are also considered (see section 7.3).
The choice between the various measurement bases will require significant judgement.
It should be noted that this section in the CF is mainly used by the IASB: the IASB will use
this section when it develops IFRSs and decides which measurement bases are most suitable
for those IFRSs. Normally IFRSs are fairly prescriptive as to which measurement basis to
use, and thus the preparer need not always consider this section of the CF that deals with
measurement. However, if an IFRS allows preparers of financial statements to choose
between measurement bases (e.g. IAS 40 Investment properties allows preparers to choose
between the cost model and the fair value model), having guidance in the CF that provides
explanations about the meaning and purpose of the different measurement bases and what
factors to consider in choosing between them, is very helpful.
7.2.1 Overview
The CF describes two measurement bases but emphasizes that it does not prefer one over
the other – both are useful measurements. However, although both measurement bases can
provide predictive and confirmatory value, depending on the particular situation, one of these
measurement bases may provide more useful information than the other.
The two main measurement bases are historical cost and current value
The CF gives three examples of measurement bases that use the current value approach:
fair value, value in use and current cost.
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The ‘historical cost’ and ‘current cost’ (the latter is a measurement basis using the current value
approach) both reflect what is referred as an ‘entry price’ (the price to acquire the asset or liability).
x The ‘historical cost’ is a measurement that is based on the actual acquisition price on the historic
transaction date (e.g. in the case of an asset, it is a measurement that is based on the actual
historic price that was incurred to acquire that asset), whereas
x The ‘current cost’ is a measurement that is based on the theoretical acquisition price on the
current measurement date (e.g. in the case of an asset, it is a measurement that reflects how
much it would cost to acquire, on measurement date, an equivalent asset based on the current
age and condition of the entity’s asset – in other words, it is the price to acquire an equivalent
second-hand asset at measurement date).
By contrast, the ‘fair value’ and ‘value in use’ both reflect what is referred to as an ‘exit price’.
Although the CF refers to the above measurement bases, these are not an exhaustive list. In
this regard, we must remember that, the measurement of assets and liabilities are generally
dictated by the requirements set out in the specific IFRSs, which often reflect a combination of
the ideas underlying the measurement bases listed in the CF. For example:
x Assets purchased with the intention of resale are measured in terms of IAS 2 Inventories:
IAS 2 requires inventories to be initially measured at ‘cost’ and subsequently measured at
the ‘lower of cost or net realisable value’.
x Assets purchased to be used over more than one period are measured in terms of
IAS 16 Property, Plant and Equipment:
IAS 16 requires this asset to be initially measured at cost and subsequently measured
using either its historical cost or fair value as the basis for the various calculations (e.g.
depreciation), and where its fair value could be based on a discounted future cash flow
technique (i.e. present value), or an active market (i.e. current cost).
As mentioned earlier, the historical cost is based on ‘the price of the transaction or other
event that gave rise to the asset or liability’. See CF 6.24
The historical cost is useful in the sense that, if the transaction was ‘a recent transaction on
market terms’, it will typically reflect:
x in the case of an asset, the minimum economic benefits that the entity expects to recover
(i.e. the economic benefits that the entity expects to flow into the entity will be at least the
carrying amount of the asset); and
x in the case of a liability, the maximum economic benefits that the entity expects to transfer
out in order to settle the liability. See CF 6.25
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The CF refers to three different methods that fall under the current value approach. These are
the fair value method, the value in use and fulfilment value method, and the current cost
method. These are described below:
x Fair value is defined in IFRS 13 as the price that would be received to sell an asset, or
paid to transfer a liability, in an orderly transaction between market participants at the
measurement date. See CF 6.12
Examples of assets or liabilities that could possibly be measured at fair value include:
investment property under the ‘fair value model’,
property plant and equipment measured under the ‘revaluation model’, and
certain financial assets and financial liabilities held for trading measured at ‘fair value
through profit or loss’.
x The value in use of an asset is the present value of the cash flows, or other economic benefits
that an entity expects to derive from the use of an asset and from its ultimate disposal. See CF 6.17
The fulfilment value of a liability is the present value of the cash, or other economic resources,
that an entity expects to be obliged to transfer as it fulfils a liability (i.e. ‘fulfilment value’ is the
equivalent of the ‘value in use’, but from the perspective of a liability). See CF 6.17
Those amounts of cash, or other economic resources, include not only the amounts to be
transferred to the liability counterparty, but also the amounts that the entity expects to be obliged
to transfer to other parties to enable it to fulfil the liability.
Value in use is used to test certain assets for impairment.
Examples of assets that are tested for impairment in this way include, for example:
Property, plant and equipment
Intangible assets
x The current cost of an asset is the cost of an equivalent asset at the measurement date,
comprising the consideration that would be paid at the measurement date, plus the transaction
costs that would be incurred at that date. ‘Equivalent’ means that, if our asset is 3 years old, we
would use the current cost of a 3-year-old asset – not the current cost of a new asset. See CF 6.21
The current cost of a liability is the consideration that would be received for an equivalent liability
at measurement date, minus the transaction costs that would be incurred at that date. See CF 6.21
Example: An entity acquired a plant three years ago for C200. The current price that the
entity would have to pay to buy a new plant is C250, whereas a three-year-old plant is
about 40% of the new price. Thus, the current cost is C100 (C250 x 40%).
7.3.1 Overview
When selecting a measurement basis, we must keep in mind the ultimate objective of
providing useful information. Thus, the measurement base must provide information that is:
x Relevant; and a
x Faithful representation of the substance of the transaction.
The choice between the various measurement bases will require significant judgement. The
CF states that when applying this judgement, we must ‘consider the nature of the information
that the choice of measurement basis will produce in both the statement of financial position
and the statement of financial performance’. See CF 6.23 & .43
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7.3.2 Relevance
The CF states that ‘the characteristics of the asset or liability’, and how it ‘contributes to future
cash flows’ are two of the factors that can affect whether a particular measurement basis
provides relevant information. See CF 6.49
For example, if an asset is sensitive to market factors, fair value might provide more relevant
information than historical cost. However, depending on the nature of the entity’s business
activities, and thus how the asset is expected to contribute to future cash flows, fair value
might not provide relevant information. This could be the case if the entity holds the asset
solely for use or to collect contractual cash flows rather than for sale, in which case a
measurement based on amortised cost might be more relevant.
The CF explains that, although information that is a ‘perfectly faithful representation is free
from error’, we are not aiming at a ‘perfectly faithful representation’. It emphasizes that even a
high level of measurement uncertainty does not mean a particular measurement basis is not a
faithful representation. However, the most important aspect is that we are striking a balance
between relevance and faithful representation. See CF 6.59-60
It should be noted, however, that if an asset and liability are ‘related in some way’, that
measuring the assets and liabilities using different measurement bases may result in a
‘measurement inconsistency’ (also called an ‘accounting mismatch’) that results in the
information not being a faithful representation. See CF 6.58
In addition to aiming to choose a measurement basis that produces relevant information that
is also a faithful representation, when choosing the measurement basis, we should also be
striving, to the extent possible, to achieve information that is:
x Comparable
x Verifiable
x Timely. See CF6.45
A further important consideration is that although we may use one particular measurement
basis to measure an asset or liability in the statement of financial position and use another
different measurement basis to measure the related income or expenses in the statement of
financial performance, it cautions us to remember that information may be more useful if the
same measurement basis is used in both statements. This is because using different
measurement bases may cause an ‘accounting mismatch’. See CF 6.58
Similarly, when choosing a measurement basis, one should also consider both the initial
measurement and subsequent measurement. See CF 6.48
Uncertainty also feeds into the measurement basis chosen. There are three identified
uncertainties: measurement uncertainty, outcome uncertainty and existence uncertainty.
Outcome uncertainty and existence uncertainty may or may not contribute to measurement
uncertainty. For example, consider an investment in shares: if the share price is quoted within
an active market, it means that there is no measurement uncertainty at all. However, there is
still a level of outcome uncertainty since there is no way of knowing what cash inflow will
eventually be achieved through this asset. See CF 6.61-62
When selecting a measurement basis, there is no single factor that is considered more
important than another. The relative importance of each factor will depend on facts and
circumstances. Professional judgement will be needed. See CF6.44
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Therefore, units of account relate to those two elements and their recognition and
measurement in terms of IFRS.
A unit of account is selected for an asset or liability when considering how recognition criteria and
measurement concepts will apply to that asset or liability and to the related income and expenses. In
some circumstances, it may be appropriate to select one unit of account for recognition and a
different unit of account for measurement. For example, contracts may sometimes be recognised
individually but measured as part of a portfolio of contracts.
The recognition criteria of an asset or liability are similarly phrased, with really, the substance
being equivalent to the above statement. With that in mind, we can further join the dots in this
long document and see that, at the heart of it, are some very basic, but fundamental
principles. If those principles can be grasped early, understanding the Conceptual
Framework, and understanding accounting, becomes much easier.
As mentioned earlier, the term ‘recognition’ means the actual recording (journalising) of a
transaction or event. Once recorded, the element will be included in the journals, trial balance
and then channelled into
x one of the financial statements presented on the accrual basis:
statement of comprehensive income, Presentation &
statement of changes in equity, or disclosure refers to the
statement of financial position; as well as level of detail in the
information given about elements
x the financial statement presented on the cash basis: that are:
statement of cash flows. x Recognised;
x Not recognised but still relevant.
The presentation of financial statements (e.g. how they are structured and the level of detail in
terms of line-items presented) is dictated by IAS 1 Presentation of financial statements and is
explained in chapter 3.
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The term ‘disclosure’ typically refers to extra detail provided in the notes to the financial statements.
Disclosure refers to giving detail about specific transactions or events that are either:
x already recognised in the financial statements; or
x not recognised in the financial statements but are considered to be relevant to the users thereof.
Some items that are recognised may require further disclosure. Where this disclosure
involves a lot of detail, this is normally given in the notes to the financial statements.
Other items that are recognised may not need to be separately presented and/ or disclosed. For
example, the purchase of a computer would be recorded in the accounting records and the
statement of financial position. Unless this computer was particularly unusual, however, it would be
included in the total of ‘property, plant and equipment’ line-item on the face of the statement of
financial position, but would not be separately disclosed anywhere in the financial statements since it
would not be relevant to the user when making his economic decisions.
Conversely, some items that are not recognised may need to be separately disclosed. This
happens where either the definition or recognition criteria (or both) are not met, but yet the
information is still expected to be relevant to users in making their economic decisions. For
example: a possible obligation arising from environmental legislation may not have been
recognised because it was subject to an unacceptable level of measurement and/ or
existence uncertainty, but it may need to be disclosed if this information could be useful to
users in making their economic decisions.
Recognition process
criteria met?
Yes No
Yes No
Disclose Ignore
Please note that these principles apply equally to elements that are recognised (i.e. those that
meet the definitions and recognition criteria) and to elements that are not recognised (i.e.
elements which failed the recognition criteria), but where it is believed that information about
these elements should be disclosed because users may find it useful.
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The main principle, as always, is to provide information that is relevant and a faithful representation
of the transactions and events (i.e. to give useful information). To achieve this, the entity must:
x focus on presentation and disclosure objectives and principles rather than focussing on rules;
x classify information in a manner that groups similar items and separates dissimilar items; and
x aggregate information in such a way that it is not obscured either by unnecessary detail or by
excessive aggregation.
The CF has stated that, in order to facilitate this effective communication between the reporting
entity and the users of its financial information, the IFRSs will be designed in such a way that a
balance is struck between:
x giving entities the flexibility to provide relevant information that faithfully represents the entity’s
assets, liabilities, equity, income, and expenses; and
x requiring information that is comparable, both from period to period for a reporting entity and in
a single reporting period across multiple entities.
10.1 Capital
There are two possible concepts of capital:
x Financial concept of capital: capital relates to the net assets or equity of the company. This
concept is adopted by most entities in preparing their financial statements.
x Physical concept of capital: capital is regarded as the productive capacity of the entity, for
example 500 units of output per day.
The choice between these concepts depends on the needs of the users. If users are more interested
in the net worth of the company, then the financial concept makes more sense. If users are more
interested in the production capability, then the physical concept would be more appropriate.
Thus, if the capital base is bigger at the end of the year compared to the beginning, a profit has been
made. How one measures this capital growth will thus affect the measurement of the profit (or loss):
x Financial capital maintenance: a profit is earned if the financial (money) amount of the net assets is
greater at the end of the period than at the beginning of the period, after excluding any distributions
to, or contributions from, owners during the period (e.g. dividends and share issues). This can be
measured in nominal monetary units or units of constant purchasing power. See CF 8.3 (a)
x Physical capital maintenance: a profit is earned only if the physical productive capacity of the
entity (or the resources or funds needed to achieve that capacity) at the end of the period
exceeds the capacity at the beginning of the period, after excluding any distributions to, or
contributions from, owners during the period. See CF 8.3 (b)
Capital maintenance adjustments are the revaluations or restatements of assets and liabilities that
give rise to increases or decreases in equity.
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11. Summary
Elements
(that have met the definitions)
Yes No
Yes No
Disclose Ignore
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Comparison of old 2010 CF with new 2018 CF: Definitions and Recognition Criteria
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Chapter 3
Presentation of Financial Statements
Reference: IAS 1, IAS 10 and IFRIC 17 (including amendments to 1 December 2019)
Contents: Page
1. Introduction 76
2. Objective of IAS 1 and purpose of financial statements 76
3. Scope of IAS 1 76
4. Complete set of financial statements 77
5. General features 77
5.1 Overview 77
5.2 Fair presentation and compliance with IFRSs 78
5.2.1 Achieving fair presentation 78
5.2.2 Compliance with IFRSs 78
5.2.3 Departure from IFRSs 78
5.2.3.1 When departure from an IFRS is required and allowed 79
5.2.3.2 When departure from an IFRS is required but not allowed 79
5.3 Going concern 79
5.4 Accrual basis of accounting 80
5.5 Materiality and aggregation 80
5.5.1 Accountancy involves a process of logical summarisation 80
5.5.2 Deciding whether an item is material and needs to be segregated 81
5.5.2.1 Materiality 81
5.5.2.2 Materiality and aggregation versus segregation 81
Example 1: Items with different nature, but immaterial magnitude 82
Example 2: Items that are material in magnitude, but not in nature or function 82
5.5.3 What to do with immaterial items 82
Worked example 1: Aggregation of immaterial items 82
5.6 Offsetting 83
Example 3: Offsetting – discussion 83
Example 4: Offsetting – application 83
5.7 Frequency of reporting 84
5.8 Comparative information 84
5.8.1 Minimum comparative information 84
Worked example 2 84
5.8.2 Voluntary additional comparative information 84
5.8.3 Compulsory additional comparative information 85
Example 5: Reclassification of assets 86
5.9 Consistency of presentation 86
6. Structure and content: financial statements in general 87
7. Structure and content: statement of financial position 87
7.1 Overview 87
7.2 Current versus non-current 87
7.3 Assets 88
7.3.1 Current assets versus non-current assets 88
Example 6: Classification of assets 88
7.4 Liabilities 89
7.4.1 Current liabilities versus non-current liabilities 89
Example 7: Classification of liabilities 89
7.4.2 Refinancing of financial liabilities 90
Example 8: Loan liability and a refinancing agreement 90
Example 9: Loan liability and the option to refinance 91
7.4.3 Breach of covenants and the effect on liabilities 91
Example 10: Loan liability and a breach of covenants 92
7.5 Disclosure: in the statement of financial position 92
Example 11: Presenting line-items 93
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1. Introduction
2. Objective of IAS 1 and Purpose of Financial Statements (IAS 1.1 & 1.9)
The objective of IAS 1, which is designed to be used when presenting general-purpose financial
statements, is to:
x achieve comparability between the entity’s financial statements and:
its own financial statements in prior periods; and
other entities’ financial statements
x by setting out the: Interesting observation:
IAS 1 is not designed for interim financial statements although certain of the general features
set out in IAS 1 do still apply. Interim financial statements are covered in IAS 34 Interim
Financial Reporting (this is not covered in this textbook).
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4. Complete Set of Financial Statements (IAS 1.10 & .10A & IAS 1.BC17)
There are five main statements in a complete set of financial statements, where each statement
must reflect information for at least the current year and the prior year (comparative year):
x the statement of financial position (SOFP); Note 1, Note 3
x the statement of comprehensive income (SOCI); Note 2, Note 3
x the statement of changes in equity (SOCIE); Note 3
x the statement of cash flows (SOCF); Note 3
x the notes to the financial statements (Notes). Note 3
Note 1. The SOFP reflects the entity’s financial position at a point in time. It normally includes balances
as at the end of the current period and end of the prior period. However, it must also reflect
balances at the beginning of the prior period if there is a retrospective change in accounting
policy, restatement of items or reclassification of items. There would be 3 sets of balances in the
SOFP. This is covered in detail in the chapter on ‘Accounting policies, changes in accounting
estimates and errors’. IAS 1.10(f)
Note 2. The SOCI reflects the entity’s financial performance. The Conceptual Framework actually calls it
the ‘statement of financial performance’, but clarifies that this is not the required title. IAS 1 states
that financial performance could, in fact, be presented either:
x in a single statement: the ‘statement of comprehensive income’; or
x in two separate statements, one called the ‘statement of profit or loss’ and the other called the
‘statement of comprehensive income’. See IAS 1.10A
This textbook uses a single statement approach and calls it the ‘statement of comprehensive
income’ (SOCI). Please see section 8.2 for more detail regarding the two approaches.
Note 3. The titles of the statements making up a set of financial statements are not ‘set in stone’ and
other titles such as balance sheet and income statement are still acceptable. See IAS 1.10
5.1 Overview
The 8 general features:
Financial statements should have eight general features,
which are that they should: x fair presentation & compliance with IFRSs;
x going concern;
x be fairly presented and comply with IFRSs,
x accrual basis;
x be presented on the going concern basis only if x materiality and aggregation;
appropriate (i.e. management must assess if the entity is x offsetting;
a going concern – if it isn’t, then another basis plus extra x frequency of reporting;
disclosure is required) x comparative information; and
x be prepared using accrual accounting (except when x consistency of presentation.
preparing the statement of cash flows)
x be presented with items of a similar nature or function having been aggregated into classes that
are then presented separately from other dissimilar classes only if the classes are material (i.e.
first aggregate into classes of similar items and, if material, segregate these from other classes
when presenting) with immaterial classes and items presented in aggregate,
x not offset assets and liabilities or income and expenses unless required or permitted by IFRSs
x be presented annually (and include extra disclosure if the period is shorter or longer than a year)
x include comparatives (for at least one prior period although an additional period may be needed)
x present and classify items consistently from one year to the next unless this needs to change
because another method thereof becomes more appropriate or an IFRS requires a change.
As you read more about these general features (see below), notice how they often involve concepts from the
CF (chapter 2). For example, IAS 1 explains that fair presentation, one of the general features, requires
faithful representation (see section 5.2), which is a qualitative characteristic per the CF (see chapter 2).
Similarly, IAS 1 refers to the going concern as a general feature, whereas the CF refers to a ‘going concern assumption’.
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5.2 Fair presentation and compliance with IFRSs (IAS 1.15 - .24)
5.2.1 Achieving fair presentation (IAS 1.15 & .17) Fair presentation is
generally achieved by:
Financial statements must fairly present the financial x application of the IFRSs, with
position, performance and cash flows of an entity. x extra disclosure if needed. See IAS 1.15
IAS 1 states that fair presentation is presumed to be achieved by ‘the application of IFRSs, with
additional disclosure when necessary.' It then explains that additional disclosure is necessary if,
despite the IFRS requirements, we think our users may still not be able to understand the financial
position and performance. The requirement for ‘additional disclosure when necessary’ puts the burden
of ensuring that the financial statements are fairly presented squarely on the accountant’s shoulders.
In other words, compliance with the IFRSs may not necessarily be enough. See IAS 1.15
If we are unsure if we have achieved fair presentation, IAS 1 tells us to refer to the Conceptual
Framework (CF), which explains that ‘fair presentation requires faithful representation of the effects of
transactions, other events and conditions in accordance with the definitions and recognition criteria for
assets, liabilities, income and expenses set out in the framework’. See IAS 1.15
These two terms look similar, but fair presentation (a general feature) is more than faithful representation
(a qualitative characteristic): fair presentation is a goal and faithful representation is one of the
characteristics needed to achieve this goal. For more information on how to achieve faithful
representation (i.e. complete, neutral and free from error), please refer back to chapter 2 and the CF.
Fair presentation needs:
IAS 1 explains that to achieve fair presentation, in addition compliance with IFRSs and
to IFRS compliance and giving extra disclosure if needed, extra disclosure where
we must also present the information in a way that needed, but it also needs:
ensures we are giving our users relevant, comparable, x Application of the CF’s definitions
and recognition criteria;
understandable and reliable information. Interestingly,
x Faithful representation (complete,
three of these adjectives, are qualitative characteristics neutral and free from error);
referred to in the CF: ‘relevance’ is a fundamental x Relevance, comparability,
qualitative characteristic, whereas ‘comparability’ and understandability and reliability.
‘understandability’ are enhancing qualitative characteristics. See IAS 1.15 & 1.17(b)
Although IAS 1 states that fair presentation is presumed to be achieved when we comply with IFRSs and
provide additional disclosures if needed, it emphasizes one particular IFRS: IAS 8 Accounting Policies,
Changes in Accounting Estimates, and Errors. In this regard, we are told to use IAS 8 when selecting
and applying accounting policies and to also use the hierarchy of guidance contained in IAS 8 if there is
no suitable IFRS for an item. (IAS 8 is the standard that explains how to account for accounting policies,
estimates and errors and is explained in chapter 26).
Disclosure regarding compliance with the IFRS must be made in the financial statements if
absolutely all standards and interpretations have been complied with in full.
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If management believes that the application of an IFRS would be so misleading that the objective
of financial reporting would not be met, the obvious solution would be to depart from the IFRS,
but this is not always allowed. The process to follow when departure from an IFRS is allowed
and when departure from an IFRS is not allowed is explained below.
5.2.3.1 When departure from an IFRS is required and allowed (IAS 1.19 - .22)
Departure from IFRS:
An entity shall depart from an IFRS: If compliance will be so
x if compliance with an IFRS is expected to result in misleading that it conflicts
financial statements that are so misleading that the with the objective of
financial statements:
objective of financial reporting won’t be met (essentially
that the financial information won’t be useful), and x depart from the IFRS; unless
x the relevant regulatory framework
x if the relevant regulatory framework (e.g. the legislation prohibits departure. See IAS 1.19 & 1.23
of the relevant country) requires or otherwise does not
If you depart, extra disclosure will be
prohibit such a departure. See IAS 1.19 needed to explain the departure.
If you do not depart, extra disclosure
The following extra disclosure is required when
will be needed to explain why you felt
departure from an IFRS is allowed: you should depart and the adjustments
x management’s conclusion that the financial statements you would have liked to make but didn’t.
‘present fairly the entity’s financial position, financial performance and cash flows’;
x a declaration that the entity ‘has complied with applicable IFRSs except that it has departed from
a particular requirement so as to achieve fair presentation’;
x the title of the IFRS from which the entity has departed;
x the nature of the departure,
x the treatment that was required by the IFRS and the reason why that treatment was considered
to be so misleading that the objective of financial reporting would not have been met;
x the alternative treatment adopted; and
x the financial impact of the departure on each item for each period presented that would
otherwise have had to be reported had the entity complied with the requirement See IAS 1.20
These disclosures (with the exception of management’s conclusion and the declaration referred to
above) are required every year after the departure where that departure continues to affect the
measurement of amounts recognised in the financial statements. See IAS 1.21 - .22
5.2.3.2 When departure from an IFRS is required but not allowed (IAS 1.23)
It may happen that although departure from an IFRS is necessary for fair presentation, the
regulatory framework in that jurisdiction does not allow departure from IFRSs. In such
situations, since our objective is to provide useful financial information, the lack of fair
presentation must be remedied by disclosing:
x the name of the IFRS that is believed to have resulted in misleading information;
x the nature of the specific requirement in the IFRS that has led to misleading information;
x management’s reasons for believing that the IFRS has resulted in financial statements
that are so misleading that they do not meet the objective of financial reporting; and
x the adjustments management believes should be made to achieve faithful representation
for each period presented.
Management must assess whether the entity is a going concern (GC). This assessment:
x is made when preparing the financial statements;
x is based on all available information regarding the future (e.g. budgeted profits, debt repayment
schedules and access to alternative sources of financing); and
x includes a review of the available information relating to, at the very least, one year from
the end of the reporting date.
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If the entity has a history of profitable operations and ready access to funds, management need not
perform a detailed analysis. See IAS 1.26
Going concern (GC):
The entity is a going concern unless management: Management must assess
x voluntarily or involuntarily (i.e. where there is no realistic whether:
alternative) x the entity is a going concern
x the entity is not a going concern
x plans to:
x there is significant doubt as to
- liquidate the entity; or whether the entity will be able to
- cease trading. See IAS 1.25 continue as a going concern or not
Results of management’s assessment of whether the entity is a going concern (GC): See IAS 1.25)
If the entity is a going concern: If the entity is not a GC: If the entity is a GC but there is
significant doubt that it will be
continue operating as a GC:
The financial statements: The financial statements: The financial statements:
x are prepared on the GC basis. x are not prepared on the GC basis; x are prepared on the GC basis;
x must include disclosure of: x must include disclosure of:
the fact that it is not a GC; the material uncertainties
the reason why the entity is not causing this doubt.
considered to be a GC;
the basis used to prepare the
financial statements (e.g. the
use of liquidation values).
5.4 Accrual basis of accounting (IAS 1.27 - 28) The accrual basis:
Is used for all financial
The accrual basis means recognising elements (assets, statements except the
liabilities, income, expenses and equity) when the definitions statement of cash flows,
which uses the cash basis.
and recognition criteria are met. Thus, for example, the date
a transaction or event would need to be recorded would not necessarily be the date on which
the related cash (if any) is received or paid.
Transaction/ event
Source document
Journal
Ledger
Trial balance
Financial statements
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5.5.2 Deciding whether an item is material and needs to be segregated (IAS 1.7 & 1.29 - .31)
Both the CF and IAS 1 define information as being material if the decisions of the primary users
could reasonably be expected to be influenced if it was omitted, misstated or obscured. Thus, to be
safe, when assessing the materiality of information, we consider both its nature and magnitude
(i.e. the amount). In other words, either the nature or magnitude (or both) could result in
information being regarded as material. However, materiality is entity-specific and thus the nature
or magnitude of something may be material to one entity but not necessarily material to another.
It is important to note the definition of materiality does not only refer to the omission or misstatement of
information but also to obscuring it. Information is considered obscured if it is ‘communicated in a way that
would have a similar effect for primary users of financial statements to omitting or misstating that
information’. Information can be obscured in many ways, such as aggregating it inappropriately with other
information, hiding material items with immaterial items, or scattering information about a material item
throughout the financial statements. See IAS 1.7
We use materiality to decide if an item, or class of items, should be included with another class
(aggregated) or presented separately in the financial statements (segregated). Classes of items are
items grouped together based on their nature or function (e.g. plant and buildings are both assets, but
they are different classes of asset because each has a different nature and function and thus, different
classes are recorded separately). When preparing financial statements, we analyse these classes,
deciding which classes should be aggregated with other classes and which should be segregated.
Immaterial items, or classes of items, must be aggregated with other items or classes whereas material
items or classes are segregated (i.e. presented separately in the financial statements).
Deciding what is material, and thus requires separate presentation (segregation), is sometimes a
subjective decision requiring professional judgement. For example, an entity may be facing two court
cases, but whether to present the expected obligation relating to each case, or to present the total
obligation from both court cases, is a subjective decision that would be considered based on the nature of
each court case and the magnitude of each related obligation.
A class of items that is material may require disclosure as a separate line-item on the face of the financial
statements (e.g. ‘Current payables’ are a grouping of liabilities with similar nature and function that is
considered material enough to present as a separate class of liability on the face of the statement of
financial position) whereas another class of items, although material, might only require separate
disclosure in the notes to the financial statements (e.g. trade creditors is a separate class of liability within
the ‘current payables’ class of liabilities, which would not be material enough to present on the face of the
statement of financial position, but would possibly be material enough to present separately in the notes ).
As mentioned above, materiality is an entity-specific concept that considers both an item’s nature and
magnitude. When considering whether the magnitude of a certain class of items means it is ‘material’,
entities sometimes apply a materiality threshold to that class. Materiality thresholds differ from entity to
entity. For example: an entity may have a materiality threshold for revenue of C100 000, meaning that, if the
total amount of a particular class of revenue exceeds C100 000, this class of revenue is material and may
need to be separately presented. Another entity may use a materiality threshold of C5 000 000.
Information could be material ‘either individually or in combination with other information’ and must be
considered ‘in the context of its financial statements taken as a whole’. Deciding whether information could
reasonably be expected to influence the decisions of primary users requires us to consider the
characteristics of these users, and also the circumstances of the entity.
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Example 2: Items that are material in magnitude, but not in nature or function
An entity has set a materiality threshold for items of property, plant and equipment of
C300 000. The total carrying amount of its:
x factory machinery is C500 000 (including machine A, with a carrying amount of C450 000);
x office furniture is C300 000; and
x office equipment is C310 000.
Required: Explain whether or not:
A. machine A should be disclosed separately from the other machinery.
B. office furniture should be separately disclosed from office equipment.
C. these assets should be segregated on the face of the statement of financial position or in the notes.
Solution 2: Items that are material in magnitude, but not in nature or function
A. Machine A and the other machinery:
Machine A and the other machines are not different classes since their nature or functions do not differ. However,
whether to provide separate information about machine A depends on the materiality of the information, which
depends on the nature or magnitude thereof. Although machine A is material in magnitude, it should probably not be
presented separately from the other machines since the nature of machine A is not materially different. Describing
each machine would be technical information (not financial) and would be irrelevant to primary users.
B. Office furniture and office equipment:
Despite the materiality of the magnitude of the carrying amount of each class (relative to the entity’s
financial statements as a whole), office furniture and office equipment should probably be aggregated
because their natures are not materially different. The decision always requires professional judgment in
assessing materiality in context of the entity’s own circumstances.
Please note: It is not necessary for a class or item to be material in both nature and magnitude.
C. Aggregation or segregation on the face or in the notes:
Although office furniture and equipment versus factory machinery represent two dissimilar classes based
on their different nature or function (office versus factory use) and both classes are individually material
(based on both nature and magnitude), they should be aggregated on the face of the statement of
financial position because, at this overall level of presentation, their different natures are immaterial. What
is more important on the face, is that different categories of assets, (e.g. ‘property, plant and equipment’
and ‘inventory’) are separated. The segregation of the material classes within the categories of property,
plant and equipment and inventory is provided in the notes.
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Presenting items (e.g. an asset) net of a valuation allowance (e.g. presenting receivables net of a related
expected credit loss allowance, previously called ‘doubtful debt allowance’) is not considered to be
offsetting. Valuation allowances are part of the measurement of the item.
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Comment:
Part A: Since the sale of machines is part of the entity’s ordinary activities (i.e. the machine would be
‘inventory’), the disclosure of the income would be governed by IFRS 15 Revenue from contracts with
customers, and must thus be shown gross (i.e. not net of expenses).
Part B: Since the sale of the machine is not part of (i.e. are incidental to) the entity’s ordinary activities, the
income may be disclosed net of the expense – since this still represents the substance of the sale.
Sometimes, however, an entity may change its year-end, with the result that the reporting
period is either longer or shorter than a year. The entity must then disclose:
x The reason for using a longer or shorter period; and
x The fact that the current year figures are not entirely comparable with prior periods. See IAS 1.36
Interestingly, if the reporting period is longer or shorter than a year, the amounts in the current
year’s statement of financial position would still be entirely comparable with the prior year’s
statement because this statement is merely a listing of values on a specific day rather than
over a period of time. On the other hand, the amounts in the current year’s statement of
comprehensive income would not be comparable with the prior year since the amounts in
each of these statements would reflect amounts accumulated over different lengths of time.
Comparative information can also be required in reverse! In other words, comparative information
doesn’t always refer to the need for prior period information to support current period information.
Current year information may be needed to support prior year information when prior year narrative
information continues to be relevant in the current year.
Worked example 2:
If the prior year financial statements disclosed information regarding an unresolved court
case, then the current year information must include details regarding how this court case
was resolved in the current year or, if not yet resolved, the status of the unresolved dispute at the
end of the current year. This would enhance the usefulness of the financial statements.
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Please note that this third column in the SOFP (i.e. the period prior to the prior period: PPP)
does not need to be supported by notes.
If the entity already voluntarily gives extra comparative periods, this third column would
already be provided. E.g. if the entity voluntarily gives two comparative periods, it will
automatically include both the minimum and compulsory comparatives (the PP and the PPP).
In addition to the third column, the following additional disclosure will also be required. These
additional disclosures depend on what the retrospective adjustment relates to. If the
retrospective adjustment is due to:
x a restatement to correct a prior error or the application of a changed accounting policy, then the
extra disclosure needed is in terms of IAS 8 Accounting policies, changes in accounting
estimates and errors;
x a reclassification, then the extra disclosure needed is in terms of IAS 1 and includes:
the nature of the reclassification;
the amount of each item or class of items that is reclassified;
the reason for reclassification.
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If there is a reclassification but reclassifying the prior periods’ figures is impracticable, IAS 1
requires the following to be disclosed instead:
x the reason for not reclassifying; and
x the nature of the changes that would have been made had the figures been reclassified.
May Limited
Statement of financial position
As at 31 December 20X3 (extract)
20X3 20X2 20X1
Notes C C C
Restated Restated
Property, plant and equipment 8 80 000 60 000 70 000
Inventory 8 70 000 40 000 50 000
May Limited
Notes to the financial statements
For the year ended 31 December 20X3 (extract)
20X2 20X1
8. Reclassification of assets C C
Previously vehicles were classified as part of property, plant and Restated Restated
equipment whereas it is now classified separately.
The reason for the change in classification is that the nature of the business
changed such that vehicles previously held for use are now held for trade.
IAS 2: Inventories requires inventories to be classified separately on the
face of the statement of financial position.
The amount of the item that has been reclassified is as follows:
x Inventory 40 000 50 000
Comment:
x The 20X1 and 20X2 columns are headed up ‘restated’ but the column for 20X3 is not. This is because the
20X3 column is published for the first time: we can’t restate something that has never been stated before.
x The note only gives detail for 20X2 and 20X1 because only 20X2 and 20X1 amounts were reclassified.
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Other documents may be included in the annual report voluntarily (e.g. a value-added
statement), due to legal requirements (e.g. an audit report) or simply in response to
community concerns (e.g. an environmental report).
Since IFRSs only apply to financial statements, each statement (e.g. statement of financial
position) in the financial statements must be clearly identified from the other documents.
These other items may need to be repeated (e.g. on the top of each page) to help make the
endless pages of financial statements easier to understand.
The statement of financial position summarises the entire trial The CF explained that an
entity’s financial position is
balance into the 3 elements of assets, liabilities and equity reflected by:
(remember that the income and expense items are closed off to x its economic resources; and the
equity accounts, such as retained earnings). These three x claims against the entity.See CF 1.12
elements are presented under two headings:
x assets;
x liabilities and equity.
7.2 Current versus non-current (IAS 1.60 - 65) Current and non-
current:
Distinguishing assets and liabilities between those that are
current and non-current gives users an indication of how We can separate As & Ls into:
long it will take: x current and non-current; or
x for an asset to be used up or converted to cash; and x list them in order of liquidity (if
this is reliable & more relevant).
x how long before a liability must be settled.
For this reason, assets and liabilities are then generally separated into two classifications:
x current; and
x non-current.
Instead of separating assets and liabilities into current and non-current, we could simply list
them in order of liquidity if this gives reliable and more relevant information.
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No matter whether your statement of financial position separates the assets and liabilities into
the classifications of current and non-current or simply lists them in order of liquidity, if the
item includes both a current and a non-current portion, then the non-current portion must be
separately disclosed somewhere in the financial statements. If preferred, this may be done in
the notes rather than on the face of the statement of financial position. (See example 7).
Where the assets and liabilities are monetary assets or liabilities (i.e. financial assets or liabilities,
such as accounts receivable and accounts payable) disclosure must be made of their maturity dates.
Examples of monetary items include:
x A monetary asset: an investment in a fixed deposit;
x A monetary liability: a lease liability.
Where the assets and liabilities are non-monetary assets or liabilities, disclosure of the
expected dates of realisation is not required unless these are considered useful in assessing
liquidity and solvency. For example:
x A non-monetary asset: inventory that is not expected to be sold within a year should be
identified separately from inventory that is expected to be sold within a year;
x A non-monetary liability: the expected date of settlement of a provision may be useful.
Non-current assets are simply defined as those assets that are not current assets.
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Non-current liabilities are simply defined as liabilities that are not current liabilities.
Note 1 It is interesting to note that liabilities that are considered part of the normal operating cycle (e.g.
trade payables and wage accruals) are always treated as current liabilities since they are
integral to the main business operations (even if payment is expected to be made more than 12
months after reporting date). However, deferred tax is always classified as non-current. See IAS 1.56
Examples of liabilities that are not part of the normal operating cycle include dividends payable,
income taxes, bank overdrafts and other interest-bearing liabilities. For these to be classified as
current liabilities, settlement thereof must be expected within 12 months after the reporting period.
Note 2 IAS 1 clarifies that if you have a liability, the terms of which allow the counterparty (i.e. the person
you owe) to choose that you pay by way of an issue of equity instruments (shares) instead of
cash, this will not have any effect on the classification as current or non-current.
Example: We issue redeemable debentures: the cash we receive is repayable within 1 year.
However, the terms allow the debenture-holder to choose to receive ordinary shares instead
of a cash redemption. The fact the debenture-holder can choose to convert his debentures
into equity instruments (instead of receiving cash) does not make this liability non-current: it
remains current since expected settlement, in cash or shares, is due within 1 year.
Required: Present the loan in the statement of financial position and related notes at 31 December 20X3
(ignoring comparatives), assuming that Pixi presents its assets and liabilities:
A. in order of liquidity;
B. using the classifications of current and non-current.
Pixi Limited
Statement of financial position 20X3
As at 31 December 20X3 (extract) Notes C
EQUITY AND LIABILITIES
Bank loan Comment: This liquidity format means we must have a note to show the 8 500 000
split between current and non-current (see note 8 below)
Pixi Limited
Notes to the financial statements 20X3
For the year ended 31 December 20X3 (extract) C
8. Bank loan
Total loan 500 000
Portion repayable within 12 months 250 000
Portion repayable after 12 months 250 000
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Pixi Limited
Statement of financial position Notes 20X3
As at 31 December 20X3 (extract) C
EQUITY AND LIABILITIES
Non-current liabilities
Bank loan 250 000
Current liabilities
Current portion of bank loan 250 000
Refinancing a financial liability means postponing the due date for repayment.
When a liability that was once non-current (e.g. a 5-year bank loan) falls due for repayment
within 12 months after reporting period, it should now be classified as current. If it is possible
to refinance this liability resulting in the repayment being delayed beyond 12 months after the
end of the reporting period, then the liability could possibly remain classified as non-current.
There are, however, only two instances where the possibility of refinancing may be used to
avoid having to classify a financial liability as a current liability, being when:
x the existing loan agreement includes an option to refinance or roll-over the obligation (i.e.
to delay repayment of) where:
- the option enables a delay until at least 12 months after the reporting period, and
- the option is at the discretion of the entity (as opposed to the bank, for example), and
- the entity expects to refinance or roll over the obligation; See IAS 1.73
x an agreement is obtained before year-end that allows repayment of the loan to be delayed
beyond the 12-month period after the reporting period. By analogy from IAS 1.75
If an agreement allowing repayment to be delayed beyond 12 months from the reporting date
is obtained, but it is obtained after the reporting date but before approval of the financial
statements, this would be a ‘non-adjusting post-reporting period event’ and could not be used
as a reason to continue classifying the liability as non-current. Thus:
x details of agreement obtained after reporting date would be disclosed in the notes; but
x the liability would have to remain classified as current.
Entity name
Statement of financial position 20X4 20X3
As at 31 December 20X4 C C
EQUITY AND LIABILITIES
Non-current liabilities 60 000 100 000
Current liabilities 40 000 -
Comment: Since the agreement is signed after reporting date, it is a non-adjusting event and thus the
instalment of C40 000 remains classified as current. However, a note will be included to explain that the
liability of C40 000 was refinanced during the post-reporting period and is now technically non-current.
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Entity name
Statement of financial position 20X4 20X3
As at 31 December 20X4 C C
Entity name
Statement of financial position 20X3 20X3 20X3 20X3
As at 31 December 20X3 C C C C
Part A Part B Part C Part D
EQUITY AND LIABILITIES
Non-current liabilities 600 000 400 000 400 000 400 000
Current liabilities 0 200 000 200 000 200 000
Comment:
x Part A: The entity has the option to delay payment of the first instalment to a date beyond 12 months
from reporting date and the entity intends to make use of this option, thus the liability is non-current.
x Part B: The entity has the option to delay payment of the first instalment, but this only extends the
repayment to 31 October 20X4 and not beyond 31 December 20X4, thus the liability remains current.
x Part C: The entity has the option to delay payment of the first instalment to a date that is beyond 12 months
from reporting date, but the entity does not intend to utilise this option, thus the liability remains current.
x Part D: The option to allow a delay in the payment of the first instalment is at the discretion of the bank
and thus the entity does not have control over this, and thus the liability remains current.
7.4.3 Breach of covenants and the effect on liabilities (IAS 1.74 - 76)
A loan agreement could include a covenant, which is, essentially a promise made by the borrower to
the lender. Breaching a covenant (breaking a promise) may enable the lender to demand repayment of
part or all the loan. For example: a loan could be granted on condition the borrower keeps his current
ratio above 2:1; and if it ever drops below 2:1, then the entire loan becomes repayable on demand.
If a covenant is breached and this breach makes all or part of a liability payable within 12 months, this
portion must be classified as current unless:
x the lender agrees before reporting date to grant a period of grace allowing the entity to rectify the breach;
x the period of grace lasts for at least 12 months after the reporting period; and
x the lender may not demand immediate repayment during this period.
If such an agreement is signed after reporting date but before the financial statements are authorised
for issue, it would be a ‘non-adjusting post-reporting period event’:
x this information would be disclosed in the notes but
x the liability would have to remain classified as current.
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Entity name
Statement of financial position 20X3 20X3 20X3 20X3
As at 31 December 20X3 C C C C
Part A Part B Part C Part D
LIABILITIES AND EQUITY
Non-current liabilities 500 000 300 000 300 000 300 000
Current liabilities 0 200 000 200 000 200 000
Comment:
x Part C: Although the agreement was obtained on/before reporting date, the period of grace was not
for a minimum period of 12 months and thus the C200 000 must be classified as current.
However, a supporting note should state that agreement was obtained on/before reporting date,
providing a short grace-period, and that the breach was rectified during this period and thus, after
reporting date, the loan became non-current.
x Part D: a note should be included to say that a period of grace had been granted after the end of
the reporting period that was more than 12 months from reporting date.
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Whether or not to present extra line items, headings or subtotals on the face of the statement
of financial position requires judgement. In this regard consider:
x whether or not it is relevant to the user’s understanding; See IAS 1.55 and
x in the case of asset and liability line items, you should consider the following:
- assets: the liquidity, nature and function of assets;
- liabilities: the amounts, timing and nature of liabilities. See IAS 1.58
7.6 Disclosure: either in the statement of financial position or notes (IAS 1.77 - 80)
7.6.1 Overview
7.6.2 Disclosure of possible extra sub-classifications (IAS 1.77 - 78 & IAS 1.58)
More SOFP-related disclosure:
Line items in the statement of financial position may
Extra sub-classifications may be
need to be separated into further sub-classifications. needed, which could be on the face/
in notes. These depend on:
These sub-classifications may either be shown as: x specific IFRS requirements;
x materiality, liquidity, nature & function of
x line items in the SOFP; or assets; and
x in the notes. See IAS 1.77 x materiality, timing & nature of liabilities.
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Items: Reason:
Revenue line-item The IFRS on revenue (IFRS 15) requires disclosure of each significant
category of revenue recognised from contracts with customers.
PPE line-item The IFRS on PPE (IAS 16) requires separate disclosure of each class of
PPE. Furthermore, office equipment and factory equipment have
different functions.
Cash line-item The cash and the fixed deposit have different liquidities.
Trade & other receivables The trade receivable and rent prepayment are different in nature.
Note: There may be more than one reason why these sub-classifications are required.
7.6.3 Further disclosures for share capital and reserves (IAS 1.79 - 80)
For each class of share capital, the extra detail that must be disclosed includes: See IAS 1.79(a)
x the number of shares authorised;
x the number of shares issued and fully paid for;
x the number of shares issued but not yet fully paid for;
x the par value per share or that they have no par value;
x a reconciliation of the number of outstanding shares at the beginning and end of the year;
x rights, preferences and restrictions attaching to that class;
x shares in the entity held by the entity itself, or its subsidiaries or its associates; and
x shares reserved for issue under options and sales contracts, including terms and amounts.
For each class of reserve within equity, the extra detail that must be disclosed includes: See IAS 1.79(b)
x its nature; and
x its purpose.
The disclosures listed above may be provided in the statement of financial position, statement
of changes in equity or in the notes.
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Also, remember that if the ‘liquidity format’ provides more meaningful disclosure for your entity than
the ‘current versus non-current’ classification, then the statement of financial position will look just the
same but simply without the headings ‘current’ and ‘non-current’.
Exam tip! Notice that the issued share capital and reserves on the face of the SOFP equals the
total equity on the face of the SOCIE. Thus, although it is not wrong to list each type of equity on
the face of the SOFP, it is unnecessary. Thus, if a question requires you to present both a SOFP
and a SOCIE, good exam technique might be to:
x start with the SOCIE and then,
x when preparing your SOFP, simply insert the total equity per your statement of changes in
equity in as the line-item ‘issued shares and reserves’.
8. Structure and Content: Statement of Comprehensive Income (IAS 1.10 & 81A-105)
8.1 ‘Total comprehensive income’, ‘profit or loss’ and ‘other comprehensive income’
The statement of comprehensive income gives information regarding the entity’s financial
performance. Overall financial performance is reflected by the total comprehensive income.
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Components of OCI:
There are ten components of OCI, which have been categorised into the six related IFRSs:
x IAS 16 Property, plant and equipment & IAS 38 Intangible assets: changes in revaluation surplus;
x IAS 19 Employee benefits: remeasurements of defined benefit plans;
x IAS 21 The effects of changes in foreign exchange rates: gains and losses arising from translating a
foreign operation’s financial statements;
x IFRS 17 Insurance contracts – insurance finance income and expenses excluded from profit or loss
x IFRS 9 Financial instruments:
- gains and losses from investments in equity instruments designated at fair value through OCI;
- gains and losses on financial assets measured at fair value through OCI;
- the effective portion of gains and losses on hedging instruments in a cash flow hedge, and
- the gains and losses on hedging instruments that hedge investments in equity instruments
measured at fair value through OCI;
- for certain liabilities designated as at fair value through profit or loss, the amount of the change in
fair value that is attributable to changes in the liability’s credit risk;
- changes in the value of the time value of options (when an option contract is separated into its
intrinsic value and time value and only the changes in this intrinsic value are designated as the
hedging instrument);
- changes in the value of the forward elements of forward contracts (when the forward element is
separated from the spot element and only the changes in this spot element are designated as the
hedging instrument, and
changes in the value of the foreign currency basis spread of a financial instrument (when excluding
it from the designation of that financial instrument as the hedging instrument). IAS 1.7 (slightly reworded)
8.2 Presentation: one statement or two statements (IAS 1.10 - 10A & IAS 1.81A)
8.2.1 Overview
An entity may choose to present its income using a single Includes two sections:
x 1st section: P/L &
statement. The single statement has two sections:
x 2nd section: OCI
x first the P/L section and
Must include 3 totals:
x then the OCI section, ending with the final total (TCI). x P/L
x OCI
This single statement must present the following 3 totals: x TCI
x profit or loss (P/L) for the period;
x other comprehensive income (OCI) for the period;
x total comprehensive income for the period (being: P/L + OCI = TCI). IAS 1.81A (reworded)
As for all statements, the title used for this single statement is fairly flexible. IAS 1 explains we can call it:
x statement of comprehensive income (SOCI), or
x statement of profit or loss and other comprehensive income (SOPLAOCI), or
x any other appropriate title even if such a title does not appear in IAS 1 e.g. income statement.
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An entity may choose to present its income using two statements, which involves:
x statement of profit or loss:
this shows the ‘profit or loss’ and must always be presented as the first of the two statements
(this statement could even be referred to as an income statement – see IAS 1.IN6); and
x statement of comprehensive income:
this shows the ‘other comprehensive income’ and ‘total comprehensive income’ and must
always start with the total ‘profit or loss’.
Entity name
Statement of comprehensive income 20X2 20X1
For the year ended 31 December 20X2 C C
Profit (or loss) for the period X X
Other comprehensive income for the period X X
x Other comprehensive income – item 1 X X
x Other comprehensive income – item 2 X X
Total comprehensive income for the period X X
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Orange Limited
Statement of comprehensive income 20X1 20X0
For the year ended 31 December 20X1 C C
Note 1: This subheading is compulsory disclosure and is explained in sections 8.3.3 and 8.6.
Orange Limited
Statement of profit or loss 20X1 20X0
For the year ended 31 December 20X1 C C
Orange Limited
Statement of comprehensive income 20X1 20X0
For the year ended 31 December 20X1 C C
Note 1: This subheading is compulsory disclosure and is explained in sections 8.3.3 and 8.6.
8.3 Line items, totals and sub-headings needed (IAS 1.81 - 87)
8.3.1 Overview
When presenting the statement/s that show profit or loss (P/L), other comprehensive income
(OCI) and total comprehensive income (TCI), IAS 1 requires that we present each of these
three totals together with certain minimum line items on the face of the statement/s.
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8.3.2 Minimum line items for: P/L (IAS 1.81A, 1.82, 1.85 & 1.87)
The minimum line items on the face of the statement that discloses profit or loss include:
x revenue (excluding interest revenue calculated using the effective interest rate method);
x revenue from interest (calculated using the effective interest rate method);
x gains and losses from the derecognition of financial assets measured at amortised cost; Note 1
x impairment losses (including impairment loss reversals/ gains) determined in accordance
with IFRS 9 Financial instruments; Note 1
x finance costs;
x share of profits and losses of equity-accounted associates and joint ventures; Note 2
x gains and losses on the reclassification of financial assets from measurement at amortised
cost to measurement at fair value through profit or loss; Note 1
x any cumulative gain or loss previously recognised in other comprehensive income that is
reclassified to profit or loss on reclassification of a financial asset from measurement at
fair value through other comprehensive income to fair value through profit or loss; Note 1
x tax expense;
x a single amount for the total relating to discontinued operations; Note 1
x profit or loss for the period. IAS 1.81A & 1.82 (reworded)
Note 1: These line items are specific to certain IFRSs and will thus be ignored in this chapter. Instead,
these will be covered in the chapters that explain those IFRSs.
Note 2: This line item is specific to certain IFRSs and is thus ignored in this chapter. Associates & Joint
Ventures are covered in a separate book entirely, called Gripping Groups (see details on page vi).
8.3.3 Minimum line items for: OCI (IAS 1.81A, 1.82A, 1.85, 1.87, 1.90 - .96)
SOCI: line items,
The minimum line items on the face of the statement that totals & sub-
discloses other comprehensive income include: headings:
x each item of other comprehensive income, classified by Minimum line items: for
nature; x P/L and
x total comprehensive income. See IAS 1.81A & 1.82A x OCI
Additional line items:
The other comprehensive income section must be grouped x if IFRS requires or
under the following sub-headings: x if relevant.
x Items that will not be reclassified* subsequently to profit Totals needed for:
or loss; and x P/L,
x OCI &
x Items that will be reclassified* subsequently to profit or x TCI.
loss (when specific conditions are met). See IAS 1.82A
No line item to be called extraordinary.
Each item of other comprehensive income (OCI) must be Line items specific to OCI:
presented in the statement of comprehensive income: x Items on face:
- classified by nature, and
x after deducting tax; or - shown before or after tax.
x before tax, in which case it will be followed by a single x Split between 2 sub-headings:
amount for the tax effect of all the relevant items per sub- - will be reclassified to P/L &
heading e.g. if there is only one item of OCI, there will be two - will not be reclassified to P/L
single amounts presented (the pre-tax amount of the OCI x Tax effects on face or notes.
item and the tax effect thereof) whereas if there are two items x Reclassification adjustments:
of OCI, there will be three amounts (the pre-tax amount for - on face or
- notes.
each of the two OCI items and one amount showing the
combined tax effect thereof). See IAS 1.91 A reclassification
adjustment is
The tax effect of each item of OCI (including reclassification x the transfer of an
income or expense
adjustments – see pop-up) may be presented either:
from OCI to P/L
x on the face of the statement; or (i.e. the item was previously recognised
x in the notes. See IAS 1.90 in OCI but must now be recognised in
P/L instead).
Reclassification adjustments may be presented: Reclassifications are discussed in
x on the face of the statement; or more detail in section 8.6.
x in the notes. See IAS 1.94
Chapter 3 99
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Entity name
Statement of comprehensive income
For the year ended 31 December 20X1
20X1 20X0
Profit or loss section: C C
....
Profit for the year X X
When using the nature method, expenses are presented based on their nature and are not
allocated to the various functions within the entity (such as sales, distribution, administration
etc). This method is simpler and thus suits smaller, less sophisticated businesses.
Entity name
Statement of comprehensive income
For the year ended 31 December 20X2 (nature method)
20X2
C
Revenue X
Other income X
Add/ (Less) Changes in inventories of finished goods and work-in-progress (X)
Raw materials and consumables used (X)
Employee benefit costs (X)
Depreciation (X)
Other expenses (X)
Total expenses (X)
Finance costs (X)
...
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However, the function method is designed for larger businesses that have the necessary
systems, can afford to do the allocation and can allocate the expenses on a reasonable basis.
Although this method has the potential to provide more relevant information, the risk of arbitrary
allocations means that it could lead to information that is less reliable and thus not relevant.
Information relating to the nature of expenses is crucial to those users attempting to predict
future cash flows. Thus, if the function method is used, information regarding the nature of the
expense (e.g. depreciation and staff costs) is also given, but this additional ‘classification by
nature’ is provided by way of a separate note. See IAS 1.97
An example showing the statement of comprehensive income using the function method
follows. The highlighted section is the part of the statement of comprehensive income that
changes depending on whether the ‘function’ or ‘nature’ method is used.
Entity name
Statement of comprehensive income
For the year ended 31 December 20X2 (function method)
20X2
C
Revenue X
Other income X
Cost of sales (X)
Distribution costs (X)
Administration costs (X)
Other costs (X)
Finance costs (X)
...
Chapter 3 101
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x In 20X1, the other comprehensive income will include income of C200 (see jnl 1).
The ledger accounts will look as follows:
Jnl 1 shows the income on the investment initially being recognised as OCI.
x In 20X2, the income of C200 is reclassified out of OCI and into profit or loss (see jnl 2).
The ledger accounts will look as follows:
Jnl 2 shows the reclassification adjustment, which means that the income is now
recognised in P/L (credit) and taken out of OCI (debit).
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Lemon Limited
Notes to the financial statements 20X2 20X1
For the year ended 31 December 20X2 C C
50. Other comprehensive income: cash flow hedge
Gains on cash flow hedge arising during the year 0 100 000
Less reclassification adjustment: gain now recognised in profit or loss (20 000) 0
(20 000) 100 000
Comment:
x The total gain on the cash flow hedge is C100 000. It is recognised in OCI but must be reclassified
from OCI to P/L over the period the hedged item will affect P/L. Since interest income on the loan will
be recognised in P/L over a 5-year period, we should reclassify the gain from OCI to P/L over 5 years:
20 000 in 20X2 (and 20 000 e over the remaining 4 years 20X3 to 20X6).
x The ‘gain on CFH: OCI’ account will reflect a balance of C80 000 at the end of 20X2.
The SOCIE and the SOFP will show this closing balance; whereas
The SOCI shows the movement in this OCI account each year.
x Notice: Since C20 000 (1/5 of the gain) was reclassified to P/L in 20X2, this C20 000 must be reversed
from OCI in 20X2 otherwise, over the 2 years, the total income recognised in TCI would be C120 000
OCI in 20X1: 100 000 + P/L in 20X2: 20 000 = TCI over both years:120 000
This would be wrong since the total income to date is only C100 000, which should be correctly
presented over the years as follows:
OCI: 80 000 (Gain recognised in OCI in 20X1 100 000 – Gain reclassified out of OCI in 20X2: 20 000) +
P/L: 20 000 (Gain recognised in P/L in 20X1: nil + Gain reclassified from OCI into P/L in 20X2: 20 000) = TCI: 100 000
x A prospective change means adjusting the prior year’s income or expense (P/L) by
processing a journal entry that adjusts the current year’s income or expense (P/L) instead.
x A retrospective change means adjusting a prior year’s income or expense (P/L) by
processing a journal that adjusts the prior year’s income or expense (P/L).
When journalising a retrospective change, adjustments to prior year income or expenses will need
to be journalised directly to the retained earnings account (i.e. not to that income or expense account).
This is because the prior year’s income and expense accounts will have already been closed off to that
prior year’s ‘P/L account’ and that prior year’s ‘P/L account’ will have been closed off to retained
earnings (only the current year’s income and expense accounts will still be ‘open’ for adjustments).
After a retrospective change has been processed, the presentation in the statement of
comprehensive income must make it clear that the prior year income and expenses have been
changed (i.e. if the prior year that was adjusted is presented as a comparative). The statement
of changes in equity will also include a line item to show the effect of the change on opening
retained earnings caused by all retrospective changes to the prior year/s income and expenses.
For more information on these adjustments, please see chapter 26 Accounting policies, estimates and errors.
Please note that the line-items in a statement of comprehensive income may need to be fewer
or greater than those shown below. It depends entirely on the line-items relevant to the entity
(e.g. if an entity does not revalue any assets, then the revaluation surplus movement shown in
other comprehensive income would not be presented).
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Entity name
Statement of comprehensive income
For the year ended 31 December 20X2 (function method)
20X2 20X1
C C
Revenue X X
Other income X X
Cost of sales (X) (X)
Distribution costs (X) (X)
Administration costs (X) (X)
Other costs (X) (X)
Finance costs (X) (X)
Profit (or loss) before tax X X
Taxation (X) (X)
Profit (or loss) for the year X X
Other comprehensive income for the year X X
x Items that may not be reclassified to profit or loss:
- Revaluation surplus, net of tax X X
x Items that may be reclassified to profit or loss:
- Gain on cash flow hedge, net of tax & reclassification adjustment X X
Total comprehensive income for the year X X
Thus, if the group includes a partly-owned subsidiary, the group’s consolidated statement of
comprehensive income must show how much of the consolidated income belongs to the:
x owners of the parent; and
x non-controlling interests.
This sharing of the consolidated income between the owners of the parent and the non-
controlling interests is referred to as the allocation of income and is presented as a separate
section at the end of the SOCI (*) as follows:
x the portion of the profit or loss that is attributable to the *:
- owners of the parent;
- non-controlling interests; and
x the portion of total comprehensive income that is attributable to the:
- owners of the parent;
- non-controlling interests.
*: The allocation of profit or loss may be presented in the statement of profit or loss if this has
been provided as a separate statement (i.e. if a two-statement approach had been used).
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Group name
Consolidated statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 (function method) C C
...
Total comprehensive income for the year X X
9.1 Overview
Components of equity include:
x each class of contributed equity (e.g. ordinary shares and preference shares);
x retained earnings (which reflects the accumulated profit or loss);
x other comprehensive income; there are currently 11 possible components, including for example:
- changes in a revaluation surplus;
- remeasurement of defined benefit plans;
- gains and losses arising from translating the financial statements of a foreign operation;
- for particular liabilities designated as at fair value through profit or loss, the amount of
the change in fair value that is attributable to changes in the liability’s credit risk;
- the effective portion of gains and losses on hedging instruments in a cash flow hedge;
- gains and losses on investments in equity instruments designated at fair value through
other comprehensive income;
- gains and losses on financial assets measured at fair value through other comprehensive
income. See IAS 1.7 & 1.108
A statement of changes in equity essentially shows the
The SOCIE must
reconciliation between the opening and closing balance for present:
each component of equity.
x changes in equity; thus it needs
Bearing in mind that equity represents the net assets, x reconciliations for each component
(E = A – L), a change in equity simply means an increase or of equity:
decrease in the net assets (or a change in position). - each class of contributed equity
- retained earnings (P/L)
Changes in equity for the period are represented by: - each of the 11 components of OCI.
x total comprehensive income (P/L + OCI); and Change in E = Change in (A – L)
x transactions with owners (including related transaction
costs): such as the issue of shares or dividends declared to shareholders.
The statement of changes in equity must present reconciliations between the opening and
closing balances for each component of equity (i.e. each class of contributed equity, retained
earnings and other comprehensive income). See IAS 1.106(d)
When presenting the reconciliations for each component of equity, we must separately present the:
x Profit or loss for the period
x Other comprehensive income period (each component of OCI to be presented separately)
x Total comprehensive income for the period. See IAS 1.106 (a) & (d)
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If the reconciliation between the opening balance and closing balance of a component of
equity involves transactions with owners in their capacity as owners, these transactions must
be separately presented as being:
x contributions by owners (e.g. through the issue of shares); and
x distributions to owners (e.g. dividends declared). See IAS 1.106(d)(iii)
9.3 Dividend distributions (IAS 1.107; IAS 1.137; IAS 10 & IFRIC 17)
The amount of the dividend distributions that have been The SOCIE may also
recognised must be presented either: present:
x in the statement of changes in equity, or x the amount of recognised dividend
x in the notes. distributions; and
x dividends per share (DPS).
The dividends per share (DPS) may also be disclosed either: The dividend amount and DPS may be
x in the statement of changes in equity, or shown in the notes instead.
x in the notes. Not all dividends are recognised!
It is submitted that the amount of the dividend distributions would be best presented in the
statement of changes in equity while the dividends per share would be best presented in the
notes, preferably alongside the earnings per share note.
If the reconciliation between the opening balance and closing balance of a component of
equity is affected by a retrospective adjustment (or retrospective restatement), the
presentation thereof must make it very clear whether it relates to:
x a change in accounting policy; or
x a correction of error. See IAS 1.110
If there has been a retrospective adjustment (or retrospective restatement), its effect on the
relevant component/s of equity must be disclosed:
x for each prior period; and
x the beginning of the current period. See IAS 1.110
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Entity name
Statement of changes in equity
For the year ended 31 December 20X2
Ordinary Retained Other Total
capital earnings compreh. equity
income
C C C C
Balance: 1 January 20X1 - restated X X X X
Balance: 1 January 20X1: as previously reported X
Change in accounting policy X
Correction of error X
Total comprehensive income X X X
Less dividends declared (X) (X)
Add issue of shares X X
Balance: 31 December 20X1 - restated X X X X
Balance: 31 December 20X2: as previously reported X
Change in accounting policy X
Correction of error X
Total comprehensive income X X X
Less dividends declared (X) (X)
Add issue of shares X X
Balance: 31 December 20X2 X X X X
Entity name
Consolidated statement of changes in equity
For the year ended 31 December 20X2
Attributable to owners of the parent Non- Total
Ordinary Revaluation Retained Total controlling equity of
capital surplus earnings equity interest the group
C C C C C C
Restated balance: 01/01/X1 x (x) x x x x
Balance: 1 Jan 20X1 - as x
previously reported
Change in accounting policy (x)
Total comprehensive income x x x x x
Less dividends (x) (x) (x) (x)
Add share issue x x x
Restated balance: 31/12/X1 x (x) x x x x
Balance: 31 Dec 20X1 - as x
previously reported
Change in accounting policy (x)
Total comprehensive income (x) x x x x
Transfer to retained earnings (x) x
Less dividends (x) (x) (x) (x)
Add share issue x x x
Balance: 31 Dec 20X2 x (x) x x x x
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IAS 1 does not cover the statement of cash flows as it is dealt with in its own standard, IAS 7.
The statement of cash flows is explained in detail in chapter 27.
11. Structure and Content: Notes to the Financial Statements (IAS 1.112-138)
11.1 Overview
Notes are defined as:
x containing information in addition to that presented in the:
- SOFP: statement of financial position,
- SOCI: statement of comprehensive income,
- SOCIE: statement of changes in equity, and
- SOCF: statement of cash flows;
x narrative descriptions or disaggregations of:
- items recognised in those statements (i.e. supporting information); and about
- items not recognised in those statements (i.e. extra information). IAS 1.7 (reworded)
Notes give information about the following: See IAS 1.7; 1.112 & 1.117
x the basis of preparation; See IAS 1.112 (a)
x the significant accounting policies, including:
- the measurement basis or bases, and See IAS 1.112 (a) & 117.(a)
- other relevant accounting policies; See IAS 1.112 (a) & 117.(b)
x supporting information (i.e. regarding items recognised in the statements) which:
- is required by the IFRSs See IAS 1.112(b) and IAS 1.7
- is required because it’s relevant See IAS 1.112(c) and IAS 1.7
x extra information (i.e. regarding items not recognised in the statements) which:
- is required by the IFRSs See IAS 1.112(b) and IAS 1.7
- is required because it’s relevant. See IAS 1.112(c) and IAS 1.7
IAS 1 also specifically refers to the requirements to provide notes that disclose details about:
x judgements made by management regarding:
- the application of accounting policies; See IAS 1.122
- making estimates; See IAS 1.125
x capital management; See IAS 1.134
x puttable financial instruments classified as equity; See IAS 1.136A
x dividends; See IAS 1.137
x various other details relating to the entity’s identity and description. See IAS 1.138
Cross-referencing is necessary where the notes refer to information contained in the other
statements. In other words, the other four statements making up the financial statements
must be cross-referenced to the notes.
Notes must be listed in an order that is systematic. This means the order must be logical, taking into
consideration the effect that the order will have on understandability and comparability. For example,
we could provide the notes supporting the items in the other four components in the same order that
each line item and each financial statement is presented. However, a note may refer to more than
one line-item, in which case we would then simply have to try to be as systematic as possible.
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Note 3. Other notes (i.e. those that do not support items recognised in other statements) could include:
- Financial information, for example:
unrecognised contractual commitments, contingent liabilities and details of events that
happened after the reporting date but before the financial statements were authorised for issue;
- Non-financial information, for example:
the entity’s objectives and policies relating to its capital management. See IAS 1.114 (c)
This textbook prefers aspects of KPMG’s interpretation above and thus submits that the ‘basis
of preparation’ should be presented separately to the ‘significant accounting policies’ and should
contain the following details, ideally under separate headings:
x Reporting entity: identifying whether the financial statements are prepared as separate
financial statements or consolidated financial statements;
x Statement of compliance: stating whether the financial statements have been prepared in
compliance with IFRSs, some other national GAAP or other set of principles;
x Other issues: such as whether the financial statements are prepared in a way that
presented assets in order of liquidity or under the headings of current and non-current.
ABC Ltd
Notes to the Financial Statements
For the year ended 31 December 20X2
1. Basis of preparation...
1.1 The reporting entity:
The following financial statements have been prepared as consolidated financial statements
for ABC Limited and its subsidiary.
ABC Limited is a company that is both incorporated and domiciled in South Africa.
The address of its registered office and principal place of business is: 50 Ten Place,
Padfield, Johannesburg.
The group of companies are involved in properties held for the purpose of rental income as
well as the printing and distribution of textbooks.
1.2 Statement of compliance:
These financial statements have been prepared in accordance with IFRS.
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11.4.1 Overview
We need to provide users with the accounting policies considered to be significant, which includes:
x the measurement basis or bases used in preparing the financial statements; and
x other accounting policies that are relevant to users (i.e. those that would help users
understand the financial statements). See IAS 1.117
We can present one single note summarising all significant accounting policies, or we could present
them in their relevant notes (e.g. the inventory accounting policies could be presented within the
inventory note) or we could even present a summary of accounting policies as an entirely separate
statement (i.e. there would then be 6 statements making up a set of financial statements). See IAS 1.116
Users are better able to understand the financial statements if they know how the items in the financial
statements have been measured. Thus, accounting policies that describe the measurement basis (or
bases) used in preparing financial statements should be disclosed. There are many measurement
bases possible and entities may use one or, more often, a combination of them. Examples include:
x Historical cost
x Current cost
x Net realisable value
x Fair values
x Recoverable amounts. See IAS 1.118
11.4.3 Significant accounting policies are those that are relevant (IAS 1.117 & 119)
Only accounting policies that are significant need to be disclosed. These include a description of the
measurement bases (see above) and those that we think may be relevant to our users. See IAS 1.117
An accounting policy is relevant (and thus should be disclosed), if knowing about the policy would help
the user to understand the entity’s performance and position. See IAS 1.119
Whether an accounting policy is relevant to an entity depends largely on the nature of its operations.
For example, if an entity is exempt from paying tax, then including accounting policies about tax
would not be relevant. Conversely, depending on the nature of its operations accounting policies
may be relevant (and thus significant) even if the related amounts are immaterial. See IAS 1.119
Accounting policies are also relevant if an IFRS allows a choice in accounting policies (e.g. IAS 40
Investment property allows a choice between the cost model or fair value model and thus we must
present which model the entity chose to use). See IAS 1.119
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Consider the following example: When purchasing shares in a business, we may have acquired
an associate or a subsidiary or simply an investment in shares. The deciding factor revolves
around the level of control that we now have over that business. Deciding whether control has
been acquired is often difficult, requiring significant judgment and, depending on the conclusion,
different IFRSs will be applied. If reaching a conclusion was difficult, then the logic management
used in making its judgements must be disclosed. However, if the effect on the amounts in the
financial statements will not be significantly different if the share purchase is regarded as having
resulted in a subsidiary, associate or merely an investment in shares, then the logic
management used when making its judgements would not need to be disclosed.
Judgements made in applying accounting policies can be disclosed as a separate note, or within the
significant accounting policies note or anywhere else in the notes (e.g. the judgement referred to above
could be explained in the investment property and property, plant and equipment notes). See IAS 1.122
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Disclosure is required if the possibility of this estimate being wrong amounts to:
x a significant risk
x that a material adjustment to the carrying amount of an asset or liability
x may need to be made within the next financial year.
ABC Ltd
Notes to the Financial Statements
For the year ended 31 December 20X2
1. Basis of preparation...
2. Significant accounting policies...
3. Judgements in applying accounting policies ...
4. Sources of estimation uncertainty
The following assumptions and estimation uncertainties carry a significant risk of resulting in a
material adjustment during the year ended 31 December 20X3:
4.1 Impairment of plant Note 15 includes plant, the carrying amount of which was impaired
by C10 000 to its recoverable amount of C80 000. This recoverable amount was estimated
based on its value in use, calculated as the present value of the future cash flows expected
from the use of the plant and present valued using a pre-tax discount rate of 7%.
The future cash flows were estimated based on the assumption that ABC secures a certain
government contract. However, if this government contract is not awarded to ABC, the value
in use would decrease to C60 000 and thus the carrying amount of plant would be measured
at C60 000 and the impairment expense would be measured at C30 000.
4.2 ...
Where disclosures are required regarding an estimate that required management to make
judgements involving ‘assumptions about the future and other major sources of estimation
uncertainty’ the disclosures should include, for instance:
x the nature and carrying amount of the assets and liabilities affected; See IAS 1.131
x the nature of the assumption or estimation uncertainty; See IAS 1.129 (a)
x the sensitivity of the carrying amounts to the methods, assumptions and estimates used in
their calculation; See IAS 1.129 (b)
x the reasons for the sensitivity; See IAS 1.129 (b)
x the range of reasonably possible carrying amounts within the next financial year and the
expected resolution of the uncertainty; See IAS 1.129 (c)
x the changes made (if any) to past assumptions if the past uncertainty still exists. See IAS 1.129 (d)
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Disclosures are not required, even if there is a significant risk of an item’s carrying amount
changing materially within the next year, if the asset or liability is measured at a fair value that
has been based on a quoted price in an active market for an identical asset or liability. This is
because the change in its carrying amount is caused by the market price changing and is not
caused by incorrect assumptions made by management. See IAS 1.128
IAS 1 does not indicate where the disclosures involving sources of estimation uncertainty
should be disclosed, but it is submitted that the required disclosures could be presented in its
own separate note (as shown above) or could be presented in the actual note dealing with the
affected estimate (e.g. assumptions involved in estimating the impairment of plant could be
included in the note involving plant).
ABC Ltd
Notes to the Financial Statements
For the year ended 31 December 20X2
1. Basis of preparation
2. Significant accounting policies
3. Judgements in applying accounting policies
4. Sources of estimation uncertainty
5. Capital management
ABC Limited has a capital base that includes a combination of ordinary shares and non-
redeemable preference shares. The total capital at 31 December 20X2 is C1 000 000.
ABC Limited is not subjected to any externally imposed capital requirements. It does, however,
have an internal policy of maintaining a solid capital base in order to enable continued
development of the business and to ensure general confidence in the business.
The business manages its capital base by monitoring its debt to equity ratio. Its policy is to keep
this ratio from exceeding 3:1. The debt to equity ratio at 31 December 20X2 was 3.3:1 (20X1:
2.9:1). The increase in the debt to equity ratio in 20X2 was due to extra financing needed due to
the refurbishment of one of its uninsured properties following a devastating flood in March.
Management intends to issue 100 000 further ordinary shares in 20X4, which will bring the debt:
equity ratio back in line with the policy of 3: 1.
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If the entity issued puttable financial instruments classified as equity, the notes must include:
x A summary of the amounts classified as equity
x How the entity plans to manage its obligation to provide cash in exchange for a returned
instrument when required to do so by the holder of the instrument;
x The future cash outflow expected in relation to this instrument; and
x How the expected future cash outflow has been calculated. See IAS 1.136A
11.9 Unrecognised dividends (IAS 1.137; IFRIC 17.10 & IAS 10.13)
11.9.1 Disclosure of unrecognised dividends (IAS 1.137)
IAS 1 requires that the notes include certain disclosures relating to unrecognised dividends.
x For dividends that have not been recognised, we must disclose the following in the notes:
- the amount in total; and
- the amount per share. See IAS 1.137
x For any cumulative preference dividends that, for whatever reason, have not been recognised,
we must disclose the following in the notes:
- the amount in total. See IAS 1.137
Dividends are recognised as
11.9.2 Why are some dividends not recognised? equity distributions when:
x there is an obligation to pay.
A dividend distribution normally has the following life-cycle: An obligation to pay arises when it
x proposal; then x has been appropriately authorised &
x declaration; then x is no longer at the entity's discretion
x payment. The obligation date is normally the:
x declaration date unless
Dividends are first proposed in a meeting. If the proposal is x the particular jurisdiction requires
accepted, the entity will declare the dividend. Declaring a further approval after the dividend
See IAS 10.13 & IFRIC 17.10
dividend means publicly announcing that the dividend will be declaration.
paid on a specific date in the future. A dividend only becomes an obligation once it is appropriately
authorised and no longer at the discretion of the entity. See IAS 10.13
In some jurisdictions, a declaration still needs to be approved before an obligation arises (e.g. it
may be declared by the board of directors, but this declaration may still need to be approved by
the shareholders). See IFRIC 17.10
Notice: the dividend is not recognised as an expense but rather as a distribution of equity because
a distribution of equity is expressly excluded from the definition of an expense (see chapter 2).
Certain dividends would not be recognised since there is not yet an obligation to pay them:
x proposed before or after the reporting date but are not yet declared or paid; and
x declared before reporting date but within a jurisdiction where further approval is required;
x declared after reporting date but before the financial statements are authorised for issue.
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12. Summary
116 Chapter 3
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Chapter 3 117
Gripping GAAP Revenue from contracts with customers
Chapter 4
Revenue from contracts with customers
Reference: IFRS 15 (including any amendments to 1 December 2019)
Contents: Page
1. Introduction 122
1.1 IFRS 15: The ‘new’ revenue standard 122
1.2 IFRS 15: The significant changes 122
1.3 IFRS 15: Transitional provisions 122
2. Scope 123
2.1 IFRS 15 only applies to contracts that involve customers 123
2.2 IFRS 15 does not apply to all contracts with customers 123
3. Income versus revenue 123
Diagram 1: Relationship between income and revenue, and the different types of revenue 124
4. IFRS 15 in a nutshell 124
4.1 Overview 124
4.2 The 5-step process to recognition and measurement 124
Diagram 2: the 5-step process for revenue recognition and measurement 124
4.3 Recognition 125
4.4 Measurement 126
4.5 Presentation 127
4.5.1 Overview 127
4.5.2 Rights are presented as assets 127
Example 1: Contract asset versus a receivable 128
4.5.3 Obligations are presented as liabilities 129
Example 2: When to recognise a contract liability 130
4.6 Disclosure 131
5. Identifying the contract (step 1) 131
5.1 Overview 131
5.2 The contract must meet certain criteria 132
5.3 The contract may be deemed not to exist 133
5.4 When the criteria are not met at inception 133
Example 3: Criteria not met at inception 133
5.5 When the criteria are met at inception but are subsequently not met 134
Example 4: Criteria met an inception but subsequently not met 134
5.6 Combining contracts 135
5.7 Modifying contracts 135
5.7.1 What is a contract modification? 135
5.7.2 Accounting for a modification 135
5.7.3 Modification accounted for as a separate contract 136
5.7.4 Modification accounted for as a termination plus creation of a new contract 136
5.7.5 Modification accounted for as part of the existing contract 136
6. Identifying the performance obligation (step 2) 137
6.1 Performance obligations are promises 137
6.2 Revenue is recognised when performance obligations are satisfied 137
6.3 Performance obligations could be explicitly stated or be implicit 137
Example 5: Explicit and implicit promises 138
6.4 The promised transfer must be distinct 138
6.4.1 Overview 138
6.4.2 The goods or services must be capable of being distinct 138
6.4.3 The good or service must be distinct in the context of the contract 139
6.5 Bundling indistinct goods or services 139
Example 6: Distinct goods and services 140
118 Chapter 4
Gripping GAAP Revenue from contracts with customers
Chapter 4 119
Gripping GAAP Revenue from contracts with customers
120 Chapter 4
Gripping GAAP Revenue from contracts with customers
Chapter 4 121
Gripping GAAP Revenue from contracts with customers
1. Introduction
122 Chapter 4
Gripping GAAP Revenue from contracts with customers
2. Scope
2.1 IFRS 15 only applies to contracts that involve A contract is defined as:
customers
x An agreement between two or
more parties
As its name suggests, IFRS 15 only deals with contracts and only
x that creates enforceable rights
those contracts that involve customers. Both these terms are and obligations. IFRS 15 Appendix A
defined in IFRS 15 (see grey boxes on the right):
x A contract is any agreement resulting in the parties to the agreement having rights and
obligations that are enforceable. It does not need to be in writing – it can be verbal or simply
implied by the way in which the entity normally conducts its business. What is important is
that it is enforceable by law.
x A customer is simply a party (e.g. a person) who has come to A customer is defined as:
an agreement with the entity, promising to give some form of x a party that has contracted with an
consideration (e.g. cash) in exchange for goods or services entity
(e.g. widgets) that the entity promises to provide as part of its x to obtain goods or services
ordinary activities. Thus, a party that agrees to pay the entity x that are an output of the entity’s
ordinary activities
for goods or services that are not part of the entity’s ordinary
x in exchange for consideration.
activities, would not be a customer. Thus, this contract would IFRS 15 Appendix A
not be accounted for under IFRS 15.
2.2 IFRS 15 does not apply to all contracts with Scope exclusions:
customers IFRS 15 does not apply to:
x contracts that do not involve customers
Although IFRS 15 applies to many contracts with customers, as defined
some contracts are not covered by IFRS 15. x contracts with customers that are
covered by other standards
x IFRS 15 does not apply to contracts that fall within the scope
- lease contracts under IFRS 16
of another standard. In other words, we first decide whether - insurance contracts under IFRS 4
other standards would apply to the contract: if other standards - financial instruments and ‘other
apply, then IFRS 15 will not apply; but if no other standards contractual rights or obligations’
apply, then IFRS 15 will apply. For example, lease contracts covered by IFRS 9, IFRS 10, IFRS 11,
IAS 27 or IAS 28
(IFRS 16), insurance contracts (IFRS 4) and financial
x exchanges of non-monetary items
instruments (IFRS 9) are scoped out of IFRS 15 if these between entities in the same line of
standards are found to apply. business to facilitate sales to
customers or potential customers.
x IFRS 15 does not apply to contracts involving the exchange See IFRS 15.5-6
‘Income’ and ‘revenue’ are not the same: ‘income’ is an umbrella term that includes ‘revenue’. Revenue
is defined as ‘income that arises in the entity’s ordinary activities’. IFRS 15 defines both terms (see pop-
up on the next page).
This difference can be explained as follows. A retailer may earn interest on surplus cash. Since this
interest income falls outside its ordinary activities of buying and selling, this entity would not present this
interest income as revenue. On the other hand, a financier (e.g. a bank) that charges interest on loans
as one of its core business activities would present its interest income as revenue. See IFRS 15.BC247
Chapter 4 123
Gripping GAAP Revenue from contracts with customers
It is also important to remember that, although IFRS 15 deals with revenue, it does not apply to all types
of revenue – it only applies to revenue arising from ‘contracts with customers’ and it only applies to
contracts with customers that do not fall within the scope of certain other standards (e.g. IFRS 16
Leases – see section 2). This relationship is shown in the diagram below:
Diagram 1: Relationship between income and revenue, and the different types of revenue
Income
Note 1: revenue from contracts with customers is disclosed separately from other revenue. See IFRS 15.113(a)
4. IFRS 15 in a nutshell
4.1 Overview
IFRS 15 explains a 5-step process to decide when to recognise revenue and how to measure it. It
also gives guidance regarding how to present revenue and how to disclose the related detail.
The 5-step process is the process followed when recognising and measuring revenue. These
steps are inter-related. This means that the process of considering step 3, for example, may
require us to simultaneously consider step 5, or vice versa.
Diagram 2: the 5-step process for revenue recognition and measurement See IFRS 15.2/IN7
IFRS 15 gives detailed guidance to help us decide if and when each of these 5 steps have been
completed. Each of these steps is covered in detail under sections 5 to 9, but first let us look at
the ‘big picture’ of the recognition, measurement, presentation and disclosure requirements.
124 Chapter 4
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The contract need not be in writing or even be verbal, it can simply be implied. What is important
is that it is enforceable by law. If we conclude that we do not have a contract with a customer,
then it falls outside of the scope of IFRS 15 and thus we do not recognise revenue from
contracts with customers.
Chapter 4 125
Gripping GAAP Revenue from contracts with customers
The transaction price is the amount of consideration that the entity expects to be entitled to for
the transfer of the goods and/ or services to the customer.
The transaction price must exclude any amounts that the entity will be collecting on behalf of a
third party (e.g. the transaction price would not include VAT since this would be an amount
collected on behalf of, and thus owed to, the tax authorities).
If the contract involves only one single performance obligation, the contract’s entire transaction
price will apply to that single obligation.
However, if a contract involves more than one performance obligation, the transaction price will
need to be allocated to each separate performance obligation.
The reason we take the trouble to allocate the transaction price to each of these obligations is because
revenue is recognised separately for each separate obligation as and when that performance obligation
is satisfied (i.e. completed). At any one time, the revenue recognised should reflect the effort the entity
has put into satisfying each individual performance obligation.
For example: a contract requiring us to supply and install a ‘complex computer network’, involves
two performance obligations: the supply of the hardware and the installation of the hardware. It is
possible that these two obligations could be satisfied at different times, in which case the revenue
from each obligation would need to be recognised at different times.
The allocation of the transaction price to each performance obligation is done in proportion to the stand-
alone transaction prices of the ‘distinct’ goods or services identified in the contract.
The portion of the transaction price that is allocated to a performance obligation is only
recognised as revenue once that obligation has been satisfied (i.e. completed).
With this in mind, we need to understand that some performance obligations are satisfied:
x at a point in time (i.e. in an instant); and others are satisfied
x over time (i.e. gradually).
If the performance obligation will be completed in an instant (i.e. at a point in time) the related
revenue will be recognised at that point in time. If it will be completed gradually (i.e. over time),
the revenue from this obligation will also be recognised gradually.
For example: If we consider our ‘complex computer network’ example referred to above, the
supply of the hardware would be a performance obligation that is completed at a point in time (at
which point, revenue from this obligation would be recognised immediately), whereas the
installation would probably be a performance obligation that would be completed over time
(revenue from this obligation would be recognised gradually).
126 Chapter 4
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When recognising revenue over time, the amount of revenue to be recognised will need to be
measured based on the progress towards complete satisfaction of the performance obligation.
This progress is measured using either an input method or an output method.
Revenue must be presented as a line-item in profit or loss (profit or loss can be presented within the
statement of comprehensive income or as a separate statement of profit or loss). See IAS 1.82 (a)
In addition to the presentation in the statement of comprehensive income, revenue also affects
the presentation of our financial position (SOFP). In this regard, a customer contract may lead to
the presentation in our statement of financial position (SOFP) of the following line-items:
x a contract asset or contract liability; and/or
x a receivable (receivables are to be presented separately from contract assets).
In order to understand the use of these line-items, we need to understand that when we enter
into a contract with a customer, we accept certain rights and certain obligations:
x the right to receive the promised consideration; and
x the obligation to transfer promised goods or services to the customer (i.e. the obligation to satisfy
certain specified performance obligations – in other words, to perform our side of the contract).
The relationship between these rights and obligations will determine whether we have:
x a contract asset: if our remaining rights are greater than our remaining obligations; or
x a contract liability: if our remaining rights are less than our remaining obligations. See IFRS 15.BC18
When measuring the contract asset (our conditional rights), we must exclude the amounts to be
included in the receivable (our unconditional rights) (i.e. contract assets and receivable assets are two
different kinds of assets: see section 4.5.2).
4.5.2 Rights are presented as assets (IFRS 15.107-.108) Rights are assets:
As mentioned above, an entity’s right to consideration is A contract asset is a:
recognised as an asset. However, as we can see, there are x conditional right
two types of assets: a contract asset and a receivable. A receivable is an:
x unconditional right.
When recognising revenue (a credit entry) that is received in cash, * The need to simply wait for time
the asset we recognise is cash in bank (a debit entry). to pass is not considered to be a
condition. See IFRS 15.107-.108
However, if the revenue is not received in cash, we would need to decide whether to debit the
contract asset or the receivable asset.
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Deciding which asset to debit depends on whether our right to receive consideration is
conditional or not. If our right to consideration:
x is conditional upon something happening, other than the passing of time* (e.g. conditional
upon the future performance of the entity), then we debit the contract asset;
x is unconditional (i.e. there are no conditions other than the possible requirement to simply
wait for the passing of time* - in other words, we have satisfied all our obligations and are
now simply waiting for the customer to pay), then we debit the receivable.
* Note: a condition that requires us to simply wait for the passage of time is not considered to be a
condition for purposes of IFRS 15 (because ‘time is an inevitability’)
In other words, a receivable represents a right that is unconditional (i.e. at most, all we have to
do is wait for time to pass) whereas a contract asset represents a right that is conditional.
Home Fires signed a contract with Deluxe Renovations (the customer) on 1 March 20X2, the
terms of which included the following:
x Home Fires would supply and install a designer fireplace on 1 April 20X2 after which it would be
required to supply and install a fire-door.
x Deluxe Renovations (the customer) promised consideration of C20 000, payable one month after both
the fireplace and the door have been supplied and installed.
x The contract is cancellable in the event of non-performance.
The stand-alone selling prices for the supplied and fitted products are as follows:
x fireplace: C15 000; and
x fire-door: C5 000.
Home Fires supplies and installs the fireplace on 1 April 20X2 and supplies and installs the door on 5 May
20X2. The customer obtains control of each product on the date of its installation.
The customer pays the promised consideration on 25 July 20X2.
Required: Prepare all journals for the information given, using the general journal of Home Fires.
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Thus, when we recognise revenue in respect of this second PO (credit revenue), we must recognise a
receivable (debit receivable).
Since the contract could have been cancelled if the second PO was not completed, the revenue from the
first PO had been recognised as a contract asset (1 April 20X2). Since this second PO is now complete, it
means that the contract asset that was recognised on 1 April 20X2 must now be recognised as a
receivable (debit receivable and credit contract asset).
x Journal on 25 July 20X2:
The receipt of cash is recorded. Please note that the date on which the customer was meant to have
paid was 5 June 20X2, in terms of the contract (being 1 month after both POs were satisfied). However,
this date is of no relevance to our journals.
1 April 20X2 Debit Credit
Contract asset (A) Given 15 000
Revenue from customer contract (I) 15 000
Recognising revenue on supply & installation of fireplace (satisfaction of PO #1),
recognised as a contract asset since the right to the consideration is not yet
unconditional (we still need to satisfy PO#2)
5 May 20X2
Accounts receivable (A) Given 5 000
Revenue from customer contract (I) 5 000
Recognising revenue on supply & installation of fire-door (satisfaction of PO #2),
recognised as a receivable since the right to this consideration is unconditional (we
have satisfied both POs)
Accounts receivable (A) Given 15 000
Contract asset (A) 15 000
Transferring the contract asset to the receivable asset since the right to the
consideration for PO#1 is now unconditional (both POs are satisfied)
25 July 20X2
Bank Given 20 000
Accounts receivable (A) 20 000
Receipt of payment from customer (also referred to as consideration)
Note that, although IFRS 15 refers to contract assets and receivables, both are actually measured in
terms of IFRS 9 Financial instruments. This will also mean applying the impairment requirements of
IFRS 9, which involves the use of the expected credit loss model (a forward-looking model), instead of
the ‘allowance for doubtful debt’ model (an incurred-loss model) that was previously applied under the
old revenue standard. See section 7 in this chapter, as well as section 4 of chapter 21 for further details.
If we have not yet satisfied our performance obligations, we cannot recognise revenue (see step 5).
However, although we may not yet recognise revenue, we may need to recognise a contract liability
instead, if we either:
x have already received the consideration from the customer (i.e. we have debited bank but
cannot yet credit revenue since the performance obligation has not yet been satisfied); or
x have an unconditional right to this consideration (i.e. we have debited accounts receivable
but cannot yet credit revenue since the performance obligation has not yet been satisfied).
This contract liability is recognised when the entity either receives the consideration or obtains
the unconditional right to this consideration, whichever happens first.
Thus, a contract liability reflects our obligation to either return any amounts received to our
customer, or to satisfy our performance obligations (i.e. do what we promised to do).
Normally, an unconditional right to consideration arises only when we have satisfied our performance
obligations (see previous example where we were only able to recognise a receivable once both
performance obligations were satisfied). However, an unconditional right to consideration can arise
before we have satisfied our performance obligations (i.e. before we are able to recognise revenue).
This happens if, for example, the contract is non-cancellable.
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If we sign a non-cancellable contract, the date on which our customer is required to make payment is
the date on which we obtain an unconditional right to the consideration, even if we have not
performed our obligations.
The due date for payment in a contract is normally irrelevant when accounting for revenue from contracts
with customers. However, the date is very important if the contract is non-cancellable, because it is the
date on which the entity obtains an unconditional right to receive the consideration.
Home Fires installed the fireplace on 10 May 20X2, on which date the customer obtained control.
The customer paid the promised consideration on 30 April 20X2 (i.e. before installation but after the due date).
Required: Prepare all journals in the general journal of Home Fires assuming that:
A. the contract is non-cancellable.
Adaptation of IFRS 15.IE38 & 39
B. the contract is cancellable in the event of non-performance.
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10 May 20X2
Contract liability (L) Given 15 000
Revenue from customer contract (I) 15 000
Reversing the contract liability and recognising it as revenue instead since
the PO is now satisfied.
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A contract will not exist if any one of the above five criteria are not met.
These criteria make it clear that the contract must specify both rights and obligations of all
parties to the contract. However, IFRS 15 clarifies that what is Please note:
important is that these rights and obligations must be legally Even if all criteria are met,
enforceable. As already mentioned, to be legally enforceable the contract may be
does not mean the contract must be in writing. deemed not to exist
(see section 5.3).
The concept of legal enforceability is interesting. Depending on where you are in the world (i.e.
in which geographical area you are doing business), contracts could be considered legally
binding if they are verbal or could even be considered legally binding based purely on the
entity’s ‘customary business practices’. Furthermore, it is not only which geographical area in
which you are doing business that may affect whether an agreement is legally binding: it is also
feasible for contracts within the same entity to take different forms depending on which customer
it is dealing with.
For example, an entity may insist on written contracts with certain customers but may be happy to
accept a handshake when contracting with other long-standing customers. Another example of a
customary business practice might be where a car dealership provides a ‘courtesy valet service’ at
every ‘maintenance service’, where this courtesy valet service’ is not specified in the maintenance
contract. Thus, when deciding whether an entity has entered into a legally enforceable contract,
we must consider that particular entity’s ‘practices and processes’. See IFRS 15.10
Goods and services promised in a contract are generally easily identifiable. However, identification of
goods and services can appear complex if the contract has no fixed duration: some contracts are
able to be terminated at any time or are able to be renewed continuously (e.g. a contract to provide
electricity to a customer on a monthly basis) or even renewed automatically on certain dates (e.g. a
cell phone contract to provide air-time for two-year periods and where the contract automatically
renews at the end of each two-year period). In such cases, we simply account for the rights and
obligations that are presently enforceable (e.g. the obligation to provide electricity for a month or the
promise to provide air-time for two years).
The payment terms refer to both the amount of consideration and the timing of the payments.
Revenue should not be recognised if the contract has no commercial substance. The exchange of
non-monetary items where the exchange has no commercial substance is an example of a contract
from which we would not be allowed to recognise revenue. These exchanges were specifically
excluded from IFRS 15 because entities would otherwise have been able to artificially inflate their
revenues by continually exchanging equal-valued non-monetary items with one another. An example
might be Entity A agreeing to deliver crude oil to Entity B’s customer, and Entity B agreeing to deliver
crude oil to Entity A’s customer. See IFRS 15.9(d) and BC40 and 41
A contract has commercial substance if we expect the contract to change the risk, timing or
amount of the entity’s future cash flows. To assess a transaction’s commercial substance, we
calculate the present value of the future cash flows from the contract. A present value calculation
takes into account the cash flows (amount), the effects of when payments will occur (timing) and
a discount rate that reflects the related risks (risk). See IFRS 15.9(d)
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When considering whether it is probable that the entity will collect the consideration, we consider
the customer’s ability to pay and intention to pay, but only when payment falls due. In other
words, a customer may currently not have the ability to pay but may be expected to have the
ability to pay when payment falls due.
It is also important to note that the consideration we are referring to is the consideration that we
expect to be entitled to – this may not necessarily be the price quoted in the contract. For
example, a contract could quote a price of C100 000 but if we offer a volume discount of
C10 000 to the customer on condition that he buys further goods within the month, and if we
expect that he will buy further goods within the month, then we only need to consider whether
the customer has the ability and intention to pay C90 000.
A contract will not exist if any one of the above five criteria are
not met (see section 5.2). However, even if all criteria are Contracts are deemed
met, the contract will be deemed not to exist if: not to exist if:
x each and every party to the contract all parties are equally entitled to
x has a ‘unilateral enforceable right to terminate’ terminate a contract that is wholly
x a ‘wholly unperformed contract’, unperformed, without compensating
x without providing any compensation to the other party/ies. the others.
A wholly unperformed contract is
A wholly unperformed contract is a contract where the entity one where the entity:
has not yet transferred any of the promised goods or services, x has not yet done anything
has not yet received any consideration and is not yet entitled x has not yet been paid; and
to any consideration. x is not yet owed anything. See IFRS 15.12
5.4 When the criteria are not met at inception (IFRS 15.14-.16)
It can happen that a contract does not meet these five criteria at inception. If this happens, the
entity must continually re-examine the contract in the light of changing circumstances in order to
establish whether these criteria are subsequently met. See IFRS 15.14
While these criteria are not met, any consideration received by the entity must not be recognised
as revenue. This is because we technically do not have a contract. This means that any
amounts received will need to be recognised as a liability. The reasoning behind recognising
amounts received as a liability is that it represents the entity’s obligation to either:
x provide the goods or services that it has promised to provide; or
x refund the amounts received. See IFRS 15.15-16 If criteria are not met,
receipts must be
The liability is simply measured at the amount of the recognised as a liability.
consideration received. See IFRS 15.16 The liability is transferred to
revenue when either the:
These receipts that are recognised as a liability will then either x 5 criteria are eventually met;
be recognised as revenue (i.e. debit liability and credit x entity has no further
revenue) or will be refunded (i.e. debit liability and credit obligations and the receipts
are non-refundable; or the
bank). However, the entity may not recognise the contract
x contract is terminated and the
liability as revenue until: receipts are non-refundable
x all five criteria (in para 9) are subsequently met; or
x it has no further obligations in terms of the contract ‘and all, or substantially all,’ of the
promised consideration has been received and is non-refundable; or
x The contract is terminated, and the consideration received is non-refundable. See IFRS 15.15-16
x
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Publications agreed to these terms but, since December is an exceedingly busy month for the printers, it
requires the customer to pay a C5 000 deposit to secure this printing time.
This deposit will be set-off against the contract price but is non-refundable in the event that the contract is
cancelled. The deposit was paid on 12 November. The contract was cancelled on 28 November.
Required: Explain how to account for this contract.
5.5 When the criteria are met at inception but are subsequently not met (IFRS 15.13)
Unlike the situation when the contract does not meet the criteria at inception, if a contract does meet the
criteria at inception, we do not continually reassess whether the criteria continue to be met. We only
need to reassess the situation when there is a ‘significant change in facts and circumstances’ (e.g. if we
become aware that one of our customers is experiencing significant cash flow problems).
If a reassessment of the facts and circumstances leads us to believe, for example, that it is no longer
probable that that we will receive payment from the customer, it means that all 5 criteria for the
existence of a contract are no longer met. In other words, in terms of IFRS 15, we have no contract.
Since revenue from contracts with customers may only be recognised if a contract exists, we
must immediately stop recognising revenue from this contract. Furthermore, any related
receivables account that may have arisen from this contract will need to be checked for
impairment losses in terms of IFRS 9 Financial instruments. These impairment losses will need
to be presented separately. The issue of impairments is discussed in more detail when we
discuss step 3: determining the transaction price (see section 7).
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On 5 May, a lawyer’s letter was received indicating that there was a ‘significant change in facts and
circumstances’ and which suggested that the criteria for the existence of a contract were no longer met (the
terms of the contract were under dispute).
The entity continued to perform its obligations during May, but since the contract criteria are no longer met,
the revenue may not be recognised. Instead, the entity must recognise this as a liability: Debit Receivable
and Credit Liability (it is submitted that this liability should not be called a contract liability since the definition
thereof is not met and we technically do not have a contract but could be called a refund liability instead). (See
the second journal below.)
The receivable balance would be measured in terms of IFRS 9 Financial instruments. This would mean
recognising a loss allowance to reflect the expected credit losses. No information has been given regarding
the estimation of these losses and thus the following journals do not reflect the journal relating to the loss
allowance.
Total of the journals from January to end April Debit Credit
Receivable (A) C1 000 x 4 months 4 000
Revenue (I) 4 000
Recognising the receivable and revenue earned (we could process 4 jnls of
C1 000 instead)
May
Receivable (A) C1 000 x 1 1 000
Refund liability (L) 1 000
Recognising the receivable and refund liability (delaying revenue recognition)
We would account for two or more contracts as if they were a single contract:
a) if they were entered into at the same time – or nearly the same time; and
b) if they involved the same customer – or the customer’s related parties; and
c) if:
- they were ‘negotiated as a package with a single commercial objective’; or
- the amount to be paid in terms of one of the contracts ‘depends on the price or
performance of’ one of the other contract/s; or
- all or some of the goods or services that are promised in these contracts are, together,
considered to form ‘a single performance obligation’ (see section 6). IFRS 15.17 reworded
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Before we account for a change, we must consider all terms and Modifications may be
conditions to be sure that the change is enforceable. Modifications accounted for as:
that are not considered enforceable are ignored.
1 an extra separate contract
2 a termination of the old and
Depending on the circumstances, if the extra goods or creation of a new contract
services are considered to be distinct from the original goods
3 part of the existing contract.
or services, the modification is either accounted for: See IFRS 15.20 & 21
x as an additional separate contract; or
x as a termination of the old contract and the creation of a new contract. IFRS 15.20 & .21 (a)
If the extra goods or services are not distinct, the modification will be accounted for:
x as part of the existing contract. IFRS 15.21 (b)
The modification is accounted for as a separate contract if the following criteria are met:
x the scope increases due to extra goods or services that are distinct; and
x the contract price increases by an amount that reflects the ‘stand-alone selling prices’ of
these extra goods or services. See IFRS 15.20
The contract price does not need to increase by an amount representing the usual stand-alone selling
prices for these extra goods or services. For example, if a contract is modified to include extra goods
or services the contract price is generally increased. It may be increased by an amount that is less
than the related stand-alone selling prices for these extra goods or services (i.e. the contract price is
increased by ‘discounted stand-alone selling prices’). This is often because the entity may not need to
incur additional costs it would have incurred to secure another customer (e.g. selling costs that are
now avoidable etc). See IFRS 15.20(b)
If the modification does not meet the criteria to be accounted for as a separate contract
(see section 5.7.3), then it would be accounted for as if it were a termination of the old contract
and a creation of a completely new revised contract if, on date of modification:
x the remaining goods or services still to be transferred are distinct from
x the goods or services already transferred. See IFRS 15.21 (a)
The amount of the consideration to be allocated to this deemed new contract is the total of:
x the portion of the original transaction price that has not yet been recognised as revenue;
x plus: the extra consideration promised as a result of the modification. See IFRS 15.21 (a)
5.7.5 Modification accounted for as part of the existing contract (IFRS 15.21(b))
If the modification does not meet the criteria to be accounted for as a separate contract
(see section 5.7.3), then it would be accounted for as an adjustment to the existing contract, if
on date of modification:
x the remaining goods or services still to be transferred are not distinct from
x the goods or services already transferred. See IFRS 15.21 (a)
Accounting for the modification as if it were an adjustment to the original contract means:
x Adding the extra consideration from the modification to the original transaction price;
x Adding the extra obligation/s from the modification to the original performance obligations that
are still unsatisfied.
Since our total obligation has changed and the total transaction price has changed, we must
reassess our estimated progress towards completion of the performance obligation and make an
adjustment to the revenue recognised to date. This method of adjusting revenue is referred to as
the cumulative catch-up method and is accounted for as a change in estimate (in terms of IAS 8,
see chapter 26).
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This definition of a performance obligation refers only to goods or services that are distinct (what
makes something distinct is explained in section 6.4). Goods or services that are indistinct will
need to be bundled together until we find ourselves with a distinct bundle, which will thus
represent a single performance obligation (this is explained in section 6.5).
Where the promise involves providing a series of goods or services (i.e. defined as being goods or
services delivered consecutively rather than concurrently; e.g. a contract that promises to mow the
lawn every week for 2 years), the series will be considered distinct if the goods or services in the
series are largely the same and have the same pattern of transfer. This is defined below:
Goods or services within a series have the same pattern of transfer if:
x the obligation to transfer each good or service in the series:
- will be satisfied over time; and
x the progress towards completion of the transfer of each good or service in the series will be:
- assessed using the same measurement method. IFRS 15.23 reworded
Not all activities necessary to complete a contract are activities necessary to complete a performance
obligation. In other words, activities that are necessary in terms of the contract but yet do not result in
the actual transfer of goods or services to the customer, would not be part of the performance
obligation (e.g. initial administrative tasks necessary in setting up a contract). See IFRS 15.25
6.2 Revenue is recognised when performance obligations are satisfied (IFRS 15.31)
It is important to identify each performance obligation (promise) contained in a customer
contract because we will be recognising the related revenue when these performance
obligations are satisfied. Some of these performance obligations will be satisfied at a single
point in time and others may be satisfied gradually over time.
It is important to note that IFRS 15 only considers implicit promises that resulted in valid
expectations arising at contract inception. Any implied promises that arise after inception are not
accounted for as performance obligations under IFRS 15. Instead, any further implied promises
would need to be accounted for in terms of IAS 37 Provisions, contingent liabilities and
contingent assets.
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The definition of a performance obligation refers to the transfer of goods or services (or a bundle
thereof) that is distinct. A good or service transferred to a customer is distinct if it is both
capable of being distinct and is distinct in the context of the contract.
This means it must be able to generate economic benefits for the customer either:
- on its own; or
- together with other resources that are readily available to the customer; and
This means that the promise to transfer the good or service is:
- separately identifiable from other promises in the contract. IFRS 15.27 reworded slightly
6.4.2 The goods or services must be capable of being distinct (IFRS 15.28)
For a good or service to be capable of being distinct, the customer must be able to benefit from it
(i.e. the customer must be able to obtain economic benefits from it). Goods or services are
considered capable of generating economic benefits for the customer in any number of ways, for
example, by the customer being able to use or consume the goods or services or being able to
sell them for a price greater than scrap value.
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We consider the goods or services capable of generating economic benefits for the customer even
if these benefits will only be possible in conjunction with other readily available resources (i.e. with
other readily available goods or services). It is worth emphasising that the customer need not
already own these other necessary resources – they need only to be resources that are readily
available. These other resources (i.e. other goods or services) would be considered readily
available if they are sold separately by the entity (or any other entity).
We could also deem that the promised good or service to be capable of generating economic
benefits for the customer under certain circumstances. An example of such circumstances is if
the entity regularly sells such goods or services separately.
6.4.3 The good or service must be distinct in the context of the contract (IFRS 15.29)
For a good or service to be distinct in the context of the contract means that the promise to
transfer it must be separately identifiable from other promises made in the contract. We look at
whether the nature of the promise was to transfer individual goods/ services or a combined item
to which the individual goods and services were just inputs.
The following are examples of goods or services promised in terms of a contract which would not
be considered separable and would thus not be distinct in the context of a contract. Goods or
services where:
x There is a significant service of integration: if the entity is using the good or service as an
input to create some other promised item for the customer within the same contract, then that
good or service being used is considered to be part of this other promised item (i.e. it is
merely an input to create an output).
For example, a construction company that signs a contract agreeing to construct a building
for a customer may include a ‘contract management’ service (a service involving a contract
manager whose task it will be to ensure that all aspects of the construction will comply with all
contract specifications and thus the ‘construction’ and ‘management’ are one PO.
x There is a significant modification/ customisation: if the entity is using a good or service as an
input to significantly modify or customise another good or service promised within the same
contract, then that good or service being used as an input is considered to be part of the output,
being the customised good or service (i.e. it is merely an input to modify an output).
For example, a software company sells standard software to a customer but since this software
will need significant modification in order to run on the customer’s server, the software company
also agrees to modify this software. In this case, the modification service is simply an input to
modify the output (the software) and thus the ‘software’ plus ‘modification’ is one PO.
x There is a high level of interdependence/ interrelatedness: if a good or service is highly
dependent on another good or service promised within the same contract (e.g. if it is not
possible for the customer to buy the one without the other), they may be so interdependent
that they cannot be considered separately identifiable from one another.
For example, an entity promises to create an experimental design from which it will then
manufacture 10 prototypes that will need constant re-work, after which a final workable
design will be manufactured. The ‘design’ and ‘manufacture’ performance obligations are
considered highly interdependent and are thus one PO. See IFRS 15.29 and BC107-BC112
Obviously, this process of bundling indistinct goods or services until we find ourselves with a
distinct bundle (i.e. a performance obligation) may result in all the promises contained in the
contract being considered to be a single performance obligation.
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7.1 Overview
The transaction price is
defined as:
The transaction price is not necessarily the total price quoted
in a contract. In other words, the contract price does not x the amount of consideration
necessarily equal the transaction price. x to which an entity expects to be
entitled
Instead, the transaction price is the amount of consideration to x in exchange for transferring
goods/ services to a customer,
which the entity expects to be entitled for satisfying the
x excluding amounts collected on
performance obligations contained in the contract. behalf of third parties.
IFRS 15.App A (reworded slightly)
When determining this transaction price, we look only at the existing contract. In other words, we
must ignore, for example, any renewals of the contract or modifications to the contract that may
possibly be expected. See IFRS 15.49
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The loss allowance relating to receivables and contract assets: covered by IFRS 9 (see chapter 21).
IFRS 9 requires us to recognise a loss allowance, measured using an ‘expected credit loss model’.
This is a forward-looking model that requires us to estimate and recognise credit losses before they occur (i.e.
before a ‘credit event’).
Please note: This differs from the previous old approach where we used to recognise doubtful debts (debit
‘doubtful debt expense’, credit ‘doubtful debt allowance’) only when evidence existed that the debtor was going
bad (i.e. when a ‘credit event’ had already occurred). This approach is now outdated.
See chapter 21, section 4.5 and example 15-16 for more detail.
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Please note that, if we entered into a contract knowing that a part of it may not be collectable, it
may be evidence of an implied price concession, which is taken into account when determining
the transaction price (see example 8).
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When determining the transaction price, we also need to consider a number of other factors:
a) Whether the contract includes any variable consideration:
b) Whether the contract includes a significant financing component
c) Whether the contract includes non-cash consideration
d) Whether the contract includes consideration payable to the customer.
Each of these issues will now be discussed in more detail in sections 7.2 to 7.5.
The total contract consideration could be fixed, variable or a combination thereof. Since the transaction
price must reflect the amount of consideration to which the entity expects to be entitled, all
consideration is considered for inclusion in the transaction price whether it is fixed or variable.
When dealing with fixed consideration, we simply have to estimate how much of it the entity
expects to be entitled to. However, when dealing with variable consideration, there are two
estimates: we first estimate the amount of the variable
Variable consideration
consideration and then estimate how much of this the entity is included in the
expects to be entitled to. transaction price
measured by:
Since variable consideration involves significant estimation, there x estimating the amount to which
is an increased risk that we might overstate revenue. In order to the entity believes it will be
avoid this, we are further required to constrain (limit) our estimate entitled; and
of the variable consideration. x constraining (limiting) the
estimate to an amount that has a
Thus, we will need to decide how much of this variable high probability of there being
consideration to include in the transaction price by: no significant reversal of
x estimating the amount to which we think we will be revenue in the future.
entitled; and then
x constraining (i.e. limiting) this estimate to the amount that has a high probability of not
resulting in a significant reversal of revenue in the future.
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Variable discounts (e.g. the amount of C5 000 in the above example), are accounted for by reducing
the revenue recognised. However, we do not reduce the specific customer’s receivables account with
this discount until the customer successfully qualifies for the discount. Hence, a settlement discount
allowance account (a ‘negative asset’; being an asset account with a credit balance) is created as an
interim measure until the entity knows if the customer will qualify for the discount.
x In so doing, the statement of account sent to the customer will show the full balance owing,
but the statement of financial position will reflect a net receivables balance (receivables
account – settlement discount allowance account).
x If the customer does not pay in time to qualify for the discount, the settlement discount
allowance account is reversed and recognised as revenue.
There are two methods that are available for estimating the variable consideration:
x the ‘expected value’ method; and
x the single ‘most likely amount’ method.
Which method to use is not a free choice: we must choose the method that is expected to be the
best predictor of the consideration to which the entity will be entitled. IFRS 15 states that:
x The ‘expected value method’ is probably ideal for situations where there are many similar
contracts on which to base the estimates of the possible outcomes; whereas
x The ‘most likely amount’ method would probably be best suited to a contract wherein there
are only two possible outcomes. See IFRS 15.53
The expected value method entails: The most-likely amount method entails:
x identifying the various possible x identifying the various possible amounts
amounts of consideration; of consideration; and
x multiplying each of these by its x selecting the single amount that is that
relative probability of occurring; and contract’s most likely outcome.
x adding together each ‘probability-
See IFRS 15.53 (a) See IFRS 15.53 (b)
weighted amount’.
When using the ‘expected value’ method, although we are required to consider all ‘historical,
current and forecast’ information that is reasonably available to us, we are not required to
include in the calculation each and every consideration amount that is possible. Instead, we
need only include a ‘reasonable number’ of possible consideration amounts.
For example,
If we estimate that there may be anything up to 100 or so different amounts possible, we do not need
to calculate and assess the probability of each and every one of these possibilities when calculating
our expected value, but may base our expected value calculation on just a selection of possible
amounts that we feel will give us a reasonable estimate of the outcome (i.e. ‘a reasonable estimate of
the distribution of possible outcomes’ IFRS 15.BC201). So if, for example, 80 of the 100 outcomes are
considered to be highly unlikely, we could base our expected value calculation on only the remaining
20 outcomes that we feel are more likely to occur – or we could base our calculation on only those
outcomes we feel are most likely to occur. The decision as to what is considered a ‘reasonable
number’ of possible outcomes will need our professional judgement.
Once we decide which method to use when estimating the variable consideration, we must apply
it consistently throughout the period of the contract. However, a contract may include different
types of variable consideration, in which case different methods may be used to estimate each
of these different types. See IFRS 15.BC202
At the end of each reporting period, we must reassess the estimates of variable consideration
and if necessary, account for a change in the estimated transaction price. See IFRS 15.59
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c) Assuming the constraint was not a limiting factor, the estimated transaction price would be C258 500
(fixed consideration: C100 000 + variable consideration: C158 500).
Example 11: Estimating variable consideration – the two methods of estimation
Estimating when the distribution is discontinuous (i.e. the
distribution includes a limited number of ‘discrete amounts’)
This example uses the same information given in the previous example, except that the performance
bonuses are not simply anything between C0 to C300 000, but instead are discrete amounts as follows:
Performance bonus: If number of plays presented is
C between:
0 0 – 24
100 000 25 – 48
200 000 49 – 60
300 000 61 – or more
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b) Using the ‘most likely amount’ method, the estimated variable consideration is C200 000. This is
because C200 000 reflected the highest probability of occurring (35%). However, this estimate of
C200 000 is before considering the required ‘constraining of the estimate’.
c) We cannot yet calculate the transaction price because, although we have the fixed consideration and
have an estimated variable consideration, this estimated variable consideration is not yet final since
we have not yet applied the principle of constraining the estimate.
The process of
7.2.4 Constraining the estimate (IFRS 15.56) constraining the
estimated variable
When calculating the amount of estimated variable consideration consideration:
to include in the transaction price, we may be faced with The transaction price may only
include the estimated variable
significant uncertainties. consideration to the extent that:
x ‘it is highly probable
These uncertainties increase the risk that we may misinterpret x that a significant reversal
something, and a misinterpretation may result in revenue being x in the amount of cumulative
overstated or understated. Since the revenue line-item is critical revenue recognised
to many users of financial statements, we must be sure that our x will not occur
estimates are as robust as possible. Furthermore, when dealing x when the uncertainty associated
with revenue, the risk of overstatement is a particular concern. with the variable consideration is
subsequently resolved’.
IFRS 15.56
Thus, in order to limit volatility in our revenue estimates, and also
to avoid significant overstatement of our revenue, we apply the principle of including only that portion
of the estimated variable consideration that we believe has a ‘high probability’ of not resulting in a
‘significant reversal’ in the future of the ‘cumulative revenue recognised’ to date. See IFRS 15.56
In other words, we only recognise variable consideration to the extent that we can reliably
measure it without there being a high probability of an excessive reduction in our estimated
revenue in the future.
Applying this principle is referred to as the process of constraining (limiting) the estimate.
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x the entity is unable to reasonably predict the variable consideration because, although it has
had experience with other similar contracts, the various outcomes have been so varied that
they have not provided a pattern on which predictions may be made (i.e. the experience
does not provide predictive value);
x the contract has a large number of outcomes and these outcomes represent a broad range
of possible consideration amounts. See IFRS 15.57
The entity has estimated that the amount of the variable consideration that is highly probable of not
resulting in any future reversal of revenue is C80 000 but the accountant is unsure whether this means that
going ahead and recognising the variable consideration of C90 000 would mean that the potential reversal
of C10 000 would be considered significant in terms of IFRS 15.
The accountant has determined that, when the entity finally knows the amount of variable consideration
that it will receive, the entity will have already recognised revenue to the extent of 10% of the fixed
consideration and 100% of the estimated variable consideration.
The entity considers amounts equal to or greater than 7% of revenue from this contract to be significant.
Required: Explain whether the estimated variable consideration should be constrained and calculate the
estimated transaction price.
Constraining estimated variable consideration differs from one situation to another. Let us now look
again at a prior example (example 11) in which we estimated the variable consideration but
stopped short of constraining the estimate. Notice that, in this example, the method of estimating
variable consideration where it involves a range of outcomes that is discontinuous (i.e. the range is
constituted by a specific number of distinct amounts rather than a continuous range of possibilities)
will also have an impact on how the estimate is constrained.
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b) Using the ‘most likely amount’ method, the estimated variable consideration is C200 000. This is
because C200 000 is the outcome that has the highest probability of occurring (35%). However, this
estimate of C200 000 is before considering the required ‘constraining of the estimate’.
When constraining the estimate, we must limit the estimated variable consideration to an amount that
is highly probable of not resulting in a significant reversal of revenue in future.
To include variable consideration of C200 000 in the transaction price, we must believe that it is highly
probable that this amount will not result in a significant reversal in the future. However, when we look
at the probabilities, we can see that, given that this would require us to present 49 or more plays, there
is actually only a 40% chance (5% + 35%) of achieving a bonus of C200 000. This means that there is
a high probability (60%) of a significant reversal of revenue in the future. In contrast, there is a 70%
chance (5% + 35% + 30%) of achieving the next best bonus of C100 000. Thus, recognising as
revenue the estimate of C200 000, while being aware that, currently, the highly probable bonus is
C100 000, means that we would be facing a highly probable reversal of C100 000 (C200 000 –
C100 000).
Thus, the estimate of C200 000 (based on the ‘most likely amount’) must be constrained to C100 000
since it is highly probable the latter will be received and thus it is highly probable that there will not be a
significant reversal of revenue.
The total estimated consideration will thus be C200 000 (fixed consideration: C100 000 + variable
consideration: C100 000).
Note: this solution assumes that the potential reversal of C100 000 is considered to be significant in
relation to the total potential consideration recognised of C300 000 (fixed consideration: C100 000 +
variable consideration: C200 000).
Until such time as the uncertainty resolves itself (i.e. and the variable consideration becomes
fixed), if our customer happens to pay us more than the variable consideration that we have
included in the transaction price (i.e. more than we are currently prepared to recognise as
revenue), this excess must be recognised as a refund liability.
This refund liability represents our obligation to refund this excess amount received if our
estimates are proved correct.
We do not have to have received any consideration before we recognise a refund liability. It is
possible, for instance, to be owed an amount before we are prepared to recognise it as revenue.
For example, a contract could require a customer to pay the entity part of the consideration as a
deposit (say C10 000), part of which may be refunded depending on future events. Assuming
the deposit owed by the customer (variable consideration), is constrained to nil (i.e. on the
expectation that the full C10 000 will be refunded), the entity would recognise a receivable of
C10 000 and a refund liability of C10 000.
Refund liabilities can also arise in relation to the sale of goods that are sold with the ‘right of
return’. How to account for goods that are sold with the ‘right of return’ are explained in detail in
section 7.2.6.3.
Please note, however, that refund liabilities only reflect obligations to refund the customer – they
do not include obligations under warranties. Warranties are explained in section 11.
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7.2.6.1 Overview
There are many different types of transactions that involve the issue of variable consideration.
However, it may be helpful if we look at a few specific and fairly common transactions:
x contracts involving a volume rebate;
x contracts involving a sale with a right to return; and
x contracts involving royalties earned from licensed intellectual property that are calculated
based on either sales or usage.
7.2.6.2 Contracts involving a volume rebate (IFRS 15.51 & .55 & B20 – B27)
When a contract includes the offer of a reduced price (e.g. a volume rebate) based on, for
example, a threshold sales volume, we need to take this into consideration when determining
the transaction price. This is variable consideration because we do not know whether the
threshold will be reached. We thus estimate the transaction price based on the amount to which
we expect to be entitled and ensure that this estimate is constrained where necessary.
Any portion of the contract price that is not included in the transaction price and will not be
recognised as revenue will thus be recognised as a refund liability.
This refund liability will need to be reassessed at each reporting date and any adjustments will
be accounted for in revenue.
The entity offers a volume rebate of 10% off the contracted price if a customer purchases more than 2 000
racquets before 31 December of a year. This rebate is offered retrospectively.
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At the time of the sale, it was expected that this customer would qualify for the rebate. However, by 31 December,
the customer had not purchased any further racquets due to being forced to close a number of shops.
7.2.6.3 Contracts involving a sale with a right of return (IFRS 15.51 & .55 & B20 – B27)
A sale of goods with a right of return occurs when our customer A sale with the right of
return involves variable
has the right to return the goods to us. This means it involves consideration:
variable consideration because we can’t be certain how much
x consideration for the products we
of the consideration we will get to keep and how much we may expect will be returned is not
have to refund in the event the goods are returned. included in the TP (i.e. it must be
recognised as a refund liability –
When accounting for a right to return, we only consider the not revenue);
possible return of goods that would have commercial x consideration for the products
substance. In other words, a sale of goods to a customer who that we expect won’t be returned
may exchange goods purchased for a different size or colour is included in the TP (i.e. it will be
recognised as revenue) – we must
is not a right of return that would be accounted for because estimate this variable
this exchange would have no effect on our net assets or profit consideration & constrain it with
(i.e. no adjustment is made for these exchanges). reference to the expected returns.
The ability to return defective goods is not a ‘sale with a right A sale with the right of
of return’. Instead, a return of defective goods is accounted for return does not refer to:
as a ‘return under warranty’ (see section 11.2). x exchanges that have no commercial
substance (changing a shirt for a
If we sell an item to a customer and, at the same time, we offer different colour/ size);
the customer a right to return it, we must exclude the x A return of defective goods (these
consideration for these items from the transaction price if the are returns under warranty).
entity expects them to be returned. This should make sense
The refund resulting from
because, if you recall, the transaction price is the amount of a return need not be in full
consideration to which the entity expects to be entitled. Thus, if or be in the form of cash:
an entity expects that certain goods may be returned, it would not x it could be a full or partial refund
expect to be entitled to the consideration for these goods. Since x a refund could come in the form
the consideration for these goods is thus excluded from the of cash or credits that the
transaction price, it means it cannot be recognised as revenue customer could use or as an
and would thus be recognised as a refund liability instead. entirely different product. .
The remaining promised consideration (i.e. the consideration to which the entity expects to be
entitled – or, in other words, the consideration for the goods or services that the entity does not
expect to be returned), is variable consideration since we cannot be certain as to what will or will
not be returned. Thus, for the purpose of including it in the transaction price (and ultimately in
revenue), we estimate how much of the consideration is variable and then constrain this
estimate, based on the products that we expect will be returned. This constrained variable
consideration (i.e. reflecting the sale of goods that we do not expect will be returned) is included
in the transaction price and will thus be recognised as revenue.
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In addition to splitting the contract price between what will be included in the transaction price
(revenue) and what will be excluded from the transaction price (refund liability), we must also
recognise an asset that reflects the right to recover the goods that the customers must physically
return in exchange for the refund.
This right to recover goods (an asset) is measured in the same way that we measure the amount
that would be expensed if it was sold (i.e. cost of sales expense, in the case of inventory sold).
However, this measurement must then be adjusted for any costs that the entity expects it will have to
incur in recovering these goods. These adjustments would also include any decreases in the value of
the goods, (e.g. due to the fact that they are no longer new or are missing their packaging).
At each reporting period, we would then have to reassess our estimation of the:
x refund liability – any adjustment will be recognised in revenue; and
x refund asset (right to recover the goods) – any adjustment will be recognised in cost of sales expense.
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The transaction price, which is estimated at contract inception, must be re-estimated at every
reporting date to reflect the circumstances at this date and the change in circumstances during
the reporting period.
Any change in the transaction price must be allocated to performance obligations on the same
basis that the original transaction price was allocated at contract inception. If one or more of
these performance obligations have already been satisfied, the related revenue from this
performance obligation will have already been recognised. Thus, if the transaction price
increases (or decreases), the portion of the increase (or decrease) that relates to this satisfied
performance obligation will be recognised as an increase (or decrease) in revenue.
An entity may sign a contract with a customer wherein the entity will earn royalties from allowing
the customer to use certain licensed intellectual property. The promised consideration may be
calculated in many ways but if it is calculated based on how many items under licence the
customer sells or uses, the promised consideration is clearly variable consideration (because we
won’t know how many items the customer will sell or use).
However, although it is variable consideration, we would not apply the usual principle of
estimating the variable consideration and then constraining this estimate. Instead, royalty
consideration from licensed intellectual property that is calculated based on sales or usage will
only be recognised as revenue when the customer sells or uses the items under licence. Thus,
at this point, there would be no variability to account for.
The related interest is then recognised separately using an appropriate discount rate over the
period of the financing using the effective interest rate method in terms of IFRS 9 Financial
instruments. See IFRS 15.IE140
The reason why we need to separate the effects of financing is because the economic
characteristics of a transaction that involves providing goods or services and a transaction that
involves financing are different. See IFRS 15.BC246
The fact that financing is being provided need not be explicitly stated in the contract – it can
simply be implied by the payment terms. This means that, whether or not the contract states that
it includes an element of financing, a financing component is deemed to exist if the timing of the
payment differs from the timing of the transfer of the good/ service. See IFRS 15.60
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We also need to realise that it could be either the entity or the customer providing financing:
x If the customer pays in advance (i.e. before he receives control over the goods or services), then
the customer is providing finance and
the entity is receiving the benefit of the financing.
Thus, the entity may need to recognise a finance expense. See IFRS 15.62
x If the customer pays in arrears (i.e. after he receives control over the goods or services), then
the entity is providing finance and
the customer is receiving the benefit of the financing.
Thus, the entity may need to recognise finance income (in terms of IFRS 9 - not IFRS 15).
For practical purposes (referred to as a practical expedient), IFRS 15 allows us to ignore the time
value of money if, at inception of the contract, this financing component is not considered
significant to the contract as a whole, and the period between the customer obtaining control and
the receipt of the consideration is expected to be 12 months or less. See IFRS 15.63
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x The interest rate implied by the payment terms was given as 10% but could have been calculated
using your calculator (FV C121 000; PV C100 000; Period 2 years). In this situation, the implicit
interest rate was considered an appropriate discount rate to use in the calculation of the interest.
x The interest is recognised on this liability over the 2 years that financing is provided, using the effective
interest rate method.
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x The difference in the timing is more than one year (it is 2 years) and the benefit from the financing is
significant (we are told to assume this). Since both criteria are met, we must adjust the transaction
price for the existence of the financing.
x Although the promised consideration is C484, we must separate out the financing component from the
transfer of goods and services and measure the related transaction price at the notional cash selling
price of C400 and account for this in terms of the five-step approach in IFRS 15.
x The financing component of C84 (promised consideration: C484 – transaction price: C400) is
measured over the period of the financing using the effective interest rate method in IFRS 9.
x In this case, the entity is providing finance and thus earns interest. The interest earned is credited to
‘interest income’’. When presenting the SOCI, the effects of the financing component must be
presented separately from the revenue from contracts with customers. If earning this interest was
considered part of the entity’s ordinary activities, then the interest would be recognised as interest
revenue (instead of interest income), but it would still be presented separately from the revenue from
customer contracts.
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Normally, if there is a significant difference between the amount of the promised consideration and
the cash selling price and the period between the date of payment and the date of transfer of the
goods or services is more than one year, a significant financing component is said to exist and we
must remove the effects of the financing when calculating the transaction price. However, a
significant financing component will be deemed not to exist in some situations. In each of these
situations, the reason for deeming that a significant financing component does not exist is because
the primary purpose of the payment terms in these situations is not to provide financing. In other
words, the payment terms are for a reason other than financing:
a) A significant financing component would not be considered to exist if the transfer of goods or
services is delayed at the customer’s request (i.e. the customer has paid in advance but has
requested/ chosen to delay the transfer of goods).
Examples of this situation include sales on a bill and hold basis, prepaid electricity and the
sale of customer loyalty points.
b) A significant financing component would not be considered to exist if a ‘substantial amount’
of the promised consideration is variable and this variability (of the amount of the payments
or timing thereof) is dependent on future events over which neither the customer nor the
entity has control.
Examples of this situation include royalty contracts where, for example, the contractual terms
may allow a delay in the payment of the promised consideration, the purpose of which is
merely to provide the parties with the necessary comfort where significant uncertainty exists
as to the value of the royalty.
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c) A significant financing component would not be considered to exist if ‘the difference between
the promised consideration and the cash selling price’ is to satisfy a purpose other than
financing.
Examples of this situation include a customer paying in arrears in order to ensure successful
completion of a project or a customer paying in advance in order to secure goods that are in
limited supply. See IFRS 15.62 & .BC233
The discount rate that we should use is the rate that the entity
and the customer would have agreed upon if they had entered The discount rate to
use is:
into a separate financing agreement on inception of the
contract. This discount rate is based on the relevant x the rate the entity & customer
circumstances on the date of inception of the contracts and would have agreed upon
must not be updated for any changes in circumstances. x if they had entered into a
separate financing agreement on
date of contract inception.
This discount rate takes into account the credit risk of the See IFRS 15.64
In other words, when deciding on an appropriate discount rate, we would not use a market-
related interest rate, a risk-free interest rate or the interest rate in the contract (whether it is
explicitly stated or whether it is the implicit rate) unless it reflects the interest rate that the entity
and the customer would have agreed upon had they entered into a separate financing
agreement at contract inception.
After contract inception the discount rate may not be changed under any circumstances (e.g. interest
rates change or there is an increase or decrease in the customer’s credit risk). See IFRS 15.64
Blue Limited signed a contract with a customer on 1 January 20X1 to transfer goods to the customer
(transfer takes place on 31 December 20X2) in exchange for consideration of:
x C100 000, if paid on 1 January 20X1, or
x C121 000, if paid on 31 December 20X2.
The payment terms are considered to constitute a significant financing component in terms of IFRS 15.
The implicit interest rate in the contract is 10% but the rate that the customer and entity would have agreed
to had they entered into a separate financing agreement on date of contract inception is 8%.
Required: Prepare all related journals for Blue Limited, using its general journal.
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7.3.5 How do we present interest from the significant financing component? (IFRS 15.65)
7.4.1 Overview
Non-cash consideration
If the contract price includes non-cash consideration, this will
need to be included in the transaction price – unless the entity x is included in the TP if the entity
does not obtain control over the non-cash items. This non- gets control of the non-cash items,
cash consideration should be measured at its fair value (per x is measured at its FV.
See IFRS 15.66
IFRS 13) assuming this is able to be reasonably estimated. If
a reasonable estimate is not possible, it is measured based on the stand-alone prices of the
goods or services to be transferred to the customer (i.e. it is measured on the basis of the goods
or services given up).
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A contract price may include non-cash consideration. Non-cash consideration arises in contracts that
require customers to pay the promised consideration, either partly or entirely, using something other
than cash. For example, the customer could be required to pay the consideration by providing the
entity with services or with some other non-cash item (e.g. a vehicle).
If the entity obtains control over these non-cash items, they are considered to be non-cash
consideration and must be included in the transaction price. If the entity does not obtain control
over these non-cash items (e.g. goods or services), these non-cash items are not considered to
be non-cash consideration and are thus not included in the transaction price.
For example, if the customer provides the entity with a machine to be used by the entity in
completing its obligations but over which the entity does not obtain control, then the transaction
price must not include the value of the machine because the machine is not considered to be
‘non-cash consideration’. Conversely, if the customer provides the entity with a machine to be
used by the entity in completing its obligations, and the entity obtains control over this asset,
then the machine is considered to be ‘non-cash consideration’ and thus the transaction price
must include the value of the machine.
When including non-cash consideration in the transaction price, we measure it at its fair value.
However, if a reasonable estimate of the fair value is not possible, we measure it indirectly
based on the stand-alone selling prices of the goods or services transferred (i.e. the goods or
services given up).
When trying to estimate the fair value of the non-cash consideration, we may find that the fair
value is variable. There are two reasons why the fair value could vary:
x it could vary due to the form of the consideration (e.g. if the non-cash consideration is a
share that the customer will give to the entity, the price of which changes daily on the stock
exchange, it may be difficult to estimate what this fair value will be); or
x it could vary due to reasons other than form (e.g. uncertainties regarding the future and thus
what or how much non-cash consideration will be received, if any).
If the variability of the fair value is due to reasons other than the form of the non-cash
consideration (e.g. it is due to uncertainty regarding whether or not it will be received), then we
must measure the non-cash consideration as variable consideration. Thus, we will need to
ensure that the estimate of its fair value is constrained (i.e. limited) to an amount that has a high
probability of not resulting in a significant revenue reversal in the future. See IFRS 15.BC252
Once the non-cash consideration is recognised as having been received, it is accounted for in
terms of the IFRS that is relevant to that item. For example, if we receive an asset that we intend
to use in our business, we would account for that asset in terms of IAS 16 Property, plant and
equipment, whereas if we receive an asset that we intend to sell as part of our normal activities,
then we would account for it in terms of IAS 2 Inventory.
Once the fair value of the non-cash consideration has been recognised, changes to that fair
value are not recognised within revenue. See IFRS 15.IE158
Required: Briefly explain what Yellow’s transaction price would be in the following instances:
a) The contract requires Yellow to provide services to Mauve over a period of 3 months and requires
Mauve to pay C100 000 in cash and to provide a machine that Yellow will use in the performance of
the services. Yellow will return the machine at the end of the contract. The fair value of the machine is
C50 000.
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b) The contract requires Yellow to transfer goods to the customer on 1 January 20X1 and requires Mauve
to pay C100 000 in cash and to issue Yellow with 1 000 shares in Mauve on 30 June 20X1, the date on
which Mauve will be issuing these shares. The fair value of these shares could be anything between
C40 and C60 per share on date of issue, but is expected to be C50 per share. The cash selling price of
the goods being transferred is C160 000.
The transaction price is thus C100 000 (i.e. the cash consideration only).
b) Yellow will obtain control over the shares and thus the contract is said to include both cash
consideration (C100 000) and non-cash consideration (shares).
We are not sure what the fair value of the shares will be. However, the variability of the fair value is
due entirely to the form of the non-cash consideration and thus it is not considered to be ‘variable
consideration’ for purposes of IFRS 15. In other words, when measuring the fair value of the shares,
we do not apply the requirements for measuring variable consideration (we do not need to estimate it
using one of the two methods and then constrain this estimate).
x If the estimate of C50 per share is a reliable estimate, then the transaction price will be C150 000
(cash consideration: C100 000 + non-cash consideration: C50 x 1000 shares).
x If the estimate of C50 per share is not a reliable estimate, then non-cash consideration will be
measured indirectly based on the stand-alone prices of the goods transferred.
The transaction price is thus C160 000 (the stand-alone selling price of the goods transferred).
The non-cash consideration is measured indirectly using this stand-alone price, (i.e. we balance
back to the non-cash consideration):
Since part of the consideration is cash of C100 000, the non-cash consideration is measured at
C60 000 (total consideration: C160 000 – cash: C100 000).
Note:
x If the actual fair value per share is, for example, C70 on the date that we receive the shares, the
increase of C20 in the share’s fair value (C70 – C50) is recognised as an adjustment to revenue.
x In other words, revenue recognised will be C170 000 (cash consideration: C100 000 + non-cash
consideration C70 x 1 000 shares).
x Any subsequent changes to the fair value of the shares will be recognised in terms of
IFRS 9 Financial instruments and not as an adjustment to revenue.
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This can happen where, for example, our customer requires the construction of a store-room (cost
C20 000) in order to house the goods he is buying from us. Since we do not obtain control of the store-
room, we are not effectively acquiring control of a distinct good or service.
If the consideration payable is for the transfer of distinct goods or services, this must simply be
recognised as a separate transaction and would not affect the transaction price.
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Debit Credit
Inventory (A) Given 20 000
Bank 20 000
Recognising payment to customer
Receivable (A) 100 000 x 40% 40 000
Revenue from customer contracts (I) 100 000 x 40% 40 000
Recognising 40% of the receivable and 40% of the revenue
based on the unadjusted transaction price
If the consideration payable is for a distinct good or service but the fair value thereof is not able
to be reasonably estimated, then the entire consideration payable to the customer is accounted
for as a reduction in the transaction price. Similarly, if the consideration payable is for a distinct
good or service but the consideration payable exceeds the fair value thereof, then the excess
will be accounted for as a reduction of the transaction price.
The consideration payable does not need to be in the form of cash – it could for example be in
the form of coupons. Similarly, the consideration need not be payable to the customer – it could
be payable to the customer’s customers.
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In this case, the consideration payable is in the form of coupons that the customer’s customers can
utilise when purchasing shampoo from the customer (i.e. the retailer). However, the retailer may then
utilise the coupons to reduce the amount owing to the manufacturer. Thus, when the manufacturer
determines the transaction price, it must deduct the potential consideration payable. Therefore, the
transaction price would be determined at C900 000.
Calculation: Consideration payable by the customer: (100 000 bottles x C10 each) – Consideration payable by the
entity: (100 000 bottles x C1 each).
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We will first discuss the allocation of a transaction price where no discount is involved, then
discuss the allocation of a transaction price that does involve discount and then finally will
discuss the allocation of a transaction price that involves variable consideration.
8.2 Allocating the transaction price based on stand-alone selling prices (IFRS 15.76 - 80)
date of inception of the contract. See IFRS 15.76-.77 The stand-alone selling price is
determined at:
The best evidence of the stand-alone selling price is an x contract inception. See IFRS 15.76
observable price.
The transaction price must be allocated to each performance obligation in the contract based on the stand-
alone selling prices.
Two performance obligations are identified in the contract and the stand-alone selling prices for each
(whether observed or estimated) were given to us. The transaction price is thus allocated as follows:
Stand-alone Allocation of
selling prices transaction price
Supply and installation of plant C180 000 TP: C200 000 x 180 000 / 220 000 C163 636
Maintenance over 2 years C40 000 TP: C200 000 x 40 000 / 220 000 C36 364
C220 000 C200 000
TP: Transaction price
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The standard does not stipulate how we should estimate a stand-alone selling price, but it does
suggest three possible approaches that may be helpful – a combination of which could be used
if necessary (the entity may also use any other approach that it may prefer):
x adjusted market assessment approach: this approach assesses the market and estimates
what the customer might be prepared to pay in this market (e.g. the entity could consider
what others in the market are selling the good or service for and could then make
appropriate adjustments for its own entity-specific costs and required margins);
x expected cost plus margin approach: this approach involves the entity first estimating the
costs it expects to incur in the process of satisfying the PO and then adding its required
margin to get to a suitable selling price;
x residual approach: this approach is suitable when the entity knows the stand-alone selling
prices for some of its goods or services, (i.e. it does not know all of the stand-alone selling
prices), in which case the unknown stand-alone selling price/s is determined as a balancing
amount as follows:
Transaction price - the sum of the observable stand-alone selling prices. See IFRS 15.79
Although the residual approach is suggested as one of the ways in which we could estimate the
stand-alone selling prices, it may only be used if one of the following criteria is met:
a) the entity sells the same goods or services to different customers but for such a broad range
of amounts that the price is considered to be highly variable; or
b) the entity has not previously sold that good or service on a stand-alone basis and has not
yet set a price for it and thus the price is uncertain. See IFRS 15.79 reworded.
Even though the standard does not stipulate how we should estimate stand-alone selling prices,
it does state that, irrespective of what method is used, the method used:
x must result in an allocation that meets the allocation objective (IFRS 15.77 – see pop-up
under the overview) – in other words, the portion of the transaction price that is allocated to
a performance obligation must depict the price to which the entity expects to be entitled for
transferring the related underlying goods or services;
x must consider all the information that is reasonably available to the entity (e.g. factors
relating to the customer, the entity and the market);
x must maximise the use of observable inputs; and
x must be applied consistently to other similar circumstances. See IFRS 15.78
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Since Green has estimated the cost of production for products X and Y and is able to suggest a suitable
margin, the ‘expected cost-plus margin approach’ may be used to estimate these SASPs.
The stand-alone selling prices are as follows:
Stand-alone
selling prices
Product X C100 000 Directly observable price: given
Product Y C110 000 Estimated cost + margin approach:
Estimated costs: C100 000 + required margin: C100 000 x 10%
Product Z C55 000 Estimated cost + margin approach:
Estimated costs: C50 000 + required margin: C50 000 x 10%
C265 000
The transaction price (TP) of C200 000 (which, incidentally, includes an inherent discount of C65 000) must now
be allocated to the POs based on their relative stand-alone selling prices (2 of which were estimated):
Stand-alone Allocation of
selling prices transaction price
Product X C100 000 TP: C200 000 x 100 000 / 265 000 C75 472
Product Y C110 000 TP: C200 000 x 110 000 / 265 000 C83 019
Product Z C55 000 TP: C200 000 x 55 000 / 265 000 C41 509
C265 000 C200 000
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When using the residual approach to estimate the SASP for one of the products, the sum of the SASPs
(C200 000) equals the transaction price (C200 000) and thus no further calculations are necessary.
However, before we accept the resultant allocation of the transaction price based on SASPs, we need to
check that, where we have estimated the SASPs for a PO (i.e. in the case of B and C), the transaction
price allocated to that particular PO meets the allocation objective. The allocation objective is that the price
allocated to the PO reflects the amount to which the entity expects to be entitled for the transfer of the
underlying goods or services.
x In the case of product B, we are told that the normal price is anything between C20 000 and C70 000
and thus the allocation of C45 000, being within this range, is acceptable.
x We are not given a range for product C and thus we assume that the allocation of C55 000 is an
amount to which the entity would expect to be entitled.
Note: If we had been told that the normal price range for product B was anything between, for example,
C50 000 and C70 000 we would not have been able to accept the allocation of C45 000 since it is outside
of the expected range. In this case, we would have to come up with another method of estimating the
stand-alone price for product B (e.g. looking at competitor prices and making appropriate adjustments for
the entity’s own cost structure and expected margins) or we would need to use a different method to
estimate the stand-alone price for product C, such that, when using the residual approach to estimate
product B, it results in an allocation that falls within the expected range.
Comment: This example involves the estimation of one of the stand-alone selling prices using the residual
approach. Note how this approach requires extra care when checking that it meets the allocation objective
(i.e. it is essential we check the reasonableness of this estimate).
It is probably also wise to remind you at this point that we are allocating the transaction price
based on the stand-alone prices that exist at contract inception. It can happen that these stand-
alone prices, whether based on observable prices or based on estimates, may change after
contract inception (e.g. through inflation, annual increases, changes in the market, improved
estimation). However, any changes in the stand-alone selling prices after date of contract
inception will not result in the re-allocation of the transaction price. See IFRS 15.88
8.3.1 Overview
If the transaction price includes a discount (i.e. if the transaction price is net of a discount), the
process of allocating this discounted transaction price to the performance obligations in the
contract based on the relative stand-alone selling prices will mean that we will have
automatically allocated the discount proportionally to each of the performance obligations.
However, we need to be careful here, because there are instances where a discount does not
apply to all the performance obligations in the contract.
To identify whether the promised transfer of goods or services are truly discounted, we simply
calculate the sum of the stand-alone selling prices of these goods or services and compare this
with the consideration promised in the contract: if the promised consideration is less than the
sum of the stand-alone selling prices, we conclude that the consideration is discounted. For
example, if we look at example 24, we see that the sum of the stand-alone prices is C220 000
when the total transaction price in the contract was C200 000. This means that the transaction
price was discounted by C20 000.
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Although no information was provided in example 24 to suggest otherwise, it is possible that this
discount applied only to one of the performance obligations. In this case, the allocation of the
transaction price would have been incorrect. See example 27 for how to allocate a transaction
price when a discount does not apply to all performance obligations in the contract.
The following three criteria must be met before a discount may be allocated to specific
POs:
a) the entity regularly sells each distinct good or service (or each bundle of distinct goods or services) in
the contract on a stand-alone basis;
b) the entity also regularly sells, on a stand-alone basis, a bundle (or bundles) of some of those distinct
goods or services at a discount to the individual stand-alone selling prices of the goods or services in
each bundle; and
c) the discount attributable to each bundle of goods or services described in paragraph 82(b) is
substantially the same as the discount in the contract and
an analysis of the goods or services in each bundle provides observable evidence of the performance
IFRS 15.82
obligation/s to which the entire discount in the contract belongs.
If any of these three criteria are not met, the evidence suggesting that the discount should not be
allocated to all of the performance obligations is not considered to be sufficiently observable.
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x supply of plant C200 000 TP for the bundle: C220 000 x C176 000 24 000
200 000 / (200 000 + 50 000)
x installation of plant C50 000 TP for the bundle: C220 000 x C44 000 6 000
50 000 / (200 000 + 50 000)
Maintenance of plant (3yrs) C80 000 Stand-alone price for the stand- C80 000 0
alone service
C330 000 C300 000 30 000
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In the above example, the discount offered when regularly selling stand-alone bundles was
exactly the same as the discount offered in the contract (C30 000). However, if the discount
regularly offered on a stand-alone basis is substantially the same as the discount offered in the
contract, this full contract discount of C30 000 would still be allocated to the performance
obligations making up that bundle.
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If we decide we need to allocate a discount to only one or some of the performance obligations (i.e. not
to all of them), and we also need to estimate the stand-alone selling prices of one or more of the other
performance obligations using the residual approach, then we must allocate the discount first before we
calculate the estimated stand-alone selling price using the residual approach.
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This variable consideration may apply ‘across the board’ to all the performance obligations in the
contract, in which case there will be no change in how we allocate our transaction price. In other
words, the total transaction price (fixed + variable) will be allocated based on relative stand-
alone prices.
Variable consideration
However, it can happen that the variable consideration applies is allocated to only one/
to only one/some of the performance obligations or may even some of the POs (or to a
apply to only part of a single performance obligation. In this part of a PO) in the contract if:
case, the variable consideration will be allocated to these x the discount is specifically
certain specific performance obligations, but only on condition connected to this PO/s (or to part
that certain criteria are met, and the remaining fixed of a PO) and
consideration would be allocated based on stand-alone selling x both criteria in para 85 are met
prices. (see pop-up below), indicating that
it is appropriate under the
circumstances to allocate it to this
For example: A contract includes the supply of product A (PO 1), specific PO/s (or part thereof) .
the supply of product B (PO 2) and the supply of a service (PO 3). See IFRS 15.85
Where the transaction price includes variable consideration that does not apply to all the
performance obligations, this variable consideration must be separated out from the transaction
price and allocated to the specific performance obligation/s (or parts thereof) to which the
variable consideration relates, but this is done only if both criteria in IFRS 15.85 are met (see
pop-up box below).
If the variable consideration does not meet both these criteria, then it may not be separated out and
allocated to the specific performance obligation/s. In other words, the sum of the ‘fixed consideration’
and the ‘variable consideration that does not meet the criteria in IFRS 15.85’ will be allocated to all
the performance obligations based on their relative stand-alone selling prices.
The following two criteria must be met before variable consideration may be allocated to
specific POs (or to parts of certain POs):
a) the terms of a variable payment relate specifically to either:
x the entity’s efforts to satisfy the performance obligation or transfer the distinct good/ service, or
x a specific outcome from satisfying the performance obligation or transferring the distinct good/
service; and
b) allocating the variable amount of consideration entirely to the performance obligation (or to the distinct
good or service) is consistent with the allocation objective (para 73) when considering all of the
performance obligations and payment terms in the contract (i.e. the result of the allocation must depict the
amount of consideration to which the entity would expect to be entitled in exchange for each promised
transfer). IFRS 15.85 (reworded)
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Note 1: notice that the transaction price including the variable consideration was allocated (200 000 + 10 000).
The following example shows that, even if the variable consideration applies to only certain
specific performance obligations, it may be necessary to allocate the variable consideration to all
the performance obligations. This is done when the allocation to a specific obligation results in
an allocation that is not representative of the consideration that the entity expects to be entitled
to (i.e. if criteria (b) of IFRS 15.85 is not met).
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Supper estimates that it will complete the building in just under two months and thus that C400 000 will be
received. This estimate is what the entity expects to be the most likely amount and it is considered highly
probable that, if it is included in the transaction price, a significant reversal of revenue will not occur in the
future.
The stand-alone selling prices at contract inception for each performance obligation are as follows:
PO 1: Machine C100 000
PO 2: Building C350 000
C450 000
Required:
Briefly explain, together with calculations, how Supper Limited should allocate the transaction price.
The promised consideration contains both fixed consideration (stated in the contract at C20 000 for PO 1)
and variable consideration (the estimated amount to which the entity expects to be entitled is C400 000 for
PO 2).
Although the contract states that the variable consideration relates purely to PO 2, before we may allocate
it entirely to PO 2 we must decide whether or not this would be appropriate by first assessing whether it
meets the two criteria listed in IFRS 15.85:
a) the terms of the variable consideration must relate to either the entity’s efforts to satisfy the PO or to a
specific outcome resulting from the PO; and
b) by allocating the variable consideration to just certain POs (i.e. not all of them), we must be sure the allocation
objective is met for all the POs. (i.e. the portion of the TP allocated to each of the POs must reflect the amount
to which the entity expects to be entitled for the transfer of the related good or service).
a) In this case, the variable consideration depends entirely on the efforts by the entity to meet the
required deadlines. Thus criteria (a) is met.
b) If we allocate the entire variable consideration of C400 000 to PO 2, it means that PO 1 will be
allocated just the fixed consideration of C20 000. However, since the C20 000 is significantly lower
than PO 1’s SASP of C100 000, it is suggested that the allocation objective would not be met. Thus,
criteria (b) would not be met if the variable consideration of C400 000 was allocated entirely to the
building.
Since only one of the criteria are met, the C400 000 cannot be allocated to the building only.
Instead, we must combine the expected variable consideration of C400 000 and the fixed consideration of
C20 000 (C400 000 + C20 000 = C420 000) and then allocate this total consideration of C420 000 in the
usual way (see the calculation overleaf).
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Stand-alone Allocation of
selling prices transaction price
A C100 000 TP: C420 000 x 100 000 / 450 000 C93 333
B C350 000 TP: C420 000 x 350 000 / 450 000 C326 667
C450 000 C420 000
Comment: This example depicts a scenario where, although the contract states that the variable consideration
relates to only one PO, allocating it entirely to that PO is not always appropriate (i.e. it may not always meet the
allocation objective). In this situation, the variable consideration is allocated to all POs.
8.5 Allocating a change in the transaction price to performance obligations (IFRS 15.87 - 90)
It is possible for a transaction price to change after initial recognition. A transaction price could
change for a number of different reasons including, for example, the resolution of previously
uncertain events (e.g. it is possible that some consideration that was previously considered to be
variable consideration is now fixed).
If the transaction price changes, any change must be allocated to the performance obligations
using the same allocation that was used at contract inception (e.g. if we used observable stand-
alone selling prices as the basis for the allocation at contract inception, we would allocate the
increase or decrease in the transaction price using these same observable stand-alone selling
prices – even if these have subsequently changed).
If the transaction price changes after some performance obligations have been satisfied, it would
mean that the revenue for these performance obligations would have already been recognised.
Thus, an increase or decrease in the transaction price allocated to these satisfied performance
obligations is recognised immediately as an adjustment to revenue.
Note: a change in the transaction price (TP) as envisaged in this section is not a contract modification.
x A contract modification entails a change in the scope or the price of a contract, (creating new or
changing existing enforceable rights and obligations).
x In this section, the change in the TP is due to the resolution of a prior uncertainty and thus is not a contract
modification (see section 5.7).
9.1 Overview
Identifying the date on which (or periods over which) we Knowing when a
satisfy our performance obligations (i.e. identifying when we performance obligation
have completed doing what we promised to do) is very is satisfied is important
important because this is the date when (or period in which) because:
we recognise the revenue from that performance obligation. x Revenue can only be recognised
x as/when we have satisfied our
Some obligations will take time to complete (i.e. satisfied over performance obligations.
time) and some will be completed in an instant (i.e. satisfied at See IFRS 15.31
a point in time).
We need to decide, at the inception of a contract, how each of the performance obligations in a
contract will be satisfied (i.e. will it be satisfied over time or in an instant).
To decide this, we have to ascertain if it meets the criteria that would classify it as a performance
obligation satisfied over time. If it does not meet these criteria, then it is classified as a
performance obligation satisfied at a point in time.
If we believe that our performance obligation will be satisfied over time, we will need to decide
how to measure our progress towards complete satisfaction of the performance obligation since
we will have to recognise this revenue gradually over this period of time.
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9.2 How do we assess when a performance obligation has been satisfied? (IFRS 15.31-33)
A performance obligation is considered to be completely satisfied
A performance
when the goods or services have been transferred to the obligation is satisfied
customer. See IFRS 15.31 when:
This transfer of goods or services occurs when the customer has x the goods or services have
transferred
obtained control over the goods or services. See IFRS 15.31
x which is when control has passed.
See IFRS 15.31
We assess whether control has passed to the customer by
referring to our understanding of the control over an asset. Interestingly, the standard clarifies that all
goods – and even services – are considered to be assets, ‘even if only momentarily’. See IFRS 15.33
Control over assets is evidenced by the ability to dictate how the Control over an asset is
asset will be used and the ability to obtain most of its remaining evidenced by the ability
benefits. Control can also be proved by the ability to prevent others to:
from obtaining most of its remaining benefits. x direct how the asset will be used;
and the ability to
Benefits refer to direct or indirect: x obtain substantially all its
x cash inflows; or remaining benefits.
IFRS 15.33 reworded
x reductions in cash outflows.
A customer could obtain these benefits in many different ways, such as by using the goods or
services or selling them onwards or pledging them as security in order to obtain a loan.
When we assess whether control over the asset has passed to a customer, we must be careful to
consider any possible repurchase agreements (e.g. where we have sold goods to a customer but
have agreed to buy them back after a period of time – or have the option to do so under certain
circumstances). Although it may look like control has passed to a customer, the existence of a
repurchase agreement may prove that control has not actually passed. Repurchase agreements
are explained in section 9.6. See IFRS 15.34
At contract inception, we first assess if the performance obligation is satisfied over time. If it is not a
performance obligation satisfied over time, we conclude that it must be a performance obligation
satisfied at a point in time. In assessing if a performance obligation is satisfied over time, we consider
whether the performance obligation meets any one of the three core criteria. If it fails to meet any of
these criteria, then we conclude that it must be a performance obligation that will be ‘satisfied at a
point in time’. This process is shown diagrammatically below: See IFRS 15.32
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A performance obligation is classified as ‘satisfied over time’ if any one of the three core criteria
given in paragraph 35 is met. These three criteria are presented diagrammatically below. Each
of these 3 criteria are then discussed in more detail in the 3 separate diagrams that follow
thereafter.
Classification of a
performance obligation (PO)
No Criterion 1
Does the customer receive the asset & consume its benefits at the
same time that the entity performs its obligations?
See IFRS 15.35(a) & .B3-B4
PO satisfied
Or
over time
Criterion 2
If the entity is creating or enhancing an asset, does the customer
obtain control of the asset as it is being created or enhanced?
See IFRS 15.35(b) & .B5
Or
Criterion 3
If the entity is creating an asset, does:
x the asset have no alternative use for the entity; and does
x the entity have an enforceable right to payment for
performance completed to date?
See IFRS 15.35(c) & .B6-B8 & .B9-B13
PO satisfied
at a point in time
As has been explained, if any one of the three criteria is met, then the performance obligation is
classified as ‘satisfied over time’. Each of these criteria are now explained in more detail.
9.4.2.1 Criterion 1: Does the customer receive the asset and consume its benefits as the
entity performs? (IFRS 15.35 (a))
The essence of the criteria given in paragraph 35 (a) is that, if the customer receives the asset
and consumes its benefits as the entity is in the process of performing its obligation, then we
conclude that the obligation is being satisfied over time.
Sometimes this is straight-forward such as in the case of an entity providing a customer with
cleaning services. However, it may not always be as straight-forward in which case the diagram
overleaf shows the logic to apply in assessing whether this criterion is met or not.
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Criterion 1: Yes
Does the customer receive & consume benefits at the same time
that the entity performs its obligations?
See IFRS 15.35(a)
PO satisfied
over time
In other words: if that other entity would not have to re-perform the work we
have already done, then we conclude that the customer was receiving and
consuming the benefits as we were performing our obligations.
Tip: Typically, the provision of services that are routine would not need re-
performance whereas specialised services probably would. However, the specific
circumstances would have to be considered carefully.
In answering this:
x ignore any contractual restrictions or practical limitations that might
prevent us from getting some other entity to complete our PO; and
x assume that any asset we have created so far in the performance of
our PO would remain in our control and would not be of benefit to the
other entity.
In other words:
We ignore any facts that would contractually or physically prevent us from
actually transferring the remaining obligations to another entity and
assume that any asset we have created to date would not be available to
the entity that takes over the remaining obligations.
See IFRS 15.B3-4
No
a) Contract 1 involves providing a customer with the services of a telephonist for six months.
b) Contract 2 involves providing a customer with legal advice and representation leading up to a court
case in which this customer is being sued.
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Required:
For each contract, classify the performance obligation by assessing whether or not the customer receives
an asset & consumes its benefits as the entity performs its obligation.
Assuming, for example, we provided the customer with only four months of the promised services, and
another entity was to complete our obligation and provide a receptionist for the remaining two months, this
other entity would not be required to ‘substantively re-perform’ the work we had done in the first four months.
Since the new entity would not (and, in this case, could not) be required to re-perform any work, we would
conclude that the customer received and consumed the related benefits of the telephonist services at the
same time that they were provided.
Conclusion:
This performance obligation would be considered to be ‘satisfied over time’.
b) The nature of the legal advice and representation is not routine, which typically suggests that ‘substantial re-
performance’ of these tasks would be necessary.
Assuming, for example, we provided the customer with only four months of legal advice and representation
and, for some reason, another entity was to take over this obligation (e.g. perhaps the customer was
unhappy with the service we had provided), this new entity would need to ‘substantively re-perform’ the work
we had done.
This is because all the work done by us, (for example, the meetings to discuss legal issues plus the ensuing
legal paperwork), is assumed to be our asset that would not be available to the new replacement entity.
Furthermore, if another entity were to take over our obligation of legal advice and representation, it would
need to start from scratch in order to understand the case against the customer and prepare its own legal
advice.
Since a replacement entity would need to ‘substantively re-perform’ the work we had done, we conclude that
the customer would not receive and consume the related benefits as we perform our obligation.
Conclusion:
This criterion is not met and thus, unless it meets one of the remaining two criteria, this performance
obligation would not be considered to be ‘satisfied over time’.
9.4.2.2 Criterion 2: Does the customer get control as the asset is being created or enhanced?
(IFRS 15.35 (b))
The essence of the criterion given in paragraph 35 (b) is that we will conclude that the obligation
is being satisfied over time, if:
x the customer gets control over an asset that the entity is either creating or enhancing, but
x the customer gets this control during the process of creation or enhancement (i.e. as
opposed to the customer only getting control once the creation or enhancement of the asset
has been completed).
This criterion obviously needs us to thoroughly understand when control passes. The customer
is said to have control over an asset when either:
x the customer is:
able to direct the use of the asset (i.e. able to decide how it will be used); and
obtain most of the benefits from that asset; or
x the customer has the ability to prevent others from doing so. see IFRS 15.33
In deciding when control is expected to pass, we must consider all indicators of control (see the
diagram overleaf for some examples of indications of control passing, per IFRS 15.38).
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PO satisfied
over time
If we assess that these control criteria will be met during the period that the
asset is being created or enhanced, then criterion 2 is met and thus the PO is
classified as ‘satisfied over time’.
If, however, we assess that these control criteria will not be met during the
period of creation or enhancement (e.g. the criteria will only be met after the
asset has been created or enhanced), then criterion 2 is not met and thus it
suggests that the PO may be satisfied at a point in time – but before we conclude
this, we would need to consider criteria 1 and 3.
No
Consider criteria 1 and 3 before concluding that the PO is satisfied
at a point in time
Notes: There are a number of important points that we need to bear in mind when assessing the indicators
of control (given as examples in paragraph 38 of IFRS 15):
1. If our assessment is that the customer will be obliged to pay for the asset after completion of the
asset, this may suggest that the obligation is satisfied at a point in time whereas, if our assessment is
that the customer will be obliged to gradually pay for the asset during completion of the asset, this
may suggest that the obligation is satisfied over time.
2. If the passing of legal title is relevant to the asset in question, we must bear in mind that, if we plan
to retain legal title purely to force our customer to pay, this fact would be ignored when assessing
when our customer obtains control. In other words, the possibility that we may end up retaining the
legal title over the asset to force the customer to pay, would not stop us from concluding that the
customer has obtained control and thus this retention would not stop us from recognising the related
revenue. See IFRS 15.38 (b)
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3. If physical possession is relevant to the asset in question, we must bear in mind that:
- physical possession may not always indicate control e.g. in the case of certain repurchase
agreements and consignment sales; and
- control can exist without physical possession e.g. in some bill-and-hold agreements. See IFRS 15.38 (c)
4. If the transfer of risks and rewards is relevant to the asset in question, we must be careful when
the risks and rewards are expected to transfer on a piecemeal basis! See IFRS 15.38 (d)
This is because the risks & rewards that remain un-transferred for a time may actually relate to a
separate performance obligation.
E.g. a contract involving the obligation to provide a customer with a car plus future maintenance
normally results in the risks and rewards over the car transferring before the risks and rewards over
the maintenance services would transfer, in which case the customer would probably have control of
the car even though not all risks and rewards in the contract have transferred.
5. If customer acceptance is relevant to the asset in question, we must consider whether the contract
includes a customer acceptance clause/s. If so, clauses that can be objectively assessed by the entity
(e.g. the goods must meet certain dimensions) could be used to determine when the customer
acceptance is expected to occur without the need for formal customer acceptance. On the other hand,
clauses that are not able to be objectively assessed would still need the customer’s formal acceptance
before concluding that the customer has obtained control. See IFRS 15.38 (e)
Conclusion: There are indications to suggest that the customer obtains control during the creation of
this asset (i.e. that criterion 2 is met) and thus the performance obligation will be classified as
‘satisfied over time’.
b) The customer is only obliged to pay at the end of the three-month period at which point the customer
would be considered able to direct the use of the widgets and be able to obtain substantially all their
benefits. Similarly, the customer will only obtain physical possession at the end of the three-month
period at which point the risks and rewards of ownership will also transfer. Physical possession, in
this case, enables the customer to not only direct the use of the widgets and obtain substantially all
their benefits, but also enables the customer to prevent others from doing so.
Conclusion: The indicators suggest that the customer obtains control after the widgets are created
(i.e. at the end of the three-month period), not during their creation and thus this second criterion is
not met. Thus, unless the obligation meets one of the other two criteria, this performance obligation
will be classified as ‘satisfied at a point in time’.
9.4.2.3 Criterion 3: Does the entity have no alternative use for the asset and an enforceable
right to payment? (IFRS 15.35 (c))
The essence of the criteria in paragraph 35 (c) is that, where a performance obligation requires an
entity to create an asset, this obligation is classified as satisfied over time if the entity:
x has no alternative use for this asset (i.e. all it can do with the asset is give it to the customer in
terms of the contract), and
x has an enforceable right to payment for performance to date throughout its creation.
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The idea behind these two requirements is that if, for example, an entity is required to create a highly
specialised asset for a customer, the entity would probably need to incur significant extra costs or would
need to sell it at a significant discount if it was forced to find another purpose for this asset.
Thus, if the entity has no other use for the asset other than for the purpose stated in the contract,
we must deem that the customer controls this asset over the period of the contract. However,
since we are only deeming the customer to have control, we must also be able to prove that, at all
times during the contract period we will have a right to be paid for the work completed to date (i.e.
in the event that the contract is terminated by the customer or some other entity for reasons other
than the entity failing to perform as promised). Having a right to receive payment for work
completed to date gives us added confidence that the customer is obtaining benefits as the entity
is performing its obligations (i.e. that they are being satisfied over time).
An entity will have no alternative use for an asset if it is prevented from being able to readily use it
for some purpose other than the purpose in terms of the contract, and where the entity is
prevented through either contractual restrictions that are substantive (section 9.4.2.3.1 explains
how to decide if a contractual restriction is ‘substantive’) or practical limitations. The enforceable
right to payment must exist throughout the contract term and must be expected to be sufficient
compensation for any performance completed to the date of termination.
Criterion 3:
Yes
If the entity is creating an asset,
See IFRS 15.35 (c)
does the entity have:
PO satisfied
x Substantive contractual x exist continually throughout over time
restrictions preventing the the period of the contract; and
entity from being able to x be sufficient compensation for
readily use the incomplete asset any performance completed to
for something else; or date.
x Practical limitations preventing
the entity from being able to
readily use the complete asset
for something else.
See IFRS 15.B6-B8 See IFRS 15.B9-B13
No
Having an alternative use for an asset means being readily able to use it for some other purpose
(i.e. other than the purpose envisaged by the contract).
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Notice that:
x The requirements for contractual restrictions:
- refer only to the use of the incomplete asset. (i.e. during its creation or enhancement).
Thus, a contractual restriction that prevents the entity from using the incomplete asset
fulfils this requirement but a contractual restriction that only prevents the entity from
using the completed asset would not fulfil this requirement (because it would then be
possible for this asset, while incomplete, to have an alternative use).
- refer only to contractual restrictions that are substantive:
A contractual restriction is substantive ‘if a customer can enforce its rights to the
promised asset’ in the event that the entity used it for some other purpose.
Thus, the contractual restriction would be substantive if, by using the asset for some other
purpose, the entity would breach the contract and incur significant extra contract costs.
x The requirement for the practical limitation refers only to the completed asset.
Thus, a practical limitation that prevents the entity from using the completed asset fulfils this
requirement but a practical limitation that only prevents the entity from using the incomplete
asset would not fulfil this requirement (because it would then be possible for this asset, while
complete, to have an alternative use).
We decide whether the entity has no alternative use for the asset at the inception of the contract
and we do not re-assess this decision unless a contract modification is approved that causes the
performance obligation to be substantively changed (see section 5.7 for more about contract
modifications). See IFRS 15.36
We conclude that the entity has a right to payment that is enforceable if:
x the entity is entitled at all times throughout the contract
x to a payment that would be sufficient to compensate for performance completed to date
x in the event of a contract termination, for reasons other than a breach by the entity, and
x this entitlement is enforceable by either contractual terms and/or any laws that apply.
When we talk about the right to payment, we are not referring to a present right but rather to the
right to be able to demand such payment (or retain payments) if the contract were to be
terminated by another party.
In the event that the customer attempts to terminate the contract without having the right to
terminate, we (the entity) may have the legal right to continue completing our performance
obligations in terms of the contract in which case we would have the right to expect the customer
to complete their obligations (i.e. we would have a right to payment in full).
When assessing whether our right to payment is enforceable, we would not only look at the
contractual terms, but would also need to look at all other laws and/ or legal precedents that may
support the contractual terms or negate the contractual terms – or even create a right that is not
referred to at all within the contractual terms.
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Solution 34: Classifying performance obligations: the first and third criterion
In order to decide whether the PO is satisfied over time or at a point in time, we need to assess whether
one of the three criteria are met.
Criterion 1 (IFRS 15.35(a)) and criterion 3 (IFRS 15.35(c)) would be relevant to this contract.
Assessment of criterion 1:
The nature of the legal advice and representation is not routine and would require substantial re-performance of the
work by another entity in the event of an early termination of the contract. Thus we conclude that the customer does
not receive the asset & consume its benefits at the same time that the entity performs its obligations. This first
criterion is thus not met. (For a full discussion, please see the solution to example 32).
Assessment of criterion 2:
Although legal advice is an asset, the nature thereof means that the customer cannot obtain control over it
or the outcome of the court case.
Assessment of criterion 3:
Since the contract involves defending a customer against a case of defamation, the legal advice and
representation is customer-specific and there would thus be no alternative use for the asset created.
Furthermore, the contract entitles the entity to expect payment for work completed to date. Since this
entitlement is stipulated in the contract, and there is no evidence to suggest that there are laws that would
negate this clause, we can assume that it makes the right to payment enforceable.
Since the compensation will be calculated based on cost plus a 20% profit, we conclude that the payment
will be sufficient compensation since it roughly equates the selling price, where selling price is considered
to be cost plus a reasonable profit and where a reasonable profit is considered to be the lower of
x the contract-specific profit (30%) and
x the normal profit applied to similar contracts (10%).
Thus, we use the lower profit of 10% as our hurdle and since the required 20% payment is higher than this
hurdle, it is considered to be sufficient compensation.
Note: had the contract required the customer to pay costs plus 5% profit, then the expected payment would
not be considered to be sufficient compensation.
Conclusion:
The third criterion is met and thus the performance obligation is considered ‘satisfied over time’.
9.5 Measuring progress of performance obligations satisfied over time (IFRS 15.39-45)
9.5.1 Overview
Where a performance obligation is satisfied at a point in time (SAPIT), the revenue is recognised
immediately. If we have a performance obligation that is satisfied over time (SOT), we recognise
revenue gradually as this obligation is satisfied.
This means that, in the case of a performance obligation that is satisfied over time (SOT), we will
continually need to assess the progress towards complete satisfaction of this performance obligation.
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The methods that may be used to measure this progress towards complete satisfaction of the
performance obligation are categorised as:
x input methods; and
x output methods.
When deciding which method is most appropriate, we will need to consider the nature of the
underlying good or service. Output methods are normally considered to be superior, but using an
output method may not always be possible and/ or may be too costly.
We may only use one method per performance obligation, but whichever method is used, it must
be used consistently for all similar performance obligations.
When measuring the progress, irrespective of the method chosen, we must only ever include in
our calculations the goods or services over which the customer has obtained control.
The input method means calculating progress based on the entity’s efforts towards complete
satisfaction of a performance obligation. We look at the effort the entity has put in relative to the
total effort required in order to complete the performance obligation. This effort can be measured
in a number of ways. We could measure the entity’s efforts using costs incurred, labour hours,
machine hours or time elapsed. See example 36.
If the entity’s efforts are considered to be evenly expended over the performance period, then
we could simply use the straight-line method to recognise revenue. See example 35.
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20X4
Receivable (A) W2 32 000
Revenue from customer contract (I) 32 000
Revenue from PO satisfied over time: input method: tasks complete
Workings:
W1. Estimated progress: input method: tasks completed 20X3 20X4
Revenue recognised to date (80 000 x 60%) (80 000 x 100%) 48 000 80 000
Less revenue recognised in prior years (0) (48 000)
Revenue recognised in current year 48 000 32 000
20X4
Receivable (A) W2 24 000
Revenue from customer contract (I) 24 000
Revenue from services satisfied over time: input method: costs
Workings:
W1. Estimated progress: input method: costs 20X3 20X4
Costs incurred to date 20X3: Given; 20X4: (35 000 + 15 000) 35 000 50 000
Total expected costs Given 50 000 50 000
Percentage progress to date (35 000 / 50 000); (50 000 / 50 000) 70% 100%
Revenue recognised to date (80 000 x 70%) (80 000 x 100%) 56 000 80 000
Less revenue recognised in prior years (0) (56 000)
Revenue recognised in current year 56 000 24 000
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When measuring progress, we must remember to only consider goods or services over which
the customer has obtained control. A downside to the use of the input method is that it can
happen that there is not always a direct relationship between the inputs and the transfer of
control. Thus, care must be taken when using the input method to make appropriate
adjustments to the inputs when measuring progress. For example:
x if an input does not contribute to an entity’s progress in satisfying a PO (a wasted cost),
we exclude these inputs when calculating the measure of progress – see example 38; and
x if an input is not proportionate to the entity’s progress in satisfying a PO (i.e. it
exaggerates the entity’s progress), the best approach may be to limit the measurement of
the revenue related to that input to the extent of the cost of that input and to then exclude
the cost of that input when calculating the measure of progress – see example 39.
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The revenue recognised to date will include the revenue relating to the plant, but measured at the cost to
acquire the plant, plus 33,3% of the transaction price, reduced by the cost of this plant.
Revenue (I) Calculation 1 C4 666 667
Less contract costs (E) Given (Plant and all other costs) (3 000 000)
Profit C1 666 667
Calculations:
(1) Adjusted TP: (TP: 10 000 000 – Plant cost: 2 000 000) x 33,3%
+ Plant revenue (at cost): 2 000 000
= C4 666 667
The output method means calculating progress based on the value that the customer has
obtained to date. To do this we calculate the value of the goods or services transferred to date
relative to the value of the total goods or services promised. This value can be measured in a
number of ways (see example 40). We could use:
x surveys of performance completed,
x appraisals of results achieved,
x time passed,
x units produced, or
x units delivered.
Irrespective of which output method we use, we must always bear in mind that our ultimate
objective is to ‘faithfully depict the entity’s performance towards complete satisfaction of the
performance obligation’. Thus, we need to be sure that the output method chosen achieves this
objective.
For example, an output method based on units delivered may not be a faithful depiction of the
entity’s performance if the entity has also produced units of finished goods (or even units that
are still a work-in-progress) that the entity has not yet delivered but over which the customer has
already obtained control.
As a practical expedient, if the contract gives the entity the right to consideration (i.e. the right to
invoice the customer) for an amount that exactly equals the value of the entity’s performance to
date, (e.g. the contract allows the entity to invoice the customer based on a rate per hour of work
done for the customer), then the entity may simply recognise the revenue as it invoices the
customer (i.e. debit receivable and credit revenue). In other words, it need not go through the
process of estimating the measure of progress.
The disadvantages of output methods include the fact that the relevant outputs are not always
directly observable and may not be easily available without undue cost. Thus, although output
methods are normally considered superior, the use of an input method may be necessary.
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Work surveyed (to date!) Given: surveys normally ‘to date’ 50 000 80 000
Total contract revenue Given 80 000 80 000
Percentage progress to date (50 000/ 80 000); (80 000/ 80 000) 62,5% 100%
Revenue recognised to date (80 000 x 62.5%) (80 000 x 100%) 50 000 80 000
Less revenue recognised in prior years (0) (50 000)
Revenue recognised in current year 50 000 30 000
Note: work surveyed is normally provided on a cumulative basis: the surveyor would say that the work
certified for invoicing is C80 000 in 20X4, not the extra C30 000 that still needs to be invoiced in 20X4.
If we do not have a reasonable measure of progress, then no revenue at all may be recognised
until a reasonable measure becomes available. In this case, if we receive payments from our
customer, we will have to recognise them as a liability instead. See IFRS 15.B44
If the outcome of the performance obligation is not able to be reliably measured (this often
happens in the early stages of a contract), but the entity believes it will recover the costs that it has
incurred, then revenue may be recognised but only to the extent of these incurred costs.
If the customer happens to have paid us more than the costs that we have incurred, this excess
would be recognised as a liability until such time that the outcome is reasonably measurable.
See IFRS 15.B44
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When we assess whether control over the asset has passed to a customer, we must be careful
to consider any possible repurchase agreements (e.g. where we have sold goods to a customer
but have agreed to buy them back after a period of time – or have the option to do so under
certain circumstances). Although it may look like control has passed to a customer, the
existence of a repurchase agreement may prove that control has not actually passed.
A repurchase agreement does not only refer to an agreement where we have committed
ourselves to buying the asset back after a period of time (a forward), but also to an agreement
where we may choose to buy the asset back (a call option) – or where the customer may choose
to force us to buy the asset back (a put option).
9.6.2 Where a repurchase agreement means the customer does not obtain control
In cases such as these, the repurchase agreement will either be accounted for as a:
x Lease agreement in terms of IFRS 16 Leases
This happens if the entity can or must repurchase the asset for an amount that is less than
the original selling price of the asset; or
x Financing arrangement in terms of IFRS 15 (para B66)
This happens if the entity can or must repurchase the asset for an amount that is more than
or equal to the original selling price of the asset. See IFRS 15.B66
If the repurchase agreement is a financing arrangement, then the asset that has been sold (and
which we are to repurchase at a later date) is not removed from our books.
The amount we receive from the customer will be recognised as a liability (because we are
effectively using our asset as security in order to borrow money). The excess of the repurchase
price that we will be expected to pay over the original selling price will be recognised as interest
(we will need to build in to this calculation the effects of the time value of money – thus we would
work with a present valued repurchase price). See IFRS 15.B67-B68
If the repurchase agreement was based on a call option (rather than a forward), and if this option
lapses without the entity choosing to repurchase the asset, then the liability will be derecognised
and recognised as revenue instead. See IFRS 15.B69
9.6.3 Where a repurchase agreement means the customer does obtain control
Where the customer may choose to force the entity to buy the asset back (i.e. a put option), we
conclude that the customer does obtain control. This is because the customer can choose whether
or not to force the entity to buy the asset back. Thus, the customer is not limited in its ability to
direct the use of and to obtain substantially all the remaining benefits from the asset. See IFRS 15.B66
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If the repurchase price is lower than the original selling price and:
x the customer has a significant economic incentive to force us to buy the asset back, this
agreement would be accounted for as a lease agreement in terms of IFRS 16 Leases.
This is because the customer will have effectively paid for the right to use the asset from the time the
entity ‘sells’ it to the customer to the time the customer forces the entity to buy it back. See IFRS 15.B70
x the customer does not have a significant economic incentive to force us to buy the asset back, this
agreement would be accounted for as a sale with a right of return (see section 7.2.6.3). See IFRS 15.B72
If the repurchase price is equal to or greater than the original selling price and
x is more than the expected market price of the asset, we would account for the agreement as
a financing arrangement (see section 9.6.2). See IFRS 15.B73
x is less than or equal to the expected market price of the asset (and yet the customer has a
significant economic incentive to exercise its right), we would account for the agreement as a
sale of a product with a right of return (see section 7.2.6.3). See IFRS 15.B74
If this put option lapses without the customer forcing the entity to repurchase the asset, then the
liability will be derecognised and recognised as revenue instead. See IFRS 15.B76
10.1 Overview
Entities incur costs in connection with their contracts with customers. These costs can be split into:
x Costs to obtain the contract; and
x Costs to fulfil the contract.
These costs may need to be recognised as an asset (i.e. capitalised) if they meet certain criteria. If
the criteria are not met, they would be expensed.
If costs are recognised as an asset, this asset will need to be amortised and checked for impairments.
The costs incurred to obtain a contract with a customer could include aspects of administration,
marketing, legal costs, commissions and the costs of preparing tenders.
A cost of obtaining a contract would be recognised as an asset (i.e. capitalised) if the cost:
x is incremental and if the entity expects to recover the cost (the expected recovery could either be
directly from the customer or indirectly via the contract profit margin); and
x is not incremental but the cost is explicitly chargeable to the customer even if the entity is not
awarded the contract (i.e. the entity will recover these costs from the customer). See IFRS 15.91 & .93
Incremental costs mean extra costs. Thus, the incremental costs of obtaining a contract refer to the
extra costs that relate to having obtained a contract (i.e. those costs that would not have been
incurred if the contract had not been obtained). See IFRS 15.92
As a practical expedient, if the asset created would be completely amortised in a year or less, then
the entity may expense the costs instead. See IFRS 15.94
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For example, if the cost to complete a contract involved the sale of goods to a customer, then the
cost of the sale would be accounted for in terms of IAS 2 Inventories.
If a cost is to be recognised in terms of IFRS 15, it will be recognised as an asset if all three of the
following criteria are met:
x the costs are directly related to a contract (or an expected contract) and where this contract can
be specifically identified (e.g. direct labour, direct materials, allocations of overhead costs such as
insurance and depreciation where they relate directly to the contract, costs that are explicitly
chargeable to the customer and other costs incurred purely due to entering the contract);
x the costs will ‘generate or enhance’ the entity’s resources that will be, or are being, used to
complete the contract; and
x the entity expects to recover these costs. See IFRS 15.95-96
Irrespective of the above criteria, the following costs are always immediately expensed:
x general and administrative costs, unless the contract enables these costs to be charged to the
customer;
x costs of abnormal wastage;
x costs that have been incurred in relation to a satisfied or partially satisfied performance
obligation (i.e. costs relating to past performance);
x costs where the entity is unsure of whether or not it relates to an unsatisfied performance
obligation (i.e. we are cautious and assume it relates to a satisfied performance obligation).
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If there is a significant change in the expected timing of the transfer of these goods or services, the
amortisation method will need to change. A change in amortisation method is accounted for as a change
in accounting estimate (i.e. per IAS 8 Accounting policies, estimates and errors; see chapter 26).
10.5 Capitalised costs are tested for impairments (IFRS 15.101 - 104)
Costs that are recognised as an asset will need to be tested for impairment. The asset will be
considered impaired if its carrying amount is greater than the net remaining consideration that the
entity expects to receive. Impairment losses are recognised as an expense in profit or loss.
If the transaction price does not include variable consideration (i.e. the consideration is fixed), the
consideration is simply calculated using the same principles that we used when calculating the
transaction price, but it must then be adjusted to reflect the credit risk specific to that customer.
If the transaction price includes variable consideration, the consideration must be calculated
using the same principles that we used when calculating the transaction price and adjusted to
reflect the credit risk specific to that customer (i.e. as above), but we must ignore the principles
relating to constraining estimates of variable consideration.
If, at a later stage, the circumstances that led to the impairment loss reverse or improve, then the
impairment expense may be reversed (i.e. recognised as income in profit or loss). When
reversing an impairment loss, we must be sure that the reversal does not increase the asset’s
carrying amount above the carrying amount that it would have had had it never been impaired.
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11.1 Overview
The 5-step approach to revenue recognition requires a holistic and integrated approach when
considering each of the steps. It is probably helpful if we now consider a few interesting and
fairly common revenue-related transactions in the context of the 5-step approach.
Goods are often sold with warranties. There are two types:
assurance-type warranties and service-type warranties.
Warranties come in two
x An assurance-type warranty is a warranty that assures the forms:
customer than the product will function as intended or that
x assurance-type: account for it in
it meets the agreed-upon specifications. terms of IAS 37
x A service-type warranty offers the customer a service in x service-type: account for it in
addition to the mere assurance that the product will terms of IFRS 15, as a separate
PO
function as intended.
An assurance-type warranty is simply a confirmation that the product is what it purports to be. In
other words, an assurance-type warranty does not promise anything in addition to the product.
Thus, the transaction price is allocated entirely to the product. However, the fact that the
assurance-type warranty exists will need to be accounted for in terms of IAS 37 Provisions,
contingent liabilities and contingent assets.
A service-type warranty involves the promise of a service (should the need arise), and is thus a
separate promise - a distinct performance obligation. Thus, if the sale of a product includes a
service-type warranty, the transaction price will have to be allocated between the two
performance obligations: the transfer of a good and a service. If and when this service is
provided, it will result in the recognition of revenue.
If a customer is able to purchase a warranty separately, this would indicate that it is a service-
type warranty and should be accounted for as a separate performance obligation. In cases
where the customer is not able to purchase a warranty separately, we will need to carefully
assess which type of warranty we are dealing with. IFRS 15 provides a list of factors that may
need consideration.
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11.3 Sale with a right of return (IFRS 15.51 & .55 & .B20-B27)
A contract involving a transfer of goods with a right of return is covered in section 7.2.6.3.
Sometimes contracts are complicated by the involvement of a third party. In such cases, we
must take care in deciding whether the entity is acting as a principal or an agent. The entity:
x is a principal if the entity transfers the goods or services to the customer
x is an agent if the entity is simply connecting a principal with a customer. See IFRS 15.B34
For the entity to be a principal it must be the party transferring the goods or services to the
customer. This means it must have had control of the goods or services immediately before it
was transferred. Control is assessed on many levels, such as who has the risks and rewards of
ownership, who has physical control, who has legal title etc. However, IFRS 15 clarifies that, in
the case of legal title, we must be aware that, if an entity simply obtained legal title on a
temporary basis for the purpose of being able to then transfer this legal title to the customer soon
after, this would not necessarily prove the entity had control and was acting as a principal. All
facts and circumstances must be carefully considered in deciding if the entity had full control prior
to transferring the item to the customer. See IFRS 15.B35
The entity would still be the principal in situations where it used a third party to complete part or all of
a performance obligation, for example, when the entity used a subcontractor to do the work.
Where the entity is acting as a principal, it recognises revenue at the gross amount of
consideration to which it expects to be entitled – any commissions payable to the agent would be
recognised as a separate expense.
11.4.3 Where the entity is the agent
The entity would be an agent if it did not have control of the good or service prior to the transfer
to the customer. In other words, the entity is an agent if its performance obligation is satisfied
once it has simply arranged for another party (i.e. the principal) to provide goods or services to
the customer.
Facts and circumstances that suggest that an entity is acting as an agent include, for example:
x the entity cannot decide the selling price of the good or service;
x the entity’s consideration will be in the form of commission;
x the entity is not exposed to credit risk in the event that the customer defaults on payment;
x the entity does not have the risk related to inventory either before or after the goods have
been ordered or during shipping. See IFRS 15.B37
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Where the entity is acting as an agent, it recognises revenue being the fee or commission
receivable from the principal. See IFRS 15.B36
An agent acts on behalf of the principal (the entity) thus, although the agent obtains physical possession
of the goods while holding them on consignment, the agent never actually obtains control of the asset.
Since IFRS 15 only allows the recognition of revenue when control passes from an entity to a customer,
revenue may not be recognised until the agent has sold the consignment goods to the final customer.
Indications that a sale is a sale on consignment include:
x the product is controlled by the entity until a specified event occurs (e.g. the sale of the
product to a customer of a dealer or until a specified period expires);
x the entity is able to insist upon the return of the product or can insist that it be transferred to a
third party (e.g. another dealer); and
x the dealer does not have an unconditional obligation to pay for the product (although it may
be required to pay a deposit)
x the entity continues to insure the product while being held by the dealer. See IFRS 15.B78
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Control has passed to the customer if the customer is able to direct the use of the product and
obtain substantially all of the remaining benefits from the product. For control to have passed in
a bill-and-hold situation, we must also ensure that the following additional criteria are met:
x the reason for the bill-and-hold arrangement must be substantive (e.g. the customer must
have requested it);
x the product must be identified separately as belonging to the customer;
x the product must be ready for physical transfer to the customer; and
x the entity must not have the ability to use the product or to direct it to another customer.
If all these criteria are met, then control is said to have passed to the customer and revenue
must then be recognised. However, since the entity is effectively providing storage for the
customer, the entity must assess whether the provision of storage is another separate
performance obligation, in which case the transaction price would need to be allocated between
the performance obligation to transfer the product (PO1) and the performance obligation to
provide storage services (PO2).
It is submitted that control over the vehicle has passed to Rondil because (using some of the indicators in
IFRS 15.38):
x Rondil was obliged to pay for the vehicle;
x Rondil has obtained legal title over the vehicle;
x Rondil has inspected the vehicle and accepted that it meets all required specification.
Conclusion:
Since control passed to Rondil on 5 January 20X1 (in terms of IFRS 15.38) and all further criteria relevant
to a bill-and-hold arrangement (in terms of IFRS 15.B81) have been met, Lemon-Drop must recognise the
revenue from the sale of the vehicle.
However, before recognising the revenue, Lemon-Drop must assess whether the request for storage
results in a separate performance obligation, in which case the transaction price would first have to be
allocated between the two performance obligations. However, the fact that the requested storage is for
such a short period suggests that the provision of storage facilities is incidental to the contract and may be
ignored. The following journal would be processed:
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11.7 Customer options for additional goods and services (IFRS 15.B39-B47)
Sometimes a contract provides a customer with the option to acquire additional goods and services –
these may be offered for free or at a discount. They are often called sales incentives, loyalty points or
award credits, contract renewal options or other discounts on future goods or services.
An option for additional goods or services must be accounted for as a separate performance
obligation only if it provides the customer with a ‘material right that it would not receive without
entering into that contract’. See IFRS 15.B40
An option to acquire further goods or services at a price that would reflect the normal relevant
stand-alone selling prices would not be a material right – even if this option can only be
exercised by entering into the first contract.
In cases where we conclude that the customer is being given a material right that it would not receive
without entering into that contract, we account for the right as a separate performance obligation.
In this case, the transaction price would need to be allocated between the obligation to transfer the
goods or services per the contract and the obligation to provide the future goods or services at a
discount (or for free). In other words, we will be accounting for the first contract as if the customer is
paying a portion of the consideration, in advance, for the future goods or services. The revenue from
the future goods or services is recognised as revenue when they are transferred (i.e. when the
customer orders the free or discounted goods or services) or when the option expires (i.e. if the
customer does not order the free or discounted goods or services).
The transaction price is allocated based on the relative stand-alone selling prices. Please note
that it is the stand-alone selling price of the option and not the stand-alone selling price of future
goods or services that we use for this allocation. For example, if the contract includes a clause
that stipulates that a customer can purchase further goods, which normally sell for C100 000, at
C80 000 instead, the stand-alone selling price that we would use for the purpose of allocating
the transaction price is the net stand-alone selling price of the option: C20 000.
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20 February 20X1
Contract liability (L) See allocation of TP above 72 727
Bank (A) Discounted price per the contract 100 000
Revenue from customer contract (I) 172 727
Recording the receipt from the customer for the trailer at the discounted price
per the contract and reversing the contract liability to revenue
Comment: If the customer had not purchased the trailer by 28 February 20X1 (when the option expired), we would
have processed a journal (on 28 Feb. 20X1), reversing the liability and recognising revenue of C72 727.
As a practical expedient, if the material right provided to the customer involves goods or services
that are the same or similar to those in the original contract (e.g. in the case of a renewal of a
contract), then the entity can choose not to bother estimating the stand-alone selling price of the
option for purposes of allocating the initial contract’s transaction price.
Instead, the entity can account for the initial contract and the potential renewal contracts as if it
were one contract. It would then calculate the total expected transaction price for the combined
contracts and then allocate across the total expected goods and services offered under the
combined contract (i.e. allocating it between the goods and services offered under the existing
contract and the future goods and services offered under the renewal contracts).
As mentioned above, this would apply in the case of contract renewals but would also apply if
the option simply involved offering the same product at a discounted price. The practical
expedient would also be available if, in the previous example, the option was to purchase
another vehicle of the same type rather than a trailer.
Example 48: Option involves similar goods or services (e.g. contract renewal)
An entity sells annual contracts for the provision of weekly home maintenance services at C10 000 each.
The contracts include a clause stating that, if a customer renews the contract for a further year, the
second annual contract would cost C12 000 instead of C15 000, being the standard price for customers entering
into a new contract rather than renewing an old contract. This option expires on 31 December 20X1 (i.e. the
customer must renew the contract by 31 December 20X1 to qualify for the discount).
The entity sells 20 contracts during January 20X1 and expects that 80% of these customers will renew their
contracts. All customers paid for the first year of their contracts in 20X1 and 80% of these customers, as expected,
renewed their contracts.
The entity chooses to measure progress towards complete satisfaction based on time elapsed.
Required: Show the journal entries for the above using the practical expedient if available to the entity.
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Solution 48: Option involves similar goods or services (e.g. contract renewal)
Since the second annual contract involves the same or similar services to those in the first-year contract,
the entity can choose the practical expedient. The practical expedient allows the entity to choose not to
estimate the stand-alone selling price of the option for purposes of allocating the transaction price (i.e. it
may choose not to allocate the transaction price between the first-year contract and the option). Instead,
the entity can choose to calculate the total expected consideration and allocate it to the total goods or
services that it expects to provide.
W1: At contract inception, the entity expects 80% of its customers to renew their contracts and thus:
x the total expected consideration = 20 x C10 000 + 20 x 80% x C12 000 = C392 000
x the total services to be provided will be provided over time and thus we will need to estimate the
measure of progress. The entity measures its progress based on time: 24 months.
Year 2
Contract liability (L) See above 4 000
Bank (A) 20 x 80% x C12 000 192 000
Revenue from customer contract (I) See allocation of TP above 196 000
Receipts from customers; related revenue from the sale of contracts for the 2 nd year and reversal of the
contract liability since the option no longer exists
Comment: If more or less than the 80% of the customers renewed their contracts, then the transaction
price would be adjusted and the adjustments would be accounted for directly in revenue.
Exactly the same principles apply in the case of customer loyalty programmes. We must first
assess whether the entity is acting as a principal or an agent in the transaction. This is because
an entity can provide customer loyalty schemes that allow the customer to claim discounted or
free goods or services either:
x from the entity, in which case the entity is acting as a principal; or
x from another third party, in which case the entity is acting as an agent.
Required:
Show the journal entries:
a) for 20X1 assuming that, by the end of 20X1, 2 000 of these points had been redeemed and that the
estimation that 90% of the points would be redeemed remained the same
b) for 20X2 assuming that, by the end of 20X2, a further 3 000 of these points had been redeemed and
that the estimation that 90% of the points would be redeemed remained the same
c) for 20X2 assuming that, by the end of 20X2, a further 3 000 of these points had been redeemed and
that the estimation that 90% of the points would be redeemed had changed to 95%.
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Stand-alone Allocation of
selling price transaction price
Goods C500 000 TP: C500 000 x 500 000 ÷ C590 000 C423 729
CLP: Future discount C90 000 TP: C500 000 x 90 000 ÷ C590 000 C76 271
C590 000 C500 000
Calculation of the stand-alone selling price of the future discount under the CLP:
C500 000 / C50 x 1 point x C10 x 90% (expected redemption) = C90 000
During 20X1 (sum of the journals recorded as the sales occurred) Debit Credit
Bank (A) TP: total sales 500 000
Revenue from customer contract (I) See allocation of TP above 423 729
Contract liability: CLP (L) See allocation of TP above 76 271
Receipt from customers allocated between sale of goods and future
discount on the expected redemption of CLP points
End 20X1
Contract liability: CLP (L) C76 271 x (C20 000 ÷ C90 000) 16 949
Revenue from customer contract (I) See allocation of TP above 16 949
Redemption of 2 000 points at C10 per point means we gave customers a
C20 000 discount off the estimated total discount of C90 000
Or: 10 000 points were granted, 90% or 9 000 are expected to be redeemed – at
year-end, 2 000 of these 9 000 points have been redeemed: thus 2/9 x C76 271
Solution 49C: Customer loyalty programme (entity is a principal) – second year and
estimated changes
Comment: When we recognise the revenue from the customer loyalty programme, we must remember to
first calculate the revenue to be recognised on a cumulative basis and work backwards to how much
revenue should be recognised in the current year. This is in case there is a subsequent change in our
estimate of how many points will be redeemed.
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12.1 Overview
Revenue must be presented as a line-item in the statement of comprehensive income (as part of
profit or loss). See IAS 1.82
Revenue also affects the presentation of our financial position (SOFP). In this regard, a
customer contract may lead to the presentation in our statement of financial position (SOFP) of
the following line-items:
x a contract asset or contract liability; and/or
x a receivable (receivables are to be presented separately from contract assets).
Company name
Statement of comprehensive income (extracts)
For the year ending 31 December 20X2
20X2 20X1
Note C C
Revenue See IAS 1.82 15 150 000 80 000
Other income xxx xxx
Cost of sales (xxx) (xxx)
... (xxx) (xxx)
Profit before tax 22 xxx xxx
Company name
Statement of financial position (extracts)
For the year ending 31 December 20X2
20X2 20X1
ASSETS C C
Contract assets See IFRS 15.105 xxx xxx
Receivables See IFRS 15.105 (unconditional rights) xxx xxx
LIABILITIES
Contract liabilities See IFRS 15.105 xxx xxx
13.1 Overview
IFRS 15 includes copious disclosure requirements. However, the objective is that there must be
enough disclosure that a user can assess the ‘nature, amount, timing and uncertainty’ of both
the revenue and cash flows stemming from the entity’s customer contracts. See IFRS 15.110
To achieve this, we must disclose both qualitative and quantitative information regarding:
x Contracts with customers
x Significant judgements (and any changes therein) made when applying IFRS 15
x Assets recognised relating to costs to obtain and costs to fulfil a contract.
The level of detail required in presenting the above disclosure requirements is not prescribed by
IFRS 15. Instead, IFRS 15 requires us to use our professional judgement in deciding how much
detail is needed in order to meet the basic objective (i.e. of enabling a user to assess the ‘nature,
amount, timing and uncertainty’ of both the revenue and cash flows).
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Contracts with customers result in revenue, contract balances (contract assets/ liability and
receivables) and possibly impairment losses, all of which will require certain disclosures. The
revenue and impairment losses that relate to customer contracts must be disclosed separately
from those that relate to other kinds of contracts. Revenue from customer contracts will need to
be disaggregated. Revenue that is recognised depends on when performance obligations are
satisfied and therefore information relating to these performance obligations is required.
Revenue may not be recognised until the performance obligation is satisfied and thus information
relating to the remaining unsatisfied performance obligations at reporting date is also required.
This is explained in more detail in the table below. A very brief example of how the revenue
amounts from customer contracts would be disclosed is presented after this table.
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x We must provide a reconciliation showing the significant changes making up the movement
between the contract asset opening and closing balance and the contract liability opening and
closing balance.
This reconciliation needs to provide both quantitative and qualitative information.
Examples of the movements in these balances include:
- a decrease in the contract asset caused by an impairment of the contract asset;
- an increase in the contract asset due to an increase in revenue caused by a change in
how we estimated the measure of progress towards satisfaction of the performance
obligation (i.e. a change in estimate resulting in a cumulative catch-up adjustment);
- a decrease in the contract liability due to a transfer to revenue, caused by a change in
time frame that resulted in a performance obligation becoming considered satisfied;
- a decrease in the contract asset caused by a transfer from the contract asset to the
receivable, caused by a change in time frame that resulted in the expected
consideration now becoming regarded as unconditional. See IFRS 15.118
x We must explain how the timing of the satisfaction of performance obligations compares with the
typical timing of payments and how this affects the contract asset/ liability balances.
13.2.5 Disclosure of the remaining unsatisfied performance obligations and how much
of the transaction price has been allocated to these
x For performance obligations that are totally or partially unsatisfied at reporting date, we will
need to disclose:
- the aggregate amount of the transaction price that has been allocated to these
unsatisfied performance obligations (i.e. we are effectively disclosing the amount of
revenue that we have not yet been able to recognise); and
- whether any consideration was excluded from the transaction price and thus not
included in the aggregate amount disclosed (e.g. variable consideration that was
constrained);
- when we expect to be able to recognise this remaining revenue – this information can
either be given quantitatively, using time bands considered appropriate to the remaining
period of the contract, or can be given qualitatively. See IFRS 15.120 and 122
x Practical expedients: As a practical expedient, we can ignore the requirement to provide the
information above if:
- the total expected duration of the related contract is one year or less; or
- the revenue from this performance obligation is to be recognised based on the right to
invoice (this aspect is not covered in this chapter, but is explained in IFRS 15.B16).
If we opt for this practical expedient, we must disclose this fact.
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13.2.6 Sample disclosure relating to the line-item ‘revenue from customer contracts’
Company name
Notes to the financial statements
For the year ending 31 December 20X2
20X2 20X1
C C
15 Revenue
Revenue from customer contracts has been disaggregated based on geographical areas because this is how the
company evaluates the performance of its segments. It has also been disaggregated based on product lines
since this was the focus of our presentation to investors when raising financing earlier in the year.
13.3.1 Judgements (and changes therein) that significantly affect the timing of revenue
We will need to explain the judgements (and changes therein) that we used when deciding when
performance obligations (POs) were satisfied. See IFRS 15.123 (a)
x When POs are satisfied (and thus revenue recognised) over time, we must:
- Disclose the method used (e.g. input method), describe the method (e.g. costs incurred
as a % of total expected contract costs) and how it was applied.
- Provide an explanation as to why this method used is considered to be ‘a faithful
depiction of the transfer of goods or services’. See IFRS 15.124
x When POs are satisfied (and thus revenue recognised) at a point in time, we must:
- Disclose the significant judgements used in deciding when control over the goods or
services passes to the customer. See IFRS 15.125
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13.3.2 Judgements (and changes therein) that significantly affect the amount of revenue
x We will need to explain the judgements (and changes therein) that we used when:
- determining the transaction price (TP); and
- determining how much of the TP should be allocated to each PO. See IFRS 15.123 (b)
x As part of the explanation, we must disclose the methods, inputs and assumptions used to:
- determine the TP: including how we estimated variable consideration, how we adjusted
for the time value of money, how we measured non-cash consideration and how we
assessed whether an estimate of variable consideration was limited;
- allocate the TP: including how we estimated the stand-alone selling prices, how we
allocated any discounts and how we allocated any variable consideration;
- measure any obligations, such as returns and refund obligations. See IFRS 15.126
x Practical expedients: If the entity chose not to account for a significant financing component,
this fact must be disclosed. See IFRS 15.129
13.4 Contract costs recognised as assets (IFRS 15.110(c) and .127 - 128)
Where costs related to a customer contract have been recognised as an asset (i.e. costs to
obtain or costs to fulfil a contract), certain qualitative and quantitative information needs to be
disclosed. This is explained in detail in the table below.
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14. Summary
Revenue recognition and measurement – the 5-step model
x Could include variable consideration (VC) –VC could be explicitly stated in the contract or be implied
- Eg: bonus (may/ may not increase the TP) and early settlement discount (may/may not decrease TP)
- We include only the ‘constrained estimate of the VC’ in the TP – this requires us to:
- estimate the VC (using either most likely amount or expected values); and then
- constrain the estimate (i.e. limit the estimate to an amount that has a high probability of
not causing a significant reversal of revenue in the future).
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- the VC can be allocated to all the POs by simply allocating the total TP (fixed consideration +
variable consideration) to all the POs in the normal way (i.e. based on the relative SASPs of
the POs) if the VC relates to all POs
- the VC can be allocated to a specific PO/s if it relates to certain specific PO/s (and the
required criteria are met – see IFRS 15.85), in which case:
- the TP excluding the VC is allocated to all POs based on SASPs and then
- VC is allocated to the specific PO/s.
IFRS 15 provides example indicators that may suggest control has passed (see IFRS 15.38).
x POs are classified based on how control over the G/Ss transfers:
- PO satisfied over time (SOT)
- PO satisfied at a point in time (SAPIT).
x A PO is classified as satisfied over time (SOT) if any of the 3 criteria are met:
- if customer receives and consumes benefits as the PO is satisfied; or
- if customer gets control of the asset while the entity creates/ enhances the asset; or
- if the entity has no alternative use for the asset and also has an enforceable right to payment
for performance completed to date (See IFRS 15.35).
x A PO is classified as satisfied at a point in time (SAPIT) if none of the 3 criteria in IFRS 15.35
are met i.e. if it is not satisfied over time (SOT).
- input methods:
- measures the entity’s efforts (e.g. costs to date ÷ total expected costs to complete the PO)
- can use the straight-line method if the entity’s efforts will be expended evenly over the
period that the PO will be satisfied.
- output methods:
- considered superior to input methods, but may be impossible or too costly to use
- measures the value received by the customer (e.g. ‘work certified to date’ ÷ ‘total transaction
price allocated to the PO’; referred to as the surveys or work certified method).
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Contract costs
SOCI – presentation
x Revenue must be presented on the face of the SOCI (IAS 1 requirement).
x Revenue from customer contracts must be presented separately from other revenue.
x The revenue from customer contracts on the face of the SOCI must be disaggregated (either on
the face or in the notes).
SOFP – presentation
x Contract asset (represents the entity’s conditional rights): must be presented on the face of the SOFP
- this is recognised when we have earned revenue because the PO is complete but our right to
consideration is still conditional
- e.g. debit contract asset and credit revenue.
x Receivable (represents the entity’s unconditional rights): must be presented on the face of the SOFP
- this is normally recognised when we have earned revenue since the PO is complete and our
right to consideration is unconditional i.e. at most, all we have to do is wait for time to pass
e.g. debit receivable and credit revenue
- this can also arise when the terms of the contract make a sum receivable, but we still have to
satisfy the PO (e.g. when the contract is non-cancellable)
e.g. debit receivable and credit contract liability.
x Contract liability (represents our obligation to perform or return the cash received): must be
presented on the face of the SOFP
- this is recognised when we have not yet completed our POs and thus cannot recognise the
revenue yet, but we either:
- have received the cash already
e.g. debit bank and credit contract liability.
- have an unconditional right to receive consideration (i.e. a receivable) (e.g. our contract
is non-cancellable)
e.g. debit receivable and credit contract liability
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Chapter 5
Taxation: Various Types and Current Income Tax
Reference: IAS 12 and IAS 1 (including amendments to 10 December 2019)
CHAPTER SPLIT:
This entire chapter revolves around tax. However, it is a long chapter which is easier to manage if you split
it into two parts, one of which deals with the various different types of taxes and the second focuses purely
on the intricacies of income tax.
The chapter has thus been split into two separate parts as follows:
PARTS: Page
PART A: Various types of tax 218
PART B: Income tax (current tax only) 227
PART A:
Various Types of Tax
Contents: Page
A: 1 Introduction 218
A: 2 Transaction tax (VAT) 218
A: 2.1 Overview 219
A: 2.2 The sale of goods 219
Example 1: VAT on sale of goods 220
Example 2: VAT on sale of goods 220
A: 2.3 The purchase of goods 221
Example 3: VAT on purchase of goods 221
Example 4: VAT on purchase of goods 222
A: 3 Employees’ taxation 223
Example 5: Employees’ tax 223
A: 4 Income tax 224
A: 5 Dividends tax 224
A: 5.1 Overview 224
A: 5.2 Measuring dividends tax 225
A: 5.3 Recognition of dividends tax 225
Example 6: Income tax and dividends tax 225
PART B:
Income Tax (Current Tax Only)
Contents: Page
B: 1 Introduction 227
B: 2 Recognition of income tax 227
B: 2.1 Overview 227
B: 2.2 Tax recognised in profit or loss 228
B: 2.3 Presentation of tax recognised in profit or loss 228
B: 2.4 Tax recognised in other comprehensive income 228
B: 2.5 Presentation of tax recognised in other comprehensive income 228
B: 3 Measurement of income tax (current only) 228
B: 3.1 Overview 228
B: 3.2 Enacted and substantively enacted tax rates 229
Example 7: Enacted and substantively enacted tax rates 229
B: 3.3 Taxable profits versus accounting profits 230
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PART A:
Various Types of Tax
A: 1 Introduction
Many different taxes are levied around the world. The following are some of the common taxes
in South Africa:
x VAT (value-added taxation): see Section A: 2
Many types of tax, for
This is a tax on goods bought: the purchaser of the goods example:
will pay the VAT and the seller, being the one to receive
the payment, pays the tax over to the tax authority. x VAT
x Employees tax
x Employees’ tax: see Section A: 3 x Income tax
x Dividends tax
This is a tax on an employee’s salary: the entity deducts x Property tax
the tax from the employee’s salary and pays it to the tax x Vehicle licences
authority; the employee is paid his salary net of tax. x Fuel levies & toll fees.
We will concentrate on some of the main taxes affecting a business entity: VAT, employees’
taxes, income tax on profits and dividend withholding tax.
What tax rates should we use?
For consistency and simplicity, the following tax rates will be used throughout this text unless
indicated otherwise:
x VAT at 15%;
x Income tax on companies at 30% of taxable profit; and
x Dividends tax at 20% on the receipt of dividends.
Remember: in an exam, you must obviously use the tax rates given in the question. If none are given, it is
generally advisable to use the latest known rates: VAT is currently 15%, income tax on companies vary widely,
but is generally taken to be 28% and dividends tax is currently 20%.
A: 2.1 Overview
A transaction tax is simply a tax levied on a transaction. 3 categories of supplies
Some countries choose to use General Sales Tax (GST) as (goods/services):
their transaction tax whereas others choose to use value x Vatable supplies;
added tax (VAT) instead. We will focus only on VAT. x Zero-rated supplies; and
x Exempt supplies.
VAT is a levied on the supply of certain goods or services.
Goods and services supplied are generally categorised into vatable supplies, zero-rated supplies
and exempt supplies.
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Zero-rated and exempt supplies are similar in that there is effectively no VAT paid on these
goods (or services), however, there is a practical difference in that zero-rated supplies technically
have VAT levied on them, but at 0%, whereas exempt supplies do not have VAT levied on them
at all. The reason for this is beyond the scope of this chapter.
What makes VAT unique from other forms of transaction taxes, such as General Sales Tax (GST),
is that, where VAT applies to the supply of a good (or service), VAT will be levied on every
transaction in the supply chain related to that good (or service), and not just on the final
transaction with the final customer. This means that every purchaser in the supply chain who is a
registered VAT vendor (in terms of the relevant tax legislation) must pay VAT and then claim it
back. If the purchaser is not registered as a VAT vendor, then he will not be allowed to claim the
VAT back and is therefore considered to be the ‘final customer’ for tax purposes.
The following picture shows the flow of cash above. Can you see that it is Mr C (the one who is not smiling!) who
is the only one in the chain of transactions who actually ends up paying the VAT. Mr. C is normally the man in the
street and not a business. Can you see that this system is quite an onerous system in terms of the paperwork that
has to be sent to the tax authorities supporting amounts owing and claimed.
A B C
1&2: 115 5&6: 230
3: 4: 7:
15 15 30
Tax authority
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The seller would then have to pay the tax authorities the C15 in VAT, thus settling the liability owing to
the tax authorities. The net effect is that the seller’s bank increases by only C100 (C115 – C15) which
was why only C100 was recognised as income.
Bank (A) Revenue (I)
Rev & CTP: VAT 115 CTP: VAT 15 Bank 100
Comment: It is clear from the above example that before we can record a sale, we need to know whether
we are a VAT vendor or not. If we are a VAT vendor, and assuming the goods are not exempt or zero-
rated, we must charge our customer VAT (i.e. the marked price will include 15% VAT). Thus, our marked
price will be greater than the selling price. The selling price is recognised as revenue. The VAT included
in our marked price is owed to the tax authorities and is thus a liability until paid.
Required:
a) Show the relevant journals processed in Mr. A’s ledger assuming:
i) Mr. A is not a VAT vendor
ii) Mr. A is a VAT vendor
b) How would your answer change if:
i) Mr. B is not a VAT vendor
ii) Mr. B is a VAT vendor.
Comment: Since the invoiced price does not include VAT, the full invoice value belongs to Mr. A.
ii. Mr. A is a VAT vendor:
Mr. A has thus charged VAT. Thus, the marked price of C115 includes VAT.
Thus, MP = SP + VAT
Since VAT = SP x 15%, we can also say that MP = SP + SP x 15% = SP + SP x 0.15
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Solution 2A Continued…
Apply this logic to the example in order to calculate:
x Selling price:
MP = SP + (SP x 0.15) ; substitute MP = C115
Thus: C115 = SP x 1,15
SP = C115 / 1,15 = C100 (or: C115 / 115 x 100)
x VAT:
MP = SP + VAT; substitute MP = C115 and substitute SP = C100
Thus: C115 = C100 + VAT ; thus VAT = C115 – C100 = C15 (or: C115 / 115 x 15)
Comment: A total of C115 is received. Of this, only C100 (100/115 x C115) belongs to Mr. A and the
balance of C15, constituting VAT (15/115 x C115), must be paid over to the tax authorities.
Journals:
1) Mr A purchases and pays for the inventory, where the marked price of C69 includes VAT of C9.
2) Mr A claims and receives the VAT refund (C9) from the tax authorities.
Notice:
x The inventory is measured at C60 and not C69 since although Mr. A initially pays C69 for the
purchase, he receives C9 back from the tax authorities, the net cost to Mr. A being C60 (see the bank
account: C69 paid – C9 received).
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If we, the purchaser, are not classified as a VAT vendor, then we need not worry about recording
VAT. However, if we are a VAT vendor, then we must record VAT where it exists.
x If the supplier is not a VAT vendor, or the goods are not vatable supplies, then there is no VAT
to record (i.e. VAT does not exist).
x However, if the supplier is a VAT vendor and the goods or services are vatable supplies, then
VAT will have been charged (i.e. VAT does exist). Since, as a VAT vendor, we can claim it back,
we must record this VAT separately from the cost of the goods or services acquired.
Explanation: Mr. B is a VAT vendor and would thus be able to claim back any VAT that he paid (input
VAT) – however, Mr. A is not a VAT vendor and thus had not charged Mr. B any VAT.
Explanation: Mr. A is a VAT vendor and will thus have included C15 VAT in the C115 marked price. Mr.
B is a VAT vendor and is thus able to claim back this C15 VAT paid (input VAT) from the tax authorities.
Thus, the inventory cost C100 (C115 MP - C15 VAT claimed back from the authorities).
iii. Mr. B is not a VAT vendor and Mr. A is not a VAT vendor
Bank (A) Inventories (A)
115 115
Explanation: Mr. B is not a VAT vendor which means he is not able to claim back any VAT that he pays
(input VAT). However, this is irrelevant since Mr. A is not a VAT vendor and has thus not charged VAT.
Explanation: Mr. A is a VAT vendor and will thus have included C15 VAT in the C115 marked price.
However, Mr. B is not a VAT vendor, meaning he is unable to claim back any VAT paid (input VAT).
Since Mr. B may not claim back any VAT paid, the inventories cost him the full amount of C115.
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A: 3 Employees’ Taxation
This is a tax that the employee effectively incurs. The entity, however, generally has the
responsibility of calculating the tax, deducting it from the salary of the employee and paying it
over to the tax authorities within a specified period of time. This means that employees’ tax is
what we refer to as a ‘withholding tax’. Thus, the company is simply acting as an agent for the
tax authorities and does not incur this tax expense itself: it is a tax expense incurred by the
employee. For this reason, the employees’ tax is not included in the company’s tax expense on
the face of the statement of comprehensive income. The company’s salaries and wages expense
will include this employees’ tax (i.e. this salaries and wage expense is measured at the gross
amount – including the employees’ tax!). In South Africa, employees’ tax is also called PAYE
(Pay As You Earn).
(1) Payment to the employee of C8 490 (his salary net of employees’ tax) and the balance of C3 510, being
employees’ tax deducted from the employee’s salary, recorded as owing to the tax authorities.
Comment: Notice how the salaries account shows the gross amount of the salary (C12 000). In other
words, the salaries expense includes:
x the net amount that will be paid to the employee (C8 490) plus
x the employee’s tax that will be paid to the tax authorities on behalf of the secretary (C3 510).
b) Financial statements at year-end (i.e. before employees’ tax paid to the tax authority)
AM Limited
Statement of comprehensive income (extracts)
For the year ended 31 December 20X1
20X1
Administration expenses C
- Salaries and wages 12 000
AM Limited
Statement of financial position (extracts)
As at 31 December 20X1
20X1
Current Liabilities C
- Current tax payable: employees’ tax 3 510
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c) Ledger accounts after year-end (i.e. showing payment of the employee’s tax)
(2) Payment to the tax authorities of the employees’ tax withheld from the employee.
Comment: It is clear from the bank account that, although the employee only receives C8 490, the entity
has to pay a total of C12 000 to retain the services of this employee. Thus the salaries expense in the
statement of comprehensive income is C12 000.
A: 4 Income Tax
Income tax is a term commonly used by the various countries’ tax authorities to refer to the
primary income tax levied on a company’s profits. In South Africa, the standard rate of income
tax applied to companies is currently 28%, but there are many other rates possible depending
on factors, such as the size of the company, and of course the possibility that your tax jurisdiction
is another country entirely. For ease of quick calculations, we will generally use 30% in this
textbook instead of the actual rate of 28%.
It is important to understand that the relevant tax rate/s is not levied on the company’s profit
before tax (i.e. what is referred to as accounting profit), but on the taxable profit.
The calculation of the taxable profit and income tax is covered in depth in Section B: 3.
The journal for income tax is illustrated below. Notice how the current tax payable is debited to
the company’s income tax expense account.
Debit Credit
Income tax (E) xxx
Current tax payable (L) xxx
Current income tax charge for the current year
A: 5 Dividends Tax
A: 5.1 Overview
Dividends tax was introduced in South Africa from
1 April 2012 (the effective date), prior to which secondary
tax on companies was levied. South Africa was one of very few
countries around the world that taxed
dividends in the hands of the company
Dividends tax is a tax imposed on shareholders at a rate of
(i.e. STC).
20% of the dividend received. Secondary tax on companies
was a tax imposed on the entity declaring the dividend and had previously been levied at 10% of the
dividends declared.
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The reason why South Africa changed from secondary tax on companies to dividends tax was to
bring its tax system in line with international standards. Very few countries levy tax on dividends
by way of secondary tax on companies. By bringing its tax system in line with international norms,
South Africa has made it easier for foreign investors to understand its economic environment and
has thus encouraged investment.
Both dividends tax and the previous secondary tax on companies are taxes on cash dividends declared.
However, there is a critical difference between these two taxes (applicable to cash dividends):
x dividends tax is levied on the shareholder receiving the dividend; whereas
x secondary tax was levied on the company declaring the dividend.
The impact of this difference on our financial statements is profound. Since dividends tax is not a
tax on the entity declaring a cash dividend, it does not form part of that entity’s tax expense.
Instead, the entity declaring the cash dividend is simply responsible:
x for calculating the dividends tax that is owed by the
shareholder, Dividends tax
x for withholding this tax when paying the dividend to
x Dividends tax is levied at 20%
the shareholder, and then
x Dividends tax is a tax on the
x for paying this tax to the relevant tax authority. shareholder, but is paid by the entity
on behalf of the shareholder
A: 5.2 Measuring dividends tax x Dividends tax thus does not form part
of the entity’s tax expense.
Dividends tax is calculated as: dividends received by the
shareholder (gross) x the rate of dividends tax. South Africa currently applies a dividends tax rate of 20%.
So, if an entity declares a dividend of C100, then 20% of the dividend to be received by the shareholder
is withheld by the entity declaring the dividend, and the shareholder receives the net amount of C80. Note
however, the above dividend tax implications do not apply to dividend in specie distributions (i.e. it only
applies to cash dividends).
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BI Limited
Statement of changes in equity (extracts)
For the year ended 31 December 20X1
Retained Total
earnings
C C
Balance at 1 January 20X1 1 250 000 xxx
Total comprehensive income 175 000 175 000
Less dividends declared We show 100% of the dividend even (50 000) (50 000)
though 20% is withheld and paid to
the tax authorities as dividends tax
Balance at 31 December 20X1 1 375 000 xxx
BI Limited
Statement of financial position (extracts)
As at 31 December 20X1
20X1
LIABILITIES AND EQUITY C
Current liabilities
Dividends payable 50 000 x (100% - 20%); OR 50 000 – 10 000 40 000
Current tax payable: dividends tax 50 000 x 20% 10 000
Please note: Not all shareholders are liable for dividends tax. For example, local South African companies
would not be liable to pay this tax. However, individuals (thus including business entities run as sole traders
and partnerships), would be. If a shareholder is not liable for this tax, then the declaring company would
not have withheld any dividends tax and the above journal would obviously not have been processed.
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PART B:
Income Tax (current only)
B: 1 Introduction
As explained in Part A, income tax is the tax levied on profits. In South Africa, there are separate
tax rates and rules used for calculating the income tax levied on individuals, companies and
various other forms of business. We will focus exclusively on the income tax applied to
companies. The principles of recognition and measurement are the same no matter whether you
are dealing with income tax on an individual, company or other entity – the only thing that
changes is the calculation of this tax in terms of the tax legislation.
I don’t plan to teach you the intricacies of the tax legislation because you will learn this when you
study tax. This chapter’s objective is to simply help you account for the amount of tax calculated.
However, in order to account for this tax, you will need to know a few of the basic principles
included in the tax legislation, and these we will learn along the way.
If the underlying transaction (or event or item) is recognised in profit or loss, then the tax thereon
must also be recognised in profit or loss. This tax is recognised as an expense and is referred
to as income tax expense. It is possible to have a tax income recognised in profit or loss. This
happens if, instead of a making a taxable profit, we make a tax-deductible loss.
If, however, the underlying transaction (or event or item) is recognised in other comprehensive
income, then the tax thereon must also be recognised in other comprehensive income. We will
recognise this tax as tax on other comprehensive income. If the underlying transaction is income
recognised in other comprehensive income, then there will be a tax expense recognised in other
comprehensive income (i.e. a debit to other comprehensive income). If the underlying
transaction is an expense recognised in other comprehensive income, then there will be a tax
income recognised in other comprehensive income (i.e. a credit to other comprehensive
income). The same principle applies if tax arises on items recognised directly in equity (i.e. the
related tax will also be recognised directly in equity).
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B: 2.4 Tax recognised in other comprehensive income (IAS 12.58 & .61A-62)
The tax on items that are recognised in other comprehensive income (OCI) must also be recognised
as part of other comprehensive income. An example of an item recognised in other comprehensive
income is a revaluation surplus created when revaluing equipment.
B: 2.5 Presentation of tax recognised in other comprehensive income (IAS 1.82-82A & .90-91)
The tax effect of each item of OCI must be presented separately. This may be done on the face of
the statement of comprehensive income or in the notes. However, although the tax effect of each
item of OCI must be presented separately, IAS 1 allows us to choose to present each item of OCI
(e.g. a revaluation surplus) gross (before tax) or net (after tax):
x Option A: Gross: before deducting the related tax. In this case the taxes on all items of OCI are
presented as a single tax line item in the ‘other comprehensive income section’, called ‘tax on
other comprehensive income’. This option means that we will need to include a note to show the
tax effects of each item of OCI separately.
x Option B: Net: after deducting the related tax. In this case the total tax on OCI will not be a
separate line item in the statement of other comprehensive income (as is the case in option A).
There are two sub-options here. We could choose to show each item of OCI:
Option B-1: gross, then show the deduction of its tax effect and then net, in which case no
note will be needed since the tax effect per item is being shown on the face;
Option B-2: net, with no evidence of how much tax was deducted per item, in which case a
note would be required to show the tax effect per item. See IAS 1.91
The current income tax charge has to be estimated by the accountant since the official tax
assessment by the tax authorities, indicating the exact amount of income tax owing on the current
year’s taxable profits, will only be received long after the reporting date.
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Enacted tax rates are rates that are already in law. But, a government could propose to change the
enacted rate, in which case we must assess if the proposal is substantively enacted.
If a ‘new’ rate has been enacted on or before reporting date, it Enacted or substantively
means that the relevant country’s Tax Act has been changed on enacted tax rates
or before this date, but if a new rate has been proposed but not Measure your current income tax using:
legally enacted on or before reporting date, deciding if it has been x the enacted tax rate, unless there is
‘substantively enacted’ by reporting date may require professional x a substantively enacted tax rate that
judgement and a careful assessment of the circumstances. existed at reporting date, &
which will affect the measurement of
For example: current income tax at reporting date.
x In some countries, the announcement can lead to a new tax
rate actually being implemented before the actual date of legal enactment, where the legal
enactment could take place much later: in this case, the date the new rate is simply announced
would be treated as the date of substantive enactment. See IAS 12.48
x In other countries, most or all of the legal stages for formal enactment may need to have occurred
before the new rate can be said to be substantively enacted, in which case the date of the
announcement is not important and can be ignored.
In South Africa, a new rate is generally considered to be substantively enacted on the date it is
announced in the Minister of Finance’s Budget Speech. But if this new rate is inextricably linked to
other tax laws, it is only substantively enacted when it has not only been announced by the Minister
of Finance but also approved, evidenced by it having been signed into statute by the President.
Whilst current tax is to be measured using either the enacted or substantively enacted tax rate at
reporting date, the over-riding rule is that it must be ‘measured at the amount expected to be paid to
(recovered from) the taxation authorities’. Thus, we must use the tax rates that apply (i.e. enacted rates)
or are expected to apply (i.e. substantively enacted rates) to the current period transactions. We must
thus also consider the effective date of any new rates. However, if a rate has been substantively enacted
after reporting date, and even if this rate will be applied retrospectively to the current or prior reporting
periods, we do not make adjustments for this change. Instead, this is accounted for as a non-adjusting
event in terms of IAS 10 Events after the reporting period with extra disclosure of the rate change
required. See IAS 12.46
The income tax rate currently enacted in South Africa is 28%, but for the sake of round numbers, this
book will assume an income tax rate of 30% unless otherwise indicated.
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The current enacted tax rate of 30% should thus be used for the year ended 31 December 20X0.
The substantively enacted tax rate of 28% should thus be used for the year ended 31 March 20X1.
It is important to realise that the applicable rate of income tax Accounting profits are
defined as the:
is not levied on the entity’s ‘accounting profit’ (i.e. profit for
x profit or loss for a period
the period, before tax), but on its ‘taxable profit’. x before deducting tax expense.
Both of these are terms that are defined in IAS 12 (see Taxable profits (or tax losses)
are defined as the:
pop- up alongside). The essence of these two definitions is
x profit (loss) for a period,
that ’accounting profits’ are determined in accordance with x determined in accordance with
the IFRSs (or other accounting standards) and ‘taxable the rules established by the
profits’ are determined in accordance with the local tax taxation authorities,
x upon which income taxes are
legislation. In other words: payable (recoverable).
IAS 12.5
x accounting profit comprises:
income earned Taxable profit and
less expenses incurred; Accounting profit
differ because:
x taxable profit is constituted by: x Accounting profits are calculated
income that is taxable in terms of IFRSs; and
less expenses that are deductible. x Taxable profits are calculated in
terms of local tax legislation.
The differences that arise between the accounting profit and
taxable profit can be categorised into:
x temporary differences (differences that resolve – i.e. disappear over time); and
x permanent differences (differences that will never disappear).
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We can thus convert our accounting profits into taxable profits as follows:
C
Accounting profit (profit before tax) xxx
Adjust for permanent differences xxx
Accounting profit that is taxable (in this year or in some other year) xxx
Adjust for movement in temporary differences xxx
Taxable profit (profit that will be taxed by the tax authorities in this year) xxx
The adjustments for permanent and temporary differences that we make when converting
accounting profits into taxable profits will be explained over the next sections.
The calculation of accounting profit (AP) may include items Permanent differences
of income that are exempt from tax per the tax legislation (i.e. are:
the tax authorities will not charge tax on this income). Income
x the differences between taxable
that is exempt from tax is called exempt income. Exempt profit and accounting profit for
income is income that will never be included in the calculation a period
of taxable profits (TP). x that originate in the current
period and never reverse in
Thus, if we wanted to convert accounting profit into taxable profit subsequent periods.
and the calculation of our accounting profit included exempt These differences are also
income, we would need to subtract the exempt income from referred to as non-temporary
accounting profit to calculate the taxable profit. differences
Conversely, the calculation of accounting profit may include an expense that is not deductible per
the tax legislation. This is called a non-deductible expense. When we say an expense is non-
deductible, we are saying that the tax authorities will never allow it as a tax deduction. In other
words, the expense will never be included as a deduction in the calculation of taxable profits.
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Thus, if we wanted to convert accounting profit into taxable profit where the calculation of our
accounting profit included the deduction of an expense that was non-deductible for tax purposes,
we would have to add back the non-deductible expense to the accounting profit in order to
calculate the taxable profit.
In summary, when converting accounting profits into taxable profits, we adjust for permanent
differences by deducting exempt income and adding back the non-deductible expenses, as
follows:
C
Accounting profit (profit before tax) xxx
Adjust for permanent differences:
Less: exempt income (income that is never going to be taxed) (xxx)
Add: non-deductible expenses (expenses that are not deductible for tax purposes) xxx
Accounting profit that is taxable (in this year or in some other year) xxx
Adjust for movement in temporary differences xxx
Taxable profit (profit that will be taxed by the tax authorities in this year) xxx
Permanent differences will cause the effective rate of tax and the applicable rate of tax to differ
from one another. Thus, since we must disclose relevant and useful information to our users, we
will be required to include a rate reconciliation in the tax expense note (see section B:5).
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Solution 8: Continued …
Comment: It is interesting to note that, although the ‘applicable tax rate’ is 30%, if we compare the tax
expense with the ‘accounting profit’ (rather than the ‘taxable profit’), the ‘effective tax rate’ is only 29.33%
(C264 000 / C900 000). Example 26 shows the disclosure required due to this difference.
We used these steps to calculate ‘taxable profit’ if you’ve been given ‘accounting profit’:
Step 1: Figure out how the transaction affected accounting profit (what is the accounting treatment?).
Step 2: Figure out how the transaction will affect taxable profit (what is the tax treatment?).
Step 3: Starting with the accounting profit, reverse the accounting treatment and replace it with the tax
treatment.
B: 3.4.2.1 General
The taxation of capital profits is a contentious issue, as it is effectively a tax on inflation. In some
countries, capital profits on the sale of an item are exempt from tax, whereas some countries tax
the entire capital profit and yet other countries tax only a certain portion of the capital profit, (i.e. the
remaining portion is exempt from tax). In these latter countries, the taxable portion is often referred
to as the taxable capital gain and is included in taxable profits and taxed at the standard corporate
rate of income tax (e.g. 28% in South Africa).
In South Africa, 80% of a company’s capital gains is taxable, whilst 40% of a natural person’s capital
gains is taxable. In this text, you may assume that 80% of the capital gain is taxable unless the
information provides otherwise.
The accountant calculates a profit or loss on the sale of a non-current asset, in accordance with
the International Financial Reporting Standards (IFRSs), as follows:
Proceeds on sale xxx
Less carrying amount (xxx)
Profit or (loss) on sale xxx
The capital profit included in the profit on sale of a non-current asset is as follows:
Proceeds on sale xxx
Less original cost (xxx)
Capital profit xxx
A capital gain on the sale of a non-current asset, determined in accordance with the tax legislation,
is generally calculated as follows:
Proceeds on sale xxx
Less base cost (xxx)
Capital gain xxx
Capital Gains Tax was introduced in South Africa and was effective from 1 October 2001. This date
is important since capital gains that arose on assets acquired before this date are excluded from
the Capital Gains Tax legislation. For this reason, one must establish the value as at 1 October
2001 (called the ‘valuation date value’) of all assets that were already owned on this date. When
calculating the capital gain (in terms of the Capital Gains Tax legislation) on the disposal of any
one of these assets, its value as at 1 October 2001 is used as its base cost. The base cost for the
disposal of an asset acquired on or after 1 October 2001 will simply be its cost.
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For the purposes of this section, you may assume, unless otherwise stated, that the asset in
question was acquired on or after 1 October 2001 and thus that its base cost (in terms of the tax
legislation) equals its cost (in terms of the relevant IFRS). Example 9 compares the situation
where the base cost equals the cost and where the base cost differs from cost.
Once we have calculated the capital gain, we then calculate the portion that is taxable. This
taxable capital gain is calculated as a percentage of the capital gain, where this percentage
depends on whether or not the taxpayer is a company or an individual. As explained above, the
examples in this text assume that the inclusion rate is 80% for companies, in which case, the
taxable capital gain is calculated as:
Capital gain xxx
Multiplied by the inclusion rate for companies @ 80%
Taxable capital gain xxx
Please note that there is a lot more detail in the tax legislation regarding aspects that affect both
the calculation of the base cost and the calculation of the taxable capital gain. You will study
these other aspects when studying Taxation and are thus outside of the scope of this chapter.
B: 3.4.2.4 Difference: exempt capital profit
In summary, the capital profit (calculated by the accountant and thus included in the accounting
profits) may differ from the taxable capital gain (calculated by the tax authorities and included in
taxable profits). The accounting and tax treatment for such differences (the exempt portion of the
capital profit) will never be the same and are thus referred to as permanent differences.
The exempt portion of the capital profit is simply calculated as:
Capital profit xxx
Less taxable capital gain (xxx)
Exempt portion of the capital profit xxx
Solution 9C: Portion of the capital profit that is exempt from tax
C
Capital profit on sale Example 9A 10 000
Less taxable capital gain Example 9B (8 000)
Exempt capital profit 2 000
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Solution 9E: Portion of the capital profit that is exempt from tax where BC ≠ CP
C
Capital profit on sale Example 9A 10 000
Less taxable capital gain Example 9D (4 000)
Exempt capital profit 6 000
Comment: The C10 000 accounting capital profit on sale is unaffected by the change in the base cost
as the base cost is purely a tax related matter and not an accounting matter.
Solution 9F: Comparing the effects of differing base costs on exempt capital profit
C
Exempt capital profit when ‘base cost = cost’, at C110 000: Example 9C 2 000
Exempt capital profit when ‘base cost ≠ cost’, at C115 000: Example 9E 6 000
Increase in exempt capital profit 4 000
Explanation:
Part E’s base cost (115 000) is higher than the base cost in Part C (100 000). The higher base cost results
in a smaller ‘capital gain’ (the CG decreased by C5 000: C10 000 - C5 000) and thus a smaller ‘taxable
capital gain’ (the TCG decreased by C4 000: C5 000 x 80%). If the ‘taxable capital gain’ gets smaller by
C4 000, it means that the portion of the ‘capital profit’ that is exempt from tax is bigger by C4 000.
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Retailer Limited
Statement of financial position
As at 31 December 20X2
Note 20X2
Current liabilities C
Current tax payable See journals 22 800
Retailer Limited
Statement of comprehensive income (extracts)
For the year ended 31 December 20X2
Note 20X2
C
Profit before tax 100 000
Income tax expense See journals (22 800)
Profit for the year 77 200
Other comprehensive income 0
When this happens, the difference between the accounting profit and taxable profit in a specific year is
thus simply a difference that is temporary because if we compare the total accounting profit and the total
taxable profit over a longer time-period, the difference disappears.
There are many areas in the tax legislation that may lead to temporary differences, but for the purposes of
this text, we will limit our examples to temporary differences caused by the following three categories:
x The accountant’s system of accrual (e.g. expenses prepaid):
The accountant uses the accrual system of accounting whereas the tax authority uses a mixture
between an accrual and a cash system.
The difference between the accountant’s system of accrual and the tax authority’s hybrid system is
discussed in section B: 3.5.2.
x The accountant’s measurement of depreciable assets:
A depreciable asset can also cause differences.
The accountant initially recognises the asset at its cost and then gradually expenses this cost
over its useful life (depreciation or amortisation), where this useful life is relevant to the
specific entity.
The tax authorities, on the other hand, allow the deduction of the cost at a rate that is
stipulated in a generic table of rates laid down in tax legislation.
The rate at which the accountant expenses the asset as depreciation/ amortisation often
differs from the rate at which the tax authority allows the cost of the asset to be deducted from
taxable profits. The difference between the rate at which the asset is expensed (e.g.
depreciation) and the rate at which it is deducted for tax purposes (e.g. wear and tear) causes
temporary differences between the accounting profit and taxable profit.
This is explained in section B: 3.5.3.
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x The method used by the tax authorities to account for tax losses:
A tax loss is a term used by the tax authorities. Instead of paying tax to the tax authorities when
making a taxable profit and receiving compensation from the tax authorities when making a tax loss,
the tax authorities require us to pay tax when making a taxable profit, but in the case of a tax loss,
there is unfortunately no compensation receivable. Instead, tax authorities typically allow this tax
loss to be carried forward to future years and deducted from future taxable profits and thus reducing
the future amount of tax payable. Since the tax loss is incurred in the current year but cannot reduce
the tax payable in the current year, but instead can reduce tax payable in future years, this causes
a temporary difference. This is explained in section B: 3.5.4.
If we know whether an item would have been included in the calculation of accounting profit in a
particular year, and whether this item would or would not also be included in that year’s calculation of
taxable profits, we can then convert our accounting profits into taxable profits. In other words, to convert
accounting profits to taxable profits we simply remove from accounting profits items that the tax authority
would not consider when calculating taxable profits for that year and replacing these items with items
that the tax authorities would consider when calculating taxable profits for that year.
Then, once we have calculated our taxable profits, we can The income tax expense on
the face of the SOCI is
calculate our current income tax for the year. Thus, temporary
the total of:
differences affect the calculation of current income tax.
x Current income tax (this chapter)
Please note that temporary differences will generally also lead x Deferred income tax (next chapter)
to the recognition of deferred income tax. The total ‘tax expense’ for the year is constituted by a
combination of ‘current income tax’ and ‘deferred income tax adjustments’. Deferred tax is explained in
the next chapter.
The accountant’s system of accrual, governed by IFRSs, results in the accountant recognising
income when it is earned and recognising expenses when they are incurred. This often requires
an accountant to utilise ledger accounts, such as the following:
x income received in advance;
x income receivable;
x expenses prepaid;
x expenses payable; and
x provisions.
In contrast, the tax authority’s system is effectively a hybrid between the accrual basis and cash basis
and is governed by a country’s tax legislation. Determining when income will be taxable and when an
expense will be tax-deductible will thus depend on the detail in the tax legislation of the country in which
the entity operates. This detail falls outside the scope of ‘financial reporting’ and is thus not covered in
this text. However, the following provides examples of how the IFRS accrual system may differ from tax
legislation, and thus lead to temporary differences:
x In many cases, tax authorities tax income on the earlier of the date of receipt (cash) or earning
(accrual) and thus:
Receivables: If we earn income before we receive it (e.g. earn it in yr 1 and receive it in yr 2), the
tax authorities will treat it as taxable income in year 1, when it’s earned. Thus, there will be no
difference in timing because the accountant will also recognise it as income in year 1, being the
year it is earned (yr 1: dr receivable, cr income and yr 2: dr bank, cr receivable).
Received in advance: If we receive cash before earning the income (e.g. receive in yr 1 but earn in
yr 2), the tax authorities will treat it as taxable income in year 1, when it’s received. Thus, there will be
a difference in timing because the accountant only recognises it as income in year 2, when it is earned
(yr 1: dr bank; cr income received in advance; yr 2: dr income received in advance, cr income).
x In most cases, tax authorities allow the deduction of an expense on the date it is incurred (i.e. the
same as the accountant), unless there is a prepayment or a provision involved, in which case the
expense could be tax-deductible before it is incurred or after it is incurred.
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Payables: If we incur an expense before we pay for it (e.g. incur in year 1 and pay in year 2), the
tax authorities will generally allow it as a deduction in year 1, when it is incurred. Thus, there will
be no difference in timing because the accountant will also recognise it as an expense in year 1,
being the year it is incurred (yr 1: dr expense, cr payable and yr 2: dr payable, cr bank).
Provisions: If we incur an expense before we pay for it (e.g. incur in year 1 and pay in year 2), but
it relates to a provision, the outcome may differ from a ‘normal’ payable. This is because, unlike a
‘payable’, a ‘provision’ is a liability of uncertain timing or amount (i.e. we may not be sure when it
will need to be paid or how much will need to be paid). Due to this uncertainty, tax authorities will
often ‘disallow’ the deduction of the related expense until year 2, when it has been paid. If this
happens, there will be a difference in timing because the accountant will recognise it as an expense
in year 1, being the year it is incurred (yr 1: dr expense, cr provision and yr 2: dr provision, cr bank).
Prepayment: If we pay cash before we incur the related expense (e.g. pay in year 1 and incur in
year 2), the tax authorities may allow it as a deduction when it is paid (yr 1). If this happens, there
will be a difference in timing because the accountant will only recognise it as an expense in year 2,
being the year it is incurred (yr 1: dr expense prepaid, cr bank and yr 2: dr expense, cr expense prepaid).
A summary of how temporary differences from the accrual system may arise is given below:
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Notes:
1) The ‘portion of the accounting profit that is taxable’ (A) and the ‘taxable profit’ (B) do not differ in either 20X1 or in
20X2. This is because both the accountant and the tax authorities recognise the income on the same
basis (on receipt of income) in 20X1. Thus, there are no temporary differences in 20X1 or 20X2.
Current tax (B x 30%) Dr: Tax expense ; Cr: CT payable 3 600 0 3 600
Notes (AP = accounting profit and TP = taxable profit):
1) 20X1: The 20X1 AP includes no income as the income is not earned in 20X1 (accrual basis).
But the 20X1 TP includes rent income on the basis that it was received (cash basis).
Thus, to convert the AP into TP, we must add C12 000 (a temporary difference arises).
2) 20X2: The 20X2 AP includes rent income as the rent income is earned in 20X2 (accrual basis).
But the 20X2 TP does not include rent income as it was included in the 20X1 TP (cash basis).
Thus, to convert AP into TP, we must deduct the income of C12 000 (temporary difference reverses).
3) Total (Overall): The ‘portion of the accounting profit that is taxable at some stage (A) and the ‘taxable
profit’ (B) differ in each of the years 20X1 and 20X2 (because the accountant recognises it as income
in 20X2 but it gets taxed in 20X1). However, notice that over the 2-year period the total AP and total
TP are the same. Thus, the differences that arose in 20X1 and 20X2 were temporary.
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Required:
A. Show the journal entries in 20X1 and 20X2 relevant to the expense and payment above.
B. Calculate the income tax for each year.
Comment: This example shows how a provision for legal costs is journalised.
20X1 Debit Credit
Legal costs (P/L: E) 150 000
Provision for legal costs (L) 150 000
Provision for legal costs as at 31 December 20X1
20X2
Provision for legal costs (L) 150 000
Bank (A) 150 000
Payment of the legal costs for 20X1
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IFRSs require that the cost of depreciable assets be expensed (as depreciation or amortisation) at a rate that
reflects the entity’s estimation regarding the manner in which the asset is expected to be used.
Tax legislation, however, requires an asset’s cost to be deducted in the calculation of taxable profits based
on standard rates set out in the tax legislation, irrespective of how the Depreciable assets may
entity expects to use up its asset’s life. This deduction, calculated by the cause temporary
tax authorities, is often called, for example, a capital allowance, wear differences
and tear, depreciation for tax purposes or simply a tax deduction. An accountant & tax authority
may deduct the cost of the asset at
The amount expensed when calculating accounting profits (e.g. different rates (e.g. depreciation at
20% versus wear & tear at 10%).
depreciation) and the amount deducted when calculating taxable
profits (e.g. wear and tear) would, however, still equal each other over time - in other words, if we compare
the total accumulated depreciation once the depreciable asset had been fully depreciated with the total
accumulated wear and tear once the cost had been fully deducted as wear and tear. Thus, this means that
any difference between accounting profit and taxable profit that arises because the expense (e.g. depreciation)
and the related tax deduction (e.g. wear and tear) are different amounts in any one year is only temporary.
When converting accounting profits into taxable profits, we aim to ‘reverse’ items that were included in the
calculation of accounting profits but which the tax authority would not use in the calculation of taxable profit
and ‘process’ the items that the tax authority would use when calculating taxable profits. In this case, to
convert accounting profit into taxable profit we would reverse the expense (e.g. depreciation) by adding it
back and subtract the relevant tax deduction instead (e.g. wear and tear).
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Comments:
x In each of the years (20X1, 20X2 and 20X3), the accounting profit differs from the taxable profit.
x However, notice that over the 3-year period, both the accountant and tax authorities agree that the
cost of the asset that may be expensed equals C150 000. Thus, the total accounting profit is C300 000
over these three years and the total taxable profit is also C300 000 over these three years.
x Thus, the difference between the accounting and taxable profits in each individual year was simply
due to annual differences that were temporary (i.e. temporary differences).
When preparing the statement of financial position, an accountant would present the carrying
amount of each of the assets. In the case of depreciable assets, this is the net amount after
deducting accumulated depreciation/amortisation (e.g. cost – accumulated depreciation).
The term that is equivalent to carrying amount but calculated based on tax legislation, is the
asset’s tax base. In the case of depreciable assets, this is the net amount after deducting
accumulated deductions for tax purposes (e.g. cost – accumulated wear and tear).
x Based on the tax legislation, the asset’s tax base is calculated as:
Original cost xxx
Less accumulated deductions for tax purposes (e.g. wear & tear) (xxx)
Tax base xxx
Obviously, if the expense (e.g. depreciation) used to calculate accounting profits differs from the tax-
deduction (e.g. wear and tear) used to calculate taxable profits, then at year-end, the asset’s ‘carrying
amount’ (per the accounting records) and its ‘tax base’ (per the tax records) will also differ.
The fact that the carrying amount and tax base may differ has implications if the asset is sold (explained
in sections B: 3.5.3.3-4) and is used when calculating deferred tax (explained in the next chapter). In
the meantime, the following example illustrates the calculation of the carrying amount and tax base and
how these can differ during the lifetime of the asset.
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B: 3.5.3.3 Depreciable assets: the effect of selling the asset – at below original cost
It can happen that an asset is sold before it has been fully depreciated (or before it has been
fully written off for tax purposes). If the asset is sold where the carrying amount and tax base
differ, the profit or loss on sale calculated in terms of IFRSs will differ from the profit or loss on
sale calculated in terms of the tax legislation.
If an asset is sold below original cost but above its tax base, the tax legislation sees this as a
‘profit on sale’, but refers to it as a ‘recoupment’. Conversely, if an asset is sold below original
cost and below its tax base, the tax legislation sees this as a ‘loss on sale’, but refers to this as
a ‘scrapping allowance’. Both a recoupment and a scrapping allowance are calculated as the
selling price (limited to cost price) less the tax base.
Once again, when converting accounting profits into taxable profits, the aim is to ‘reverse’ items
that were included in the calculation of accounting profits but which the tax authority would not
use in the calculation of taxable profit and ‘process’ the items that the tax authority would use
when calculating his taxable profits. In the case of the sale of a depreciable asset that resulted
in, for example, a profit on sale in terms of IFRSs and a recoupment in terms of tax legislation,
we would reverse the profit by subtracting it from the accounting profit and replace it by adding
the recoupment.
x Based on the tax legislation, the sale could lead to a recoupment or scrapping allowance:
Proceeds on sale, limited to original cost xxx
Less tax base (xxx)
Recoupment / (scrapping allowance) on sale xxx
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B: 3.5.3.4 Depreciable assets: the effect of selling the asset – at above original cost
In the previous section, we limited our discussion to the situation in which a depreciable asset could be
sold for an amount less than the original cost. However, it is entirely possible that the asset could be
sold for more than we originally paid for it.
In this case, our profit on sale, calculated in terms of IFRSs (proceeds – carrying amount) can be split
into two components – the portion of the profit resulting from selling above original cost is referred to as
the capital profit and the remaining portion is the non-capital profit.
The profit or loss on sale of a non-current asset (capital and non-capital portions) in terms of IFRSs, is:
Proceeds on sale xxx
Less carrying amount (xxx)
Profit or (loss) on sale xxx
The capital profit included in this profit on sale of a non-current asset is as follows:
Proceeds on sale xxx
Less original cost (xxx)
Capital profit or (loss) xxx
The non-capital profit included in this profit on sale of a non-current asset is as follows:
Proceeds on sale, limited to original cost xxx
Less carrying amount (xxx)
Non-capital profit or (loss) xxx
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While the profit on sale, calculated in terms of IFRSs, can be split into its capital and non-capital portions,
this is not necessary. However, from a tax perspective, the fact that the asset has been sold at above
original cost could mean that there is a taxable capital gain. This is explained below.
A capital gain on the sale of a non-current asset, determined in accordance with the tax
legislation, is generally calculated as follows:
Proceeds on sale xxx
Less base cost (xxx)
Capital gain xxx
The base cost, which is calculated based on tax legislation, is either equal to the original cost or is a
higher amount. The calculation of the base cost is outside the scope of this chapter. For simplicity, you
may assume that the base cost equals the asset’s cost, unless the information given states otherwise.
The taxable capital gain is then generally a percentage of the capital gain, where this percentage
depends on whether the taxpayer is a natural person or not (e.g. a company). Currently in South
Africa, the inclusion rate is 40% for a natural person and 80% for a company.
Capital gain xxx
Multiplied by inclusion rate for companies @ 80%
Taxable capital gain xxx
The following table summarises a comparison between the various terms used by the
accountant and the tax authorities regarding depreciable assets
Accountant Tax Authorities Notes
N/A: no comparative term Base cost 1 1. Base cost either equals cost or is
greater than cost – used for CGT only
Cost Cost
Depreciation Tax deduction 2 2. Tax deduction can also be called capital
allowance/ wear & tear/ depreciation for
tax purposes etc
Carrying amount 3 Tax base 4 3. Cost less Accumulated depreciation
4. Cost less Accumulated wear and tear
5 6
Capital profit on sale Capital gain & Taxable capital gain 5. Arises if proceeds > cost
6. Arises if proceeds > base cost
7
Non-capital profit on sale Recoupment 8 7. Arises if proceeds (limited to cost) >
carrying amount
8. Arises if proceeds (limited to cost)> tax base
Loss on sale 9 Scrapping allowance 10 9. Arises if proceeds < carrying amount
10. Arises if proceeds < tax base
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Example 19: Capital profit vs. capital gains on sale (proceeds > original cost)
A company sells a vehicle on 1 January 20X2 for C200 000. Details of this vehicle are:
x Cost of vehicle purchased on 1 January 20X1 C150 000
x Depreciation on vehicles to nil residual value 2 years (straight-line)
x Wear and tear on vehicle (allowed by the tax authorities) 3 years (straight-line)
Additional information:
x Profit before tax (after deducting any depreciation on the vehicle but before considering the profit or loss on
sale) in each of the years ended 31 December 20X1 and 20X2 is C100 000.
x Income tax is levied at 30%, the capital gains tax inclusion rate is 80% and the base cost is C150 000.
x There are no temporary differences, no exempt income and no non-deductible expenses other than those
evident from the information provided.
Required:
A. Calculate the profit/ loss on sale in 20X2 per IFRSs: show the capital and non-capital portions.
B. Calculate the recoupment or scrapping allowance on sale in 20X2 per the tax legislation.
C. Calculate the taxable capital gain per the tax legislation.
D. Calculate the taxable profits and current income tax per tax legislation for 20X1 & 20X2.
Solution 19A: Calculation of profit or loss on sale, where it includes a capital profit
20X2
Proceeds on sale C200 000
Less carrying amount Cost: 150 000 – Acc depreciation: (150 000 / 2 x 1year) (75 000)
Profit on sale 125 000
Capital profit Proceeds: 200 000 – Cost: 150 000 50 000
Non-capital profit Proceeds limited to cost: 150 000 – Carrying amount: 75 000 75 000
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B: 3.5.4 Temporary differences caused by tax losses (also known as an assessed loss)
If when calculating taxable profits you get a A deductible tax loss is See IAS 12.5 Reworded
negative figure, it means that the entity has x the loss for a period,
made a tax loss (assessed loss) … not a x calculated in terms of tax legislation,
taxable profit. In other words, a tax loss x upon which income tax is recoverable (i.e. a tax loss
means that, in terms of the tax legislation, the that may be deducted when calculating taxable
entity has made a loss. profits in a future period).
No current tax is payable for the year of assessment in which there is a tax loss (i.e. there will be no current
tax expense).
Sometimes tax losses may be ‘carried forward’ and used as a tax deduction in the following year/s
of assessment. In other words, it may be allowed as a deduction against the taxable profits in the
following year/s, thus reducing that year’s taxable profit and thus that year’s current tax charge (i.e.
it will reduce tax payable in that future year).
If the tax loss is allowed to be carried forward and used as a tax deduction in a future year of
assessment, the tax loss is a temporary difference and is referred to as a deductible tax loss.
If the tax loss is not allowed to be carried forward and deducted in future, the tax loss is a
permanent difference, referred to as a non-deductible tax loss.
Example 20: Tax losses (assessed losses)
Cost of vehicle purchased on 1 January 20X1 C120 000
Depreciation on vehicles to nil residual value 2 years straight-line
Wear and tear on vehicle (allowed by the tax authority) 33% per annum
Income tax rate 30%
Profit/ (loss) before tax (after deducting any depreciation on the vehicle) for the year ended:
x 31 December 20X1: (80 000)
x 31 December 20X2: 30 000
x 31 December 20X3: 100 000
There are no temporary differences, no exempt income and no non-deductible expenses other than
those evident from the information provided.
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Required:
A. Calculate the income tax per the tax legislation for 20X1, 20X2 and 20X3 assuming tax losses can
be used as a tax deduction for future financial years.
B. Calculate the income tax per the tax legislation for 20X1, 20X2 and 20X3 assuming tax losses can
NOT be used as a tax deduction for future financial years.
Solution 20A: Tax losses allowed as a deduction for future financial years
Comment: This shows the calculation of current tax where tax losses are incurred over consecutive years.
Calculation of current income tax 20X3 20X2 20X1
Profit/ (loss) before tax (AP) 100 000 30 000 (80 000)
Add back depreciation (120 000 – 0) / 2 years 0 60 000 60 000
Less wear and tear 120 000 / 3 years (40 000) (40 000) (40 000)
Less assessed loss brought forward (10 000) (60 000) 0
Taxable profit/ (tax loss) (TP/TL) 50 000 (10 000) (60 000)
Current tax at 30% [Dr: TE; Cr: CTP] 15 000 0 0
Solution 20B: Tax losses NOT allowed as a deduction for future financial years
Comment: This shows the calculation of current tax where tax losses are not allowed as a deduction in
the following years and how this simply results in a higher tax charge.
20X3 20X2 20X1
Calculation of current income tax C C C
Profit/ (loss) before tax (AP) 100 000 30 000 (80 000)
Add back depreciation (120 000 – 0) / 2 years 0 60 000 60 000
Less wear and tear 120 000 / 3 years (40 000) (40 000) (40 000)
Less assessed loss brought forward 0 0(1) 0
Taxable profit/ (tax loss) (TP/TL) 60 000 50 000 (60 000)
Current tax at 30% [Dr: TE; Cr: CTP] 18 000 15 000 0
Note:
1) The tax loss of C60 000 in 20X1 is not carried forward to the 20X2 financial year which results in a tax
expense of C15 000 being incurred.
2) Let’s compare Part A and Part B: the total of the current tax charges over the 3 years is lower in Part A
(C15 000) than in Part B (C33 000). The difference of C18 000 is because, in Part B, the tax loss of
C60 000 was not allowed as a deduction (C60 000 x 30%).
Required: Calculate the current tax and show the related journal for the year ended 31 December 20X1.
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Explanatory notes:
(1) At 31 December 20X1, both the interest receivable and electricity payable had already been included in
the calculation of the 20X1 profit before tax (accounting profits) of C100 000, because:
x the accountant will have recognised the interest receivable as interest income in 20X1 (debit interest
receivable and credit interest income) on the grounds that it was earned in 20X1; and
x the accountant will have recognised the electricity payable as an electricity expense in 20X1 (debit
electricity expense and credit electricity payable) on the grounds that it was incurred in 20X1.
Similarly, we are told that the interest was taxable in 20X1 and the electricity was tax-deductible in 20X1.
Thus, since the tax authority ‘agrees’ that the interest is income in 20X1 and that the electricity is an expense
in 20X1, no adjustment is made to the 'profit before tax’ in order to convert it into the ‘taxable profit’ (i.e.
there is no difference between the accounting and tax treatment of these amounts).
(2) Rent received in advance will not have been included in the ‘profit before tax’ (accounting profits) because
amounts received in advance are recognised as liabilities…not income (i.e. received but not yet earned)
(debit bank and credit income received in advance).
However, we are told that this tax authority will tax this rent in 20X1 on receipt of the rental amount (i.e. even
though it is received in advance).
Thus, to convert ‘profit before tax’ into ‘taxable profits’, we need to add the income received in advance.
(3) The prepaid water will not have been included in the ‘profit before tax’ (accounting profits) because
prepayments are recognised as assets…not expenses (i.e. paid but not yet incurred) (debit prepaid
expense and credit bank).
However, we are told that the tax authority will deduct the cost of water in 20X1 when payment is made (i.e.
even though it is paid in advance).
Thus, to convert the ‘profit before tax’ into ‘taxable profits’, we need to deduct the prepaid expense.
(4) Depreciation will have been deducted in the calculation of the 20X1 ‘profit before tax’ (accounting profits).
We are told that this depreciation is calculated at 25% per annum.
However, this tax authority will deduct a capital allowance calculated at a different rate (10% pa on cost).
Since the depreciation deducted when calculating profit before tax (accounting profits) will not be the same
amount as the capital allowance deducted by the tax authority, the accountant’s depreciation must be
added back (reversed) and then the tax authority’s capital allowance must be deducted.
Please note: Both the accountant and the tax authority ‘agree’ that the full cost of C56 000 will be deducted
– the issue is simply how much to deduct each year.
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Solution 21 Continued…
(5) The research costs of C6 400 were expensed in full when calculating the 20X1 profit before tax.
However, the tax authority deducts the C6 400 over 4 years, thus only C1 600 is deductible in 20X1.
Thus, we remove (add back) the C6 400 and deduct the C1 600 to calculate taxable profit.
(6) The increase in the provision for legal costs of C7 200 will have already been included in the
calculation of the 20X1 profit before tax (accounting profits), on the grounds that it was incurred in 20X1
(debit legal expense and credit provision for legal costs).
However, this tax authority will only allow a deduction for legal costs when they have actually been
paid. Since no legal costs have been paid in 20X1, no tax deduction will be allowed in 20X1.
Thus, to convert ‘profit before tax’ into ‘taxable profits’, we add back (reverse) the legal cost expense.
B: 4.1 Overview
The payment system regarding income tax is important to understand. It requires two
prepayments of tax during the year. These are called provisional tax payments. In order to make
each of these payments, the entity will have to estimate the total year’s current income tax half
way through the year and then again at the end of the year. These tax estimates are made by
applying the tax legislation to the profits in the same manner as would be applied by the tax
authority. However, it is important to note that, when making provisional tax payments during the
course of the year, these tax estimates are obviously based on estimated profits (even the
second provisional payment, due on the last day of the current year, would still be based on
estimated profits because the actual profits will only be known with certainty a few months later
when the financial statements have been finalised).
The entity then estimates the total current income tax yet again when the accounting records for
the current year are being finalised, at which point the actual profit on which the current income
tax charge will be based is now known. This third estimate is made for purposes of measuring
the current income tax to be recognised as an expense in the financial statements.
This third estimate is then documented on an official form, commonly referred to as a ‘tax return’,
and submitted to the tax authorities. The tax authorities assess this ‘tax return’ and send the
entity an official assessment thereof, commonly referred to as a ‘tax assessment’. The receipt of
the ‘tax assessment’ will typically occur after the financial statements for the current year under
review have been authorised for issue. Now, it is important to understand that this third estimate
made by the accountant was calculated by applying the tax legislation to the actual profits and
in the same manner as would be applied by the tax authority. Thus, in a perfect world, this should
mean that the tax estimated by the accountant, and recognised as the current income tax
expense for the year (and also documented in the ‘tax return’), will equal the tax calculated by
the tax authorities (documented in the ‘tax assessment’). However, we don’t live in a perfect
world and thus differences may arise that will require an adjustment.
In this regard, if the ‘tax assessment’ indicates that the tax authorities disagree with the total tax
calculated per the ‘tax return’ that was submitted by the entity, an adjustment will have to be
made to the current income tax expense that was recognised. This adjustment will have to be
made in the year in which the assessment is received. The assessment may also require the
entity to make a further top-up payment, if the provisional payments were insufficient, or may
lead to the entity receiving a refund if the provisional payments were greater than required.
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The requirement for provisional payments to be made during the year is intended to reduce the
cash flow shortages of the government during the year and also to ease the company’s burden
of paying an otherwise very large single sum at the end of the year.
These payments are based on estimates made during the year of the expected profit for the year
(please note: tax legislation allows provisional payments to be based on a ‘base amount’ instead
of profits, but this option will be best explained when you study the subject ‘Taxation’ rather than
‘Financial Accounting’). Since circumstances continuously change during the course of any one
year, the expected profit for the year that is estimated half way through the year, (for purposes
of the first provisional payment), will typically differ from the expected profit for the year that is
estimated at the end of the year, (for purposes of the second provisional payment).
After the end of the financial year, when finalising the accounting records, the accountant will be
able to calculate the actual profit for the year. At this point, he will apply the tax legislation to
these actual profits (in the same manner as would be applied by the tax authority) in order to
calculate the estimated current income tax for the year. We still refer to this an estimate of the
tax because the tax authorities must first assess our estimate before it can be said to be final.
As mentioned before, in a perfect world, one would imagine that the accountant’s third and final
estimate of tax should equal the tax calculated by the tax authorities because the accountant
bases his final estimate on final taxable profits, calculated by applying the same legislation that
will be applied by the tax authorities. However, we don’t live in a perfect world and thus
differences may arise that would then require an adjustment to be made.
The final accurate amount of income tax for the year will only be known once the tax authority
has assessed the estimate made by the company. This final tax amount will only be known when
the entity receives this official ‘tax assessment’, which typically occurs well after the financial
year has ended and the financial statements have been published. Thus, whether we over-
provided or under-provided the income tax expense in the statement of comprehensive income
of a financial year, can only ever be discovered in a following financial year. Thus, any
adjustment to correct an over-provision or under-provision of a prior year’s income tax expense
will be made in the financial period in which the relevant assessment is received.
B: 4.3 The first provisional payment (1st estimate of current income tax)
The first payment must be made within six months after the beginning of the financial year.
Therefore, if a company has a 28 February year-end, the first provisional payment will fall due
on 31 August (and the second will fall due on the 28 February).
The first provisional tax payment reflects half the tax the company estimates it will owe for the
full year. The first payment is only half of the total estimated tax because the payment is made
halfway through the year (the rest will be paid when paying the second provisional payment).
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B: 4.4 The second provisional payment (2nd estimate of current income tax)
The second payment must be made on a date not later 1st and 2nd Provisional
than the last day of the financial year. Thus, if a company Payment
has a 28 February year-end, the second provisional
x 1st provisional payment =
payment must be made not later than 28 February.
(estimated taxable profits for the yr
x tax rate) / 2
The second provisional payment represents the
x 2nd provisional payment =
estimated balance still owing to the tax authorities, after
(estimated taxable profits for the yr
taking into account the fact that the first provisional
x tax rate) – (1st provisional pmt)
payment has already been made.
The journal for the second provisional payment is the same as the first:
Debit Credit
Current tax payable/ receivable: income tax (L/A) xxx
Bank (A) xxx
Payment of second provisional payment
Note: the second provisional payment is still based on estimated taxable profits for the year
(although this estimate will generally differ from the estimated taxable profits when making the first
provisional payment) because, due to the complexities involved in finalising financial statements
for the year, the actual taxable profit is only known with accuracy a few months after the financial
year-end (i.e. after the due date for the second provisional payment).
B: 4.5 The final estimate of current income tax (3rd estimate of current income tax)
The accountant makes the final estimate of current income taxation for the current year while
preparing the annual financial statements for publication.
The final estimate of current tax, for purposes of recognising the current income tax expense for
the year, is calculated as:
x Actual taxable profits for the year x Tax rate.
The journal for the final estimated current income tax for the year is:
Debit Credit
Income tax (P/L: E) xxx
Current tax payable/ receivable: income tax (L/A) xxx
Recording estimated current tax in the current year
This estimate is shown as the current portion of the income taxation in the taxation note. Please
note: the total income taxation expense for the year includes both a current portion and a deferred
portion – this chapter explains only the current tax portion – the deferred tax portion is explained
in the next chapter.
The final estimate of how much tax will be charged by the tax authority for the year is seldom equal
to the sum of the first and second provisional payments. This simply results in either a balance
owing to or by the tax authority. This is shown in the statement of financial position as a current
tax asset or a current tax liability.
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Required:
A. Calculate the current income tax expense for 20X1 and current tax payable/ receivable at 31 December 20X1.
B. Show the relevant ledger accounts.
C. Present the income tax expense and the income tax payable in the financial statements for the year
ended 31 December 20X1. Ignore deferred tax.
Company name
Statement of comprehensive income (extracts) 20X1
For the year ended 31 December 20X1 C
Company name
Statement of financial position (extracts) 20X1
As at 31 December 20X1 C
Current liabilities
Current tax payable 20 000
In certain instances, a company may need to make a third provisional payment (generally referred to
as top-up payment) if it is feared that the first and second provisional payments will be significantly
lower than the final tax charge expected from the tax authority’s assessment. The ability to make this
third provisional payment (top-up payment) is useful because there are heavy penalties and interest
that would otherwise be charged by the tax authority if the provisional payments are significantly less
than the final tax amount per the official tax assessment.
B: 4.6 The formal tax assessment and resulting under/ over provision of current tax
This section, dealing with possible under/over-provisions, deals with whether the current income tax
expense had been correctly estimated by the entity. Once the entity finalises the estimate of its current
income tax expense for the year, it journalises it.
In South Africa, this estimate is then also submitted to the tax authorities (i.e. the entity submits its
‘tax return’). The tax authorities then assess this ‘tax return’ and send their ‘tax assessment’ to the
entity. This official ‘tax assessment’ arrives after the financial statements have been finalised.
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The assessment will show the tax charge for the whole year,
based on the tax authority’s calculations, minus the Tax assessment
provisional payments made by the entity leaving either a The assessment should provide
balance owing or receivable. confirmation that
x the tax authority agrees with
Generally, the current income tax that is estimated by the x the current tax expense calculated by
the entity.
entity should equal the actual final income tax charge per the
assessment. In some cases, however, the tax authority may, for example, not allow the deduction of
certain of the expenses claimed. In an instance like this, it will mean that the income tax charge per
the assessment will be greater than the estimated current income tax expense that was recognised
in the entity’s financial statements.
Since the assessment will be received by the entity after its financial statements have been finalised,
any adjustment relating to the prior year’s tax expense will have to be processed in the financial year
in which the assessment is received. The adjustment will either be:
x an under-provision adjustment (increasing the current income tax expense) or
x an over-provision adjustment (decreasing the current income tax expense).
The journal adjusting for an under-provision of a prior year’s current income tax expense is as follows:
Debit Credit
Income tax (E) xxx
Current tax payable/ receivable: income tax (L/A) xxx
The under-provision of tax in yr 1 is adjusted in yr 2
The journal adjusting for an over-provision of a prior year’s current income tax expense is as follows:
Debit Credit
Current tax payable/ receivable: income tax (L/A) xxx
Income tax (E) xxx
The over-provision of tax in yr1 is adjusted in yr 2
B: 4.7 The formal tax assessment and resulting under/ overpayment of current tax
This section, dealing with any under/over-payment deals with the actual cash outflow made to the tax
authority. Compare this to the previous section that deals with the expenses incurred and whether
these were under/over-provided.
When receiving the tax assessment, it will also become apparent whether or not our provisional
payments were sufficient. We may find that our provisional payments:
x were too much, (i.e. we overpaid) in which case the assessment will indicate that a refund will be
paid to us, or
x were too little (i.e. we underpaid), in which case the assessment will indicate that we need to make
a further top-up payment.
Carl Limited has a 31 December year-end. For the purposes of making the first provisional payment,
which falls due on 30 June 20X1, the accountant estimated the taxable profits for the whole of the
20X1 year to be C100 000, being 25% higher than 20X0 taxable profits of C80 000 (C80 000 x 1,25).
The income tax rate is 30%
Required: Calculate the first provisional payment due and post the entries in t-account format assuming it was
paid on due date.
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The first provisional tax payment (paid on 30 June 20X1): (C100 000 x 30%) / 2 = C15 000
Required: Calculate the income tax and show the related ledger accounts for the 20X1 year.
(4) The entity has the option of making a third provisional payment (top-up), but we were told that the
company chose not to make a top-up payment.
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(5) The 20X2 tax expense is adjusted for the under-provision of the tax expense in 20X1.
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Notes:
(6) Payment of the first (and only) provisional payment made in 20X2
(7) Recognising the accountant’s final estimate of current tax relating to the 20X2 taxable profits.
Notice:
x The 20X2 o/balance in the CTP account of C10 000 is the net effect of:
the payments in 20X1 of C60 000 (cr: 40 000 + 20 000) and
the income tax expense in 20X1 of C50 000 (i.e. cr: 60 000 – dr: 50 000 = net credit of C10 000
at end 20X1).
x The under-provision of the 20X1 tax expense is processed in the 20X2 ledger accounts.
Conclusion:
This situation requires a further payment since we have effectively underpaid (P.S. Since the assessment
has already been received, this would not be referred to as a third provisional payment (top-up payment)
but simply a ‘further payment’ – provisional payments are the payments made before the tax assessment
is received).
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Comment:
The revised balance in the tax payable account of C12 000 reflects the under-payment of tax. No journal
is processed for an under-payment. All we do is journalise the payment when it is made.
B: 5.1 Overview
IAS 1 and IAS 12 require certain tax disclosures in the statement of comprehensive income,
statement of financial position and related notes. On occasion, tax may also be disclosed in the
statement of changes in equity. The disclosure of tax in the statement of changes in equity is
covered in the chapters dealing with items that are charged directly to equity.
The amount owing to (or from) the tax authority may relate to a variety of taxes, for instance:
x VAT;
x Employees’ tax; Disclosure
x Dividends tax; and Remember that amounts
x Income tax. owing for various types of
taxes discussed in the beginning of the
If we have a current tax receivable (e.g. a VAT refund chapter must be disclosed separately.
expected) and a current tax payable (e.g. income tax
payable), these balances must not be set-off against each other (i.e. the asset and liability
balances must be presented separately) unless we:
x are legally allowed to settle these taxes on a net basis; and
x either intend to settle the asset or liability on a net basis or intend to settle the liability and
realise the asset at the same time.
Required: Show the disclosure of the current tax asset and liabilities in the entity’s statement of financial
position assuming that:
A. the tax authority allows the VAT and income tax to be settled on a net basis and the entity intends
to settle on a net basis.
B. the tax authority does not allow the VAT and income tax to be settled on a net basis.
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Entity name
Statement of financial position (extracts)
As at …
Part A Part B
Current assets : C C
Current tax receivable: VAT A: N/A (set-off against the liability) 0 50 000
B: Given
Current liabilities
Current tax payable: income tax A: 180 000 liability – 50 000 asset 130 000 180 000
B: Given
IAS 1 (chapter 3) requires that the taxes levied on the entity’s profits should be disclosed as a tax
expense line item on the face of the statement of comprehensive income. This line item should be
presented in the profit or loss section of the statement of comprehensive income and should be
referenced to a supporting note. The supporting note should also provide details of all the major
components of the tax expense (current and deferred).
The note should also provide a reconciliation explaining why the effective rate of tax differs from the
applicable rate of tax (also known as the standard rate of tax) (i.e. this chapter used 30% as the
applicable income tax rate). This reconciliation can be presented in terms of absolute amounts or as
percentages.
Effective tax rate:
The effective tax rate is simply calculated as the tax expense
as a percentage of accounting profit (e.g. profit before tax). x taxation expense in the SOCI
x expressed as a percentage of
The effective tax rate will differ from the applicable tax rate due accounting profit (e.g. the profit
before tax in the SOCI). See IAS 12.86
to permanent differences (also referred to as non-temporary
differences), over/under provisions or rate changes. Please note that temporary differences will not
cause the applicable tax rate and effective tax rate to differ. This is because temporary differences
will be accounted for by processing a deferred tax adjustment, and where this deferred tax will be
included in the tax expense. Deferred tax is explained in the next chapter. A rate change that affects
the rate reconciliation refers to when the tax rate changes in a way that affects the measurement of
deferred tax. Temporary differences and related deferred tax, as well as the concept of rate changes
in the rate reconciliation, will all be explained in chapter 6 on deferred tax.
Entity name
Notes to the financial statements (extracts)
For the year ended …
20X2 20X1
25. Income tax expense C C
x Current income tax xxx xxx
current tax: for the current year xxx xxx
current tax: for the prior year - under/ (over) provided in prior year xxx xxx
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Entity name
Notes to the financial statements (extracts) continued …
For the year ended …
20X2 20X1
25. Income tax expense continued … C C
Rate reconciliation:
The applicable tax rate differs from that of the prior year because a change to the corporate income
tax rate was substantively enacted on … (date).
Retailer Limited
Notes to the financial statements (extracts)
For the year ended 31 December 20X2
20X2
4. Income tax expense C
Current income tax - for the current year 22 800
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Retailer Limited
Statement of comprehensive income (extracts)
For the year ended 31 December 20X2
Note 20X2
C
Profit before taxation 100 000
Income tax expense 4 (22 800)
Profit for the year 77 200
Other comprehensive income 0
Total comprehensive income 77 200
A Limited
Notes to the financial statements
For the year ended 31 Dec 20X2
20X2 20X1
4. Income tax expense C C
Current income tax 56 000 39 000
- Current tax: for the current year 50 000 39 000
- Current tax: under-provision of a prior year 6 000 0
Income tax expense per statement of comprehensive income 56 000 39 000
Reconciliation
Applicable tax rate 30% 30%
Tax effects of:
Profits before tax (PBT) 20X2: 166 667 x 30%; 50 000 39 000
20X1: 130 000 x 30%
Under-provision of current tax in a prior year Per above 6 000 0
Income tax expense per statement of comprehensive income 56 000 39 000
Effective tax rate 20X2: Tax exp: 56 000 / PBT: 166 667 33,6% 30%
20X1: Tax exp: 39 000 / PBT: 130 000
A Limited
Statement of comprehensive income
For the year ended 31 December 20X2
Note 20X2 20X1
C C
Profit before tax Given 166 667 130 000
Income tax expense 4 (56 000) (39 000)
Profit for the year 110 667 91 000
Other comprehensive income 0 0
Total comprehensive income 110 667 91 000
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A Limited
Statement of financial position
As at 31 December 20X2
Note 20X2 20X1
Current Liabilities C C
Current tax payable 31 400 5 400
Required: Disclose the above in the statement of comprehensive income and related notes showing:
A. Items of OCI after tax (i.e. net) in the statement of comprehensive income.
B. Items of OCI before tax (i.e. gross) in the statement of comprehensive income.
Suri Limited
Statement of comprehensive income
For the year ended 31 December 20X1
Notes 20X1
C
Profit before taxation 200 000
Income tax expense 5 (60 000)
Profit for the period 140 000
Suri Limited
Notes to the financial statements
For the year ended 31 December 20X1
20X1
5. Income tax expense C
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Suri Limited
Statement of comprehensive income
For the year ended 31 December 20X1
20X1
Notes C
Profit before taxation 200 000
Income tax expense 5 (60 000)
Profit for the period 140 000
Other comprehensive income (before tax) 77 000
Suri Limited
Notes to the financial statements
For the year ended 31 December 20X1
20X1
5. Income tax expense C
Current income tax - for the current year 60 000
Income tax expense per the SOCI 60 000
Reconciliation:
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Summary
Incurred:
Non-vendors:
x Current (charged)
x Don’t charge VAT
x Deferred (next chapter)
x Can’t claim VAT
Current
VAT vendors must keep a record of VAT
x Estimate of CY assessment
x VAT on purchases (Input VAT)
x Adjustments to PY estimates
x VAT on sales (Output VAT)
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Summary calculations
Calculation of current income tax (converting accounting profit into taxable profit)
Profit before tax xxx
Adjust for permanent differences
(less exempt income and add non-deductible expenses):
x Less exempt dividend income (xxx)
x Less exempt capital profit
- Less capital profit SP - CP (xxx)
- Add taxable capital gain (SP – BC) x 80% xxx
x Add non-deductible fines xxx
x Add non-deductible donations xxx
Profit before tax that the accountant knows will be taxable at some stage xxx
Adjust for movement in temporary differences:
x Add depreciation xxx
x Less wear and tear (xxx)
x Less non-capital profit on sale; or SP (limited to CP) - CA (xxx) or
Add loss on sale xxx
x Add recoupment on sale; or SP (limited to CP) - TB xxx or
Less scrapping allowance on sale (xxx)
x Add income received in advance (c/balance) xxx
x Less income received in advance (o/balance) (xxx)
x Less expense prepaid (c/balance) (xxx)
x Add expense prepaid (o/balance) xxx
x Add provision (c/b) xxx
x Less provision (o/b) (xxx)
Taxable profits/ (loss) xxx
Part of the CP may be exempt from tax: TCG = CG X inclusion rate (80% for companies and
Exempt CP = CP - TCG 40% for individuals in SA);
NCP/ (NCL) = Proceeds (limited to cost) – CA Recoup/ (SA) = Proceeds (limited to cost) – TB
Key
POSA: Profit on sale of asset TPoSA = Taxable profit on sale of asset
CP: Capital profit CG: Capital gain
NCP: Non-capital profiton sale BC: Base cost
NCL: Non-capital loss on sale TCG: Taxable capital gain
CA: Carrying amount TB: Tax Base
AD: Accumulated depreciation Recoup: Recoupment
SA: Scrapping allowance
AW&T: Accumulated wear & tear
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Chapter 6
Taxation: Deferred Taxation
Reference: IAS 12, FRG 1 and IAS 1(including any amendments to 10 December 2019)
Contents Page
1. Introduction to the concept of deferred tax 269
1.1 The inter-relationship of current tax, deferred tax and tax expense 269
Example 1: Current and deferred tax interaction 270
1.2 Creating a deferred tax asset (a debit balance) 271
Example 2A: Creating a deferred tax asset 271
Example 2B: Reversing a deferred tax asset 272
1.3 Creating a deferred tax liability (a credit balance) 273
Example 3A: Creating a deferred tax liability 273
Example 3B: Reversing a deferred tax liability 274
1.4 Deferred tax balance versus the current tax payable balance 275
1.5 Recognition of deferred tax adjustments 275
2. Measurement of deferred tax: the two methods 276
2.1 Overview 276
2.2 The income statement method 276
Example 4A: Income received in advance (income statement approach) 277
2.3 The balance sheet method 279
2.3.1 Overview 279
2.3.2 Tax base of an asset 281
2.3.3 Tax base of a liability 281
2.3.4 Deferred tax is calculated using tax bases and carrying amounts 282
Example 4B, C, D: Income received in advance (balance sheet approach, journals, disclosure) 282
3. Deferred tax caused by year-end accruals and provisions 285
3.1 Overview 285
3.2 Expenses prepaid 285
Example 5: Expenses prepaid 286
3.3 Expenses payable 289
Example 6: Expenses payable 290
3.4 Provisions 292
Example 7: Provisions 293
3.5 Income receivable 296
Example 8: Income receivable 296
4. Deferred tax caused by non-current assets 299
4.1 Overview 299
4.2 Deductible assets 300
Example 9: Cost model – PPE – Deductible and depreciable 301
4.3 Non-deductible assets and the related exemption 304
4.3.1 Overview 304
4.3.2 The exemption from recognising deferred tax liabilities 305
Example 10: Cost model – PPE – Non-deductible and depreciable 306
Example 11: Cost model – PPE – Non-deductible and non-depreciable 308
4.4 Non-current assets measured at fair value 310
4.4.1 Overview 310
4.4.2 Non-current assets measured at fair value and presumed intentions 312
4.4.2.1 Non-depreciable assets measured using IAS 16’s revaluation model 312
4.4.2.2 Investment property measured using IAS 40’s fair value model 312
Example 12: Non-current asset at fair value and presumed intentions 312
4.4.3 Measuring deferred tax based on management intentions 313
4.4.3.1 Intention to sell the asset (actual or presumed intention) 314
4.4.3.2 Intention to keep the asset 314
4.4.4 Measuring deferred tax if the fair valued asset is also non-deductible 314
Example 13: Revaluation above cost: PPE: Non-deductible; depreciable: keep 315
Example 14: Revaluation above cost: PPE: Non-deductible; depreciable: sell 317
Example 15: Revaluation above cost: PPE: Non-deductible; non-depreciable: keep 319
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268 Chapter 6
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1.1 The inter-relationship of current tax, deferred tax and tax expense
As mentioned in the previous chapter, the total income tax expense for disclosure purposes is
broken down into two main components:
Accounting profit and
x current tax; and
Taxable profit definitions:
x deferred tax.
x Accounting profit is profit or loss
The total tax expense, presented on the face of the statement of for the period before deducting tax
expense. IAS12.5
comprehensive income, is the tax incurred on the accounting profits.
These accounting profits are calculated based on the international x Taxable profit is the profit or loss
for the period, determined in
financial reporting standards (IFRSs). The IFRSs involve the accordance with the rules established
concept of accrual and thus the tax expense is based on the by the taxation authorities, upon
concept of accrual. which income taxes are payable (or
recoverable). IAS12.5
This current tax is the tax charged on the current period’s taxable
profits. These taxable profits are calculated based on tax Tax expense is defined as:
legislation (discussed in chapter 5). The tax legislation is not
focussed on the accrual concept, and thus, for example, income x the aggregate amount
x included in the determination of P/L
might be included in taxable profits before it is earned (i.e. before it for the period in respect of
is included in accounting profits). x current tax and deferred tax. IAS12.5
The current tax charged (the amount based on tax legislation) is Current tax is defined as:
debited to the tax expense account (debit tax expense; credit
x amount of income taxes
current tax payable). We then adjust this tax expense account
x payable/(recoverable) in respect of
upwards or downwards so that it shows the tax expense incurred x taxable profit/ (tax loss)
(the amount based on IFRSs). This adjustment is called a deferred x for the period. IAS12.5
tax adjustment and is thus simply an accrual of tax.
This deferred tax adjustment, results in the creation of a deferred tax asset or liability (e.g. a deferred tax
adjustment may involve debiting the tax expense and crediting the deferred tax liability).
Worked example: Imagine we have taxable profit of C100 on which the tax authorities charge us tax, at 30%, of C30
(current tax). The current tax journal would be: Debit tax expense and Credit current tax payable: C30
The following table shows the deferred tax adjustments needed depending on the accounting profit (assume there
are no permanent differences):
Scenario Accounting Tax expense Current tax Deferred tax Deferred tax adjustment:
profit (incurred) (charged) (adjustment) the journal
A C150 C45 (150 x 30%) C30 (given) +15 (45 – 30) Debit tax expense; Credit DT liability
B C80 C24 (80 x 30%) C30 (given) -6 (24 – 30) Credit tax expense; Debit DT asset
The logic described above, of why we process deferred tax Deferred tax is not defined but
adjustments, is often called the ‘income statement method’. the logic of it is that it arises:
However, IAS 12 uses another method commonly called the x when income/expenses (or A/Ls) are
‘balance sheet method’. This chapter will first explain the logic treated differently:
using the income statement method and then the balance under IFRSs (accounting profit); and
under tax legislation (taxable profit)
sheet method. Let’s now work through the following basic x and where these differences will
example (based on example 16 from chapter 5) to explain the reverse (i.e. they are temporary).
logic behind deferred tax.
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Current tax (tax on taxable profit) at 30% 90 000 15 000 37 500 37 500
Debit: Tax expense; Credit: Current tax payable
20X1 & 20X2 journals: Current tax > Tax incurred 20X3 journals: Current tax < Tax incurred
Thus, DT adjustment = Thus, DT adjustment =
x Credit: Tax expense, x Debit: Tax expense;
x Debit: Deferred tax asset x Credit: Deferred tax asset (derecognising the DT asset)
Notice: The tax expense account in each year shows the tax expense incurred. Also notice that over 3 years, the total
current tax charged (90 000) equals the total tax expense incurred (90 000) and thus, that the deferred tax adjustments
net off to nil. This means that the differences in each year were just timing issues.
Tax expense account (debit/credit) Total 20X3 20X2 20X1
Current tax (on taxable profits, per tax legislation) 90 000 15 000 37 500 37 500
Deferred tax adjustment needed: increase/ (decrease) - 15 000 (7 500) (7 500)
Tax incurred (on accounting profits, per IAS 12) 90 000 30 000 30 000 30 000
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Gripping GAAP Taxation: deferred taxation
accountant’s belief that tax has been charged but which x the amounts of taxes recoverable
has not yet been incurred. This ‘premature’ tax charge x in future periods in respect of:
must be deferred (postponed). In some ways, this - deductible temporary differences
treatment is similar to that of a prepaid expense. - unused tax losses carried forward;
- unused tax credits carried forward.
Required: Show the ledger accounts and disclose the deferred tax asset/ liability line-item (in the SOFP)
and tax expense line-item (in the SOCI) together with the tax expense note for 20X1.
Notes:
(1) We record the current tax charge (the estimated amount that will be charged/ assessed by the tax authority).
(2) We record a deferred tax adjustment: we defer a portion of the current tax expense to future years so that the
balance in the tax expense account is the amount we believe has been incurred (i.e. C24 000).
Notice the deferred tax account now has a debit balance of C6 000, meaning we have created a deferred tax asset:
this reflects tax charged in 20X1 that will only be incurred in the future (similar to a prepaid expense).
(3) Please note that it is only the income tax expense account that is closed off to profit or loss (because the current tax
payable is a liability and the deferred tax account is an asset).
Disclosure for 20X1: (the deferred tax asset note will be ignored at this stage)
Entity name
Statement of financial position (extract) 20X1
As at … 20X1 C
Non-current assets
Deferred tax asset 6 000
Entity name
Statement of comprehensive income (extract) 20X1
For the year ended …20X1 Note C
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Entity name
Notes to the financial statements (extract) 20X1
For the year ended …20X1 C
Entity name
Statement of financial position (extract) 20X2 20X1
As at … 20X2 C C
Non-current assets
Deferred tax asset 0 6 000
Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended …20X2 Note C C
Profit before tax xxx xxx
Income tax expense (20X2: CT charge: 42 000 + DT adjustment: 6 000) 3. (48 000) (24 000)
Profit for the year xxx xxx
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Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended ……20X2 C C
3. Income tax expense
x Current 42 000 30 000
x Deferred 6 000 (6 000)
Tax expense per the statement of comprehensive income 48 000 24 000
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Entity name
Statement of comprehensive income (extract) 20X1
For the year ended …20X1 Note C
Profit before tax xxx
Income tax expense CT charge: 15 000 + DT adjustment: 7 000 3. (22 000)
Profit for the year xxx
Entity name
Notes to the financial statements (extract) 20X1
For the year ended …20X1 C
20X1
x The estimated current tax charged by the tax authorities (i.e. based on tax legislation) was C15 000.
x The tax incurred estimated by the accountant (i.e. based on IFRSs): C22 000.
20X2:
x The estimated current tax charged by the tax authorities (i.e. based on tax legislation): C19 000.
x The tax incurred estimated by the accountant (i.e. based on IFRSs): C12 000.
There are no other items affecting deferred tax (i.e. no opening balance and no other temporary differences).
Required: Show the ledger accounts and disclose the deferred tax asset/ liability line-item (in the SOFP)
and tax expense line-item (in the SOCI) together with the tax expense note in 20X2.
274 Chapter 6
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Entity name
Statement of financial position (extract) 20X2 20X1
As at ……..20X2 C C
Non-current liabilities
Deferred tax liability 0 7 000
Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended …..20X2 Note C C
Profit before tax xxx xxx
Income tax expense (CT charge and DT adjustment) 3. (12 000) (22 000)
Profit for the year xxx xxx
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended …20X2 C C
3. Income tax expense
x Current 19 000 15 000
x Deferred (7 000) 7 000
Tax expense per the statement of comprehensive income 12 000 22 000
1.4 Deferred tax balance versus the current tax payable balance (IAS 1.56)
The deferred tax balance differs from current tax payable balance in the following ways:
x The current tax payable / receivable account reflects the amount currently owing to or by the tax
authorities, estimated based on tax legislation. This payable shows tax that has been charged by the
tax authorities and is thus presented as a current liability or asset; whereas
x The deferred tax asset / liability account reflects the additional amount that will be owing in the future
to or by the tax authorities, estimated based on tax legislation. Since this tax is not currently owed to or
by the tax authorities, deferred tax must always be presented as a non-current liability or asset.
Deferred tax adjustments, like current tax adjustments, are Recognition of deferred tax
recognised in profit or loss, other comprehensive income or adjustments:
equity, depending on where the underlying transaction or x If the TD arose due to something in P/L
event was recognised. For example: then the DT adj is recognised in P/L.
x Depreciation is recognised in profit or loss, and thus x If the TD arose due to something in
OCI, then the DT adj is recognised in
any deferred tax adjustment arising because the OCI.
depreciation differs from the related tax deduction (e.g. x If the TD arose due to something in
wear and tear), is also recognised in profit or loss. Thus, equity, then the DT adj is recognised in
this deferred tax adjustment is included in the tax equity.
expense line-item in profit or loss.
x A revaluation surplus arising when revaluing property, plant and equipment (chapter 8: section 4) is
recognised in other comprehensive income and thus the related deferred tax adjustment is also
recognised in other comprehensive income (i.e. it is not included in the tax expense in profit or loss).
x The adjustment to opening retained earnings due to the retrospective correction of a material
prior period error (chapter 26) is recognised directly in equity and thus the related deferred tax
adjustment is also recognised in equity (i.e. it is not included in the tax expense in profit or loss).
A deferred tax adjustment is only processed if the deferred tax asset or liability can be recognised. In this
regard, we may be dealing with a ‘deferred tax exemption’ (see section 5), in which case the deferred tax
asset or liability would not be recognised (i.e. thus we would not process the deferred tax adjustment).
Similarly, deferred tax assets might also not be recognised because the future tax saving is not probable
(i.e. the recognition criteria are not met) (see section 8).
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2.1 Overview
Deferred tax is measured using the relevant tax rates. The tax rate to be used is explained in section 3.
Although deferred tax is always presented as a non-current liability (or asset), IAS 12 expressly prohibits
the discounting (present valuing) of these deferred tax balances.
There are two methods of measuring deferred tax: The income statement and
x the income statement method; and balance sheet approaches:
x the balance sheet method. x Income statement approach:
DT adj = (Accounting profits – Taxable
The previous version of IAS 12 referred to the income profits) x tax rate
statement method, which involves measuring deferred x Balance sheet approach:
tax based on the difference between the tax effects of: DTA/L bal = (CA – TB) x tax rate
x taxable accounting profits and x The DT adjustment and balances will be
x taxable profits. the same for both approaches.
The latest version of IAS 12 describes the measurement of deferred tax in terms of the balance
sheet method. This method requires deferred tax to be measured based on the difference between:
x the carrying amount (CA) of the assets and liabilities, and
x the tax base (TB) of each of these assets and liabilities.
Both methods will give the same answer, but you will generally be required to present your workings
and discussions using the ‘balance sheet method’. The ‘income statement method’ has been used in
prior examples and is explained in more detail below since it is very helpful in understanding the
concept of deferred tax (i.e. that it is rooted in the accrual concept). Furthermore, knowing how to use
the ‘income statement method’ enables us to check our ‘balance sheet method’ calculations.
As we can see, there are two types of differences between accounting profits and taxable profits:
x permanent differences; and
x movement in temporary differences.
We can also see that this calculation can be used to calculate not only the current tax charge
(C x 30%), but also tax expense (B x 30%) and the deferred tax adjustment ((C-B) x 30%).
276 Chapter 6
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The difference between ‘accounting profits’ (A) and ‘taxable accounting profits’ (B) includes
differences that will never reverse: income that is included in the accounting profit but which will
never be taxed and expenses that are included in accounting profit but which will never be tax-
deductible. These are called permanent differences (also known as non-temporary differences).
The difference between ‘taxable accounting profits’ (B above) and ‘taxable profits’ (C above) is
caused by the movement in temporary differences. This movement relates to issues of timing
e.g. when income is taxed versus when it is recognised in the accounting records.
Thus, deferred tax adjustments are only made if there is a movement in the temporary differences.
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The balance sheet method, on the other hand, is the method whereby we first calculate the deferred tax
balances; and then balance back to the deferred tax adjustment (i.e. we calculate the adjustment by
comparing the opening deferred tax balance with the required closing deferred tax balance).
Taxable temporary differences
The idea behind the balance sheet method is that the are defined as:
deferred tax balance (liability or asset) represents the x those that will result in
expected future tax (payable or receivable) that will be x taxable amounts
levied on the expected future transactions that have x in determining taxable profit (tax loss)
already been recognised in the financial statements. x of future periods
x when the CA of the asset or liability is
recovered or settled. IAS 12.5
The expected future transactions that have already been
P.S Taxable temporary differences lead
recognised are reflected in our assets and liabilities (presented to deferred tax liabilities (TD x 30%)
in our statement of financial position). If you revisit the asset
and liability definitions per the Conceptual Framework (see chapter 2), you will see that:
x assets represent the expected future inflow of economic benefits, e.g. future income, and
x liabilities represent the expected future outflow of economic benefits, e.g. future expenses.
Deductible temporary
Let us consider a couple of examples: differences are defined as:
x The carrying amount of plant (an asset) reflects the x those that will result in
expected future inflow of economic benefits (future x amounts that are deductible
x in determining taxable profit (tax
income from future transactions involving the plant). loss)
x The carrying amount of an expense payable reflects x of future periods
x when the CA of the asset or liability is
the expected future outflow of economic benefits recovered or settled. IAS 12.5
(future expenses involving the payable). P.S Deductible temporary differences
lead to deferred tax assets (TD x 30%)
Let us now consider the logic behind why we recognise deferred tax on assets and liabilities. For the
purpose of this exercise, let’s think about why we recognise deferred tax on an asset, such as a
plant (the logic is the same for why we recognise deferred tax on a liability… it is just easier and
quicker to understand the logic of deferred tax using an asset rather than using a liability ͧ
ͪ).
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The logic here is that, in the same way that our current year profits are shown after tax, any future
profits recognised should also be after tax. Thus, when we recognise future income (i.e. when we
recognise the asset), we should also recognise the expected future tax effect (i.e. deferred tax).
x This ‘future tax effect’ could either be a future tax payable (deferred tax liability) or a future tax
saving (deferred tax asset). It depends on what the future tax deductions on this asset are.
The ‘future tax deductions’ relating to an asset (e.g. plant) are referred to as its tax base. In
the case of plant, they include things like wear and tear or capital allowances (i.e. the tax
authority’s equivalent of depreciation … ‘tax-depreciation’).
x Thus, to work out whether the asset (plant) will lead to a future tax payable (deferred tax liability)
or a future tax saving (deferred tax asset), we need to compare its ‘future income’ (i.e. the
asset’s carrying amount) with its related ‘future tax deductions’ (i.e. the asset’s ‘tax base’).
If an asset’s ‘future income’ (carrying amount: CA) exceeds its ‘future tax deductions’ (tax
base: TB), it means we expect a future taxable profit from the asset.
This difference (CA minus TB) is called a taxable temporary difference.
Expecting a ‘future taxable profit’ (taxable temporary difference) means we expect a future
tax payable, which we recognise as a deferred tax liability.
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If an asset’s ‘future income’ (carrying amount) is less than its ‘future tax deductions’ (tax
base), it means we expect a future tax loss/ net tax-deduction from the asset.
This difference (CA minus TB) is a deductible temporary difference.
Expecting a ‘future tax loss/ net deduction’ (deductible temporary difference) means we expect
a future tax saving (i.e. when we get to deduct this excess deduction, it will reduce our
taxable profit and thus reduce our current tax), which we recognise as a deferred tax asset.
Thus, when using the balance sheet method to calculate deferred tax, we compare the carrying
amount of each asset and liability with its tax base. For example, in the case of an asset:
x The carrying amount is its balance recognised in terms of IFRSs (future income);
x The tax base is effectively its balance calculated based on tax legislation (future tax deductions).
We have referred to the term ‘tax base’ a few times already, particularly in context of an asset. However,
the concept of ‘tax base’ can be simply explained as the tax authority’s equivalent of a carrying amount.
In other words, imagine if the tax authorities were to draw up our ledger based on the tax legislation, the
balances in the asset and liability accounts would be called ‘tax bases’.
For example: We buy a plant for C100 000 and depreciate it over 10 years.
After one year the accountant will show the plant’s carrying amount at C90 000 (cost 100 000 – accumulated
depreciation 10 000).
However, if this plant is tax-deductible over 5 years and if the tax authorities were to draw up our ledger for us
(using tax legislation as the basis), after one year, the tax authority would show our plant’s tax base at C80 000
(cost 100 000 – accumulated tax-depreciation 20 000).
P.S. Notice the tax base equals the future deductions on the plant: the tax authorities allow the cost of C100 000
to be deducted over 5 years: since C20 000 is deducted in year one, there are future tax deductions of C80 000.
Any difference between the carrying amount and tax base, Tax base is defined as:
is called a temporary difference.
x the amount attributed to that A or L
x for tax purposes. IAS 12.7
Generally, the existence of a temporary difference means we
must recognise a deferred tax balance (sometimes we don’t – see section 5 and section 8). We
measure the deferred tax balance by multiplying the temporary difference by the relevant tax rate.
For example: The plant in the example above causes a taxable temporary difference, at the end of year 1, of
C10 000 [CA (future income): 90 000 – TB (future tax-deductions): 80 000] and thus, if the tax rate is 30%,
a deferred tax liability of C3 000 must be recognised (temporary difference 10 000 x 30%).
Please note that the deferred tax balance is not the same thing as a deferred tax adjustment.
The ‘deferred tax adjustment’ that we process is calculated by comparing the required closing
‘deferred tax balance’ (temporary differences at the current reporting date x tax rate) with the
opening ‘deferred tax balance’ (temporary differences at the prior reporting date x tax rate).
For example: If there were taxable temporary differences, at the end of year 2, of C50 000, and the tax
rate is 30%, then a deferred tax liability closing balance of C15 000 must be recognised (TD x 30%).
However, if there were taxable temporary differences, at the beginning of year 2, of C10 000 and the tax
rate was 30%, then the deferred tax liability opening balance was C3 000 (TD x 30%).
Thus, since our closing deferred tax balance must be C15 000 (liability), we must journalise a deferred
tax adjustment of C12 000 (DTL closing balance 15 000 – DTL opening balance 3 000), as follows:
Debit Tax expense 12 000
Credit Deferred tax liability 12 000
Although we can visualise the ‘tax base’ as the tax authority’s equivalent of a carrying amount, the ‘tax
base of an asset’ and the ‘tax base of a liability ‘are both defined in IAS 12, and so we need to know
these definitions and how to apply them when calculating a tax base. See sections 2.3.2 and 2.3.3.
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Tax base of an asset e.g. Plant is one of the assets used by the
whose economic
benefits
= Future tax deductions
entity to generate sales. This inflow of sales
will be taxed; thus, the tax base of the plant is
will be taxable the related future tax deductions
(i.e. the tax base is the portion that will be taxed in the future);
x in the case of any other liability:
the tax base will be its carrying amount less any portion that represents future tax deductions
(i.e. the tax base is the portion that will not be allowed as a tax deduction in the future).
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2.3.4 Deferred tax is calculated using tax bases and carrying amounts
A/L Carrying amount: Temporary difference (opening balance) A/L Tax base:
Temporary difference x 30% =
Opening balance Deferred tax (opening balance) Opening balance
Movement:
DT journal
adjustment
A/L Carrying amount: Temporary difference (closing balance) A/L Tax base:
Temporary difference x 30% =
Closing balance Deferred tax (closing balance) Closing balance
A useful format for calculating deferred tax (DT) using the balance sheet approach is as follows:
Deferred tax table Carrying Tax Temporary Deferred Details re the
amount base difference taxation DT bal/ adjust
(CA) (TB) (TD) (DT)
(per SOFP) (per IAS 12)
(a) (b) (b – a) TD x 30%
Opening balances xxx xxx xxx xxx DT A/L
Dr DT A/L
Movement: DT adjustment xxx xxx xxx xxx Cr TE
Or vice versa
Closing balances xxx xxx xxx xxx DT A/L
Note: When using this deferred tax table there are no rules as to how to use brackets. However, in this textbook,
an asset balance (or debit) is always shown without brackets and a liability balance (or credit) is always in brackets.
Also, the temporary difference (TD) is always calculated as ‘tax base – carrying amount’ (not vice versa). If the TD is
positive, it means it is a deductible TD, leading to a deferred tax asset balance. Conversely, if the TD is negative, it
means it is a taxable TD, leading to a deferred tax liability balance. Although it is important to be able to explain if the
outcome is that we have a deductible TD and thus a deferred tax asset, or a taxable TD and thus a deferred tax
liability, by being consistent with brackets, we can quickly and easily identify these outcomes.
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1) CA end 20X1: During 20X1, rent of C120 000 is received before it is earned. Thus, the accountant does
not recognise the receipt of an income but, instead, recognises it as a liability: IRIA. Thus, at the end of 20X1, the
accountant has an IRIA liability with a carrying amount of C120 000.
2) CA end 20X2: The IRIA liability’s carrying amount is zero since the income was earned in 20X2 thus the
balance on this liability account was reversed out to income (Dr IRIA liability and Cr income).
3) TB end 20X1 & end 20X2: The tax authority treats the receipt as income in 20X1, when it is received (the rent is
taxed on the earlier of receipt or earning). Visualising an ‘imaginary tax ledger’, the tax authority debits bank and
credits income, thus not recording an IRIA liability. Thus, the IRIA liability tax base is nil in 20X1 & 20X2. The tax
base can also be calculated using the relevant ‘tax base of a liability’ definition (see W2).
4) TD end 20X1: Since the IRIA liability’s carrying amount (CA) and tax base (TB) differ at the end of
20X1, there is a temporary difference (TD) at the end of 20X1, of 120 000.
Let’s try to understand this TD: the IRIA CA reflects ‘future income’ (120 000) and its TB reflects the
‘portion of the future income that will be taxed in the future’ (nil). This means the resultant TD equals the
‘portion of the future income that will not be taxed in the future’.
Thus, the TD of 120 000 is income that will not be taxed in the future, because it has already been taxed.
This means when we earn this income in the future, we will need to deduct it from the accounting profit to
calculate taxable profit. Thus, we call it a deductible TD.
TD end 20X2: The CA and TB of the IRIA liability are now both nil, and thus the TD is now nil (there is no
difference now since both the accountant and tax authority have recognised the receipt as income.
5) DT end 20X1: Since, at the end of 20X1, we have a deductible temporary difference of C120 000, it means we
have a future tax saving of C36 000 (i.e. when we recognise the rent as income in 20X2, we won’t be charged
tax on it, because we were charged tax on it in 20X1). The future tax saving is an asset to the entity and is thus
recognised as a deferred tax asset (DTA) balance, similar to a tax that has been ‘prepaid’.
DT end 20X2: At the end of 20X2, the temporary difference is nil. This means the deferred tax asset must be nil.
6) DT adjustment in 20X1: To get the DTA opening balance of nil to be a closing balance of C36 000.
DT adjustment in 20X2: To get the DTA opening balance of C36 000 to be a closing balance of nil.
W2. Tax base calculated using the definition of a TB of a L that is IRIA: 20X1 and 20X2
The TBs at the end of both 20X2 and 20X1 were nil (see W1). These can be calculated by applying
the definition of the ‘TB of a liability that is IRIA’: ‘the carrying amount of the liability less the portion
representing income that will not be taxable in future periods’.
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This tax base calculation can also be laid out as follows: 20X1 20X2
Carrying amount (income received in advance) 120 000 0
Less Portion that will not be taxed in the future (120 000) (0)
(20X1: 120 000 won’t be taxed in future because it is taxed in 20X1)
(20X2: Not applicable since there is no carrying amount to consider)
Tax base (Portion that will be taxed in the future) 0 0
Entity name
Statement of financial position (extracts) 20X2 20X1
As at 31 December 20X2 Note C C
Non-current assets
Deferred tax asset 6 0 36 000
Current liabilities
Current tax payable 36 000 36 000
Income received in advance 0 120 000
Entity name
Statement of comprehensive income (extracts) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit before taxation 120 000 0
Income tax expense 15 (36 000) (0)
Profit for the year 84 000 0
Entity name
Notes to the financial statements (extracts) 20X2 20X1
For the year ended 31 December 20X2 C C
6. Deferred tax asset
The closing balance arose due to the effects of:
x Year-end accruals 0 36 000
15. Income tax expense
x Current 0 36 000
x Deferred 36 000 (36 000)
Income taxation per the statement of comprehensive income 36 000 0
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An expense prepaid is an asset. The tax base of an asset is If the asset’s FEB are taxable the:
measured by applying the definition of the ‘tax base of an x TB = future tax deductions
asset’ (see section 2.3.2, or the pop-up alongside). There If the asset’s FEB are not taxable, the
x TB = CA See IAS 12.7
are two versions of this definition – one that applies if the
future economic benefits are taxable and another if the future economic benefits are not taxable.
In most cases the future economic benefits from an asset are taxable, in which case the tax base
will be the asset’s related ‘future tax deductions’.
To calculate the ‘future tax deductions’, we need to know how the tax authorities will treat this expense. If
the expense is not tax-deductible, it means there are no tax deductions at all and thus the tax base is
nil. However, if it is tax-deductible, we need to know when the tax deduction would be granted:
x Generally, tax authorities calculate taxable profits by deducting from income the tax-deductible
expenses when they have been incurred.
If this tax law applies, the tax authorities will not allow the deduction of the actual payment of a
tax-deductible expense if it is prepayment (i.e. since a prepayment means it is not yet incurred).
Instead, the tax authorities will only allow this deduction in the future, when it is incurred.
Thus, in terms of the definition of the tax base of an asset, a prepaid tax-deductible expense of
C100 in year 1 will have a tax base of C100, reflecting that we have a future deduction of C100.
Thus, the tax base is the same as the expense prepaid asset’s carrying amount.
Another way of determining the tax base, without using the definition of the tax base of an
asset, is to think about it as simply being the tax authority’s equivalent of the asset’s carrying
amount. In other words, imagine the tax authority creates a ledger for us based on tax
legislation (an ‘imaginary tax ledger’). Now, let’s consider how the tax authority would record
the payment: since this expense is deductible only when it is incurred, the tax authority will not
yet recognise the payment as an expense (since it is not yet incurred) but as an expense
prepaid asset instead (i.e. Debit Expense prepaid; Credit Bank). Thus, the expense prepaid
asset has a tax base of C100.
Since the carrying amount and tax base are equal, the temporary difference and related
deferred tax is nil.
x Sometimes, the tax authorities allow the deduction of a payment when the payment is made,
even though the payment is made before the tax-deductible expense is incurred.
In this case, in the year the payment is made, the accountant will, as usual, recognise the
payment as an asset (expense prepaid) but the tax authorities will recognise it as a tax-
deduction (i.e. the tax authority will deduct the payment when calculating our taxable profits).
Thus, a prepaid tax-deductible expense of C100 in year 1 will be presented as an asset with a
carrying amount of C100, but it will have a tax base of nil, reflecting that we are expecting
future deductions of nil, because we had already been granted the deduction in year 1.
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The other way of looking at the tax base, by thinking about the 'imaginary tax ledger’, is to
consider how much the tax authority would have debited to the asset account: if the expense is
deducted when it is paid, instead of when incurred, the tax authority would debit an expense in
year 1 (because it was paid in year 1), not an expense prepaid asset (i.e. the tax authority would
not have an asset), thus the tax base of the expense prepaid asset would be nil.
Since an expense prepaid asset has a carrying amount (of C100) and a tax base (of nil) that differ, a
temporary difference and related deferred tax arise:
x Since the temporary difference reflects ‘future taxable profits’, it is a taxable temporary
difference, which thus results in the recognition of a deferred tax liability (future tax: 30).
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Taxable profits and current tax expense 12 000 3 600 20 000 6 000
Notice: This calculation not only shows the current tax charge to be journalised, but also the deferred tax
adjustment (and the total tax expense for each year).
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Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 Note C C
Current assets
Expense prepaid 0 8 000
Non-current liabilities
Deferred tax liability 6 0 2 400
Current liabilities
Current tax payable 9 600 3 600
Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
6. Deferred tax asset/ (liability)
The closing balance is constituted by the effects of:
x Year-end accruals 0 (2 400)
15. Income tax expense
x Current 6 000 3 600
x Deferred (2 400) 2 400
Tax expense per the statement of comprehensive income 3 600 6 000
incurred but not paid) and thus, when we measure its tax base, If the L represents expenses:
we apply the definition of the ‘tax base of a liability’ (see section x TB = CA – Future tax deductions
2.3.3, or the pop-up alongside). This is an example of a liability If the L represents income in advance:
that reflects expenses (as opposed to a liability that represents x TB = CA – Portion not taxable in future
income in advance).
The tax base of an expense payable is ‘carrying amount – future tax deductions’, and thus we need to
know what the ‘future tax deductions’ will be.
x In this regard, the tax authority generally allows tax-deductible expenses to be deducted when they
have been incurred irrespective of whether the amount incurred has been paid.
If this tax law applies, the tax authorities will treat the expense as a tax-deduction now, before it is
paid (on the basis that it has been incurred). This means the ‘future tax deductions’ will be nil.
If we then apply the definition of the ‘tax base of a liability’ (TB = CA – Future deductions), it means
the payable’s tax base will equal its carrying amount (TB = CA – Future deductions: nil = CA).
For example: A tax-deductible expense payable with a carrying amount of C100 at the end of year
1 will have a tax base of C100 (TB = CA: 100 – Future deductions: 0 = 100).
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The other way of looking at the tax base, by thinking about an 'imaginary tax ledger’, is that,
because the tax authority allows the expense to be deducted in year 1, the tax authority would
debit an expense in year 1. Since this expense has not been paid, the tax authority would credit
expense payable. Thus, the tax authority records the transaction in the same way the accountant
does. Thus, the payable’s tax base equals its carrying amount.
Since the carrying amount and tax base are equal (in the example above, the CA and TB are
both C100), the temporary difference and related deferred tax is nil.
x Sometimes the tax authority does not allow the expense to be deducted until it is paid.
In this case we would be expecting ‘future tax deductions’. These future deductions will result in
the tax base being nil (TB = CA – Future deductions).
For example: If we have a tax-deductible expense of C100 that we have not yet paid, and which
the tax authorities will only allow as a deduction in the future (when it is paid), then we have ‘future
tax deductions’ of C100. Thus, our expense payable, which has a carrying amount of C100, will
have a tax base of nil (TB = CA 100 – Future deductions 100).
Since the expense payable has a carrying amount of C100 and a tax base of nil, there will be a
temporary difference of C100 (TB = CA: 100 – TB: nil). This would be a deductible temporary
difference (since it reflects a future tax deduction) and would thus result in a deferred tax asset
(since it reflects a future tax saving).
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Tax base of a
liability that is not
income received
= Carrying amount - Future deductions
in advance
TB in 20X2 = 0 - 0 (1) = 0
This tax base calculation can also be laid out as follows: 20X1 20X2
Comments:
Since both the accountant and tax authorities recognise the telephone cost of C4 000 as an expense/ deduction in
20X1, the accounting profit and taxable profit are the same in both years. In other words, no adjustments are
required in order to convert accounting profits (profit before tax) into taxable profits.
Notice:
This calculation not only shows the current tax charge to be journalised, but also the deferred tax
adjustment (and the total tax expense for each year).
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Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 Note C C
Current liabilities
Expense payable 0 4 000
Current tax payable 10 800 4 800
Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit before taxation 20X1: 20 000 – 4 000 20 000 16 000
Income tax expense 5 (6 000) (4 800)
Profit for the year 14 000 11 200
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
5. Income tax expense
x Current 6 000 4 800
x Deferred 0 0
Income tax expense per the statement of comprehensive income 6 000 4 800
The tax base of an expense payable is ‘carrying amount – future tax deductions’, and thus we need to
know what the ‘future tax deductions’ will be.
x ‘Provisions’ and ‘expenses payable’ may sound similar, but there is a distinct difference: a
provision is a liability of uncertain timing or amount (see chapter 18) and this uncertainty generally
affects when the tax authorities will allow the related expense to be deducted.
x Thus, although tax authorities generally treat expenses as being tax-deductible when they
have been incurred, if the expense relates to a provision (debit expense and credit provision) it
means it involves a high level of uncertainty, and thus the tax authority treats the expense with
more ‘suspicion’. This means the tax authority will generally postpone allowing the tax
deduction of this expense until it is paid (i.e. the tax deduction will only be allowed in the future).
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x If this happens, a temporary difference will arise because the provision will have a carrying amount
but a tax base of nil:
Using the ‘tax base of a liability’ definition (TB = CA – Future tax deductions), the tax base will be nil
because the entire carrying amount represents a future tax-deduction.
For example, if we have a provision with a carrying amount of C100, which the tax authorities will
only allow as a tax-deduction in the future, it means we expect ‘future tax deductions’ of C100, and
thus the tax base will be nil (TB = CA: 100 – Future tax deductions: 100 = 0).
The other way of calculating the tax base is by using an ‘imaginary tax ledger’: since the tax
authority delays allowing the expense as a tax-deduction, it means he effectively does not yet
recognise the transaction at all (i.e. he would not process a journal at all). Thus, this liability has a
tax base of nil.
x In other words, we have deferred tax because, from a balance sheet approach, there is a carrying
amount for the provision but no tax base. Similarly, from an income statement approach, the
accountant recognises an expense, but the tax authority does not yet allow the expense as a tax-
deduction (the tax deduction will only be allowed when it is paid).
x The temporary difference that arises (CA – TB) is a deductible temporary difference (because
we are expecting a future tax deduction when the amount we have recognised is eventually paid).
x Since we have a deductible temporary difference, it means we will recognise a deferred tax asset.
This deferred tax asset reflects a future tax saving (future taxable profits will be reduced when the
related expense is eventually allowed as tax-deduction).
When our provision is reversed, our related deferred tax asset will also be reversed: the provision will be
derecognised when the amount is paid (CA: nil), which is also when we will get the tax-deduction (TB =
CA: 0 – Future deductions: 0 = nil) and thus the expected tax saving is realised (DT asset: nil).
Example 7: Provisions
Profit before tax is C20 000 in 20X1 and in 20X2, according to the accountant and the tax
authority, before taking into account the following information:
x A provision for warranty costs of C4 000 is recognised in 20X1 and paid in 20X2.
x The tax authority will allow the warranty costs to be deducted only once they are paid.
No payments were made to the tax authority in either year (amount owing at end 20X0: nil).
There are no other temporary or permanent differences and no taxes other than income tax at 30%.
Required:
A. Calculate the deferred income tax using the balance sheet approach.
B. Calculate the current income tax for 20X1 and 20X2.
C. Show the related ledger accounts.
D. Disclose the above information in as much detail as possible for the 20X2 financial year.
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Tax base of a
liability that is not
income received
= Carrying amount - Future deductions
in advance
TB in 20X2 = 0 - 0 (2)
= 0
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Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 Note C C
Non-current assets
Deferred tax asset 6 0 1 200
Current liabilities
Provision for warranty costs 0 4 000
Current tax payable 10 800 6 000
Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit before taxation (20X1: 20 000 – 4 000) 20 000 16 000
Income tax expense 15 (6 000) (4 800)
Profit for the year 14 000 11 200
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
6. Deferred tax asset/ (liability)
The closing balance is constituted by the effects of:
x Year-end accruals 0 1 200
15. Income tax expense
x Current 4 800 6 000
x Deferred 1 200 (1 200)
Tax expense per the statement of comprehensive income 6 000 4 800
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If the future inflow that we are expecting is not taxable income (e.g. a dividend receivable generally
leads to the receipt of a dividend that is exempt from tax), then the tax base is simply the asset’s
carrying amount. In this case, there will thus be no temporary difference and no deferred tax.
However, if the future inflow that we are expecting is taxable income (e.g. interest receivable relates to
interest income; a trade receivable relates to sales income, rent receivable relates to rent income etc),
then the tax base is the asset’s ‘future tax deductions’. In this case, to calculate the future deductions,
we need to know when the tax authority will tax the income. In this regard, the tax authority generally
taxes income on the earlier of the date the income is earned or the date it is received. The implications
of this scenario are best explained by way of example.
For example: We have rent receivable of C100 at the end of 20X1. The rent income is taxable.
x The rent income, although not received, is taxed in 20X1 (because it is earned in 20X1 and
the tax authority is taxing this income on the earlier of the date received or earned).
x Since the receivable involves taxable income, the tax base is represented by the asset’s
‘future tax deductions’. This means the tax base is C100.
The future tax deductions are C100 because when we eventually receive the cash of C100,
in order to calculate taxable profits, the tax authorities will have to deduct C100 on the basis
that it has already been taxed in the past (in 20X1).
Taxable profit in the year it is received in cash (i.e. in the future) =
Receipt: 100 – Deduction: portion of the receipt ‘already taxed’: 100 = 0
x Alternatively, the tax base can also be visualised by considering an ‘imaginary tax ledger’.
Since the tax authority recognises the rent of C100 as taxable income in 20X1, he would ‘credit
rent income’, and since it had not been received, he would have to ‘debit rent receivable’.
Thus, the rent receivable would have a tax base of C100.
x Since the receivable’s carrying amount and tax base at end of 20X1 are both C100, the
temporary difference is nil and thus the deferred tax balance is nil.
x From an income statement approach, both the accountant and tax authority treat the rent
receivable as income in 20X1. Since there is no difference in the timing of the income
recognition, the accounting profit and taxable profit will be the same. This means the tax
expense and current tax will be the same. Since there are no differences, no deferred tax
adjustment is necessary.
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will be taxable
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Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 Note C C
Current assets
Income receivable 0 6 000
Current liabilities
Current tax payable 13 800 7 800
Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit before taxation (20X1: 20 000 + 6 000) 20 000 26 000
Income tax expense 5 (6 000) (7 800)
Profit for the year 14 000 18 200
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
5. Income tax expense
x Current 6 000 7 800
x Deferred 0 0
Tax expense per the statement of comprehensive income 6 000 7 800
Another interesting type of receivable is a trade receivable, which is measured net of a loss
allowance (a trade receivable arises from sales income, where the sales are made on credit). How
we measure the deferred tax on this receivable is best explained by way of example.
Trade receivable example: We have a trade receivable at the end of 20X1 with a carrying amount
of C80 (Gross trade receivable account: C100 – Loss allowance account: C20).
The related sales income is taxable when it is earned or received, whichever comes first. Thus, the
sales income of C100 is taxed in 20X1 (when it is earned).
However, since the impairment expense relating to the loss allowance has not yet been realised
(Debit Impairment expense and Credit Loss allowance), it is not yet tax deductible. The tax authority
will only allow the deduction of this impairment when the debt has ‘gone bad’ (i.e. been realised).
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In other words, the impairment will be treated as ‘realised’ (i.e. an actual bad debt) when we have
received all the cash we will ever receive, and we find we have been short-paid.
x In this scenario, our carrying amount is C80, but the tax base, represented by our ‘future tax
deductions’, is C100.
x The reason that our ‘future tax deductions’ are C100 is because we are expecting to receive
cash of only C80, in full and final settlement of the debt of C100. This means that, when the
tax authority calculates the taxable profits in the year that we receive the C80, we will be
granted a total tax-deduction of C100, constituted by:
A deduction of the entire receipt of C80, on the basis that it has already been taxed; plus
A deduction for the bad debt of C20 (bad debts are allowed as a deduction when realised).
Thus, if we received C80 in settlement in 20X2, the taxable profit would be as follows:
Taxable profit 20X2 20X1
Income/ receipts 80 100
Less tax deductions (100) (0)
Portion of receipt already taxed (80)
Bad debt (20)
x The tax base could also be visualised by considering an ‘imaginary tax ledger’. Since the tax
authority recognises the sales income in 20X1, he would credit sales income, and since it had
not been received, he would debit trade receivable. However, whereas the accountant would
then also recognise a loss allowance (Dr Impairment expense and Cr Loss allowance), the tax
authority does not recognise this transaction yet (he will only recognise this when this
estimated impairment is an actual bad debt). Thus, the trade receivable tax base is C100.
x Since, at the end of 20X1, the receivable’s carrying amount is C80, but its tax base is C100, we
have a deductible temporary difference of C20 and thus a deferred tax asset balance of C6.
x From an income statement approach, since the accountant recognises net income of C80 (sales
income: 100 – impairment expense: 20) but the tax authority recognises the sales income of
C100 (i.e. with no expense), the profit before tax is less than taxable profit in 20X1 (i.e. there is a
difference in the timing of the expense). Thus we need a deferred tax adjustment.
If we acquire a non-current asset that is non-deductible, it means its tax base will start off at nil (and will
remain nil). Since the carrying amount starts off at cost, it means that a temporary difference will arise on
initial acquisition. This temporary difference is generally exempt from deferred tax.
Another issue is that, so far, when adjusting deferred tax, the contra entries have always been recognised
as a tax expense in profit or loss (e.g. dr tax expense; cr deferred tax liability). However, if an asset is
measured at fair value under the revaluation model, the contra entry may be the ‘revaluation surplus’
instead, thus recognized in other comprehensive income. Please see section 4.4 and chapter 8.
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The measurement of the deferred tax balance arising from non-current assets is, in principle, no
different to the measurement of deferred tax arising from other assets or liabilities. In essence,
the deferred tax balance must always be measured in a way that is:
x ‘consistent with the expected manner of recovery or settlement’ of the underlying asset. IAS 12.51A
Generally, this means that, if deferred tax is to be recognised on a temporary difference, it is normally
simply measured at the amount of the temporary difference multiplied by the appropriate tax rate.
1. The deferred tax balance is measured as:
Temporary difference x applicable tax rate
2. The temporary difference is measured as:
Tax base (of the asset)
Less carrying amount (of the asset)
However, if the manner in which management expects to recover the carrying amount of a non-current
asset (e.g. management may intend to make income through the use of the asset or through selling it)
might affect the measurement of the future tax that could be payable, then we should take these
management intentions into account when measuring the deferred tax balance. This is because how
we earn future profits from the asset (e.g. through using the asset to make normal operating profits or
selling the asset and perhaps making a capital profit) may impact on the measurement of the future tax,
and it is this future tax that must be reflected in the measurement of our deferred tax balance.
However, if the non-current asset is measured under the cost model (e.g. cost less accumulated
depreciation), management intentions would not have an impact on the measurement of the
related deferred tax balance. It is only if the non-current asset is measured at fair value
(revaluation model or fair value model), that we need to consider management intentions (i.e.
whether management intends to make income from the use of the asset or through selling it).
Interestingly, sometimes we will use management’s actual intentions to measure the deferred
tax, but in other cases we are forced to use presumed intentions (e.g. under certain
circumstances, despite management intending to use an asset, we may have to measure the
deferred tax balance based on a presumed intention to sell the asset).
Measurement of the deferred tax balance when the non-current asset is measured at fair value
(considering management intentions, whether actual or presumed) is explained in section 4.4.
If we sell a non-current asset, the amount we sell it for (sale proceeds) will affect the amount of current
tax payable. This could get fairly complex (e.g. involving recoupments/ scrapping allowances and
taxable capital gains) and was explained in detail chapter 5.
By contrast, the deferred tax implication arising from the sale of a non-current asset is very simple: if the
asset is sold, the carrying amount of the asset is derecognised, and any remaining tax base will fall
away, at which point both the carrying amount and tax base will be nil and thus, since any temporary
difference will have disappeared, any related deferred tax balance must be derecognised.
A few examples involving the sale of non-current assets are included in section 4.5. Notice how the
purpose of the deferred tax adjustment is simply to reverse the deferred tax balance to zero.
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From a tax-perspective, the cost of a non-current asset is generally deductible when calculating
taxable profits (e.g. through wear and tear). Since the tax base of a non-current asset is defined
as ‘future tax-deductions’, if the asset’s cost is deductible, then its initial tax base will reflect its
cost. This tax base will then gradually reduce to nil, as and when the deductions are granted (i.e.
the tax base at the end of each year must reflect the future tax deductions remaining).
Thus, in the case of a tax-deductible asset, the carrying amount and tax base both start off at
cost and will both ultimately reduce to nil. However, the rate at which the asset is expensed
(e.g. through depreciation) versus the rate at which the cost is deducted from taxable profits
(e.g. through a ‘wear and tear’ tax deduction) may differ. For example, plant may be depreciated
at 10% per annum whereas it is allowed as a tax-deduction at 20% per annum. This means that
there will be differences between the plant’s carrying amount and tax base over its useful life.
If the tax base (expected future tax-deductions) exceeds the carrying amount (expected future
taxable income from the asset):
x the difference is called a deductible temporary difference (because it means we expect a
future net tax-deduction); and
x we will recognise a deferred tax asset (a future tax saving).
Conversely, if the tax base (expected future tax-deductions) is less than the carrying amount
(expected future taxable income from the asset):
x the difference is called a taxable temporary difference (because it means we expect a
future taxable profit); and
x we will recognise a deferred tax liability (a future tax payable).
This deferred tax balance will be nil when both the carrying amount and tax base are nil.
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x A deductible temporary difference arises at the end of both 20X1 and 20X2 because, at the end of each
of these years, the future tax deductions (tax base) exceed the future economic benefits (carrying amount):
20X1: Future benefits (CA) – Future tax deductions (TB) = 15 000 – 20 000 = 5 000 (net deduction)
20X2: Future benefits (CA) – Future tax deductions (TB) = 0 – 10 000 = 10 000 (net deduction)
x Since net future deductions are expected (a deductible temporary difference), it means we expect
future tax savings, which must be recognised as a deferred tax asset. For example, at the end of 20X1,
we expect net future tax deductions of C5 000 and thus we expect future tax savings of C1 500.
x Notice the total depreciation of C30 000 (C15 000 x 2 years) equals the total tax-deductions of C30 000
(C10 000 x 3 years). Thus, both accountant and tax authority eventually write-off the plant’s cost.
x This example involves the cost model and thus the asset’s carrying amount cannot possibly exceed cost
(if we use the revaluation model, the carrying amount could exceed cost, in which case we may need to
calculate the deferred tax slightly differently if the tax legislation exempts capital gains and management
intends to sell). Anyway, since we are using the cost model, we can ignore management intentions and
simply apply the tax rate to the temporary difference. In case you are interested, the following proves
management intentions have no effect when the cost model is used:
Intention to sell the asset: no capital profits are possible and thus the entire TD simply reflects an
expected recoupment (or scrapping allowance) that would be taxable (or tax deductible) at 30%;
Intention to keep the asset: the entire TD would simply reflect expected future taxable profits from
the use of the asset (e.g. through the sale of products that it makes) that would be taxable at 30%.
W1. Deferred income tax (balance sheet approach):
Plant: x Depreciable Carrying Tax Temporary Deferred Details re DT bal /
x Deductible amount base difference tax adjust
Tax base of an asset (if future benefits are taxable) = Future tax deductions
In the case of PPE, the tax base is automatically calculated in the deferred tax table (W1) (e.g. the TB at the end
20X1 is 20 000, end 20X2 is 10 000 & end 20X0 is nil (cost – accumulated tax deductions granted to date).
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Entity name
Statement of financial position (extract) 20X3 20X2 20X1
As at …20X3 Note C C C
Non-current assets
Deferred tax asset 4 0 3 000 1 500
Property, plant and equipment 0 0 15 000
Current liabilities
Current tax payable 9 000 6 000 3 000
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Entity name
Statement of comprehensive income (extract) 20X3 20X2 20X1
For the year ended 20X3 Note C C C
Profit before tax 20 000 5 000 5 000
Income tax expense 12 (6 000) (1 500) (1 500)
Profit for the year 14 000 3 500 3 500
Entity name
Notes to the financial statements (extract) 20X3 20X2 20X1
For the year ended 20X3 C C C
4. Deferred tax asset
The closing balance is constituted by the effects of:
x Property, plant and equipment 0 3 000 1 500
12. Income tax expense
x Current 3 000 3 000 3 000
x Deferred 3 000 (1 500) (1 500)
Income taxation expense 6 000 1 500 1 500
4.3.1 Overview
Non-deductible assets
with taxable FEB result in
As mentioned in section 4.2, non-current assets are initially temporary differences on
recognised at cost. Thus, the non-current asset’s carrying acquisition date because:
amount always starts off at cost, and gradually reduces to x the CA starts off at cost
nil by the time its useful life has ended, or if it is disposed of x the TB will start off at zero.
before the end of its life, when it is derecognised.
From a tax-perspective, the cost of a non-current asset Tax base of an asset –the
might be deductible or non-deductible when calculating essence of the definition is:
taxable profits. This will also affect its tax base.
If the asset’s FEB are taxable the:
x TB = future tax deductions
The tax base of a non-current asset reflects the ‘future tax- If the asset’s FEB are not taxable, the :
deductions’ that will be granted. Thus, if the cost of a non- x TB = CA See IAS 12.7
current asset is:
x deductible for tax-purposes, then the tax base starts off at cost and gradually reduces to nil
(see section 4.2).
x not deductible for tax-purposes, then the tax base starts off at nil and simply remains nil.
An exempt temporary
Interestingly, in the case of a non-deductible asset, if the tax
difference is
base starts off at nil, it means that, on the date of initial
a temporary difference on
acquisition, the carrying amount and tax base will differ: which we do not recognise def. tax.
x the carrying amount will equal the asset’s cost, but
x the tax base will be nil.
Due to accounting complications that would occur if we were to recognise deferred tax on this initial
temporary difference, we generally treat this as a temporary difference on which we must not
recognise deferred tax – in other words, this temporary difference is exempt from deferred tax.
The next section explains the reasoning behind the exemption from deferred tax in more detail.
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4.3.2 The exemption from recognising deferred tax liabilities (IAS 12.15 and IAS 12.24)
A taxable TD on
IAS 12.15 states that (the following is slightly reworded):
acquisition date is an
x a deferred tax liability shall be recognised for all taxable exempt TD if it relates to:
temporary differences, x the initial acquisition of an A or L:
- does not relate to goodwill;
x except where the deferred tax liability arises from:
- does not relate to a business
goodwill; or combination; and
the initial recognition of an asset or liability which: - does not affect accounting profit
is not a business combination and or taxable profit. IAS 12.15 reworded
at the time of the transaction, affects neither accounting profit nor taxable profit.
Please note: There is a similar exemption from recognising deferred tax assets: for more information
relating to both exemptions, please see section 5.
IAS 12.15 simply means that a deferred tax liability should always be recognised on taxable
temporary differences except if it meets the requirements to be exempted from deferred tax.
Please note: Although we are focussing on the exemption from recognising deferred tax liabilities arising
from non-current assets in this section, the exemption from recognising deferred tax liabilities could arise on
the acquisition of goodwill and/ or a variety of others assets or liabilities.
Let us apply IAS 12.15 to a non-deductible asset that is not acquired through a business combination:
x A taxable temporary difference will arise on the initial recognition thereof because:
A non-deductible asset is an asset whose cost is not allowed as a deduction when
calculating taxable profits. In such cases, the tax base on date of purchase is zero.
The carrying amount on date of purchase is, as always, the asset’s cost.
Our tax base and carrying amount are usually the same on initial recognition (i.e. date of
purchase) but as you can see, in the case of a non-deductible asset, we have a
temporary difference that arises on initial recognition (TB: zero - CA: cost).
This temporary difference is taxable since these future economic benefits (CA of an
asset = future economic benefits = cost) exceeds the future tax deductions (TB = 0).
x The initial recognition (i.e. purchase) does not affect accounting profit or taxable profit:
It does not affect accounting profit (the purchase involves a debit to the asset account
and a credit to bank or a liability account – it does not affect income or expenses), and
It does not affect taxable profit (the purchase itself does not cause taxable income and
there are no tax-deductible expenses flowing from this purchase).
x Thus, although a deferred tax liability is normally recognised on taxable temporary
differences, no deferred tax is recognised on this taxable temporary difference since it meets
the requirements in IAS 12.15 to be exempted from deferred tax.
Why do we have an
You may be wondering why this taxable temporary exemption?
difference was exempted from the requirement to recognise It is interesting to consider
a deferred tax liability. the reason why such an
exemption was required at all.
Let us consider this question with specific reference to the In order to recognise a DTL on a
taxable TD we obviously need to credit
purchase of a non-deductible asset. As already explained, the DTL and debit something else.
the purchase of a non-deductible asset leads to a taxable The problem was that, in certain
temporary difference that would normally have led to the situations, such as the acquisition of a
non-deductible asset, no-one agreed
recognition of a deferred tax liability, which would have on what we should debit!
required a credit to the deferred tax liability account. But let’s And so the exemption from having to
think where we could have put the corresponding debit... recognise this DT liability arose!
x We cannot debit ‘tax expense’ because:
deferred tax adjustments made to the tax expense account are those relating to temporary
differences that cause taxable profits to differ from accounting profits, so debiting tax expense
would clearly be inappropriate because the purchase of the asset:
did not affect accounting profit, and
did not affect taxable profit.
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The mystery behind exempt temporary differences is thus simply this: where there is no logical
contra-account, the deferred tax on the temporary difference was simply ignored.
Let us consider the effect of the exemption on non-deductible items that involve property, plant
and equipment, by way of example.
Non-deductible items of property, plant and equipment may either be depreciable or non-
depreciable, which means that we could be faced with the following possible combinations:
x Non-deductible but depreciable: see example 10; and
x Non-deductible and non-depreciable: see example 11.
Required:
A. Calculate the deferred income tax using the balance sheet approach.
B. Calculate the current income tax for 20X1, 20X2 and 20X3.
C. Show the related ledger accounts.
D. Disclose the above in as much detail as is possible for all three years (don’t do the deferred tax note).
Notes:
(1) The carrying amount shows the accountant recognising the building at cost and then depreciating
it at 50% pa (i.e. no depreciation in 20X3 since the asset was fully depreciated at the end of 20X2).
(2) The tax base (future tax deductions) shows nil because there are no future tax deductions expected
on this building (i.e. the tax authorities will not allow the deduction of the cost of this building).
(3) Temporary differences arise from the cost of acquisition and subsequent depreciated carrying
amounts since the tax base reflects the future tax deductions of nil.
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(4) Deferred tax is nil, despite the existence of the temporary differences, due to the IAS 12.15 exemption.
The exemption applies to all temporary differences arising from this asset (i.e. the exemption applies
to the original temporary difference of C30 000 arising due to the recognition of the cost, and also to
the subsequent movement in temporary differences caused by the depreciation of this cost).
Notice that depreciation causes the original temporary difference to reduce each year until it is completely
reversed (i.e. when the asset has been fully depreciated, it will have a carrying amount of nil).
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Entity name
Statement of financial position (extract) 20X3 20X2 20X1
As at …20X3 Note C C C
Non-current assets
Property, plant and equipment Ex 10A 0 0 15 000
Current liabilities
Current tax payable Ex 10B/C 18 000 12 000 6 000
Entity name
Statement of comprehensive income (extract) 20X3 20X2 20X1
For the year ended 20X3 Note C C C
Profit before tax Ex 10B 20 000 5 000 5 000
Income tax expense 12 (6 000) (6 000) (6 000)
Profit / (loss) for the year 14 000 (1 000) (1 000)
Entity name
Notes to the financial statements (extract) 20X3 20X2 20X1
For the year ended 20X3 C C C
12. Income tax expense
x Current Ex 10B 6 000 6 000 6 000
x Deferred Ex 10A: W1 0 0 0
Income taxation expense per SOCI 6 000 6 000 6 000
Reconciliation:
Applicable tax rate 30% 30% 30%
Tax effects of:
Profit before tax 20X1 & 20X2: 5 000 x 30% 6 000 1 500 1 500
20X3: 20 000 x 30%
Exempt temporary difference:
x Depreciation on the cost of a non-deductible asset 0 4 500 4 500
20X1 & 20X2: 15 000 x 30%
Income taxation expense per SOCI 6 000 6 000 6 000
Effective tax rate 20X1 & 20X2: 6 000 / 5 000 30% 120% 120%
20X3: 6 000 / 20 000
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Notes:
(1) The carrying amount remains at C30 000 since it is not depreciated.
(2) The tax base (TB = future tax deductions) is zero from the start since the cost of land is not tax deductible
(3) A temporary difference originates in 20X1 since there will be no tax deductions on the asset.
Since land is not depreciated, this original temporary difference never reverses.
(4) There is no deferred tax on this temporary difference due to the IAS 12.15 exemption.
The exemption of the related temporary difference acts much like a non-deductible expense and you
will therefore find it in the tax rate reconciliation in the tax expense note.
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Entity name
Statement of financial position (extract) 20X3 20X2 20X1
As at …20X3 C C C
Non-current assets
Property, plant and equipment W1 30 000 30 000 30 000
Current liabilities
Current tax payable Solution 11C 18 000 12 000 6 000
Entity name
Statement of comprehensive income (extract) 20X3 20X2 20X1
For the year ended 20X3 Note C C C
Entity name
Notes to the financial statements (extract) 20X3 20X2 20X1
For the year ended 20X3 C C C
3. Income tax expense (2)
x Current W2 6 000 6 000 6 000
x Deferred (1) W1 0 0 0
Income taxation expense per SOCI 6 000 6 000 6 000
Notes:
(1) Since there is no movement in temporary differences (see W1), there is no deferred tax adjustment.
(2) Although an exempt temporary difference arose on the original cost, there is no need for a rate
reconciliation since there is no movement in the temporary difference and therefore no effect on either
accounting profit (there is no depreciation) nor taxable profit (there is no tax deduction). Compare this
to example 10D where a rate reconciliation was required since the asset subsequently affected
accounting profits (through the depreciation charge) while no deferred tax was recognised.
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If an asset is measured using the cost model, its carrying amount is its depreciated cost (cost less
accumulated depreciation). Under the cost model, the carrying amount may never exceed this
depreciated cost. Thus, even if management intends to sell the asset at more than its cost (i.e. at a
capital profit), the carrying amount under the cost model will not reflect this expected selling price
and thus the measurement of the related deferred tax balance will not be complicated by a potential
capital profit / taxable capital gain.
Although all prior examples have involved only the cost model, we must remember that it is possible
for non-current assets to be measured at fair value instead, for example:
x Property, plant and equipment and intangible assets may be measured at fair value using the
revaluation model offered by IAS 16 (see chapter 8 and chapter 9 respectively); or
x Investment property may be measured at fair value using the fair value model offered by
IAS 40 (see chapter 10).
If the asset is measured at fair value (using the revaluation model or fair value model), the carrying
amount could end up:
x greater than the asset’s original cost; or
x less than the asset’s original cost.
Bearing in mind that the carrying amount of an asset reflects the future economic benefits from the
asset, if the carrying amount is measured at fair value and management intends to sell the asset, it
means the carrying amount reflects the expected selling price of the non-current asset (i.e. as
opposed to sales income from the sale of the inventory that the non-current asset makes). Thus, if
this carrying amount is greater than cost, it means we are expecting to sell the asset at an amount
greater than cost, which means that a capital gain is expected. This could affect the measurement
of our deferred tax balance if the tax authority taxes capital gains in a different manner to other
income (incidentally, if we actually sell it at this expected selling price, rather than just intend to sell
it, the sale will affect the measurement of our actual current tax payable – not deferred tax).
If the carrying amount is less than cost, the possibility that the expected future economic benefits
could include a capital profit obviously does not exist.
Although the deferred tax balance is normally measured based on how management intends to earn the
future economic benefits, there are two exceptions, where irrespective of what management’s actual
intentions are, the deferred tax balance is measured based on a presumed intention to sell the asset.
Section 4.4.2 explains when we must use presumed intentions and section 4.4.3 explains how these
management intentions (actual or presumed) affect the measurement of the deferred tax balance.
If the non-current asset is measured at fair value, it not only has the potential to affect the measurement
of deferred tax, but it may also affect the recognition thereof. In this regard, in all our prior examples,
when creating or adjusting the deferred tax asset or liability, the contra-entry has always been the ‘tax
expense’, in profit or loss (e.g. credit deferred tax liability and debit tax expense). However, if the non-
current asset is measured at fair value under the revaluation model, the contra entry when adjusting
deferred tax may need to be recognised as an adjustment to the revaluation surplus, in other
comprehensive income (e.g. credit deferred tax liability and debit revaluation surplus).
If the non-current asset’s carrying amount changes (e.g. by 100) but its tax base does not change,
we have a movement in the temporary difference and thus a deferred tax adjustment is required.
x If the change in the asset’s carrying amount was caused by an adjustment affecting profit or loss
(e.g. credit plant and debit depreciation expense), the related deferred tax adjustment must also be
recognised in profit or loss (tax expense) (e.g. debit deferred tax asset credit tax expense).
x If the non-current asset is measured at fair value under the revaluation model (see chapter 8), a
change to its carrying amount due to a revaluation to fair value may affect the ‘revaluation
surplus’, which is an account recognised in other comprehensive income (debit plant and credit
revaluation surplus). If this happens, the related deferred tax adjustment must also be
recognised in other comprehensive income (revaluation surplus) (e.g. debit revaluation surplus
credit deferred tax liability). This is covered in more depth in chapter 8 where the revaluation of
property, plant and equipment is explained in detail.
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4.4.2 Non-current assets measured at fair value and presumed intentions (IAS 12.51B-C)
We normally measure the deferred tax balance based on the expected tax consequences
relevant to the manner in which management intends to recover the asset. However, we ignore
management’s actual intentions and presume the intention is to sell the asset if it is a:
x non -depreciable asset measured at fair value in terms of the revaluation model in IAS 16; IAS 12.51B; or
x investment property measured at fair value in terms of the fair value model in IAS 40. IAS 12.51C
4.4.2.1 Non-depreciable assets measured using IAS 16’s revaluation model (IAS 12.51B)
If the asset is a non-depreciable asset that is measured at fair value in terms of the revaluation
model in IAS 16 Property, plant and equipment, then the presumption is always that the
management intention is to sell the asset. IAS 12.51B
Study tip
The reasoning for this presumption is based on the Read about IAS 16’s
revaluation model in
reasoning behind depreciation: chapter 8 (section 4).
x depreciation reflects that part of the carrying amount
that will be recovered through use (i.e. depreciation is expensed during the same periods in
which revenue is earned through usage); and thus
x if you can’t depreciate an asset, it means that it can’t be used up and thus the presumption
is that the carrying amount (fair value) can only have been measured based on the potential
sale of the asset – even if an attempt had indeed been made to measure the asset’s fair
value based on usage.
4.4.2.2 Investment property measured using IAS 40’s fair value model (IAS 12.51C)
Study tips
If the asset is an investment property that is measured in
terms of the fair value model in IAS 40 Investment property, Revise IAS 40’s fair value
model in chapter 10
then the presumption should be that the management (section 4.5 & 5.3).
intention is to sell the asset. However, the presumption in
the case of investment property is a rebuttable presumption (notice that the presumption in the
case of property, plant and equipment was not rebuttable).
The presumption that investment property would be sold would only be rebutted if the:
x Investment property is depreciable (i.e. had the cost model been used, this particular
property would have been depreciated – in other words, the presumption could never be
rebutted in the case of land since land would not have been depreciable); and
x The investment property is held within a business model the objective of which is to
consume substantially all the economic benefits embodied in the investment property over
time, rather than through sale. IAS 12.51C
Example 12: Non-current asset measured at fair value and presumed intentions
An entity owns a non-current asset that it intends to keep and use. This asset is measured at its
fair value of C140 which exceeds its original cost of C100.
The tax authorities allow the cost of this asset to be deducted over 10 years.
The asset’s base cost is C100 and only 80% of capital gains are included in taxable profits.
The tax authorities levy tax of 30% on taxable profits.
Required: Briefly explain how the deferred tax balance should be measured assuming:
A. The non-current asset is a plant measured in terms of IAS 16’s revaluation model.
B. The non-current asset is a land measured in terms of IAS 16’s revaluation model.
C. The non-current asset is a building measured in terms of IAS 40’s fair value model.
D. The non-current asset is a land measured in terms of IAS 40’s fair value model.
Solution 12: Non-current asset measured at fair value and presumed intentions
Comment: In this example, normal profits (i.e. profits from trading) are taxed at 30% but only 80% of a capital gain
is included in taxable profits and taxed at 30% (i.e. 80% of the capital gain is taxable). Thus, since capital profits
are taxed differently, we must consider management’s intention – or presumed intention.
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A. The asset is plant (depreciable) revalued in terms of IAS 16 Property, plant and equipment.
- IAS 12.51B applies to revalued assets but only to non-depreciable assets.
- Since this plant is depreciable, IAS 12.51B does not apply to it. Thus, we must measure the
deferred tax balance in terms of IAS 12.51A using management’s real intention: the deferred tax
balance will reflect the tax payable/receivable on profits derived from the use of the asset.
B. The asset is land (non-depreciable) measured in terms of IAS 16’s revaluation model.
- IAS 12.51B states that we must presume that all non-depreciable assets measured at fair value in
terms of IAS 16 are to be sold.
- Thus, the deferred tax balance must reflect the tax payable/receivable on profits from the sale of the
asset, even though management intends to recover the carrying amount through usage.
C. The asset is an investment property measured in terms of IAS 40’s fair value model.
- IAS 12.51C states that we should presume investment properties measured under the fair value model
are to be sold. However, the presumption is rebuttable if the property is depreciable and is held within a
business model the objective of which is to consume substantially all the economic benefits from the
investment property over time, rather than through sale.
- In this case, the asset is a building and a building is depreciable (i.e. a building would have been
depreciated had the cost model applied to it). Thus, if the property is held within a business model
the objective of which is to consume substantially all the asset’s future economic benefits over
time, rather than through sale, both criteria for rebuttal will be met and the deferred tax balance
will then be measured based on the actual intention to use the asset.
- If the related business model does not involve consuming substantially all the economic benefits
embodied in the investment property over time, then the deferred tax balance must reflect the
presumed intention to sell. Thus, the balance will reflect the tax that will be payable/ receivable on
profits derived from the sale of the asset, even though management actually intends keeping the
asset and thus recovering the carrying amount through usage
D. The asset is an investment property measured in terms of IAS 40’s fair value model.
- IAS 12.51C states that we should presume investment properties measured under the fair value
model are to be sold. Although the presumption can be rebutted in the case of some investment
properties, the presumption in this case may not be rebutted since one of the requirements for
rebuttal is not met: the asset must be depreciable, but land is not depreciable.
- Thus, the deferred tax balance must reflect the presumed intention to sell: the balance will reflect
the tax payable/ receivable on profits derived from the sale of the asset, even though
management intends to recover the carrying amount through usage.
If the asset is measured at fair value, we must consider what the management intentions are
regarding how the carrying amount of the asset is expected to be recovered. Sometimes we
have to base the measurement of our deferred tax balance on management’s actual intentions
and sometimes we need to base it on the presumed intention to sell the asset.
Management expectations can really only relate to one of the following three intentions. Notice
how the deferred tax calculation differs in each case:
x Sell the asset:
If the intention is to sell the asset, then measure the deferred tax liability or asset to reflect
the tax that would be due or receivable in terms of tax legislation if the asset was sold. The
tax that will be due in terms of tax legislation on the sale of the asset could involve
recoupments/scrapping allowances and capital gains.
x Keep the asset:
If the intention is to keep the asset, then measure the deferred tax liability or asset to reflect
the tax that would be due or receivable in terms of tax legislation based on the income
expected from the use of the asset.
x Keep the asset for a period of time and then sell it:
If the intention is to keep and then sell the asset, then measure the deferred tax liability or asset to
reflect the tax that would be due or receivable in terms of tax legislation on the expected income
from the use of the asset plus the sale of the asset.
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If the asset is measured at fair value and the intention is to sell the asset, the deferred tax on
the revaluation will be measured using the following logic:
x The fair value is the expected selling price of the actual asset.
x The tax deductions do not change simply because the You can find more examples
asset is measured at fair value (i.e. the tax authority will on assets revalued to FV
not increase or decrease the tax deductions allowed). where the intention is to
sell in
x The deferred tax caused by the asset is measured
x Chapter 8: example 13: revaluation to a
based on the tax that would be due on the sale FV that does not exceed cost
thereof at its carrying amount. This could involve: x Chapter 8: example 16 – 18: revaluation
Recoupment (or scrapping allowance), and a to a FV that exceeds cost.
Taxable capital gain: if the asset was revalued to a fair value that exceeded cost.*
* If the asset is revalued to a fair value that does not exceed cost, the taxable profits
cannot involve a capital gain, because capital gains only arise on the proceeds above
cost, but could involve a recoupment or scrapping allowance.
4.4.3.2 Intention to keep the asset You can find more examples
on assets revalued to FV
where the intention is to
If the asset is measured at fair value and the intention is keep:
to keep the asset, the deferred tax caused by this asset x Chapter 8: example 13: revaluation to a
will be measured using the following logic: FV that does not exceed cost
x The fair value is the expected future revenue from the x Chapter 8: example 14 - 15: revaluation
to a FV that exceeds cost
sale of items produced by the asset;
x The tax deductions will not change simply because the asset has been measured at fair value;
x The deferred tax caused by the asset must be measured based on the tax that applies if
sales income were earned to the value of its carrying amount.
Thus, any increase in the carrying amount when re-measuring an asset to fair value would
mean extra sales income is expected but no extra tax deductions would be expected.
It can happen that the non-current asset that is measured at fair value is a non-deductible asset
(i.e. an asset the cost of which is not deductible when calculating taxable profits).
x any temporary difference arising from the initial recognition of such an asset (other than an
asset acquired through a business combination) is exempt from deferred tax; but
x any further temporary difference arising from the revaluation of such an asset is not exempt
from deferred tax (see IAS 12.15 and section 4.3 for revision of the exemption).
The principle that the deferred tax balance should reflect the future tax based on the relevant
intention (to keep or sell) does not change. This is explained below.
If the asset is non-deductible and the intention is to keep the asset, the temporary difference caused by:
x the portion of the carrying amount up to depreciated cost would not lead to deferred tax (that
portion of the temporary difference is exempt from deferred tax in terms of the IAS 12.15);
x the portion of the carrying amount above depreciated cost (i.e. the revaluation surplus) would lead
to the recognition of deferred tax and this deferred tax would be measured by calculating the tax
that would be due/ receivable assuming this increase in carrying amount reflected future sales
(i.e. deferred tax on this increase is measured at tax rates applicable to operating profits).
If the asset is non-deductible and the intention is to sell the asset, the temporary difference caused by:
x the portion of the carrying amount up to depreciated cost would not lead to deferred tax (that
portion of the temporary difference is exempt from deferred tax in terms of the IAS 12.15);
314 Chapter 6
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x the portion of the carrying amount above depreciated cost (i.e. the revaluation surplus)
would lead to the recognition of deferred tax and this deferred tax would be measured as the
tax that would be due/ receivable assuming the asset were sold. Thus:
x If the asset’s fair value does not exceed cost, the There are more examples on
deferred tax balance will be nil: non-deductible assets in:
There is no recoupment possible because there
x Chapter 8: example 21: intention to keep
are no prior deductions to recoup; and (depreciable);
There is no taxable capital gain possible since the x Chapter 8: example 20: intention to sell
expected selling price is less than cost. (depreciable).
x If the asset’s fair value does exceed cost, the deferred tax balance will reflect tax on the
extent to which the fair value over cost is included in taxable profits:
There is no recoupment possible because there are no prior deductions to recoup; but
A taxable capital gain is possible to the extent that the excess of the fair value over
cost is included in taxable profits.
Let us consider why we provide deferred tax on the revaluation surplus by using, as an example, a
non-deductible asset that has been revalued upwards in terms of IAS 16’s revaluation model:
x The taxable temporary difference that arose when the asset was initially acquired (equal to
the cost of the asset (TB – CA) is exempt from deferred tax in terms of IAS 12.15: the
exemption applies to the initial recognition of a non-deductible asset.
x As and when this asset’s cost is depreciated (or impaired), its carrying amount (depreciated
cost) decreases and the resulting decrease in the temporary difference is also exempt from
deferred tax in terms of IAS 12.15: the exemption from recognising deferred tax on the initial
recognition of the cost of a non-deductible asset, also applies to the consequential
movement in temporary differences relating to this cost (i.e. the exemption also applies to the
gradual writing-off of this same initial cost – e.g. depreciation or impairments etc).
x However, if this asset is then revalued upwards, we are adding (debiting) an amount to the
carrying amount (which had previously reflected ‘depreciated cost’): this debit does not involve
the initial recognition of an asset and thus the exemption from deferred tax in IAS 12.15 does
not apply (it only applies to the temporary difference arising from the initial recognition of the cost
of the asset – a revaluation has nothing to do with the initial recognition of an asset – instead, a
revaluation is simply a remeasurement of the asset).
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Comments:
x The tax base of the asset (i.e. future tax deductions) is nil because the asset’s cost is not tax deductible.
x The closing deferred tax balances of C252 and C126 in W1, the ‘deferred tax table’, are actually
calculated separately in W2.
However, instead of calculating our deferred tax using the combination of W1 and W2, we could add
more detail into the deferred tax table. This alternative, more detailed layout is shown in W3.
Using a combination of W1 and W2 can be helpful when trying to understand the deferred tax implications,
but W3 tends to be quicker under exam conditions. Thus, this alternative (W3) is the layout we will use in
chapter 8, which is the chapter that explains how to account for revaluations.
x When the deferred tax movement is caused by an adjustment to the asset’s carrying amount that was
recognised in revaluation surplus, part of ‘other comprehensive income’ (OCI) (not ‘profit or loss’), then
the contra entry when debiting/crediting ‘deferred tax’ is to credit/debit the ‘revaluation surplus’ (not
‘tax). The DT adjustment is thus recognised in OCI instead of P/L (see section 4.4.1)
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x Instead of using W2, the DT balance of C252 at 31 December 20X2 (see W1) could be calculated using
the following structure, which would replace the line that reads ‘Balance: 31/12/20X2’ in the W1 table.
CA TB TD DT
Balances: 31/12/20X2 1 440 0 (1 440) (252) DTL
CA before revaluation: 600 0 (600) 0 Exempt (0%) (1)
Depreciated cost: (1 200 – 300 x 2yrs)
Effect of revaluation - up to cost: 600 0 (600) (180) (0-600) x 30% (2)
Depreciated cost 600 – FV, limited to cost 1 200
Effect of revaluation – above cost: 240 0 (240) (72) (0-240) x 30% (2)
Cost 1 200 – FV 1 440
x Instead of using W2, the DT balance of C126 at 31 December 20X3 could be calculated using the
following structure, which would replace the line that reads ‘Balance: 31/12/20X3’ in the W1 table.
CA TB TD DT
Balances: 31/12/20X3 720 0 (720) (126) DTL
CA before revaluation: 300 0 (300) 0 Exempt (0%) (1)
Depreciated cost 1 200 – 300 x 3yrs
Effect of revaluation - up to cost: 420 0 (420) (126) (0-420) x 30% (2)
Depreciated cost 300 – FV, limited to cost 720
(cost not a limiting factor)
Effect of revaluation – above cost: 0 0 0 0 (0-0) x 30% (2)
N/A
Notes:
(1) DT is not recognised because it is exempt
(2) DT is recognised and measured at the tax that will be due if these extra benefits are earned as operating profits.
Entity name
Notes to the financial statements (extract) 20X4 20X3
For the year ended …20X4 C C
3. Income tax expense
Income taxation expense 516 xxx
x Current 13A 516 xxx
x Deferred 13B: W1 (the DT adj was credited to RS not TE) 0 xxx
Rate reconciliation:
Applicable tax rate 30% xxx
Tax effects of
x Profit before tax 1 000 (13A) x 30% 300 xxx
x Non-deductible depreciation 720 (13B: W1) x 30% 216 xxx
Tax expense on face of statement of comprehensive income 516 xxx
Effective tax rate 516 / 1 000 51,6% xxx
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Comments: The tax base of the asset (i.e. future tax deductions) is nil because the asset’s cost is not tax
deductible. The closing deferred tax balances in the deferred tax table in W1, are calculated separately in W2.
However, instead of using W2, we could use a slightly more detailed deferred tax table. This alternative working is
shown in W3. This alternative is used in chapter 8, example 20. Both alternatives achieve the same answer.
318 Chapter 6
Gripping GAAP Taxation: deferred taxation
x The line in the DT table (W1) that reads ‘Balance: 31/12/20X3’ could be replaced by.
Balances: 31/12/20X3 720 0 (720) 0 DTL
CA before revaluation 300 0 (300) 0 TD 300 = Exempt (1)
Depreciated cost 1 200 – 300 x 3yrs
Effect of revaluation - up to cost: 420 0 (420) 0 TD 420 x 0% (2)
Depreciated CA 300 – FV, limited to cost 720
(cost not a limiting factor)
Effect of revaluation - above cost 0 0 0 0 TD 0 x 80% x 30% (3)
N/A
Notes:
1) This portion of the TD is exempt from DT since it relates to depreciated cost – no DT is recognised
2) This portion of the TD normally reflects the increase in the expected recoupment caused by the
revaluation. However, this is a non-deductible asset (i.e. no tax-deductions are granted) and thus there is
nothing to recoup. Thus, we simply multiply this TD by 0% (instead of 30%).
(P.S. If the asset was deductible, then, at the end of 20X2, just before revaluation, the TD of C600 would
mean we are expecting a recoupment of C600, but after the revaluation upwards by C600 to original cost of
C1 200 , we would be expecting a recoupment of C1 200 – being an increase in the recoupment of C600).
3) This portion of the TD reflects the capital gain. In this example, 80% of the capital gain is included in taxable
profits, which are then taxed at 30% (i.e. the DT on this TD is calculated at an effective tax rate of 24%).
Entity name
Notes to the financial statements (extract) 20X4 20X3
For the year ended …20X4 C C
3. Income tax expense
x Current Sol 14A and Sol 13A 516 xxx
x Deferred Sol 14B: W1 (the DT adj was credited to RS not TE) 0 xxx
Income taxation expense per statement of comprehensive income 516 xxx
Rate reconciliation:
Applicable tax rate 30% xxx
Tax effects of
x Profit before tax 1 000 (Sol 14A/13 A) x 30% 300 xxx
x Non-deductible depreciation 720 (Sol 14B: W1) x 30% 216 xxx
Income taxation expense per statement of comprehensive income 516 xxx
Effective tax rate 516 / 1 000 51,6% xxx
Chapter 6 319
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320 Chapter 6
Gripping GAAP Taxation: deferred taxation
Entity name
Notes to the financial statements (extract) 20X4 20X3
For the year ended …20X4 C C
Rate reconciliation:
Tax effects of
x Profit before tax Sol 15A: 760 x 30% 228 xxx
x Non-deductible loss Sol 15A: Accounting loss on sale 240 x 30% 72 xxx
x Taxable capital gain Sol 15A: Taxable capital gain: 480 x 30% 144 xxx
Tax expense on face of statement of comprehensive income 444 xxx
Effective tax rate Tax: 444 / Profit before tax: 760 58,4% xxx
Recoupments and scrapping allowances can only ever apply to an asset that is tax deductible.
Please note that capital losses are not covered in this text.
These differences are covered in detail in chapter 5. A summary of the calculations in the
accounting records and tax records follows.
IFRS and the accounting records Tax legislation and the tax records
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A recoupment is the reversal of tax deductions allowed in prior years whereas a scrapping
allowance is simply the granting of a further deduction where the asset is sold at a loss.
The deferred tax implications of the sale of an asset is very simple. Its carrying amount is
derecognised when set off against the proceeds, to calculate profit or loss on sale. Similarly,
any remaining tax base is also ‘derecognised’ when set off against the proceeds to calculate the
recoupment/ scrapping allowance. At this point, both the carrying amount and tax base will be nil.
Thus, since any temporary difference will have disappeared, any related deferred tax balance
must be derecognised. So, we simply reverse the deferred tax balance to zero.
The following two examples revise how the sale of an asset affects current tax (see chapter 5).
Then, examples 18 - 23 show the deferred tax implications of the sale of an asset.
The tax authority is recouping C300 of the prior tax deductions because the total tax deductions granted to
date is C800 and yet the net cost to the company is only C500 (800 – 500).
Solution 16D: Comparison of effect of the asset on Profit before tax and Taxable profits
The real net cost to the company is a net cash outflow of C300 (see example 16B).
This is reflected in both ‘profit before tax’ and ‘taxable profit’: Profit before tax Taxable profit
Depreciation/ Tax deductions 20X1 & 20X2 (Solution 16A) 800 600
Profit / Recoupment on sale 20X3 (Solution 16C W1 and W2) (500) (300)
Net expense/ tax deduction 300 300
322 Chapter 6
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Note 1: The scrapping allowance reflects an extra tax deduction that will be granted when calculating taxable profit
in the year of the sale.
The tax authority is giving an extra deduction of C300 because the total tax deductions granted to date is
only C600 (Sol 17A) and yet the net cost to the company is C900 (Sol 17B).
Solution 17D: Comparison of effect of the asset on Profit before tax and Taxable profits
The real net cost to the company is a net cash outflow of C900 (see example 17B). This is reflected in both
the profit before tax and the taxable profit over the 3 years (20X1, 20X2 and 20X3). This proves that any
difference over the years is purely a temporary difference (i.e. the differences disappear over time):
Profit before tax Taxable profit
Depreciation/ Tax deductions 20X1 & 20X2 (Solution 17A) 800 600
Loss / Scrapping allowance on sale 20X3 (Solution 17C W1 and W2) 100 300
Total expense/ tax deduction 900 900
Example 18: Sale of a deductible, depreciable asset (plant) at below cost, and
showing the deferred tax implications
A plant was purchased on 1 January 20X1 for C30 000 and sold on 1 January 20X2 for C21 000.
x The plant is measured under the cost model and is depreciated straight-line at 50% p.a. to a nil
residual value. There are no other items of property, plant and equipment.
x The rate of wear and tear allowed as a tax deduction is 33 1/3 % p.a. straight-line.
x The profit before tax is C20 000 in 20X1 and 20X2, according to both the accountant and the tax
authority, before taking into account the asset in any way.
x No payments were made to the tax authority in any of the years (amount owing at end 20X0: nil).
x There are no other temporary or permanent differences and no taxes other than income tax at 30%.
Required:
A. Calculate the deferred income tax using the balance sheet approach.
B. Calculate the current income tax for 20X1 and 20X2.
C. Show the tax-related ledger accounts.
D. Disclose the above in the SOFP, SOCI and tax-related notes for the year ended 31 December 20X2.
Chapter 6 323
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324 Chapter 6
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Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit before tax (20 000 + 6 000); (20 000 – 15 000) 26 000 5 000
Income tax expense 15. (7 800) (1 500)
Profit for the year 18 200 3 500
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
Notice: This tax expense note does not include a tax rate reconciliation. This is because the effective tax
rate is 30% each year (7 800 / 26 000 and 1 500 / 5 000), which equals the applicable tax rate of 30%
x Plant is measured under the cost model and depreciated straight-line at 50% p.a. to a nil residual value.
x The tax authorities allow the tax deduction of 331/3 % p.a. of the plant’s cost, straight-line. Any capital
gain on the sale of this asset is included in taxable profits using an inclusion rate of 80%. The base cost
used in calculating the capital gain is C31 000. The income tax rate is 30%.
x The profit before tax, and before taking into account the sale, is C20 000 according to both the
accountant and the tax authority, for 20X1 and 20X2.
x No payments were made to the tax authority in any of the years (amount owing at end 20X0: nil).
x There are no other temporary or permanent differences.
x Assume you have all the information necessary to calculate the balances on all affected accounts.
Required:
A. Calculate the deferred income tax using the balance sheet approach.
B. Calculate the current income tax for 20X1 and 20X2.
C. Show the tax-related ledger accounts.
D. Disclose the above in the statement of comprehensive income, the tax expense note and deferred tax asset or
liability note for the year ended 31 December 20X2.
Chapter 6 325
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20X2 20X1
W4. Current income tax Profit Tax: 30% Profit Tax: 30%
Profit before tax (accounting profits) 20 000 + 20 000; 20 000 – 15 000 40 000 12 000 5 000 1 500
Permanent differences (and tax rate reconciling items) (1 800) (540) 0 0
x Exempt income: (portion of capital profit exempt from tax)
x Less capital profit on sale W3 (5 000) 0
x Add taxable capital gain W2 3 200 0
Taxable accounting profits (and tax expense) 38 200 11 460 5 000 1 500
Movement in temporary differences (and DT adjustment) (5 000) (1 500) 5 000 1 500
x Add depreciation (30 000 – 0) x 50% (N/A in 20X2 0 15 000
x Less tax deduction (30 000 – 0) x 33% (N/A in 20X2 (0) (10 000)
x Less non-capital profit on sale W3 (15 000) (0)
x Add recoupment on sale W1 10 000 0
Taxable profits and current income tax 33 200 9 960 10 000 3 000
326 Chapter 6
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Entity name
Statement of comprehensive income (extract) Note 20X2 20X1
For the year ended 31 December 20X2 C C
Profit before tax 20X2: 20 000 + 20 000; 20X1: 20 000 – 15 000 40 000 5 000
Income tax expense 12 (11 460) (1 500)
Profit for the year 28 540 3 500
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
The following examples (Examples 20 – 23) involve non-deductible assets. Since they are not
deductible, their tax bases are nil from date of acquisition and, in terms of IAS 12.15, the related
temporary differences are exempt from deferred tax. Exempt temporary differences act in the
same way as permanent differences. Thus, in each of these examples, we need to include a tax
rate reconciliation in the tax expense note (because permanent differences, which include exempt
temporary differences, cause the effective tax rate to deviate from the applicable rate).
Required:
A. Calculate the deferred income tax using the balance sheet approach.
B. Calculate the current income tax for 20X1 and 20X2.
C. Disclose this in the statement of comprehensive income, statement of financial position and tax expense
note for the year ended 31 December 20X2.
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Note 1: Since the asset was not tax-deductible, there are no past tax-deductions for the tax authority to recoup
(i.e. the tax base was not nil because it had been fully deducted – instead, it was nil, from the
beginning, because it was not tax deductible at all).
20X2 20X1
W4. Current income tax Profit Tax: 30% Profit Tax: 30%
Profit before tax (accounting profits) (and TE) 20X2: 20 000 – 10 000 10 000 3 000 20 000 6 000
Permanent difference (and reconciling item)
x Add back loss on sale (non-deductible) W3 10 000 3 000 (0) 0
Taxable profits and current income tax 20 000 6 000 20 000 6 000
TE = Tax expense DT adj = Deferred tax adjustment
Notice: The loss on sale (calculated by the accountant) was not allowed as a tax deduction and is thus a
permanent difference. This means there will be a reconciling item of 3 000 in the tax rate reconciliation.
Entity name
Statement of financial position 20X2 20X1
As at 31 December 20X2 Note C C
Non-current assets
Property, plant and equipment W1 0 30 000
Deferred tax asset W1 0 0
Notice: We did not show the current tax payable balance as we were not given enough information (e.g. we
were not given the opening balance and details of the amounts paid to the tax authorities).
Entity name
Statement of comprehensive income 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit (loss) before tax (20 000 – 10 000) (20 000 + - 0) 10 000 20 000
Income tax expense 5. (6 000) (6 000)
Profit for the year 4 000 14 000
328 Chapter 6
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Entity name
Notes to the financial statements (extracts) 20X2 20X1
For the year ended 31 December 20X2 C C
5. Income tax expense
x Current W4 6 000 6 000
x Deferred W1 0 0
Income tax expense per the statement of comprehensive income 6 000 6 000
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20X2 20X1
W4. Current income tax Profit Tax: 30% Profit Tax: 30%
Profit before tax (accounting profits) (20 000 + 10 000);(Given: 20 000) 30 000 20 000
Permanent differences (and reconciling items)
Exempt income (Portion of capital profit that is exempt from tax) (2 000)
x Less capital profit on sale W3 (10 000)
x Add taxable capital gain W2 8 000
Taxable accounting profits (and tax expense) 28 000 8 400 20 000 6 000
Movement in temporary differences (and DT adj) Solution 21A / 20A 0 0 0 0
Taxable profits and current income tax 28 000 8 400 20 000 6 000
Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 Note C C
Non-current assets
Property, plant and equipment W1 (Example 20A) 0 30 000
Deferred tax asset W1 (Example 20A) 6 0 0
Current liabilities
Current tax payable 20X1: o/b: 0 + CT 6 000 – Pmt: 0 14 400 6 000
20X2: o/b: 6 000 + CT 8 400 – Pmt: 0
Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
Effective tax rate (8 400 / 30 000) & (6 000 / 20 000) 28% 30%
330 Chapter 6
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Chapter 6 331
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Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 C C
Non-current assets
Property, plant and equipment W1 0 27 000
Deferred tax asset W1 0 0
Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit (loss) before tax (20K + 1K) (50K – 3K) 21 000 47 000
Income tax expense 5. (6 000) (15 000)
Profit for the year 15 000 32 000
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
5. Income tax expense
x Current W4 6 000 15 000
x Deferred W1 0 0
Income tax expense per statement of comprehensive income 6 000 15 000
Tax rate reconciliation
Applicable tax rate Given 30% 30%
Tax effects of:
x Profit before tax 20X2: 21 000 x 30%; 20X1: 47 000 x 30% 6 300 14 100
x Non-taxable profit on sale 20X2: non-capital profit 1 000 x 30% (300) 0
x Non-deductible depreciation 20X1: add depreciation: 3 000 x 30% 0 900
Income tax expense per statement of comprehensive income 6 000 15 000
Effective tax rate 20X2: 6 000/ 21 000; 20X1: 15 000 / 28.6% 31.9%
47 000
Notice: The depreciation and non-capital profit are presented as reconciling items in the tax rate
reconciliation. This is because the asset to which they relate is non-deductible and thus what would
normally be a temporary difference leading to deferred tax was a temporary different exempt from
deferred tax, thus causing the effective tax rate to deviate from the applicable tax rate.
332 Chapter 6
Gripping GAAP Taxation: deferred taxation
Proceeds (40 000) limited to cost (30 000): (therefore 30 000 is a limiting factor) 30 000
Less tax base TB = Future tax deductions = 0 (the building is not tax-deductible) (0)
Recoupment See note 1 Not applicable
Note 1: Since the asset was not tax-deductible, there are no past tax-deductions for the tax
authority to recoup.
Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit before tax W4 33 000 17 000
Income tax expense 5. (8 400) (6 000)
Profit for the year 24 600 11 000
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Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
5. Income tax expense
x Current W4 8 400 6 000
x Deferred W1: Example 22 0 0
Income tax expense per statement of comprehensive income 8 400 6 000
Tax rate reconciliation
Applicable tax rate Given 30% 30%
Tax effects of:
x Profit before tax 20X2: 33 000 x 30% 20X1: 17 000 x 30% 9 900 5 100
x Exempt capital profit (Capital profit 10 000 – taxable capital gain (600) 0
8 000) x 30%
x Exempt non-capital profit Non-capital profit 3 000 x 30% (900) 0
x Non-deductible depreciation (3 000 x 30%) 0 900
Income tax expense per statement of comprehensive income 8 400 6 000
Effective tax rate 20X2: 8 400/ 33 000; 20X1: 6 000 / 17 000 25.5% 35.3%
Notice: The depreciation and non-capital profit are presented as reconciling items in the tax rate
reconciliation. This is because the asset to which they relate is non-deductible and thus what would
normally be a temporary difference leading to deferred tax was a temporary different exempt from deferred
tax, thus causing the effective tax rate to deviate from the applicable tax rate.
IAS 12 offers two exemptions from the requirement to recognise deferred tax:
x IAS 12.15 provides us an exemption from recognising deferred tax liabilities; and
x IAS 12.24 provides us an exemption from recognising deferred tax assets.
The exemption from recognising deferred tax liabilities is covered in depth in section 4.3.2. This
section summarises the exemption relating to both deferred tax liabilities and deferred tax assets.
A deferred tax liability is normally recognised on taxable temporary differences, but if the taxable
temporary difference meets the criteria in IAS 12.15, it is exempt from deferred tax.
Similarly, a deferred tax asset is normally recognised on deductible temporary differences, but if
this difference meets the criteria in IAS 12.24, it may be exempt from deferred tax.
In other words, no deferred tax will be recognised on a temporary difference that arises on goodwill or
on the initial recognition of an asset or liability where this initial recognition does not affect accounting
profit or taxable profit, and if the asset or liability is not acquired as part of a business combination.
334 Chapter 6
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We covered some examples that showed the exemption from Important! The exemptions
recognising a deferred tax liability on the taxable temporary from deferred tax
difference arising on the acquisition of non-current assets (IAS 12.15 & IAS 12.24):
(see section 4.3.2). x only apply to the initial recognition
(e.g. the cost of purchase);
Since the exemption principles apply equally to the x applies to any asset (not just non-
exemption from recognising a deferred tax asset on current assets) or liability;
deductible temporary differences, this text does not include x do not apply to acquisitions arising
any further examples. through business combinations.
The measurement of current tax and deferred tax is essentially the same: they are both measured
at the amount we expect to pay (or recover from) the tax authorities. See IAS 12.46 - 47
The current income tax is the estimated tax that will be charged for the current period:
x the current period’s taxable profits (current year transactions per the tax legislation);
x multiplied by the tax rates that we expect will be applied by the tax authorities.
Deferred tax differs from current tax only in that it is the estimated future tax payable/ receivable. In
other words, it is the estimated future tax on future transactions i.e. future taxable income and
future tax deductions… thus it is the future tax expected on the future recovery of assets and
settlement of liabilities.
From time to time, governments will change the tax rates. Deferred tax assets or
When this happens, we measure the current tax and liabilities are measured at:
deferred tax, using the:
x tax rates that are expected to
x enacted tax rate at the reporting date, or the apply to the period when
x proposed new rate, if it has been substantively enacted x the A is realised or the L settled;
by reporting date. Re-worded IAS 12.46-47 x based on tax rates (& tax laws)
that are
However, we must also take into consideration when the - enacted at reporting date, or
proposed new rate will become applicable (effective) - substantively enacted at
because the intention could be for the new rate to apply reporting date. IAS 12.47 Reworded
retroactively, immediately or at some future date. In this regard, it is useful to remember the
overriding principles:
x current tax must be ‘measured at the amount expected to be paid to (recovered from) the
taxation authorities’ See IAS 12.46
x deferred tax 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’. See IAS 12.47
Consider the following example: Before reporting date, the government announced a proposed
change to the currently enacted tax rate. The proposed new rate is substantively enacted at
reporting date. However, this proposed new rate will only be applicable to taxable profits in the next
tax year. In this case, although the proposed new rate is substantively enacted at reporting date:
x We will measure our current tax using the currently enacted tax rate at reporting date (i.e. the old
rate) since this is the rate that the tax authorities will apply when taxing our current taxable profits.
x We will measure our deferred tax using the substantively enacted tax rate (i.e. the proposed
new rate) since it seems likely that this is the rate that the tax authorities will apply when the
taxable income or tax deductions from our assets and liabilities eventually arise.
The date on which the new tax rate is written into law and this new legislation is passed by Parliament,
is referred to as the date of enactment.
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In South Africa, the date of substantive enactment is generally considered to be the date on which
the new rate is announced by the Minister of Finance’s Budget Speech.
But if the announcement of this new rate is inextricably linked to changes to other tax laws, it is only
substantively enacted when the other changes to the legislation ‘have been approved by
Parliament and signed by the President’. See SAICA FRG1.6 A substantively enacted
tax rate that has an
effective date that won’t
Care needs to be taken when deciding whether a proposed new
affect the current tax
rate (i.e. a rate that has been announced but not yet enacted) is assessment but will affect future tax
substantively enacted at reporting date. See chapter 5, section assessments,
B: 3.2 for an example. x the CT payable will be measured
using the enacted rate, whereas
x the DT liability (or asset) will be
If a proposed new tax rate is announced before reporting
measured using the substantively
date but it is not considered substantively enacted by enacted tax rate.
reporting date, then our deferred tax balance at reporting
date must remain measured using the old rate (i.e. the rate that was currently enacted at
reporting date).
This is interesting because if, for example, this proposed new tax rate gets enacted after the
reporting date but before the financial statements are authorised for issue, it means that, before
our financial statements were published, we would actually know that our taxes payable in the
future (deferred tax) will no longer be based on the old rate. However, the tax balances at
reporting date may not be adjusted to reflect the new rate. Instead, a change in tax rate that is enacted
or substantively enacted after reporting date but before publication of the financial statements is
considered to be a non-adjusting event after the reporting period (see chapter 18: part B)
To counter the problem of not being allowed to adjust our deferred tax balances to reflect new rates that
are enacted or substantively enacted after reporting date, we will disclose the change in tax rate in our
notes as a ‘non-adjusting event after the reporting period’, showing the new rate and the effect that the
new rate will have on our deferred tax balances, assuming we think that this information will be useful to
our users. See IAS 10.21
At time of writing, the currently enacted corporate income tax rate in South Africa was 28% and no new
tax rates had been proposed. For ease of calculation, however, we use 30% as the income tax rate.
Tax rates to be used in measuring Solution 24A Solution 24B Solution 24C
the following balances: Year end: Year end: Year end:
31 December 20X0 28 February 20X1 31 March 20X1
Current tax payable/ receivable 30% 30% 29%
Deferred tax liability/ asset 30% 29% 29%
Comments in general:
x The date of substantive enactment is 20 January 20X1 (because no significant changes to other taxes
were announced at the time).
336 Chapter 6
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7. Rate Changes and Deferred Tax (IAS 12.47 and SAICA FRG1)
A deferred tax balance is simply an estimate of the tax owing to the tax authority in the future (or
the tax savings expected from the tax authority in the future). The estimate is made based on the
temporary differences multiplied by the applicable tax rate. If this rate changes, so does the
estimate of the amount of tax owing by or owing to the tax authority in the future. Therefore, if an
entity has an opening deferred tax balance in a year during which the rate of tax changes, the
opening deferred tax balance may need to be re-estimated.
An adjustment to the opening deferred tax balance is accounted for as a ‘change in accounting
estimate’, which means it is accounted for prospectively. This simply means we process
adjustments to prior year balances in the current year’s accounting records (see chapter 26).
Thus, if there has been a change in tax rate that requires us to remeasure our opening deferred tax
balance, our tax expense in the current year effectively includes an adjustment relating to the prior
year closing deferred tax balance. This will mean that, in the current year, our effective tax rate will
not equal the current year’s applicable tax rate. The difference between the effective and applicable
tax rates means we will need to include a ‘tax rate reconciliation’ in the tax expense note.
These principles apply if a new rate was enacted by reporting date, or if it is not yet enacted, if it
was substantively enacted by reporting date.
The opening deferred tax balance is adjusted to reflect the new tax rate unless it has neither been
enacted nor substantively enacted on or before reporting date (see section 6). In other words, we
generally adjust for the new rate:
x If it is enacted on/ before reporting date;
x If it is not yet enacted but is substantively enacted on/ before reporting date.
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If the proposed change in tax rate has not been enacted or substantively enacted on or before
reporting date, no adjustments are made. Instead, the proposed rate change is disclosed as a non-
adjusting event in terms of IAS 10 Events after the reporting period. (Also see section 6).
Required: Show the journal entries relating to the rate change in 20X2 assuming that:
A. the balance in 20X1 is an asset and that the rate was 30% in 20X1 and 40% in 20X2;
B. the balance in 20X1 is a liability and that the rate was 30% in 20X1 and is 40% in 20X2;
C. the balance in 20X1 is an asset and that the rate was 40% in 20X1 and is 30% in 20X2;
D. the balance in 20X1 is a liability and that the rate was 40% in 20X1 and is 30% in 20X2.
Calculations
(a) Tax rate increased by 10%: DTA: 60 000 / 30 % x (40% – 30%) = 20 000 (DT asset increases)
(b) Tax rate increased by 10%: DTL: 60 000 / 30 % x (40% – 30%) = 20 000 (DT liability increases)
(c) Tax rate decreased by 10%: DTA: 60 000 / 40 % x (40% – 30%) = 15 000 (DT asset decreases)
(d) Tax rate decreased by 10%: DTL: 60 000 / 40 % x (40% – 30%) = 15 000 (DT liability decreases)
The opening balance of deferred tax at the beginning of 20X2 is C45 000, (credit balance).
This deferred tax balance arose purely due to temporary differences caused by tax-deductible capital
allowances on depreciable items of property, plant and equipment.
x The tax rate in 20X1 was 45% but changed to 35% in 20X2.
x The profit before tax in 20X2 is C200 000, all of which is taxable in 20X2.
x There are no other adjustments that would affect current tax payable (amount owing at end 20X1: nil).
x There were no permanent differences and there was no movement in temporary differences during 20X2.
Required:
A. Calculate and explain the effect of the rate change on deferred tax.
B. Show the calculation of deferred income tax using the balance sheet method.
C. Calculate the current income tax for 20X2.
D. Show the tax-related ledger accounts.
E. Disclose the above in the financial statements for the year ended 31 December 20X2.
The opening balance in 20X2 (closing balance in 20X1) was calculated by multiplying the total temporary
differences at the end of 20X1 by 45%.
Therefore, the temporary differences (TD) provided for at the end of 20X1 (opening deferred tax balance in
20X2) are as follows:
The credit deferred tax balance means we have a deferred tax liability and thus that the company is
expecting the tax authority to charge them tax in the future on the temporary difference of C100 000.
338 Chapter 6
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Since the tax rate has now dropped to 35%, the estimated future tax on this temporary difference of
C100 000 needs to be changed from C45 000 to C35 000:
Dr/ (Cr)
Deferred tax liability balance was (45 000) Balance: credit
Deferred tax liability balance should now be (35 000) Balance: credit
Adjustment needed 10 000 Debit deferred tax liability, Credit tax expense
Notes:
(1) There is no movement as we are told there was no movement in temporary differences during 20X2.
Taxable profits and current income tax - 20X2 Profits Tax at 35%
Profit before tax (accounting profits) (given) 200 000
Permanent differences (given) 0
Taxable accounting profits 200 000 70 000
Movement in temporary differences: (given) 0 0
Taxable profits and current income tax 200 000 70 000
The credit balance of the deferred tax account must be reduced, thus requiring this account to be debited.
The contra entry will go to the tax expense account, since this is where the contra entry was originally
posted when the 45 000 was originally accounted for as a deferred tax liability.
Chapter 6 339
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Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 Note C C
Non-current liabilities
Deferred tax liability 26A or 26B or 26D 4 35 000 45 000
Current liabilities
Current tax payable (o/balance: 0 + current tax exp: 70 000 0
70 000 (26C) – payment: 0); Or: 26D
Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit before tax (given) 200 000 xxx
Income tax expense 3 (60 000) xxx
Profit for the year 140 000 xxx
Entity name
Notes to the financial statements (extract) 20X2
For the year ended 31 December 20X2 C
3. Income tax expense
x Current 200 000 x 35% 70 000
x Deferred
- Current year Ex 26B: (no temporary differences) 0
- Rate change Ex 26A or 26B (10 000)
Income tax expense per statement of comprehensive income 60 000
340 Chapter 6
Gripping GAAP Taxation: deferred taxation
In summary, all three categories are generally able to be carried forward from one year to the
next until they are able to be used in a way that reduces the future income tax charge. Thus, all
three categories represent future tax savings. A future tax saving is obviously an asset to the
entity, but it will obviously only be recognised if it meets the recognition criteria (see section 8.2).
All three deferred tax assets, whether arising from DTDs, UTCs, and UTLs, are affected in the same
way: they may only be recognised if the inflow of future economic benefits is probable. However, it is
the deferred tax asset arising from an unused tax loss that is generally the most difficult to recognise.
The reason why it is more difficult to recognise deferred tax To recognise or not to
assets on unused tax losses than on unused tax credits or recognise… that is the
deductible temporary differences is simply that, if we make question!
a tax loss, it may mean that we are already in financial x A DTA may only be recognised if the
difficulty, in which case it is possible that we may never future tax saving is probable.
make future profits big enough to be able to deduct the tax x It may be difficult to recognise a
loss and realise the related tax saving. DTA on unused tax losses
Worked Example 1: Tax losses may or may not reflect probable future tax savings
Consider the two scenarios below.
In both cases, the tax rate is 30% and we are allowed to carry the tax losses forward to future
years when they may be set-off against future taxable profits.
Scenario 1:We make a tax loss in 20X1 of C100 000 and expect to make a taxable profit in 20X2 of
C300 000 (before carrying forward the tax loss from 20X1).
Scenario 2:We make a tax loss in 20X1 of C100 000 and expect to make another tax loss in 20X2 of
C300 000 (before carrying forward the tax loss from 20X1) after which we expect to cease trading.
Solution to Worked Example 1: Tax losses may or may not reflect probable future tax savings
Scenario 1:
20X2 20X1
Calculation of estimated current income tax: C C
Taxable profit/ (tax loss) before adjusting for tax losses b/ forward 300 000 (100 000)
Tax loss brought forward (100 000) 0
Taxable profit/ (tax loss) 200 000 (100 000)
Current income tax at 30% 60 000 0
Since the company expects to make taxable profits of C300 000, before adjusting for tax losses brought
forward, the tax loss of C100 000 will be able to be used to reduce the future tax from C90 000 (C300 000
x 30%) to C60 000 (calculation above). This is clearly a tax saving of C30 000.
Conclusion: This predicted saving is therefore a deferred tax asset of C30 000 at the end of 20X1 which
should be recognised if the future taxable profits are probable.
Chapter 6 341
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Scenario 2:
20X2 20X1
Calculation of estimated current income tax:
C C
Taxable profit/ (tax loss) before adjusting for tax losses b/ forward (300 000) (100 000)
Tax loss brought forward (100 000) 0
Taxable profit/ (tax loss) (400 000) (100 000)
Current income tax at 30% 0 0
Conclusion:
x We would not recognise the deferred tax asset at the end of 20X1 since, at this date, it was not
considered probable that we would make sufficient taxable profits in the future.
x If, however, our forecast for the years beyond 20X2 had indicated that sufficient profits were expected to
be made, thus enabling us to utilise the C100 000 tax loss, then we would be able to recognise the
deferred tax asset of C30 000 at 31 December 20X1 (assuming that the tax loss does not expire in terms
of tax legislation before the company becomes sufficiently profitable to be able to utilise it).
The two most important paragraphs in IAS 12 guiding us as on whether to recognise the deferred
tax asset are:
x IAS 12.34: A deferred tax asset shall be recognised for:
- the carry forward of unused tax losses (also called assessed losses) and unused tax credits
- 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. IAS 12.34
x IAS 12.24: A deferred tax asset shall be recognised for:
- all deductible temporary differences
- to the extent that it is probable that taxable profit will be available against which the deductible
temporary difference can be utilised (except if the temporary difference is exempted). IAS 12.24
These paragraphs clarify that the decision regarding whether to recognise the deferred tax asset
is the same in all three cases: there must be sufficient future taxable profits expected such that we
can conclude that we will be able to utilise the future deduction, unused tax credit or unused tax
loss, and thus that the future benefit (tax saving) is probable.
Taxable profits are considered to be available if the entity currently has more taxable temporary
differences than deductible differences. In this case, the deferred tax assets on the deductible temporary
differences will be recognised in full on the basis that the deferred tax liabilities on the taxable temporary
differences are greater, and thus the entity’s net deferred tax balance will be a liability. IAS 12.28
If the entity does not have sufficient taxable temporary differences against which the deductible
temporary differences can be off-set (i.e. the net deferred tax balance will be an asset), then the deferred
tax asset may only be recognised if it is probable that there will be sufficient future taxable profits against
which the deductible temporary differences may be off-set. When estimating the probable future profits,
we must obviously ignore taxable profits arising from future (further) deductible temporary differences.
See IAS 12.29
Example 27: Recognising deferred tax assets: tax loss expected to expire: discussion
Human Limited made a tax loss of C100 000 in 20X1.
x There was no tax loss brought forward from 20X0.
x The income tax rate is 30%.
x The entity’s final management-reviewed forecast shows a further tax loss of C50 000 in 20X2
(before considering the tax loss from 20X1).
x Per the tax legislation, the 20X1 tax loss will expire on 31 December 20X2.
Required: Explain whether or not a deferred tax asset should be recognised at the end of 20X1.
342 Chapter 6
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Taxable profit/ (tax loss) 210 000 (20 000) (270 000)
Future income tax payable at 30% 63 000 0 0
Chapter 6 343
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Conclusion:
By looking at the tax that would have been payable had there been no deductible temporary differences, and
comparing it to the tax that is payable after taking into account these differences, one can assess the extent to
which the future deductible temporary differences will result in tax savings and thus whether the company should
recognise a deferred tax asset, and if so at what amount. The deferred tax asset at 31 December 20X1
should thus be measured at: Scenario A Scenario B Scenario C
Deferred tax asset balance to be recognised: C9 000 C3 000 C0
344 Chapter 6
Gripping GAAP Taxation: deferred taxation
Profit or loss before tax (after deducting any depreciation on the vehicle) for the year ended:
x 31 December 20X1 Loss: C40 000
x 31 December 20X2 Loss: C20 000
x 31 December 20X3 Profit: C400 000
Other information:
x There are no permanent or temporary differences other than those evident from the information given.
x The company recognised deferred tax assets in full, since:
it had always expected to make sufficient future taxable profits and therefore
it expected to realise the related tax savings.
Required:
A. Calculate the taxable profits and current tax per the tax legislation for 20X1 to 20X3.
B. Calculate the deferred income tax balances for 20X1 to 20X3.
C. Show all tax-related journals that would be processed in 20X1, 20X2 and 20X3.
D. Disclose the above tax-related information in the financial statements for 20X3.
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Entity name
Statement of financial position (extract) 20X3 20X2
As at 31 December 20X3 Note C C
Non-current assets
Deferred tax asset 5 0 18 000
Non-current liabilities
Deferred tax liability 5 9 000 0
Entity name
Statement of comprehensive income (extract) 20X3 20X2
For the year ended 31 December 20X3 Note C C
Profit before tax 400 000 (20 000)
Income tax income/ (expense) 12 (120 000) 6 000
Profit for the period 280 000 (14 000)
Entity name
Notes to the financial statements (extract) 20X3 20X2
For the year ended 31 December 20X3 C C
5. Deferred tax asset/ (liability)
The deferred tax balance comprises tax on the following types of temporary differences:
x Property, plant and equipment W2.1 (9 000) (18 000)
x Tax losses W2.2 0 36 000
(9 000) 18 000
346 Chapter 6
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Entity name
Notes to the financial statements continued … 20X3 20X2
For the year ended 31 December 20X3 C C
12. Income tax expense
x Current Journals 93 000 0
x Deferred Journals: 20X3: 9 000 cr – 36 000 dr 27 000 (6 000)
20X2: 9 000 dr – 15 000 cr
Income tax expense per statement of comprehensive income 120 000 (6 000)
Rate reconciliation:
Applicable tax rate 30% 30%
Effective tax rate 20X3: 120 000 / 400 000; 20X2: 6 000 / 20 000 30% 30%
Example 30: Tax losses: deferred tax asset recognised in full then written-down
Repeat Example 29 assuming that:
x Deferred tax assets had been recognised in full in 20X1.
x In 20X2 future taxable profits sufficient to be able to utilise the tax loss were no longer
probable, with the result that deferred tax assets could only be recognised to the extent that
taxable temporary differences were available.
The information from Example 29 is repeated here for your convenience:
x Cost of vehicle purchased on 1 January 20X1
C120 000
x Depreciation on vehicles to nil residual value 4 years straight-line
x Capital allowance on vehicle allowed by the tax authorities 2 years straight-line
x Income tax rate 30%
x Profit or loss before tax (after deducting any depreciation on the vehicle) for the year ended:
x 31 December 20X1 Loss: C40 000
x 31 December 20X2 Loss: C20 000
x 31 December 20X3 Profit: C400 000
x There are no permanent or temporary differences other than those evident from the question.
Required:
Show the deferred tax asset/ liability note and the tax expense note for 20X2.
Solution 30: Tax losses: deferred tax asset recognised in full then written-down
Although W2.1 and W2.2 are the same as in Example 29, a further working (W2.3 below), showing the
prior year DTA written-down and the current year DTA that is now not recognised, is useful.
Comment:
x Since, in 20X2, future taxable profits are no longer considered probable, it means that from 20X2 the
total net deferred tax balance must not go into debit (i.e. the net effect of the deferred tax liability on
the vehicle and deferred tax asset on the tax loss can result in a net liability or can net each other off
to nil, but must not result in a net deferred tax asset).
Chapter 6 347
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x Thus, although the deferred tax asset resulting from the tax loss is C36 000, since the deferred tax
liability caused by the vehicle is only C18 000, recognising the full deferred tax asset would result in a
net deferred tax asset of C18 000, which is not allowed. This means the maximum deferred tax asset
that we can recognise is limited to the deferred tax liability balance of C18 000 (resulting in a net
deferred tax balance of nil).
x Thus, the unrecognised portion of the deferred tax asset on the tax loss is C18 000:
Total DT asset on tax loss C36 000 – DT asset recognised C18 000 = DT asset unrecognised C18 000.
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
The deferred tax balance comprises tax on the following types of temporary differences:
x Property, plant and equipment W2.1 (Sol 29B) (18 000) (9 000)
x Tax losses W2.2 (Sol 29B) 18 000 21 000
0 12 000
A deferred tax asset of C18 000 relating to a tax loss of C60 000 has not been recognised (20X1
unrecognised deferred tax asset: nil). The tax loss has no expiry date.
Effective tax rate (12 000 exp / 20 000 loss) (12 000 inc / 40 000 loss) (60%) 30%
Calculations:
(1) The DT adjustments arising from the current year movement in TDs (these amounts have been extracted
from W2.1 and W2.2 of Solution 29B – or you could extract them from the journals in Solution 29C) are
calculated as follows:
20X1: 9 000 dr + 21 000 cr = 12 000 credit expense
20X2: 9 000 dr + 15 000 cr = 6 000 credit
Required:
Show how your answer to Example 29 would change.
348 Chapter 6
Gripping GAAP Taxation: deferred taxation
Comment:
x The effect of the situation in 20X2 was that the total net deferred tax balance was not allowed to go
into debit.
This resulted in part of the deferred tax asset of C36 000 not being recognised (i.e. we were allowed
to recognise a deferred tax asset of C18 000, leaving us an unrecognised portion of C18 000).
x Although in 20X2 we did not expect the tax loss to be used in full, in 20X3 the tax loss is fully utilised,
(i.e. we achieved a tax saving of C36 000, not just C18 000 as we had predicted).
x However, a deferred tax asset of only C18 000 had been recognised.
Thus, since we need to show that a deferred tax asset of C36 000 has been used up, the
unrecognised portion of the deferred tax asset of C18 000 must now be recognised.
Journals 20X2
Chapter 6 349
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Entity name
Statement of financial position (extract) 20X3 20X2 20X1
As at ……..20X3 Note C C C
Non-current liabilities
Deferred tax liability W2.3 5 9 000 0 0
Entity name
Statement of comprehensive income (extract) 20X3 20X2 20X1
For the year ended …..20X3 Note C C C
Entity name
Notes to the financial statements (extract) 20X3 20X2 20X1
For the year ended 31 December C C C
The deferred tax balance comprises tax on the following types of temporary differences:
x Property, plant and equipment (9 000) (18 000) (9 000)
x Tax loss 0 18 000 9 000
(9 000) 0 0
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Entity name
Notes to the financial statements (extract) 20X3 20X2 20X1
For the year ended 31 December C C C
Effective tax rate (102 000 / 400 000) (0/loss) (0/loss) 25.5% N/A N/A
Calculations:
(1) DT adj to tax expense due to temporary differences: vehicle (9 000) cr 9 000 dr 9 000 dr
DT adj to tax expense due to temporary differences: tax loss 36 000 dr (15 000) cr (21 000) cr
(adjustments extracted from W2.1 and W2.2 in Solution 29B)
27 000 dr (6 000) cr (12 000) cr
9.1 Overview
IAS 1 and IAS 12 require certain tax disclosure in the statement of comprehensive income,
statement of financial position and related notes to the financial statements.
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended …20X2 C C
2. Significant accounting policies
1.1 Deferred tax
Deferred tax is provided on the comprehensive basis. Deferred tax assets are provided
where there is reason to believe that these will be utilised in the future.
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The deferred tax asset or liability is always classified as a non-current asset or liability. Even if
an entity believes that some of its deferred tax balance will reverse in the next year, the amount
may never be classified as current. See IAS 1.56
If there is a deferred tax asset and a deferred tax liability, these should be disclosed as separate
line-items on the face of the statement of financial position (i.e. they should not be set-off
against one another) unless IAS 12.74:
x Current tax assets and liabilities are legally allowed to be set-off against each other when
making tax payments; and
x The deferred tax assets and liabilities relate to taxes levied by the same tax authority on:
the same entity; or on
different entities in a group who will settle their taxes on a net basis or at the same time.
Example layout of tax balances in the statement of financial position is shown below:
The following example applies if the above criteria were not met and thus set-off of the deferred tax
asset and deferred tax liability was not allowed
Entity name
Statement of financial position (extract) 20X2 20X1
As at ……..20X2 C C
Non-current assets
Deferred tax asset 5. xxx xxx
Non-current liabilities
Deferred tax liability 5. xxx xxx
Current liabilities
Current tax payable xxx xxx
Entity name
Statement of financial position (extract) 20X2 20X1
As at ……..20X2 C C
Non-current liabilities
Deferred tax: income tax 80 000 - 20 000 60 000 xxx
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Entity name
Statement of financial position (extract) 20X2 20X1
As at ……..20X2 C C
Non-current assets
Deferred tax asset: municipal tax 20 000 xxx
Non-current liabilities
Deferred tax liability 80 000 xxx
9.3.2.1 The basic structure of the deferred tax note (IAS 12.81 (g)(i))
The deferred tax balance may reflect an asset or liability balance and therefore it makes sense
to explain, in the heading of the ‘deferred tax note’ in the ‘notes to the financial statements’,
whether the balance is an asset or liability (if, for example, you reflect liabilities in brackets, then
the heading would be: ‘deferred tax asset/ (liability)’).
In practice, it is also common for the ‘deferred tax line-item’ on the face of the ‘statement of
financial position’ to indicate whether the deferred tax balance is as asset or liability.
You must disclose the amount of the deferred tax asset and liability recognised for each:
x type of temporary difference (e.g. property, plant and equipment, prepayments and provisions);
x unused tax losses; and
x unused tax credits. IAS 12.81 (g) (i)
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended continued … C C
5. Deferred tax asset / (liability)
Tip
Be careful not to confuse the breakdown of the deferred tax movement (i.e. the statement of
comprehensive income effect) with the deferred tax closing balance (i.e. the statement of financial
position effect) when compiling this note. In an exam situation, you can find the closing balance easily in
your deferred tax balance sheet approach working (see section 2.3)
9.3.2.2 A deferred tax reconciliation may be required (IAS 12.81 (g) (ii))
For each type of temporary difference, unused tax loss and unused tax credit, the amount of the
deferred tax adjustment recognised in profit or loss must be disclosed.
This separate disclosure could be provided in the ‘tax expense note’. Alternatively, one may be
able to identify the deferred tax adjustment that was recognised in profit or loss by simply
comparing the opening and closing balances per type of temporary difference (e.g. property,
plant and equipment).
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On occasion, however, it is not possible to identify each deferred tax adjustment per type of
temporary difference that was recognised in profit or loss by simply comparing the opening and
closing balances per type of temporary difference.
This could happen, for example, when the difference between the opening and closing balance
of deferred tax resulting from the temporary differences on property, plant and equipment may
have involved ‘other comprehensive income’ (e.g. a revaluation surplus), in which case, the
deferred tax movement would be due to:
x a deferred tax adjustment recognised in ‘other comprehensive income’, and
x a deferred tax adjustment recognised in ‘profit or loss’ (i.e. tax expense),
In such cases, a reconciliation between the opening and closing balance of deferred tax per
type of temporary difference would be required.
Example of the layout of the reconciliation that may be needed in the deferred tax asset/ liability note:
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended continued … C C
5. Deferred tax asset / (liability) continued ...
… Continued from note 5 on prior page:
Reconciliation:
Opening deferred tax balance relating to PPE (xxx) xxx
Deferred tax recognised in other comprehensive income:
- revaluation surplus xxx xxx
Deferred tax recognised in profit or loss 6. xxx (xxx)
Closing deferred tax balance relating to PPE (xxx) (xxx)
9.3.2.3 Extra detail needed on unrecognised deferred tax assets (IAS 12.81 (e))
In respect of any unrecognised deferred tax assets, disclosure must be made of:
x the amount of the deductible temporary difference, unused tax loss and unused tax credit;
x the expiry date of the tax loss/ tax credit, if any. IAS 12.81 (e)
The following is an example of what might then be included in the above deferred tax note:
Example of the detail regarding unrecognised deferred tax assets in the deferred tax asset/ liability note:
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended continued … C C
An entity shall disclose the amount of a deferred tax asset and the nature of the evidence
supporting its recognition, when:
x the entity has suffered a loss in either the current or preceding period in the tax jurisdiction
to which the deferred tax asset relates; and
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. IAS 12.82
9.3.2.5 Extra detail needed on unrecognised deferred tax liabilities (IAS 12.81 (i))
We must also disclose the amount of income tax relating to dividends proposed or declared before the
financial statements were authorised for issue, but which were not recognised as a liability.
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Income tax and any other forms of tax considered to be a tax levied on the entity’s profits are
combined to reflect the income tax expense in the statement of comprehensive income
(sometimes referred to as tax expense). The tax expense must be reflected as a separate line
item in the statement of comprehensive income (required by IAS 1, chapter 3).
The tax effect of other comprehensive income may be shown on the face of the statement of
comprehensive income or in the notes. The following example adopts the option of presenting
tax on other comprehensive income in the notes. IAS 1.90
Example of the disclosure of tax expense on the face of the statement of comprehensive income:
Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended …20X2 C C
9.4.2.1 Basic structure of the income tax expense note (IAS 12.79-80)
The tax expense line item in the statement of comprehensive income should be referenced to a
supporting note.
The supporting note gives details of the adjustments made in the tax expense account.
Step 1
Separate the tax note into the two main types of tax levied on company profits: income tax and
any other tax that may be levied on the entity’s profits.
Step 2
Separate the two types of tax into the two types of tax adjustments: the current adjustment and
the deferred adjustment. IAS 12.80 (a) & (c)
x In respect of current tax, show the:
x Current tax for the current year; IAS 12.80 (a)
x Any under/ (over) provision of current tax in a prior year/s. IAS12.80(b)
x In respect of deferred tax:
x The adjustment on the current year movement in temporary differences IAS 12.80 (c)
x The effects of rate changes on prior year deferred tax balances. IAS 12.80 (d)
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Step 3
Include a reconciliation explaining why the effective rate of tax differs from the applicable rate of
tax (only if these rates differ, of course!). IAS 12.81(c)
x The reconciliation can be provided in either or both of the following forms:
a reconciliation between tax expense (income) and the product of accounting profit
multiplied by the applicable tax rate(s); or
a reconciliation between the average effective tax rate and the applicable tax rate.
x The reconciliation should also include:
The basis on which the applicable tax rate(s) was computed (if a computation was
required); IAS 12.81 (c)
An explanation regarding any changes in the applicable tax rate(s) compared to the
previous accounting period. IAS 12.81(d)
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended … C C
Income tax expense per the statement of comprehensive income xxx xxx
Rate reconciliation:
Income tax expense per the statement of comprehensive income xxx xxx
9.4.2.2 Effect of deferred tax assets on the income tax expense note (IAS 12.80 (e) - (g))
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Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended ... C C
6. Income tax expense
current income tax
current year provision 80(a) xxx xxx
prior year under/ (over) provision 80(b) xxx xxx
deferred income tax 5.
current year movement in temporary differences 80(c)
prior year def tax balance: rate change adjustment 80(d) xxx (xxx)
current year def tax asset: not recognised xxx xxx
prior year recognised def tax asset: write-down/ (back) 80(g) xxx (xxx)
prior year unrecognised def tax asset: recognised: 80(f) (xxx) (xxx)
Income tax expense per the statement of comprehensive income xxx xxx
Rate reconciliation:
Applicable tax rate (ATR) Income tax rate: 30% x% x%
Tax effects of:
x Profit before tax Profit before tax x ATR xxx xxx
x Exempt income Exempt income x ATR (xxx) (xxx)
x Non-deductible expenses Non-deductible expenses x ATR xxx xxx
x Prior year under/ (over) provision Per above xxx xxx
x Prior year deferred tax balance: rate change Per above xxx (xxx)
x Current year deferred tax asset not recognised Per above xxx xxx
x Prior year recognised def tax asset written-down/ (back) Per above xxx (xxx)
x Prior year unrecog def tax asset now recognised Per above (xxx) (xxx)
x Other tax on profits Per above xxx xxx
Income tax expense per the statement of comprehensive income xxx xxx
Effective tax rate (ETR) Taxation expense/ profit before tax x% x%
9.4.2.3 Tax relating to changes in accounting policies and correction of errors (IAS 12.80 (h))
The tax on an adjustment that had to be made in the current year because it was impracticable to
process in the relevant prior year must be shown separately from other tax if it was caused by either:
x a change in accounting policy or
x correction of error
This can be done in aggregate (i.e. current plus deferred tax). IAS 12.80 (h)
9.4.2.4 Extra detail required with regard to discontinuing operations (IAS 12.81 (h))
9.4.3 Tax on other comprehensive income (IAS 12.81 (a) and (b))
The statement of comprehensive income shows the following separately from one another:
x Profit or loss; and
x Other comprehensive income (OCI, being part of equity).
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Tax on profit or loss is shown in the ‘income tax expense’ line item and details thereof are disclosed in
the ‘income tax expense’ note. Tax on other comprehensive income (OCI), on the other hand, is not
recognised as an expense. Instead it is recognised by netting it off in the relevant OCI ledger account.
Although this netting off occurs, the tax effect (current plus deferred tax) must still be separately
disclosed. The tax effect must be separately disclosed for each item of OCI that exists.
Chapter 3 explained that each item of other comprehensive income, classified by nature must be:
x presented as separate line items on the face of the statement of comprehensive income, and
x grouped under the relevant category heading of either:
- items that may be reclassified to profit or loss; and
- items that will never be reclassified to profit or loss. IAS 1.82A
An item of other comprehensive income may have been affected by a tax adjustment and may
also have been affected by a reclassification adjustment (where applicable) during the period.
For each such item of other comprehensive income:
x any reclassification adjustment that may have occurred must be separately disclosed;
x the tax adjustment that may have occurred must be separately disclosed, and where there was a
reclassification adjustment, then the related tax effect must also be separately disclosed.
The abovementioned reclassification adjustments and tax effects may be presented on either
the face of the statement of comprehensive income, or in the notes. IAS 1.90
This textbook adopts the approach of presenting each item of other comprehensive income net
of any reclassification and tax adjustments on the face of the statement and presenting the
reclassification adjustments (where applicable) and tax effects in the notes.
Example of the layout of OCI notes showing the disclosure of the tax effects
Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended … C C
23. Other comprehensive income: cash flow hedge
Cash flow hedge gain/ (loss) xxx (xxx)
Tax on gain/ loss (xxx) xxx
Reclassification of cash flow gain (xxx) (xxx)
Tax on reclassification of cash flow gain/ (loss) xxx xxx
Cash flow hedge gain/ (loss), net of reclassifications and tax xxx (xxx)
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10. Summary
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Versus
Income
Taxable profits
statement
per accountant
approach
Methods of
calculation
Carrying value of
Balance sheet
Assets &
approach
Libilities
Versus
Note that the 30% rate is given as the applicable tax rate which could change depending on the scenario.
Tax base
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Measurement of tax:
x Use enacted; or
x Substantively enacted tax rates
If a new rate is announced before reporting date:
x Use prof judgement to decide whether it has been substantively enacted
x In SA, it is generally considered substantively enacted
o If the new rate is not linked to other tax laws:
On the date announced by the Minister of Finance
o If the new rate is inextricably linked to changes to other tax laws, when:
announced by the Minister of Finance; and
President has approved the change.
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Gripping GAAP Property, plant and equipment: the cost model
Chapter 7
Property, Plant and Equipment: The Cost Model
Reference:
IAS 16, IAS 36, IAS 12, IAS 20, IFRIC 1, IFRS 13, IAS 21(incl. any amendments to 1 December 2019)
Contents: Page
1. Introduction 364
2. Recognition 364
2.1 Overview 364
2.2 Meeting the definition 364
2.3 Meeting the recognition criteria 365
2.4 Recognising significant parts 365
Example 1: Significant parts 365
3. Initial measurement 366
3.1 Overview 366
3.2 Cost and the effect of the method of acquisition 366
3.2.1 Item acquired by way of cash (or something similar) 366
Example 2: Cash payments – ‘within’ vs ‘beyond’ normal credit terms 367
3.2.2 Item acquired via an asset exchange 367
Example 3: Asset exchange – fair values are known 368
Example 4: Asset exchange – involving cash and cash equivalents 368
Example 5: Asset exchange – with no commercial substance 369
3.2.3 Item acquired via a government grant 369
Example 6: Government grant is a non-monetary asset 370
Example 7: Government grant is a monetary asset (to acquire another asset) 370
3.3 Initial costs 371
3.3.1 Overview 371
3.3.2 Purchase price 371
Example 8: Initial costs: purchase price 371
Example 9: Initial costs: purchase price with settlement discount 372
3.3.3 Directly attributable costs 373
Example 10: Initial costs: purchase price and directly attributable costs 373
Example 11: Initial costs: purchase price, directly attributable costs and 374
significant parts
3.3.4 Future costs: dismantling, removal and restoration costs 375
3.3.4.1 Future costs: overview 375
3.3.4.2 Future costs: existing on acquisition 375
Example 12: Initial cost involving future costs 375
3.3.4.3 Future costs: caused/increases over time 376
Example 13: Subsequent costs involving future costs 376
3.3.4.4 Future costs: caused/increases over time – more detail 377
3.4 Subsequent costs 378
3.4.1 Day-to-day servicing 378
Example 14: Vehicle repainting 378
Example 15: Vehicle acquired without engine: engine purchased afterwards 378
Example 16: Vehicle engine overhaul – extending the useful life 379
Example 17: Vehicle engine service 379
3.4.2 Replacement of parts and de-recognition of assets 379
3.4.2.1 Derecognition of the old part 379
3.4.2.2 Capitalisation of a new part 380
Example 18: Replacement of a part 380
Example 19: Replacement of a part that was not previously identified 381
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Chapter 7 363
Gripping GAAP Property, plant and equipment: the cost model
1. Introduction
This chapter deals with a vital component of most businesses: its property, plant and
equipment. Property, plant and equipment refers to the physical (tangible) assets that are used
to make profits. There are many different types of property, plant and equipment, each of
which shares one important characteristic: they are used by the business over more than one
year, and are used to generate income. They are thus non-current in nature.
With regard to the two measurement models: this chapter explains the use of the cost model
and the next chapter explains the revaluation model.
The cost model first measures the asset at cost. The The PPE carrying amount
asset is then subsequently measured to reflect the effects (under the cost model) is
reflected by three amounts:
of usage (depreciation) and the effects of any damage
x Cost: this shows how much it was
(impairments). Please note that 'damage', for purposes of initially measured at (see section 3).
impairment testing, includes all kinds of events, such as x Accumulated depreciation: this
physical damage or even a downturn in the economy. Thus, shows the cumulative effect of usage
when measuring the asset using the cost model, its carrying of the asset.
amount is measured as a combination of three amounts: x Accumulated impairment losses: this
shows the cumulative effect of
x cost damage (any kind – not just physical)
x less accumulated depreciation, and to the asset.
x less accumulated impairment losses.
2.1 Overview
Before we can recognise the acquisition of an item as ‘property, plant and equipment’, it must meet:
x the definition of property, plant and equipment; and
x the recognition criteria.
PPE is defined as:
2.2 Meeting the definition (IAS 16.6) x tangible items, that are held:
- for use in the production or
Before one can recognise an asset as ‘property, plant and equipment’, supply of goods or services,
the definition thereof must be met. This definition (see pop-up - for rental to others or
alongside) requires that the item be tangible. This means that it must - for administration
have a physical form (e.g. a machine has physical form, but a patent purposes; and
x are expected to be used
does not). A second aspect to the definition is that we must be during more than one period.
planning to use the asset. We could use it in one of three ways – we IAS 16.6
could use it to produce or supply goods or services (e.g. a machine that we use to make inventory or
a machine that we use to resurface roads), to rent to third parties (e.g. a machine that we rent out to
someone) or for administration purposes (e.g. a building that we use as our head office). The third
issue is that we must plan to use the item for more than one period. An asset that will be used for a
year or less is a current asset (property, plant and equipment is a non-current asset).
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2.3 Meeting the recognition criteria (IAS 16.7 - 10) Recognition criteria
(per IAS 16):
If this definition is met, the next step is to check if the recognition x the inflow of future
economic benefits to the
criteria are also met. There are two recognition criteria in IAS 16: the entity is probable; and
expected inflow of future economic benefits from the asset must be x the asset’s cost can be
probable, and the asset must have a cost that is reliably measurable. reliably measured.
IAS 16.7 reworded
When recognising an item of property, plant and equipment, we must consider whether it has
significant parts, in which case each significant part should be recognised in a separate asset
account. A part of an asset is considered to be significant if the cost of that part is significant in
relation to the total cost of the asset. The idea behind recognising each part separately is that
this will enable us to make more accurate estimates of depreciation because we will then be
able to depreciate each part separately (significant parts often have different useful lives and
residual values to the remaining parts of the item of property, plant and equipment). See IAS 16.43
Whoosh Limited
Statement of financial position (extracts) 20X1
As at 30 June 20X1 C
Non-current assets
Property, plant and equipment Other: 3 000 000 + Ship: 1 000 000 4 000 000
Comment: When disclosing the ship in the SOFP, did you notice how a single line item for total
property, plant and equipment is shown:
x the separate (significant) parts are not disclosed separately, and
x the ship is not disclosed separately.
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Cost is a defined term (see pop-up) that clarifies that cost could be
Cost is defined as
a cash amount (or cash equivalent), a fair value, or in certain
cases, it could even be an amount simply attributed to that asset. x the amount of cash or cash
equivalents paid; or
The cost of the asset on the date it is initially recognised is called the x the fair value of the
initial cost (see section 3.3). This initial cost includes: consideration given (if it is not
cash) at the time of acquisition
x its purchase price (see section 3.3.2); or construction; or
x directly attributable costs (see section 3.3.3); and x the amount attributed to that
x certain future costs (see section 3.3.4). See IAS 16.16 asset if initial recognition is
per other IFRSs. Reworded IAS 16.6
Later in the asset’s life, further costs may be incurred in relation to the
asset, which we refer to as subsequent costs (see section 3.4).
Initial costs
These subsequent costs include, for example: include:
x Day-to-day servicing (i.e. repairs and maintenance); x purchase price
x Replacement of parts; and x directly attributable costs
x Major inspections. x certain future costs See IAS 16.16
The method of acquisition can affect the measurement of cost (see section 3.2 below).
3.2.1 Item acquired by way of cash (or something similar) (IAS 16.23)
If the acquisition price is paid in cash (or something similar If payment is deferred
to cash), then the cost of the item is the cash price beyond normal credit
terms, cost is the present
equivalent on date of recognition. value of the cash payments.
Note:
The ‘cash price equivalent’ is the amount of the cash Total amount we’ll pay
payment (i.e. the nominal amount) if the payment occurs Less: present value of the payment (cost)
immediately on date of acquisition or within normal credit = Interest (expensed over the pmt
period, or capitalised: section 3.2.3)
terms.
However, the ‘cash price equivalent’ is not the future cash payment/s (nominal amount) if the
payment is delayed beyond normal credit terms. In this case, the ‘cash price equivalent’ is the
present-value of the future cash payment/s, measured at date of recognition (i.e. the amount that
would have been paid had it been paid in full on date of recognition). The difference between this
cash price equivalent (the present value of the future cash payments) and the total future cash
payments (the nominal amount) is interest. This interest is generally recognised as an interest
expense. However, interest may need to be capitalised (i.e. recognised as part of the cost of the
asset), section 3.3.3 of this chapter.
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Required: Show the journals relating to the purchase and payment of the machine assuming:
A. Payment within one year is considered to be within normal credit terms.
B. Payment within one year is considered to be beyond normal credit terms. The present value of
this amount, calculated using an appropriate interest rate of 10%, is C90 909.
Comment: The payable amount is the same in Part A and Part B, but depending on the part, it is
considered to be:
Part A: within normal credit terms, so the asset is measured at the cash amount.
Part B: beyond normal credit terms, so the asset is measured at the present value of the cash amount.
Sometimes an item of property, plant and equipment is not Fair value is defined
acquired in exchange for a cash payment but instead involves an as:
exchange of a non-monetary asset (e.g. we could acquire a x the price that would be:
machine by giving up a vehicle) …or it could involve an exchange received to sell an asset, or
of a combination of non-monetary and monetary assets. paid to transfer a liability
x in an orderly transaction
The cost of an item acquired through an exchange of assets is x between market participants
ideally measured at the fair value of the asset/s given up. x at the measurement date IFRS 13.9
However, the cost of the asset would be taken to be the fair value of the asset received instead, if:
x the fair value of the asset given up is not available; or
x the fair value of the asset received is ‘more clearly evident’. See IAS 16.26
If we cannot reliably measure the fair value of either of the assets, then the cost of the acquired
asset is assumed to be the carrying amount of the asset given up.
Similarly, the cost of the acquired asset is measured at the carrying amount of the asset given
up if the exchange of assets is deemed to have no commercial substance (e.g. two vehicles
are exchanged, of the same vintage, with the same mileage and in the same condition.
The diagram on the following page may help to visualise the treatment of exchanges of assets.
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Exchange of assets
Comment:
Scenario A: Explanation:
The vehicle is measured at the fair value of the machine (FV of asset given up): 11 000
The asset sold is removed from the books (derecognised) and the new asset is recognised at the fair value
(FV) of the asset given up because the FV of the asset given up (machine) is readily available.
Note: Where the FV of the asset given up and FV of the asset received are materially different, the FV of
the asset received may be considered ‘more clearly evident’. In this example, however, we were told that
the difference between the two fair values (C1 000) is immaterial.
Scenario B: Explanation:
The vehicle is measured at the fair value of the vehicle (FV of asset received): 15 000
The asset given up must be derecognised and the newly acquired asset must be recognised at the fair
value (FV) of the acquired asset.
This fair value is used because the difference in the fair values is material, and thus the fair value of the
asset acquired is assumed to be ‘more clearly evident’ than the fair value of the asset given up.
Scenario C: Explanation:
The vehicle is measured at the fair value of the vehicle (FV of asset received): 12 000
The asset given up is derecognised and the newly acquired asset is recognised at the fair value of the
acquired asset. The reason is that the fair value of the asset given up is not available.
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Comment:
Scenario A: The old asset is removed (derecognised) and the new asset (machine) is recognised at the
fair value of both assets given up (i.e. the vehicle and the cash).
Scenario B: Although the fair value of cash is known, the fair value of the vehicle given up is not available and
thus the fair value of the acquired machine must be used instead. This resulted in a profit on exchange.
Debit Credit
Machine A: accumulated depreciation (-A) 5 000
Machine A: cost (A) 50 000
Machine B: cost (A) 45 000
Exchange of assets: machine A given up in return for machine B
Comment:
x If the fair value of the asset received is much lower than the value of the asset given up, it may be an
indication that the asset given up was impaired. In this case, before journalising the exchange, we must first
calculate the recoverable amount of the asset given up.
x The recoverable amount of an asset is essentially the higher of the amount expected from either using or
selling the asset (‘recoverable amount’ is defined in IAS 36 and chapter 11 Impairment of assets).
x If the recoverable amount is lower than the carrying amount, the asset is considered to be impaired and thus
the carrying amount must be reduced before accounting for the exchange.
x More information relating to impairments (damage) can be found in chapter 11 (Impairment of assets).
3.2.3 Item acquired via a government grant (IAS 16.28 and IAS 20)
It is the ‘grants related to assets’ that are relevant to this chapter on property, plant and equipment.
Government grants are covered by IAS 20 and are explained in detail in chapter 15 (see
chapter 15, section 3.4, for the explanation as to how to account for ‘grants related to assets’).
The following is just a brief overview of grants in the context of property, plant and equipment.
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A grant received from a government meets the definition of income (because it is not a contribution from a
holder of an equity claim). This grant income must be recognised in profit or loss over the same period in
which any related costs are recognised in profit or loss. Thus, the receipt of a grant relating to the
acquisition of an item of property, plant and equipment would first need to be recognised as deferred grant
income. This will then be transferred out and recognised as income in profit or loss on the following basis:
x if the item is depreciable, it will be recognised as income in profit or loss over the asset’s useful life.
x if the item is non-depreciable, it will be recognised as income in profit or loss as and when the cost of
meeting the conditions attached to the grant, if any, are expensed. See IAS 20.18
A government grant relating to an item of property, plant and equipment could either be received in the
form of the actual non-monetary asset (e.g. a machine) or a monetary asset (e.g. cash) that must be used
to acquire such an asset. Irrespective of how it is received (e.g. whether as a machine or as cash to be
used to buy a machine), the recognition principles are the same: the grant is income that must be
recognised in profit or loss over the asset’s useful life. However, the form in which it is received, could
affect the measurement of the asset. Let’s look at the impact of these two forms.
x If the grant is received in the form of an actual item of property, plant and equipment (non-monetary
asset), the grant income could either be measured at the item’s fair value or a nominal amount.
A ‘nominal amount’ is simply a small amount (e.g. C1) used to record the transaction (e.g. if the entity
cannot determine the item’s fair value or prefers not to use fair value).
Debit Property, plant and equipment & Credit Deferred grant income (liability).
This deferred grant income is then recognised as grant income in P/L over the item’s useful life:
Debit Deferred grant income & Credit Grant income).
x If the grant is received in the form of cash (monetary asset) to be used to acquire an item of property,
plant and equipment, then grant income would be measured at the cash amount.
Debit Bank & Credit Deferred grant income (liability). NOTE 1 Government grants
relating to PPE affect
This deferred grant income is then recognised as grant measurement of cost:
income in P/L over the item’s useful life:
x If we receive PPE for free, its cost
Debit Deferred grant income & Credit Grant income. is either measured:
at FV or
NOTE 1: if we must use the cash to acquire a depreciable asset, we at nominal amount (e.g. C1)
may choose to credit the asset’s carrying amount instead of deferred x If we receive cash to buy PPE:
grant income. The grant will then reach P/L as a reduced depreciation the PPE’s cost could be reduced
charge. This option does not apply if the asset is non-depreciable (e.g. by this cash amount (cr PPE) or
deferred income could be
land), because then the grant would never affect P/L. See IAS 20.26-7 recognised instead (cr def income).
Required: Show the journals relating to the grant and subsequent purchase of the nuclear plant.
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The cost of an item of property, plant and equipment comprises x purchase price;
x directly attributable costs; and
three elements: the purchase price, any directly attributable x initial estimates of future
costs (those that are necessary to bring the asset to a location costs (if the entity has the
and condition suitable for the use intended by management), obligation). See IAS 16.16
and the initial estimate of the costs of dismantling and removing the item and restoring the site on
which it is located, if the entity has an obligation to incur these costs. See IAS 16.16
The ‘purchase price’ includes import duties and non-refundable taxes. If the invoiced price includes a
tax that is able to be claimed back from the tax authorities (i.e. refundable, such as VAT), this tax is
excluded from the purchase price.
The purchase price is reduced by trade discounts and rebates received. Although not expressly stated,
cash discounts received, and even settlement discounts offered, should also be deducted from the
purchase price. If a settlement discount is subsequently forfeited (i.e. because we do not pay in time),
then both the cost of the purchased item and the payable will need to be increased accordingly. (When
initially recognising the purchase transaction, the account payable could be measured at the amount
net of the potential settlement discount or at the gross amount with a separate ‘discount receivable’).
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3.3.3 Directly attributable costs (IAS 16.16-17 & 16.19–21 & IAS 23)
We include ‘directly attributable costs’ in the cost of an asset. This term refers to those costs that
we believe were necessary to get the asset into a location and condition that enabled it to be
used as management intended. Examples include:
Directly attributable
x cost of preparing the site; costs are those
x initial delivery and handling costs;
x that were necessary;
x installation and assembly costs;
x to get the asset to the
x professional fees; location and condition;
x employee benefits (salaries, wages etc.) relating directly to x that enabled it to be used as
its construction or acquisition; and intended by management.
Reworded IAS 16.16(b)
x cost of testing that the asset is functioning correctly (net of any
proceeds earned from the sale of items produced during testing). See IAS 16.17 and the pop-up below
Please note: The IASB has proposed an amendment to IAS 16 that would require us to recognise the
proceeds from the sale of units produced during testing as income, instead of deducting it from cost.
At the time of writing, it is still being debated, but it looks likely that this amendment will be issued.
Another example is borrowing costs. If we incur costs (e.g. interest) that meet the definition of borrowing
costs and if they ‘are directly attributable to the acquisition, construction or production’ of an item of
property, plant and equipment that meets the definition of a qualifying asset (‘an asset that necessarily
takes a substantial period of time to get ready for its intended use or sale’ e.g. construction of a factory),
then these borrowing costs must be capitalised to the asset’s cost (instead of being expensed) if certain
criteria are met. Borrowing costs is covered by IAS 23 Borrowing costs (see chapter 14).See IAS 16.22 8
Any cost that is not a ‘directly attributable cost’ is not included in the asset’s cost. Examples include:
x administration and other general overheads;
x advertising and other costs relating to introducing a new product or service;
x conducting business in a new location or with a new type of customer;
x cost of training staff, for example, on how to use the newly acquired asset. See IAS 16.19
If a cost was not necessary in bringing the asset to a location and condition that enables it to be
used as intended by management, it is not a ‘directly attributable cost’ and thus not included in
the cost of the asset, for example:
x income and expenses that result from incidental operations occurring before or during
construction of an asset (e.g. using a building site as a car park until construction starts);
x abnormal wastage. See IAS 16.21 and .22
Similarly, costs incurred after the asset was brought into the required location and condition that
enables it to be used as intended by management cannot be referred to as ‘directly attributable’
and thus may not be capitalised (i.e. capitalisation ceases at that point). Examples include:
x staff training and costs of opening new facilities;
x initial operating losses made while demand for an asset’s output increases;
x costs of moving the asset to another location; and
x costs incurred while an asset, which is now capable of being used, remains idle or is being
utilised at below intended capacity. See IAS 16.19 and .20
Example 10: Initial costs: purchase price and directly attributable costs
A Limited (a registered VAT vendor) constructed a factory plant, details of which follow:
x Construction costs, including materials (including VAT of 15%) C575 000
x Import duties on certain construction materials - non-refundable (no VAT) 100 000
x Fuel used to transport construction materials to the construction site (no VAT) 45 000
x Fuel destroyed by construction workers during an illegal strike (no VAT) 30 000
x Administration costs (no VAT) 10 000
x Staff party to celebrate the completed construction of the new plant (no VAT) 14 000
x Testing to ensure plant fully operational before start of production (no VAT) 42 123
x Borrowing costs (all criteria for capitalisation in terms of IAS 23 were met) (no VAT) 15 000
x Advertising of the ‘amazing widgets’ to be produced by the new plant (no VAT) 50 000
x Initial operating loss (due to an initial insufficient demand for widgets) (no VAT) 35 000
Required: Calculate the initial costs to be capitalised to the plant account.
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Solution 10: Initial costs: purchase price and directly attributable costs
C
Construction costs, including materials (Exclude VAT: 575 000 x 100/115) Note 1 IAS 16.16 500 000
Import duties - non-refundable Note 1 IAS 16.16 100 000
Fuel used to deliver construction materials to construction site IAS 16.16 45 000
Fuel destroyed (abnormal wastage) Note 2 IAS 16.22 0
Administration costs Note 2 IAS 16.19(d) 0
Staff party Note 2 IAS 16.19(c) 0
Testing the plant before start of production IAS 16.17(e) 42 123
Borrowing cost IAS 16.22 15 000
Advertising Note 3 IAS 16.19(b) 0
Initial operating losses Note 3 IAS 16.20 0
Initial costs (these will all be debited to the ‘plant: cost’ account) 702 123
Note 1: The VAT paid is not capitalised because the company is registered as a VAT vendor and thus this
VAT is refundable. The import duties are capitalised since they are not refundable.
Note 2: These costs are not capitalised because they were not directly attributable to (not necessary in) bringing
the asset to a location and condition necessary for it to be used as intended by management.
Note 3: This cost is excluded because it is a loss incurred after the asset was brought to a location and
condition that enabled it to be used as intended by management.
Example 11: Initial costs: purchase price, directly attributable costs & significant parts
B Air bought an aircraft on 1 January 20X2, incurring the following related costs in January 20X2:
Purchase price: C’000
Outer-body component 50 000
Engine component 70 000
Internal fittings component 20 000
Other costs:
Delivery costs* 500
Legal costs associated with purchase rights* 200
Costs of safety certificate 1 000
*These costs are incurred in proportion to the purchase price across the 3 components.
x Under local aviation authority regulations, all passenger aircraft must be granted a safety certificate by
the aviation authority, which must be renewed every 2 years.
x All components have a nil residual value. The estimated useful lives of these parts are as follows:
Outer-body 30 years
Engines 10 years
Internal fittings 5 years
Required: Determine the carrying amount of the separate components at 31 December 20X2.
Solution 11: Initial costs: purchase price, directly attributable costs & significant parts
Outer-body Engine Interior fittings Safety certificate
C’000 C’000 C’000 C’000
Initial cost 50 000 70 000 20 000 0
Safety certificate 1 000
Delivery costs 50/140 x 500 179 250 71 0
70/140 x 500
20/140 x 500
Legal costs 50/140 x 200 71 100 29 0
70/140 x 200
20/140 x 200
50 250 70 350 20 100 1 000
Less: depreciation 50 250/30 years (1 675) (7 035) (4 020) (500)
70 350/10 years
20 100/ 5 years
1 000/ 2 years
Carrying amount: 31/12/20X2 48 575 63 315 16 080 500
Total carrying amount 128 470
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3.3.4 Future costs: dismantling, removal and restoration costs (IAS 16.16 (c) & 16.18 & IFRIC 1)
The ownership of an asset may come with an obligation to Future costs could
dismantle it, remove it and/or restore the site on which it is arise:
located at some stage in the future. This obligation may arise: x simply due to an acquisition; or
x On acquisition (i.e. simply by having purchased it); or x due to the usage of an asset.
x Over time (i.e. through having used the asset). IAS 16.6(c)
If an obligation arises through simply having purchased the Future costs arising
asset (i.e. by having acquired ownership), then the estimated on acquisition are:
future costs must be included in the initial cost of the asset.
x capitalised as an initial cost;
The time value of money, if material, must also be taken into and
account in calculating the initial amount to be recognised in x measured at its PV if “FV – PV
terms of future dismantling, removal and restoration costs. = a material amount”.
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3.3.4.3 Future costs: caused/ increases over time (IAS 16.16 (c) & 16.18)
If the obligation for future costs arises as a result of the asset being used (rather than simply
an obligation that already exists on the date of purchase), the present value of the obligation
that arises as the asset is used must also be capitalised to the cost of the asset (i.e. added as
a subsequent cost). However, if the asset is being used to produce inventories, then this
present value would be capitalised to inventories instead.
This means that the cost of the asset will change every time the Future costs arising
due to usage:
usage of the asset leads to an additional obligation.
x are capitalised as a
The fact that cost keeps changing will obviously also affect our subsequent cost;
depreciation calculation. This is because depreciation is the x unless the asset has reached
the end of its UL, in which
expensing of the asset’s ‘depreciable amount’, which is its ‘cost less case the future costs are
residual value’, over the asset’s useful life (see section 4.3). recognised in P/L; and
x are measured at PV if:
If the asset has reached the end of its useful life (i.e. it has been FV – PV = a material amount
fully depreciated), then any changes to the liability from that
point on, would have to be recognised directly in profit or loss.
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x The plant had always been used solely to manufacture products for sale to customers,
but from 20X4, some of these products were used to manufacture a machine:
Plant usage/year
The plant was used in the manufacture of products: 20X4 20X5
x that would be sold to customers 70% 70%
x that would be used to manufacture a machine (classified 30% 30%
as property, plant and equipment)
Required: Show the related journals for the years ended 31 December 20X4 and 20X5.
1: Carrying amount on 1 January 20X5: Cost: (600 000 + 17 363) – Acc Depr: (100 000 x 4 years) = 217 363
2: Remaining useful life (RUL) on 1 January 20X5: 6 years – 4 years = 2 years left
Comment: Notice how the amount of the provision was not debited to a separate ‘plant rehabilitation:
cost’ account (as it was in the prior example) but was included in the ‘plant: cost’ account (and inventory)
instead. This is because the rehabilitation will take place at the end of the plant’s useful life and thus the
rehabilitation cost and the plant cost (excluding the rehabilitation cost) will be depreciated to P/L at the
same rates (unlike the previous example, where the useful lives differed).
3.3.4.4 Future costs: caused/ increases over time – more detail (IFRIC 1)
The provision for future costs may require adjustment over time, resulting from:
x The unwinding of the discount as one gets closer to the date of the future cost (e.g. getting
closer to the date on which the asset has to be decommissioned);
x A change in the expected outflow of economic benefits (e.g. cash outflows); and
x A change in the estimated current market discount rate.
The unwinding of the discount is expensed in profit or loss as a finance cost. Capitalisation of
these finance costs under IAS 23 Borrowing costs is not permitted. IFRIC 1.8
However, a change in the expected outflows (i.e. a change in the amount of the future cost) or a
change in the estimated current market discount rate would affect the asset’s carrying amount.
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The journal adjustments to account for changes expected outflows or changes in discount
rates are detailed in IFRIC 1 and depend on whether property, plant and equipment is
measured using the cost model or revaluation model.
Since IFRIC 1 requires an understanding of both the cost model (explained in this chapter) and
the revaluation model (explained in chapter 8) and also requires an understanding of
provisions (explained in chapter 18), these journals are not covered in this chapter or the
chapter on the revaluation model, but in the chapter relating to provisions (chapter 18).
3.4 Subsequent costs (IAS 16.7; 16.10 & 16.12-14)
Subsequent costs are
After incurring the initial costs of acquiring or constructing an
only capitalised if:
asset, further related costs may continue to be incurred. The
same recognition criteria that apply to these initial costs apply x IAS 16’s recognition criteria are met
equally to these further costs: a cost should only be added to (if not, cost must be expensed)
the asset’s carrying amount if it is reliably measureable and We account for replacement of parts
and major inspections as follows:
leads to probable future economic benefits. Further costs can
x derecognise old carrying amount, and
involve adding to the asset, day-to-day servicing of the asset,
x capitalise new cost (generally as a
replacing parts thereof and performing major inspections. separate part).
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For interest: If the cost of the overhaul is considered significant in relation to the cost of the vehicle and
now results in the vehicle ‘engine’ having a materially longer useful life than the vehicle ‘body’, then the
carrying amount of the engine and the body should be accounted for as two separate parts of the vehicle.
If the original purchase transaction had been simply recorded as a ‘vehicle’, the carrying amount of the
old engine will now need to be estimated and removed from this ‘vehicle’ account and recorded as a
separate ‘vehicle engine’ account and the cost of the overhaul would need to be added to this account.
For example, if the cost of the old engine in the second-hand vehicle is estimated to be 15% of the cost of
the vehicle purchase, the journals will be as follows:
Debit Credit
Vehicle: cost (A) Given 100 000
Bank/ Payable 100 000
Purchase of second-hand vehicle (this includes the old engine)
Vehicle: engine: cost 100 000 x 15% 15 000
Vehicle: body: cost Balancing: 100 000 – 15 000 85 000
Vehicle: cost (A) Given 100 000
Separation of the significant parts: engine and body (because, after
the overhaul, the engine now has a longer useful life than the body)
Vehicle: engine: cost (A) 20 000
Bank/ Payable 20 000
Payment for engine overhaul
The engine (15 000 + 20 000 = 35 000) and the body (cost: 85 000) will be depreciated separately.
Some items of property, plant and equipment have parts that regularly need replacing (e.g. an
aircraft may need its seats to be replaced every 3 years). Conversely, a part may unexpectedly
need replacement (e.g. a part may need to be replaced because it was damaged). Where a
part of an asset is replaced, the carrying amount of the old part must be removed from the
asset accounts by expensing its carrying amount in profit or loss (i.e. credit cost, debit
accumulated depreciation and debit/ credit the profit or loss with the carrying amount).
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The derecognition is easy if the replaced part had been recognised and depreciated as a
separate part of the asset, but if the replaced part was not originally recognised separately, the
carrying amount of the part will need to be estimated (see example 18).
If the part needed replacing because it was damaged (as opposed to needing replacing simply
because the part has reached the end of its useful life), we must first check for impairments
before we derecognise the part’s carrying amount.
If this damage caused the value of the part (its recoverable amount) to drop below its carrying
amount, the carrying amount must first be reduced to reflect this impairment (i.e. debit
impairment loss expense and credit accumulated impairment losses), and then be
derecognised (i.e. debit profit or loss with the carrying amount that is being expensed with the
contra entry being a combination of a credit to cost, a debit to accumulated depreciation and a
debit to accumulated impairment losses). Impairments are explained in section 4.4.
If the property, plant and equipment definition and recognition criteria given in IAS 16 are met, the cost
of the replacement part must be recognised as an asset. If the cost of this new part is significant in
relation to the value of the asset as a whole and has a useful life and method of depreciation that is
different to the rest of the asset, then this new part must be recorded in a separate asset account.
However, all immaterial replacement parts should be expensed as day-to-day servicing.
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When an asset requires ‘regular major inspections as a condition to its continued use’ (a good
example, given in IAS 16.14, is an aircraft), then the cost thereof (or an estimate thereof), must
be capitalised as soon as either the cost is incurred, or an obligation arises. This inspection
will be recognised as an asset.
This ‘major inspection’ asset is then depreciated over the period until the date of the next
inspection. If the cost of the inspection is significant and the rate and method of depreciation
of the inspection differs from that applied to the other parts of the related asset, then the cost of
the inspection must be recognised as a separate part.
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If an entity buys an asset that, on the date of purchase, has already been inspected and thus
does not require another inspection for a period of time, the cost must be separated into:
x the cost that relates to the physical asset (or its separate significant parts), and
x the cost that relates to the balance of the previous major inspection purchased.
The cost of the inspection need not be separately identified on the sale documentation i.e. an
estimate of the cost can be made based on the expected cost of future similar inspections.
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On 31 December 20X3 the first major inspection is performed at a cost of C400 000. New legislation now
requires that major inspections be performed every 2 years starting from 31 December 20X3. The next
major inspection is estimated to cost C600 000.
Required: Show the journals in 20X2, 20X3 and 20X4.
4.1 Overview
The measurement of an item of property, plant and equipment is reflected in its carrying
amount and is constituted by its initial measurement and subsequent measurement.
Initial measurement of property, plant and equipment is always at cost and thus the
measurement of its carrying amount will initially simply reflect cost.
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This chapter focuses only on the cost model. The revaluation model is explained in the next chapter.
When using the cost model, our cost account reflects the total costs capitalised to the asset (in
contrast, when using the revaluation model, the asset is revalued to a fair value and so its cost
account is adjusted to reflect the fair value instead). These capitalised costs will include both:
x the initial cost (see section 3.3); and
x any subsequent costs (see section 3.4). The cost model
measures PPE as:
When using the cost model, the subsequent measurement of our x the cost (initial + subsequent)
asset (which is initially measured at cost), involves processing x less accumulated depreciation
x subsequent depreciation, if the asset is depreciable (land x less accumulated impairment
losses (if applicable) See IAS 16.6
may not necessarily be depreciable), and possibly also
x subsequent impairment losses (all items of property, plant and equipment are
subsequently tested for impairment).
4.3 Depreciation
Depreciation is
defined as:
4.3.1 Overview
x systematic allocation of the
Depreciation reflects the extent to which the asset’s carrying amount x depreciable amount of an asset
has decreased because of having used the asset. All items of x over its useful life. IAS 16.6
property, plant and equipment, with the exception of land in most
cases, must be depreciated. Land is generally not depreciated because it generally cannot be used
up: it always remains there, ready to be used, again and again. Obviously, land that is used, for
example, as a quarry or landfill site, would mean that the land would have a limited useful life (i.e. from
the perspective of the entity, it does get used up) and thus would need to be depreciated.
The portion of a cost that we believe will not be lost through usage is referred to as its residual
value. We thus exclude the residual value when calculating the depreciation. It is thus only the
depreciable amount (cost less residual value) that is depreciated.
Depreciation is usually recognised as an expense in profit or loss. However, the asset may be used to
produce another asset, in which case the depreciation would be capitalised to that other asset.
Property, plant and equipment is depreciated on a significant parts basis. This means that, if
an asset can be broken down into parts where one (or more) of these parts has a cost that is
considered to be significant relative to the asset's total cost, we must depreciate this part (or
parts) separately from the rest of the asset if it has:
x a different useful life; or
x a different pattern of future economic benefits. See IAS 16.43 - 47
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4.3.2 Residual value and the depreciable amount (IAS 16.51 – 54)
Since the asset's residual value is just an estimate, it must be reviewed at each year-end. If it
changes, it will be accounted for as a change in accounting estimate. See IAS 16.51 & IAS 8
The straight-line method gives an equal depreciation expense in each of the years of the
asset's useful life and thus is ideal when we expect that the asset will be used to an equal
extent during each of the years of its useful life. The straight-line method is a simple calculation
involving dividing the depreciable amount (i.e. remember to deduct the residual value from the
cost) over the life of the asset. It is calculated as follows:
Depreciable amount Cost – Residual value
Depreciation expense = =
Useful life Useful life
Obviously, the effect of the useful life (e.g. 4 years) could be expressed as a percentage
instead (e.g. (1 ÷ 4) x 100 = 25%), in which case the formula will involve multiplying the
depreciable amount by this straight-line depreciation rate as follows:
Depreciation expense = Depreciable amount x straight-line depreciation rate (%)
= (Cost – Residual value) x straight-line depreciation rate (%)
The diminishing balance method results in a decreasing depreciation expense in each of the
years of the asset's useful life and thus is ideal if we expect that the asset will be used the
most during the earlier years of its life and that the usage thereof will diminish as it ages.
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The diminishing balance method involves multiplying the carrying amount (which will obviously
be decreasing each year) by a fixed rate of depreciation. It is important to note that this rate is
not applied to the depreciable amount (cost – residual value). This is because the effect of the
residual value is already built into the diminishing balance rate of depreciation. In the following
equation, 'n' represents the useful life in years.
n
Depreciation rate for diminishing balance (%) = 1 –
√ (Residual value ÷ Cost)
Once you have calculated the rate of depreciation for purposes of the diminishing balance
method, you simply apply it to the opening carrying amount of the asset.
Depreciation expense = Carrying amount x Depreciation rate for diminishing balance (%)
= 1 – 0,595
= 0,405 = 40,5% (rounded)
Using this depreciation rate, we then calculate the depreciation expense over the useful life. Notice that after
4 years, the closing carrying amount reflects the residual value of C62 667, close to C62 500 (there is a
rounding error of C167 because the depreciation rate of 40,5% was rounded):
Opening carrying amount Depreciation expense Closing carrying amount
Year 1 500 000 202 500 500 000 x 40.5% 297 500
Year 2 297 500 120 488 297 500 x 40,5% 177 012
Year 3 177 012 71 690 177 012 x 40,5% 105 322
Year 4 105 322 42 655 105 322 x 40,5% 62 667
This is possibly the most accurate method of depreciation and can be used assuming it is
possible to estimate the asset's total estimated output and that the actual output achieved in
each period can be determined. It is calculated as follows:
Actual output in the period
Depreciation expense = Depreciable amount x Total estimated output over the useful life
The method chosen should match the way in which we expect to earn the future economic
benefits through use of the asset. See IAS 16.60
The depreciation method
However, it must be emphasised that the depreciation should reflect:
method should reflect the pattern of the consumption of the x the pattern in which,
asset’s expected future economic benefits rather than x the FEB from the asset,
reflect the revenue generated by the asset. The reason for x are expected to be consumed.
IAS 16.60 reworded
this is that revenue that is generated by an activity that
includes the use of an asset is affected by numerous factors that may have no relation to how
the asset is being used up. For example, the revenue generated from the use of an asset
would be affected by factors such as inflation and pricing that is manipulated for marketing
purposes. It would also be affected by sales volumes where the volumes sold would be
affected by, for example, marketing drives and economic slumps. See IAS 16.62A
Worked example: Depreciation method
x An asset is expected to produce 100 000 units in year 1 and 80 000 units in year 2.
x The total expected output of 180 000 units is expected to be sold evenly over a 3-year period (i.e. 60 000
units pa).
x The sales department plans to market the units at C10 per unit in year 1, C12 per unit in year 2 and C15 per
unit in year 3. Thus budgeted sales are: C600 000 in year 1, C720 000 in year 2 and C900 000 in year 3.
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Since the depreciation method is based on an expected pattern of future benefits, it is simply
an estimate and must be reviewed at the end of each financial year. If it changes, it will be
accounted for as a change in accounting estimate. See IAS 16.61 & IAS 8
Depreciation does not cease if an asset is idle (unless the units of production method is used
to calculate the depreciation). See IAS 16.55
Determining the useful life involves a careful consideration of many factors, including:
x ‘the expected usage of the asset’ (for example, the total number of units expected to be
manufactured by a plant);
x ‘the expected physical wear and tear’ on the asset (for instance, this would be less in a
company that has a repairs and maintenance programme, than in another company that
does not have such a programme);
x ‘technical or commercial obsolescence’, which may shorten the asset’s useful life. We
should also be on the look-out for an expected reduction in the selling price of the output
produced by the asset because this may suggest imminent ‘technical or commercial
obsolescence’ of the asset and thus may indicate a potential decrease in the asset’s useful
life; and
x other limits on the asset’s useful life, including legal limits (with the result that the useful life
to the company may be shorter than the asset’s actual useful life). See IAS 16.56
Since the asset's useful life is just an estimate, it must be reviewed at the end of each financial
year. If it changes, it will be accounted for as a change in accounting estimate. See IAS 16.51 & IAS 8
4.3.5 Depreciating the whole asset or the parts thereof (IAS 16.43 - 47)
In order for depreciation to be more accurately measured, we may need to recognise and
depreciate each part of an asset separately, rather than as a whole, single asset. This is
necessary if the various parts each have a significant cost and have differing variables of
depreciation (useful life, residual value or method).
For example: a vehicle may have an engine and a body where these two parts have different
useful lives. Similarly, the depreciation method could differ: the engine may need to be
depreciated over the number of kilometres travelled whereas the body may need to be
depreciated over a certain number of years.
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If an entity uses an existing asset to construct another asset, the depreciation charge must be
capitalised to the cost of the newly constructed asset: IAS 16.48 - .49
Debit Credit
Constructed asset: cost (A) xxx
Depreciation: the name of the other asset that was used (E) xxx
Capitalisation of depreciation to the cost of the constructed asset
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Solution 25: Table showing consumption of the asset over its life
Depreciation calculated per year Opening Depreciation Closing Calculations
of its useful life (UL): balance at 20% balance
1st yr of its UL ending 31/03/X2 12m 800 000 160 000 640 000 800 000 x 20% x 12/12
2nd yr of its UL ending 31/03/X3 12m 640 000 128 000 512 000 640 000 x 20% x 12/12
3rd yr of its UL ending 31/03/X4 12m 512 000 102 400 409 600 512 000 x 20% x 12/12
4th yr of its UL ending 31/03/X5 12m 409 600 81 920 327 680 409 600 x 20% x 12/12
Accumulated depreciation: 472 320
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Required:
Show the journals for the year ended 31 December 20X1 that relate to the asset, assuming:
A. The constructed asset is a plant that became available for use on 1 October 20X1 and was
depreciated for 5 years to a nil residual value.
B. The constructed asset is inventory, half of which was sold on 1 October 20X1.
There are two methods that may then be used to calculate the revised depreciation when there
is a change in estimate:
x the reallocation method; and
x the cumulative catch-up method.
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These two methods are covered in detail in chapter 26 where further examples are provided
(together with disclosure requirements when there is a change in estimate). The journals for a
change in estimate are really simple and are best explained by way of the following example.
Please note that damage is not referring exclusively to physical damage. We look for any kind
of damage that reduces the value of the asset (e.g. an economic downturn may reduce
demand for an asset’s output, in which case the asset becomes less valuable to the entity).
Thus, in essence, impairment testing is checking to ensure the asset’s carrying amount is not
overstated. However, if we think the carrying amount may be too high, it may simply be because we
have not processed enough depreciation …the variables of depreciation may need to be re-estimated:
x If we believe that we have not processed enough depreciation, extra depreciation is then
processed (and accounted for as a change in estimate in accordance with IAS 8); but
x If we believe that the depreciation processed to date is a true reflection of past usage, but
yet we are worried that the carrying amount may be too high, we will have to then calculate
the recoverable amount and compare it with the asset’s carrying amount.
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The detail regarding how to calculate the value in use and fair value less costs of disposal is
set out in IAS 36 Impairment of assets and is explained in depth in the chapter dedicated to
impairments (Chapter 11).
If the indicator test suggests that the asset is impaired (i.e. that the accumulated depreciation
is a fair reflection of the usage of the asset and thus a shortage of depreciation is not the
reason for the carrying amount being too high), the carrying amount must be compared with
the asset’s recoverable amount.
Impairment loss reversed
If the carrying amount is greater than this recoverable
amount, the carrying amount is reduced by processing an
x If at a subsequent date the RA
impairment loss expense. increases above CA,
x increase the CA,
If circumstances change and the recoverable amount increases
in a future year, the carrying amount may be increased to this x but only to the extent that the CA
does not exceed the depreciated
higher recoverable amount. The increase is recognised in cost (historical CA).
profit or loss as an impairment loss reversal (income).
However, when increasing our carrying amount to this higher recoverable amount, we may not
increase the carrying amount above the carrying amount that it would have had had it never been
impaired. Thus, this means that, when using the cost model, we may not increase the carrying
amount above cost, if the asset is non-depreciable, or above depreciated cost (also called
depreciated historic cost) if the asset is depreciable. In the case of the cost model, you can think of
this limit as a ‘magical’ historical carrying amount line, above which the asset may not venture.
In other words, when using the cost model, the carrying amount of an asset may be decreased below
its historical carrying amount (cost or depreciated cost) but may never be increased above it.
The depreciation in future years will be based on the reduced carrying amount. In other words,
the depreciation in the year after the impairment will be calculated by depreciating the asset’s
new revised carrying amount over its remaining useful life to the residual value.
The following diagrams may help you to visualise the effects of the cost model:
Diagram 1: Cost model summarised
Recoverable amount
greater than HCA No adjustments allowed
HCA
Recoverable amount Recognised in P/L
less than HCA
HCA: historical carrying amount (depreciated cost, or just cost in the case of a non-depreciable asset)
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HCA/
ACA HCA HCA RA
Imp
Not
loss allowed
(E)
RA ACA RA HCA
Further: Imp loss Imp loss
Imp Reversed Reversed
loss (E) (I) (I)
RA ACA ACA
Scenario 1: the RA is less than the ACA (which was still the same as the HCA)
Scenario 2: the RA is less than the ACA (the ACA was already less than the HCA due to a prior impairment)
Scenario 3: the RA is greater than the ACA but still less than the HCA (the ACA was less than the HCA due to
a prior impairment)
Scenario 4: the RA is greater than the ACA and greater than the HCA (the ACA was less than the HCA due to
a prior impairment)
The cost model can also be explained by way of a graph. First, plot the ‘magical’ historical
carrying amount line (HCA), otherwise known as the depreciated cost (or cost, if the asset is
non-depreciable). After this, you need to plot your actual carrying amount (ACA) and your
recoverable amount (RA):
0 Useful Life
Notice how the line is a diagonal line representing the gradual reduction in the depreciated cost
(historical carrying amount) as the asset is depreciated over its useful life. It would be a horizontal line if
the asset is not depreciated.
When using the cost model, the asset’s actual carrying amount may be decreased below this diagonal
line (HCA) but may never be increased above it. For example, assume that the recoverable amount is
greater than the historical carrying amount.
x If the actual carrying amount equalled the historical carrying amount, no adjustment will be made
since this would entail increasing the actual carrying amount above its historical carrying amount.
x If the asset had previously been impaired, then the asset’s actual carrying amount would be less
than the historical carrying amount. In this case, the actual carrying amount must be increased, but
only up to the historical carrying amount (reversing a previous impairment loss) but not all the way
up to the recoverable amount (i.e. not above the historical carrying amount).
Chapter 7 393
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0 Useful Life
Note: No further impairment loss was required to be journalised at 31/12/20X2 since the new
carrying amount (60 000 – 15 000 = 45 000) equals the recoverable amount.
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W2: Actual carrying amount 31/12/20X2 (before the impairment testing): A and B
Cost 100 000
Accum. depr. and imp. losses Depr20X1:20 000 + IL20X1: 20 000 + Depr20X2: 15 000 (55 000)
45 000
60 000( HCA)
Cost
55 000(RA)
10 000 (Credit reversal of impairment loss)
Historical carrying amount line
45000( ACA)
0 Useful Life
65 000(RA)
(No increase allowed)
60 000( HCA)
Cost
0 Useful Life
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Example 31: Cost model – a summary example (the asset is not depreciated)
x Cost of land at 1/1/20X1: C100 000
x Depreciation: This land is not depreciated
Recoverable amount
x 31/12/20X1 120 000
x 31/12/20X2 70 000
x 31/12/20X3 90 000
x 31/12/20X4 110 000
Required:
A. Show the ledger accounts for the years ended 31 December.
B. Draft the statement of financial position for the years ended 31 December.
Solution 31A: Cost model – a summary example (the asset is not depreciated)
Ledger accounts:
Solution 31B: Cost model – a summary example (the asset is not depreciated)
Entity name
Statement of financial position 20X4 20X3 20X2 20X1
As at 31 December (extracts) C C C C
ASSETS
Non-current assets
Land 20X1: Cost: 100 000 – AIL: 0 100 000 90 000 70 000 100 000
20X2: Cost: 100 000 – AIL:30 000
20X3: Cost: 100 000 – AIL:10 000
20X4: Cost: 100 000 – AIL:0
Comment:
As this asset is not depreciated, its actual carrying amount remains unchanged, at original cost. In other
words, its actual carrying amount (ACA) always equals is historical carrying amount (HCA) of cost.
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Solution 31A and B: Cost model – a summary example (the asset is not depreciated)
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Disclosure:
Entity name
Statement of financial position 20X4 20X3 20X2 20X1
As at 31 December (extracts) C C C C
ASSETS
Non-current Assets
Machine 20X1: Cost: 100 000 – AD&IL: 25 000 0 25 000 40 000 75 000
20X2: Cost: 100 000 – AD&IL:60 000
20X3: Cost: 100 000 – AD&IL:75 000
20X4: Cost: 100 000 – AD&IL:100 000
Workings:
W1: Machine: carrying amount and adjustments 20X1 20X2 20X3 20X4
Jnl No Dr/ (Cr) Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
To derecognise an asset means to remove its carrying amount from the accounting records.
To remove a carrying amount you need to remove all its related accounts. In other words, one
side of the entry requires us to credit its cost account and debit its accumulated depreciation
and accumulated impairment loss accounts. The other side of the entry (i.e. the contra entry) is
to recognise an expense in profit or loss (i.e. you are essentially processing an entry that
credits the carrying amount and debits an expense).
If, when derecognising the asset, the entity earned proceeds on the disposal, these proceeds would
be recognised as income in profit or loss. The amount of these proceeds is measured in the same
way that a transaction price is measured in terms of IFRS 15 Revenue from contracts with customers.
Since we are allowed to offset the expense (i.e. the expensed carrying amount) and the
income (i.e. the proceeds), the process of recognising the carrying amount as an expense and
recognising the proceeds as income is generally processed in one account, generally called a
‘profit or loss on disposal’ account. If it results in a gain, this gain may not be classified as
revenue (i.e. it is simply classified as income in profit or loss.
Disposals occur if, for example, the asset is sold, leased to someone else under a sale and
leaseback agreement or donated.
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The date on which the disposal must be recorded depends on how it is disposed of;
x The date on which the disposal must be recorded revolves around when the other entity
obtains control of our asset. To determine when control passes from us to the other entity, we
must use IFRS 15 (the standard on revenue), and its explanation as to when a performance
obligation has been satisfied. If we have sold our asset and are now leasing it back (called a
‘sale and leaseback’) we must then apply IFRS 16 Leases. (see chapter 16).
x If a disposal occurs in any other way (e.g. by way of a sale or donation), the asset is
derecognised on the date that the recipient obtains control of the item (the recipient is said to
have obtained control when the IFRS 15 criteria for determining when a performance
obligation has been satisfied are met). See IAS 16.69
Please note: although the performance obligation criteria in IFRS 15, (the standard on revenue),
are used to determine when to derecognise an item of property, plant and equipment that is
disposed of in any manner other than by way of sale and leaseback, any gain on de-recognition
(e.g. profit on sale of plant) may not be classified as revenue. Any gain that may be made would
thus simply be classified as part of ‘other income’.
Sometimes entities, as part of their ordinary activities, rent items of property, plant and equipment
to third parties, after which they sell these second-hand items. In such cases:
x after the entity has stopped renting the item of property, plant and equipment to third parties
and decides to sell it, the carrying amount of this item is transferred to inventory;
x the inventory is derecognised when the revenue recognition criteria are met; and
x the sale of the asset is then classified as part of revenue because it would be a sale of
inventory and not a sale of property, plant and equipment: the related revenue would thus be
accounted for in terms of IFRS 15 Revenue from contracts with customers. See IAS 16.68A
6.1 Overview
Deferred tax balance
=
Temporary differences will arise if the tax authorities do not
measure the tax base of the item of property, plant and x Temporary difference x tax rate
equipment in the same way that the carrying amount is (unless TD is exempt)
measured in terms of IFRSs. x Nil if TD is exempt:
Exemption may occur if a TD
Deferred tax should be recognised on temporary differences arises on initial acquisition
unless the temporary difference is:
x exempt from deferred tax; or
x a deductible temporary difference (i.e. causing a deferred tax asset) where sufficient taxable
profits to absorb the entire tax deduction are not probable (i.e. the deferred tax asset is only
recognised to the extent that the related future tax saving is probable). See IAS 12.15 & .24
This section merely revises some of the deferred tax consequences of property, plant and equipment
because these deferred tax effects were explained in detail in the chapter on deferred tax. If you are
unsure of the deferred tax consequences of property, plant and equipment, please revise the following:
x Deductible assets: See chapter 6: section 4.2;
x Non-deductible assets (and the exemption): See chapter 6: section 4.3 and section 5;
x Sale of property, plant and equipment: See chapter 6: section 4.5.
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The tax base of an item of property, plant and equipment (PPE) changes if and when:
x the asset is acquired;
x deductions are allowed on the cost of the asset; and
x the asset is sold.
Generally, when the carrying amount and tax base are not the same, it means that the rate at
which the cost of the asset is expensed (depreciated) is different to the rate at which the cost
of the asset is allowed as a tax deduction (e.g. through a wear and tear deduction).
The following examples show the deferred tax effects of PPE measured under the cost model:
x Example 33: shows us how to account for the deferred tax effects arising from basic
transactions involving PPE (purchase, depreciation and sale of the asset).
x Example 34: shows us how to account for the deferred tax effects arising from PPE that
has been impaired (impairment loss).
x Example 35: shows us the deferred tax implications when accounting for an item of PPE
that is not tax-deductible (i.e. where the tax authorities do not allow a related tax-deduction
when calculating taxable profit) (i.e. a deferred tax exemption).
Example 33: Deferred tax caused by purchase, depreciation and sale of PPE
x An entity buys plant on 2 January 20X0 for C100 000 in cash.
x Depreciation on the plant is calculated:
- using the straight-line basis
- to a nil residual value
- over 4 years.
x The plant is sold on 30 June 20X2 for C80 000.
x The tax authorities allow the cost of plant to be deducted from taxable profits at 20% pa.
x The tax authorities apportion the tax deduction for part of a year.
x The income tax rate is 30%.
x The financial year-end is 31 December.
Required:
Show all related journal entries possible.
Solution 33: Deferred tax caused by the purchase, depreciation and sale of PPE
Comment:
x It is not necessary to know how much the asset is sold for when calculating the deferred tax
balance! This is because the selling price has no impact on either the asset’s carrying amount or
its tax base: both are reduced to zero, no matter how much it was sold for.
x The selling price is only used in calculating profit before tax and taxable profits, which leads to
the calculation of the current tax charge (see chapter 5).
x The only effect that a sale of an asset has on the asset account is that its carrying amount is
reduced to zero. If you recall from earlier years of study, when disposing of an asset, you:
- transfer the carrying amount of the asset to the disposal account (debit the disposal account);
- record the proceeds on sale, if any (credit the disposal account); and then
- transfer the net amount in the disposal account to either profit on disposal (if the proceeds
exceed the carrying amount) or loss on disposal (if the carrying amount exceeds the proceeds).
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Calculations:
Tax deduction:
x Each year (20X1 – 20X5): 100 000 x 20% = 20 000
Depreciation:
x 20X1: (100 000 - 0) / 4 yr = 25 000
x 20X2: (60 000 - 0) / 3 yr = 20 000
x 20X3: (45 000 - 0) / 2 yr = 22 500
x 20X4: (25 000 - 0) / 1 yr = 25 000
x 20X5: nil (fully depreciated)
Impairment loss:
x 20X1: CA: 75 000 – RA: 60 000 = 15 000 impairment loss
x 20X2: CA: 40 000 – Lower of RA & HCA: 45 000 = 5 000 impairment loss reversed
P.S. RA was not limited since HCA = 50 000; (Cost 100 000 – Acc. depreciation (100 000 – 0) / 4 x 2)
x 20X3: CA: 22 500 – Lower of RA & HCA: 25 000 = 2 500 impairment loss reversed
P.S. RA of 30 000 was limited to HCA of 25 000 (Cost 100 000 – Acc. depreciation (100 000 – 0) / 4 x 3)
This is because, under the cost model, the asset’s CA must not exceed its HCA.
If the tax authorities do not allow the deduction of the cost of the asset (i.e. do not allow a wear
and tear or similar tax deduction), the tax base is zero on purchase date because the future tax
deductions are nil. However, the carrying amount on purchase date will be the asset’s cost. Thus,
the purchase of this asset will cause a taxable temporary difference immediately on acquisition (this
will gradually decrease to zero as the asset is depreciated to zero).
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However, if we recognise the deferred tax liability on this temporary difference, where would we
process the debit side of the entry (i.e. credit deferred tax liability and debit what?):
x It can’t be debited to tax expense (which is what we normally do when recognising a deferred
tax liability), because this deferred tax was caused by the purchase journal, which does not
involve income or expenses and thus does not affect accounting profit (debit asset and credit
bank/payable) and does not affect taxable profit (because it is not allowed as a tax deduction);
x We could try to argue that, since it cannot be debited to tax expense it should be debited to the
account that caused the temporary difference (i.e. the item of property, plant and equipment),
but this can’t be done either since this would increase the value of this asset simply because of
a deferred tax liability (this does not make sense because this does not represent a cost).
Since this question couldn’t be solved, IAS 12 states that the deferred tax liability should not be
recognised if the taxable temporary difference arises due to:
x goodwill; or
x the initial recognition of an asset or liability which
- is not a business combination, and
- at the time of the transaction, affects neither accounting profit nor taxable profit. See IAS 12.15
In other words, this initial taxable temporary difference is exempt from deferred tax. However, all
subsequent expenses relating to the initial cost (e.g. depreciation) are also exempt. See IAS 12.22
7.1 Overview
Presenting and disclosing property, plant and equipment involves all financial statements:
x The total closing balance is presented as a single line-item on the face of the statement of financial position.
x Income and expenses emanating from property, plant and equipment (e.g. depreciation) are
included in the statement of comprehensive income but are generally not presented on its face.
x The opening and closing balances by class of asset, together with the related movements, are
disclosed in the supporting notes together with details relating to the accounting policies.
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x The statement of changes in equity is affected if we use the revaluation model (see chapter 7).
x Property, plant and equipment also affects the presentation and disclosure of the statement of
cash flows (e.g. acquisitions and sales), but this is covered in another chapter (see chapter 27).
Since property, plant and equipment is explained over two chapters, only the core disclosures are
explained here. The complete disclosure requirements are provided in the next chapter.
If there was a change in estimate (e.g. change in estimated useful life), the nature and effect
thereof must be disclosed in terms of IAS 8, the standard governing ‘accounting policies, changes in
accounting estimates and errors’ (see chapter 26).
x Increasing profit: reversals of depreciation (changes in estimate), x Profit before tax note:
reversals of impairments and profits on disposal. - depreciation,
- impairment loss/reversal
If we use the function method, then, instead of presenting the nature - profit or loss on disposal
and amount of the related income and expenses on the face of the statement of comprehensive income
(i.e. as we do if using the nature method), these income and expenses would be included in one of the
line-items classified by function. For example:
x depreciation on a plant used to manufacture inventories would be capitalised to the inventory
assets, and this would then be included in the ‘cost of sales’ line-item when the inventory was sold;
x depreciation on office desks would be included directly in the ‘cost of administration’ line-item.
x a profit on disposal could be included in the ‘other income’ line-item.
In other words, when using the function method, the ‘separately’ disclosable income and expenses
relating to property, plant and equipment are not presented as separate line items in the statement
of comprehensive income. Instead, they are included within the line-items based on function (e.g.
cost of sales) and thus the nature and amount of these items must then be disclosed in the notes.
The related income and expenses that are separately disclosable include:
x depreciation expense See IAS 1.102 & 104
x impairment losses; See IAS 1.98 (a) and IAS 36.126 (a) – also see note 1
x impairment losses reversed; See IAS 1.98 (a) and IAS 36.126 (b) – also see note 1
x profits or losses on the disposal of items of property, plant and equipment. See IAS 1.98 (c)
Note 1. If the function method has been used, then we would also need to indicate the line-item of the
statement of comprehensive income in which the income or expense has been included. See IAS 36.126
Interestingly, we also disclose ‘depreciation, whether recognised in profit or loss or as a part of the cost of
other assets’ (see section 7.4). This depreciation is presented in the reconciliations per class of asset,
which are given within the ‘property, plant and equipment note’. However, this depreciation will not equal
the ‘depreciation expense’ if part of our depreciation is capitalised to another asset (i.e. the depreciation
expense will be smaller than the amount disclosed as the total depreciation in the asset note). Therefore, it
is suggested that we provide a reconciliation between total depreciation and the depreciation expensed to
help our users understand (see the suggested ‘profit before tax note’ in section 7.7). See IAS 16.74
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For each class of property, plant and equipment (e.g. - gross carrying amount and
land, buildings, plant etc.) we disclose: - accumulated depreciation
x ‘gross carrying amount’ and ‘accumulated depreciation and impairment losses’ at the beginning
and end of each period (the net of these two amounts is the ‘net carrying amount’);
x a reconciliation between the ‘net carrying amount’ at the beginning and end of the period
separately disclosing each of the following where applicable (this reconciliation effectively
shows the users the movements that occurred during the period within the cost, accumulated
depreciation and accumulated impairment loss accounts):
additions;
disposals;
depreciation;
impairment losses/ impairment losses reversed;
acquisitions through business combinations;
assets transferred to ‘non-current assets held for sale’ in accordance with IFRS 5;
other movements (e.g. currency translation differences);
x the existence and amounts of restrictions on title;
x the existence and amounts of property, plant and equipment pledged as security for a liability;
x the costs capitalised in respect of property, plant and equipment being constructed;
x the amount of any contractual commitments relating to future acquisitions of PPE.. See IAS 16.73 - 74
ABC Limited
Statement of financial position (extracts) 20X2 20X1
As at 31 December 20X2 C C
ASSETS Note
Non-current assets
Property, plant and equipment 3 1 070 000 785 000
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ABC Limited
Notes to the financial statements (extracts)
For the year ended 31 December 20X2
2. Accounting policies
Add additions 200 000 260 000 250 000 450 000
Less disposals See comment below (0) (30 000) (0) (45 000)
Less depreciation (0) (0) (150 000) (75 000)
Less impairment losses (0) (20 000) (40 000) (15 000)
Add impairment losses reversed 5 000 0 0 30 000
Net carrying amount: 31 December 515 000 310 000 555 000 495 000
Gross carrying amount 530 000 330 000 1 225 000 975 000
Accumulated depreciation and impairment losses (15 000) (20 000) (670 000) (480 000)
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The only movements in property, plant and equipment during 20X0 was depreciation.
The only movements in property, plant and equipment during 20X1 included:
x The purchase of a second plant on 1 June 20X1 for C100 000
x Machine sold on 30 June 20X1 for C70 000 on which date the following was relevant:
cost: C100 000,
accumulated depreciation: C35 000
Depreciation is provided as follows:
x Land is not depreciated.
x Plant is depreciated at 20% per annum to a nil residual value.
x Machines are depreciated at 10% per annum to a nil residual value.
The entity pledged both plants as security for a loan. Details of the loan will be given in note 16.
The entity used one of its machines on the installation of the new plant.
x This machine was used for one month (June 20X1) in this process.
x The plant was installed and ready to use from 1 July 20X1.
x Depreciation on machines is usually classified as ‘other costs’ in the statement of
comprehensive income.
x Plant is used to manufacture inventories.
Required:
Disclose the above in the financial statements for the year ended 31 December 20X1 in accordance
with International Financial Reporting Standards. Ignore deferred tax
Flowers Limited
Statement of financial position (extracts) 20X1 20X0
As at 31 December 20X1 C C
ASSETS Note
Non-current assets
Property, plant and equipment 15 980 750 1 600 000
Flowers Limited
Notes to the financial statements (extracts)
For the year ended 31 December 20X1
2. Accounting policies
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Flowers Limited
Notes to the financial statements (extracts) continued.... 20X1 20X0
For the year ended 31 December 20X1 C C
15.2 Machine
15.3 Plant
Chapter 7 409
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Entity name
Statement of financial position 20X4 20X3 20X2 20X1
As at 31 December 20X4 (extracts) C C C C
ASSETS Note
Non-current Assets
Property, plant and equipment 4 0 25 000 50 000 60 000
Entity name
Notes to the financial statements
For the year ended 31 December 20X4
2. Accounting policies
2.5 Property, plant and equipment
x Plant is measured using the cost model: cost less accumulated depreciation & impairment losses.
x Depreciation is provided on all property, plant and equipment over the expected economic useful life
to expected residual values using the following rates and methods:
Plant: 25% per annum, straight-line method.
4. Property, plant and equipment 20X4 20X3 20X2 20X1
C C C C
Plant
Net carrying amount: 1 January 25 000 50 000 60 000 0
Gross carrying amount: 100 000 100 000 100 000 0
Accumulated depreciation and impairment losses: (75 000) (50 000) (40 000) 0
x Additions 0 0 0 100 000
x Depreciation (25 000) (25 000) (20 000) (25 000)
x Impairment loss 0 0 0 (15 000)
x Impairment loss reversed 0 0 10 000 0
Net carrying amount: 31 December 0 25 000 50 000 60 000
Gross carrying amount: 100 000 100 000 100 000 100 000
Accumulated depreciation and impairment losses: (100 000) (75 000) (50 000) (40 000)
25. Profit before tax 20X4 20X3 20X2 20X1
C C C C
Profit before tax is stated after taking the following disclosable (income)/ expenses into account:
x Depreciation on plant 25 000 25 000 20 000 25 000
x Impairment loss 0 0 0 15 000
x Impairment loss reversed 0 0 (10 000) 0
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Disclosure:
ABC Limited
Statement of financial position 20X4 20X3 20X2 20X1
As at 31 December 20X4 (extracts) C C C C
ASSETS Note
Non-current assets
Property, plant and equipment 4 0 25 000 50 000 60 000
Deferred taxation 5 0 0 0 4 500
ABC Limited
Notes to the financial statements 20X4 20X3 20X2 20X1
For the year ended 31 December 20X4 (extracts) C C C C
5. Deferred taxation asset/ (liability) 0 0 0 4 500
The deferred taxation balance comprises:
- Capital allowances See the balances in W1 0 0 0 4 500
Workings:
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8. Summary
RECOGNITION
MEASUREMENT: PPE
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Temporary difference
Carrying amount versus Tax base
DISCLOSURE: PPE
(main points only)
Accounting policies note: Profit before tax note: Property, plant and equipment note:
x depreciation methods x depreciation x Reconciliation between opening
x rates (or useful lives) x impairment losses/ reversals and closing balances
x profit or loss on disposal x Break-down of these balances
into
- gross carrying amount, &
- accumulated depreciation &
impairment losses
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Chapter 8
Property, Plant and Equipment: The Revaluation Model
Reference: IAS 16, IAS 12, IFRS 16, IAS 40 and IFRS 13
(incl. any amendments to 1 December 2019)
Contents: Page
1. Introduction 416
1.1 Overview of the two models 416
1.2 Choosing between the two models 416
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5. Disclosure 456
5.1 Overview 456
5.2 Accounting policies and estimates 456
5.3 Statement of comprehensive income and related note disclosure 457
5.4 Statement of financial position and related note disclosure 457
5.5 Statement of changes in equity disclosure 458
5.6 Further encouraged disclosure 458
5.7 Sample disclosure involving property, plant and equipment 459
Example 23: Revaluation model disclosure 460
6. Summary 467
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1. Introduction
The revaluation model refers to the measurement of an asset’s carrying amount at:
x fair value;
x less subsequent accumulated depreciation;
x less subsequent accumulated impairment losses. See IAS 16.31
The carrying amount under the cost model is often called ‘depreciated cost’ and the carrying
amount under the revaluation model is often called ‘depreciated fair value’.
You can choose either model (cost or revaluation model) but must then apply that model to an entire
class of assets. This means, for example, that an entity may not use the cost model for a machine
that makes bread and the revaluation model for a machine that slices bread. All types of machines
are considered to be a single class of property, plant and equipment and thus machines will have to
be measured using the same model, for example, the cost model. Using the cost model for
machines would not, however, prevent the entity from measuring its vehicles using the revaluation
model. This is because vehicles are a different class of asset to machines. See IAS 16.29 & .37
The cost model is based on the asset’s original cost. The revaluation model requires
revaluation of the asset to its fair value. Both models still involve the principles of depreciation
and impairment testing.
The choice of the model affects only one aspect of subsequent measurement. The principles
that apply to recognition, initial measurement and other aspects of subsequent measurement
(such as depreciation and impairment testing) are identical whether you are applying the cost
model or revaluation model. These principles are revised in the next section, section 2.
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2.1 Overview
The recognition and initial measurement principles that apply when using the cost model (explained
in the previous chapter) are exactly the same as those that apply when using the revaluation
model. The use of the revaluation model is a choice that may be applied in the subsequent
measurement of the asset. The following is a very brief overview of the recognition and
measurement principles applicable to property, plant and equipment.
2.3 Initial measurement (IAS 16.15 - 22 and IAS 23.2 and .4)
Items of property, plant and equipment are always initially The principles of the
measured at cost. If the asset is acquired via an asset revaluation model and the
cost model are the same in
exchange or by way of a government grant, the cost is terms of:
generally its fair value. In all other cases, cost would include x Recognition criteria
the purchase price, directly attributable costs and the initial x Initial measurement
estimate of certain future costs. x Subsequent measurement:
- Depreciation
Examples of directly attributable costs are given in chapter 7.
- Impairments
One of these examples is borrowing costs. If we incur
‘borrowing costs that are directly attributable to the acquisition, construction or production’ of our
asset, and assuming it is a ‘qualifying asset’ (defined as ‘an asset that necessarily takes a
substantial period of time to get ready for its intended use or sale’), we are normally required to
capitalise these costs. However, if the asset is measured under the revaluation model, then
capitalisation of these borrowing costs is not a requirement but a choice (see chapter 14 and
IAS 23 Borrowing costs). Calculating the amount of borrowing costs to capitalise can become fairly
complex and thus one may be forgiven for thinking that this advantage to the revaluation model
may be a good enough reason to choose to use the revaluation model (so that we do not have to
capitalise the borrowing costs). However, we cannot avoid the complexity of calculating the amount
of borrowing costs to capitalise. This is because, if we choose to use the revaluation model, we
have to disclose the carrying amount of the asset had it been measured under the cost model.
See IAS 23.4 and 8
If the purchase price is paid within normal credit terms, the price paid is called a ‘cash price
equivalent’ and used as the measurement of cost. However, if the payment is beyond normal credit
terms, we must determine this ‘cash price equivalent’. If this cash price is not available, then we will
need to estimate it based on the present value of the future payment/s. The difference between this
‘cash price equivalent’ (present value of the future payments) and the future payments is recognised
as an interest expense, unless it is capitalised in accordance with IAS 23 Borrowing costs.
Items of property, plant and equipment must be depreciated to their residual values on a
systematic basis over their estimated useful lives. The only exception is land, which generally has
an unlimited useful life.
Each significant part of an item (i.e. where the cost of the part is significant in relation to the total
cost of that item) must be depreciated separately.
Depreciation begins when the asset is first available for use and ends when the asset is
derecognised or is classified as held for sale (in terms of IFRS 5), whichever date comes first.
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At the end of every reporting period, assets must be assessed for possible impairments. If there is
an indication that an asset may be impaired, the asset’s recoverable amount must be calculated. If
the carrying amount exceeds the recoverable amount, the carrying amount must be reduced. The
reduction in the carrying amount is generally expensed and called an impairment loss expense.
However, if the revaluation model is used, part of the reduction may need to be debited to the
revaluation surplus instead (see section 3).
If compensation was received as a result of this impairment (e.g. insurance proceeds), this
compensation is considered to be a separate economic event and must be recognised as income
in profit or loss (it must not be set-off against the impairment loss expense).
The entity may choose to measure its assets using either the cost model or the revaluation model.
However, the revaluation model may only be used if the fair value of an asset is reliably
measurable. The cost model was explained in the previous chapter. The rest of this chapter is
dedicated to explaining the revaluation model.
The revaluation model may only be used if the fair value can be measured reliably. Revaluations to
fair value do not have to occur every year and may be done periodically. However, they must be
performed regularly enough so that the carrying amount of the asset at year-end does not differ
materially from its fair value at that date. See IAS 16.31
If an entity wishes to use the revaluation model for a particular asset, it will have to apply this model to all
items within that class of assets – and all assets within that class will need to be revalued simultaneously.
For example, all land could be measured under the revaluation model and all equipment could be
measured under the cost model. See IAS 16.36 & .38
When using the revaluation model, the asset’s carrying amount is adjusted to whatever its fair value is,
whether this means the carrying amount needs to be decreased or increased. Please note that, if using
the revaluation model, the carrying amount can be increased above depreciated cost whereas, if using the
cost model, the carrying amount may never be increased above depreciated cost.
If we increase the asset’s carrying amount to a fair value that is in excess of its depreciated cost, this
excess will be recognised in revaluation surplus account and shown as an adjustment in other
comprehensive income (not in profit or loss). Thus, the revaluation surplus adjustment will appear in the
other comprehensive income section of the statement of comprehensive income. The revaluation surplus
account is an equity account and will thus also appear in the statement of changes in equity.
If we revalue our asset above depreciated cost, it means an amount greater than cost will eventually be
expensed through profit or loss (e.g. if the asset is depreciable, then the depreciation charge will be higher
than it would otherwise have been; if the asset is non-depreciable, then the carrying amount that is
expensed on derecognition will be higher than it would otherwise have been). Thus, if we revalue an asset
above depreciated cost (thus creating a revaluation surplus), it will cause an ‘artificial’ decrease in our profit
over time (or an increase in a loss). Profit or loss is accumulated in retained earnings and thus, to offset the
‘artificial decrease’ in our retained earnings, we transfer our revaluation surplus balance (equity account) to
our retained earnings account (another equity account). This transfer can be done gradually over the
asset’s life, or as one single adjustment when the asset is derecognised (when it is disposed of or retired).
See IAS 16.41
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In other words, if the asset’s carrying amount increases, the increase would first be recognised in
profit or loss (as a credit to revaluation income) to the extent that it reverses a previous decrease that
was recognised in profit or loss. Any increase that does not reverse a previous decrease recognised
in profit or loss is recognised in other comprehensive income (as a credit to revaluation surplus).
If the asset’s carrying amount decreases as a result of a If FV < CA See IAS 16.40
x after any revaluation surplus balance that may have existed is reduced to nil, any further
decrease is recognised in profit or loss as a revaluation expense:
credit carrying amount, and
debit revaluation expense. IAS 16.40
In other words, if the asset’s carrying amount is decreased, this decrease must first be debited
to the revaluation surplus account (if any) before being expensed as a revaluation expense.
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A revaluation that decreases the carrying amount of an asset does not necessarily mean it is impaired:
x This is because when revaluing, we are restating the carrying amount to a fair value
whereas when an asset is impaired, we are restating it to a recoverable amount.
x It is possible for the recoverable amount (higher of fair value less costs of disposal and
value in use) to be greater than the fair value and thus for the asset to be restated
downwards to a lower fair value but yet not be impaired.
x Thus, we will use the term ‘revaluation expense’ for decreases in the carrying amount to
fair value that are expensed in profit or loss (as opposed to the term ‘impairment loss’ when
decreasing the carrying amount down to the recoverable amount).
The revaluation surplus is removed by transferring it to retained earnings. The transfer is made
directly to the retained earnings account (i.e. from one equity account to another equity account,
without being recognised in profit or loss):
Debit Credit
Revaluation surplus (OCI) xxx
Retained earnings (Eq) xxx
Transfer of the revaluation surplus to retained earnings
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This transfer makes sense if you consider the effect of the revaluation on profits. We will first
consider a non-depreciable asset (e.g. land) and then a depreciable asset (e.g. plant).
If a non-depreciable asset is revalued upwards, thus creating a revaluation surplus, it will mean that,
when that asset is finally derecognised (through retirement or disposal), an amount larger than its
original cost will get expensed. This means the profit on disposal will be lower (or loss on disposal
higher) than it would have been had it not been revalued. This effect on profit or loss then impacts
retained earnings, when the profit or loss is closed off to retained earnings. Thus, to negate the artificial
decrease in retained earnings, we transfer the ‘revaluation surplus’ balance to ‘retained earnings.
Worked example 1: Revaluation surplus and a sale of a revalued non-depreciable asset (land)
Land with a cost of C100 000 is revalued to its fair value C150 000:
Debit Credit
Land: cost (A) 50 000
Revaluation surplus (OCI) 50 000
Revaluation of land
A few years later, this land is then subsequently sold for C220 000:
x the land’s carrying amount, at FV of C150 000, will be expensed;
x we recognise the proceeds on sale, of C220 000;
x we thus recognise a profit on sale of C70 000.
Debit Credit
Asset disposal (Temporary account) 150 000
Land: cost (A) 150 000
Bank 220 000
Asset disposal (Temporary account) 220 000
Asset disposal (Temporary account) 70 000
Profit on sale of land (I) 70 000
Sale of land
However, we know that the ‘real’ profit was actually C120 000 (Proceeds: 220 000 – Cost: 100 000). This
means our retained earnings balance at the end of the year will be understated by C50 000. Thus, to
counter this, we transfer the revaluation surplus balance to the retained earnings account:
Debit Credit
Revaluation surplus (OCI: Equity) 50 000
Retained earnings (Equity) 50 000
Transfer of revaluation surplus to retained earnings on sale of land
The retained earnings balance will now include the ‘real’ profit of C120 000 (profit on sale: 70 000 +
transfer from revaluation surplus: 50 000).
There are three methods of transferring the revaluation surplus to retained earnings:
x Transfer it as the asset is used (i.e. transfer it gradually over the useful life of the asset,
often referred to as an ‘annual transfer to retained earnings’); or
x Transfer it when the asset is retired (i.e. transfer it as one lump sum); or
x Transfer it when the asset is disposed of (i.e. transfer it as one lump sum). See IAS 16.41
If the asset is non-depreciable (e.g. land), it means the asset does not get used up (i.e. it does
not have a useful life) and thus we will only able to reverse the revaluation surplus balance
when the asset is derecognised: when it is retired or disposed of.
If the entity chooses to transfer the revaluation surplus to retained earnings over the life of a
depreciable asset (i.e. gradually), the revaluation surplus will decrease at the same rate as the
asset’s carrying amount.
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This means that, if the asset’s fair value subsequently decreases (i.e. if the asset is devalued) and
this fair value is below its historical carrying amount (cost or depreciated cost, depending on whether
the asset is depreciable or not), the decrease in the asset’s carrying amount:
x Down to the historical carrying amount, will be debited against the revaluation surplus:
Credit Asset and Debit Revaluation surplus (OCI)
x Below the historical carrying amount, will be debited If we transfer the RS to RE
as a revaluation expense in profit or loss: over the asset’s useful life,
the amount transferred each
Credit Asset and Debit Revaluation expense (P/L).
year will be the difference
between the:
However, please note that, if the revaluation surplus is
x depreciation based on fair value; and
only transferred to retained earnings when the asset is
x depreciation based on historic cost.
retired or disposed of, then the revaluation surplus
balance will still reflect the full original amount of the revaluation surplus on the date of the
previous upward-revaluation. This means that, in the case of a depreciable asset, the portion of
the revaluation decrease below historical carrying amount (which, in this case would be
depreciated cost) would not all be debited to profit or loss – some of this would first need to be
debited to the revaluation surplus, to be sure that the revaluation surplus is first reduced to zero.
For the purposes of this text, we will assume that the revaluation surplus is transferred to retained
earnings over the life of the underlying asset unless otherwise indicated. However, the following
example shows you how to transfer the revaluation surplus using each of the above three methods.
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3.5 Presentation of the revaluation surplus (IAS 16.39 & 41, IAS 1.82A & 106)
A revaluation surplus is a component of ‘other comprehensive income’ and is ‘accumulated in
equity’. This means that:
x because a revaluation surplus is ‘other Reclassification adjustments
comprehensive income’, an increase or decrease in are defined as:
the revaluation surplus would be presented in the x amounts reclassified to P/L in the
‘other comprehensive income’ section of the current period
statement of comprehensive income; and x that were recognised in OCI in the
current or previous periods. IAS 1.71
x because other comprehensive income is accumulated
in ‘equity’, the revaluation surplus balance is also presented in the statement of changes in equity.
These diagrams and graphs assume that the entity has chosen to transfer the revaluation surplus
to retained earnings over the life of the asset, in which case the revaluation surplus would reduce
at the same rate as the asset’s carrying amount.
Recognised in P/L
FV less than HCA
HCA: historical carrying amount OCI: Other comprehensive income P/L: profit or loss
Please remember: This diagram assumes that the entity has chosen to transfer the revaluation surplus to retained
earnings over the life of the asset.
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FV ACA
Revaluation Revaluation surplus
surplus (OCI) (OCI)
(created/ (reversed/
HCA/ increased) decreased)
HCA HCA
ACA
Reval expense Reval income
(P/L) (P/L) Reval expense (P/L)
FV ACA FV
HCA: historical carrying amount (depreciated cost, or cost if non-depreciable) OCI: other comprehensive income
ACA: actual carrying amount (which may differ from the HCA) P/L: profit or loss
FV: fair value
Remember: This diagram assumes the revaluation surplus is transferred to retained earnings over the asset’s useful life.
Scenario 1: the FV is less than the ACA (which was still the same as the HCA)
Scenario 2: the FV is greater than the ACA (but ACA was less than the HCA due to a prior decrease in value)
Scenario 3: the FV is less than the ACA and also less than the HCA (the ACA was greater than the HCA due to a
prior increase in value)
You may find it easier to draw a graph of the situation, plotting the depreciated cost line (HCA):
0 Useful Life
Notice how the line is a diagonal line reflecting the gradual reduction in the historical carrying amount (depreciated cost) as the
asset is depreciated over its useful life (this would be a horizontal line if the asset is non-depreciable).
Note: This diagram assumes the revaluation surplus is transferred to retained earnings over the asset’s useful life.
For a revaluation to fair value, you would then plot your asset’s actual carrying amount (ACA) and fair value (FV) onto
this graph. Then look at your graph carefully:
x If you are increasing the asset’s actual carrying amount to its fair value, the increase will be accounted for as follows:
- Any increase up to HCA: the previous revaluation expense that was recognised in profit or loss, is now
reversed by recognising this adjustment in profit or loss as a revaluation income; after which
- Any increase above HCA: is recognised in other comprehensive income as a revaluation surplus.
x If you are decreasing the asset’s actual carrying amount to its fair value, the decrease in value would be accounted
for as follows:
- any decrease down to HCA: the previous increase that was recognised in other comprehensive income as a
credit to revaluation surplus is now reversed (or perhaps only partially reversed), where this reversal is also
recognised in other comprehensive income but as a debit to the revaluation surplus; after which
- any decrease below HCA: is recognised in profit or loss as a revaluation expense (in other words: any balance
in the revaluation surplus account (from a previous increase in value) is first reduced to zero, after which any
further decrease is then recognised as an expense in profit or loss).
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The prior examples, graphs and diagrams show how to account for a revaluation by simply
debiting or crediting the asset’s carrying amount. However, we need to know exactly how much
to debit and credit to the separate accounts that make up this carrying amount (i.e. the cost and
accumulated depreciation accounts). This is best explained by first doing examples involving
non-depreciable assets and then doing examples involving depreciable assets.
To start with, we will look at an example that involves land, since land is an asset that is
generally not depreciated. This will allow us to see the essence of the revaluation model. From
there we will progress to an example that involves a depreciable asset.
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Entity name
Statement of financial position 20X5 20X4 20X3 20X2 20X1
As at 31 December (extracts) C C C C C
Non-current assets
Land 110 000 70 000 90 000 120 000 100 000
Equity
Revaluation surplus 10 000 0 0 20 000 0
W1. PPE carrying amount and adjustments Jnl 20X2 20X3 20X4 20X5
No. Dr/ (Cr) Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
O/ balance Purchase in 20X1 1 100 000 120 000 90 000 70 000
Depreciation Land not depreciated (0) (0) (0) (0)
Fair value adjustments:
Above HCA Cr: revaluation surplus 2; 7 20 000 10 000
Down to HCA Dr: revaluation surplus 3 (20 000)
Below HCA Dr: revaluation expense 4; 5 (10 000) (20 000)
Up to HCA Cr: revaluation income 6 30 000
Closing balance fair value 120 000 90 000 70 000 110 000
Historical carrying amount: (cost) 100 000 100 000 100 000 100 000
Notice:
x The decrease in CA in 20X3 is accounted for by first debiting RS to the extent that there was a
balance in RS (C20 000) and any further decrease was then debited to the expense (C10 000).
x The increase in CA in 20X5 is accounted for by first crediting the revaluation income to the extent
that it reversed a previous revaluation expense (C30 000), thus first bringing the CA up to HCA of
C100 000. Thereafter, the further increase in CA is then credited to RS (C10 000).
Now let us do an example that involves a depreciable asset. To keep things simple, we will
start by combining the cost and accumulated depreciation accounts into one account that
reflects carrying amount. It is not difficult to separate the entries between these two accounts,
but is important to see the big picture before getting bogged down with that detail.
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Entity name
Statement of financial position 20X5 20X4 20X3 20X2
As at 31 December (extracts) C C C C
Non-current assets
Machine C/ balance per ledger 100 000 66 000 52 500 160 000
Equity
Revaluation surplus C/ balance per ledger 50 000 6 000 0 80 000
W1: PPE carrying amount and adjustments Jnl 20X2 20X3 20X4 20X5
No. Dr/ (Cr) Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
Opening balance 20X2: 100 000 / 10 x 9 yr 90 000 160 000 52 500 66 000
Adjustment:
Above HCA Cr: revaluation surplus 1;7; 9 90 000 7 000 54 000
Down to HCA Dr: revaluation surplus 3 (80 000)
Below HCA Dr: revaluation expense 4 (20 000)
Up to HCA Cr: revaluation income 6 17 500
Fair value 180 000 60 000 77 000 120 000
Depreciation: See calculations below 2;5;8;10 (20 000) (7 500) (11 000) (20 000)
Closing balance 160 000 52 500 66 000 100 000
This previous example showed how to account for a revaluation but did not specify the adjustments
that would need to be made to the cost account and accumulated depreciation account. Instead,
these examples made use of a ‘carrying amount’ account. The adjustments that would be made to
the cost and accumulated depreciation accounts depend on which of the following two methods are
used (explained in section 3.9):
x the gross replacement value method (or proportional restatement method); or
x the net replacement value method (or net method).
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3.9.1 Overview
As mentioned in the cost model chapter, whether the cost model or the revaluation model is used,
the asset’s carrying amount is represented by the following accounts:
x cost account (disclosed as gross carrying amount: GCA); and
x accumulated depreciation and impairment loss account.
Under the cost model, adjustments to the carrying amount only occur in the accumulated
depreciation and impairment loss accounts. In other words, under the cost model, the cost
account continues to reflect the asset’s cost.
Under the revaluation model, however, adjustments to the carrying amount could be made to the
cost account and/or to the accumulated depreciation and impairment loss accounts. Since
adjustments are sometimes made to the cost account, the cost account would no longer reflect its
cost. (Incidentally, this so-called ‘cost account’ is presented in the financial statements, within the
property, plant and equipment note, as a line-item called ‘gross carrying amount’).
Irrespective of the model used (gross or net method), the carrying amount of the asset would be
the same after processing the revaluation: immediately after the revaluation, the carrying amount
will reflect its fair value (which is equivalent to what we call the ‘net replacement value’).
However, the balances in the separate accounts that constitute carrying amount (cost,
accumulated depreciation and impairment loss accounts) will differ depending on whether the
gross or net method was used. Since the balances on these separate accounts need to be
separately disclosed in the notes, we must know how to process the journals using each method.
3.9.2 Proportionate restatement method (gross replacement value method) (IAS 16.35(a))
The proportionate restatement method is often called the gross replacement value method (or
simply, the gross method). When using this method, we must:
x proportionately restate the cost account, and
x proportionately restate the accumulated depreciation and impairment loss account.
Proportionately restating the cost account means adjusting the balance in the cost account to
reflect the gross replacement value. The gross replacement value is the re-estimated original
economic benefits embodied in the asset on date of purchase. In other words, it is an estimation of
the fair value on date of purchase (as opposed to the fair value today) (or, simply, the amount that
the valuer thinks we should have paid for the asset on date of purchase).
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Thus, when using the proportionate restatement method (i.e. the gross method), the carrying
amount immediately after the revaluation will reflect the fair value on the date of revaluation (often
called the net replacement value), but the cost account will reflect the fair value on date of original
purchase (often called the gross replacement value).
Comment:
Since, by definition, an asset represents potential economic benefits, the asset’s carrying amount should
reflect the future economic benefits that we expect from the asset over its remaining useful life.
x This means that a fair value that is estimated as at, for example, 1 January 20X3, is an estimation of
the future economic benefits that are still remaining in this asset, calculated on this date.
x The fair value of C90 000 was measured on 1 January 20X3, (2 years after it was first available for
use), when it had a remaining life of 3 years. This means that the valuer is expecting future benefits of
C90 000 to be earned over the remaining useful life of 3 years, or C30 000 per year (90 000 / 3 years).
Assuming estimated benefits of C30 000 per year, the total future benefits on the date the asset was
purchased (i.e. fair value on 1 January 20X1) is estimated to be C150 000 (30 000 pa x 5 total years).
x The valuer is effectively saying the asset was actually worth C150 000 on 1 January 20X1 (i.e. not the
C100 000 that we actually paid) and the accumulated depreciation on 1 January 20X3 should thus
have been C60 000 [(150 000 – 0)/ 5yrs x 2 yrs = 60 000].
x The following working is not necessary in answering the question, but may help you understand it better:
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3.9.3 Elimination restatement method (net replacement value method) (IAS 16.35(b))
The elimination restatement method is often called the net replacement value method (or just the
net method).
This method involves processing a journal immediately before re-measuring the asset’s carrying
amount to its fair value. This journal removes the balance that was in the accumulated depreciation
account and sets it off against the cost account (debit accumulated depreciation and credit cost). In
other words, the net method means that before we revalue the asset, we must first eliminate the
balance in the accumulated depreciation account, with the result that the cost account then reflects
the carrying amount of the asset immediately before the revaluation.
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W1: Plant accounts at 1/1/X3 Using cost: Using FV: Revaluation surplus
Cost 100 000 5 years in total 90 000 Given
Acc deprec (100K-0) / 5 x 2 (40 000) 2 years used (0)
Carrying amount: 1/1/X3 60 000 3 years remaining 90 000 Given 30 000
Notice: Compare the previous example (example 7) and this example (example 8). Notice that all accounts
are the same as at 31 December 20X3 except for the cost and accumulated depreciation accounts:
Comparison of account balances: GRVM (Ex 7) NRVM (Ex 8) Difference
Carrying amount at 31/12/X3 60 000 60 000 0
- Cost account 150 000 90 000 60 000
- Accumulated depreciation account (90 000) (30 000) (60 000)
Revaluation surplus at 31/12/X3 30 000 30 000 0
Depreciation in 20X3 30 000 30 000 0
The following examples continue to compare the gross and net method, but also show the
transfer of revaluation surplus to retained earnings. These ignore the effects of deferred tax
(the deferred tax effects of revaluations are not difficult but are covered later in the chapter).
Journals Ex 9A Ex 9B
NRVM GRVM
1/1/20X1 Dr/ (Cr) Dr/ (Cr)
Plant: cost (A) 100 000 100 000
Bank/ Liability (100 000) (100 000)
Purchase of asset: (1/1/20X1)
31/12/20X1
Depreciation: plant (E) (100 000 – 0) / 5 years remaining 20 000 20 000
Plant: accumulated depreciation (-A) (20 000) (20 000)
Depreciation of asset
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Journals continued … Ex 9A Ex 9B
NRVM GRVM
1/1/20X2: revaluation (increase) Dr/ (Cr) Dr/ (Cr)
Plant: accumulated depreciation (-A) 20 000 N/A
Plant: cost (A) (20 000) N/A
NRVM: set-off of acc. depreciation before revaluing asset
Plant: cost (A) W2 or 90 000 FV – 80 000 CA 10 000 N/A
Revaluation surplus (OCI) (10 000) N/A
NRVM: Revaluation journal – cost account now reflects fair value
Plant: cost (A) 112 500 (W3) - 100 000 N/A 12 500
Plant: accumulated depreciation (-A) 22 500 (W3) - 20 000 N/A (2 500)
Revaluation surplus (OCI) 90 000 - 80 000; or Balancing N/A (10 000)
GRVM: revaluation of asset: (1/1/20X2)
31/12/20X2: depreciation and transfer of revaluation surplus
Depreciation: plant (E) (90 000 – 0) / 4 years remaining 22 500 22 500
Plant: accumulated depreciation (-A) (22 500) (22 500)
Depreciation: new CA over remaining useful life
Revaluation surplus (OCI) 10 000 / 4 years remaining; Or 2 500 2 500
Retained earnings (Eq) Revalued depr: 22 500 – Historic (2 500) (2 500)
depr: 20 000
Transfer of revaluation surplus to retained earnings: over life of asset (the
extra depreciation for 20X2 due to the revaluation above HCA)
Gross replacement value (GRV): 1/1/20X1 90 000 / 4 years remaining x 5 total years 112 500
Accum. depreciation on GRV: 31/12/20X1 112 500 / 5 total years x 1 year to date (22 500)
Fair value: 1/1/20X2 Given 90 000
90 000 (FV)
10 000 (Credit revaluation surplus)
80 000 (HCA & ACA)
Cost
0 Useful Life
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Required:
Show the journals for the year ended 31 December 20X3 using the:
A net replacement value method (NRVM)
B gross replacement value method (GRVM)
W1: NRVM (A) & GRVM (B): Historical carrying amount at 1/1/20X3: C
Cost: 1/1/20X1 Given 100 000
Accumulated depreciation: 31/1/20X2 100 000 x 20% x 2 yr (40 000)
60 000
W2: NRVM (A) & GRVM (B): Actual carrying amount at 1/1/20X3:
Carrying amount at 1/1/20X2 after revaluation to FV 90 000
Depreciation in 20X2 (90 000 – 0)/ 4yrs; Or (112 500 – 0)/ 5 yrs (22 500)
67 500
W3: NRVM (A) & GRVM (B): Devaluation required at 1/1/20X3:
Fair value 54 000
Actual carrying amount (67 500)
(13 500)
- Reverse revaluation surplus Down to HCA: ACA 67 500 – HCA 60 000 7 500
- Revaluation expense Below HCA: HCA 60 000 – NRV 54 000 6 000
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67 500 (ACA)
7 500 (Debit revaluation surplus)
60 000 (HCA)
Cost
0 Useful Life
Notice:
x The difference between the journals using the NRVM and the GRVM is important because it affects the
disclosure of ‘gross carrying amount’ and ‘accumulated depreciation and impairment losses’ in the
property, plant and equipment note. However, irrespective of the method used, the effect of these
journals on ‘net carrying amount’ is the same and can be seen in the following simplified journal:
NRVM and GRVM
Debit Credit
Revaluation surplus 7 500
Revaluation expense 6 000
Plant at net carrying amount 13 500
Revaluation journal: decrease in CA: first debit the revaluation surplus
until it is nil and then debit any further reduction to revaluation expense
x The asset’s carrying amount (CA) is reduced to below historical carrying amount (depreciated cost).
Dropping the CA to historical carrying amount, means the revaluation surplus is reduced to zero. This
also means that there is no journal transferring revaluation surplus to retained earnings in 20X3.
Dropping the CA C6 000 below the historical carrying amount of C60 000, means C6 000 is expensed.
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Ex 11A Ex 11B
NRVM GRVM
31/12/20X4: Depreciation and transfer of RS to RE Dr/ (Cr) Dr/ (Cr)
Depreciation: plant (E) (FV 44 000 – 0) / 2 remaining yrs 22 000 22 000
Plant: accum deprec (-A) (22 000) (22 000)
Depreciation 20X4: new carrying amount over remaining useful life
Revaluation surplus (OCI) RS 4 000/ 2 remaining yrs; Or 2 000 2 000
Retained earnings (Eq) Revalued depr 22 000 – Historical depr 20 000 (2 000) (2 000)
Transfer of revaluation surplus to retained earnings: over life of asset (the
extra depreciation for 20X4 due to the revaluation above HCA)
44 000 (FV)
4 000 (Credit revaluation surplus)
40 000 (HCA)
Cost
0 Useful Life
3.10 The revaluation model and impairments (IAS 36 and IAS 16.63 - 66)
All property, plant and equipment must undergo an impairment indicator review at the end of
every financial year – even those measured under the revaluation model. The indicator review
involves looking for indicators that the asset may be impaired and is not the actual impairment
test. If, during the indicator review, we find anything that indicates the asset may be impaired,
we carry out an impairment test. This test involves calculating the recoverable amount and
comparing it to the carrying amount. If the recoverable amount is less than the carrying amount,
the asset is impaired and the carrying amount must be reduced to the recoverable amount.
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As you can see, the calculation of the recoverable amount involves choosing the higher of two
amounts (VIU and FV-CoD). However, if we measure an asset using the revaluation model (i.e. in
which case the carrying amount reflects FV) and where this asset's costs of disposal are
considered to be negligible, there is actually no need to calculate the VIU. This is because, in this
case, the FV-CoD (i.e. FV – an amount that is close to nil) would not be materially lower than the
asset's carrying amount (FV) and thus the asset will not be impaired, and the recoverable amount
need not be estimated. See IAS 36.5 See the worked example below (also chapter 11, example 10).
IAS 16 does not tell us what to name the income and expense accounts that arise when adjusting
an asset’s carrying amount. However, where an adjustment is to be recognised in profit or loss, we
should differentiate between adjustments to fair value (a revaluation expense/ income) and
adjustments to recoverable amount (an impairment expense/ impairment reversal income).
This differentiation is relevant because decreasing an asset’s carrying amount to reflect a lower fair
value does not necessarily mean the recoverable amount has also decreased. Instead, recoverable
amount might be represented by the value in use (because RA = higher of VIU and FV-CoD), in
which case, although we might have to reduce the carrying amount to a lower fair value (in terms of
a revaluation), the recoverable amount reflecting value in use could be higher than this carrying
amount (in terms of impairment testing). Thus, decreasing a carrying amount to fair value does not
mean that the asset is impaired. Consider the following example.
Example 12: A low fair value does not necessarily mean an impairment loss
Plant, bought for C100 000 cash on 1/1/20X1, is measured using the revaluation model. The
entity uses the net replacement value method to account for the revaluation adjustments.
The plant is depreciated on the straight-line method over its useful life of 5 years to a nil residual value.
The following values applied on 31 December 20X1:
Fair value C70 000
Value in use C110 000
Costs of disposal C10 000
Required: Provide the journal entries necessary in 20X1.
Solution 12: A low fair value does not necessarily mean an impairment loss
Comment:
x The asset is measured under the revaluation model. Thus, we first revalue it to fair value of C70 000. This
revaluation was a decrease in value, called a revaluation expense (or something similar – no guidance is
given in either of the standards: IAS 16 or IAS 36), but should not be called an impairment loss expense.
x IAS 36 Impairment of assets requires that, at year-end, items of property, plant and equipment be
checked for impairments unless the revaluation model is used, and the costs of disposal are negligible.
In terms of IAS 36.5(c), when the revaluation model is used and the costs of disposal are not negligible,
as was the case in this example, an impairment is possible.
However, in this example, although the fair value less costs of disposal of C60 000 (FV 70 000 – Costs
of disposal 10 000) is less than the carrying amount of C70 000 (fair value), the actual recoverable
amount of C110 000 (the higher of fair value less costs of disposal and value in use) exceeds the
carrying amount. Thus, there is no impairment loss.
x Notice how there was a revaluation expense, but the asset is not impaired.
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In summary then:
x If the carrying amount is decreased and part or all of the decrease is to be recognised as an
expense in profit or loss, this expense is referred to as:
- a revaluation expense if the CA is being decreased to a fair value; or
- an impairment loss expense if the CA is being decreased to a recoverable amount.
x If the carrying amount is increased and part or all of the increase is to be recognised as an
income in profit or loss, this income is referred to as:
- a revaluation income if the CA is being increased to a fair value; or
- an impairment loss reversal if the CA is being increased to a recoverable amount.
The above discussion refers only to income and expenses recognised in profit or loss (P/L).
However, when adjusting an asset measured under the revaluation model for impairments or
impairment reversals, the income or expense might also affect other comprehensive income (OCI).
x If the asset has previously been revalued and thus has a balance in a revaluation surplus
account (OCI), then any impairment loss must first be debited to the revaluation surplus
(OCI), and only once this balance is reduced to nil, would any further impairment loss be
recognised as an expense in profit or loss (P/L). (See chapter 11 example 9).
x Conversely, when using the revaluation model, an impairment loss reversal is allowed to
increase the carrying amount above historical carrying amount (HCA): depreciated cost if
the asset is depreciable, or cost if the asset is non-depreciable.
To the extent the impairment reversal increases the carrying amount:
up to HCA, the reversal is credited as income in profit or loss (P/L); and
above HCA, the reversal is credited as a revaluation surplus in other comprehensive income (OCI).
However, when reversing a prior impairment loss, we must not increase the asset’s carrying
amount above the carrying amount it would have had, had it never been impaired. This
means, if an asset is measured under the revaluation model, its carrying amount should
never be increased above the previous fair value less subsequent accumulated depreciation
(i.e. depreciated fair value). (See chapter 11 example 12).
Further discussion and examples of the impairment of an asset measured under the revaluation
model are included in the chapter on impairments (see chapter 11, section 4.3 and section 5.3)
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4.1 Overview
Deferred tax consequences arise if the tax base of an asset (measured in terms of IAS 12) does
not equal its carrying amount (measured in terms of IAS 16). Deferred tax should be recognised
on these temporary differences unless:
x the temporary difference is exempt from deferred tax (see chapter 6, section 4.3 and 5); or
x the temporary difference is a deductible temporary difference, thus causing a deferred tax asset
but where the inflow of future economic benefits is not probable (chapter 6, section 8).
As explained in chapter 7, which focussed on the cost model, temporary differences (and thus
deferred tax) can arise from basic transactions such as:
x buying the asset (if the asset is not tax-deductible);
x depreciating and impairing the asset;
x selling the asset.
However, when using the revaluation model, there is a further transaction that could lead to
temporary differences (and thus deferred tax): when we revalue an asset to fair value, its carrying
amount changes, but its tax base (which simply reflects ‘future tax deductions’) does not change.
When recognising the deferred tax on this temporary difference, we need to remember that a change
in an asset’s carrying amount that is recognised as a revaluation surplus (e.g. debit asset, credit
revaluation surplus), affects other comprehensive income and does not affect profit or loss. Thus, the
deferred tax effect of the revaluation surplus must also be recognised in other comprehensive income
(i.e. debit revaluation surplus, credit deferred tax liability).This is explained in section 4.2.
Another issue to watch out for is when revaluing an asset’s carrying amount to a fair value that
exceeds cost. If this happens, the measurement of the deferred tax balance may get a little
complicated. However, the trick here is to remember the golden rule that the deferred tax balance
must simply reflect the expected tax consequences from the expected manner of recovery of the
economic benefits inherent in the asset. This is explained in section 4.3.
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4.3 Deferred tax effects of the revaluation surplus and management intentions
When using the revaluation model, it is possible for an asset’s carrying amount to be increased to a fair
value that exceeds its historical carrying amount (depreciated cost if the asset is depreciable, or simply
cost if the asset is non-depreciable). Importantly, if the asset’s carrying amount is increased to a fair
value that exceeds cost, we must consider the possible impact of management intentions when
measuring the related deferred tax balance.
The measurement of the DT
on a RS is affected by
To understand this, we must remember the deferred tax whether mgmt intends to:
liability (or asset) balance related to an asset simply reflects
x Use the asset:
the future tax payable (or receivable) on the estimated future - measure DT normally
inflows of economic benefits expected from that asset. x Sell the asset:
If the CA ≤ Cost:
If management intends to recover the asset’s carrying - measure DT normally
amount (i.e. the estimated future inflow of economic benefits) If the CA > Cost,
through the sale thereof rather than through its use, and if its - measure DT in a way that takes
into account the fact that part
carrying amount reflects a fair value greater than cost, the of the potential profit on sale
measurement of the related deferred tax balance will be would be taxed as a capital gain.
affected if the tax authorities tax capital profits from the sale
of an asset differently to any other profit (e.g. at different rate). The effect of managements’ intentions
on the measurement of deferred tax is explained in chapter 6, section 4.4.2 and 4.4.3.
Please note, however, that if the item of revalued property, plant and equipment is non-depreciable (i.e.
land), then we ignore management’s actual intentions and presume that the intention of management
is to sell the asset. IAS 12.51B Presumed intentions are explained in chapter 6, section 4.4.2.
4.3.1 Deferred tax and a revaluation that does not exceed cost
If we have a revaluation surplus, it means that an asset’s carrying amount has been increased above
its historical carrying amount. However, if this revalued carrying amount does not exceed its original
cost, then there is no expected capital profit possible. This makes the deferred tax calculation easier.
Depending on management’s intentions, an increased carrying amount (that does not exceed cost)
refers to the estimated future inflow of economic benefits expected from:
x sales revenue (e.g. from selling the items manufactured through use of the asset), if the
entity intends to keep the asset: these sales will be taxed at the income tax rate; or
x proceeds on sale of the asset if the entity intends to sell the asset: the proceeds could result in
a recoupment of prior tax deductions, which will be taxed at the income tax rate; or a further
deduction of a scrapping allowance, being a tax saving, also measured at the income tax rate.
Thus, if the carrying amount does not exceed cost, management intentions may be ignored
because the deferred tax consequences of the entire temporary difference will be measured at a
constant income tax rate.
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x If the intention was to keep (use) the asset, the plant’s carrying amount would reflect future income
from the sale of the plant’s output: C
Future sales income Carrying amount at fair value 140 000
Less Future tax deductions Tax base = ‘future tax deductions’ (100 000)
Future taxable profits 40 000
Future tax 40 000 x 30% 12 000
x If the intention was to sell the asset, the plant’s carrying amount, at fair value, would reflect future
income from the expected selling price (SP) of the plant: C
Future selling price of plant (FV), limited to cost price SP of 140 000 (FV), limited to cost of 140 000
150 000 (cost not a limitation)
Less Tax base Tax base = future tax deductions (100 000)
Future recoupment on sale (increases taxable Tax deductions already received 40 000
profits) Note 1 that will be recouped
Future tax Note 2 40 000 x 30% 12 000
This situation (intention to sell, but fair value (expected selling price) < cost price) can be shown as follows:
Solution 13B: Revaluation upwards but not exceeding cost: deferred tax: journals
As already mentioned, if an asset is revalued above its historical carrying amount (depreciated
cost if it is a depreciable asset, and cost if it is a non-depreciable asset), it is important to
ascertain whether it has also been increased above its cost.
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If the revalued carrying amount exceeds cost, it is important to ascertain if management intends to keep
the asset or sell the asset. If the entity intends to:
x keep the asset, the future economic benefits will be the expected future revenue from normal
trading activities;
x sell the asset, the future economic benefits will be the expected future proceeds on sale;
x keep the asset for a while and then sell it, the future economic benefits will be a mixture of the above.
These management intentions are important to consider because the tax laws and tax rates may differ
depending on the type of income we earn. For example, the tax rate applicable to income from normal
trading (e.g. sales revenue) may be 30% whereas the effective tax rate applicable to income from the
sale of an item of property, plant and equipment (e.g. profit on sale of an asset) may, for example, be
24%. Thus, the entity’s intention regarding the asset must be considered when measuring the deferred
tax liability (or asset), because this balance must reflect how much tax the entity is expecting to pay (or
receive) in the future, and this amount may be affected by the type of income it is expecting to earn.
An exception occurs when the deferred tax balance relates to a revalued non-depreciable asset
(for example, land), in which case we must always presume that management intends to sell the
asset irrespective of management’s actual intention. (See section 4.3.4) IAS 12.51 B
4.3.2.1 Deferred tax: Revaluation above cost: intention to keep the asset
If the intention is to keep the asset (i.e. use it rather than sell it), then the entire carrying amount
(the future economic benefits) is expected to be earned through normal trading activities. In other
words, we expect that the future economic benefits (i.e. inflows) emanating from the asset will be
in the form of sales revenue or similar.
These future economic benefits that are expected to be earned through normal trading activities
will be taxed at the normal rate of income tax. If the asset is revalued upwards, the extra future
economic benefits (represented by the revaluation surplus) will thus also be taxed at this same
income tax rate. Therefore, assuming, for example, that trading profits are taxed at an income tax
rate of 30%, the future tax on the revaluation surplus will also be measured at 30%.
Note: when measuring deferred tax relating to non-depreciable land, we ignore management’s
actual intention to keep the land and presume that management intends to sell the land. IAS 12.51B
Example 14: Deferred tax: revaluation above cost: intend to keep – Short example
A depreciable and tax-deductible machine is revalued to a fair value of C140 000 when:
x its carrying amount (actual and historical) was C100 000;
x it original cost was C110 000 (not C150 000 as in the previous example);
x its tax base is C100 000.
The tax rate is 30%.
The intention is to keep the asset.
Required: Calculate the deferred tax balance and show the related journal entries.
For the purposes of this example, you may combine the cost and accumulated depreciation accounts.
Comment: Since the intention is to keep the asset, there is no complication of a capital profit on sale and thus, the
increase in the asset’s carrying amount simply reflects extra future income expected from the use of the asset.
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Balances after revaluation: 140 000 100 000 (40 000) (12 000) DT Liability (2) (3)
CA/ TB before revaluation 100 000 100 000 0 0 TD: 0 x 30% (1) (3)
Revaluation surplus – up to cost 10 000 0 (10 000) (3 000) TD: -10K x 30% (3)
Revaluation surplus – above cost 30 000 0 (30 000) (9 000) TD: -30K x 30% (3)
Notes
1) There are no temporary differences at this point since the historical carrying amount (depreciated cost)
and tax base are the same (both equal C100 000), and therefore there is no deferred tax.
2) The revaluation surplus causes a taxable temporary difference of C40 000, which reflects the future
taxable profits from the use of the asset in excess of those originally expected. Since these profits
would be trading profits taxed at 30%, the future tax on these extra profits would be levied at 30%.
Thus, the deferred tax liability is measured at C12 000 (taxable temporary difference: 40 000 x 30%).
3) Although the revalued amount is greater than original cost, this profit is expected to be earned through
the use of the asset – and not through the sale of the asset. Thus, since the entire temporary
difference will be taxed at the income tax rate of 30%, there is no need to show this breakdown of the
carrying amount after revaluation into the components of 100 000, 10 000 and 30 000.
4) The deferred tax adjustment is a balancing figure (t is the journal you need to process to convert the
DT opening balance into the DT closing balance).
Yet another way of explaining the deferred tax balance is to imagine that, since we intend to keep the
asset, by revaluing the asset to 140 000, it means that we are expecting future sales of 140 000. A tax
base of 100 000 means that we will be able to deduct 100 000 against this future revenue:
Future sales income Carrying amount at fair value 140 000
Less future tax deductions Tax base = ‘future tax deductions’ (100 000)
Future taxable profit 40 000
Future tax payable at 30% 40 000 x 30% 12 000
This situation (intention to keep, and fair value (expected sales income) > cost price) can also be shown as follows:
Example 15: Deferred tax: revaluation above cost: intend to keep – full example
A machine is purchased for C100 000 on 2 January 20X1.
x The machine is depreciated at 25% per annum straight-line to a nil residual value.
x Machines are revalued to fair value using the net replacement value method.
x The fair values were: 1 January 20X2: C120 000
1 January 20X3: C60 000
x The revaluation surplus is transferred to retained earnings over the life of the asset.
x The tax authorities allow the cost to be deducted at 20% pa and levy income tax at 30%.
x The intention is to keep the asset.
Required: Provide all journals. When calculating the deferred tax using the balance sheet method, include
an extra column showing the movement in the revaluation surplus.
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Balance: 1/1/20X1 0 0 0 0
Purchase 100 000 100 000
Dr DT (SOFP)
Depreciation/ deduction (25 000) (20 000) 5 000 1 500
Cr TE (P/L)
100 000 / 4 years; 100 000 x 20%
Balance: 31/12/20X1 75 000 80 000 5 000 1 500 DT Asset
Cr DT (SOFP) (45 000)
Revaluation surplus (increase) 45 000 0 (45 000) (13 500)(1)
Dr RS (OCI) (3) 13 500
120 000 80 000 (40 000) (12 000) Subtotal (31 500)
Depreciation/ deduction Dr DT (SOFP)
(40 000) (20 000) 20 000 6 000 10 500 (4)
120 000 / 3 years; 100 000 x 20% Cr TE (P/L)
Balance: 31/12/20X2 80 000 60 000 (20 000) (6 000) DT Liability (21 000)
Dr DT (SOFP) 20 000
Revaluation surplus (decrease) (20 000) 0 20 000 6 000(2)
Cr RS (OCI)(3) (6 000)
60 000 60 000 0 0 (7 000)
Depreciation/ deduction Dr DT (SOFP)
(30 000) (20 000) 10 000 3 000 3 500 (4)
60 000 / 2 years; 100 000 x 20% Cr TE (P/L)
Balance: 31/12/20X3 30 000 40 000 10 000 3 000 DT Asset (3 500)
Notes:
1) Since the intention is to keep the asset, there is no need to separate out any capital profit: the entire
increase (or decrease) in carrying amount is expected to be realised through normal trading activities,
which is taxed at 30%: 45 000 x 30% = 13 500
2) The drop in carrying amount reflects a drop in expected future income (all from trading activities
because we plan to keep the asset). A decrease in future income from trading activities will result in a
corresponding decrease in income tax: 20 000 x 30% = 6 000
3) The deferred tax contra entry is the revaluation surplus in OCI (not the P/L tax expense account).
4) Transfer from revaluation surplus to retained earnings:
20X2: 31 500 / 3 years = 10 500
20X3: 7 000 / 2 years = 3 500
20X4: 3 500 / 1 year = 3 500
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4.3.2.2 Deferred tax: Revaluation above cost: intention to sell the asset
If the intention is to sell the asset, then the fair value reflects the expected selling price of the
asset. Thus, if the asset is revalued to fair value, the revaluation surplus (fair value less carrying
amount) reflects this expected profit on sale (selling price less carrying amount).
From a tax perspective, if the fair value exceeds cost, the amount by which the fair value exceeds
cost reflects the expected ‘capital profit on sale’, part of which may be exempt from tax. Any
remaining portion of the profit on sale will reflect a non-capital profit on sale (generally taxable).
Therefore, when measuring the deferred tax on a revaluation surplus where the fair value
exceeded cost and our intention is to sell, we must remember that part of the capital profit on
sale may be exempt from tax (and thus the deferred tax will not simply be the resultant
‘temporary difference x tax rate: 30%).
Example 16: Deferred tax: Revaluation surplus above cost: intention to sell
A depreciable and tax-deductible plant, with a carrying amount of C60 000 and original cost
of C100 000, is revalued to a fair value of C110 000. The entity intends to sell this plant.
Required:
a) Calculate the revaluation surplus and analyse it into capital and non-capital profit components.
b) If the tax rate is 30%, the base cost equalled the cost price of C100 000, the tax base equalled the
carrying amount of C60 000, and 80% of capital gains are taxable, calculate the deferred tax that
would be recognised on the revaluation surplus.
Solution 16: Deferred tax: Revaluation surplus above cost: intention to sell
Comment: When the intention is to sell the asset, it is useful to visualise the revaluation surplus as being
the expected future profit on sale. We then ascertain whether we revalued above cost, in which case:
x part of the revaluation surplus brings the asset’s carrying amount back up to cost: this would be the
non-capital portion of the profit on sale (i.e. from carrying amount of C60 000 to cost of C100 000); and
x part of the revaluation surplus increases the carrying amount above cost: this would be the capital
portion of the profit on sale (i.e. from cost of C100 000 to fair value of C110 000).
Notice: If we compare part (a) and (b), we can see that the only difference is that capital profit was C10 000, but
the taxable capital gain was C8 000 (i.e.C2 000 of the capital profit was exempt from tax). As a result, the deferred
tax recognised on this revaluation surplus is C14 400, and cannot simply be calculated as 30% of the revaluation
surplus (i.e. it was not: RS 50 000 x 30% = C15 000), (compare this to example 15, where we recognised
deferred tax of C13 500, being 30% of the revaluation surplus of C45 000).
The principle is simply that the measurement of the deferred tax balance should reflect the tax
that would be owing if the asset were sold. In this regard, taxable profits might include:
x a recoupment of past tax deductions (increases taxable profit), or a further tax deduction
such as a scrapping allowance (decreases taxable profit); and/ or
x a taxable capital gain.
The next page reminds us how to calculate the tax that would be levied if an asset is sold.
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If the tax authorities allow an entity to deduct an asset’s cost by way of annual tax deductions
(i.e. if the asset is ‘deductible’), and the asset is subsequently sold, then, depending on whether
the selling price is greater or less than its tax base, the taxable profit could include either:
x a taxable recoupment of some, or all, of the past tax deductions; or
x a further tax deduction (e.g. a scrapping allowance).
Furthermore, if the asset is sold at more than its cost, then there will also be a capital profit.
Depending on the tax laws, only a portion of the capital profit might be included in taxable profits
(i.e. part, or all, of the capital profit may be exempt from tax). For example, in some tax jurisdictions:
x a capital profit is totally exempt from tax, in which case deferred tax is not recognised on the
entire portion of the revaluation surplus that reflects an expected capital profit;
x a capital profit is completely taxable, in which case deferred tax is recognised on the entire portion
of the revaluation surplus that reflects an expected capital profit (i.e. capital profit x tax rate); or
x a capital profit is partially exempt (i.e. partially taxable), in which case deferred tax is
recognised, but only on the portion of the revaluation surplus that reflects the ‘taxable portion
of the capital profit’ (i.e. taxable capital gain x tax rate).
The impact of our intention (to keep or sell the asset) on the deferred tax balance will be best
understood by trying a few examples. All prior examples (with the exception of example 16)
involved assets that we intend to keep whereas the following examples (example 17 and 18)
involve assets we intend to sell. Then example 19 shows what to do if we change our intention.
Solution 17: Revaluation above cost: deferred tax: intention to sell – short example
Comment: Since the intention is to sell the asset, the fair value (FV) reflects the selling price (SP). Since
this exceeds the cost price, there is an expected capital gain, 80% of which would be taxable. The
measurement of the deferred tax balance must take this into account (i.e. the DT balance is C10 200, and
not simply TD 40 000 x 30% = 12 000).
Balances after revaluation 140 000 100 000 (40 000) (10 200) DT Liability (2) (W2) (W3)
CA/ TB before revaluation 100 000 100 000 0 0 TD: 0 x 30% (1) (2)
Revaluation surplus – up to cost 10 000 0 (10 000) (3 000) TD: 10K x 30% (2)
Revaluation surplus – above cost 30 000 0 (30 000) (7 200) TD: 30K x 80% x 30% (2)
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Notes
1) There are no temporary differences when we compare the historical carrying amount and tax
base, as these happen to be the same (both equal C100 000), and thus there is no deferred tax.
2) The entire revaluation surplus of 40 000 (10 000 + 30 000) reflects the expected future profit on
sale of the asset (because the intention is to sell). Because the expected selling price exceeds
cost, part of this profit is a capital profit, of which a portion is exempt from tax. The measurement
of the deferred tax balance must thus reflect the expected tax liability if we were to sell:
x The profit on sale up to cost leads to a recoupment of past tax deductions (selling price,
limited to cost price – tax base) and will be taxed at 30%.
x The profit on sale above cost leads to a capital gain (proceeds – base cost), 80% of which will be
taxed at 30%
Thus, the DT closing balance = (Recoupment x 30%) + (Capital gain x 80% taxable x 30%)
= (SP ltd to Cost: 110 000 – TB: 100 000) x 30% + (SP 140 000 – BC: 110 000) x 80% x 30%
= (10 000 x 30%) + (30 000 x 80% x 30%)
= 3 000 + 7 200 = 10 200
Please note: If, for example, the base cost was 130 000 (i.e. if the base cost did not equal cost of 110 000),
then the deferred tax on the taxable capital gain would not be 7 200, but would be 2 400 instead:
= (SP – BC) x 80% x 30% = (140 000 – 130 000) x 80% x 30% = 2 400.
In this case, the DT closing balance would be 5 400 (3 000 + 2 400). If you are battling, other workings
that may help you understand are shown in W2 and W3.
3) This is the DT journal needed to convert the DT opening balance (nil) to the DT closing balance
(10 200 liability). P.S. Since the cause of the DT was a revaluation surplus, the contra entry is
the revaluation surplus.
W2: Deferred tax closing balance using a ‘diagram’
Tax base (future deductions) 100 000 Recoupment of past deductions: 3 000
10 000 x 30%
Original cost (and base cost) 110 000 Taxable capital gain:
7 200
30 000 x 80% x 30% (see 3 above)
Revalued carrying amount (SP) 140 000
10 200
W3: Deferred tax closing balance using income statement approach Taxable profits Deferred tax
Capital portion
Selling price Fair value 140 000
Less Base cost (110 000)
Capital gain 30 000
Taxable capital gain (TCG) 30 000 x 80% 24 000
Tax on TCG 24 000 x 30% 7 200
Non-capital portion
Selling price limited to cost 140 000 ltd to 110 000 110 000
Less Tax base Given (100 000)
Recoupment 10 000 10 000
Tax on recoupment 10 000 x 30% 3 000
Future taxable profits and deferred tax liability 34 000 10 200
Example 18: Revaluation above cost: Deferred tax: Intention to sell – full example
A machine is purchased for C100 000 on 2 January 20X1. The company:
x measures it under the revaluation model and revalued it to C120 000 on 1 January 20X2
x depreciates it at 25% per annum straight-line to a nil residual value
x transfers the revaluation surplus to retained earnings on disposal of the asset
x uses the net replacement value method to record its revaluations.
On date of revaluation (1 January 20X2), the entity’s intention is to sell the asset.
x The criteria for reclassification as a non-current asset held for sale are not met (see chapter 12).
x The asset is not sold until 1 January 20X3 (for C90 000).
The tax authorities levy income tax at 30% and will:
x allow the deduction of the cost of the asset at 20% of the cost per annum
x use a base cost of C100 000 and apply an 80% inclusion rate if sold at a capital gain.
Required: Provide all related journal entries. When calculating the deferred tax using the balance sheet
method, include an extra column showing the movement in the revaluation surplus.
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C/ balance: X3 0 0 0 0 0
1) 20X1 Depreciation and Tax deduction calculations: Depreciation (20X1) = (100 000 – 0) / 4 years = 25 000
Tax deduction (20X1) = 100 000 x 20% = 20 000
2) 20X1 DT adjustment on temporary difference between depreciation and tax deduction: TD: 5 000 x 30% = 1 500
3) 31/12/20X1: The deferred tax balance. Whether the intention is to sell the asset or to keep the asset, the
deferred tax implications will be the same. This is because the carrying amount of the asset does not exceed the
cost. The deferred tax balance is a DT asset (reflecting expected tax savings of C1 500) calculated as follows:
Tax base 80 000 If we sell: we’d get an extra tax deduction of 5 000; or
If we keep: we’d have a tax loss from trade of 5 000 1 500
Carrying amount 75 000 Both cases: Decrease in taxable profits 5 000 x 30%
Expected tax saving: 1 500 DTA
4) 1/1/20X2: The deferred tax balance (an interim balance immediately after the revaluation). Since we now intend
to sell, the measurement of the deferred tax balance must reflect the expected tax liability if we were to sell: there is
an expected recoupment of past tax deductions (selling price, limited to cost price – tax base), which will be taxed at
30% and there is an expected capital gain (selling price – base cost), 80% of which will be taxed at 30%
Thus, the DT closing balance = (Recoupment x 30%) + (Capital gain x 80% taxable x 30%)
= (SP limited to Cost: 100 000 – TB: 80 000) x 30% + (SP 120 000 – BC: 100 000) x 80% x 30%
= 6 000 + 4 800 = 10 800 … If you prefer, this calculation can be illustrated as follows, instead:
6) 20X2 Depreciation and Tax deduction calculations: Depreciation (20X2) = (120 000 – 0) / 3 years = 40 000
Tax deduction (20X2) = 100 000 x 20% = 20 000
7) 20X2 DT adjustment on temporary difference between depreciation and tax deduction: TD: 20 000 x 30% = 6 000
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8) 31/12/20X2: The deferred tax balance. Since the intention is still to sell the asset, the measurement of the
deferred tax balance must continue to reflect the expected tax liability if we were to sell: we still expect a
recoupment of past tax deductions (selling price, limited to cost price – tax base), but there is no longer an expected
capital gain (because the carrying amount of 80 000, which reflects the expected selling price, has dropped below
cost of 100 000). Thus, we could simply calculate the deferred tax closing balance at 30% on the entire temporary
difference. Alternatively, we can calculate it as follows: (Recoupment x 30%) + (Capital gain x 80% taxable x 30%)
= Recoupment: (SP ltd to Cost: 80 000 – TB: 60 000) x 30% + Capital gain: N/A = 6 000
This calculation can also be illustrated as follows, instead:
Required: Show the deferred tax journal on 1 January 20X4 to account for the change in intention.
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If we have an asset that is non-deductible for tax purposes (i.e. if the tax authority does not
allow the cost of our asset to be deducted in the calculation of taxable profits), a temporary
difference will arise immediately on the purchase of our asset because:
x the carrying amount is the cost, but
x the tax base is nil (since there will be no future tax deductions).
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Tax base 0
NOTE 1
Recoupment: N/A 0
Original cost (and base cost) 110 000
Taxable capital gain (TCG): 30 000
7 200
Revalued carrying amount 140 000 (SP: 140 000 – Base cost 110 000) x 80% x 30%
7 200
Note 1: This portion of the temporary difference (C110 000) normally reflects the taxable recoupment if the
asset was sold at C140 000. However, since the tax authorities did not allow deductions on this asset, there
can be no recoupment (i.e. if there were no previous tax deductions granted, there is nothing to recoup).
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1) This temporary difference of C100 000 arises due to the difference between the depreciated cost of C100 000 and
the tax base of nil. Because the asset is non-deductible, the TD is exempt from deferred tax (in terms of IAS 12.15)
2) The entire revaluation surplus of 40 (10 + 30) represents future profits from the use of the asset in excess of
those originally expected. Since these profits are simple trading profits and will thus be taxed at 30%, a deferred
tax liability of C12 000 must be recognised (Future trading profits 40 000 x 30%) (i.e. we do not treat it as exempt
if the intention is to keep the asset).
3) Since the entire temporary difference relates to the revaluation surplus and since this entire revaluation surplus
represents extra trading profits that will be taxed at 30%, the deferred tax liability is 30% of the temporary difference.
If we have an asset that is non-deductible for tax purposes (i.e. if the tax authority does not
allow the cost of our asset to be deducted in the calculation of taxable profits), a temporary
difference will arise immediately on the purchase of our asset because:
x the carrying amount is the cost, but
x the tax base is nil (since there will be no future tax deductions).
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As was explained in the previous chapter previous chapter (and chapter 6 section 4.3), deferred tax is
not recognised on the related temporary differences since these are exempted in terms of IAS 12.15.
The exemption does not apply, however, to any further temporary differences caused by a
revaluation above the historical carrying amount (cost if the asset is non-depreciable and
depreciated cost if the asset is depreciable).
The carrying amount of an asset that is not depreciated will remain at cost (unless it is revalued). Thus,
if the asset is not revalued, the exempt temporary difference will always be the same: carrying amount
(i.e. the original cost) less its tax base of zero.
DT on the reval surplus of a
However, if a non-depreciable asset is revalued, its carrying non-depreciable,
non-deductible asset:
amount will no longer reflect cost, but a fair value instead. The
extra temporary difference caused by the revaluation is not x Always assume intention to sell:
exempt from deferred tax and the calculation of the related - FV - Cost: Tax @ CGT rates
deferred tax must always be based on an assumed intention to sell (i.e. the carrying amount is always
assumed to be the expected selling price even if the intention is actually to keep the asset!):
x since a non-depreciable asset (e.g. land) never gets ‘used up’, it is argued that it is not
possible to calculate a fair value based on future use; thus
x the fair value could only have been estimated using its expected selling price. See IAS 12.51B
The result is that the revaluation surplus above historical cost will be subject to deferred tax to the
extent that the capital profit is considered taxable under the capital gains tax legislation.
In summary: when dealing with the revaluation of a non-depreciable and non-deductible asset:
x The revaluation surplus above cost is not exempt for purposes of calculating deferred tax
x The deferred tax on this revaluation surplus is always based on an assumed intention to sell,
even if your stated intention is to keep the asset.
Example 22: Revaluation of land above cost: Deferred tax: Intention to keep:
x non-depreciable,
x non-deductible asset
x A company owns land that cost C100 000. This land is not depreciated.
x The land is revalued to C140 000.
x The tax authorities do not allow the deduction of capital allowances on land. The tax rate is 30% and
80% of capital gains are included in taxable profits. The base cost equalled cost.
Required: Show the journal entries for the revaluation assuming that the intention is to:
A sell the asset. Include a revaluation surplus column in your deferred tax table.
B keep the asset. Include a revaluation surplus column in your deferred tax table.
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W1: Deferred tax on land – actual intention to keep but use presumed intention to sell
PPE x Non-depreciable Carrying Tax Temporary Deferred Revaluation
(sell) x Non-deductible amount base difference tax surplus
Balance before revaluation 100 000 0 (100 000) 0 Exempt(1) 0
Cr DT (40 000)
Revaluation surplus 40 000 0 (40 000) (9 600)
DR RS (balancing) 9 600
Balance after revaluation 140 000 0 140 000 (9 600) DT Liability (4) 30 400
CA/TB before revaluation 100 000 0 (100 000) 0 Exempt (1)
Cost (not depreciated)
Revaluation surplus – up to cost: 0 0 0 0 N/A (2)
No depreciation was provided
Revaluation surplus – above cost 40 000 0 (40 000) (9 600) TD: - 40 000
Cost: 100 000 – FV: 140 000 x 80% x 30% (3)
Note 1: Comparing the cost and TB suggests there is a recoupment of C100 000, but since no deductions
were granted by the tax authorities, clearly no recoupment of prior deductions is possible.
5.1 Overview
The disclosure of property, plant and equipment involves various aspects: accounting policies to
be included in the notes to the financial statements, disclosure in the statement of
comprehensive income, statement of financial position and the statement of changes in equity.
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The nature and effect of a change in estimate must be disclosed in accordance with IAS 8
(the standard on ‘accounting policies, changes in accounting estimates and errors’). See IAS 16.76
The note that supports the ‘profit before tax’ line item in the statement of comprehensive
income should include the following items, disclosed per class of property, plant and
equipment (including all these items in this one note helps to save time in exams):
x depreciation expense (whether in profit or loss or in the cost of another asset); IAS 1.102-104
x impairment losses and the line item in the statement of comprehensive income in which it
is included, (i.e. this loss arises if the recoverable amount is less than carrying amount,
and any revaluation surplus has already been written off);
x reversal of impairment losses and the line item in the statement of comprehensive income
in which it is included (i.e. this reversal arises if the recoverable amount is greater than
carrying amount, but a reversal of an impairment loss only reflects an increase in carrying
amount up to historical carrying amount, being cost or depreciated cost depending on
whether the asset is depreciable or not, and only if it reverses a previous impairment loss);
x revaluation expense (i.e. if the fair value is less than depreciated cost and there is no
balance in the revaluation surplus account, the decrease is a revaluation expense);
x revaluation income (i.e. if the fair value is greater than depreciated cost and the increase
in carrying amount up to depreciated cost reverses a previous revaluation expense);
x profits or losses on the realisation, scrapping or other disposal of a non-current asset.
Where an asset is measured under the revaluation model with the result that a revaluation
surplus has been created or adjusted, this creation or adjustment to the revaluation surplus:
x must be presented as a separate line item under ‘other comprehensive income’, under
the sub-heading ‘items that may never be reclassified to profit or loss’;
x must be presented per class of property, plant and equipment (i.e. if there is a revaluation
surplus on machines and a revaluation surplus on plant, each of these movements in
revaluation surplus must be disclosed as separate line items); and
x may be shown on the face of the statement of comprehensive income either:
- after tax, with the gross and tax effects shown in a separate supporting note; or
- before tax, with the gross and tax effects shown on the face of the statement of
comprehensive income. See IAS 1.90 and .91
5.4 Statement of financial position and related note disclosure (IAS 16 & IFRS 13)
The following is the primary information that IAS 16 requires to be disclosed in the note to the
‘property, plant and equipment’ line item in the statement of financial position.
This information must be disclosed separately for each class of property, plant and equipment
(e.g. land, buildings, machinery, etc):
x ‘gross carrying amount’ and ‘accumulated depreciation and impairment losses’ at the
beginning and end of each period; See IAS 16.73(d)
x a reconciliation between the ‘net carrying amount’ at the beginning and end of the period
separately disclosing each of the following where applicable:
additions;
disposals;
depreciation;
impairment losses recognised in profit or loss;
impairment losses reversed through the statement of comprehensive income;
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revaluation income;
revaluation expense;
revaluation surplus increase, due to a revaluation;
revaluation surplus increase, due to an impairment loss reversed;
revaluation surplus decrease, due to a revaluation;
revaluation surplus decrease, due to an impairment loss;
assets transferred to ‘non-current assets held for sale’ in accordance with IFRS 5;
other movements (e.g. currency translation differences); See IAS 16.73(e)
x the existence and amounts of restrictions on title; See IAS 16.74(a)
x the existence and amounts of assets that have been pledged as security for a liability; IAS 16.74(a)
x the costs capitalised in respect of property, plant and equipment being constructed; IAS 16.74(b)
x the amount of any contractual commitments to acquire assets in the future; See IAS 16.74(c)
x when the revaluation model is adopted, then disclose:
the effective date of the latest revaluation;
whether or not the valuer was independent;
the carrying amount of the property, plant and equipment had the cost model been
adopted (per class of revalued property, plant and equipment). See IAS 16.77
The standard also requires that the accumulated depreciation be disclosed (as opposed to
the aggregate of the accumulated depreciation and accumulated impairment losses that is
given in the reconciliation of the carrying amount of the asset) at the end of the period.
IFRS 13 Fair value measurement requires certain minimum disclosures relating to how the
fair value was measured (the following is a brief outline of these requirements: details are
provided in chapter 25):
x If the asset is measured using the revaluation model, detailed disclosures are required in
relation to:
the valuation techniques (e.g. market, cost or income approach);
the inputs (e.g. quoted price for identical assets in an active market; an observable
price for similar assets in an active market) and whether these inputs were considered
to be level 1 inputs (most reliable) or level 3 inputs (least reliable). See IFRS 13.91 & .93
x If the asset is measured using the cost model and thus its measurement does not involve
fair value but its fair value still needs to be disclosed in the note (see further encouraged
disclosure, section 5.6 below), the required disclosures are similar but fewer. See IFRS 13.97
5.5 Statement of changes in equity disclosure (IAS 16.77(f); IAS 1.106(d) & IAS 1.106A)
If property, plant and equipment is measured under the revaluation model, there may be a
revaluation surplus which would need to be disclosed as follows:
x increase or decrease in revaluation surplus during the period (net of tax): this will be the
amount per the statement of comprehensive income;
x realisations of revaluation surplus (e.g. transfer to retained earnings as the asset is used); and
x any restrictions on the distribution of the surplus to shareholders.
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Entity name
Notes to the financial statements
For the year ended 31 December 20X2 (extracts)
2. Accounting policies
Plant is measured under the revaluation model and is revalued annually to fair values. It is thus
carried at fair value less accumulated depreciation and impairment losses. All other property, plant
and equipment is measured under the cost model and is thus carried at cost less accumulated
depreciation and impairment losses.
Depreciation is not provided on land. Depreciation is provided on all other property, plant and
equipment over the expected economic useful life to expected residual values using the following
rates and methods:
- Plant at 10% per annum, reducing balance method.
Land Plant
20X2 20X1 20X2 20X1
C C C C
Net carrying amount: 1 January b a e d
Gross carrying amount
Accumulated depreciation & impairment losses
Additions
(Disposals)
(Depreciation)
(Impairment loss)/ Impairment loss reversed
Revaluation increase/ (decrease) through OCI
Revaluation increase/ (decrease) through P/L
Other
Net carrying amount: 31 December c b f e
Gross carrying amount
Accumulated depreciation & impairment losses
Plant was revalued on 1/1/20X1, by an independent sworn appraiser, to its fair value.
The valuation technique used to determine fair value was the market approach and the inputs used
included observable prices for similar assets in an active market. All inputs are level 1 inputs.
The fair value adjustment was recorded on a net replacement value basis.
Revaluations are performed annually.
Had the cost model been adopted, the carrying amount would have been Cxxx (20X0: Cxxx).
Land is provided as security for a loan (see note 15: loans).
20X2 20X1
28. Other comprehensive income: Revaluation surplus: PPE C C
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Entity name
Statement of financial position 20X2 20X1
As at 31 December 20X2 (extracts) Note C C
ASSETS
Non-current assets
Property, plant and equipment 4
Entity name
Statement of changes in equity
For the year ended 31 December 20X2 (extracts)
Revaluation Retained Total
surplus earnings
C C C
Balance at 1 January 20X1
Total comprehensive income
Realised portion transferred to retained earnings
Balance at 31 Dec 20X1
Total comprehensive income
Realised portion transferred to retained earnings
Balance at 31 December 20X2
Entity name
Statement of comprehensive income 20X2 20X1
For the year ended 31 December 20X2 (extracts) Note C C
Required:
A. Disclose the plant and all related information in the financial statements for the years ended
31 December 20X1, 20X2, 20X3 and 20X4 in accordance with IAS 16 and IFRS 13.91(a).
Ignore tax.
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B. Provide the journals (using the net replacement value method) and show all additional or revised
related disclosure assuming that:
x Deductible allowance (wear and tear) granted by the tax authorities 20% straight-line p.a.
x Income tax rate 30%
x The entity intends to keep the plant.
x There are no other temporary differences other than those evident in the information provided.
x Other comprehensive income is presented net of tax in the statement of comprehensive income.
C. Assume the information given in B above except that the entity presents other comprehensive
income gross and net on the face of the statement of comprehensive income. Show how the
disclosure would change.
The journals for part A may be found under examples 9, 10 and 11.
Entity name
Notes to the financial statements (extracts)
For the year ended 31 December 20X4 (extracts)
2. Accounting policies
Plant is measured under the revaluation model and is revalued annually to fair values. It is thus
carried at fair value less subsequent accumulated depreciation and impairment losses.
Depreciation is provided on all property, plant and equipment over the expected economic useful life
to expected residual values using the following rates and methods:
Plant: 20% per annum, straight-line method.
Plant
Net carrying amount: 1 January 36 000 67 500 80 000
Gross carrying amount 54 000 90 000 100 000 0
Acc dep and impairment losses (18 000) (22 500) (20 000) 0
The last revaluation was performed on 1/1/20X4 by an independent sworn appraiser to its fair value.
The valuation technique used to determine fair value was the income approach, where the inputs
included the market expectations regarding discounted future cash flows. All inputs are level 1 inputs.
The fair value adjustment was recorded on a net replacement value basis. Revaluations are
performed annually.
Carrying amount if the cost model was used: 20 000 40 000 60 000 80 000
Profit before tax is stated after taking the following disclosable (income)/ expenses into account:
x Depreciation on plant 22 000 18 000 22 500 20 000
x Revaluation expense 0 6 000 0 0
x Revaluation income (4 000) 0 0 0
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Entity name
Notes to the financial statements (extracts)
For the year ended 31 December 20X4 continued …
33. Other Comprehensive Income : Revaluation Surplus: Property, plant and equipment
Entity name
Statement of financial position (extracts) 20X4 20X3 20X2 20X1
As at 31 December 20X4 C C C C
Note
ASSETS
Non-current assets
Property, plant and equipment 12 22 000 36 000 67 500 80 000
Entity name
Statement of comprehensive income (extracts) 20X4 20X3 20X2 20X1
For the year ended 31 December 20X4 C C C C
Notes
Profit for the period 100 000 100 000 100 000 100 000
Total comprehensive income for the period 104 000 92 500 110 000 100 000
Entity name
Statement of changes in equity (extracts)
For the year ended 31 December 20X4
Revaluation Retained Total
surplus earnings
C C C
Balance at 1 January 20X1 0 X X
Total comprehensive income 0 100 000 100 000
Balance at 31 December 20X1 0 X X
Total comprehensive income 10 000 100 000 110 000
Realised portion transferred to retained earnings (2 500) 2 500
Balance at 31 December 20X2 7 500 X X
Total comprehensive income (7 500) 100 000 92 500
Balance at 31 December 20X3 0 X X
Total comprehensive income 4 000 100 000 104 000
Realised portion transferred to retained earnings (2 000) 2 000
Balance at 31 December 20X4 2 000 X X
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Disclosure:
Entity name
Statement of financial position (extracts) 20X4 20X3 20X2 20X1
As at 31 December 20X4 C C C C
Note
ASSETS
Non-current assets
Property, plant and equipment 12 22 000 36 000 67 500 80 000
Deferred taxation 4 0 1 200 0 0
Entity name
Statement of comprehensive income (extracts) 20X4 20X3 20X2 20X1
For the year ended 31 December 20X4 C C C C
Note
Profit for the period 100 000 100 000 100 000 100 000
Total comprehensive income 102 800 94 750 107 000 100 000
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Entity name
Statement of changes in equity (extracts)
For the year ended 31 December 20X4
Revaluation Retained Total
surplus earnings
C C C
Balance at 1 January 20X1 0 X X
Total comprehensive income 0 100 000 100 000
Balance at 31 December 20X1 0 X X
Total comprehensive income 7 000 100 000 107 000
Realised portion transferred to retained earnings (1 750) 1 750 0
Balance at 31 December 20X2 5 250 X X
Total comprehensive income (5 250) 100 000 94 750
Balance at 31 December 20X3 0 X X
Total comprehensive income 2 800 100 000 102 800
Realised portion transferred to retained earnings (1 400) 1 400 0
Balance at 31 December 20X4 1 400 X X
Entity name
Notes to the financial statements (extracts) 20X4 20X3 20X2 20X1
For the year ended 31 December 20X4 C C C C
Workings:
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Calculations:
(1) Depreciation 20X1 (100 000 – 0) / 5 years
(2) Depreciation 20X2 (90 000 – 0) / 4 remaining years
(3) Depreciation 20X3 (54 000 – 0) / 3 remaining years
(4) Depreciation 20X4 (44 000 – 0) / 2 remaining years
Entity name
Statement of comprehensive income (extracts) 20X4 20X3 20X2 20X1
For the year ended 31 December 20X4 C C C C
Notes
Profit for the period 100 000 100 000 100 000 100 000
Total comprehensive income for the period 102 800 94 750 107 000 100 000
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6. Summary
Temporary difference
Carrying amount versus Tax base
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Revaluation model:
Disclosure (main points only)
Accounting policies
depreciation methods
rates (or useful lives)
cost or revaluation model
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Chapter 9
Intangible Assets and Purchased Goodwill
References: IAS 38, IAS 36, IFRS 13, IFRS 3, IAS 1, IAS 20, IFRIC 12 & SIC 32 (incl. amendments to 1 December 2019)
Contents: Page
1. Introduction 471
2. Scope 471
3. Recognition and initial measurement 471
3.1 Overview 471
3.2 Recognition 472
3.2.1 Overview 472
3.2.2 Definition 472
3.2.3 Recognition criteria 472
3.2.4 Difficulties in meeting the definitions 473
3.2.4.1 The item must have no physical substance 473
Example 1: Physical substance and a fishing licence 473
Example 2: Physical substance and software 473
Example 3: Physical substance and a prototype 473
3.2.4.2 The item must be identifiable 474
Example 4: Identifiability 474
Example 5: Identifiability in a business combination 474
3.2.4.3 The item must be controllable 475
Example 6: Control 475
3.3 Initial measurement – the basics 475
3.3.1 Overview 475
3.3.2 Purchase price 475
3.3.3 Directly attributable costs 475
Example 7: Recognition and initial measurement 476
3.4 The effect of the method of acquisition on recognition and initial measurement 477
3.4.1 Overview of the methods of acquisition 477
3.4.2 The effect of the method of acquisition on the initial measurement 477
3.4.3 Intangible assets acquired through a separate purchase 477
3.4.3.1 Recognition 477
3.4.3.2 Initial measurement 478
3.4.4 Intangible assets acquired through an exchange of assets 478
3.4.4.1 Recognition 478
3.4.4.2 Initial measurement 478
3.4.5 Intangible assets acquired by government grant 478
3.4.5.1 Recognition 478
3.4.5.2 Initial measurement 478
3.4.6 Intangible assets acquired in a business combination 479
3.4.6.1 Recognition 479
3.4.6.2 Initial measurement 480
Example 8: Intangible asset acquired in a business combination 480
3.4.7 Intangible items that are internally generated 480
3.4.7.1 Overview 480
3.4.7.2 Internally generated goodwill 481
3.4.7.3 Internally generated intangible items other than goodwill 482
3.4.7.3.1 Overview of issues regarding recognition 482
3.4.7.3.2 Certain internally generated items may never be capitalised 482
3.4.7.3.3 The stages of internal generation 482
3.4.7.3.4 Recognition of costs in the research phase 483
3.4.7.3.5 Recognition and measurement of costs in the development phase 483
Example 9: Research and development costs 484
3.4.7.3.6 In-process research and development that is purchased 485
Example 10: In-process research and development 486
3.4.7.4 Web site costs 486
3.4.8 Intangible assets acquired through a service concession agreement 487
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1. Introduction
Something that is intangible is simply something that is ‘unable to be touched’. Thus, this chapter is
simply about assets that have no physical substance. Examples of items without physical substance
include research and development, software, patents, trademarks, copyrights, brands, licences and
even things like the cost of training employees.
Intangible items are interesting because although we may know they exist and may know they are
beneficial to the entity, the fact that we can’t see or touch them sometimes makes it difficult to prove
that they are assets. In other words, we are sometimes unable to recognise an intangible item as an
intangible asset, in which case any costs related to this invisible item will have to be expensed instead.
The standard that covers these invisible and untouchable assets is IAS 38 Intangible assets.
Note: An intangible asset that is a licencing agreement (involving items such as movies, videos, plays,
manuscripts, patents and copyrights) held under a lease is covered by IAS 38 Intangible assets (i.e. it
will not be accounted for as a leased asset in terms of IFRS 16 Leases).
Before an intangible asset may be recognised, it must meet both: Recognise an IA if it meets IAS 38’s:
x the definition of an intangible asset; and x IA definition; and
x the recognition criteria laid out in IAS 38. See IAS 38.18 x recognition criteria. See IAS 38.18
Interestingly, due to the intangible nature of the item, it may be x at cost. See IAS 38.24
difficult to prove that it should be recognised as an intangible
asset. Similarly, even if we successfully prove it should be recognised as an intangible asset, we may
then find it difficult to establish the amount at which it should be initially measured (cost may be difficult
to determine). These difficulties may also be compounded by the way in which the item is acquired.
Difference between IAS 38 and the 2018 Conceptual Framework: Definition and Recognition criteria
The asset definition in IAS 38 (see section 3.2.2) differs from the asset definition in the ‘2018 Conceptual
Framework’: a present economic resource controlled by the entity as a result of past events. CF 4.3
Similarly, the two recognition criteria given in IAS 38 (see section 3.2.3) differ from the two recognition criteria in
the ‘2018 Conceptual Framework’, which are that an item should only be recognised if it provides relevant information
and would be a faithful representation of the phenomena it purports to present. See CF 5.7
However, the IASB concluded that we should continue to use the definition and recognition criteria in IAS 38 because
these will still achieve the same outcome.
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The following sections explain the recognition of an intangible asset (section 3.2), the initial
measurement thereof (section 3.3) and also how the various methods of acquiring it could affect its
recognition and measurement (section 3.4).
When recognising an intangible
asset, the IA definiton and
3.2 Recognition (IAS 38.18 - .23) recognition criteria must be met:
The ‘asset definition’ refers to an expectation of future economic benefits. These benefits could be in
any form e.g. revenue, other income or even cost savings. For example: a new recipe may reduce
production costs. See IAS 38.17
However, due to the nature of intangible assets, it may be difficult to meet certain aspects of
both the ‘intangible asset definition’ and ‘asset definition’. For example:
x If we cannot touch it or see it:
- how can we say the asset is identifiable? (see the intangible asset definition)
- how can we prove that we control it? (see the asset definition)
x We may even have difficulty in deciding that the asset does not have physical substance (see the
intangible asset definition) (interestingly, this is not always as obvious as it may seem!).
Each of these difficulties (identifiability, control and physical substance) is explained in section 3.2.4.
Before an item that meets the ‘intangible asset definition’ (which includes meeting the ‘asset definition’)
may be recognised as an intangible asset, it must also meet the following recognition criteria:
x the expected inflow of future economic benefits from the asset must be probable; and
x the cost must be reliably measured. See IAS 38.21
Note: IAS 38 uses the recognition criteria from the old conceptual framework (2010 CF) and thus, when
recognizing an intangible asset, we do not use the recognition criteria in the new ‘2018 CF’.
The nature of intangible assets can also lead to difficulties in meeting the recognition criteria. Possibly
the greatest difficulty is proving that the cost of the asset is ‘reliably measurable’. For example:
x A reliable measure of the cost may be possible if the intangible asset was the only asset
purchased as part of a purchase transaction.
x However, if an intangible asset was purchased as part of a group of assets, the purchase
price would reflect the cost of the group of assets.
x In this case we would need to be able to prove that we can reliably measure the portion of the
cost of the group of assets that should be allocated to the intangible asset within this group.
x To be able to reliably measure the portion of the cost that should be allocated to an invisible
asset is far more difficult than measuring it for an asset we can see.
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Costs are frequently incurred on items that have both No physical substance
intangible and tangible aspects. We will need professional
judgment to assess which element is more significant: the x If the item has physical and
tangible (physical) or the intangible (non-physical) aspects. non-physical aspects:
x apply IAS 38 or IAS 16
The standard that should be applied to the asset depends on depending on which aspect is
which aspect is the most significant, either: more significant.
x IAS 38 Intangible Assets; or x Needs professional judgement.
x IAS 16 Property, Plant and Equipment or any other appropriate standard.
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Identifiable: an item is
3.2.4.2 The item must be identifiable (IAS 38.11 - 12) identifiable if it:
Even if the asset is not separable, identifiability can still be proven through the existence of
contractual or other legal rights. These rights must be considered even if they are:
x not transferrable; and/ or
x not separable from either the entity or other rights and obligations. See IAS 38.12 (b)
If we cannot prove that an individual asset is identifiable, we must not recognise it as a separate asset.
Instead, we account for it as goodwill. However, there are two kinds of goodwill:
x Acquired goodwill: this is recognised as an asset. It arises during business combinations and
reflects the synergies of all those assets acquired but which were not separately identifiable and
thus not able to be separately recognised.
x Internally generated goodwill: this is recognised as an expense. It arises from the synergies of the
assets within a business but where the costs involved in creating it are so similar to the general
running costs of a business, that they are expensed. In other words, these costs were not
considered ‘separable’ from the costs of just running the business.
Acquired goodwill is not covered by the standard on ‘intangible assets’ (IAS 38) but rather by the
standard on ‘business combinations’ (IFRS 3). However, since it is linked to intangible assets, it is
briefly explained in section 3.4.6 and section 10.
Example 4: Identifiability
Guff Limited incurred C300 000 on a massive marketing campaign to promote a new
product. The accountant wishes to capitalise these costs.
Required: Briefly explain whether these costs are considered to be identifiable or not.
Solution 4: Identifiability
The advertising campaign is not separable as it cannot be separated from the entity and sold, transferred,
rented or exchanged. Further, the advertising campaign does not arise from contractual or legal rights.
Thus, since neither criteria are met, the cost of the advertising campaign is not identifiable.
Comment: Since it is not identifiable, the intangible asset definition is not met and thus advertising costs
must be expensed. P.S. these costs create internally generated goodwill, which is always expensed.
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As mentioned above, the ‘intangible asset definition’ refers to an ‘asset’, which IAS 38 defines
as being a ‘resource controlled by the entity as a result of past events and from which an inflow
of future economic benefits is expected’. This means that for something to meet the ‘intangible
asset definition’, it will need to be controlled by the entity.
Control over an intangible asset is difficult to prove, but it may be achieved if the entity has:
x the ability to restrict accessibility by others to the asset’s future economic benefits; and
x the power to obtain the asset’s future economic benefits. See IAS 38.13
An asset’s future economic benefits can be controlled through legally enforceable rights (e.g.
copyright) but legal rights are not necessary to prove control; it is just more difficult to prove that
control exists if legal rights do not exist. See IAS 38.13
Control
For example, an entity may be able to identify a team of skilled
staff, a portfolio of customers, market share or technical We must be able to control the
asset’s FEB:
knowledge that will give rise to future economic benefits.
However, the lack of control over the flow of future economic We control the FEB if we:
benefits means that these items seldom meet the definition of x can restrict access to the FEB; &
x have the power to obtain the FEB.
an intangible asset. On the other hand, control over technical See IAS 38.13
knowledge and market knowledge may be protected by legal Legal rights: are useful when trying to
rights such as copyrights and restraint of trade agreements, in prove control but are not necessary!
which case these would meet the requirement of control.
Example 6: Control
Awe Limited incurred C200 000 on specialised training to a core team of employees.
The accountant wishes to capitalise these costs.
Required: Briefly explain whether these costs could possibly be recognised as an asset.
Solution 6: Control
Even if this training can be linked to an expected increase in future economic benefits, the training
cost is unlikely to be recognised as an intangible asset as, despite permanent employment
contracts, it is difficult to prove that there is sufficient control over both the employees (who can
still resign) and the future economic benefits that they might generate. If we cannot prove control,
x the item is not an asset – and
x if the item is not an asset, it automatically cannot be an intangible asset either.
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Only those costs that were necessary are capitalised to Quick! Do this…Compare
an intangible asset. This also means that any income and x the list of examples of directly
expenses arising from incidental operations occurring attributable costs in IAS 38 with
before or during the development or acquisition of an x the list of examples of directly attributable
costs in IAS 16 (see chapter 7, section 3.3.3).
intangible asset may not be included in the cost of the
Try to explain why these differences exist
recognised asset (i.e. they must be recognised as
Ans: The directly attributable costs that apply to PPE include a few
income or expenses in profit or loss instead). See IAS 38.31 extra examples that cannot apply to IAs due to the nature of IAs (e.g.
it is impossible to install an IA and so the list of directly attributable
The necessary costs that may be capitalised are those costs given in IAS 38 does not include ‘installation costs’).
that bring the asset to a particular condition that enables it to be used as management intended. Thus,
capitalisation of costs ceases as soon as the asset has been brought to that condition. See IAS 38.30
x Advertising campaign: The extra advertising incurred in Costs incurred after the -
order to recover market share is an example of a cost that IA is available for use
was incurred after the rights were acquired. Furthermore, may not be capitalised
advertising costs are listed in IAS 38 as one of the costs
that may never be capitalised as an intangible asset.
IAS 38 also includes a list of examples that may never be capitalised to the cost of an intangible
asset. These include costs related to:
a) introducing a new product or service (including advertising or promotions);
b) conducting business in a new area or with a new class of customer (including staff training); and
c) administration and other general overheads. Reworded from IAS 38.29
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Intangible assets must meet the definition and recognition criteria if they are to be recognised. If
they are to be recognised, they must be initially measured at cost. Both the recognition of the
intangible asset and the initial measurement of its cost may be affected by the manner in which
the intangible asset was acquired or created. It could have been:
x acquired as a separate purchase (i.e. purchased as a separate asset); or
x acquired by way of an exchange of assets; or
x acquired as part of a business combination; or
x acquired by way of a government grant; or
x acquired by way of a service concession agreement (IFRIC 12); or
x internally generated.
For intangible assets acquired for cash, the measurement of cost is simple (i.e. the cash price). If
it was acquired in any other way (e.g. through an exchange of assets or by way of a government
grant) its cost is measured at its fair value. However, IAS 20 Government grants allows an
intangible asset that was received by way of a government grant to be measured at fair value or
the nominal amount paid for it (if any), or simply at a nominal amount used for purposes of
recording the acquisition of the asset, assuming nothing was paid for it (see chapter 15).
IFRS 13 Fair value measurement provides guidance on how fair value should be measured,
defining fair value as:
Method of acquisition and initial
x the price that would be received to sell an measurement
asset (or paid to transfer a liability)
x Initial measurement = cost
x in an orderly transaction x Cost is measured at FV, unless the asset was purchase
x between market participants as a separate asset (in which case, follow the norma
x at the measurement date. IFRS 13: Appendix A rules).
This definition refers to market participants, meaning ‘fair value’ is a market-based measurement.
See IAS 38.33
Although the definition of fair value requires that market participants exist, the initial measurement at fair
value on acquisition date does not require that an active market for the asset exists. Of course, an active
market would make it easier to determine the fair value, but where one does not exist, IFRS 13 allows
the fair value for purposes of initial measurement to be determined in terms of valuation techniques
instead. However, although the initial measurement at fair value does not require the existence of an
active market (i.e. valuation techniques can be used instead), the subsequent measurement at fair value
in terms of the revaluation model does require the fair value be determined in terms of an active market.
The revaluation model is explained in section 6.3.
3.4.3 Intangible assets acquired through a separate purchase (IAS 38.25 -26)
The recognition criteria are considered to be met automatically for the following reasons:
x Since the asset is purchased separately, it has a value that is reliably measured: its purchase price;
x The mere fact that the asset was purchased means the entity expects the inflow of future economic
benefits to be probable (i.e. in the case of a purchase, the probability criterion is also automatically met.
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If the asset was acquired separately (i.e. not as part of a ‘bundle of assets’) for cash, its ‘cost’ is relatively
easy to measure and follows the general rules (see section 3.3):
x its purchase price, calculated after:
- deducting: discounts, rebates, refundable taxes and interest included due to the
payment being deferred beyond normal credit terms;
- adding: import duties and non-refundable taxes
x directly attributable costs.
x If payment is deferred such that there is a difference between the ‘cash cost’ and total
payments made, the difference between these two amounts is recognised as a finance
cost/interest expense in profit or loss. See IAS 38.27 & .32
3.4.4 Intangible assets acquired through an exchange of assets (IAS 38.45 - 47)
3.4.4.1 Recognition
In order to recognise an asset that was acquired via an asset exchange, it must meet both the definition
and recognition criteria. However, the asset acquired will only be recognised and the asset given up
will only be derecognised if the transaction has commercial substance. A transaction is said to have
commercial substance if its future cash flows are expected to change as a result of the transaction.
For examples on the exchange of assets, see the chapter on property, plant and equipment.
3.4.5.1 Recognition
On occasion, the government may grant an entity an intangible asset, such as a fishing licence. This
asset may be granted either at no charge or at a nominal amount.
If acquired through a
The recognition of an intangible asset that is acquired by way of a government grant:
government grant simply follows the general principles: meet the x Recognition: if it meets the
definition of an intangible asset and the recognition criteria. definition & recognition criteria
(i.e. we follow the normal rules)
3.4.5.2 Initial measurement x Measurement: cost
This cost is measured at:
The initial measurement of intangible assets acquired by way of - FV of asset acquired; or
- Nominal amount plus directly
government grants is ‘cost’. We may choose to measure cost either: attributable costs
x at the fair value of the asset acquired, or
x at the nominal amount plus any directly attributable costs (i.e. those necessarily incurred in
order to prepare the asset for its intended use).
Please note that if an intangible asset acquired by way of government grant is measured at ‘fair
value’, then any further directly attributable costs that are incurred must be expensed through
profit or loss since the asset would otherwise be overstated.
For further detail on intangible assets acquired by way of government grants, please see chapter 15.
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The acquirer (A) must recognise each intangible asset acquired on condition that it meets the
intangible asset definition. The recognition criteria are automatically assumed to be met.
The recognition criteria are always assumed to be met in a business combination because:
x The ‘reliable measurement’ criterion will be met. This is because, to meet the intangible asset
definition, the asset acquired in a business combination would have had to be identifiable (i.e. it
either is separable or arises from contractual/ legal rights): therefore the standard explains that,
because an asset acquired in a business combination is identifiable (either due to it being separable
or arising from contractual/legal rights) sufficient information will exist to reliably measure its fair value.
x The ‘probability’ criterion will be met. We assume this because the cost of an intangible asset acquired
in a business combination equals its fair value, and, as the standard explains, the fair value of an
intangible asset acquired in a business combination will automatically reflect the market participants’
expectations, at acquisition-date, of the probability of the inflow of future economic benefits. Thus, the
mere existence of the reliably measurable fair value is proof enough that the inflow of future economic
benefits is probable even if there is uncertainty over the timing and amount of the inflow. See IAS 38.33
Interestingly, this means that any intangible assets that the acquiree (B) was unable to recognise
because the recognition criteria were not met, will now be recognised by the acquirer (A) in a
business combination. For example,
x Internally generated goodwill is prohibited from being capitalised by the entity that created it. This is
because the costs of generating goodwill are inextricably mixed up with the costs incurred in running a
business i.e. there is no reliable way of separating the portion of the costs that relate to the creation of
goodwill from the general running costs. (e.g. how much of a teller’s salary relates to (a) just performing
a job, which must be expensed; and (b) a smiling face, which pleases our customers and generates
goodwill?). Since the cost of creating goodwill and the cost of running a business are so inextricably
linked, it means that internally generated goodwill is not reliably measurable.
x Purchased goodwill may, however, be capitalised. It arises when an entity purchases another
entity for a price that exceeds the fair value of its individual net assets. This excess is an asset
that is recognised in the acquirer’s books as ‘purchased goodwill’:
Purchased goodwill (A) = Purchase price – Fair value of the net assets acquired that are separately recognised.
(P.S. if the acquirer paid less than the fair value of these net assets, the acquirer recognises an income:
‘gain on a bargain purchase’)
In other words, the entity that created the goodwill will not recognise it as an asset in its own books
(because it is not reliably measurable), but if another entity buys it and pays a premium for it, this
premium (purchased goodwill) is recognised as an asset in the purchaser’s books. The logic is that,
by buying a business at a premium over the fair value of its net assets, it means that a reliable
measure of its value has finally been established.
Important comparison!
If an intangible asset does not meet the definition in full (e.g. it is
not identifiable), then its value is excluded from the ‘net asset value Goodwill that is:
of the entity’. The value of this unrecognised intangible asset will x internally generated: expensed
thus be included and recognised as part of the purchased goodwill. x purchased: capitalised
Another issue: For an asset to meet the intangible asset definition it must be identifiable. One way
to prove identifiability is to be ‘separable’. However, an intangible asset acquired in a business
combination is sometimes only separable from the rest of the entity that is being acquired if it is
grouped with certain other assets (e.g. a ‘’trademark’ for a chocolate may be useless without the
related ‘recipe’). In such cases, the group of related intangible assets (trademark and recipe) is
recognised as a single asset, provided that the individual assets have similar useful lives.
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3.4.7 Intangible items that are internally generated (IAS 38.48 - 67)
3.4.7.1 Overview
We may expend resources on the creation of intangible items that we hope will generate future
economic benefits. However, not all costs incurred in creating an intangible item may be recognised
as an intangible asset.
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The intangible items may be very specific items (e.g. patents and trademarks) or could be a bit
‘more vague’ but which, nevertheless, promote the creation of a successful business (e.g.
customer loyalty and efficient staff). Intangible items that promote the creation of a successful
business are contributing to ‘goodwill’. Since the entity is creating goodwill (as opposed to
purchasing another entity’s goodwill) it is referred to as ‘internally generated goodwill’.
Internally generated goodwill does not meet the intangible asset definition or recognition criteria
and so it is always expensed. Other intangible items may meet the intangible asset definition
and recognition criteria, in which case they must be recognised as intangible assets but
sometimes they won’t, in which case they are expensed.
These costs are very difficult to identify and measure separately from the general costs of simply
running the business (as opposed to running a successful business). Although internally
generated goodwill is expected to produce future economic benefits, it may not be capitalised.
This is because it does not completely meet certain aspects of the definition and recognition
criteria per IAS 38:
x it is not an identifiable resource (i.e. it is not separable from the costs of running a business
and it does not arise from any contractual or legal right);
x it may not be possible to control items such as customer loyalty; and more importantly
x it is not possible to reliably measure its value. See IAS 38.49
Important comparison!
As mentioned in the prior section (section 3.4.6),
Goodwill that is:
internally generated goodwill is always expensed by the
entity that creates it, but if this goodwill is then purchased x internally generated: expensed
by another entity in a business combination, it becomes x purchased: capitalised
purchased goodwill, which is capitalised by the purchaser.
This is because internally generated goodwill is not reliably measurable while it is being created
whereas purchased goodwill is reliably measurable, using the following equation:
Purchase price of entity – Fair value of the entity’s recognised net assets.
Some argue that the entity that creates the internally generated goodwill should be allowed to
recognise it by measuring it using an adaptation of the above equation by simply replacing ‘purchase
price’ with the ‘fair value’ of the entity. Problems with this idea include:
x the fair value of the entity would reflect a wide range of factors (including, for instance, the economic
state of the country), not all of which relate to the customer loyalty or other items forming part of
internally generated goodwill and thus would not be a good indicator of cost; and
x there is no control over these factors (e.g. we may be able to influence but we are unable to control the
economic state of the country or customer loyalty) and thus the asset definition would not be met.
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3.4.7.3 Internally generated intangible items other than goodwill (IAS 38.51 - 67)
An entity may have an intangible item that has been internally generated. As always, before an
item may be recognised as an intangible asset, it must meet both the definition of an intangible
asset and the recognition criteria.
IAS 38 bans certain internally generated items from being capitalised (see section 3.4.7.3.2).
If the internally generated item is not banned and it does not relate to internally generated
goodwill, we must consider whether we can capitalise the costs by first assessing at what stage
of the process of internal generation the cost was incurred (see section 3.4.7.3.3).
The reason why the internal generation of these items results in them being expensed is
because the nature of the costs incurred in the process of creating them is very similar to the
nature of the costs incurred in operating a business. In other words, they are not separately
identifiable from the costs of developing the business as a whole. This means it is impossible to
separate the one from the other and reliably measure the costs to be capitalised. See IAS 38.64
There are two distinct stages (phases) that occur during the process of creating an intangible
asset, each of which will be discussed separately: Internal generation is
x research See IAS 38.54 - 56 split between 2 phases:
x development. See IAS 38.57 - 62 - research phase;
- development phase.
The research phase is the gathering of knowledge and
understanding. This is then applied to the development phase which is when the entity uses
this knowledge and understanding to create a plan or design.
It is only once the research stage is completed, that the development stage may begin. Once
development is complete, the completed plan or design is available for use or production.
The ability to prove that the future economic benefits are probable (i.e. being one of the two
recognition criteria) differs depending on what phase the item is in (research or development).
In order to assess whether the costs incurred in the internal generation of an intangible asset
meet the criteria to be recognised as an asset or whether they must be expensed, we must
separate the costs into those that were incurred during each of these two phases.
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3.4.7.3.5 Recognition and measurement of costs in the development phase (IAS 38.57 - 71)
Before development costs may be recognised as an intangible asset, we must be able to prove
that six recognition criteria are met (i.e. the first 5 help us prove that the future economic benefits
are probable and the 6th criteria requires that the cost is reliably measurable).
If any one of these six criteria is not met, then the related costs must be expensed.
However, if all six criteria are met it is said that the recognition criteria are met. Then, assuming
the definition of an intangible asset was also met, the item must be capitalised.
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Once an internally generated item meets the definition and recognition criteria (as discussed
above), the next step is to decide which of the related costs may be capitalised.
Only costs that are
Costs that may be capitalised are only those that are: ‘directly attributable’ may be
x directly attributable capitalised. See IAS 38.66
x to creating, producing and preparing the asset
x to be able to operate in the manner intended by management. Reworded from IAS 38.66
Costs that were expensed in a prior financial period Development costs that are
because not all 6 recognition criteria were met when expensed:
they were incurred, may never be subsequently x because the RC are not met, may not be
capitalised, even if all 6 criteria are subsequently met. subsequently capitalised when the RC are met,
See IAS 38.71
x due to an impairment, may be subsequently
When development is complete and the development capitalised if and when the reason for the
asset is available for use, capitalisation of costs to impairment disappears! See IAS 38.71 & IAS 36.114
this asset must stop. At this point, the inflow of
economic benefits from the use of the developed asset can begin and thus amortisation begins.
Amortisation is explained in section 5.2.
The development asset must be tested for impairments both during its development and after
its completion. Impairment losses are expensed. If, later, the reason for the original impairment
disappears, the impairment expense may be reversed and capitalised to the asset (debit asset
and credit impairment loss reversed). However, this does not apply to an impairment of goodwill:
these may never be reversed. Impairment testing is explained in section 5.3.
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Additional information:
x The costs listed above were incurred evenly throughout each year.
x Included in the costs incurred in 20X1 are administrative costs of C60 000 that are not
considered to be directly attributed to the research and development process. The first two
months of the year were dedicated to research. Development began from 1 March 20X1 but all
6 recognition criteria for capitalisation of development costs were only met on 1 April 20X1.
x Included in the costs incurred in 20X2 are administrative costs of C20 000 that are considered
to be directly attributed to the research and development process.
x Included in the costs incurred in 20X3 are training costs of C30 000 that are considered to be
directly attributed to the research and development process: in preparation for the completion
of the development process, certain employees were trained on how to operate the asset.
Required: Show all journals related to the costs incurred for each of the years ended 31 December.
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The cost of the asset is measured at the fair value on acquisition date. This is the fair value of both the
research and development. So, when we buy somebody else’s research and development we end up
capitalising not only the cost of development but also the cost of research (whereas research costs are
normally expensed). IAS 38.33 - .34
However, subsequent costs on this purchased ‘in-process research and development’ project
will be analysed and recognised in the normal way:
x costs that relate to research must be expensed;
x costs that relate to development:
- must be expensed if all recognition criteria are not met; and
- must be capitalised if all recognition criteria are met. See IAS 38.43
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Irrespective of these 5 stages, if a company’s web site is mainly Accounting for web
involved in advertising, then all the web site costs should be expensed site costs:
as advertising (since it is impossible to reliably measure the specific x Stage 1 (Planning):
future economic benefits that would flow from this advertising). On - research expense
the other hand, if the web site is able to take orders, then it may be
x Stage 2 – 4 (Development):
possible to identify and measure the future economic benefits
- development asset; or
expected from the web site. If the web site is expected to result in an
- development expense
inflow of future economic benefits, we will need to analyse the costs
into the various stages and account for them as follows: x Stage 5 (Operating):
- operating expense (unless it
x Stage 1 costs (planning): are always expensed as research. is a subsequent expense to
x Stage 2–4 costs (developing): are recognised either as a development be capitalised)
asset or development expense:
- development asset if all six recognition criteria are met, or
- development expense if the six recognition criteria are not all met.
x Stage 5 costs (operating): are expensed unless they meet the requirements for capitalisation as
subsequent costs.
The development stages involve many different tasks, some of which may or may not meet the 6
recognition criteria. For example, content development (stage 4) could involve:
x photographing products available for sale, the cost of which would be considered to be a cost
of advertising and would therefore be expensed; or
x the acquisition of a licence to reproduce certain copyrighted information, the cost of which
would probably be capitalised (assuming the six recognition criteria are met).
An entity may incur web site costs relating to the creation of content other than for advertising and
promotional purposes. When this is a directly attributable cost that results in a separately
identifiable asset (e.g. a licence or copyright), this asset should be included within the ‘web site
development asset’ and should not be recognised as a separate asset. See SIC 32.8 - .9
The web site asset must be amortised, because its useful life is considered to be finite. The useful
life selected should be short. See SIC 32.10
3.4.8 Intangible assets acquired through a service concession agreement (IFRIC 12)
A service concession agreement (SCA) is an agreement between a public-sector entity (grantor) and an
operating entity (entity) under which the entity undertakes to provide services to the public and in return,
will receive payments (consideration) from the grantor. The entity would be required to either use existing
infrastructure owned by the grantor, or construct or otherwise acquire the necessary infrastructure.
IFRIC 12 clarifies many aspects regarding how to account for an SCA, but this section focuses on how an
SCA might result in the recognition of intangible asset.
IFRIC 12 applies if we enter into such an agreement and if the terms mean that the grantor:
x controls/ regulates what services we provide, who we provide them to and the price we charge; and
x will have a significant residual interest in the infrastructure that we use to provide the services.
See IFRIC 12.7
In terms of IFRIC 12, the consideration an entity is entitled to receive in return for providing services to the
public is accounted for as revenue (IFRS 15). Thus, the agreement itself represents a right to receive
revenue, and a right to receive future revenue (economic benefits) represents an asset. If the agreement
requires the entity to construct or upgrade the infrastructure, this asset may not necessarily be a financial
asset, but may need to be recognised as an intangible asset, or a combination, instead. If the agreement:
x gives us an unconditional contractual right to receive cash or another financial asset from the grantor/
upon the insistence of the grantor, then we recognise a financial asset (e.g. the contract has committed
someone to paying us a certain sum each year of the agreement in return for us providing the service);
x gives us a right to charge users directly (even if the amount we charge is controlled by the grantor), then
we only have a conditional right (because receiving any revenue would be conditional upon users using
the public services we provide) and thus it does not meet the definition of a financial asset (it is not a
contractual right to receive cash or other financial assets) and thus we recognise it as an intangible asset.
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IFRIC 12 explains that, if such an agreement results in us acquiring an intangible asset, it must be
measured in terms of IFRS 15 Revenue from contracts with customers. Thus, it must be measured
at its fair value (e.g. an entity is given a licence to operate a state hospital, and measures it at
C1 million since this is the market price for similar licences). If the entity is not able to reasonably
estimate the fair value of the intangible asset, it must be measured at the stand-alone selling price
of the services rendered (i.e. the public services we provide in terms of the agreement).
The same criteria that we applied when deciding whether to recognise the initial expenditure as an asset
or expense, is also applied when accounting for this subsequent expenditure. In other words, subsequent
costs are capitalised to the carrying amount of the asset if:
x The definition of an intangible asset is met; and
x The recognition criteria are met (i.e. the recognition criteria provided in IAS 38: probable inflow
of economic benefits and the cost is reliably measurable).
Where an internally generated intangible item was not allowed to be recognised as an intangible
asset (e.g. an internally generated brand), then any related subsequent expenditure is also not
allowed to be capitalised. See IAS 38.20
5.1 Overview
Whether it has a finite or indefinite life is important because it affects both We refer to indefinite
the amortisation and impairment testing of that asset: useful lives.
x If it has a finite useful life, it will be amortised and tested for Indefinite ≠ Infinite
impairment in much the same way that property, plant and equipment is depreciated and tested
for impairment;
x If it has an indefinite useful life, it is not amortised but has more stringent impairment tests than
the impairment tests that apply to assets with finite lives. See IAS 38.108 & IAS 36.10
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Please note that indefinite does not mean infinite. If an asset has an indefinite useful life, it means
‘there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows
for the entity’. In other words, an indefinite useful life means we do not know when its useful life will
end. Infinite would mean there is no limit at all to the asset’s useful life! See IAS 38.91
There are many factors to consider when assessing the useful life of the asset and whether
the useful life is finite or indefinite. Examples of some of these factors include:
x possible obsolescence expected as a result of technological changes;
x the stability of the industry in which the asset operates;
x the stability of the market demand for the asset’s output;
x expected actions by competitors;
x the level of maintenance required to obtain the expected future economic benefits and
management’s intent and ability to provide such maintenance. See IAS 38.90
An asset reflects expected future economic benefits. As this asset gets used, these future economic
benefits get used up (what was a future benefit becomes realised). This gradual reduction in the
asset’s remaining future economic benefits is reflected through the process of amortisation. General
principles regarding amortisation can be summarised as follows:
x Amortisation is expensed unless the intangible asset is being used to create yet another
asset, in which case it is capitalised to this other asset.
x Only intangible assets with finite lives are amortised. Amortisation:
x There are three variables that must be estimated Reflects: the usage of the IA
when calculating the amortisation: Recognise: normally as an exp.
- residual value; Only applies to IAs that are:
- period of amortisation; and x available for use & with a finite life
Does not apply to IAs:
- method of amortisation. x available for use but with indefinite life
x Amortisation of an intangible asset does not cease x not yet available for use
IAS 38.97 & IAS 38.107
when it is not being used – unless, of course, it has either x goodwill.
been fully amortised or been reclassified as ‘held for sale’ (i.e. and accounted for under IFRS 5 Non-
current assets held for sale and discontinued operations). See IAS 38.117
5.2.2 Residual value and the depreciable amount (IAS 38.100 - 103)
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In the case of intangible assets, the residual value should always be zero unless:
x a third party has committed to purchasing the asset at the end of its useful life; or
x there is an active market (as defined in IFRS 13) for that asset and
- it is possible to measure the residual value using such market and
- it is probable that the market will still exist at the end of the asset’s useful life. IAS 38.100
The residual value must be assessed at every reporting date (e.g. year-end). Any change in
the residual value is accounted for as a change in accounting estimate (per IAS 8). See IAS 38.102
5.2.3 Period of amortisation (IAS 38.88, .94 - 99 and .104) Amortisation period:
Starts:
Amortisation of an intangible asset begins on the date x When available for use
on which it becomes available for use (i.e. which is not Ceases: When the asset is:
x derecognised; or
necessarily when we actually start to use it). See IAS 38.97 x reclassified as a NCA held for sale.
Useful life:
Amortisation must cease at the earlier of the date of: x Measured in time or in units
x derecognition of the asset; and x Shorter of:
x reclassification of the asset as a ‘non-current asset - useful life, or
- legal life (include renewal periods if
held for sale’. See IAS 38.97 evidence suggests renewal will occur at
insignificant cost).
The amortisation period should be the shorter of: Should be reassessed at least:
x the asset’s expected economic useful life; and x at the end of every financial year.
x If indefinite life changes to a finite life:
x its legal life. See IAS 38.94 - process amortisation (as a change in
estimate) and
If an asset has a limited legal life (i.e. its future economic - check for impairments.
benefits are controlled via legal rights for a finite period),
its amortisation period must be limited to the period of the legal rights. If the legal rights are
renewable, we should include the renewal periods if:
x there is evidence to suggest that the rights will be renewed; and
x the cost of renewal is not significant. See IAS 38.94
The period of amortisation must be reassessed at every reporting date (e.g. year-end). Any change
in the period is accounted for as a change in accounting estimate. See IAS 38.104
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The method used should be a systematic one that reflects the pattern in which the entity
expects to use up the asset’s economic benefits. Various methods are possible, including:
x straight-line
x diminishing balance
x units of production method. See IAS 38.97 - .98
If the pattern in which the asset is expected to be used cannot be reliably estimated, then the
straight-line method must be used. See IAS 38.97
The amortisation method chosen should result in amortisation that reflects the pattern in which
we expect to consume (use up) the economic benefits that are contained in the intangible asset
(i.e. it should reflect the pattern by which we expect the asset will be used up). In other words,
the amortisation expense should reflect how much of these economic benefits have been used
and the asset’s remaining carrying amount should reflect how much of the economic benefits
are still waiting to be consumed. See IAS 38.97
Notice that the method used is closely aligned to its useful life.
IAS 38 clarifies that a method of amortisation that allocates the cost of the asset on the basis
of revenue (whether in terms of currency or units) would not normally be suitable. This is
because there is a concern that revenue generated from the asset would be affected by a host
of factors that have no bearing at all on how the asset is being used up (e.g. the number of
units actually sold could be affected by marketing drives or economic slumps and the unit price
could be affected by inflation or competitive pricing – or any combination thereof).
However, the presumption that revenue would be an inappropriate basis for the amortisation
method of an intangible asset is a rebuttable presumption. The fact that this presumption is
rebuttable, means that, under certain limited circumstances, we are able to argue that an
amortisation method based on revenue is, in fact, appropriate. This presumption may be
rebutted (i.e. we will be able to use revenue as the basis for the amortisation method), if:
x the intangible asset is expressed as a measure of revenue; or
x it can be shown that the ‘consumption of economic benefits’ is ‘highly correlated’ with ‘revenue’.
See IAS 38.98A and 13.98C
For example, an entity may own the right to use an asset where this right is limited based on a revenue
threshold. IAS 38 provides the example of a mining concession that expires as soon as a certain
amount of revenue has been generated (instead of expiring as soon as a certain number of tons of
raw material have been mined from the ground). In this case, the ‘predominant limiting factor’ in the
contract is clearly revenue (i.e. not units or time) and so on condition that the contract specifies the
total amount of revenue that may be generated under the mining concession, then an amortisation
method that is based on revenue would be considered appropriate. See IAS 38.98C
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5.2.5 Annual review (IAS 38.102 and .104 and IAS 36)
Assets that are available for use and have finite useful lives are amortised. The variables of
amortisation must be reassessed at the end of each financial period (i.e. the amortisation
period, amortisation method and residual value). See IAS 38.102 & .104
5.3 Impairment testing (IAS 36.9 - 12, .80 - 99 and IAS 38.111)
The impairment testing of intangible assets is very similar to the impairment testing of property, plant
and equipment. In a nutshell:
x Impairment testing involves first searching for evidence that an asset may possibly have been
damaged in some or other way (this is the impairment indicator review).
x Generally, this must be done at reporting date (however, see section 5.3.3 and 5.3.4 for exceptions).
x When we talk about damage, we are referring to any kind of damage that reduces the value of
the asset (e.g. an economic downturn may reduce demand for an asset’s output, in which case
the asset becomes less valuable to the entity, similarly, new legislation may affect the continued
use of the asset).
x Damage is different to usage. Both usage and damage reduce an asset’s carrying amount, but
usage is called ‘amortisation’ whereas damage is called an ‘impairment’.
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Impairment testing is thus essentially a check to ensure that the asset’s carrying amount is not
overvalued. However, if we think the carrying amount may be too high, it may simply be because we
have not processed enough amortisation. If we believe we have not processed enough amortisation,
extra amortisation is then processed (and accounted for as a change in estimate per IAS 8).
If we believe that the amortisation processed to date is a true reflection of past usage, but yet we are
worried that the carrying amount may be too high, and we believe this difference may be material, we
must then calculate the recoverable amount and compare it with the asset’s carrying amount. The
recoverable amount is the higher of:
x fair value less costs of disposal; and
x value in use.
Avoiding the recoverable amount calculation: Please note, however, that if the asset’s recoverable
amount was calculated in a prior year and found to be ‘significantly greater’ than the carrying amount
at that time, and if there have been no events since this calculation to suggest that this difference may
have been ‘eliminated’, then we do not need to recalculate the recoverable amount. The ability to use
a prior recoverable amount calculation
x does not apply to intangible assets that are not yet available for use (see section 5.3.4), and
x may not necessarily be allowed in the case of intangible assets with indefinite useful lives
(see section 5.3.3). See IAS 36.15 & .11 &.24
If the asset’s carrying amount exceeds its recoverable amount, the asset is said to be impaired: the
carrying amount must be reduced to reflect its recoverable
Impairment testing of an IA
amount and this adjustment is recognised as an impairment that has a finite useful life
loss expense in profit or loss. (general impairment testing)
x Perform an impairment indicator
Impairment testing of an intangible asset is affected by review at reporting date
whether the intangible item: x If there is a possible impairment that:
x is available for use and: - is material; and
- has a finite useful life - cannot be ‘fixed’ by processing
extra amortisation
- has an indefinite useful life;
we calculate the RA at reporting date
x is not yet available for use; or
x if the CA > RA = the IA is impaired
x is purchased goodwill. See IAS 36.10
Notice that, due to the levels of uncertainty involved, the impairment testing is more stringent in the
case of indefinite useful life assets, assets not yet available for use and purchased goodwill.
The impairment testing process for each of these categories of intangible assets is explained in the
following sections (although impairment testing of purchased goodwill is covered in section 10).
The impairment testing of an intangible asset with a finite useful life follows the same general
impairment testing process described above (i.e. it is the same as the impairment testing used for
property, plant and equipment). See IAS 36.9-10
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x if available, we may use a prior year’s detailed calculation of recoverable amount, but only
on condition that:
if this intangible asset is part of a cash-generating unit, then the carrying amount of
the assets and liabilities making up that unit have not changed significantly; and
the most recent detailed estimate of the recoverable amount was substantially greater
than the carrying amount at the time; and
events and circumstances after calculating this prior recoverable amount suggest that
there would only be a remote chance that the current recoverable amount would now
be less than the carrying amount. See IAS 36.10 & .24
Note 1. For purposes of these ‘annual tests’, IAS 36 clarifies that different intangible assets
may be tested for impairment at different times. See IAS 36.10
Remember: intangible assets with ‘indefinite useful lives’ must have their useful lives reassessed
annually to confirm that it is still an appropriate assessment. If circumstances have changed and
the useful life is now thought to be ‘finite’, it may indicate a possible impairment. See IAS 38.110
5.3.4 Impairment testing of intangible assets not yet available for use
The impairment testing of an intangible asset that is not yet Impairment of IAs that are
available for use is the same as the impairment testing that not yet available for use:
applies to intangible assets that have indefinite useful lives
(see section 5.3.3), with the one exception: we may never x Calculate RA annually, at any time, but
the same time every year
use a prior year’s calculation of recoverable amount. This x This annual calculation may not be
is due to the extreme uncertainty involved in assessing the avoided See IAS 36.10-11
recoverability of the carrying amount of intangible assets
that are not yet available for use (i.e. the recoverable amount must be calculated every year, even if
there is no indication of impairment). The capitalisation of costs incurred while developing a prototype
is an example of an intangible asset that is not yet available for use.
Example 12: Impairments and reversals of an asset not yet available for use
Busy Limited has a 31 December financial year-end. In 20X7, Busy began a project involving
development of a new recipe, incurring the following costs evenly over each year:
20X7: C120 000
20X8: C100 000
20X9: C100 000
Development began on 1 September 20X7, on which date all the recognition criteria for
capitalisation of development costs were met.
Since the development asset is an intangible asset not yet available for use, Busy must calculate
its recoverable amount every year (at any chosen time but the same time every year). Busy
decides to calculate this recoverable amount at reporting date (i.e. at 31 December).
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Solution 12: Impairments and reversals of an asset not yet available for use
6.1 Overview
There are two alternative measurement models that may be used in the subsequent
measurement of intangible assets:
x the cost model; and
x the revaluation model.
These are the same two measurement models that are allowed to be used in the subsequent
measurement of property, plant and equipment (IAS 16). Please see chapter 7 and 8 for
examples on how these models are applied.
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Please note that although most intangible assets do not have active markets, some intangible
assets could have active markets. Fishing licences or production quotas are examples of
intangible assets for which active markets may exist.
If the revaluation model is used, revaluations must be performed with sufficient regularity that
the intangible asset’s carrying amount does not differ significantly from its fair value. The
frequency of the revaluations depends on the:
x volatility of the market prices of the asset; and
x the materiality of the expected difference between the carrying amount and fair value.
A downside to adopting the revaluation model for an asset is that all assets in that same class
must be revalued at the same time. This makes it an expensive alternative to the cost model.
If, within a class of assets measured at fair value, there is an intangible asset for which the fair
value is not reliably measurable in terms of an active market, then that specific asset only must
be measured at cost less accumulated depreciation and impairment losses. See IAS 38.81
If the revaluation model is used but at a later stage the fair value is no longer able to be reliably
measured (i.e. there is no longer an active market), this asset should continue to be carried at the fair
value measured at the date of the last revaluation less any subsequent accumulated amortisation and
impairment losses. Thus, we simply leave the fair value at the last known fair value and continue
amortising and testing for impairment. See IAS 38.82
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If, at a later date, the fair value can once again be measured in terms of an active market, then
a revaluation is performed at that date: the carrying amount will once again reflect the latest fair
value less any subsequent accumulated amortisation and impairment losses. See IAS 38.84
Notice that, if we are simply not using an asset at the moment (i.e. it is currently idle), it would
not qualify for derecognition and we would thus continue amortising it.
To derecognise an asset means to remove its carrying amount from the accounting records.
The carrying amount is removed (credit cost and debit accumulated amortisation & impairment
losses) and expensed as part of profit or loss (debit the disposal account).
If, when disposing of the asset, the entity earned proceeds on its disposal, these proceeds
would be recognised as income in profit or loss (debit bank and credit disposal account). The
amount of these proceeds is measured in the same way that a transaction price is measured
in terms of IFRS 15 Revenue from contracts with customers. See IAS 38.116
The disposal account now shows the expensed carrying amount on the debit side and any proceeds
on the credit side. The carrying amount and proceeds are set off against each other to determine if a
gain or loss arose (e.g. if the proceeds exceed the carrying amount, we will have a credit balance,
which would reflect a gain on disposal: we would debit the disposal account to remove this credit
balance and we would credit ‘gain on disposal’). It is important to note that a gain on disposal is not
classified as revenue (i.e. it is simply classified as income). See IAS 38.113
If a part of an intangible asset is being disposed of and replaced, we derecognise the carrying amount
of that part and recognise the cost of the replacement part. However, if the carrying amount of the
replaced part cannot be determined, we can ‘use the cost of the replacement as an indication of what
the cost of the replaced part was’ when it was originally acquired or internally generated. See IAS 38.115
The date on which the disposal is recorded depends on how it is disposed of:
x If disposed of via a sale and leaseback agreement, we follow IFRS 16 Leases (chapter 16).
x If disposed of in any other way (e.g. by way of a sale), the asset is derecognised on the
date that the recipient obtains control of the item in terms of IFRS 15 Revenue from
contracts with customers (i.e. when the performance obligations are satisfied). See IAS 38.114
The carrying amount of an intangible asset is measured at cost or fair value less any subsequent
amortisation and impairments. Its tax base represents the future tax-deductions, if any. Any difference
between an intangible asset’s carrying and tax base will lead to:
x a taxable temporary difference (if the carrying amount exceeds the tax base) and the recognition
of a deferred tax liability, or
x a deductible temporary difference (if the tax base exceeds the carrying amount), in which case it
will lead to the recognition of a deferred tax asset (unless the deferred tax asset is not recoverable).
If an asset’s cost is not deductible when calculating taxable profits, then its tax base is nil and an exempt
temporary difference will arise (i.e. no deferred tax will be recognised on the temporary difference).
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9.1 General
Information should be provided for each class of intangible asset, distinguishing between
intangible assets that have been:
x internally generated; and those
x acquired in another manner. IAS 38.118 reworded slightly
x ‘Gross carrying amount’ and ‘accumulated amortisation and impairment losses’ at the
beginning and end of each period; IAS 38.118 (c)
x A reconciliation between the ‘net carrying amount’ at the beginning and end of the period
separately disclosing each of the following where applicable:
- additions (separately identifying those acquired through internal development, acquired
separately and acquired through a business combination);
- retirements and disposals;
- amortisation;
- impairment losses recognised in the statement of comprehensive income;
- impairment losses reversed through the statement of comprehensive income;
- increases in a related revaluation surplus;
- decreases in a related revaluation surplus;
- foreign exchange differences; and
- other movements. IAS 38.118 (e)
If the asset has a finite useful life, disclosure of the following is also required:
x line item in the statement of comprehensive income in which amortisation is included;
x methods of amortisation; and
x period of amortisation or the rate of amortisation. IAS 38.118 (a); (b) & (d)
If the asset has an indefinite useful life disclosure of the following is also required:
x significant supporting reasons for assessing the life as indefinite; and
x the carrying amount of the asset. IAS 38.122 (a)
The following information is required but need not be categorised into ‘internally generated’
and ‘acquired in another manner’:
x The existence and carrying amounts of intangible assets:
- where there are restrictions on title; or
- that have been pledged as security for a liability; IAS 38.122 (d)
x If an individual intangible asset is material to the entity’s financial statements, the nature,
carrying amount and the remaining amortisation period thereof must be disclosed. IAS 38.122 (b)
x Information relating to impaired intangible assets: should be disclosed in accordance with the
standard on impairment of assets. IAS 38.120
x Information relating to changes in estimates: should be disclosed in accordance with the
standard on accounting policies, estimates and errors. IAS 38.121
x Research and development costs expensed during the period must be disclosed in aggregate. IAS 38.126
x If there are contractual commitments for the acquisition of intangible assets, the amount
thereof must be disclosed. IAS 38.122 (e)
x Where the intangible asset was acquired by way of government grant and initially recorded at
fair value rather than at its nominal value, the following should be disclosed;
- its initial fair value,
- its carrying amount; and
- whether the cost or revaluation model is being used. IAS 38.122 (c)
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x Where intangible assets are carried under the revaluation model, the following should be
disclosed by class of asset (unless otherwise indicated):
- a reconciliation between the opening balance and closing balance of that portion of the
revaluation surplus relating to intangible assets, indicating the movement for the period
together with any restrictions on the distribution of the balance to the shareholders;
- the carrying amount of the intangible asset;
- the carrying amount that would have been recognised in the financial statements had the
cost model been applied; and
- the effective date of the revaluation. IAS 38.124
Since the following information is considered to be useful to the users, the disclosure thereof is
encouraged, but it is not required:
x A description of: fully amortised intangible assets that are still being used; and
x A description of: significant intangible assets that are controlled by the entity but which were
not allowed to be recognised as assets. IAS 38.128
Entity name
Statement of financial position
At 31 December 20X9 (extracts)
Note 20X9 20X8
ASSETS C C
Non-current assets
Property, plant and equipment xxx xxx
Intangible assets 4 xxx xxx
Entity name
Statement of changes in equity (extracts)
For the year ended 31 December 20X9
Revaluation Retained
surplus earnings Total
C C C
Balance at 1 January 20X8 xxx xxx xxx
Total comprehensive income (xxx) xxx xxx
Realised portion transferred to retained earnings (xxx) xxx 0
Balance at 31 December 20X8 xxx xxx xxx
Total comprehensive income xxx xxx xxx
Realised portion transferred to retained earnings (xxx) xxx 0
Balance at 31 December 20X9 xxx xxx xxx
Entity name
Statement of comprehensive income (extracts)
For the year ended 31 December 20X9
Notes 20X9 20X8
C C
Profit for the year xxx xxx
Other comprehensive income for the year: xxx (xxx)
x Items that may never be reclassified to profit/loss
Revaluation surplus/ (devaluation), net of tax – 24 xxx (xxx)
intangible assets
Total comprehensive income for the year xxx xxx
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Entity name
Notes to the financial statements
For the year ended 31 December 20X9 (extracts)
2. Significant accounting policies
2.3 Intangible assets
Amortisation is provided on all intangible assets over the expected economic useful life to an
expected residual values of zero, unless the intangible asset has no foreseeable limit to the
period over which future economic benefits will be generated.
The following rates and methods have been used:
x Patent (purchased): 20% per annum, straight-line method
x Development (internally generated): 10% per annum, straight-line method
x Casino licence (purchased): indefinite
The casino licence is considered to have an indefinite life since the period of the licence is not
limited in any way other than the meeting of certain prescribed targets. These targets have been
adequately met in the past and are expected to continue to be met in the future.
The casino licence is revalued annually to fair value and is carried at fair value less accumulated
impairment losses. All other intangible assets are carried at historic cost less accumulated
depreciation and impairment losses.
At the end of each reporting period the company reviews the carrying amount of the intangible assets to
determine whether there is any indication of an impairment loss. If such an indication exists, the
recoverable amount of the assets is estimated in order to measure the extent of the impairment loss.
4. Intangible assets Patent Development Licence
20X9 20X8 20X9 20X8 20X9 20X8
C C C C C C
Patent xxx xxx xxx xxx xxx xxx
Development xxx xxx xxx xxx xxx xxx
Casino licence xxx xxx xxx xxx xxx xxx
xxx xxx xxx xxx xxx xxx
Net carrying amount - opening balance xxx xxx xxx xxx xxx xx
Gross carrying amount xxx xxx xxx xxx xxx xxx
Accum amortisation & impairment losses (xxx) (xxx) (xxx) (xxx) (xxx) (xxx)
Additions
- through separate acquisition xxx xxx xxx xxx xxx xxx
- through internal development xxx xxx xxx xxx xxx xxx
- through business combination xxx xxx xxx xxx xxx xxx
Less retirements and disposals (xxx) (xxx) (xxx) (xxx) (xxx) (xxx)
Add reversal of previous impairment loss/ xxx (xxx) xxx (xxx) xxx (xxx)
Less impairment loss through profit or loss
Revaluation increase/ (decrease):
- through OCI xxx (xxx) xxx (xxx) xxx (xxx)
- through P/L xxx (xxx) xxx (xxx) xxx (xxx)
Less amortisation for the period (xxx) (xxx) (xxx) (xxx) (xxx) (xxx)
Other movements (xxx) xxx (xxx) xxx (xxx) xxx
Net carrying amount - closing balance xxx xxx xxx xxx xxx xxx
Gross carrying amount xxx xxx xxx xxx xxx xxx
Accum amortisation & impairment losses (xxx) (xxx) (xxx) (xxx) (xxx) (xxx)
x The patent has been offered as security for the loan liability (see note …).
x The amortisation of the development asset is included in cost of sales.
x The development asset is material to the entity. The following information is relevant:
Nature: Design, construction and testing of a new product
Remaining amortisation period: 7 years
x The amortisation of the casino licence is included in cost of sales.
x The licence is measured using the revaluation model: the last revaluation was performed on 1/1/20X9 by
an independent appraiser to the fair value measured in accordance with an active market.
The revaluation was recorded on a net replacement value basis.
Revaluations are performed annually. 20X9 20X8
Carrying amount had the cost model been used instead: xxx xxx
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Entity name
Notes to the financial statements continued …
For the year ended 31 December 20X9 (extracts)
24. Other comprehensive income: revaluation surplus: intangible assets 20X9 20X8
C C
Increase/ (decrease) in revaluation surplus on intangible assets xxx (xxx)
Deferred tax on increase in revaluation surplus (xxx) xxx
Increase/ (decrease) in revaluation surplus, net of tax xxx (xxx)
10.1 Overview
Goodwill is described as the synergy between the identifiable assets or individual assets that
could not be recognised as assets. There are two distinct types of goodwill:
x purchased goodwill (covered by IFRS 3); and
x internally generated goodwill (covered by IAS 38).
Internally generated
10.2 Internally generated goodwill (IAS 38.48 - 50) goodwill:
x Always expensed
Internally generated goodwill is never capitalised since:
x it is not identifiable (i.e. is neither separable from the business nor does it arise from
contractual rights);
x it cannot be reliably measured; and
x it is not controllable (e.g. can’t control customer loyalty). See IAS 38.49
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When the value of the assets acquired exceeds the amount paid
for these assets, we have what is referred to as a gain on a Negative goodwill:
bargain purchase, also called purchased negative goodwill.
x Recognise as: income
A bargain purchase gain is immediately recognised as income and presented in profit or loss.
Negative goodwill sounds like a ‘bad thing’ and yet it is treated as income. It will make more sense
if you consider some of the situations in which negative goodwill arises (the first two situations are
‘win situations’ for the purchaser and should help to understand why it is considered to be income):
x the seller made a mistake and set the price too low, or
x the selling price is a bargain price, or
x the entity that was purchased was sold at a low price since it is expected to make losses in the future.
In the third situation above, the negative goodwill is recognised as income in anticipation of the future
losses (i.e. over a period of time, the negative goodwill income will be eroded by the future losses).
Comment: Negative goodwill is a gain made on the purchase and is thus recognised as income immediately.
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When the fair value of certain assets or liabilities acquired in a business combination can only
be provisionally estimated at the date of acquisition, these assets and liabilities must be
measured at their provisional fair values and the goodwill accounted for as the difference
between the purchase price and these provisional fair values.
The provisional fair values must, however, be finalised within twelve months from acquisition date.
When the ‘provisional’ values are finalised, the comparatives must be retrospectively restated from the
acquisition date, as if the asset value was known with certainty at the purchase date.
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x Plant is depreciated during 20X9. Thus, the following journal would be processed:
31 December 20X9 Debit Credit
Depreciation: plant (E) 42 000 / 10 years x 12/12; or 4 200
Plant: acc. depreciation (-A) (42 000 – 350) / (120 – 1) x 12 months 4 200
Depreciation of plant (acquired through acquisition of Nurse Limited)
x The 20X9 financial statements would therefore reflect the following balances/ totals:
Goodwill Assuming no impairment necessary 38 000
Plant O/bal: 41 650 – Depr: 4 200 37 450
Depreciation 4 200
Except for the possible need to re-measure fair values on the date of acquisition (see above),
the only other subsequent adjustments to the fair values of any assets, liabilities and goodwill
acquired in a business combination, would be in connection with the correction of errors.
Any correction of errors would need to be adjusted for retrospectively and disclosed in
accordance with the standard on accounting policies, estimates and errors (IAS 8).
The entity may be able to use a recent detailed calculation of the recoverable amount of a cash-
generating unit to which goodwill has been allocated, instead of having to measure the
recoverable amount again, assuming that certain specified criteria are met. These specific
criteria are covered in more depth in the chapter on impairment of assets. See IAS 36.99
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Entity name
Statement of financial position
At 31 December 20X9 (extracts)
Note 20X9 20X8
ASSETS C C
Non-current Assets
Property, plant and equipment xxx xxx
Goodwill 7 xxx xxx
Intangible assets 8 xxx xxx
Entity name
Notes to the financial statements
For the year ended 31 December 20X9 (extracts)
2.5 Goodwill
Goodwill arising from the acquisition of a subsidiary represents the excess of the cost of the
acquisition over the group’s interest in the net fair value of the assets, liabilities and contingent
liabilities of the acquiree. Goodwill is measured at the cost less accumulated impairment losses.
20X9 20X8
7. Goodwill C C
Additions
- through business combination xxx xxx
Profit before tax is stated after taking the following disclosable (income)/ expenses into account:
x Gain on a bargain purchase (xxx) (xxx)
x Impairment loss on goodwill xxx xxx
A South African accounting interpretation (FRG 2) was released in order to clarify how to
account for such BEE transactions. The interpretation concluded that the difference between
the following must be expensed, and not capitalised as an intangible asset:
x the fair value of the equity instruments granted (e.g. ordinary shares); and the
x the fair value of the identifiable consideration received (cash and non-cash assets).
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The reason that they decided that it should be expensed is because the entity cannot fully
control the future economic benefits of the BEE equity credentials. Competitors could also
obtain BEE credentials over which the entity would not have control, and which could impact
the entity’s possible future economic benefits from their own BEE credentials.
That being said, the cost of acquiring BEE equity credentials may be indirectly recognised as
an intangible asset in the following two situations:
x if the cost of acquiring the BEE credentials is directly attributable to the acquisition of another
intangible asset, the cost of these BEE credentials may be capitalised to the cost of that other
intangible asset; and
x if the BEE credentials were obtained as part of the net assets acquired in a business
combination, the cost thereof would form part of goodwill (an asset).
Solution 16B: BEE Equity Credentials – cash and an intangible asset received
Debit Credit
Bank (A) Given 5 000
Patent: cost (A) Balancing 4 000
Stated capital (equity) Fair value: C3 x 3 000 9 000
BEE transaction with Mr Oke to acquire BEE credentials & a patent.
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12. Summary
Intangible assets
Definitions
Intangible asset definition (per IAS 38) Asset definition (per IAS 38)
(not the same asset definition in CF)
x identifiable x resource
x non-monetary x controlled* by the entity
x asset x from past events
x without physical substance x from which we expect an inflow of future
economic benefits
Recognition criteria
(per IAS 38)
(these are not the recognition criteria per 2018 CF)
x Cost of the asset must be reliably measured
x Inflow of future economic benefits must be probable
Initial measurement
x Initially measure at cost
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Amortisation
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Goodwill
Measurement Disclosure
Positive = Asset Positive = Asset
Initial amount (cost): x reconciliation of opening and closing balances
x Amount paid (same as for PPE)
x less value of net assets acquired
Subsequent amount:
x Cost
x Less accumulated impairment losses
Negative = Income
Negative = Income x amount recognised as income
x Amount paid
x Less value of net assets acquired
Abbreviations:
A/L = Asset or liability
FV = fair value
C and CE = cash and cash equivalents
CA = carrying amount
IA = intangible asset
RV = residual value
RA = recoverable amount
AM = active market
PPE = property, plant and equipment
RC = recognition criteria
RD = reporting date
NCA = non-current asset
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Chapter 10
Investment Properties
Reference: IAS 40, IAS 12, IFRS 13, IFRS 15 and IFRS 16 (including any amendments to 10 December 2019)
Contents: Page
1. Introduction 512
4. Measurement 518
4.1 Overview 518
4.2 Initial measurement: cost 518
4.2.1 Overview 518
4.2.2 Initial cost of owned investment property 518
4.2.2.1 Owned property that was not acquired in an asset exchange 518
4.2.2.2 Owned property that was acquired in an asset exchange 519
4.2.3 Initial cost of investment property held as a right-of-use asset 519
4.2.4 Subsequent costs 520
Example 4: Subsequent expenditure 520
4.3 Subsequent measurement: the cost model 521
4.3.1 Overview 521
4.3.2 Property that is owned 521
4.3.3 Property that is owned, but is to be reclassified as held for sale 521
4.3.4 Property held under a lease 521
4.4 Subsequent measurement: the fair value model 522
4.4.1 Overview 522
4.4.2 Property that is owned 522
4.4.3 Property that is owned, but meets the criteria as held for sale 522
4.4.4 Property that is held under a lease 522
4.4.5 Fair value model: What is a fair value? 523
4.4.6 Fair value model used, but unable to measure fair value 523
4.4.6.1 Overview 523
4.4.6.2 Investment property that is not under construction 524
4.4.6.3 Investment property under construction 524
Example 5: Fair value cannot be reliably measured 525
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5. Transfers 526
5.1 Change in use 526
Example 6: Transfers in and out of investment property 527
5.2 Measurement of transfers due to a change in use – an overview 527
5.3 Measurement of the transfer: investment property under the cost model 528
5.4 Measurement of the transfer: investment property under the fair value model 528
5.4.1 Change from owner-occupied property to investment property (FVM) 528
Example 7: Change from owner-occupied to investment property 529
5.4.2 Change from inventories to investment property 530
Example 8: Change from inventory to investment property 530
5.4.3 Change from investment property to owner-occupied property or inventories 531
Example 9: Change from investment property to owner-occupied property 531
6. Derecognition 532
Example 10: Disposal 533
9. Disclosure 541
9.1 General disclosure requirements 541
9.1.1 An accounting policy note for investment properties 541
9.1.2 An investment property note 541
9.1.3 Profit before tax note 541
9.1.4 Contractual obligations note 542
9.2 Extra disclosure when using the fair value model 542
9.2.1 Investment property note 542
9.3 Extra disclosure when using the cost model 542
9.3.1 An accounting policy note for investment properties 542
9.3.2 Investment property note 543
9.4 Sample disclosure involving investment properties 543
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1. Introduction
This chapter deals with property, which is a term that refers to both land and/or buildings that are
classified as investment property. The effect of IAS 40 Investment properties is that we will
account for investment properties differently from other properties, such as:
x owner-occupied property (this is property, plant and equipment),
x property held for sale in the ordinary course of business (this is inventory), and
x property leased out under a finance lease to a third party (this is property, plant and equipment).
For an item to be classified as investment property, it must meet the definition of investment
property. Investment property is essentially property from which the entity intends to earn capital
appreciation or rental income or both. Once an item has been classified as investment property,
we must decide whether it meets the criteria for recognition as an asset. If it does, we will need
to know what amount it will be recognised at – this is called initial measurement (initial
measurement is at cost) (section 4.2). We will then need to know how to measure it on an
ongoing basis thereafter – this is called subsequent measurement (the subsequent measurement
of an investment property involves the choice between the cost model and fair value model)
(section 4.3 and 4.4). If we have investment property at reporting date, this will need certain
disclosures. Each of the aspects of classification, recognition, measurement and disclosure will
now be discussed. See IAS 40.5
All these classification issues will now be considered, with the exception of a change in use.
Issues involving change in use are explained in section 5.
To classify a property as an investment property, we simply have to ensure that it meets the
definition of an investment property (see pop-up above).
When deciding whether the investment property definition is met, we basically need to decide what
the entity’s intention is for acquiring or holding the property: if the intention is to earn rentals or
capital appreciation or both, then land and / or buildings are classified as an investment property.
The following are examples of property that are not classified as investment property:
x property that is owner-occupied or held with the intention of being owner-occupied (this is
covered by IAS 16 Property, plant and equipment or IFRS 16 Leases);
x property that is leased out to an entity under a finance lease (covered by IFRS 16 Leases); and
x property held for sale in the ordinary course of business (this is IAS 2 Inventory). IAS 40.9
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Owner occupied
Owner-occupied property is essentially land or buildings that are property is defined
either owned or are held by a lessee as a right-of-use asset and as:
x land or buildings (or both,
are used to produce goods or services or used for administration or part of a building)
purposes. Examples include: x held by an owner, or by a
lessee as a right-of-use asset,
x Property that is owner-occupied and awaiting disposal; x for use in the production or
x Property held for future use as owner-occupied property; supply of goods or services,
x Factory buildings or shops; or for administration use.
x Administration buildings IAS 40.5 reworded
x Employee housing (even if the employees pay market-related rentals). See IAS 40.7 & 40.9
Now that you have an idea of what would not be classified as investment property, take a look
at the following examples of property that are classified as investment property:
x property held for long-term capital appreciation (i.e. not a short-term sale);
x a building (owned by the entity or held as a right-of-use asset) that is leased out under an
operating lease;
Transfers in /
x a vacant building that is held with the intention to lease it out
out of investment
under an operating lease; property occur if:
x a property being constructed or developed for future use as an x there is evidence
investment property; x of a change in use,
x a property that is being redeveloped for continued use as an x with the result that the:
- IP definition is now met
investment property; and (transfer into IP)
x land held for an undetermined future use (i.e. land is regarded - IP definition is not met
as held for capital appreciation) See IAS 40.8 & IAS 40.58 (transfer out of IP)
It is also possible that a property that was classified as investment property could cease to be
classified as an investment property, in which case it would need to be transferred out of
investment property (e.g. investment property to inventory). Conversely, a property that was
classified as something else other than investment property (e.g. inventory) could become
classified as investment property, in which case it would need to be transferred into investment
property (e.g. inventory to investment property). Situations do arise where there is a change in
use that results in the investment property definition subsequently failing to be met, or being met,
as the case may be. This is discussed in more detail in section 5.
x a portion of the property is used to earn capital appreciation and/or rental income (an
investment property); and
x a portion of the property is used in the production or supply of goods or services and/or for
administration purposes (an owner-occupied property). IAS 40.10 (reworded)
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IAS 40 does not provide a quantitative guideline on how to assess whether a portion is
significant or not (i.e. it does not state, for example, that if an owner-occupied portion represents
60% or more of a property, this portion would be a significant portion). The IASB deliberately
decided not to provide any such guidance as this could lead to ‘arbitrary decisions’. IAS 40 is
also silent on whether significance should be based on a relative percentage in terms of the
physical area occupied by each of the portions, or whether it should be based on the relative
significance, in monetary terms, of the business carried out in each of the portions – or both.
See IAS 40.10 and .B39
Thus, it is clear that the decision as to whether an owner-occupied portion is significant or not
will require professional judgement. In this regard, an entity is required to develop criteria so that
it can exercise its judgement consistently. See IAS 40.14 and .B39
Required: Briefly explain how Stunning should classify its properties in each of these areas, details of
which are as follows:
A Durban: Stunning owns two freestanding buildings on adjoining but separate sites in Durban, South
Africa: one is used by Stunning for administration purposes and the other is leased to Runofdamill
Limited under an operating lease.
B Port Elizabeth: Stunning owns a twenty-storey building in Port Elizabeth: it leases out nineteen floors (each
operating lease contract includes an option to purchase) and uses the top floor as its head office.
C Cape-Town: Stunning owns an eight-room house in Cape Town: six rooms are used for administration
purposes and two rooms are leased to Unpleasant Limited under an operating lease. The layout of the
house makes it impossible for the rooms to be separately sold or leased under a finance lease.
D D’Aar: Stunning owns a two-storey house in D’Aar: one floor houses Stunning’s entire business and one floor
is leased to S. Kwatter under an operating lease. A single set of title deeds exists for the house, prohibiting
both the piecemeal sale of the house and piecemeal transfer of ownership by way of finance lease.
Comment:
This example explains how to identify joint use properties and how to classify land and buildings that are
joint use properties (IAS 40.10).
A. There are two distinct and separate buildings: owner-occupied and leased out. Since each building is
on a separate site, it is assumed that they can be sold and/ or leased out separately. These buildings,
being so separate from one another would not be considered joint-use properties.
The building used for administrative purposes falls within the definition of owner-occupied property and
must therefore be disclosed as property, plant and equipment.
The building leased out under an operating lease must be disclosed as an investment property.
B. There are two portions within a single property: owner-occupied and leased out. This is thus a joint-
use property.
Since each of the nineteen tenants have also been offered options to purchase, it is clear that each of
these nineteen floors are separable.
Since the property is separable, the nineteen floors that are leased out must be classified as an
investment property and the remaining one floor used as the company head office must be classified
as property, plant and equipment.
C. There are two portions within a single property: owner-occupied and leased out. Since these two
portions are in one property, this is a joint-use property.
The layout of the property means that the two portions cannot be sold separately or leased out
separately under a finance lease. Thus, we must consider if the portion used as owner-occupied is
significant or insignificant.
Six of the eight rooms are owner-occupied. It is submitted that this is a significant portion and thus
Stunning must classify the entire house as owner-occupied (i.e. as property, plant and equipment).
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D. There are 2 portions within a single property: owner-occupied and leased out. This is thus a joint-use property.
The title deeds prevent the building from being sold in parts and from being leased out separately under
a finance lease. Thus, we must consider if the portion used as owner-occupied is insignificant or not.
One floor is owner-occupied (property, plant and equipment) and the other floor is leased out under an
operating lease (investment property). The physical split between owner-occupied and leased is 50:50
and thus we cannot determine ‘significance’ purely on physical area.
However, since the 50% owner-occupied portion houses the entire business, it is submitted that the
owner-occupied portion must be considered significant and thus the entire building is classified as
owner-occupied (i.e. as property, plant and equipment).
A property leased out within a group (the lessee is a subsidiary How entities in a group
and the lessor is the parent company, or vice versa), is classified: account for investment
x in the lessor’s financial statements: as an investment property properties held under
leases:
(but only if it is leased out under an operating lease);
x Lessor: Investment property (as
x in the lessee’s financial statements: either it earns rental income)
as a right-of-use asset (with a lease liability); or x Lessee: Right-of-use asset or
an expense (if lessee elects to
as an expense: if the lessee elects this option, the cost recognise the lease as an
of leasing the property is recognised as an expense expense)
Group: PPE (as it is owner-
on the straight-line basis or another systematic basis x occupied)
(this election is available in the case of short-term
leases, where the election is made by class of asset, or when the underlying asset is of
low value, where this election is made on a lease-by-lease basis); See IFRS 16.5; .8 & .22
x in the group financial statements: as property, plant and equipment (since, from a group
perspective, it is owner-occupied). IAS 40.15 (reworded)
Please note: with the introduction of IFRS 16 and the withdrawal of IAS 17, the classification of
the lease as an operating lease is now only ever determined from the perspective of the lessor.
Lessees no longer differentiate between finance leases and operating leases – from a lessee
perspective, all leases are just leases and are accounted for either by recognising a right-of-use
asset with a lease liability or by expensing the lease.
Required: Explain how the building should be accounted for in the financial statements of:
A. Small Limited’s company financial statements.
B. Big Limited’s company financial statements.
C. Big Limited’s group financial statements.
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As with partly leased out properties, the entity must develop criteria for classification purposes
so that it can exercise its judgement consistently.
Solution 3: Ancillary services (this example explains the concepts in IAS 40.13)
Comment: this example shows how providing ancillary services affects the classification of a property.
A. The office building is classified as an investment property because the security services are
insignificant to the rental arrangement as a whole.
B. Hotel Mystique is classified as property, plant and equipment (i.e. in terms of IAS 16) because the
services provided by Clumsy Limited are significant to the property.
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C. Hotel D’Africa is classified as an investment property since the lease contract is such that, in
substance, Clumsy Limited is simply a passive investor.
D. Hotel Brizzy is classified as property, plant and equipment since, whilst there is a lease contract that
outsources the day-to-day functions of running the hotel, Clumsy is still significantly involved in
management decisions and is exposed to significant variations in cash flows from the hotel.
3.1 Overview
How and when to recognise an investment property depends on whether it is:
x owned; or
x held under a lease as a right-to-use asset.
Applying the general approach in terms of IFRS 16 means that a leased property would be
recognised as a right-of-use asset with a related lease liability. In this case, IFRS 16 requires
that the initial recognition of the investment property (with related lease liability) must happen on
the commencement date of the lease, where this date is the date on which the ‘lessor makes an
underlying asset available for use by a lessee’. See IAS 40.19A; IFRS 16.22 & IFRS 16 App A
There is an exception to IFRS 16’s general approach, where, instead of recognising the property as
a ‘right-of-use asset’ with a related lease liability, the cost of leasing the property would simply be
expensed (generally on the straight-line basis). This is a simplified approach and is referred to as a
recognition exemption. This simplified approach is only allowed in the case of short-term leases (a
lease that, at commencement date, has a lease term of 12 months or less and does not contain a
purchase option) or if the underlying leased asset is a low value asset. An investment property held
by a lessee would not qualify as a low value asset, but the lease of the investment property could
qualify as a short-term lease and could thus be expensed. See IFRS 16.B3 - .B6
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4.1 Overview
The initial measurement of investment property is always Measurement of IP:
at cost. This initial measurement and how to calculate x Initial: at cost
x Subsequent:
cost is explained in section 4.2.
Cost model (CM) or
FV model (FVM)
The subsequent measurement of investment property
involves choosing between two measurement models, which must then be applied to all its
investment property. The two models allowed are the cost and fair value models. Although
there is a choice between these two models, the standard encourages the use of the fair value
model because it increases the relevance of the financial statements by giving a better
reflection of the true value of the property. The subsequent measurement under each of these
models is explained under sections 4.3 and 4.4, respectively.
Regardless of the model chosen, since the property’s fair value is so useful to users, the fair
value will actually be measured for all investment property:
x if the fair value model is used, fair values will be needed for measurement purposes;
x if the cost model is used, fair values will be needed for disclosure purposes. See IAS 40.32
Before choosing to apply the fair value model, it is important to realise that, if the fair value
model is chosen, it may be very difficult to change the accounting policy to the cost model at a
later stage. This is because, although IAS 8 Accounting policies, changes in accounting
estimates and errors allows accounting policies to be changed voluntarily, it only allows
voluntary changes if the change would result in ‘reliable and more relevant’ information. In this
regard, IAS 40 explains that it would be ‘highly unlikely’ that the cost model could provide more
relevant information than the fair value model. See IAS 8.14 and IAS 40.31
An investment property is initially measured at its cost, x the amount of cash equivalents paid
which is a defined term (see pop-up alongside). The (or FV of any other consideration
measurement of cost depends on whether the asset is given) to acquire an asset
owned or held under a lease (as a right-of-use asset), x determined at the time of its
acquisition or construction; or
and if it was owned, whether it was acquired in an asset
x the amount at which the asset is
exchange. See IAS 40.20; .27 & 29A initially recognised in terms of another
IFRS. IAS 40.5 (reworded)
4.2.2 Initial cost of owned investment property (IAS 40.20 - 24)
In the case of investment property that is owned, and not acquired in an asset exchange, its initial cost
is measured in terms of IAS 40 Investment properties. The cost in this case would comprise its
purchase price and any directly attributable expenditure, including transaction costs. See IAS 40.21
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Directly attributable costs include, for example, legal fees and Cost of owned IP, not
would include construction costs, if the investment property acquired in an exchange,
was self-constructed. Another example is borrowing costs. If includes:
we incur ‘borrowing costs that are directly attributable to the x the purchase price; and
x any directly attributable costs
acquisition, construction or production’ of the property, we
(including transaction costs e.g.
must capitalise these costs. However, we only capitalise legal fees and transfer taxes).
these costs if the property is a qualifying asset, being ‘an IAS 40.21 (reworded slightly)
Cost excludes:
x start-up costs (unless they are necessary to bring the property to the condition necessary for
it to be capable of operating in the manner intended by management);
x operating losses incurred before the property achieves the planned level of occupancy;
x abnormal amounts of wasted material, labour or other resources incurred in constructing or
developing the property. IAS 40.23 (extract)
If the purchase price is deferred, the cost is measured at its cash price with the difference
between the cash price and the total that will be paid ‘recognised as an interest expense over
the period of credit’ (i.e. between the date of purchase and date of final payment). See IAS 40.24
4.2.2.2 Owned property that was acquired in an asset exchange (IAS 40.27 - 29)
In the case of an owned investment property that was Cost of owned IP that
acquired by way of an asset exchange, the cost of the is acquired in an
property for purposes of initial recognition is measured at the exchange is:
fair value of the asset given up, unless the fair value of the x FV of the asset given up; or the
asset received is ‘more clearly evident’. x FV of the asset received, if this
is ‘more clearly evident’; or the
If the fair value of neither asset is reliably measurable, then x CA of the asset given up if:
- neither FV is reliably
the initial cost of the investment property must be measured at measurable; or
the carrying amount of the asset that was given up. - the exchange has no commercial
substance. See IAS 40.27 - .29
Similarly, the initial cost of the investment property will be the carrying amount of the asset given
up if the exchange lacks commercial substance. See IAS 40.27 - .29
4.2.3 Initial cost of investment property held as a right-of-use asset (IAS 40.29A & IFRS 16.24)
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The initial measurement of the lease liability is the present value of total lease payments due at
commencement date, discounted at the interest rate implicit in the lease. Please see the
leasing chapter for more information. See IFRS 16.26
Subsequent costs incurred in relation to investment property may only be capitalised to the cost
of the asset if it meets the two recognition criteria which are:
x it is probable that future economic benefits will flow to the entity; and
x the costs are reliably measurable. See IAS 40.16 - .17
Costs incurred after the initial purchase frequently relate to day-to-day servicing (often called
repairs and maintenance). These costs would never meet the recognition criteria and are thus
simply expensed. See IAS 40.18
There may, however, be occasions where costs are incurred on replacing parts of the property
(for instance replacing damaged walls or roofs, or building interior walls). In this case:
x the replaced part is derecognised (see section 6 on derecognition), and
x the replacement part is recognised as part of the original investment property if the
recognition criteria are met. See IAS 40.19
Notice: the method of accounting for subsequent costs on investment property is identical to the
method of accounting for subsequent costs on property, plant and equipment (i.e. the principles
in IAS 40 are the same as those in IAS 16 Property, plant and equipment).
x C500 000: to build an extra floor to be rented out as a penthouse flat under an operating lease;
x C10 000: to replace all globes in the building that had blown in the last month;
x The building’s lift was damaged due to vandalism and Flower Limited had to pay C25 000 to replace
it. The fair value of the damaged lift was C10 000.
Required: Explain how Flower Limited should account for the amounts it spent and show the journals.
Explanation of the extra floor: The C500 000 for the extra floor is capitalised to the asset, because:
x extra revenue (future economic benefits) is expected by Flower from the rental income; and
x the cost is reliably measurable: C500 000.
Debit Credit
IP: Building: flats (A) 500 000
Bank/ Accounts payable (A/L) 500 000
Cost of building the penthouse (the extra floor)
Explanation of the globes: The replacement of the globes is considered to be day-to-day servicing and
should be expensed.
Debit Credit
Maintenance (E) 10 000
Bank/ Accounts payable (A/L) 10 000
Payment for the replacement of globes (minor parts)
Explanation of the lift: The lift that was destroyed due to vandalism must be impaired to zero as it was
scrapped for a nil return. The new lift must then be capitalised because:
x the replacement lift will restore the expected future economic benefits; and
x the cost is measurable: C25 000.
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Debit Credit
Lift written off (E) 10 000
IP: Building: flats (A) 10 000
Write-off of lift destroyed through vandalism (estimated fair value)
IP: Building: flats (A) 25 000
Bank/ Creditor (A/L) 25 000
Replacement lift capitalised at cost
4.3 Subsequent measurement: the cost model (IAS 40.56 and IFRS 16)
4.3.1 Overview
If the entity chooses to measure its investment property under the cost model, the version of the
cost model used depends on whether the investment property is:
x owned, or
x held under a lease. See IAS 40.56
The measurement would be further impacted if it is owned but meets the criteria to be classified
as held for sale. See IAS 40.56
Investment property measured
Each of these situations are explained below. under the cost model is:
This means that this investment property would be measured initially at cost, depreciated
annually and tested for impairments (in terms of IAS 36 Impairment of assets).
If the entity uses the cost model for investment property that is owned but meets the criteria to
be classified as held for sale, this property must:
x be measured in terms of this standard, IAS 40 (this requires us to use the same cost model
as described in IAS 16) to the date on which the criteria for reclassification are met,
x then it must be classified as held for sale, and
x then remeasured to the lower of its carrying amount and fair value less costs to sell (in terms
of IFRS 5 Non-current assets held for sale).
If the entity measures its investment property using the cost model, and one of the investment
properties is held under a lease and recognised as a right-of-use asset, this property must be
measured in terms of the cost model described in IFRS 16 Leases. This version of the cost
model (i.e. contained in IFRS 16 Leases) is very similar to the cost model described in IAS 16
Property, plant and equipment in that the asset is measured at cost less any accumulated
depreciation and any accumulated impairment losses. However, there are two important
differences, explained below.
First difference: In the case of an investment property held under a lease, the right-of-use asset’s
carrying amount must be adjusted for any remeasurement made to the related lease liability (e.g.
if the future lease payments change due to a lease modification).
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Second difference: When depreciating a leased asset, we must analyse the lease as follows.
x If ownership transfers at the end of the lease or if the lease includes a purchase option and
the asset’s cost was measured based on the assumption that the option will be exercised,
then the asset must be depreciated:
x from commencement date
x to the end of the underlying asset’s useful life;
x In all other cases, the asset must be depreciated:
x from commencement date
x to the earlier of:
- the end of the right-of-use asset’s useful life, and
- the end of the lease term. See IFRS 16.32
4.4 Subsequent measurement: the fair value model (IAS 40.33-55, IAS 36.2 & IFRS 13)
4.4.1 Overview (IAS 40.33; .35 & .40A) Investment property
measured under the fair
If the entity chooses to measure its investment property value model:
under the fair value model, the fair value model used is x is initially measured at cost;
x is re-measured to fair value at the
the same whether the investment property is owned or end of the reporting period;
held under a lease and even if it meets the criteria to be x any gains or losses arising from a
classified as held for sale. change in the fair value must be
recognised in profit or loss.
If the fair value model is chosen for a property, all investment properties must be measured using
this model, unless the fair value cannot be reliably measured (see section 4.4.6). See IAS 40.33
The fair value model requires that the investment property be initially measured at cost. At the end
of the reporting period the property must be subsequently remeasured to its fair value.
Any subsequent gains or losses resulting from a change in the fair value of the investment
property shall be recognised in profit or loss for the period in which they arise. See IAS 40.35
The fair value model used to measure investment properties differs from the revaluation model
used for property, plant and equipment (see chapter 8). When using the fair value model:
x there is no depreciation;
x there are no impairment tests, as investment property measured using the fair value model is
excluded from the scope of IAS 36;
x investment property may be classified as held for sale, but it will not be measured in terms of
IFRS 5 (i.e. it must continue to be measured in terms of IAS 40’s fair value model);
x fair value adjustments are recognised in profit or loss (not other comprehensive income).
4.4.3 Property that is owned, but meets the criteria as held for sale (IAS 40.33 & IFRS 5.5)
An investment property that meets the criteria to be classified as held for sale would have to be
classified and presented as a ‘held for sale’ asset (in terms of IFRS 5 Non-current assets held for
sale and discontinued operations).
However, investment properties that had been measured using the fair value model would not
be measured in terms of IFRS 5, but instead, would continue to be measured under the fair value
model in terms of IAS 40 Investment properties. This fair value model is identical to the fair value
model used when measuring a straight-forward ‘owned property’ (see section 4.4.2 above).
See IAS 40.33 and IFRS 5.5
4.4.4 Property that is held under a lease (IAS 40.33 & .40A and IFRS 16.34)
An investment property held under a lease and recognised as a right-of-use asset, would be measured
under the same fair value model that is used to measure a straight-forward ‘owned property’. (See
section 4.4.2).
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It is important, however, that when applying the fair value model to an investment property that is
held under a lease and recognised as a right-of-use asset, we must make sure we measure the
fair value of the right-of-use asset – not the fair value of the property. See IAS 40.33 & .40A and IFRS 16.34
4.4.5 Fair value model: What is a fair value? (IAS 40.40 - 40A & IFRS 13)
Fair value is a market-based value measured in terms The fair value of a property
of IFRS 13, which must reflect, amongst other things: is defined as:
x rental incomes from current leases; and x the price that would be received to sell
x other assumptions that market participants would the property in an orderly transaction;
use when pricing investment property under current x between market participants;
x at the measurement date. IFRS 13.9 (reworded)
market conditions. IAS 40.40
The emphasis here is that the fair value is an exit price and thus, the assumptions used are
always those that a market participant would use when pricing the asset.
The standard recommends, but does not require, that this fair value be measured by an
independent and suitably qualified valuer. See IAS 40.32
In terms of IFRS 13, fair value is a market-based measurement and can, in fact, be measured
using a variety of valuation techniques (such as the market, cost or income approach) and can
involve a variety of inputs of varying quality.
These inputs are classified into a hierarchy of level 1 inputs through to level 3 inputs.
x Level 1 inputs are ideal, being quoted prices (unadjusted) for identical assets in an active
market. These are unlikely to be found for an investment property.
x Level 2 inputs are directly or indirectly observable prices for the asset. An example would be
a quoted price for a similar asset, when this has to be adjusted for the condition and location
of the asset.
x Level 3 inputs are unobservable inputs. Level 3 inputs enable the entity to use assumptions
in a situation where there is little if any market activity for the asset.
It is important when measuring fair value that we do not double-count the fair value of assets or
liabilities that may have already been recognised as separate assets or liabilities. For example:
x A building that includes a built-in lift would typically have a fair value that is higher than the
fair value of a building that does not have a lift. Thus, generally, the fair value of the ‘building
with the lift’ will effectively have included the fair value of the lift and thus we would need to be
careful not to recognise the lift as a separate asset.
x When investment property is let under an operating lease, the lessor (who owns the asset or
holds it as a right-of-use asset) will account for the operating lease income on a straight-line
basis or another systematic basis. Thus, the lessor of the operating lease may have
recognised income received in advance or income receivable. However, the fact that the fair
value of the right-of-use asset would typically reflect the fact that there is an amount
receivable or received in advance, and thus, since the receivable or amount received in
advance will have already been separately recognised, we must adjust the fair value to avoid
double-counting: the fair value should be increased by the amount received in advance or
decreased by the amount receivable. See IAS 40.50 & IFRS 16.81
4.4.6 Fair value model used, but unable to measure fair value (IAS 40.53 - 55)
4.4.6.1 Overview
As mentioned previously, if the fair value model is chosen, the entity is expected to apply the fair
value to all investment properties. This is based on the presumption that, when dealing with
investment properties, fair values will be reliably measurable on a continuing basis.
However, this is a rebuttable presumption, which means that, in certain ‘exceptional cases’, one
may rebut this presumption where there is clear evidence to prove that the fair values are not
expected to be reliably measurable on a continuing basis.
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The method of accounting for situations in which fair values are not reliably measurable on a
continuing basis, or are difficult to measure under the current circumstances will be discussed
under the following categories:
x Investment property that is not under construction
x Investment property that is under construction.
If an entity that uses the fair value model has an investment property that is currently under
construction and for which a reliable measure of fair value is currently unavailable, but the entity
believes that a reliable measure will be possible on a continuing basis once construction is
complete, the investment property must, in the interim, be measured at cost (this is not the same
as the cost model!). It is measured at cost until either a fair value becomes reliably measurable, or
the construction is completed (whichever happens first).
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If the fair value then becomes reliably measurable during construction, the property must be
remeasured from cost to fair value, under the fair value model (with the difference between the
cost and fair value recognised in profit or loss).
If the FV of ‘IP that is
However, being able to determine a fair value during under construction’ is not
construction means that, when construction is complete, reliably measurable and
we will not be allowed to reassess the situation and rebut this is determined:
the presumption that fair values will be reliably x during construction: measure at cost
measurable on a continuing basis – we will be forced to until FV becomes measurable or until
continue to use the fair value model until the property is completion date, whichever is earlier
disposed of (or transferred out of investment property due x on completion:
to a change in use). - if still at cost, we can rebut the
presumption and use CM for that
In other words, if we are able to reliably measure the property (must use CM until disposal
& a RV of nil)
property’s fair value during construction and thus began
using the fair value model during construction, but then on - if already at FV, we cannot rebut the
presumption now, so must continue to
completion of construction, we decide that the fair value
measure under the FVM until disposal.
will not be reliably measurable on a continuing basis, we See IAS 40.53 & .55
will not be allowed to switch from the fair value model to
the cost model. IAS 40.53; .53A & .53B
If the fair value was not reliably measurable during construction, we start by measuring this under-
construction property at cost. Then, on the date that construction is complete, we re-assess
whether we believe the fair value for this property will be reliably measurable on a continuing basis.
We start with the rebuttable presumption that the fair value will be reliably measurable on a
continuing basis:
x If the presumption is not rebutted, the investment property must now be measured under the
fair value model. Since the property, at this point, would still have been measured at cost, it
must now be remeasured to fair value (the difference recognised in profit or loss).
x If the presumption is rebutted, the investment property must now be measured under the
cost model (per IAS 16 or IFRS 16). Since the property, at this point, would still have been
measured at cost, it must now be measured under the cost model. This means that we must
now start depreciating the property and testing for impairments (the property must be
measured under the cost model until disposal and depreciation must be measured assuming
that the residual value is nil). See IAS 40.53 & .53A
Required: Calculate the carrying amount of the property at the year ended 31 March 20X5 and 20X6.
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Even though the fair value can be measured at the next financial year end, the building must remain at
depreciated historic cost and must never be revalued to fair value.
When we are forced to use the cost model, (because the FV could not be reliably measured), then
depreciation must be calculated using a nil residual value, even if the entity estimates another amount for
the residual value.
The carrying amounts of the property would therefore be:
x 31 March 20X5: 1 000 000 – [(1 000 000 – 0) / 20 years x 0 yrs] = C1 000 000
x 31 March 20X6: 1 000 000 – [(1 000 000 – 0)/ 20 years x 1 yr] = C950 000
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The measurement of the property at the point of the transfer depends on whether the entity
measures its investment properties using the cost model or the fair value model.
A summary of the situation is contained in table 1 below, and is explained in more detail in
section 5.3 (where the entity measures investment property using the cost model) and
section 5.4 (where the entity measures investment property using the fair value model).
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5.3 Measurement of the transfer: investment property under the cost model
(IAS 40.59)
If the entity uses the cost model, a change in use that results in a transfer into or out of
investment property will not involve a change in the carrying amount of the property at the date
of transfer:
x For a transfer into investment property, the property will first be measured in terms of the
previous relevant standard (e.g. IAS 16/ IFRS 16 or IAS 2) to the date of change in use. It
will then be transferred into investment property and be measured in terms of IAS 40 (i.e.
using the cost model in IAS 16 or IFRS 16 or will be measured in terms of IFRS 5).
x For a transfer out of investment property, the property will be measured in terms of IAS 40
(i.e. using the cost model in IAS 16 or IFRS 16 or using IFRS 5) to the date of change in
use. It will then be transferred out of investment property and be measured in terms of the
relevant standard (e.g. IAS 16 or IFRS 16 or IAS 2).
The transfer will not alter the cost for measurement or disclosure purposes. See IAS 40.59
5.4 Measurement of the transfer: investment property under the fair value model
(IAS 40.60 - 65)
If the entity uses the fair value model, then there may be measurement implications when there
is a transfer in or out of investment property due to a change in use.
5.4.1 Change from owner-occupied property to investment property (FVM) (IAS 40.61 - 62)
Owner-occupied property is accounted for either in terms of IAS 16 Property, plant and
equipment or accounted for as a right-of-use asset
in terms of IFRS 16 Leases. Transferring from
owner-occupied property
When owner-occupied property is to be reclassified to investment property (FVM):
to investment property that will then be measured x account for any depreciation and impairment
losses until the date of change in use and;
under the fair value model (FVM), the entity must
x revalue the property to fair value (even if the
revalue the property to its fair value immediately cost model has been used to measure PPE)
before making the transfer to investment property:
x any change from the carrying amount to fair value is accounted for in the same way that a
revaluation is accounted for under the revaluation model in IAS 16, and
x this revaluation is done even if the property had been measured using the cost model.
See IAS 40.61
The steps to follow before making the transfer of property from the property, plant and equipment
classification (IAS 16) to the investment property classification (IAS 40) are as follows:
x Depreciate and check the property for impairments up to the date of change in use;
x Then revalue to fair value where:
x a decrease in the carrying amount:
is first debited to other comprehensive income (to the extent that the revaluation
surplus account has a balance in it from a prior revaluation); and
is then debited as an expense in profit or loss (impairment loss/ revaluation expense);
x an increase in the carrying amount:
is first credited as income in profit or loss (to the extent that it reverses a previous
impairment loss/ revaluation expense – thus, this step should not increase the
carrying amount above the historic carrying amount); and
is then credited to other comprehensive income (i.e. revaluation surplus). See IAS 40.62
Once a property becomes investment property measured using the fair value model, it is no longer
depreciated. This means that if the property was previously classified as property, plant and
equipment under the revaluation model and had a revaluation surplus at the time of reclassification
to investment property, we could no longer transfer this revaluation surplus to retained earnings
over the life of the asset (since it is longer depreciated). Thus, any revaluation surplus relating to a
property that is reclassified to investment property could only be transferred to retained earnings on
its eventual disposal.
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As always, this transfer from revaluation surplus to retained earnings may not be made through
profit or loss: the transfer must be made directly to retained earnings (i.e. debit revaluation
surplus and credit retained earnings). IAS 40.62(b) (ii) (reworded)
Required: Show the journals relating to Fantastic’s head-office for the year ended 31 December 20X5.
You may use a single account to record movements in the head office’s carrying amount (i.e. do not use a
cost and accumulated depreciation account). Ignore tax.
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If property is held for sale in the ordinary course of business, it would be classified as inventory.
However, if there is evidence of a subsequent change in use such that the property no longer
meets the definition of inventory but meets the definition of investment property instead, the
property must be transferred from inventories to investment properties.
Property that was classified as inventories would have been measured at the lower of cost and
net realisable value. If this property is transferred to investment property, where the entity
measures its investment property under the fair value model (FVM), it will mean that an
adjustment to the carrying amount of the property will be required on date of transfer.
The difference between the property’s previous carrying amount and its fair value is recognised
immediately in profit or loss. See IAS 40.63
Comment: this example shows how to account for a change from inventory to investment property.
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5.4.3 Change from investment property to owner-occupied property or inventories (IAS 40.60)
Investment property that was measured under the fair value model but is now being reclassified
as an owner-occupied property or inventory must first have its carrying amount adjusted to fair
value on the date of change. This fair value adjustment must be recognised in profit or loss.
The fair value on date of transfer, measured in accordance with IAS 40, will then be deemed to
be the initial cost of the owner-occupied property or inventory. See IAS 40.60
The standard only permits a transfer from investment property to inventories if there is a change in use
that is evidenced by commencement of development with a view to sale (see example 6, part A). If an
entity decides to dispose of an investment property without development, it continues to treat the
property as investment property (although we must obviously consider whether the investment property
meets the criteria to be classified as held for sale in terms of IFRS 5 Non-current assets held for sale).
See IAS 40.57(b) & 58
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An investment property (or a part thereof) must be derecognised (i.e. eliminated from the
statement of financial position) on:
x disposal (by way of sale or finance lease); or Investment property is
x permanent withdrawal from use (e.g. abandonment) derecognised on:
and where no future economic benefits are expected x Disposal; or
from its disposal. IAS 40.66 (reworded) x Permanent withdrawal from use.
The date on which the disposal must be recorded depends on how it is disposed of.
x If the investment property is disposed of by way of entering into a finance lease, the date will
be determined in accordance with IFRS 16 Leases (see chapter 17).
x If the investment property is disposed of by way of a sale, the date of disposal is the date on
which the recipient obtains control of the investment property (the recipient obtains control
when the criteria in IFRS 15 Revenue from contracts with customers are met and indicate
that the performance obligation has been satisfied). See IAS 40.67
If, when derecognising the investment property, the entity earned proceeds on the disposal,
these proceeds must be recognised as income in profit or loss. The amount of these proceeds
(also called ‘consideration’) is measured in the same way that a transaction price is measured in
terms of IFRS 15 Revenue from contracts with customers. See IAS 40.70
When we retire a property (i.e. withdraw from use) or when we dispose of it, we will generally
have made a gain or incurred a loss. This gain or loss is:
x measured as the difference between the net proceeds we receive for the property (if any)
and its expensed carrying amount; and
x recognised in profit or loss (unless IFRS 16 Leases requires an alternative treatment in the
case of a sale and leaseback). See IAS 40.69
As mentioned above, disposal proceeds are measured in the same way that we determine the
transaction price in terms of IFRS 15 (see chapter 4 on revenue). This means, if a property is
disposed of by way of a sale but the receipt of these proceeds will be delayed, and this delay
gives the purchaser a significant financing benefit, these proceeds must be measured at the price
the customer would have paid for the investment property had it been disposed of for cash. The
difference between the price the property would have been sold for had it been sold for cash (i.e.
the notional cash price) and the actual agreed selling price must be recognised separately over
the payment period as interest revenue measured using an appropriate discount rate.See IFRS 15.60-65
It can also happen that only a part of the investment property is disposed of (e.g. a roof
destroyed in a storm, a lift that needed to be replaced etcetera). The carrying amount of this
replaced part needs to be derecognised.
The following guidance is provided for cases where you find it difficult to establish the carrying
amount of the replaced part:
x if the cost model is used and this part was not recognised and depreciated in a separate
account: the cost of the replacement part may be used to estimate the cost of the part on the
date that the property was purchased;
x if the fair value model is used, you may either decide to:
remove an estimated fair value of the replacement part and then add the cost of the
replacement part; or
not bother removing the estimated fair value of the replacement part and add the cost of
the replacement part and then revalue the investment property as a whole to its fair value:
this option is available only if it is believed that the fair value will reflect the changes owing
to the part requiring replacement. See IAS 40.68
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Any compensation receivable from a claim made following an impairment or giving up of a property
is considered to be a separate economic transaction and is thus accounted for separately when the
compensation becomes receivable. The compensation will be recognised in profit or loss. See IAS 40.73
Comment: This example shows a disposal where the fair value is known.
Debit Credit
Bank/ debtor 100 000
Investment property (A) 75 000
Profit on sale of investment property (P/L) Proceeds: 100 000 – CA: 75 000 25 000
Sale of investment property
If the cost model is used, the deferred tax implications are the same as those arising from property,
plant and equipment measured in terms of the cost model in IAS 16 (see chapter 7).
If the fair value model is used, the carrying amount of the investment property changes each time it
is fair valued, but the tax base doesn’t change for these adjustments. The tax base will simply
reflect the tax deductions allowed, if any. The difference between the carrying amount and the tax
base will cause temporary differences. So far, this is no different to the calculation of temporary
differences when accounting for a property classified as property plant and equipment in IAS 16.
Please note that if an asset is not deductible for tax purposes, its tax base will be nil (because the
tax base of an asset is a reflection of the future tax deductions). The resulting temporary difference
that arises on initial recognition (i.e. the difference between the carrying amount of cost and the tax
base of nil) is exempt from deferred tax. This exemption from deferred tax is covered in more depth
in chapter 6 (see chapter 6: section 4.3). The principle of exempting these temporary differences
from deferred tax is the same principle we applied when accounting for non-deductible property
classified as property plant and equipment in IAS 16.
However, there is a fundamental difference in the deferred tax journal entries depending on whether
the property is classified as an investment property and measured under the fair value model (in
terms of IAS 40) or is classified as property plant and equipment and measured under the
revaluation model (in terms of IAS 16):
x fair value adjustments on property, plant and equipment may create a revaluation surplus,
which is recognised in other comprehensive income: any deferred tax relating to the
revaluation surplus will be debited or credited to the revaluation surplus account (OCI); but
x fair value adjustments on investment properties are all recognised in profit and loss: thus all
related deferred tax journals will be debited or credited to the tax expense account (P/L).
The general rule when measuring the deferred tax balance is to measure it based on how
management intends to recover the carrying amount of the asset (i.e. whether the entity intends to
make money from using the asset or selling the asset). See IAS 12.51
Management intentions affect the measurement of deferred tax assuming that the way in which the
tax authorities levy tax is affected by whether income is earned through the use or sale of the asset.
In other words, if the tax authorities tax normal operational income (e.g. rent income) at 30% but tax
capital profits differently, we must build this into the measurement of our deferred tax balance (e.g.
in SA, although a capital gain is taxed at the same income tax rate that is levied on other income
such as rent income, only 80% of it is taxable in the case of companies).
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However, if investment property is measured using the fair value model, the presumption is that
its carrying amount will be recovered entirely through the sale of the property rather than through
the use thereof. However, this presumption of sale is rebutted if the investment property is:
x depreciable; and
x held within a business model whose objective is to consume substantially all the economic
benefits embodied in the property over time rather than through a sale. IAS 12.51C
In other words, if an investment property measured using the fair value model is land, the related
deferred tax is always based on the presumed intention to sell because the presumption is not
able to be rebutted. It is not able to be rebutted because land is an asset that is typically not
depreciable. However, if the investment property was a building, the presumed intention to sell
would be rebutted if it is held within a business model whose objective it is to recover most of the
carrying amount through use (because the building would have been depreciated had it been
measured under the cost model).
Example 11: Deferred tax: fair value model (depreciable and deductible)
Tiffiny Limited owns a building which it leases out under an operating lease.
This building originally cost C1 500 000 (1 Jan 20X2) and has a total useful life of 10 years.
Tiffany intends to continue leasing this property for the foreseeable future and uses the fair value model to
account for investment properties.
Fair value was C3 000 000 on 31 December 20X5 (31 December 20X6: C3 600 000).
The tax authorities:
x allow the cost of the building to be deducted at 5% per annum;
x levy income tax on taxable profits at a rate of 30%;
x include all rent income in taxable profits; and
x include capital gains in taxable profits at a 80% inclusion rate (the base cost equals the cost price).
Required:
A. Calculate the deferred tax balance at 31 December 20X6 and provide the deferred tax adjusting journal
for the year ended 31 December 20X6.
B. Show how your answer would change, if at all, if the building falls with a business model the objective of
which is to obtain substantially all of the property's economic benefits through use rather than sale.
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Example 12: Deferred tax: fair value model (depreciable and non-deductible)
Cowie Limited owns a building which it leases out under an operating lease. This building
originally cost: C1 500 000 (1 January 20X2) and had a total useful life of 10 years and a nil
residual value. Cowie intends to keep the building.
Cowie uses the fair value model to account for investment properties. The fair values of the building were
measured as follows:
x 31 December 20X5: C3 000 000
x 31 December 20X6: C3 600 000.
Required:
A. Calculate the deferred tax balance at 31 December 20X6 and provide the deferred tax adjusting journal
for the year ended 31 December 20X6.
B. How would your answer change if the building falls with a business model the objective of which is to
obtain substantially all the economic benefits embodied in the property through use rather than sale.
Answer:
x The deferred tax balance at 31 December 20X6: C504 000 liability (see W1)
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Answer:
x The deferred tax balance at 31 December 20X6: C630 000, liability (see W1)
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Balance: 1/1/20X2 0 0 0 0
(1) (4) (5)
Purchase: 1/1/20X2 1 500 000 0 (1 500 000) 0 Exempt
(3) (4) (3)
FV adj’s: 20X2 – 20X5 1 500 000 0 (1 500 000) (450 000) Cr DT Dr TE
Example 13: Deferred tax: fair value model (land and building):
x Non-depreciable and non-deductible; and
x Depreciable and deductible
Faith Limited owns a property which it is holding for rent income. The property originally cost C1 500 000 (1
January 20X2) and had a total useful life of 10 years. The property, which is classified as investment
property and which is measured using the fair value model, consists of a building and a large empty tract of
land. The estimated split is:
x 40% of the cost and the fair values relate to the land, and
x 60% of the cost and the fair values relate to the building.
The profit before tax and before any adjustments relating to fair value adjustments, rental income and
depreciation, is C500 000. The property earns an annual rental of C300 000.
Tax-related information:
x The income tax rate is 30%.
x Taxable profit will include all rent income but only 80% of a capital gain.
x The base cost is equal to its original cost.
x The tax authorities allow the deduction of an annual building allowance equal to 5% of the cost of the
building but do not allow deductions against the cost of land.
There are no temporary differences or permanent differences other than those evident from the above.
Required: Calculate the deferred tax balance as at 31 December 20X6 and show the deferred tax adjusting
journal for the year ended 31 December 20X6.
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Solution 13: Presumed intentions (rebutted and not rebutted) and exemption
Comments:
x The details regarding the profit before tax and rent income that were provided in the question are
irrelevant when calculating deferred tax.
x It is important to account for land and buildings separately wherever material. In this regard, the land
portion is considered material enough to be recognised separately.
x This question involves:
- presumed intentions (IAS 12.51C) and
- deferred tax exemptions (IAS 12.15).
x We must consider the presumed intention to sell (IAS 12.51C) since this is an investment property that
is measured under the fair value model.
x Certain of the temporary differences relating to land will be exempt from deferred tax because the land
is not deductible for tax purposes.
x When considering the presumed intention, we apply the principle to each of the components of the
investment property: the land and the building.
x In the case of the land, the presumed intention to sell may not be rebutted:
- although it falls within a business model the objective of which is to obtain substantially all of the
economic benefits embodied in the property through use rather than sale ,
- it is land and is thus not a depreciable asset.
The land thus fails the criteria for the presumption to be rebutted and thus the deferred tax must be
measured based on the presumed intention to sell this asset.
x In the case of the building, this presumed intention to sell is rebutted:
- it is a building and thus considered to be a depreciable asset, and
- it falls within a business model the objective of which is to obtain substantially all of the economic
benefits embodied in the property through use rather than sale.
The deferred tax is thus measured based on the actual intention to use this asset.
Answer:
x The deferred tax balance at 31 December 20X6: C647 100 liability (W1: 445 500 L + W2: 201 600 L)
x The deferred tax journal during 20X6 will be as follows:
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8. Current Tax
In most countries (including SA) the fair value gains and losses recognised in profit or loss are
not taxable for income tax purposes until they are actually realised through a sale. In other
words, when converting profit before tax to taxable profits, unrealised fair value adjustments
must be reversed.
Depreciation on a building would also be ignored for tax purposes and would be replaced by the
actual tax deduction granted, if any. In other words, when converting profit before tax to taxable
profits, you need to add back the depreciation and subtract any tax deduction.
Example 14: Current tax: intention to keep and use (including land)
This example uses the same information that was provided in the prior example (dealing with
Faith Limited). In this example, we focus only on calculating the current income tax.
Required: Calculate and journalise the current income tax payable as at 31 December 20X6.
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Solution 14: Current tax: intention to keep and use (including land)
Comment: This example focussed only on the current income tax effects - the deferred tax consequences
were calculated in the prior example (example 13).
General disclosure requirements (i.e. irrespective of whether the cost model or fair value model
is used) include:
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9.2 Extra disclosure when using the fair value model (IAS 40.76-78 & IFRS 13.91)
The investment property note should, if the fair value model was used, also disclose:
x the reconciliation between the opening and closing balance of investment property, showing all:
- additions (either through acquisition or a business combination);
- subsequent expenditure that was capitalised;
- assets classified as held for sale or included in a disposal group classified as held for
sale in accordance with IFRS 5;
- transfers into and out of investment property (i.e. from and to inventories and owner-
occupied property e.g. property, plant and equipment);
- fair value adjustments;
- exchange differences;
- other changes. IAS 40.76 (reworded slightly)
x if a specific property is measured using the cost model because the fair value could not
be reliably measured then the reconciliation above must be presented separately, and the
following must be disclosed in relation to that property:
- a description of the property; IAS 40.78(a)
- the range of estimates within which the fair value is highly likely to lie; IAS 40.78(c)
- if such a property is disposed of, a statement to this effect including the carrying
amount at the time of sale and the resulting gain or loss on disposal. IAS 40.78 (d)
x if the valuation obtained had to be significantly adjusted to avoid double-counting assets
and liabilities recognised separately in the financial statements, then include a
reconciliation between the valuation obtained and the adjusted valuation. IAS 40.77
IFRS 13 also requires certain minimum disclosures relating to fair value. If the asset is
measured using the fair value model, IFRS 13.91 requires disclosure of how the fair value was
measured:
x the valuation techniques (e.g. market, cost or income approach); and
x the inputs (e.g. quoted price for identical assets in an active market or an observable
price for similar assets in an active market).
Further minimum disclosures relating to this measurement of fair value are listed in
IFRS 13.93 and are covered in the chapter on Fair value measurement (IFRS 13).
9.3 Extra disclosure when using the cost model (IAS 40.79)
If the cost model had been used, then the accounting policy note should also disclose the:
x depreciation method and rates / useful lives. IAS 40.79 (a)-(b)
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If the cost model had been used, then the investment property note should also disclose the:
x the reconciliation between the opening balance and closing balance of investment property
must show all:
- the gross carrying amount and accumulated depreciation (at the beginning and end of the year);
- additions (either through acquisition or a business combination);
- subsequent expenditure that was capitalised;
- assets classified as held for sale or included in a disposal group classified as held for
sale in accordance with IFRS 5 and other disposals;
- transfers into and out of investment property (i.e. from and to inventories and owner-
occupied property e.g. property, plant and equipment);
- depreciation for the current year (and in the profit before tax note);
- impairments (and reversals) for the current year (and in the profit before tax note);
- exchange differences;
- other changes. IAS 40.79 (c) – (d)
x the fair values of the property unless, in exceptional circumstances, these cannot be
measured, in which case also disclose:
- a description of the property
- the reasons why the fair value was considered to not be reliably measurable;
- the range of estimates within which the fair value is highly likely to lie. IAS 40.79 (e)
Entity Name
Statement of financial position 20X5 20X4
As at 31 December 20X5 (extracts) C C
ASSETS
Non-current assets Note
Investment property 27 xxx xxx
Entity Name
Notes to the financial statements
For the year ended 31 December 20X5 (extracts)
1. Statement of compliance …
....
2. Accounting policies
2.1 Investment property:
Investment properties are land and buildings held by the group to earn rentals and/or for
capital appreciation. Properties held for resale or that are owner-occupied are not included in
investment properties. Where investment property is occupied by another company in the
group, it is classified as owner-occupied.
Investment properties are measured using the fair value model (or the cost model).
The company uses the following criteria to identify investment properties from inventory:
x …..
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Entity Name
Notes to the financial statements continued …
For the year ended 31 December 20X5 (extracts)
The investment property has been fair valued by suitably qualified and independent valuator with recent
experience in similar property in similar areas.
The valuation technique used when measuring fair value was the market approach and the inputs
involved level one inputs (quoted prices for similar properties, adjusted for condition and location).
Included in the above is a property measured at … that has been offered as security for a loan (see
Note … Loan obligations)
Included in the above is a property situated in Zimbabwe: income from rentals earned may not be received
due to exchange controls and the property may not be sold to anyone other than a Zimbabwean national.
10. Summary
Property
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Investment property
Recognition and measurement
Recognition Measurement
Owned property x Initial measurement: cost.
x Cost is different for
Same principle as for PPE (IAS 16): the property - Owned property
needs to meet the: - Property held as right-of-use asset
x definition and x Subsequent measurement:
choose between 2 models (cost & FV models)
x recognition criteria x Subsequent expenditure:
Held under a lease (as a right-of-use asset) normal capitalisation rules (IAS 16)
Same principles as in IFRS 16 x Transfers in / out (when evidence of change
in use)
x Disposals / purchases (IAS 16)
x Impairments (IAS 36) – cost model only
Initial measurement
Initial costs:
x Acquisition: Purchase price
x Construction: IAS 16 costs
x Right-of-use asset: IFRS 16 cost
x Exchange:
o FV of asset given up/ received (if more clearly evident) or
o CA of asset given up (if no FV’s or lack of commercial substance)
Includes:
x transaction costs,
x directly attrib. costs, professional fees etc
Excludes:
x wastage
x start-up costs
x initial operating losses
If payment deferred:
x PV of future payments
Subsequent costs:
x Same as above but often expensed – must meet the usual recognition criteria
Subsequent measurement
The models
Exceptions: p53
Investment property not under construction
x if on acq. date, you think FV not reliably measurable on a continuing basis: use CM for this particular
property until disposal – all other investment property can still be measured using FVM.
Investment property under construction:
x During construction: measure at cost if FV not measurable but switch to FVM if FV becomes measurable
during construction or at completion
x On completion: If FV not reliably measurable on continuing basis on completion date, use CM until disposal
(but if FV was used during construction, we may not switch to CM – we must continue using FVM)
No choice in models if:
x p53B and 55: properties previously measured using FV model: always measure using FVM
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FV is not:
x FV – CtS
x VIU (i.e. not entity-specific!)
If FV no longer able to be reliably measured, leave CA at the last known FV (do not change to CM)
Change in policy:
x generally only possible if policy changes from CM to FVM
Cost model
Measure in terms of:
x IFRS 16: if the property is a right-of-use asset. Apply:
- Depreciation requirements in IAS 16 (slight variations!)
- Impairment requirements in IAS 36
x IFRS 5: if it meets all criteria in IFRS 5 to be classified as 'held for sale'; or
x IAS 16: for all other assets, in which case measure at:
- Cost
- Less acc depreciation
- Less acc imp losses
Must still determine FV for disclosure purposes
Inventories IP PPE
x IP (IAS 40) x PPE (IAS 16/ IFRS 16) Carrying amount Fair value
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Measurement
Deferred tax
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Main disclosure
General
x Accounting policies
x Profit before tax:
Rental income from investment properties
Direct expenses re IP’s that earn rental income
Direct expenses re IP’s that do not earn rental income
Depreciation, impairment loss & reversals (if cost model)
x Investment property note:
Reconciliation between opening and closing balance
Fair value (if CM used, this must still be disclosed)
How fair value measured
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Chapter 11
Impairment of Assets
Reference: IAS 36 and IFRS 13 (including amendments to 10 December 2019)
Contents: Page
1. Introduction 551
2. Indicator review 552
2.1 Overview 552
2.2 External information 552
2.3 Internal information 552
2.4 Materiality 552
2.5 Reassessment of the variables of depreciation 553
Example 1: Indicator review 553
Example 2: Indicator review 555
3. Recoverable amount 556
3.1 Overview 556
Example 3: Recoverable amount and impairment loss: basic 556
3.1.1 Recoverable amounts: indefinite useful life intangible assets 557
3.1.2 Recoverable amounts: all other assets 557
3.2 Fair value less costs of disposal 558
Example 4: Recoverable amount: fair value less costs of disposal 558
3.3 Value in use 559
3.3.1 Cash flows in general 560
3.3.1.1 Relevant cash flows 560
3.3.1.2 Assumptions 560
3.3.1.3 Period of the prediction 560
3.3.1.4 Growth rate 561
3.3.1.5 General inflation 561
3.3.2 Cash flows from the use of the asset 562
3.3.2.1 Cash flows from use to be included 562
3.3.2.2 Cash flows from use to be excluded 562
3.3.3 Cash flows from the disposal of the asset 562
Example 5: Recoverable amount: value in use: cash flows 563
3.3.4 Discount rate and present valuing the cash flows 563
Example 6: Value in use: discounted (present) value 564
3.3.5 Foreign currency future cash flows 565
Example 7: Foreign currency future cash flows 565
4. Recognising and measuring an impairment loss 565
4.1 Overview 565
4.2 Impairments and the cost model 566
Example 8: Impairment loss journal: basic 566
4.3 Impairments and the revaluation model 567
Example 9: Impairment loss journal: with a revaluation surplus 568
Example 10: Fair value and recoverable amount – disposal costs are negligible 569
Example 11: Fair value and recoverable amount – disposal costs are not 569
negligible
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1. Introduction
IAS 36 Impairment of assets is designed to ensure that an The purpose of IAS 36:
asset’s carrying amount does not exceed its recoverable To ensure an asset’s CA is not
amount, and thus that its value is not overstated. overstated. See IAS 36.1
The carrying amount of an asset must reflect the economic Carrying amount is
benefits an entity expects it to produce. However, an asset’s defined as:
carrying amount could end up being overstated. For example: a x the amount at which an asset is
plant costing C100 000, that is depreciated to a nil residual value recognised
x after deducting any accumulated:
over 5 years, would have a carrying amount of C80 000 at the - depreciation (amortisation) &
end of year 1. However, if it was damaged in a storm in year 1, it - impairment losses. See IAS 36.6
is possible that the carrying amount is no longer a reasonable measurement of its expected economic
benefits. In this case, we must assess the amount we could truly obtain (recover) from this plant.
There are only ever two options for an asset: (a) dispose of it now or (b) continue using it and then
dispose of it. Thus, we calculate the net amount we could obtain from disposing of it (fair value less
cost of disposal) and the amount expected from continuing to using it (value in use). The higher of
these two amounts is the recoverable amount (we use the higher amount since we assume the entity
would choose the most advantageous outcome).
The term ‘asset’ in this chapter refers to both ‘individual assets’ and ‘cash-generating units’ (i.e. a group
of assets that cannot produce cash inflows independently of one another). We will first look at how to
account for impairments and impairment reversals in terms of individual assets and then apply these
principles to cash-generating units.
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x The entity expects the usage of the plant to be limited to non-existent beyond 20X9, therefore the
useful life needs to re-assessed according to this change in expected usage. Thus, the estimated
useful life of 10 years that is currently being used to calculate depreciation, is too long. By changing
the useful life to a shorter period, the depreciation will increase and the carrying amount of the
plant will decrease and may possibly decrease sufficiently such that there is no need to calculate
the recoverable amount.
Total useful life – original estimate 10 years
Used up to end of 31 December 20X8 (5 years)
Remaining useful life at 31 December 20X8 – original estimate 5 years
Remaining useful life at 31 December 20X8 – according to latest budget (1 years)
Remaining useful life at 31 December 20X8 – reduction (from 5 yrs to 1 yr) 4 years
The decrease in useful life must be recorded as a change in accounting estimate (IAS 8). The useful life
decreases by 4 years, whether we look at the total life or remaining life. At 31 December 20X8, it is a:
decrease in total useful life (TUL), from 10 yrs to 6 yrs (5 past yrs to the end of 20X8 + 1 more yr: 20X9)
decrease in remaining useful life (RUL) from 5 years to 1 year (working above).
These calculations at 31 December 20X8 establish that there is a change in useful life. However, since the
20X8 financial statements are not yet finalised, we account for this change from the beginning of 20X8.
Assuming one uses the reallocation approach to calculate the effect of the change in estimate, the change
to the carrying amount, calculated and accounted for from the beginning of 20X8, is as follows:
10-year 6-year Drop in carrying
W1 Change in estimate useful life useful life amount
Cost: 1/1/20X4 Given 700 000
Acc depr: 31/12/20X7 700 000 / 10 x 4 (280 000)
Carrying amount: 1/1/20X8 420 000 420 000
Remaining useful life 10 – 4; 1 + 1 6 2
Depreciation: 20X8 420 000 / 6; (70 000) (210 000) (140 000)
420 000 / 2
Carrying amount: 31/12/20X8 350 000 210 000 (140 000)
After processing the extra depreciation (of C140 000) in 20X8, the plant’s carrying amount at
31 December 20X8 will now be C210 000 instead of C350 000. This means that the net asset
value will decrease, and this revised net asset value must now be compared with the market value:
Assets per the SOFP before the change in useful life Given C400 000
Less reduction in carrying amount of plant due to extra depr. See W1 above (140 000)
Assets per the SOFP after the change in useful life 260 000
Less liabilities Given 100 000
Net asset value C160 000
The revised net asset value is now less than the company’s market value of C220 000 (2.2 x
100 000) and therefore the market value no longer suggests a possible impairment.
x The new reduced carrying amount is now also more in line with the present value of the future net
cash inflows per the management accountant’s budget:
Carrying amount of plant – revised See W1 above 210 000
Present value of budgeted future cash inflows from plant Given 230 000
As the carrying amount is now less than the present value of the expected future cash inflows, the
budgeted future cash flows no longer suggest an impairment.
Conclusion: Although the review initially suggested there were possible impairments and that these
impairments were possibly material, no recoverable amount needed to be calculated since the revised
depreciation resulted in the carrying amount being reduced. The following journal would be processed:
Debit Credit
Depreciation – plant (P/L: E) 140 000
Plant: Acc depr (-A) 140 000
Extra depreciation due to a reduction in useful life
(change in estimated depreciation)
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Lilguy Limited performed an indicator review (at 31/12/20X5) to assess if this asset may be impaired.
x The net asset value of the company is presented in the statement of financial position as C300 000
(Assets: 400 000 – Liabilities: 100 000) and this works out to a net asset value of C3 per share
(300 000 / 100 000 shares).
However, the market perceives the value of the company to be C3.50 per share or C350 000 in total
(C3,50 x 100 000 shares), which is more than the value reflected in the statement of financial
position (C300 000). This suggests that the assets in the statement of financial position are not
over-valued and therefore that there is possibly no impairment required.
x The fact that the management accountant believes that there are only 3 years of usage left in the
plant suggests that the 10 years over which the plant is being depreciated is too long.
By revising the useful life to a shorter period, the carrying amount of the plant will be reduced and
may be reduced sufficiently such that there is no need to calculate the recoverable amount.
Total useful life – original estimate 10 years
Used up to end 31 December 20X5 5 years
Remaining useful life – original estimate 5 years
Remaining useful life according to latest budget 3 years
Reduction in remaining useful life (from 5 years to 5 – 3 = 2 years) 2 years
This change in useful life (total life of 10 years decreased to 5 + 3 = 8 years; or change in remaining life
changed from 5 years to 3 years) must be accounted for as a change in accounting estimate (IAS 8).
Assuming that one uses the reallocation approach to account for the change in estimate, the change to
the carrying amount is as follows: 10 year 8 year Drop in
useful life useful life CA
Cost: 1/1/20X1 Given 700 000
Accum deprec: 31/12/20X4 700 000 / 10 x 4 (280 000)
Carrying amount: 1/1/20X5 420 000 420 000
Remaining useful life (10 – 4); (1 + 3) 6 4
Depreciation: 20X5 420 000/ 6; (70 000) (105 000) (35 000)
420 000/ 4
Carrying amount: 31/12/20X5 350 000 315 000 (35 000)
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x The new carrying amount will adjust the net asset value downwards and the revised net asset value
must be compared again with the market value:
Assets per the statement of financial position before the change in useful life 400 000
Less reduction in carrying amount of plant (35 000)
Assets per the statement of financial position after the change in useful life 365 000
Less liabilities 100 000
Net asset value 265 000
The revised net asset value is still lower than the company’s market value of 350 000 (3.5 x 100 000
shares) and therefore the market value still does not suggest a possible impairment.
x The new carrying amount will have brought the carrying amount downwards to be more in line with
the estimated fair value less costs of disposal.
Although the carrying amount is reduced, it is still materially greater than the fair value less costs of
disposal, and thus these budgeted future cash flows still suggest that the asset may be impaired.
Although this extra depreciation will be processed (see above journal), there is still evidence of a
possible material impairment and therefore the recoverable amount must be calculated.
This recoverable amount must then be compared with the revised carrying amount (i.e. after
deducting the depreciation per the journal above). If the recoverable amount is less than the carrying
amount, an impairment journal would need to be processed, as follows:
Debit Credit
Impairment loss – plant (P/L: E) xxx
Plant: Acc imp losses (-A) xxx
Impairment of plant
3.1 Overview
Recoverable amount is
defined as:
The recoverable amount is a calculation of the estimated
economic benefits that the entity expects to obtain from the x the higher of an asset’s:
asset. It is measured at the higher of the expected benefits - fair value less costs of disposal
(FV-CoD); and
from the entity using the asset or the entity disposing of the
- value in use (VIU). See IAS 36.6
asset. It is important to note that recoverable amount is
thus an entity-specific measurement.
Required:
A. Calculate the recoverable amount of the asset at 31 December 20X9.
B. Calculate whether or not the asset is impaired if its carrying amount is:
i. C200 000
ii. C150 000.
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ii) If the CA is C150 000, the asset is not impaired, because RA exceeds CA: C
Carrying amount 150 000
Less recoverable amount (170 000)
Impairment (carrying amount less than the recoverable amount) N/A
3.1.1 Recoverable amounts: indefinite useful life intangible assets, intangible assets
not yet available for use and goodwill (IAS 36.10 & 24)
Goodwill, intangible assets with indefinite useful lives and intangible assets not yet available for use
are subject to more stringent impairment testing. This is because they are not amortised and, by
their nature, their expected economic benefits are subject to a greater level of uncertainty.
In the case of these three assets, the recoverable amount must be estimated annually (i.e. not
only when an indicator review suggests an impairment). This estimate may be made any time
during the year (i.e. the estimate does not have to made as at reporting date), but it must be
made at the same time each year (e.g. if the reporting date is 31 December, the recoverable
amount may be estimated during September). However, if the asset was acquired during the
current year (e.g. in October), the recoverable amount must be calculated before reporting date.
In the case of intangible assets with indefinite useful lives, there is an exception to the ‘annual
recoverable amount calculation’ requirement: if a recent detailed estimate of the recoverable
amount was made in a preceding year, this estimate may be used instead of re-calculating the
recoverable amount, on condition that:
x if this intangible asset is part of a cash-generating unit, the assets and liabilities making up
that unit have not changed significantly; and
x the most recent detailed estimate of the asset’s recoverable amount was substantially
greater than the carrying amount at that time; and
x events and circumstances subsequent to the previous calculation of the recoverable
amount suggest that there is only a remote chance that the asset’s current recoverable
amount would have dropped below its carrying amount. See IAS 36.24
When faced with calculating recoverable amounts, remember that the recoverable amount
should be measured for each individual asset, unless the asset produces cash inflows in
tandem with a group of inter-dependent assets.
In this case, the recoverable amount for the group of assets is calculated rather than for an
individual asset. This group of assets is referred to as a cash-generating unit. This will be
covered later in this chapter. See IAS 36.22
Although the recoverable amount is the higher of ‘value in use’ and ‘fair value less costs of
disposal’, it is not always necessary (or possible) to calculate both these amounts. Consider
the following examples on the next page.
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Situations where we would not have to calculate both amounts include, for example:
x If it is impossible to measure the ‘fair value less costs of disposal’, then we will have no
option but to assume that the recoverable amount is its ‘value in use’.
x If the first of the two amounts is calculated and found to be greater than carrying amount,
the other amount will not need to be calculated. This is because a recoverable amount is
the higher of these two amounts, and thus this situation would have already proved that
the recoverable amount exceeds the carrying amount, and thus the asset is not impaired.
x If there is no indication that ‘value in use’ materially exceeds ‘fair value less costs of
disposal’ (this often happens if an asset is held for disposal), we can simply calculate the
‘fair value less costs of disposal’ (often easier to calculate than value in use). See IAS 36.19 - .21
Summary
Normal approach x calculate FV-COD; and then
x if FV-COD < CA then also calculate VIU (because this may be higher than CA)
But if you know that the:
x VIU> FV-COD : only calculate VIU
x FV-COD > VIU : only calculate FV-COD
x VIU = FV-COD : only calculate FV-COD (easier!)
x If calculation of FV-COD impossible : only calculate VIU
VIU = value in use FV-COD = fair value less costs of disposal CA = carrying amount
3.2 Fair value less costs of disposal (IAS 36.6 and IAS 36.28-9 and IAS 36.53A)
Fair value less costs of disposal is a measure of the estimated Fair value is
net proceeds that would be received if we were to sell the asset, defined as:
after taking into account disposal costs that we expect would be x the price that would be
incurred. x received to sell an asset (or
paid to transfer a liability)
By definition, fair value is a market-based measurement, x in an orderly transaction
because it takes into consideration only those assumptions that x between market participants
market participants would use when pricing the asset (see ‘fair x at the measurement date.
IAS 36.6
value’ definition in the pop-up).
For example, the cost of advertising an asset for sale is not included in the disposal costs
because advertising costs will be incurred even if the asset is not sold. Conversely, a sales
commission payable to a sales agent is incremental, and thus included in the disposal costs,
because it would only be incurred if the asset is sold. Based on definition of ‘incremental cost’ provided in IFRS 15
Termination benefits (as defined in IAS 19) and costs to restructure (re-organise) a business
must not be included as a disposal cost. IAS 36.28 (reworded)
558 Chapter 11
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x Costs to re-organise the layout of the factory due directly to the asset disposal C15 000
x If Apple were to sell the asset, it will result in a taxable recoupment of C150 000, on C45 000
which tax of C45 000 will be incurred (the income tax rate is 30%).
Required: Calculate the fair value less costs of disposal of the asset at 31 December 20X9.
Comment:
x VAT is a transaction tax (not an income tax) and thus is included in disposal costs (230 000 x 15/115 = 30 000).
x The cost of reorganising the factory after disposal of the asset is excluded from the costs of disposal
because this cost is not directly attributable to the disposal (it is only indirectly related).
x The income tax expense is excluded from the costs of disposal since IAS 36 specifically excludes
income tax from the definition of ‘costs of disposal’. See IAS 36.28
If the disposal of an asset requires the acquirer to assume a liability, then the asset’s FV would
effectively be determined on a net basis (FV of the asset – FV of the liability), and the disposal
costs would be deducted from this. An example: the acquisition of a nuclear plant that requires
environmental restoration upon its decommission in 10 years’ time. In this case, the FV-CoD
would equal: (FV of Plant – FV of Restoration obligation) less disposal costs. See IAS 36.29
Value in use (VIU) is
3.3 Value in use (IAS 36.30 – 57) defined as:
x the present value of the
Value in use includes the net cash flows from an asset’s:
x future cash flows expected to be
x use, and derived from
x disposal after usage. x an asset or cash-generating unit.
IAS 36.6
e) other factors that may affect the pricing of the cash flows (e.g. illiquidity). See IAS 36 Appendix A:A1
The time value of money is take into consideration when estimating an appropriate discount rate,
which is the market risk-free rate (element b).
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We will now discuss the calculation of the value in use under the following headings:
x cash flows in general;
x cash flows from the use of the asset;
x cash flows from the disposal of the asset; and
x present valuing the cash flows.
General factors to bear in mind when estimating the future cash flows include the:
x relevant cash flows (cash flows to be included and excluded);
x assumptions made;
x period of the prediction;
x growth rate used;
x general inflation.
The cash flows that should be included in the calculation of value in use are:
x From usage: the cash inflows from continuing use as Relevant cash flows
well as those cash outflows that are necessary to include inflows & outflows
create these cash inflows; and from:
x Usage &
x From eventual disposal: the net cash flows from the
x Disposal.
eventual disposal of the asset. See IAS 36.39
Projected cash flows should ideally not extend beyond five Period of prediction:
years since projections usually become increasingly unreliable.
However, they may extend beyond five years if management: x should ideally be 5 years/ shorter
x should be based on most recent &
x is confident the projections are reliable; and approved budgets and forecasts.
x can, based on past experience, demonstrate its ability
to forecast cash flows accurately over that longer period. See IAS 36.35
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If the projected cash flows cover a period that exceeds the period covered by the most recent,
approved budgets and forecasts (or indeed beyond the normal five-year limit), then the
projected cash flows for these extra years should be estimated by:
x extrapolating the approved budgets and forecasts;
x using either a steady or a declining growth rate (i.e. this would be more prudent than using
an increasing growth rate), unless an increasing growth rate is justifiable, for example, on
objective information regarding the future of the product or industry; and
x using a growth rate that should not exceed the long-term average growth rate of the
products, industries, market or countries in which the entity operates, unless this can be
justified (prudence once again).
For example: Imagine that our current year’s growth rate is 15%, which is significantly higher than our
average growth rate over the past 10 years, of 10%.
x In this case, even if we feel certain that the future growth rate will be 15%, it would be inadvisable to use 15%
as the projected future growth rate in our calculations of value in use.
x This is because it is difficult to justify a growth rate that exceeds the long-term average growth rate. A
projected growth rate that exceeds the past long-term average growth rate is obviously based on favourable
conditions that the entity is either currently experiencing, or is expecting to experience in the future. However,
when experiencing – or expecting to experience – favourable conditions, it means we should also expect
competitors to enter the market to take advantage of these same favourable conditions. If this happens, the
higher than normal projected growth rate of 15% would be reduced over this longer term.
x The effects of future unknown competitor/s are obviously impossible to estimate and thus, to be prudent, one
should use a growth rate of 10%, and not 15%. See IAS 36.37
Similarly, in declining markets, simply basing projections on past sales that are just extrapolated, even at zero
growth rate, might be very inaccurate. Declining markets reflect higher uncertainties and not only could
cash inflows from sales decrease, but cash outflows from costs may increase.
In essence, nominal cash flows include general inflation, whereas real cash flows, exclude
general inflation. Thus:
x if we use nominal cash flows (i.e. including inflation), the discount rate must reflect the
effects of this inflation;
x if we use real cash flows (i.e. excluding general inflation), the discount rate must not reflect the
effects of this inflation.
Worked example: General inflation – effect on discount rate and cash flows
If we currently pay rent of $100 and expect to pay $110 next year due to general inflation of
10%, then our nominal cash flow is $110 (actual amount we expect to pay) and our real cash
flow is $100 (nominal cash flow adjusted backwards to remove the inflation: 110 / 1.1 = $100).
x If we use nominal rent of $110, then our discount rate would be 10% (the PV factor for 10% after
one year is 0.9091 and thus the present value would be $110 x 0.9091 = $100).
x If we used real rent of $100, then our discount rate would be 0% (the PV factor for 0% after one
year is 1, and thus the present value would be $100 x 1 = $100).
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3.3.2 Cash flows from the use of the asset (IAS 36. 39–51)
3.3.2.1 Cash flows from use to be included (IAS 36.39(a) & (b); IAS 36.41-42)
3.3.2.2 Cash flows from use to be excluded (IAS 36.43-48 & IAS 36.50-51)
Future cash flows are estimated based on the asset’s current Cash flows from
disposal:
condition. The following expected cash flows are thus excluded:
x cash inflows that relate to other assets, (since these will be x Expected proceeds
taken into account when assessing the value in use of these x Less expected disposal costs
other assets);
x cash outflows that have already been recognised as liabilities (for example, a payment of an
accounts payable) since these outflows will have already been recognised (either as part of
the asset or as an expense); See IAS 36.43
x cash inflows and outflows relating to future expenditure to enhance the asset in excess of
its current standard of performance at reporting date; See IAS 36.44 & .45
x cash inflows and outflows relating to a future restructuring to which the entity is not yet
committed; See IAS 36.44 & .45
x cash inflows and outflows from financing activities (since cash flows will be discounted to
present values using a discount rate that takes into account the time-value of money);
x cash flows in respect of tax (because the discount rate used to discount the cash flows is
a pre-tax discount rate). See IAS 36.50
3.3.3 Cash flows from the disposal of the asset (IAS 36.43(c); .52 and .53)
The net cash flows from the future disposal of an asset is estimated as follows:
x the amount the entity expects to receive from the disposal of the asset at the end of the
asset’s useful life in an arm’s length transaction between knowledgeable, willing parties;
x less the estimated costs of the disposal. IAS 36.52 (slightly reworded)
The net cash flow from the future disposal of an asset is estimated based on prices currently
achieved from the disposal of similar assets that are already at the end of their useful lives and
have been used under similar conditions.
562 Chapter 11
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The machine is expected to last for 5 years, and management does not expect to be able to sell it at
the end of its useful life. The growth rate in the business in 20X4 was an unusual 15% whereas the
average growth rate over the last 7 years is:
x in the industry 10%
x in the business 8%
Required: Calculate the future net cash flows to be used in the calculation of the value in use of the
machine at 31 December 20X4 assuming that a 5-year projection is considered to be appropriate.
Comment:
x The net cash inflows per year still need to be present valued and the total of the present values per
year is then totalled to give the ‘net present value’ or ‘value in use’.
x It was assumed in this question that the machine would not be able to be sold at the end of its useful
life and the disposal thereof would not result in any disposal costs.
x The current year growth rate of 15% seems unusual given the company’s average growth rate was
only 8%. The industry average of 10% is also greater than the business average of 8%. Prudence
dictates that we should thus use 8%.
3.3.4 Discount rate and present valuing the cash flows (IAS 36.55 - 57)
The cash inflows and cash outflows relating to the use and eventual disposal of the asset must
be present valued (i.e. discounted to a present value). This means multiplying the cash flows
by an appropriate discount factor (or using a financial calculator). Choosing an appropriate
discount rate requires professional judgement.
Chapter 11 563
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The discount rate is a pre-tax discount rate, which is estimated using the:
x current market assessment of the time value of money; and Discount rate should
x the risks specific to the asset for which the future cash be:
flows have yet to be adjusted. IAS 36.55 (reworded) x pre-tax
x market-related risk-free rate
When an asset-specific rate is not available, a surrogate rate
x Adjusted for risks specific to
is used. Guidance for estimating a surrogate rate is as follows: the asset for which future cash
x Estimate what the market assessment would be of: flows haven’t yet been adjusted
- the time value of money for the asset over its PVF = 1 ÷ (1 + k) n
remaining useful life;
Where:
- the uncertainties regarding the timing and amount of k = discount rate and
the cash flows (where the cash flow has not been n = number of periods to cashflow
adjusted);
- the cost of bearing the uncertainties relating to the asset (if the cash flow was not adjusted);
- other factors that the market might apply when pricing future cash flows (e.g. the entity’s
liquidity) (where the cash flow has not been adjusted).
x The weighted average cost of capital of the entity (using the Capital Asset Pricing Model),
the entity’s incremental borrowing rate and other market borrowing rates could be
considered although these rates would need to be adjusted to reflect how the market would
assess the following risks in context of the expected cash flows (unless the cash flows have
already been appropriately adjusted):
- country risk;
- currency risk; and
- price risk. IAS 36 Appendix A, A16 - 18
Net present value (NPV) (value in use): 54 540 + 49 560 + 48 064 C152 164
564 Chapter 11
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If the future cash flows are generated in a foreign currency, the value in use must be calculated as:
x the future cash flows must first be estimated in that foreign currency;
x these foreign currency future cash flows must then be discounted to a present value by
using a discount rate that is appropriate for that foreign currency; and
x this foreign currency present value is then translated into the local currency using the spot
rate at the date of the value in use calculation. IAS 36.54 (reworded)
Net present value in dollars (value in use) 45 450 + 41 300 + 40 554 $127 304
Net present value in Rand (value in use) $127 304 x R6 R763 824
4 Recognising and Measuring an Impairment Loss (IAS 36.58-64 and IAS 36.5)
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Please note that it is not uncommon for the residual value to be reduced and/ or for the remaining useful
life to be reduced as a result of the same circumstances that caused an impairment to be processed.
Changes to the residual value and useful life are accounted for as changes in estimate in terms of
IAS 8 Accounting policies, changes in accounting estimates and errors.
Impairments are processed whether the asset is measured using the cost model or revaluation
model. The journals will be slightly more complex if the revaluation model is used.
To process an impairment on an asset that is measured using the cost model (e.g. in terms of IAS 16
Property, plant and equipment, IAS 38 Intangible assets or IAS 40 Investment properties), the carrying
amount is not reduced by crediting the asset's cost account but rather by crediting either:
x accumulated impairment loss account; or Cost model
x accumulated depreciation and impairment loss account impairment journal:
(‘accumulated depreciation’ is not required to be separately
disclosed from ‘accumulated impairment losses’ and thus the x Dr: Impairment loss
two accounts can be combined). x Cr: Accumulated imp loss
HCA
RA RA
HCA: Historical carrying amount ACA: Actual carrying amount RA: Recoverable amount
Explanation:
x Historical carrying amount (HCA) reflects the asset’s
cost if it is non-depreciable, or
depreciated cost, if it is a depreciable asset.
x If the ACA = HCA (cost less accumulated depreciation) and this ACA must be reduced to a lower amount
in order to reflect RA, this is recognised as an impairment loss expense.
x If the ACA had already been reduced below the HCA and must now be reduced to an even lower RA,
the treatment is the same: the decrease is recognised as an impairment loss expense.
For further examples of an impairment loss involving an asset measured under the cost model,
see chapter 7: see example 29, 31 and 32.
566 Chapter 11
Gripping GAAP Impairment of assets
In other words, if no revaluation surplus existed, then the entire decrease in the carrying amount is
recognised as an impairment loss expense as follows:
Debit Credit
Impairment loss (E) xxx
Plant: Accumulated impairment losses (-A) xxx
Impairment of PPE (no revaluation surplus balance existed)
If there was a balance on the revaluation surplus, we journalise the impairment in two steps:
x Step 1: first reduce the revaluation surplus account (debit revaluation surplus)
x Step 2: once the revaluation surplus account has been reduced to zero, any excess impairment is
recognised as an impairment expense (debit impairment loss expense).
Debit Credit
Revaluation surplus (OCI) xxx
Plant: Accumulated impairment losses (-A) xxx
Step 1: Impairment of PPE: first against existing RS balance
Notice that we credit the accumulated impairment loss account for both the:
x debit to impairment loss expense, and
x debit to revaluation surplus.
The effect of the above treatment is that the cost account remains reflected at fair value and the
carrying amount of the asset is thus reflected at fair value less subsequent accumulated depreciation
and impairment losses. See IAS 16.31
HCA RA ACA
Imp loss Imp loss
NOTE 1
RA HCA RA
Note 1:
x The summary above assumes that any revaluation surplus is transferred to retained earnings over the
life of the asset, in which case, the difference between the ACA and the HCA will reflect the revaluation
surplus balance.
x If the revaluation surplus is not transferred to retained earnings over the life of the asset, the table above
does not apply since the balance in the revaluation surplus account will not be the difference between
ACA and HCA: however, the over-riding principle of first removing whatever balance exists in the
revaluation surplus account and then expensing any further impairment still applies.
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x In essence: any impairment is first debited against whatever balance is in the revaluation surplus
account, and any further impairment after having completely reversed the revaluation surplus balance
is then expensed as an impairment loss expense (i.e. first debit revaluation surplus and then debit
impairment loss expense with any excess). This obviously assumes that the ACA already reflected FV,
since the revaluation model is being used. The asset must be measured at its fair value less accumulated
depreciation and subsequent impairment losses. However, in reality, since revaluations to FV are not
required to be performed each year, when 'impairing' ACA to RA, check that the ACA reflected this FV
before assuming the entire decrease is an ‘impairment loss’. If not, then one must first adjust the ACA
to FV, accounting for this adjustment as a ‘revaluation’.
When processing an impairment loss for an asset that uses the revaluation model, if a revaluation is
due to be performed during the year, we would account for the revaluation before we account for the
impairment. In other words:
x Revalue the asset to fair value following the normal revaluation process (see Chapter 8)
x Calculate the recoverable amount of the asset
x Process an impairment loss (if the new CA exceeds the asset’s RA).
This process is based on the principle that the asset measured under the revaluation model must be
carried at its ‘fair value at the date of the revaluation less any subsequent accumulated depreciation
and impairment losses’. See IAS 16.31
Please also remember that the carrying amount of an asset measured under the revaluation model,
must never differ materially from its current fair value at year-end. See IAS 16.31
The difference between fair value (used in the revaluation model) and fair value less costs of disposal
(used in calculating the recoverable amount) is obviously the ‘cost of disposal’:
x If the costs of disposal are negligible, the fair value less costs of disposal would be almost the
same as the fair value and thus, irrespective of what the value in use is, the asset cannot be
materially impaired (the recoverable amount will be equal to or higher than the fair value). Thus,
if the costs of disposal are negligible, the asset need not be tested for impairment. See IAS 36.5(a) as
amended by IFRS13
x If the costs of disposal are not negligible, then the fair value less costs of disposal will be less
than the fair value, in which case the asset would be impaired unless the value in use is greater
than fair value. See IAS 36.5(c)
568 Chapter 11
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Required: Determine if the asset is impaired at the financial year ended 31 December 20X5, and
calculate the impairment loss, if any.
Chapter 8: example 12 is another example of impairment testing and the revaluation model
Chapter 11 569
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An impairment loss reversal will have the effect of increasing the carrying amount (carrying
amount before the reversal + impairment loss reversal = new carrying amount). Thus, the
depreciation after the reversal of an impairment loss will be calculated based on the:
x new depreciable amount (i.e. new carrying amount less residual value)
x divided by the asset’s remaining useful life (RUL). See IAS 36.121
Please note that it is not uncommon for the remaining depreciation variables (e.g. useful life), to
be increased as a result of the change in circumstances that caused an impairment to be
reversed. Changes to the variables of depreciation are accounted for prospectively as a ‘change
in estimate’ in terms of IAS 8 Accounting policies, changes in accounting estimates and errors.
Impairment reversals are processed whether the asset is measured using the cost model or
revaluation model. The journals are slightly more complex if the revaluation model is used.
5.2 Impairment reversals and the cost model (IAS 36.117 & .119)
Impairment loss
When reversing an impairment, we must never increase an reversals under the
asset’s carrying amount above the carrying amount it would have cost model:
had, had the asset never been impaired. Thus, in the case of the x Up to HCA (depreciated cost):
cost model, we may not increase the asset’s carrying amount - Dr: Accum. impairment loss
above its historical carrying amount, which is its depreciated cost: - Cr: Impairment loss reversal
x original cost x Above HCA (depreciated cost)
x less accumulated depreciation. See IAS 36.117 Not allowed (the ACA under the
cost model must never exceed
If the cost model is used, the increase in carrying amount is depreciated cost)
recognised in profit or loss as an impairment reversal (income), calculated as: C
Recoverable amount (limited to historical carrying amount) xxx
Less the actual carrying amount (xxx)
Impairment loss reversed xxx
RA HCA
Not allowed
HCA RA
Imp loss Imp loss
reversed reversed
ACA ACA
HCA: Historical carrying amount ACA: Actual carrying amount RA: Recoverable amount
570 Chapter 11
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For further examples of an impairment loss reversal involving an asset measured under the
cost model, please see chapter 7: examples 30, 31 and 32.
5.3 Impairment reversals and the revaluation model (IAS 36.118 - 120)
When reversing an impairment, one must take care that the carrying amount is not increased
above what the carrying amount would have been had the asset never been impaired. In other
words, in the case of the revaluation model, the carrying amount may not be increased above
its most recent fair value less subsequent accumulated depreciation (depreciated fair value).
Solution 12A: Revaluation model and impairment loss reversed (not limited)
Comment:
x This example involves a situation where:
- the recoverable amount exceeds the historical carrying amount (depreciated cost) of C120 000 and
thus the impairment loss reversed is recognised partly in profit or loss (increasing the CA back up to
HCA) and partly in other comprehensive income (increasing the CA above HCA); but
- the recoverable amount does not exceed the depreciated fair value of C180 000, and thus the
increase will not be limited by this depreciated fair value.
x On 31 December 20X5, the recoverable amount (RA) is C160 000.
On this date, the actual carrying amount (ACA) is C60 000:
- CA at 31/12/X4: 70 000 – Depr in 20X5: (70 000 – 0) / 7 yrs x 1 = 60 000.
The increase in carrying amount of C100 000 (from C60 000 to C160 000) occurs after a previous
impairment loss had been processed (on 31/12/X4). This means that the portion of the increase on
31/12/X5 that increases the actual carrying amount of C60 000 up to the historical carrying amount
(depreciated cost) of C120 000 (see W1) is an impairment reversal (i.e. it is not ‘revaluation income’).
x The recoverable amount of C160 000 exceeds the historical carrying amount (depreciated cost) of
C120 000 (W1) and thus this portion of the increase (C40 000) is recognised in OCI.
x We must be careful not to increase the carrying amount above the depreciated fair value. However,
the recoverable amount of C160 000 does not exceed the depreciated fair value of C180 000 (W2:
FV - AD) and thus none of the increase is disallowed.
Chapter 11 571
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Note: The above journal can also be combined as shown in solution 12B that follows.
Workings:
W3: Roll forward from purchase (01/01/X2) to reporting date (31/12/X5) (NOT REQUIRED)
Cost: 01/01/20X2 Given 200 000
Accumulated depreciation: 20X2 (200 000 – 0) / 10 yrs x 1 yr (20 000)
Carrying amount: 31/12/20X2 180 000
Revaluation surplus: 01/01/20X3 Balancing: FV: 270 000 – CA: 180 000 90 000
Fair value: 01/01/20X3 Given 270 000
Depreciation: 20X3 & 20X4 (270 000 – 0) / 9 remaining yrs x 2yrs (60 000)
210 000
Revaluation surplus (OCI): 31/12/20X4 Balancing: 210 000 – HCA: 140 000 (70 000)
HCA (i.e. depreciated cost): 31/12/20X4 HCA: 200 000 – (200 000 – 0) / 10 x 3 140 000
Impairment loss (P/L): 31/12/20X4 Balancing: HCA: 140 000 – RA: 70 000 (70 000)
Carrying amount: 31/12/20X4 Recoverable amount: Given 70 000
Depreciation: 20X5 (70 000 – 0) / 7 remaining yrs x 1 yr (10 000)
Actual carrying amount: 31/12/20X5 ACA before the impairment is reversed 60 000
Imp loss reversed (P/L): 31/12/20X5 Balancing: ACA: 60 000 – HCA: 120 000 60 000
HCA (i.e. depreciated cost): 31/12/20X5 200 000 – (200 000 – 0) / 10 x 4 120 000
Revaluation surplus (OCI): 31/12/20X5 Balancing: HCA: 120 000 – RA: 160 000 40 000
Carrying amount: 31/12/20X5 Lower of: x RA: 160 000 (Given), and 160 000
x Depreciated FV: 180 000 (W2)
572 Chapter 11
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Workings:
W3: Roll forward from purchase (01/01/X2) to reporting date (31/12/X5) (NOT REQUIRED)
Cost: 01/01/20X2 Given 200 000
Accumulated depreciation: 20X2 (200 000 – 0) / 10 yrs x 1 yr (20 000)
Carrying amount: 31/12/20X2 180 000
Revaluation surplus: 01/01/20X3 Balancing: FV: 270 000 – CA: 180 000 90 000
Fair value: 01/01/20X3 Given 270 000
Depreciation: 20X3 & 20X4 (270 000 – 0) / 9 remaining yrs x 2yrs (60 000)
210 000
Revaluation surplus (OCI): 31/12/20X4 Balancing: 210 000 – HCA: 140 000 (70 000)
HCA (i.e. depreciated cost): 31/12/20X4 HCA: 200 000 - (200 000 – 0) / 10 x 3 140 000
Impairment loss (P/L): 31/12/20X4 Balancing: HCA: 140 000 – RA: 70 000 (70 000)
Carrying amount: 31/12/20X4 Recoverable amount: Given 70 000
Depreciation: 20X5 (70 000 – 0) / 7 remaining yrs x 1 yr (10 000)
Actual carrying amount: 31/12/20X5 ACA before the impairment is reversed 60 000
Imp loss reversed (P/L): 31/12/20X5 Balancing: ACA: 60 000 – HCA: 120 000 60 000
HCA (i.e. depreciated cost): 31/12/20X5 200 000 - (200 000 – 0) / 10 x 4 120 000
Revaluation surplus (OCI): 31/12/20X5 Balancing: HCA: 120 000 – RA: 180 000 60 000
Carrying amount: 31/12/20X5 Lower of: x RA: 210 000 (Given), and 180 000
x Depreciated FV: 180 000 (W2)
Summary: Increases in carrying amount using the revaluation model
HCA RA RA
Not allowed/ Not allowed/
Creation of RS Increase in RS
(See note 1 & 2) (See note 1 & 2)
RA HCA ACA
Increase Increase
allowed (P/L) allowed (P/L)
(See note 3) (See note 3)
ACA ACA HCA
HCA: Historical carrying amount ACA: Actual carrying amount RA: Recoverable amount
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Note 1: If the revaluation model is used, an increase above HCA (depreciated cost) is allowed but only to
the extent that the new CA does not exceed the CA the asset would have had had it not been
impaired (i.e. it is limited to depreciated fair value under the revaluation model). See IAS 36.117
See IAS 36.120
Note 2: Any increase above HCA that is allowed is recognised as a revaluation surplus.
Note 3: An increase up to HCA is recognised in profit or loss. It will be called:
x an impairment loss reversal if it reverses a prior impairment loss (i.e. the asset was previously
impaired to recoverable amount, through an impairment loss expense),
x a revaluation income if it reverses a prior devaluation (i.e. the asset was previously devalued
to a lower fair value, through a revaluation expense). See IAS 36.119 read together with IAS 16.40
6.1 Overview
A cash generating unit
(CGU) is defined as:
When testing assets for impairment, the recoverable amount
should ideally be estimated for an individual asset. However, x the smallest identifiable group of
assets
it is often not possible to estimate the recoverable amount of
x that generates cash inflows that are
the individual asset. In this case, we must decide to which
cash-generating unit (CGU) the asset belongs and test x largely independent of the cash
inflows from other assets or groups
the CGU for impairment instead.
of assets. IAS 36.6
The instances where the recoverable amount of an individual asset cannot be estimated are:
x it does not generate cash inflows from continuing use that are largely independent of those
from other assets (i.e. it is a part of a cash-generating unit) and thus its individual value in
use cannot be measured; and
x its value in use cannot estimated to be close to its fair value less costs of disposal. See IAS 36.67
We are a successful mining entity that owns a private railway for transporting coal. This railway can
only be sold as scrap metal of C1 000 (net of disposal costs).
x Since this railway does not generate its own cash inflows but works in tandem with the other
mining assets to help generate cash inflows from the sale of coal, we cannot calculate its individual
‘value in use’.
x Although the railway’s ‘fair value less costs to sell’ reflects its scrap metal value, there is no
evidence that the entity plans to dispose of the railway and thus it is unlikely that its ‘value in use’
would be similar to its ‘fair value less costs to sell’.
Since we cannot directly calculate the railway’s individual ‘value in use’ and we can’t indirectly estimate
it by concluding that it’s similar to its ‘fair value less costs of disposal’ of C1 000, we cannot calculate
the railway’s recoverable amount (because we need both amounts to do this). Thus, the railway must
be tested for impairment by including it in the cash-generating unit to which it belongs (i.e. the mine).
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Sometimes the output of an asset, or group of assets, is used partly or entirely by another asset,
or group of assets, within the entity (e.g. plant A produces widgets that are then used by
plant B). In this situation, it may seem that the cash inflows from this asset, or group of assets,
are not independent of one another and should thus be considered as one single CGU (e.g.
plant A and plant B may be considered dependent on one another and thus accounted for as a
single CGU). However, IAS 36 states that if it is simply possible for the output to be sold on an
active market, then this asset, or group of assets, is classified as a CGU even though its output
is being used internally by another asset or group of assets. See IAS 36.70
For example:
If plant A produces widgets that are then used by plant B, but these widgets could be sold on
an active market, then, even though this is not currently happening and thus it is not currently
producing independent cash inflows, plant A is considered to be its own separate CGU).
In this case, budgets relating to this asset or group of assets may need to be adjusted to reflect
the market prices that would be achievable if the output was sold on the active market instead
of the internal prices currently achieved by using the output internally. See IAS 36.70
When calculating the carrying amount and the recoverable amount (greater of fair value less
costs of disposal and value in use) of a CGU:
x we include the carrying amount of only those assets that can be attributed directly, or
allocated on a reasonable and consistent basis, to the CGU and that will generate the future
cash flows used in determining the CGU’s value in use; IAS 36.76 (a)
x we exclude all liabilities relating to the group of assets unless the recoverable amount of
the CGU cannot be measured without consideration of this liability, for example, where the
disposal of a group of assets would require the buyer to assume (accept responsibility for)
the liability (e.g. a nuclear power station where there is a legal requirement to dismantle it
at some stage in the future); IAS 36.76 (b) (reworded) & IAS 36.78
If we know the recoverable amount of one of the individual assets within a CGU, we first test
that individual asset for impairment. Incidentally, if one of the individual assets within a CGU is
to be scrapped, then:
x its ‘fair value less costs of disposal’ (FV-CoD) will reflect the expected net proceeds from
scrapping, and
x since there would be zero, or negligible, cash inflows expected from use, then its ‘value in use’
(VIU) would also roughly equal the cash inflows from the expected net proceeds on scrapping.
This means that, if one of the individual assets within a CGU is to be scrapped, its recoverable
amount will be known (RA = FV-CoD = VIU = proceeds from scrapping) and thus assets to be
scrapped should always be tested for impairment as an individual asset before impairment
testing the CGU to which it belongs. See IAS 36.21 and .66
Required: Calculate and journalise the impairment of the machine assuming that:
A. the intention is to repair the machine and return it to the assembly line; and
B. the intention is to scrap the machine for C1 000.
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Debit Credit
Impairment loss (P/L: E) 39 000
Machine: Accumulated impairment loss (-A) 39 000
Impairment of machine
If a cash generating unit is impaired, the impairment loss must be allocated to the relevant
individual assets within the group.
Allocating a CGU
The allocation of an impairment of a cash-generating unit to impairment loss to its
individual assets
the relevant individual assets is as follows:
x first allocate the IL to goodwill;
x the impairment is first allocated to goodwill, if any; and
x then allocate any remaining IL to
x any remaining impairment is allocated on a pro rata basis
the other assets on a pro rata basis
based on the relative carrying amounts of the individual based on their carrying amounts
scoped-in assets within the group (see section 6.2.4 for
more about scoped-in and scoped-out assets). See IAS 36.104
However, when allocating a CGU’s impairment loss, the The CA of each asset
individual assets’ carrying amounts may not be reduced can’t be reduced below
below the greater of their individual: the higher of its:
x fair value less costs of disposal (if measurable); x fair value less costs of disposal
x value in use
x value in use (if determinable); or x zero. IAS 36.105
x zero. IAS 36.105 (slightly reworded)
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Example 14 shows the impairment of a CGU that does not contain goodwill whereas example 15 (and
example 17) shows the impairment of a CGU that does contain goodwill.
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CA Impairment CA
W2: Impairment loss allocated to individual assets before IL allocated after IL
Calculation C C C
Goodwill Goodwill is impaired first 4 000 (4 000) 0
Equipment 6 000/ 8 000 x 5 000 remaining impairment 6 000 (3 750) 2 250
Vehicles 2 000/ 8 000 x 5 000 remaining impairment 2 000 (1 250) 750
Remaining impairment = 9 000 – 4 000
12 000 (9 000) 3 000
Notes:
x If a CGU contains goodwill, the first round of impairment allocations is always against this goodwill.
x After impairing the goodwill, there was still a remaining impairment (C9 000 – C4 000 = C5 000) that needed to
be allocated to the remaining scoped-in assets. All assets in this example were scoped-in assets.
If one (or more) of the individual assets within a CGU show signs of being impaired, the entity must
try to determine its recoverable amount. If this individual asset's recoverable amount is determinable
and found to be less than its carrying amount, this individual asset must be impaired.
See IAS 36.66
If this CGU:
x does not contain goodwill, it is not essential to process the impairment on this individual asset
before calculating and allocating any impairment loss on the CGU; but if it
x does contain goodwill, it is essential to process the impairment on this individual asset before
calculating and allocating any impairment loss on the CGU. See IAS 36.97-8
For consistency, all solutions to the examples in this chapter will be approached in a way that first
processes the individual asset impairments (if any), before any impairment on the cash-
generating unit is calculated and allocated. See IAS 36.97-98
6.2.3 If we know one of the amounts relating to an individual asset’s recoverable amount
Recoverable amount is the higher of value in use and fair value less cost of disposal. The nature
of CGUs means that value in use is often not determinable on an individual asset basis. However,
the measurement of an individual asset's fair value less costs of disposal may be possible.
If an individual asset's fair value less costs of disposal is known, the portion of the cash-generating
unit's impairment loss that is allocated to this individual asset must not reduce its carrying amount
below its fair value less costs of disposal.
This may require us to limit the amount of the impairment loss that was going to be allocated to
this asset, resulting in a portion of the cash-generating unit's impairment loss remaining
unallocated. In this case, a second round of allocation (or even a third/ fourth round etc) must be
performed until the entire impairment loss is re-allocated to those assets within the cash-
generating unit that have not yet reached their minimum value (i.e. higher of value in use, fair
value less costs of disposal and zero). See IAS 36.105
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Although the recoverable amount of the building is unknown, we know that its fair value less costs of
disposal (FV-CoD) is C3 600.
Required: For each asset in the CGU, calculate its impairment loss and its final carrying amount.
W3: Allocation of the CGU impairment loss (2 000) to the individual assets
Other assets possibly not yet fully impaired 3 889 (489) 3 400
x Equipment 2 333 / 3 889 x 489 2 333 (293) 2 040
x Vehicles 1 556 / 3 889 x 489 1 556 (196) 1 360
12 489 (489) 12 000
CGU impairment still to be allocated (489 – 489) 0
Notes:
1. We know the RA of the plant and thus impair this individual asset first – see W1. See IAS 36.97-8
Once the plant has been impaired, its CA will have been reduced to its RA and thus plant may not
be impaired further. See IAS 36.105
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2. Although we did not know the RA of the building, we know that its FV-CoD was C3 600. Thus, we
must be careful not to reduce its CA below C3 600. See IAS 36.105
Therefore, although the impairment allocation was supposed to be C889 (4K/9K x 2 000), this
would have reduced its CA to C3 111 (C4 000 – C889), and since we know we may not reduce its
CA to below C3 600, we must limit the IL allocation to C400.
As a result of this limitation, there needs to be a second round of allocations to allocate the
remaining unallocated impairment loss of C489 (C889 – C400).
After processing the C400 impairment loss to the building, the building is fully impaired and thus
the second round of allocations now also excludes the building (i.e. the plant and the building are
excluded in the second round of allocations).
IAS 36 Impairment of assets applies to all assets except certain scoped-out assets (see
section 1) and liabilities:
x These scoped-out assets (and liabilities) are included in
A CGU may include
the calculation of the CGU’s carrying amount, which is scoped-out assets.
then compared with the CGU’s recoverable amount to
x A CGU's CA and RA includes any
determine whether the CGU is impaired.
scoped-out assets; but
x However, an impairment of a scoped-out asset is not x A CGU impairment is never
measured in terms of IAS 36 but in terms of its own allocated to a scoped-out asset
standard instead (e.g. inventory is measured at ‘the lower of cost and net realisable value’
in terms of IAS 2 Inventory) and thus any impairment (or impairment reversal) relating to
the CGU must not be allocated to these assets (or liabilities).
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W3: Allocation of the CGU impairment loss (2 800) to the individual assets
CA Impairment loss CA
before IL allocation after IL
Remember that intangible assets with indefinite useful lives, intangible assets not yet available
for use, and goodwill must be tested every year for possible impairments, even if there is no
indication that it is impaired. They may be tested at any stage during the year so long as they
are tested at the same time every year (see section 3.1.1).
The fact that they must be tested every year is important when deciding when to test a CGU
for impairment because, if the CGU contains one or more of these assets, it means the CGU
will have to be tested annually in the same way, assuming the individual recoverable amounts
for these assets cannot be calculated (P.S. the recoverable amount for goodwill can never be
calculated individually). See IAS 36.66
Where goodwill is allocated across various cash-generating units, these cash-generating units
may be tested for impairment at different times. See IAS 36.10
If the CGU contains intangible asset with an indefinite useful life, then it is possible that a prior
recent, detailed recoverable amount calculation could be used, assuming three criteria are met
(see section 3.1.1). See IAS 36.24
Similarly, the most recent detailed calculation made in a preceding period of the recoverable
amount of a cash-generating unit to which goodwill has been allocated may be used in the
impairment test of that unit in the current period provided all of the following criteria are met:
x the assets and liabilities making up the unit have not changed significantly since the most
recent recoverable amount calculation;
x the most recent recoverable amount calculation resulted in an amount that exceeded the
carrying amount of the unit by a substantial margin; and
x based on an analysis of the events that have occurred and the circumstances that have
changed since the most recent recoverable amount calculation, the likelihood that the unit’s
current recoverable amount is less than its current carrying amount is remote. IAS 36.99
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6.3 Impairment reversals relating to cash generating units (IAS 36.119 & 122-125)
6.3.1 Calculating impairment loss reversals relating to CGUs
Allocating an
If we find we need to reverse an impairment loss relating to a
impairment loss
cash-generating unit (CGU), we start by calculating the total reversal:
impairment loss reversal that we think we need to recognise. x Allocate first to all assets on a
We do this by subtracting the recoverable amount of the CGU pro rata basis (but making sure
from the carrying amount of the CGU (we may not necessarily that the new CA doesn’t exceed
the lower of HCA & RA)
be able to recognise this total impairment reversal due to the
x Never allocate to goodwill!
limitation, which will be explained below).
After calculating the total impairment loss reversal that we expect to recognise, we then allocate
this total to each of the scoped-in assets within the CGU, (except to goodwill, because any
impairment once allocated to goodwill may never be reversed). This allocation is done on a
pro rata basis using the carrying amounts of the individual scoped-in assets relative to the
carrying amount of the CGU in total. However, we leave goodwill out of this allocation
calculation entirely because an impairment of goodwill may never be reversed. See IAS 36.124 - .125
Now, when allocating the total impairment loss to the individual scoped-in assets in the CGU,
we must be careful because the amount of the impairment loss reversal allocated to each of
these assets may be limited. This is because the carrying amount of each of the assets in the
CGU may not be increased above the lower of its:
An IL reversal is
x Recoverable amount; and recognised:
x Carrying amount, had no impairment loss been x in P/L if cost model is used;
recognised in prior years. x in P/L, and possibly also in OCI
- if the cost model is used, this is depreciated cost; and (RS), if revaluation model used
- if the revaluation model is used, this is depreciated fair value. See IAS 36.123
Notice that the limitation described above means that, when using the cost model, the carrying
amounts of the individual assets may not increase above the historical carrying amount
(depreciated cost), but if the revaluation model is used, the carrying amounts can be. However,
when using the revaluation model, the carrying amounts of the individual asset may never
increase above depreciated fair value.
The difference between the impairment loss reversals relating to CGUs under the cost model
and revaluation model are described in section 6.3.2 and section 6.3.3 respectively.
If an impairment loss reversal to be allocated to a particular asset is limited (i.e. the portion of
the impairment loss reversal to be allocated to this asset could not be allocated at all or could
only be partially allocated), then the excess reversal that could not be allocated to the asset
must be allocated to the remaining assets. This is done as a ‘second round allocation’ (which
may need to be followed by a third and fourth round allocation etc). For example, if we have a
total impairment loss reversal of C2 000, of which C100 is to be allocated to a particular asset,
but due to the upper limit on this asset’s carrying amount, we could only allocate an impairment
reversal of C80, then the excess reversal of C20 that could not be allocated to the asset must
be allocated to the remaining assets. See IAS 36.123
The basic principles applied when reversing an impairment loss for an individual asset (see
section 5) also apply to a CGU (see section 6.3.2). These principles are that, when we use the:
x cost model (see section 5.2)
- the impairment reversal is always recognised in profit or loss as income.
x revaluation model (see section 5.3)
- the impairment reversal is recognised as income in profit or loss only to the extent that it
increases the carrying amount up to historical carrying amount (depreciated cost).
- Any further impairment reversal is then recognised as income in other comprehensive
income (i.e. the portion that increases the carrying amount above depreciated cost…
though never above ‘depreciated fair value’).
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The effect of the limitation, when using the cost model, is that the carrying amounts of the individual
assets in the CGU may not increase above historical carrying amount (depreciated cost). For example,
if our actual carrying amount before the reversal is C80 and the recoverable amount is C110, we
have a potential impairment loss of C30, but:
x If our historical carrying amount (depreciated cost) is C100, the impairment reversal would be limited
to C20: the CA would be increased from C80 to C100 (i.e. the impairment reversal is C20).
ACA: 80 Increase (20): allowed HCA: 100 Increase (10): disallowed RA: 110
x If our historical carrying amount (depreciated cost) was C120, the impairment reversal would not be
limited: the CA would be increased from C80 to C110 (i.e. the impairment reversal would be C30).
ACA: 80 Increase (30): allowed RA: 110 Not applicable HCA: 120
When using the cost model, impairment loss reversals are recognised as income in profit or loss:
x Debit accumulated impairment losses (i.e. increasing the asset) &
x Credit impairment loss reversal income (P/L).
Example 18: Impairment and reversal thereof (no goodwill) – cost model
On 31 December 20X4, as a result of a government ban on a product produced by Outlaw Limited, a
cash-generating unit had to be impaired to its recoverable amount of C2 000 000. On this date, the
details of the individual assets in the unit (each measured using the cost model) were as follows:
Remaining Residual Carrying Recoverable
useful life value amount amount
31 December 20X4: C C C
x Equipment 5 years Nil 1 000 000 unknown
x Plant 5 years Nil 3 000 000 unknown
4 000 000 2 000 000
One year later, on 31 December 20X5, the ban was lifted and the cash-generating unit was brought back
into operation. Its revised recoverable amount is C3 000 000:
31 December 20X5: Historical CA * RA
x Equipment 800 000 unknown
x Plant 2 400 000 unknown
*: the carrying amount had the assets not been impaired C3 200 000 C3 000 000
Required: Calculate and allocate the impairment losses and reversals thereof to the cash-generating unit.
Solution 18: Impairment and reversal thereof (no goodwill) – cost model
W1: 31 December 20X4: Impairment loss of cash-generating unit C
Carrying amount Given 4 000 000
Less: Recoverable amount Given (2 000 000)
Impairment loss 2 000 000
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Example 19: Impairment and reversal thereof (with goodwill) – cost model
On 31 December 20X4, due to a government ban on a product produced by Banme Limited,
the affected cash-generating unit must be impaired to its recoverable amount of C2 000 000.
This was the first time that there had ever been an indication of an impairment.
On this date, the details of the individual assets in the unit (each measured using the cost model) were:
Remaining Residual Carrying Recoverable
useful life value amount amount
On 31 December 20X4: C C C
x Goodwill 5 years Nil 2 000 000 unknown
x Plant 5 years Nil 3 000 000 unknown
x Building 5 years Nil 5 000 000 unknown
10 000 000 2 000 000
One year later, the ban was lifted and the cash-generating unit was brought back into operation. On this date, the
CGU's and individual asset's carrying amounts and recoverable amounts were recalculated – as follows:
Historical Carrying Recoverable
carrying amount amount amount
On 31 December 20X5: C C C
x Goodwill 2 000 000 0 Unknown
x Plant 2 400 000 600 000 Unknown
x Building 4 000 000 1 000 000 Unknown
8 400 000 1 600 000 4 000 000
Required:
a) Calculate the impairment in 20X4 and how much should be allocated to each asset.
b) Calculate the impairment reversal in 20X5 and how much should be allocated to each asset.
Solution 19: Impairment and reversal thereof (with goodwill) – cost model
a) The impairment in 20X4 is C8 000 000 (W1), of which C2 000 000 should be allocated to goodwill,
C2 250 000 to plant and C3 750 000 to buildings (W2).
b) The impairment loss reversal in 20X5 is C2 400 000 (W4), of which C900 000 is allocated to plant and
C1 500 000 is allocated to buildings (W5).
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When allocating the impairment loss reversal to each of the individual assets in the CGU, we
must be careful not to allow the carrying amount to increase above the lower of its:
x Recoverable amount; and
x Carrying amount, had no impairment loss been recognised in a prior year: in the case of
the revaluation model, this carrying amount is the depreciated fair value. See IAS 36.123
The effect of the limitation, if the revaluation model is used, is that the carrying amounts may be
increased above historical carrying amount (i.e. depreciated cost), but the carrying amounts of the
individual asset may never increase above depreciated fair value. Depreciated fair value may or may
not be higher than historical carrying amount (depreciated cost).
Chapter 11 585
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When using the revaluation model, an impairment loss reversal will be recognised:
x as income in profit or loss to the extent that it increases the asset’s carrying amount (actual
carrying amount) up to its historical carrying amount (depreciated cost):
Debit accumulated impairment losses & Credit impairment loss reversal income (P/L)
x as income in other comprehensive income (i.e. the revaluation surplus account) to the extent that
it increases the carrying amount above historical carrying amount (depreciated cost):
Debit accumulated impairment losses & Credit revaluation surplus (OCI).
Notice that any increase above historical carrying amount (i.e. depreciated cost) is recognised
in other comprehensive income as a credit to revaluation surplus. Please also note that we
debit the accumulated impairment loss account instead of debiting the cost account. This is
because the cost account would currently reflect the asset’s fair value and thus a debit to this
account would result in it reflecting an arbitrary balance.
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W3: Limitations per asset: lower of historical carrying amount and recoverable amount
HCA: Depreciation HCA: RA: Lower
31/12/20X4 31/12/20X5 31/12/20X5
Goodwill N/A (1& 2) 0 N/A (1) N/A (1) ? N/A (1)
(2)
Machine 200 000 40 000 200K/5yrs 160 000 220 000 160 000
Factory 300 000 (2) 50 000 300K/6yrs 250 000 240 000 240 000
Equipment 400 000 (2) 100 000 400K/4yrs 300 000 ? 300 000 (3)
W4: Allocation of the CGU impairment reversal (W2) to the individual assets in the CGU
CA before impairment Imp reversal CA after impairment
reversal allocation reversal
(W1)
Goodwill N/A N/A 1 N/A
Machine (152/592 = 25.7% 6) 152 000 8 000 2 160 000
Factory (200/592 = 33.8% 6) 200 000 40 000 3 240 000
Equipment (240/592 = 40.5% 6) 240 000 60 000 4 300 000
592 000 108 000 5 700 000
Notes:
(1) The impairment is never reversed to goodwill, so we leave goodwill out of the calculation entirely.
(2) 25.7% x 308 000 = 79 156. This would increase the CA to 231 156 (152 000 + 79 156). But, the
maximum CA is 160 000 (W3), thus the allocation is limited to 160 000 – 152 000 = 8 000
(3) 33.8% x 308 000 = 104 104. The CA would increase to 304 104 (200 000 + 104 104), but the
maximum CA is 240 000 (W3), thus the allocation is limited to 240 000 – 200 000 =40 000
(4) 40.5% x 308 000 = 124 740. The CA will increase to 364 740 (240 000 + 124 740). But the maximum
CA is 300 000(W3), thus the allocation is limited to 300 000 – 240 000 = 60 000
(5) The impairment reversal of 308 000 was limited to 108 000. The excess (C200 000) cannot be re-
allocated pro-rata, since the CA of each asset in the CGU (other than goodwill) has already being
increased to its upper limit (the lower of its RA and HCA/ depreciated fair value). If this were not the
case, a second-round of allocation would be necessary.
(6) These percentages have been rounded. The notes above use these rounded percentages. You
could work with the exact percentages instead, which would mean that your calculations would be
slightly more accurate than the calculations shown in the notes above.
Note 1: The calculations of how much of the impairment loss reversal income is recognised in profit or loss (i.e.
presented as an impairment loss reversal income in P/L) and how much is recognised in other
comprehensive income (presented as a revaluation surplus in OCI) can be found in solution 19C
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Solution 20C: Impairment reversal – journals for factory building (revaluation model)
Comment:
x The reversal of the impairment loss relating to the machine and the equipment involved the cost model.
This means that the related carrying amounts are not allowed to increase above the historical carrying
amount (i.e. cost less accumulated depreciation; also known as depreciated cost).
x The reversal of the impairment loss relating to the factory involved the revaluation model. This means
that its carrying amount is allowed to increase above the historical carrying amount (depreciated cost).
The increase above this historical carrying amount is recognised in other comprehensive income as a
revaluation surplus.
x To understand the building’s imp. Reversal journal, we must understand the revaluation model.
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Note: If you scribble down the ledger accounts (posting these journals), you can do a quick check:
x The cost account must reflect the fair value of C350 000 (notice we did not debit any part of the impairment
loss reversal to ‘cost’, even though part of the reversal is credited to revaluation surplus – the entire reversal is
debited to ‘Acc IL’).
x The revaluation surplus reverses to zero at end 20X5.
x The total of the AD account and AIL account on 31 December 20X5 is C110 000
(AD: 90 000 + AIL: 20 000 = 110 000).
This correctly reflects the total of the AD and AIL that would have been processed had we not impaired
on 31 December 20X4. We would have depreciated the fair value by C50 000 in both 20X4 and in 20X5
(i.e.by total of C100 000) thus reducing the CA from C350 000 to C250 000 and would have then found
that we have a RA of C240 000, so would have impaired the CA by C10 000.
So, the total of the AD and AIL accounts would have been C110 000 (AD: 100 000 + AIL: 10 000).
The previous sections in this chapter have referred to CGUs as being the smallest grouping of
assets generating independent cash inflows. CGUs include a variety of assets (and sometimes
liabilities), including goodwill and corporate assets. The previous sections referred to the
existence of goodwill in the CGU and how its existence affects the allocation of a CGU impairment
or CGU impairment reversal. However, these previous sections have not yet explained how
goodwill or corporate assets come to be included in the CGU. Let us now consider this.
x Goodwill and its allocation to a CGU is explained in section 6.4.2 and
x Corporate assets and their allocation to a CGU is explained in section 6.4.3.
When testing a cash-generating unit (CGU) for impairment, one must include any goodwill asset
that the CGU benefits from.
Goodwill can be internally generated, or it can be purchased (e.g. goodwill arising from a
business combination). It is only purchased goodwill that may be recognised as an asset
(internally generated goodwill is always expensed). This goodwill asset reflects the economic
benefits expected from the assets that were acquired in the business combination but were not
able to be separately recognised – it is often described as reflecting the value of the synergies
arising from the related business combination. Goodwill is not able to generate cash flows
independently of other assets, but it may improve the cash inflows of one or more CGU.
If a goodwill asset is recognised, it must be allocated to the CGU or CGUs that are expected to
benefit from the synergies arising from the acquisition. Where more than one CGU benefits from
the goodwill, the goodwill allocation could be done based on the relative carrying amounts of the
affected CGUs, or using whatever method best reflects the extent to which we think the goodwill
benefits the various CGUs.
In some cases, it is not possible to allocate goodwill to one of more of the individual CGUs
without the allocation being arbitrary, in which case the goodwill must be allocated to the smallest
group of CGUs where such an allocation makes sense and is not considered to be an arbitrary
allocation. In such cases, the group of CGUs to which goodwill has been allocated gets tested
for impairment (i.e. rather than the individual CGUs).
Sometimes, by the end of the period in which the acquisition (e.g. business combination)
occurred, the fair value of the identifiable assets and liabilities acquired have not yet all been
confirmed. This would mean that, at this reporting date, these acquired assets and liabilities would
all still be measured at provisional fair values and thus the goodwill (a balancing figure), would
also be provisional. These provisional values must be finalised within 12 months of acquisition
date (IFRS 3.45). This delay may mean that the allocation of goodwill to the CGUs is only possible
when these values are finalised. See IAS 36.85 and IFRS 3.45
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6.4.3 Corporate assets and their allocation to a CGU (IAS 36.100 - 102)
When testing a cash-generating unit (CGU) for impairment, one must include any corporate
assets that are capable of being allocated on a reasonable and consistent basis to that unit.
Like goodwill, a corporate asset cannot generate cash flows independently of other assets.
However, whereas goodwill may improve the cash inflows of either a single or multiple CGUs,
corporate assets are, by definition (see pop-up), assets that affect the cash inflows of multiple CGUs.
A head office building, for example, does not generate cash inflows on its own, but if used by
both a manufacturing CGU and retail CGU, then we would call it a corporate asset because it
affects the cash inflows of multiple CGUs.
Since a corporate asset does not generate its own cash inflows, we are unable to determine its
value in use and therefore we are unable to determine its recoverable amount (RA = higher of VIU
and FV-CoD). Thus, if we believe the corporate asset may be impaired, the only way we can check
is by comparing the carrying amount and recoverable amount of the CGUs to which it belongs. In
order to do this, we would need to have allocated the corporate asset to these CGUs.
Corporate assets are allocated to the CGUs to which they relate on a basis that is ‘reasonable
and consistent’. This could involve allocating the corporate asset to its related CGUs based on:
x their relative carrying amounts, or
x on some other basis (e.g. we might choose to allocate the corporate asset evenly across
the CGUs that use it, if these CGUs all use the corporate asset to an equal extent).
Impairment tests are performed by comparing the carrying amount of the CGU, including the
portion of the carrying amount of the corporate asset allocated to the unit, with the recoverable
amount of the CGU. IAS 36.102 (reworded)
If the entity owns corporate assets that are unable to be allocated to its cash-generating units
on a ‘reasonable and consistent basis’, the impairment test/s will simply be performed from the
bottom-up.
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The head-office building supports all cash-generating units while the computer platform supports the
toothpaste and wire-brush units only.
Required: Calculate the amount of the impairment to be allocated to each CGU, assuming that:
A. the corporate assets can be allocated to the relevant cash-generating units: the building is to be allocated
to the 3 CGU’s based on their relative carrying amounts whereas the computer platform is used equally
by the toothpaste and wire-brush CGUs and should thus be allocated evenly between them.
B. the corporate assets cannot be allocated to the relevant cash-generating units.
Note
This impairment of C2 723 092 relates to all the other assets contained in the three CGUs. However, in reality,
this impairment would be broken down further and journalised against each of the individual assets, but
insufficient information was given to do this. Had we known what the individual assets in the CGUs were, we
would have allocated the impairment to each in the usual way, based on their relative carrying amounts (see
section 6.2).
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The impairment testing of this entity’s assets, where its corporate assets were incapable of being
allocated to its three cash-generating units, involves three levels of testing, as follows:
Cash-generating units
W1: First test: without any corporate assets: Toothpaste Wire-brushes Rubber tyres
Carrying amount before first impairment 1 000 000 2 000 000 4 000 000
Recoverable amount 600 000 1 500 000 3 200 000
First impairment 400 000 500 000 800 000
W2: Second test: toothpaste and wire-brush units with computer platform C
Cash-generating unit toothpaste 1 000 000 – 400 000 first impairment 600 000
Cash-generating unit wire-brushes 2 000 000 – 500 000 first impairment 1 500 000
Computer platform (supports only the toothpaste and wire-brush unit) 1 050 000
Carrying amount before level 2 impairment 3 150 000
Recoverable amount 600 000 + 1 500 000 (2 100 000)
Second impairment 1 050 000
W3: Third test: all cash-generating units with all corporate assets: C
Toothpaste, wire-brushes and computer platform 3 150K – 1 050K second impairment 2 100 000
Cash-generating unit: rubber tyres 4000K – 800K first impairment 3 200 000
Building (supports all 3 units) 700 000
Phone system (supports all 3 units) 350 000
Carrying amount before level 3 impairment 6 350 000
Recoverable amount 600 000 + 1 500 000 + 3 200 000 (5 300 000)
Third impairment 1 050 000
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Chapter 6 dealt extensively with the concept of deferred tax. Let us now apply the deferred tax
principles discussed in that chapter to an impairment (or impairment reversal).
Generally, tax authorities only allow deductions relating to the usage of an asset and would not
permit a deduction relating to the impairment of an asset. Certainly, this is the case in South
Africa, where the SA Income Tax Act (ITA) only grants deductions relating to the usage of an
asset (i.e. see deductions allowed in terms of sections 11(e), 12 and 13). This difference in
treatment (between tax and accounting) will result in a temporary difference, which will give rise
to deferred tax.
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8.1 In general
These disclosures may be included in a note supporting the calculation of profit or loss (e.g. ‘profit
before tax’ note) or in the note supporting the asset (e.g. the ‘property, plant and equipment’ note
in the reconciliation of carrying amount).
8.2 Impairment losses and reversals of previous impairment losses (IAS 36.130 - 131)
For every material impairment loss or impairment loss reversal, the entity must disclose:
x the events and circumstances that led to the impairment loss or reversal thereof;
x the nature of the asset (or the description of a cash-generating unit);
x the amount of the impairment loss or impairment loss reversed;
x if applicable, the reportable segment in which the individual asset or cash-generating unit
belongs (i.e. if the entity reports segment information in terms of IFRS 8);
x if the recoverable amount is fair value less costs of disposal or value in use;
x if recoverable amount is fair value less costs of disposal, the basis used to measure fair value
(in terms of IFRS 13) less costs of disposal;
x if recoverable amount is value in use, the discount rate used in the current and previous
estimate (if any) of value in use. See IAS 36.130
For impairment losses and impairment loss reversals that are not disclosed as above, indicate
x the main class of assets affected; and
x the main events and circumstances that led to the recognition or reversal of the impairment
losses. IAS 36.131 (reworded)
If a cash-generating unit includes goodwill or an intangible asset with an indefinite useful life, and
the portion of the carrying amount of that goodwill or intangible assets that is allocated to the unit
is significant in relation to the total carrying amount of goodwill or intangible assets with indefinite
useful lives of the entity (as a whole), then we also need to disclose:
x the carrying amount of the allocated goodwill;
x the carrying amount of intangible assets with indefinite useful lives;
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x the recoverable amount of the unit and the basis for calculating the recoverable amount of
the cash-generating unit (either its fair value less costs of disposal or value in use);
x where the recoverable amount is based on value in use:
- each key measurement assumption on which management-based cash flow projections;
- a description of how management measured the values assigned to each key
assumption, whether those values reflect past experience or external sources of
information or both, and if not, why and how they differ from past experience or external
sources of information;
- the period over which management has projected cash flows based on financial budgets
approved by management and, when a period of more than five years is used for a cash-
generating unit, an explanation of why that longer period is justified;
- the growth rate used to extrapolate cash flow projections beyond the period covered by
the financial budgets and the justification for using a growth rate that exceeds the long-
term average growth rate; and
- the discount rate applied to cash flow projections;
x where the recoverable amount is based on fair value less costs of disposal, state that this
value has been measured using a quoted price for an identical unit (or group of units), unless
this is not the basis, in which case disclose:
- each key measurement assumption on which management has estimated the fair value
less costs of disposal;
- a description of how management measured the values assigned to each key assumption,
whether those values reflect past experience and external sources of information, and if not,
why and how they differ from past experience or external sources of information;
- the level of fair value hierarchy (see IFRS 13), ignoring observability of disposal costs;
- if there have been changes to the valuation techniques the reason(s) for these changes;
- if the fair value less costs of disposal has been measured using cash flow projections,
the following must also be disclosed:
- The period over which the projected cash flows have been estimated;
- The growth rate used to extrapolate the cash flows over this period; and
- The discount rate used. See IAS 36.134
If a cash-generating unit has goodwill or an intangible asset with an indefinite useful life and the
portion of the carrying amount of goodwill or intangible asset allocated to the unit is insignificant
compared to the total carrying amount of goodwill or intangible assets with indefinite useful lives
of the entity, this shall be disclosed, with the aggregate carrying amount of goodwill or intangible
assets with indefinite useful life allocated to those units. See IAS 35.135
If the recoverable amount of any of those units is based on the same key assumptions, and the aggregate
carrying amount of goodwill and intangible assets with an indefinite useful life allocated to those units
based on same key assumptions is significant compared with the entity’s total carrying amount of goodwill
or intangible assets with an indefinite useful life, this fact shall be disclosed, together with:
x the aggregated carrying amount of goodwill or intangible assets with indefinite useful lives or
allocated to those units;
x the key assumptions
x a description of how management measured the values assigned to each key assumption,
whether those values reflect past experience or external sources of information or both, and
if not, why and how they differ. See IAS 36.135
Whether allocated goodwill or intangible assets with indefinite lives is significant/insignificant, if a key
assumption that was used in determining the recoverable amount might reasonably be expected to
change such that the recoverable amount could decrease below the carrying amount, then disclose:
x the amount by which the recoverable amount currently exceeds the carrying amount;
x the value assigned to the key assumption;
x the amount by which this value would have to change in order for the recoverable amount
to equal the carrying amount. See IAS 36.134(f) & .135(e)
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9. Summary
Indicator Review
Impairment of Assets
596 Chapter 11
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Value in use
Recognition of adjustments
or or
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Corporate Assets
See IAS 36.6
A corporate asset is defined as:
x assets other than goodwill
x that contribute to the future cash flows of more than 1 CGU
ACA = actual carrying amount HCA = historical carrying amount RA = recoverable amount
RS = revaluation surplus IL = impairment loss
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Chapter 12
Non-current Assets Held for Sale and
Discontinued Operations
Main reference: IFRS 5 (including any amendments to 10 December 2019)
CHAPTER SPLIT:
This chapter covers IFRS 5, which is the standard that explains the topics of:
x Non-current assets held for sale - a term that refers to both:
- individual assets held for sale, which we will refer to as NCAHFS, and
- disposal groups held for sale, which we will refer to as DGHFS; and also
x Discontinued operations (DO).
Although the concepts in the first topic do have a bearing on the second topic, these topics can be studied
separately. Thus, the chapter is separated into these two separate topics as follows:
PARTS: Page
PART A: Non-current assets held for sale 601
PART B: Discontinued operations 651
PART A:
Non-Current Assets Held for Sale
Contents: Page
A: 1 Overview 601
A: 2 Scope 602
A: 2.1 Non-current assets held for sale: scoped-out non-current assets 602
A: 2.2 Disposal groups held for sale: scoped-out items 603
A: 3 Classification: as ‘held for sale’ or ‘held for distribution’ 603
A: 3.1 What happens if something is classified as ‘held for sale’ (HFS) or ‘held for disposal’ (HFD)? 603
A: 3.2 The classification criteria in general 603
A: 3.2.1 Overview 603
A: 3.2.2 Classification as held for sale 603
A: 3.2.2.1 The core criterion 603
A: 3.2.2.2 The further supporting criteria 604
A: 3.2.2.3 Meeting the criteria 604
A: 3.2.2.4 An intention to sell may be an indication of a possible impairment 605
A: 3.2.3 Classification as held for distribution 605
A: 3.2.4 Comparison of the classification as held for sale and held for distribution 605
A: 3.3 Criteria when a completed sale is expected within one year 606
A: 3.4 Criteria when a completed sale is not expected within one year 607
A: 3.5 Criteria when an NCA or DG is acquired with the intention to sell 607
A: 4 Measurement: individual non-current assets held for sale 608
A: 4.1 Overview 608
A: 4.2 Measurement if the sale is expected within one year 609
A: 4.3 Measurement when the NCA is not expected to be sold within one year 609
A: 4.4 Measurement when the NCA is acquired with the intention to sell 609
A: 4.5 Initial and subsequent measurement of a NCAHFS or NCAHFD 610
A: 4.5.1 Initial measurement (on the date of classification) 610
A: 4.5.2 Subsequent measurement (after the date of classification as held for sale) 610
A: 4.6 Measurement principles specific to the cost model 611
A: 4.6.1 The basic principles when the cost model was used 611
Example 1: Measurement on date classified as HFS (previously: 612
cost model)
Example 2: Re-measurement after classified as HFS: impairment loss 613
reversal limited
Example 3: Measurement on date classified as a NCAHFS and re- 615
measurement of NCAHFS: reversal of impairment loss
limitation (previously: cost model)
A: 4.6.2 The tax effect when the cost model was used 619
Example 4: Tax effects of classification as NCAHFS and the cost model 619
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600 Chapter 12
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INTRODUCTION
This standard (IFRS 5 Non-current assets held for sale and discontinued operations) covers both
non-current assets held for sale (NCAHFS) and discontinued operations (DO):
x Non-current assets held for sale will be explained in this part: Part A.
x Discontinued operations are explained in Part B.
PART A:
Non-current Assets Held for Sale
A: 1 Overview
Although half of the title of IFRS 5 refers to ‘non-current Part A explains how to
assets held for sale’, this term actually refers to: classify, measure, present
x individual ‘non-current assets held for sale’ (NCAHFS); and disclose:
x a group of items held for sale, where this group x Individual assets held for sale
(NCAHFS); and
sometimes includes not only non-current assets but x Disposal groups held for sale
also current assets and directly related liabilities, (DGHFS) … these are just groups of
called a ‘disposal group held for sale’ (DGHFS); and assets held for sale.
x individual ‘non-current assets held for distribution to owners’ or ‘disposal groups held for
distribution to owners’ (as opposed to being held for sale) (NCAHFD and DGHFD).
This can possibly be better understood by looking at the following diagrammatic summary:
The term ‘non-current assets held for sale’ actually refers to:
We will first look at how to account for an individual non-current asset that is held for sale
(NCAHFS) and then how to account for a disposal group that is held for sale (DGHFS).
The method of accounting for individual assets (and disposal Important definitions:
groups) classified as held for sale is almost identical to the
A non-current asset (NCA) is
method of accounting for those held for distribution. For
defined as:
this reason, we will not discuss individual non-current x an asset that is not a CA. IFRS 5 App A
for sale, that the principles will apply equally if it were held
A disposal group (DG) is defined as:
for distribution – unless stated otherwise.
x a group of assets
to be disposed of,
When we talk about how to account for items that are held
by sale/ otherwise,
for sale (or held for distribution), we are talking about their:
together as a group in a single
x Classification; transaction,
x Measurement; x and liabilities directly associated with
x Presentation and disclosure. those assets that will be transferred
in the transaction. See IFRS 5 Appendix A
Classification:
We apply certain criteria when deciding if an asset or disposal group should be classified as ‘held for
sale’ (HFS) and there is a similar set of criteria when deciding if an asset or disposal group should
be classified as ‘held for distribution’ (HFD). These criteria will be the same whether we are
considering how to classify an individual non-current asset or a disposal group. See section A:3.
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Measurement:
Assets/disposal groups ‘held for sale’ are measured at the lower of carrying amount and fair value
less costs to sell. Assets/disposal groups ‘held for distribution’ are measured, in a similar way, at
the lower of carrying amount and fair value less costs to distribute. See section A:4.
However, some non-current assets that are held for sale (or distribution) are not affected by the
measurement requirements stipulated in IFRS 5. We will call these non-current assets the ‘scoped-
out non-current assets’. These are listed in section A:2.
Sometimes we have a ‘disposal group’ (rather than an individual non-current asset) that is held for
sale (or distribution). This would also be measured at the lower of carrying amount and fair value
less costs to sell (or to distribute). However, when measuring this disposal group, we will need to
remember that the items in our disposal groups could include:
x a variety of assets (current and non-current, some of which may be scoped out); as well as
x directly related liabilities.
IFRS 5’s measurement
The mixture of items in our disposal groups makes it slightly requirements only apply
more complex because the IFRS 5 measurement requirements to certain NCAs.
only apply to certain non-current assets – they do not apply to They do not apply to:
current assets, liabilities or to scoped-out non-current assets. x Certain scoped-out NCAs
Due to this slight complexity, we will first study the measurement x Current assets
of individual non-current assets held for sale/ distribution x Liabilities
(section A:4) and then study disposal groups held for sale/ distribution section A:5.
A: 2.1 Non-current assets held for sale: scoped-out non-current assets (IFRS 5.5)
The IFRS 5 measurement requirements do not apply to the The IFRS 5 measurement
following non-current assets: requirements do not
apply to the following
x Financial assets within the scope of IFRS 9 NCAs (scoped-out NCAs):
(IFRS 9 Financial instruments) x Financial assets covered by IFRS 9
x Investment property measured under the fair value model x Investment property measured under
the FV model (IAS 40)
(IAS 40 Investment property) x Agricultural NCAs measured at ‘FV
x Agricultural non-current assets measured at fair value less less costs to sell’ (IAS 41)
x Assets for which FV may be difficult
costs to sell (IAS 41 Agriculture) to determine (e.g. DT assets)
See IFRS 5.5
x Assets for which fair values may be difficult to determine:
- Deferred tax assets (IAS 12 Income taxes)
- Assets relating to employee benefits (IAS 19 Employee benefits)
- Contractual rights under insurance contracts (IFRS 4 Insurance contracts). See IFRS 5.5
Please note that these non-current assets are scoped-out only from the measurement requirements of
IFRS 5. Thus, a non-current asset held for sale would still be subject to the classification, presentation
and disclosure requirements of IFRS 5. See IFRS 5.2
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This means that if the disposal group contains at least one non-current asset, IFRS 5’s classification,
measurement, presentation and disclosure requirements would then apply. However, IFRS 5’s
measurement requirements will not apply to items in the group that represent liabilities, current assets
and specific non-current assets that are scoped out from the IFRS 5 measurement requirements
(see section A: 2.1). Let’s call these three the ‘scoped-out items’.
Please note that these ‘scoped-out items’ (scoped-out non-current assets, all current assets and
all liabilities) are scoped-out only from the measurement requirements of IFRS 5. In other words,
the measurement requirements do not apply to these ‘scoped-out items’ ... but the classification,
presentation and disclosure requirements of IFRS 5 will still apply to them.
A: 3.2.1 Overview
When to classify a non-current asset (NCA) or disposal group (DG) as ‘held for sale’ depends on
whether certain criteria are met. Similarly, when to classify a non-current asset (NCA) or disposal
group (DG) as ‘held for distribution’ depends on whether certain criteria are met.
The criteria relating to classification as held for sale and classification as held for distribution differ
(though they are very similar) and thus we will discuss them separately (see section A:3.2.4 for a
summary that compares these two set of criteria).
A NCA/ DG is classified as
A: 3.2.2 Classification as held for sale HFS when we expect that:
x its carrying amount
A: 3.2.2.1 The core criterion x will be recovered principally through
x a sale transaction rather than
The core criterion driving the classification of a non-current asset through continuing use. IFRS 5.6
(NCA) or disposal group (DG) as ‘held for sale’ is that it may only P.S. There are more criteria to be met
be classified as held for sale when most of its carrying amount before we can say we expect the CA to
is expected to be recovered through the inflows from the sale of be recovered mainly through sale.
the NCA or DG rather than from the use thereof. See IFRS 5.6
If we look at this criterion carefully, we can see that a non-current asset (NCA) or disposal group
(DG) may continue to be used by the entity and yet still be classified as ‘held for sale’. The important
issue is whether the inflows from the sale thereof are greater than from the use thereof: if the inflows
from the sale thereof are greater, then it is classified as ‘held for sale’.
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If we look at this criterion again, we can also see that a non-current asset (NCA) or disposal group (DG)
that is to be abandoned could not possibly be classified as ‘held for sale’ because an abandonment means
no sale and thus none of its carrying amount would be recovered through a sale.
Abandonment means just that – the non-current asset (NCA) or An abandoned asset can
disposal group (DG) will be discarded, dumped, ditched, never be classified as HFS
discontinued, closed down – there is no future sale involved. Its because:
carrying amount will therefore be recovered through future use x it is not going to be sold, thus
(until date of abandonment) after which it will not be sold but will x its CA will be recovered principally
through continuing use. See IFRS 5.13
be thrown away instead. See IFRS 5.13
Please note that assets that have been permanently taken out
Abandoned assets include
of use and for which there is no plan to sell (e.g. the entity plans
NCAs or DGs that are to be:
to drop it off at the local dump) are treated as abandoned.
However, assets that have simply been temporarily taken out of x used to the end of their economic life, or
use are not accounted for as abandoned assets. See IFRS 5.14 x closed rather than sold. IFRS 5.13
Now, look at the core criterion again (see above). Before we conclude that the carrying amount of
the NCA or DG is expected to be recovered mainly through a sale rather than through usage, the
following two criteria must also be met:
The CA of the NCA/DG
x the asset must be available for sale immediately, in its
will be said to be
present condition and based on normal terms, and recovered mainly through
x the sale must highly probable of occurring. See IFRS 5.7 a sale transaction if:
x it is available for immediate sale
To prove that the sale is highly probable, a further five criteria - in its present condition
must be met: - subject only to terms that are usual
x the appropriate level of management must be committed and customary for sales of such
NCAs (or DGs) and
to the plan to sell;
x its sale must be highly probable.
x an active programme to try and sell the asset has begun; IFRS 5.7
It is quite difficult to meet all these supporting criteria and thus a non-current asset (NCA) or disposal
group (DG) that is intended to be sold will often fail to be classified as ‘held for sale’.
However, if all these criteria are met before reporting date, the non-current asset (NCA) or disposal
group (DG) must be classified as ‘held for sale’ in those financial statements.
If these criteria are met after the reporting date, but before the financial statements are issued, the
non-current asset (NCA) or disposal group (DG) is not classified as ‘held for sale’ in that set of
financial statements, but certain disclosures are still required (see section A:6.6.3). See IFRS 5.12
A more thorough discussion of all these criteria outlined above appears in section A:3.3.
One of the criteria when proving that a sale is highly probable of occurring is that the sale must be
expected to be completed within one year from date of classification. However, an asset whose
sale is not expected to be completed within a year could still be classified as ‘held for sale’ if further
specified criteria are met. This is discussed in section A:3.4.
Yet a further variation to the criteria that need to be met arises when a non-current asset is
acquired with the sole intention of being sold. This is discussed in section A:3.5.
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The mere intention to sell a non-current asset – even if it is The mere intention to sell a
not classified as ‘held for sale’ – may be an indication that NCA or DG could be:
the asset could be impaired (see chapter 11). x an indication of a possible impairment
x If the intention to sell is considered an indication of a
possible impairment, we would need to calculate the recoverable amount. See IAS 36.9
x If the recoverable amount is calculated and found to be less than the carrying amount, an
impairment loss would need to be recognised.
A: 3.2.4 Comparison of the classification as held for sale and held for distribution
The following diagrammatic summary may be helpful in seeing how the process of classifying a non-
current asset or disposal group as held for sale differs from classifying it as held for distribution.
Classification
Highly probable sale: See IFRS 5.8 Highly probable distribution: See IFRS 5.12A
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A: 3.3 Criteria when a completed sale is expected within one year (IFRS 5.6- .8)
For a non-current asset (NCA) or disposal group (DG) to To prove that a CA will be
be classified as ‘held for sale’ the carrying amount of the recovered mainly via a
asset is to be recovered mainly through a sale sale, ALL the following
transaction than through continuing use. See IFRS 5.6 criteria must be met:
x the NCA is immediately available for
sale in its present condition and on
In order to prove this, we must meet all of the following normal terms:
criteria listed in IFRS 5: See IFRS 5.7 - .8 - Mgmt must have intention & ability
to complete this sale
x The non-current asset (NCA) or disposal group (DG) x The sale must be highly probable:
- Must be commitment to the sale
must be available for immediate sale: from appropriate level of mgmt,
- in its present condition - Active programme to find a buyer &
complete the sale must’ve begun,
- subject only to terms that are usual and - Sale expected within 1 year of
customary for sales of such asset. IFRS 5.7 classification,
- Selling price reasonable compared
For an asset to be available for immediate sale, the to its FV, and
- Unlikely to be significant changes
entity must currently have both the intention and made to the plan of sale See IFRS 5.7 & .8
ability to transfer the NCA (or DG) to a buyer in its
present condition.
For example, an entity intending to sell its factory where any outstanding customer orders
would be transferred to and completed by the buyer would meet this criterion, but an entity
intending to sell its factory only after completing any outstanding customer orders first would
not meet this criteria (since the delay in timing of the sale of the factory, which is imposed
by the seller, means that the factory is not available for immediate sale in its present
condition). See IFRS 5: Implementation Guidance: Example 2
Highly probable is
x The sale must be highly probable: IFRS 5.7
defined as:
For the sale to be considered highly probable, there are five x significantly more likely than
sub-criteria to be met: x probable. IFRS 5 App A
If all the criteria above are met before reporting date, the non-current asset (or DG) must be
separately classified as a ‘non-current asset held for sale’.
If the entity is committed to a plan that involves the loss of control of a subsidiary and if the above
criteria are met, all the subsidiary’s assets and liabilities must be classified as held for sale,
regardless of whether we retain a non-controlling interest in it. IFRS 5.8A (reworded)
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A: 3.4 Criteria when a completed sale is not expected within one year (IFRS 5.9 & App B)
On occasion, we might classify something as ‘held for sale’ even A NCA/ DG may still be
though the sale is not expected to be completed and recognised classified as HFS even if
as a sale within one year. This happens when: the sale is not expected
within 1 year on condition that:
x the expected delay is caused by events or circumstances
x the delay is beyond the entity’s
beyond the entity’s control; and control; and
x there is sufficient evidence that the entity remains committed x there is sufficient evidence that the
to its plan to sell the asset. entity is still committed to the sale.
Certain extra criteria must be met
depending on the scenario.
There are three different scenarios that IFRS 5 identifies as See IFRS 5.9 & IFRS 5 App B
possibly leading to a sale taking longer than one year. For each
scenario, certain extra criteria will need to be met for the one-year requirement to fall away. See IFRS 5 App B
A firm purchase
Scenario 1: The entity initially commits to selling a non-current commitment is defined as:
asset (or disposal group), but it has a reasonable expectation x an agreement with an unrelated party,
that someone other than the buyer will impose conditions that x binding on both parties and usually
will delay the completion of the sale. legally enforceable, that:
- specifies all significant terms,
In this scenario, the NCA (or DG) is classified as ‘held for sale’ if: (incl. the price and timing); and
- includes a disincentive for non-
x the entity is unable to respond to these expected conditions ‘until performance that is large enough
a firm purchase commitment is actually obtained’, and that performance is highly
probable. IFRS 5 Appendix A (reworded)
x ‘a firm purchase commitment is highly probable within one year’.
See IFRS 5.B1(a)
Scenario 2: On the date that an entity obtains a firm purchase commitment, someone unexpectedly
imposes conditions that will delay the completion of the sale of the non-current asset (or disposal
group) that was previously classified as held for sale.
In this scenario, the NCA (or DG) must continue to be classified as ‘held for sale’ if:
x the entity has timeously taken the necessary actions to respond to the changed conditions, and
x the entity expects that the delaying conditions will be ‘favourably resolved’. See IFRS 5.B1(b)
Scenario 3: A non-current asset (or disposal group) that was initially expected to be sold within one
year remains unsold at the end of this one-year period due to unexpected circumstances that arose
during the one-year period.
In this scenario, the NCA (or DG) must continue to be classified as held for sale if:
x the entity took the necessary actions during that year to respond to the change in circumstances,
x the entity is actively marketing the non-current asset (or disposal group) at a ‘reasonable price’
bearing in mind the ‘change in circumstances’, and
x the asset must be available for immediate sale in its present condition and at normal terms and
the sale must be highly probable (i.e. para 7 and 8 must be met). See IFRS 5.B1(c)
A: 3.5 Criteria when an NCA or DG is acquired with the intention to sell (IFRS 5.11)
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A: 4.1 Overview
Assets classified as HFS or
HFD will be measured as
There are two phases in the life of an individual non-current follows:
asset (NCA) that is classified as ‘held for sale’ (HFS): x before classification:
x before the date of classification (clearly irrelevant to - measured in terms of its previous standard;
newly acquired assets) when it is measured in terms of x on or after the classification date:
its previous relevant standard (e.g. IAS 16); and - measured in terms of IFRS 5:
- initial measurement
x on and after the date of classification when it is measured
- subsequent measurement.
in terms of IFRS 5.
Before the NCA is classified as ‘held for sale’, it is simply measured in terms of its previous relevant
IFRS. For example, if the NCA was an item of property, plant and equipment, the NCA would have
been measured in terms of IAS 16 Property, plant and equipment, which means that:
x on initial acquisition, the asset would have been recorded at cost; and
x subsequently, the asset would have been measured under either the:
- Cost model: depreciated and reviewed annually for impairments, or
- Revaluation model: depreciated, reviewed annually for impairments and revalued to fair
value on a regular basis.
On and after the date that the NCA is classified as ‘held for sale’, the measurement principles in IFRS 5
must be followed. These measurement principles can be separated into:
x initial measurement; and
Fair value is defined as:
x subsequent measurement.
x the price that would be received to sell
Essentially, initial measurement of a NCA that is classified an asset (or paid to transfer a liability)
as ‘held for sale’ (i.e. on the date that it is classified as such) x in an orderly transaction
is at the lower of its: x between market participants
x at the measurement date. IFRS 5 App A
x carrying amount (CA) and its
x fair value less costs to sell (FV-CtS). See IFRS 5.15
Please note that ‘fair value’ and ‘costs to sell’ are both defined terms (see pop-ups).
The subsequent measurement of a NCA from the date that it is classified as ‘held for sale’ involves
ceasing all depreciation and amortisation. See IFRS 5.25
Apart from the cessation of depreciation and amortisation, subsequent measurement of a NCA held
for sale (NCAHFS) involves remeasuring it on each subsequent reporting date to the lower of its
carrying amount (CA) and its latest fair value less costs to sell (FV-CtS).
The principles described above apply equally to NCA that is Costs to sell are defined as:
classified as ‘held for distribution’ with the only difference x the incremental costs
being that we measure it at the lower of its: x directly attributable to the disposal
x carrying amount (CA) and its of an asset (or disposal group),
x fair value less costs to distribute (FV-CtD). See IFRS 5.15A x excluding finance costs and income
tax expense. IFRS 5 Appendix A
We will first explain the basic measurement principles in terms of the normal situation where the
asset is expected to be sold within one year.
After this we will look at how these principles may need to be modified if the asset ‘held for sale’ is:
x expected sell later than one year from date of classification or
x acquired with the intention to sell.
Thereafter, we will look at the detailed steps involved in the initial measurement and subsequent
measurement of a non-current asset held for sale.
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A: 4.2 Measurement if the sale is expected within one year (IFRS 5.15; .20-21 & .25)
Non-current assets that are classified as ‘held for sale’ are measured on date of classification
and then on subsequent reporting dates at the lower of its:
x carrying amount (CA), and
Measurement of a NCAHFS:
x fair value less costs to sell (FV-CtS). See IFRS 5.15
x the lower of:
Assets that are ‘held for sale’ are not depreciated (or - carrying amount; and
- FV less costs to sell.
amortised). This is because their carrying amount is
x depreciation/ amortisation ceases.
principally made up of the future income from the sale of See IFRS 5.15 & .25
When re-measuring a non-current asset ‘held for sale’ after the date on which it was classified
as ‘held for sale’, (i.e. if the asset had not yet been sold at year-end):
x further impairment losses may be recognised, but
x any impairment loss reversal would be limited to the cumulative impairment losses
recognised, both in terms of IFRS 5 and IAS 36 Impairment of assets. See IFRS 5.20-21
A: 4.3 Measurement when the NCA is not expected to be sold within one year
(IFRS 5.17)
If, in the unusual instance a sale is expected beyond one year,
If the sale is not
it may be necessary (depending on materiality) to measure the expected within 1 year:
‘costs to sell’ at their present value. The gradual increase in the
x the costs to sell may need to be
present value due to the passage of time shall be recognised present valued. See IFRS 5.17
as a financing cost in profit or loss. See IFRS 5.17
A: 4.4 Measurement when the NCA is acquired with the intention to sell
(IFRS 5.16)
The measurement of a NCA that is acquired with the intention NCAs acquired with the
of it being sold follows similar principles as above, but with a intention of being sold are
slight modification. The modification is explained below. measured:
x using the same principles = lower of:
- carrying amount; and
Normally, the acquisition of a NCA would first be classified as, - FV less costs to sell.
for example, an item of property, plant and equipment, initially x where the CA is what it would have
measured at cost and subsequently depreciated and tested for been if it wasn’t classified as HFS.
impairment, after which it would then being reclassified and Thus, generally, it will be effectively
remeasured as ‘held for sale’. measured at:
x FV-CtS. See IFRS 5.15 & .16
However, in the case of a NCA acquired with the express intention of it being sold, the NCA is
immediately classified and measured as a ‘held for sale’ asset.
This initial measurement of a NCA that is immediately classified as ‘held for sale’ is the lower of its:
x carrying amount had it not been classified as held for sale (e.g. its cost), and
x fair value less costs to sell. IFRS 5.16 (slightly reworded)
Interestingly, this measurement principle normally results in the NCA being initially measured at ‘fair
value less costs to sell’, because this will normally be lower than the carrying amount it would have
had if it had not been classified as ‘held for sale’. This can be explained as follows:
x The normal approach is to initially measure a NCA at cost. This means that, on initial recognition,
the NCA would have had a carrying amount equal to cost if had not been classified as ‘held for sale’.
x The ‘cost’ of acquiring a NCA normally reflects its ‘fair value’ on purchase date. If this is the
case, since selling costs are normally expected to be incurred when selling a NCA, its fair value
less costs to sell would normally be less than fair value and thus less than its cost (i.e. the
‘carrying amount on date of purchase had the item not been classified as HFS’ = ‘cost’ = ‘fair
value’… and thus ‘fair value less costs to sell’ will be the lower amount).
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A: 4.5 Initial and subsequent measurement of a NCAHFS or NCAHFD (IFRS 5.18-21 & 5.25)
A: 4.5.1 Initial measurement (on the date of classification)
Remember, that there are certain non-current assets that, although are subjected to IFRS 5
classification and presentation requirements, will not be subjected to IFRS 5’s measurement
requirements. These are referred to as the scoped-out non-current assets (See section A:2.1).
A: 4.5.2 Subsequent measurement (after the date of classification as held for sale)
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IFRS 5 does not define ‘carrying amount’ and thus there are a number of interpretations as to how to apply the
measurement rule of ‘lower of carrying amount and fair value less costs to sell’.
This text has adopted the following Deloitte interpretation:
x the measurement rule ‘lower of CA and FV-CtS’ means that the NCAHFS may not be re-measured to ‘FV-CtS’
if this is greater than the carrying amount, which for IFRS 5 purposes, means the:
x carrying amount that the plant would have had:
- on the date it was classified as held for sale,
- assuming ‘no prior impairment loss had been recognised under IAS 36’. See IAS Plus Guide Example 4.1F
- i.e the depreciated historic cost of the asset (Cost – Accum depreciation to date of classification).
By way of explanation, let us now consider examples of ‘property, plant and equipment’ that are to
be reclassified as ‘held for sale’. Under IAS 16 Property, plant and equipment, these assets would
have been measured using either the cost model or revaluation model and thus we will separately
discuss the implication of the IFRS 5 measurement principles on each of these models.
If an asset measured under the cost model is classified as ‘held for sale’:
x immediately before classifying the asset as ‘held for sale’, measure the asset in terms of its
previous standard … in this case using the cost model in terms of IAS 16:
x depreciate it to the date of classification as NCAHFS, and
x test for impairments; See IFRS 5.18
x then transfer it to NCAHFS (i.e. reclassify it);
x immediately after reclassifying the asset as ‘held for sale’, measure the asset in terms of IFRS 5:
x Measure it to the lower of:
- Carrying amount (CA), and
- Fair value less costs to sell (FV-CtS); See IFRS 5.15
x Stop depreciating it; See IFRS 5.25 and
x Periodically re-measure to ‘fair value less costs to sell’ whenever appropriate. This may
require the recognition of an impairment loss or an impairment loss reversal. See IFRS 5.20-22
Impairment losses are always recognised as expenses in profit or loss whereas impairment losses
reversed are recognised as income in profit or loss. See IFRS 5.37
When recognising an impairment loss reversal, we must remember that the NCAHFS must always
be measured at the lower of its CA (i.e. interpreted to mean the depreciated cost, see the Deloitte’s
interpretation explained in section A:4.5.2) and its FV-CtS. See IFRS 5.15
Furthermore, impairment loss reversals are limited to the asset’s cumulative impairment losses, in
other words the impairment losses previously recognised in terms of IAS 36 plus the impairment
losses recognised in terms of IFRS 5. See IFRS 5.20-21
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A B C
W1: Measurement of plant before reclassification: (i.e. measured as PPE: IAS 16 & IAS 36)
PPE: Carrying amount Cost: 100 000 – Acc depr: 20 000 80 000 80 000 80 000
PPE: Recoverable amount Higher of: (90 000) (72 000) (65 000)
FV-CoD: 70 000 – 5 000 = 65 000 &:
x A: VIU: 90 000; thus RA=90 000
x B: VIU: 72 000; thus RA=72 000
x C: VIU: 60 000; thus RA=65 000
PPE: Impairment IAS 36 Impairment of PPE on 1 January 20X3 0 8 000 15 000
PPE: Carrying amount just A: CA 80 000 –IL 0 80 000 72 000 65 000
before transfer B: CA: 80 000 – IL: 8 000
C: CA: 80 000 – IL: 15 000
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Journals: A B C
1 January 20X3 Dr/(Cr) Dr/(Cr) Dr/(Cr)
Chapter 12 613
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Journal: A B
Dr/(Cr) Dr/(Cr)
30 June 20X3
NCAHFS: accumulated impairment losses (-A) W1.3 3 000 15 000
Impairment loss reversed – NCAHFS (I) (3 000) (15 000)
Reversal of impairment loss: on re-measurement of ‘NCA held for sale’
W1: Subsequent measurement after reclassification as NCAHFS (see above 1B): See IFRS 5.15 and 5.20-.21
Impairment loss reversal (proposed) A: not limited (3 000 – excess: N/A)* 3 000 15 000
after first limitation: * B: limited (20 000 – excess: 5 000)
(20 000 Increase > 15 000 AIL) *
* Explanatory notes regarding the first limitation:
The prior accumulated impairment loss recognised on this asset, before the reversal, was 15 000. Thus:
A. The reversal of 3 000 is not limited (because the accumulated impairment loss before the
reversal is 15 000, which is bigger than 3 000). A further 12 000 may be reversed in future, if
necessary (accumulated impairment loss 15 000 – reversal of impairment loss 3 000).
B. The reversal of 20 000 is limited (because the accumulated impairment loss before the reversal
is 15 000, which is less than 20 000, and thus the potential reversal of 20 000 is limited to 15 000).
No further reversals are possible in the future.
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The following working is an alternative working that combines the previous W1.1, W1.2 and W1.3:
See IFRS 5.15 &.20-.21
W1 (Alternative): Subsequent measurement of plant after reclassification as NCAHFS:
A B
Latest measurement of NCAHFS on reporting date (30/06/X3), at the lower of: 68 000 80 000
x Latest FV - CtS: 30/06/X3 A: 70 000 – 2 000 = 68 000 68 000 85 000
B: 90 000 – 5 000 = 85 000
x CA on date reclassified, but ignoring i.e. Depreciated cost on 01/01/X3 80 000 80 000
impairment losses: 01/01/X3 A&B: Cost: 100 000 – AD: 20 000
Less: Prior carrying amount: 01/01/X3 Lower of CA & FV-CtS: 01/01/X3 (65 000) (65 000)
CA 72 000 vs FV-CtS 65 000
(See example 1B W2)
Impairment loss reversal 3 000 15 000
Check: The impairment loss reversal may not exceed the prior cumulative impairment losses See IFRS 5.21
P.S. This alternative layout of W1 will automatically limit any impairment loss reversal to prior cumulative
impairment losses and thus the comparison of the planned impairment loss reversal to prior cumulative
impairment losses in the above table is only a ‘check’ on your workings.
On 5 January 20X3, the company that originally supplied the plant to Light Limited announced the release of
an upgraded version of the plant that could decrease processing costs by nearly 20%. On this date,
management placed an order for the new plant and decided that the plant on hand would be sold.
All criteria for classification as a ‘non-current asset held for sale’ are met on 8 January 20X3 on which date
the following values were established:
x Value in use: C75 000
x Fair value less costs to sell (IFRS 5) & Fair value less costs of disposal (IAS 36): C60 000
Required:
A. Journalise the re-classification from PPE to NCAHFS on 8 January 20X3 (depreciation for the period
01/01/X3 – 08/01/X3 is considered insignificant and must be ignored);
B. Journalise the re-measurement on 30 June 20X3 if the fair value less costs to sell are 75 000;
C. Journalise the re-measurement on 30 June 20X3 if the fair value less costs to sell are 82 000;
D. Journalise the re-measurement on 30 June 20X3 if the fair value less costs to sell are 85 000.
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x Part B, C and D show that an impairment loss reversal on a NCAHFS is limited in two ways:
it is limited to the total of all prior cumulative impairment losses (IAS 36 impairments + IFRS 5 impairments), and
the carrying amount of a NCAHFS may not exceed the carrying amount calculated as if it had never been
impaired/ classified as HFS.
The first limit is based on IFRS 5.21.
The second limit is based on IFRS 5.15, which requires a NCAHFS to be measured at the lower of:
carrying amount (interpreted to mean CA as at reclassification date, ignoring impairment losses, thus, when
using the cost model, is calculated as: cost – accumulated depreciation on reclassification date); and
fair value less costs to sell.
PPE: Plant: acc imp. loss (-A) O/bal (given): 18 000 – IL reversal: 11 000 (W1) 7 000
PPE: Plant: acc depreciation (-A) Given 18 000
PPE: Plant: cost (A) Given 100 000
NCAHFS: Plant: Cost – AD (A) Cost: 100 000 – AD: 18 000 82 000
NCAHFS: Plant: acc imp loss (-A) Bal in the PPE: AIL account 7 000
Transfer of plant to non-current asset held for sale: CA was 75 000
Impairment loss – NCAHFS (E) IFRS 5 impairment (W2) 15 000
NCAHFS: Plant: acc impairment loss (-A) 15 000
IFRS 5 Impairment loss on date of classification as held for sale
Note:
x This asset will no longer be depreciated.
x The cumulative impairment loss to date is now C22 000 (IAS 36: 7 000 + IFRS 5: 15 000)
W1: Measurement of plant before classification as NCAHFS: (IAS 16 & IAS 36) C
PPE: CA: 08/01/X3 Cost: 100 000 – AD: 18 000 – AIL: 18 000 Note 1
64 000
PPE: RA: 08/01/X3 Higher of VIU: 75 000 and FV-CoD: 60 000 (75 000)
PPE: Impairment reversal 08/01/X3 RA > CA: In terms of IAS 36, there is no further impairment, 11 000
but there is an impairment loss reversal
PPE: Carrying amount just before transfer CA: 64 000 + ILR: 11 000 (i.e. measured in terms of IAS 16) 75 000
Note 1: depreciation between 01/01/X3 to 08/01/X3 was ignored because immaterial
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Solution 3B, 3C & 3D: Re-measurement of NCAHFS: reversal of impairment loss, with a
limitation (previously: cost model)
Comment:
x The solutions to Part B, C and D show that any impairment reversal is limited by the following two rules:
- First limit: The impairment loss reversal may not exceed the prior accumulated impairment losses
(whether in terms of IAS 36 and / or IFRS 5) – this limit is shown in W1.2. See IFRS 5.21
- Second limit: The new carrying amount after the impairment loss reversal may not exceed the PPE’s
carrying amount, where this carrying amount is interpreted to mean the carrying amount on date of
reclassification, ignoring prior impairment losses (i.e. when using the cost model, ‘cost – accumulated
depreciation’ – or in other words, ‘depreciated cost’) – this limit is shown in W1.3. See IFRS 5.15
x Part B shows an impairment reversal that is not limited at all. (first limit and second limit)
x Part C shows an impairment reversal that was not limited by the first limit (i.e. prior accumulated impairment
losses) but was limited by the second limit (i.e. the CA of the NCAHFS may not exceed the CA of the PPE
on the date of classification, ignoring prior impairment losses).
x Part D shows an impairment reversal that is limited by both the first and second limit.
Journals: B C D
Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
30 June 20X3
NCAHFS: Plant: acc impairment loss (-A) W1.3 or W1 (alternative) 15 000 20 000 20 000
Impairment loss reversal – NCAHFS (I) (15 000) (20 000) (20 000)
Reversal of impairment loss when re-measuring the NCAHFS
W1: Subsequent measurement of plant after reclassification as NCAHFS: See IFRS 5.15 and 5.20 -.21
Impairment loss reversal (proposed), See explanatory notes below: * 15 000 22 000 22 000
after first limitation: *See notes A: not limited (15 000 – excess: 0)
B: not limited (22 000 – excess: 0)
C: limited (25 000 – excess: 3 000)
Calculation 1: PPE imp loss = AIL: 18 000 (given) – IL: 11 000 (Ex 3A W1) = 7 000
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The following is an alternative working that combines the previous W1.1 and W1.2 and W1.3:
W1 (Alternative): Subsequent measurement of plant after reclassification as NCAHFS: See IFRS 5.15 &20-21
B C D
Latest measurement of NCAHFS on reporting date (30/06/X3), at 75 000 80 000 80 000
the lower of:
x Latest FV-CtS: 30/06/X3 Given 75 000 82 000 85 000
x CA on date reclassified, but i.e. Depreciated cost: 80 000 80 000 80 000
ignoring imp losses: 08/01/X3 Cost: 100 000 – AD: (100 000 - 0)
x 10% x 2 yrs Note 1
Less Prior carrying amount Lower of CA and FV-CtS: 08/01/X3 (60 000) (60 000) (60 000)
(See Example 3A: W2)
Impairment loss reversal 15 000 20 000 20 000
Note 1: depreciation between 01/01/X3 to 08/01/X3 was ignored because immaterial
See IFRS 5.21
Check: The impairment loss reversal may not exceed prior cumulative impairment losses
B C D
Impairment loss reversal Above 15 000 20 000 20 000
Limited to prior cumulative imp losses IAS 36: 7 000 + IFRS 5: 15 000 (22 000) (22 000) (22 000)
Excessive IL Reversal disallowed See note below * N/A N/A N/A
P.S. The above alternative layout of W1 will automatically limit any impairment loss reversal to prior
cumulative impairment losses and thus the comparison of the planned impairment loss reversal to
prior cumulative impairment losses in the above table is only a proof or a ‘check’ on your workings.
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A: 4.6.2 The tax effect when the cost model was used
As soon as an asset is classified as held for sale, we stop depreciating it. However, the tax
authorities generally do not stop allowing tax deductions (assuming the cost of the asset was tax
deductible) simply because you have decided to sell the asset.
This means that temporary differences will arise due to a combination of the accountant’s nil
depreciation and any impairment losses or reversals compared with the tax authority’s continued
tax deductions (assuming the asset’s cost is tax deductible). When temporary differences arise,
we will need to recognise deferred tax.
The principles affecting the current tax payable and deferred tax balances are therefore exactly
the same as for any other non-current asset.
Chapter 12 619
Gripping GAAP Non-current assets held for sale and discontinued operations
A: 4.7.1 The basic principles when the revaluation model was used
If an asset measured under the revaluation model is classified as ‘held for sale’, we need to
follow these steps:
x Step 1: immediately before reclassifying the asset as ‘held for sale’, the asset must be
measured using its previous revaluation model in terms of IAS 16:
- depreciate it to date of classification as ‘held for sale’;
- re-measure to fair value (if materially different to the carrying amount); and
- check for impairments;
x Step 2: transfer it to NCAHFS;
x Step 3: immediately after reclassifying the asset as ‘held for sale’, the asset must be
measured in terms of IFRS 5:
- Measure it to the lower of:
- Carrying amount (CA), and
- Fair value less costs to sell (FV-CtS); See IFRS 5.15
- Stop depreciating it; See IFRS 5.25 and
x Step 4: Periodically re-measure to ‘fair value less costs to sell’ whenever appropriate: this
may necessitate the recognition of an impairment loss or an impairment loss reversal.
A further limitation is possible in that, when reversing an The CA after the IL reversal must
never exceed the lower of CA (if the
impairment loss, the NCAHFS must always be measured at reval model was used, the CA is the
the lower of ‘depreciated FV’) and FV-CtS (see
interpretation in section A: 4.5.2)
x its ‘carrying amount’ and
x ‘fair value less costs to sell’. See IFRS 5.15
The ‘carrying amount’ used in the above ‘further limitation’ is measured on reclassification date,
calculated as if the asset had never been impaired (see interpretation explained in section A: 4.5.2).
When the cost model was used, this carrying amount is the ‘depreciated cost’ on reclassification date,
but when using the revaluation model, it is the ‘depreciated fair value’ on reclassification date. See IFRS 5.15
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Journals:
A B C
1 January 20X4 Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
PPE: Plant: acc. depreciation (-A) W1.1: Acc depr to 15 000 15 000 15 000
PPE: Plant: cost (A) 31/12/X3 and see Note 2 (15 000) (15 000) (15 000)
NRVM: Acc. depreciation set-off against cost
PPE: Plant: cost (A) W1.1 (5 000) 45 000 (45 000)
Revaluation surplus – plant (OCI) W1.1 5 000 (45 000) 35 000
Revaluation expense – plant (E) W1.1 0 0 10 000
Revaluation of plant (PPE) to FV immediately before
reclassification to NCAHFS
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Note 3. Even though a revaluation surplus balance remains after the revaluation on 1/1/X4 (see W3: A & B),
any subsequent impairment losses after the plant is reclassified as NCAHFS must be expensed (i.e.
impairments in terms of IFRS 5 are always expensed). See note 5 below.
Note 4. While the plant is PPE, we transferred the revaluation surplus to retained earnings over its useful life
(i.e. at the same rate as the asset is depreciated) but once the plant is a NCAHFS (from 1/1/X4), both
depreciation and this transfer must cease.
Note 5. The balance in the revaluation surplus on date of classification as a NCAHFS remains there until the
asset is disposed of, at which point it will be transferred to retained earnings.
W1: Measurement of plant before reclassification as NCAHFS (i.e. measured as PPE: IAS 16 & IAS 36)
PPE: FV: 1/01/X4 Given (latest FV) 100 000 150 000 60 000
PPE: Impairment loss expense (IAS 36) RA is greater than CA N/A N/A N/A
NCAHFS: Carrying amount after impairment : 01/01/X4 CA - IL 91 000 130 000 40 000
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This example is based on example 5A’s plant, which was measured using the revaluation model.
The following information is repeated here for your convenience:
x Cost: C100 000 (purchased 1 January 20X1).
x Depreciation: 10% per annum straight-line to nil residual values.
x Fair value: C120 000 (as at date of revaluation: 1 January 20X3).
x Revaluations are performed using the net replacement value method.
x The revaluation surplus is transferred to retained earnings over the asset’s useful life.
x The recoverable amount had always exceeded the carrying amount.
x This plant met all criteria for classification as ‘held for sale’ on 1 January 20X4, on which date the following
values applied:
- Fair value of C100 000 and expected selling costs of C9 000 (equal to expected disposal costs);
- Value in use of C105 000.
Required: Journalise the remeasurement of the NCAHFS at year-ended 30 June 20X4 (i.e. 6 months after
reclassification) assuming that:
A. on 30 June 20X4, the fair value is C110 000 and the expected selling costs are C15 000;
B. on 30 June 20X4, the fair value is C110 000 and the expected selling costs are C3 000;
C. on 30 June 20X4, the fair value is C90 000 and the expected selling costs are C3 000.
Journals: A B C
30 June 20X4 Dr/(Cr) Dr/(Cr) Dr/(Cr)
NCAHFS: acc impairment loss (-A) W1 or W1.3 4 000 9 000 N/A
Reversal of impairment loss – NCAHFS (I) (4 000) (9 000) N/A
Remeasurement of NCAHFS: increase in FV-CtS
Impairment loss – NCAHFS (E) W1 or W1.1 * Note 1 N/A N/A 4 000
NCAHFS: acc impairment loss (-A) N/A N/A (4 000)
Remeasurement of NCAHFS: decrease in FV-CtS
*Note 1: Notice that the impairment (in Part C) is recognised in P/L even though there is a balance of
C30 000 in the revaluation surplus (see example 5A: W3).
W1: Subsequent measurement of plant after reclassification as NCAHFS: See IFRS 5.15 & 5.20-21
Chapter 12 623
Gripping GAAP Non-current assets held for sale and discontinued operations
NCAHFS: CA on 01/01/X4 was: Given (See 5A: W2) 91 000 91 000 N/A
Plus: Proposed imp loss reversal 30/06/X4 W1.2 4 000 9 000 N/A
NCAHFS: CA on 30/06/X4 would be: 95 000 100 000 N/A
Limited to: CA of PPE on date reclassified, Depreciated fair value: 100 000 100 000 N/A
ignoring imp losses: 01/01/X4 FV: 100 000 – AD: 0
(AD is nil as it was immediately
reclassified after revaluation)
Excess disallowed A, B & C: not limited N/A N/A N/A
Thus, impairment loss reversal is: See calculations below 4 000 9 000 N/A
Calculations:
x A: Proposed reversal of 4 000 (W1.2) – excess disallowed 0 (W1.3) = 4 000 reversal of imp loss
x B: Proposed reversal of 9 000 (W1.2) – excess disallowed 0 (W1.3) = 9 000 reversal of imp loss
x C: N/A: there was no planned reversal (W1.2); the asset was further impaired instead.
The following is an alternative working that combines the previous W1.1 and W1.2 and W1.3:
W1 (Alternative): Subsequent measurement of plant after reclassification as NCAHFS: See IFRS 5.15 & 20-21
A B C
Latest measurement of NCAHFS on reporting date (30/06/X4), 95 000 100 000 87 000
at the lower of:
x FV - CtS: 30/06/X4 A: FV: 110 000 – CtS: 15 000 95 000 107 000 87 000
B: FV: 110 000 – CtS: 3 000
C: FV: 90 000 – CtS: 3 000
x CA on date reclassified, but ignoring i.e. Depreciated fair value 100 000 100 000 100 000
impairment losses: 01/01/X4 FV: 100 000 – AD: 0
Less: Prior carrying amount (01/01/X3) Lower of CA (100 000) and (91 000) (91 000) (91 000)
FV-CtS (91 000) (Ex5A W2)
Impairment loss reversal / (impairment loss) 4 000 9 000 (4 000)
624 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations
Calculation (1): PPE AIL (IAS 36): 0 (See Ex 5A: W1.2) + NCAHFS AIL (IFRS 5): 9 000 (See Ex 5A: W2) = 9 000
Note: This alternative layout of W1 will automatically limit any impairment loss reversal to prior accumulated
impairment losses and thus the comparison of the proposed impairment loss reversal to prior accumulated
impairment losses in the above table is only a ‘check’ on your workings.
This example is based on example 5C’s plant, which was measured using the revaluation model.
The following information is repeated here for your convenience:
x Cost: 100 000 (purchased 1 January 20X1)
x Depreciation: 10% per annum straight-line to nil residual values.
x Fair value: 120 000 (as at date of revaluation: 1 January 20X3).
x Revaluations are performed using the net replacement value method.
x The revaluation surplus is transferred to retained earnings over the life of the underlying asset.
x The recoverable amount has always been greater than its carrying amount and thus the asset
has not previously been impaired in terms of IAS 36.
x This plant met all criteria for classification as ‘held for sale’ on 1 January 20X4, on which date
the following values applied:
- Fair value of C60 000 and expected selling costs of C20 000 and
- Value in use of C65 000.
Required:
Journalise the re-measurement of the NCAHFS at year-end 30 June 20X4 when its fair value is C80 000 and
the expected selling costs are C10 000.
Comment:
x This example follows on from example 5C, which showed the journals relating to the initial measurement
of the NCAHFS on the date it was classified as a NCAHFS (1 January 20X4).
x This example (example 7) shows the subsequent measurement of the NCAHFS on reporting date.
It highlights that:
- prior impairment loss expenses may be reversed, but that
- prior revaluation expenses may not be reversed.
Journals: Dr/(Cr)
30 June 20X4
NCAHFS: acc impairment loss (-A) W1 or W1.3 20 000
Reversal of impairment loss – NCAHFS (I) (20 000)
Re-measurement of NCAHFS: increase in FV-CtS
W1: Subsequent measurement of plant after reclassification as NCAHFS: See IFRS 5.15 & 5.20-21
Less: Prior carrying amount: 01/01/X4 Lower of CA & FV-CtS (01/01/X4) (40 000)
x CA: 60 000 (FV: given) vs
x FV-CtS: 40 000 (60 000 - 20 000)
(See example 5C W1)
Chapter 12 625
Gripping GAAP Non-current assets held for sale and discontinued operations
Impairment loss reversal (proposed), after first limitation* IL Reversal 30 000 – 10 000 20 000
Calculation 1:
The following is an alternative working that combines the previous W1.1 and W1.2 and W1.3:
626 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations
Check: The impairment loss reversal may not exceed the prior cumulative impairment losses See IFRS 5.21
Impairment loss reversal Above 20 000
Limited to prior accumulated imp losses (AIL) See calculation 1 (below) (20 000)
Excessive reversal disallowed N/A
Calculation (1): PPE AIL (IAS 36): 0 (See Ex 5C: W1.2) + NCAHFS AIL (IFRS 5): 20 000 (See Ex 5C: W2) = 9 000
A: 4.7.2 The tax effect when the revaluation model was used
Depreciation stops as soon as an asset is classified as ‘held for sale’. However, the tax authorities
generally do not stop granting the tax deductions relating to the cost of the asset (assuming the cost
of the asset is tax deductible) simply because you have decided to sell the asset.
Thus, there will generally be a difference between the accountant’s expenses relating to the asset
(depreciation, which will be nil from the date of classification, and any impairment losses or reversals)
and the tax authority’s deductions relating to the asset (assuming the asset’s cost was tax
deductible). Thus, from the ‘income statement perspective’, the accountant’s ‘profit before tax’ and
the tax authority’s ‘taxable profits’ will differ. This means, when converting profit before tax to taxable
profit, we would need to reverse any impairments (or impairment reversals) as well as any
depreciation that had been incurred before classification as ‘held for sale’ and then subtract the tax
deductions. Similarly, from the ‘balance sheet perspective’, the asset’s carrying amount and tax base
will differ, thus causing a temporary difference on which deferred tax must be recognised.
The principles affecting the current tax payable and deferred tax balances are thus exactly the same
as for any other non-current asset. However, one must be careful when measuring the deferred tax
balance if an asset has been revalued above its original cost.
The reason for this is that this deferred tax balance may have previously been calculated based on
the assumption that the carrying amount of the asset represents the future inflow of benefits resulting
from the usage of the asset. Profits from the usage of the assets are sometimes referred to as trading
profits or non-capital profits and the deferred tax balance would have been calculated at the tax rate
that would apply to profits arising from trading (i.e. commonly referred to as the 'normal' tax rate).
However, when an asset is reclassified as ‘held for sale’, it means the future benefits are now
expected to come from the sale of the asset rather than the use thereof. Profits from the sale of the
asset involve capital profits if one expects to sell the asset at a price that exceeds original cost.
Depending on the country, the tax legislation may apply tax methods and tax rates to capital profits
that differ from the tax methods and tax rates that apply to normal trading profits. If this is the case,
the deferred tax balance will need to be adjusted to take into account the entity’s change in intention
and the resultant different tax calculations. In South Africa, the Income Tax Act has specific
provisions relating to capital gains (commonly referred to as capital gains tax legislation).
As a result, reclassifying an asset into the ‘held for sale’ classification will, at a minimum, generally
result in an adjustment to deferred tax in order to remeasure the deferred tax balance using the
‘capital gains tax legislation’ rather than the 'normal tax legislation’.
Chapter 12 627
Gripping GAAP Non-current assets held for sale and discontinued operations
x On 31 December 20X4, the fair value was now C140 000 and the cost to sell C20 000.
x Tax related information:
- The tax authorities allow a deduction of 20% on the cost of this asset;
- Only 80% of the capital gain (proceeds - base cost) is taxable;
- The base cost is 120 000;
- The tax rate is 30%.
x Profit before tax is correctly calculated to be C200 000 for the year ended 31 December 20X4.
x There are no temporary or permanent differences other than evident from the above.
Required:
Show all related journal entries for the year ended 31 December 20X2, 20X3 and 20X4 (including the current
tax and deferred tax entries) to the extent possible from the information provided.
Comment: This example shows the effect on the deferred tax adjustments when the intention changes from using
the asset to selling it and when there has been a previous upward revaluation.
Journals
31 December 20X2 Debit Credit
PPE: Plant: acc depreciation (-A) (100 000 – 0) / 10 yrs x 2 years 20 000
PPE: Plant: cost (A) 20 000
NRVM: Accumulated depreciation to 31/12/20X2 set-off against cost
PPE: Plant: cost (A) FV: 120 000 – CA: (100 000 - 20 000) 40 000
Revaluation surplus: PPE: Plant (OCI) 40 000
Revaluation of PPE according to IAS 16’s revaluation model
31 December 20X3
PPE: Plant: acc depreciation (-A) 10 000 + 10 000 – 20 000 + 15 000 15 000
PPE: Plant: cost (A) 15 000
NRVM: Accumulated depreciation to 31/12/20X3 set-off against cost
PPE: Plant: cost (A) FV: 150 000 – CA: (120 000 - 15 000) 45 000
Revaluation surplus: PPE: Plant (OCI) 45 000
Revaluation of PPE according to IAS 16’s revaluation model
Revaluation surplus: PPE: Plant (OCI) (40 000 revaluation gain – 12 000 3 500
Retained earnings deferred tax)/ 8 remaining yrs 3 500
Transfer of revaluation surplus to retained earnings
628 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations
Impairment loss – NCAHFS (E) CA: 150 000 – FV -CtS: (150 000–20 000) 20 000
NCAHFS: Plant: acc impairment losses (-A) 20 000
Re-measurement to lower of CA or FV -CtS on reclassification:
31 December 20X4
Impairment loss – NCAHFS (E) CA: 130 000 – FV -CtS: (140 000 –20 000) 10 000
NCAHFS: Plant: acc impairment losses (-A) 10 000
Re-measurement to lower of CA and FV -CtS after reclassification:
Workings
Chapter 12 629
Gripping GAAP Non-current assets held for sale and discontinued operations
Values:
W3: Deferred tax adjustment in above table 01/01/X4 01/01/X4 31/12/X4
150 000 130 000 120 000
DT (i.e. future tax) on the capital gain
Expected selling price Carrying amount ( FV) 150 000 130 000 120 000
Base cost Given (120 000) (120 000) (120 000)
Capital gain 30 000 10 000 0
Inclusion rate Given 80% 80% 80%
Taxable capital gain Capital gain x Inclusion rate 24 000 8 000 0
Taxed at 30% Taxable capital gain x 30% (A) 7 200 2 400 0
Selling price limited to cost CA (150 000), limited to cost (100 000) 100 000 100 000 100 000
CA (130 000), limited to cost (100 000)
CA (120 000), limited to cost (100 000)
Tax base 1/1/X4: 100 000 – 100 000 x20% x3yrs (40 000) (40 000) (20 000)
31/12/X4: 100 000 – 100 000 x20%x4yrs
Recoupment 60 000 60 000 80 000
Taxed at 30% Recoupment x 30% (B) 18 000 18 000 24 000
Therefore:
630 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations
A non-current asset that was previously classified as held for sale (or held for distribution) could
subsequently fail to meet the criteria to remain classified as held for sale (or held for distribution). If this
occurs, then the non-current asset must be reversed out of the held for sale (or distribution) classification
and back into its previous classification (e.g. property, plant and equipment). See section A: 4.8.2.
It can also happen that a non-current asset that was previously held for sale is now held for
distribution (or vice versa). In this case, there is still a plan to dispose of the asset and thus the
change in classification is considered to be a continuation of the original plan of disposal. However,
this does not mean that there are no adjustments required. See section A: 4.8.3.
A: 4.8.2 If a NCAHFS subsequently fails to meet the HFS or HFD classification criteria
If a non-current asset that was previously classified as ‘held for sale’ (or held for distribution) no
longer meets the criteria necessary for such a classification, the asset must be removed from this
classification. See IFRS 5.26
This means, it will have to be transferred out of the held for sale (or held for distribution) classification
and back into its previous classification (e.g. PPE). See IFRS 5.26
Before the transfer out of ‘held for sale’ (or ‘held for distribution’), the asset must be remeasured to
the lower of the following, measured on the date it ceased to be classified as held for sale:
x its carrying amount assuming the asset had never been classified as ‘held for sale’ (i.e. take the
asset’s carrying amount before reclassification and adjust it for any depreciation, amortisation,
impairments, impairment reversals and/or revaluations that would have been recognised had the
asset not been reclassified as held for sale/ distribution); and
x its recoverable amount. See IFRS 5.27
An adjustment to the asset’s carrying amount is recognised in profit or loss unless the asset is an
item of property, plant and equipment or an intangible asset that was previously measured under the
revaluation model. In the case of the asset having previously been measured under the revaluation
model, the adjustment would be recognised in the same way that you would recognise increases or
decreases under the revaluation model. See IFRS 5.28 & footnote 6
A non-current asset that was previously ‘held for sale’ (HFS) may become ‘held for distribution’ (HFD)
instead (or vice versa). In this case, the asset would simply be transferred from the HFS classification
to the HFD classification (or vice versa).
This non-current asset, which was previously HFS (or HFD) would then effectively be classified,
measured and presented as HFD (or HFS ).
A measurement adjustment may be needed since the two classifications are measured slightly differently:
x the HFS classification is measured at the lower of carrying amount and fair value less costs to
sell, whereas
x the HFD classification is measured at the lower of carrying amount and fair value less costs to
distribute.
When remeasuring the asset, we simply follow the normal rules for initial measurement on
reclassification date (IFRS 5.15) and subsequent measurement after reclassification (IFRS 5.20-25).
The adjustments would simply be accounted for as an impairment loss or impairment loss reversal.
Since a reclassification from HFS to HFD (or vice versa) does not change the fact that the non-
current asset is to be disposed of, and is thus considered to be a continuation of the original plan of
disposal, the date on which it was originally classified as HFS (or HFD) is not changed.
Chapter 12 631
Gripping GAAP Non-current assets held for sale and discontinued operations
31 December 20X3
Current carrying amount (30 June 20X3) Fair value – costs to sell (Given) (65 000)
Impairment loss reversal 10 000
*: Please note depreciation on this asset is backdated (i.e. calculated as if it had never ceased).
As mentioned in section A: 2, the measurement provisions of IFRS 5 do not apply to the following
non-current assets:
x Deferred tax assets (IAS 12 Income tax)
x Assets relating to employee benefits (IAS 19 Employee benefits)
x Financial assets (IFRS 9 Financial instruments)
x Investment properties measured under the fair value model (IAS 40 Investment property)
x Non-current assets measured at fair value less point-of-sale costs (IAS 41 Agriculture)
x Contractual rights under insurance contracts (IFRS 4 Insurance contracts). See IFRS 5.5
632 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations
The scope exclusion simply means that, even though these non-current assets may be ‘held for
sale’ (or ‘held for disposal’), they will not be measured in terms of IFRS 5. For example: a
financial asset that meets the criteria for classification as ‘HFS’ will not be remeasured on initial
reclassification to the lower of its carrying amount and fair value less cost to sell and would not
be subsequently remeasured to its latest fair value less costs to sell. However, IFRS 5 still
requires them to be classified, presented and disclosed as ‘HFS’ (or HFD).
W1: Measurement of investment property before reclassification (i.e. measured as IP: IAS 40)
C
Investment property at fair value on 1 January 20X3 Given 80 000
Investment property at fair value on 30 June 20X3 Given (70 000)
Fair value loss on investment property 10 000
A: 5.1 Overview of disposal groups (IFRS 5 Appendix A and IFRS 5.4-5.6; 5.15 and .25)
As was explained earlier (see section A:1), IFRS 5 refers not only to individual non-current assets
held for sale (or distribution), but also to disposal groups held for sale (or distribution).
First we have to identify if we have a disposal group, as defined (see section A:5.2).
If we have a disposal group as defined, we will then need to apply the same criteria to decide if
we must classify this disposal group as ‘held for sale’ (or distribution) (previously discussed in
section A:3). If we have a disposal group that should be classified as ‘held for sale’ (or distribution),
we will then have to measure, present and disclose it as ‘held for sale’ (or distribution).
The classification, presentation and disclosure of individual non-current assets held for sale
(or distribution) is the same for disposal groups ‘held for sale’ (or distribution): see section A:5.3.
Chapter 12 633
Gripping GAAP Non-current assets held for sale and discontinued operations
When measuring a disposal group held for sale (or distribution), we use the same basic
measurement principles used for individual non-current assets held for sale (or distribution)
(previously discussed in section A:4). However, because a disposal group includes a variety of items
(non-current assets and current assets and possibly even liabilities), some of which might be scoped-
out items, measuring a disposal group held for sale is slightly more complex than measuring an
individual non-current asset held for sale. This is explained in section A:5.4.
634 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations
We will refer to those assets that the IFRS 5 measurement requirements do apply to as ‘scoped-
in non-current assets’.
If the disposal group includes at least one ‘scoped-in non-current asset’, the disposal group as
a whole will be subject to the IFRS 5 measurement requirements (as well as the classification,
presentation and disclosure requirements).
If the disposal group does not contain any ‘scoped-in non-current assets’, then the disposal
group will not be subject to the IFRS 5 measurement requirements at all (although it will still be
subject to IFRS 5’s classification, presentation and disclosure requirements).
If the disposal group includes at least one ‘scoped-in non- A disposal group may
current asset’, the disposal group as a whole is thus include goodwill acquired in
measured in terms of IFRS 5 at: a business combination if it:
x is an operation within a cash-
x the lower of its carrying amount and its fair value less
generating unit (CGU); or
costs to sell (if held for sale); or
x is a CGU to which goodwill has been
x the lower of its carrying amount and its fair value less allocated in accordance with the
costs to distribute (if held for distribution). requirements of IAS 36 Impairment
of assets (IAS 36.80-87).
IFRS 5 Appendix A
An entity must not depreciate (or amortise) a disposal
group once it has been classified as held for sale (or held for distribution).
If the disposal group contains liabilities, any interest or other expenses related to these liabilities
must continue to be recognised. See IFRS 5.25
A: 5.4.1 Initial measurement of disposal groups held for sale (IFRS 5.4 & .15-18 & .20 & .23
& IAS 36.104)
The process to be followed on initial measurement is:
Initial measurement of
x Immediately before reclassification, all individual assets a DGHFS (or DGHFD):
and liabilities within the disposal group (DG) must be
x Before reclassification:
measured one last time in terms of their own standards.
Measure each item in the DGHFS
For example: a plant measured under the cost model using its own IFRSs;
must be depreciated to reclassification date and x After reclassification:
checked for impairments, whereas inventory must be Measure DGHFS at lower of CA and
measured to the lower of cost and net realisable value FV-CtS (could lead to an imp loss).
on reclassification date.
x The individual assets and liabilities must then be
An impairment loss on
transferred to the disposal group held for sale (DGHFS)
the initial measurement
or the disposal group held for distribution (DGHFD). of a DGHFS is allocated:
x The disposal group, as a whole, is then remeasured on x First to: goodwill, if applicable;
reclassification date in terms of IFRS 5 as follows:
x Then to: Scoped-in NCAs.
for a DG held for sale, to the lower of its:
- carrying amount; or
- fair value less costs to sell.
for a DG held for distribution, to the lower of its:
- carrying amount; or
- fair value less costs to distribute.
Any impairment loss is then allocated to those assets in the disposal group that fall within
the measurement scope of IFRS 5 (i.e. allocated to the scoped-in non-current assets):
If goodwill is present, any impairment loss is first allocated to goodwill; and
Any remaining impairment loss is then allocated proportionately to the other assets in the
disposal group that fall within the IFRS 5 measurement requirements (i.e. to the other
scoped-in non-current assets) based on their relative carrying amounts. See IAS 36.104
Chapter 12 635
Gripping GAAP Non-current assets held for sale and discontinued operations
In other words, none of the impairment loss must be allocated to current assets, scoped-out non-
current assets or to the liabilities within a disposal group.
The requirement that the impairment loss on a DGHFS (or DGHFD) be allocated only to those items in the
group that are ‘scoped-in non-current assets’ means that it is possible that the carrying amount of these
individual assets may be decreased to the point that they no longer reflect their value.
In fact, these individual values may drop not only below their true recoverable amounts but may even end up
being negative (i.e. an asset with a credit balance!)
It seems this was not intentional and that either an interpretation on this issue or an amendment to IFRS 5 is
clearly necessary.
Answer: The impairment loss is C100 000. The allocation thereof is shown in the table below.
636 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations
Note 3. The impairment loss is first set-off against any goodwill, and any impairment loss remaining is
then allocated to the remaining ‘scoped-in non-current assets’ on the basis of the relative
carrying amounts:
Total IL: 100 000 – Goodwill: 30 000 = IL still to be allocated: 70 000
Note 4. The remaining impairment loss of 70 000 is allocated based on the carrying amounts of the
scoped-in non-current assets:
Property, plant and equipment: 70 000 x 150 000 / (150 000 + 50 000) = 52 500
Investment property (cost model): 70 000 x 50 000 / (150 000 + 50 000) = 17 500
Note 5. Notice how the carrying amounts of the scoped-in non-current assets were dropped below the
carrying amounts that they would have had under IAS 36 Impairment of assets (i.e. property, plant
and equipment would not have dropped below C150 000 had it not been part of a disposal group).
Note 6. If the impairment loss was greater than the carrying amounts of the scoped-in non-current
assets, the allocation of the impairment loss would have resulted in the property, plant and
equipment and investment property under the cost model being measured at negative amounts!
Chapter 12 637
Gripping GAAP Non-current assets held for sale and discontinued operations
Answer: The impairment loss of the disposal group is C35 000, of which:
x C10 500 is allocated to plant and
x C24 500 is allocated to the factory building.
Building: CA after impairment CA: 175 000 – Impairment loss: 0 175 000
Disposal group: CA after impairment CA: 320 000 – 35 000 285 000
638 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations
Note 3. The impairment loss is first set-off against any goodwill in the disposal group:
Total impairment loss: 35 000 – Goodwill: 0 = IL still to be allocated: 35 000
Any impairment loss remaining after first setting it off against goodwill (i.e. C35 000 in this case), is
then allocated to the other ‘scoped-in non-current assets’ on the basis of the relative carrying amounts:
Plant (scoped-in): 35 000 x 75 000 / (75 000 + 175 000) = 10 500
Building (scoped-in): 35 000 x 175 000 / (75 000 + 175 000) = 24 500
A: 5.4.2 Subsequent measurement of a disposal group held for sale (IFRS 5.4; 5.15; 5.19-
20; 5.23; IAS 36.122)
As with an individual asset, a disposal group would need to be remeasured to its latest ‘fair value
less costs to sell’ at the subsequent reporting date if it remains unsold at this date. However, if a
disposal group includes items that are excluded from the measurement requirements of IFRS 5 (i.e.
if it includes scoped-out items), please remember that the carrying amounts of these items must be
measured in terms of their own relevant IFRS before the disposal group is remeasured to its latest
‘fair value less costs to sell’. In other words:
Subsequent measurement
x A disposal group might contain two categories of items:
of a DGHFS or DGHFD:
- Scoped-in non-current assets (measured in terms of IFRS 5);
x Before remeasurement:
- Scoped-out items (not measured in terms of IFRS 5): Scoped-in NCAs in the DG: do not
these items could include current assets, scoped-out depreciate or amortise
non-current assets and liabilities, all of which continue to All other items in the DG: measure
be measured in terms of their own relevant standards. using their own IFRSs;
x Remeasurement:
x The total carrying amount of the disposal group is recalculated Measure the DG at its latest FV-CtS
to reflect any changes to the individual carrying amounts of the (or FV-CtD): this could lead to an:
scoped-out items, measured in terms of their own standards. - impairment loss
x The disposal group’s latest carrying amount (calculated - impairment loss reversal.
above) is then compared to its latest fair value less costs to sell (or costs to distribute), and
appropriate adjustments may be necessary, involving either:
An impairment loss on
- a further impairment loss; or subsequent measurement
- an impairment loss reversal. of a DG is allocated:
x First to: goodwill, if applicable;
An impairment loss is recognised if the latest ‘carrying amount’ x Then to: scoped-in NCAs.
of the disposal group, as a whole, is greater than the latest ‘fair (i.e. same as for initial measurement).
value less costs to sell’ (or fair value less costs to distribute). An
impairment loss arising on subsequent measurement of the disposal group is allocated to individual
assets in the disposal group in the same way that an impairment loss on initial measurement of the
disposal group was allocated. In other words, the impairment loss is:
x first allocated against any goodwill that may be included in the disposal group, and then
x any remaining impairment loss is allocated to the other scoped-in non-current assets based on
their relative carrying amounts. See IAS 36.104
An impairment loss
An impairment loss reversal is recognised if the latest ‘carrying reversal on subsequent
measurement of a DG is:
amount’ of the disposal group, taken as a whole, is less than the
x allocated to scoped-in NCAs (there
latest ‘fair value less costs to sell’ (or fair value less costs to is no limit to the amount allocated
distribute). However, an impairment loss reversal is limited in to these items);
that it may only be recognised to the extent that: x never allocated to goodwill or any
x It has not been recognised in the remeasurement of any current of the other items in the DG.
See IAS 36.122
assets, scoped-out non-current assets or liabilities; and
x It does not exceed the accumulated impairment losses in terms of IAS 36 Impairment of assets and/
or IFRS 5. IFRS 5.22 & See IAS 36.117
This impairment loss reversal would then be allocated to scoped-in non-current assets based on
their relative carrying amounts but may never be allocated to goodwill (this is because an
impairment of goodwill may never be reversed). See IAS 36.122-123
Chapter 12 639
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Answer: The impairment loss of the disposal group is C14 000 (W2), allocated as follows:
x C4 200 is allocated to plant; and
x C9 800 is allocated to the building (W3 or W4).
W1: Measurement of investment property at reporting date (as IP, in terms of IAS 40 C
Carrying amount is currently Example 12 (W3 and W5; or W6) 70 000
Fair value is currently Given (69 000)
Fair value loss 1 000
Investment property: CA after FV loss CA: 70 000 – FV loss: 1 000 69 000
W2: Measurement of disposal group at reporting date (as a DGHFS, in terms of IFRS 5) C
Plant Ex 12 (W6) 64 500
Building Ex 12 (W6) 150 500
Investment property Given, Or W1 above 69 000
Carrying amount: 31/12/X3 284 000
FV - Costs to sell: 31/12/X3 Given (270 000)
Impairment loss (relating to the whole disposal group) 14 000
Disposal group: CA after impairment CA: 284 000 – 14 000 270 000
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Example 14: Disposal group held for sale – subsequent impairment reversal
Rescue Limited has a disposal group that met the criteria for classification as ‘held for sale’
on 5 May 20X2. The disposal group contained three items (inventory, plant and goodwill).
x Carrying amounts immediately before the reclassification on 5 May 20X2:
- Inventory: C30 000 (inventory cost C90 000 but was written down to its net realisable value of C30 000);
- Plant: C50 000 (cost: C120 000, accumulated depreciation: C70 000);
- Goodwill: C5 000 (at cost).
x The fair value less costs to sell of the disposal group was estimated as follows:
- 5 May 20X2: C70 000;
- 31 December 20X2: C150 000.
x On 31 December 20X2, the inventory’s net realisable value had increased to C75 000.
Required: Calculate all carrying amounts relating to the disposal group on 5 May and 31 December 20X2
and show all journals from reclassification date (5 May 20X2) to reporting date (31 December 20X2).
Solution 14: Disposal group held for sale – subsequent impairment reversal
Comment:
x This example shows a disposal group held for sale (DGHFS) involving:
- An initial impairment on reclassification date; and
- A subsequent impairment loss reversal on reporting date.
x This example also involves goodwill and thus shows how any impairment is first allocated to goodwill
and that goodwill impairments are never reversed.
x The example shows that subsequent impairment loss reversals relating to a DGHFS may be limited.
Answer:
The carrying amount of the DG is C70 000 on 31 May 20X2 (W1) and C125 000 on 31 December 20X2 (W2).
The carrying amounts of the individual assets in the DG on these dates are shown in W1 and W2, respectively.
Chapter 12 641
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Note 1. All individual items in the disposal group are first measured in terms of their own relevant
standards before classifying the items into the disposal group held for sale.
Note 2. The disposal group is then initially measured to the lower of its carrying amount (85 000)
and fair value less costs to sell (70 000). An impairment loss of 15 000 must be processed.
Note 3. The impairment loss must first be allocated to goodwill (5 000) and then any remaining
impairment loss (15 000 – 5 000 allocated to goodwill = 10 000) must then be allocated to
the scoped-in non-current assets based on their relative carrying amounts. There was only
one such item (plant) and thus the remaining impairment loss of C10 000 is allocated
entirely to the plant. None is allocated to inventory because inventory is scoped-out.
A: 5.5 Measurement of disposal groups not expected to be sold within one year
When measuring the fair value less costs to sell of a DGHFS that is not expected to be sold
within a year, we must measure the costs to sell at their present value. This present value will
obviously ‘unwind’ over time (i.e. the present value will increase over time) and this increase in
the present value must be recognised in profit or loss. See IFRS 5.17
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A disposal group that is acquired with the intention to sell, and meets the necessary criteria for
classification as held for sale, will be immediately recognised and measured as a disposal group
held for sale and measured in terms of IFRS 5 (i.e. at the lower of carrying amount and fair value
less costs to sell). In other words, the assets and liabilities contained within the newly acquired
disposal group will not first be recognised and measured in terms of their own relevant standards
before then being transferred to the held for sale classification and measured in terms of IFRS 5.
Thus, the measurement of a disposal group held for sale that was acquired with the purpose of
selling, will be initially measured at the lower of:
x its carrying amount had it not been so classified (for example, cost); and
x its fair value less costs to sell. IFRS 5.16 (slightly reworded)
When measuring the DGHFS on initial recognition, the carrying amount is the cost that would
have been recognised had the assets and liabilities contained in the disposal group not been
immediately classified as held for sale.
A: 5.7.1 Overview
A disposal group classified as held for sale (or held for distribution) could subsequently fail to
meet the criteria to remain classified as held for sale (or held for distribution). If this occurs, then
the disposal group must be reversed out of the held for sale (or distribution) classification and
back to its previous classification (e.g. property, plant and equipment). See section A: 5.7.2.
It can also happen that a disposal group that was previously held for sale is now held for
distribution (or vice versa). In this case, there is still a plan to dispose of the disposal group and
thus the change in classification is considered to be a continuation of the original plan of disposal.
However, this does not mean that there will be no adjustments needed. See section A: 5.7.3.
If a disposal group that was previously classified as ‘held for sale’ (HFS) or 'held for distribution'
(HFD) no longer meets the criteria necessary for such a classification, the disposal group must
be removed from this classification. See IFRS 5.26
This means that the disposal group (i.e. the individual assets and liabilities that were contained in
the disposal group) will have to be transferred out of the classification as ‘held for sale’ (or ‘held for
distribution’) and back into its previous classification (e.g. property, plant and equipment). See IFRS 5.26
Before transferring the disposal group out of the classification as ‘held for sale’ (or ‘held for
distribution’), the disposal group must be re-measured to the lower of:
x its carrying amount had the disposal group never been classified as such (adjusted for any
depreciation, amortisation and/ or revaluations that would have been recognised had the
disposal group not been classified as held for sale/ distribution); and
x its recoverable amount. See IFRS 5.27
Any re-measurement adjustments necessary (i.e. any adjustments to the carrying amounts of the
individual assets and liabilities) are generally recognised in profit or loss. However, if the item
that is being adjusted is either property, plant and equipment or an intangible asset that was
previously measured under the revaluation model, then the adjustment would be recognised in
the same way that you would recognise increases or decreases under the revaluation model.
See IFRS 5.28 & footnote 6
Chapter 12 643
Gripping GAAP Non-current assets held for sale and discontinued operations
If it is only an individual asset or liability from within the disposal group that subsequently fails
to meet the criteria to be classified as held for sale (HFS) or held for distribution (HFD), then we
remove that asset or liability from the disposal group held for sale (or held for distribution) but
we must then also reassess whether the remaining disposal group will continue to meet the
criteria necessary for it to be classified as held for sale (or distribution). See IFRS 5.29
If the remaining disposal group continues to meet the relevant classification criteria, then it
remains measured as a disposal group in terms of IFRS 5.
However, if the remaining disposal group no longer meets the relevant classification criteria,
then it may no longer be measured as a group in terms of IFRS 5. However, each of the
individual non-current assets that were contained in the disposal group will need to be
individually assessed in terms of these criteria.
A disposal group that was previously held for sale may cease to be held for sale and become
held for distribution instead (or vice versa). In this case, the disposal group must simply be
transferred from the held for sale (HFS) classification to the held for distribution (HFD)
classification (or vice versa). This disposal group, which was previously held for sale (or
distribution) is now effectively classified, measured and presented as held for distribution (or sale).
A measurement adjustment may be necessary since there is a tiny difference in how each
classification is measured: the held for sale classification is measured at the lower of carrying
amount and fair value less costs to sell, whereas the held for distribution classification is
measured at the lower of carrying amount and fair value less costs to distribute. Any
measurement adjustment would simply be accounted for as an impairment loss or impairment
loss reversal in terms of IFRS 5.20-25.
Since a reclassification from HFS to HFD (or vice versa) does not change the fact that the DG
is to be disposed of, and is thus considered to be a continuation of the original plan of disposal,
the date on which it was originally classified as HFS (or HFD) is not changed.
A: 6.1 Overview
In other words, presentation is more ‘surface level’ whereas disclosure refers to the ‘detail’ or
‘deeper level’ information.
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When talking about presentation of a non-current asset (or disposal group) held for sale, the key
word to remember is ‘separate’.
Extra disclosure will be required where the financial statements include either:
x a ‘non-current asset (or disposal group) held for sale’; or
x a ‘sale of a non-current asset’.
Please note that the classification of a non-current asset (or disposal group) as ‘held for sale’
will only affect the period during which it was classified as ‘held for sale’. This means that no
adjustment should be made to the measurement or presentation of the affected assets in the
comparative periods presented. See IFRS 5.40
The presentation and disclosure requirements will now be discussed with reference to each
component that is affected.
A non-current asset (and any asset held within a disposal group) that is classified as ‘held for
sale’ must be presented separately from the other assets in the statement of financial position.
If a disposal group includes liabilities, these liabilities must also be presented separately from
other liabilities in the statement of financial position.
Liabilities and assets within a ‘disposal group held for sale’ may not be set-off against each other – the
assets held for sale must be shown under assets (but separately from the other assets) and the
liabilities held for sale must be shown under liabilities (but separately from the other liabilities).
See IFRS 5.38
A non-current asset (or disposal group) held for sale is presented as a current asset. See IFRS 5.3
The major classes of assets and major classes of liabilities that are classified as held for sale
must be separately presented from one another. In other words, this means that if an item of
property, plant and equipment is classified as held for sale and an investment property is
classified as held for sale, each of these classifications must be presented as held for sale, but
separately from one another.
This presentation may be made on the face of the statement of financial position or in the notes.
If the major class of asset that is classified as held for sale and major class of liability that is
classified as held for sale are each presented separately in the notes, these may then be added
together and presented as a single line-item on the face of the statement of financial position.
See IFRS 5.38
Any other comprehensive income recognised on a non-current asset (or disposal group) held
for sale must be separately presented and separately accumulated in equity. See IFRS 5.38
Comparative figures are not restated to reflect a reclassification to ‘held for sale’. In other words,
this would mean that, for example, if an item of property, plant and equipment is reclassified to
‘held for sale’ during the current period, the asset remains presented as property, plant and
equipment in the comparative period.
Chapter 12 645
Gripping GAAP Non-current assets held for sale and discontinued operations
An entity shall disclose the following information in the notes in the period in which a non-current
asset (or disposal group) has been classified as held for sale or sold:
a) a description of the non-current asset (or disposal group);
b) a description of the facts and circumstances of the sale, or leading to the expected disposal,
and the expected manner and timing of that disposal;
c) the gain or loss recognised in accordance with IFRS 5 (paragraph 20-22) and, if not
separately presented in the statement of comprehensive income, the caption in the
statement of comprehensive income that includes that gain or loss;
d) if applicable, the reportable segment in which the non-current asset (or disposal group) is
presented in accordance with IFRS 8 Operating Segments. See IFRS 5.41
If, during the current period, there was a decision to reverse the plan to sell the non-current
asset (or disposal group), the following extra disclosure would be required:
a) the description of the facts and circumstances leading to the decision not to sell; and
b) the effect of the decision on the results of operations for all periods presented. See IFRS 5.42
A: 6.6.3 Events after the reporting date (IFRS 5.12 and 5.41)
If the criteria for classification as ‘held for sale’ are met after the year-end, the non-current asset
must not be classified as held for sale in that reporting period (no re-measurements should be
performed and no reclassification of the asset to ‘held for sale’ should take place). Instead, it is
treated as a non-adjusting event, with the following disclosure:
a) a description of the non-current asset (or disposal group);
b) the facts and circumstances of the sale, or leading to the expected disposal;
c) the expected manner and timing of that disposal; and
d) the segment (if applicable) in which the non-current asset (or disposal group) is presented.
IFRS 5.12 and 5.41 (a) (b) & (d)
The note disclosure of an event after the reporting period might look like this:
Entity name
Notes to the financial statements
For the year ended 31 December 20X3 (extracts)
4. Events after the reporting period
On 15 February 20X4, the board of directors decided to dispose of the shoe division following severe
losses incurred by it during the past 2 years.
The division is expected to continue operations until 30 April 20X4, after which its assets will be sold on
a piecemeal basis. The entire disposal of the division is expected to be completed by 31 August 20X4.
This shoe division is reported in the Clothing Segment.
646 Chapter 12
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Entity name
Statement of financial position 20X3 20X2
At 31 December 20X3 C C
Non-current assets
Property, plant and equipment 26 70 000 480 000
Current assets
Non-current assets (and disposal groups) held for sale 27 445 000 65 000
Current liabilities
Liabilities of a disposal group held for sale 27 xxx xxx
Entity name
Notes to the financial statements 20X3 20X2
For the year ended 31 December 20X3 C C
26. Property, plant and equipment
Factory building 0 480 000
Plant 70 000 0
70 000 480 000
Factory building:
Net carrying amount – 1 January 480 000 540 000
Gross carrying amount – 1 January 600 000 600 000
Accumulated depreciation and impairment losses – 1 January (120 000) (60 000)
Depreciation (to 30 June 20X3) (30 000) (60 000)
Impair loss in terms of IAS 36 (CA: 450 000 – FV-CoD: 445 000) (5 000) 0
Non-current asset now classified as ‘held for sale’ (445 000) 0
Net carrying amount – 31 December 0 480 000
Gross carrying amount – 31 December 0 600 000
Accumulated depreciation and impairment losses – 31 December 0 (120 000)
Plant:
Net carrying amount – 1 January 0 90 000
Gross carrying amount – 1 January 0 100 000
Accumulated depreciation and impairment losses – 1 January 0 (10 000)
Non-current asset no longer classified as ‘held for sale’ COMMENT 1 75 000 0
Depreciation (20X3: (75 000 – RV: 0) / 7,5 remaining years x 6/12) (5 000) (10 000)
Impairment loss in terms of IAS 36 (CA: 80 000 – FV-CoD: 65 000) 0 (15 000)
Non-current asset now classified as ‘held for sale’ 0 (65 000)
Net carrying amount – 31 December 70 000 0
Gross carrying amount – 31 December 100 000 0
Accumulated depreciation and impairment losses – 31 December (30 000) 0
Chapter 12 647
Gripping GAAP Non-current assets held for sale and discontinued operations
Entity name
Notes to the financial statements 20X3 20X2
For the year ended 31 December 20X3 C C
27. Non-current assets held for sale
Factory buildings 445 000 0
Plant 0 65 000
Less non-current interest-bearing liabilities COMMENT 2 0 0
445 000 65 000
The company is transferring its business to a new location and thus the existing factory building is to be
sold (circumstances leading to the decision).
The sale is expected to take place within 7 months of year-end (expected timing). The factory building is
expected to be sold for cash (expected manner of sale).
No gain or loss on the re-measurement of the buildings was recognised in terms of IFRS 5.
Plant is no longer classified as ‘held for sale’ since it is now intended to be moved to other existing factories
instead of being sold as part of the factory buildings (reasons for the decision not to sell).
The effect on current year profit from operations is as follows: C
- Gross (impairment loss reversed: 10 000 – depreciation:5 000) 5 000
- Tax (1 500)
- Net 3 500
Comment 1: The NCAHFS is transferred back to PPE on 30 June 20X3: It is remeasured as if it had always
been measured in terms of IAS 16. Thus, its CA of 65 000 is remeasured to 75 000, being the
lower of its RA: 85 000 and historical CA: 75 000 (100 000 – 100 000 x 10% x 2,5 years).
Comment 2: The presentation of the non-current interest-bearing liabilities is shown here purely for interest
purposes since there are no liabilities in this example.
Classification
648 Chapter 12
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Chapter 12 649
Gripping GAAP Non-current assets held for sale and discontinued operations
If the DG includes at least one scoped- If the DG does not include any scoped-
in non-current asset in non-current assets
The disposal group as a whole will be measured in The disposal group as a whole will not be
terms of IFRS 5 measured in terms of IFRS 5
The disposal group will be classified and disclosed The disposal group will be classified and disclosed
in terms of IFRS 5 in terms of IFRS 5
650 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations
PART B:
Discontinued Operations
The definition of a discontinued operation explains that, before an operation may be classified
as a discontinued operation, it must meet the definition of a component (i.e. being a CGU or
group of CGU’s), meet one of three specified criteria (see grey pop-up below) and must either
be classified as held for sale or be disposed of already.
A component comprises operations and cash flows that are clearly distinguishable from the rest
of the entity, from both an operational and financial reporting perspective (see definition in grey
pop-up in the section above). This means that a component is either a cash-generating unit or a
group of cash-generating units (while it was in use). If, for example, a disposal group meets the
criteria to be classified as held for sale but is only part of a cash generating unit, it would not
meet the definition of a component and thus would not meet the definition of a discontinued
operation. See IFRS 5.31 and App A
A discontinued operation
A component that represents a separate major line of is defined as:
business or geographical area of operations and which is x a component of an entity that has
either classified as held for sale or is disposed of would either been
meet the definition of a discontinued operation. For - disposed of, or
example, an entity may wish to dispose of all it operations - is classified as held for sale;
(component) within KwaZulu-Natal (a geographical area) x and meets one of the following
and thus these operations would be classified as held for criteria:
sale. In this case, these operations would qualify as a - is a separate major line of
business or geographical area
discontinued operation. of operations; or
- is part of a single co-ordinated
However, if only some of the outlets in KwaZulu-Natal are plan to dispose of a separate
to be disposed of, this would not represent a separate major line of business or
geographical area of
geographical area. If one then concluded that it was also operations; or
not a separate major line of business, then the disposal of - is a subsidiary acquired
these outlets would not meet the definition of a exclusively with a view to resale.
See IFRS 5 Appendix A (Reworded)
discontinued operation, unless the disposal of these
outlets formed part of a single co-ordinated plan to dispose of a separate major line of business
or geographic area of operations. In other words, if the disposal of some of the outlets in
KwaZulu-Natal was just a stepping stone to selling all the outlets in that geographic area or a
stepping stone to selling a larger major line of business of which these outlets were just a part,
then the disposal of these outlets would qualify as a discontinued operation.
Chapter 12 651
Gripping GAAP Non-current assets held for sale and discontinued operations
Now let us consider an operation that is a component that has not yet been disposed of but is
intended to be disposed of by abandonment instead of by sale. Such a component would not meet
the criteria to be classified as held for sale because its carrying amount will not be recovered
principally through a sale transaction than through use (see section A:3.2.2.1). Since a component
that is to be abandoned does not qualify to be classified as held for sale, it will not be able to be
classified as a discontinued operation until the operation has actually been abandoned (i.e. in which
case it will have been disposed of). Abandonment includes the following two situations:
x the non-current assets (or DGs) will be used until the end of their economic life; and
x the non-current assets (or DGs) will not be sold but will be simply closed down instead. See IFRS 5.13
A discontinued operation is, in effect, a disposal group (or multiple disposal groups) that is held for
sale (or one that has already been disposed of) and that also meets the definition of a component of
the entity and also meets the definition of a discontinued operation. See IFRS 5.31
Thus, the principles that we applied when measuring non-current assets (or disposal groups) as held
for sale are also applied when measuring the individual items within a discontinued operation. In
other words, just as with ‘disposal groups held for sale’ (DG), ‘discontinued operations’ (DO) could
also involve all sorts of assets as well as directly related liabilities.
Whereas the classification and presentation requirements of IFRS 5 applies to all ‘discontinued
operations’, the measurement requirements apply only to those non-current assets that are included
in the discontinued operation and which are ‘not scoped-out’ from the measurement requirements.
B: 4.1 Profit or loss from discontinued operation (IAS 1.82 (ea) & IFRS 5.33)
A separate line-item showing the total profit for the period from the discontinued operation must be
presented on the face of the profit or loss section in the statement of comprehensive income where
this total amount comprises:
x the post-tax profit or loss of the discontinued operations;
x the post-tax gain or loss recognised on measurement to fair value less costs to sell; and
x the post-tax gain or loss recognised on the disposal of assets/ disposal groups making up the
discontinued operations. IFRS 5.33 (a)
An analysis of this single amount that is presented in the statement of comprehensive income must
be presented ‘for all periods presented’. This single amount must be analysed into the following:
x revenue of discontinued operations; IFRS 5.33 (b) (i)
x expenses of discontinued operations; IFRS 5.33 (b) (i)
x profit (or loss) before tax of discontinued operations; IFRS 5.33 (b) (i)
x tax expense of the profit (or loss) on the discontinued operations; IFRS 5.33 (b) (ii)
x gain or loss on re-measurement to fair value less costs to sell; IFRS 5.33 (b) (iii)
x gain or loss on disposal of discontinued operation’s assets/disposal groups; IFRS 5.33 (b) (iii)
x tax effects of gain/ loss on re-measurement or disposal. IFRS 5.33 (b) (iv)
The analysis of this single amount must be provided ‘for all periods presented’. IFRS 5.34
The analysis of this single amount may be provided on the face of the statement of comprehensive
income (see option A) or in the notes (see option B). IFRS 5.33 (b)
652 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations
Option A: If the analysis of the profit is presented on the face of the statement of comprehensive
income, the presentation would be as follows (the figures are assumed):
Entity name
Statement of comprehensive income
For the year ended 31 December 20X3 (extracts)
20X3 20X3 20X3 20X2 20X2 20X2
C’000 C’000 C’000 C’000 C’000 C’000
Continuing Discontinued Total Continuing Discontinued Total
Revenue 800 150 800 790
Expenses (300) (100) (400) (500)
Profit before tax 500 50 400 290
Taxation expense (150) (32) (180) (97)
Gains/ (losses) after tax 40 7
Gain/ (loss): remeasurement 30 10
to fair value less costs to sell
Gain/ (loss): disposal of assets 20 0
in the discontinued operations
Tax on gains/ (losses) (10) (3)
Option B: If the total profit or loss is presented on the face of the statement with the analysis in
the notes, the presentation would be as follows (the figures are assumed):
Entity name
Statement of comprehensive income
For the year ended 31 December 20X3 (extracts)
20X3 20X2
Note C’000 C’000
Revenue 800 800
Expenses (300) (400)
Profit before tax 500 400
Taxation expense (150) (180)
Profit for the period from continuing operations 350 220
Profit for the period from discontinued operations 4 58 200
Profit (or loss) for the period 408 420
Other comprehensive income 0 0
Total comprehensive income 408 420
Entity name
Notes to the financial statements
For the year ended 31 December 20X3 (extracts)
20X3 20X2
C’000 C’000
4. Discontinued operation: analysis of profit
The profit from discontinued operations is analysed as follows:
x Revenue 150 790
x Expenses (100) (500)
x Profit before tax 50 290
x Tax on profit before tax (32) (97)
x Gains/ (losses) after tax (this line item is not required) 40 7
Gain/ (loss) on re-measurement to fair value less selling costs 30 10
Gain/ (loss) on disposal of assets 20 0
Tax on gains/ (losses) (10) (3)
Profit for the period 58 200
Chapter 12 653
Gripping GAAP Non-current assets held for sale and discontinued operations
654 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations
Entity name
Statement of comprehensive income
For the year ended 31 December 20X3 (extracts)
20X3 20X2
C’000 C’000
Re-presented
Revenue X2: 800 + DO revenue: 790 + DO gain: 10 1 000 1 600
X3: 800 + DO revenue: 150 + DO gains: 50
Expenses X2: 400 + DO expense: 500 (400) (900)
X3: 300 + DO expense: 100
Profit before tax 600 700
Tax expense X2: 180 + DO taxes (97 + 3) (192) (280)
X3: 150 + DO taxes (32 + 10)
Profit for the period 408 420
Other comprehensive income 0 0
Total comprehensive income 408 420
Comment: The above amounts tie up with the previous Option A and Option B (see Section B: 4.1).
B: 4.5.2 If the discontinued operation also meets the definition of ‘held for sale’
Bearing in mind that a discontinued operation is a component that either has already been disposed
of or is still held for sale, it means that if the component has not yet been disposed of, then all the
disclosure relating to non-current assets (or disposal groups) held for sale would also be required:
x The assets in the discontinued operation would be presented as held for sale and separated
from the entity’s other assets. The same would apply to its liabilities. IFRS 5.38
x A note would be required showing:
x a description of the non-current asset (or disposal group); IFRS 5.41 (a)
x a description of the facts and circumstances leading to the expected disposal; IFRS 5.41 (b)
x the expected manner and timing of the disposal; IFRS 5.41 (b)
x the gain or loss on re-measurements in accordance with IFRS 5 and, if not presented on the face of
the statement of comprehensive income, the line item that includes this gain or loss; and IFRS 5.41 (c)
x the segment (if applicable) in which the NCA (or DG) is presented. IFRS 5.41 (d)
Discontinued operations
Identification A component that has been disposed of or is classified as held for sale and is:
x Separate major line or geographical area; or
x Part of a single disposal plan to dispose of a separate major line or geographical area; or
x Is a subsidiary acquired to sell
Measurement Same as for non-current assets held for sale
Disclosure Statement of comprehensive income:
Face:
Total profit or loss from discontinued operations (show in profit or loss section)
Notes or on the face:
Analysis of total profit or loss for the period:
x Profit or loss
x Tax effects of P/L
x Gain or loss on re-measurement
x Gain or loss on disposals
x Tax effects of gains/ losses
x Changes in estimates
Statement of cash flows: (face or notes)
x Operating activities
x Investing activities
x Financing activities
Other notes:
x Components no longer held for sale
x Criteria met after the end of the reporting period
Chapter 12 655
Gripping GAAP Inventories
Chapter 13
Inventories
Main references: IAS 2; IFRS 13; IFRS 15, IAS 16 (incl. amendments to 10 December 2019)
Contents: Page
1. Introduction 658
2. Scope 659
3. The recognition and classification of inventory 659
4. Recording inventory movement: periodic versus perpetual systems 660
4.1 Overview 660
4.2 Perpetual system 660
4.3 Periodic system 661
Example 1: Perpetual versus periodic system 663
4.4 Stock counts, inventory balances and missing inventory 664
4.4.1 The perpetual system and the use of stock counts 664
4.4.2 The periodic system and the use of stock counts 664
Example 2: Perpetual versus periodic system and missing inventory 665
Example 3: Perpetual and periodic system: stock loss due to theft and profits 666
4.4.3 Presenting inventory losses 668
5. Initial measurement: cost 669
5.1 Overview 669
5.2 Purchase costs 669
5.2.1 Overview 669
5.2.2 Transaction taxes and import duties 669
Example 4: Transaction taxes and import duties 670
5.2.3 Transport costs 670
5.2.3.1 Overview 670
5.2.3.2 Transport/ carriage inwards 670
5.2.3.3 Transport/ carriage outwards 671
Example 5: Transport costs 671
5.2.4 Rebates 671
Example 6: Rebates 671
5.2.5 Discount received 672
Example 7: Discounts 673
5.2.6 Finance costs 674
Example 8: Deferred settlement terms 675
5.2.7 Imported inventory 676
5.2.7.1 Spot rates 676
Example 9: How to convert a foreign currency into a local currency 676
5.2.7.2 Transaction Dates 676
Example 10: Imported inventory – transaction dates 676
5.3 Conversion costs (manufactured inventory) 677
5.3.1 Overview 677
5.3.2 Conversion costs are split into direct costs and indirect costs 677
Example 11: Conversion costs 679
5.3.3 The ledger accounts used by a manufacturer 680
5.3.3.1 Overview 680
5.3.3.2 Accounting for the movements: two systems 681
5.3.3.3 Calculating the amount to transfer: three cost formulae 681
Example 12: Manufacturing journal entries 682
5.3.4 Manufacturing cost per unit 684
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1. Introduction
The standard that explains how we account for inventories is IAS 2 Inventories. Its main focus
is on the determination of the cost of the inventories, and when to recognise this cost as an
inventory expense (e.g. when the revenue is recognised or when it needs to be written-down).
Interestingly, unlike other standards that show us how to account for assets, such as
IAS 16 Property, plant and equipment and IAS 38 Intangible assets, this standard does not deal
with when to recognise costs as an inventory asset.
Inventory is an asset that the entity either ultimately intends to sell or is an asset that is in the
form of ‘materials and supplies’ that the entity intends to use in the production process or in
providing a service (often called ‘consumable stores’). Inventories can be tangible or intangible.
Notice that the classification of inventories, as with all other asset classifications, depends on
intentions. For example, if we owned the following 3 properties, but have a different intention
for each, we would have to classify and account for them separately as follows:
x Property that we purchased with the intention of using as our factory: this would be
classified as property in terms of IAS 16 Property, plant and equipment;
x Property that we purchased with the intention of holding for capital appreciation: this would
be classified as investment property in terms of IAS 40 Investment property; and
x Property that we purchased with the intention of selling in the ordinary course of business:
this would be classified as inventories in terms of IAS 2 Inventories.
The type of inventory that a business has depends on the nature of the business, for instance,
whether the business is a retailer, manufacturer, or perhaps a combination thereof.
In the case of retailers and manufacturers, inventories often represent a significant portion of
the entity’s total assets (inventory is presented as a current asset in the SOFP).
As an item of inventory is sold, a relevant portion of the cost of inventory must be removed
from the inventory asset and expensed. Inventory that is sold is generally called cost of sales,
and is expensed in profit or loss. This expense is often the biggest expense that a retailer or
manufacturer has, thus it also significantly affects an entity’s profit or loss.
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2. Scope
IAS 2 applies to all assets that meet the definition of inventories except for the following:
x Financial instruments (these are accounted for in terms of IFRS 9 Financial instruments and
IAS 32 Financial instruments: Presentation)
x Biological assets related to agricultural activity and agricultural produce at the point of
harvest (these are accounted for in terms of IAS 41 Agriculture). IAS 2.2 (reworded)
Although IAS 2 does apply to the following assets, its measurement requirements do not:
x producers of agricultural and forest products, agricultural produce after harvest, and
minerals and mineral products, to the extent that they are measured at net realisable value
in accordance with well-established practices in those industries. When such inventories
are measured at net realisable value, changes in that value are recognised in profit or loss
in the period of the change.
x commodity broker-traders* who measure their inventories at fair value less costs to sell.
When such inventories are measured at fair value less costs to sell, changes in fair value
less costs to sell are recognised in profit or loss in the period of the change. IAS 2.3
*Commodity brokers are similar to investment bankers, except that, instead of trading in equities,
commodity brokers buy and sell commodities (i.e. products or services), such as wheat, cattle, etc.
Changes to IAS 2 since the new IFRS 15 Revenue from contracts with customers was issued
Please note that:
x Before the publication of IFRS 15 Revenue from contracts with customer, IAS 2 clarified that costs
incurred by a service provider would be recognised as inventory to the extent that the related revenue
could not be recognised. This has now been removed from IAS 2 (previously para 8 of IAS 2).
x After the publication of IFRS 15, IAS 2 was also amended to clarify that any costs that are not able to be
accounted for in terms of IAS 2 Inventories or in terms of any other standard (e.g. IAS 16 Property, plant
and equipment) must be accounted for in terms of IFRS 15 instead. See IAS 2.8
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Looking at the inventory definition again, we also see that it clarifies that, other than consumables, an
asset may only be classified as inventory if it is held for sale (or held in the process of manufacture for
the eventual sale) in the ordinary course of business. Thus, if our ordinary business involves buying
and selling properties, we would classify these properties as inventories. However, if our ordinary
business does not involve the buying and selling of properties and yet we happen to buy a property
that we intend to sell as soon as we can make a profit, although our intention is to sell it, we would not
classify this property as inventory because it will not be sold as part of our ordinary business activities.
Inventory assets are subsequently recognised either as expenses or as other assets as follows:
x inventory is subsequently recognised as an expense in the periods in which:
- the inventory is sold and the related revenue is recognised, or
- the inventory is written down to net realisable value; or
x inventory is subsequently recognised as part of another asset if the inventory was used in
the manufacture of the other asset (e.g. a self-constructed plant), in which case the cost of
this inventory will eventually be expensed (e.g. when depreciating the plant). See IAS 2.34 -.35
4.1 Overview
The movement of inventory refers to the purchase, and subsequent sale of inventory. However,
the focus of this section is the sale of inventory. Entities often experience high volumes of
inventory sale transactions. The perpetual system, which requires processing a separate
journal entry for each one of these transactions, can be difficult for certain entities, especially
smaller entities. Thus, s simpler system, called the periodic system, was devised. This system
processes a single journal entry to record the sales transaction at the end of a period.
These systems are not laid down in IAS 2, and thus the exact mechanisms of how to record
inventory movements under these two systems differ slightly from entity to entity.
Essentially, however, the difference between these two systems is simply that:
x Under the perpetual system, we perpetually (i.e. continually) update our ledger to account
for the cost of each ‘inventory purchase transaction’ and for the cost of each ‘inventory sale
transaction’; whereas
x Under the periodic system, although we update our ledger to account for the cost of each
‘inventory purchase transaction’, we do not update it to account for the cost of each ‘inventory
sale transaction’ but, instead, we record the total cost of all ‘inventory sale transactions’ for a
period (e.g. the period could be a month or a year) as a single transaction.
Although the periodic system is simpler, the ability to detect any theft of inventory is generally
not possible. This means that the gross profit calculated under the perpetual system may differ
from that calculated under the periodic system. The final profit or loss, calculated in the profit
or loss account will, however, be the same. This is explained under section 4.4.
The periodic system is generally used by smaller businesses that do not have the necessary
computerised accounting systems to run a perpetual system. However, with the proliferation
of computerised accounting packages, most businesses nowadays, and certainly most of the
larger manufacturing businesses, would normally apply the perpetual system.
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The fact that our inventory account reflects what the closing balance should be means that a physical
stock count can then be used to check our closing balance. This stock count is performed at the end
of the period (normally at year-end). This comparison between the balance in the inventory account
and the results of the physical count will thus be able to identify any missing inventory, which is then
recorded as a separate expense (e.g. inventory loss due to theft).
This stock count is done periodically, generally at year-end. It involves physically counting all
the items of inventory on hand. We then calculate the total cost of all items of inventory on hand
by multiplying the number of units counted by the cost per unit. This total cost of the inventory
on hand (per the stock count) is then used as our inventory closing balance.
Once we have determined our inventory closing balance, we can balance back to our cost of sales.
We do this by comparing this inventory closing balance with the total of our inventory opening balance
plus the cost of our inventory purchased during the year (i.e. opening balance + purchases – closing
balance). All inventory that is ‘missing’ is assumed to have been sold and thus the cost of the ‘missing
inventory’ is recognised, by way of one single entry, as the total cost of all the ‘inventory sale
transactions’ during the period (i.e. the total cost of sales). Thus, we are overlooking the possibility that
some of this inventory may not have been sold but could, for example, have been stolen instead. This
means that this periodic system is not designed to automatically detect and separately record stock
theft and thus this system is not as accurate as the perpetual system.
For example, an entity with no inventory on hand at the beginning of a year, records each of the
inventory purchases during the year, totalling C5 000. The entity then counts the inventory on hand at
year-end and calculates the cost thereof to be C2 000. In this case, the entity will record the difference
of C3 000 as the cost of sales for the year.
In summary, when using the periodic system, we need a physical stock count to determine the
value of our closing inventory, which we then use to balance backwards to the cost of sales.
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The journals that are processed under the periodic system will now be explained. During the
period, we would process the following journal for each and every purchase of inventory (let’s
call this journal 1). Notice that we are not debiting the purchases to the ‘inventory asset’ account
but are using a ‘purchases’ account – this account is simply a temporary account (T) the total
of which will eventually be transferred to the ‘cost of sales’ account:
Journal 1 Debit Credit
Purchases (T) xxx
Bank/ accounts payable xxx
Purchase of inventories
We would record the following three journals after both physically counting the stock on hand
(at reporting date) and then calculating the cost of this stock.
Journal 2: Remove the opening balance in inventory (credit) and transfer it to cost of sales (debit)
Rationalise this journal as follows: We start by assuming that all of our opening inventory
must have been sold during the year – thus we simply expense it to cost of sales.
Journal 3: Remove the amount in the purchases account (credit) and transfer it to cost of sales (debit)
Rationalise this journal as follows: we then assume that all the inventory we purchasedd
during the year was also sold during the year – thus we simply expense this to cost of sales
Journal 4: Recognise the inventory on hand (the cost of the items counted in the stock count) as the
new closing inventory balance (debit) and simultaneously reduce the cost of sales (credit).
Rationalise this journal as follows: The first 2 journals assumed that we had sold the entire opening
inventory plus the entire purchases of inventory during the year. But when we look at our closing
inventory it is obvious that these assumptions were not entirely correct! We clearly did not sell
everything, which means that expensing all of the opening inventory and all of the purchases was
a little too optimistic. This journal is thus reversing an amount back out of cost of sales and into
inventory to the extent that this inventory is still on hand.
At this point, we simply balance our cost of sales account to calculate what the cost of sales
expense is for the period:
Cost of sales (expense)
Inventory (opening balance) Jnl 2 xxx Inventory (closing balance) Jnl 4 xxx
Purchases Jnl 3 xxx Balance c/f
xxx xxx
Balance b/f xxx
An obvious problem with the periodic system is that it requires us to assume that the inventory
on hand according to the stock count is indeed what the inventory closing balance should be.
This means that this system cannot detect inventory that may have gone missing, in which case
it would result in an overstatement of cost of sales.
The periodic system and the detection of stock theft is explained in more detail in section 4.4.2.
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In example 1, the cost of sales and inventory balances are not affected by whether the periodic
or perpetual system is used (i.e. cost of sales was C65 000 and inventory was C90 000 in both
part A and part B), since there was no missing inventory. Let us now look at the difference
between the perpetual and periodic system where there is missing stock.
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If the physical count reveals a lower stock level than is reflected by the theoretical balance on
the inventory account (i.e. there is missing stock), the difference will be accounted for by
reducing the carrying amount of the inventory asset and recognising this reduction as an
inventory loss expense, as follows:
Debit Credit
Inventory loss (E) xxx
Inventory (A) xxx
Inventory loss recognised due to missing stock (e.g. theft of inventories)
If a physical count reflects more stock than appears in the inventory account, then it suggests that
an error occurred either in recording the purchases or sales during the period, or in the physical
stock count. Further investigation would be needed to decide what adjustments to process.
When using the periodic system, the accountant does The periodic system
not know what either his inventory balance is or what his
x requires a stock count in order to
cost of sales are, until the inventory on hand is physically calculate the closing inventory
counted and its cost calculated. This cost of the inventory balance & to balance back to the cost
physically on hand is recorded as the inventory closing of sales; & thus it
balance, and is used to balance back to the cost of sales. x cannot detect stock losses.
This system, where we do not balance to the closing balance, means that there is no way of
knowing what the actual inventory balance should be. Thus, it means that when using the
periodic system, any missing inventory (e.g. due to theft) will generally be ‘hidden’ in the cost
of sales. For example, if there were thefts during the period and we thus counted a low number
of units during the stock count, this would translate into a lower inventory closing balance and
this lower inventory closing balance would then mean we would balance back to a higher cost
of sales. This cost of sales would thus be overstated by the cost of the missing inventory.
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Notice:
x The cost of sales is higher than it should have been because it includes the theft of C15.
x It is correct to expense C95 because this is truly the cost of inventory that is no longer on hand.
x The problem with this system is simply that it is not accurate to reflect C95 as the cost of sales when
the cost of sales is truly C80 and the remaining C15 is truly a cost of theft (or inventory loss expense).
If we were able to identify the loss at the time they occurred (e.g. imagine that we were
unfortunate enough to experience a significant robbery where it was possibly clear to us what
had been stolen), then we would process the following adjustment:
Debit Credit
Inventory loss (E) xxx
Purchases (Temporary account) xxx
Inventory loss recognised due to stolen stock
Solution 2A: The periodic system does not identify missing inventory
Purchases (Temporary) Cost of sales (Expense)
Bank (2) 96 000 Inventory o/b(3) 24 000 Inventory c/b(5) 32 000
Cost of sales (4)
96 000 Purchases (4) 96 000 Total c/f (6) 88 000
96 000 96 000 120 000 120 000
Total b/f 0 Total b/f (6) 88 000
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Example 3: Perpetual and periodic system: stock loss due to theft and profits
C Units
Inventory balance: 1 January 20X1 (cost per unit: C5) 55 000 11 000
Purchases during 20X1 (cash) (cost per unit: C5) 100 000 20 000
Stock count results at 31 December 20X1 (cost per unit: C5) 16 000
Revenue from sales for 20X1 (cash) 95 000
Required: Assuming we prefer to present our inventory losses separately to our cost of sales:
A. Show the ledger accounts using the perpetual system (including closing accounts): we sold
13 000 units during 20X1.
B. Show the ledger accounts using the periodic system (including closing accounts).
C. Prepare the extracts of the statement of comprehensive income for each of the two methods,
assuming there were no other income and expenses during the year.
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Solution 3A: Perpetual system: stock loss due to theft and profits
Inventory (Asset) Cost of sales (Expense)
O/ balance (1) 55 000 Cost of sales(2) 65 000 Inventory (2) 65 000 Trading a/c (4) 65 000
Bank (1) 100 000 Subtotal c/f 90 000
155 000 155 000
Subtotal b/f 90 000 Inv loss: theft(3) 10 000 Inventory loss: theft (Expense)
C/ bal c/f 80 000 Inventory (3) 10 000 P/L a/c (6) 10 000
90 000 90 000
C/ balance 80 000
Sales (Income)
Trade Acc (4) 95 000 Bank (1) 95 000
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Entity name
Statement of comprehensive income
For the period ended 31 December 20X1 (extracts)
Perpetual Periodic
C C
Revenue from sales 95 000 95 000
Cost of sales (65 000) (75 000)
Gross profit (1) 30 000 20 000
Inventory loss (10 000) (0)
Profit for the period (2) 20 000 20 000
Comment:
(1) Notice how gross profit is C20 000 under the periodic system but is C30 000 under the perpetual system. The
perpetual system’s gross profit of C30 000 is a more accurate reflection of what happened.
(2) The final ‘profit for the period’ in both cases is, however, C20 000.
Inventory losses arise due to many reasons (e.g. theft of stock or damage). Whatever the reason for the
loss, inventory that is no longer available for sale (e.g. it’s been stolen) must be recognised as an expense.
As we now know, it is easier to detect lost stock when using the perpetual system than when using
the periodic system since the perpetual system provides us with a theoretical inventory closing
balance against which we can check the actual results of our physical count (see section 4.4.1).
Depending on the circumstances, however, we could still detect certain losses when using the
periodic system. For example, although constant petty theft may be difficult or impossible to detect
using the periodic system, we may be able to identify the exact inventory stolen if, for example, we
identified a specific theft and were able to quantify the loss (see section 4.4.2).
Thus, an inventory loss (e.g. cost of stolen inventory or an impairment due to damage) could, under certain
circumstances, be included in the ‘cost of inventory expense’ as an ‘other amount’. Professional judgement
is thus required. It is suggested that a general rule of thumb would be to apply the following logic:
x if the loss is considered to be a normal part of trading, this inventory loss expense could be
included in the ‘cost of inventory expense’ (cost of sales expense);
x if the loss is abnormal (e.g. a theft took place during a significant armed robbery), this inventory
loss expense should not be included in the ‘cost of inventory expense’ (cost of sales); but rather
as a separate ‘inventory loss expense’.
The reason why one would want to exclude the cost of an ‘abnormal loss’ of inventory from the cost
of inventory expense is that if one included this loss, it would distort the gross profit percentage and
damage comparability of the current year profits with prior year profits and would also damage
comparability of the entity's results with the results of its competitors.
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Conversion costs arise if an entity buys goods that still need to be put into a saleable or usable
condition (i.e. an entity that manufactures its own inventory). In other words, entities that simply
purchase goods for immediate resale (merchandise), would not incur conversion costs.
Cost is relatively easy to determine but, when dealing with inventory that constitutes agricultural
produce harvested from biological assets, the cost is measured on the date it is harvested at
fair value less costs to sell. See IAS 2.20
5.2 Purchase costs (IAS 2.11 & IAS 2.11’s Educational Footnotes: E1, E2 & E3)
5.2.1 Overview
All purchase costs should be capitalised as part of the cost of the inventory asset. Purchase
costs are the costs directly associated with the acquisition, being the:
x purchase price,
x transaction taxes and import duties that the entity is unable to reclaim from tax authorities
(section 5.2.2), and
x transport costs (inwards) (section 5.2.3.2) and other directly attributable costs. See IAS 2.11
Purchase costs exclude the following (i.e. these would not be capitalised to inventory):
x transport costs (outwards) (section 5.2.3.3),
x transaction taxes and import duties that are reclaimable by the business (section 5.2.2),
x financing costs due to extended payment terms (section 5.2.6).
The following would be set-off against (i.e. deducted from) the cost of the inventory:
x rebates received (section 5.2.4);
x discounts received, including:
- trade, bulk and cash discounts received, and
- settlement discounts received or expected to be received (section 5.2.5).
A further issue to consider (although not complicated at all) is how to calculate the inventory's
cost when it was imported rather than purchased from a local supplier (section 5.2.7).
In summary:
x If the transaction taxes and import duties are not reclaimable, then obviously the business
has incurred a cost and this cost may then be capitalised to the inventory account.
x If the transaction taxes and import duties are reclaimable at a later date from the tax
authorities, then no cost has been incurred.
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Comments:
(1) The VAT portion of the invoice price must be recognised separately as a receivable because the
entity claims this VAT back: C9 200 / 115 x 15 = C1 200. The rest of the invoice price is recognised
as inventory since this represents a real cost to the entity: C9 200 / 115 x 100 = C8 000
(2) The import duties payable directly to the Customs Department were refundable and therefore the
entire import duty paid is recognised as a receivable – and not as part of the cost of the inventory.
(3) VAT refund received.
(4) Import duty refund received.
(5) Notice that the inventory account reflects C8 000 and that this equals the net amount paid per the
bank account: Payments: (C9 200 + C5 000) – Receipts: (C1 200 + C5 000).
Comments:
(1) The VAT portion of the invoice price is not separated since none of it is refundable.
(2) The import duties payable directly to the Customs Department were not refundable and are
therefore part of the costs of acquiring the inventory.
(3) Notice that the inventory account reflects a balance of C14 200 and that this equals the amount
paid per the bank account: C9 200 + C5 000.
The cost of transport inwards refers to the cost of transporting the purchased inventory from
the supplier to the purchaser’s business premises.
It is a cost that was incurred in ‘bringing the inventory to its present location’ and should
therefore be capitalised to (i.e. included in) the cost of inventory asset.
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Frequently, when a business sells its inventory, it offers to deliver the goods to the customer’s
premises. The cost of this delivery is referred to as ‘transport outwards’.
It is a cost that is incurred in order to sell the inventory rather than to purchase it and may therefore
not be capitalised (since it is not a cost that was incurred in ‘bringing the inventory to its present
location’). Transport outwards should, thus, be recorded as a selling expense in the statement of
comprehensive income instead of capitalising it to the cost of the inventory.
Example 6: Rebates
An entity purchased inventory for cash. The details thereof were as follows: C
x Invoice price (no VAT is charged on these goods) 9 000
x Rebate offered to the entity by the supplier 1 000
Required: Show the ledger accounts assuming that the terms of the agreement indicated the rebate:
A. was a reduction to the invoice price of the inventory;
B. was a refund of the entity’s expected selling costs.
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Trade, bulk and cash discounts are generally agreed to on the transaction date. Settlement
discounts, however, are estimated on transaction date based on when the entity expects to
settle its account with the creditor.
The cost of our inventory is reduced by any discounts offered to us; it is even reduced by
settlement discounts... even though we may be unsure of being able to pay in time, and thus
unsure of being able to secure the settlement discount.
While trade discounts, bulk discounts, and cash discounts are straight-forward, settlement
discounts require more explanation. As mentioned above, when purchasing inventory where
there is the possibility of a settlement discount, the cost of the ‘inventory’ is measured net of
the settlement discount (we apply the same principle to all discounts received). If we do not pay
on time and thus forfeit this settlement discount, the cost of the ‘inventory’ will need to be
increased by the amount of this forfeited discount. When recording a purchase that involves
settlement discount (and the subsequent payment to the supplier), there are a number of ways
in which we can account for the related contra account, the ‘trade payable’. We will discuss two
options. These are best explained by way of a worked example: we buy inventory for C1 000 and
are offered a C200 settlement discount that we have the ability to take advantage of:
Option 1:
When processing the purchase, we could recognise the ‘trade payable’ measured at the net amount
after deducting the expected discount (debit inventory and credit payable: 800):
When processing the payment, we will either have paid on time or not:
x If we pay on time, we process the payment of 800 (debit payable and credit bank: 800).
x If we do not pay on time, there will be two steps:
- the inventory and payable accounts will first need to be increased by the amount of the
forfeited discount of 200 (debit inventory and credit payable: 200); and then
- the payment of 1 000 is recorded (debit payable and credit bank: 1 000).
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Option 2:
We could be more detailed and keep track of both the full amount we owe the supplier, in case we do not
pay on time (1 000), and the settlement discount we have been offered (200). This alternative involves
using the following two accounts instead of just one, recognising both
x a ‘payable’ measured at the gross amount (we credit this): 1 000, and
x a ‘deferred discount’ measured at the amount of the possible discount (we debit this): 200.
The payable would be reflected in the statement of financial position at the net of these account balances,
at C800 and the inventory is measured at the net amount of 800 (same as option 1).
Thus, when processing the purchase, although the journal is a little more detailed, the net effect is still that
the inventory and payable are measured at the amount net of discount, 800 (debit ‘inventory’ 800; credit
‘payable’ 1 000 and debit ‘deferred discount’ 200)
When processing the payment, we will either have paid on time or not:
x If we pay on time, there will be two steps:
- Since the discount of 200 is realised, it is no longer deferred, so we reverse the ‘deferred discount’
and set it off against the payable (debit ‘payable’ and credit ‘deferred discount’: 200) – the payable
balance is now 800, which is the same amount that the inventory was initially measured at.
- the payment of 800 is recorded (debit payable and credit bank: 800).
x If we do not pay on time, there will be two steps:
- Since the discount of 200 is forfeited, it is no longer deferred, so we reverse the ‘deferred discount’
and add it to the cost of inventory (debit ‘inventory’ and credit ‘deferred discount’: 200) – the
payable balance is still 1 000, and although inventory was initially measured at 800, the inventory
cost has now been increased to 1 000.
- the payment of 1 000 is recorded (debit payable and credit bank: 1 000).
Example 7: Discounts
An entity purchased inventory. The costs thereof were as follows: C
x Marked price (no VAT is charged on these goods) 9 000
x Trade discount 1 000
Required: Show the ledger accounts assuming:
A. The entity pays in cash on transaction date and receives a cash discount of C500.
B. The supplier offers an early settlement discount of C400 if the account is paid within 20 days: the entity pays
within the required period of 20 days. Record the initial payable at the net amount (option 1).
C. The supplier offers an early settlement discount of C400 if the account is paid within 20 days: the entity pays
after a period of 20 days. Record the initial payable at the net amount (option 1).
D. Repeat Part B, but record the initial payable by using a deferred discount account (option 2).
E. Repeat Part C, but record the initial payable by using a deferred discount account (option 2).
(1) The marked price is reduced by the trade discount and the cash discount: 9 000 – 1 000 – 500 = 7 500
Solution 7B: Trade discounts and settlement discounts – payment on time (using option 1)
Inventory (Asset) Trade payables (Liability)
T/payable (1) 7 600 Inventory (1) 7 600
Bank (2) 7 600
Bank
TP (2) 7 600
Comments:
(1) We measure the inventory and trade payable at the amount net of discount: 7 600 (9 000 – 1 000 - 400)
(2) Since we ‘receive’ the discount, we make a payment of only 7 600 (9 000 – 1 000 – 400)
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Solution 7C: Trade discounts and settlement discounts – payment late (using option 1)
Inventory (Asset) Trade payables (Liability)
T/payable (1) 7 600 Inventory (1) 7 600
T/payable (2) 400 Bank (3) 8 000 Inventory (2) 400
Bank
TP (3) 8 000
Comments:
(1) We measure the inventory and trade payable at the amount net of the discount: 7 600 (8 000 – 400)
(2) We ‘forfeit’ the discount and thus will need to pay 8 000, (i.e. the inventory actually costs C8 000).
Thus, we must increase both the inventory cost and the payable with the forfeited discount of 400.
(3) Since we ‘forfeit’ the discount, we make a payment based on the gross amount: 8 000.
Solution 7D: Trade discounts and settlement discounts – payment on time (using option 2)
Inventory (Asset) Trade payables (Liability)
TP & DD (1) 7 600 Inventory (1) 8 000
Def Discount (2) 400
Bank (3) 7 600
Bank Deferred discount (DD)
Trade Payable (3) 7 600 Inventory (1) 400
Trade Payable (2)
400
Comments:
1. We recognise both the inventory and payable at the net amount of 7 600, but we recognise the
payable using two accounts: credit ‘trade payable’ with 8 000 and debit ‘deferred discount’ with 400
2. We pay on time and thus ‘receive’ our discount. We record this by transferring the deferred discount
(DD) to the payable account, thus reducing the payable balance. The discount is no longer deferred.
3. Since we ‘receive’ the discount, we make a payment of the net amount of only 7 600 (8 000 – 400)
Solution 7E: Trade discounts and settlement discounts – payment late (using option 2)
Inventory (Asset) Trade payables (Liability)
TP & DD (1) 7 600 Inventory (1) 8 000
DD (2) 400 Bank (3) 8 000
8 000
Bank Deferred discount (DD)
TP (3) 8 000 Inventory (1) 400
Inventory (2) 400
Comments:
(1) We recognise both the inventory and payable at the net amount of 7 600, but when recognising inventory, the
contra entry involves two accounts: credit ‘trade payable’ with 8 000 and debit ‘deferred discount’ with 400
(2) We pay late and thus ‘forfeit’ our discount. We record this by transferring the deferred discount (DD)
to the inventory account. There is no longer any deferred discount and the inventory is now measured
at its cost of C8 000.
(3) Since we ‘forfeited’ the discount, we make a payment based on the gross amount: 8 000.
If inventory is purchased on deferred settlement terms, the total amount we end up paying is generally
more than the price we would pay on normal terms. In this case, we measure inventory at the price
that would be paid on normal terms (e.g. cash price). The difference between the higher amount we
will actually pay and the price on normal terms is the cost of financing, which is recognised as interest
expense, assuming the difference is material. If the price on normal terms price is not obvious, we can
estimate it by calculating the present value of the future payments, discounted using a market interest
rate (i.e. estimating a cash price). See IAS 2.18
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Before we can record this purchase, the foreign currency amount must be:
x converted into the reporting entity’s functional currency (generally his local currency)
x using the spot exchange rate (the exchange rate on a specific date) on transaction date.
The ‘transaction date’ is not a defined term but it is the date on which we recognise the inventory
purchase and measure its cost. When importing inventory, identifying the correct transaction date is
very important because we measure its cost using the currency exchange rate ruling on transaction
date (i.e. the spot exchange rate on transaction date). This means that the cost of inventory could
vary wildly depending on which date it is measured. See IAS 21.21
To identify the transaction date, we consider the terms of the transaction to assess when the
entity obtains control over the inventory and thus when the inventory should be recognised.
One of the indicators of control is when the entity obtains the risks and rewards of ownership.
When dealing with imports (or exports), we refer to these terms as InCoTerms (International
Commercial Terms). These are the trade terms used under international commercial law and
published by the International Chamber of Commerce. There are many such terms, each of
which differs in terms of when risks are transferred,.
For example, two common INCO terms are ‘free on board’ (FOB) and ‘delivered at terminal’ (DAT):
x if goods are purchased on a FOB basis, risks are transferred to the purchaser as soon as
the goods are delivered over the ship’s rail at the foreign port (i.e. loaded onto the ship);
x if goods are purchased on a DAT basis, the risks of ownership are transferred when the
goods are unloaded at the named destination terminal/ port/ other named destination.
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x The following are the spot rates (rates of exchange on a particular date):
Date: R: $1
1 January 20X2 R7,20: $1
15 February 20X2 R7,30: $1
15 March 20X2 R7,50: $1
Required: Show the related journal entries, assuming the following:
A. The goods are purchased FOB.
B. The goods are purchased DAT: Durban harbour (South Africa).
Comment:
x The amount paid under both situations is R750 000 (using the spot rate on payment date).
x The transaction dates differed between part A (FOB) and part B (DAT) and thus the cost of
inventory differs in each case since inventory is measured at the rate ruling on the transaction date.
x The movement in the spot rate between transaction date and payment date is recognised in the profit or
loss account (i.e. not as an adjustment to the inventory asset account). See chapter 20 for more detail.
Some entities purchase goods in an ‘already complete’ state (also called merchandise), which they
then sell to customers. These are called retailers. Other entities manufacture goods (also called
finished goods), which they then sell to their customers. These entities are called manufacturers.
The cost of goods that are purchased in a ‘ready-to-sell’ state (merchandise) is often referred to simply
as the ‘purchase cost’. The cost of goods that are manufactured include both ‘purchase costs’ (i.e. the
cost of purchasing raw materials), and ‘conversion costs’. ‘Conversion costs’ are those costs that are
incurred during the manufacturing process, when converting the raw materials into finished goods .
Other costs: to bring to present location & condition Conversion costs (other direct costs & indirect costs)
5.3.2 Conversion costs are split into direct costs and indirect costs
The conversion process refers to the process of turning Conversion costs include:
raw materials into a finished product. It is also called the
x Direct manuf. costs (e.g. wages)
production or manufacturing process. Conversion costs x Indirect manuf. costs (overheads)
are thus part of the production costs (i.e. part of the - Variable manuf. overheads
manufacturing costs). Please note the difference: raw (e.g. cleaning)
material is being converted, and thus raw material is not - Fixed manuf. overheads (e.g. rent)
a conversion cost. However, the cost of raw materials is a production cost.
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When calculating the cost of manufactured inventory, we must ensure that we exclude:
x costs that do not relate to the manufacturing process (e.g. administration costs relating to
sales or to head office activities); and
x costs incurred during periods of idleness. See IAS 2.12-.13
The following diagram provides an overview of what makes up ‘conversion costs’ and how
conversion costs ‘fit into’ the total manufacturing cost.
Note: Direct costs generally vary with production, but some don’t (e.g. the cost of wages for factory workers
where the terms of the wage contracts result in a constant wage irrespective of the level of production)
As far as ledger accounts go, we first debit the raw material purchase costs to the ‘raw materials’
inventory account. As we start converting raw materials into finished goods, the cost of these raw
materials is transferred out of the raw materials account and into the ‘work-in-progress’ inventory
account. We then allocate conversion costs to this work-in-progress account. When the item is
complete, we then transfer its total manufacturing cost (raw material cost + conversion costs) out
of the work-in-progress account and into the ‘finished goods’ inventory account, (section 5.3.3).
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Comments:
x All costs capitalised to the inventory work-in-progress account are ‘manufacturing costs’. However,
not all of these costs are called ‘conversion costs’. The cost of the raw materials is a manufacturing
cost, but it is not a conversion cost (all the other manufacturing costs debited to work-in-progress
are conversion costs).
x The depreciation on machinery:
- that is incurred while inventory is being manufactured is capitalised to the inventory account
as part of the ‘costs directly related to the units of production’ [IAS 2.12];
- while the machinery is idle is expensed [costs while idle must not be capitalised: see IAS 2.13].
Thus, since the machinery was idle 30% of the time, the depreciation on machinery to be
capitalised to the cost of inventory (indirect cost: fixed manufacturing overhead) is only C28 000
(C40 000 x 70%).
x The depreciation on office equipment that relates to the management/ administration of the factory
qualifies to be capitalised to the cost of inventory, but the depreciation on equipment that is used
for administration purposes outside of the factory process remains expensed [IAS 2.12 & .16(c)]
x A neat way to account for depreciation is to first expense it and then, at the end of the period, reallocate
the relevant portion to inventory (i.e. first expensed in full and then a portion capitalised), as done above.
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5.3.3.1 Overview
The physical sequence of events in a manufacturing business is reflected in the inventory ledger
accounts that we use. Start by imagining three hypothetical buildings:
x A store-room: we use this to store our raw materials;
x A factory building: we use this to convert our raw materials into finished goods;
x A shop: we use our shop to sell our finished goods.
Now, what happens in each of these 3 imaginary buildings is actually depicted in our ledger:
x What happens in our store-room is reflected in the raw materials account;
x What happens in our factory building is reflected in the work-in-progress account; and
x What happens in our shop is reflected in the finished goods account.
All events occurring in the factory are reflected in the work-in-progress account. Thus, as
the raw materials arrive in the factory building (from the store-room), the work-in-progress
account is increased. But, it is not just the raw materials that enter the factory building – it’s
the conversion costs too: the factory workers come inside (costing us factory wages), as do
many other supplies such as cleaning materials, electricity, water and our machinery gets
used up too. So each of these conversion costs is also added to the work-in-progress
account (notice: costs that are incurred in the production process, such as wages and
depreciation, are capitalised to this inventory account and are thus not expensed!)
x When some of the raw materials have been successfully converted into finished products
(i.e. completed), the finished products are loaded onto a vehicle and driven out of the factory
and delivered to our shop. The accountant reflects this movement of inventory out of the
factory and into the shop by taking an appropriate amount out of the work-in-progress
account and putting it into the finished goods account instead (an inventory asset account).
x The finished goods account shows the story about what happens in our hypothetical shop.
When these goods are sold to customers, the relevant cost per unit sold is removed from
this account and allocated to the cost of goods sold account (an expense account).
As you can see, in this manufacturing scenario, there would actually be three inventory asset
accounts. The total of these three balances will be the inventory carrying amount presented on
the face of the statement of financial position.
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Work-in-progress account
5.3.3.2 Accounting for the movements: two systems There are two systems:
x Perpetual system
The movement of inventory between these inventory x Periodic system
accounts can be accounted for in two different ways, commonly referred to as the perpetual system
and the periodic system.
These two systems are not referred to in IAS 2 Inventories, but are simply two systems that have been
designed by accountants to help in how and when to account for inventory movements.
x The perpetual system involves accounting for each inventory movement as and when it
occurs. For example, we would record a transfer from raw materials to work-in-progress
each time units of raw material are taken out of storage to use in the factory.
x The periodic system involves counting the items of inventory on hand periodically (e.g. at year-
end) and assuming all items that are no longer on hand were either sold or used. In other
words, the periodic system does not continually record the movement, rather it balances back
to the movement. For example: if we had 50 units of raw materials on hand at the beginning
of a period and bought another 100 units during the period, and counted 30 units on hand at
the end of the period, we assume that 120 units (50 + 100 – 30) must have been transferred
from the store-room to the factory in order to be used. Thus, at the end of the period, we record
this movement by transferring the cost of 120 units from raw materials to work-in-progress.
The perpetual and periodic systems are explained in more detail in section 4.
5.3.3.3 Calculating the amount to transfer: three cost formulae (IAS 2.23-27)
In the above explanation, where we spoke about the physical There are three cost
movement in and out of the three imaginary buildings being formulae:
reflected in the relevant inventory accounts (raw materials, x Specific identification
work-in-progress, finished goods and eventually cost of x First-in-first-out
inventory expense – often called cost of sales), we spoke of x Weighted average
an amount being transferred out from one account to another.
For example, we mentioned that an amount would be taken out of the raw materials account and put
into our work-in-progress account when raw materials were taken out of our store-room and put into
the factory (where they would then be worked on in order to convert into finished goods). In this
example, this amount would be the cost of the raw materials being transferred.
There are three formulae which may be used to calculate the cost of the inventory being transferred:
the specific identification formula, the weighted average formula and the first-in-first-out formula.
These cost formulae are explained in more depth in section 6, but a quick discussion in the context of
a manufacturing environment may be helpful to you.
x The specific identification formula must be used in certain situations. However, if your
situation does not warrant the use of the specific identification formula, then you could
choose between the weighted average formula and the first-in-first-out formula.
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x The first-in-first-out formula assumes that the items that are bought or manufactured first
are the items that will be sold first. This approach is ideal for items of inventory that may
perish (e.g. food) or may quickly become obsolete (e.g. technology items).
x The weighted average formula calculates the average cost per item based on the cost of the items
on hand at the beginning of the period plus the cost of the items purchased during the period.
Entities manufacturing mass-produced goods (i.e. interchangeable items) would use either the
weighted average or first-in-first-out formula. Entities manufacturing unique and individualised
items of inventory would have to use the specific identification formula.
The same formula should be used for all inventory with similar natures and similar uses. This
means we may use different formulae for inventory with different natures or uses. For example,
if we manufacture sweets and cups, we could argue that the first-in-first-out formula is the most
appropriate formula to use for sweets since these have a sell-by date and we may prefer to use
a formula that reflects the physical reality (i.e. the first sweets made are the first sweets sold)
and yet use the weighted average formula to measure the cost of the cup movements.
The next example shows the flow of costs from raw materials through to cost of inventory
expense (also called cost of sales). It only involves variable costs (fixed conversion costs are
explained in examples 14 – 19), uses the perpetual system and has been designed in such a
way that the complications of which cost formula to use (specific identification, first-in-first-out
or weighted average) was not necessary. These cost formulae are explained in more depth in
section 6 together with a more complex version of example 12 (example 27: involving
manufacturing ledger accounts using the first-in-first-out and weighted average formulae).
x C20 000 of raw materials were available on 1 January 20X1, (20 000 kilograms).
x C40 000 of raw materials (40 000 kilograms) were purchased and paid for in cash.
x 40% of the raw materials available during January 20X1 were used in January 20X1.
x Wages of C100 000 were incurred and paid during January 20X1:
- 80% related to factory workers,
- 6% related to cleaning staff operating in the factory,
- 4% related to cleaning staff operating in the head office and
- 10% related to office workers in the administrative offices.
x Electricity incurred and paid during January 20X1: C62 000 (100% of the electricity
relates to the factory operations).
x Depreciation on machinery was C28 000 for the month based on the units of production
method (thus a variable cost). All machinery was used in the production of inventory.
x Depreciation on office equipment was C10 000, all of which was used by head office.
x There was no opening balance of work-in-progress on 1 January 20X1.
x All work-in-progress was complete by 31 January 20X1 (20 000 complete units).
x Finished goods had an opening balance of C30 000 on 1 January 20X1 (3 000 units).
x All units of finished goods were sold during January 20X1.
Required: Show all the above information in the ledger accounts using the perpetual system.
Comments: This example involves purchase costs (raw materials) and conversion costs (electricity, wages, depreciation).
Debit Credit
Inventory: raw materials (A) Given: 40 000kg for C40 000 (thus C1/kg) 40 000
Bank (A) 40 000
Raw materials purchased Note: the cost/ kg of these purchases is
unchanged from the cost/ kg of the opening inventory (C1/ kg)
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(5) Transfer from WIP to FG: Items of work-in-progress (WIP) that are no longer ‘in progress’ but are now
finished (completed) must be transferred from WIP to finished goods (FG).
Since all WIP was completed, we simply transfer the entire balance on the WIP account to the FG account.
This example was kept simple in that all WIP was started and completed in the same month.
Had there been some WIP incomplete at either the beginning or end of the year, we would have had
to decide whether to use the specific identification, first-in first-out or weighted average formula to
measure the cost of the amount to be transferred to FG (i.e. the cost of the finished items).
These three formulae are explained in section 6.
(6) Transfer from FG to Cost of sales: 100% of the FG are sold and since we no longer have these FG assets, the
cost thereof must be expensed as cost of sales.
Since all the FG were sold, we simply transferred the entire balance on the FG account to the cost of sales
account. However, had there been some FG that remained unsold at either the beginning or end of the year,
we would have had to decide whether to use the specific identification, first-in first-out or weighted average
formula to measure what portion of the FG balance had been sold and thus was needed to be transferred out
of FG and expensed to cost of sales. These three methods are explained in section 6.
As explained previously, when goods are completed, they are moved, hypothetically, from the
factory to the shop (or warehouse) and thus a journal is processed to transfer the cost of these
goods from the work-in-progress account to the finished goods account. This previous example
was simple in that the entire work-in-progress balance was completed and thus we simply
transferred the entire balance of the work-in-progress costs to the finished goods account.
However, if only a portion of the work-in-progress was completed, we would have to identify how
many units had been completed and how many were incomplete. We would then need to calculate
how much it had cost the entity to manufacture each of these completed units. This cost per unit
is called the manufacturing cost per unit. When journalising the transfer of completed goods from
the work-in-progress account to the finished goods account, we would multiply the manufacturing
cost per unit by the number of items that had been completed.
The manufacturing cost per unit of inventory includes variable and fixed costs, comprising:
x the purchase cost of the raw materials (section 5.2) plus
x the conversion costs (section 5.3.1 and 5.3.2) and possibly
x other costs related to bringing it ‘to its present location and condition’ (section 5.4). See IAS 2.10
It is important, when calculating the total manufacturing cost per unit, to assess each manufacturing
cost as either:
x A variable manufacturing cost:
Variable costs are the costs that vary directly with the level of production.
Direct costs (e.g. raw materials, direct labour) are generally variable and many indirect costs are
also variable (e.g. electricity) (i.e. indirect costs can vary directly – see note 1, below).
OR
x A fixed manufacturing cost:
Fixed costs are the costs that do not vary directly with the level of production.
Some indirect costs are fixed (e.g. factory rent) (see note 1, below).
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5.3.5 Variable manufacturing costs (costs that vary directly with production)
The variable manuf. cost
Variable manufacturing costs are simply costs that vary
per unit could include:
with the level of production. Thus, by their very nature,
x Purchase cost of raw materials
it is easy to calculate the variable manufacturing cost per
unit. This cost per unit would be the total of all the x Direct conversion costs that vary
manufacturing costs per unit that vary with production. x Indirect conversion costs
(manufacturing overheads) that vary
Variable manufacturing costs per unit would typically
x Other costs that vary
include costs such as:
x the purchase cost of the raw materials;
x the direct conversion costs that vary with production (e.g. factory labour)
x the indirect conversion costs (i.e. manufacturing overheads) that vary with production, in
which case they would be called variable manufacturing overheads, (e.g. electricity).
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Debit Credit
Inventory: work-in-progress (A) 10 units x 2 hours x C10 200
Bank (A) 200
Cost of cleaning labour used (manufacture of 10 units: 10 units x C20)
5.3.6 Fixed manufacturing costs (costs that do not vary directly with production)
Manufacturing costs that do not vary with the level of Fixed manufacturing costs
production are referred to as fixed manufacturing costs. are:
x First debited to a suspense account
These manufacturing costs generally include only those x Then the suspense account is
indirect conversion costs that are fixed (fixed manufacturing allocated to:
overheads). - Inventory: no. of units x fixed
manufacturing cost per unit
However, as was explained, even direct costs may actually
- Expense: Any remaining unallocated
turn out to be fixed in nature. balance is expensed
For example, factory wages that are considered to be core
production costs, and thus termed direct costs, may be considered to be fixed costs if the wage bill
remains the same irrespective of the number of units produced.
Fixed manufacturing costs are thus costs that do not vary in relation to the number of units
produced. What makes accounting for these fixed costs slightly different to how we account
for variable costs is that these fixed costs cannot simply be debited to the work-in-progress
account when they are incurred (as is the case with variable manufacturing costs).
Why? Because imagine the extreme situation where we pay, on the first day of the year,
C100 000 rent for our factory building (a fixed cost): if we debit this amount directly to the
inventory account and were then immediately required to draft a statement of financial position
(e.g. to raise a loan from the bank), we would be declaring that we had C100 000 of inventory
on hand – and yet manufacturing had not yet even begun! To get around this problem, our fixed
manufacturing costs are initially debited to a suspense account instead.
As units are produced during the period, the amount in the suspense account gets gradually
allocated to the inventory work-in-progress account. To do this, we need to calculate a fixed
manufacturing cost per unit. Each time a unit is worked on, we transfer this ‘per unit cost’ out
of the suspense account to the work-in-progress account. This fixed manufacturing cost per
unit is often referred to as the ‘fixed manufacturing cost application rate’ (FMCAR).
There are two such rates – one that we estimate at the There are two fixed
beginning of the period (budgeted) and one that we manufacturing application
rates:
calculate at the end of the period (actual):
x Budgeted rate (BFMCAR)
x Budgeted fixed manufacturing cost application rate x Actual rate (AFMCAR)
(BFMCAR) The budgeted rate is used to allocate
our fixed costs to inventory during the
x Actual fixed manufacturing cost application rate year – we only know what our actual rate
(AFMCAR). is after our year has ended.
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The actual rate (AFMCAR) obviously depends on the actual level of inventory produced in any
one year and is thus only determinable at year-end. This actual rate is calculated as:
Fixed manufacturing costs (currency)
Greater of: actual and normal production level (units)
Example 14: Fixed manufacturing costs and the use of a suspense account
Fixed annual head-office rent (paid for at the beginning of the year) C50 000
Fixed annual factory rent (paid for at the beginning of the year) C100 000
Budgeted annual production (normal expected production in units) 50 000
Actual production for 3 months (units) 15 000
Required: Show the journals and the ledger accounts after the 3-month period.
Solution 14: Fixed manufacturing costs and the use of a suspense account
Comment:
x We do not have an actual fixed rate per unit yet since our year has not yet ended and thus we do not yet
know what our actual production for the year will be. Thus, we calculate a budgeted rate in the interim.
x We use the budgeted rate (C2/unit) when quoting customers and when processing journals during the year.
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Since we are processing journals using a budgeted rate during the year, there are three possible
outcomes (see example 15). These are that, at year-end the suspense account could have:
x a zero balance because our actual production equalled our normal production,
x a debit balance because our actual production was less than the normal production,
x a credit balance because our actual production exceeded the normal production.
Required: Show the journals and the ledger accounts at the end of the year, before any possible
adjustments that may be necessary due to under- or over-production, assuming:
A. 50 000 units were produced during the year;
B. 40 000 units were produced during the year;
C. 60 000 units were produced during the year.
Solution 15: Fixed manufacturing cost suspense account – the budgeted rate used
Calculation: Budgeted fixed manufacturing cost per unit (BFMCAR):
= Fixed manufacturing costs
Normal production level
= C100 000
50 000 units
= C2 per unit
Solution 15A: Fixed manufacturing cost suspense account – no balance (AP = BP)
Comment:
Notice that, when actual production equals normal production, the fixed manufacturing costs are perfectly
absorbed into the inventory account (i.e. there is no balance left in the suspense account).
Journals: Debit Credit
Fixed manufacturing costs (Suspense a/c) Given 100 000
Bank (A) 100 000
Fixed manufacturing costs are first allocated to the suspense account
Inventory: work-in-progress (A) 50 000u x C2 (BFMCAR) 100 000
Fixed manufacturing costs (Suspense a/c) 100 000
Allocation of fixed manufacturing costs to the number of units of inventory
actually produced during the year
Ledger accounts:
Bank Fixed manufacturing costs (Suspense)
FMCS (1) 100 000 Bank (1) 100 000 Inv WIP (2) 100 000
Balance (3) 0
100 000 100 000
Balance (3) 0
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Solution 15B: Fixed manufacturing cost suspense account – a debit balance (AP < BP)
Comment:
Notice that, when actual production is less than normal production, fixed manufacturing costs are under-
absorbed into the inventory account (i.e. a debit balance remains in the suspense account).
Ledger accounts:
Bank Fixed manufacturing costs (Suspense)
FMCS (1) 100 000 Bank (1) 100 000 Inv WIP(2) 80 000
Balance (3) 20 000
100 000 100 000
Balance (3) 20 000
Solution 15C: Fixed manufacturing cost suspense account – a credit balance (AP >BP)
Comment:
Notice that, when actual production exceeds normal production, the fixed manufacturing costs are over-
absorbed into the inventory account (i.e. a credit balance remains in the suspense account).
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Ledger accounts:
If an entity actually produces at a level below the budgeted normal production level, the use of
the budgeted rate means that a portion of the fixed manufacturing costs in the suspense account
will not get allocated to the inventory asset account (see part B of the previous example).
Since an under-absorption results from under-productivity, it effectively reflects the cost of the
inefficiency, which quite obviously cannot be an asset! It thus makes sense that the amount of
the under-absorption must be expensed instead.
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Solution 16D: Explanation of the actual fixed manufacturing cost application rate
The actual fixed manufacturing costs application rate (AFMCAR) is the rate at which the fixed manufacturing
costs actually ends up being applied to the units of inventory that were actually produced – it is commonly
referred to as the ‘actual rate’ (C1 per unit – see solution 13C).
To calculate this actual rate (i.e. the actual fixed cost that we ended up allocating to each unit), we divide the
fixed manufacturing costs by the greater of the normal production (100 000u) and actual production (50 000u).
If, in this case, where actual production was less than normal production, we had incorrectly used an application
rate that was calculated by dividing the fixed cost by the actual production levels rather than the normal
production levels, we would have calculated a rate of C2 per unit (C100 000 / 50 000u). If we had then used
this rate of C2 to allocate the fixed costs to the inventory account (i.e. instead of the C1 per unit), we would have
allocated the full C100 000 to inventories (C2 x 50 000u actually produced).
This would not have made sense, because we would have effectively capitalised inefficiency: capitalising fixed
costs of C2 per unit instead of the normal C1 per unit doesn’t make sense given that the only reason for the
higher cost of C2 is that we produced less than we should have. In other words, a C2 fixed cost per unit is
inflated (i.e. higher than the C1 per unit) purely due to the company’s inefficiency!
If the actual production exceeds the normal budgeted production for a period (i.e. we experience
over-production), then, when we apply our budgeted rate to these actual units, it will mean the
fixed manufacturing costs allocated from the suspense account to the inventory account will
initially be greater than the actual costs incurred. We call this an over-allocation of costs.
This over-allocation (over-absorption) of costs into the inventory account results in too much being
taken out of the suspense account (leaving the suspense account with a credit balance) and results
in the inventory asset being overstated (i.e. the inventory asset will be shown at a value that exceeds
the costs that were actually incurred). Since inventory may not be measured at an amount higher than
cost (inventory is measured at the lower of cost and net realisable value), the over-absorption is thus
simply reversed out of the inventory account (credit) and back into the suspense account (debit).
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The actual fixed manufacturing costs application rate (AFMCAR) refers to the actual rate at which the
fixed manufacturing costs effectively ends up being applied to the units of inventory that were actually
produced. In other words, it is the amount of fixed manufacturing costs that each unit actually cost.
This actual application rate was C1 per unit in this example (see solution 17C).
To calculate the actual rate (the actual fixed cost to be allocated to each unit), we divide the fixed manufacturing
costs incurred by the greater of budgeted normal production (50 000u) and actual production (100 000u).
The budgeted fixed manufacturing costs application rate (BFMCAR) is the rate used throughout the
year to quote customers and to allocate fixed manufacturing costs to the inventory account during the
period. This budgeted application rate was C2 per unit in this example (see solution 17A).
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At the end of the period, we compare our actual production with our budgeted normal production. In
this example, our actual production exceeded our normal production, and thus our actual rate per unit
(C1) was lower than the budgeted rate per unit (C2). This drop in the cost per unit reflects efficiency.
However, since we used the budgeted rate (C2) to allocate fixed costs to the units of inventory actually
produced (100 000u), by the end of the year we will have allocated too much to the inventory account:
we will have allocated C200 000 (100 000u x C2), when the fixed costs were only C100 000. This
excess allocation of C100 000 (C200 000 capitalised – C100 000 incurred) means that, instead of
clearing the debit balance in the suspense account to nil, the suspense account will now have a credit
balance of C100 000 and we will have effectively debited inventory with costs that were not incurred.
This cannot be allowed since the inventory standard prohibits the measurement of inventory at above
cost – since it did not cost C200 000, we cannot capitalise C200 000. See IAS 2.13 Thus, the over-allocation
of C100 000 must be reversed out of inventory (credit) and back to the suspense account (debit) and
in so doing, reversing the nonsensical credit balance in this suspense account.
The budgeted fixed manufacturing cost application rate is calculated at the start of the year:
Fixed manufacturing costs
BFMCAR =
Normal production level
The actual fixed manufacturing cost application rate is calculated at the end of the year:
Fixed manufacturing costs
AFMCAR =
Greater of: normal production and actual production
x greater than normal production, the actual fixed cost x Over-production = Over absorption
= Adjust: Cr Inventory & Dr Suspense
application rate (AFMCAR) is calculated using actual
x Under-production = Under-absorption
production since this avoids inventory being overvalued = Adjust: Cr Suspense & Dr Expense
as a result of over-efficiency.
So, if AP > BP, use AP.
x less than normal production, the actual fixed cost application rate is calculated using normal
production level, since this avoids inventory being overvalued as a result of inefficiencies.
So, if AP < BP, use BP.
Budgeted normal production seldom equals actual production. As a result, the budgeted rate
(BFMCAR) seldom equals the actual rate (AFMCAR). Thus, when the actual units produced
are multiplied by the budgeted rate (BFMCAR), either too much (over-absorption) or too little
(under-absorption) of the actual fixed overheads incurred will be capitalised to inventory.
Adjustments will be required to correct this.
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Solution 18A: Budgeted fixed manufacturing overheads rate (AP > BP)
= Fixed manufacturing costs
Normal production level
= C40 000
1 000 units
Solution 18C: Actual manufacturing cost per unit (AP > BP)
C
Variable manufacturing cost per unit Given 12.00
Fixed manufacturing cost per unit: AFMCAR W1 26.67
38.67
W1: Actual fixed manufacturing cost application rate:
= Fixed manufacturing costs
Greater of: normal and actual production
= C40 000
1 500 units
= C26,67 per unit
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Solution 19A: Budgeted fixed manufacturing overheads rate (BP > AP)
= C40 000
1 000 units
Solution 19C: Actual manufacturing cost per unit (BP > AP)
C
Variable manufacturing cost per unit Given 12.00
Fixed manufacturing cost per unit (actual): AFMCAR W1 40.00
52.00
W1: Actual fixed manufacturing cost application rate:
= C40 000
1 000 units
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Joint products are two or more products that share a process. In a manufacturing plant, inventory may
go through many processes on its conversion from raw materials to finished goods. Where two products
share the same process, the costs associated with that process must be apportioned to each product.
An example of joint products is brown and white sugar, produced by the same sugar mill. The raw
sugar is extracted from sugar cane and refined until all the molasses is removed (this is the shared
process). Once this is complete, the sugar is ‘split up’ into the quantity that will be sold as white sugar,
and the quantity sold as brown sugar. In a separate process, a certain quantity of molasses is added
back to the brown sugar to give it the brown colour (this is a separate process).
The costs incurred by the initial extracting and refining process (i.e. the shared process… the joint
process) must be apportioned to each of the products on a rational and consistent method IAS 2.14.
Examples of these methods are the ‘physical methods measure’, the ‘selling price at split-off method’
and the ‘relative sales value (net realisable value) method’.
By-products are products that are created incidentally in the production process. For instance, in the
sugar mill example above, the excess molasses would be considered a by-product, as it is created
incidentally in the process of refining sugar. The sales value of a by-product is often negligible, and
thus, the net realisable value of the by-product is simply deducted from the total cost of the main
product. Sugar refineries often sell the excess molasses to bakeries or other companies in the food
manufacturing industry. See IAS 2.14
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Solution 20B: Allocating Joint Costs using the selling price at split-off method
Product Units SP at Total Joint Cost Cost per
Produced split-off allocated unit
C C C C
Chocolate 1 000 40 (2) 40 000 40 000/120 000 x 60 000 (1) 20 000 20
Vanilla 2 000 40 (2) 80 000 80 000/120 000 x 60 000 (1) 40 000 20
3 000 120 000 60 000
Comments
(1) The joint cost is C60 000 (C60 500 – C500 = C60 000) (The net amount received from the by-
product (crumbs) is considered negligible and is thus deducted from the joint costs incurred).
(2) Notice that we use the selling price of the sponge since this is the sales value at split-off point.
Solution 20C: Allocating Joint Costs using the relative sales value method
Product Units Relative Total Joint Cost Cost per
Produced Sales Value allocated unit
C C C C
Chocolate 1 000 200-20 (2) 180 180 000 180K/300K x 60 000 (1) 36 000 36
Vanilla 2 000 80-20 (2) 60 120 000 120K/300K x 60 000 (1) 24 000 12
3 000 300 000 60 000
Comments
(1) The joint cost is C60 000 (C60 500 – C500 = C60 000) (The net amount received from the by-
product (crumbs) is considered negligible and is thus deducted from the joint costs incurred).
(2) This method allocates joint costs on a net realisable value method i.e. ‘selling price’ less ‘further
processing costs’. The further processing cost of C20/ cake includes the cost of icing the cake.
Borrowing costs (e.g. interest expense) may need to be capitalised to the inventory. This happens if the
inventory is a qualifying asset, as defined in IAS 23 Borrowing costs. A qualifying asset is ‘an asset that
necessarily takes a substantial period of time to get ready for its intended use or sale’.
x Inventory that is purchased as a finished product, for example, would not meet this definition and
thus any related interest expense would not be capitalised; whereas
x Inventory that an entity produces, and where the production process takes a substantial period of
time, would meet the definition of a ‘qualifying asset’, in which case, any related financing costs
recognised as an interest expense must now be capitalised to that inventory
Debit Interest expense xxx
Credit Interest payable / bank xxx
Interest expense is incurred
Debit Inventory xxx
Credit Interest expense xxx
Interest expense is capitalised
For example, the process of manufacturing cheese can involve a substantially long period of time,
in which case the inventory of cheese would be a qualifying asset.
x There is one exception: if this inventory is produced in large quantities on a repetitive basis, then the
entity may choose whether to capitalise this interest expense or not. See IAS 23.4-6
We determine how much, if any, of a borrowing cost must be capitalised by using IAS 23 Borrowing
costs (see chapter 14).
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There are many types of ‘other costs’ that you may come across, including some which may
never be capitalised. The 'other costs' that may never be capitalised include:
x abnormal amounts of production costs (e.g. excessive wastage of materials or labour);
x administration costs, unless these help bring the inventory to its location and condition;
x storage costs, unless storage was necessary in the production process before a further production
stage (i.e. the costs of storage during a production process or after the completion of a final
production process must always be expensed…however, the cost of storage necessary between
one production process and another production process must be capitalised); and
x selling costs.
x Advertising costs totalling C100 000 were incurred and paid for during the year.
x Salaries to administration personnel totalling C200 000 was incurred during the year:
- 10% was for paperwork related to the importation of some of the raw materials
- 70% was for general head-office administration costs
- 20% was for paperwork involved in the sale of finished goods
Required: Show the journal entries that would have been necessary during the period.
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There are three different cost formulae allowed when measuring these movements:
x specific identification (SI);
x first-in, first-out (FIFO); and
x weighted average (WA).
We first assess whether the specific identification formula is suitable for our specific type of inventory.
If it is suitable, then it must be used, but if it is not appropriate, then we may choose between the
first-in-first-out formula and the weighted average formula.
The cost of the initial recognition of inventory does not differ with the method chosen but, if the cost
of each item of inventory purchased (or manufactured) during the year is not constant, then the
measurement of the cost of goods sold or converted will differ depending on the formula chosen.
The same cost formula must be used for all inventories having a similar nature and use.
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The specific identification formula is perfect, for example, for inventory that is made up of items
that are dissimilar in value (e.g. a retailer of exotic cars). How it works is that each item of
inventory is assigned its actual cost and it is this actual cost that is expensed when this specific
item is sold (using any of the other formulae would be materially inaccurate and misleading).
Comment: The profit on sale can now be accurately determined as C175 000 – C150 000 = C25 000.
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Required: Post the related journal entries in the ledger accounts using the weighted average method.
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Required: Post the cost of sale journal in the ledger accounts using the weighted average method.
If, for example, the manufacturing entity applied the first-in-first-out formula, it simply means
that before you transfer the cost of raw materials used from the raw materials account to the
work-in-progress account, you need to stop and calculate what the cost per unit should be
based on the first-in-first-out principles explained above.
Complexities arise only when dealing with the work-in-progress account since this requires
application of cost accounting principles (process costing) that are not dealt with in financial
accounting. However, once having applied your process costing principles to your work-in-
progress account, you can easily calculate the amount to be transferred to finished goods.
Due to space constraints, process costing will not be explained in this text. Instead, the
following examples will give you the amounts to be transferred from the work-in-progress
account to finished goods account as if you had applied your process costing principles. The
following examples will thus only require you to calculate the costs per unit when transferring
the cost of raw materials from the raw materials account to the work-in progress account and
when transferring the cost of finished goods that have been sold from the finished goods
account to the cost of sales expense account.
The previous example that dealt with the inventory accounts of a manufacturing entity
(example 12) had been deliberately simplified in the following respects:
x the cost per unit of the raw materials opening balance was the same as the cost per unit of
the raw material purchases during the year;
x the cost per unit of the finished goods opening balance was the same as the cost per unit
of the finished goods completed during the year;
x all the work-in-progress was completed during the year; and
x all the finished goods were sold during the year; and
x none of the manufacturing costs were fixed costs.
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Example 12 was kept deliberately simple so as to avoid the issue of the cost formulae and to
avoid the issue of fixed manufacturing cost application rates, both of which had not yet been
explained. The following example is based on example 12 but has been changed so that the
impact of the different cost formulae can be demonstrated. A fixed manufacturing cost has also
been added so this is now a comprehensive example which shows how the application rate
works. The changes from example 12 have been highlighted in bold for your interest.
x C20 000 of raw materials were available on 1 January 20X1, (15 000 kilograms).
x C40 000 of raw materials were purchased during January 20X1 (40 000 kilograms).
x 26 000kg of raw materials were used during January 20X1.
x Wages of C100 000 were incurred and paid during January 20X1:
- 80% related to factory workers,
- 6% related to cleaning staff operating in the factory,
- 4% related to cleaning staff operating in the head office and
- 10% related to office workers in the administrative offices.
All factory-related wages were considered to be variable.
x Electricity of C62 000 was incurred and paid during January 20X1. All of this related to the factory
operations. The entire electricity bill was considered to be variable.
x Depreciation of C38 000 is incurred during January 20X1:
- C28 000 relates to machinery used exclusively in the factory; and
- C10 000 relates to equipment used by head office.
Depreciation of C28 000 is calculated using the units of production method and is thus a variable cost.
x The factory building is rented at C40 000 per month (and always paid in cash).
x Budgeted normal production for January 20X1 was 20 000 units.
x 21 000 units were put into production during January 20X1.
x Work-in-progress on 1 January 20X1 was C35 000.
x 18 000 units were completed during January 20X1, at a cost of C162 000.
x The finished goods opening balance (01/01/X1) was C30 000 (representing 3 000 units).
x 80% of all finished goods were sold during January 20X1.
Required: Show the ledger accounts for raw materials, work-in-progress and finished goods using the
perpetual system and assuming that:
A. the first-in-first-out formula is used.
B. the weighted average formula is used.
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Workings:
W1: The cost of the 26 000kg raw materials is allocated from RM to WIP using the FIFO formula:
Available Used Used
kg C C/kg kg Calculation C
Open/ balance 15 000 kg 20 000 C1.3/ kg 15 000kg 15 000 kg x C1.3/ kg 20 000
Purchases 40 000 kg 40 000 C1/ kg 11 000kg (26 000kg – 15 000kg) x C1 11 000
55 000 kg 60 000 26 000kg 31 000
W2: Allocation of the fixed manufacturing costs to WIP using the budgeted rate:
W3: Check for over or under-allocation of the fixed manufacturing costs at end January 20X1
= Fixed manufacturing costs total – Fixed manufacturing costs allocated
= C40 000 (Given) – C42 000 (W2) = C2 000 (Over-allocation)
W4: Wages related to the manufacturing process
= C100 000 x (80% + 6%) = C86 000
W5: The cost of the units sold from FG to cost of sales using the FIFO formula:
Units C C/ unit Units Calculation C
available sold
Open/ balance 3 000 u 30 000 C10/ u 3 000 u 3 000u x C10/ u 30 000
Purchases 18 000 u 162 000 C9/ u 13 800 u (80% x 21 000u – 3 000u) x C9 124 200
21 000 u 192 000 16 800 u 154 200
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W1: The cost of the 26 000kg raw materials is allocated from RM to WIP using the WA formula:
W5: The cost of the units sold from FG to cost of sales using the WA formula:
Available Sold
units C C/ unit units Calculation C
Open/ 3 000 u 30 000
balance
Completed 18 000 u 162 000
21 000 u 192 000 C9.14286 16 800 u (80% x 21 000u) x C9.14286 153 600
7.1 Overview
In the interests of ensuring that the inventory balance is not overstating the potential inflow of future
economic benefits, we measure the inventory balance at the lower of cost and net realisable value.
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Since ‘net realisable value’ is the net amount an entity expects to receive when it sells inventory in
the ordinary course of business, it is an entity-specific measurement, which means that different
entities may have different net realisable values for the same item of inventory. However, ‘fair value’
is measured in terms of IFRS 13, which means it is not entity-specific but is, instead, the price the
item would sell for in the most advantageous/principal market. See IAS 2.7
When estimating the net realisable value, we must use the most reliable evidence available to us.
This may mean using information that comes to light due to events after the reporting date but
before the financial statements are finalised for issue (see chapter 18). Information that arises
during this period (i.e. before reporting date and the date on which the financial statements are
finalised) may be used on condition that it gives more information about events that existed at
reporting date. See example 28.
When estimating the net realisable value, we must also take into account the purpose for which the
inventory is held (see example 29). If, for example, certain inventory has been set aside for a
specific customer at a specified contractual price, then:
x the net realisable value for the part of the inventory that has been set aside for the specific
customer is based on the related contracted price while
x the net realisable value for the remaining inventory is based on general selling prices.
When testing for write-downs, each inventory item should generally be tested separately. Thus,
providing for an estimated percentage write-off across all inventory would not be acceptable.
However, whether to test on an item-by-item basis depends on the actual circumstances. For
example, in certain circumstances a product line (e.g. a cutlery set) must be looked at as a whole
rather than on an individual item-by-item basis if the individual items cannot be sold separately: e.g.
if the knives, forks and spoons manufactured as part of the cutlery set are not sold separately, then
the cutlery set should be tested for impairment as a separate product-line rather than trying to
measure the individual knives, forks and spoons. See IAS 2.29
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Inventory should generally not be tested for impairment based on general classifications, such
as raw materials, work-in-progress, finished goods and consumable stores. For example, raw
materials with a net realisable value lower than cost, will still be used in the manufacture of a
final product and will thus not be sold in their raw state. Thus, a write down of raw materials
based on a net realisable value in its raw state makes no sense.
On the other hand, the testing for impairment of a general classification such as raw materials
would be appropriate if, for example, the finished product in which the raw materials were used
is no longer profitable and the expectation is that the raw materials (or work-in-progress) will be
sold in their current unfinished state or even dumped.
If the price of raw materials has dropped to below cost, no write-down is processed unless the
drop in the price of the raw material causes the net realisable value of the finished product
dropping below its cost. If the drop in the price of raw materials has resulted in the net realisable
value of the finished product also dropping below cost, then the affected raw materials on hand
would need to be written down. However, the net realisable value of the raw material will then
generally be the replacement cost of the raw materials. See IAS 2.32
Example 28: Net realisable value and events after reporting period
Cold Limited has a branch in Woop Woop. There is very little infrastructure in Woop Woop
and, as a result, the Woop Woop factory manager only managed to send a fax through to
head office on 10 January 20X2 to advise that the entire warehouse and the entire finished
goods inventory contained therein (with a carrying amount of C900 000) had been destroyed
in a series of storms.
x The first storm hit the warehouse on 29/12/20X1 destroying 70% of the inventory.
x The remaining undamaged inventory was quickly moved to higher ground but flood
waters from a second storm on 5 January 20X2 destroyed this too.
The factory manager estimates that the entire inventory:
x will be saleable as scrap for C100 000 and the related costs to sell will be C1 000;
x would normally have sold for C1 500 000, with related selling costs being 10% thereof.
Required: Calculate the net realisable value at 31 December 20X1
Solution 28: Net realisable value and events after reporting period
Comment:
x Although the entire inventory at Woop Woop has been destroyed, only 70% of the inventory was
destroyed before reporting date. This means that:
- the net realisable value of 70% of the inventory is based on scrap values; but
- the net realisable value for the remaining 30% of the inventory that existed at reporting date
should be based on normal prices.
- The valuation was conducted after reporting date and is thus an event after reporting date,
however the inventory has to be written down as it was destroyed before year end.
C
Damaged Inventory Estimated selling price C100 000 x 70% 70 000
(70%) Less estimated selling costs C1 000 x 70% (700)
Net realisable value 69 300
This NRV would be compared to the CA of the damaged inventory at year-end of C63 000 (900 000 x 70%).
The write down of the damaged inventory at year-end would be C560 700 (CA: C630 000 – NRV: C69 300)
C
Undamaged Inventory Estimated selling price C1 500 000 x 30% 450 000
(30%) Less estimated selling costs C1 500 000 x 10% x 30% (45 000)
Net realisable value 405 000
This NRV would be compared to the CA of the undamaged inventory at year-end of C270 000 (C900 000 x 30%).
The write down of the undamaged inventory at year-end would thus be NIL (CA: C270 000- NRV: C405 000 =N/A)
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If the net realisable value is less than its carrying amount, we write the inventory balance down
to the net realisable value.
The comparison between carrying amount (cost) and net realisable value should be done on an item-
for-item basis. In other words, at the end of each financial year, the inventory balances on an item-for-
item basis should be checked to be sure they do not exceed the lower of cost or net realisable value.
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iv) Disclosure
Entity name
Statement of comprehensive income
For the year ended 31 December 20X2 (extracts)
Note Part A Part B
C C
Revenue x x
Cost of inventory expense (A: cost of sales + write-down: 20) See note below (x + 20) (x + 0)
(B: cost of sales + write-down: 0) See note below
Other costs disclosed using function or nature method (x) (x)
Profit before tax 3 (x) (x)
Entity name
Notes to the financial statements
For the year ended 31 December 20X2
Part A Part B
3. Profit before tax C C
Profit before taxation is stated after taking into account the following separately disclosable items:
- Write-down of inventories expense See note below 20 N/A
Note: The inventory write-down may be included in cost of inventory expense or could be shown as part
of the entity’s other expenses – this choice is based on professional judgement (see section 7.5)
Be careful not to increase the inventory to an amount that exceeds its cost! In other words, if
the net realisable value exceeds the carrying amount, the carrying amount may be increased
back up to cost but not above cost. The write-back is limited since the principle of lower of cost
or net realisable value must always be observed.
Required: Process the journals in 20X1 and 20X2 and show how the write-back (if any) would be
disclosed in 20X2 assuming that the net realisable value of this stock at 31 December 20X2 is:
A. C55;
B. C75.
Solution 31A: Lower of cost or net realisable value: reversal of write-downs (write-back)
31 December 20X1 Debit Credit
Inventory write-down (E) 20
Inventories (A) 20
Write-down of inventories to net realisable value: W1
31 December 20X2
Inventories (A) 5
Reversal of inventory write-down (I) 5
Reversal of previous write-down of inventories: W1
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Disclosure
Entity name
Statement of comprehensive income 20X2 20X1
For the year ended 31 December 20X2 (extracts) C C
Note
Revenue x x
Cost of inventory expense (x) (x)
Other costs Comment 1 (20X2: x - 5) (20X1: x + 20) Comment 2 (x - 5) (x + 20)
Profit before tax 7 (x) (x)
Comments:
1. ‘Other costs’ would need to be disclosed either by function or by nature.
2. Instead of including the inventory write-down and reversal in ‘other costs’, it could have been included
in cost of inventory expense. This choice is based on professional judgement.
Entity name
Notes to the financial statements 20X2 20X1
For the year ended 31 December 20X2 C C
7. Profit before tax
Profit before taxation is stated after taking into account the following separately disclosable
(income)/ expense items:
- Write-down/ (Reversal of write-down) of inventories (W1) (5) 20
Disclosure
Entity name
Statement of comprehensive income 20X2 20X1
For the year ended 31 December 20X2 (extracts) C C
Note
Revenue x x
Cost of inventory expense (x) (x)
Other costs Comment 1 (20X2: x - 20) (20X1: x + 20) Comment 2 (x - 20) (x + 20)
Profit before tax 5 (x) (x)
Comments:
1. ‘Other costs’ would need to be disclosed either by function or by nature.
2. The inventory write-down and reversal could be included in cost of inventory expense or in the entity’s
other expenses – this is a choice based on professional judgement (see section 7.5).
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Entity name
Notes to the financial statements 20X2 20X1
For the year ended 31 December 20X2 C C
5. Profit before tax
Profit before taxation is stated after the following separately disclosable (income)/ expense items:
- Write-down/ (Reversal of write-down) of inventories (W1) (20) 20
7.5 Presenting inventory write-downs and reversals of write-downs (IAS 2.34 & .38)
An ‘inventory write-down’ expense and ‘reversal of inventory write-down’ income are both separately
disclosable items, which means that the write-down (or reversal) will have to be disclosed somewhere
in the financial statements. We could disclose this detail on the face of the financial statements or in
the notes to the financial statements. However, disclosure and presentation are not the same thing.
However, IAS 2 describes the ‘cost of inventory expense’ (cost of sales) as including the cost of the
inventory items that have been sold, any unallocated manufacturing costs and also any abnormal
production costs (e.g. wastage). It also goes on to explain that the circumstances facing the entity may
justify including other amounts in this ‘cost of inventory expense’ (cost of sales). Thus, professional
judgement is needed when deciding if an inventory write-down expense (or reversal of inventory write-
down income) should be included in the ‘cost of inventory expense’ line-item or presented as a separate
line item. See IAS 2.38
It is submitted that, unless circumstances suggest otherwise, a general rule of thumb is that:
x if the write-down is considered to be a normal part of trading, this inventory write-down expense
could be presented as part of the ‘cost of inventory expense’ line-item (cost of sales expense); but
x if the write-down is not normal, this inventory write-down expense should not be presented as part
of the ‘cost of inventory expense’ line-item (cost of sales). See IAS 2.34 and IAS 2.38
Sometimes write-downs are simply a normal part of an entity’s business. For example, inventory
represented by fresh vegetables with a short-shelf life may result in regular write-downs. It could be
argued in this case that such an inventory write-down should be presented as part of the cost of inventory
expense line-item (cost of sales).
Presentation of inventory
Conversely, write-downs may be caused by something that write-downs/ reversals:
is not part of an entity's normal business. For example, if a
Inventory write-downs/reversals may be
new technology was released resulting in certain inventory included in:
on hand becoming obsolete and thus needing to be written- x the cost of inventory expense line item,
down, this type of write-down may be considered so x other costs line item,
significant and out of the ordinary that we may argue that x any other relevant line item, or even
the write-down should not be presented as part of the cost x an entirely separate line item.
of inventory expense line-item (cost of sales) but should (IAS 2 does not prescribe where it should
be presented).
rather be presented as an entirely separate line-item.
One of the reasons behind excluding the cost of an unusual and significant inventory write-down expense
(or reversal income) from the cost of inventory expense is that the cost of this inventory write-down
expense may otherwise distort the gross profit percentage and thus damage comparability of the current
year financial results with those of the prior year and also damage comparability of the entity's results
with its competitors' results.
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Deciding where to present an inventory write-down or reversal will need your professional judgement.
This judgement needs to be guided by the fact that we must provide financial information that is useful
(the presentation should provide information that is relevant and a faithful representation).
Example 32: Lower of cost or net realisable value – involving raw materials
A bookkeeper provided you with the following working papers regarding inventory on hand
at 31 December 20X2. The entity manufactures two product lines: motorbikes and bicycles:
Cost NRV: Write-down
C C C
Raw materials 100 000 75 000 25 000
x Motorbike parts 40 000 25 000
x Bicycle parts 60 000 50 000
Work-in-progress 80 000 85 000 0
x Incomplete motorbikes 30 000 25 000
x Incomplete bicycles 50 000 60 000
Finished Goods 160 000 165 000 0
x Complete motorbikes 80 000 55 000
x Complete bicycles 80 000 110 000
340 000 325 000
Due to the strengthening of the local currency, the parts used in the manufacture of both the
motorbikes and bicycles became cheaper. As a direct result thereof, the net realisable value of both
the finished motorbikes and bicycles also dropped.
Required: The bookkeeper asked that you explain whether his calculated write-down is correct.
Solution 32: Lower of cost or net realisable value – involving raw materials
Comments:
x A write-down of the raw material of motorbike parts is necessary because the NRV of the complete
motorbikes has dropped below cost.
x No write-down of the raw material of bicycle parts is processed since the NRV of the complete
bicycles remained above cost.
Explanation to the bookkeeper:
Inventory write-downs should generally not be done based on inventory classifications (raw materials,
work-in-progress and finished goods) but should be done on an item-by-item basis.
Although both items of raw materials have net realisable values that are lower than cost, raw materials
should not be written-down unless the reason for the drop in the NRV of the raw materials has also
resulted in the NRV of the related finished product also dropping.
x Since the NRV of the finished motorbikes has dropped below cost, motorbike parts (raw materials) should
be written-down to their net realisable value (the NRV in this case is usually the net replacement cost).
x Despite the NRV of the finished bicycles having dropped, the NRV of the bicycles has not dropped
below cost. The bicycle parts (raw materials) should therefore not be written-down.
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An accounting policy note is required indicating the accounting policy in respect of:
x the measurement of inventories (i.e. lower of cost and net realisable value) and
x the cost formula used (FIFO, WA or SI formulae).
Inventories must be presented as a separate line item on the face of the statement of financial
position and must be included under the classification of current assets. See IAS 1.54(g) and IAS 1.66(a)
The note supporting this inventories line item should indicate the:
x Carrying amount of inventories broken down into classifications appropriate to the entity:
- Merchandise or Finished goods
- Work-in-progress
- Raw materials
- Other production supplies (e.g. cleaning materials & other consumables); See IAS 2.36 (b)
x Carrying amount of inventories measured at fair value less costs to sell (this applies to
agricultural produce only – agricultural industries are not covered in this text); See IAS 2.36 (c)
x Amount of inventories pledged as security. IAS 2.36 (h)
The following disclosure is required, either on the face of the statement of comprehensive
income or in a note supporting specific line items on the face:
x The cost of inventories expense (often referred to as cost of sales). See IAS 2.36 (d)
Cost of inventory expense constitutes:
- cost of goods sold,
- fixed manufacturing overheads expensed (i.e. due to under-production),
- abnormal production costs (e.g. abnormal wastage of raw materials), and
- other costs, depending on ‘the circumstances of the entity'. IAS 2.38
x Write-down of inventories. See IAS 2.36 (e)
- Write-downs may be included in cost of sales depending on ‘the circumstances of
the entity'. See IAS 2.38
- If write-downs are not included in cost of sales, they may be included as a separate
line item in operating costs.
x Reversal of an inventory write-down (an income item), together with the circumstances that
led to this reversal. See IAS 2.36 (f and g)
The cost of inventories expense is disclosed whether the function or nature method is used.
Remember that the cost of inventories expense, which must be presented separately, includes
costs such as depreciation on factory-related property, plant and equipment (which are
capitalised to inventory), and which are line-items that must also be disclosed separately.
Chapter 13 713
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Entity name
Statement of comprehensive income
For the year ended 31 December 20X2 (extracts)
Note 20X2
C
Revenue 290 000
Other income 10 000
Less cost of inventory expense W3 (180 000)
Less distribution costs (30 000)
Less administrative costs (30 000)
Less finance costs (10 000)
Profit before tax 50 000
Taxation (20 000)
Profit for the year 30 000
Other comprehensive income 0
Total comprehensive income 30 000
Workings:
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Entity name
Statement of comprehensive income 20X2
For the year ended 31 December 20X2 (extracts) C
Revenue 290 000
Add other income 10 000
Add increase in inventory of finished goods W3. 80 000 – 60 000 20 000
Less decrease in inventory of work-in-progress W2. 30 000 – 40 000 (10 000)
Less Raw materials and consumables used W1. (50 000)
Less Staff costs (60 000)
Less Depreciation (80 000)
Less other operating expenses No detail given so 30 000 + 30 000 (60 000)
Less finance costs (10 000)
Profit before tax 50 000
Taxation (20 000)
Profit for the year 30 000
Other comprehensive income 0
Total comprehensive income 30 000
Chapter 13 715
Gripping GAAP Inventories
Entity name
Notes to the financial statements
For the year ended 31 December 20X2 (extracts)
20X2
3. Profit before tax
C
Profit before tax is stated after the following separately disclosable (income)/ expense items:
Depreciation – office equipment 25 000
Depreciation – distribution vehicles 35 000
Depreciation – plant 5 000
- Total depreciation 5 000 expensed + 75 000 capitalised 80 000
- Less capitalised to work-in-progress Given (75 000)
Write-down of inventories 20 000 + 30 000 50 000
Reversal of write-down of inventories (10 000)
Reason for the reversal of the write-down of inventories: The new technology which caused the
write-down of white paint (raw materials) and white fencing (finished product) in 20X1 was declared
illegal during 20X2 due to health concerns.
Example 35: Disclosure of the inventory asset and related accounting policies
The following were included in the trial balance at 31 December 20X2 (year-end):
x Finished goods (tyres: styles XYZ and XXX): C500 000;
x Work-in-progress: C100 000;
x Raw materials: C300 000.
Finished goods of C500 000 have been pledged as security for a loan.
Required: Disclose the above in the statement of financial position and related notes.
Solution 35: Disclosure of the inventory asset and related accounting policies
Entity name
Statement of financial position
As at 31 December 20X2 (extracts)
20X2 20X1
Current assets Note C C
Inventories 500 000 + 100 000 + 300 000 5 900 000 xxx
Accounts receivable xxx xxx
Cash xxx xxx
Entity name
Notes to the financial statements
For the year ended 31 December 20X2 (extracts)
20X2 20X1
Note C C
2. Accounting policies
2.1 Inventories Inventories are valued at the lower of cost and net realisable value, where the cost is
calculated using the actual cost/ standard cost/ retail method (selling price less gross profit percentage).
Inventory movements are recorded using the weighted average formula (or FIFO or SI).
5. Inventories
The entire finished goods has been pledged as security for a loan (see ‘note xxx’ for further details).
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9. Summary
Inventory measurement:
Lower of ‘cost’ and
‘net realisable value’
Include Exclude
- The general rule: costs that are incurred in
order to bring the asset to its present - Abnormal wastage;
location and condition: - Storage costs (unless necessary mid-
- purchase cost (e.g. of raw material – a production);
direct cost);
- conversion cost - Administrative costs that do not
- other costs contribute to the ‘general rule’
- Purchase cost include, for example, - Selling costs;
purchase price, transport costs inwards,
non-refundable taxes and import duties, - Transport costs outwards (involved in
other directly attributable costs the sale);
- Conversion costs include for example: - Transaction taxes that are recoverable
- direct costs e.g. direct labour: these are (e.g. VAT).
normally variable but could be fixed);
- indirect costs (variable manuf.
overheads and fixed manuf. overheads)
- Other cost include, for ex., borrowing costs
- All discounts plus rebates that are
designed to reduce the purchase price
should be set-off against the costs
Inventory measurement:
The cost formulae used for measuring inventory movements
Same cost formulae for all inventory with similar nature and use
If goods are similar: use either If goods are not similar: use
- Weighted average (WA) formula - Specific identification (SI) formula
- First-in, first-out (FIFO) formula
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Inventory Systems:
Periodic: Perpetual:
Inventory account updated at the end of the Two accounts are used, both of which are
period (typically this is year-end) with the: updated immediately on purchase and sale of
x new closing balance (physically count) goods:
x old opening balance transferred out. x Inventory account (and any sub-
accounts such as Raw Materials, WIP,
Finished Goods etc); and
Purchases during the period are debited to
purchases account. This is transferred out at x Cost of sales account.
year-end.
Derecognition:
Inventory is derecognised
once it is sold or written-off
(due to theft/being scrapped)
Disclosure of inventory
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Chapter 14
Borrowing Costs
Reference: IAS 23 (including amendments to 10 December 2019)
Contents: Page
1. Introduction 720
2. Scope 720
3. Understanding the terms: borrowing costs and qualifying assets 720
3.1 Borrowing costs 720
3.2 Qualifying assets 721
4. Expensing borrowing costs 721
4.1 Recognition as an expense 721
4.2 Measurement of the expense 722
Example 1: Expensing borrowing costs 722
5. Capitalising borrowing costs 722
5.1 Recognition as an asset 722
5.1.1 Commencement of capitalisation 723
Example 2: Capitalisation of borrowing costs: all criteria met at same time 723
Example 3: Commencement of capitalisation: criteria met at different times 724
Example 4: Commencement of capitalisation: criteria met at different times 724
5.1.2 Suspension of capitalisation 725
Example 5: Suspension of capitalisation: delays in construction 725
5.1.3 Cessation of capitalisation 726
Example 6: Cessation of capitalisation: end of construction 726
5.2 Measurement of the amount capitalised 727
5.2.1 Measurement: specific loans 727
Example 7: Specific loans 727
Example 8: Specific loans: costs paid on specific days 728
Example 9: Specific loans: costs paid evenly over a period 729
Example 10: Specific loans: loan raised before construction begins 730
5.2.2 Measurement: general loans 730
Example 11: General loan: the effect of when payments are made 731
Example 12: General loan: more than one general loan 734
5.2.3 Measurement: Foreign exchange differences 736
Example 13: Foreign exchange differences 736
6. Deferred tax effects of capitalisation of borrowing costs 738
Example 14: Deferred tax on a qualifying asset (cost model): deductible 738
Example 15: Deferred tax on a qualifying asset (cost model): non-deductible 739
7. Disclosure 741
8. Summary 742
Chapter 14 719
Gripping GAAP Borrowing costs
IAS 23 is the standard that sets out how to account for borrowing costs. If borrowing costs are
directly attributable to the acquisition, construction or production of a qualifying asset’, these
borrowing costs must be capitalised as part of the cost of that asset. All other borrowing costs
are expensed when they are incurred. There are two exceptions where the entity may choose
not to capitalise the borrowing costs (see section 2).
Before we capitalise borrowing costs as part of the cost of that asset, we must be sure:
x that the borrowing costs do indeed meet the definition of borrowing costs (‘interest and
other costs that an entity incurs in connection with the borrowing of funds’); and
x that the asset meets the definition of a qualifying asset (‘an asset that necessarily takes a
substantial period of time to get ready for its intended use or sale’).
Both terms are explained in more detail in section 3.
Capitalisation of the borrowing costs incurred takes place from commencement date, ends on
cessation date and must be suspended during ‘extended periods’ during which the entity
‘suspends active development’ of the asset. This is explained in section 5.1.
The measurement of the borrowing costs that must be capitalised can become a little technical
and will depend on whether the borrowings are specific borrowings (i.e. specifically raised to
fund the acquisition, construction production of the asset) or general borrowings (i.e. the entity
simply tapped into the entity’s available borrowings). This is explained in section 5.2.
The capitalisation of borrowing costs has deferred tax implications. Tax authorities generally allow the
deduction of borrowing costs when they are incurred and thus, if we capitalise these costs to the cost
of our asset, a temporary difference will arise on which deferred tax must be recognised. This
deferred tax will reverse as the asset is expensed (e.g. depreciation). This is explained in section 6.
And finally, there are a few small disclosure consequences – see section 7.
Costs that meet the definition of borrowing costs and relate to the ‘acquisition, construction or
production of a qualifying asset’ must be accounted for in terms of IAS 23 (i.e. they must be
capitalised). However, you are not forced to apply IAS 23 if the qualifying asset is:
x ‘measured at fair value’; or is
x inventory that is produced ‘in large quantities on a repetitive basis’. See IAS 23.1 and .4
The reason we are not forced to apply IAS 23 to assets measured at fair value is that it makes
no difference to the closing carrying amount at fair value (the borrowing costs would first be
capitalised and then would be remeasured to fair value). See IAS 23.4 & IAS 23.BC4
The term borrowing costs does not include the costs of equity (e.g. dividends on shares).
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Notice that this list excludes certain costs associated with raising funds or otherwise financing a
qualifying asset. This suggests that these costs that do not appear on this list may not be
capitalised. Borrowing costs therefore exclude:
x cost of raising share capital that is recognised as equity, for example:
- dividends on ordinary share capital;
- dividends on non-redeemable preference share capital (note: dividends on redeemable
preference share capital would be capitalised because redeemable preference shares
are recognised as liabilities and not equity – thus these dividends are recognised as
interest calculated using the effective interest rate method described in IFRS 9);
x cost of using internal funds (e.g. if one uses existing cash resources instead of borrowing
more funds, there is an indirect cost being the lost income, often measured using the
companies weighted average cost of capital or the market interest rates that could
otherwise have been earned).
Borrowing costs is a broad definition that encompasses interest expense. The implication of
this is that any costs recognised as an interest expense in terms of the effective interest rate
method (in IFRS 9 Financial instruments) may also be capitalised. For example: a premium
payable on the redemption of preference shares is recognised as an interest expense using the
effective interest rate method and thus this premium
may also effectively be capitalised. Borrowing costs must be
capitalised to the cost of the
asset if they:
If borrowing costs are incurred as a direct result of x are directly attributable
acquiring, construction or producing an asset that x to the acquisition, construction or
meets the definition of a qualifying asset, these costs production
x of a qualifying asset. IAS 23.8 (reworded)
must be capitalised-there is no choice.
Sometimes proving that borrowing costs are directly attributable is difficult because:
x the borrowings may not have been specifically raised for that asset, but may be general
borrowings (i.e. the entity may have a range of debt at a range of varying interest rates);
x the borrowings may not even be denominated in your local currency (i.e. the borrowings
may be foreign borrowings). See IAS 23.11
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Directly attributable means: if the assets had not been acquired, constructed or produced then
these costs could have been avoided.
x An example of an acquisition is the purchase of a building.
x An example of the construction of an asset is the building of a manufacturing plant.
x An example of the production of an asset is the manufacture of inventory.
Borrowing costs are recognised as part of the cost of the asset (capitalised) during what can
be called the capitalisation period. This capitalisation period has a start date and an end date
and may be broken for a period of time somewhere between these dates:
x Commencement date: capitalisation starts from the date on which certain criteria are met;
x Suspension period: capitalisation must stop temporarily when certain criteria are met;
x Cessation date: capitalisation must stop permanently when certain criteria are met.
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When borrowing costs are capitalised, the carrying amount of the asset will obviously be
increased by the borrowing costs incurred. The cost of these borrowings will eventually
reduce profits, but only when the qualifying asset affects profit or loss (e.g. through the
depreciation expense when the qualifying asset is an item of property, plant and equipment).
It is interesting to note that expenditures on a qualifying asset include only those for which
there have been payments of cash, transfers of other assets or the assumption of interest-
bearing liabilities. Thus, the expenditures incurred for purposes of capitalisation must be
calculated net of any government grants received (IAS 20) and any progress payments
received in relation to the asset. See IAS 23.18
The activity referred to above need not be the physical activity of construction, but could also
be associated technical and administrative work prior to the physical construction.
The date that all three criteria are met is known as the commencement date.
Chapter 14 723
Gripping GAAP Borrowing costs
Required: Discuss when Dawdle Limited may begin capitalising the interest incurred.
Discussion: All three criteria must be met before the entity may begin capitalisation.
x From 30 June 20X5, Dawdle borrowed funds and began incurring borrowing costs, but had not yet met the
other two criteria (i.e. activities had not begun and construction costs were not yet being incurred).
x On 31 August 20X5, Dawdle incurred the cost of acquiring the construction materials and began
construction, thus fulfilling the remaining two criteria.
Dawdle must thus begin capitalising the borrowing costs from the 31 August 20X5, assuming that the basic
recognition criteria were also met (probable inflow of economic benefits and cost is reliably measurable).
The loan was raised specifically to finance the construction of a building, a qualifying asset.
Construction began on 1 February 20X5 and was not yet complete at 31 December 20X5.
Required: Show the related journals in Hoorah’s books for the year ended 31 December 20X5.
31 December 20X5
Finance costs (E) 100 000 x 12 / 12 100 000
Bank/ liability 100 000
Interest on loan incurred first expensed: total interest incurred
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We must temporarily suspend (i.e. stop for a time) the Capitalisation of BCs must
capitalisation of borrowing costs when active development be suspended during:
of a qualifying asset is suspended (i.e. interrupted or
x extended periods during which
delayed) for a long period of time. Let’s call this the x active development is suspended.
IAS 23.20 (reworded)
suspension period.
The capitalisation of borrowing costs will resume (i.e. capitalisation will start again) after the
suspension period has ended, assuming the criteria for capitalisation continue to be met.
In other words, any borrowing costs incurred in a long period during which construction has
been suspended may not be capitalised. But as soon as construction begins again, the
capitalisation of borrowing costs must resume.
When referring to the suspension of borrowing costs, the standard specifically refers to the
words ‘extended periods’ (see grey pop-up above). This means that the capitalisation of
borrowing costs would not be suspended in cases when the delay is only a short delay.
The standard also clarifies that the capitalisation of borrowing costs must not be suspended if
the delay is due to substantial technical or administrative work. It is submitted that an example
of when borrowing costs should continue to be capitalised during a delay that is due to
substantial technical work would be the development and submission of engineering plans
necessary before the construction of the second stage of a particular project may begin.
Required: Discuss how much of the interest may be capitalised during Halt Inn’s year ended
31 December 20X5 assuming that:
x The builders go on strike for a period of two months, during which no progress is made.
x The builders of the hotel had to wait for a month for the cement in the foundations to dry.
Chapter 14 725
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Please note that, after cessation date, the asset is technically no longer a qualifying asset as
it is now in the condition required for use or sale. As such, the criteria for capitalising
borrowing costs are no longer met and thus borrowing costs may not be capitalised.
For an asset completed in parts where each part is capable of being used separately, the
capitalisation of borrowing costs ceases on each part as and when each part is completed.
x An example of an asset that would be capable of being used or sold in parts would be an
office park, where buildings within the park are able to be used by tenants as and when
each building is completed.
x An example of an asset that would not be capable of being used or sold in parts is a
factory comprising a variety of plants (i.e. a variety of parts) but where the operation of the
factory will require full operation of these plants before manufacturing could begin (i.e. all
plants have to be complete and fully-functional before the factory could be used).
Interest of C200 000 (at 10% on a C2 000 000 loan raised specifically for this construction) was
incurred during the 12-month period ended 31 December 20X5.
Required: Explain when the capitalisation of the interest should cease and journalise the interest.
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The formula used to measure the borrowing costs that Measurement of borrowing
may be capitalised depends on the purpose of the costs to be capitalised
borrowings that are being used. depends on whether:
x the borrowings are specific; or
The borrowings being used could have been raised for: x the borrowings are general.
It is important to remember that whilst a bank overdraft facility is often used as general
purpose borrowings, it is also possible for a bank overdraft facility to be arranged specifically
for a qualifying asset. The particular circumstances should, therefore, always be considered
when deciding whether the borrowing is specific or general.
Although borrowing costs are not limited to interest expense, and investment income is not
limited to interest income, this text focuses on interest to simply explain the principles.
The borrowing costs on specific borrowings that must be capitalised would therefore be:
x Total interest incurred on specific borrowings during the construction period:
capital borrowed x interest rate x period borrowed
x Less investment income earned on any surplus borrowings during the construction period:
amount invested x interest rate x period invested.
Chapter 14 727
Gripping GAAP Borrowing costs
When calculating the interest income, you may find that actual amounts invested can be
used. This happens when, for example, the expenditures are infrequent and/ or happen at
the start or end of a period. This means that the investment balance will remain unchanged
for a period of time. (See example 8).
Very often, however, average amounts invested need to be used instead of actual amounts
invested. This happens more frequently when the borrowing is a general borrowing, but can
apply to a specific borrowing where, for example, the expenditure is paid relatively evenly
over a period of time, with the result that the balance on the investment account (being the
surplus borrowings that are invested) is constantly changing. In this case, it is easier and
acceptable to calculate the interest earned on the average investment balance over a period
of time (rather than on the actual balance on a specific day). (See example 9).
The borrowing costs on specific borrowings to be capitalised could thus also be:
x total interest incurred on specific borrowings during the construction period:
capital borrowed x interest rate x period borrowed
x less investment income earned on any surplus borrowings during the construction period:
(investment o/ balance + investment c/ balance) / 2 x interest rate x period invested
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Chapter 14 729
Gripping GAAP Borrowing costs
As the term suggests, a 'general loan' is used for many Borrowing costs to be
purposes. Thus, if we use a general loan to construct a capitalised on general loans
qualifying asset, we cannot simply capitalise all the are measured as:
interest incurred on this loan because not all the interest x Expenditures incurred
will be ‘directly attributable to the qualifying asset’. x Multiplied by the capitalisation rate
If the entity has used a general loan to construct a qualifying asset (QA), the finance costs
eligible for capitalisation are calculated as follows:
x The expenditure on the qualifying asset: For practical purposes, if the expenditure was not
incurred on the first day of a period, but is incurred evenly over this period (e.g. a month),
this expenditure may need to be averaged, for example:
Expenditure incurred evenly during the period
Average expenditure on QA =
2
The expenditures to which the capitalisation rate is applied must be net of any government
grants received (IAS 20), or progress payments received, relating to the asset.
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x The capitalisation rate: The capitalisation rate is the weighted average interest rate on the
general borrowings during that period:
Interest incurred on general borrowings during the period
Capitalisation rate =
Weighted average total general borrowings outstanding during the period
The capitalisation rate to be used is the weighted average interest rate on the general
borrowings during ‘the period’. IAS 23 does not clarify what is meant by ‘the period’ and
thus its meaning is open to interpretation. It is submitted that whilst ‘the period’ could mean
the financial period (e.g. 12 months), a more accurate answer may be achieved if the
actual construction period were used instead (this may be less than 12 months). However,
it may be impractical to calculate the rate for the relevant construction periods for each
qualifying asset and thus it may be necessary to simply calculate and use the rate relevant
to the financial period. This text assumes that ‘the period’ refers to the financial period.
Example 11: General loans – the effect of when payments are made
Bizarre Limited had a C500 000 7% existing general loan outstanding on 1 January 20X5 on
which date it raised an additional general loan of C600 000 at an interest rate of 12.5%.
The terms of the loan agreement include the annual compounding of interest.
Bizarre Limited did not make any repayments on either loan during the year ended 31 December 20X5.
Construction on a building, a qualifying asset, began on 1 January 20X5.
The company incurred the following monthly amounts on the construction:
C per month
1 January – 31 July (7 months) costs paid evenly during this period 50 000
1 August – 30 November (4 months) costs paid evenly during this period 30 000
1 – 31 December (1 month) costs paid evenly during this period 100 000
Required:
A. Calculate the capitalisation rate.
B. Provide the journals for 20X5 assuming that the costs were paid evenly during each of the three
periods referred to above.
C. Provide the journals for 20X5 assuming that the total costs for each of the three periods referred to
above were incurred evenly during each month, but were paid at the end of each month.
D. Show the journals for 20X5 assuming that the total costs for each of the three periods referred to
above were incurred evenly during each month, but were paid on the first day of each month.
Solution 11A: General loans – the effect of when payments are made
Comment:
x There are two borrowings, both of which are general borrowings and therefore our capitalisation rate
is calculated as a weighted average interest rate.
x The loans are general loans and thus the formula is: ‘Capitalisation rate x Expenditures’.
x Since the borrowings are general, investment income is ignored when calculating how much to capitalise.
Capitalisation rate (weighted average interest rate):
= interest incurred on general borrowings/ general borrowings outstanding during the period
= [(C500 000 x 7% x 12 / 12) + (C600 000 x 12.5% x 12 / 12)] / 1 100 000 total borrowings
= 10%
Chapter 14 731
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Solution 11C: General loans – payments are made at the end of each month
Comment: Since the expenditures are incurred at month-end, we calculate the borrowing costs to be
capitalised using the capitalisation rate as follows: Capitalisation rate x Actual expenditures (i.e. a more
accurate measurement is achieved if actual expenditures are used instead – this is important if the
difference between actual and average expenses is considered to be material).
Note 1: This journal would actually be processed separately for each and every payment but is shown
here as a cumulative journal for ease of understanding the ‘big picture’.
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(1) This example involved payments at the end of the month. Thus, when calculating C, B is not added (C = A + 0)
x B is not added if the payments occur at the end of the period (this is relevant to this example)
x B is divided by 2 if the payments occur evenly during the period (not relevant in this example); or
x B is added in full if the payments occur at the beginning of the period (i.e. B is not divided by 2) (not
relevant in this example)
(2) D is only added when the interest is compounded in terms of the loan agreement (31 Dec in this example)
(3) 470 000 + 100 000 + 25 835 = 595 835 (interest accrues annually)
Solution 11D: General loans – payments are made at the beginning of each month
Comment:
x Since the expenditures are incurred at the beginning of each month, we calculate the borrowing costs
to be capitalised as follows:
Capitalisation rate x Actual expenditures
x In other words, a more accurate measurement is achieved if actual expenditures are used instead – this
is important if the difference between actual and average expenses is considered to be material.
Note 1: This journal would actually be processed separately for each and every payment but is shown here
as a cumulative journal for ease of understanding the ‘big picture’.
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Calculations:
(1) This example involved payments at the beginning of the month and thus B is added in full (C = A + B)
x B is added if the payments occur at the beginning of the period (i.e. B is not divided by 2)
x B is divided by 2 if the payments occur evenly during the period (not relevant to this example)
x B is not added if the payments occur at the end of the period (not relevant to this example)
(2) D is only added when interest is compounded per the loan agreement (31 Dec in this example)
(3) 470 000 + 100 000 + 30 585 = 600 585
x The company had the following general loans outstanding during the year:
Bank Loan amount Interest rate Date loan raised Date loan repaid
A Bank C300 000 15% 1 January 20X1 N/A
B Bank C200 000 10% 1 April 20X1 30 September 20X1
C Bank C100 000 12% 1 June 20X1 31 December 20X1
x The interest on the loans was paid for out of other cash reserves as it was charged to the loan.
Required:
a) Calculate the interest incurred for the year ended 31 December 20X1.
b) Calculate the weighted average interest rate (i.e. the capitalisation rate).
c) Calculate the interest to be capitalised.
d) Show the journal entries to account for the interest during the year ended 31 December 20X1.
734 Chapter 14
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a) Interest incurred
A Bank 300 000 x 15% x 12 / 12 = 45 000
B Bank 200 000 x 10% x 6 / 12 = 10 000
C Bank 100 000 x 12% x 7 / 12 = 7 000
62 000
b) Weighted average interest rate:
Interest incurred during the year / Average general loans outstanding during the year:
62 000 / 458 333 = 13.5273%
Average loan balances outstanding during the period of construction (apportioned for time):
A Bank 300 000 x 12 / 12 = 300 000
B Bank 200 000 x 6 / 12 = 100 000
C Bank 100 000 x 7 / 12 = 58 333
458 333
c) Borrowing costs to be capitalised
Chapter 14 735
Gripping GAAP Borrowing costs
This wording appeared to mean that foreign exchange differences could only be capitalised if
they related to the interest element, and that any foreign exchange difference arising on the
principal amount owing would not be capitalised.
The IFRIC was asked to issue an interpretation because many argued that foreign exchange
differences on the principal amount should be capitalised. Despite the confusion, the IFRIC
did not think it was necessary to issue an interpretation, saying the IFRS was clear enough.
However, in its deliberations, the IFRIC clarified the following (see educational footnote, E1, in
the annotated version of IAS 23, which refers to ‘IFRIC Update, January 2008’):
‘Some exchange differences relating to the principal may be regarded as an adjustment to
interest costs. Exchange differences may be considered as an adjustment to borrowing costs,
and hence, taken into account in determining the amount of borrowing costs capitalised, to the
extent that the adjustment does not decrease or increase the interest costs to an amount below
or above, respectively, a notional borrowing cost based on commercial interest rates prevailing
in the functional currency as at the date of initial recognition of the borrowing.’
In other words, this means that the total amount of borrowing costs relating to foreign
borrowings that may be capitalised should lie between the following two amounts:
a) the actual interest costs denominated in the foreign currency translated at the actual
exchange rate on the date on which the expense is incurred; and
b) the notional borrowing costs based on commercial interest rates prevailing in the
functional currency as at the date of initial recognition of the borrowing.
The IFRIC emphasised that ‘how an entity applies IAS 23 to foreign currency borrowings is a
matter of accounting policy requiring the exercise of judgement’. This means that whether the
above principles are applied is an accounting policy choice and should be applied consistently.
736 Chapter 14
Gripping GAAP Borrowing costs
Deon Limited secured foreign borrowings of FC1 000 000 for the construction of the building:
x The loan attracts interest at 5% accrued over the year.
x Interest rates available on similar borrowings in local currency as at the date of initial recognition of
the foreign loan were 10%.
x The capital plus all interest owing was repaid on 31 December 20X0.
x The foreign currency rates for the 20X0 year were as follows:
1 January 20X0 FC1 : LC5
31 December 20X0 FC1 : LC7
Average for 20X0 FC1 : LC6
Required: Calculate the amount of borrowing costs to be capitalised to the corporate head-office and
show all related journals for the year-ended 31 December 20X0.
Chapter 14 737
Gripping GAAP Borrowing costs
The tax authorities generally allow deductions for interest in the period in which it is incurred.
This means that if interest (or part thereof) was capitalised to the cost of a qualifying asset, a
difference between the asset’s carrying amount (which includes the borrowing cost) and its
tax base (which will not include the borrowing costs) will arise in the year in which the asset is
brought into use. This difference will gradually reverse over the life of the qualifying asset.
Journals:
738 Chapter 14
Gripping GAAP Borrowing costs
CA TB TD DT
O/balance 20X1 0 0 0 0
Construction Given 300 000 300 000
Borrowing costs W1 and Note 1 92 000 92 000
Tax deduction 0 (92 000)
Depreciation 392 000 x 20% x3/12 (19 600) 0 (26 220) Cr DT; Dr TE
Deduction 300 000 x 20% x3/12 0 (15 000)
C/balance 20X1 372 400 285 000 (87 400) (26 220) L
Note 1: The tax base relating to the borrowing costs starts off at C92 000 but is then reduced by
C92 000 because the total borrowing costs are allowed as a deduction now (in 20X1).
The net effect is that the tax base relating to borrowing costs at the end of the year is now nil
(because there are no future deductions that will be allowed in this regard).
W3. Current income tax C
Chapter 14 739
Gripping GAAP Borrowing costs
CA TB TD DT
O/balance: 20X1 0 0 0 0
Construction Given; Note 1 300 000 0 (300 000) 0 Exempt
Borrowing costs W1 and Note 2 92 000 92 000 0 0
Tax deduction W1 and Note 2 0 (92 000) (92 000) (27 600) Cr DT; Dr TE
Depreciation 392 000 x 20% x 3/12 (19 600) 0
- cost 300 000 x 20% x 3/12 (15 000) 0 15 000 0 Exempt
- b/costs 92 000 x 20% x 3/12 (4 600) 0 4 600 1 380 Dr DT; Cr TE
Note 1. The tax base relating to the construction costs is nil since these are not allowed as a deduction.
Since the carrying amount is the cost of construction, a taxable temporary difference arises.
Since the taxable temporary difference arises on acquisition, it is a taxable temporary
difference that is exempt in terms of IAS 12.15. This is because the asset does not arise by
way of a business combination and at the time of the transaction (the acquisition of the plant),
neither accounting profits nor taxable profits are affected.
Note 2: The tax base relating to the borrowing costs starts off at C92 000 but is then reduced by
C92 000 because the total borrowing costs are allowed as a deduction now (in 20X1).
The net effect is that the tax base relating to borrowing costs at the end of the year is now nil
(because there are no future deductions that will be allowed in this regard).
Since the carrying amount is the cost of borrowing costs that are capitalised, a taxable
temporary difference arises.
This is a temporary difference which leads to deferred tax (i.e. it is not an exempt temporary
difference since it does not relate to a temporary difference that arises on acquisition of an asset).
740 Chapter 14
Gripping GAAP Borrowing costs
Proof: proof that the differences are permanent in nature and therefore exempt from deferred tax:
The amount of finance costs expensed in profit or loss must be presented on the face of the statement
of comprehensive income (this is an IAS 1 requirement – not an IAS 23 requirement). See IAS 1.82(b)
Entity name
Notes to the financial statements (extracts)
For the year ended 31 December 20X5
20X5 20X4
C C
3. Finance costs
Interest incurred Z Z
Less borrowing costs capitalised IAS 23 requirement (Y) (Y)
Finance cost expense IAS 1 requirement X X
Borrowing costs capitalised were measured using a capitalisation rate of 15%.
Entity name
Statement of comprehensive income (extracts)
For the year ended 31 December 20X5
20X5 20X4
Note C C
Profit before finance costs x x
Finance costs IAS 1 requirement 3. x x
Profit before tax x x
Income tax expense x x
Profit for the year x x
Other comprehensive income for the year x x
Total comprehensive income for the year x x
Chapter 14 741
Gripping GAAP Borrowing costs
8. Summary
IAS 23
Borrowing costs
Qualifying asset
x those that take a long time to get ready
Measurement
Construction period
Disclosure
The amount of BCs capitalised IAS 23
The amount of BCs expensed IAS 1
For general loans only: the capitalisation rate IAS 23
742 Chapter 14
Gripping GAAP Borrowing costs
Measuring the borrowing costs to be capitalised is sometimes more fiddly than it first appears.
The basic questions that one needs to answer when measuring the borrowing costs to be
capitalised include:
x are the borrowings specific or general or is there a mix of both specific and general?
x is the borrowing a precise amount (e.g. a loan) or does it increase as expenditure is paid for
(e.g. a bank overdraft)?
x are the expenditures (on which interest is incurred) incurred evenly or at the beginning or end
of a period or at haphazard times during a period?
x how long are the periods during which capitalisation is allowed?
In considering whether the borrowings are specific or general or whether there is a mix of both
specific and general, remember that:
x where the borrowings are specific:
x you will need the actual rate of interest/s charged on the borrowing/s; and
x you will need to know if any surplus borrowings were invested upon which investment
income was earned (if so, remember to reduce the interest expense by the investment
income);
x where the borrowings are general:
x you will need the weighted average rate of interest charged (assuming there is more than
one general borrowing outstanding during the period); and
x you will need the actual expenditure.
In considering whether the borrowing is a static amount (e.g. a loan) or whether it increases as
expenditure is paid for (e.g. a bank overdraft), bear in mind that:
x if the borrowing is a loan (a static amount), you will use the principal sum; and
x if the borrowing is an overdraft (a fluctuating amount), you will use the relevant/ actual
expenditures incurred on the construction of the qualifying asset and will need to know when
they were incurred (or whether they were incurred relatively evenly).
In assessing whether the expenditures (on which interest is incurred) are incurred evenly or at
the beginning or end of a period or at haphazard times during a period, bear in mind that:
x interest expense can be measured using average borrowing balances if the costs are incurred
evenly, whereas actual borrowing balances should be used (whether specific or general
borrowings) if costs are incurred at the beginning or end of a period; and
x if the investment income is interest, it should be measured using average investment balances
if the costs are incurred evenly, whereas actual investment balances should be used (if it is a
specific borrowing) if costs are incurred at the beginning or end of a period.
The construction period (during which capitalisation of borrowing costs takes place):
x starts on the commencement date:
borrowings may be outstanding (and incurring interest) before commencement date in which
case interest expense (and investment income on any surplus funds invested) up to
commencement date must be ignored when calculating the portion to be capitalised;
x ends on the cessation date:
borrowings may be outstanding (and incurring interest) after cessation date in which case
interest expense (and investment income on any surplus funds invested) after cessation date
must be ignored when calculating the portion to be capitalised; and
x is put on hold during a suspension period between these two dates:
borrowings may be outstanding (and incurring interest) during a suspension period in which
case interest expense (and investment income on any surplus funds invested) during this
period must be ignored when calculating the portion to be capitalised.
Chapter 14 743
Gripping GAAP Government grants and government assistance
Chapter 15
Government Grants and Government Assistance
Reference: IAS 20, SIC 10, IFRS 13 and IAS 12 (incl. any amendments to 1 December 2019)
Contents: Page
1. Introduction 746
2. Scope 746
3. Recognition, measurement and presentation of government grants 747
3.1 Overview 747
3.2 Grants related to immediate financial support or past expenses 748
3.2.1 Overview 748
3.2.2 Recognition 748
3.2.3 Measurement 749
3.2.4 Presentation 749
Example 1: Grant for past expenses 749
3.3 Grant related to future expenses 750
3.3.1 Overview 750
3.3.2 Recognition 750
3.3.3 Measurement 750
3.3.4 Presentation 750
Example 2: Grant for future expenses - conditions met over two years 750
3.4 Grants involving assets 751
3.4.1 Overview 751
3.4.2 Recognition and measurement of a grant of a non-monetary asset 752
3.4.2.1 Initial recognition and measurement of a non-monetary asset 752
Example 3: Grant is a non-monetary asset: measurement: fair 752
value or nominal amount
3.4.2.2 Subsequent recognition and measurement related to a non- 752
monetary asset
3.4.3 Recognition and measurement of a grant of a monetary asset 753
3.4.3.1 Initial recognition and measurement of a monetary asset 753
3.4.3.2 Subsequent recognition and measurement of a monetary asset 753
Example 4: Monetary grant related to a depreciable asset – 754
credit to income or asset
Example 5: Monetary grant is a package involving a non- 755
depreciable asset and future costs that are not
measurable
Example 6: Monetary grant is a package involving a non- 756
depreciable asset and future costs that are
measurable
Example 7: Monetary grant is a package involving a non- 757
depreciable asset and a depreciable asset
3.4.4 Presentation of a grant related to assets 758
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Chapter 15 745
Gripping GAAP Government grants and government assistance
It is often provided to assist businesses in starting up. This obviously benefits the business but
also benefits the government through the creation of jobs and thus a larger base of taxpayers.
Government assistance is
Government assistance can come in many forms, for defined as:
example: grants of income, grants of a non-monetary x action by government
asset, low interest loans or even advice. These grants x designed to provide an economic
are often referred to by other names such as subsidies, benefit to
subventions and premiums. x a specific entity (or range of
entities) that
x qualifies under certain criteria
From an accounting perspective, we split government x excluding indirect benefits
assistance into: provided through action affecting
x ‘government grants’ (e.g. a grant of cash or another general trading conditions.
IAS 20.3 (reworded)
asset); and
x ‘other government assistance’ (e.g. the receipt of government advice).
Whereas government grants are recognised and disclosed, Government grants are
other government assistance (i.e. ‘government assistance’ defined as:
that does not meet the definition of a ‘government grant’) will x government assistance that is a
x transfer of resources
only be disclosed.
x in exchange for compliance with
conditions (past/ future) relating to
IAS 20, however, does not cover: government actions that operating activities of the entity
result in indirect benefits received by an entity. For instance, x excluding government assistance
a government may construct roads and provide electricity that cannot be reasonably valued
and transactions that cannot be
and water to areas that were previously underdeveloped: separated from the entity’s
these actions benefit the trading conditions of all entities normal trading transactions.
IAS 20.3 (reworded)
operating businesses in that area and are not provided to a
specific entity. See IAS 20.3
According to the definition, government grants only include government assistance in the form
of a transfer of resources that are in exchange for the entity meeting certain conditions (see
‘government grant’ definition in the pop-up above). Furthermore, the term government grants
only includes government assistance an entity receives if:
x we can attach a value to it (e.g. we do not recognise ‘advice from government’ as a
government grant, because it is not possible to attach a value to it); and
x it can be distinguished from the normal trading transactions with the government. See IAS 20.3
746 Chapter 15
Gripping GAAP Government grants and government assistance
Government assistance is
3.1 Overview (IAS 20.7 – 29) split into two categories:
x government grants:
Government grants are effectively a form of income recognised
- recognised and disclosed
in profit or loss. However, please note:
x other government assistance:
x Only government assistance that meets the definition of a - not recognised but disclosed.
‘government grant’ would potentially be recognised:
The grant must involve a transfer of resources and these must be in exchange for the meeting
of certain conditions (see complete definition in the pop-up in section 1) and
x a ‘government grant’, as defined, will only be recognised in profit or loss if it is ‘reasonably
assured’ that the conditions that the entity must meet in order to qualify for the grant will indeed
be met and that the grant will eventually be received. See IAS 20.3 & .7
The mere fact that a grant is received does not mean we can Government grants are only
recognise the grant as income because we normally have to recognised when there is:
meet certain conditions to ‘earn’ the grant. Conversely, meeting x reasonable assurance that
the pre-requisite conditions doesn’t always mean the grant will - the entity will comply with the
ever be received. Thus, there must be reasonable assurance conditions; and
- the grants will be received. See IAS 20.7
that both these recognition criteria will be met. See IAS 20.7
IAS 20 refers to the recognition of government grants on both the capital approach
(recognising it directly in equity, without first recognising it in profit or loss), and the income
approach. However, IAS 20 states that we may only use the income approach. See IAS 20.13
Government grants are
Recognising government grants on the income approach, recognised on the income
means that the grant must be recognised in profit or loss on basis:
a rational basis over the same periods in which the entity x in profit or loss (directly/ indirectly)
x on a rational basis
recognises as expenses the costs that the grant was
x in the same period/s in which the
intended to compensate. See IAS 20.12 costs that the grant was intended
to reduce are expensed. See IAS 20.12
There are two ways in which the grant could be recognised
in profit or loss. Either by: We can recognise a grant
x recognising it directly as ‘grant income’, or in P/L by either:
x crediting income (direct income); or
x recognising it indirectly as income, by way of a
x crediting asset/ expense (indirect
‘reduced expense’, through crediting the cost that the See IAS 20.24 & .29
income).
grant was intended to subsidise (i.e. an asset, such as
plant, or an expense, such as wages) See IAS 20.24 and .29
Grants related to assets are
defined as: IAS 20.3 reworded
IAS 20 refers to three categories of government grants: x a government grant
x A grant related to an asset: This is a grant of either: x with a primary condition requiring:
- a long-term (i.e. non-monetary) asset (e.g. a tangible - the qualifying entity to
building or an intangible right); or - purchase, construct or otherwise
acquire long-term assets;
- cash (i.e. monetary asset) that must be used to acquire
x and may have a secondary condition/s
some sort of long-term asset.
restricting:
x A grant related to income: This is a grant of cash that - the type or location of the assets,
does not involve the acquisition of an asset, but is and/ or
simply received as either: - the periods during which the
assets are to be acquired or held.
- immediate financial support or compensation for
past expenses; or as
A grant related to income is
- compensation for future expenses to be incurred. defined as: IAS 20.3 reworded
x A grant related to a loan: This is a grant that could either be: x a government grant that is
- a forgivable loan (i.e. we might not pay back); or a x not a grant related to an asset.
- low-interest loan.
Chapter 15 747
Gripping GAAP Government grants and government assistance
The form of the grant will affect its measurement. For example, a grant in the form of:
x a low-interest loan is measured in terms of IFRS 9 Financial instruments; See IAS 20.10A
x an actual non-monetary asset is measured at the asset’s Recognition, measurement &
fair value in terms of IFRS 13 Fair value measurement, presentation of government
grants depends on whether:
or a nominal amount; See IAS 20.23 x the grant relates to income, for:
x cash is measured at its cash amount. - immediate support/past expenses,
- future expenses;
The recognition, measurement and presentation of x the grant relates to assets;
government grants will be discussed in respect of each x the grant relates to loans; or
of these forms of grants: x the grant is a combination (a package)
3.2 Grants related to immediate financial support or past expenses (IAS 20.20)
3.2.1 Overview
Grants are often offered to entities on a prospective basis, to encourage some future action.
However, it can happen that an entity qualifies for a government grant on a retrospective basis
(i.e. the entity having already met all conditions, in the past). In other words, there are no
future conditions that the entity still has to meet. These grants could come in the form of:
x immediate financial support, or
x relief from past expenses or losses (i.e. the grant relates to expenses or losses already incurred).
3.2.2 Recognition (IAS 20.12, .20 - 22, .26 & .29) Grants for immediate
financial support/ past
In the case of a grant in the form of immediate financial expenses are recognised:
support or as relief from past expenses or losses, since the x in profit or loss
conditions have already been met, it is reasonably assured - as a credit to expense; or
that the grant will be received and thus the grant transaction - as a credit to grant income
must be recognised. See IAS 20.7 x when the grant is receivable.
See IAS 20.20 - 22
In terms of IAS 20’s income approach, we must recognise a relevant portion of the grant in profit or
loss on a systematic basis over the periods in which the entity expenses the costs that the grant
intended to compensate. See IAS 20.7 & .16
However, in the case of grants relating to ‘immediate financial support’, or relating to ‘relief
from expenses or losses already incurred’, the conditions have already been met and there
are thus no future costs to be incurred. For this reason, these types of grants are simply
recognised as income in the period it becomes receivable. See IAS 20.20 - 22
When recognising a grant for immediate financial support, we would credit grant income.
However, if the grant provides relief from past expenses or losses, we could either credit
grant income or credit the related expense (e.g. the grant could have been given to an entity
as compensation for a wage bill incurred in a prior year, in which case we could credit grant
income or credit the current year’s wages bill…even though we were being granted relief from
a wage bill that was incurred in a prior year). See IAS 20.29
However, we must always remember to identify any further hidden conditions attaching to the
grant as this will obviously affect when to recognise the income. If there are indeed further
conditions, then we would have to first recognise the grant as a credit to a deferred income
account, where this will then make its way into profit or loss when the conditions are met and
the related costs are incurred. We may even need to simultaneously recognise a provision
(or disclose a contingent liability) for any future costs in meeting these conditions. See IAS 20.11
748 Chapter 15
Gripping GAAP Government grants and government assistance
The benefit of the grant that relates to immediate financial support or to compensate for past
expenses must be presented in profit or loss, either as:
x income, presented either as:
Grants for immediate financial
- a separate line item for grant income; or support/ past expenses are
- part of ‘other income’; or as a presented:
x reduction of the related expense. See IAS 20.29 x in P/L,
x either as
- income (separate income line item
A grant for immediate financial support does not relate to any or part of ‘other income’); or
particular expense and is thus presented as income. - reduction of the expense. See IAS 20.29
A grant to compensate for a past expense or loss that was recognised in a prior year, where it is a
recurring type of expense (e.g. electricity), may be presented as a reduction of that expense in the
current year (or as grant income, if preferred). However, if the past expense was a once-off expense
and thus has not recurred (perhaps a legal expense), the grant cannot be credited to an expense
(because it does not exist in the current year) and so it would simply be presented as income.
Giveme Limited incurred C30 000 of these specified labour costs during its year ended 31 December 20X0
and presented the government with the requisite audited statement of expenses on 31 March 20X1 as proof.
Required: Show Giveme Limited’s journals assuming the grant is considered receivable upon
presentation of the audited financial statements and:
A. the entity recognises the grant as income;
B. The entity recognises the grant as a reduction in the expenses.
Chapter 15 749
Gripping GAAP Government grants and government assistance
It sometimes happens that the government gives an entity cash, to either help subsidise
future expenses that the entity is expecting to incur or even to encourage the entity to incur
certain expenses that it might have otherwise avoided. Such grants, as with all other grants,
may come with certain conditions, which need to be considered when deciding when to
recognise the grant income and how much to measure it at.
Government grants are recognised when the recognition criteria are met (i.e. it is reasonably
assured that the conditions will be met and thus that the grant will be received). See IAS 20.7
As soon as the recognition criteria are met, we will begin to recognise the grant:
x as income Grants for future expenses
x in profit or loss are recognised:
x on a systematic basis over the periods in which x in profit or loss Note
x the entity expenses the costs that the grant intends - as a credit to expense; or
to compensate. IAS 20.12 reworded - as a credit to grant income
x when these related future costs are
Grants that are to be used to subsidise certain future expensed. See IAS 20.12 & .17
expenditure should thus be recognised in profit or loss Note: if a grant is received before the
costs are incurred, credit deferred
when that related expenditure is incurred. IAS 20.12 & .17 income (liability) before crediting P/L.
When recognising these grants in profit or loss, we could either recognise it directly as income by
crediting grant income or indirectly as income by crediting the related expense instead. See IAS 20.29
As always, we must remember that there may be further conditions attaching to the grant and
we need to use our professional judgement when deciding when to recognise the income. If
we receive a grant before it is reasonably assured that the conditions will be met, or before
the related costs are incurred, we would have to first recognise the grant as a credit to a
deferred income account. This deferred grant income will then be transferred to profit or loss
when the conditions are met and the related costs are incurred.
3.3.3 Measurement (IAS 20.12 & .17) Grants for future expenses
are measured as follows:
The entire grant for future expenses is measured at the x The portion of the amount
total amount of cash received, but the portion of this grant received/receivable to be recognised
in P/L is measured
that is recognised as income in profit or loss is measured
x systematically
on a basis that reflects the pattern in which the expenses
x over the period/s
are expected to be recognised. See IAS 20.12 & .17
x that these future costs are
expensed. See IAS 20.12
3.3.4 Presentation (IAS 20.29)
Grants for future expenses
The benefit of a grant that relates to future expenses are presented:
must be presented in profit or loss, either: x in P/L,
x as income, presented either as: x either as
- a separate line item for grant income; or - income (separate income line item
or part of ‘other income’); or
- part of ‘other income’; or
- reduction of the expense. See IAS 20.29
x as a reduction of the related expense. See IAS 20.29
Example 2: Grant for future expenses - conditions met over two years
An entity receives a cash grant of C10 000 from the government to contribute 10% towards
future specified wages totalling C100 000 (future wages: 100 000 x 10% relief).
x The grant was received on 1 January 20X1 based on the fact that certain pre-conditions
were met in 20X0. All conditions attaching to the grant (with the exception of the
incurring of the future wages) had all been met on date of receipt.
750 Chapter 15
Gripping GAAP Government grants and government assistance
Solution 2: Grant for future expenses - conditions met over two years
Comment: In this example, the conditions were met over 2 years and thus the deferred income was
amortised (transferred) to profit or loss over the 2 years, apportioned based on the expenditure incurred
per year relative to the total expenditure to be incurred.
x In Part A, the profit or loss is adjusted by recognising an income account; whereas
x In Part B, it is adjusted by reducing an expense account.
x Notice how the effect on overall profits is the same irrespective of the company policy.
Part A Part B
1 January 20X1 Dr/ (Cr) Dr/ (Cr)
Bank (A) 10 000 10 000
Deferred grant income (L) (10 000) (10 000)
Recognising a government grant intended to reduce future expenses
31 December 20X1
Wage expenditure (E) 20 000 20 000
Bank/ Wages payable (20 000) (20 000)
Wage expenditure incurred
Deferred grant income (L) C10 000 x C20 000 / C100 000 2 000 2 000
Grant income (I) (2 000) N/A
Wage expenditure (E) N/A (2 000)
Recognising 20% of the grant in P/L since 20% of the costs that the
grant was intended to compensate have been incurred
31 December 20X2
Wage expenditure (E) 80 000 80 000
Bank/ Wages payable (80 000) (80 000)
Wage expenditure incurred
Deferred grant income (L) C10 000 x C80 000 / C100 000 8 000 8 000
Grant income (I) Recognised directly as income (8 000) N/A
Wage expenditure (E) N/A (8 000)
Recognising 80% of the grant in P/L since 80% of the costs that the
grant was intended to compensate have been incurred
When dealing with grants that involve assets, we will find that the recognition and
measurement thereof is fairly inter-related and will be affected by whether the grant is
received as the non-monetary asset itself or whether the grant is received as a monetary
asset. The subsequent recognition and measurement as grant income in profit or loss is
affected by whether the related non-monetary asset is depreciable or non-depreciable.
Chapter 15 751
Gripping GAAP Government grants and government assistance
If the non-monetary asset was initially measured at the nominal amount paid, then it is submitted
that, assuming there were no further conditions attaching to the grant, the receipt of the non-
monetary asset should have been recognised immediately as grant income in profit or loss. In this
case, there would be no further subsequent recognition and measurement issues to consider.
However, if the non-monetary asset was initially measured at the asset’s fair value, then we
would have initially recognised the grant as deferred grant income (a liability).
Although the grant was initially recognised as deferred grant income, all grants must eventually be
recognised in profit or loss. This subsequent transfer of the deferred grant income to profit or loss
(debit deferred grant income and credit grant income/ related expense) must be done in a way that
the grant income matches the pattern in which the asset is expensed. The subsequent recognition
and measurement of the grant is thus affected by whether the asset is depreciable or not.
752 Chapter 15
Gripping GAAP Government grants and government assistance
If the asset is depreciable, then the grant initially recognised as deferred grant income will be
subsequently recognised as income in profit or loss in a manner that reflects the pattern in
which the non-monetary asset is expensed. In other words, the grant income will be
recognised and measured at the same rate as the related depreciation charge.
The journal for subsequent recognition of deferred grant income as income in profit or loss is:
x debit: deferred grant income (L), and
x credit: grant income (I).
As with all grants, we must eventually recognise the grant as income in profit or loss.
The subsequent recognition and measurement is affected by whether the grant of a monetary
asset was initially recognised as:
x a reduction to the cost of the related non-monetary asset; or
x deferred grant income.
If the monetary asset was initially recognised as a reduction in the cost of a depreciable non-
monetary asset, then no further journal is needed to recognise this grant as grant income in
profit or loss. This is because the grant will be automatically and indirectly recognised as
grant income in profit or loss (i.e. indirect income) by way of a reduced depreciation expense.
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Gripping GAAP Government grants and government assistance
However, if the monetary asset was initially recognised as A grant of a monetary asset is
deferred grant income, it will need to be subsequently subsequently recognised &
recognised as grant income in profit or loss. measured in P/L as follows:
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Gripping GAAP Government grants and government assistance
Part A Part B
31 December 20X2 Dr/ (Cr) Dr/ (Cr)
Depreciation: plant (E) A: (90 000 – 0) / 3 years 30 000 26 000
Nuclear plant: acc depr (-A) B: (90 000 – 12 000 – 0) / 3 years (30 000) (26 000)
Depreciation on plant
Deferred grant income (L) 12 000 / 3 years 4 000 N/A
Grant income (I)/ Depreciation (E) (4 000)
Grant income recognised on the same basis as plant depreciation
31 December 20X3
Depreciation: plant (E) A: (90 000 – 0) / 3 years 30 000 26 000
Nuclear plant: acc depr (-A) B: (90 000 – 12 000 – 0) / 3 yrs (30 000) (26 000)
Depreciation on plant
Deferred grant income (L) 12 000 / 3 years 4 000 N/A
Grant income (I)/ Depreciation (E) (4 000)
Grant income recognised on the same basis as plant depreciation
Comment:
x This example involves recording the receipt of a grant before we can recognise it in profit or loss. Thus, it
shows that we initially recognise the receipt as deferred income (liability) until the conditions are met.
x Then the example shows that, once we are reasonably assured the conditions will be met, the
deferred grant income must begin to be recognised in profit or loss in a way that matches the
expensing of the related costs. In this example, the related cost is the cost of acquiring the plant, so
the grant is recognised in profit or loss from the date the plant is available for use (i.e. as the cost of
the plant is recognised in profit or loss as depreciation).
x From the date the plant is available for use (and thus depreciated), the entity can either:
- transfer the entire balance on the deferred grant income to the cost of the acquired non-monetary
asset (Part B: debit deferred income and credit plant), in which case the grant is automatically
recognised in profit or loss over the life of the asset by way of a reduced depreciation charge; or
- gradually transfer the deferred grant income to profit or loss over the life of the asset (Part A), in
which case the entity can present this either as:
- a credit to grant income; or
- a credit to the depreciation expense (this will also appear as a reduced depreciation charge).
The effect on profit or loss is the same (C26 000) no matter which of these options the entity selects.
Solution 5: Monetary grant for a non-depreciable asset and future non-measurable costs
Comment: Since we could not measure the cost associated with one of the two conditions, we could not
separate the grant into the portions relating to these two conditions. This also meant that the grant was
best recognised as income on the straight-line basis over the period that the second condition is met.
Answer:
This cash grant was received to buy a non-monetary asset and to assist with future costs.
Normally there is a choice in how to recognise grants received to buy non-monetary assets:
x the grant could first be recognised as deferred income (liability) and then this deferred income could be
transferred out and recognised in profit or loss over the life of the asset, or
x the grant could first be recognised as a deduction against the non-monetary asset and then be recognised
indirectly in profit or loss over the life of the asset by way of a reduced depreciation expense.
But, since the land is non-depreciable, it is not possible to choose between these two methods. Instead, the grant
received must first be recognised as deferred income, and then as income when the costs of meeting the condition
are recognised in profit or loss. This means that, since the condition relating to acquiring land has been met, the
portion of the grant relating to the land acquisition may, technically, now be recognised as income.
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However, we are unable to calculate the portion of the grant that relates to the land acquisition because the grant
also assists with future costs, which are not reliably measurable. In this case, since the grant is to assist with these
costs over a 5-year period, an appropriate method of recognising the grant as income is the straight-line basis
over the 5-years during which the employee costs will be recognised in profit or loss.
The journals for a grant for a non-depreciable asset and future expenses that are not reliably measurable:
Solution 6: Monetary grant for a non-depreciable asset and measurable future costs
Comment:
x IAS 20 states that grant income must be recognised in a manner that matches the periods in which the costs to
meet the obligation are borne. However, this grant has two conditions: purchasing land and clearing vegetation.
IAS 20 also states that we must take care ‘in identifying the conditions giving rise to costs and expenses
which determine the periods over which the grant will be earned’. It also states that ‘it may be appropriate to
allocate part of a grant on one basis and part on another. See IAS 20.18-19
x Thus, since there are 2 conditions, it may be appropriate to allocate part of the grant to each of these
conditions, measured based on their relative costs of C1 700 000 and C300 000. If so, the grant would be
apportioned between the acquisition of the land, C510 000 (C600 000 x C1 700 000 / C2 000 000), and the
clearing of the land, C90 000. Compare this example to example 5, where an allocation was not possible
because the cost associated with one of the conditions (future employee costs) were immeasurable.
- Since land is non-depreciable, the portion of the grant relating to it (C510 000) would be recognised as
grant income immediately (assuming this portion of the grant did not become repayable if the second
condition was not met). Although the entity’s accounting policy is to recognise grants as a credit to the
asset, this does not apply in the case of an asset that is non-depreciable, because that would mean the
grant would never be recognised in profit or loss.
- The portion of the grant relating to clearing vegetation (C90 000) would be deferred and recognised as
grant income when the related costs are incurred.
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Grants related to assets can be presented on the statement of financial position either:
x Gross, as deferred grant income, or
x Net, as a reduction of the carrying amount of the related non-monetary asset. See IAS 20.24
Although the presentation can either be on a gross or net basis, IAS 20 prefers the deferred
grant income and asset to be presented gross (i.e. separately).
The presentation in the statement of cash flows of the receipt of the grant is ideally shown
separately from the outflow relating to the acquisition of the related asset. See IAS 20.28
Grants needs not be in the form of an asset – the grant A forgivable loan is defined as
a loan:
could consist of a waiver of debt or a cheap loan. These
are referred to as: x the repayment of which the lender
may waive
x forgivable loans, and
x assuming certain conditions are met.
x low-interest loans. IAS 20.3 Reworded
A forgivable loan from government that is recognised as x Forgivable loan: measured as amount
a grant is measured at the amount that is reasonably reasonably assured of being waived.
assured of being forgiven (waived). See IAS 20.10 x Low-interest loan: measured as the
difference between:
A low-interest loan received from government must be the CA in terms of IFRS 9 &
measured in terms of IFRS 9 Financial instruments. The the amount received.
benefit of the low-interest rate is recognised as a
government grant, measured at the difference between the carrying amount (measured in terms
of IFRS 9) and the actual loan proceeds received. See IAS 20.10A
The amount of the grant is then ‘recognised in profit or loss on a systematic basis over the
period/s in which the entity recognises as expenses the costs for which the grant is intended to
compensate’. See IAS 20.16
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Notice how the effect on overall profits will always be the same under either option.
Required: Show the journals for the year ended 31 December 20X1 assuming:
A. all conditions were met by 1 January 20X1.
B. all conditions were met by 30 September 20X1.
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Gripping GAAP Government grants and government assistance
The entity does not intend to trade this loan and it was not designated as fair value through profit or loss on
acquisition. The loan is therefore measured at amortised cost.
Required: Show the journal entries for the year ended 31 December 20X1 assuming:
A. the low interest rate was granted on certain conditions, which were all met by 1 January 20X1.
B. the low interest rate was granted to meet general running costs over a 2-year period and the company
policy is to recognise grants as a credit to income.
C. the low interest rate was granted to meet salary costs over a 2-year period and the company policy is to
recognise grants as a credit to the related expense.
Notice:
x The effect on profit or loss over the 3 years will be: 25 971
Interest expense: over 3 years (20X1-20X3) 9 464 + 10 411 + 11 452 (W3) 31 327
Grant income: recognised in full in first year (20X1) 20X1: 5 356 (Jnl) (5 356)
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Gripping GAAP Government grants and government assistance
Solution 9B: Grant related to a low-interest loan: conditions met later: credit to income
1 January 20X1 Debit Credit
Bank Given 100 000
Loan: government (L) W2 94 644
Deferred grant income (L) Amt received: 100 000 – CA: 94 644 5 356
Government loan raised at 8% interest when market rate is 10%.
Conditions to this low-interest loan were not met on date of receipt so
the low-interest benefit is first credited to deferred income
31 December 20X1
Interest expense (E) W3 9 464
Loan: government (L) 9 464
Interest on the government loan calculated at the market interest rate
Deferred grant income (L) 5 356 / 2 years 2 678
Grant income (I) 2 678
Grant credited to income over the 2-year condition: first year met
Notice:
x The effect on profit or loss over the 3 years will be: 25 971
Interest expense: over 3 years (20X1-20X3) 9 464 + 10 411 + 11 452 (W3) 31 327
Grant income: recognised over 2 years (20X1–20X2) 20X1: 2 678 + 20X2: 2 678 (5 356)
Solution 9C: Grant related to a low-interest loan: conditions met later: credit to expense
1 January 20X1 Debit Credit
Bank Given 100 000
Loan: government (L) W2 94 644
Deferred grant income (L) Amt received: 100 000 – CA: 94 644 5 356
Government loan raised at 8% interest when market rate is 10%.
Conditions to this loan were not met on date of receipt so the low-interest
benefit is first deferred
31 December 20X1
Interest expense (E) W3 9 464
Loan: government (L) 9 464
Interest on the government loan calculated at the market interest rate
Deferred grant income (L) 5 356 / 2 years 2 678
Salary expense (E) 2 678
Grant credited to related expense over the 2 yr condition: first year met
Notice:
x The effect on profit or loss over the 3 years will be: 25 971
Interest expense: over 3 years (20X1-20X3) 9 464 + 10 411 + 11 452 31 327
Salary expense: decrease over 2 years (20X1-20X2) 20X1: 2 678 + 20X2: 2 678 (5 356)
Each of the abovementioned portions of the grant may also come with their own unique set of
conditions. Depending on the materiality of each of these portions, it may be more
appropriate to recognise each portion in the grant package on a different basis, depending
what the grant relates to (as explained in earlier sections and examples 5 - 7).
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Each portion of a grant package is recognised separately. For example, the part of the grant
that relates to:
x past expenses, should be recognised in profit or loss:
in the same period that the grant becomes receivable and conditions are met; See IAS 20.20
x general and immediate financial support, should be recognised in profit or loss:
in the same period that the grant becomes receivable and conditions are met; See IAS 20.20
x future expenses, should be recognised in profit or loss:
in a way that reflects the pattern of future expenses; and
x an asset, should generally be recognised in profit or loss:
in a way that reflects the pattern of depreciation.
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Gripping GAAP Government grants and government assistance
Where a grant becomes repayable, the treatment depends on whether the grant related to
expenses or assets.
If the original grant related to expenses, the repayment of the grant (credit bank) is:
x first debited against the balance in the deferred income account, if any; and
x then debited to profit or loss (if a further debit is required). See IAS 20.32
If the original grant related to an asset, the repayment of the grant (credit bank) is either:
x debited against the balance on the deferred income account, if any; or
x debited to the balance on the asset account. See IAS 20.32
If we have to repay a grant that related to a non-monetary asset, and as a result had to debit
the asset's cost account with the amount of the repayment, we will have effectively increased
its carrying amount. We thus need to check whether the asset's carrying amount has
increased above its recoverable amount.
If the asset’s carrying amount has increased above its recoverable amount, it will need to be
adjusted by processing an impairment loss. Please watch out for this! Impairments are
explained in more detail in Chapter 11. See IAS 20.33
Part A Part B
1 January 20X1 Dr (Cr) Dr (Cr)
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Gripping GAAP Government grants and government assistance
Other information:
x The entity ceased manufacturing on 30 September 20X2 due to unforeseen circumstances.
x The asset was not considered impaired and the entity intended to resume manufacturing in the next year.
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Gripping GAAP Government grants and government assistance
Required: Show the journal entries relating to the grant for the year ended 31 December 20X1 and up
until 30 September 20X2 assuming that:
A. the company recognises grants as grant income.
B. the company recognises grants as a reduction of the cost of the related asset.
Comment: First of all, please notice, in both parts, that the deferred grant income is recognised in profit
or loss in a manner that reflects the period over which the cost of the asset is recognised as an
expense even though the condition was simply a 2-year condition.
x Part A shows that a grant that is forfeited must first be reversed out of the deferred income account,
assuming it has a balance, and any remaining debit is expensed. Thus, the principle behind the
repayment of the 10 000 in this example is the same as in example 11A: it is first debited to the
‘deferred grant income acc’ (reversing any balance in this account) and any excess payment is then
debited to a ‘grant income reversed expense account’.
x In Part B, the deferred income account had no balance remaining on the date of repayment (since it
had all been transferred to the asset on 2 January 20X1), and therefore the full amount repaid was
simply debited to the cost of the asset.
x Notice that the effect on profit or loss is the same in each year irrespective of the policy applied.
Part A Part B
1 January 20X1 Dr/ (Cr) Dr/ (Cr)
Bank 10 000 10 000
Deferred grant income (L) (10 000) (10 000)
Recognising a government grant
2 January 20X1
Plant: cost (A) 100 000 100 000
Accounts payable/ bank (100 000) (100 000)
Purchase of plant
Deferred grant income (L) N/A 10 000
Plant: cost (A) (10 000)
Recognising grant income as a credit to the asset
31 December 20X1
Deferred grant income (L) A: 10 000 / 4 years x 12 / 12 2 500 N/A
Grant income (I) (2 500)
Recognising 25% of the government grant since the grant relates to the
acquisition of an asset that is depreciated over 4 years
Depreciation: plant (E) A: (100 000 – 0) / 4 years x 12 / 12 25 000 22 500
Plant: acc depr (-A) B: (100 000 – 10 000 – 0) / 4 years x 12 / 12 (25 000) (22 500)
Depreciation of plant
30 September 20X2
Deferred grant income (L) A: 10 000 / 4 years x 9 / 12 1 875 N/A
Grant income (I) (1 875)
Recognising 9 months of the remaining 75% of the government grant to
the date of repayment of the grant
Deferred grant income (L) A: Bal in this acc: 10 000 – 2 500 – 1 875 5 625 N/A
Grant income reversed (E) A: 10 000 – 5 625 4 375
Bank A: 100% of the grant received is repayable (10 000)
Repayment of the full grant required (10 000) when mining ceased
(breach of conditions), first reducing the balance on the deferred income
account (5 625) and then expensing the rest (4 375)
Plant: cost (A) B: debit to asset (since originally credited) N/A 10 000
Bank B: 100% of the grant received is repayable (10 000)
Repayment of the full grant due to breach of the grant condition
Chapter 15 765
Gripping GAAP Government grants and government assistance
5. Deferred Tax
5.1 Overview
The deferred tax consequences of receiving a government grant depend on a variety of factors:
x if the government grant is exempt from tax; or
x where a grant relates to the acquisition of an asset, whether tax deductions (e.g. wear
and tear) will be granted on this underlying asset.
Since the grant forms part of both sums, there will be no deferred tax consequences at all.
5.2.2 Grant for immediate financial support or past expenses: not taxable (i.e. exempt)
The amount received will thus cause a permanent difference in the current tax calculation.
Since the difference is permanent and not temporary, there will be no deferred tax
consequences.
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Gripping GAAP Government grants and government assistance
The accounting treatment of a grant such as this would have given rise to deferred grant income
(a liability account). The treatment of this for deferred tax purposes is the same as that for
income received in advance i.e. there is a carrying amount but the tax base will be zero.
Since the carrying amount and tax base differ and since this difference will reverse in future
periods when the deferred grant income is recognised as grant income in the accounting
records, the difference is said to be a temporary difference. Since we have a temporary
difference, we have deferred tax to account for.
Thus, all conditions attaching to the grant (with the exception of the incurrence of the future wages) had all
been met on date of receipt.
In 20X1, the entity's profit before tax was C100 000, after incurring C20 000 of the required wages.
The grant received is taxable in the year in which it is received at a tax rate of 30%.
Required:
Show the tax journals for the year ended 31 December 20X1.
Comment:
For deferred tax purposes, it does not matter whether the grant income is recognised indirectly by being
recognised as a credit against the expense or directly by being credited to a separate income account.
This is because deferred tax is based on the asset and liability balances in the SOFP.
Profit before tax Given: (X – wages: 20 000 + grant income: 2 000 = 100 000) 100 000
Less grant income recognised Grant: 10 000 x Conditions met: 20 000 / 100 000 (wages) (2 000)
Add taxable grant income Grant is fully taxable when received 10 000
Taxable profit 108 000
Chapter 15 767
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5.2.4 Grant to assist with future expenses: not taxable (i.e. exempt)
The grant received will initially be recognised as deferred grant income (a liability account). If
the grant is exempt from tax, however, the tax base for this liability will immediately (on grant
date) be nil (the tax base representing the portion that will be taxed in the future).
This therefore creates a temporary difference on initial recognition (which affects neither
accounting profit nor taxable profit). Such temporary differences are exempt from deferred
tax in terms of IAS 12 (i.e. there will be no deferred tax journal entries). See IAS 12.15
When calculating current income tax, remember that any grant income included in profit
before tax that is not taxable will need to be reversed, because that income is exempt from
tax. This will lead to the presentation of a reconciling item in our tax rate reconciliation.
Required: Show the tax journals for the year ended 31 December 20X1.
Profit before tax Given: (X – wages: 20 000 + grant income: 2 000 = 100 000) 100 000
Less grant income recognised Grant: 10 000 x Conditions met: 20 000 / 100 000 (wages) (2 000)
Add taxable grant income Nil – exempt from tax 0
Taxable profit 98 000
Notice:
In the prior example, example 13, the tax base was also nil, but the temporary difference was not exempt.
x In example 13, the tax base is nil because the grant had immediately been recognised as taxable
income (and was thus included in taxable profit).
x In example 14, it is the initial tax base that is nil: the tax base is nil because no portion of the grant
will ever be taxed. Thus the resulting temporary difference, which arose on initial recognition, did
not affect taxable profits. It also did not affect accounting profits (debit bank, credit deferred income
liability). Where a temporary difference arises on initial recognition that affects neither accounting
profit nor taxable profit, the temporary difference is exempted from deferred tax. See IAS 12.15
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Gripping GAAP Government grants and government assistance
Deferred tax will arise if the grant relating to an asset is taxable. This is irrespective of
whether the government grant is recognised as deferred grant income or as a credit against
the carrying amount of the asset:
x If it is credited to deferred grant income (liability):
deferred tax will arise on this liability account (similar to example 13) and the related
asset account (e.g. plant).
x If it is credited to the related asset account:
deferred tax will arise solely on this asset account (and remember that depreciation will
now be lower than if a deferred grant income account had been created).
Comments in general:
x This example involves the grant being taxable and the related plant being deductible. It compares
the situation where the grant is:
credited to deferred income (finally recognised in profit or loss as grant income); and
credited to the asset (finally recognised in profit or loss as a reduced depreciation charge).
x Either way, the grant is recognised in profit or loss over a period of time and the grant income will
also be recognised in taxable profit. Since this can only lead to possible temporary differences (no
exempt income), no rate reconciliation will be required in the tax expense note.
Part A Part B
31 December 20X1 Dr/ (Cr) Dr/ (Cr)
Tax expense: income tax (E) W1 36 000 36 000
Current income tax payable (L) (36 000) (36 000)
Current tax
Deferred tax: income tax (A) 15A: W2.1; 15B: N/A 2 400 N/A
Tax expense: income tax (E) (2 400) N/A
Deferred tax on deferred grant income
Deferred tax: income tax (A) 15A: W2.2; 15B: W3.1 3 600 6 000
Tax expense: income tax (E) (3 600) (6 000)
Deferred tax on plant
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Entity name
Notes to the financial statements (extracts)
For the year ended 31 December 20X1
Part A Part B
5. Income taxation expense C C
x Current W1 or journals 36 000 36 000
x Deferred 15A: W2 & 15B: W3; or journals (6 000) (6 000)
Tax expense per the statement of comprehensive income 30 000 30 000
Tax rate reconciliation
Applicable tax rate 30% 30%
Tax effects of:
x Profit before tax 100 000 x 30% 30 000 30 000
x Reconciling items 0 0
Tax expense per statement of comprehensive income 30 000 30 000
Effective tax rate 30 000 / 100 000 30% 30%
Balance: 1/1/20X1 0 0 0 0
Grant income deferred (12 000) 0 12 000
(1)
2 400 Dr DT Cr TE
Grant income recognised 4 000 0 (4 000)
(2)
Balance: 31/12/20X1 (8 000) 0 8 000 2 400 Asset
(1) Grant income recognised in 20X1: 12 000 x 1/3 (recognised at year end)
(2) TB = CA – any amount which will not be taxable in future periods
Since the entire carrying amount is taxable now, none of it will be taxable in future periods… or, put in
other words, ‘all of it will be not taxable in the future’.
Thus, TB = 8 000 – 8 000 = 0
P.S. the fact that it is taxable obviously means it affects taxable profit and thus the closing temporary
difference of 12 000 is not an exempt temporary difference.
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The grant received will initially be recognised as a credit to the related asset (e.g. the plant
cost account) or a credit to deferred grant income.
If the grant is exempt from tax, however, the tax base for this credit will immediately be nil (the
tax base representing the portion that will be taxed in the future).
This therefore creates a temporary difference on initial recognition, which affects neither
accounting profit nor taxable profit. Temporary differences that arise on initial acquisition and
affect neither accounting profit nor taxable profit are exempt from deferred tax in terms of
IAS 12.15 (i.e. there will be no deferred tax journal entries).
Thus, grants that are not taxable (i.e. exempt from income tax) will not lead to deferred tax
because the resulting temporary differences are exempt from deferred tax.
The only deferred tax which will result is in the difference between depreciation (calculated on
the cost of the asset and ignoring the grant received) and the related tax deductions.
When calculating the current income tax, remember that any grant income included in profit
before tax by way of a reduced depreciation charge will lead to a permanent difference. In other
words, the reduction in depreciation will appear in the tax expense note as a reconciling item.
Example 16: Deferred tax: Cash grant relating to asset: not taxable
Use the same information as in example 15 except that the tax authorities:
x Do not tax the receipt of the grant; and
x Allow the deduction of the cost of the plant (i.e. 90 000) over 5 years.
Required:
Assuming we recognise government grants as a credit to the related asset (i.e. following on from
example 15B), show the tax journals and tax expense note for the year ended 31 December 20X1.
Solution 16: Deferred tax: cash grant relating to asset: not taxable
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Entity name
Notes to the financial statements (extracts) 20X1
For the year ended 31 December 20X1 C
5. Income taxation expense
x Current W1 32 400
x Deferred W2 (3 600)
Tax expense per the statement of comprehensive income 28 800
Tax rate reconciliation
Applicable tax rate 30%
Tax effects of:
x Profit before tax 100 000 x 30% 30 000
x Exempt temporary difference:
- depreciation reduction due to exempt grant 4 000 (W2) x 30% (1 200)
Tax expense per statement of comprehensive income 28 800
Effective tax rate 28 800 / 100 000 28.8%
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Entity name
Statement of comprehensive income 20X5 20X4
For the year ended 31 December 20X5 C C
Notes
Revenue x x
Other income 40 150 000 170 000
Cost of Sales/Admin/Distribution/Other 41 x x
Finance costs 42 x x
Profit before tax 43 x x
Entity name
Notes to the financial statements
For the year ended 31 December 20X5
2. Accounting policies
2.15 Government grants:
Government grants are recognised in profit or loss:
x on a rational basis, over the period/s that
x matches grant income with the costs that they were intended to compensate.
Government grants are recognised when there is reasonable assurance that:
x the conditions of the grant will be complied with; and
x the grant will be received.
Government grants are presented as grant income.
20X5 20X4
40. Other income
C C
Rent income 25 000 45 000
Government grant 50 125 000 125 000
Other income per the statement of comprehensive income 150 000 170 000
Entity name
Notes to the financial statement 20X5 20X4
For the year ended 31 December 20X5 C’000 C’000
41. Costs by function
Cost of sales 800 900
Cost of distribution 190 200
Total 315 325
Less government grant 50 (125) (125)
Cost of administration 210 300
1 200 1 400
Further adjustments to the disclosure in Ex 17A:
x There would be no grant income of C125 000 in the ‘other income note’.
x The last line of the ‘accounting policy note’ (see Ex 17A) would read the following instead:
Government grants are presented as a reduction of the related expense/ asset.
Chapter 15 773
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Entity name
Statement of financial position 20X5 20X4
As at year ended 31 December 20X5 C’000 C’000
LIABILITIES
Deferred grant income 0 125
Example 18: Disclosure of government grants related to assets – the asset note
A government grant of C250 000 is received at the beginning of 20X4.
The grant was provided to help finance the costs of an existing plant.
x The plant’s accumulated depreciation is C300 000 at 01/01/20X4 (cost: C900 000).
x The plant is depreciated straight-line over its remaining life of 2 years to a nil residual value.
x Depreciation is provided on the straight-line method.
Required: Show the property, plant and equipment note for the year ended 31 December 20X5 assuming
the entity recognises grants as a reduction of the related asset.
Entity name
Notes to the financial statements 20X5 20X4
For the year ended 31 December 20X5 C’000 C’000
20. Property, plant and equipment
Plant:
Net carrying amount – 1 January 175 600
Gross carrying amount – 1 January 650 900
Accumulated depreciation – 1 January (475) (300)
Grant received 50 - (250)
Depreciation (CA: 600 – GG: 250 – RV: 0) / 2 years (175) (175)
Net carrying amount – 31 December 0 175
Gross carrying amount – 31 December 650 650
Accumulated depreciation – 31 December (650) (475)
Entity name
Notes to the financial statements
For the year ended 31 December 20X5
50. Government grants & assistance
Nature: Cash government grants have been received in return for … (e.g. mining in the …area).
Extent: The amounts of the grant have been presented (select one of the following):
as grant income (included in other income/ as a separate line item on the face of the SOCI)
as a deduction against the …expense (see note …)
as a deduction against the… asset in property, plant and equipment (see note …).
Unfulfilled conditions: The unfulfilled conditions at reporting date include: …e.g. ‘We must mine for a further 12 yrs'.
There is no evidence to suggest that this condition will not be met (or give details of any evidence that suggests
that the unfulfilled conditions will probably not be met).
Other government assistance that is unrecognised : Other government assistance from which we have directly
benefited includes … (e.g. a government procurement policy requiring the government to buy 50% of all … from us).
Contingent liabilities: If we fail to meet the conditions of the grant recognised in note …, we will be liable to repay
Cxxx. These conditions must be met over the next … years, after which we will no longer be exposed to this risk.
774 Chapter 15
Gripping GAAP Government grants and government assistance
7. Summary
Government assistance
Recognised Recognised
Yes No
When there is reasonable assurance that the:
x entity will comply with the conditions, and
x grant will be received
Recognition
Disclosed Disclosed
Yes Yes
Chapter 15 775
Gripping GAAP Government grants and government assistance
Non-monetary Monetary
Debit: x Bank
Debit: x Non-monetary asset (e.g. land): FV
AND
Credit: x Bank (nominal amount, if any); AND Credit: x Income (deferred/
Asset
realised) OR
x Grant income (deferred or realised): acquired
x Asset
(fair value – nominal amount)
OR
Credit: x Income (deferred/
Future
realised) OR
expenses
x Expense
OR
Credit: x Income (realised) OR Past expense/
x Expense loss or
immediate
OR assistance
Credit: x Loan AND
x Income (deferred/ Loans
realised)
Non-monetary Monetary
x Fair value of asset granted OR x Fair value of asset granted
x Nominal amount paid (if any) (i.e. cash amount received or receivable)
Debit: Depreciation
Credit: Asset: acc depr
776 Chapter 15
Gripping GAAP Leases: lessee accounting
Chapter 16
Leases: Lessee Accounting
Main References: IFRS 16 (with any updates to 10 December 2019)
Contents: Page
1. Introduction 779
2. IAS 17 – almost history 779
3. The new IFRS 16 – a brief overview 780
4. Scope 780
5. Identifying whether we have a lease 780
5.1 Overview 780
5.2 Is the asset identified? 781
5.2.1 Identification can be explicit or implicit 781
Example 1: Identified asset – explicit or implicit 781
5.2.2 Assets are not ‘identified’ if supplier has substantive right of substitution 781
Example 2: Identified asset – substantive right of substitution 782
5.2.3 Portions of assets can be identified 782
Example 3: Identified asset – capacity portions 782
5.3 Do we have the right to ‘control the use’ of the identified asset? 783
5.3.1 Overview 783
5.3.2 The right to obtain substantially all the economic benefits 784
Example 4: Substantially all the economic benefits – primary & by-products 784
Example 5: Substantially all the economic benefits – portion payable to lessor 785
5.3.3 The right to direct the use 785
5.3.3.1 Overview 785
Example 6: Right to direct the use – ‘how and for what purpose’ is 786
predetermined
Example 7: Right to direct the use: ‘how and for what purpose’ is 787
predetermined
5.3.3.2 Decisions restricted to operations and maintenance 787
5.3.3.3 Protective rights 787
Example 8: Right to control the use with protective rights and maintenance 788
5.4 Flowchart: analysing the lease definition 789
6. Separating the lease components in a contract 789
Example 9: Allocating consideration to the lease and non-lease components 791
7. Combining contracts 791
8. Recognition exemptions (optional simplified approach) 792
8.1 Overview 792
8.2 Low-value asset leases and the simplified approach 792
Example 10: Exemptions and low-value assets 793
8.3 Short-term leases and the simplified approach 794
Example 11: Exemptions and short-term leases 794
9. Recognition and measurement – necessary terminology 795
9.1 Overview 795
9.2 Lease term 795
Example 12: Lease term – basic application 796
Example 13: Lease term – option to extend: theory 797
9.3 Lease payments 799
9.3.1 Overview 799
9.3.2 Fixed payments 800
9.3.3 Variable lease payments 800
9.3.4 Exercise price of purchase options 801
9.3.5 Termination penalties 801
9.3.6 Residual value guarantees 801
9.3.7 Summary of the calculation of lease payment 801
9.4 Discount rate 802
Chapter 16 777
Gripping GAAP Leases: lessee accounting
Contents: Page
10. Recognition and measurement – the simplified approach 802
Example 14: Leases under the recognition exemption (simplified approach) 802
11. Recognition and measurement – the general approach 803
11.1 Overview 803
11.2 Initial recognition and measurement 803
Example 15: Initial measurement of lease liability and right-of-use asset 805
11.3 Subsequent measurement – a summary overview 806
11.4 Subsequent measurement of the lease liability 807
11.4.1 Overview 807
11.4.2 The effective interest rate method 807
Example 16: Lease liability – subsequent measurement 807
Example 17: Lease liability – initial and subsequent measurement (advance pmts) 809
11.5 Subsequent measurement of the right-of-use asset 810
11.5.1 Overview 810
11.5.2 Subsequent measurement of the right-of-use asset: in terms of the cost model 810
Example 18: Right-of-use asset – subsequent measurement: depreciation 811
Example 19: Right-of-use asset – subsequent measurement: impairments 812
11.5.3 Subsequent measurement of the right-of-use asset: in terms of revaluation model 813
11.5.4 Subsequent measurement of the right-of-use asset: in terms of fair value model 813
11.6 Subsequent measurement - changing lease payments 813
Example 20: Remeasurement - change in lease term 814
11.7 Subsequent measurement - lease modifications 815
Example 21: Lease modification – scope decreases resulting in partial termination 816
12. Tax consequences 817
12.1 Overview 817
12.2 Tax treatment of leases 817
12.3 Accounting for the tax consequences: lease accounted for using the simplified approach 818
12.3.1 From a tax-perspective, the lessee is renting the asset (the lease meets the 818
definition of ‘rental agreement’ or ‘part (b) of the ICA definition’
Example 22: Lease under simplified approach – tax consequences 819
12.3.2 From a tax-perspective, the lessee owns the asset (the lease meets the
definition of ‘part (a) of the ICA definition’) 821
12.4 Accounting for tax consequence: lease accounted for using the general approach 821
12.4.1 From a tax-perspective, the lessee is renting the asset (the lease meets the
definition of ‘rental agreement’ or ‘part (b) of the ICA definition’ 821
Example 23: Lease under general approach – tax consequences 822
12.4.2 From a tax-perspective, the lessee owns the asset (the lease meets the
definition of ‘part (a) of the ICA definition’) 824
12.5 Accounting for the tax consequences involving transaction taxes (VAT): lease meets ‘part 824
(b) of the ICA’ definition
12.5.1 Overview 824
12.5.2 VAT and the effect on the right-of-use asset 825
12.5.3 VAT and the effect on the lease liability 825
12.5.4 VAT and the effect on taxable profits and current income tax 825
12.5.5 VAT and the effect on deferred income tax 826
Example 24: Lease under general approach - with VAT (basic) 827
Example 25: Lease under general approach - with VAT 827
12.6 Accounting for the tax consequences involving transaction taxes (VAT): lease meets the
definition of a ‘rental agreement’ 829
13. Presentation and disclosure requirements 830
13.1 Presentation 830
13.1.1 Presentation in the statement of financial position 830
13.1.2 Presentation in the statement of comprehensive income 831
13.1.3 Presentation in the statement of cash flows 832
13.2 Disclosure 832
14. Summary 835
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Gripping GAAP Leases: lessee accounting
1. Introduction
A lease transaction involves one party (the lessor) that grants the right to use an asset to
another party (the lessee). In other words, a lease is characterised by the right of use of an
asset that is granted by a lessor (the owner of the asset) to a lessee (the user of the asset).
This chapter explains how to account for leases from the lessee’s perspective and the next
chapter explains how to account for the lease from the lessor’s perspective. In the rest of this
chapter, reference to the ‘entity’ may be assumed to refer to the lessee.
The long-awaited new standard on leases, IFRS 16 Leases, was issued during 2016, replacing the
previous standard, IAS 17 Leases, and its three related interpretations (IFRIC 4, SIC15 and SIC 27).
IFRS 16 is effective for periods beginning on or after 1 January 2019.
IFRS 16 must be
Before we proceed with how to apply IFRS 16, a little history is needed applied to:
so as to understand, in broad brush-strokes, the effects of the change periods starting
from IAS 17 to IFRS 16. on/ after 1 Jan 2019.
Under IAS 17 Leases, an entity entering into a lease as a lessee The ‘old’ IAS 17
must decide whether the lease should be accounted for as a finance accounts for leases
lease or as an operating lease. This decision is based on the based on their
classification as:
substance of the lease agreement (i.e. rather than its legal form).
x operating (expensed); or
Based on its substance, the entity, as lessee, would account for the
x finance leases (on the
lease as: balance sheet/
x a finance lease if it concluded that the agreement effectively capitalised asset &
liability).
involved purchasing the asset (e.g. the entity did not expect to
return the asset to the lessor); or
x an operating lease if it concluded that the substance of the agreement effectively involved
a true borrowing of the asset (i.e. in essence, the entity would, at the end of the lease,
expect to return the asset, in working order, to the lessor).
When accounting for a finance lease (i.e. a lease, the substance of which suggested the asset
was actually purchased rather than borrowed), the lessee would immediately recognise the item
being leased as an asset and recognise the future lease instalments as a liability. On the other
hand, when accounting for an operating lease (i.e. a lease, the substance of which suggested
the asset was truly borrowed), the lessee would simply recognise the lease instalments as an
expense, as and when they were incurred. This meant that, in the case of an operating lease,
the entity would not recognise the asset and nor would it recognise, as a liability, its obligation to
pay future lease instalments. The fact that the obligation to pay future lease instalments would
not appear as a liability in the lessee’s financial statements is referred to as ‘off-balance sheet
financing’ and was the core reason behind the need to replace IAS 17.
The fact that IAS 17 offers these two different lease classifications (finance and operating
leases), has enabled entities to structure each of their lease contracts so that they would be
accounted for as either an operating lease or finance lease, depending on the specific
outcome that the entity desired. This ability to 'manipulate’ the situation has been causing
users concern for many years on the basis that the financial statements are not transparent.
In fact, in March 2016, the IASB estimated that leases around the world amounted to US$3.3
trillion, with ‘over 85% of these leases labelled as ‘operating leases’ and are not recorded on
the balance sheet.’1 It has also been estimated that some retailers have off-balance sheet
debt that is 66 times the debt currently reflected on the balance sheet. 2
1. Shining the light on leases; by Hans Hoogervorst, IASB Chairman; IFAC Global Knowledge Gateway; 22 March 2016
2. On balance, companies would rather not show debt; by James Quinn; The Telegraph; 13 January 2016
Chapter 16 779
Gripping GAAP Leases: lessee accounting
IFRS 16 requires that, unless the scope exclusions apply (see section 4) or the optional
simplifications involving short-term leases and low-value asset leases apply (see section 5), the
lessee must recognise the lease by recognising: The ‘new’ IFRS 16
x a ‘right-of-use’ asset; and accounts for leases on
x a lease liability. See IFRS 16.22 the balance sheet
(similar to a finance lease in
the ‘old’ IAS 17).
This means that the right to use the underlying leased asset (right-of-use
asset) and the obligation to pay the related lease instalments (lease liability) will appear in the lessee’s
statement of financial position (i.e. the lease is recognised ‘on balance sheet’).
A lessee involved in the lease of any intangible asset other than a right under a licensing
agreement (referred to in (e) above) may choose whether or not to apply IFRS 16 See IFRS 16.4.
IFRS 16 elaborates on this lease definition, explaining that although the definition refers simply to:
x ‘an asset’, this asset must be ‘identified’; and
x the entity having the ‘right to use’ this asset, this ‘right to use’ the asset must translate into
the ‘right to control the use’ of that asset. See IFRS 16.9
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Gripping GAAP Leases: lessee accounting
5.2.2 Assets are not ‘identified’ if supplier has substantive right of substitution
Chapter 16 781
Gripping GAAP Leases: lessee accounting
The fact that a contract may allow, or may even require, a supplier to substitute one asset for
another in the event that it needs repairs, maintenance or an upgrade, should not be interpreted
as the supplier having the substantive right to substitute an asset for purposes of assessing
whether the lease definition is met. See IFRS 16.B18
If it is difficult to determine if a supplier’s right to substitute is substantive or not, we must assume that the
‘substitution right is not substantive’. See IFRS 16.B19
Conclusion:
The 16 square meters of space is not an identified asset because Entity B has the right to substitute
the asset (the space) and this right to substitute is substantive because Entity B has the practical ability
to substitute and would benefit economically from the substitution.
An identified asset could be just a portion of an asset if the portion is physically distinct. An
identified asset cannot, however, simply be a portion of the asset’s capacity, unless the portion of
the asset’s capacity is physically distinct or if the portion of the capacity is substantially all of the
asset’s capacity. See IFRS 16.B20
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Gripping GAAP Leases: lessee accounting
Since we are dealing with a capacity portion, we must analyse whether the capacity portion is physically
distinct or, if not, whether it represents substantially all of the asset’s capacity.
Although the actual pipeline is physically distinct, the 20% capacity requirement does not represent a
physically distinct portion of the pipeline.
Thus, since the capacity portion of the asset is not physically distinct, we consider whether the capacity
reflects substantially all of the capacity of the pipeline.
In this case, we are told the portion that will be used represents only 20% of the total capacity and thus we
conclude that the capacity portion does not reflect substantially all of the capacity of the pipeline.
Conclusion: There is no identified asset because we are dealing with a capacity portion that is neither
physically distinct nor representative of substantially all of the capacity of the asset.
5.3 Do we have the right to ‘control the use’ of the identified asset?
We have the right to control the
5.3.1 Overview use of an identified asset if,
during the period of use, we have
The lease definition (see pop-up in section 5.1) includes the the right to:
requirement that the entity must have a ‘right to use’ the x obtain substantially all the economic
benefits from the use of the asset; and
asset.
x direct the use of the asset.
IFRS 16.B9 reworded
The standard then clarifies that, for there to be ‘a right to use’,
it means that the entity needs to have the ‘right to control the use of the asset’ (see pop-up).
As explained above, this ‘right to control the use of the asset’ is established if two criteria are met:
x the entity must have the ‘right to obtain substantially all the economic benefits’ and
x the ‘right to direct the use’.
This ‘right to direct the use’ of the asset will need to be established if the entity has the ‘right to
direct how and what for purpose’ the asset will be used. As there are a variety of similar, but very
distinct terms, it may be useful to you to see the interrelationship of these terms diagrammatically.
‘Right to control the use’ of the asset (section 5.3) IFRS 16.9
IFRS 16.9 clarifies that:
A ‘right to use’ the asset = A ‘right to control the use’ of the asset
The ‘right to control the use’ exists if the entity has the following two rights:
Right to obtain substantially all the AND Right to direct the use (section 5.3.3)
economic benefits (section 5.3.2) IFRS 16.B9 (a) IFRS 16.B9 (b)
IFRS 16.B24
Right to direct how and for what purpose the asset is used
The entity (customer) has this right if it:
x can decide how and for what purpose the asset is used; OR
x cannot decide this because the ‘how and what for’ is predetermined. but it can operate the asset; OR
x cannot decide this because the ‘how and what for’ is predetermined. but the entity designed the
asset AND it is this design that is the reason why the ‘how and what for’ is predetermined’
Chapter 16 783
Gripping GAAP Leases: lessee accounting
5.3.2 The right to obtain substantially all the economic benefits (IFRS 16.B21-23)
When trying to establish that an entity (customer) has the ‘right to control the use’ of the asset, one of
the two criteria that needs to be met is that the entity (customer) must have the ‘right to obtain
substantially all the economic benefits’ from the use of the asset during the period of use.
When assessing whether the entity (customer) has the right to these benefits, it does not matter whether
it can obtain these benefits directly or indirectly. This means that the entity could obtain the benefits from
using the leased asset (direct usage) or, for example, sub-leasing the asset (indirect usage). The phrase
‘all the economic benefits’ refers to the benefits from both the primary output and also any secondary
output (i.e. it includes the inflows expected from, for example, the sale of by-products). See IFRS 16.B21
When assessing whether the entity (customer) has the The right to obtain
‘right to obtain substantially all the economic benefits’ substantially all the benefits:
from the use of the asset, we limit our assessment to the x Include direct and indirect benefits
scope of the customer’s rights as defined in the contract. x Consider only the total benefits
See IFRS 16.B21 possible in context of the scope of the
contracted right of use
In other words, it is obvious that, if an entity (customer) has x The requirement to refund/pay part of
the exclusive and unconditional use of an asset throughout a the benefits to the lessor/third party
particular period, this entity would have the right to all the is ignored. See IFRS 16.B21-23
economic benefits from the use of the asset during that period. However, the entity does not always
have exclusive use of an asset.
For example: A contract provides an entity (the customer) with the right to use a truck for three
years, but only within the city limits (that means, the truck cannot be used to deliver goods
outside of the city). When assessing whether the customer has the ‘right to obtain substantially all
the benefits’ we must consider the benefit the customer obtains, in relation to the total economic
benefits from utilising the truck within the city limits. We would not consider the benefit that the
entity obtains, in relation to the total economic benefits that would have been possible if the
customer was able to use the truck outside of the city limits. See IFRS 16.B21-22
Tee has the rights to all the electricity and the renewable energy credits (the primary product and one of
the by-products), but it does not have the rights to the tax benefits (the other by-product). However, the
electricity and the renewable energy credits actually represents 100% of the economic benefits from the
right of use of the asset because the tax benefits (the by-product to which it does not have the right), is
not related to the use of the asset but rather to the ownership of the asset.
Conclusion:
Tee has the right to obtain substantially all the benefits from the wind farm and thus, assuming all other
criteria are met, we conclude that it holds the wind farm as a right-of-use asset.
784 Chapter 16
Gripping GAAP Leases: lessee accounting
The fact that the contract may require the entity (customer) to pay the supplier some of the benefits
earned from using the asset does not mean that the customer has not obtained substantially all the
economic benefits from using the asset. Instead, when assessing whether we have the ‘right to
receive substantially all the benefits’, we consider the gross benefits received by the entity (not the
benefits net of any portion thereof that must be paid over to the lessor or any third party). If any
portion of the benefits are to be paid to the supplier, or some other third party, this portion is simply
accounted for as part of the consideration paid for the lease. See IFRS 16.B23
This is an important point since it prevents entities from structuring their lease contracts in such a
way that they can avoid meeting the definition of a lease, and thus avoid having to account for
them on the balance sheet. In other words, entities could otherwise have structured their contracts
such that the lease payments were simply based on a percentage of revenue (e.g. 30% of
revenue) and then concluded that, since they only retained a portion of the revenue (e.g. the
balance of 70% of revenue), they did not have the right to substantially all the economic benefits.
Required: Explain whether Jay has the right to obtain substantially all the economic benefits.
5.3.3 The right to direct the use We have the right to direct the
use of an asset:
Chapter 16 785
Gripping GAAP Leases: lessee accounting
The customer has the ‘right to direct how and for what purpose the asset is used’, OR
right to direct the use
The entity (customer)
The relevant decisions about ‘how and for what purpose’ the asset is used is predetermined, but:
x the customer designed the asset (or parts thereof) and
x it is this design that predetermines the ‘how and for what purpose’.
Example 6: Right to direct the use: ‘how and for what purpose’ is predetermined
Adaptation of IFRS 16.IE6
Eff Limited enters into a contract with Gee Limited where Gee will transport Eff’s cargo from
South Africa to Australia. The volume of cargo to be transported is such that it requires the
exclusive use of a ship. The contract specifies the cargo to be transported, the dates it will be
transported, the route the ship must take and that Gee will operate the ship and be responsible for all
maintenance and safety aspects. The ship is specified in the contract.
Required:
a) Explain whether Eff has the right to direct the use of the ship.
b) Assuming all other criteria are met, explain whether the contract contains a lease.
Solution 6: Right to direct the use: ‘how & for what purpose’ is predetermined
a) Eff (customer) does not have the right to direct how and for what purpose the ship will be used: the
details regarding the dates and route that will be taken (the ‘how’) and the details of the cargo to be
transported (the ‘purpose’) are specified in the contract.
Since the decisions regarding ‘how and for what purpose’ is pre-determined in the contract, we must
analyse whether Eff either operates the ship or designed the ship. In this case, Eff neither operates
nor designed the ship.
Conclusion: Since the decisions regarding how and for what purpose the ship will be used are
predetermined in the contract, and since Eff neither operates the ship nor designed the ship, we
conclude that Eff does not have the right to direct the use of the ship.
b) Since Eff does not have the right to direct the use of the ship, it automatically means that it does not
have the right to control the use of the asset. Since Eff does not have the right to control the use of
the asset, the contract does not involve a lease.
For your interest: Before we can say there is a lease, an identified asset must exist and Eff must have
the right to control its use. In part (b), we looked at whether Eff had the right to direct the use of the ship,
which is only one of the criteria to prove if Eff has the right to control its use: the other criteria is that Eff
must be able to obtain substantially all the economic benefits from its use. In part (b) we were told to
simply assume that all other criteria were met. A full explanation regarding these other criteria follows:
x Is there an identified asset? In this case, the ship is explicitly specified in the contract and there
appears to be no evidence that the supplier has a substantive right to substitute the ship with another
ship. We thus conclude that there is an identified asset.
x Does Eff have the right to control the use of the ship? Two criteria must be met to prove this. The first
criteria is that Eff (customer) must have the right to substantially all the economic benefits from the use of the
ship throughout the contract. In this case, there is so much cargo that it will occupy the entire ship such that no
other parties can obtain any benefit from the use of the ship during this period of use. Thus, Eff has the right to
substantially all the benefits. The second criteria is that Eff must have the right to direct its use. Eff does not
have this right (see part b). Thus, Eff does not control the use of the ship (Eff has the right to substantially
all the economic benefits during the period of use but does not have the right to direct its use)
x Conclusion: There is no lease because, although there is an identified asset (the ship), Eff does not
have the right to control its use .
Hypothetically, if we had concluded that Eff had the right to control the use of an identified asset and thus that
the contract included the lease of a ship, Eff would not necessarily account for the lease on the balance sheet.
This is because the use of the ship is for one trip only, and thus the lease is for less than 1 year, which means Eff
has the option to expense the lease instead (see section 8).
786 Chapter 16
Gripping GAAP Leases: lessee accounting
Required: Explain whether Em has the right to direct the use of the asset and, assuming all other
criteria are met, whether the nuclear plant is leased by Em.
Solution 7: Right to direct the use – ‘how & for what purpose’ is predetermined
Aitch (supplier) operates the plant and thus Em (customer), on the face of it, appears not to have
anything to do with directing the use of the plant. However, the reality is that neither Em nor Aitch can
actually decide to change how the asset is used or for what purpose the asset is used. This is because
the specialised nature of the plant predetermines this:
x the ‘how’ is very technical and thus there is only one way to operate this plant; and
x the ‘for what purpose’ is clearly the production of power.
The decisions regarding the ‘how and for what purpose’ are thus ‘predetermined’.
When decisions are predetermined, we must then consider whether the customer operates the asset or
designed it and whether it was this design that predetermined these decisions.
In this case, Em (the customer) does not operate the plant but it did design the plant for Aitch (supplier)
and this design actually predetermines how and for what purpose the asset is used. This fact is used as
evidence that Em has, in effect, the right to direct the use of the asset.
Conclusion: Em has the right to ‘direct the use’ of the power plant and thus, assuming all other criteria
are met, it should conclude that it holds the power plant under a lease.
Contracts can grant either the customer or supplier the decision-making rights regarding the
operation and/or maintenance of an asset. However, although decisions regarding the
operation and maintenance of an asset have a direct impact on whether or not the use of the
asset will be efficient, they have no bearing on who has the ‘right to direct how and for what
purpose’ the asset is used.
In fact, in most cases, the converse is true: the decisions regarding ‘how and for what purpose’
the asset is used will have a bearing on the decisions needed to be made regarding the
operation (and maintenance) of the asset.
The only time that we should consider who has the right to operate the asset is if the decisions
regarding ‘how and for what purpose’ the asset is used are predetermined. See IFRS 16.B27
When assessing whether an entity (customer) has the right to direct the use of the asset, we may
come across certain restrictions. These restrictions are termed protective rights.
Protective rights are ignored if they are merely designed, for example, ‘to protect the supplier’s
interest in the asset or other assets, to protect its personnel, or to ensure the supplier’s
compliance with laws or regulations’.
Protective rights come in many forms, such as limiting the usage of the asset for safety reasons,
or requiring that the customer follows certain ‘operating practices’ in order to ensure longevity of
the asset etc.
Protective rights are terms and conditions that generally simply ‘define the scope of the
customer’s right of use, but do not, in isolation, prevent the customer from having the right to
direct the use of the asset’. See IFRS 16.B30
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Example 8: Right to control the use with protective rights and maintenance
Adaptation of IFRS 16.IE6B
Jay Limited enters into a contract with Elle Limited for the right to the exclusive use of a passenger
train to be used along a specified train route.
Jay will be able to make all the decisions regarding when to operate the train, who it will use to operate it and how
many passengers will be transported.
However, the contract specifies that Jay may not carry more than 1 000 passengers at a time and may not
operate the train for more than 1 200 km per day.
The contract also specifies that Elle will be exclusively responsible for repairs and maintenance of the train
(including the scheduling of when maintenance takes place). If any of the train carriages requires maintenance or
a repair, Elle will substitute the train carriage with an alternative.
Required:
Indicate whether Jay has the right to control the use of the train and thus, assuming all other criteria are
met, whether it should conclude that the train is leased.
Solution 8: Right to control the use with protective rights and maintenance
In order to decide whether Jay (customer) has the right to control the use of the train, we must establish
whether the entity has the:
x right to substantially all the economic benefits; and
x the right to direct the use of the asset.
Jay has exclusive use of the train along a specified route. As such, within the scope of this contract, Jay
has the right to substantially all the economic benefits from the use of the train.
The fact that Jay can operate the train is not relevant when assessing whether it has the right to direct
the use of the train because merely being able to operate an asset does not mean that one is able to
make the decisions regarding ‘how and for what purpose’ the asset will be used (we only consider
whether the entity can operate the asset if the decisions regarding ‘how and for what purpose’ the asset
is used are predetermined).
What is relevant is that Jay can decide when and whether to operate the train, how far to travel (within
limits) and how many people to transport (within limits), thus suggesting that Jay is able to direct how
and for what purpose the train will be used, which means it has the right to direct the use of the train.
The fact that Elle (supplier) puts restrictions on how many passengers it may carry in one trip and how
many kilometres may be travelled in one day are simply protective rights (i.e. they are protecting Elle’s
investment in its train). These protective rights simply define the scope of Jay’s right to use the train and
do not detract from Jay’s right to decide how and for what purpose the train is used. We thus ignore
Elle’s rights, because they are protective rights
Similarly, the fact that Elle is responsible for scheduling and carrying out maintenance and repairs does not
mean that Jay does not have the right to direct the use of the train. In fact, the converse is true: the decisions
made by Jay regarding how and for what purpose the train will be used (e.g. to travel 1 200 km per day carrying
the maximum passenger load) affects how often the train will require maintenance and repairs.
Thus, we conclude that Jay has the right to direct the use of the train.
Since Jay has the right to substantially all the economic benefits and has the right to direct the use of the
train, we conclude that it has the right to control the use of the asset. If all other criteria are met, we
would conclude that Jay is leasing the train from Elle.
One of the other criteria that must be met before concluding that the contract involves a lease is that the
asset must be identified. In this case, the train is explicitly identified in the contract and is thus an
identified asset. The fact that the supplier may substitute the train or parts thereof with another train in
the event that the identified train requires repairs or maintenance is not considered to be a substantive
right to substitute the train.
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Is there a contract? No
Yes
There is no lease
Yes
Do we have the right to ‘control the use’ of the asset throughout the
No
period of use?
Core guideline – the 2 requirements: Further guidelines:
Do we have the right to obtain substantially all We consider
the economic benefits from the use of the x only the economic benefits within the
identified asset throughout the period of use? scope of the contract
See IFRS 16.B9(a)
(see section 5.3.2) x the direct and indirect benefits (e.g.
through using or sub-leasing the asset)
AND
Do we have the right to direct the use of the We have this right if:
identified asset throughout the period of use? x we can decide ‘how and for what
See IFRS 16.B9(b)
(see section 5.3.3) purpose’ the asset is used.
x if these decisions are predetermined,
we may conclude we have this right if:
we can operate the asset (or tell
others how to operate it), or
we designed the asset for the
supplier and the design dictates
how and for what purpose the
asset will be used
Yes
There is a lease
It can happen that a contract deals only with a lease and that this lease involves only one
underlying asset. However, a contract could deal with many aspects, including the lease of
more than one asset, and may even contain aspects that are not lease-related.
If a contract contains one or more lease components, each lease component must be
accounted for separately. A lease component refers to a right to use an underlying asset that
meets certain criteria (see pop-up on the next page).
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If a contract involves the lease of a number of underlying assets, we would identify the right to
use each asset as a separate lease component if both of the following two criteria are met:
x the entity (lessee) is able to obtain the benefit from using that asset separately from other
assets (or, if other resources are needed to be able to use that asset, then only if these
resources ‘are readily available to the lessee’) See IFRS 16.B32(a); and
x the asset is not highly interrelated with or dependent on the other assets in the contract
(e.g. if the entity could choose not to lease the asset and if this choice would not
significantly affect its right to use the other assets in the contract, then it suggests that these
underlying assets are not highly interrelated or dependent on each other). See IFRS 16.B32(b)
Please note that, when analysing a contract, we assess whether it ‘contains a lease for each
potential separate lease component’. See IFRS 16.B12
Our second step is to allocate the consideration to each component of the contract:
If a contract contains multiple components, with at least one lease component (e.g. the contract
contains two lease components, or it contains a lease component and a non-lease component), we
must allocate the consideration to each of these components. This allocation is done on the basis of:
x the relative stand-alone price of each lease component; and
x the aggregate stand-alone price of the non-lease components. See IFRS 16.13
Allocating consideration to
The stand-alone prices are based on the price that the
separate lease components and
lessor would charge the entity (lessee) if it supplied that non-lease components:
component on a separate basis. If an observable price is not x is based on the relative stand-alone
readily available, then the entity would simply estimate it. prices (observed or estimated)
See IFRS 16.14 x of each lease component and non-lease
The portion of the consideration that is allocated to component
each lease component will be accounted for in terms of x unless the entity chooses the practical
expedient (not to separate non-lease
IFRS 16 and the portion that is allocated each of the components – in which case the
non-lease components will be accounted for in terms consideration is simply allocated
of the relevant standard. See IFRS 16.16 between separate lease components)
See IFRS 16.13-16
If a contract contains more than one lease component, there is no choice but to account for
each lease component separately (separation is compulsory). If the contract also contains
non-lease components, it is recommended that the non-lease components be accounted for
separately from the lease components (this separation is not compulsory). Where non-lease
components exist, a practical expedient exists that allows the lessee not to bother separating the
non-lease components. In this case, a lease component and any related non-lease component may
be accounted for as one single lease component.
The option to apply the practical expedient is an accounting policy that the entity (lessee) may
choose on a class of asset basis (i.e. it may wish to apply the practical expedient to its leased
vehicles but may choose not to apply it to its leased machinery). However, the practical
expedient shall not apply to embedded derivatives that meet the criteria of paragraph 4.3.3 of
IFRS 9 Financial Instruments. See IFRS 16.15
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Enne Limited (lessee) enters into a one-year contract over a plant. The lessor undertakes to
insure the plant and to maintain it by having it serviced every month. The contract stipulates
that the payments are C12 000 for the year, of which C2 000 relates to the annual insurance and C3
600 relates to the provision of the monthly services.
Similar insurance provided by third parties would normally cost C2 000 per year and the cost for the
monthly services would normally be C5 000 per year. The price to rent a similar plant for a year (without
the additional maintenance services and insurance) is C10 000.
Required: Identify the components of the contract and calculate the amount of consideration that
should be allocated to the lease component/s.
The total consideration is allocated based on the relative stand-alone price per lease component and the
aggregate stand-alone prices of all non-lease components (in this case there is only one non-lease component):
Stand-alone prices
Allocation of annual contractual consideration:
C
Stand-alone price per lease component Given – plant 10 000
Stand-alone prices for all non-lease components Given – maintenance only 5 000
Total stand-alone prices 15 000
The consideration allocated to the lease component (C8 000) is accounted for in terms of IFRS 16,
either using the simplified approach (see section 8 and 10) or using the general approach (see section
11). The consideration allocated to the non-lease component (C4 000) is accounted for separately and
expensed as maintenance.
Note that the allocation of the consideration is based on the stand-alone prices, and not the payments
stipulated in the contract.
For your interest: If the stand-alone price (SAP) of the plant was not observable, we would estimate it.
One way of estimating it would be as a balancing amount: Total consideration C12 000 – SAP of non-lease
component C5 000 = Estimated SAP of lease component: C7 000
If an entity (lessee) enters into more than one contract with the If we have multiple
same counterparty (or related parties of the counterparty) (i.e. if the contracts with one
entity is effectively contracting with the same person in all the person, we may
contracts), these contracts must be accounted for as a single need to combine them.
contract if any one of the following criteria are met:
The assets in each contract would, together, meet the description of a single lease component.
x The amount of consideration payable in terms of one contract would be dependent on the
price or performance of another contract.
x The contracts can only be understood if one considers them together (i.e. as a package)
and they are negotiated as a package.
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Entities choosing this simplified approach would recognise the lease instalments either as an
expense on the straight-line basis (SL basis) over the period of the lease, or may expense it using
another systematic basis if it is ‘more representative of the pattern of the lessee’s benefit’. See IFRS 16.6
8.2 Low-value asset leases and the simplified approach (IFRS 16.8; B3-B8; BC100)
In the case of a lease of a low-value asset, the entity may choose to Low-value asset
apply the ‘simplified approach’ (i.e. expensed instead of ‘on balance leases & the
sheet’) on a lease-by-lease basis. See IFRS 16.8 simple approach:
x The choice to opt for
The assessment of whether or not an asset is considered to have a the simpler approach is
available on a ‘lease-by-
low value is based on its value when it was new. It is not based on lease’ basis
the leased asset’s current age or value. See IFRS 16.B6 x Value of asset assessed
on its value when new.
Furthermore, no consideration is given to whether or not the asset’s x Examples: phones, PC’s,
value is material to the lessee – in other words, this assessment is tablets etc (not cars).
not entity-specific. See IFRS 16.B4 x Exemption not available if
leased asset to be sub-
leased. See IFRS 16.8 & B4-B8
IFRS 16 suggests that low-value assets could include, for example,
‘tablet and personal computers, small items of office furniture and telephones’ but would
normally not include items such as vehicles, because vehicles typically do not have a low
value when new. See IFRS 16.B6 & B8
The IASB’s thoughts on low-value assets
The ‘basis of conclusions’ (included in IFRS 16) explains that, during the discussions in 2015
when originally proposing this low-value asset exemption, the IASB agreed that a rough rule of
thumb of US$5 000 or less would qualify the asset as a low-value asset.
However, this amount must not be misinterpreted to be a ‘hurdle rate’ because it was only raised in
discussions and is not included in the body of the IFRS. Obviously, this amount would also have no
relevance over time due to the effects of inflation and would be difficult to apply by entities that do
not operate in US dollars and whose currency exchange rates fluctuate significantly.
However, the buying power of $5 000 at the time of the discussions suggested that the types of assets
that would be considered to be ‘low-value assets’ would include items such as ‘tablets and personal
computers, small items of office furniture and telephones’.
Interestingly, the fact that their discussions referred to this one specific amount ($5 000) highlights
that the thinking behind the application of the low-value exemption was that the value of the asset
should not be considered in relation to the entity’s circumstances (i.e. it is not an entity-specific
measure). Instead, a large multi-national business and small corner bakery should both arrive at the
same conclusion as to whether a leased asset is a low-value asset or not. See IFRS 16.B3-B5 & IFRS 16.BC100
An asset can only be considered to have a low value if it also meets the following criteria:
x The lessee can benefit from either:
using it on its own, or
using it together with other readily available resources; and
x It is not highly dependent on or highly interrelated with other assets. IFRS 16.B5 (reworded)
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In addition to the abovementioned two criteria, if a lessee intends to sub-lease an asset (i.e. an
entity that is a lessee but becomes – or intends to be – a lessor over the same leased asset), the
entity, as lessee, may never account for the head lease as a low-value asset (i.e. the head lease
must be recognised on the balance sheet (as a right-of-use asset and lease liability), even if it
involves an asset that would otherwise have been described as having a low value). See IFRS 16.B7
Lease A. An entity entered into a lease (as a lessee) over a new personal computer with a value of
$4 000. The retailer regards amounts greater than $2 000 to be material.
Lease B. An entity entered into a lease (as a lessee) over a second-hand computer with a current
value of $2 000 and a new value of $20 000.
Lease C. An entity entered into a lease (as a lessee) over a new tablet with a value of $2 000. The
entity intends to lease this asset to an employee.
Lease D. An entity enters 5 separate leases (as a lessee). The first lease is over a new machine with a
value of $2 000. The machine comes without an engine and three key components, all of
which must be acquired from other suppliers. The second lease involves the lease of the new
engine (valued at $5 000). The remaining three leases involve the three key components
needed for the machine to function (each component had a value, when new, of $3 000).
Required: For each lease referred to above, briefly explain whether the leased asset (underlying asset)
is a low-value asset and thus whether the lease could be accounted for in terms of the simplified
approach (i.e. if the low-value asset recognition exemption is available).
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8.3 Short-term leases and the simplified approach (IFRS 16.8 & Appendix A)
In the case of a short-term lease (a defined term – please see pop-up Short-term leases
below), the choice of applying the simplified approach must ‘be made & the simple
by class of underlying asset to which the right of use relates’. In other approach:
words, the choice made in respect of short-term leases (i.e. to x The choice to opt for the
expense, or recognise ‘on balance sheet’) is an accounting policy simpler approach is available
by ‘class of asset’ (it’s an
choice that must be applied consistently to that entire class of asset. accounting policy choice).
x Lease term must be 12m/less
For example, if we have a right to use a delivery vehicle that from commencement date & the
qualifies as a short-term lease, we would have to decide what lease may not include a purchase
option.
our accounting policy is with regard to accounting for short-term
leases of delivery vehicles: either, we would account for all short-term leases of delivery
vehicles ‘on balance sheet’ , or account for all short-term leases of delivery vehicles in terms
of the exemption (i.e. using the simplified approach). See IFRS 16.8
Notice that the definition of a short-term lease is fairly self-explanatory, but that it contains two
further defined terms: ‘lease term’ and ‘commencement date’. The application of all three
defined terms is best explained by way of example.
Lease A. Kew enters a lease agreement where the contractual terms result in a lease term of 6
months, with no option to purchase.
Lease B. Kew enters into a lease where the contractual terms result in a non-cancellable lease term of 12
months, plus an option to extend the contract for a further 6-months. Given that the rentals in
the extra 6-month period would be significantly below market value, management concludes
that it is reasonably certain that it will exercise its option to extend the contract to the full 18-
months.
Lease C. Kew enters into a lease where the contract terms include a non-cancellable lease term of 12
months, and a further 6 months during which Kew may, at any stage, choose to cancel the
contract. Management considers the cancellation penalty to be insignificant and thus that it
was not ‘reasonably certain that it would not exercise the termination option’ (i.e. it is possible that
Kew could exercise its termination option).
Required: For each of the leases above, briefly explain if the lease meets the definition of a short-term
lease and thus if it would qualify for the option to apply the recognition exemption.
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Lease A. This lease meets the definition of a short-term lease, since it is shorter than 12 months and includes
no purchase option.
Thus, the lease costs will be expensed, assuming Kew has adopted the accounting policy of
accounting for short-term leases of delivery vehicles under the recognition exemption.
Lease B. The definition of a ‘lease term refers to the non-cancellable period, which in this case is 12 months
and would thus seem to qualify the lease as a short-term lease. However, the definition of ‘lease
term’ also includes any optional extension periods that are reasonably certain of being exercised.
In this case, there is an option to extend for a further 6 months and management believes, given the
economics of the lease, that it is reasonably certain the option will be exercised. Thus, the lease term
is 18 months (non-cancellable period: 12m + reasonably certain extension period: 6m). This means
the lease is not a short-term lease (the lease term is not 12 months or less) and this means it does
not qualify for the recognition exemption.
The lease must be recognised ‘on balance-sheet’ instead.
Lease C. When calculating the lease term, we include both the non-cancellable period and any further
cancellable periods (i.e. periods during which the lessee could terminate the contract), but only if it is
reasonably certain that the lessee would not exercise its cancellation option.
Since Kew is not reasonably certain that it would not cancel the contract, this cancellable period is
excluded from the lease term. The lease term is thus 12 months.
Thus, the lease meets the definition of a short-term lease. The lease costs will thus be expensed
(assuming Kew’s accounting policy is to account for short-term leases of vehicles under the
recognition exemption).
9.1 Overview
Recognition of leases:
There are two options regarding the recognition of leases. x General approach: on-balance sheet
Either the lease qualifies for the optional recognition x Simplified approach: off-balance
exemption and the entity chooses this option (the sheet
simplified approach, which involves expensing the lease (only if short-term lease or a low-
costs), or the lease is recognised on balance sheet (the value asset). (See section 8)
general approach). Before we explain how to recognise and measure leases under each of
these approaches, there are a few core terms we need to understand.
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Please note that, if a lease contains an optional cancellable period, the lessee only considers
including this cancellable period if it is only the lessee that has the option to terminate. In other
words, if the lessor also has the option to terminate the lease during this ‘cancellable period’,
we must not consider including this period in the lease term, even if the lessee also has this
option and is reasonably certain that it will not exercise it. See IFRS 16.B35
Please also note that the estimation of the lease term would not be altered in the event that
certain periods during the lease term are rent-free (i.e. the fact that certain of the periods may
be rent-free is irrelevant when estimating the lease term). See IFRS 16.B36
Scenario 1. The lease is non-cancellable for a period of 3 years from commencement date, after which
Ag then has the option to extend the lease for a further 2 years. Ag is reasonably certain
that it will exercise the renewal option (e.g. Ag believes there is an economic incentive to
renew the lease).
Scenario 2. The lease is non-cancellable for a period of 3 years from commencement date after which
Ag then has the option to extend the lease for a further 2 years. Ag is reasonably certain
that it will not exercise the renewal option (e.g. Ag believes there is no economic incentive
to renew the lease).
Scenario 3. The lease is for a 10-year period during which the first 7 years is non-cancellable. At the
end of the 7-year period, Ag has the option to terminate the lease. Ag is reasonably certain
that it will exercise the termination option (e.g. Ag believes there is an economic incentive to
terminate the lease).
Scenario 4. The lease is for a 10-year period during which the first 7 years is non-cancellable. At the
end of the 7-year period, Ag has the option to terminate the lease. Ag is reasonably certain
that it will not exercise the termination option (e.g. Ag believes there is no economic
incentive to terminate the lease).
Scenario 5. The lease is for a 10-year period during which the first 7 years is non-cancellable. At the
end of the 7-year period, both Ag and the lessor have the option to terminate the lease. Ag is
reasonably certain that it will not exercise the termination option (e.g. Ag believes there is
no economic incentive to terminate the lease).
Required: Calculate lease term for each of the scenarios above.
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When deciding whether it is reasonably certain that the entity (lessee) would exercise an option to
extend (a renewal option), or an option to terminate a lease (termination/ cancellation option), we
must consider all relevant facts and circumstances that might provide the necessary economic
incentives. For example:
x significant penalties: if an option to terminate involves the payment of a significant penalty,
this may be a sufficient economic incentive not to terminate;
x the importance of the underlying asset to the entity: if an underlying asset is critical to the entity’s
operations, being of such a specialised nature that it will be needed beyond the non-cancellable
period, this may be sufficient evidence that the lessee would choose to exercise an option to extend,
or would choose not to exercise an option to terminate (depending on the available options);
x significant leasehold improvements or initial installation costs: if the lessee has incurred
significant costs to install or improve an underlying leased asset, this may be sufficient
evidence that the lessee would choose to exercise an option to extend, or would choose not
to exercise an option to terminate (depending on the available options)
x below market-rentals: if an option to extend a lease would result in lower than market-related
lease payments during an optional extension period, this may provide a sufficiently large
economic incentive to choose to extend the lease. See IFRS 16.19 and .B37
It is important to be aware that significant professional judgement is required when analysing all
these facts and circumstances. However, estimating the lease term is a critical part of accounting
for a lease. The correct determination of the lease term is important because:
x it will be used to decide whether the lease is a short-term lease and thus whether it qualifies
to be recognised as an expense (in terms of the simplified approach offered by the
‘recognition exemption’); and
x it will be used to determine which payments to include in the measurement of the lease
liability (which will then also affect the measurement of the related right-of-use asset).
Required: Calculate the lease term and provide a brief explanation to justifying your calculation.
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Non-cancellable period 3 years + Extension period that is reasonably certain: 2 years = 5 years
Explanation: When estimating the lease term, we must assess all relevant facts and circumstances that
may provide the lessee with the economic incentive to exercise an option to extend or exercise an
option to terminate the contract.
In this case, the lessee has the option to extend the contract.
x The lease rentals during the ‘optional 2-year extension period’ are expected to be higher than market-
related rentals and thus do not provide the lessee with an economic incentive to extend the lease.
However, we must also consider all other facts and circumstances (see below).
x The lessee expects to need the use of this plant (or a replacement plant) for a period well beyond
the expiry of the possible 5-year term of the lease, thus providing an incentive to extend the lease.
x Since the entity needs to use the plant, or a replacement plant, for more than 3 years, it will mean
that if the entity does not renew the lease, it will need to source another plant. Although the cost of
negotiating the lease of another plant is expected to be insignificant, (which provides no incentive to
extend the lease), the cost to install the replacement plant will be a significant cost. The significant
extra installation costs provide a significant economic incentive to extend the lease.
Thus, it seems it is reasonably certain that the entity will renew the contract and thus that the optional
extension period should be included in the calculation of the lease term.
Please note: You could also have argued that the lease term is 3 years on the grounds that it is
reasonably certain the entity will not extend the lease because the lease rentals during the optional
extension period will exceed market-related lease rentals and where these extra costs are assumed to
outweigh the significant cost of having to install a different plant.
Since the calculation of the lease term involves estimating whether it is reasonably certain that
the entity (lessee) will exercise its option to renew or that it will not exercise its option to
terminate the lease, the entity (lessee) is required to reassess these estimations if and when:
x there is a significant event or change in circumstances;
x that is within its control; and
x may affect whether the entity may be reasonably certain to exercise or not to exercise an
option that was or was not previously included in the lease term. See IFRS 16.20
Just as we did when originally estimating the lease term (i.e. at the commencement of the
contract), we must consider all relevant facts and circumstances that may create an economic
incentive for the entity (lessee) to change its original decision regarding whether it is
reasonably certain that it would exercise or not exercise an option.
For example, at commencement date, we may have concluded that it appeared reasonably
certain that we would exercise an option to extend the lease but, during the course of the
lease, something happens that makes it uneconomical for us to extend the lease. In other
words, under the new circumstances, it now appears reasonably certain that we will not
exercise our option to extend and thus, the revised estimate of the lease term is shorter than
the original estimate.
We must revise our estimated lease term whenever there is a change in facts or
circumstances that would alter the reasonable certainty of our decision to exercise/not
exercise our options (whether our options are to extend or terminate the lease).
Since the lease term has a bearing on the payments that are considered to be lease
payments for purposes of measuring the lease liability (and related underlying right-of-use
asset), a change in the lease term will require adjustments to the measurement of the lease
liability and the right-of-use asset. Please see example 20 for an example that shows the
adjustment necessary due to a change in lease term. See IFRS 16.39
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9.3.1 Overview
Lease payments is a defined term (see pop-up below). The definition of lease payments differs
slightly from the perspective of a lessee or lessor. In the case of a lessee, the definition of the
term lease payments refers to five possible categories of payments, which may or may not be
included in the lease payments, depending on the circumstances:
x Fixed lease payments
x Variable lease payments that are dependent on an index or rate
x Exercise price of purchase options
x Termination penalties
x Amounts due in terms of residual value guarantees. See IFRS 16.27
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.
(e) For the lessee:
x Lease payments also include amounts expected to be payable by the lessee under residual value guarantees.
x Lease payments do not include payments allocated to non-lease components of a contract, unless the
lessee elects to combine non-lease components with a lease component and to account for them as a single
lease component (see the practical expedient of IFRS 16.15). IFRS 16 App A (slightly reworded)
There is a slightly different variation on this definition when being applied by a lessor (see chapter 17).
Apart from each of these five categories, which may or may not be included in the lease
payments (and which will be discussed in more detail below – see sections 9.3.2 to 9.3.6), it is
also important to note that a contract could involve payments for the right to use a variety of
different underlying assets, each of which may meet the definition of a separate lease
component and may even involve payments for non-lease components.
If a contract involves payments for the right to use a variety of different assets, we would need
to determine which of these rights meet the definition of a separate lease component. If we
then find that we have more than one lease component in the contract, we must remember
that each of these lease components must be accounted for as a separate lease. Since each
of these must be accounted for as a separate lease, we will need to calculate the lease
payments relevant to each of these lease components.
Furthermore, the contract may also include payments relating to non-lease components (e.g.
the contract may require payments in return for the provision of services). Because the
provision of a service is not the provision of a right to use an asset, this aspect of the contract
would not meet the definition of a lease and would thus be referred to as a non-lease
component. Payments that are made in respect of non-lease components should not be
included in the calculation of lease payments, unless the lessee has opted to apply the
practical expedient whereby it need not bother separating the payments for the lease
component from the payments for any non-lease components.
See section 6 for a detailed explanation of how to allocate the consideration among separate lease
components.
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Let us now return our attention to whether variable lease payments will be included in the calculation
of lease payments. The definition of lease payments includes only those variable payments that vary
in line with an index or a rate (e.g. lease rentals that will increase over time in tandem with the
consumer price index). Thus, variable payments that depend on, for example, the level of revenue
generated from the leased asset, would not be considered to be a lease payment.
It is interesting to note that, since the measurement of the lease liability is based on the
present value of the lease payments, and since the lease payments include variable lease
payments that vary based on an index or rate, the lease liability will require constant
remeasurement (i.e. each and every time that the index or rate changes).
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In other words, if lease payments include variable lease payments, the amount of the variable
lease payment that must be included in the calculation of the present value of the lease payments
must be based on the relevant index or prevailing rate at the commencement of the lease. When
the relevant index changes, we will need to recalculate the variable lease payment, which will then
alter the lease payments. This, in turn, will change the measurement of the lease liability. This is
explained in detail in section 11.6.
Worked example 1: A variable lease payment may start at C1 000 per year, to be increased each year at
the rate of change of CPI. On commencement date, we include C1 000 per year as the variable lease
payment in the initial measurement of the lease liability. However, in the next year, when CPI increases by
10%, the new amount of the variable lease payment is C1 100, and this latter amount must be included in
the lease payment calculation, which will require a remeasurement of the lease liability.
If the lessee has an option to purchase the leased asset, then the total lease payments must include the
exercise price of this purchase option, but only if the lessee is reasonably certain it will exercise this option.
If the lessee has an option to terminate the lease, then any termination penalties must be included in
the total lease payments, but only if the lessee is reasonably certain it will exercise this option. In
other words, we would only include the termination penalty if it was reasonably certain that it would
exercise the option to terminate the lease and thus that the expectation that the lease would be
terminated had also been factored into the calculation of the lease term.
Worked example 2: A lessee guarantees that the underlying asset will have a value of C100 at the end of
the lease. However, at commencement date, the lessee actually believes that, at the end of the lease, the
asset will have a value of only C20. This lessee will need to include in the calculation of its ‘lease payments’
an amount of C80, because it has guaranteed a residual value of C100 but expects the physical asset to be
worth C80 less than this, which means it expects to have to pay a further C80 in order to honour its promise.
x Fixed payments (including in-substance fixed payments) less lease incentives xxx
x Variable payments (only those that vary with an index on rate) xxx
x Exercise price for a purchase option (only if reasonably certain to exercise the option) xxx
x Penalties for a termination option (only if lease term calculated on the assumption that the entity xxx
will exercise this option)
x Amounts expected to be payable in terms of residual value guarantees xxx
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Gripping GAAP Leases: lessee accounting
The discount rate that we should ideally use is the interest rate implicit in the lease
agreement. However, this rate is not always readily determinable by the lessee because, in
order to calculate it (being the rate that causes the present value of the lease payments and
unguaranteed residual value to equal the sum of the fair value of the underlying asset and
any initial direct costs of the lessor), we would require knowledge of the lessor’s
circumstances. For example, it assumes that the lessee has knowledge of the unguaranteed
residual value (which is essentially the asset’s fair value at the end of the lease if the residual
value is not being guaranteed’). If the lessee cannot ‘readily determine’ the implicit interest
rate, it may use its incremental borrowing rate instead. We expect that the lessee would
normally use the incremental borrowing rate.
The interest rate implicit in the lease A lessee’s incremental borrowing rate
is defined as: is defined as:
x The rate of interest that causes: x the rate of interest the lessee would have to pay
x the present value of (a) the lease payments and x to borrow over a similar term, and with similar
(b) the unguaranteed residual value security,
to equal x the funds necessary to obtain an asset of a
x the sum of (i) the fair value of the underlying similar value to the right-of-use asset
asset and (ii) any initial direct costs of x in a similar economic environment. IFRS 16 App A
the lessor. IFRS 16 App A
If the lease involves a low-value asset or is a short-term lease, the lease may be accounted for in
terms of the recognition exemption (if the entity chooses to apply this option). This optional
recognition exemption is a simplified approach to accounting for the lease. See section 8 for a
detailed explanation on when this recognition exemption may be used.
The simplified approach is:
If the lease is to be accounted for under the optional recognition Expense lease pmts over the
exemption, it means the costs are recognised as an expense in lease term using straight-line
P.S. It’s similar to how operating leases
profit or loss, and measured on a straight-line basis over the lease
were accounted for per IAS 17 Leases
term (or using some other systematic basis). (See also section 8)
This process of accounting involves debiting the lease expense with an amount reflecting the lease
payments recognised over the lease term on the straight-line basis, crediting the bank with the lease
payments actually made, and recognising any difference as a lease payable or prepaid. See IFRS 16.6
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The lease payments are C1 000 per month for the first year and C1 300 per month for the second year.
The lease commenced on 1 April 20X1. Entity A has a 31 December year-end.
Required: Show the journal entries in Entity A’s general journal.
Comment:
x Since the recognition exemption is applied to this lease, the lease rentals are recognised as an
expense on the straight-line basis over the lease term of 2 years.
x This means we measure the lease expense at C1 150 per month (see calculation below).
x Since the lease payments differ from the lease expense, it results, in this example, in a payable that
reverses by the end of the lease.
31 December 20X2
Lease expense (low-value asset) (E) C1 150 x 12 m 13 800
Bank (A) C1 000 x 3 m + C1 300 x 9 m 14 700
Lease payable (L) Balancing 900
Lease of computer under the optional simplified approach
31 December 20X3
Lease expense (low-value asset) (E) C1 150 x 3 months 3 450
Bank (A) C1 300 x 3 months 3 900
Lease payable (L) Balancing 450
Lease of computer under the optional simplified approach
11.1 Overview
A lease that does not qualify for the recognition exemption (i.e. is not a low-value asset, or
short-term lease) must be accounted for ‘on balance-sheet’. This means that we must
recognise a right-of-use asset and a lease liability.
A lease, which is not accounted for in terms of the recognition exemption, will be accounted
for at commencement date by recognising:
x a right-of-use asset, and
Initial measurement of
x a lease liability. See IFRS 16.22
lease liability:
x PV of lease payments
The lease liability is initially measured, at commencement x that are still payable at
date, at the present value of the unpaid lease payments commencement date,
on this date (i.e. it would exclude any lease payments that x discounted using either the implicit
are paid in advance or had been prepaid). interest rate or the lessee’s
incremental borrowing rate
See IFRS 16.26
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Gripping GAAP Leases: lessee accounting
The right-of-use asset is initially measured at its cost, where this cost includes the following:
x The initial measurement of the lease liability; Initial measurement of
right-of-use asset:
x Lease payments made on/ before commencement date;
x Lease liability (initial measurement)
x Any initial direct costs incurred by the lessee; and x Initial direct costs
x The provision for any future costs to dismantle and remove x Prepaid lease payments (i.e. pmts on/
the underlying asset, restore the site on which it was before commencement date)
x PV of estimated future costs (to
situated or restore the asset to a predetermined condition, dismantle, remove or restore)
unless the obligation for these future costs arose because x Less lease incentives received.
the underlying asset was used to make inventories; See IFRS 16.24
Let us look at each of the above bullet-points in a bit more detail and also consider how these
would appear as journal entries.
Initial measurement of the lease liability: The lease liability is generally the primary cost in
acquiring the right to use the asset and thus the initial measurement of this liability is included
in the cost of the right-of-use asset.
Lease liability (initial PV) Debit Credit
Right-of-use asset: cost (A) xxx
Lease liability (L) xxx
PV of lease liability is part of the cost of the RoU asset
Lease prepayments: When calculating the cost of the right-of-use asset at commencement date,
we must remember that any lease payments made, either on or before commencement date, will
obviously not be part of the lease liability (which will constitute inter-alia, the remainder of the lease
payments to be paid), so we add these payments, if any, to the cost of the right-of-use asset.
Prepaid lease rentals Debit Credit
Right-of-use asset: cost (A) Prepaid lease rentals (e.g. xxx
Bank (A) rentals payable in advance xxx
Prepaid lease rental (paid on or before commencement date)
is part of the cost of the RoU asset
Initial direct costs: Any initial direct costs (being the incremental costs of obtaining the lease
that would not have been incurred had the lease not been obtained e.g. directly related legal
costs) are also considered to be part of the cost of the right-of-use asset. See IFRS 16.24
Initial direct costs Debit Credit
Right-of-use asset: cost (A) Initial direct costs that are xxx
Bank/ Payable etc (A/L) paid/payable xxx
Initial direct costs paid or payable is part of cost of RoU asset
Provision for future costs: If the contract requires the lessee, at the end of the lease, to dismantle
and remove the asset, or restore the asset or the site on which it was situated, then the lessee has a
contractual ‘obligation’. The lessee must recognise the obligation for these future costs as a provision
(in terms of IAS 37) when the obligation is incurred (sometimes this obligation arises merely by
signing the lease contract and sometimes the obligation is incurred/ increases as the underlying
asset is used). The initial measurement of this provision (i.e. the present value of the expected future
outflows) is added to the cost of the right-of-use asset (debit right-of-use asset; credit provision) (per
IFRS 16 Leases). However, if the obligation for these future costs is incurred as a result of the
underlying asset being used to make inventories, then the obligation for these future costs would be
included in the cost of inventories instead (debit inventory asset; credit provision). See IFRS 16.24 (d)
P.S. This principle of including the initial measurement of the provision in the cost of the related asset
also applies to property, plant and equipment (debit PPE; credit provision). See IAS 16.16 (c)
Provision for obligation to dismantle or restore Debit Credit
Right-of-use asset: cost (A) PV of future costs to restore, xxx
Provision (L) dismantle etc xxx
Provision for future costs is part of the cost of the RoU asset
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Gripping GAAP Leases: lessee accounting
Lease incentives: These are defined as ‘the payments made by the lessor to the lessee associated
with the lease, or the reimbursement or assumption by a lessor of the costs of the lessee’.
Lease incentives would thus include outright receipts from the lessor, (e.g. received to simply
incentivise the lessee to enter into the lease) and also receipts from the lessor that constitute refunds of
costs, relating to the lease, that the lessee has already paid for.
The lessee does not have to actually receive an amount for there to be a lease incentive: the lessor
could undertake to pay certain of the lessee’s costs on the lessee’s behalf.
All lease incentives received or receivable are credited to the cost of the right-of-use asset. However,
we must be careful not to reduce the cost of the asset by receipts or receivables that are not actually
lease incentives. For example, a receipt of a reimbursement from a lessor for leasehold improvements
(e.g. the painting of a leased building) is not considered to be a lease incentive (it does not relate
directly to the lease), and should thus not be accounted for as a reduction in the cost of the right-of-use
asset (building): the leasehold improvements would be expensed, and the related reimbursement
would be accounted for as a reduction in this expense.
On 1 January 20X1, Exe Limited (the lessee) enters into a lease over a building, for a non-
cancellable period of four years, with Entity B (the lessor).
x The lease payments include five fixed lease payments of C10 000, with the first payment of
C10 000 payable in advance on 1 January 20X1 and the remaining four payments of C10 000
payable annually in arrears, starting 31 December 20X1.
x In addition, Exe is required to pay 10% of the revenue generated from the use of the
building per year, payable annually in arrears. Exe expects to generate revenue of
C80 000 per year from the use of the building.
x Exe incurred initial direct costs of C4 000 to obtain the lease (which it only paid in
20X2), of which C1 000 was received as a reimbursement from the lessor.
x Exe also paid for leasehold improvements (painting of the building) of C8 000, 70% of
which were also received as a reimbursement by the lessor.
x The appropriate discount rate is 10%.
Required: Using Exe’s general journal, show the journals to account for the initial recognition of the
lease on 1 January 20X1.
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Gripping GAAP Leases: lessee accounting
x The reimbursement of a portion (C1 000) of the initial direct costs is regarded as a lease incentive,
as it is a payment by the lessor to the lessee in order to refund costs incurred in securing the lease
(Journal 3). Note that the reimbursement for the leasehold improvement is not a lease incentive, as
it relates to the improvements effected by the lessee, and is thus not related directly to the lease
Workings:
W1.1: Present value of lease liability – at 1 January 20X1
The PV of the lease payments, using a financial calculator:
n = 4 i = 10% PMT = -10 000
COMP PV ... and your answer should be: 31 699!
A lease that is accounted for under IFRS 16’s general approach is accounted for ‘on-balance
sheet’, with the result that a lease liability and right-of-use asset will be recognised.
x The initial recognition and measurement at commencement date of both these elements
was explained in section 11.2.
x The subsequent measurement, after commencement date, of both elements is as follows:
the lease liability is accounted for under the effective interest rate method, which means
that it is increased by an amount recognised as interest and decreased by the lease
payments; and
the right-of-use asset is depreciated and tested for impairments, normally under the
cost model, although the revaluation model or fair value model may, under certain
circumstances, be used instead.
The subsequent measurement of the lease liability and right-of-use asset may also involve
remeasurement adjustments, or lease modification. This happens if there is a reassessment,
lease modification or a revision to the in-substance fixed lease payments. See IFRS 16.36
More detail regarding the subsequent measurement of each of these elements can be found in:
x Section 11.4 – subsequent measurement of a lease liability
x Section 11.5 – subsequent measurement of a right-of-use asset
x Section 11.6 – subsequent measurement involving remeasurements
x Section 11.7 – subsequent measurement involving lease modifications.
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The subsequent measurement of the lease liability is at amortised cost i.e. using the effective
interest rate method.
The effective interest rate method is often described as apportioning the lease payments
between interest expense and a reduction in the lease liability but, effectively, it means that we:
x increase the lease liability with the interest on the liability (i.e. unwinding the discounting that
occurred at initial measurement) and recognise this interest as an interest expense; and
x we decrease the lease liability by the lease payments.
x On 1 January 20X1, Exe Limited (the lessee) entered a lease over a building, for four years.
x The lease payments include five fixed lease payments of C10 000, with the first payment of
C10 000 payable in advance on 1 January 20X1 and the remaining four payments of C10 000
payable annually in arrears, starting 31 December 20X1.
x Exe is also required to pay, in arrears, 10% of the revenue generated from the use of the building
per year. At commencement date, Exe expected to generate revenue of C80 000 per year.
x Exe incurred initial direct costs of C4 000 to obtain the lease (which is only paid in 20X2), of which
C1 000 was subsequently received as a reimbursement by the lessor.
x The appropriate discount rate (lessee’s incremental borrowing rate) was 10% at commencement date.
Additional information:
x Exe generated revenue from the use of the building of C70 000 in 20X1 and C60 000 in 20X2 and
paid the variable lease payments on due date.
The implicit interest rate was not readily determinable and thus the entity uses its incremental borrowing rate.
The incremental borrowing rates were as follows:
01 January 20X1: 10%
31 December 20X1: 11%
31 December 20X2: 12%
Required: Journalise the subsequent measurement of the lease liability, and the variable lease payments,
using Exe’s general journal for 20X1 and 20X2 assuming Exe has a 31 December financial year-end.
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Gripping GAAP Leases: lessee accounting
W1: Lease liability – effective interest rate table: as at 1 January 20X1 (payments in arrears)
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Gripping GAAP Leases: lessee accounting
Required:
a) Show the journals to account for the lease liability in Entity A’s general journal for each year affected
assuming that Entity A has a 31 December financial year-end. Ignore all journals relating to the
subsequent measurement of the asset.
b) Calculate the lease liability balance to be included in the statement of financial position and the lease
interest expense to be included in the statement of comprehensive income for the years ended 31
December 20X1 to 31 December 20X4.
Solution 17: Lease liability - initial and subsequent measurement (advance lease payments)
Comments:
x The initial measurement of the lease liability includes only those lease payments that are payable on
commencement date (thus it excludes lease payments made on or before commencement date).
This means the lease liability on commencement date is the present value of only 4 lease payments,
since it excludes the first lease payment made on commencement date.
x The right-of-use asset includes both the initial measurement of the lease liability (present value of the
4 lease payments) plus the first lease payment paid on commencement date.
a) Journals:
Chapter 16 809
Gripping GAAP Leases: lessee accounting
Workings:
W1: Lease liability – present value of lease payments payable on commencement date
The PV of the lease payments , using a financial calculator:
x n = 4 i = 16% PMT = -20 000
COMP PV ... and your answer should be: 55 964
W2: Lease liability – effective interest rate table: as at 1 January 20X1 (payments in ADVANCE)
Although the right-of-use asset is normally measured in terms of the cost model, it may be
accounted for in terms of the revaluation model (per IAS 16) or fair value model (per IAS 40)
instead, depending on the asset being leased.
11.5.2 Subsequent measurement of the right-of-use asset: in terms of the cost model
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Gripping GAAP Leases: lessee accounting
IFRS 16 explains that this cost model is effectively the same cost model used in IAS 16 Property, plant
and equipment, since the right-of-use asset is initially measured at cost and then depreciated and
tested for impairments in terms of IAS 36 Impairment of assets. However, although the cost model is
essentially the same as the cost model described in IAS 16, the cost model used for a right-of-use
asset is slightly different in terms of the measurement of cost and the measurement of depreciation.
The period of depreciation differs slightly as well. Whereas IAS 16’s cost model requires that an
item of property, plant and equipment be depreciated over its useful life, the depreciation period of
IFRS 16’s cost model is dependent on the circumstances regarding expected ownership:
x If ownership transfers, or if there is a purchase option that the lessee is reasonably certain it will
exercise (i.e. if the expected exercise of this purchase option is also reflected in the measurement
of the lease payments, and thus in the measurement of the lease liability and thus also in the cost
of the right-of-use asset), then the depreciation period is from commencement date to:
the end of the underlying asset’s useful life.
x If ownership of the asset is not expected to transfer to the lessee at the end of the lease (e.g. there
are either no purchase options or the lessee does not expect to exercise them), the depreciation
period of the right-of-use asset is from commencement date to the earlier of:
the end of the right-of-use asset’s useful life, and
the end of the lease term. See IFRS 16.32
Chapter 16 811
Gripping GAAP Leases: lessee accounting
When testing a right-of-use asset for impairment, we follow IAS 36 Impairment of assets. This
means that we follow the same process that we used when we tested, for example, items of
property, plant and equipment for impairment. Please see chapter 11 for further details.
812 Chapter 16
Gripping GAAP Leases: lessee accounting
If the right-of-use asset is an asset that falls within a class of property, plant and equipment to
which the lessee applies the revaluation model, then the lessee may choose to measure all right-
of-use assets falling within this class of property, plant and equipment using the revaluation
model (i.e. this is an accounting policy choice). See IFRS 16.29 & .35
11.5.4 Subsequent measurement of the right-of-use asset: in terms of fair value model
If the right-of-use asset is an asset that is investment property and if the lessee applies the fair
value model to its investment property, then the lessee must measure the right-of-use asset in
terms of the fair value model (per IAS 40) (i.e. there is no choice in this case). See IFRS 16.29 & .34
If there is an increase in the lease payments, the adjustment made to increase the lease liability is
also made to the right-of-use asset. E.g. a lease liability increase of C100 is journalised as:
Remeasurement adjustment – increase in lease payments Debit Credit
Right-of-use asset (A) 100
Lease liability (L) 100
Remeasurement of lease liability and right-of-use asset due to
an increase in lease payments
However, if there is a decrease in the lease payments, the lease liability must be decreased.
However, the adjustment to the right-of-use asset (i.e. decreasing the asset) will be limited to the extent
of the asset’s carrying amount, with any excess recognised as an expense in profit or loss.
In other words, if the adjustment made to the lease liability exceeds the asset’s carrying amount, we
simply reduce the asset’s carrying amount to zero and the excess adjustment (that would otherwise drop
the asset’s carrying amount below zero) is recognised as an expense in profit or loss instead. See IFRS 16.39
x If the decrease in the lease liability would not decrease the carrying amount of the asset below
zero, the adjustment made to the lease liability is also made to the asset. E.g.: The right-of-use
asset has a carrying amount of C300 and the lease liability must decrease by C100 is:
Remeasurement adjustment – decrease in lease payments Debit Credit
(CA of RoU asset does not drop below 0)
Lease liability (L) 100
Right-of-use asset (A) 100
Remeasurement of lease liability and right-of-use asset due to
a decrease in lease payments (decrease in L is = or < A’s CA)
x If the decrease in the lease liability would decrease the carrying amount of the asset below zero,
the adjustment to the lease liability is made partly to the asset and partly to profit or loss.
E.g.: A right-of-use asset has a carrying amount of C300 and the lease liability decreases by C400:
Remeasurement adjustment – decrease in lease payments Debit Credit
(CA of RoU asset would drop below 0)
Lease liability (L) 400
Right-of-use asset (A) Carrying amount 300
Lease remeasurement income (P/L: I) Balancing 100
Remeasurement of lease liability and right-of-use asset due to a
decrease in lease payments (decrease in L > A’s CA)
Chapter 16 813
Gripping GAAP Leases: lessee accounting
When remeasuring the lease liability, we calculate the present value of the revised remaining lease
payments at the date of the reassessment and will have to either use a revised discount rate or the
original discount rate.
x We must use a revised discount rate if the lease payments change due to:
a change in the estimated lease term, or
a change in the assessment of whether an option to purchase will be exercised or not (e.g. if we
did not believe it was reasonably certain that a purchase option would be exercised, then the
purchase price would not have been included in the lease payments, but if the situation changes
and we now believe that a purchase option will be exercised, then the purchase price needs to be
included in the lease payments). See IFRS 16.40
x We must use the original discount rate if the remaining lease payments change due to:
a change in the amount expected to be payable in terms of a residual value guarantee; or
a change in the variable lease payments that vary based on an index or rate;
unless the above changes resulted from a change in a floating interest rate, in which case a
revised discount rate is used instead. See IFRS 16.42-43
When using a revised discount rate, the revised discount rate must either reflect the interest rate
implicit over the remainder of the lease term (assuming this can be determined) or the lessee’s
incremental borrowing rate at the date of the reassessment. See IFRS 16.41
x The lease covers a 4-year non-cancellable period at the end of which the lessee has the option to
extend the lease for a further 3 years.
x The lease payments, payable in arrears, will be C10 000 p.a. for the first 4 years and C8 000 p.a. during
the extra 3 years, should the lessee opt to extend the contract.
x At 1 January 20X1, Gee felt it was reasonably certain that it would not extend the lease. However, the
facts and circumstances at 31 December 20X2 made it reasonably certain that the lease would be
extended for the extra 3 years.
x The implicit interest rate is not known and thus the entity uses the incremental borrowing rate as the
discount rate. The incremental borrowing rates were as follows:
01 January 20X1: 10%
31 December 20X1: 11%
31 December 20X2: 12%
Required: Journalise the change in lease term on 31 December 20X2.
Explanation: At 1 January 20X1, the lease term was originally estimated to be 4 years (i.e. excluding the optional
extension period), at which point the incremental borrowing rate was 10%. The lease liability at commencement is
thus initially measured at its present value of C31 699 (see W1).
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Gripping GAAP Leases: lessee accounting
x At 31 December 20X2, the total lease term (LT) is revised to be 7 years (i.e. including the optional extension
period). This means, at this date, instead of the remaining lease term being 2 years (original LT: 4 yrs – 2 yrs), it
is now 5 years (revised LT: 7 yrs – 2 yrs). At this date, the lease liability’s carrying amount
- actual carrying amount is C17 356 (present value based on the original lease term and discount rate : W1).
- revised carrying amount is C32 218 (present value based on the revised lease term and discount rate: W2).
x Thus, the increase in the lease term causes an increase in the lease liability of C14 862 (C32 218 – C17 356).
x This is processed after processing all other journals relating to the lease liability for the 20X2 year (i.e. interest
expense of C2 487 and lease payment of C10 000).
W1: Lease liability – effective interest rate table: ORIGINAL as at 1 January 20X1
W2: Lease liability – effective interest rate table: REVISED at 31 December 20X2
Chapter 16 815
Gripping GAAP Leases: lessee accounting
If a modification does not meet the criteria to be accounted for as a separate lease, then we
account for it, at the effective date of the modification, as follows:
x allocate the modified consideration to the lease components and non-lease components
(using the same principles as always);
x determine the lease term of the modified contract (use the same principles as always);
x remeasure the lease liability to reflect the present value of the modified lease payments,
present valued using a revised discount rate, being either:
the revised implicit interest rate over the remainder of the term or
the lessee’s incremental borrowing rate at the effective date of the modification (if the
revised implicit rate is not readily determinable). See IFRS 16.45
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Gripping GAAP Leases: lessee accounting
x We remeasure the lease liability to be C280 000. This is based on the revised lease payments
over the remaining lease term (3 yrs) using the revised implicit interest rate of 8,687% (see below)
x The liability balance prior to the modification was C548 784 (W1) and thus the remeasurement to
C280 000 (W2) requires a debit of C268 784 (C548 784 - C280 000).
x Since we reduce the asset by C262 500 and reduce the liability by C268 784, we recognise a gain
on the partial termination of C6 284
x The implicit interest rate in the original contract is 9,826344%
PV = -700 000 N = 4 PMT = 220 000 Comp i … your answer should be = 9,826344%
x The implicit interest rate in the modified contract is 8,687602%
PV = -280 000 N = 3 PMT = 110 000 Comp I … your answer should be = 8,687602%
Journal
See definitions of each in the pop-ups on the right and on the next page.
Chapter 16 817
Gripping GAAP Leases: lessee accounting
If we have a lease (regardless of recognition approach), we will need to assess whether it meets:
x part (a) of the VAT Act’s definition of an ‘instalment credit
agreement’, Rental agreement is defined
x part (b) of the VAT Act’s definition of ‘instalment credit as:
agreement’, or x a lease agreement other than that
in part (b) of ICA definition.
x the VAT Act’s definition of a ‘rental agreement’. See s1 of VAT Act (significantly summarised)
If the lease meets either the definition of a ‘rental agreement’ or ‘part (b) of the ICA definition’
(per the VAT Act), then the tax authorities effectively view the asset as still belonging to the lessor
and merely rented to (borrowed by) the lessee.
As a result, the tax authorities will neither allow the lessee a For tax purposes, if the
deduction of allowances on the cost of the asset nor will it lease meets
allow the deduction of interest on the lease liability. Instead, x ‘part (a) of the ICA’ definition in
the lessee will only be allowed to deduct the lease payments the VAT Act,
when incurred/ paid (in terms of section 11(a) of the ITA). then the lessee is assumed to own
the asset and thus:
However, if the lease payments paid in cash include a lease x asset: tax base = future
payment that has been prepaid, then this prepayment will be deductions (e.g. wear & tear)
allowed as a deduction on the following basis: x liability: tax base = liability bal
in terms of EIR method
x It relates to lease payments that were due to be paid in the
first 6 months of the following year, or
For tax purposes, if the
x If then this prepayment is added together with all other lease meets the definition
prepayments and the total prepayments are less than of:
R100 000, then all prepayments will be allowed as a x a ‘rental agreement’ or
deduction. See South African Tax Act S11(e) and S23H x ‘part (b) of the ICA’ definition
in the VAT Act,
If the lease meets ‘part (a) of the ICA definition’ (per the VAT then the lessee is assumed not to
Act), then the tax authority views the asset as belonging to the own the asset, and thus:
lessee. In other words, the tax authority views the asset as having x asset: nil tax base
been purchased by the lessee (the lease agreement is simply x liability: nil tax base (except
financing the lessee’s purchase of the asset). where there is VAT in case of part
(b) of ICA definition )
As a result, the tax authority will allow the lessee to deduct an
allowance (wear and tear) based on the cost of the asset (cash value per the VAT Act) and
will allow the deduction of finance costs on the lease liability (calculated using the effective
interest rate method: EIR method).
12.3 Accounting for the tax consequences where the lease is accounted
for using the simplified approach
If the lease is recognised by the lessee ‘off-balance sheet’ (i.e. the simplified approach), the entity
does not recognise a right-of-use asset and lease liability but simply recognises the lease payments
as an expense, calculated using the straight-line method (or another systematic basis). The process
of ‘straight lining’ the lease payments may lead to the recognition of a lease payable (liability) or a
lease prepayment (asset).
Simplified approach &
12.3.1 From a tax-perspective, the lessee is renting the asset it’s a ‘lease’ from a
(i.e. the lease meets the definition of ‘rental agreement’ tax perspective:
or ‘part (b) of the ICA definition ) Current tax: adjust profit
before tax as follows:
If the lease is recognised by the lessee ‘off-balance sheet’ (i.e. using x add back:
the simplified approach), and the tax authority believes the lease lease payment expenses
meets the definition of a ‘rental agreement’ or that it meets ‘part (b) of x deduct:
lease payments i.e. cash pmts
the ICA definition’ (i.e. if the tax authority views the lessee as simply
Deferred tax: arises on CA
borrowing/ leasing the asset), then the accounting treatment and tax
of Expense prepaid/ payable
treatment will be similar. (TB = nil)
818 Chapter 16
Gripping GAAP Leases: lessee accounting
This is because the accountant will expense the lease payments (simplified approach) and
the tax authority will allow the deduction of the lease payments (although possibly limited by
section 23H in the ITA, if there has been a prepayment of the lease instalments – see
section 12.2). In other words, both the accountant and tax authorities ‘agree’ that the entity
does not have a leased asset or a lease liability.
However, there is a slight difference between the accounting treatment and tax treatment
described above. The accounting treatment may result in a lease prepayment/ payable in the
accounting records due to the ‘straight lining’ of the lease expense:
x If the ‘straight lining’ results in a lease prepaid (asset) or payable (liability), deferred tax
arises on the resultant temporary difference (the asset/ liability has a carrying amount but
its tax base is nil).
x If the ‘straight lining’ does not lead to the recognition of a lease prepaid/ payable, then
deferred tax will not arise.
Chapter 16 819
Gripping GAAP Leases: lessee accounting
Calculations:
x Total lease payments = (C2 000 x 12 months + C3 000 x 12 months) = C60 000.
x Straight-lining of the lease payments (assumed there was no other systematic basis that was
preferable) = C60 000 ÷ 24 months = C2 500 per month
Please note: The journals above have been summarised on an annual basis but the payments are
monthly and thus, in reality, they would have been processed monthly.
Notice: The final ‘profit before tax’ could have been given instead, in which case we would not have
needed to first deduct the lease expense to calculate profit before tax.
Comment:
x Since the tax authority is treating this lease as a ‘rental agreement’ or a ‘lease agreement’ as defined
in the ‘part (b) of the ICA definition’ in the VAT Act, they simply grant the lease instalments as
deductions when they are paid, and thus there will be no tax base for the lease payable (the payable
arising from having straight-lined the lease payments) that arises in the accounting records.
(Remember that the tax base of a liability is the carrying amount of the liability less the amount
allowed as a deduction in the future. Since the entire carrying amount of the lease payable will be
allowed as a tax deduction in the future, when it is paid, the tax base is nil)
x This example deals with an expense payable and thus a comparison of the carrying amount of the
expense payable and the nil tax base leads to a deferred tax asset.
x Had the lease rentals been prepaid instead, it would have resulted in a deferred tax liability.
820 Chapter 16
Gripping GAAP Leases: lessee accounting
If the lease is recognised by the lessee ‘off-balance sheet’ (i.e. If using the simplified
the simplified approach), and the tax authority believes the lease approach & the lessee
meets ‘part (a) of the ICA definition’ (i.e. the lessee is deemed to ‘owns’ the asset from
the tax perspective:
own the asset), then the accounting treatment and the tax
treatment would differ. Current tax: adjust profit
before tax as follows:
x add back:
This is because the accountant is expensing the lease payments lease payment expenses
on the straight-line method, thus potentially resulting in a lease x deduct:
prepaid/ payable, whereas the tax authority treats the lessee as wear and tear allowance
being the owner of the asset and will thus allow the lessee to finance costs (using EIRM)
deduct wear and tear and finance costs using the effective Deferred tax: arises on CA
of Expense prepaid/ payable
interest rate method (EIRM).
(TB = future W&T and finance
cost deductions)
Thus, since the accountant may have a carrying amount for a
lease payable/ prepaid, the tax bases would be different amounts since they would reflect the
future deductions relating to wear and tear and the future deductions of finance costs. Since
the carrying amount and tax base would differ, temporary differences will arise on which
deferred tax must be recognised.
12.4 Accounting for the tax consequences where the lease is accounted
for using the general approach
If the lease is recognised by the lessee ‘on-balance sheet’ (i.e. the general approach), the
entity would recognise:
x an asset (subsequently depreciated and impaired), and
x a lease liability, on which interest is expensed.
If the lease is recognised by the lessee ‘on-balance sheet’ (i.e. If using the general
the general approach), and the tax authority believes the lease approach & it’s a
meets the definition of a ‘rental agreement’, or that it meets ‘part ‘lease’ from the tax
(b) of the ICA definition’ (i.e. it believes that the lessee is simply perspective:
borrowing/ leasing the asset), then the accounting treatment and
Current tax: adjust profit
the tax treatment will differ.
before tax as follows:
x add back: depreciation &
This is because, whereas the accountant recognises a right-of-
interest expense and
use asset and a lease liability, the tax authority will only allow the
x deduct: the lease payments
deduction of the lease payments, subject to section 23H (ITA)
limitations, in the event that there has been a prepayment (see Deferred tax: arises on
section 12.2). In other words, the tax authority does not x CA of RoU asset (TB = nil) &
‘recognise’ that the entity has an asset and a lease liability. x CA of LL (TB = nil)
Chapter 16 821
Gripping GAAP Leases: lessee accounting
Since the carrying amounts and tax bases of the right-of-use asset and lease liability differ,
temporary differences arise on which deferred tax will be recognised.
Required:
A. Prepare the journals for the year ended 31 December 20X4 in Dave Limited’s books.
B. Repeat Part A assuming the lease was signed on 1 March 20X4 (not 1 January 20X4) and thus that
the first instalment was payable on 28 February 20X5 (not 31 December 20X4).
822 Chapter 16
Gripping GAAP Leases: lessee accounting
Part A Part B
31/12/20X4 continued … Dr/ (Cr) Dr/ (Cr)
Deferred tax: income tax (A) W3 26 273 63 580
Income tax expense (P/L: E) (26 273) (63 580)
Deferred tax asset arising on the lease
Comment: Although not specified by IFRS 16, IAS 1 (para 60) requires that the lease liability be
separated into its current and non-current portions.
Chapter 16 823
Gripping GAAP Leases: lessee accounting
If the lease is recognised by the lessee ‘on-balance sheet’ (i.e. the general approach), and the
tax authority believes the lease meets ‘part (a) of the ICA definition’ (i.e. the lessee owns the
asset), then the accounting treatment and the tax treatment would be similar.
In the case of a lease that meets the definition of part (a) of the ICA definition per the VAT
Act, the tax authority ‘agrees’ that the lessee has an asset, the cost of which will be allowed
as a tax deduction (i.e. wear and tear) and that the lessee has a liability for the cost of
financing the acquisition of the asset, where these finance costs will be allowed as a tax
deduction using the same effective interest rate method used by the accountant.
Although the carrying amount and tax base have the possibility of being the same, temporary
differences would arise if the rate of the tax deduction (wear and tear) granted by the tax
authority differs from the depreciation rate. This is because the carrying amount of the asset
and the tax base thereof would then differ. This is very similar to the tax treatment of an item
of property, plant and equipment.
In South Africa, if the lease meets certain requirements per the VAT Act’s definition of an
‘instalment credit agreement’, the lessor would need to charge the lessee VAT on the cash
selling price of the asset, and the lessor would be required to pay this VAT to the tax
authorities at the time of signing the lease contract. The existence of VAT has implications for
the measurement of the right-of-use asset, lease liability and both current and deferred tax.
824 Chapter 16
Gripping GAAP Leases: lessee accounting
As already explained, if the lease meets certain requirements per the VAT Act, the lessor
would have to charge VAT on the lease, calculated based on the asset’s cash selling price.
The lessor has to then pay this VAT to the tax authorities on the lease at the time of signing
the lease contract (even before receiving a single payment from the lessee).
Requiring the vendor (lessor) to make this upfront payment of VAT to the tax authority can
cause the lessor severe cash flow problems if he recovers this VAT from the customer
(lessee) via lease payments. Thus, a lessor that is required to make an advance payment of
VAT, might choose to require the lessee to the pay the lessor the VAT in full on
commencement date. In other words, the lessor could recover VAT from the lessee in one of
two ways:
x the lessor may require the lessee to pay the VAT to the lessor at commencement date, or
x the lessor may include the VAT in the lease instalments (the lessee will be paying the VAT
to the lessor gradually over the lease term).
12.5.4 VAT and the effect on taxable profits and current income tax
If the lease meets ‘part (b) of the ICA definition’, it means the tax authority sees the lease as a
‘true lease’, in which case the lease payments are deductible for income tax purposes (see
section 12.4.1). However, how much of the lease payment may be deducted in the calculation
of the lessee’s taxable profits will depend on whether the lease includes VAT and, if it does,
whether the lessee is charged this VAT upfront or as part of the lease payments and then also
on whether the lessee is able to claim from the tax authorities any VAT paid:
x If the lessor does not charge VAT, then the lease payments will not include VAT and thus
the lessee simply deducts the full lease payment.
x If the lessor does charge VAT but requires this VAT to be paid upfront on commencement
date, then the lease payments will not include VAT and thus the lessee deducts the full
lease payment.
Chapter 16 825
Gripping GAAP Leases: lessee accounting
x If the lessor does charge VAT and does not charge it as an upfront payment, then the
lease payments will include VAT. In this case:
if the lessee can claim back the VAT paid as a VAT input, then the lease payments to be
deducted in the calculation of taxable profit each year, must exclude VAT (otherwise the
lessee would be claiming the VAT as a deduction for income tax purposes when the VAT
wasn’t a cost to the lessee at all because it had already been claimed back as a VAT input).
See below on how to calculate the portion of the VAT to be removed from each lease
payment.
if the lessee cannot claim back the VAT, then the lease payments to be deducted in the
calculation of taxable profit each year, must include VAT.
If we need to remove the VAT from lease payments, we apply section 23C of the ITA. The essence
of this is that the portion of the total VAT to be removed from each lease payment (instalment) is
calculated based on the ratio of the lease payment relative to the total lease payments in the lease:
The discussion above explains the impact of VAT on the calculation of the taxable profit and
thus current income tax. However, there are also deferred tax consequences. There are
countless permutations but one must simply apply the usual principles: calculate the carrying
amount of the right-of-use asset and lease liability in terms of IFRS 16 and then compare it to
the tax base of each, where the tax base is calculated by considering the taxation legislation.
For example: Let us consider a lease that includes VAT in then lease payments, where the
lessee can claim VAT back and where the lease is recognised:
x by the accountant ‘on-balance sheet’ (i.e. the general approach): the accountant will
recognise a right-of-use asset and a lease liability; and
x by the tax authority as a true lease (i.e. it meets ‘part (b) of the ICA definition’): the tax
authorities do not believe the lessee has an asset or liability and thus allows the deduction of
the lease payments.
826 Chapter 16
Gripping GAAP Leases: lessee accounting
Required:
A. Journalise the initial capitalisation of the right-of-use asset and lease liability.
B. Calculate the lease liability’s tax base for each year of the lease term.
Solution 24A: Lease under general approach – with VAT – initial measurement
Solution 24B: Lease under general approach – with VAT – tax base
Calculation of the lease liability’s tax base C
Total VAT at beginning of year 1 126 500 x 15/115 16 500
Movement (4 125)
Tax base at end of year 1 [(39 907 x 3 years) ÷ (39 907 x 4 years)] x 16 500 12 375
Movement (4 125)
Tax base at end of year 2 [(39 907 x 2 years) ÷ (39 907 x 4 years)] x 16 500 8 250
Movement (4 125)
Tax base at end of year 3 [(39 907 x 1 years) ÷ (39 907 x 4 years)] x 16 500 4 125
Movement (4 125)
Tax base at end of year 4 [(39 907 x 0 years) ÷ (39 907 x 4 years)] x 16 500 0
Chapter 16 827
Gripping GAAP Leases: lessee accounting
Comment:
x Notice how the introduction of VAT now creates a tax base for the liability (W2). Compare this to
example 23 where VAT was ignored and the tax base was therefore nil.
x There are a number of ways in which the tax authority may deal with the VAT. The tax base of the
asset and liability depend entirely on the relevant tax legislation
Profit before tax 200 000 200 000 200 000 200 000
Add back expenses
x Finance cost – lease 12 650 9 924 6 926 3 628
x Depreciation on right-of-use asset (a) 27 500 27 500 27 500 27 500
Less tax-deductions
x Lease payments (b) (35 782) (35 782) (35 782) (35 782)
Taxable profit 204 368 201 642 198 644 195 346
Current tax TP x 30% 61 310 60 493 59 592 58 605
Calculations:
(a) Depreciation: (126 500 x 100 / 115 – RV: 0) / 4 years x 12/12 = 27 500
(b) Tax deduction: Lease payment – proportional amount of VAT
= 39 907 – (126 500 x 15 / 115 x 39 907 / 159 628) = 39 907 – 4 125 per year = 35 782
828 Chapter 16
Gripping GAAP Leases: lessee accounting
Adjustment Jnl: debit deferred tax, credit tax expense NOTE 1 1 310
Adjustment Jnl: debit deferred tax, credit tax expense NOTE 1 493
Adjustment Jnl: credit deferred tax, debit tax expense NOTE 1 (408)
Adjustment Jnl: credit deferred tax, debit tax expense NOTE 1 (1 395)
Balance: 31/12/20X4 0 0 0 0
x Right-of-use asset 0 0
x Lease liability 0 0
Notes:
1. The direction and amount of the journal are balancing (DT: opening balance – closing balance).
2. The total tax expense (current tax + - deferred tax adjustment) is 60 000, being 30% of profit before tax
From the lessee perspective, each lease instalment includes VAT. The lessee may be able to
claim from the tax authorities the VAT that is included in each of the lease instalments paid (if
the lessee is a VAT vendor and uses the underlying right-of-use asset to make taxable supplies).
x If the lessee can claim the VAT, the lease payments claimed by the lessee as a deduction
for income tax purposes must exclude VAT. Assuming VAT is 15%, the lease payments
that will be allowed as a deduction for income tax purposes will be:
Instalment (consideration) x 100/115 = Instalment that will be allowed as a deduction
x If the lessee cannot claim VAT, the lease payments deducted for income tax purposes is simply
the instalment paid, including VAT.
Chapter 16 829
Gripping GAAP Leases: lessee accounting
When the lease payments include VAT, the measurement of the lease liability will include VAT.
The deferred tax consequences are better illustrated by way of an example: consider a lease that
includes VAT (that the lessee can claim back), where this lease:
x is recognised by the accountant ‘on-balance sheet’ (i.e. the general approach), and
x is treated by the tax authority as a ‘rental agreement’.
The VAT effect on DT for
In this example, the lessee has a right-of-use asset and a lease under the general
approach (on-balance
lease liability:
sheet):
x The right-of-use asset’s carrying amount will exclude the CA/TB with VAT: notice effect of
VAT. This is because the VAT was claimable and will be VAT being claimable/ not
recognised as a separate VAT asset. claimable:
x Asset:
The tax base of this right-of-use asset will be nil. - CA = excl VAT (if claimable),
- CA = incl VAT (if not claimable)
This is because the tax base of an asset represents the
- TB = nil
future deductions that will be granted on that asset. In x Liability:
this regard, since this lease is recognised as a ‘rental - CA = incl VAT (PV!)
agreement’ per the VAT Act, the tax authority will only - TB = PV of VAT (if claimable)
allow the deduction of the lease payments made. - TB = nil (if VAT not claimable)
This means that no deductions will be granted against the asset as it does not believe the
lessee has an asset (thus TB of the asset = 0).
x The lease liability’s carrying amount will be the present value of the lease payments, including VAT.
The tax base of the liability will be the present value of the VAT included in the lease liability.
This is because the tax base of a liability is the portion of the carrying amount that
the tax authority will not allow as a deduction for income tax purposes.
Since the lessee can claim the VAT back when it makes the lease payments, the tax
authority will not allow the deduction of the VAT included in the lease payments when
calculating taxable income. Only the portion of the liability’s carrying amount, net of
VAT, is deductible in the future.
Because the tax base of a liability is the portion of the liability that will not be allowed
as an income tax deduction, the tax base is the VAT included in the liability.
As the lease liability is measured at its present value, the tax base will reflect the
present value of the VAT included in the carrying amount of the lease liability.
Where there is a lease that has been recognised on-balance sheet (i.e. the general approach),
the statement of financial position will include the right-of-use asset and the lease liability.
830 Chapter 16
Gripping GAAP Leases: lessee accounting
Exception: A right-of-use asset that meets the definition of investment property must always
be presented in the investment property line-item – it may never be presented within the right-
of-use assets line-item. See IFRS 16.48
Where there is a lease that has been recognised off-balance sheet (i.e. the simplified approach),
the statement of financial position may include an expense payable or expense prepaid. The
expense payable would be included in the ‘trade and other payables’ line-item whereas an
expense prepaid would be included in the ‘trade and other receivables’. See IAS 1.54 (h) & (k)
Although not a requirement in IFRS 16, the lease liability should be separated into its current
and non-current portions, unless the entity presents its liabilities in order of liquidity. See IAS 1.60
Happy Limited
Statement of financial position (extracts) 20X5 20X4
As at 31 December 20X5 Note C C
ASSETS
Non-current assets
Right-of-use assets 15 xxx xxx
Investment property (if a property is leased, it must be xxx xxx
included here)
There are several expenses that may arise from the recognition of a lease, whether the lease
was recognised on-balance sheet (general approach) or off-balance sheet (simplified
approach). Although many of these require separate disclosure (see section 13.2), it is only
expenses from a lease recognised on-balance sheet that require separate presentation:
x The finance costs arising from the lease must be presented separately from the
depreciation on the right-of-use asset; and
x This finance costs arising from the lease must be included in the finance costs line-item
and be presented separately as a component thereof.
Happy Limited
Statement of comprehensive income (extracts) 20X5 20X4
For the year ended 31 December 20X5 Note C C
Profit before finance charges (the depreciation is included here) xxx xxx
Finance charges (the finance cost from the lease is included here) 3 (xxx) (xxx)
Profit before tax 4 xxx xxx
Chapter 16 831
Gripping GAAP Leases: lessee accounting
The cash paid when paying a lease payment must be separated into its constituent parts and
presented separately as follows:
x The cash payment that reduces the principal portion of the liability must be presented
under financing activities; and
x The cash payment that represents the interest charged on the liability must be presented
in the section under which interest payments are normally presented (if the entity is a
financial institution, it must present the interest payment under operating activities but in
all other cases, entities may choose between presenting it under operating activities or
financing activities). See IFRS 16.50 and IAS 7.33
If a lease payment was not included in the measurement of the lease liability, the cash payments
must be presented under operating activities. This would thus include cash payments relating to:
x Short-term lease payments that were accounted for off-balance sheet;
x Low-value asset lease payments that were accounted for off-balance sheet; and
x Variable lease payments that do not vary in line with an index or rate. See IFRS 16.50 (c)
The disclosure requirements are extensive and thus, only the main aspects are explained in
this text. Obviously, the general principle to apply is to disclose enough information such that
the users will have a sound basis upon which ‘to assess the effect that leases have on the
financial position, financial performance and cash flows of the lessee’. See IFRS 16.51
Lessees must have one single note that discloses all information regarding the lease that is
not already presented elsewhere in the financial statements. Where information has been
presented elsewhere, this note must include the relevant cross-reference so that users can
find this other information easily. See IFRS 16.52
The following items must be presented in this note, which must ideally be in a tabular format:
x Depreciation on the right-of-use asset, by class of asset (e.g. the depreciation on the
right-of-use asset relating to a plant should be presented separately from the depreciation
on the right-of-use asset relating to vehicles)
x Lease interest expense
x Short-term lease expense (recognised in terms of the simplified approach)
x Low-value asset lease expense (recognised in terms of the simplified approach)
x Variable lease payments that were not included in the measurement of the lease liability (i.e.
variable lease payments that do not vary in tandem with an index or rate would be disclosed here)
x Rent income from subleasing a right-of-use asset
x Total cash outflow for leases
x Additions to right-of-use assets
x The carrying amount of the right-of-use asset at year-end, listed separately by class of
underlying asset. See IFRS 16.53-54
It is important to note that, even if one of the above items (e.g. lease interest) has been
capitalised to another asset, this must still be included in the abovementioned note. See IFRS 16.54
If a right-of-use asset is an investment property, then it will need to comply with the disclosure
requirements in terms of IAS 40 Investment properties. As a result, although details regarding
this lease must be presented in the single lease note, we will not need to present the following
for a right-of-use asset that is an investment property:
x Depreciation on the right-of-use asset
x Rent income earned on sub-leasing the right-of-use asset
x Additions to the right-of-use asset
x The carrying amount of the right-of-use asset at the end of the year. See IFRS 16.56
832 Chapter 16
Gripping GAAP Leases: lessee accounting
If the right-of-use asset is measured in terms of the revaluation model, then the lease note
must also include disclosure of the following information required by IAS 16:
x the effective date of the revaluation;
x whether an independent valuer was involved;
x for each revalued class of property, plant and equipment, the carrying amount that would
have been recognised had the assets been carried under the cost model;
x the revaluation surplus, indicating the change for the period and any restrictions on the
distribution of the balance to shareholders. See IFRS 16.57 and IAS 16.77
The lease note must also include a ‘maturity analysis’ for any lease liability. This maturity
analysis must be presented separately from the ‘maturity analyses’ of other financial liabilities.
The maturity analysis must be in accordance with the requirements of IFRS 7 Financial
instruments: disclosures, and, in this regard, the analysis must show the remaining
contractual maturities and include a description of how the entity manages the related liquidity
risks. See IFRS 16.58 and IFRS 7.39 &.B11
The lease note must also include ‘additional qualitative and quantitative information about its
leasing activities’ that are necessary to enable the users to assess the impact of the leases on
the entity’s financial position, performance and cash flows. For example, the following
information would typically be considered useful:
- the nature of the lessee’s leasing activities;
- future cash outflows to which the lessee is potentially exposed that are not reflected in the
measurement of lease liabilities. This includes exposure arising from:
variable lease payments
extension options and termination options
residual value guarantees
leases not yet commenced to which the lessee is committed
- restrictions or covenants imposed by leases . IFRS 16.59 (extract, slightly reworded)
The information to be disclosed regarding the potential future cash flows to which the entity is
exposed as a result of variable lease payments, extension / termination options and residual value
guarantees (see above) can be found in IFRS 16.B49, B50 and B51 respectively. In this regard, the
type of information to be disclosed includes, for example, the reasons for using variable lease
payments, their size relative to fixed lease payments, options to extend a lease that have not been
included in the measurement of the lease liability, the reasons why a lessee has given a residual
value guarantee and the amount to which the lessee is exposed in terms of the residual value risk.
If a short-term lease or a lease over a low-value asset has been accounted for in terms of the
recognition exemption (i.e. the simplified approach), then this fact must be presented.
Chapter 16 833
Gripping GAAP Leases: lessee accounting
Happy Limited
Notes to the financial statements (extracts)
For the year ended 31 December 20X5
3. Lease note
Plant Vehicles Total
3.1 Right-of-use assets C C C
Carrying amount – beginning of year xxx xxx xxx
Depreciation (xxx) (xxx) (xxx)
Impairments (xxx) (xxx) (xxx)
Additions xxx xxx xxx
Remeasurement due to reassessment of lease payments xxx (xxx) (xxx)
Carrying amount – end of year xxx xxx xxx
The right-of-use asset relating to vehicles are measured under the cost model.
The right-of-use assets relating to plant are measured under the revaluation model. In this regard:
- the effective date of the last revaluation is ….., and was performed by valuer who is ……. (independent/ not
independent of the entity).
- Had the right-of-use asset over plant been measured under the cost model, its carrying amount would have
been C……
- The revaluation surplus relating to the right-of-use asset over plant ……(increased/ decreased) during the
year by an amount of C…… and now has a balance of C….., over which there are ….. (no restrictions on
the distribution to shareholders/ the following restrictions over the distribution to shareholders….).
Undiscounted
amounts
3.2 Maturity analysis of future lease payments C
Due in 20X2 xxx
Due in 20X3 xxx
Due in 20X4 xxx
Due in 20X5 xxx
Total xxx
The related liquidity risks are managed in the following way: …..
3.4 Other expenses relating to leases not included elsewhere in this note C
Finance cost - lease (included in the finance cost line-item) xxx
Variable lease payment expense xxx
Short-term lease expense xxx
Low-value asset lease expense xxx
834 Chapter 16
Gripping GAAP Leases: lessee accounting
14. Summary
Leases are accounted for by lessees either using the
General approach; or
Simplified approach i.e. the optional recognition exemption, which is available to:
x low-value assets and
x short-term leases (can only be applied to a short-term lease of an asset if the
accounting policy is to apply the recognition exemption to short-term leases of
that class of asset)
General approach
Chapter 16 835
Gripping GAAP Leases: lessor accounting
Chapter 17
Leases: Lessor Accounting
Reference: IFRS 16 (including any amendments to 1 December 2019)
Contents:
1. Introduction 837
2. Lease classification 839
Example 1: Lease classification 840
3. Finance leases 841
3.1 Overview – basic overview of recognition 841
3.2 Overview – various defined terms and their measurements 841
3.2.1 Gross investment and net investment in a lease 841
Example 2: Finance lease – gross investment in the lease 842
3.2.2 Interest rate implicit in the lease 842
Example 3: Finance lease – implicit interest rate & net investment in the lease 843
3.2.3 Initial direct costs 846
Example 4: Finance lease – includes initial direct cost 847
3.2.4 Fair value 849
Example 5: Finance lease – initial recognition journal (basic) 849
3.3 ‘Manufacturer/ dealer lessors’ versus ‘non-manufacturer dealer lessors’ 850
3.3.1 Overview 850
3.3.2 Non-manufacturer/ dealer lessor 851
3.3.3 Manufacturer/ dealer lessor 851
Example 6: Finance lease – manufacturer/ dealer 852
3.4 Two methods to record a finance lease: gross method or net method 854
3.4.1 Overview 854
3.4.2 If the lessor is a manufacturer or dealer 855
Example 7: Finance lease: lessor is a manufacturer or dealer 855
3.4.3 If the lessor is neither a manufacturer nor a dealer 859
Example 8: Finance lease: lessor is not a manufacturer or dealer 860
3.5 Lease payments receivable in advance or in arrears 863
Example 9: Finance lease: lease payments receivable in advance 863
3.6 Lease payments receivable during the year 866
Example 10: Finance lease – lease payments receivable during the period 866
3.7 Disclosure of a finance lease 869
3.8 Tax implications of a finance lease 870
Example 11: Finance lease deferred tax: no S23A limitation, VAT ignored 871
Example 12: Finance lease deferred tax: S23A limitation, VAT ignored 873
Example 13: Finance lease deferred tax: (manuf./ dealer): S23A limit, ignore VAT 875
4. Operating leases 878
4.1 Recognition of an operating lease 878
4.2 Measurement of an operating lease 878
Example 14: Operating lease – recognition and measurement 878
4.3 Tax implications of an operating lease 879
Example 15: Operating lease – tax implications 880
4.4 Disclosure of an operating lease 881
Example 16: Operating lease – disclosure 883
5. Lease involving both land and buildings 884
5.1 Separate classification of the elements 884
Example 17: Lease of land and building 884
5.2 How to allocate the lease payments to the separate elements: land and building 885
Example 18: Lease of land and building 885
5.3 Land and buildings that are investment properties 887
6. Change in classification: modifications versus changes in estimates 887
7. Transaction taxes (e.g. VAT) 888
7.1 The effect of transaction taxes on a finance lease 888
Example 19: Finance lease with transaction taxes (VAT) 889
7.2 The effect of transaction taxes on an operating lease 891
7.2.1 Input VAT, S23C and Interpretation Note 47 891
Example 20: Operating lease with tax and VAT 891
8. Summary 893
836 Chapter 17
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1. Introduction
IFRS 16 Leases was issued during 2016 and replaces the Lessors classify leases as
previous standard on leases IAS 17 Leases, together with its either finance or
three related interpretations (IFRIC 4, SIC 15 and SIC 27). operating leases:
IFRS 16 is effective for periods beginning on or after • if significant risks and rewards
1 January 2019. of ownership
- transferred: finance lease
When applying IFRS 16, lessees no longer classify leases as - not transferred: operating
See IFRS 16.61
either finance or operating leases. However, IFRS 16 still
requires lessors to make this classification. In other words, in terms of IFRS 16, the lessor
continues to first classify its leases as either operating or finance leases, accounting for each
of these differently. This is quite interesting because it means that the method of accounting
from the lessee and lessor perspective is not always ‘symmetrical’. For instance, a lessor
involved in an operating lease agreement will continue to recognise the leased asset in his
statement of financial position, but yet, the lessee in this lease agreement will also recognise
this same asset in his statement of financial position (as a right-of-use asset). In other words,
both entities will reflect the asset in their statement of financial position. This is a contentious
area in the new IFRS 16 and was the subject of much debate leading up to its publication.
A lease is defined as:
A lessor classifies a lease as either an operating or finance
lease by assessing the substance of the lease, rather than its • a contract, or part of a contract,
legal form. When assessing the substance of the lease • that conveys the right to use an
agreement, we assess whether or not substantially all the risks asset
and rewards of ownership transfer from the lessor to the lessee: • for a period of time in exchange
for consideration. IFRS 16 App A
• if they transfer, then the substance of the agreement is
that it is more like a sale agreement in which financing has been provided by the lessor:
this is a finance lease; or
• if they do not transfer, then the substance of the agreement is that it is a ‘true lease’: this
is an operating lease. See IFRS 16.62
The definitions relevant to a lessee are the same definitions used by a lessor, with the
exception of the ‘lease payment’ definition, which differs slightly depending on whether we are
a lessee or lessor (please revise all definitions in the chapter 16: Lessees). However, there are
a few extra definitions that are relevant only to lessors, which are as follows:
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The following ‘lease payment’ definition differs slightly from the lessor’s perspective:
Please notice that the fifth aspect of the ‘lease payment’ definition (see above), which deals with
residual value guarantees, differs depending on whether we are looking at the lease from the
lessee perspective or the lessor perspective.
• When looking at it from the lessee perspective, we would only include the amount the
lessee expects have to pay as a result of having provided a residual value guarantee (see
chapter 16, section 9.3.6).
• When looking at it from the lessor perspective, we include the entire residual value
guarantee, and we would also include all residual value guarantees, whether provided by
the lessee or another party.
Some of the other important definitions that you have already covered when studying leases
from the perspective of lessees (chapter 16) are listed below. These definitions are the same
whether we are looking at the lease from the perspective of the lessee or the lessor.
The lease term is defined as: The commencement date of the lease
is defined as:
• the non-cancellable period for which the lessee has the
right to use an underlying asset • the date on which a lessor
• together with periods covered by an option to: • makes an underlying asset available for use by a
IFRS 16 App A
lessee.
− extend the lease if the lessee is reasonably certain to
exercise that option
− terminate the lease if the lessee is reasonably certain
not to exercise that option. IFRS 16 App A (slightly adapted)
838 Chapter 17
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Please note that the above list is not exhaustive. Thus, just because a lease agreement is
characterised by some of the elements above does not automatically imply that we are dealing
with a finance lease: if it is clear from other features that the lease does not transfer substantially
all risks and rewards incidental to ownership, the lease is classified as an operating lease.
For example, this may be the case if the contract transfers ownership of the asset at the end of
the lease, but it will be transferred in exchange for a variable payment that will be based on its fair
value at the end of the lease term. See IFRS 16.65
b) Does the lessee (Co. B) have an option to purchase the vehicle at a price expected to be
lower that the fair value at the date the option became exercisable? No
c) Is the lease term for the major part of the economic life of the vehicle? (see conclusion) Yes
d) At the inception of the lease, does the present value of the lease payments amount to at
least substantially all of the fair value of the leased asset (i.e. the vehicle)? (W1) Yes
e) Is the vehicle of such a specialised nature that only the lessee (Co. B) can use it, without
major modifications? No
f) Is there an option to extend the lease for a second period at a rental substantially below
market rental? No
Conclusion:
Overall, although legal ownership does not transfer, and there is no option to purchase the asset at the end of the
lease term, and not even an option to renew the lease, the lease term is a major part of the economic life of the
vehicle (4yrs / 5 years = 80%) and, at inception of the lease, the present value of the lease payments amounts to
substantially all the fair value of the vehicle (31 698 / 31 700 =99%). It is thus submitted that the lease transfers
substantially all the risks and rewards of ownership and thus the lease should be classified as a finance lease.
(Note: only one of the above conditions need to be met for the lease to be classified as a finance lease).
Answer: At inception, the present value is C31 698 (W1.1) and the fair value is C31 700 (given) and
thus the present value amounts to substantially all the fair value of the asset.
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When accounting for a finance lease in the books of a lessor, we must remember that the
substance of the lease is that the underlying asset has been sold and that the lessor is providing
financing to the lessee (customer) for this sale. Thus, this asset must be derecognised and the
amount owed to the lessor by the lessee must be recognised as a receivable. See IFRS 16.67
After this, the lessor earns interest on the receivable over the lease term (because the lessor is
providing finance to the lessee). See IFRS 16.75 This increases the lease receivable as follows:
Debit Credit
Lease receivable (Net investment in the finance lease) xxx
Interest income on finance lease xxx
Interest income earned on finance lease receivable
After this, the lessor receives lease payments from the lessee, decreasing the lease receivable:
Debit Credit
Bank xxx
Lease receivable (Net investment in the finance lease) xxx
Receipt of lease payment from lessee reduces the lease receivable
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The term ‘gross investment in the lease’, is yet another defined term. If we look carefully at this
definition, we can see that the ‘gross investment’ is the total undiscounted amount of:
• the future lease payments (remember the definition of The gross investment (GI)
lease payments includes guaranteed residual values, in the lease is defined as
amongst other items – see section 1 for the full the sum of:
definition), plus • the lease payments receivable by
a lessor under a finance lease; and
• any unguaranteed residual value – the portion of the • any unguaranteed residual value
IFRS 16.App A
residual value of the asset the realisation of which is not accruing to the lessor.
guaranteed to the lessor.
In other words, the gross investment represents the total of the expected gross inflows, including
whatever value is left of the asset at the end of the lease term (i.e. we include the entire residual
value, whether guaranteed or not).
It is important to note that, from the lessee’s perspective, any unguaranteed residual value is
not included in the measurement of the lease liability; but that, from a lessor’s perspective, it is
included in the measurement of the lease liability (because it is included in the calculation of
the gross investment in the lease – see pop-up above.).
3.2.2 Interest rate implicit in the lease The interest rate implicit
in the lease is defined as:
As mentioned above, the net investment (NI) is the present • the rate of interest that causes
value of the gross investment (GI). the sum of:
(a) the PV of the lease pmts plus
When measuring this present value, we discount the gross (b) the PV of the unguaranteed
amounts using the interest rate implicit in the lease (see residual value
pop-up alongside). • to be equal to the sum of:
(a) the fair value of the underlying
asset plus
This implicit interest rate is (IRR) the rate that makes the:
(b) any initial direct costs of the
• present value of gross investment, (i.e. the PV of the lease lessor. IFRS 16 App A (reworded slightly)
payments and any unguaranteed residual value), equal
• the sum of the asset’s fair value plus any initial direct costs incurred by the lessor.
Yet another way of putting it, is the implicit interest rate is the rate that makes:
• the net investment equal
• the sum of the asset’s fair value plus any initial direct costs incurred by the lessor.
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Example 3: Finance lease – implicit interest rate & net investment in the lease
This example continues from the previous example. Use the information provided in the prior
example, together with the following additional information:
• The plant’s carrying amount and fair value on commencement date is C220 000.
• The initial direct costs incurred by the lessor were nil.
Required:
A. Calculate the interest rate implicit in the lease.
B. Using the implicit interest rate, calculate the net investment in the lease.
C. Journalise the initial recognition of the lease.
D. Journalise the subsequent measurement of the lease in the year ended 31 December 20X0 and show
the journals in the year ended 31 December 20X9 (the last year of the lease) assuming the asset was
returned with a value of C110 000.
E. Show the journals in the year ended 31 December 20X9 assuming that the asset was returned with a
value of C50 000 and thus that the lessee had to contribute cash of C16 000 (remember that the
lessor guaranteed to return the asset with a residual value of C66 000).
Comment:
• The implicit interest rate is the rate that makes:
− the PV of the lease payments plus the PV of the unguaranteed residual value equal
− the fair value of the asset plus any initial direct costs.
• The prior example gave us the lease payments and unguaranteed residual values (C440 000) whereas
this example gave us the fair value (C220 000) and initial direct costs (C0).
• The asset’s carrying amount is irrelevant when calculating the implicit interest rate. We use the fair
value of the asset instead. In this example, the fair value equalled the carrying amount.
(1) The definition of ‘lease payments’ includes ‘guaranteed residual values’, but we leave this out of the
amount that we ‘input’ into the calculation as the ‘PMT’.
This is because the PMT that we input into this calculation must be the payment that occurs in
each and every one of the years (33 000): since the ‘guaranteed residual value’ will only be
received once, at the end of the lease term, this ‘guaranteed residual value’ is input as part of
the future value amount ‘FV’
(2) From the lessor’s perspective, ‘FV’ reflects the future expected value of the underlying asset, whether it
is an unguaranteed or guaranteed residual value (i.e. we include 100% of the residual value).
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• However, the net investment could also simply be calculated as being the ‘fair value of the underlying asset’
plus the ‘initial direct costs’:
This is based on the logic derived from the definition of the ‘implicit interest rate’, which is that the implicit interest
rate is the rate that will make the net investment (present value of the gross investment) equal the sum of the fair
value and any initial direct costs. In other words, the implicit interest rate is the rate that makes the following two
amounts equal:
− Net investment = Fair value of the leased asset + Initial direct costs
− Net investment = Gross investment, discounted at the Implicit interest rate
Thus, the calculation of net investment base on the definition of the ‘implicit interest rate’ would be as follows:
Net investment = FV: 220 000 + initial direct costs: 0 = 220 000
W1: Net investment calculated as a present value calculation (using a financial calculator)
Net investment = Gross investment, discounted at the Implicit interest rate (i.e. PV of GI)
Implicit interest rate = 12.174776% (see solution 3A)
Gross investment = Lease payments (P.S this includes guaranteed RVs) + Unguaranteed RV
Thus, we need to calculate:
− PV of the lease payments (LP) =
The PV of the LPs receivable at the end of every year for 10 years (C33 000 for 10 years), and
The PV of the single LP receivable at the end of the 10th year, being the guaranteed residual value
(C66 000 after 10 years); plus
− PV of the unguaranteed residual value =
The PV of the unguaranteed residual value at the end of the 10 th year (C44 000 after 10 years).
PMTS = Lease payments (excluding guaranteed residual value) = fixed payment = 33 000
N = number of times we receive the amount that we input as being the PMT = 10
FV = Guaranteed residual values + Unguaranteed residual value = 66 000 + 44 000 = 110 000
i = implicit interest rate = Solution 3A = 12,174776%
Compute PV = C220 000
Comment:
• When initially recognising the finance lease, the lessor derecognises the underlying asset (at its carrying
amount) and recognises a receivable, measured at the ‘net investment in the lease’.
• In this case, the asset’s carrying amount equals its fair value (and there were no initial direct costs). Thus,
the amount of the credit to derecognise the asset (carrying amount: 220 000) equals the amount of the
debit to recognise the receivable (measured at the net investment of the lease: 220 000).
• This means there is no profit to be recognised on the initial recognition of the finance lease.
1/1/20X0 Debit Credit
Lease receivable (net investment) (A) W1 220 000
Plant: carrying amount Given 220 000
Initial recognition at commencement date of sale of plant via a FL
844 Chapter 17
Gripping GAAP Leases: lessor accounting
• This example only asks us to show the journals relating to the subsequent measurement of the lease
receivable in the first and last year of the lease. The journals in the years in-between would follow the
same format as the two journals shown in the first year of the lease (though the amount of interest in
the first journal would change each year).
W1: Effective interest rate table Finance income:Lease pmts plus Receivable
at 12,174776% unguaranteed balance
RV
1 January 20X0 220 000
31 December 20X0 26 785 (33 000) 213 785
31 December 20X1 26 028 (33 000) 206 812
31 December 20X2 25 179 (33 000) 198 991
31 December 20X3 24 227 (33 000) 190 218
31 December 20X4 23 159 (33 000) 180 377
31 December 20X5 21 960 (33 000) 169 337
31 December 20X6 20 616 (33 000) 156 953
31 December 20X7 19 109 (33 000) 143 062
31 December 20X8 17 417 (33 000) 127 480
31 December 20X9 15 520 (33 000) 110 000
Residual value that is guaranteed (66 000) 44 000
Residual value that is unguaranteed (44 000) 0
220 000 (440 000)
(a) (b) (c)
Notes relating to W1:
(a) Finance income: the total of this column represents the unearned finance income at the start of the
lease and shows how this income is expected to be earned over the lease period.
(b) Lease pmts & unguaranteed RV (Gross Investment in Finance Lease: GI): the total of this column
represents the gross investment in the lease (the total amounts actually receivable from the lessee)
and shows how we expect to receive them over the lease period. The last payment includes the cash
payment that will be received from the lessee together with the receipt of the asset at the value
guaranteed by the lessee (i.e. at its guaranteed residual value): 33 000 + 66 000 = 99 000, after
which we reflect the portion of the expected residual value that was unguaranteed, of C44 000.
(c) Receivable balance (Net Investment in Finance Lease: NI): This column shows the present value of
the future lease payments (the portion of the principal sum that the lessee (debtor) will owe at the
end of each year of the lease plus the unguaranteed residual value, if any, that the underlying asset
is expected to have at the end of the lease).
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Comment:
• If a lessee returns the asset with a value (C50 000) that is less than its guaranteed residual
value (C66 000), the lessee will have to contribute cash to make up the difference. In this case,
the lessee would need to contribute cash of C16 000 (C66 000 – C50 000).
• Thus, the last lease payment from the lessee will be C49 000, being the fixed pmt (C33 000)
plus the extra pmt due to the residual value guarantee (C16 000).
If the lessor incurs costs to obtain the lease, and if these were incremental costs that would not
have been incurred had the lease not been obtained these would normally be called ‘initial
direct costs’. However, there is an exception. The exception is that, if these incremental costs
were incurred by a lessor that is a manufacturer or dealer,
Initial direct costs are
then we would not call them ‘initial direct costs’ because defined as:
initial costs incurred by ‘manufacturer/ dealer lessors’ are
expressly excluded from the definition of ‘initial direct costs’ • Incremental costs of obtaining
a lease
(see pop-up alongside).
• that would not have been incurred
if the lease had not been obtained,
This distinction between a ‘manufacturer/ dealer lessor’ and • except for such costs incurred by
a ‘non-manufacturer/dealer lessor’ is very important − a manufacturer/dealer lessor
because it determines whether these initial costs meet the − in relation to a finance lease.
definition of ‘initial direct costs’ or not. IFRS 16 App A (reworded slightly)
If the costs do meet the definition of ‘initial direct costs’, then they are taken into account when
calculating our implicit interest rate (see pop-up in section 3.2.2) and thus they will also affect
the measurement of our net investment (i.e. our receivable).
If the costs do not meet the ‘definition of ‘initial direct costs’ (i.e. because they were incurred by
a ‘manufacturer/ dealer lessor’), these costs would thus not be included in our implicit interest
rate and would not be included in our net investment. Instead, these ‘so-called initial direct
costs’, would simply be expensed.
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Gripping GAAP Leases: lessor accounting
When accounting for the initial direct costs incurred by a ‘manufacturer/ dealer lessor’, the
justification for excluding the initial costs from the definition of ‘initial direct costs’ and thus
excluding it from the calculation of the implicit interest rate and the net investment (receivable)
and expensing it instead, is that, the initial direct costs are considered to be a cost related to
the sale of the goods and should be expensed at the same time that we recognise the cost of
sale expense and sales income.
Solution 4A: Finance lease – implicit interest rate (with initial direct costs)
Answer: Implicit interest rate = 11,267746%
Comment:
• The implicit interest rate is the rate that makes the
− PV of the lease payments plus the PV of the unguaranteed residual value equal
− the fair value of the asset plus any initial direct costs.
• The previous examples (examples 2 and 3) did not involve initial direct costs.
PV = fair value + initial direct costs = 220 000 + 10 000 = -230 000
PMTS = lease payments (excluding guaranteed residual values) = fixed payment = 33 000
N = number of times we receive the amount that we input as being the PMT = 10
FV = guaranteed residual value + unguaranteed residual value = 66 000 + 44 000 = 110 000
Compute i = 11,267746%
Solution 4B: Finance lease – net investment in the lease (with initial direct costs)
Answer: Net investment in lease = C230 000
Comment:
• We can calculate the net investment (NI) by starting with our gross investment (GI), and then present
value this using the implicit interest rate (IRR) of 11,267746% (see solution 4A). Whereas the implicit
interest rate changes from the prior examples (because of the initial direct costs), the gross
investment remains unchanged from the prior examples:
− lease payments: C33 000 x 10 fixed payments + C66 000 guaranteed residual value
− unguaranteed residual value: C44 000
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• However, since the implicit rate is the rate that makes the net investment equal the sum of the fair
value and any initial direct costs, we could simply calculate the NI as this sum. Thus, there are two
ways of calculating our net investment (NI):
− Net investment = FV: 220 000 + initial direct costs: 10 000 = 230 000
− Net investment = Gross investment, discounted at the implicit interest rate (see W1 below)
W1: Net investment calculated as a present value calculation (using a financial calculator)
PMTS = lease payments (excluding guaranteed residual values) = fixed payment = 33 000
N = number of times we receive the amount that we input as being the PMT = 10
FV = guaranteed residual values + unguaranteed residual value = 66 000 + 44 000 = 110 000
i = implicit interest rate = see solution 4A = 11,267746%
Compute PV = C230 000
Solution 4C: Finance lease – initial recognition journal (with initial direct costs)
Comment:
• When initially recognising a finance lease, the lessor derecognises the underlying asset (at its carrying
amount) and recognises a receivable, (measured at the net investment (NI) in the lease’).
• In this example, the lessor incurred initial direct costs, which must be included in the ‘net investment
(NI) in the lease’ . The contra entry is bank (or a payable).
• Please note: if this was an example involving a manufacturer/ dealer lessor, the initial costs would be
expensed (see section 3.3).
Comment:
• On initial recognition, the lease receivable is initially measured at the amount of the ‘net investment
on commencement date’ (i.e. present value of the gross investment, the latter being the sum of the
LPs and Unguaranteed RV).
• The lease receivable is then subsequently measured at amortised cost.
• Measurement at amortised cost means that the lease receivable will be:
− increased by the interest income, calculated using the effective interest rate method, and
− decreased by the payments received.
• The fact that there were initial direct costs incurred by the lessor is simply built into the implicit
interest rate (IRR) and does not affect any of the principles followed.
848 Chapter 17
Gripping GAAP Leases: lessor accounting
W1: Effective interest rate table Finance income: Lease pmts plus Receivable
at 11,267746% unguaranteed RV balance
1 January 20X0 230 000
31 December 20X0 25 916 (33 000) 222 916
31 December 20X1 25 118 (33 000) 215 033
31 December 20X2 24 229 (33 000) 206 263
31 December 20X3 23 241 (33 000) 196 504
31 December 20X4 22 142 (33 000) 185 646
31 December 20X5 20 918 (33 000) 173 564
31 December 20X6 19 557 (33 000) 160 120
31 December 20X7 18 042 (33 000) 145 162
31 December 20X8 16 357 (33 000) 128 519
31 December 20X9 14 481 (33 000) 110 000
Residual value that is guaranteed (66 000) 44 000
Residual value that is unguaranteed (44 000) 0
220 000 (440 000)
Notes: (a) (b) (c)
(a) Finance income: the total of this column represents the unearned finance income at the start of the
lease and shows how this income is expected to be earned over the lease period.
(b) Lease payments + Unguaranteed RV: this column represents the gross investment (GI) in the lease
(c) Receivable balance: this column represents the net investment in the lease (NI). In other words, this
column shows the present value of the future lease payments (the portion of the principal sum that
the lessee (debtor) will owe at the end of each year of the lease plus the unguaranteed residual
value (RV), if any, that the underlying asset is expected to have at the end of the lease.
When calculating the implicit interest rate and the net investment in the lease, we have used
the term ‘fair value’.
When using the term ‘fair value’ in context of IFRS 16 Leases, we do not apply IFRS 13 Fair
value measurement. Instead, fair value for the purposes of IFRS 16 is simply ‘the amount for
which an asset could be exchanged, or a liability settled, between knowledgeable, willing
parties in an arm’s length transaction’. See IFRS 16.App A & IFRS 13.6
If the fair value of the underlying asset does not equal its carrying amount at commencement
date, then a profit or loss will arise on commencement of the lease. How we account for this
profit depends on whether the lessor is a ‘manufacturer/dealer lessor’ or a ‘non-
manufacturer/dealer lessor’. Manufacturer/dealer lessors are explained in section 3.3.
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• The implicit interest rate (IRR) in this example is now 9,301512% (W1)
This is because the implicit interest rate is the rate that makes the
− PV of the lease payments plus the PV of the unguaranteed residual value (UGRV) equal
− the fair value of the asset plus any initial direct costs.
The previous examples (examples 2, 3 and 4) involved a different fair value.
• Net investment (NI) in lease in this example is now C254 200 (W2)
Remember, this net investment can be calculated in one of two ways:
− Net investment = FV: 244 200 + initial direct costs: 10 000 = 254 200
− Net investment = Gross investment, discounted at the implicit interest rate (see W2 below)
W2: Net investment: alternative calculation using GI and IIR, and using a financial calculator:
PMTS = lease payments (excluding guaranteed residual values) (1) = fixed payment = 33 000
N = number of times we receive the amount that we input as being the PMT = 10
FV = guaranteed residual values + unguaranteed residual value = 66 000 + 44 000 = 110 000
i = implicit interest rate = W1 = 9,301512%
Compute PV = C254 200
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If the lessor is not a manufacturer/ dealer, then it means that the lessor’s normal operating activities
do not revolve around dealing in (selling) goods that he has manufactured or purchased. In this case,
it means that the asset that the lessor ‘sold’ under the finance lease will not be inventory. Instead, the
asset might be, for example, an item of property, plant and equipment. Thus, if the carrying amount of
the underlying asset and the receivable differ, then we would simply account for this difference as a
profit or loss on sale of the asset (e.g. if a receivable exceeds the asset’s carrying amount, then we
would recognise a profit on sale):
Debit Credit
Lease receivable (Net investment in the finance lease) xxx
Carrying amount of the underlying asset (e.g. PPE) xxx
Profit on sale of asset (e.g. PPE) xxx
Sale of PPE in terms of a finance lease at a profit
Thus, a finance lease from the perspective of a lessor who is neither a manufacturer nor dealer, is
regarded simply as the sale of an asset (other than inventory) where financing has been provided to
the lessee to facilitate the sale. Thus, although a profit or loss may arise on the initial recognition of the
lease, the only other lease income recognised is interest income.
The other aspect to remember (explained in section 3.2.3 and example 4) is that, if the lessor is not a
manufacturer or dealer, any incremental costs incurred in obtaining the lease will meet the definition of
‘initial direct costs’. Since ‘initial direct costs’ are included in the definition of how we calculated the
‘implicit interest rate’, these costs will be included in the measurement of the ‘net investment in the
lease’ (the receivable). Thus, this will also have an effect on the measurement of the interest income
thereafter (since the interest income on the lease is measured by applying the implicit interest rate to
the receivable balance).
The aspects of a finance lease
to be recognised in P/L depend
3.3.3 Manufacturer/ dealer lessor
on whether the lessor:
If the lessor is a manufacturer/ dealer, it means his • Is a manufacturer/dealer:
- sales and interest income
normal operating activities involve dealing in (selling)
- cost of sales and initial costs expense
goods that he has either manufactured/ purchased. Thus,
• Is not a manufacturer/dealer:
the asset ‘sold’ under the finance lease is inventory. - interest income
- P/L on sale of the asset (if applicable)
When we derecognise the asset (inventory), it thus also
means that we must recognise a cost of sales expense.
It also means that we must recognise revenue on the sale. The revenue from the inventory sold in
terms of a finance lease must be measured at:
• the lower of the fair value of the underlying asset or
• the present value of the lease payments, discounted at a market interest rate. See IFRS 16.71(a)
Another aspect to remember is, if the lessor is a ‘manufacturer/ dealer lessor’, the initial incremental
costs that it incurs at the time of obtaining the lease are explicitly excluded from the definition of ‘initial
direct costs’. Thus, these costs will not be included in the calculation of the implicit interest rate and
will not be included in the net investment (i.e. will not be capitalised to the receivable). Instead, these
initial costs must be expensed in P/L. This was explained in section 3.2.3. See IFRS 16.App A
In summary, a finance lease from the perspective of a lessor who is a manufacturer or dealer,
is actually regarded as a sale of inventory where financing has been provided to the lessee to
facilitate the sale. Thus, the lessor recognises revenue from sales (sales income) as well as
the interest income on such a lease, and of course, it also recognises the cost of sales
expense and initial incremental costs incurred at the commencement of the lease.
Chapter 17 851
Gripping GAAP Leases: lessor accounting
852 Chapter 17
Gripping GAAP Leases: lessor accounting
W2: Net investment: alternative calculation using GI and IIR, and using a financial calculator:
PMTS = lease payments (excluding guaranteed residual values) = fixed payment = 33 000
N = number of times we receive the amount that we input as being the PMT = 10
FV = guaranteed residual values + unguaranteed residual value = 66 000 + 44 000 = 110 000
i = implicit interest rate = W1 = 10,078261%
Compute PV = C244 200
W5: Effective interest rate table Finance income: Lease pmts plus Receivable
at 10,078261% unguaranteed RV balance
1 January 20X0 244 200
31 December 20X0 24 611 (33 000) 235 811
31 December 20X1 23 766 (33 000) 226 577
31 December 20X2 22 835 (33 000) 216 412
31 December 20X3 21 811 (33 000) 205 222
31 December 20X4 20 683 (33 000) 192 905
31 December 20X5 19 441 (33 000) 179 347
31 December 20X6 18 075 (33 000) 164 422
31 December 20X7 16 571 (33 000) 147 993
31 December 20X8 14 915 (33 000) 129 908
31 December 20X9 13 092 (33 000) 110 000
Residual value that is guaranteed (66 000) 44 000
Residual value that is unguaranteed (44 000) 0
220 000 (440 000)
Notes (a) (b) (c)
(a) Finance income: The total of this column shows the unearned finance income at the start of the
lease and shows how this income is expected to be earned over the lease period.
(b) Lease pmts + Unguaranteed RV: This column shows the gross investment in the lease (GI)
(c) Receivable balance: This column shows the net investment in the lease (NI). In other words, this column
shows the present value of the future lease payments: the portion of the principal sum the lessee (debtor)
will owe at the end of each year of the lease plus the unguaranteed residual value, if any, that the underlying
asset is expected to have at the end of the lease.
Chapter 17 853
Gripping GAAP Leases: lessor accounting
3.4 Two methods to record a finance lease: gross method or net method
3.4.1 Overview
There are two methods whereby a lessor can record a finance lease:
• the gross method or
• the net method.
An entity may choose which method it wishes to adopt. All prior examples have used the net
method because they are perhaps simpler to visualise, but the gross method provides more
detail, which becomes useful when preparing the disclosure (see section 3.7).
If the gross method is adopted, then we use two accounts to reflect the carrying amount of
our receivable asset (net investment in lease):
• The ‘gross investment in lease’ account (GI account): The gross method
recognises the
This account has a debit balance and reflects the gross investment in lease receivable
the investment, measured at the sum of the undiscounted: by using two accounts:
- lease payments (see previous definitions), plus the • gross investment
- unguaranteed residual value (see previous definitions). account (GI) (A); and an
• unearned finance income
This GI account is then decreased over the lease term by the account (UFI) (-A)
lease payments received (including the guaranteed residual
value) and then by any unguaranteed residual value.
• The ‘unearned finance income’ account (UFI account):
This account has a credit balance and is set-off against the ‘gross investment account’ so that our
net lease receivable to be presented the statement of financial position is measured at an amount
equal to the ‘net investment in the lease’ (GI – UFI = NI).
This UFI account is amortised to profit or loss as interest income over the lease term (i.e. the UFI
account is decreased over the lease term by the interest income earned).
The balance on this account, at any one time, can also be measured by subtracting from the
balance in the ‘gross investment in lease’ account the ‘net investment in the lease’ (i.e. PV of the
lease payments + PV of the unguaranteed residual value, discounted at the implicit interest rate).
If the net method is adopted, then we only use one account to reflect the carrying amount of
our lease receivable (net investment in lease): The net method
recognises the
• The ‘lease receivable’ account (net investment in the lease’) (NI): lease receivable
This account is measured at the present value (discounted at by using one account:
the interest rate implicit in the lease) of the: • net investment (NI).
- lease payments (a defined term); plus the Where NI = GI - UFI
- unguaranteed residual value.
This receivable account equals the ‘gross investment in the lease’ less ‘unearned finance income’:
Receivable = NI = GI – UFI.
This receivable account (net investment account) is adjusted over the lease term as follows:
- Increased by interest income earned (debit the lease receivable account), and
- Decreased by lease payments received and by any unguaranteed residual value
(credit the lease receivable account).
The choice of method obviously involves different journal entries, however, under both
methods the overall effect on the assets, liabilities and income will be the same and the
disclosure requirements will be the same.
We will now illustrate the difference between these two methods for a lessor that is a ‘non-
manufacturer/ dealer’ and then for a lessor that is a ‘manufacturer dealer’.
854 Chapter 17
Gripping GAAP Leases: lessor accounting
As was explained previously, lessors who are manufacturers or dealers that are offering
finance leases are effectively offering financed sales as opposed to cash sales. Since the
finance lease is considered to be a sale that has been financed, our journals must account for
the sale, cost of sale, interest income and the receipt of the lease payments.
Just as a reminder, when accounting for a finance lease in the books of a manufacturer/dealer,
the key items are measured as follows:
• lease receivable:
The lease receivable reflects the present value of the gross investment. However, the
implicit interest rate used to calculate the present value is affected by whether the lessor
is a manufacturer/ dealer or not. If you are a manufacture/ dealer, any incremental costs
in obtaining the lease will not meet the definition of ‘initial direct costs’ and will thus be
expensed and not included in the implicit interest rate calculation.
• sales revenue:
is measured at the lower of (a) the fair value of the asset or (b) the present value of the
lease payments, computed using a market interest rate;
• interest income:
should be measured at (a) the rate implicit in the agreement, (or (b) the market interest
rate if the present value of the lease payments is less than the fair value of the asset
sold), multiplied by the cash sales price of the asset sold;
• any costs incurred in securing or negotiating the lease (initial direct costs):
are simply expensed at the time that the sales revenue is recognised.
Example 7: Finance lease: lessor is a manufacturer or dealer
Lemon Tree Limited is a dealer in machines, which it sells for cash or under a finance lease. It
has a 31 December financial year-end.
• Lemon Tree sold only one machine (purchased on 1 January 20X1 for C250 000), in 20X1. The
machine was sold under a finance lease (cash sales price: C320 000), the terms of which were:
− commencement date: 1 January 20X1
− lease period: 5 years
− lease payments (LPs): C100 000, annually in arrears, payable on 31 December of each year.
• The implicit interest and market interest rate applicable is 16,9911%.
Chapter 17 855
Gripping GAAP Leases: lessor accounting
Required:
A. Prepare Lemon Tree’s journals for each of the years 20X2 to 20X5, using the gross method.
B. Prepare Lemon Tree’s journals for each of the years 20X2 to 20X5, using the net method.
C. Prepare Lemon Tree’s disclosure for the year ended 31 December 20X1. (See Section 3.7 on
Disclosures)
Ignore comparatives and ignore tax.
W2: Effective interest rate table Finance Lease pmts plus Receivable
income: unguaranteed RV balance
16.9911%
01 Jan X1 320 000
31 Dec X1 54 372 (100 000) 274 372
31 Dec X2 46 618 (100 000) 220 990
31 Dec X3 37 549 (100 000) 158 539
31 Dec X4 26 938 (100 000) 85 477
31 Dec X5 14 523 (100 000) 0
180 000 (500 000)
Notes: (a) UFI (b) GI (c) NI
(a) The total of this column represents the unearned finance income (UFI) at the commencement of the
lease and shows the periods in which this income is expected to be earned over the lease term.
(b) The total of this column represents the gross investment in the lease (GI in finance lease) at the
commencement of the lease, being the total gross amount receivable from the lessee (i.e. the lease pmts and
unguaranteed RV), and shows the periods in which we expect to receive each of these pmts.
(c) The balance reflected in this column represents the present value of the future lease payments plus
the present value of the unguaranteed RV, if any (nil in this case). This balance reflects the lease
receivables balance, otherwise known as the net investment in the finance lease (NI).
856 Chapter 17
Gripping GAAP Leases: lessor accounting
Chapter 17 857
Gripping GAAP Leases: lessor accounting
Finance lease receivable: net investment (A) W2: EIRT: FI column 54 372
Lease finance income (P/L: I) 54 372
Interest income earned at 16.9911% , (effective int. rate table: FI column)
31/12/20X2
Bank (A) 100 000
Finance lease receivable: net investment (A) 100 000
Lease payment received under finance lease
Finance lease receivable: net investment (A) W2: EIRT: FI column 46 618
Lease finance income (P/L: I) 46 618
Interest income earned at 16.9911%, (effective int. rate table: FI column)
31/12/20X3
Bank (A) 100 000
Finance lease receivable: net investment (A) 100 000
Lease payment received under finance lease
Finance lease receivable: net investment (A) W2: EIRT: FI column 37 549
Lease finance income (P/L: I) 37 549
Interest income earned at 16.9911%, (effective int. rate table: FI column)
31/12/20X4
Bank (A) 100 000
Finance lease receivable: net investment (A) 100 000
Lease payment received under finance lease
Finance lease receivable: net investment (A) W2: EIRT: FI column 26 938
Lease finance income (P/L: I) 26 938
Interest income earned at 16.9911%, (effective int. rate table: FI column)
31/12/20X5
Bank (A) 100 000
Finance lease receivable: net investment (A) 100 000
Lease payment received under finance lease
Finance lease receivable: net investment (A) W2: EIRT: FI column 14 523
Lease finance income (P/L: I) 14 523
Interest income earned at 16.9911%, (effective int. rate table: FI column)
858 Chapter 17
Gripping GAAP Leases: lessor accounting
Profit before tax has been stated after taking into account the following separately
disclosable items:
• Profit or loss on sale of asset under a finance lease (manufacturer/ dealer) See W1 70 000
• Finance income on net investment in lease See Jnls/ W2 54 372
− Income from variable lease payments that do not depend on an index or rate 0
− Other lease payments 0
3.4.3 If the lessor is neither a manufacturer nor a dealer For a lessor who is
neither
As already explained, lessors who are neither manufacturer nor manufacturer/dealer:
dealer are financing a sale of assets to customers, but their business • recognise only interest
is mainly to earn finance income. These lessors derecognise their income
assets, recognise a lease receivable and then simply recognise interest income. Thus, if the lessor is
not a manufacturer or dealer, the basic journals will be as follows:
Chapter 17 859
Gripping GAAP Leases: lessor accounting
Just as a reminder, when accounting for a finance lease in the books of a ‘non-
manufacturer/dealer’, the key items are measured as follows:
• Lease receivable:
The lease receivable reflects the present value of the gross investment. However, the
implicit interest rate used to calculate the present value is affected by whether the lessor
is a manufacturer/ dealer or not.
If you are a non-manufacturer/ dealer, any incremental costs in obtaining the lease will
meet the definition of ‘initial direct costs’ and will thus be included in the implicit interest
rate calculation. This means they will effectively be capitalised into the lease receivable.
This will reduce the interest income recognised over the period of the lease.
• Interest income:
Interest income is measured by multiplying the interest rate implicit in the agreement by
the balance in the lease receivable account.
860 Chapter 17
Gripping GAAP Leases: lessor accounting
W2: Effective interest rate table Finance income: Lease pmts plus Receivable
at 15.5819% unguaranteed RV balance
1 January 20X1 210 000
31 December 20X1 32 722 (90 000) 152 722
31 December 20X2 23 797 (90 000) 86 519
31 December 20X3 13 481 (100 000) 0
70 000 (280 000)
(a) UFI (b) GI (c) NI
Comments: For explanation of (a) ; (b) and (c), please see example 7 (W2).
Chapter 17 861
Gripping GAAP Leases: lessor accounting
Comment:
When doing disclosure on the face of the Statement of Financial Position it is usually easier to draw
up the note first and then do the disclosure on the face with the information from the note.
Current assets
Finance lease receivable LP due next year: 90 000 – future interest income 30/1 66 203
included in this LP: 23 797 (per EIRT/ jnls)
Profit before tax has been stated after taking into account the following separately
disclosable items:
• Finance income on net investment in lease Per Jnl/ W2 32 722
862 Chapter 17
Gripping GAAP Leases: lessor accounting
If, however, the lease payments are received in advance or when the lessee does not make a
lease payment on due date, the balance owing by the lessee (receivable) at the end of the
period will include not only the remaining principal sum still owing by the lessee (e.g. present
value of future lease payments) but also the interest owing between the date of the last lease
payment made and the end of the period.
Depending on whether the lease payments are payable in advance or in arrears will also affect
the disclosure of the finance lease receivable in the notes to the financial statements, since the
gross investment in the finance lease must be reconciled to the present value of the future
lease payments (principal outstanding) – which is now no longer equal to the balance on the
finance lease receivable account (net investment in the finance lease).
Chapter 17 863
Gripping GAAP Leases: lessor accounting
Comment: Interest is calculated on the commencement daters opening balance adjusted for the lease
payment when lease payments are in advance and coincide with the start of the financial year.
Journals
Debit Credit
1/1/20X1
Machine: cost (A) Given; W2 210 000
Bank (A) 210 000
Purchase of machine
31/12/20X1
Finance lease receivable: unearned finance income (-A) 24 431
Lease finance income (P/L: I) W2: EIRT 24 431
Interest income earned
1/1/20X2
Bank (A) Given; W2 80 000
Finance lease receivable: gross investment (A) 80 000
Finance lease payment received
31/12/20X2
Finance lease receivable: unearned finance income (-A) 13 988
Lease finance income (P/L: I) W2: EIRT 13 988
Interest income earned, (effective interest table, W2)
1/1/20X3
31/12/20X3
Finance lease receivable: unearned finance income (-A) W2: EIRT 1 581
Lease finance income (P/L: I) 1 581
Interest income earned, (effective interest table, W2)
864 Chapter 17
Gripping GAAP Leases: lessor accounting
W2: Effective interest rate table Finance income: Lease pmts plus Receivable
18.7927% unguaranteed RV balance
01 January 20X1 210 000
01 January 20X1 0 (80 000) 130 000
31 December 20X1 24 431 154 431
01 January 20X2 (80 000) 74 431
31 December 20X2 13 988 88 419
01 January 20X3 (80 000) 8 419
31 December 20X3 1 581 10 000
31 December 20X3 (10 000) 0
40 000 (250 000)
(a) UFI (b) GI (c) NI
Comments: For explanation of (a) ; (b) and (c), please see example 7 (W2).
Comments: For explanation of (a) ; (b) and (c), please see solution 7C (note 31).
Calculations:
(1) 80 000/(1.187927) + 10 000/(1.187927)2 = 74 431
Chapter 17 865
Gripping GAAP Leases: lessor accounting
3.6 Lease payments receivable during the year Lease payments during the
year:
Lease payments may be receivable during the year rather than
• this occurs when the year-end
on either the first or last day of the year. You can deal with this
does not coincide with the lease
by drawing up the effective interest rate table as follows: payment dates
• plot all the payments on the dates on which they fall due. • therefore plot the lease payments
• the portion of the interest earned for each reporting period on the EIR Table and apportion
can then either be shown within this table (see W2 in interest
example 10) or can be apportioned in a separate calculation.
Example 10: Finance lease – lease payments receivable during the period
Avocado Tree Limited is a dealer in machines.
• It entered into an agreement to lease a machine to Giant Limited.
• Avocado Tree Limited purchased the machine on 1 July 20X1 at a cost of C100 000.
• The cash sales price of this machine is C210 000.
• The lease is a finance lease, the terms of which are as follows:
- commencement date: 1 July 20X1
- lease term: 5 years
- lease payments: C60 000, annually in advance, payable on 1 July of each year
- interest rate implicit in the agreement: 21.8623%.
Required:
A. Prepare the journals for Avocado for each of the years ended 31 December that are affected.
B. Disclose the above for the year ended 31 December 20X1 in Avocado Tree’s books. Ignore tax.
31/12/20X1
Finance lease receivable: unearned finance income (-A) 16 397
Lease finance income (P/L: I) W2: 16 397 16 397
Finance income earned, effective interest rate table
1/7/20X2
Bank (A) 60 000
Finance lease receivable: gross investment (A) 60 000
Finance lease payment received
31/12/20X2
Finance lease receivable: unearned finance income (-A) 29 819
Lease finance income (P/L: I) W2: 16 396 + 13 423 29 819
Finance income earned, effective interest rate table:
866 Chapter 17
Gripping GAAP Leases: lessor accounting
31/12/20X3
Finance lease receivable: unearned finance income (-A) 23 221
Lease finance income (P/L: I) W2: 13 422 + 9 799 23 221
Finance income earned, effective interest rate table
1/7/20X4
Bank (A) 60 000
Finance lease receivable: gross investment (A) 60 000
Finance lease payment received
31/12/20X4
Finance lease receivable: unearned finance income (-A) 15 181
Lease finance income (P/L: I) W2: 9 799 + 5 382 15 181
Finance income earned, effective interest rate table
1/7/20X5
Bank (A) 60 000
Finance lease receivable: gross investment (A) 60 000
Finance lease payment received
31/12/20X5
Finance lease receivable: unearned finance income (-A) 5 382
Lease finance income (P/L: I) W2: 5 382 5 382
Finance income earned, effective interest rate table
W2: Effective interest rate table Finance income: Lease pmts plus Receivable
21.8623% unguaranteed RV balance
01 July 20X1 210 000
01 July 20X1 (60 000) 150 000
31 Dec 20X1 32 793 x 6/12 16 397 166 397
01 July 20X2 32 793* x 6/12 16 396 (60 000) 122 793
31 Dec 20X2 26 845 x 6/12 13 423 136 216
01 July 20X3 26 845 x 6/12 13 422 (60 000) 89 638
31 Dec 20X3 19 598 x 6/12 9 799 99 437
01 July 20X4 19 598 x 6/12 9 799 (60 000) 49 236
31 Dec 20X4 10 764 x 6/12 5 382 54 618
01 July 20X5 10 764 x 6/12 5 382 (60 000) 0
(*) Rounded to allow the table to equal zero 90 000 300 000
(a) UFI (b) GI (c) NI
Comments: For explanation of (a) ; (b) and (c), please see example 7 (W2).
Note: If payment occurs during the period, we must apportion the interest income to the correct
period. The table above has been adapted to show this apportionment and extract the correct year-
end closing balances. This is not necessary though (i.e. the table could be drawn up as in previous
examples and the calculation of the apportionment could simply be shown in the journals instead).
Chapter 17 867
Gripping GAAP Leases: lessor accounting
Profit before tax has been stated after taking into account the following separately
disclosable items:
• Finance income on net investment in lease 16 397
Notice: The 3 carrying amounts in the SOFP (122 793 + 27 207 + 16 397) add up to C166 397.
Is it a finance lease?
YES, if substantially all risks and rewards of ownership have transferred (see examples in IFRS 16.63-65)
868 Chapter 17
Gripping GAAP Leases: lessor accounting
In addition to the above note, which was ideally provided in a tabular format, the following
disclosures are also required (the following disclosures need not be in tabular format):
• a maturity analysis showing the undiscounted lease payments that are expected to be
received after reporting date, showing the payments that are expected to be received:
- within 5 years after reporting date on a ‘per annum basis’, and
- after 5 years from reporting date as a ‘total’ (although you can obviously also present
this on a ‘per annum’ basis instead if you prefer).
• a reconciliation between the undiscounted lease payments (i.e. the total of the future lease
payments per the maturity analysis referred to above) and the net investment in the lease,
where the reconciliation must show the following as reconciling items:
- unearned finance income, and
- unguaranteed residual value;
• additional qualitative and quantitative information about its leasing activities that would
enable users ‘to assess the effect that leases have on the financial position, financial
performance and cash flows of the lessor’, including, for example:
- ‘the nature of the lessor’s leasing activities’; and
- ‘how the lessor manages the risk associated with any rights it retains in underlying
assets’, including how it plans to reduce these risks (e.g. through stipulating extra
variable lease payments in the event that the lessee uses the asset above certain
specified limits and the inclusion of residual value guarantees in the contract); and
- Significant changes in the carrying amount of the net investment in finance leases.
See IFRS 16.89 and .93-94
The following is a suggested layout that would satisfy the main presentation and disclosure
requirements for lessors involved in a finance lease:
Happy Limited
Notes to the financial statements (extracts) 20X1 20X0
For the year ended 31 December 20X1 C C
Chapter 17 869
Gripping GAAP Leases: lessor accounting
Happy Limited
Notes to the financial statements (extracts) continued …
For the year ended 31 December 20X1
Gross Unearned Net
9. Maturity analysis: future lease payments investment finance investment
receivable (undiscounted) charges (discounted)
C C C
Future lease payments expected to be received
(at undiscounted amounts):
− in 20X2 xxx
− in 20X3 xxx
We must show expected cash inflows on
− in 20X4 xxx
a per-annum basis for at least 5 years
− in 20X5 xxx
− in 20X6 xxx
− after 20X6 All lease pmts after 20X6 shown in total xxx
Future lease payments xxx (xxx) xxx
Unguaranteed residual value xxx (xxx) xxx
Total (future lease payments & unguaranteed RV) xxx (xxx) xxx
870 Chapter 17
Gripping GAAP Leases: lessor accounting
• the lessor then recognises the instalments as income using an effective interest rate table (i.e. using
the accrual basis to recognise interest income plus, if a manufacturer/ dealer, sales income) but the
tax authorities tax the instalments on a cash basis.
To complicate matters further, some tax authorities do not allow the tax deductions (e.g. capital
allowances) to exceed the taxable lease income in any one period. In South Africa, for
example, section 23A of the Income Tax Act limits certain tax deductions on the cost of the
asset being leased out by the lessor to the lessor’s taxable lease income.
See the section on transaction taxes (e.g. VAT) and its impact on a lessor in a finance lease.
Example 11: Deferred tax on a finance lease with no S23A limitation, VAT ignored
The facts from example 9 apply, repeated here for your convenience:
Pear Tree Limited is neither a dealer nor a manufacturer. Pear Tree Limited entered into
an agreement in which Pear Tree leased a machine to Giant Limited (cost C210 000 on
1 January 20X1).
The lease is a finance lease, the terms of which are as follows:
• commencement date: 1 January 20X1
• lease period: 3 years
• lease payments: C80 000, annually in advance, payable on 1 January of each year
• guaranteed residual value: C10 000, payable on 31 December 20X3;
• interest rate implicit in the agreement: 18.7927%.
Assume further that the tax authorities:
• tax lease payments when received;
• allow the deduction of the cost of the asset over three years (capital allowance);
• the income tax rate is 30%.
This is the only transaction in the years ended 31 December 20X1, 20X2 and 20X3.
Required: Prepare the current and deferred tax journals for each of the years affected. Ignore VAT.
Solution 11: Deferred tax on a finance lease with no S23A limitation, VAT ignored
Comment:
• This example is actually based on the same basic facts as given in example 9.
• The effective interest rate table for example 9 has been repeated here for your convenience.
• Please see example 9 for any other calculation and/ or for the journals.
Chapter 17 871
Gripping GAAP Leases: lessor accounting
W1: Effective interest rate table Finance income: Lease pmts & Receivable
18.7927% unguaranteed RV balance
01 January 20X1 210 000
01 January 20X1 0 (80 000) 130 000
31 December 20X1 24 431 154 431
01 January 20X2 (80 000) 74 431
31 December 20X2 13 988 88 419
01 January 20X3 (80 000) 8 419
31 December 20X3 1 581 10 000
31 December 20X3 (10 000) 0
40 000 (250 000)
872 Chapter 17
Gripping GAAP Leases: lessor accounting
Example 12: Deferred tax on a finance lease: S23A limitation, VAT ignored
The facts from example 9 apply, repeated here for your convenience, together with
slightly different tax-related information:
Pear Tree Limited is neither a dealer nor manufacturer. Pear Tree entered into a contract in which it
leased a machine to Giant Limited (cost C210 000). The lease is a finance lease, the terms being:
• commencement date: 1 January 20X1 with the lease period being 3 years
• lease payments: C80 000, annually in advance, payable on 1 January of each year
• guaranteed residual value: C10 000, payable on 31 December 20X3
• interest rate implicit in the agreement: 18.7927%.
There are no other transactions during the years ended 31 December 20X1, 20X2 and 20X3.
There are no temporary differences other than those evident from the information provided and
there are no non-deductible expenses and no exempt income.
Required: Prepare the current and deferred tax journals for each of the years affected. Ignore VAT.
Solution 12: Deferred tax on a finance lease with a s23A limitation, VAT ignored
31/12/20X1 Debit Credit
There is no current tax charge and therefore no current tax journal (W5)
Income tax (P/L: E) W4 7 329
Deferred tax liability (L) 7 329
Deferred tax adjustment
31/12/20X2
There is no current tax charge and therefore no current tax journal (W5)
Income tax (P/L: E) W4 4 197
Deferred tax liability (L) 4 197
Deferred tax adjustment
31/12/20X3
Income tax (P/L: E) W5 12 000
Current tax payable (L) 12 000
Current tax charge
Deferred tax liability (L) W4 11 526
Income tax (P/L: E) 11 526
Deferred tax adjustment
Chapter 17 873
Gripping GAAP Leases: lessor accounting
W1: Effective interest rate table Finance income: Lease pmts & Receivable
18.7927% Unguaranteed RV balance
01 January X1 210 000
01 January X1 0 (80 000) 130 000
31 December 20X1 24 431 154 431
01 January X2 (80 000) 74 431
31 December 20X2 13 988 88 419
01 January X3 (80 000) 8 419
31 December 20X3 1 581 10 000
31 December 20X3 (10 000) 0
40 000 250 000
Comment: When doing a ‘lessor – finance lease’ question, it may be best to first do the s23A
check (W2.1) to see whether or not the limitation applies.
874 Chapter 17
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Solution 13: Def tax on a finance lease (manuf./ dealer) with a s 23A limit, VAT ignored
Comment:
This example is based on the same basic facts as given in example 7.
The effective interest rate table for example 7 has been repeated here for your convenience.
Please see example 7 for any other calculation and/ or for the journals.
Chapter 17 875
Gripping GAAP Leases: lessor accounting
W1: Effective interest rate table Finance income: Lease pmts & Receivable balance
16.9911% unguaranteed RV
01 Jan X1 320 000
31 Dec X1 54 372 (100 000) 274 372
31 Dec X2 46 618 (100 000) 220 990
31 Dec X3 37 549 (100 000) 158 539
31 Dec X4 26 938 (100 000) 85 477
31 Dec X5 14 523 (100 000) 0
180 000 (500 000)
W2: Current tax charge 20X1 20X2 20X3 20X4 20X5 Total
Sales income 320 000 320 000
Less cost of sale (250 000) (250 000)
Finance income earned 54 372 46 618 37 549 26 938 14 523 180 000
Profit before tax: 124 372 46 618 37 549 26 938 14 523 250 000
Adjust for temporary differences
- less profit on sale (70 000) 0 0 0 (0) (70 000)
- less finance income earned (54 372) (46 618) (37 549) (26 938) (14 523) (180 000)
- add lease instalment received 100 000 100 000 100 000 100 000 100 000 500 000
- less 50% once-off allowance (125 000) 0 0 0 0 (125 000)
- less 20% annual allowance (25 000) (25 000) (25 000) (25 000) (25 000) (125 000)
- add back s 23A limitation 50 000 0 0 0 0 50 000
- less s 23A catch-up allowance (0) (50 000) (0) (0) (0) (50 000)
Taxable profit 0 25 000 75 000 75 000 75 000 250 000
Current income tax at 30% 0 7 500 22 500 22 500 22 500 75 000
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An operating lease is a ‘pure lease’ since ownership of the asset is not transferred at any stage
during the lease. The lessor therefore keeps his asset in his statement of financial position
(and presents his asset according to its nature, as he would normally, e.g. as property, plant
and equipment), and recognises:
• the costs incurred on the lease as expenses over the period (e.g. depreciation on the
leased asset where the leased asset is a depreciable asset); and
• the lease payments as income over the lease period (normally on a straight-line basis).
Costs that are considered to be ‘initial direct costs’ (defined as ‘incremental costs of obtaining a
lease that would not have been incurred if the lease had not been obtained’) should be added
to the cost of the leased asset. These will then be expensed as the leased asset is expensed
(e.g. through depreciation). However, these costs are depreciated over the lease term, on the
same basis that the lease income is recognised (e.g. normally on the straight-line basis) – not
over the useful life of the underlying asset.
Other information:
• Banana incurred legal fees of C8 000 on 1 January 20X1 to obtain the lease (initial direct costs).
• Front paid both lease instalments on due date.
• Frond purchased the plant on 31 December 20X2 at its market price of C200 000.
• Banana depreciates its plant over ten years on the straight-line basis.
Required:
Prepare the journal entries for each of the years affected. Ignore tax.
878 Chapter 17
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Journals
31/12/20X1 Debit Credit
Income tax expense (P/L: E) W4 19 200
Current tax payable (L) 19 200
Current tax charge
Income tax expense (P/L: E) W3 12 300
Deferred tax liability (L) 12 300
Deferred tax adjustment
Check: tax expense in 20X1 will be C31 500 (CT: 19 200 + DT: 12 300), which = 30% x accounting profit: 105 000
31/12/20X2
Income tax expense (P/L: E) 44 400
Current tax payable (L) 44 400
Current tax charge
Deferred tax liability (L) 12 300
Income tax expense (P/L: E) 12 300
Deferred tax adjustment
Check: tax expense in 20X2 will be C25 200 (CT: 44 400 – DT: 12 300), which = 30% x accounting profit: 107 000
W1: DT – plant CA TB TD DT
Opening balance 20X1 0 0 0 0
Purchase 240 000 240 000
Legal fees capitalised 8 000 8 000
Depreciation/ deduction [calc (a) & (b)] (25 000) (48 000)
Legal fee deduction [given] - (8 000)
Closing balance 20X1 223 000 192 000 (31 000) (9 300) DTL
Depreciation/ deduction [calc (a) & (b)] (25 000) (48 000)
Subtotal 198 000 144 000
Sale of asset (CA/ TB derecognised) (198 000) (144 000)
Closing balance 20X2 0 0 0 0
Calculations:
a) Depreciation of plant (20X1 and 20X2) = (240 000 – 30 000) / 10 years + (8 000/2) = 25 000
b) Tax deduction of plant (20X1 and 20X2) = 240 000 x 20% = 48 000
880 Chapter 17
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• depending on the underlying asset that is being rented out under an operating lease, the
entity would have to provide the disclosures required by the relevant IFRS:
- IAS 16 Property, plant and equipment;
- IAS 38 Intangible assets;
- IAS 40 Investment property;
- IAS 41 Agriculture. See IFRS 16.95-96
• if the underlying asset in the operating lease is an item of property, plant and equipment,
the disclosures required by IAS 16 Property, plant and equipment (see bullet point above)
must be shown separately by class of asset (e.g. vehicles, plant etc) as follows:
- those that are owned and used by the entity; and
- those that are owned and rented out by the entity under an operating lease. See IFRS 16.95
• if the underlying asset in the operating lease was impaired (or had an impairment
reversed) during the year, then the entity must provide the disclosures required by:
- IAS 36 Impairment of assets. See IFRS 16.96
Happy Limited
Notes to the financial statements (extracts)
For the year ended 31 December 20X0
Owned Owned Total
and used and leased
25 Property, plant and equipment C C C
Machinery
Net carrying amount – beginning of 20X0 xxx xxx xxx
Gross carrying amount xxx xxx xxx
Less accumulated depreciation and impairment losses (xxx) (xxx) (xxx)
…Detail of movements during 20X0 (shown here)… (xxx) xxx (xxx)
Net carrying amount – end of 20X0 xxx xxx xxx
Gross carrying amount xxx xxx xxx
Less accumulated depreciation and impairment losses (xxx) (xxx) (xxx)
Undiscounted
40. Maturity analysis of future lease payments receivable amounts
C
Future lease payments expected to be received (at undiscounted amounts): xxx
− in 20X1 xxx
− in 20X2 xxx
− in 20X3 We must show expected cash inflows per year for at least 5 years xxx
− in 20X4 xxx
− in 20X5 xxx
− after 20X5 Any lease payments expected after 5 years are shown in total xxx
41. Additional qualitative and quantitative information regarding operating and finance leases
Include a description of the nature of the lessor’s leasing activities (operating and finance leases).
(e.g. A group leased out a portion of its head office buildings. All risk and rewards with regards to the
head office building remains with the group, hence it is an operating lease as per IFRS 16).
The risks associated with the rights retained in the underlying assets (e.g. the risk and rewards with
regards to the underlying asset lies with the lessor Any damages to the property for example, would
be at the cost of the lessor).
The risk management strategy includes the incorporation of residual value guarantees in the contracts.
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Banana Limited
Statement of financial position (extracts) 20X2 20X1
As at 31 December 20X2 C C
Notes
Non-current assets
Plant W1 14 0 223 000
Current assets
Operating lease receivable W2 0 10 000
Non-current liabilities
Deferred tax liability W3 15 0 12 300
Current liabilities
Current tax payable W4 63 600 19 200
Banana Limited
Statement of comprehensive income (extracts) 20X2 20X1
For the year ended 31 December 20X2 C C
Notes
Profit before tax W4 107 000 105 000
Taxation expense 17 (32 100) (31 500)
Profit for the year 74 900 73 500
Banana Limited
Notes to the financial statements (extracts) 20X2 20X1
For the year ended 31 December 20X2 C C
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Banana Limited
Notes to the financial statements (continued …) 20X2 20X1
For the year ended 31 December 20X2 C C
18. Profit before tax
Profit before tax has been stated after the following separately disclosable
(income)/ expenses:
• Depreciation 25 000 25 000
• Operating lease income from:
− variable lease payment that do not depend on an index or rate xxx xxx
− other lease payments (130 000) (130 000)
Notice: there was no maturity analysis because the lease receivable was nil at 31 December 20X2.
Leases of land and leases of buildings are classified as operating or Recognise lease
of land
finance leases in the same way as leases involving any other assets.
separately from
In fact, if a lease contract involves a property that combines land and lease of buildings:
buildings, IFRS 16 clarifies that classification of the lease of the
• Except if the land
property as either an operating or finance lease, must involve the element is immaterial
separate consideration and classification of the land element and the (then classify the
building element. This may result in a single lease contract involving property as a single
land and buildings being recognised partly as an operating lease and unit and use UL of
building as the UL of
partly as a finance lease.
the property)
Now, an interesting feature of land is that its economic life is normally deemed to be indefinite.
This is an important consideration when determining whether the lease of the land element
should be classified as a finance lease or operating we have no way of concluding that the
lessee will receive substantially all the risks and rewards of ownership (unless legal title (legal
ownership) is expected to pass to the lessee at the end of the lease term). Thus, we normally
classify leases over land as operating leases. In other words, this would mean that the land
would remain recognised in the lessor’s accounting records.
However, it is not true to say that every lease of land where the legal title (ownership) does not
transfer from the lessor to the lessee should automatically be accounted for by the lessor as an
operating lease. The ‘basis of conclusions’ within IFRS 16 explains a
scenario that was debated where one could lease land over a 999- When classifying
year period. It explains that even if legal ownership does not pass to the lease of
land, an
the lessee, the lessor will have effectively handed over the risks and
important consideration
rewards of ownership. Substantiating this fact is that, from the lessor’s is that it normally has an
perspective, the present value of the residual value of its land would indefinite economic life
be negligible even after leasing land for just a few decades, let alone
999 years. Thus, it may be necessary to classify a relatively long lease of land as a finance
lease. In this case, it means the lessor would have to derecognise the land (remove from its
records as if it had been sold).
However, as always, it is important to examine the substance of the arrangement. The general
principle is, as always, if substantially all the risks and rewards have transferred, we must account for
the lease as a finance lease, even if this is inconsistent with the legal nature of the transaction.
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Required: Discuss the classification of the lease based purely on the information provided above.
Note: The classification of a lease combining land and buildings as either finance or operating would not
normally be restricted to the information above: all factors affecting the lease would need to be
considered (e.g. fair values versus present values of future lease payments etcetera).
5.2 How to allocate the lease payments to the separate elements: land
and buildings (IFRS 16.B55 - B57)
When classifying a lease of a combination property (i.e. the property includes a land element
and a building element), the lease payments (as defined) plus any prepaid lease payments
(which are excluded from the definition of lease payments) will need to be allocated between
the two elements in proportion to the relative fair values of the leasehold interests in the land
and the building elements, measured at lease inception. See IFRS 16. B56
If the fair value of the leasehold interest in the land is immaterial, then we do not consider the
land element separately from the building element when classifying the lease. Instead, we
classify the property as ‘a single unit’. In this case, the useful life of the property must be
assumed to be the useful life of the building. See IFRS 16. B57
If we are not able to reliably allocate the lease payments, the entire lease is classified as:
• an operating lease, if it is clear that both the land element and the building element are
operating leases; or
• a finance lease. See IFRS 16. B56
Required: Prepare the journal entries for 20X3 and for 20X4 in the lessor’s accounting records.
Chapter 17 885
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• However, by way of example, one of the factors we would have considered is the following:
− The lease term is 20 years, which is a major portion of the building’s remaining useful life thus
suggesting that the lease is a finance lease.
− The land has an indefinite useful life and thus the lease term of 22 years does not represent a
major portion of the asset’s life thus suggesting that the lease was an operating lease.
Step 1: Splitting the lease instalments into operating and finance portions
5 000 000
Land: x 500 000 = 345 264 (operating lease)
7 240 832
2 240 832
Buildings: x 500 000 = 154 736 (finance lease)
7 240 832
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Comment: Operating lease income must be recognised on the straight-line basis (or other systematic
basis) over the lease term. However, the operating lease payments remained constant over this period.
5.3 Land and buildings that are investment properties (IAS 40.5)
Investment property comprises land and buildings that are held to earn rentals or for capital
appreciation or both. Thus, land that is leased to a third party under an operating lease (thus
earning rentals) would meet the definition of investment property. Land and buildings that are
leased under an operating lease must be classified as investment property and be recognised
and measured in terms of IAS 40 Investment property.
The classification of a lease is decided upon at the inception of the lease. The classification
should only be changed during the lease period if there is a Lease classifications may
lease modification. need to change if:
• there has been a contract
This means that if there is a change in estimate of the underlying modification – cancel old lease,
asset (e.g. change in the asset’s estimated economic life or treat modified contract as if it
residual value), the classification of the lease is not changed. were a new lease; or
• a correction of error.
For example, if the useful life is re-estimated to be shorter Otherwise classifications should
never change (i.e. changes in
than the previous estimate, such that the lease term is now
estimates do not lead to a lease
considered to be a substantial part of the economic life of the classification changing).
asset, where this was previously not the case and thus where
the lease had been classified as an operating lease, we would not subsequently reclassify the
lease as a finance lease.
Modifications only include, by definition (see pop-up), changes to the lease contract’s original terms
and conditions that affect the scope or consideration. See IFRS 16.App A
A change made to a finance lease as a result of a modification will only be accounted for as a
separate lease if the following two criteria are met:
• ‘the modification increases the scope by adding the right to use one or more underlying assets; and
• 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’. IFRS 16.79 (Extract)
If there is a modification made to a finance lease that is not accounted for as a separate lease
(because the two criteria mentioned above are not met), then the lessor:
• applies the requirements of IFRS 9 Financial instruments
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• unless the finance lease would have been classified as an operating lease had the
modifications been in existence at inception of the original contract, in which case, instead
of applying IFRS 9, the lessor:
− accounts for the modification as a new lease from the effective date of the modification, and
− derecognises the balance in the ‘net investment in the finance lease’ account (credit)
and recognises it as the carrying amount of the underlying asset (debit). See IFRS 16.80
The approach above does not apply to normal renewals and to changes in estimates, for
example changes in estimates of the useful life or the residual value of the leased property.
The only exception would be if, for example, an original useful life was incorrect and thus that
the subsequent change in the useful life is a correction rather than a change in estimate. In this
case, the classification of the lease would have been incorrect and we would thus need to
correct an error. If the error was material and occurred in the prior year, the correcting
adjustments would be made retrospectively, with prior years restated. See IAS8.41 - .49
The existence of a transaction tax (e.g. VAT) in a finance lease has certain accounting
implications. To understand these implications, one must know what tax legislation applies.
Output VAT is In South Africa, the VAT Act requires ‘VAT vendors’ to calculate
charged on initial lease and charge VAT (i.e. output VAT) on “instalment credit
capitalisation: agreements”. A finance lease satisfies the criteria as an
• being the earlier of date of “instalment credit agreement” and thus a lessor in a finance
delivery or date of payment. lease must charge VAT if he is a VAT vendor. The VAT charged
• It is recognised as a VAT payable becomes payable to the tax authorities at the commencement
immediately. date, being the earlier of delivery, or payment (see chapter 16 for
detailed discussion).
In other words, this output VAT is payable in total and upfront – it is not payable piecemeal
based on the lease payments over the lease term. Thus, this full VAT is included in the
receivables balance and credited to the VAT output account (VAT payable).
888 Chapter 17
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As previously discussed, the VAT Act requires that VAT is charged on the lease, payable
immediately. We recognise this entire VAT on the initial capitalisation of the lease.
This machine was then sold under a finance lease, on the same day.
This is the only transaction for the year ended 31 December 20X5.
Required: Prepare all the journals (including tax) for the year ended 31 December 20X5.
Comment:
Section 23A of the Income Tax Act does not apply as the instalments (C150 000) exceed the tax
deductions (C570 000/5 = C114 000).
Chapter 17 889
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W2: Effective interest rate table Finance income @ 9.90505% Instalment Balance
890 Chapter 17
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W4.2 Machine CA TB TD DT
Opening balance 0 0 0 0
Purchase (excluding VAT) 500 000 500 000
Lease disposal (500 000) 0
Tax deductions 0 (100 000)
Closing balance 0 400 000 400 000 120 000 DTA
When an input VAT deduction for the purchase of an asset is available for a lessor who is a
VAT vendor (i.e. when VAT paid on the purchase of an asset is reclaimable), the tax base will
exclude the amount of input VAT. Thus, the tax deductions or allowances on this asset will be
calculated on the cost of the asset excluding the VAT that is reclaimable.
If the VAT was not reclaimable (e.g. the lessor is not a VAT vendor and thus when purchasing
an asset that included VAT, the lessor was not in a position to claim the VAT back), then the
cost of the asset for purposes of calculating an allowance includes the VAT.
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8. Summary
Lessors
Finance leases
Subsequent measurement
• Finance income recognised over lease term using effective interest rate (Dr lease
receivable and Credit Finance income)
• Payments received reduce receivable (Dr Bank and Credit Lease receivable)
• Lease receivable (NI) is subject to derecognition and impairment requirements
• Unguaranteed residual value should be reviewed regularly – any reduction in this value
impacts income allocation over the lease term.
• Notice that
− manufacturer/ dealers recognise two types of income: finance income and sales
− non-manufacturer/dealers recognise one type of income: finance income
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894 Chapter 17
Gripping GAAP Provisions, contingencies & events after the reporting period
Chapter 18
Provisions, Contingencies and
Events after the Reporting Period
Reference: IAS 37, IAS 10, IFRIC 21, IFRIC 1 (including any amendments to 1 December 2019)
CHAPTER SPLIT:
This chapter involves two standards IAS 37 (together with IFRIC 1, being a related interpretation)
and IAS 10. IAS 37 (and IFRIC 1) covers certain types of liabilities and assets, whereas IAS 10
deals with events that occur after the reporting period but before the financial statements are
authorised for issue. The reason they are combined into one chapter is that they are very much
inter-related. However, since the chapter is fairly long, it is split into these two separate parts as
follows:
PARTS: Page
PART A: Provisions, Contingent Liabilities and Contingent Assets (IAS 37) 897
PART B: Events after the Reporting Period (IAS 10) 926
PART A:
Provisions, Contingent Liabilities and Contingent Assets
Contents: Page
A: 1 Introduction 897
A: 2 Scope 897
A: 3 Recognition: liabilities, provisions and contingent liabilities 898
A: 3.1 Overview 898
A: 3.2 Comparison: liabilities and provisions 898
A: 3.3 Comparison: liabilities and contingent liabilities 898
A: 3.4 Discussion of the liability definition 899
A: 3.4.1 Present obligations 899
A: 3.4.2 Past events 899
A: 3.4.3 Obligating events 899
Example 1: Obligating events 900
Example 2: Obligating events 901
A: 3.5 Discussion of the recognition criteria 901
A: 3.5.1 Overview 901
A: 3.5.2 Probable outflow of future economic benefits 901
A: 3.5.3 Reliable estimate 901
Example 3: Reliable estimate 902
A: 4 Measurement: liabilities, provisions and contingent liabilities 903
A: 4.1 Overview 903
A: 4.2 Best estimates 904
Example 4: Best estimate using expected values 905
A: 4.3 Risks and uncertainties 905
A: 4.4 Future cash flows and discounting 905
Example 5: Discounting liabilities to present values and related journals 906
Example 6: Calculating present (discounted) values and related journals 907
A: 4.5 Future events 908
Example 7: Future events 908
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Contents: Page
A: 4.6 Gains on disposal of assets 909
Example 8: Gains on disposal of assets 909
A: 4.7 Provisions and reimbursement assets 909
Example 9: Guarantees 910
Example 10: Reimbursements 911
A: 4.8 Changes in provisions 911
A: 4.8.1 Change in provisions and the cost model 912
Example 11: Changes in decommissioning liability: cost model 913
A: 4.8.2 Change in provisions and the revaluation model 915
Example 12: Changes in decommissioning liability: revaluation model 916
A: 4.9 Changes in provisions through usage or derecognition 918
Example 13: Reduction in provisions 919
A: 5 Recognition and measurement: four interesting cases 919
A: 5.1 Future operating losses 919
A: 5.2 Contracts 920
Example 14: Onerous contracts 920
A: 5.3 Restructuring provisions 920
Example 15: Restructuring costs 921
A: 5.4 Levies 922
Example 16: Levies 922
A: 6 Recognition and measurement: contingent assets 922
A: 6.1 Recognition of contingent assets 922
A: 6.2 Measurement of contingent assets 923
A: 7 Disclosure: provisions, contingent liabilities and contingent assets 923
A: 7.1 Disclosure of provisions 923
A: 7.2 Disclosure of contingent liabilities 924
Example 17: Disclosure: decommissioning provision (change in estimate) 924
A: 7.3 Disclosure of contingent assets 925
A: 7.4 Exemptions from disclosure requirements 925
A. Summary 931
PART B:
Events after the reporting period
Contents: Page
B: 1 Introduction 926
B: 2 Adjusting events after the reporting period 926
Example 18: Event after the reporting period 927
B: 3 Non-adjusting events after the reporting period 927
Example 19: Non-adjusting events after the reporting period 927
B: 4 Exceptions: no longer a going concern 928
Example 20: Events after the reporting period – various 928
B: 5 Disclosure: events after the reporting period 930
B. Summary 932
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PART A:
Provisions, Contingent Liabilities and Contingent Assets
A: 1 Introduction
This chapter is separated into two parts: Part A and Part B. Part A explains IAS 37 Provisions,
contingent liabilities and contingent assets, and Part B explains IAS 10 Events after the
reporting period.
Before we begin, we consider what is excluded from the scope of IAS 37 (section A.2). After that we
will look at provisions and contingent liabilities, focusing first on recognition (section A.3) and then on
measurement (section A.4). A few interesting cases that involve both recognition and measurement
are then discussed (section A.5). Then we will look at contingent assets – these are never
recognised but may need to be disclosed, so we will focus on the measurement of any contingent
asset needing to be disclosed (section A.6). And we will end by looking at the detailed disclosure
requirements affecting all three: provisions, contingent liabilities and contingent assets (section A.7).
IAS 37 shall be applied by all entities in accounting for provisions, contingent liabilities and
contingent assets, except:
x those resulting from executory contracts, unless the contract is onerous Note 1; and
x those covered by another standard. IAS 37.1
Note 1: Executory contracts and onerous contracts are discussed in section A: 5.2.
Some types of provisions, contingent liabilities and contingent assets are not covered by
IAS 37 but by other standards, for example:
x income taxes (see IAS 12 Income taxes);
x leases (see IFRS 16 Leases);
x employee benefits (see IAS 19 Employee Benefits);
x insurance contracts (see IFRS 4 Insurance Contracts); and
x revenue from contracts with customers (see IFRS 15 Revenue from contracts with
customers), excluding onerous contracts (i.e. a revenue contract that is or has become
onerous will be accounted for in terms of IAS 37). See IAS 37.5
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A: 3.1 Overview
There are significant differences between a ‘pure’ liability, provision and contingent liability.
These differences boil down to the extent to which they meet the liability definition (per IAS 37)
and the recognition criteria (per IAS 37) – if at all. If an item doesn’t meet both the definition
and the recognition criteria, then it won’t be recognised as a liability – although it may still
need to be disclosed.
IAS 37 defines a liability in terms of the prior 2010 CF. It A liability is defined in IAS 37
is a present obligation of the entity, having arisen from a (old 2010 CF) as:
past event, and which we expect will result in a future x a present obligation
x of the entity
outflow of economic benefits (see pop-up). See IAS 37.10 x arising from past events
x the settlement of which is expected to
A fundamental part of this definition is that there must be an result in an outflow from the entity of
obligation and this obligation must be present. Deciding if resources embodying economic benefits.
IAS 37.10
there actually is an obligation at a specific point in time can
be difficult and require professional judgement. If we can’t be sure we have a present obligation, then
we know we do not have a ‘pure’ liability or ‘provision’ but we may have a ‘contingent liability’.
IAS 37 refers to the recognition criteria that were given in the prior 2010 CF. In terms of
these recognition criteria, a liability may not be recognised unless:
x It is reliably measurable; and
x The outflow of benefits is probable. See IAS 37.14
In order to differentiate between a pure liability, a provision and a contingent liability, we need
to thoroughly understand every aspect of the definition and recognition criteria. These will be
explained below. Before we do this, however, let us compare the meanings of:
x the term ‘provision’ and the term ‘liability’, and then
x the term ‘contingent liability’ and the term ‘liability’.
Since a provision is a type of liability, a provision may only be recognised if it meets the
liability definition and recognition criteria (per IAS 37). Thus, despite the measurement
uncertainty involved, a provision may be recognised on condition that we believe that the
estimate of the amount is reliably measurable (this is one of the recognition criteria).
Both provisions and liabilities are recognised in the statement of financial position but,
because of the level of uncertainty involved with provisions, we disclose them separately.
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In very rare instances, it may be difficult to determine if there is a present obligation or even if
there is a past event.
How to decide if we actually
In these instances, the entity must decide if it is: have an obligation?
x more likely that a present obligation did exist at year- A tip that may be helpful when
deciding whether an obligation exists, is
end, in which case a provision is recognised (i.e. to ask yourself the following question:
greater than 50% chance); or if the entity closed down tomorrow,
would the obligation still exist?
x more likely that a present obligation did not exist at
year-end (i.e. less than 50% chance), in which case If the answer to that is yes, then the
entity has a present obligation as a
a contingent liability is disclosed (unless the possible result of a past event.
outflow of future economic benefits is remote, in
which case it is ignored).
In making this decision, the entity uses its professional judgement, other expert opinions (e.g.
legal opinion) and events after the reporting period.
For example: A typical example of where an entity may be unsure of whether or not it has a
present obligation due to a past event, is a court case in progress at year-end where there is
currently no indication as to whether the deed that the entity is being accused of actually
occurred (i.e. whether there is a past event) and even if it did occur, whether or not the entity
will be required to pay a fine or other settlement (i.e. whether there is a resulting obligation).
A: 3.4.2 Past events (IAS 37.17 – 22) Past events are those:
x Events that
x Occurred on/ before RD.
We need an event and it must have happened on or before
the reporting date (year-end) for it to be a past event.
An obligating event is defined as:
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IAS 37 has many great examples that explain the principles of recognition.
See IAS 37 Appendix C!
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Required: Explain whether Damij should recognise a liability or a provision at 31 December 20X3.
Before a liability may be recognised, it needs to meet the liability definition and the recognition
criteria given in IAS 37 (these definition and recognition criteria are not the same as those
given in 2018 CF). The recognition criteria given in IAS 37 are the following:
x The outflow of economic benefits must be probable; and
x The amount of the obligation can be reliably estimated.
In deciding whether a future outflow of economic benefits is probable, one must be sure that
the outflow is more likely to occur than not to occur, in which case a provision should be
recognised. If it is more likely that the outflow will not occur, then a contingent liability should
be disclosed (unless the possible outflow is remote).
It should be remembered that uncertainty and estimates are a normal part of the recognition
and measurement process. This means that, although a provision is a liability of uncertain
timing or amount, it does not mean that this liability cannot be reliably measured.
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If the estimated amount of an obligation involves a larger degree of uncertainty than normal,
but yet a reliable estimate is still possible, the liability is still recognised but is termed a
provision. Provisions should be disclosed separately from ‘pure’ liabilities and therefore it is
important to be able to differentiate a provision from a pure liability.
If an amount is so uncertain that the estimate is not reliable, then it is a contingent liability.
A typical example of a contingent liability would be where the entity is being sued but:
x it is either not yet possible to estimate whether the courts will probably rule against the
entity (i.e. the outflow of future economic benefits is not yet probable) or
x it is not yet possible to estimate the amount that the courts will force the entity to pay (i.e.
a reliable estimate is not yet possible).
Contingent liabilities are disclosed in the notes to the financial statements unless the
possibility of the outflow of future economic benefits is considered to be remote.
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A: 4.1 Overview
The same measurement principles are used whether we are measuring provisions or contingent
liabilities. The same logic would even apply to the measurement of ‘pure liabilities’ although,
since provisions and contingent liabilities involve more uncertainty, the measurement thereof will
involve the use of a higher degree of professional judgement.
Provisions should be measured at the ‘best estimate of the expenditure required to settle the
present obligation at the end of the reporting period’. See IAS 37.36
x The term ‘expenditure’ refers to the payment the entity would have to make.
x IAS 37 clarifies that the best estimate could include either ‘settling’ (paying) the obligation directly
or transferring the obligation to a third party (indirect settlement). In either case, the entity would
make a payment (either paying the person directly or paying the person indirectly by paying a third
party to take over the responsibility (transferring)).
x When we calculate the best estimate, it must reflect the expenditure required to settle the
obligation on a specific date, being ‘the end of the reporting period’ (i.e. the ‘reporting date’).
However, being able to settle an obligation (that may not yet even be due) on the actual
reporting date may actually be impossible or ridiculously expensive or both, and thus IAS 37
clarifies that this best estimate should reflect the amount that the entity would ‘rationally pay’ to
settle the obligation or transfer it to a third party at the end of the reporting period. See IAS 37.37
Although a contingent liability is never recognised, it must be disclosed, unless the possibility of
an outflow is remote.
x If we are to disclose it, we must try to estimate the amount thereof (remember that, by
definition, a reliable estimate of certain contingent liabilities may not actually be possible).
x If a reliable estimate of a contingent liability is possible, we measure it in the same way that
we measure a provision. See IAS 37.86
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Provisions and contingent liabilities are measured at the best estimate of the expected amount of the
settlement (where the best estimate takes into account all the related risks and uncertainties).
The measurement would be calculated at the present value of the future cash flows, if the effects of
discounting to its present value are considered material.
Measurement:
The measurement should ignore: The measurement of a
x future events unless there is ‘sufficient objective provision (or contingent
liability) involves:
evidence that they will occur’; and
x deciding the best estimate of the
x gains made on the expected disposal of assets. amount needed to settle/ transfer the
obligation
The measurement of the balance presented at year-end x after considering all related risks &
uncertainties
can also be affected by:
x calculating it at its present value, if
x changes to estimated provisions; and the effects of discounting are material.
x reductions in provisions.
The following are ignored in the
measurement:
Some of these aspects involved in measurement will x Future events for which there is
now be explained in more detail. insufficient evidence.
x Gains on disposals of assets.
A: 4.2 Best estimates (IAS 37.36 - 41)
The best estimate of the amount of an obligation is the amount an entity would rationally pay to
settle or transfer the liability at year-end. It is often difficult for management to estimate the
amount of the obligation, and management may have to base its estimate upon a combination of:
x management’s professional judgement;
x previous experience with similar transactions;
x independent expert advice, if available; and
x events after the reporting period. See IAS 37.38
The best estimate of an obligation can be calculated in a number of ways. IAS 37 suggests a
few methods, including the calculation of the:
x expected value;
x mid-point in the range;
x most likely outcome.
The expected value method is useful if prior experience suggests that there is a range of possible
outcomes where we are able to estimate the probability of each of these possible outcomes. We
then weight each of these possible outcomes based on their individual probabilities – this involves
multiplying each outcome by its individual probability and adding each of these products together,
the total of which is referred to as the ‘expected value’. The application of the expected value
method when calculating the best estimate is explained in example 4.
However, if there is a continuous range of possible outcomes, where each and any point in the range is
equally likely to be ‘the outcome’, then we would not bother trying to allocate a probability to each
and every possible outcome but would simply select the item in the middle of this continuous
range. In this case, the best estimate is thus simply the ‘mid-point’ in that range.
Another method of calculating the best estimate is the ‘most likely outcome’ method. This method
is ideal if there is a single obligation that must be measured with a few distinct possible outcomes.
For example: we may win a court case, in which case the costs will only be in the region of C10 000, or
we may lose the court case, in which case the costs will be around C1 000 000, or we may reach an
out-of-court settlement, in which case the costs will be around C500 000. Our view may be that the
most likely outcome is that we will win the court case. However, before simply concluding that our
provision should thus only be C10 000, we should consider the other possible outcomes. If most of the
other possible outcomes are higher (or most are lower) than the most likely outcome, then the
provision should be measured at an amount that is higher (or lower) than the most likely amount. Thus,
in our example, we would acknowledge that the other possible outcomes would result in a significantly
higher cost and thus the best estimate of the obligation is an amount higher than the most likely amount.
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Care must be taken not to duplicate a risk adjustment thus overstating liabilities or
understating assets.
Imagine being asked whether you would prefer to receive Discount rate
C100 today or C100 in 10 years’ time. For many reasons, The rate to be used is:
(including the fact that you could utilise the C100
x a pre-tax discount rate
immediately), you would choose to receive it immediately.
x based on the current market
This is because you can buy more with C100 today than assessment of:
you can with C100 in the future. In other words, today’s - the time value of money and
value (the present value) of a future cash flow is less than - the risks specific to the liability.
See IAS 37.47
the actual (absolute/ future) amount of the cash flow. This
is essentially the present value effect or the effect of the time value of money.
If the difference between the actual amount of the future Using a WACC rate as the
cash flow and its present value is material, then the discount rate is not
appropriate!
liability should be measured at its present value.
The WACC (Weighted average cost of
The present value is calculated using a pre-tax discount capital) is not an appropriate discount
rate based on the current market assessment of the time rate as the WACC takes into account
the risk of the entity as a whole and not
value of money and the risks specific to the liability. The just the risk related to the provision.
discount rate must not include any risks which have
already been adjusted for in the expected future cash flows. See IAS 37.47
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As the period between now (the present) and the date of the payment (the future) gets
shorter, so the difference between the present value and the future value (actual amount) of
the cash flow gets smaller.
When you finally get to the day that the payment is due, the present value will equal the
actual amount due.
Thus, each year between the date that the provision is recognised and the date that the
provision is settled (paid), the present value of the future outflow must be recalculated.
Each year, as we get closer to the future payment date, the present value will increase until
the actual payment date is reached, when the provision (calculated as the present value) will
finally equal the actual value of the liability.
Unwinding the discount
The increase in the liability each year will be debited to The following journal is
finance charges and credited to the provision such that processed each year to
at each reporting date, the provision is measured at its unwind the discount:
present value. DR Finance charges (E)
CR Provision/Liability (L)
These finance charges are often called ‘notional finance
charges’ (meaning ‘make-believe finance charges’) and is really just the ‘unwinding of the
discount’ process.
Required:
Show the related journal entries for each of the three years.
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Journals
Debit Credit
1 January 20X1
Plant: cost (A) Given 450 000
Bank (A) 450 000
Purchase of plant for cash
Plant (decomm.): cost (A) PV of future amount (W1) 300 000
Decommissioning liability 300 000
Initial recognition of the decommissioning obligation
31 December 20X1
Finance charges (P/L: E) PV 31/12/X1: 330 000 – PV 1/1/X1: 300 000; 30 000
Decommissioning liability OR 300 000 x 10% 30 000
Increase in liability as a result of unwinding of the discount
Depreciation: plant (P/L: E) (450 000 + 300 000 - 0) / 3 years 250 000
Plant: acc. depr (-A) 250 000
Depreciation of plant
31 December 20X2
Finance charges (P/L: E) PV 31/12/X2: 363 000 – PV 31/12/X1: 33 000
Decommissioning liability 330 000; OR 330 000 x 10% 33 000
Increase in liability as a result of unwinding of the discount
Depreciation: plant (P/L: E) (450 000 + 300 000 - 0) / 3 years 250 000
Plant: acc. depr (-A) 250 000
Depreciation of plant
31 December 20X3
Finance charges (P/L: E) PV 31/12/X3: 399 300 – PV 31/12/X2 36 300
Decommissioning liability 363 000; OR 363 000 x 10% 36 300
Increase in liability as a result of unwinding of the discount
Depreciation: plant (P/L: E) (450 000 + 300 000 - 0) / 3 years 250 000
Plant: acc. depr (-A) 250 000
Depreciation of plant
Decommissioning liability Given 399 300
Bank (A) 399 300
Payment in respect of decommissioning
Notice:
x The decommissioning cost (measured at PV) is debited to the plant’s cost account. IAS 16.16
x The total asset-related expense over 3 years is C849 300:
Depreciation: 750 000 (250 000 p.a. for 3 years) + Finance charges: 99 300 = 849 300
x This total expense equals the total cost of both acquiring and decommissioning the plant:
Purchase cost: 450 000 + Decommissioning cost: 399 300 = 849 300
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W2 Present value *
PV = Cash outflow after 3years: 399 300 x PVF after 3 years: 0.751 = 300 000 (see W3 for PVF calculation)
Or: Cash outflow after 3 years: 399 300 x (1/(1+0.1)3) = 300 000
Or: Present values can be calculated using a financial calculator instead, as follows:
FV= 399 300 n = 3 i = 10% Comp PV = 300 000
W3 Calculating discount factors manually *
Number of years to cash settlement Calculation of discount factor Discount factor (rounded): 10%
0 years (i.e. it’s due) Actual = 1 1
1 year 1/ (1+10%) 0.909
2 years 0.909/ (1+10%) 0.826
3 years 0.826/ (1+10%) 0.751
Notice:
x As we get closer to the date on which the C399 300 is to be paid, the discount factor increases.
x The gradual increase in the discount factor over time is often called the ‘unwinding of discount’.
x The increase in the discount factor causes the liability to gradually increase from its original
present value of C300 000 (on 1 January 20X1) to C399 300 (on 31 December 20X3).
x This increase in the liability will be recognised as finance charges over the 3 years.
x The finance charges are sometimes referred to as ‘notional’ finance charges.
x The discount rate used (10% in this case) must be a pre-tax discount rate.
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Whilst the recognition of the liability (obligation) is based on the usual principles already
discussed in this chapter, any asset relating to an expected reimbursement (e.g. from a
manufacturer or other third party) should:
x only be recognised if it is virtually certain that the reimbursement will be received;
x be disclosed as a separate asset (i.e. the asset should not be set off against the liability); and
x be measured at an amount not exceeding the amount of the related provision. IAS 37.53 (reworded)
Please note that although the liability (obligation) and the asset (reimbursement) may not be set-off
against each other, the related expenses and income may be set-off against each other. The fact
that the asset and liability may not be set-off is because this would obscure the actual sequence of
events (e.g. the entity offers a guarantee, being a liability, and the entity receives a counter-
guarantee, being an asset) and would thus not result in fair presentation.
x Where the entity provides a guarantee (or warranty) to a customer, the entity has created
an obligation for itself and must recognise a liability. This guarantee could be a written
guarantee (i.e. a legal obligation) or could simply be due to past actions that created an
expectation that the entity will provide a guarantee (i.e. a constructive obligation).
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x If, however, the manufacturer (the supplier) of a product provides the guarantee to the
entity’s customer and the entity (the retailer) simply communicates this guarantee (or
warranty) to the customer, then it is the manufacturer, and not the entity (the retailer) that
has the obligation. The entity (the retailer) will therefore not recognise a liability since the
entity is simply acting as the conduit for a manufacturer.
x If the manufacturer and the entity (retailer) are jointly and severally obligated to the
customer, then the entity must recognise a provision for its share of the obligation and must
disclose a contingent liability to reflect the extent to which the entity is exposed, in the
event that the manufacturer defaults on its share of the obligation.
Where a provision is recognised reflecting a guarantee offered by the entity to its customer, we must
consider whether there is a possible reimbursement available to the entity. If the entity has received
a counter-guarantee (i.e. a reimbursement) from the supplier and it is virtually certain to be received,
we must assess to what extent the provision may be recovered.
For example:
x If an entity expects to incur costs of C100 to settle a guarantee and expects proceeds from
a counter-guarantee of only C70, the entity has a provision of C100 and an asset of C70.
x If an entity expects to incur costs of C100 to settle a guarantee and expects proceeds from
a counter-guarantee C110, the entity has a provision of C100 and an asset of C100 (the
measurement of the asset must be limited to the amount of the provision).
A guarantee is provided by the entity (e.g. retailer) to its customer and where the manufacturer
offers a counter-guarantee to the entity in case of any return:
x The customer returns goods to entity (retailer) under the guarantee (this is a L to the entity);
x The entity returns goods to manufacturer under the guarantee (this is an A to the entity)
Example 9: Guarantees
A retailer sells goods to its customers that are guaranteed.
Required:
State whether the retailer must raise a provision for the cost of meeting future guarantee obligations if:
A. The retailer provides the guarantee.
B. The manufacturer provides the guarantee. The retailer is not liable in any way.
C. The manufacturer provides the guarantee, but the retailer provides a guarantee irrespective of
whether the manufacturer honours his guarantee.
D. The manufacturer and retailer provide a joint guarantee, whereby they share the costs of providing
the guarantee: they jointly and severally accept responsibility for the guarantee.
E. The manufacturer and retailer provide a joint guarantee, whereby they share the costs of fulfilling the
guarantee: the retailer is not liable for amounts the manufacturer may fail to pay.
Solution 9: Guarantees
A. The retailer has the obligation and must therefore raise the provision.
B. The manufacturer has the obligation. The retailer has no obligation. No provision (i.e. no liability)
should be raised in the retailer’s books.
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C. The retailer must raise a provision for the full cost of the provision and must recognise a separate
reimbursement asset to the extent that it is virtually certain to receive the reimbursement.
D. The portion of the costs that the retailer is expected to pay is recognised as a provision, whereas
the portion of the costs that the manufacturer is expected to pay is disclosed as a contingent liability
in case the manufacturer does not honour his obligations. IAS 37.29
E. The portion of the costs the retailer is expected to pay is recognised as a provision. A contingent
liability is not recognised for the portion of the costs the manufacturer is expected to pay since the
retailer has no obligation to pay this amount if the manufacturer fails to honour his obligations.
Entity name
Statement of financial position (extracts) 20X2
As at 31 December 20X2 C
Current assets
Guarantee reimbursements 100 000
Current liabilities
Provision for guarantees 100 000
Comment:
x The asset and liability should be separately disclosed and may not be set-off against each other
(therefore both asset and liability will appear in the statement of financial position); whereas
x The income and expense may be set-off against each other (as they both affect profit or loss). In this case,
they would cancel each other out (and would thus not appear in the statement of comprehensive income).
There are a number of reasons that could necessitate a change being made to the estimated
measurement of a provision:
x the unwinding of the discount as one gets closer to the date of the future outflow (e.g.
getting closer to the date on which an asset has to be decommissioned);
x a change in the estimated future cash outflow (due to a change in the amount or timing);
x a change in the estimated current market discount rate; and/ or
x the future outflow is no longer probable.
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We could also pay one of the costs that had been included in the provision. This is a transaction
rather than an adjustment to the estimate and is thus discussed separately under section A: 4.9.
If the future outflow subsequently becomes no longer probable, then the provision would be
derecognised entirely (if the outflow is now only possible, then it would be disclosed as a
contingent liability, but if it is now only remotely possible, then it would be ignored entirely).
The unwinding of the discount is really just the natural increase in the measurement of a
present-valued liability as we get closer to the day on which the future outflow is expected to
occur (we could call this D-Day).
If you recall, if the effects of discounting are considered material, then the initial measurement of
the provision must be at its present value – i.e. at the discounted amount. The subsequent
‘unwinding of the discount’ will reverse this original discounting (see example 6):
x The balance of the provision must be gradually increased as the present value increases
so that it finally equals the actual amount to be paid (the future amount).
x This increase in the provision is recognised directly in profit or loss as a finance cost.
The cost model measures the carrying amount of the asset at:
x cost
x less accumulated depreciation (decrease in carrying amount due to normal usage), and
x less accumulated impairment losses (the decrease in carrying amount due to damage).
If the provision requires an adjustment due to the unwinding of discount (i.e. the passage of
time), the contra entry is recognised as a finance cost expense in profit or loss: debit finance
cost expense and credit provision. This finance cost may never be subsequently capitalised.
(i.e. we are not allowed to subsequently credit the expense and debit the asset).
However, if the adjustment to the provision is due to some other reason (e.g. a change in the
estimated discount rate), then we must use the following logic instead. If the cost model is
used and an adjustment to the provision is needed (i.e. other than due to the unwinding of
discount), IFRIC 1 requires that the adjustment be processed as follows:
x An increase (credit) in the liability:
- is added (debited) to the cost of the related asset in the current period; but
- the entity shall consider whether this is an indication that the new carrying amount of
the asset may not be fully recoverable:
If it is such an indication, the entity must:
- test the asset for impairment (damage) by estimating its recoverable amount, and
- account for any impairment loss in accordance with IAS 36.
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31 December 20X6
Depreciation: plant (P/L: E) (1 027 321 – 256 830 – 7 514 – 0) 254 326
Plant: accumulated depreciation (-A) / 3 remaining years x 1 year 254 326
Depreciation for 20X6 year: (CA – RV) / remaining useful life
Finance charge (P/L: E) W1 2 254
Provision: decommissioning costs (L) 2 254
Finance charge for 20X6 based on the new estimate
Note 1: If our plant’s carrying amount had, for whatever reason, been lower than the decrease that
needed to be credited to the asset, the excess would be recognised immediately in profit or loss.
For example, had the plant’s carrying amount dropped to C7 000 on 1 January 20X6 (e.g. through an
impairment in the prior year), then:
x only C7 000 of the decrease would have been able to be credited to the plant; and
x C514 would have had to be recognised in profit or loss.
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x An increase in the provision – credit the provision and process the debits as follows:
- First debit the revaluation surplus account (i.e. other comprehensive income), if there is
one for this asset, until this balance is zero;
- Then debit any excess to a revaluation expense account (i.e. in profit or loss).
x A decrease in the provision – debit the provision and process the credits as follows:
- First credit a revaluation income account (i.e. in profit or loss) if the decrease reverses a
previous revaluation expense on the asset;
- Then credit any excess to the revaluation surplus account (i.e. other comprehensive income).
But, if the ‘decrease in the liability exceeds the carrying amount that would have been
recognised had the asset been carried under the cost model (i.e. the historical carrying
amount: depreciated cost), the excess shall be recognised immediately in profit or loss’.
For example: An asset with a historical carrying amount (HCA) of C200 000 (depreciated
cost), was previously revalued. The revaluation surplus balance is currently C300 000. The
related dismantling provision decreases by C250 000. We cannot credit the revaluation
surplus account (OCI) with C250 000, because the amount of the decrease exceeds the
asset’s HCA of C200 000. Thus, only C200 000 is credited to the revaluation surplus (OCI),
and the excess of C50 000 is credited to a revaluation income account in P/L.
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Notice:
x Payment of parking fines – although the fines occurred at the time of the court case, these fines had not
originally been provided for and therefore may not be debited to the provision.
x When we know that payments that have been provided for will not occur, the balance in the provision
must be derecognised. When the case was thrown out of court, it becomes clear that no further legal
fees will be incurred. This therefore means that the extra fee of C30 000 provided for in respect of lawyer
B will not be incurred and this balance must therefore be derecognised (C100 000 – C70 000).
A: 5.1 Future operating losses (IAS 37.63 - 65) Future operating losses
A future operating loss does not meet the liability definition A provision may never be
recognised for future operating losses
since there is no obligation to incur a future loss, and thus it
as it is avoidable. No present obligation
may not be recognised as a provision (remember: a liability exists to incur the loss.
exists independently of the entity’s future actions and thus, if
there is any future action that may avoid the obligation, there is no liability). However, expecting a
future loss may indicate that some of or all the entity’s assets may be impaired (see chapter 11).
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x a contract where:
There are two kinds of contracts referred to in IAS 37:
- the unavoidable costs of
x Executory contracts, and
meeting the obligations (terms) of
x Onerous contracts. the contract
- exceed the economic
Executory contracts are simply contracts still being benefits expected to be received
executed – in other words, either: from the contract IAS 37.10 reworded
x ‘neither party has performed any of its obligations; or
x both parties have partially performed their obligations to an equal extent.’ IAS 37.3
Costs that have been contractually committed to by an entity but not yet incurred should not
be recognised as a liability since these are considered to be future costs (there is no past
event and thus no present obligation exists).
The only time that costs in respect of a contract should be provided for is when the executory
contract is an onerous contract. Therefore, a provision may only be recognised if the contract
is an onerous contract as defined in IAS 37.
Measuring an onerous
An onerous contract is one where the unavoidable costs contract provision
to fulfil the terms of the contract are greater than the The provision must be measured
benefits that will be derived from it (i.e. the contract will at the lower of the:
make a loss). In this case, a provision must be x costs of fulfilling the contract, and;
recognised for the unavoidable costs, measured at the x any compensation/ penalties arising
‘least net cost of exiting’, this being the lower of: from failure to fulfil the contract
x the cost of fulfilling the contract; and See IAS 37.68
x the compensation or penalties that would be incurred if the contract were to be cancelled.
See IAS 37.68
An entity that is planning a restructuring will be expecting to incur a variety of costs. For example,
retrenchment packages will probably need to be paid out and, in the case of the sale of a
factory, there may be costs incurred in the removal of certain machinery. However, before
recognising a provision for the expected costs of restructuring, the same basic definition and
recognition criteria for a provision must be met. In this regard, IAS 37 provides further criteria to
assist us in determining whether the basic definition and recognition criteria have been met.
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These further criteria for recognising a constructive obligation to restructure are as follows:
x there must be a detailed formal plan that identifies at least all the following:
the business or part of a business concerned;
the principal locations affected;
the location, function and approximate number of employees who will be compensated
for terminating their services;
the expenditure that will be undertaken; and
when the plan will be implemented.
x the entity must have raised valid expectations in those affected before the end of the
reporting period that it will carry out restructuring, by either having:
started to implement the plan; or
announced its main features to those affected by it. IAS 37.72 (reworded slightly)
Costs of restructuring a business entity should be provided for (i.e. should be recognised as a
provision) on condition that the costs provided for are only those costs that are directly
associated with the restructuring, being:
x those that are necessary; AND
x not related to the ongoing activities of the entity (i.e. future operating costs are not part of
the provision, for example: retraining and relocation costs for continuing staff, investment
in new systems, marketing, etc.). See IAS 37.80
Restructuring is defined as:
Where a restructuring is to be achieved by selling an x A programme that is planned and
operation, no obligation arises until there is a binding controlled by management, and
sale agreement. x materially changes either:
- the scope of a business
undertaken by an entity; or
The logic behind this is that the entity is able to - the manner in which that business
reconsider the restructuring if a buyer on suitable terms is conducted IAS 37.10
cannot be found (e.g. it may have to abandon the idea of
restructuring entirely – and if it can do that, there is clearly no obligation yet).
However, if only part of the restructuring involves a sale of an operation, it is possible for a
constructive obligation to arise for the ‘non-sale part’ (i.e. the other aspects of the
restructuring that do not involve a sale of an operation) before a binding sale agreement
exists, in which case a restructuring provision would have to be recognised. See IAS 37.78-.79
Note:
x The cost of retraining staff is a future operating cost and must thus not be provided for, as these costs
are avoidable.
x The loss on sale of assets simply indicates a possible need to impair the assets at year-end.See IAS 37.81(a)
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A levy is defined as ‘an outflow of resources embodying economic benefits that are imposed
by governments on entities in accordance with legislation, other than:
x those outflows of resources that are within the scope of other standards (such as income
taxes, which are covered by IAS 12); and
x fines or other penalties that are imposed for breaches of the legislation’. IFRIC 21.4
Over and above the items excluded from this definition, IFRIC 21 also states that it does not
apply to liabilities arising from emission trading schemes. See IFRIC 21.6
IFRIC 21 on Levies does not
IFRIC 21 gives guidance on the accounting treatment
apply to:
and recognition principles for the liability to pay a levy if
x Outflows within the scope of other
that levy is within the scope of IAS 37.
standards (e.g. income taxes),
x The obligating event that gives rise to the recognition x Fines or penalties, and
of a liability to pay a levy is the activity that triggers x Liabilities arising from emissions
the payment of the levy, as identified by legislation. trading schemes. See IFRIC 21.4 & .6
IFRIC 21.8 (reworded slightly)
x The liability to pay a levy is recognised progressively, if the obligating event occurs over a
period of time. IFRIC 21.11
x If an obligation to pay a levy is triggered by reaching a minimum activity threshold, the
corresponding liability will be recognised when that threshold is reached. See IFRIC 21.12
922 Chapter 18
Gripping GAAP Provisions, contingencies & events after the reporting period
A: 6.2 Measurement of contingent assets (IAS 37.89 and IAS 37.36 - 52)
Although contingent assets are not recognised, they may Contingent assets are
need to be disclosed (if the inflow of economic benefits is accounted for as follows:
probable), in which case its value will need to be measured. x Inflow possible or remote:
- Ignore
We measure contingent assets in the same way we x Inflow probable:
measure provisions and contingent liabilities: - Disclose
x it must be measured at the best estimate of the expected x Inflow virtually certain:
benefits to be received, as at the reporting date; - Recognise (i.e. journalise) a ‘pure’
x it must include any risks and uncertainties associated asset (no longer a contingent asset)
with the contingent asset;
x if the effect of discounting is material, then it must be measured at its present value (using
a pre-tax discount rate reflecting market conditions and factors specific to the liability); and
x future events that may affect the amount to be received is only included where there is
‘sufficient objective evidence’ of their occurrence. See IAS 37.89
For each class of provision, disclose the following in the notes to the financial statements:
x a brief description of the nature of the obligation;
x the expected timing of the outflows;
x the uncertainties relating to either or both the amount and timing of the outflows;
x major assumptions made concerning future events (e.g. future interest rates; the
assumption that a future law will be enacted with the result that a related provision was
raised; future changes in prices and other costs);
x the expected amount of any reimbursements including the amount of the reimbursement
asset recognised (if recognised at all);
x a reconciliation between the opening and closing carrying amounts of the provision (for
the current period only) indicating each movement separately:
additional provisions made, including increases to existing provisions;
increases in a provision based on increasing present values caused by the normal
passage of time and from any changes to the estimated discount rate;
amounts used during the year (debited against the provision); and
unused amounts reversed during the year.
comparative information is not required in the notes.
Since provisions are estimates, a change in a provision must be accounted for as a change in
estimate in terms of IAS 8 Accounting policies, changes in accounting estimates and errors.
Chapter 18 923
Gripping GAAP Provisions, contingencies & events after the reporting period
Entity name
Statement of financial position (extracts) Note 20X2 20X1
As at 31 December 20X2 C C
Non-current assets
Property, plant and equipment 7 360 000 500 000
Non-current liabilities
Provision for decommissioning 6 605 000 330 000
Entity name
Notes to the financial statements (extracts) 20X2 20X1
For the year ended 31 December 20X2 C C
6. Provision for decommissioning
Opening carrying amount 330 000 0
Provision for decommissioning raised 0 300 000
Increase in provision – increase in future cost 220 000
Increase in provision – unwinding of discount: finance charges (note 8) 55 000 30 000
Closing carrying amount 605 000 330 000
The plant is expected to be decommissioned on 31/12/20X3 and is expected to result in cash outflows of C665
500 (20X1: C399 300). The amount of the outflow is uncertain due to changing prices. The timing of the outflow is
uncertain due to the changing asset usage, which may result in a longer or shorter useful life. Major assumptions
include the 10% interest rate and the 3-year useful remaining unchanged.
7. Property, plant and equipment
Net carrying amount: 1 January 500 000 0
Gross carrying amount: 1 January 750 000 0
Accumulated depreciation: 1 January (250 000) 0
Acquisition 450 000 + 300 000 0 750 000
Depreciation Per profit before tax note (360 000) (250 000)
Increase in present value of future decommissioning costs W1 220 000 0
Net carrying amount: 31 December 360 000 500 000
Gross carrying amount: 31 December 970 000 750 000
Accumulated depreciation: 31 December (610 000) (250 000)
8. Profit before tax
Profit before tax is stated after accounting for the following disclosable (income)/ expense items:
Finance charges W1 55 000 30 000
Depreciation W3 360 000 250 000
9. Change in estimate
The expected cash outflow on 31 December 20X3 in respect of the decommissioning of plant was
changed. The effect of the change is as follows: increase/(decrease)
x Current year profits (before tax) W2: 22 000 + W3: 110 000 (132 000)
x Future profits (before tax) W2: 24 200 + W3: 110 000 (134 200)
924 Chapter 18
Gripping GAAP Provisions, contingencies & events after the reporting period
There are two instances where the above disclosure of provisions, contingent liabilities and
contingent assets are not required:
x where disclosure thereof is not practicable, in which case this fact should be stated; and
x where the information required would be seriously prejudicial to the entity in a dispute with a
third party. If this is the case, then simply disclose the general nature of the dispute together
with the fact that full disclosure has not been made and the reason for this.
Chapter 18 925
Gripping GAAP Provisions, contingencies & events after the reporting period
PART B:
Events After the Reporting Period
B: 1 Introduction
Although one might assume that events that occur after the current year-end should not be
taken into account in the current year’s financial statements, this is not always the case!
There is generally a fairly significant time delay between our financial year-end and the date
on which our financial statements are ready to be authorised for issue. This period between
the end of the reporting period (the year-end) and the date on which the financial statements
are authorised for issue is often called the ‘post-reporting date period’.
During this period, certain things (events) may happen that we must consider carefully in
terms of our users’ information needs. Some of the events that happen during this period
could influence our users’ decisions and thus we need to consider whether this information
should somehow be included in our financial statements. The events need not be
unfavourable to be included – they could be favourable as well!
Events after the reporting
Each event after the reporting period will need to be period are defined as events
analysed and categorised as being either: that:
x an adjusting event; or x are favourable or unfavourable
x a non-adjusting event. x occur between the:
- end of the reporting period and
For example: An entity has a 31 December year-end and - date when the f/statements are
its financial statements for 20X1 were completed and authorised for issue. IAS 10.3
ready for authorisation on 25 March 20X2. In this case, the period 1 January 20X2 to
25 March 20X2, is the ‘post-reporting date period’, and events taking place during this period
need to be carefully analysed in terms of this standard.
When considering whether or not to make adjustments for Adjusting events after the
an event that occurred after our reporting date but before reporting period are defined as
the financial statements are authorised for issue, (i.e. events that:
referred to as an ‘event after the reporting date’ or ‘post- x provide evidence of
reporting period event’) we simply need to ask ourselves x conditions that existed at the end of
if the event is one that gives more information about a the reporting period IAS 10.3
condition that existed at year-end.
If the event does give us information about a condition that existed at year-end, then we must
adjust the financial statements that we are about to issue. In other words, we will actually
need to post journal entries to account for the event in the current year financial statements.
The essence here is that the condition must already have been in existence at year-end. For
example, many estimates are made at year-end (e.g. impairment losses, legal and settlement
costs) where these estimates are made based on the circumstances prevailing at the time
that the estimate is made. If new information is discovered during the post-reporting date
period that gives a better indication of the true circumstances at year-end, then these
estimates would need to be changed accordingly.
Please remember that the event need not be unfavourable to be an adjusting event; for
example, a debtor that was put into provisional liquidation at year-end may reverse the
liquidation procedure during the post-reporting date period, in which case it may be
considered appropriate to exclude the value of his account from the estimated allowance for
credit losses and thus increase the value of the receivables balance at year-end.
926 Chapter 18
Gripping GAAP Provisions, contingencies & events after the reporting period
Required: Explain whether or not the above event should be adjusted for in the financial statements of
Newyear Limited as at 31 December 20X2. If it is an adjusting event, provide the journal entries.
Comment: Disclosure of this may also be necessary if the amount is considered to be material.
As already mentioned, when we decide whether to adjust for an event that occurred after the
reporting date but before the financial statements are authorised for issue, (i.e. referred to as
an ‘event after the reporting date’ or ‘post-reporting period event’) we simply need to ask
ourselves if the event gives more information about a:
Non-adjusting events after
x condition that existed at reporting date; or about a the reporting period are
x condition that arose after reporting date. defined as events that:
x are indicative of
If the event gives us information about a condition that x conditions that arose after the
only developed after year-end, then this event obviously reporting period. IAS 10.3
has no connection with the current financial statements
that are being finalised, and thus no adjustments should be made to these current financial
statements. However, if the event is material (i.e. useful to our users) we should disclose
information about this event in the notes.
A typical example of an event after the reporting period is a dividend distribution that is
declared after the reporting date but before the financial statements are authorised for issue.
Chapter 18 927
Gripping GAAP Provisions, contingencies & events after the reporting period
If a dividend distribution relating to the period under review is declared during this post-
reporting period, this dividend would not be recognised (adjusted for) as a dividend
distribution in the statement of changes in equity in the current period under review.
x This is because the obligation only arises on the date that the dividend is declared (being
the obligating event).
x Since the dividend was declared after the reporting date, the obligating event cannot be
considered to be a past event.
x Since the obligating event was not a past event, it means the obligation could not have
existed on reporting date. In other words, there is no present obligation at reporting date.
Thus, the dividend declaration represents a condition that arose after reporting date. These
dividends declared must not be journalised, but must be disclosed in the notes to the financial
statements instead (in accordance with IAS 1 Presentation of financial statements).
928 Chapter 18
Gripping GAAP Provisions, contingencies & events after the reporting period
Required: None of the above events has yet been considered. Explain whether the above events
should be adjusted for or not when finalising the financial statements for the year ended 31 December
20X2. If the event is an adjusting event, provide the relevant journal entries.
A. An adjusting event: the event that caused the debtor to go insolvent occurred before year-end: the
lawyer’s announcement simply provided information regarding conditions in existence at year-end.
20X2 Debit Credit
Impairment loss (E) 36 000
Receivables: allowance for credit losses (-A) 36 000
Further impairment of receivables: 110 000 x 60% – 30 000
B. An adjusting event: the event that caused the debtor to go insolvent was the strike, which happened
before year-end.
20X2 Debit Credit
Impairment loss (E) 60 000
Receivables: allowance for credit losses (-A) 60 000
Impairment of receivables: 150 000 x (100% - 60%)
C. An adjusting event: the event that caused the inventory to be sold at a loss happened before year-end.
Thus, the post-reporting period event gives more information about the net realisable value at year-end.
20X2 Debit Credit
Inventory write-down (E) 20 000
Inventory (A) 20 000
Write-down of inventory to net realisable value: 100 000 – 80 000
D. The discovery of this error during the post-reporting date period is an adjusting event since it gives
us more information about a condition that existed at year-end.
20X2 Debit Credit
Income tax expense (E) 30 000
Revenue (I) 30 000
Correction of error
E. Non-adjusting event: A liability is based on either a legal obligation or present obligation. There is
no legal obligation at year-end to close the factory and there is no constructive obligation at year-
end since the announcement was only made after year-end. The announcement is therefore a non-
adjusting event. If the decision-making ability of the users may be affected by this information,
details of the decision should be disclosed.
F. A liability (present obligation) is based on either a legal obligation or constructive obligation. There
is no evidence suggesting a constructive obligation existed at year-end and thus the situation
appears to be based purely on whether a legal obligation existed at year-end.
At year-end, alleged radiation had already taken place (the past event) but Finito was disputing the
related legal claims, and thus it was not clear whether a present obligation existed. Therefore:
x no provision would have been recognised at year-end since it was considered more likely that
no obligation existed at year-end. See IAS 37.16(b)
x a contingent liability would have been disclosed instead, unless the outflow of economic
benefits was considered to be remote. See IAS 37.16(b)
Since the sales of the allegedly radioactive cell phones were made before year-end, we have a past
event that leads to a possible legal obligation at year-end. Where it is not clear that an obligation
exists at year-end, events that occur during the post reporting period must be considered and may
result in us having to deem that an obligation existed at year-end. See IAS 37.15
The court ruling during the post-reporting date period is therefore an adjusting event.
Since the court ruled against Finito, a legal obligation is deemed to exist at year-end, and thus a
liability should be recognised.
The exact amount owed is not available, but an estimate is available, meaning the liability should be
classified as a provision.
Chapter 18 929
Gripping GAAP Provisions, contingencies & events after the reporting period
Since the estimate was made by a team of experts, the estimate is assumed to be reliable: the
definition and recognition criteria are met and thus the following journal should be processed:
20X2 Debit Credit
Legal costs and damages (E) 200 000
Provision for legal costs and damages (L) 200 000
Provision for legal costs and damages
If the estimate is not considered reliable, then a contingent liability must be disclosed in the notes instead.
Please note: Had the court ruling not occurred during the post-reporting period, there would have
been no journal entry to recognise a liability (remember that contingent liabilities are not recognised)
although Finito Limited would have disclosed a contingent liability note instead.
G. The inventory:
Information arising in the post-reporting period that brought to the attention the fact that inventory
at 31 December 20X2 was poisoned, requires an adjustment to the carrying amount thereof (i.e. an
adjusting event) since it is representative of conditions in existence at year-end.
The inventory of poisoned cans on hand at year-end must be written-off:
20X2 Debit Credit
Inventory write-down (E) 80 000
Inventory (A) 80 000
Write-down of inventory to net realisable value:
The claim:
The event that caused the claim was poisoning that occurred in January 20X3, being after year-
end. No provision is raised for this claim since the event that lead to it was poisoning that occurred
after year-end. Any information relating to this claim is therefore a non-adjusting event.
Claims in the post-reporting period due to poisoning that occurred after year-end would therefore
normally be non-adjusting events, but if they are so significant that they could result in Finito
having a going concern problem, then the entire financial statements would need to be adjusted to
reflect this fact (i.e. use liquidation values).
The possible future claims:
Since it is clear, however, that all inventory on hand at year-end was also poisoned, it is evidence
to suggest that there were other instances of poisoning that took place before year-end.
Poisoning that occurred before year-end would lead to an obligation at year-end. The fact that
claims had not yet been received does not alter the fact that an obligation exists (Finito will either
have a constructive obligation through past practice to reimburse customers for poisoning or legal
claims will be lodged against the company which the company will not be able to defend).
Whether or not Finito expects claims to be made in connection with poisoning that occurred
before year-end is simply taken into account in the measurement of the liability (using the theory of
probability and expected values): the liability exists.
Although Finito’s lawyers have estimated that Finito may expect claims of up to C1 000 000, this
was not considered to be a reliable estimate.
Since no reliable estimate is possible, the recognition criteria are not met and therefore a provision
may not be recognised. A contingent liability note would be included instead.
H. Non-adjusting event: Since the declaration was announced after year-end, there is no past event
and no obligation at year-end. Thus, the declaration is a non-adjusting event. Details of the
dividend declaration must, however, be disclosed (IAS 1) See IAS 10.13.
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Part A: Summary
Liabilities
Liability
Yes Yes
Probable Possible
No No Remote: Ignore
outflow? outflow?
Yes Yes
Disclose as a
Reliable
No contingent
estimate?
liability
Yes but
high degree of
Yes uncertainty
Note: IAS 37 defines an outcome as being probable if it is ‘more likely than not’ to occur. This applies only to this
standard and is not always appropriate for other standards. The term ‘possible’ referred to in the flowchart above
refers to both ‘as likely to occur as not to occur’ (i.e. an equal possibility) and ‘less likely to occur than not to occur’.
Chapter 18 931
Gripping GAAP Provisions, contingencies & events after the reporting period
Contingent asset
x Possible asset arising from past events
x The existence of which will be confirmed by the occurrence/ non-occurrence
x of uncertain future events not wholly within the entity’s control. See IAS 37.10
e.g. the entity is a claimant in a court case where the outcome is uncertain
Asset
Reliable Disclose as a
estimate? contingent asset Ignore
Yes
Recognise (pure
asset – not
contingent)
Part B: Summary
932 Chapter 18
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Chapter 19
Employee Benefits
Reference: IAS 19; IFRIC 14 (updated for any amendments to 1 December 2019)
Contents: Page
1. Introduction 934
6. Disclosure 951
7. Summary 952
Chapter 19 933
Gripping GAAP Employee benefits
1 Introduction
Why do we work? Apart from philosophical reasons (that are unfortunately beyond the scope
of this book), we generally work for rewards.
In the mid 1890’s a Russian scientist, by the name of Ivan Pavlov, began investigating the
gastric function of dogs. He very importantly noticed that dogs tend to salivate before food
was delivered to their mouths. He called this a ‘psychic secretion’. He became so interested
in this phenomenon that his research, which began as a scientific study of the chemistry of
their saliva, mutated into a psychological study and led to the establishment of what is
commonly referred to as ‘conditional reflexes’ or ‘Pavlovian response’.
The answer to ‘why do we work’ lies in this Pavlovian theory of conditional reflexes: we work
since we expect to receive a benefit – a bit like the dog salivating in expectation of food!
The term ‘employee’ includes all categories: full-time, part-time, permanent, casual,
temporary, management, directors and even their spouses or dependants where the benefits
are paid to them.
The benefit we, as employees, expect to receive may be summarised into four categories:
x benefits in the short-term (benefits payable to us while employed and shortly after we
provide the service, e.g. a salary payable within 12 months);
x benefits in the long-term (benefits payable to us while employed but where the benefits
may become payable long after we provide the service, e.g. a long-service award);
x benefits post-employment (i.e. after we have retired from employment e.g. a pension); and
x termination benefits (those that would be receivable if our employment were to be
terminated before normal retirement age (e.g. a retrenchment package).
Employee benefits:
The different types
Employee benefits include settlements made to both past and present employees. Benefits
given to an employee’s spouse, children or others in exchange for services provided by that
employee would be considered to be a benefit given to that employee.
Employee benefits apply to any type of settlement, with the exception of IFRS 2: Share based
payments. Thus, employee benefits only include settlements an entity makes in the form of:
x cash (e.g. cash salary);
x goods (e.g. free products); or
x services (e.g. free medical check-ups).
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In addition to the other standards that require disclosure relating to employee benefit/s, other
related disclosure may also be required due to the requirements of the Companies Act, the JSE
Listing Requirements and King IV (see principle 14 regarding remuneration reports).
Short-term benefits
Wages, salaries and Paid leave Profit sharing and/or Non-monetary benefits
Note 1
social security (e.g. annual/sick bonuses
contributions leave) (e.g. a car, medical care,
(e.g. medical aid) housing & free/subsidised
goods/services)
Note 1: For current employees only (e.g. excluding non-monetary benefit given to a past employee)
Short-term benefits are recognised when the employee renders the service (this is the accrual
concept). This means that:
x an expense is recognised (debit); and
x bank is reduced (credit) to the extent that it is paid, or a liability is recognised (credit) to the
extent that any amount due has not been paid.
In the case of non-monetary assets, items such as ‘free or cheap’ housing, lunches, weekends
(etc) are straight-forward (debit employee benefit, credit bank). But the free use of a car has
caused some debate. The car is a depreciable asset, which thus involves depreciation and
other related costs such as maintenance. It is submitted that these costs be recorded in the
usual manner and then a portion of all these car-related expenses be transferred to employee
benefit expense. Note that IAS 1 requires that depreciation be separately presented.
IAS 19 does not require any disclosure of a short-term benefit although other standards may
require certain limited disclosure. This is covered in the section on disclosure (section 6).
Chapter 19 935
Gripping GAAP Employee benefits
Step 3: If the expense has been underpaid, there will be a credit balance on the account
payable. But if the expense has been overpaid, there will be a debit balance on the account
payable. If an overpayment cannot be recovered from the employee (e.g. the employee is not
obligated to return the cash, or a future payment to the employee may not be reduced by the
overpayment) then the overpayment (which will be reflected as a debit balance in, for
example, the wages payable account) is expensed:
Debit Credit
Employee benefit expense xxx
Account payable (e.g. wages payable) (L) xxx
Over-payment of short-term employee benefit (e.g. wages) expensed
It is also possible that another standard allows or requires that the employee cost be
capitalised instead of expensed. This may happen if, for example, an employee is used on
the construction of another asset such as inventory. In this case, the benefits payable to this
employee (or group of employees) will be capitalised to inventory (IAS 2) instead of expensed
(see Step 1 above).
Debit Credit
Inventory (or other asset) xxx
Employee benefit expense xxx
A portion of the short-term employee benefit expense relating to
inventory manufacture is included in the cost of inventories
Whereas we are all probably capable of processing the journals for wages (or salaries
etcetera), the following other types of short-term benefits warrant a bit more attention:
x short-term paid absences;
x profit sharing and bonuses.
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If the leave is vesting leave, the possibility that an employee may resign, for example, before
having taken all his accumulative leave will not reduce the amount of the obligation (liability)
that should be recognised. This is because all untaken leave on the date that the employee is
no longer employed by the entity would then have to be paid to the employee in cash. Thus,
the measurement of the liability for leave is simply based on all the accumulative leave
currently owed to the employee.
If the leave is non-vesting, however, any leave that was owed to an employee but which the
employee had not yet taken by the time that he/she was no longer employed by the entity will
be forfeited. Thus, if the leave is non-vesting, the probability that the employee may resign, for
example, before taking his leave must be taken into consideration when measuring the leave-
pay liability. In other words, if accumulative leave owed to an employee is non-vesting leave,
the leave-pay liability would be lower than if the leave owed to that employee had been
vesting leave.
In summary, a liability to pay the employee for unused leave may need to be recognised: the
decision on whether to recognise this leave-pay liability depends on whether the leave is non-
accumulating (there is no obligation and thus no liability is recognised) or accumulating (there
is an obligation and thus a liability is recognised). If the leave is accumulating leave, our next
step is to measure the amount of the liability to be recognised, which involves considering
whether it is vesting or non-vesting.
When an employee takes leave from work, the cost of this employee’s short-term absence is
recognised as part of his salary expense (no separate adjustment is required). For example,
if you were to take paid annual leave, your salary would be paid to you while you were on
holiday: there would be no extra amount owing to you and thus the leave that you have taken
is simply absorbed into the usual salary expense journal (i.e. there is no extra journal entry).
If leave was earned by an employee during the year but was not taken by the employee, a
distinction will need to be made between whether the leave was:
x non-accumulating: where unused leave cannot be carried forward (i.e. it falls away if not
used in the current period); or
x accumulating: where unused leave can be carried forward to another period.
The cost of giving employees short-term paid leave that is non-accumulating is simply recognised
when the leave is taken. In other words, we recognise the salary expense as usual despite the
employee not being at work. We do not recognise a liability for any non-accumulating leave that may
be currently owed to an employee. The reason for not recognising a liability for non-accumulating
leave is that, if an employee fails to take all the non-accumulating leave that he earned during the
year, his unused leave would simply be forfeited (i.e. the employee would simply lose his rights to
take that leave and would not be entitled to receive a cash payment in lieu thereof). Thus, since the
entity has no obligation to let the employee take this unused leave in future years or to pay him out,
the definition of a liability is not met and thus a leave-pay liability is not recognised.
Example 1: Short-term paid leave: non-accumulating: single employee
Mitch Limited has one employee. His name is Guy.
Chapter 19 937
Gripping GAAP Employee benefits
Comment: When leave is non-accumulating, it means that any leave that is not taken at year-end
simply falls away and thus the entity has no obligation to provide the employee with this leave. Since
there is no obligation, there can be no liability (since the definition of a liability is not met) and thus a
leave-pay liability is not recognised.
Whereas non-accumulating leave is effectively recognised when the leave is taken (with no
liability recognised for any leave that the employee might have earned but not taken),
accumulating leave is recognised as an obligation when the employee renders the service
that increases their entitlement to leave. See IAS 19.13
If an employee fails to take all the leave that was owing to him and this leave is accumulating
leave, the unused leave will continue to be owed to the employee. Since the entity has an
obligation to allow the employee to take the unused leave in future years, a liability for unused
leave must be recognised. This liability is recognised when the employee has rendered the
service that entitles him to that leave.
938 Chapter 19
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The measurement of this leave-pay liability depends on how many days are owing multiplied by
what his average salary per day is expected to be when he takes this leave. The reason for
using the future salary per day is because the entity will effectively be losing this future value on
the days that the employee eventually does stay away from work.
The measurement of the leave-pay liability for accumulating leave is also affected by whether the leave is:
x vesting: unused leave can be taken in the future or can be exchanged for cash when
leaving the entity; or
x non-vesting: unused leave can be taken in the future but cannot be exchanged for cash.
If the leave is accumulating but non-vesting and the employee leaves (e.g. resigns or retires)
before taking all of his accumulative leave, the entity would not need to pay the employee out
for the unused leave. This possibility needs to be considered when measuring this leave-pay
liability (i.e. a liability for unused accumulating leave that is non-vesting would possibly be
measured at a lower amount than if the leave was vesting).
Chapter 19 939
Gripping GAAP Employee benefits
In practice, there are many more employees than just one employee. It is normally impractical
to estimate the amount of the leave pay obligation relating to each employee and this is
therefore estimated on an average basis. When measuring the leave-pay liability on an
average basis, we will need to:
x identify the number of employees within a certain salary/ leave bracket;
x calculate the average salary per employee within this salary bracket;
x calculate the average employee salary per day; and then
x estimate the average days leave that the entity owes each employee at year-end (either
in days or in cash).
940 Chapter 19
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Chapter 19 941
Gripping GAAP Employee benefits
Compare this to part A where the liability was based on the full 12 days since the terms of part A’s
leave entitlement was that the employee would be paid out for every day that he does not take.
Although the entity will not be paying the employee out in cash, the cost to the entity is still C191.78
per day since the entity will effectively lose this value on the days that the employee stays at home.
The liability to be recognised = C47 945
[C191.78 x 5 days (20X4 unused leave expected to be used in 20X5) x 50 employees = C47 945]
x 20X5 expected unused leave: No obligation: (C191.78 x 0 days x 50 employees = 0)
The 20X5 leave entitlement of 20 days of which 9 days will probably be taken in 20X5 is ignored since
the employee has not yet provided the 20X5 services that would entitle him to the 20X5 leave. Since
there is no past event (services rendered) there is no present obligation. No liability is therefore
recognised for any of the 20X5 leave entitlement.
Profit sharing or bonuses given to employees as a reward for services rendered are also
considered to be employee benefits. If these are payable within 12 months of the year-end in
which the employee provided the services, these would be considered to be short-term
employee benefits (otherwise they would be other long-term employee benefits).
The obligation can be either be a legal obligation or constructive obligation. For instance:
x a legal obligation would arise if the employment contract detailed the profit-sharing or
bonus arrangement, and if all conditions of service were met;
x a constructive obligation could arise if the entity created an obligation for itself through, for
instance, a past practice of paying bonuses (or sharing in profits). Therefore, even
though the employment contract may be silent on such profit-sharing or bonuses (in
which case there would be no legal obligation), it is possible for the entity to create a
constructive obligation through its past practices, policies, actions or public
announcements etc.
A characteristic of profit sharing and bonuses are that they often accrue over a period of time,
and may end up being only partially earned or even forfeited if an employee resigns before
the payment date. This characteristic will impact on the measurement of the liability: the
probability that the employee/s may leave before they become entitled to the benefit must be
factored into the calculation.
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Required: Measure the liability to be recognised in the financial statements of Luke Limited for the year
ended 31 December 20X2 and show the journal if the terms of the agreement are such that:
A. the bonus accrues to those employees still employed at year-end (31 December 20X2);
B. the bonus accrues proportionately based on the number of months worked during 20X2;
C. the 20X2 bonus accrues only if the employee is still employed at 31 December 20X3.
Ex 5A Ex 5B Ex 5C
31 December 20X2 Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
Employee benefit expense (E) 960 000 900 000 600 000
Bonuses payable (L) W1 (960 000) (900 000) (600 000)
Bonuses provided for
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It is important to note that it is the services that he provided whilst employed that entitle him to
these benefits after employment. Therefore, the services that he provided whilst employed
are considered to be the past event for which the entity has an obligation.
Since the obligation arises (accrues) during the employee’s work-life, the journal recognising
the obligation and related cost must be processed as and when the services are provided:
Debit Credit
Employee benefit expense (E) xxx
Post-employment benefits (L) xxx
Post-employment benefit obligation arising during the current year
The classification will affect the measurement of the obligation. If the plan is a defined
contribution plan, the entity’s obligation ‘is limited to the amount that it agrees to contribute to
the fund’. In the case of a defined benefit plan, the obligation is a lot harder to measure since
the benefit is usually based on many unknown factors, such as the salary of the employee on
the date he retires, and the number of years of service he provided to the entity.
The classification of the plan as either a defined contribution plan or a defined benefit plan
depends on whether the entity has an obligation (legal or constructive) to fund any possible
short-fall that the plan might experience.
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In the case of a defined benefit plan, it is the entity who bears the risk for any possible shortfall,
whereas in the case of a defined contribution plan, it is the employee who bears the risk.
Classifying a post-employment benefit plan as either a defined contribution plan or a defined benefit
plan can be complicated in practice. This is because the entity might have entered into an
agreement that commits it to not only making certain contributions towards a post-employment plan,
but also opening itself up to an obligation to fund a certain level of the benefits. In such cases, the
classification must be based on the concept of substance over form. In this regard, if the agreement
(which could be legal or constructive) results in the entity:
x having an obligation to make contributions to a plan, then it is a defined contribution plan.
x having an obligation to pay benefits to the ex-employee, then it is a defined benefit plan.
Defined contribution plans are easier to recognise, measure and require almost no disclosure
whereas defined benefit plans are more complex to measure and thus require lots of
disclosure.
The classification of such plans as defined contribution plans or defined benefit plans,
although not complicated, is not covered further in this chapter. Instead, this chapter focuses
on single-employer plans only.
The amounts recognised in the entity’s accounting records are simply the contribution paid/
payable by the employer to the defined contribution fund. This contribution is expensed.
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As already explained (see section 3.1), the post-employment benefit expense and related
liability is recognised as and when the employee provides the services.
Matthew Limited
Notes to the financial statements (extracts)
For the year ended 31 December 20X4
20X4 20X3
3. Profit before tax C C
Profit before tax is stated after taking into account the following disclosable expenses/ (income):
x Employee benefit expenses 4 000 000 + 400 000 4 400 000 xxx
Comment:
x Both the employer and the employees contributed to the plan: the employees contributed C280 000
over the year whereas the employer contributed C400 000.
x Both the employees’ and the employer’s contributions (280 000 + 400 000, respectively) are
included in the total employee benefit expense (this expense is disclosable in terms of IAS 1).
x The entity’s cost relating to the defined contribution plan (DCP) must be disclosed (IAS 19.53),
being the 400 000. The 280 000 contribution is a cost relating to the DCP that was incurred directly
by the employees (who effectively paid 280 000 out of their salaries of 4 000 000) and not directly
by Matthew Limited.
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Where an entity guarantees (promises) that it will pay certain Defined benefit plans are
specific benefits to its employees after employment, we have defined as:
a ‘defined benefit plan’ (e.g. a pension fund). This is quite
x Post-employment benefit plans
different to an entity that simply commits to paying
x Other than defined contribution plans.
contributions to an external fund, where it is then the IAS 19.8
The contra entries processed when accounting for the plan obligation and plan assets are
collectively referred to as the defined benefit costs. They include interest costs, service costs and
remeasurement adjustments.
x The interest costs and service costs will be included in the total employee benefit
expense for the period (i.e. together with the other costs associated with employees, such
as salaries) and are generally recognised in profit or loss (unless they are included in the
cost of another asset).
x The remeasurement adjustments (i.e. when remeasuring the obligation to its year-end
present value and the assets to their year-end fair values) are never recognised in profit
or loss. Instead, these are recognised in other comprehensive income (unless these are
included in the cost of another asset). See IAS 19.120
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When presenting a defined benefit plan in the statement of financial position, the plan obligation
account and the plan asset account are set-off against each other and presented as either a:
x ‘net defined benefit plan asset’; or
x ‘net defined benefit plan liability’. Deficit or surplus
On the other hand, if we find that the balance on our plan asset account is bigger than the
obligation, we say that our plan has a surplus (we own
Presentation of deficits &
more than we owe and are thus ‘in a healthy position’,
surpluses
having a net asset position). Having a surplus means
that we will present a ‘net defined benefit asset’. x A deficit is presented in the SOFP
as a ‘net DBP liability’
However, if we have a surplus, the amount of the surplus
x A surplus is presented in the SOFP
does not always equal the amount presented as the ‘net as a ‘net DBP asset’, but must first
defined benefit plan asset’. This is because, whenever be limited to the asset ceiling (if
we have a surplus, we must first check that it does not the ceiling is lower).
exceed the amount referred to as the ‘asset ceiling’. In other words, the ‘net defined benefit
plan asset’ must be measured at the lower of the surplus and the asset ceiling. See IAS 19.64
This ceiling represents a formal calculation of the present value of certain available future
economic benefits that the entity expects from the plan assets. If the amount of the surplus
exceeds the amount of the asset ceiling, the amount presented as the ‘net defined benefit
asset’ must be limited to the lower ‘asset ceiling’ amount. In other words, if the surplus
exceeds the asset ceiling, the amount presented as the ‘net defined benefit asset’ will not
equal the surplus but will equal the asset ceiling instead. This will require the use of an ‘asset
ceiling adjustment account’. This is explained in the journal below.
Interrelationship between the surplus/deficit, asset ceiling and the net DBP asset/
liability to be presented
Scenario A: We have a surplus of C100 (caused by the assets exceeding the obligation by C100). This needs
to be checked to the asset ceiling, which is then found to be C80. Thus, an asset ceiling adjustment account is
created to ensure the ‘net DBP asset’ presented in the SOFP is measured at the lower amount of C80.
Scenario B shows a deficit caused by the obligation exceeding the assets by C70. There is no surplus and
thus no need to check the asset ceiling and thus no need for an asset ceiling adjustment account. The net DBP
liability presented in the SOFP simply equals the deficit.
Scenario A Scenario B
C C
Plan assets Fair value 800 800
Less: Plan obligation Present value of future obligation (700) (870)
Surplus/ (Deficit) 100 (70)
Asset ceiling adj account To limit a surplus to an asset ceiling of C80 see IAS 19.64 (20) N/A
Net DBP asset/ (liability) 80 (70)
For further information on defined benefit plans, please see IAS 19 Employee benefits.
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Whereas short-term benefits are due before twelve months after the end of the period during
which the employee rendered the service, long-term benefits are due after twelve months
after the end of the period during which the employee rendered the service. Examples of
‘other long-term benefits’ include: long-term disability benefits, long-term paid absences (e.g.
long-service leave), deferred remuneration and profit-sharing or bonuses that are not payable
within 12 months of reporting date. See IAS 19.153
‘Other long-term employee benefits’ are recognised and measured in the same way as we
recognise ‘defined benefit plans’ (a post-employment benefit) with the exception that all
adjustments are recognised in profit or loss (unless these are included in the cost of another
asset). In other words, re-measurements of ‘other long-term benefits’ are not recognised in
other comprehensive income. The reason we recognise these remeasurements directly in
profit or loss is that, whereas remeasurement adjustments affecting ‘post-employment
benefits: defined benefit plans’ are prone to a high degree of uncertainty, this same high level
of uncertainty does not apply in the case of ‘other long-term employee benefits’. See IAS 19.154-155
Another important difference between ‘other long-term employment benefits’ and ‘post-
employment benefits’ is that the former refers to a benefit that both accrues and is given to an
employee during his employment whereas the latter is a benefit that, although it accrues to an
employee during his employment, it is given to the employee after his employment.
The net asset or liability relating to ‘other long-term employee benefits’ that would be included
in the statement of financial position is the difference between the present value of the
obligation and the fair value of the assets (if any). If the difference between the obligation and
the assets results in a surplus, this surplus would have to be limited to the asset ceiling. It
must be noted, however, that it is fairly unusual (but not impossible) for plan assets to be set
aside to cover an obligation to provide ‘other long-term benefits’ such as long-service leave.
C
Obligation account Present value of future obligation (xxx)
Plan asset account (if any) Fair value of the related assets xxx
(Deficit)/ surplus xxx
Asset ceiling adjustment account (xxx)
(Net liability)/ asset of the ‘other long-term employee benefits’ xxx
Whereas all other benefits are earned by the employee for services provided to the employer,
termination benefits are those that arise due to a termination of a service (i.e. the past event
is the termination rather than the employee services provided).
Termination benefits are those that are not conditional upon future services. Instead, they
relate purely to the termination of employment.
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Be careful! If the benefit payable on termination does not relate to either a forced termination or an offer
of a voluntary termination, the benefit is a post-employment benefit and not a termination benefit. Thus,
if an employee requests early termination (i.e. is not offered or forced into an early termination), this is a
post-employment benefit and not a termination benefit. See IAS 19.160
The termination benefits are recognised as an expense and related liability at the earlier of:
x when the entity can no longer withdraw the offer of those benefits, and
x when the entity recognises the related restructuring costs in terms of IAS 37 Provisions, contingent
liabilities and contingent assets and where this restructuring involves the payment of termination
benefits. See IAS 19.165 (slightly reworded)
If the termination benefit is payable due to an employee’s decision to accept an offer of termination, the
date on which the entity can no longer withdraw an offer of termination is the earlier of:
x the date when a restriction (e.g. legal, regulatory or contractual) on the entity’s ability to withdraw the
offer takes effect (e.g. if labour law does not allow an entity to withdraw an offer of termination, then
the date would be the day on which the offer is made); or
x the date when the employee accepts the offer. See IAS 19.166
Since termination benefits do not provide the entity with future economic benefits, they are recognised as
an expense. If they are not paid at the same time, a liability will be recognised.
When the termination benefit is an offer of benefits that is made to encourage termination, the
measurement of the benefits will be based on the number of employees who will probably accept the offer:
x If we can estimate this number of employees who will accept this offer, we must measure the
liability using this number of employees.
x If we cannot estimate the number of employees who may accept the offer, we won’t
recognise a liability (since we cannot measure it) but will disclose a contingent liability.
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For example: if we offered each of our 100 employees a C1 000 retrenchment package, and:
x we estimate that 20 of these employees will accept the package, we must recognise a
liability and expense equal to C20 000 (C1 000 x 20 employees); or
x we are unable to estimate the number of employees who may accept the offer, we would
simply disclose in the contingent liability note the fact that we have offered employees a
redundancy package together with as many details as we possibly can.
6 Disclosure
The disclosure requirements relating to defined benefit plans are dictated not only by IAS 19, but also
IAS 37, IAS 24 and IAS 1:
x IAS 37 may require the entity to disclose information about contingent liabilities arising from
the plan. See IAS 19.152
x IAS 24 may require the entity to disclose information about related party transactions
involving the plan and also to disclose the post-employment benefits owed to key
management personnel. See IAS 19.151
x IAS 1 requires the employee benefit expense to be disclosed. See IAS 1.102 & 104
x IAS 19 requires copious disclosures for a defined benefit plan. See IAS 19.135-150
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7. Summary
Employee benefits
Defined in IAS 19 as: All forms of consideration given by an entity in
exchange for services rendered by the employees or for the termination of
their services.
Recognise: Recognise:
As and when the employee provides the services At the earlier of the date on which the entity:
x can no longer withdraw its offer of
termination benefits
x recognises the restructuring costs in terms of
IAS 37 and where these costs include
termination benefits
Measurement: Measurement:
Statement of financial position: Balance Statement of financial position:
Net asset/ liability for Other LT EBs: Liability (or credit bank):
x Plan obligation: PV of benefit promised (Credit) x amount of the benefit
x Plan assets: FV of separate plan assets Debit
x Surplus/ (deficit) Dr/ (Cr)
x Asset ceiling adjustment: if applicable (Cr)
Net asset/ (liability) Dr/ (Cr)
The measurement of the net asset/ liability involve The measurements are subject to:
recognising: x discounting only if the termination is payable
x interest (due to discounting) more than 12 months after the end of the
x service costs (current and past) reporting period
x remeasurements of the:
- Asset: return on plan asset (if any)
- Obligation: actuarial gains and losses
- Asset Ceiling Adjustment Account (if any)
Interest, service costs and remeasurement
adjustments are all recognised in P/L (part of the
employee benefit expense), unless these defined
benefit costs are included in the cost of another asset
(This is not the case when accounting for DBPs, where
remeasurement adjustments are recognised in OCI)
Statement of comprehensive income: Statement of comprehensive income:
P/L: employee benefit expense: P/L: employee benefit expense:
x includes all movements in the net asset/ liability x includes the amount of the benefit
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Short-term benefits
Recognise when:
x entity has an obligation,
x the settlement of which cannot be reasonably avoided, and
x a reliable estimate is possible
Measurement:
Measure using:
x formula stipulated in the plan (or contract);
x the entity-determined amount; or
x past practice where this gives a clear indication of amount of the
obligation
x Factor into the calculation the probability that the employee may
leave without receiving his profit share/ bonus.
Note: the number of actual working days can either be given (i.e. 260-day working year) or, if not explicitly
given, then a reasonable calculation may be 365 x 5 / 7 days.
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Post-employment benefits
Variations
x Single employer plans
x Multi-employer plans
x Group administration plans
x Common control shared risk plans
x State plans
x Insured benefit plans
Recognise: Recognise:
As & when the employee provides the services As & when the employee provides the services
Measurement: Measurement:
The amount of the contributions: Statement of financial position: Balance
x no actuarial assumptions needed Net DBP asset or liability:
x undiscounted normally (but will need to discount if x Plan obligation: PV of benefit promised (Credit)
the contributions become payable after 12 months x Plan assets: FV of separate plan assets Debit
from the end of the period in which the employee
x Surplus/ (deficit) Dr/ (Cr)
provides the service) x Asset ceiling adjustment (if there was a (Credit)
surplus)
Net DBP asset/ (liability) Dr/ (Cr)
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Chapter 20
Foreign Currency Transactions
Reference: IAS 21 and IFRS 9 (all including any amendments to 1 December 2019)
Contents: Page
1. Introduction 956
2. Foreign currency transactions 956
2.1 Overview 956
2.2 Monetary and non-monetary items 957
2.3 How exchange rates are quoted 957
Example 1: Exchange rates 957
2.4 Dates 957
2.4.1 Determining the transaction date 958
2.4.2 Determining the settlement date 958
2.4.3 Determining the reporting date (if applicable) 959
Example 2: Dates: transaction, settlement and reporting dates 959
2.5 Initial recognition and measurement: monetary and non-monetary items 959
2.6 Subsequent measurement: monetary items 960
2.6.1 Overview 960
2.6.2 Translation at the end of the reporting period: monetary items 960
2.6.3 Translation at settlement date: monetary items 960
2.7 Exchange differences: monetary items 960
2.7.1 Overview 960
Example 3: Exchange differences – monetary item: debtor 960
2.7.2 Import and export transactions 961
2.7.2.1 Transaction and settlement on same day (cash transaction) 961
Example 4: Import transaction: settled on same day (cash transaction) 961
Example 5: Export transaction: settled on same day (cash transaction) 962
2.7.2.2 Settlement deferred (credit transactions) 962
2.7.2.2.1 Settlement of a credit transaction before year-end 962
Example 6: Import: credit transaction settled before year-end 962
Example 7: Export: credit transaction settled before year-end 963
2.7.2.2.2 Settlement of a credit transaction after year-end 964
Example 8: Import: credit transaction settled after year-end 964
Example 9: Export: credit transaction settled after year-end 964
Example 10: Import: credit transaction: another example 965
2.7.3 Foreign loans 967
Example 11: Foreign loan received 968
Example 12: Foreign loan granted 969
2.8 Subsequent measurement: non-monetary items 970
Example 13: Non-monetary item: measurement of plant purchased from foreign supplier 971
Example 14: Non-monetary item: measurement of inventory owned by foreign branch 972
Example 15: Non-monetary item: measurement of plant owned by foreign branch 973
2.9 Exchange differences: non-monetary items 974
Example 16: Revaluation of PPE owned by a foreign branch 974
3. Presentation and Functional Currencies 975
3.1 General 975
3.2 Determining the functional currency 975
3.3 Accounting for a change in functional currency 975
3.4 Using a presentation currency other than the functional currency 976
3.4.1 Explanation of the foreign currency translation reserve 976
Example 17: Foreign currency translation reserve 976
4. Presentation and Disclosure 977
5. Summary 978
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1. Introduction
IAS 21 The effects of changes in foreign exchange rates IAS 21 does not apply to:
explains how an entity accounts for transactions that involve x foreign currency derivatives
foreign currency, how to account for foreign operations and or balances (e.g. from hedge
accounting) that fall within
how to translate a set of financial statements into a foreign IFRS 9 Financial instruments; and
presentation currency. See IAS 21.3 x presentation of cash flows related to
foreign currency transactions or the
This section is not difficult and simply requires that you translation of cash flows of a foreign
operation. See IAS 21.4 - .5 & .7
understand that currencies are being traded every day, and
thus the value of a foreign currency today is not the same as it will be tomorrow, or was yesterday. If
we happen to have a transaction that involves a foreign currency, the changing value of the foreign
currency may need to be taken into consideration in our accounting records.
Transactions that businesses frequently enter into with foreign entities may be denominated in
foreign currencies (e.g. an invoice that is in dollars, is referred to as ‘denominated in dollars’). Since
financial statements are prepared in one currency only, any foreign currency amounts must be
converted into the primary currency used by the entity (functional currency). This conversion may
involve converting certain items at the exchange rate ruling
on the date of the conversion (spot exchange rate). To Foreign currency is
defined as:
complicate matters, there is often a considerable time lag
between the date that a foreign debtor or creditor is created x a currency
and the date upon which that debtor pays or creditor is paid. x other than the functional currency of
the entity. IAS 21.8
As explained above, currencies are being traded daily and
thus the spot exchange rate used to measure a foreign Functional currency is
debtor or creditor on initial recognition of the transaction will defined as:
no doubt be different to the spot rate on the date the debtor
x the currency
pays or the creditor is paid. This difference is an exchange x of the primary economic environment
difference. Additionally, an entity may present their financial x in which the entity operates. IAS 21.8
statements in one or more currencies that could be different
from the functional currency (presentation currency). The conversion from a functional currency to a
presentation currency will also result in exchange differences that the entity will have to account for.
2.1 Overview
A foreign currency
In this section, we will look at how a transaction that is transaction is defined as:
denominated in a foreign currency impacts both the initial x a transaction that:
recognition and measurement of that transaction and also its - is denominated; or
subsequent measurement. In this regard, a distinction must - requires settlement
also be made between monetary items (e.g. cash) and non- x in a foreign currency. IAS 21.20 extract
monetary items (e.g. plant), because whether an item is monetary or non-monetary will affect how we
account for the item’s subsequent measurement and related exchange differences (section 2.2).
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A non-monetary item is not defined but it is described in IAS 21 as being an item is that it
involves neither a right to receive, nor an obligation to deliver, a fixed or determinable number
of units of currency. Non-monetary items include:
x property, plant and equipment;
x intangible assets; Exchange rate is defined
x inventories; and as:
x prepaid expenses. See IAS 21.16 x the ratio of exchange
x for two currencies. IAS 21.8
2.3 How exchange rates are quoted
An exchange rate is the price of one currency in another currency. For example, if we have
two currencies, a local currency (LC) and a foreign currency (FC), we could quote the
exchange rate directly as, for example, FC1: LC4. This effectively means that to purchase
1 unit of FC, we would have to pay 4 units of LC.
It is also possible to quote the same exchange rate indirectly as LC1: FC0.25. This effectively
means that 1 unit of LC would purchase 0.25 units of the FC.
2.4 Dates
Dates involved with foreign currency transactions are very important because exchange rates differ
from day to day. The following dates are significant when recording a foreign currency transaction:
x transaction date – this is when we recognise the transaction (e.g. when we recognise the
money borrowed/ lent or when we recognise the purchase/ sale of an item);
x settlement date – this is when cash changes hands in settlement of the transaction (e.g.
the creditor is paid or payment is received from the debtor); and
x reporting date – this normally refers to the financial year-end of the local entity (or could
refer to any other date upon which financial information is to be reported).
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The transaction date is the date on which the transaction qualifies for recognition in terms of
the relevant IFRS (e.g. if our foreign currency transaction involved the purchase of plant, we
would determine the recognition date in terms of IAS 16 Property, plant and equipment). It
can happen that the date we place an order is also the date on which the transaction qualifies
for recognition (i.e. order date = transaction date). However, generally the process of placing
an order does not yet qualify for recognition of a transaction, in which case, the order date
occurs before the transaction date. Since we are not normally interested in events before
transaction date, the order date is normally irrelevant. However, sometimes events before
transaction date are important: for example, when hedging a foreign currency transaction (see
IFRS 9 Financial instruments & chapter 21).
2.4.1 Determining the transaction date (IAS 21.22)
Transation date is
described as:
The first important date in a foreign currency transaction is
the transaction date. This is the date on which the transaction the date on which the transaction first
will be recognised, and must be established with reference to qualifies forIASrecognition
21.22 (extract)
in accordance
with IFRSs.
the IFRS that is relevant to the type of transaction in
question. Many aspects must be considered when determining the date on which a transaction
should be recognised (i.e. depending on the type of transaction, there are specific definitions and
recognition criteria that must be met). As part of this process, we often need to consider ‘when the
risks and rewards of ownership transfer from the one entity to the other entity’. In the case of the
purchase of an asset, for example, after all relevant definitions and recognition criteria have been
considered, the transaction date is often found to be the same date on which the risks and rewards
of ownership transferred from the seller to the buyer.
For regular import or export transactions, establishing the date that risks and rewards are
transferred is complicated by the fact that goods sent to or ordered from other countries
usually spend a considerable amount of time in transit (e.g. on a ship at sea).
The exact wording of the terms used in shipping documentation must always be investigated
first before determining the transaction date as it can often be confusing and can vary
considerably. The general principle is that risks and rewards transfer to the buyer when the
seller has completed their primary duties. In order to assist one in determining when the risks
and rewards have transferred, the International Chamber of Commerce produced a list of
trading terms, called the International Chamber of Commerce Terms of Trade (commonly
referred to as “Incoterms”). The following are some of the common terms used:
x Free on Board (F.O.B.) – The risks and rewards transfer when goods are loaded onto the
ship at the port of shipment.
x Carriage, Insurance and Freight (C.I.F.) – The seller arranges and pays for the carriage and
insurance of shipping the goods so one might think the risks and rewards remain with the seller
until the goods reach the destination port. However, the buyer is the beneficiary of the insurance
with the seller having completed their primary duties from the date that the goods are loaded
onto the ship, with carriage and insurance paid for. Therefore, risks and rewards transfer when
the goods are ‘delivered over the ship’s rail’ (i.e. loaded onto the ship) at the port of shipment.
x Delivery at terminal (D.A.T.) – The risks and rewards transfer when goods are offloaded
at the named destination terminal.
x Delivered Duty Paid (D.D.P.) – The risks and rewards transfer when goods have arrived at
the named destination port or other place and the import clearances have been obtained.
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Comment:
Please bear in mind that the events before the transaction date have no influence on the foreign
currency transaction unless the transaction has been hedged (see chapter 22).
Part A
x The transaction date is 1 February 20X4: in terms of an F.O.B. transaction, the risks of ownership of
the bicycles pass to Home Limited on the date the bicycles are loaded at the originating port.
x The reporting date is 28 February 20X4 since this is Home Limited’s year-end: on this date, the foreign
currency monetary item (foreign creditor) still exists (the transaction date has occurred and settlement
has not yet happened) and thus it will need to be converted from foreign currency into local currency.
x The settlement date is 30 April 20X4, the date on which Home Limited pays the foreign creditor.
Part B
x The transaction date is 31 March 20X4: in terms of a D.A.T. transaction, the risks of ownership pass
to Home Limited on the date that the bicycles are off loaded at the destination port.
x The reporting dates are 28 February 20X4 and 28 February 20X5: no translation is required on
either of these reporting dates, however, since no foreign currency monetary item (foreign creditor)
existed (at 28 February 20X4 the transaction date had not yet occurred and the foreign transaction
had already been settled by 28 February 20X5).
x The settlement date is 30 April 20X4 being the date when the foreign creditor was paid.
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Thus, we measure both the monetary and non-monetary items at the spot exchange rate. It is
permissible to use an average exchange rate for the past week or month, as long as it
approximates the spot exchange rate.
As the exchange rate changes (and most fluctuate on an hourly basis!), the measurement of
amounts owing to or receivable from a foreign entity changes. For example, an exchange rate
of FC1: LC4 in January can change to an exchange rate of FC1: LC7 in February and
strengthen back to FC1: LC6 in March. Due to this, a foreign debtor or creditor will owe
different amounts depending on which date the balance is measured.
Monetary items (e.g. receivable balances) are translated to the latest exchange rates:
x on each subsequent reporting date; and
x on settlement date.
If a monetary item is not settled by the end of the reporting Closing rate is defined as
period, and if there is a difference between the spot rate on the:
transaction date and the spot rate on reporting date, then an x spot exchange rate
exchange difference will arise. This is because the item x at reporting date. IAS 21.8 slightly reworded
(originally measured at the spot rate on transaction date) must be restated at the closing rate.
The amount paid or received is based on the spot rate on settlement date. If the spot rate on
transaction / reporting date (whichever is applicable) is different to the spot rate on settlement
date, an exchange difference will arise.
Consolidations are not covered in this book and thus all exchange gains or losses will be
recognised in profit or loss.
A sale transaction on 31 January led to the recognition of a foreign debtor, of FC2 000.
The local currency is denominated as LC and the foreign currency is denominated as FC.
The exchange rates of FC: LC are as follows:
31 January: FC1: LC4
28 February: FC1: LC7
31 March: FC1: LC6
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Required:
A. Calculate the foreign debtor balance in local currency at the end of January, February and March.
B. Calculate the exchange differences arising over those 3 months and in total.
C. Show how the debtor and exchange differences would be journalised in the entity’s books on
31 January, 28 February and 31 March. Ignore the journal required for the cost of the sale.
Comment: Notice that the amount of sales income is unaffected by changes in the exchange rates.
It should now be clear that fluctuating currency exchange rates will have an effect on all
monetary items that are denominated in a foreign currency, including but not limited to:
x receivables arising from sales to a foreign customer (export) on credit;
x payables arising from purchases from a foreign supplier (import) on credit;
x loans made to a foreign borrower; and
x loans raised from a foreign lender.
Exchange differences that arise on the translation of monetary items are recognised in profit or loss
(as a foreign exchange gain or loss). Although the basic principles apply to import, export and loan
transactions, loan transactions have an added complexity, being the interest accrual. Let us
therefore first look at the journals involving exports and imports and then at loan transactions.
If the date on which the transaction is journalised (transaction date) is the same date on which
cash changes hands in settlement of the transaction (settlement date), then there would
obviously be no exchange differences to account for.
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Debit Credit
5 March 20X1
Inventory (A) £100 x 3 300
Bank (A) 300
Purchase of inventory
Required: Show the journal entries in the books of the company in the United Kingdom.
Exchange differences arise when the settlement date occurs after transaction date.
x The non-monetary item e.g. asset acquired, expense incurred or sale earned (the initial
transaction) is recorded at the spot rate on transaction date. Non-monetary items are
unaffected by movements in the exchange rates, thus no exchange differences will occur.
x The monetary item, being the amount payable or receivable, is affected by the movement
in the exchange rate after transaction date. The monetary item is translated at the spot
rates on reporting dates and payment dates and any increase or decrease in the
monetary item is recognised in profit or loss as either a foreign exchange gain or loss.
When the transaction date and settlement date occur in the same reporting period:
x record the initial transaction at spot rate on transaction date;
x convert the outstanding monetary item balance (i.e. payable or receivable) from the spot
rate on transaction date to the spot rate on settlement date; and
x record the payment (made or received).
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5 April 20X1
A company in the United Kingdom sold inventory for P1 200 to a company in Botswana on
17 May 20X5, the transaction date. The inventory was paid for on 13 June 20X5.
The inventory cost the UK company £150.
The year-end of the company in the United Kingdom is 30 September .
Relevant exchange rates are:
Date Spot rates (Pound: Pula)
17 May 20X5 £1: P4
13 June 20X5 £1: P3
Required:
Show the journal entries in the books of the company in the United Kingdom.
13 June 20X5
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When the transaction date and the settlement date occur in two different reporting periods:
x record the initial transaction at spot rate on transaction date;
x translate the outstanding monetary item balances (payable or receivable):
- to the spot rate on translation date (year-end); and then again
- to the spot rate on settlement date;
x record the payment (made or received).
31 March 20X1
Foreign exchange loss (E) (£100 x 3.7) – 300 = P70 70
Foreign creditor (L) 70
Translation of creditor to spot rate at year-end
5 April 20X1
Foreign exchange loss (E) (£100 x 4) – (£100 x 3,7) = P30 30
Foreign creditor (L) 30
Translation of creditor to spot rate on settlement date
Foreign creditor (L) £100 x 4 = P400 400
Bank (A) 400
Payment of creditor at spot rate on settlement date
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31 May 20X5
Foreign debtor (A) P1200 / £3.4 = £353 – 300 = £53 53
Foreign exchange gain (I) 53
Translating the foreign debtor at year-end
13 June 20X5
Foreign debtor (A) P1200 / £3 = 400 – (300 + 53) = £47 47
Foreign exchange gain (I) 47
Translating foreign debtor at settlement date
Journals:
Debit Credit
5 February 20X1
Inventory (A) $900 / £2.5 360
Bank (A) 360
Purchase of inventory: exchange rate £1: $2.5
Trial balance
As at 31 March 20X1 (extracts) Debit Credit
Inventory 360
Creditor 0
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Trial Balance
As at 31 March 20X1 (extracts) Debit Credit
Inventory 360
Foreign creditor 0
Foreign exchange loss (P/L) 40
Trial Balance
As at 31 March 20X1 (extracts) Debit Credit
Inventory 360
Foreign creditor 400
Foreign exchange loss (P/L) 40
Comment on A, B and C:
There is no exchange gain or loss when the amount is paid on transaction date (part A). Compare this to:
x part B where the foreign exchange loss recognised to payment date is 40; and
x part C where a foreign exchange loss of 40 is recognised in 20X1 and a foreign exchange gain of
100 is recognised in 20X2 (i.e. a net foreign exchange gain of 100 – 40 = 60 on this transaction).
In all 3 scenarios, the inventory remains at £360 because inventory is a non-monetary item.
In all 3 scenarios, no entry is made on 16 January 20X1 (the order date), because control of the
inventory had not been acquired and no obligation had yet been incurred.
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The next thing to consider is interest. Interest incurred (or earned) on foreign currency loans raised (or
given) must first be calculated in terms of foreign currency and based on the outstanding foreign
currency amount (e.g. if our loan of FC10 000 accrues interest at 10% pa, the interest incurred for a
year would be FC1 000). Once we have calculated the interest incurred (or earned) in the foreign
currency, we then translate it into the local currency based on the spot rate on the date that the
interest was incurred (or earned). However, for practical purposes, IAS 21 allows us to use the
average rate for the period that the interest was earned (or incurred), unless the exchange rates
fluctuate significantly during the period. So, using our example, if the average spot rate over the year
that the interest of FC1 000 was incurred was LC14: FC1, then we would recognise interest expense
of LC14 000 (thus increasing our loan liability by LC14 000). See IAS 21.22
Similarly, as with all payments (or receipts) made in foreign currency, we do the translation into the local
currency using the spot rate on payment date. Thus, if we pay FC2 000 to our lender a day before
reporting date, when the spot rate was LC15: FC1, we recognise a payment of LC30 000 (FC2 000 x LC15).
Similarly, as with all other monetary items, a loan balance (whether this is a liability or asset) is first
calculated in the foreign currency. Using our example thus far, this balance would be FC9 000
(FC10 000 capital + FC1 000 interest payable - FC2 000 paid). This foreign currency denominated
balance is then translated at the spot rate on reporting date (i.e. at the closing rate). Thus, using our
example so far and assuming the exchange rate on reporting date was LC16: FC1, our loan liability
balance should be measured at LC144 000 (FC9 000 x LC16).
Now, of course, we have been using a variety of exchange rates to account for different aspects of our
loan (e.g. the spot rate on date of receipt of the loan, the average rate used to account for the interest
incurred, the spot rate on date of repayment of the loan capital and the spot rate on reporting date) and
thus our loan liability balance is currently reflecting LC104 000 (LC120 000 capital + LC14 000 interest
payable – LC30 000 paid). The fact that this balance should reflect the remeasured carrying amount of
LC144 000 (the foreign currency balance of FC9 000 translated at the closing rate of LC16: FC1) means
that our current loan liability balance is understated by LC40 000 (RLC44 000 – LC104 000). This
difference is obviously because we have used constantly changing exchange rates to translate the
foreign currency amounts. Thus, when we increase our liability balance by LC40 000 (so as to reflect
LC144 000 instead of LC104 000), we debit the foreign exchange loss expense account, as an
exchange difference (of LC40 000) has arisen.
Thus, in summary, if, for example, we are the borrower in a loan transaction and we receive a loan
amount that is denominated in a foreign currency:
x the receipt of the loan is journalised at an amount that is translated at the spot exchange rate on
transaction date;
x each loan repayment is journalised at an amount that is translated at the spot exchange rate on
settlement date;
x the interest incurred is journalised at an amount that is translated at the average rate over the
accrual period (or spot rates if the exchange rates fluctuate significantly during this period); and
x the loan balance at reporting date is adjusted so that it reflects the foreign currency balance
translated at the closing rate (spot rate on reporting date), which requires us to journalise a foreign
exchange difference.
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Required: Show the journals to record the above loan in Incredible Limited’s accounting records for the
years ended 31 December 20X5 and 31 December 20X6.
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Foreign currency can affect non-monetary items (e.g. plant and expenses prepaid) in two
basic ways:
x Local currency denominated non-monetary items: Non-monetary items are
A non-monetary item, the purchase of which had described as items:
been denominated in a foreign currency, would have x that do not have a right to receive/
been converted into the local currency at the spot an obligation to deliver
x a fixed or determinable number of
rate on transaction date, at which point we can say it units of currency. IAS 21.16 (slightly reworded)
is now denominated in the local currency (called the
functional currency). Since this item is now already accounted for in the local currency,
there is no need to translate it into the local currency at a later date. See IAS 21.21
x Foreign currency denominated non-monetary items:
The local entity may have a foreign branch or foreign operation (the latter would require
consolidation into the books of the entity).
If this is the case, any non-monetary items owned by the foreign branch or foreign
operation would obviously be accounted for in the books of the foreign branch or operation
using the currency in which it operates (i.e. using its own functional currency).
From the perspective of the local entity, however, these non-monetary items are
denominated in a foreign currency. When the local entity presents the assets of the foreign
branch or consolidates the foreign operation, these foreign currency denominated non-
monetary items will obviously need to be converted into the local entity’s local currency
(i.e. into the local entity’s functional currency). See IAS 21.23 (b) & (c)
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The reason that an exchange rate can affect such items is because:
x the cost or carrying amount is translated at the spot rate on transaction date; and
x the net realisable value or recoverable amount, for example, is translated at the spot rate
on, for example, reporting date.
Solution 13: Non-monetary item: measurement of plant purchased from foreign supplier
Comment:
x Notice how the measurement of the non-monetary asset (plant) is not affected by the changes in the
exchange rates. This is because it is a local-currency-denominated item. However, had the
recoverable amount been determined in a foreign currency it could have resulted in an impairment
loss measured in one of the currencies, foreign or local, see example 15.
x This example also deals with a monetary item (foreign creditor), which is affected by the exchange
rates. This is because the monetary item is denominated in a foreign currency.
1 January 20X1 Debit Credit
Plant: cost (A) $100 000 x R6 600 000
Foreign creditor (L) 600 000
Purchased plant from a foreign supplier (translated at spot rate)
31 March 20X1
Foreign exchange loss (E) $100 000 x R6.30 – R600 000 30 000
Foreign creditor (L) 30 000
Translating foreign creditor on settlement date (at latest spot rate)
Foreign creditor (L) $100 000 x R6.30 630 000
Bank (A) 630 000
Payment of foreign creditor
31 December 20X1
Depreciation: plant (E) (R600 000 – 0) / 5 years 120 000
Plant: accumulated depreciation (-A) 120 000
Depreciation of plant
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Comment on Part B: The British branch recognises a write-down whereas the South African branch does not.
x There is no write-down of inventory in the SA entity’s books because the net realisable value is measured
using the spot rate on the date at which the net realisable value is calculated (R12: £1) yet the cost is
measured using the lower spot rate on transaction date (R10: £1). See W1.2 (Rand).
x The fact that the British branch recognises a write-down whereas the South African branch does not
is purely as a result of the difference in the exchange rates!
Part A Part B
Pounds (£) Rands (R)
1 January 20X1 Debit/(Credit) Debit/ (Credit)
Inventory (A) A: Given: £100 000 100 000 1 000 000
Bank (A) B: £100 000 x R10 (100 000) (1 000 000)
A: Purchased inventory from a local supplier (British); or
B: Purchased inventory from a foreign supplier (translated at spot rate)
31 December 20X1
Inventory write-down (E) A: £100 000 – £90 000: See W1 10 000 N/A
Inventory (A) B: No write-down applicable: See W1 (10 000) N/A
A only: Inventory written down to lower of cost or net realisable value
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The plant is depreciated to a nil residual value over 5 years using the straight-line method.
The recoverable amount was calculated on 31 December 20X2: $70 000.
Required: Show all journal entries for the years ended 31 December 20X1 and 31 December 20X2:
A. in the books of the United States branch (the foreign branch); and
B. in the books of the South African entity (the local entity).
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Please also note that when a gain or loss on a foreign-currency denominated non-monetary item:
x is recognised in other comprehensive income, any exchange component of that gain or
loss shall also be recognised in other comprehensive income. For example: IAS 16
requires gains and losses arising on a revaluation of property, plant and equipment to be
recognised in other comprehensive income. Thus, any exchange difference arising from
the remeasurement will also be recognised in other comprehensive income. IAS 21.30
x is recognised in profit or loss, any exchange component of that gain or loss shall be recognised
in profit or loss. For example: IAS 40 requires fair value adjustments on investment property
carried under the fair value model to be recognised in profit or loss, thus, any exchange
differences arising from remeasurement will be recognised in profit or loss.
Comment on Part A: Notice that there is obviously no exchange difference in this example since the
purchase in dollars is recorded in dollars in the books of the United States branch.
Comment on Part B: Notice how the difference between the exchange rate on date of purchase (R12: $1)
and the exchange rate on date of revaluation (R10: $1) gets absorbed into the revaluation surplus (OCI).
Part A Part B
$ R
1 January 20X1 Dr/ (Cr) Dr/ (Cr)
Plant: cost (A) A: Given as $100 000 100 000 1 200 000
Bank (A) B: $100 000 x R12 (100 000) (1 200 000)
Purchase of plant
31 December 20X1
Depreciation: plant (E) A: ($100 000 – 0)/5yr x 1 20 000 240 000
Plant: acc depreciation (-A) B: R1 200 000 / 5yr x 1 (20 000) (240 000)
Depreciation of plant
31 December 20X2
Depreciation: plant (E) A: ($100 000 – 0)/5yr x 1 20 000 240 000
Plant: acc depreciation (-A) B:: R1 200 000 / 5yr x 1 (20 000) (240 000)
Depreciation of plant
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Part A: $ Part B: R
31 December 20X1 Dr/ (Cr) Dr/ (Cr)
Plant: accum. depreciation (-A) A: $20 000 x 2 years 40 000 480 000
Plant: cost (A) B: R240 000 x 2 years (40 000) (480 000)
NRVM: set-off of accumulated depreciation before revaluation
Plant: cost (A) A: W1 50 000 380 000
Revaluation surplus (OCI) B: W1 (50 000) (380 000)
Revaluation of plant to fair value of $110 000
3.1 General
IAS 21 allows an entity to present its financial statements in whichever currency it chooses to, which is
then known as the presentation currency. However, IAS 21 requires that an entity’s transactions and
balances be measured in that entity’s functional currency. Thus, it is important that entities know how to
correctly establish their functional currencies. An entity’s functional and presentation currency is often
the same currency, but where it is not the same, a translation reserve will arise.
In determining its functional currency, an entity must consider the following factors:
x The currency that influences its selling prices (this is often the currency in which prices for its
goods and services are denominated and settled).
x The country whose competitive forces and regulations mainly determine its selling prices, and the
currency of that country.
x The currency that influences its costs (this is often the currency in which such costs are
denominated and settled).
x The currency in which the entity obtains most of its financing (i.e. where financing includes the
issuing of both debt and equity instruments).
x The currency in which the entity usually invests amounts received from its operating activities.
See IAS 21.9 - 10
As these factors usually do not change often, once a functional currency is determined it is not
changed unless an entity’s circumstances have changed so significantly that the above factors
would result in a different functional currency being more appropriate. See IAS 21.13
Should there be a change in functional currency, it must be accounted for prospectively from
the date of change of functional currency See IAS 21.35.
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Accounting for such a change is relatively simple. All items are translated into the new functional
currency using the spot exchange rate available at the date of change. For non-monetary items,
the new translated amount shall now be considered to be their historical cost.
3.4 Using a presentation currency other than functional currency (IAS 21.38 - 41)
An entity may choose to present its financial statements
in any currency of its choice (presentation currency). Presentation currency is
However, if an entity chooses to present its financial defined as:
statements in a currency other than its functional x the currency in which the
currency, it will have to translate all its items from the x financial statements are presented.
IAS 21.8
functional to the presentation currency at year end.
The following procedure (often referred to as the closing rate method) is used to translate an
entity’s trial balance into a presentation currency that is different to its functional currency:
x all assets and liabilities (including comparative amounts) shall be translated into the
presentation currency using the closing rate available at the reporting date;
x all incomes and expenses shall be translated at the If functional currency ≠
spot rate available at the dates of the various presentation currency,
translate:
transactions (for practical purposes, it is often
acceptable to use the average rate for the x assets & liabilities @ spot rate at
reporting date (e.g. YE)
presentation period, provided the currency did not
x income & expenses @ spot rate on
fluctuate too much); and transaction date (or at average SR).
x all resulting exchange differences are recognised in other
comprehensive income (in an account that is referred to as the ‘foreign currency translation
reserve’, being an equity account). See IAS 21.39
As these exchange rate differences do not affect future cash flows (i.e. they are just book entries), they
are not recognised in ‘profit or loss’, but rather in ‘other comprehensive income’ (accumulated in equity).
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If the foreign currency translation reserve relates to the consolidation of a foreign operation
and if this foreign operation is subsequently disposed of, the reserve would be:
x reclassified from other comprehensive income (where the exchange differences are
accumulated as a separate component of equity) to profit or loss, and
x disclosed as a reclassification adjustment. See IAS 21.48
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5 Summary
Exchange rates
Variety of formats:
x How much LC is required to buy 1 unit of FC = LCxxx: FC1; (direct) or
x How much FC can be bought for 1 unit of LC = LC1: FCxxx (indirect)
Dates Currencies
Dates: Currencies:
x Transaction date (TD) x The functional currency is used in our
x Translation (reporting) date (RD) own records
x Settlement (payment) date (SD) x Presentation currency is the currency we
use to present our F/S’s
Initial Subsequent
Spot rate on TD MI: If functional currency differs from
Spot rate on: presentation currency; translate:
RD or SD x Asset and liabilities:
@ spot rate at year-end
x Income and expenses:
@ spot rate on transaction date
(otherwise an average spot rate)
NMI:
Historic cost:
x SR on TD
Fair value:
x SR on FV date
Interest on loan:
x Average SR
Abbreviations:
MI: monetary item SR: spot rate RD: reporting date
NMI: non-monetary item TD: transaction date SD: settlement date
LC: local currency FC: foreign currency
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Gripping GAAP Financial instruments – general principles
Chapter 21
Financial Instruments – General Principles
Main References: IFRS 9, IAS 32, IFRIC 19, IFRS 7, IFRS 13 & IAS 1 (updated to 1 December 2019)
Contents: Page
1. Introduction 982
1.1 A bit of history 982
1.2 Overview of the main financial instrument standards: IFRS 9, IAS 32 and IFRS 7 982
1.3 Scope of IFRS 9 982
2. Financial instruments 983
3. Financial assets 983
3.1 Financial assets: identification 983
Example 1: Financial assets 984
Example 2: Financial assets versus financial instruments 984
3.2 Financial assets: recognition 985
3.3 Financial assets: classification 985
3.3.1 Overview of the different classifications 985
3.3.2 Overview of the classification process 985
3.3.3 Classification: financial assets at amortised cost 986
3.3.4 Classification: financial assets at fair value through OCI – debt instruments 986
3.3.5 Classification: financial assets at fair value through profit or loss 987
3.3.6 Classification: financial assets at fair value through OCI – equity investments 987
3.3.7 Classification process – a diagrammatic summary 988
3.3.8 The contractual cash flows criteria 989
Example 3: Classifying financial assets – considering the cash flows 989
3.3.9 The business model criteria 990
Example 4: Classifying financial assets – considering the business model 991
3.4 Financial assets: measurement overview 992
3.5 Financial assets: initial measurement 992
3.5.1 Initial measurement: fair value and transaction costs 992
3.5.2 Initial measurement: fair value and day-one gains or losses 993
3.6 Financial assets: subsequent measurement 994
3.6.1 Overview 994
3.6.2 Subsequent measurement: Financial assets at amortised cost 995
3.6.2.1 If the financial asset is not credit impaired 995
Example 5: Calculating the effective interest rate using a calculator 997
Example 6: Financial assets at amortised cost 997
3.6.2.2 If the financial asset is credit-impaired 998
3.6.2.2.1 If the financial asset becomes credit impaired after 998
initial recognition
3.6.2.2.2 If the financial asset was already credit impaired on 999
initial recognition
3.6.2.3 If the financial asset is renegotiated or modified 999
Example 7: Financial assets at amortised cost – with modification 999
3.6.3 Subsequent measurement: Financial assets at FVOCI – debt instruments 1000
Example 8: Debentures at fair value through other comprehensive income 1001
Example 9: Financial assets at FVOCI-debt (foreign currency treatment) 1002
3.6.4 Subsequent measurement: Financial assets at FVOCI – equity instruments 1004
Example 10: Financial assets at fair value through OCI – equity 1005
3.6.5 Subsequent measurement: Financial assets at fair value through profit or loss 1006
Example 11: Financial assets at fair value through profit or loss 1006
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6.7.3 Extinguishment results in derecognition of the liability and recognition of another liability 1036
Example 25: Financial liability: modification lead to extinguishment 1036
6.7.4 Extinguishments using equity instruments after renegotiating terms 1037
Worked example: Debt for equity swaps 1038
7. Reclassifications of financial instruments 1038
7.1 Reclassifications overview 1038
Example 26: Reclassification date 1038
7.2 Reclassifying from amortised cost to fair value through P/L 1039
Example 27: Reclassification of a financial asset from AC to FVPL 1039
7.3 Reclassifying from fair value through P/L to amortised cost 1041
Example 28: Reclassification of a financial asset: FVPL to AC 1041
7.4 Reclassifying from amortised cost to fair value through OCI 1042
Example 29: Reclassification of a financial asset from AC to FVOCI 1043
7.5 Reclassifying from fair value through OCI to amortised cost 1044
Example 30: Reclassification of a financial asset from FVOCI to AC 1045
7.6 Reclassifying from fair value through OCI to fair value through P/L 1047
7.7 Reclassifying from fair value through profit or loss to fair value through OCI 1047
8. Compound financial instruments 1047
8.1 Overview 1047
Example 31: Compound financial instruments: initial recognition & measurement 1049
8.2 Compound financial instruments consisting of convertible instruments 1050
Example 32: Convertible debentures – theory 1050
Example 33: Convertible debentures – calculations 1051
Example 34: Compulsorily convertible debentures 1052
8.3 Compound financial instruments consisting of non-convertible preference shares 1053
8.3.1 Overview 1053
8.3.2 Preference shares: dividends 1054
8.3.3 Preference shares: redemptions 1054
Example 35: Non-redeemable preference shares – discretionary dividends 1057
Example 36: Non-redeemable preference shares – mandatory dividends 1057
Example 37: Non-redeemable preference shares – mandatory & discretionary dividends 1058
Example 38: Redeemable preference shares – discretionary dividends 1059
9. Settlement in entity’s own equity instruments 1060
Example 39 Settlement in entity’s own equity instruments 1060
10. Interest, dividends, gains and losses 1061
11. Derivatives 1062
11.1 Overview 1062
11.2 Options 1062
11.3 Swaps 1063
Example 40: Swaps 1063
11.4 Futures and forwards 1063
11.5 Embedded derivatives 1063
Example 41: Hybrid instruments 1064
12. Offsetting of financial assets and liabilities 1065
13. Deferred tax consequences of financial instruments 1065
13.1 Overview 1065
13.2 Financial assets and liabilities subsequently measured at amortised 1066
13.3 Financial assets subsequently measured at fair value 1066
Example 42: Deferred tax consequences of financial assets 1066
14. Financial risks 1067
14.1 Overview 1067
14.2 Market risk 1067
14.2.1 Interest rate risk 1068
14.2.2 Currency risk 1068
14.2.3 Price risk 1068
14.3 Credit risk 1068
14.4 Liquidity risk 1068
15. Disclosure 1068
16. Summary 1071
Chapter 21 981
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1. Introduction
1.2 Overview of the main financial instrument standards: IFRS 9, IAS 32 and IFRS 7
Apart from IFRS 9, there are two other standards that also deal with financial instruments:
IAS 32 Financial instruments: presentation and IFRS 7 Financial instruments: disclosures.
IAS 32 provides some essential definitions and clarification that assist in identifying whether an item is
a financial instrument, whether it should be presented as a financial asset, financial liability or equity
instrument and whether a financial asset and financial liability may be offset against each other. It also
deals with how to present compound financial instruments (i.e. where an instrument is partly equity and
partly liability). These issues are explained in this chapter and in chapter 23 on 'share capital'.
IFRS 7 explains the disclosures requirements. These help us ensure our users will be able to assess our:
x financial instrument's 'significance' in relation to an entity's 'financial position and performance'; and
x 'nature and extent of risks' to which the financial instruments have exposed the entity, as well as
how the entity is managing these risks.
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A financial instrument is an item, born from a contract, which will be recognised as a financial
asset by one entity and recognised as either a financial liability or equity instrument by another
entity. This means that a financial instrument involves matching, where one entity has a
financial asset (for example, the right to receive cash) and another entity has a financial liability
or equity instrument (for example, an obligation to pay cash).
If we look at the financial instrument definition (see above), we see that an item can only be a financial
instrument if it arises from a contract. This contract can even be a verbal contract, but whatever its
form, there must be a contract. Interestingly, this means that an item could qualify as a financial asset
(see section 3), but, if it does not involve a contract, it would fail to qualify as a financial instrument (e.g.
cash in your pocket is a financial asset but it is not a financial instrument). See example 2.
You will find that a statement of financial position includes many financial instruments, including
common items such as cash, trade receivables and trade payables as well as the more complex
items such as derivatives.
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- ‘To exchange financial assets or financial liabilities under conditions that are potentially
favourable to the entity’. For example, an option to buy shares in another entity at C3 per
share when the market price is C8 per share is a financial asset because the conditions
appear to be potentially favourable. Essentially, a contractual right to exchange financial
instruments will be recognised as a financial asset if the right will ultimately lead to the receipt
of cash or an equity instrument. See IAS 32.AG7
d) a contract that will or may be settled in the entity’s own equity instruments and is:
- ‘a non-derivative for which the entity is or may be obliged to receive a variable number of the
entity’s own equity instruments’ (see section 8.2); or
- ‘a derivative* that will or may be settled other than by the exchange of a fixed amount of cash or
another financial asset for a fixed number of the entity’s own equity instruments'.
*: A derivative is simply a financial instrument whose value depends on the value of another
item. For example: an ‘option’ to buy oil at a certain price in the future is a derivative, because
it is a financial instrument that becomes more or less valuable depending on what price the
oil price is currently trading at (see section 11). Extracts from IAS 32.11: Financial asset & IFRS 9 App A: Derivatives
The situations described in (d) above may sound confusing because it refers to the entity
expecting to receive its own equity instruments in settlement of a receivable (either a variable
number or a fixed number of its own shares). In essence, the substance of the transaction is that
the entity is expecting to receive its own equity instruments back as 'currency'. Transactions that
involve an entity expecting to receive its own shares in settlement of a receivable is fairly rare
and it is more likely that the entity might expect to settle an obligation by paying with its own
shares (see section 6.1 and section 9).
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How to measure amortised cost and fair value is explained in section 3.4.
Other than cash, financial assets are essentially comprised of investments in debt instruments,
investments in equity instruments, and derivatives. Each one of these assets is classified by assessing:
x Its contractual cash flow characteristics (step 1 – the CCF test); and
x The business model within which that financial asset is managed (step 2 – the BM test).
Step 1 - the CCF test: The contractual cash flows test involves assessing whether the asset's
contractual terms will lead to the entity receiving:
x cash flows on specified dates
x that are solely payments of:
- principal, and
- interest on the principal (SPPI). See IFRS 9.4.1.2b
Investments in equity instruments (e.g. ordinary shares) fail this test since they do not offer contractual
cash flows at all, whereas investments in debt instruments (e.g. bonds) will generally pass the test. The
assessment of cash flow characteristics is explained in detail in section 3.3.8.
Step 2 - the BM test: The business model test involves assessing the business model relevant to the asset to
determine the objectives applied in managing that asset. These objectives may be:
x to hold the asset with the principal aim being to sell the asset (hold to sell);
x to collect the contractual cash flows (hold to collect); or
x to collect the contractual cash flows and to sell the asset (hold to collect and sell).
The assessment of the business model is explained in more detail in section 3.3.9.
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If classification at AC or FVOCI would cause an accounting mismatch (see section 3.3.5), the asset
may be designated at FVPL instead (although this designation can only happen on initial
recognition and is irrevocable).
A financial asset shall be classified as amortised cost (AC) if Financial assets classified
both the following conditions are met: at AC:
x The contractual cash flows: the contractual terms of the asset This classification only applies to
must give rise to cash flows on specified dates and these cash investments in debt instruments:
flows must be solely payments of principal and interest on the x CCF = specified dates & SPPI; &
x BM = held to collect CCF.
principal amount outstanding (i.e. SPPI); & See IFRS 9.4.1.2
x The business model: the objective of the business model Note: if classifying at AC leads to
an accounting mismatch, it may be
relevant to this asset must be to collect contractual cash flows classified at FVPL instead.
See IFRS 9.4.1.5
(i.e. no intention to trade in the instruments). See IFRS 9.4.1.2
However, a financial asset that should be classified at AC (on the basis that it meets both these
conditions), may be designated as fair value through profit or loss (FVPL) instead, if classifying at
AC would cause an accounting mismatch (see section 3.3.5).
3.3.4 Classification: Financial assets at fair value through other comprehensive income
– debt instruments (IFRS 9.4.1.2A)
Financial assets classified
at FVOCI – debt:
A financial asset shall be classified as fair value through other
comprehensive income (FVOCI) if both the following conditions are This classification only applies to
investments in debt instruments:
met (which means, by implication, that the asset will be an x CCF = specified dates & SPPI; &
investment in some kind of debt instrument e.g. a loan asset): x BM = held to collect CCF and sell.
See IFRS 9.4.1.2A
x The contractual cash flows (CCF): the contractual terms of Note: if classifying at FVOCI leads
the financial asset must give rise on specified dates to cash to an accounting mismatch, it may
flows that are solely payments of principal and interest on be classified at FVPL instead.
See IFRS 9.4.1.5
the principal amount outstanding (i.e. SPPI); and
x The business model (BM): the objective of the business model relevant to this asset must be to both
collect contractual cash flows and sell the asset. See IFRS 9.4.1.2A
However, a financial asset that meets both these requirements, and should thus be classified at
FVOCI, may be designated as fair value through profit or loss (FVPL) instead if the FVOCI
classification would cause an accounting mismatch (see section 3.3.5). See IFRS 9.4.1.5
Please note that since this classification requires that the asset has contractual cash flows, the AC
and FVOCI classifications would include only debt instruments (i.e. these classifications would not
include equity or derivative instruments because these instruments do not offer contractual cash
flows). There is a further classification of FVOCI that deals exclusively with equity instruments that
the entity has elected to classify at FVOCI (see section 3.3.6).
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The FVOCI classification that deals only with debt instruments is accounted for differently to the
FVOCI classification that deals with equity instruments. For this reason, we will refer to the one
classification as FVOCI-debt and the other as FVOCI-equity.
3.3.5 Classification: Financial assets at fair value through profit or loss (IFRS 9.4.1.4 – 4.1.5)
The fair value through profit or loss (FVPL) classification is essentially a 'catch-all' classification for
financial assets that do not qualify for classification as either amortised cost (AC) or fair value through
other comprehensive income (FVOCI). However, financial assets that do meet one of these other
classifications (i.e. AC or FVOCI) may be designated as fair value through profit or loss (FVPL)
instead, if the other classification would have caused an 'accounting mismatch'.
Example of an accounting mismatch: A financial asset is bought to offset the risks in a particular
financial liability. The liability is measured at fair value, but the asset is to be measured at amortised
cost. This situation would mean that the gains and losses on the asset and liability may be recognised
in different periods and would be measured on different bases. To avoid this, one is able to choose to
designate the asset to be measured at FVPL instead of amortised cost. This designation as FVPL
due to there being an accounting mismatch may only be made on initial recognition and is irrevocable
(i.e. management may not change its mind). See IFRS 9.4.1.5
In summary, a financial asset shall be classified as fair value through profit or loss (FVPL) if:
x it does not meet the criteria for classification at amortised cost (AC) Financial assets
and does not meet the criteria for classification as fair value through classified at FVPL:
other comprehensive income (FVOCI-debt), i.e.: x This classification applies to any
- the contractual terms do not lead to cash flows on specified FA that does not meet the
requirements to be classified as
dates that are solely payments of principal and interest on AC or FVOCI See IFRS 9.4.1.4
principal (i.e. the SPPI test fails); and/or x FAs that are designated as FVPL
so as to avoid an accounting
- the business model is neither to 'hold to collect ' nor to 'hold to mismatch. See IFRS 9.4.1.5
collect and sell' (i.e. the objective of the business model is to Note: some equity investments that
'hold to sell') (i.e. the BM test fails); or meet these requirements may be
designated as FVOCI-equity instead.
x the entity chooses to designate the asset as FVPL because See IFRS 9.
A financial asset that is an equity investment would fail the SPPI test and thus automatically meet
the FVPL classification but may be classified as FVOCI-equity instead depending on the
circumstances. See section 3.3.6.
3.3.6 Classification: Financial assets at fair value through other comprehensive income
– equity investments (IFRS 9.4.1.2 & IFRS 9.4.1.2A & IFRS 9.4.1.4 & IFRS 9.5.7.5)
Financial assets classified
The classification of certain equity instruments at fair value through at FVOCI – equity:
other comprehensive income (FVOCI-equity) is regarded as a fourth
This classification is one that may be
classification because the measurement thereof differs from the elected if the FA is an:
measurement of the classification of fair value through other x investment in equity instruments that is
comprehensive income (FVOCI-debt) described in section 3.3.4. x not held for trading &
x not contingent consideration in an
IFRS 3 business combination
The FVOCI-debt classification only involves investments in debt This election is
instruments and is a mandatory classification (i.e. if the requirements x only possible on initial recognition
are met, the debt instrument must be classified at FVOCI). In contrast, x irrevocable. See IFRS 9.4.1.4 and IFRS 9.5.7.5
the FVOCI-equity classification described in this section involves only Reclassification to P/L: prohibited.
See IFRS 9.5.7.5 & B5.7.1
investments in equity instruments and is purely an elective
classification.
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An entity may elect to classify a financial asset as fair value through other comprehensive income
for equity instruments (FVOCI - equity) if it:
x is an investment in an equity instrument that is:
x not held for trading; and
x is not 'contingent consideration recognised by an acquirer in a business combination to which
IFRS 3 applies'. See IFRS 9.5.7.5
In other words, if a financial asset is an investment in an equity instrument that is held for trading,
the entity may not elect to classify it at 'FVOCI-equity' (i.e. it will have to be classified at FVPL).
The reason why this elective classification was introduced was because investments in equity
instruments (e.g. ordinary listed shares) would otherwise always be classified as fair value
through profit or loss (FVPL). This means that as the relevant share price rises and falls, fair
value gains or losses would be recognised in 'profit or loss'. However, if an entity has no intention
to trade in its equity investments, it would generally prefer to present the related fair value gains or
losses in 'other comprehensive income' to avoid its 'profit or loss' from being needlessly affected.
However, a factor that should be considered before electing to classify an equity instrument at
FVOCI-equity is that, if and when the equity instrument is eventually sold, the fair value gains or
losses previously recognised in 'other comprehensive income' may never be reclassified to 'profit or
loss’. See IFRS 9.B5.7.1
This election to classify the equity investment at FVOCI-equity may only be made on initial
recognition and is irrevocable (i.e. management may not change its mind). See IFRS 9.4.1.4
FV through OCI
i.e. is the objective to i.e. is the objective to
collect only the:
(equity instrument)
collect both the:
x contractual cash
x contractual cash
flows (i.e. the entity
flows; and
does not intend
dealing in the x cash flows from selling
instruments) the asset
No (Neither BM applies)
Yes Yes
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Let us now look in more detail at the issues surrounding the contractual cash flows and then the
business model and its characteristics.
3.3.8 The contractual cash flows criteria (IFRS 9.4.1.3 & B4.1.7-B4.1.19)
All financial instruments, by definition, involve a contract of some form or another (whether in
writing or not).
Depending on the contract, the cash flows will be stipulated to some degree or another. Bank loan
agreements normally stipulate all the cash flows, such as the loan amount granted (i.e. the principal
amount to be repaid), the rate of interest that will be charged as well as the dates on which payments
will need to be made. In contrast, investments in equity instruments, such as ordinary shares, may
involve a prospectus stipulating the price per share that the investor would have to pay but the future
cash flows, such as dividends, would be unspecified and dependent on an uncertain future.
The cash flows that are stipulated in the contract are referred to as 'contractual cash flows'.
For a financial asset to be classified at amortised cost or fair value through other comprehensive
income (debt instruments only), the contractual cash flows must be set to occur on specific dates
and must relate solely to payments of the ‘principal sum’ and ‘interest on this principal’ (SPPI).
The term 'principal' refers to 'the fair value of the financial asset at initial recognition'. The term
'interest' includes a return that compensates the holder for the time value of money and credit risk
and possibly also other lending risks (e.g. liquidity risk) and costs (e.g. administration costs) as
well as a profit margin.
Essentially, contractual cash flows are solely payments of principal and interest (SPPI) if they 'are
consistent with a basic lending arrangement'. Thus, if the contract stipulates cash flows that are
linked, for example, to equity or commodity prices, it will have introduced factors that are not
normal in a basic lending arrangement and thus the contractual cash flows cannot be said to be
solely payments of principal and interest. See IFRS 9.4.1.3 & IFRS 9.B4.1.7A
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b) The CCF = SPPI: The interest charged is based on the risk of default of the debtor and thus the
interest would compensate the issuer not only for the time value of money but also for the credit risk
faced, both of which are considered to be 'interest'. The fact that the loan is collateralised does not
affect the assessment of whether the contractual cash flows are SPPI.
c) The CCF ≠ SPPI: The payments received will not be solely principal and interest on the principal
because the principal is not guaranteed to be repaid in cash…it could come back as shares instead,
in which case the holder would be exposed to the value of the ordinary shares.
d) The CCF = SPPI: The loan has a maturity date suggesting that the principal is repayable. As for the
interest rate being linked to the inflation rate, inflation is what causes the time value of money to
deteriorate. Payment of interest linked to inflation thus simply 'resets the time value of money to a
current level', with the result that the interest rate 'reflects real interest'. Thus, the interest payments
relate to time value and credit risk – and are thus considered to be 'interest'.
e) The CCF ≠ SPPI: Although the bond involves repayment of principal and interest, as a result of the
contractual terms, interest charges may have to be deferred and since no interest is charged on the
deferred interest, the cash payments are not considered to be related to the time value of money,
which is one of the basic requirements of a basic lending arrangement. Since the payments are not
consistent with a basic lending arrangement, the contractual cash flows are not solely payments of
principal and interest. Note: if the requirement to defer interest and not charge interest on the deferred
interest had been a legal requirement rather than a contractual term, then the contractual cash flows
would have been solely payments of principal and interest (i.e. CCF = SPPI).
The business model essentially considers the intention of the entity in holding the financial asset/s,
that is whether the financial asset is being held in order to collect the contractual cash flows (hold
to collect) or whether it is being held to realise the gains in changes in the fair value through sale
thereof (hold to sell) – or whether the intention is a mixture of the two (hold to collect and sell).
It is the responsibility of key management personnel (as defined in IAS 24 Related party
disclosures) to determine the business model. Determining the business model requires judgement
and an assessment of 'all relevant evidence that is available at the date of assessment'. The
business model used to manage the financial asset/s is considered to be a matter of fact rather
than a mere assertion. In other words, it requires observing the actual activities undertaken by the
entity in achieving its stated objectives. See IFRS 9.B4.1.2B
Interestingly, although the business model’s objective may be to hold financial assets in order to collect
contractual cash flows, the entity need not actually hold all of those instruments until maturity. For example,
it can happen that the business model is to collect the contractual cash flows, but the entity is forced to sell
the asset because it needs cash – referred to as a 'stress-case scenario'. In such a case, the business
model remains 'hold to collect'. Realising cash flows in a manner that differs from the expectations when
the business model was assessed does not result in a correction of error in terms of IAS 8, but could result
in a reclassification – see section 6 of this chapter on reclassifications.
This assessment is not performed on the basis of scenarios that the entity does not reasonably
expect to occur. However, if sales of assets from this portfolio of investments are found to be 'more
than infrequent' or 'more than insignificant in value', the entity must reconsider if the objective to
collect contractual cash flows is still relevant. IFRS 9.B4.1.2, B4.1.3 & .B4.1.3B
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In a 'hold to collect' business model, assets are managed in a way that enables the collection of the
contractual cash flows over the life of the asset. However, if one of these assets is sold due to a
sudden liquidity problem, it does not necessarily mean that the 'hold to collect' model was incorrect.
Such a sale may have been purely incidental to the main objective of collecting cash flows.
Judgement is obviously necessary to assess the true situation but as a general rule, the sale of
assets within this business model would generally be 'infrequent'. See IFRS 9.B4.1.2C
In a 'hold to collect and sell' business model, both the collection of contractual cash flows and the
sale of the asset are integral to the objective. An example of an objective under this business model
would be for the assets to not only generate contractual cash flows but to also be kept at a level for
purposes of maintaining a given liquidity. Thus, in this model, the number of assets sold would
normally be 'more than infrequent'. See IFRS 9.B4.1.4A
The 'hold to sell' business model means that decisions regarding the assets will be based on their
fair values. This model is normally evidenced by active buying and selling and thus the sale of assets
would typically be considered 'frequent'. However, the fact that contractual cash flows are received
while the entity holds the asset does not detract from the model being 'hold to sell' because if the
assets are being managed and evaluated based on their fair values, the receipt of contractual cash
flows are considered incidental – not integral – to the business mode's objective. See IFRS 9.B4.1.5
a) The entity has bought an investment in order to collect contractual cash flows but has indicated that it
would certainly sell the asset if it needed the cash or if the asset no longer met the credit criteria
documented in the entity’s investment policy.
b) The entity bought a portfolio of debtors. These debtors are charged interest on their outstanding balances.
Some of these debtors will not pay and many debtors need to be phoned to encourage payment. On
certain occasions the entity found it necessary to enter into interest rate swaps (swapping the variable
rate with a fixed rate).
c) Entity A lends money to clients and then sells these loan assets to Entity B, being an entity that focuses
on collecting the cash flows. Entity A owns Entity B.
d) Entity A has budgeted for capital expenditure in a few years. Excess cash is invested in short and long-
term investments. When the opportunity arises, investments are sold to reinvest in investments with a
higher return. Portfolio managers are remunerated on the return of the portfolio. See IFRS 9.4.1.4C, eg 5
Note: Sales to manage credit concentration risk of a portfolio without an increase in the asset’s credit risk
may still meet the BM test, provided that sales are infrequent (even if significant in value), or insignificant
in value (even if such sales occur frequently). If this is not the case, the entity will need to reconsider
whether the BM is consistent with collecting contractual cash flows. See IFRS 9.B4.1.3B
b) BM = hold to collect. The fact that some debtors may lead to bad debts and that the entity enters into
derivatives to protect its interest cash flows does not detract from the fact that the entity’s business model
relating to these debtors is simply to collect the principal and interest. There is no evidence that the entity
bought the portfolio in order to make a profit from the sale thereof.
c) Entity A's BM = hold to sell. Entity A’s business model involves trading the assets rather than collecting
the contractual cash flows. Thus, the loan assets must be measured at fair value through profit or loss in
Entity A's separate financial statements.
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Entity B's BM = hold to collect. Entity B’s business model involves collecting the contractual cash flows,
thus the loan assets must be measured at amortised cost* in Entity B's separate financial statements.
The group's BM = hold to collect. For the purposes of the group financial statements, the loans are issued
with the objective of ultimately collecting the contractual cash flows and thus the loan assets must be
measured at amortised cost* in the group's consolidated financial statements.
* The loan assets would be measured at amortised cost assuming the cash flows related solely
to payments of principal and interest.
d) BM = hold to collect and sell. The objective of the BM is to maximise the return of the portfolio. Holding
the portfolio to collect contractual cash flows and selling financial assets to maximise the yield of the
portfolio are both integral to achieving this objective.
Initial measurement of financial assets (and, in fact, all financial instruments) is at:
x fair value, and
x may involve the adjustment for transaction costs (added in the case of financial assets).
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There are exceptions, where we may not necessarily use fair value for the initial measurement:
x Trade receivables that do not have a significant financing component (or do have one, but IFRS 15
allows us to ignore it because the financing involves less than one year) are always measured at
the transaction price as defined by IFRS 15 Revenue from contracts with customers. See IFRS 9.5.1.3
x In the unusual event that the transaction price does not equal fair value, we have what is called a
day-one gain or loss. In certain situations, this gain or loss must be deferred, which will mean we
effectively measure the asset at transaction price. See section 3.5.2
Whether or not to adjust a financial asset's fair value for transaction costs depends on the asset
classification. This is summarised below. See IFRS 9.5.1.1
Transaction costs relating to a financial asset are, by definition (see pop-up), the incremental costs that
are directly attributable to its acquisition or disposal. Incremental costs are, by definition (see pop-up),
costs ‘that would not have been incurred’ if the financial asset had not been ‘acquired, or disposed of’.
Transaction costs are
Transaction costs: defined as:
x include payments made, for example, to: x incremental costs that are
x directly attributable to the acquisition,
- agents or brokers in respect of their commissions/ fees; issue or disposal of a FA/FL.
- regulatory agencies and securities exchanges for levies; or An incremental cost is defined as a cost that:
- government bodies in respect of transfer taxes and duties. x would not have been incurred
x if the entity had not acquired, issued or
x exclude costs such as: disposed of the fin instrument. IFRS 9 App A
- internal administration or holding costs, e.g. the monthly fee
charged for servicing loans;
- debt premiums; or
- financing costs. See IFRS 9.B5.4.8
3.5.2 Initial measurement: fair value and day-one gains or losses (IFRS 9.5.1.1A and B5.1.2A)
The fair value at which all financial assets (except trade receivables with no significant financing
component) are initially measured, is determined in terms of IFRS 13 Fair value measurement.
The financial asset's fair value at initial recognition is normally equal to its transaction price, and in
fact, the transaction price is often considered to be a good indicator of its fair value. However, it is
possible that the fair value (the amount we use to initially measure the financial asset) does not equal
the transaction price (the amount we actually paid for this asset).
If the fair value and the transaction price differ, the amount by which they differ is referred to as a day-
one gain or loss. This difference is either immediately accounted for in profit or loss or deferred
depending on how reliable the determination of fair value is:
x If the fair value was considered to have been reliably measured (i.e. level 1 or 2 inputs), the
difference is recognised immediately in profit or loss.
This occurs if the fair value was determined either:
- as a quoted price in an active market, referred to as a level 1 input; or
- by using a valuation technique that was based on observable inputs, referred to as level 2 inputs.
Example: We pay C120 for an asset with a FV of C100, measured using observable inputs:
credit bank: C120,
debit financial asset: C100 (fair value)
debit day-one loss expense (P/L): C20 (balancing amount)
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x If the fair value measurement was less reliable (i.e. level 3 inputs), the difference is deferred (delayed).
This occurs if the fair value was determined using a valuation technique that used unobservable inputs,
referred to as level 3 inputs.
In this case, the asset is measured at fair value but the recognition in profit or loss of the difference
between fair value and the transaction price (i.e. day-one gain or loss) is deferred. We defer it by
recognising the difference as an adjustment directly to the asset's carrying amount instead. The result is
that the asset's carrying amount will reflect its transaction price (TP) (FV ± Day-one gain/loss = TP).
The deferred gain/ loss may be subsequently reversed out of the asset's carrying amount and recognised
in profit or loss, but only to the extent ‘it arises from a change in a factor (including time) that market
participants would take into account when pricing the asset’. See IFRS 9.B5.1.2A
Example: We pay C120 for an asset with a FV of C100, measured based on unobservable inputs:
credit bank: C120,
debit: ‘financial asset’ (A): C100 (fair value)
debit: ‘financial asset deferred day-one loss’ (A): C20 (balancing amount)
The net effect is that the ‘financial asset’ is measured at its transaction price of C120 (FV 100 + deferred
loss C20). This deferred loss may or may not be subsequently reversed out of the asset and expensed
in profit or loss (by crediting the ‘financial asset deferred loss’ and debiting the ‘day-one loss expense’).
Fair value: Measured using Level 1 or Level 2 inputs. Measured using Level 3 inputs
Accounting: x FA = measured at FV x FA = measured at TP (FV + deferred loss / - deferred gain)
x Day-one gain/ loss = recognised in P/L x Day-one gain/ loss = deferred (i.e. recognised as an
adjustment to the carrying amount of the FA)
3.6.1 Overview
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Thus, the classification of the financial asset affects its measurement in a number of ways:
x whether the asset is measured at fair value or amortised cost, and whether transaction costs should
be included or expensed.
x whether the asset will require the recognition of a loss allowance.
x whether any fair value gains or losses should be recognised in other comprehensive income.
x whether any fair value gains or losses that may need to be recognised in other comprehensive
income will ever be reclassified to profit or loss.
The treatment of foreign currency gains or losses will also differ depending on the classification,
although this has nothing to do with the requirements of IFRS 9, but rather the requirements of
IAS 21 Foreign currency transactions. This is explained in the grey box below.
The treatment of foreign currency gains or losses is also affected by the classification!
When reading the following sections on how to measure the 4 different classifications, you
might also notice that foreign currency gains or losses are sometimes recognised in P/L and
sometimes in OCI. IAS 21 Foreign currency transactions requires foreign exchange gains or
losses on monetary items to be recognised in P/L.
Thus, since a debt instrument is a monetary item, & an equity instrument is a non-monetary item,
foreign exchange gains or losses would, for example, be recognised:
x in P/L under the FVOCI classification for debt instruments (because it is a monetary item);
x in OCI under the FVOCI classification for equity instruments (because it is a non-monetary item).
See IFRS 9.B5.7.2-3
The requirement to recognise a loss allowance applies to assets classified at amortised cost (AC)
and debt instruments classified at fair value through other comprehensive income (FVOCI-debt).
It also applies to lease receivables, trade receivables and contract assets (arising from IFRS 15
Revenue from customer contracts), loan commitments and certain financial guarantee contracts.
See IFRS 9.5.5.1
How to journalise a loss allowance is shown within the section on subsequent measurement at
amortised cost (see section 3.6.2) and the section on subsequent measurement of debt
instruments at fair value through other comprehensive income (see section 3.6.3). However,
these journals apply equally to all financial assets to which a loss allowance applies (e.g. it also
applies to lease receivables, trade receivables, contract assets). A more detailed explanation of
the impairment of financial assets and how to measure the loss allowance (expected credit losses)
is included in section 4.
3.6.2 Subsequent measurement: Financial assets at amortised cost (IFRS 9.4.1.2; 9.5.4)
3.6.2.1 If the financial asset is not credit-impaired Amortised cost FAs are
measured as follows:
Financial assets classified at amortised cost are initially x Initially at FV plus transaction costs.
measured at fair value (plus any transaction costs). They are x Subsequently measured using the
then subsequently measured at ‘amortised cost’ (i.e. using the effective interest method.
effective interest rate method). x Tested for impairment
x All gains or losses recognised in P/L.
This effective interest rate method requires that we measure the asset and the related interest
income through a process that involves applying the effective interest rate (EIR) to the gross
carrying amount (GCA).
The effective interest
The effective interest rate is the rate that exactly discounts the method is defined as
future cash flows throughout the life of the financial asset, to x the method that is used in the
the gross carrying amount of the asset (i.e. its present value). - calculation of the amortised cost of
a FA (or FL) and the
- allocation & recognition of the
Please note: when calculating this effective interest rate, we interest revenue (expense) in P/L
must take into account all the cash flows that are expected over the period. See IFRS 9 App A (Reworded)
to arise from the terms of the contract (i.e. the contractual
cash flows) and must ignore the fact that we may expect, as a result of the asset’s credit risk, that
some of these contractual cash flows may not be received (i.e. we ignore expected credit losses).
Section 4 explains how to measure the expected credit losses.
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Thus, the effective interest rate method recognises the The effective interest rate
difference between the future contractual cash flows and the is defined as
present value thereof as interest income over the life of the
x the rate that exactly discounts
asset. The ‘present value’ at any one point in time is referred x estimated future cash flows through
to as the ‘gross carrying amount’ at that point in time). the expected life of the financial asset
x to the asset’s gross carrying amount.
We measure this interest income by multiplying the These cash flows are the contractual
cash flows, not adjusted for expected
opening gross carrying amount (GCA) by the effective credit losses. See IFRS 9 App A (Reworded)
The asset's closing gross carrying amount is then calculated The gross carrying amount
by adding this effective interest income to the opening gross is defined as:
carrying amount and subtracting any receipts x the amortised cost of a FA, but
x before adjusting for any loss
Asset’s closing GCA = allowance.
See IFRS 9 App A (reworded)
Opening GCA + Interest income – Receipts
The journals to account for the above interest income and cash flows would be as follows:
Debit Financial asset (gross carrying amount)
Credit Interest income (P/L: I)
Income earned on financial asset (interest income at the effective interest rate)
Debit Bank
Credit Financial asset (gross carrying amount)
Receipt of cashflow from financial asset (e.g. interest received at the coupon rate on a corporate bond)
The ‘amortised cost’ classification also requires the application of IFRS 9’s impairment requirements:
the expected credit loss model. This ‘expected credit loss model’ involves recognising a loss allowance
and a related ‘impairment loss’ (or reversal). This is journalised as follows:
Debit Impairment loss (E: P/L)
Credit Financial asset: Loss allowance (-A).
Recognising the loss allowance (this is an ‘asset measurement account’ i.e. a ‘negative asset’)
The loss allowance must be measured at each reporting date to reflect the ‘expected credit losses’. We
normally base this measurement on the estimated ‘12-month expected credit losses’, although,
depending on the situation, they may need to reflect ‘lifetime expected credit losses’.
How to measure this loss allowance is explained in more detail in section 4.
Assets classified at amortised cost (AC) must obviously be presented at amortised cost. The ‘amortised
cost’ is the ‘gross carrying amount’ (i.e. the balance per your effective interest rate table), less the ‘loss
allowance’: See IFRS 9.5.2.2
Asset’s closing carrying amount at ‘amortised cost’ (AC) = Net carrying amount (NCA) =
Gross carrying amount (GCA) – Loss allowance (LA)
Under amortised cost, all gains and losses are recognised in profit or loss. This includes the interest
income on the asset as well as the impairment loss (or gain) arising from the loss allowance.
See IFRS 9.5.7.2
Please note that if a financial asset that is classified at amortised cost is either already credit-impaired on
initial recognition, or became credit-impaired after initial recognition, then we do not use the same
effective interest rate method described above (i.e. the effective interest rate method would not involve
recognising interest income measured at the effective interest rate multiplied by the gross carrying
amount). Credit-impaired assets are explained in section 3.6.2.2.
Sometimes the terms relating to an asset are renegotiated or modified. Modifications are
explained in section 3.6.2.3.
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The measurement of the financial asset and its related interest income differs slightly from the
calculation described above if the asset is credit impaired:
If the financial asset becomes credit-impaired after initial recognition, the effective interest rate method
would involve calculating the effective interest rate (i.e. the ‘normal’ effective interest rate described in
section 3.6.2.1), but when calculating the effective interest income on this asset, this rate is applied to
the amortised cost of the asset (not to the gross carrying amount):
Interest income (if asset becomes credit-impaired) = Amortised cost x EIR.
If in a subsequent period, the asset's credit risk subsequently improves with the result that the asset is
no longer considered to be credit-impaired (e.g. if there is an improvement in the borrower’s credit
rating), then we would revert to measuring the asset’s carrying amount and related interest income in
the usual way, by applying the effective interest rate to the gross carrying amount:
Interest income (if asset ceases being credit-impaired) = Gross carrying amount x EIR
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In other words, we would apply the original effective interest rate to the gross carrying amount at
the start of the period in which the asset is no longer considered to be credit impaired. See section
4.2 for more detail. See IFRS 9.5.4.1-2
When we calculate this credit-adjusted effective interest rate (see pop-up for definition) we include:
x all contractual cash flows arising from the financial asset (i.e. based on the terms of the contract),
x but these are adjusted for the lifetime expected credit losses (i.e. we adjust the contractual cash flows
downwards to reflect the lifetime expected credit losses). See IFRS 9 Appendix A: defined term ‘credit-adjusted EIR
Please note, this differs from the calculation of the ‘normal’ effective interest rate which:
x involved discounting the future cash flows to the financial asset’s gross carrying amount, and
x included all contractual cash flows arising from the financial asset, but where these were not
adjusted for expected credit losses. (See section 3.6.2.1)
If the asset was credit-impaired on initial recognition, the asset and its interest income will always be
measured using a credit-adjusted effective interest rate applied to the amortised cost, even if the credit risk
subsequently improves.
When buying a financial asset that is already credit-impaired, the assumption is that the fair value
on initial acquisition would already reflect the expected losses inherent in the asset (i.e. the fair
value and transaction price will have already taken the expected losses into account, and thus the
price will already have been reduced). Thus, there is no loss allowance to recognise on initial
acquisition. Furthermore, the lifetime expected credit losses that existed on initial recognition date,
are already built into the credit-adjusted effective interest rate. For these reasons, the subsequent
loss allowance on this asset is measured at the changes to the lifetime expected credit losses since
initial recognition date (i.e. it is not measured at the amount of the lifetime expected credit losses
at reporting date, but at the increase or decrease in the lifetime expected credit losses since initial
recognition date). See IFRS 9.5.5.13
Sometimes the terms relating to an asset are renegotiated or modified. Depending on the extent of
the modification, this can lead to the asset being derecognised and a new asset recognised. The
derecognition of a financial asset is explained in section 5. However, if the renegotiation or
modification does not lead to the derecognition of the asset, the entity would need to:
x calculate the asset's revised gross carrying amount: this is done by calculating the present value of the
revised future contractual cash flows, discounted using the original effective interest rate; and
x recognise a modification gain or loss in profit or loss, based on the difference between the current
carrying amount and the revised gross carrying amount.
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The issuer paid all costs related to the negotiation of terms (i.e. Eternity did not incur any further transaction
costs). The debentures have never been considered to be credit-impaired.
Required: Prepare the journals for the year ended 31 December 20X6. Ignore the loss allowances.
3.6.3 Subsequent measurement: Financial assets at fair value through other comprehensive
income – debt instruments (IFRS 9.5.7 & 9.5.7.10-11 & 9.B5.7.1A)
If the financial asset is a debt instrument classified at fair FVOCI – debt instruments
value through other comprehensive income (FVOCI- are measured as follows:
debt), the asset is presented in the statement of financial x Initially at FV plus transaction costs.
position at an amount reflecting its fair value. All fair value x Subsequently measured:
adjustments are recognised in other comprehensive - 1st step: using the EIR method; &
income (OCI). - 2nd step: at FV.
x Tested for impairment
However, the objective of this classification is to provide x Gains or losses due to:
users with information on both a fair value basis and on - Changes in FV: recognised in OCI
(reclassify to P/L on derecognition),
an amortised cost basis. Thus, before we measure the - Anything else: recognised in P/L.
asset to fair value, we first measure it using the effective
interest rate method. Thus, the effect of the debt instrument on profit or loss should be the same
as if it had been classified and measured at amortised cost. See IFRS 9.BC5.119 & IFRS 9.5.7.11 & IFRS 9.B5.7.1A
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Debt instruments that are classified as fair value through other comprehensive income (FVOCI-
debt) are also subject to the impairment requirements of IFRS 9. These requirements involve
recognising a loss allowance to reflect the expected credit losses relevant to the asset,
remeasured at each reporting date.
The recognition and measurement of the loss allowance follow the same basic impairment
principles in IFRS 9 that are applied to assets classified at amortised cost (see sections 3.6.2.1-
2). However, when accounting for a loss allowance for assets classified FVOCI-debt instruments
there is one significant difference: the loss allowance will be recognised in ‘other comprehensive
income’ and not as an ‘asset measurement account’ as was the case for assets classified at
amortised cost. In other words, the carrying amount of a financial asset classified at FVOCI-debt
will not be presented net of the loss allowance. The reason for this is that the asset is measured
at its fair value, which already reflects the credit risk specific to the asset. However, although the
‘loss allowance’ is recognised in other comprehensive income, the related ‘loss allowance
adjustments’ (impairment losses/ reversals) are recognised in profit or loss. See IFRS 9.5.2.2
Thus, the steps to follow for debt instruments classified at FVOCI (FVOCI-debt) are as follows:
Step 1: Measure the asset as if it were classified at amortised cost, and in so doing, recognise
interest income, (as well as foreign exchange gains or losses, refer to section 3.6.1),
presenting them all in profit or loss.
Step 2: Recognise a loss allowance for the expected credit losses. Remember that this loss allowance
is recognised in other comprehensive income (i.e. it is not an asset measurement account – in
other words, it will not be set-off against the carrying amount of the financial asset). Although
the loss allowance is recognised in other comprehensive income, the related loss allowance
adjustments (impairment losses/ reversals) are recognised in profit or loss.
Step 3: The entity then remeasures the asset to its fair value at reporting date and recognises
the related fair value adjustment in other comprehensive income. These cumulative fair
value gains or losses recognised in other comprehensive income will eventually be
reclassified to profit or loss, but only upon derecognition. See IFRS 9.5.7.10
20X5 20X6
1 January Dr/ (Cr) Dr/ (Cr)
FA: Debentures at FVOCI (A) Fair value 200 000 + 202 000 N/A
Bank Transaction costs (200 000 x 1%) (202 000) N/A
Purchase of debentures at FVOCI (thus add transaction costs)
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20X5 20X6
1 January continued … Dr/ (Cr) Dr/ (Cr)
Impairment loss (E: P/L) Given 7 000 N/A
FA: Debentures: Loss allowance (OCI) See note 1 (7 000) N/A
Recognising a loss allowance, measured at the appropriate ECL (given)
31 December
Bank Face value: 200 000 x Coupon rate: 10% 20 000 20 000
Interest income (I: P/L) Per EIR Table (see Example 6: W1) (33 610) (35 874)
FA: Debentures at FVOCI (A) Balancing 13 610 15 874
Recognising interest earned on debentures, measured using EIR method
(as if the asset was classified at amortised cost!), and cash received
Impairment loss (E: P/L) 20X5: ECL at reporting date: 10 000 – o/b: 7 000 3 000 2 000
20X6: ECL at reporting date: 12 000 – o/b: 10 000
FA: Debentures: Loss allowance (OCI) See note 1 (3 000) (2 000)
Remeasuring the loss allowance to reflect the ECLs at each reporting date
FA: Debentures at FVOCI (A) 20X5: FV 260 000 – Bal in this a/c: 215 610 Calc 1 44 390 4 126
20X6: FV 280 000 – Bal in this a/c: 275 874 Calc 2
Fair value gain (I: OCI) Balancing (44 390) (4 126)
Remeasuring debentures to FV at reporting date, with FV adjustment
recognised in OCI (because classified at FVOCI-debt)
Note 1: Since the FA was measured at FVOCI-debt, this loss allowance is recognised in OCI and is NOT a
‘negative asset’ measurement account
Calculations: Balance in the FA account just before the FV adjustment can be calculated using journals or Ex 6 W1:
1) 20X5: Using journals = o/bal 0 + 202 000 + 13 610 = 215 610; or
Using Ex 6 W1 = 215 610
2) 20X6: Using journals = o/bal 260 000 + 15 874 = 275 874; or
Using Ex 6 W1 =: 231 484 + FV adj: 44 390
= 275 874
Notice: The journals are very similar to those in example 6, however, the loss allowance is now
recognised in OCI and there is an additional journal for the fair value adjustment.
As mentioned previously (section 3.6.1), if our financial asset involves foreign currency (e.g. we
have invested in bonds denominated in a foreign currency), then we must bear in mind the
requirements of IAS 21 The effect of changes in foreign exchange rates. In this regard, IAS 21
requires that the foreign exchange gains or losses on monetary items (e.g. debt instruments)
always be recognised in profit or loss, but that foreign exchange gains or losses on non-
monetary items (e.g. equity instruments) must be recognised in the same component (P/L or
OCI) that any fair value gains or losses are recognised. Thus, since debt instruments are
monetary items, all foreign currency exchange differences will be recognised in profit or loss,
even if the debt instrument is classified at FVOCI, and thus its fair value gains or losses are
recognised in OCI. When dealing with foreign currency denominated transactions, it is
important to do all the calculations (e.g. calculate the effective interest rate and the interest
earned etc) in foreign currency, and only after all amounts have been calculated, translate the
amounts using the relevant exchange rates (e.g. spot rates or average rates etc.). Please see
chapter 20.
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J&M purchased these debentures for $200 000 on 1 January 20X5. The debentures are compulsorily
redeemable at $250 000 on 31 December 20X6. Coupon payments (at 10% of cost) are made in arrears
on 31 December each year.
The fair value on 31 December 20X5 was $240 000.
The asset was not considered to be credit-impaired at any stage. Ignore any loss allowance.
Exchange rates (Rand: Dollar) were as follows:
Date 20X5 20X6
1 January R10.0: $1 R10.3 $1
31 December R10.3: $1 R13.3: $1
Average exchange rate R10.2: $1 R11.5: $1
Required: Prepare the journals for the year ended 31 December 20X5 and 20X6.
20X5 20X6
1 January Dr/(Cr) Dr/(Cr)
FA: Debentures at FVOCI (A) W1 (EIRT) 2 000 000 -
Bank (A) (2 000 000) -
Purchase of debentures
31 December
FA: Debentures at FVOCI (A) Balancing 228 459 279 169
Bank (A) W1 (EIRT) 206 000 266 000
Interest income (I: P/L) W1 (EIRT) (434 459) (545 169)
Interest earned & interest received on debentures
FA: Debentures at FVOCI (A) W1 (EIRT) 64 259 753 113
Forex gain (I: P/L) (64 259) (753 113)
Foreign exchange gain on debentures
FA: Debentures at FVOCI (A) 20X5: FV: $240 000 x 10.3 – GCA: 179 281 -
Fair value gain (I: OCI) 2 292 719 (179 281) -
20X6: FV = GCA, thus no FV adj.
Fair value gain on debentures at FVOCI
Bank $250 000 x 13.3 3 325 000
FA: Debentures at FVOCI (A) (3 325 000)
Redemption of debentures
Chapter 21 1003
Gripping GAAP Financial instruments – general principles
Notice: This calculation can be confusing if performed in the incorrect sequence. As a rule of thumb,
financial assets subsequently measured at FVOCI-debt should be translated and measured by applying
the following steps:
Step 1. Calculate the effective interest rate (EIR) in the foreign currency.
Step 2. Prepare the effective interest table in the foreign currency.
Step 3. Translation difference: Translate the effective interest table into the entity’s functional
currency, using the relevant exchange rates (spot or average, as the case may be). Restate
the GCA at the spot rate at year-end. The adjustment must be recognised in P/L as foreign
exchange gain or loss. See IAS 21.28
Step 4. Fair value adjustment: Translate the fair value into the functional currency at the spot rate
at year-end. The FV less the GCA (both in the functional currency) reflects a cumulative
gain or loss which must be recognised in OCI. In subsequent periods, the gain or loss to be
recognised is determined by deducting the cumulative gain/loss in the prior period from the
cumulative gain/loss in the current period.
3.6.4 Subsequent measurement: Financial assets at fair value through other comprehensive
income – equity instruments (IFRS 9.5.7.5-6 & IFRS 9.B5.7.1-2)
However, if the dividend is not received immediately (i.e. the dividend has been declared, but we have
not received the cash), the usual approach is to debit a separate ‘receivable’ (e.g. debit dividend
receivable, credit dividend income). However, IFRS 9 is silent on this issue and thus one could debit the
carrying amount of the investment, if preferred (e.g. debit investment in equity; credit dividend income).
When the cash flow occurs, we will reduce the carrying amount of the financial asset (whether a
‘receivable’ or the ‘investment in equity’) and recognise the receipt of cash. In other words, we account
for it as follows:
x Earn the dividend: Debit dividend receivable (or investment in equity); Credit dividend income
x Receive the dividend: Debit bank, Credit dividend receivable (or investment in equity).
Please note that the FVOCI-debt classification and the FVOCI-equity classification have some significant
differences (these are listed below):
x Assets at FVOCI-debt are first measured at amortised cost before being measured to fair value. This
is not the case for assets at FVOCI-equity.
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x There are no impairment tests required for an equity instrument at FVOCI. This is because
impairment testing focuses on credit risk, and whilst credit risk exists on debt instruments, it does
not exist in the case of equity investments (because there are no contractual cash flows on which
the counterparty may default).
x The treatment of foreign exchange gains or losses will differ. This is due to the requirements of
IAS 21 The effects of changes in foreign exchange rates and is explained as follows:
- An investment in an equity instrument is a non-monetary asset (because it does not meet the
definition of a monetary item: it is not an asset that will be received in a fixed or determinable number
of currency units).
This is important because IAS 21 requires that, in the case of non-monetary assets, a foreign
exchange gain or loss must be recognised in the same component as the related fair value gain or
loss (i.e. in P/L or OCI).
Thus, since investments in equity instruments are measured at fair value, with fair value gains or
losses recognised in OCI, any related foreign exchange difference must also be recognised in OCI.
- By contrast, an investment in a debt instrument meets the definition of a monetary item, and thus,
in terms of IAS 21, all foreign exchange differences are simply recognised in P/L.
See chapter 20 for more detail. See IAS 21.30
x Dividends earned on equity instruments at FVOCI (i.e. FVOCI-equity) are recognised as dividend
income (unless they reflect a partial recovery of the asset’s cost), but dividends earned on debt
instruments at FVOCI (FVOCI-debt) (e.g. an investment in redeemable preference shares) are
recognised as interest income under the effective interest rate method.
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3.6.5 Subsequent measurement: Financial assets at fair value through profit or loss
The classification of fair value through profit or loss (FVPL) includes the entire spectrum of
financial assets: investments in equity, debt, and all derivatives. Compare this with the
classification of:
x FVOCI-debt, which only applies to debt instruments,
x FVOCI-equity, which only applies to investments in equity instruments, &
x Amortised cost, which only applies to debt instruments.
However, it is important to remember that, if the financial asset is an investment in an equity instrument
that generates dividends, these dividends would be recognised in profit or loss only if and when certain
criteria are met (see the pop-up under section 3.6.4 for the 3 criteria that must be met before dividend
income may be recognised).
Foreign exchange gains/ losses are recognised in profit or loss whether the financial asset is a
monetary (e.g. loan receivable) or non-monetary (e.g. equity) item. See IAS 21.28 & .30 & IFRS 9B5.7.2
This FVPL classification is not subject to any impairment requirements. Impairment tests focus
on the credit risk relating to the asset's contractual cash flows. Thus, the impairment test would
not apply to an investment in equity instruments classified at FVPL (because there are no
related contractual cash flows). But the point is that the impairment test does not apply to any
asset classified at FVPL – even to assets that do have contractual cash flows, such as loan
assets. The reason for this is that financial assets at FVPL are measured at fair value, which
already reflects credit risk and since the fair value adjustments are recognised in profit or loss,
the effects of credit risk will have automatically been recognised in profit or loss. See IFRS 9.5.2.2
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The ECL model will thus apply to the following classifications, where, by definition, the 'collection of
contractual cash flows' is integral to the entity’s business model:
x The ‘amortised cost’ classification (AC); and
x The ‘fair value through other comprehensive income - debt’ classification (FVOCI-debt), being a
classification that includes only financial assets that involve debt instruments.
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As mentioned earlier, the ‘FVOCI’-debt’ classification does involve the recognition of a loss allowance.
Notice that this is despite the fact that the financial asset will be measured at fair value, where fair value
already reflects the effects of credit risk. The reason for this is that, when we use this classification, the
related fair value adjustments are recognised in other comprehensive income (OCI).
x The ‘problem’ with this is that IFRS 9 states that the effects of any change to the asset’s
credit risk must be recognised in profit or loss (P/L).
x So, to fix this problem, we need to process a journal that:
- will reflect the asset’s changing credit risk within profit or loss (i.e. debit impairment loss
or credit impairment reversal), and then,
- in order to avoid double-counting the negative effects of credit risk on the asset’s
carrying amount (because it is already measured at fair value), this journal must
recognise the related ‘loss allowance’ in other comprehensive income (OCI).
x In other words, in the case of a financial asset classified at FVOCI-debt, the loss allowance
will not be recognised as an ‘asset measurement account’ that reduces the financial asset’s
carrying amount. Instead, it will be recognised in OCI (part of equity). Also, because the
impact on ‘profit or loss’ of a financial asset classified at FVOCI-debt must be the same as
if it was classified at AC instead, when we recognise the loss allowance (or subsequently
adjust the loss allowance balance), the contra entry must be recognised in profit or loss
(e.g. Debit Impairment expense (P/L) and Credit Loss allowance (OCI)).
Thus, the impact of the principles explained above, is that the ECL model results in the following journals:
The ECL model requires that a loss allowance be recognised for financial assets classified at
amortised cost. This loss allowance is an ‘asset measurement account’ (with a credit balance)
that effectively reduces the carrying amount of the financial asset. When recognising this loss
allowance account, the contra-entry is an impairment loss adjustment (an expense), recognised
in profit or loss. The journal would be as follows:
Debit Credit
Impairment loss (P/L: E) xxx
Financial asset: loss allowance (-A) xxx
Recognising the loss allowance on a FA at amortised cost
The ECL model requires that a loss allowance be recognised for financial assets that are
investments in debt instruments classified at fair value through other comprehensive income
(FVOCI-debt). However, as explained above, although the impairment loss is recognised
in profit or loss, the related loss allowance account is not recognised as an ‘asset
measurement account’ (i.e. it does not reduce the carrying amount of the financial asset).
Instead, the loss allowance is recognised as 'other comprehensive income' (i.e. part of
equity). The journal would thus be as follows:
Debit Credit
Impairment loss (P/L: E) Note 2 xxx
Loss allowance on financial asset (OCI) Note 1 xxx
Recognising the loss allowance on a FA at FVOCI
Notes:
1) Remember, the fact that the loss allowance is recognised in OCI, (instead of as an ‘asset
measurement account’ that reduces the asset’s carrying amount), does not result in the asset
being overstated. This is because assets in this classification are measured at fair value, where
fair value automatically reflects the market’s reaction to the asset’s credit risk.
2) Remember that IFRS 9 requires that the effects of credit risk of an asset at ‘FVOCI-debt’ must
be measured and reflected in profit or loss (P/L) as if it were an asset at ‘amortised cost’ (AC),
instead. Thus, the adjustment to the loss allowance must be recognised as an impairment loss
(or impairment reversal) in profit or loss. Notice that the effects of the credit risk will not be double-
counted in profit or loss because the fair value adjustments (which automatically include the
effects of changing credit risk) are recognised in other comprehensive income (OCI) and not in
profit or loss (P/L).
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The ECL model does not only apply to the financial assets referred to above. Instead, the ECL
model applies to all the following assets:
x Financial assets at amortised cost (AC);
x Financial assets (debt) at fair value through other comprehensive income (FVOCI-debt);
x Lease receivables (see IFRS 16 Leases);
x Contract assets and trade receivables (see IFRS 15 Revenue from Contracts with Customers);
x Loan commitments and certain financial guarantee contracts. See IFRS 9.5.5.1 & 15
The principles underlying the recognition of the loss allowance apply equally to both the general and
simplified approaches. The only difference is in the measurement of the loss allowance.
Financial assets are initially measured at fair value, where this Expected credit losses
fair value will reflect the asset’s credit risk on this initial are calculated as –
recognition date. If the general approach is followed (and a probability-weighted estimate of
assuming the asset is not already credit-impaired on initial credit losses (i.e. the present value
recognition), the loss allowance on initial recognition would be of all cash shortfalls)
measured at 12-month expected credit losses. The loss over the expected life of the
allowance is then remeasured at each reporting date based on financial instrument. IFRS 9.B5.5.28
an assessment of the changes in credit risk since this initial recognition date. Depending on the level
of change in credit risk on reporting date, we will categorise the asset as being stage 1, stage 2 or
stage 3. Depending on this assessment, the loss allowance will be measured either at an amount
equal to ‘12-month expected credit losses’ or ‘lifetime expected credit losses’.
Chapter 21 1009
Gripping GAAP Financial instruments – general principles
However, an exception to the above general approach is in the case of assets that were ‘already
credit-impaired’ on initial recognition. In this case no loss allowance is recognised on initial recognition
of the asset (this is explained in section 4.3.1.2), but a loss allowance would be recognised at each
subsequent reporting date, measured at the ‘change in lifetime expected credit losses since initial
recognition’. Financial assets that are already credit-impaired on initial recognition were explained in
section 3.6.2.2 and are also referred to again in section 4.3.2. See IFRS 9.5.5.13-14
The simplified approach requires that the loss allowance always be measured at lifetime expected
credit losses. See section 4.5 for when to use and how to use this approach.
4.3 Expected credit loss model – the general approach (IFRS 9.5.5.1–14 & B5.5.33)
4.3.1 Assessment of credit risk on initial recognition date
If the assessment of the credit risk on initial recognition date Expected credit losses
are defined as –
indicates that the financial asset is not ‘already credit-impaired’
on initial recognition, then the loss allowance initially The weighted average of
recognised is measured at an amount equal to the credit losses credit losses with
expected in the next 12 months (i.e. the 12-month expected the respective ‘risks of a default
occurring’ as the weights IFRS 9 App A
credit losses calculated from date of initial recognition).
The journal entries to recognise the purchase of the financial asset (that is not credit-impaired) and the
related loss allowance assessed on initial recognition date would be as follows:
On initial recognition date Debit Credit
Financial asset (A) xxx
Bank (A) xxx
Purchase of financial asset that is not credit impaired on initial recognition
Impairment loss (P/L: E) xxx
Financial asset: loss allowance (-A or OCI) Note 1 xxx
Recognising loss allowance of financial asset that is not credit impaired on
initial recognition
Note 1: Remember the loss allowance of a financial asset recognised at amortised cost is recognised as an
‘asset measurement account’ (i.e. it has a credit balance, that reduces the asset’s carrying amount), whereas
the loss allowance of a financial asset recognised at FVOCI-debt will be recognised in OCI. (See section 4.1).
If the assessment of the credit risk on initial recognition date indicates that the financial asset is ‘already
credit-impaired’ on initial recognition date, then we do not recognize a separate loss allowance on
this date. This is because, since the asset was already in a credit-impaired state on initial
recognition, its fair value would already reflect this fact and recognizing a loss allowance on top
of this would simply be double-counting. Furthermore, since the asset’s credit risk is so serious
on initial recognition, we will be measuring the asset’s interest income and subsequent carrying
amount using a credit-adjusted effective interest rate. This is calculated by taking into account
the expected cash flows rather than the contractual cash flows (i.e. the rate takes into account
the contractual cash flows after adjusting for the expected credit losses that were estimated
when assessing the credit risk on this initial recognition date). (Please also see section 3.6.2.2)
The result of this is that the expected credit losses that were estimated based on the assessment of
credit risk on initial recognition date will automatically be recognized by way of a lower interest income
over the life of the asset, which also ensures that the asset has a lower carrying amount.
Thus, in other words, recognizing a loss allowance for the credit risks that existed on initial
recognition date would be duplicating the effects of having built this credit risk into the credit-
adjusted effective interest rate, which is then used in the measurement of the asset. See IFRS 9.5.5.13
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The journal entry to account for the purchase of a financial asset that is already credit-impaired
would be as follows:
On initial recognition date Debit Credit
Financial asset (A) Note 1 xxx
Bank (A) xxx
Purchase of financial asset that is credit impaired on initial recognition
Note 1: Notice that there is no separate journal to record a loss allowance on initial recognition. This is
because the asset’s credit risk is so serious, that a credit-adjusted effective interest rate will be determined
for the financial asset. Thus, any initial expected credit losses will be taken into account indirectly through
lower interest income recognised. A loss allowance will be recognised at subsequent reporting dates to reflect
the cumulative change in lifetime expected credit losses since initial acquisition. See IFRS 9.5.5.13
4.3.2.1 Overview
We need to re-assess the credit risk of the financial asset at each reporting date after initial
recognition and, depending on the outcome of this assessment, we must either
x continue measuring the loss allowance at an amount equal to the latest estimate of the '12-
month expected credit losses'; or
x if the credit risk has deteriorated significantly, we must measure the loss allowance at an
amount equal to the latest estimate of the 'lifetime expected credit losses'. See IFRS 9.5.5.9
The measurement of the loss allowance relating to an asset that was ‘already credit-impaired
on initial recognition’ must always equal the latest estimate of ‘the cumulative changes in
lifetime expected credit losses since initial recognition'. In other words, the measurement of the
loss allowance may never be changed to reflect 12-month expected credit losses. See IFRS 9.5.5.13
The assessment of whether there has been an increase in credit risk needs to consider all
reasonable and supportable information, including information that is forward-looking. We may
perform this assessment on an individual asset basis or on a collective basis. See IFRS 9.5.5.4
To assess if there has been a significant increase in the credit risk of a financial asset, we must focus
on the change in the risk of default (or probability of default: PD) occurring during the life of the financial
instrument, rather than the change in the amount of the expected credit losses. Thus, to determine
whether there has been a significant increase in credit risk, we compare the risk of default as at
reporting date with the risk of default that existed on initial recognition. In other words, a significant
increase in the amount of the expected credit losses since initial recognition is not an indication that
there has been a significant increase in the asset's credit risk. See IFRS 9.5.5.9
If a financial asset is regarded as having a low risk of default at the reporting date, then the
entity may automatically assume that there has not been any ‘significant increase in credit risk’
since initial recognition. See IFRS 9.5.5.10
There is a rebuttable presumption that if the contractual cash flows on a financial asset are 30 days or more
‘past due’ (30 days or more overdue), that there has been a ‘significant increase in credit risk’. See IFRS 9.5.5.11
If the contractual terms of a financial asset are modified, the basis for assessing the change in
credit risk is a comparison between the risk of default at reporting date, using the modified
contractual terms, and risk of default at initial recognition, based on original terms. See IFRS 9.5.5.12
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Gripping GAAP Financial instruments – general principles
4.3.2.3 The effect of the credit risk assessment at subsequent reporting dates
When a financial asset is already credit-impaired on initial recognition, the entity shall always
apply the credit-adjusted effective interest rate to the amortised cost of the financial assets.
See IFRS 9.5.4.1(a)
Was mentioned above (section 4.3.2.2), where the financial asset is not credit impaired on date
of initial recognition, the remeasurement of the loss allowance to reflect the expected credit loss
at reporting date must be determined by comparing the assessment of the financial asset's
credit risk (risk of default) at reporting date with its credit risk (risk of default) at initial recognition.
We then categorise our financial asset into one of the following 3 stages:
x Stage 1:
If our asset's credit risk has not increased significantly since initial recognition, then our
asset is considered to be 'performing' and falls into stage 1.
We can assume the credit risk has not increased significantly if the credit risk is low.
If our asset falls into stage 1:
- the loss allowance continues to reflect only '12-month expected credit losses', and
- interest revenue is calculated by applying the effective interest rate to the gross carrying
amount.
For an example of this, see example 12A and example 13A.
x Stage 2:
If the asset's credit risk has increased significantly since initial recognition, but there is no
objective evidence that it is credit-impaired, then it is said to be 'under-performing' and falls
into stage 2.
If our asset falls into stage 2:
- the loss allowance is increased to reflect 'lifetime expected credit losses', but
- interest revenue is still calculated by applying the effective interest rate to the gross
carrying amount.
For an example of this, see example 12B, example 13B and example 14A.
x Stage 3: A credit-impaired
financial asset is defined
If objective evidence exists that the asset has become as a FA:
credit-impaired (i.e. events have already taken place that x whose estimated future cash flows
have decreased the asset's estimated future net cash x have been detrimentally affected
inflows), then our asset is considered to be 'not-performing' x by an event that has already
and falls into stage 3. occurred. IFRS 9 Appendix A (Reworded).
By present-valuing the contractual and expected cash flows, we are taking into account the timing of
these cash flows. Due to the time value of money, receiving a contractual cash flow later than expected
will result in a lower present value of the financial asset. Thus, a credit loss will be recognised even if
the cash flows are merely expected to be late. See IFRS 9.B5.5.28
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If the financial assets are not credit-impaired at initial recognition but subsequently become
credit-impaired (that means the asset would be categorised as stage 3), the lifetime expected
credit losses are measured as the difference between the gross carrying amount of the financial
asset and the present value of the estimated future cash flows discounted using the original
effective interest rate (i.e. Lifetime credit losses for a credit-impaired asset = GCA – PV of
estimated future cash flows, discounted using the original EIR). See IFRS 9.B5.5.33
The ’12-month expected credit loss’ is the portion of the lifetime expected credit loss (see
section 4.3.2.4) reflecting the present value of the lifetime cash shortfalls that would result if a
default had to occur within the next 12 months after reporting date, weighted by the probability
that the default will occur within this period. See IFRS 9.B5.5.43
This means that the entity must consider what percentage of the asset it stands to forfeit if the
financial asset had to default within the next financial year, as well as the probability that this
will occur within this 12-month period.
A ‘credit loss’ refers to the present value of the total remaining cash shortfalls over the life of
the asset’ (‘contractual cash flows that should be received’ less ‘cash flows expected to be
received’, discounted at either the original effective interest rate, or the credit-adjusted effective
interest rate if the asset was already credit-impaired on initial recognition).
The ‘expected credit loss’ is the credit loss adjusted for the probabilities of default.
When an entity measures ‘expected credit losses’ on a financial instrument, it shall use
information that reflects the following:
x probability-weighted amounts that consider a range of possible outcomes,
x time value of money, and
x readily available information that is reasonable and supportable and falls within the
contractual period over which the entity is exposed to credit risk. IFRS 9.5.5.17-19
Please note that when we say that an expected credit loss must be measured using probability-
weighted amounts, it does not mean that every possibility must be identified and taken into
account in the calculation. However, credit losses must be built into the calculation of ‘expected
credit loss’ even if the possibility of the loss occurring is very low (i.e. the low probability is
simply built into the measurement thereof). See IFRS 9.5.5.18
The following events may indicate that a financial asset has become credit-impaired:
Chapter 21 1013
Gripping GAAP Financial instruments – general principles
Gross carrying amount (GCA) is defined as the amortised cost of a FA, before adjusting for any loss allowance *
Amortised cost is the gross carrying amount after adjusting for any loss allowance (GCA – Loss allowance)
The financial asset is classified at amortised cost and has an effective interest rate of 10%.
Required:
Calculate the loss allowance balance at 31 December 20X2, the interest income to be recognised for
the year ended 31 December 20X2 and for the year ended 31 December 20X3, assuming that the
assessment at 31 December 20X2 was that:
A. there was no significant increase in credit risk since initial recognition (i.e. the asset was stage 1).
B. there was a significant increase in credit risk since initial recognition (i.e. the asset was stage 2).
C. the asset had become credit-impaired (i.e. the asset was stage 3).
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Required:
Discuss how Joyous should account for the expected credit losses on the financial instrument for the year
ended 31 December 20X4 and show the journals for the initial recognition and any journal adjusting the
loss allowance at year-end assuming the asset does not qualify for the simplified approach and that:
A. At 31 December 20X4, the lifetime expected credit loss remained unchanged, but the probability of
default increased to 1,5%, although this was not considered a significant increase in credit risk.
B. At 31 December 20X4, Joyous becomes aware that Sadness is considering filing for protection from
its creditors as it was possibly facing bankruptcy. This is assessed by the directors of Joyous to be
an objective indicator that Sadness will not be able to discharge all its financial obligations.
Consequently, the probability of default increased to 40%, which is considered to be a significant
increase in credit risk, although the lifetime expected credit loss remained unchanged.
Solution 13: Loss allowance – effect of increase in credit risk (AC – the basics)
By estimating that there is a 0.5% probability of a default occurring within the first 12 months, Joyous is
implicitly stating that there is a 99.5% probability that there will be no default in the first 12 months.
However, the total expected loss should a default occur is 20%. In other words, the ‘loss given default’
(LGD) is equal to 20%. However, our loss allowance must only equal the expected credit losses over the
next 12-month period.
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Gripping GAAP Financial instruments – general principles
x At initial recognition (02/01/20X4): Joyous must recognise a loss allowance equal to the 12-month
expected credit losses: C100
Exposure x LGD x Probability of default over 12 months [PD] =
= Amount receivable x % loss if the customer defaults during asset’s lifetime x probability of this
default occurring within 12 months
= C100 000 x 20% x 0.5% = C100
Therefore, at initial recognition, Joyous recognises the financial asset and also recognises an
allowance for credit losses equal to C100.
Although there has been an increase in the probability of default (from 0.5% to 1,5%), this was not
considered to be a significant increase in the credit risk of Sadness since initial recognition. Thus,
the loss allowance must still reflect '12-month expected credit losses'. The 12-month expected credit
loss has, however, increased to C336:
Exposure x LGD x Probability of default over 12 months [PD] =
= Amount receivable x % loss if the customer defaults during asset’s lifetime x probability of this
default occurring within 12 months
= (100 000 + interest income 12 000 – receipts: 0) x 20% x Probability 1,5% = C336.
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Solution 14: Loss allowance – significant increase in credit risk (AC – complete picture)
Comment:
x This example compares the situation of an asset, which is not credit-impaired on initial recognition
that experiences a significant increase in credit risk, but where there:
- was no objective evidence of it becoming credit-impaired (see Part A);
- was objective evidence of it becoming credit-impaired (see Part B).
x Notice that this example gave us the 12m ECLs and Lifetime ECLs and thus we did not have to
calculate these, as was the case in the prior example (example 13).
x The FA is classified at amortised cost & thus (1) it is initially measured at fair value plus transaction
costs (2) a loss allowance must be recognised and (3) the general approach applies to the
measurement thereof.
x Using the general approach, we assess if the asset is credit-impaired on initial recognition. Since it is not,
the effective interest rate method involves using a ‘normal’ effective interest rate (not a ‘credit-adjusted
effective interest rate’).
x At 31 December 20X4, the reporting date, the debenture’s credit risk had significantly increased
since initial recognition and thus the loss allowance must, at this date, be measured at 'lifetime
expected credit losses'.
Furthermore:
- Part A only: Since the asset has not become credit-impaired, (it is at stage 2), the interest
income recognised in future periods will continue to be calculated as: GCA x EIR.
- Part B only: Since the asset has become credit-impaired, (it is at stage 3), the interest income
recognised in future periods will now be calculated as: Amortised cost x EIR.
In this regard, notice that since ‘amortised cost’ means ‘gross carrying amount – loss allowance’,
when we apply the EIR to the amortised cost, it means that both the ‘gross carrying amount’ and the
‘loss allowance’ are now being unwound at the effective interest rate.
Chapter 21 1017
Gripping GAAP Financial instruments – general principles
x At 31 December 20X5, the situation remains unchanged (the credit risk is still significantly higher than
at initial recognition date) and thus the loss allowance must still reflect lifetime expected credit losses
(though notice the lifetime expected credit losses have increased since the previous reporting date).
x Notice that, after an asset has become credit-impaired, the related interest income is lower than if it had
not become credit-impaired (interest income in 20X5 is C46 783 in Part A versus C45 126 in Part B).
This difference plays out in the impairment loss adjustment and thus the net effect on profit or loss is the
same (in both Part A and Part B, the net income in 20X5 is C44 283).
x Notice that, whether the asset has become credit-impaired or not, the statement of financial
position would still reflect the asset at its amortised cost.
31/12/20X5: Financial asset = GCA 494 129 – Loss allowance: 17 500 = C476 629 (amortised cost)
31/12/20X6: Financial asset = GCA 495 912 – Loss allowance: 20 000 = C475 912 (amortised cost)
Part A Part B
Journals Not credit- Credit-
impaired impaired
2 January 20X4 Dr/ (Cr) Dr/ (Cr)
Debentures: amortised cost (A) 5 000 x C98 490 000 490 000
Bank (A) (490 000) (490 000)
Purchase of debentures at fair value classified at amortised cost
Debentures: amortised cost (A) 2 500 2 500
Bank (A) (2 500) (2 500)
Transaction costs capitalised
31 December 20X4
Bank (A) 5 000 x C100 x 9% 45 000 45 000
Debentures: amortised cost (A) Balancing 1 629 1 629
Interest income (I) W1; Or GCA: (490 000 + 2 500) x EIR: 9.4678% (46 629) (46 629)
Recognition of interest income (effective interest rate) and interest
received (coupon rate)
31 December 20X5
Bank (A) 5 000 x C100 x 9% 45 000 45 000
Debentures: amortised cost (A) Balancing 1 783 1 783
Interest income (I) Part A: GCA: 494 129 (W1) x EIR: 9.4678% (46 783) (45 126)
Part B: Amortised cost: (GCA: 494 129 (W1) –
loss allowance: 17 500) x EIR: 9.4678%
Debentures: loss allowance (-A) Part B only: 17 500 x EIR 9,4678% N/A (1 657)
Recognition of interest income (effective interest rate) and interest
received (coupon rate) (EIR method)
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4.5 Expected credit loss model – the simplified approach (IFRS 9.5.5.15)
There is a simplified approach to the measurement of the loss allowance, where the loss
allowance is always measured at the lifetime expected credit losses.
This simplified approach is not available to all assets. An entity must use the simplified approach for
certain assets and has a choice as to whether to use it for other assets:
The entity may choose to use the simplified approach (i.e. as an accounting policy choice) for:
x a trade receivable or contract asset accounted for in terms of IFRS 15 Revenue from Contracts
with Customers if it does involve a significant financing component that has not been ignored (we
could also choose to apply the simplified approach to the ‘trade receivable’ but not to ‘contract
assets’, or vice versa, but we must simply apply the accounting policy consistently);
x a lease receivable accounted for in terms of IFRS 16 Leases (we can also choose to apply the
simplified approach to ‘lease receivables from finance leases’ and not to ‘lease receivables from
operating leases’, or vice versa, but we must simply apply the accounting policy consistently).
Required:
Provide the journal entries for the years ended 31 December 20X5 and 20X6.
Chapter 21 1019
Gripping GAAP Financial instruments – general principles
Joyous has a portfolio of trade receivables of C9 250 000 at 31 December 20X4. The trade
receivables do not have a significant financing component in terms of IFRS 15.
Joyous has constructed a reliable provision matrix to determine expected credit losses for the portfolio.
This provision matrix, based on the expected default rates per ageing category, has been included in the
current age analysis of trade receivables as follows:
Gross carrying amount Provision matrix reflecting
expected default rates
Current C3 750 000 0,30%
1 – 30 days past due C3 500 000 1,75%
31 – 60 days past due C1 000 000 3,60%
61 – 90 days past due C750 000 5,75%
More than 90 days past due C250 000 9,00%
Grand total C9 250 000
Required: Provide the loss allowance journal that will be processed assuming the balance in this account
at 31 December 20X3 was C50 000.
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Debit Credit
Impairment loss (E) ECL at reporting date: 174 125 (W1) - 124 125
Trade receivables: loss allowance (-A) Balance in this account: 50 000 124 125
Remeasurement of loss allowance on trade receivables based on lifetime
expected credit losses (because using the simplified approach)
5.1 Overview
Derecognition is
defined as:
A financial asset may only be derecognised if either of the
following criteria are met: x the removal of
x a previously recognised FA/ FL
x The contractual rights to the financial asset's cash flows
x from an entity’s SOFP. IFRS 9 App A
have expired; or
x The entity has transferred a financial asset, and this transfer qualifies for derecognition. See IFRS 9.3.2.3
We may need to assess whether to derecognise a single financial asset or a group of similar
financial assets. Furthermore, we may need to consider the derecognition of the entire financial
asset (or the entire group of similar financial assets), or a part thereof. These are important issues
to establish because the criteria that need to be met before derecognition occurs will need to be
applied to the single asset, group of assets, and to the whole or part thereof. See IFRS 9.3.2.2
Let us now look at the criteria for derecognition (referred to above). If the financial asset’s cash flows
have expired, then we must process the derecognition. However, a financial asset that is transferred
may not necessarily qualify for derecognition. In fact, there are three possible outcomes:
x The transfer does qualify for derecognition;
x The transfer does not qualify for derecognition; or
x The transfer entails continuing involvement.
The reason we have to be very careful before derecognising a financial asset that has been
transferred is because, in the past, entities were found to be hiding the existence of financing
liabilities by derecognising financial assets that they had argued had been ‘transferred’. For
example, an entity might need C100 000 in cash and manage to raise the cash, but instead of
recognising it as a liability (debit bank and credit liability), the entity creates a clever transaction
in which it derecognises an asset instead (debit bank and credit asset), but where this asset is,
in substance, still the entity’s asset. Although the impact on net assets is the same, entities often
prefer to reduce their assets than to increase their liabilities.
Chapter 21 1021
Gripping GAAP Financial instruments – general principles
A financial asset is considered to have been transferred if the following criteria are met:
x The entity has transferred its contractual right to receive the financial asset's cash flows
(e.g. the entity has sold the asset); or
x The entity has retained its contractual right to receive the financial asset's cash flows, but
has assumed a contractual obligation requiring it to pay these cash flows 'to one or more
recipients in an arrangement that meets' all three of the following conditions:
x The entity is not obliged to pay the recipients 'unless it collects equivalent amounts from
the original asset' (i.e. if we do not receive the cash flows from the asset, then we have
no obligation to pay the recipient).
If this criterion is not met (i.e. if we will have to pay the recipient even if we do not
receive the cash flows from the asset), then it would seem that we have an obligation
and thus we should credit a liability instead of derecognising the asset.
x The transfer contract contains terms that prohibit the entity from selling or pledging the
original asset to anyone else (i.e. this condition would be met if the asset was only
pledged as security to the recipients in terms of the arrangement).
If this criterion is not met (i.e. we still have something to sell or use as a pledge), then it
would seem that we still have a resource (i.e. it seems we still have an asset and thus we
should not derecognise it).
x The entity is obliged to remit (pass on) the cash flows collected on behalf of the eventual
recipients 'without material delay'. The entity must be prohibited from reinvesting the cash
flows received on behalf of the eventual recipients, except to invest in cash or cash
equivalents during the period between collection date and date of required remittance and
where this period is short. Any interest earned on this short-term investment must also be
paid over to the eventual recipients.
If this criteria is not met (i.e. if we are expecting to receive cash from the asset and
expect to be able to invest this cash and earn interest on it before transferring the cash
from the asset to the recipients), then it would seem we still have a resource (i.e. it
seems we still have an asset and thus should not derecognise it). See IFRS 9.3.2.4-5
The essence of the above is that we must recognise the substance of the transaction and thus we
derecognise the asset only if, in substance, we no longer have the risks and rewards associated
with the asset.
Thus, if the criteria are met with the result that the asset is considered to have been transferred,
the next step is to consider the extent to which the related risks and rewards of ownership have
transferred.
x If substantially all the risks and rewards have been transferred, the asset is derecognised
and any rights and obligations created in the transfer transaction must be recognised as
separate assets and liabilities;
x If substantially all the risks and rewards have been retained, the asset transfer does not
qualify for derecognition (i.e. the asset remains in the books).
x If the substantial risks and rewards have neither been transferred nor retained, we then
need to consider who controls the asset.
If the entity retains control of the asset (through some level of continuing involvement),
then the asset continues to be recognised to the extent of its continuing involvement.
If the entity has lost control of the asset, then the asset is derecognised and any rights
and obligations created in the transfer transaction must be recognised as separate
assets and liabilities. See IFRS 9.3.2.6
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An excellent summary flowchart is provided in IFRS 9 that outlines the process to be followed
in determining whether the asset should be derecognised, should not be derecognised or
should continue to be recognised but only to the extent of the continuing involvement. A part of
this flowchart is presented below (for the complete flowchart, please see IFRS 9.B3.2.1).
Where a transfer of an entire financial asset qualifies for derecognition, we process journals to:
x remeasure the asset's carrying amount on date of derecognition;
x recognise the consideration received, derecognise the carrying amount, and if there is a
difference between these two amounts (i.e. proceeds – carrying amount = gain/loss)
recognise a gain or loss on derecognition in profit or loss;
x reclassify to profit or loss any gains or losses previously recognised in other comprehensive
(unless the asset is at FVOCI-equity, in which case reclassification is prohibited, but the
amount in other comprehensive income may be transferred to another equity account such
as retained earnings). See IFRS 9.3.2.12 & IFRS 9.B5.7.1
IFRS 9 is unclear on the accounting treatment of transaction costs that may be incurred in order
to transfer the financial asset, but, if one applies the principles contained in other standards
(e.g. sale of inventory, where related selling and distribution costs are expensed), it is submitted
that any transaction costs incurred should be expensed.
Required: Show the necessary journal entries to account for the derecognition, assuming that:
A. The investment in shares had been classified at fair value through profit or loss.
B. See next page…
Chapter 21 1023
Gripping GAAP Financial instruments – general principles
B. The investment in shares had been classified at fair value through other comprehensive income.
Andile's policy on derecognition is to transfer to retained earnings any fair value gains or losses that
may have accumulated in other comprehensive income.
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The debentures were originally issued on 1 January 20X5 and had a carrying amount at its prior financial
year-end (31 December 20X5), measured at amortised cost, of C250 000. The effective interest rate on
these debentures is 10% with interest payable annually in arrears.
The debentures have never been credit-impaired. Ignore the loss allowance.
Required: Show the necessary journal entries to account for the derecognition.
Notice:
x There was a gain on derecognition (recognised in profit or loss). It is normal to have a gain or loss on
derecognition when the asset is measured at amortised cost because it is unlikely the asset's amortised
cost would equal its fair value.
If only a part of an asset is transferred, it makes sense that only a part of the asset is
derecognised.
x The carrying amount of the part that is to be derecognised is measured by allocating the
carrying amount of the total asset between the part that is to be derecognised and the part
that remains based on their relative fair values on transfer date (i.e. CA of the derecognised
part = CA of total original asset ÷ FV of total original asset x FV of derecognised part).
x If the asset that is being partly derecognised has a cumulative gain or loss in other
comprehensive income (e.g. the financial asset is an investment in equity instruments at
FVOCI), then the balance in other comprehensive income will also be allocated based on
the relative fair values (determined on transfer date) of the part that is to be derecognised
and the part that remains.
5.3 A transfer of a financial asset that does not qualify for derecognition
If the entity transfers a financial asset in a way that leaves the entity still holding the significant
risks and rewards of ownership, the asset will not qualify for derecognition. For example, an
entity that has a loan asset which it sells, but in a way, that provides the purchaser with full
recourse over the entity in the event that the debtor defaults on the loan, is not a real sale
because the entity continues to hold the significant risks relating to the asset.
We account for the transfer of an asset that does not allow the asset to be derecognised as follows:
x The asset remains in the entity's accounting records and any income on this asset, even
though it will no longer be received, continues to be recognised.
x The consideration that the entity receives when transferring this asset must be recognised
as a financial liability. Thus, the financial liability is initially measured at the amount of the
consideration received. This liability is then subsequently remeasured to reflect the change
in the extent of the obligation, with changes to the liability balance expensed.
x We may not offset this financial asset and its associated financial liability, and nor may we
offset any income arising on the asset against any expenses arising on the liability.
Chapter 21 1025
Gripping GAAP Financial instruments – general principles
Example 19: Financial asset that does not qualify for derecognition
Meer Limited sells a loan asset of C330 000 on 1 January 20X1 at its fair value of C310 000.
This loan bears interest at 10% and is repayable in full on 1 January 20X2.
One of the effects of the sale agreement is that Meer Limited has indemnified the purchaser against
any loss in the event of a default on the loan. The debtor pays the loan principal plus interest in full on
1 January 20X2.
Solution 19: Financial asset that does not qualify for derecognition
Comments:
x Since the significant risks and rewards are retained by Meer, the asset may not be derecognised.
Although Meer will not receive further interest, it continues to recognise the interest income.
x Since the transfer does not lead to derecognition of the asset, the related consideration is
recognised as a liability. The financial liability is adjusted at reporting date to reflect its current
obligation and the adjustment is recognised as interest expense.
If a financial asset is transferred but substantially all of the risks and rewards of ownership of
this asset have neither been transferred nor retained (i.e. some of the risks and rewards have
been transferred and some have been retained) and, at the same time, the entity has somehow
retained control of the asset, the asset remains recognised to the extent of this remaining
continuing involvement. In other words, the asset may be partially derecognised.
Substantially all of the risks and rewards would be considered to be neither transferred nor
retained if, for example, the entity and the purchaser of the asset agreed to share the risks.
Similarly, an entity would be considered to have retained control over a transferred asset if, for
example, the terms of the transfer prevented the purchaser from selling the asset or pledging it
as security to someone else.
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x On top of this, the entity must recognise an 'associated liability'. The liability must be
measured in a way that results in the net carrying amount of the transferred asset and
liability being equal to:
- the 'amortised cost of the rights and obligations retained by the entity', assuming the
financial asset is classified at amortised cost; or
- at the 'fair value of the rights and obligations retained by the entity', assuming the
financial asset is classified at fair value. IFRS 9.3.2.17 (extracts)
x Income on this asset is recognised to the extent of the continuing involvement. See IFRS 9.3.2.18
x Any expense incurred on the associated liability must also be recognised. See IFRS 9.3.2.18
The financial asset and the associated liability may not be offset. Similarly, the income from the
asset that continues to be recognised and any expenses recognised relating to the associated
liability may not be offset.
6. Financial Liabilities
a. A trade creditor is a financial liability because the entity is contractually obligated to settle the
creditor with cash.
b. The preference shares are a financial liability because they are redeemable, which means that the
entity must, in the future, refund the preference shareholders with cash.
c. If the warranty obligation requires the entity to make a cash payment to the customer, it is a financial
liability. However, if the warranty obligation only requires the entity to repair the goods, there is no
obligation to pay cash or other financial instrument. Thus, it is not be a financial liability.
d. Current tax payable is not a financial liability because a contractual obligation does not exist – the
obligation is a statutory obligation.
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Gripping GAAP Financial instruments – general principles
Worked example: Settling a contractual obligation with the entity’s own equity
instruments
Steffen Limited owes C100 000, a debt that will be settled by issuing its own equity instruments
(ordinary shares).
Scenario one:
Steffen is required to issue a variable number of its ordinary shares to settle the debt (C100 000).
In this case, the contractual obligation is a financial liability. This is because it fails the ‘fixed for fixed test’.
In other words, there is a fixed currency amount owing (C100 000) but a variable number of shares to be
issued in settlement thereof. The outcome of this scenario is that, no matter what our shares are trading
at, we will only be exposed to an outflow of C100 000 (i.e. when we need to settle our debt, we could buy
C100 000 of our own shares and hand them over to the creditor – if the shares are trading at C1 each,
then we buy 100 000 shares to give to the creditor – if the shares are trading at C20 each, then we buy
5 000 shares to give to the creditor. It is the creditor who is exposed to the risk of the share price
fluctuations on the settlement date.
Scenario two:
Steffen is required to issue a fixed number of its ordinary shares (5 000 shares) to settle the debt (C100 000).
In this case, the contractual obligation is an equity instrument. This is because it meets the ‘fixed for fixed
test’. In other words, there is a fixed currency amount owing (C100 000) and a fixed number of shares to
be issued in settlement thereof (5 000 shares). The outcome of this scenario is that it is Steffen that is
exposed to the fluctuations in its share price. For example, if Steffen decides to buy the shares from the
market in order to give to the creditor in settlement of the debt (i.e. instead of just issuing more shares),
then if the share price is trading at C1 on settlement date, then Steffen will need to pay C5 000 to settle
the debt (5 000 shares x C1). However, if the share price is trading at C20 each, then Steffen will need
to pay C100 000 to settle the debt (5 000 shares x C20). In other words, it is Steffen who is exposed to
the risks of share price fluctuations. Or, put another way, the instrument is affected by Steffen’s
performance (Steffen’s performance influences the share price). Thus, this instrument is more suited to
being recognised as an equity instrument.
Once the financial liability is classified, it may never be reclassified. IFRS 9.4.4.2
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All financial liabilities that are 'held for trading' must be classified as at FVPL. A financial liability
is considered to be 'held for trading' if:
x it is a derivative (except if it is a derivative that is a contract providing a financial guarantee or
if it is a designated and effective hedging instrument); or
x its main purpose, from initial recognition, has been to
be sold or repurchased in the near term; Held for trading is
defined as a FA or FL that:
x from initial recognition, it has been managed as part
of a portfolio of financial instruments that has recently x is acquired or incurred principally for
the purpose of selling/ repurchasing
evidenced short-term profits. See IFRS 9 App A it in the near term; or
x is a derivative (except for a
6.3.1.3 Designated at FVPL derivative that is a financial
guarantee contract or is a designated
and effective hedging instrument); or
Financial liabilities that do not meet the definition of 'held for
x on initial recognition, is part of a
trading' may be designated as FVPL. Most designations at portfolio of identified financial
FVPL may only take place on initial recognition and are instruments that are managed
irrevocable. The following summarises the conditions under together and for which there is
evidence of a recent actual pattern
which a designation as at FVPL may occur. of short-term profit-taking.
IFRS 9 App A
x Designations that are only possible on initial
recognition and which are irrevocable include:
x Designating a liability as at FVPL in order to provide 'more relevant information' since
- by classifying it as at FVPL, it avoids an accounting mismatch; or
- the liability is part of a 'group of financial liabilities' or a 'group of financial liabilities
and financial assets' that are managed and evaluated on a fair value basis.
See IFRS 9.4.2.2
x If it involves a hybrid contract:
- that contains an embedded derivative
- within a host that is not a financial asset in terms of IFRS 9.
However, this designation would not be allowed if the embedded derivative:
- does not significantly change the required contractual cash flows; or
- is prohibited from being separated out. See IFRS 9.4.3.5
x Designations that are possible on initial recognition:
x In certain circumstances, a financial liability may be designated at FVPL if its credit risk
is being managed using a credit derivative that is also measured at FVPL. See IFRS 9.6.7.1
There are four exceptions to the general classifications of amortised cost and fair value through
profit or loss. Under the exceptions, the measurement of the financial liability will differ somewhat
from the measurement requirements of the amortised cost (AC) or fair value through profit or loss
(FVPL) classifications. The four exceptions to the two general classifications are as follows:
x Financial liabilities that arise when a transfer of a financial asset does not qualify for de-
recognition or when the continuing involvement approach applies.
- Should the entity retain substantially all the risks and rewards the financial liability is
measure at the amount of consideration received. Any subsequent movements to this fair
value are measured through profit and loss. IFRS 9.3.2.15 (slightly reworded)
- If the entity continues to recognise a financial asset due to continual involvement, the
liability is measured in a way that reflects the rights and obligations that the entity has
retained. In other words, if the financial asset retained is subsequently measured at AC,
then the financial liability is also subsequently measured at AC and if the financial asset
retained is subsequently measured at FVPL then the financial liability should also be
recognised subsequently at FVPL. IFRS 9.3.17 (slightly reworded)
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Both the initial measurement and subsequent measurement are affected by whether the liability
has been classified as amortised cost or fair value through profit or loss. Initial measurement
is explained in section 6.5 and subsequent measurement is explained in section 6.6.
Initial measurement of financial liabilities (and, in fact, all financial instruments) is always at:
x fair value, and
x may involve an adjustment for transaction costs (deducted in the case of financial liabilities).
Whether or not to adjust a financial liability's fair value for transaction costs depends on the
liability's classification. Transaction costs are defined and explained in section 3.5.1. This is
summarised below. See IFRS 9.5.1.1
It can happen that the fair value on initial recognition does not equal the transaction price. This
results in what is referred to as a day-one gain or loss. This is explained in section 3.5.2.
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6.6 Financial liabilities: subsequent measurement (IFRS 9.5.3 and IFRS 9.4.2.1-2)
Financial liabilities that are classified at amortised cost The effective interest rate,
are obviously measured at amortised cost. of a FL, is defined as
x the rate that exactly discounts
To be measured at amortised cost means that the x estimated future cash flows through the
subsequent measurement of a financial liability will expected life of the financial liability
involve using the effective interest rate method. This x to the liability’s amortised cost.
method means that interest on the liability will be These cash flows are the contractual
cash flows. See IFRS 9 App A (Reworded extract)
recognised in profit or loss over its life.
Required:
Prepare the effective interest rate table over the life of the debentures and then prepare the journals
for the year ended 31 December 20X4.
Chapter 21 1031
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Notes:
1) Measurement at initial recognition = (FV: 150 000 x C10 – Transaction costs: C100 000) = 1 400 000
2) Effective interest = Opening balance x EIR: 16,32688%
3) The effective interest rate is calculated using a financial calculator as 16,32688%
PV = 1 400 000 (150 000 x C10 – Transaction costs of C100 000)
FV= -1 800 000 (150 000 x C12)
Pmt = -150 000 (150 000 x C10 x 10%)
N= 4 COMP i
4) Payment of interest based on coupon interest = 150 000 debentures x C10 x 10% = C150 000
5) Payment of redemption amount = 150 000 debentures x C12 = C1 800 000
6) Notice: The total of the interest expense is C1 000 000, which is the difference between the
net amount originally received (C1 400 000) and the total of the payments (C2 400 000).
6.6.3 Financial liabilities at fair value through profit or loss: subsequent measurement
Financial liabilities that are classified at ‘fair value through profit or loss’ are initially measured at fair
value, with transaction costs expensed (see section 6.5) and are subsequently remeasured at each
reporting date to their latest fair values. The fair value adjustments (fair value gains or losses) are
generally recognised in profit or loss, although there are exceptions (see discussion overleaf).
Financial liabilities at
Financial liabilities generate cash outflows (e.g. interest fair value are measured
paid on a debenture liability, or dividends paid on a as follows -
redeemable preference share liability). x Initially measured at fair value.
x Transaction costs are expensed
IFRS 9 does not stipulate how to account for the cash flows, x Subsequently measured at fair value
but the approach generally followed in practice is to:
x first recognise the expense (i.e. interest or dividend) when it is incurred, by debiting the expense
and crediting the financial liability, and
x then recognise the cash flow when we make the payment, by debiting the financial liability and
crediting bank.
This is the approach used in this text.
Other alternative approaches are possible. For example, we could simply recognise any cash
flow without first recognising a separate expense, and thus we could simply debit the financial
liability and credit bank. In this case, the interest or dividend, which would otherwise have
been recognised as a separate dividend/ interest expense, would now be absorbed into the
fair value adjustment. In other words, the approach used will affect the amount of the fair
value adjustment, but the effect on profit or loss will be the same.
Exceptions: when fair value gains are recognised in other comprehensive income instead
Fair value gains or losses at reporting date are generally recognised in profit or loss. However, there
are exceptions to this. Fair value gains or losses will be recognised in other comprehensive income if:
x the liability is part of a hedging relationship, and is a cash flow hedge (hedges are explained
in chapter 22); or
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x the liability was designated as at fair value through profit or loss, in which case:
- the amount of a fair value adjustment that is attributable to changes in credit risk of that
liability (i.e. own credit risk) must be presented in other comprehensive income; and
- the rest of the fair value adjustment must be presented in profit or loss,
unless the financial liability is a financial guarantee contract, or a loan commitment, or if
recognising part of the fair value adjustment in ‘other comprehensive income’ would create
or enlarge an accounting mismatch in ‘profit or loss’, in which case the entire fair value
adjustment is presented in profit or loss. IFRS 9.4.2.2 & IFRS 9.5.7.1 & 5.7.7-.9
The credit risk referred to is the risk relating specifically to that specific liability rather than
the entity as a whole. This means that a liability that has been collateralised would be lower
than a liability for which no collateral has been offered.
The reason why the effect on fair value that is caused by changes to the 'liability's credit risk'
should not be included in profit or loss is interesting. As the credit risk of a financial liability
deteriorates, so its fair value drops (if it improved, the fair value would increase). Thus, if a
liability is measured at fair value and its credit risk deteriorates, the liability balance will be
decreased to the lower fair value and a fair value gain will have to be recognised.
For example, at the end of 20X1, an entity had issued debentures with a fair value of C100 000.
In 20X2, due to the increase in credit risk during the year, the debentures now had a fair value
of C50 000, as traders were willing to sell the debentures for a lower price, to avoid the
increased risk. If we had to recognise this transaction through profit or loss, we would have to
debit the liability with C50,000 and credit fair value gain with C50,000. However, this does not
make sense, as the ‘gain’ is only due to an increase in credit risk.
Recognising a gain (or loss) because the credit risk of the liability deteriorated (or improved)
is clearly counter-intuitive (i.e. does not make sense). Thus, in order to ensure that this
counter-intuitive fair value gain (or loss) does not distort the entity's profit or loss, it should
be separated out and presented in other comprehensive income instead (unless by doing
so it creates or enlarges an accounting mismatch).
Fair value gains or losses that are recognised in other comprehensive income may not be
reclassified to profit or loss. However, the entity may subsequently transfer the cumulative gains
or losses to another equity account. IFRS 9.B5.7.9
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As mentioned in section 6.3, although there are essentially two measurement classifications
(amortised cost and fair value through profit or loss), the following financial liabilities are
exceptions to these classifications and are thus measured slightly differently:
x financial liabilities that arise when a transfer of a financial asset
- does not qualify for de-recognition (i.e. a derecognition prohibition), or
- results in applying the continuing involvement approach (i.e. a partial derecognition);
x financial guarantee contracts;
x commitments to provide a loan at a below-market interest rate. IFRS 9.4.2.1 (b) – (d) (extracts)
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6.6.4.1 Financial liabilities due to a derecognition prohibition (IFRS 9.3.2.15 and 9.3.2.11)
If the transfer of a financial asset does not qualify for derecognition (i.e. because the entity
retains significant risks and rewards of ownership), the consideration that the entity receives for
this asset must be recognised as a financial liability. This financial liability is thus initially
measured at the amount of the consideration received and any changes to this liability in
subsequent periods will be expensed.
We may not offset this financial asset and its associated financial liability. Similarly, we may not
offset any income arising on the asset against any expenses arising on the liability.
For an example of the recognition of a financial liability due to a transfer of an asset not
qualifying for derecognition, please see example 19 (Meer Limited) in section 5.3.
If a financial asset is transferred but the risks and rewards of ownership of this asset are only
partially transferred and the entity somehow retains control of the asset, the asset will only be
partially derecognised. In other words, the financial asset continues to be recognised to the
extent of the entity's continuing involvement. For example, if a financial asset is transferred but
the entity guarantees this asset to some extent, the financial asset will be measured at the lower
of (i) the amount of the asset and (ii) the amount of the guarantee. However, on top of this, the
entity must recognise an 'associated liability'. The liability must be measured in a way that
results in the net carrying amount of the transferred asset and liability being equal to:
x the 'amortised cost of the rights and obligations retained by the entity', assuming the
financial asset is classified at amortised cost; or
x at the 'fair value of the rights and obligations retained by the entity', assuming the financial
asset is classified at fair value. IFRS 9.3.2.17 (extracts)
6.6.4.3 Financial liabilities that are financial guarantee contracts (IFRS 9.4.2.1 (c))
If the financial liability arises from the issue of a financial guarantee contract, then the liability
is measured at the higher of:
(i) The loss allowance (in terms of IFRS 9.5.5); and
(ii) The amount initially recognised in terms of IFRS 9.5.1.1 (i.e. at fair value, possibly
adjusted for transaction costs and for day-one gains or losses) less the cumulative
income recognised in terms of IFRS 15, where applicable. See IFRS 9.4.2.1 (c)
The above measurement would not apply if the financial liability is classified at fair value through
profit or loss (see section 6.6.3) or if it was involved in the transfer of a financial asset that either
did not qualify for derecognition (see section 6.6.4.1) or qualified for only a partial derecognition
due to continuing involvement in the asset (see section 6.6.4.2).
6.6.4.4 Financial liabilities that are loan commitments at below-market interest rates
Where a financial liability arises due to the entity committing to provide a loan at an interest
rate that is below the market interest rate, it will be measured in the same way that a financial
guarantee contract referred to above is measured. See IFRS 9.4.2.1 (d)
This measurement would not apply if the financial liability is classified at fair value through profit
or loss (see section 6.6.3).
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x debt instruments have been exchanged between a borrower and lender of debt instruments
with substantially different terms, resulting in the extinguishment of the original financial
liability and the recognition of a new financial liability; or
x there has been a substantial modification of the terms of a financial liability, accounted for
by extinguishment of the original financial liability and the recognition of a new financial
liability. See IFRS 9.3.3.1
An entity must remove a financial liability from its statement of financial position (i.e.
derecognise it) when it is extinguished. An extinguishment occurs when the contractual
obligation is discharged, cancelled or it simply expires. In other words, the entity either settles
its liability (discharges it) or is legally released from its liability (this could happen through legal
proceedings or the creditor itself could simply release the entity).
When derecognising a financial liability, any resulting gain or loss is recognised in profit or loss.
This gain or loss is calculated as the difference between:
x the carrying amount of the financial liability (or part of financial liability) extinguished or
transferred to another party; and
x the consideration paid, including any non-cash assets transferred or liabilities assumed.
Example 24: Financial liability extinguishment
Cream Limited owed a sum of C90 000 in terms of a loan received from a bank. Due to a
technicality in the manner in which the loan had been issued, the courts found in favour of
Cream being released from its obligation to the bank.
Required: Prepare the journals relating to the information above.
An extinguishment could result in the derecognition of the original financial liability and the
recognition of a new financial liability in its place. This occurs when:
x 'there is an exchange between an existing borrower and lender of debt instruments with
substantially different terms';
x 'the terms of an existing financial liability' or part thereof are substantially modified. IFRS 9.3.3.2
Terms are considered to be substantially different if there is at least a 10% difference between:
x the present value of the new cash flows ('including any fees paid, net of any fees received'),
discounted at the original effective interest rate, and
x 'the discounted present value of the remaining cash flows of the original financial liability'.
IFRS 9.B3.3.6 (extracts)
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The consensus provided in IFRIC 19 is that the equity instruments should be treated as
‘consideration paid’ and, as a result:
x the issue of the equity instruments to the creditor should be recognised and measured at their fair value;
x the liability should be reduced by the carrying amount of the financial liability that is settled
through this issue of equity instruments; and
x any difference between the fair value of the equity instruments and the carrying amount of the
liability extinguished is recognised in profit or loss.
If the fair value of the equity instruments cannot be reliably measured, then the equity instruments
must be measured at the fair value of the financial liability extinguished.
If only part of the financial liability is extinguished, the entity must assess whether:
x some of the consideration paid relates to a modification of the terms of the liability outstanding,
in which case the entity will need to allocate the consideration paid between:
the part of the liability that is extinguished, and
the part of the liability that remains outstanding; or
x the terms of the remaining outstanding liability have been substantially modified, in which case
the entity must:
derecognise the original liability and recognise a new liability.
IFRIC 19 also only explains how the debtor accounts for the issue of its equity instruments in order
to settle its liability. It does not explain how the creditor would account for the receipt of these equity
instruments.
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Gripping GAAP Financial instruments – general principles
Worked example: Use of equity to extinguish financial liability (‘debt for equity swaps’)
Papaya borrowed C500 000 (a financial liability to Papaya) from Guava on 31 December 20X6.
The gross carrying amount of the financial liability was C420 000 on 31 December 20X7. The financial liability
is accounted for at amortised cost. On this date, it was decided that Papaya would settle the financial liability
through the issue of 4000 equity shares after which it would be fully extinguished.
The fair values of Papaya’s equity shares are C100 on 31 December 20X6 and C103 on 31 December 20X7.
The journals to account for the derecognition of the financial liability are as follows:
Debit Credit
FL: loan from Guava (L) Given 420 000
Gain on derecognition of loan from Guava (I: P/L) Balancing 8 000
Equity: Share capital (Eq) 4 000 x 103 412 000
Extinguishment of loan following renegotiation of terms
The reclassification is accounted for prospectively from the first day of the financial year after
the change in business model is put into effect (i.e. prospectively from reclassification date).
There must be no restatement of gains, losses or interest previously recognised. See IFRS 9.5.6.1
Example 26: Reclassification date Adaptation of example in IFRS 9.B4.4.2
Faith decides to shut down its retail mortgage division. The decision to shut it down is made
on 1 November 20X7 but it continues operating this division (i.e. continues to create loan
assets) whilst looking for a purchaser for the division.
Three potential purchasers are found during February 20X8 and the division formally ceases to acquire
new retail mortgage business from 1 March 20X8. Faith has a 31 December financial year-end.
Required: Explain when the reclassification date would be.
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If the business model for managing a group of financial assets changes, all the affected financial
assets must be reclassified. See IFRS 9.4.4.1
However, when an entity sells a financial asset that it was holding to receive contractual cash
flows, it does not automatically mean that the entire portfolio should be reclassified. A
reclassification of financial assets can only take place if the business model that was used to
manage the asset changes. Whether or not a change in business model has been made:
x is determined by senior management,
x can be based on either external or internal changes,
x must be significant relative to the entity's operations, and
x must be 'demonstrable to external parties'. See IFRS 9.B4.4.1
You may recall that, when classifying financial assets, certain of the classifications were
irrevocable, which means that a reclassification out of this classification would not be allowed
(e.g. (1) classifying a debt instrument at FVPL in order to avoid an accounting mismatch when
it met the requirements to be classified at AC or FVOCI-debt and (2) classifying an equity
instrument not held for trading as FVOCI-equity instead of at FVPL). These irrevocable
classifications were also only available on initial recognition and thus there can be no
reclassifications into these classifications at a later date.
7.2 Reclassifying from amortised cost to fair value through profit or loss
(IFRS 9.5.6.2)
To reclassify a financial asset from amortised cost (AC) to fair value through profit or loss
(FVPL) we must:
x determine the fair value on reclassification date;
x calculate, on reclassification date, the difference between the carrying amount of the
financial instrument measured at amortised cost and measured at fair value, and recognise
this difference in profit or loss.
Please remember that amortised cost is the gross carrying amount less the loss allowance (AC = GCA
– Loss allowance). This means that any loss allowance is derecognised on reclassification.
IFRS 9 is silent on how to account for any cash flows accruing on a financial asset at fair value
through profit or loss (for example interest on an investment in bonds or dividends on an
investment in redeemable preference shares). These accruals may be presented as a separate
income (interest or dividend income) or may be presented as part of the fair value gain or loss.
It is submitted that, if it is presented as a separate income (e.g. interest income), the income
should simply be measured based on the contractual terms. If it is not presented as a separate
income and is thus absorbed into the fair value gain or loss, we will need to disclose this fact
(see IFRS 7). This approach (showing the journals to process) was explained in section 3.6.5.
Chapter 21 1039
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Initially, the bonds were being held to receive contractual cash flows. However, on 30 June 20X3,
management decided to manage these bonds within another portfolio of assets that are actively traded.
The change in the business model objective (i.e. from collecting contractual cash flows to being actively
traded) was put into immediate effect. Fair values of the investment in bonds were as follows:
x 30 June 20X3: C540 000
x 1 January 20X4: C510 000
x 31 December 20X4: C545 000
The bonds have never been credit-impaired and there have been no significant increases in the credit
risk of the bonds since their initial recognition. The expected credit losses were estimated as:
12 month expected credit Lifetime expected credit
losses: losses:
x 01 January 20X1 5 000 12 500
x 31 December 20X1 7 000 15 000
x 31 December 20X2 8 000 16 700
x 31 December 20X3 9 200 17 000
Required: Provide the journals for the year ended 31 December 20X3 and 31 December 20X4.
Solution 27: Reclassification of financial asset from amortised cost to FVPL
Comment: Notice how even though the business model changed from 30 June 20X3, the new
measurement model is only applied from the first day of the year after the business model changes.
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7.3 Reclassifying from fair value through profit or loss to amortised cost
(IFRS 9.5.6.3)
To reclassify a financial asset from fair value through profit or loss (FVPL) to amortised cost (AC) we must:
x use the fair value on reclassification date as the new gross carrying amount;
x thereafter, measure the asset and related interest income using the amortised cost method, having
calculated the effective interest rate as if the reclassification date was the date of initial recognition;
x recognise a loss allowance based on credit risks that existed on reclassification date (i.e. as
if this date was the date of initial recognition) and recognise changes to this loss allowance
at each subsequent reporting date. See IFRS 9.B5.6.2
1 January 20X3:
Impairment loss (E: P/L) 12m expected credit loss (given) 8 000
FA: Bonds: Loss allowance (-A) 8 000
Recognising a loss allowance (because the asset is now classified as AC)
based on the assessment of credit risk on initial recognition: not credit-
impaired & thus measured at 12-m expected credit losses, recognised as a
credit to the asset
Chapter 21 1041
Gripping GAAP Financial instruments – general principles
Impairment loss (E: P/L) Latest estimate of 12m expected credit 1 200
FA: Bonds: Loss allowance (-A) losses: 9 200 – Balance in this a/c: 8 000 1 200
Loss allowance remeasured: no significant increase in credit risk since
initial recognition, thus still measured at 12-month expected credit
losses, recognised as a credit to the asset
To reclassify a financial asset from amortised cost (AC) to fair value through other
comprehensive income (FVOCI-debt) we must:
x determine the fair value on reclassification date;
x transfer the asset's carrying amount from its amortised cost account to a new account
identifying the asset to be at fair value through other comprehensive income;
x remeasure the asset to its fair value on reclassification date and recognise this difference
(i.e. the asset's CA at amortised cost – the asset's fair value on reclassification date) as an
adjustment in other comprehensive income.
x Transfer the asset's loss allowance account to a loss reserve account in other
comprehensive income. See IFRS 9.B5.6.1
There is no change needed to the loss allowance because both these classifications apply the
same impairment requirements … however it should be remembered that, although both these
classifications recognise the ‘impairment adjustments’ in ‘profit or loss’:
x the AC classification recognises the ‘loss allowance account’ as an ‘asset measurement
account’ (i.e. an account that acts to reduce the carrying amount of the asset), whereas
x the FVOCI-debt classification recognises the loss allowance as a loss reserve in OCI.
There is also no change needed to the recognition of interest income or the effective interest rate,
since both classifications require the same recognition of the effective interest on the asset.
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The face value of the debentures is C100 000 and interest is paid annually in arrears at a coupon rate
of 20% per annum. The debentures will be redeemed at a premium of C30 000 on 31 December
20X3. The subsequent fair values of the debentures were as follows:
x 31 December 20X1 and 1 January 20X2 C145 350
x 31 December 20X2 and 1 January 20X3 C148 850
The debentures have never been credit-impaired and there have been no significant increases in the
credit risk of the debentures since their initial recognition. Expected credit losses were estimated as:
12 month expected credit losses Lifetime expected credit losses
x 01 January 20X1 5 000 12 500
x 31 December 20X1 7 000 15 000
x 31 December 20X2 8 000 16 700
The debentures were classified at amortised cost on initial recognition but need to be reclassified to fair
value through other comprehensive income (FVOCI-debt). The reason for the reclassification is that
Revolution purchased another business on 1 September 20X1, and this business was immediately
tasked with managing the debentures as part of one of its own portfolio of assets. This portfolio is
managed with the objective of both collecting the contractual cash flows and selling the assets.
Required: Provide the journals for the year ended 31 December 20X1 and 31 December 20X2.
Solution 29: Reclassification of financial asset from amortised cost to fair value
through other comprehensive income (AC to FVOCI)
Comment:
x The reclassification date is 1 January 20X2, being the first day on the year following the change in
the business model that has been put into effect. Thus, 1 September 20X1 is irrelevant.
x Both the AC and FVOCI-debt classifications use the effective interest rate method and account for
expected credit losses in the same way. However, credit losses are recognised in OCI under the FVOCI-
debt classification but recognised as a credit to the asset account under the AC classification
FA: Debentures at amortised cost (A) Fair value (given) 147 408
Bank 147 408
Purchase of debentures
31 December 20X1
Bank 100 000 x Coupon rate 20% (or W1) 20 000
Interest income (I: P/L) (147 408 x EIR: 10%) or (W1) 14 741
FA: Debentures at amortised cost (A) Balancing 5 259
Debentures measured at amortised cost and related interest recognised
based on the effective interest rate in P/L
Impairment loss (E: P/L) Latest estimate of 12m expected credit 2 000
FA: Debentures: Loss allowance (-A) losses: 7 000 – previous balance: 5 000 2 000
Remeasurement of loss allowance: no significant increase in credit risk since
initial recognition, thus still measured at 12-month expected credit losses,
and recognised as a credit to the asset
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To reclassify a financial asset from fair value through other comprehensive income (FVOCI-
debt) to amortised cost (AC) we must:
x Transfer the asset's carrying amount (i.e. which will be its fair value) from its FVOCI account
to a new account that identifies the asset as now being at amortised cost (i.e. an amortised
cost account).
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x Transfer the balance in the ‘cumulative fair value gains or losses account’ in other
comprehensive income (being the difference between the latest fair value and the gross
carrying amount) and recognise this as an adjustment to the asset’s carrying amount. This
has the effect of re-adjusting the asset's carrying amount to its gross carrying amount so
that the asset is now measured as if it had always been classified as at amortised cost. *
x Transfer the balance in the asset's ‘expected credit loss reserve account’ in other
comprehensive income to the 'asset's loss allowance account'. *
* Notice that, when transferring the balance in the ‘expected credit loss reserve account’ (OCI) to the
asset's ‘loss allowance account’ and when transferring the ‘cumulative fair value gains or losses’
(OCI) to the asset’s ‘cost account’ (gross carrying amount), these transfers are made from OCI to
an asset account. Since these transfers from OCI do not affect profit or loss, they are not
reclassification adjustments.
From this point onwards, one simply continues to recognise the interest income on the effective
interest rate method, using the same effective interest rate as was used when recognising this
interest income under the previous FVOCI classification (remember, both these classifications
require the recognition of the effective interest on the asset).
Similarly, one then also simply continues to recognise the adjustments to the loss allowance
because both these classifications apply the same impairment requirements. However,
although the expected credit loss adjustment is expensed, the contra entry is now credited
directly to the asset's loss allowance account (whereas it was previously credited to the
expected credit loss reserve in OCI).
Example 30: Reclassification of financial asset from fair value through other
comprehensive income to amortised cost (FVOCI to AC)
Use the same information as that provided in the previous example (Revolution), with the
only difference being that, instead of the debentures being initially classified at amortised
cost and requiring reclassification to FVOCI-debt:
x the debentures were classified at fair value through other comprehensive income (FVOCI-debt) on
initial recognition but need to be reclassified to amortised cost (AC).
x The reason for the reclassification is that, on 1 September 20X1, Revolution purchased another business,
which was immediately tasked with managing the debentures as part of one of its own portfolio of assets.
x This portfolio is managed with the objective of simply collecting the contractual cash flows.
Required: Show the journals for the year ended 31 December 20X1 and 31 December 20X2.
Solution 30: Reclassification of financial asset from fair value through other
comprehensive income to amortised cost (FVOCI-debt to AC)
Comment:
x The reclassification date is 1 January 20X2, being the first day on the year following the change in
the business model that has been put into effect. Thus, 1 September 20X1 is irrelevant.
x Both the AC and FVOCI-debt classifications use the effective interest rate method and both account
for expected credit losses. However, credit losses are recognised in OCI under the FVOCI-debt
classification but recognised as a credit to the asset account under the AC classification
Impairment loss (E: P/L) 12m expected credit loss: 5 000 (given) 5 000
FA: Debentures: Loss allowance (OCI) 5 000
Recognising a loss allowance, measured at the 12-month ECL (since the
assessment of risk on initial recognition was that it was not credit-impaired) P.S.
Since the FA was measured at FVOCI-debt, this loss allowance is recognised
in OCI and is NOT a ‘negative asset’ measurement account
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Impairment loss (E: P/L) Latest estimate of 12m expected credit 2 000
FA: Debentures: Loss allowance (OCI) losses: 7 000 – previous balance: 5 000 2 000
Remeasuring loss allowance: no significant increase in credit risk since initial
recognition, thus still measured at 12-month expected credit losses
1 January 20X2
FA: Debentures at amortised cost (A) Transferred at the prior yr CA = FV 145 350
FA: Debentures at FVOCI (A) 145 350
Reclassification of debentures: transfer from 'asset at FVOCI' account to the
'asset at AC' account; at prior year carrying amount (FV)
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To reclassify a financial asset from fair value through other comprehensive income (FVOCI-
debt) to fair value through profit or loss (FVPL), the asset continues to be measured at fair
value. However:
x We must reclassify the cumulative gains or losses due to fair value adjustments that were
previously recognised in ‘other comprehensive income’ to ‘profit or loss’.
x Similarly, we must also reclassify the cumulative gains or losses due to loss allowance
adjustments that were previously recognised in ‘other comprehensive income’ to ‘profit or
loss’ (remember that an impairment loss within the FVOCI classification, although
recognised as an expense in profit or loss, would have been credited to a loss allowance
reserve in other comprehensive income).
Please note that, the transfer from other comprehensive income to profit or loss, is referred to
as a reclassification adjustment.
7.7 Reclassifying from fair value through profit or loss to fair value
through other comprehensive income (IFRS 9.5.6.6 & IFRS 9.B5.6.2)
To reclassify a financial asset from fair value through profit or loss (FVPL) to fair value through
other comprehensive income (FVOCI-debt) it continues to be measured at fair value, but we:
x Recognise the fair value gains or losses in OCI (instead of in P/L);
x Recognise a loss allowance account (the FVPL asset would not have had a loss allowance
account). When measuring the loss allowance, we use the date of reclassification as if it
was the date of initial recognition.
8.1 Overview
Non-derivative financial instruments must be classified by the issuers thereof as equity
instruments or financial liabilities by analysing the terms of issue. In other words, a non-
derivative financial instrument must be classified by its issuer based on its substance rather
than its legal form. See IAS 32.28
Essentially, the difference between the financial liability and equity instruments is that:
x financial liabilities involve a contractual obligation to
Compound financial
deliver cash or another financial asset or exchange instruments (CFIs) are:
financial instruments with another entity under conditions
x Non-derivative FIs
that are potentially unfavourable and where the issuer of
x That, from the issuer's perspective,
the financial liability does not have an unconditional right contain both:
to avoid settling the obligation, whereas - A financial liability; and
x equity instruments involve no such obligations (the - An equity instrument. See IAS 32.28
equity is simply the residual interest in the asset after deducting the liability).
While analysing the terms of an issued non-derivative financial instrument, we may find that:
x some terms meet the definition of a financial liability (e.g. the terms may result in the issuer
having an obligation to deliver cash, such as interest payments and/ or redemption of the
'principal' amount), whereas
x some terms meet the definition of an equity instrument (e.g. the terms may give the holder
the option to convert the liability instrument into a fixed number of the entity's equity
instruments, such as ordinary shares).
A non-derivative financial instrument that contains both a financial liability component and an
equity instrument component is called a compound financial instrument (CFI).
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The issuer of a compound financial instrument must split the instrument, thereby recognising
the financial liability and equity instrument components separately. This is commonly referred
to as 'split accounting'.
It is interesting to note that a compound financial instrument must always be split. In other words,
the issuer of a compound financial instrument must always recognise the financial liability
component and equity instrument component separately, even if the issuer does not believe that
a potential equity instrument will ever come into existence. For example, imagine that our financial
instrument is a debenture that contains an obligation to pay interest and possibly redeem the
debenture (both are financial liabilities) but also gives the holder the option to choose to convert
the debenture into a fixed number of equity instruments (equity instrument) instead of having the
debentures redeemed. We must split the debenture, thus recognising the financial liability and
equity instrument separately, even if we did not believe that the debenture holder would ever
choose to convert its debentures into equity instruments. See IAS 32.30
Correctly splitting the instrument into its financial liability component and equity instrument
component is very important because:
x it affects ratios used by financial analysts (e.g. the debt ratio); and
x it affects the measurement of the instrument both on date of initial issue and subsequently:
- Liabilities are initially measured at fair value and subsequently measured at either fair
value or amortised cost; whereas
- Equity is initially measured at the residual of the assets after deducting liabilities and is
not subsequently remeasured.
The initial measurement of the components under 'split accounting' involves 3 steps:
Step 1: Determine the fair value of the compound financial instrument as a whole
The fair value of the whole compound financial instrument (CFI) is normally the
transaction price, being the proceeds received on the issue (i.e. proceeds received from
the issue = fair value of the CFI).
However, if the proceeds on date of issue do not equal the fair value of the whole
instrument on this day, then a day-one gain or loss is recognised. Day-one gains or
losses are recognised in profit or loss. These are explained in section 3.5.2 under
'financial assets', but the principle of accounting for day-one gains or losses applies
equally to all financial instruments. See IFRS 9.5.1.1 and IFRS 9.B5.1.2A
Step 2: Determine the fair value of the financial liability component
The liability component is measured at its fair value on the date of issue. See IFRS 9.5.1.1
The fair value of the liability portion is determined based on the fair value of another
similar financial liability that is not part of a compound financial instrument (i.e. a similar
financial instrument that does not include an equity component). See IAS 32.32
For example: If we were measuring the liability portion of a 5%, 10-year, convertible
debenture, we would try to use the fair value of a similar 5%, 10-year debenture but
one that was a non-convertible debenture.
Step 3: Determine the value of the equity instrument component
The equity portion is measured as a residual amount, calculated as the difference
between the fair value of the whole compound financial instrument (CFI) and the fair
value of the financial liability portion (FV of the CFI – FV of the L). See IAS 32.31
If directly attributable transaction costs are incurred when issuing a compound financial
instrument, these costs must be deducted from the equity and liability components in the same
proportion as the proceeds are allocated to the equity and liability components. For example:
The proceeds on issue are C100 000, of which C80 000 (80%) is credited to the financial liability
account and C20 000 (20%) is credited to the equity instrument account. If the transaction costs
are C1 000, then C800 (80%) will be debited to this liability account and C200 (20%) will be
debited to this equity account. See IAS 32.38
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The liability portion is subsequently measured in terms of IFRS 9, either at fair value or
amortised cost, whereas there is no subsequent measurement of the equity portion. In other
words, whatever value is initially given to the equity instrument will remain unchanged for the
life of the instrument.
Debit Credit
Bank Proceeds: given 100 000
Day-one gain (I: P/L) Proceeds 100 000 – FV: 95 000 5 000
CFI: financial liability (L) FV: given 80 000
CFI: equity instrument (Eq) Balancing: FV of CFI: 95 000 – FV of L: 80 000 15 000
Issue of compound financial instruments
Thus, a compound financial instrument (i.e. classified partly as financial liability and partly as
an equity instrument), would result in the recognition of any related interest, dividends, gains or
losses partly in profit or loss (e.g. as an interest expense) and partly in equity (e.g. as a dividend
declared to an equity participant). It can happen that a dividend on a share that is classified as
a compound financial instrument gets recognised as an interest expense instead.
The main body of IAS 32 refers to compound financial instruments as those instruments that
create a financial liability for the entity and yet also create an equity component due to the fact
that the instrument has given the holder the option to convert the instrument into a fixed number
of equity instruments (e.g. convertible debentures, bonds, preference shares or similar). These
are referred to as 'convertible instruments'. However, the application guidance within
IAS 32 also refers to certain preference shares, which are not convertible, as being compound
financial instruments. See IAS 32.29 & IAS 32.AG37
Let us now look at the concept of compound financial instruments first in terms of 'convertible
instruments' and then in terms of 'non-convertible preference shares'.
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Please note that for a convertible non-derivative financial instrument to land up being a
compound financial instrument, it is essential that the
possible conversion of the instrument involves conversion An equity instrument is
defined as:
into a fixed number of equity instruments. If the non-
derivative instrument was convertible into a variable x a contract that evidences a
number of equity instruments, then the possible x residual interest in the entity's As
x after deducting all of its Ls.
conversion would meet the definition of a financial liability IAS 32.11 (slightly reworded)
(please re-read this definition).
For example: Consider a debenture that is convertible into a variable number of ordinary shares,
the exact number of which will only be determined in the future based on the market value of
the debenture on the date of conversion. In this case, the entire debenture would be classified
as a liability because the obligation to pay interest meets the definition of a financial liability
(obligation to deliver cash) and the obligation to potentially have to convert the debentures into
a variable number of ordinary shares also meets the definition of a financial liability (a non-
derivative settled in a variable number of equity instruments). Thus, this convertible debenture
is a pure financial liability and does not have an equity instrument component, meaning that it
is not a compound financial instrument. See IAS 32.11: the 'financial liability' definition
Explanation: The terms of the debenture issue create an obligation to pay the holder interest on the
debentures (at the coupon rate of 5%) and to either redeem the principal of C100 000 or convert the
debentures into 5 000 ordinary shares (a fixed number of equity instruments).
x The terms require Lostit to pay interest and to possibly also redeem the debentures. This meets
the definition of a liability since it represents a contractual obligation to deliver cash.
x However, further terms give the holder the option to convert the debentures into Lostit's equity
instruments. This means that Lostit could possibly be required to settle the debenture liability with
the issue of its own equity instruments instead of with cash.
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At first glance, these further terms may appear to meet the definition of a financial liability. However,
since the debenture is a non-derivative that the entity may be required to settle by way of delivering
a fixed (not variable) number of equity instruments, the possible conversion of the debenture does
not meet the definition of a liability. Since it is not a liability, it must be recognised as an equity
instrument instead. The reason we deduce that it must be an equity instrument is as follows:
- We received proceeds on the issue, which is an asset.
- Only a portion of these proceeds is a financial liability.
- Thus, the rest of the asset (proceeds – financial liability) represents a residual interest in
assets after deducting the liability, thus meeting the definition of an equity instrument.
Since the debenture is a non-derivative that has a component that meets the definition of a liability (i.e.
the interest and possible redemption) and also has a component that meets the definition of an equity
instrument (i.e. the holder's option to convert the debenture into a fixed number of ordinary shares), the
debenture is considered to be a compound financial instrument.
The potential liability that Barmy is facing is thus measured based on:
(1) the debenture interest that Barmy must pay each year for three years, plus
(2) the possible redemption amount (repayment of the 'principal') after three years.
This total potential liability is recognised as a financial liability and must be measured at its fair value,
being the present value of these two cash outflows. The rate at which we discount the cash outflows is
15%, being the market rate that applies to similar debt without the option to convert.
The difference between the fair value of the debentures as a whole, (which we are told equals the
proceeds received), and the fair value of the financial liability (measured at its present value) is
recognised as an equity instrument.
Debit Credit
1 January 20X5
Bank 100 000 x C5 500 000
Debenture: financial liability W1.3 442 210
Debenture: equity instrument W2 57 090
Issue of convertible preference shares
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Fair value of the issue (equal to proceeds) 100 000 x C5 500 000
Less recognised as a liability W1.3 (442 910)
Equity instrument portion Balancing 57 090
The 20% debenture interest is payable on 31 December each year and the debentures are compulsorily
convertible into ordinary shares (1 ordinary share for every 5 debentures held) on 31 December 20X6.
An appropriate adjusted market dividend rate for ‘pure’ redeemable debentures: 25%.
The debentures are not held for trading.
Required:
Prepare journals to record the financial instrument over its three-year life in the accounting records of
Crazee Limited. You may ignore the journal entry for its conversion on 31 December 20X6.
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31 December 20X4
Finance costs (E: P/L) W3 732 000
Debenture: financial liability Balancing 768 000
Bank 500 000 x C15 x 20% 1 500 000
Payment of interest on debentures
31 December 20X5
Finance costs W3 540 000
Debenture: financial liability Balancing 960 000
Bank 500 000 x C15 x 20% 1 500 000
Payment of interest on debentures
31 December 20X6
Finance costs W3 300 000
Debenture: financial liability Balancing 1 200 000
Bank 500 000 x C15 x 20% 1 500 000
Payment of interest on debentures
Debenture: equity instrument W2 4 572 000
Ordinary stated capital 4 572 000
Conversion of debentures into ordinary shares
8.3.1 Overview
Although the body of IAS 32 focused exclusively on compound financial instruments that arose
due to the holder having the option to convert the instrument into a fixed number of equity
instruments, the application guidance in IAS 32 also indicated that certain preference shares,
which were non-convertible, could also be compound financial instruments (CFI).
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The reason for this is that preference shares frequently offer a combination of terms which could
result in both the financial liability definition and the equity instrument definition being met.
Preference shares could give the preference shareholder the right to preference dividends
and/or the right to receive an amount on redemption. Each of these 'legs' (dividends and
redemption) should be considered separately.
Preference dividends are based on a coupon rate. Preference dividends based on a coupon rate is
similar to debenture interest based on a coupon rate. However, the payment of debenture interest is
always compulsory whereas the payment of preference dividends is not. The terms of the preference
share may result in these dividends being either non-discretionary dividends (i.e. mandatory or
compulsory) or discretionary dividends (i.e. dividends payable at the discretion of the issuing entity).
x If the dividend is non-discretionary (i.e. mandatory or compulsory), the issuing entity does
not have an unconditional right to avoid the delivery of cash (i.e. the entity has an obligation
to pay the dividend) and thus the financial liability definition is met.
x If the dividend is discretionary, the issuing entity has the ability to avoid the delivery of cash
(i.e. the entity does not have an obligation to pay the dividend) and thus the dividend will not
meet the financial liability definition. However, this means, by default, that the discretionary
dividend meets the definition of an equity instrument.
Please note that preference dividends are often referred to as either being cumulative or non-
cumulative. These terms have no bearing on whether an obligation exists to pay the dividend.
x If a preference dividend is cumulative, it simply means that if it is not declared in any one
year, no dividend may be declared to the ordinary shareholders until this preference
dividend is declared. This does not mean that the entity is obliged to declare the preference
dividend and this is because the entity is not obliged to declare an ordinary dividend.
x If a preference dividend is non-cumulative, it simply means that if this dividend is not
declared in any one year, the shareholder's right to ever receive this dividend lapses.
A discretionary dividend does not lead to an obligation. Since it is thus not a liability, it is equity.
x These dividends are recognised as distributions of equity to equity participants (and
presented in the statement of changes in equity)
x They will only be recognised if and when they are declared.
In the case of redeemable preference shares, the terms of the preference shares could indicate
that the redemption:
x is mandatory (i.e. the terms stipulate that the preference shares are redeemable on a certain
date in the future at a determinable amount);
x is at the option of the holder; or
x is at the option of the issuing entity.
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If the redemption is either mandatory or at the option of the holder, the issuing entity would not
have an unconditional right to avoid the outflow of cash on redemption.
x Thus, this means the cash outflow – or possible cash outflow – on redemption meets the
definition of a financial liability (i.e. the entity has an obligation to deliver cash on redemption
that it does not have an unconditional right to avoid). See IAS 32.AG25
However, if the redemption is at the option of the issuing entity, the possible cash outflow on
redemption does not meet the definition of a financial liability because the entity can avoid this
cash outflow (i.e. the entity effectively does not have a present contractual obligation to deliver
cash on redemption).
x Thus, this means that, by default, this possible cash outflow on redemption meets the
definition of an equity instrument. See IAS 32.AG25
In the case of non-redeemable preference shares, the issuing entity clearly does not have an
obligation to deliver cash on redemption.
x Thus, this means that the financial liability definition is not met and thus that the definition
of an equity instrument would be met instead.
x However, the classification of a non-redeemable preference share may not necessarily be
that of a pure equity instrument because the preference share may involve ‘other rights’
(e.g. mandatory dividends) that may need to be classified as a financial liability. We must
look at all the rights attaching to the share in combination. See IAS 32.AG26
Thus, if we look at both of these legs (preference dividends and redemption) in combination, we may
find ourselves with a dividend and a redemption that both meet the definition of an equity instrument
or a dividend and a redemption that both meet the definition of a financial liability. In such cases, the
preference share is not a compound financial instrument because it is classified either entirely as an
equity instrument or entirely as a financial liability. However, if the dividend meets the definition of a
financial liability and the redemption meets the definition of an equity instrument (or vice versa), then
we would have a compound financial instrument. In this case, the principles of accounting for
compound financial instruments would apply.
A summary of the various terms relating to preference shares and the resulting accounting
treatment is outlined in the table below:
Summary: Accounting for preference shares based on the relevant terms of issue
Please note: to illustrate the basic principles of separating an issue into its L & Eq components, the
following summary assumes that, if there is a liability component, it is classified at amortised cost
Chapter 21 1055
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Summary: continuation…
Redeemable/ Pref dividends: Pref dividends:
Non-redeemable Non-discretionary (i.e. mandatory) (L) Discretionary (Eq)
Redeemable: Compound financial instrument Pure equity
x at the issuer's option (Eq)
Liability initially measured at FV: Equity measured at the entire proceeds
x PV of the dividends
Equity measured as residual: P.S. There is no need to determine
x FV of CFI – FV of L FVs because equity is the residual
interest in the A (the proceeds) after
deducting the L (nil).
The preference dividends will be The preference dividends will be
recognised as an interest expense in P/L recognised as a distribution of equity
(in the SOCI) due to the process of (in the SOCIE)
unwinding of the L using the EIR method
See IAS 32.AG25 See IAS 32.AG25-.26
Comments:
x The PV is calculated by discounting the cash flows using an appropriate market-related rate.
x If the proceeds on issue (i.e. the transaction price) reflect the fair value of the compound financial
instrument as a whole, then the market rate will equal the instrument's effective interest rate.
Note 1:
x In effect, non-redeemable preference shares will always be classified based on the classification of
the other rights attaching to the share.
- If the non-redeemable share offers discretionary dividends (equity), the entire instrument ends
up being classified as equity (i.e. it is, in effect, similar to an ordinary share).
- If the non-redeemable share offers mandatory dividends (liability), the entire instrument ends up
being classified as a financial liability (i.e. the instrument is, in effect, a perpetual debt instrument).
- If the non-redeemable share offers mandatory dividends (liability) plus additional discretionary
dividends (equity) the instrument is a compound financial instrument: the mandatory dividends are
a financial liability whereas the discretionary dividends are an equity instrument. See IAS 32.AG26
Note 2:
x Where a preference share is non-redeemable but carries with it the right to receive mandatory
dividends, then, if the dividends are set at a market-related rate that is reflected in the transaction
price (proceeds), then the entire proceeds will be classified as a financial liability with no equity
instrument recognised.
x This is because the fair value of the liability, calculated at the present value of the mandatory perpetual
dividend annuity, discounted at the market rate, would then equal the transaction price.
x Recognising these shares as pure liability makes sense since the combination of being non-redeemable
together with rights to mandatory dividends effectively make them perpetual debt instruments.
x The preference dividends in this situation would be recognised as interest in P/L based on the unwinding
of the L using the EIR method (i.e. presented in the SOCI).
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Note 3:
x If a non-redeemable preference share carries with it the right not only to mandatory dividends (which
will effectively mean dividends in perpetuity) but also to discretionary dividends (e.g. a further
preference dividend based on 5% of any ordinary dividend), then the transaction price (proceeds) should
reflect that there is both a mandatory perpetual dividend stream (liability) and a discretionary dividend
stream (equity).
x The present value of the obligation to pay the mandatory dividend stream (the FV of the financial
liability) would be calculated by discounting the mandatory perpetual dividends using the market rate
relevant to similar debt instruments that offer mandatory perpetual dividends but do not offer the
discretionary dividends as well. The balance of the proceeds received would then be allocated to the
equity instrument.
x The mandatory preference dividends would be recognised as interest in P/L based on the unwinding of
the L using the EIR method (i.e. in the SOCI) but the discretionary preference dividends would be
recognised as a distribution to equity participants (i.e. in the SOCIE).
Required: Prepare Dippy's journals to record the transactions for the year ended 31 December 20X3.
Required: Prepare Kooky's journals to record the transactions during the year ended
31 December 20X1 assuming:
A. An appropriate market-related rate is 8% and the proceeds on issue totalled C125 000, being a
fair value for these preference shares.
B. An appropriate market-related rate is 10% and the proceeds on issue totalled C100 000, being a
fair value for these preference shares.
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Gripping GAAP Financial instruments – general principles
Part A Part B
1 January 20X1 Dr/ (Cr) Dr/ (Cr)
Bank Given 125 000 100 000
FL: Preference shares (L) A: (125 000 x C1 x 8%) ÷ 8%
B: (125 000 x C1 x 8%) ÷ 10% (125 000) (100 000)
Issue of preference shares – financial liability measured at the PV of
the dividend stream, discounted at the market rate
31 December 20X1
Interest expense (E: P/L) A: C125 000 x mkt rate 8% 10 000 10 000
FL: Preference shares (L) B: C100 000 x mkt rate 10% (10 000) (10 000)
Interest on pref share liability: unwinding the discount (use mkt rate)
FL: Preference shares (L) 125 000 x C1 x coupon rate 8% 10 000 10 000
Bank (10 000) (10 000)
Payment of preference dividends
Comment:
x The mandatory perpetual dividend is an obligation and thus represents a financial liability, whereas
the discretionary dividend is not an obligation and thus represents an equity instrument. These
preference shares are thus compound financial instruments (CFIs).
x The financial liability is measured at the present value of this mandatory perpetual dividend stream,
discounted using a market-related rate: Dividend stream ÷ Market-related rate
x The equity instrument will be recognised as a residual amount.
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x The mandatory preference dividend (the perpetual dividend) is thus recognised as interest
expense (based on the concept of unwinding the discount): Liability balance x Market-related rate.
x The discretionary preference dividend will be recognised as a distribution to equity participants if
and when it is declared.
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A contract that will be settled by delivering a fixed number of its own equity instruments (shares)
in exchange for a fixed amount of cash or another financial asset is an equity instrument.
A contract that will be settled in a variable number of the entity’s own equity instruments
(shares) whose value equals a fixed amount, or an amount based on changes in an underlying
variable (e.g. a commodity price) is a financial liability.
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Basically, the intention behind this is that if an instrument is recognised in the statement of
financial position, then any of the ‘items’ related to that instrument must be recognised in the
profit or loss section of the statement of comprehensive income. Conversely, if the instrument
is recognised in the statement of changes in equity, then any ‘items’ relating to that instrument
must also be recognised in the statement of changes in equity.
This approach may require, for example, that dividends declared be recognised in profit or loss
because they relate to the issue of a share that is classified as a financial liability. In this case,
this dividend declaration may end up being included with other traditional interest (such as
interest on loans). However, in the event that, for example, the tax deductibility of the 'dividend
recognised as an expense' and the tax deductibility of 'real interest' differ, it may, in the interests
of improved usefulness, be better to present 'dividends recognised as expenses' separately
from the 'real interest expenses'. See IAS 32.40
We would apply these same principles if the financial instrument was considered to be a
compound financial instrument (i.e. if part of the instrument is classified as a financial liability
and part as an equity instrument). Thus, items relating to a compound financial instrument will
be partly recognised:
x as an income or expense in profit or loss to the extent that they relate to the financial liability; and
x as a direct adjustment to equity to the extent that they relate to the equity instrument.
Transaction costs incurred on the issue of equity instruments are deducted from the equity
instrument account (although these costs must be separately disclosed, according to IAS 1).
However, if transaction costs are incurred but the issue of the equity instrument fails to
materialise, then these costs are simply expensed. See IAS 32.35 & .37
Transaction costs that apply to compound financial instruments are allocated to the financial
liability component and the equity instrument component in the same proportion that the
proceeds received on the issue of the instrument as a whole was allocated to these separate
components. See IAS 32.38
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11. Derivatives (IAS 32.AG15 - .AG19; IFRS 9.4.3 & IFRS 9.BA.1 – .BA.5)
11.1 Overview
Financial instruments are either non-derivative (also called primary) or derivative instruments.
If you were to ask a man on the street what he understood the word derivative to mean, he
would say it is a spin-off, an off-shoot or by-product. A derivative, in financial terms, is much the
same.
A derivative is simply a financial instrument whose value is derived (determined) from the value
of something else. A derivative may result in a financial asset or financial liability, depending on
the nature of the derivative and the movement of the underlying variable on which the value of
the derivative depends.
x Derivatives held for trading are accounted for at fair value through profit and loss. This is
appropriate as a derivative does not meet the BM or SPPI test, thus cannot be measured
at amortised cost or at fair value through other comprehensive income. In addition, financial
liabilities held for trading are accounted for as fair value through profit or loss. See IFRS 9.4.2.1
& IFRS 9.4.1.4
x Derivatives utilised for hedging are accounted for in terms of IFRS 9.6 (see chapter 22).
If one simplifies this definition of a derivative, a derivative is just an instrument whose value is
derived from another specified variable, requires little or no investment and will be settled in the
future. There are many examples of derivatives of which we will discuss a few:
x options,
x swaps, and
x futures.
Stand-alone derivatives meet the definition of a derivative in their own right (in a single contract).
Embedded derivatives exist as part of a combination of a number of instruments in a single
contract, where one or more of these instruments is a derivative (see section 11.5).
An option gives the holder the right (but not the obligation) to buy or sell a financial instrument
on a future date at a specified price.
The most common option that we see are options to buy shares on a future date at a specific
price (strike or exercise price). These are often granted to directors or employees of companies.
Another example is an option to purchase currency on a future date at a specific exchange rate.
Options may be used to limit risks (as the exercise price of an option is always specified) or
they may be used for speculative purposes (i.e. to trade with).
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Required: Journalise the receipts/ payments of cash in Company A’s books for year 2 and year 3.
A forward contract is identical to a futures contract except for the form the contract takes:
x A futures contract is a standard contract drawn up by a financial services company that
operates an exchange
x A forward contract is based on a non-standard contract written up by the parties
themselves.
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It may sound complicated but is not complex at all. Essentially, there is a contract that combines
a number of instruments where one or more of these instruments is a derivative. For this
derivative to be embedded, it must be unable to be transferred (e.g. sold) separately from the
host contract and must not have a separate counterparty to the counterparties of the other
financial instruments within the contract.
The entire hybrid contract, provided the host contract is a financial asset per IFRS 9, is
accounted for as a single instrument. In other words, it would be accounted for based on the
normal classification criteria. IFRS 9.4.3.2
If the host contract is not a financial asset, then IFRS 9 requires the embedded derivative to be
separated from the host and accounted for as a derivative under IFRS 9 if, and only if:
x the economic characteristics and risks of the embedded derivative are not closely related
those of the host
x the separate instrument meets the definition of a derivative per IFRS 9 and
x the hybrid contract has not been designated at fair value through profit and loss See IFRS 9.4.3.3
The separated host and derivative shall be accounted for in accordance with appropriate
standards. See IFRS 9.4.3.4
Required: Discuss how to account for these debentures in both ABC’s and XYZ’s financial statements.
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x Once separated, the embedded derivative meets the definition of an equity instrument in accordance
with IAS 32: settlement of the transaction will result in XYZ delivering a fixed number of its own shares
in settlement for a fixed amount of debt owing to ABC (see IAS 32.21-24). Equity instruments are
initially recognised at the residual of the assets after all liabilities, and this amount is never
subsequently remeasured (see section 8.1). In other words, after measuring the financial liability
portion (i.e. the non-derivative host), the equity portion (i.e. the embedded derivative) is measured as
the balancing amount (cash received on issue – liability portion)
12. Offsetting of Financial Assets and Liabilities (IAS 32.42-50, AG38A-38F, IFRS 7.13C-13E)
Financial assets and liabilities may not be offset against one another unless:
x the entity has a legally enforceable right to set-off the recognised asset and liability; and
x the entity intends to realise the asset and settle the liability simultaneously, or on a net basis.
If the requirements for offsetting are met, the financial asset and financial liability must be offset.
When an entity has the right to receive or pay a single net amount and intends to do so, it has,
in effect, only a single financial asset or financial liability. However, the existence of an
enforceable right, by itself, is not a sufficient basis for offsetting. There has to be an intention to
exercise this right or to settle simultaneously. Conversely, an intention to settle on a net basis
without the legal right to do so is not sufficient to justify offsetting.
It is important to note that offsetting a financial asset and a financial liability (presenting the net
amount) differs from derecognising a financial asset and a financial liability. This is because
derecognising a financial instrument not only results in the removal of the previously recognised
item in the statement of financial position but may also result in the recognition of a gain or loss
in the statement of comprehensive income whereas this does not occur in the case of offsetting.
13.1 Overview
The measurement of deferred tax in respect of financial instruments is, as usual, dependent on
management’s intention in recovering the future economic benefits of a financial asset or the
settlement of a financial liability. However, the accounting for deferred tax is complicated by the
detailed and complex legislation governing the tax consequences of financial instruments. The
following explanation assumes that the income tax legislation applicable in South Africa applies
and addresses the tax consequences of ‘plain vanilla’ financial instruments.
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The amortised cost method requires the calculation of the DT effect of FAs that are
held at amortised cost (AC):
effective interest rate, which takes into account premiums,
discounts, as well as the amount and timing of future cash x Carrying amount = AC;
flows. These calculations are the same as those used to x Tax base = AC
determine the “yield to maturity” in terms of the South x Therefore TD = 0; DT = 0
African Income Tax (this is the tax term for effective
interest rate). As a result, the tax base of a financial instrument carried at amortised cost will
usually equal it’s carrying amount, and thus, no temporary difference will arise.
In all other cases, the future economic benefits of the x Carrying amount = FV
financial asset will be consumed through the eventual x Tax base = Base cost (cost)
sale of the financial asset. Thus, the tax base of the x Tax rate = income tax rate x CGT
inclusion rate
financial asset will equal its base cost and deferred tax will
be measured on the effective capital gains tax rate.
Example 42: Deferred tax consequences of financial assets
FI Limited holds a number of investments in ordinary shares. Additionally, FI Limited is
involved in the trading of shares. The details of all financial instruments held are as follows:
Description Classification Original FV on FV on
cost 1 Jan 20X5 31 Dec 20X5
A Shares held for trading FVPL C5 000 C6 000 C8 000
B Shares held to collect dividends FVPL C4 000 C5 000 C5 500
C Shares held for long-term capital growth FVOCI 8 000 10 500 11 750
The entity has elected that the shares in portfolio C will be measured at FVOCI. No other elective
provisions have been applied. The corporate tax rate is 30%, and the CGT inclusion rate is 80%.
Required: Prepare the journal entries to record the implications of the investments in financial
instruments for the year ended 31 December 20X5.
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14.1 Overview
There are three categories of financial risks and they are:
x market risk;
x credit risk; and
x liquidity risk.
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Interest rate risk is the risk that the fair value or the future cash flows of a financial instrument will
fluctuate with changes in the market interest rate. A typical example is a bond: a bond of C100
earning a fixed interest of 10% (i.e. C10) would decrease in value if the market interest rate changed
to 20%, (theoretically, the value would halve to C50: C10/ 20%). If the bond earned a variable interest
rate instead, the value of the bond would not be affected by interest rate fluctuations.
Currency risk is the risk that the value or the future cash flows of a financial instrument will fluctuate
because of changes in the foreign exchange rates. A typical example would be where we have
purchased an asset from a foreign supplier for $1 000 and at the date of order, the exchange rate
is $1: C10, but where the local currency weakens to $1: C15. The amount owing to the foreign
creditor has now grown in local currency to C15 000 (from C10 000).
Other price risk is the risk that the value or the future cash flows of the financial instrument will
fluctuate because of changes in the market prices (other than those arising from interest rate risk or
currency risk). For example: imagine that we committed ourselves to purchasing 1 000 shares on a
certain future date, when the share price was C10 on commitment date. This commitment opens us
to the risk that the share price increases (e.g. if the share price increases to C15, we will have to pay
C15 000 instead of only C10 000).
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IAS 1 requires that on the face of the statement of comprehensive income, the movement in
other comprehensive income must be shown in total and must be split between:
x Items that may be subsequently reclassified to profit of loss, and
x Items that may never be subsequently reclassified to profit or loss
The following is a suggested disclosure layout that you may find useful.
Entity name
Statement of comprehensive income (extracts) 20X5 20X4
For the year ended 31 December 20X5 C C
Note
Revenue xxx Xxx
Other income:
x Fair value adjustment of financial asset through profit or loss xxx Xxx
x Fair value gains/(losses) on reclassifications of financial assets
Impairment losses (expected credit losses) (xxx) (xxx)
Distribution costs (xxx) (xxx)
Profit before finance costs xxx Xxx
Finance costs (xxx) (xxx)
Profit before tax xxx xxx
Taxation expense xxx Xxx
Profit for the year xxx Xxx
Other comprehensive income for the year xxx xxx
x Items that may be reclassified to profit of loss
- Cumulative gain/loss on financial assets classified at
FVOCI-debt derecognised/reclassified to FVPL
- Gain/(loss) on cash flow hedge, net of reclassification 23 xxx xxx
adjustments and tax
x Items that may never be reclassified to profit or loss
- Gain/ loss on the portion of a financial liability designated 24 xxx xxx
at fair value through profit or loss that relates to the
changes in fair value due to changing credit risk, net of tax
- Gain/ loss on a financial asset that is an investment in 25 xxx xxx
equity instruments elected to be measured at fair value
through other comprehensive income, net of tax
- (Increase)/decrease in loss allowance on financial assets
classified at FVOCI-debt
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Entity name
Statement of changes in equity
For the year ended 31 December 20X5 (extracts)
Ordinary Retained Gains/ losses on Gains/ losses Total
shares earnings financial assets on cash flow
at FVOCI hedge
C C C C C
Balance: 1 January 20X5 xxx xxx xxx xxx xxx
Ordinary shares issued xxx xxx
Total comprehensive income xxx xxx xxx xxx
Balance: 31 December 20X5 xxx xxx xxx xxx xxx
Entity name
Statement of financial position (extracts) 20X5 20X4
As at 31 December 20X5 Note C C
Entity name
Notes to the financial statements (extracts) 20X5 20X4
For the year ended 31 December 20X5 C C
1. Statement of compliance
…
2. Accounting policies
2.1 Financial instruments
The following recognition criteria are used for financial instruments…
The fair values of the financial instruments are determined with reference to …
23. Other comprehensive income: cash flow hedge, net of reclassifications and tax
Cash flow hedge gain / (loss) xxx (xxx)
Tax on gain / (loss) (xxx) xxx
Reclassification of cash flow gain / (loss) (xxx) xxx
Tax on reclassification of cash flow gain / (loss) xxx (xxx)
Cash flow hedge gain/ (loss), net of reclassification and tax xxx xxx
24. Other comprehensive income: gain or loss on a financial liability designated at fair value
through profit or loss relating to credit risk, net of tax
Fair value gain / (loss) xxx xxx
Tax on fair value gain / (loss) (xxx) (xxx)
Fair value adjustment of financial instrument, net of tax xxx xxx
25. Other comprehensive income: gain or loss on a financial asset that is an investment in
equity instruments at fair value
Fair value gain / (loss) xxx xxx
Tax on fair value gain / (loss) (xxx) (xxx)
Fair value adjustment of financial instrument, net of tax xxx xxx
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16. Summary
Financial Assets: Classification Process
FV through P/ L
i.e. is the objective to i.e. is the objective to FV through OCI
collect only the: collect both the: (equity instrument)
x contractual cash x contractual cash
flows (i.e. the entity flows; and
does not intend dealing x cash flows from
in the instruments) selling the asset No (Neither BM applies)
Yes Yes
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FV through other comprehensive income Measure the asset at fair value on subsequent reporting dates with
(investments in equity instruments) FV gains/losses in OCI (foreign exchange gains/losses also in OCI*);
Dividend income in P/L (unless part recovery of the asset’s cost).
Gains/losses in OCI may not be reclassified to P/L. See IFRS 9.B.5.7.1 & .3
Loss allowance: N/A
* IAS 21 Foreign currency transactions requires foreign exchange gains or losses on monetary items to
be recognised in P/L. Since a debt instrument is a monetary item whereas an equity instrument is not a
monetary item, foreign exchange gains or losses:
x are recognised in P/L under the FVOCI classification for debt instruments; whereas they
x are recognised in OCI under the FVOCI classification for equity instruments. See IFRS 9.B.5.7.2-3
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Chapter 22
Financial Instruments – Hedge Accounting
Reference: IAS 32, IFRS 7, IFRS 9 and IFRS 13 (including any amendments to 1 December 2019)
Contents: Page
1. The basics of hedge accounting 1075
1.1 Overview 1075
1.2 What do we mean by hedges and hedging? 1075
1.3 What is a hedged item? 1076
1.3.1 Overview 1076
Worked example 1: Hedged items 1076
1.3.2 Recognised transactions 1077
1.3.3 Forecast transactions (an uncommitted future transaction) 1077
1.3.4 Firm commitments (committed future transaction) 1077
1.3.5 Hedged items can be single items, groups of items or hedged components 1078
1.3.6 Summary of the periods during which items may be hedged 1078
1.4 What is a hedging instrument? 1078
1.5 How hedging is achieved using a forward exchange contract 1079
Worked example 2: Settlement of a FEC 1080
Worked example 3: FEC’s can result in gains or losses 1080
Worked example 4: Accounting for speculative FECs 1081
1.6 How to measure FEC at its present value 1082
Example 1: Present value of a FEC 1082
2. Hedge accounting 1083
2.1 What is the objective of hedge accounting? 1083
2.2 Hedging accounting qualifying criteria 1084
2.3 Hedge effectiveness as a qualifying criterion 1084
2.4 Types of hedges 1085
3. Fair value hedges 1086
3.1 What is a fair value hedge? 1086
Worked example 5: Fair value hedge of a foreign debtor 1086
3.2 Accounting for a fair value hedge 1086
4. Cash flow hedges 1087
4.1 What is a cash flow hedge? 1087
Worked example 6: Cash flow hedge of a foreign creditor 1087
4.2 Accounting for a cash flow hedge 1087
4.2.1 General approach 1087
4.2.2 Accounting for a cash flow hedge that contains an ineffective portion 1088
4.2.3 Calculating the effective and ineffective portions of a cash flow hedge 1089
Example 2: Cash flow hedges and the concept of ineffective portions 1089
5. Designation of hedging instruments 1090
Example 3: Splitting the interest element and the spot price of a FEC 1091
6. Discontinuance of hedge accounting 1091
6.1 Discontinuing hedge accounting 1091
6.2 How to stop using cash flow hedge accounting 1092
6.3 Rebalancing 1092
Worked example 7: A rebalancing exercise 1092
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1.1 Overview
You may be forgiven for thinking a hedge is a series of bushes planted along the boundary of a
property, a hedged item is the house in the middle of this property, a hedging instrument is the
pair of garden shears used to trim the hedge and that hedging is the act of trimming the hedge.
But, our world of accounting is a bit like a parallel universe where concepts such as hedges,
hedged items, hedging instruments and hedging take on similar, yet very different meanings.
This chapter first explains some terminology and the theory of hedge accounting and then shows
how to apply this theory using a series of examples. To keep things simple and comparable, the
examples will all focus on hedging items (e.g. a foreign loan) that are exposed to ‘foreign currency
risks’, and will all involve the use of a relatively common hedging instrument: ‘the forward exchange
contract (FEC)’.
Hedging involves protecting against risks and thus most entities will be involved in hedging
transactions to some degree or another. However, accounting for hedging transactions using
IFRS 9’s ‘hedge accounting’ principles is optional. The purpose of hedge accounting is to ensure
that the financial statements reflect the entity’s risk management activities, to the extent these
activities involve using financial instruments to manage risks that could affect profit or loss (or, in
some cases, other comprehensive income). Although the application of hedge accounting is optional,
once we start hedge accounting, we may not stop hedge accounting unless certain criteria are met.
The terms ‘hedge’ or ‘hedging’ are not defined in IFRS 9. However, if we take out a hedge, it simply
means we are trying to protect ourselves against a risk. Thus, a hedge is our protection against a
risk (e.g. that our asset might lose value) and hedging is the act of protecting against risk.
Hedging, from the perspective
Hedging involves any activity designed to protect
of IFRS 9, is a risk mgmt.
ourselves against the risk of incurring losses. For activity that uses a financial
instance, when taking out insurance, we are trying to instrument as the hedging instrument
hedge against possible losses from certain risks (e.g. we to protect against the risk that a
might insure our car against loss due to theft). hedged item could negatively affect
P/L (or in certain cases, OCI)
See IFRS 9.6.1.1
However, hedging from the perspective of IFRS 9
refers specifically to the use of a financial instrument (normally a derivative) to protect against
risks that could otherwise negatively affect profit or loss (or, in certain cases, other comprehensive
income). Interestingly, although insurance contracts could be considered as financial instruments,
they are excluded from the scope of IFRS 9 Financial instruments (see IFRS 9.2.1). This means
that, although insurance contracts are used to hedge risks, they cannot be accounted for as a
hedging instrument (i.e. using IFRS 9’s hedge accounting principles), because a ‘hedging
instrument’ must be a financial instrument in terms of IFRS 9.
The idea behind hedging is that changes in our hedging instrument’s fair value or cash flows will
offset the changes in our hedged item’s fair value or cash flows and thus reduce the impact on
profit or loss (or in certain cases, other comprehensive income). For example: if our hedged item is
an asset and its fair value decreases (debit loss; credit hedged item), our hedging instrument’s value
should increase (debit hedging instrument; credit gain) so that the loss on the hedged item and the
gain on the hedging instrument offset each other and negate or reduce the impact on profit or loss.
Since this chapter explains hedging mainly using hedges of foreign currency transactions, it would
be useful to define the hedge of a foreign currency transaction. In this regard, we could define it as:
x taking a position in a hedging instrument that would
x counter any change (position) in the hedged item;
x caused by a currency exchange rate fluctuation.
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The eligible hedged item must also be reliably measurable and must involve parties external to the entity
(i.e. third parties). For example, we could not designate a firm commitment as a hedged item unless it
involved a commitment to a third party (i.e. a decision simply made in a management meeting to purchase
an asset is not a firm commitment). Interestingly, the requirement for third party involvement means that
if hedging has been achieved using transactions between entities within a group, hedge accounting can
be applied in the separate financial statements but not in the consolidated financial statements.
See IFRS 9.6.3.2 and 6.3.5
Entities hedge items that are exposed to a risk of some kind. For example, an item that is a recognised
liability denominated in a foreign currency (i.e. a foreign payable) would be exposed to the risk that the
resultant cash outflows might increase due to unfavourable changes in the foreign currency exchange rate.
This particular risk is referred to as a foreign currency risk. Thus, the entity might consider hedging this risk.
In scenario A, the dollar becomes cheaper to South Africans ($1 used to cost R10, but now it only costs
R8). Thus, we say that the Rand has strengthened against the dollar. The effect of this is that, in Rand
terms, the amount we expect to have to pay our creditor decreases from R100 000 to R80 000 (good).
Conversely, in scenario B the Rand weakened ($1 used to cost R10, but now costs R14). The result is that
the amount we expect to have to pay our creditor increases from R100 000 to R140 000 (bad). This is
journalised as follows:
Scenario A Scenario B
1 January 20X3 (transaction date = TD) Dr/ (Cr) Dr/ (Cr)
Inventory (A) A & B: $10 000 x SR on TD: R10 100 000 100 000
Creditor (L) (100 000) (100 000)
Purchase of inventory from foreign supplier (import)
31 March 20X3 (settlement date = SD)
Foreign exchange gain (I) A: $10 000 x (SR on SD: R8 – SR on TD: R10) (20 000) -
Foreign exchange loss (E) B: $10 000 x (SR on SD: R14 – SR on TD: R10) - 40 000
Creditor (L) 20 000 (40 000)
Remeasurement of creditor to spot rate (SR) on settlement date
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Scenario A Scenario B
31 March 20X3 continued … Dr/ (Cr) Dr/ (Cr)
Creditor (L) A: $10 000 x SR on SD: R8 80 000 140 000
Bank B: $10 000 x SR on SD: R14 (80 000) (140 000)
Payment of creditor at spot rate (SR) on settlement date
When entering a foreign currency denominated transaction like this one, we can either decide to take a chance
that the exchange rate will move in our favour (like scenario A) or we could decide to hedge against the possibility
that the exchange rate will move in a way that is unfavourable to us (like scenario B).
If we decide to hedge the item (the creditor), we must choose an instrument to hedge it with (see section 1.4).
Please note: If a foreign debtor owed us $10 000 (instead of us owing a foreign creditor), then scenario A would
be an exchange rate movement that was unfavourable to us (our debtor would pay us less) whereas scenario B
would be an exchange rate movement that was favourable to us (our debtor would pay us more).
An item that is eligible to be designated as a ‘hedged item’ could be a single such item in its entirety, or a
group thereof, or even just a component (part) of one of these items or groups of items. See section 1.3.5.
The hedged item could be a recognised asset or liability (see section 1.3). A recognised asset or
liability is simply an asset or liability that has been recorded (recognised) in our accounting records.
For example, an account payable is a recognised liability – and if it was denominated in a foreign
currency, we may choose to protect it against changes in foreign exchange rate fluctuations (see
section 7.3 for details on how we account for hedges of recognised transactions).
x not yet happened (i.e. it is a future transaction); and x an uncommitted but anticipated
x not yet been committed to (no firm order exists); but x future transaction. IFRS 9 Appendix A
x is expected to happen.
An entity can hedge a forecast transaction but can only account Highly probable
for it as a hedged item if it is highly probable that the transaction is not defined in IFRS 9 but it
will occur (just ‘expecting it’ is not good enough!). In other words, is defined in IFRS 5 as:
we can only account for hedges of ‘highly probable forecast x significantly more likely
x than probable IFRS 5 App A
transactions’. (see section 7.4.2 for details on how we account
Thus, it means roughly 'likely to occur'.
for hedges of forecast transactions).
In terms of its definition (see pop-up), a firm commitment is a future A firm commitment is
transaction (i.e. one that has not yet happened) but one that we defined as: IFRS 9Appendix A
have already committed to. In other words, it is a transaction we x a binding agreement
cannot avoid. IFRS 9 Appendix A x for the exchange of a specified
quantity of resources
A commitment is binding (unavoidable) if it is enforceable, legally x at a specified price
x on a specified future date/ dates.
or otherwise. Something would be enforceable if non-performance
would result in penalties, whether these were stipulated in the agreement or would apply for other
reasons (e.g. through a court of law).
An example of a firm commitment is an entity signing a contract, ordering goods to be delivered from
a foreign supplier. In this case, the future transaction is a future purchase and the fact that we signed
a legally binding contract makes the order enforceable. It is this enforceability that has now made
our future transaction a 'firm commitment'.
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A firm commitment exists from the date we make the commitment until the transaction is eventually
recognised in our books (i.e. when the ‘firm commitment’ becomes a ‘transaction’ instead). In our
example, this recognition date would be the day we obtain control over the imported goods.
In other words, the ‘life-span of a firm commitment’ begins on the date we make a commitment and
ends on the date the transaction is recognised (transaction date). (See section 7.4.3 for details on
how we account for hedges of firm commitments).
1.3.5 Hedged items can be single items, groups of items or hedged components
Items that are eligible to be designated as a ‘hedged item’ (e.g. a recognised asset) could be:
x a single item in its entirety, in which case we would be hedging all the cash flow changes or all
the fair value changes (e.g. hedging against the change in fair value of an investment in shares).
x a group of items, in which case certain extra criteria must be met before it can be designated as
a hedged item (e.g. all items in the group must, individually, be eligible hedged items, and must
be managed together for risk purposes). See IFRS 9.6.6.1 for the extra criteria
x a part of the change in the cash flows or fair value of an item (this part is called a hedged component).
Risk components can only be designated as hedged items if they are separately identifiable and
reliably measurable (this is a requirement that applies to all hedged items). In this regard, if our
hedged item is going to be a risk component, this risk component could be explicitly referred to in a
contract (contractually specified) or simply be implied (non-contractually specified). If it is non-
contractually specified, it does not mean it cannot be designated as a hedged item, it just makes it
slightly more difficult to prove it is separately identifiable and that its effect on the fair value or cash
flows can be reliably measurable. See IFRS 9.B6.3.10
Components of a nominal amount can be designated on a layer or proportional basis. For example:
x A ‘layer component’: only purchases after the first C200 000 sales are designated as a hedged item.
x A ‘proportional component’: only 50% of the contractual cash flows of a loan are designated as a hedged
item. See IFRS 9.B6.3.17 & .18
A summary of the periods during which items may be hedged are as follows:
Date a future transaction Date that a firm Date the transaction Date the
becomes highly probable commitment is made is recognised transaction is settled
It is important to realise we do not have to enter into a firm commitment before a transaction is entered
into – nor do future expected transactions always become highly probable before actually happening.
We also do not have to hedge during all of these periods. For example, we could even hedge an item
after the transaction has occurred in which case we would be hedging a recognised asset or liability.
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x Non-derivative financial asset or liabilities measured at fair value through profit or loss,
including natural hedges that minimises foreign currency risk (e.g. internal matching of foreign
debtors & foreign creditors in the same currency). See IFRS 9.6.2.2
But please note the following non-derivatives may not be used as hedging instruments:
equity instruments issued by an entity (because these are not financial assets or liabilities)
financial liabilities designated at fair value through profit or loss where fair value changes
resulting from changes in credit risk are recognised in OCI.
If we are hedging a foreign currency risk, then there is a further non-derivative that may not
be used as a hedging instrument:
the foreign currency risk component of a non-derivative financial asset/ liability that has
been designated at fair value through other comprehensive income. See IFRS 9.6.2.2
Financial instruments that qualify to be used as hedging instruments are generally required to be
designated in their entirety but there are three exceptions to this:
x separating the intrinsic value (i.e. the value obtained from the instrument itself) from the time value
of the instrument;
x separating the forward element and spot element of a forward contract and designate only the
change in value of the spot element as our hedging instrument.
x A proportion of the entire instrument may be designated as the hedging instrument. See IFRS 9.6.2.4
Obviously, these financial instruments could be held to collect contractual cash flows or for speculative
reasons, but if they are to be accounted for as hedging instruments, there must be a clear intention by
management to use them as hedging instruments.
If the hedged item is, for example, a recognised liability denominated in a foreign currency (e.g. an
amount payable to a foreign creditor) we could use a forward exchange contract (FEC) as the hedging
instrument. FEC’s are entered into between an entity and a bank or other financing house.
For example, imagine we expect the spot exchange rate to move in a way that will result in us
needing an extra LC100 when we settle a foreign liability in a few months from now (i.e. we expect
the value of our local currency to weaken and thus the foreign liability balance to increase when
we remeasure it to the spot rate on settlement date). We could hedge against this possible loss
by using a FEC to ‘lock in’ a specific future exchange rate (called a forward rate). This contract
allows the entity to avoid or minimise possible losses on the hedged item due to a fluctuating
foreign exchange rate (forex rate). However, the contract may work against us instead, resulting
in us making a loss or reducing possible gains.
The forward rate agreed upon in the FEC contract (the FEC rate) will differ from the spot rate available
on that date. This is because the FEC's forward rate reflects the financing house's prediction of what
the spot rate will be on the date the FEC is set to expire. Thus, depending on the financing house’s
expectations about the exchange rate movements and the contract terms (e.g. whether the contract
covers a future receipt or future payment of foreign currency), the forward rate that we would be offered
would consist of the current spot rate plus a premium, or less a discount.
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When the FEC expires, the difference between the forward rate agreed to in the contract and
the spot rate ruling on expiry date will get settled. Settling the difference means either:
x we pay the difference to the financing house, in which case we would have already
recognised a FEC liability and a foreign exchange loss
debit forex loss and credit FEC liability, and then
debit FEC liability and credit bank; or
x we receive the difference from the financing house, in which case we would have already
recognised a FEC asset and a foreign exchange gain
debit FEC asset and credit forex gain, and then
debit bank and credit FEC asset.
Important comparison!
Thus, whether our forward exchange contract (FEC)
will result in a gain or loss to us will obviously only be x The spot rate is the exchange
known on expiry date, when we know the final spot rate that is being offered at
exchange rate. any one given point in time.
x The forward rate is the
When our FEC expires, our accounting records will be exchange rate you agree to
updated to reflect either the ‘FEC asset and gain’, or pay or receive in the future.
the ‘FEC liability and loss’, measured by comparing:
x the forward rate agreed to in our forward exchange contract (FEC); and
x the spot rate ruling on expiry of the FEC.
However, between the date the FEC is entered into and the date the FEC expires, we
obviously won’t know what the final spot rate will be, and thus, if there is a reporting date
between these two dates, we will need to recognise an estimated ‘FEC asset and gain’ or
estimated ‘FEC liability and loss’. This estimate is based on the difference between:
x the forward rate agreed to in our forward exchange contract (FEC); and
x the forward rate currently being offered (i.e. on the date we are estimating our FEC asset
or liability) in similar forward exchange contracts that expire on the same date as our FEC.
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When signing an FEC with a bank, we are effectively gambling on the exchange rates. When signing
the FEC, we secure a forward rate to cover either a future foreign currency denominated payment or
receipt. When we agree to this forward rate, we are hoping that when the FEC expires, our forward rate
compared to the spot rate will result in the bank having to pay us rather than us having to pay the bank.
Imagine we secure a forward rate (FR) of R11: $1 in an FEC to cover a future payment of $10 000.
This means we know our future cash outflow will be R110 000 ($10 000 x R11). However, if the spot
rate is R9: $1 when this FEC expires, we will regret having signed the FEC. This is because, had we
not signed the FEC, and thus simply been left exposed to the spot rate (SR), our cash outflow when
paying our creditor would only have been R90 000 ($10 000 x R9). However, the FEC has resulted in a
loss to us of C20 000 and thus we will pay the bank R20 000 ($10 000 x FR: R11 - $10 000 x SR: R9)
when the FEC expires. Thus, in this case, the FEC was a liability to us.
However, if this same FEC (with a forward rate of R11: $1) had been covering a future receipt of
$10 000, then we know our future cash inflow will be R110 000 ($10 000 x R11) and thus, a spot rate
of R9: $1 on the date the FEC expires would have been a 'good thing'. This is because, had we not
signed the FEC, and thus been left exposed to the spot rate, our only cash inflow would have been from
our debtor at R90 000 ($10 000 x R9). However, this FEC resulted in a gain to us of C20 000 and thus
the bank will pay us R20 000 when the FEC expires. Thus, in this case, the FEC was an asset to us.
Thus, depending on which way the spot rate goes, and depending on whether we are effectively hedging
a future payment or receipt, we may either be glad we signed the FEC (i.e. the FEC was an asset and
thus made us a gain) or we may regret it (i.e. the FEC was a liability and thus made us a loss).
However, please note that, irrespective of whether a speculative FEC improved or worsened the cash
flow, when it is used as a hedge, it has achieved its objective, which was simply to lock into a price
and thus reduce risk attached to the hedged item
However, if a few days after signing the FEC we notice that the financing house is now offering forward
rates of R9: $1 on similar FECs that expire on 31 March (i.e. we compare our forward rate with forward
rates currently being offered in similar FEC’s with the same expiry date), it means that the financing
house is now predicting that our local currency will have strengthened by 31 March. Although we have
the comfort of knowing that our creditor will cost us R110 000 and nothing more, we will be regretting
that we 'locked-in' at R11: $1 instead of at R9: $1 (if we had locked-in at R9: $1, paying our creditor
would cost us R90 000 instead of R110 000). The fact that the FEC seems to be working against us, is
recognised as a FEC liability and foreign exchange loss (credit: FEC liability and debit: forex loss with
an amount of R20 000).
Because it is too time-consuming to keep checking daily to compare the latest forward rates on offer
with the forward rate we obtained, we simply check whether the FEC is working for or against us on
certain specific dates, such as every reporting date until the FEC expires.
Then, when the FEC expires on 31 March, we will compare the forward rate we obtained with the final
spot rate on 31 March. We will now know for sure whether the FEC worked for or against us.
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In scenario A, the strengthening Rand reduces the amount we owe our creditor (good) but our FEC
locked us into a higher forward rate (R11: $1) than if we simply been left exposed to the spot rates (bad)
– thus the FEC in this case was a liability to us.
In scenario B, the weakening Rand increases the amount we owe our creditor (bad) but our FEC locked
us into a lower forward rate (R11: $1) than if we had been left exposed to the spot rate (good) – thus the
FEC was an asset to us.
Scenario A Scenario B
31 March 20X3 (settlement date = SD) Dr/ (Cr) Dr/ (Cr)
FEC liability (L) A: $10 000 x (SR on SD: R8 – FR secured: R11) (30 000) -
Foreign exchange loss (E) 30 000 -
FEC asset (A) B: $10 000 x (SR on SD: R14 – FR secured: R11) 30 000
Foreign exchange gain (I) (30 000)
Recognising the FEC asset or liability (and resulting gain or loss)
FEC liability (L) The balance in the FEC liability a/c on expiry 30 000 -
FEC asset (A) The balance in the FEC asset a/c on expiry (30 000)
Bank (30 000) 30 000
Settling the FEC when it expires: if the FEC is a liability it means we will
pay the bank, whereas if the FEC is an asset, the bank will pay us
Notice that we did not bother recording the fact that the forward rates being offered on 31 January would have
made us 'unhappy' in scenario A and 'happy' in scenario B. This is because this was not a 'special date'.
This next example shows the effect of present valuing, but all other examples thereafter will ignore
present valuing in order to better illustrate hedging principles.
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W3: Remeasurement adjustment at 31 August 20X5 Not Present Valued Present Valued
FEC asset at 30 June 20X5 reversed W1 (273) (263)
FEC liability at 31 August 20X5 recognised W2 (311) (304)
(584) (567)
2. Hedge Accounting
The idea of hedge accounting arose because, when we apply the usual IFRS requirements
to the hedged item and to the hedging instrument, we would not necessarily recognise the loss
(or gain) on the ‘hedged item’ and the gain (or loss) on the ‘hedging instrument’ in the same
period and/or in the same place (e.g. a loss on the hedged item might be recognised in P/L
whereas the gain on the hedging instrument is recognised in OCI). These are referred to as
accounting mismatches.
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Hedge accounting is entirely voluntary but there are certain criteria that must be met before we
are allowed to apply hedge accounting (see section 2.2).
If we have an item that we believe is at risk, we may decide to hedge these risks, by using an
instrument that we believe will offset these risks.
If our item meets the definition of a hedged item (see section 1.3) and if our instrument meets the
definition of a hedging instrument (see section 1.4) then we have two ingredients necessary for
hedge accounting. However, we may only account for the relationship between the hedged item
and the hedging instrument as a hedge if all 3 criteria are met. These are listed in the pop-up below.
Hedge accounting may only be applied if all of the following 3 criteria are met:
x The hedging relationship must consist only of eligible hedging instruments and hedged items.
IFRS 9.6.4.1 (a) (slightly reworded)
x At the inception of the hedging relationship, there must be a ‘formal designation and
documentation of the hedging relationship and the entity’s risk management objectives and
strategy for undertaking the hedge’.
That documentation must identify:
the hedging instrument,
the hedged item,
the nature of the risk being hedged (e.g. in this chapter we focus on foreign exchange risk), &
how the entity will assess the hedging effectiveness of the hedging relationship’.
IFRS 9.6.4.1 (b) (slightly reworded)
x The hedging relationship must meet ‘all of the following hedge effectiveness requirements’:
an economic relationship must exist between the hedged item and the hedging instrument,
the effect of credit risk must ‘not dominate the value changes that result from that
economic relationship’, &
the hedge ratio of the hedging relationship for accounting purposes must mirror the
ratio for risk management purposes (i.e. ‘the quantity of the hedged item’ that is
actually hedged relative to ‘the quantity of the hedging instrument that the entity
IFRS 9.6.4.1 (c)(reworded)
actually uses to hedge’ it).
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This requires an entity to monitor changes in the fair x The risk that one party to a
value of the instruments within the economic financial instrument
relationship and assess the extent to which such x Will cause financial loss to the
other party
changes are driven by changes in credit risk. x By failing to discharge an
x The hedge ratio for accounting purposes mirrors the obligation
IFRS 7 Appendix A
hedge ratio for risk management purposes, provided
the ratio does not reflect a deliberate imbalance designed to achieve an accounting
outcome that is not consistent with the purposes of either hedge accounting or risk
management. See IFRS 9.6.4.1(c)
Hedge ratio is defined as
Despite the fact that there is no pre-determined level of the relationship between
hedge effectiveness required for this particular qualifying x the quantity of the hedging
instrument and
criterion to be met, it is important to understand what is x the quantity of the hedged item
meant when people refer to the ‘level of hedge x in terms of their relative weighting.
effectiveness’. IFRS 9 Appendix A
The level of hedge effectiveness is simply a comparison between the movement in the value of
the hedging instrument compared to the movement in the value of the hedged item, where this
comparison is generally expressed as a percentage or ratio.
If a hedge becomes ineffective, by failing to adequately meet one of the three criteria (see the
characteristic features listed above), we do not discontinue hedge accounting. Instead, we may
need to rebalance the quantities of either the hedging instrument or the hedged item, and also
immediately recognise the ineffective portion in profit or loss. Refer to section 6.3 for further
explanation on rebalancing.
If, for example, a gain on a hedging instrument equals the loss on the hedged item, the instrument
is said to be 100% effective. It is, however, highly unlikely that the hedging instrument is 100%
effective. For example, a weakening exchange rate may result in us needing an extra LC100 to
settle a foreign creditor, while the FEC only gains in value by LC80. In this case, the hedge is no
longer 100% effective, but 80% effective (gain on instrument: 80 ÷ loss on item: 100). Hedge
ineffectiveness does not pose a problem for fair value hedges, because all gains or losses are
already reflected in profit or loss. The effects of hedge ineffectiveness are discussed in
section 4.2.2 and section 4.2.3.
In simple terms, a fair value hedge is a hedge that protects against changes in the fair value
of the hedged item whereas a cash flow hedge is a hedge that protects against changes in
the cash flows relating to the hedged item.
Fair value hedges and cash flow hedges are accounted for differently. Although the accounting
is similar to the extent that, in both cases, we recognise the effect of the hedging instrument (e.g.
FEC contract) as an FEC asset or liability, it differs in that the related gains or losses (which are
recognised when creating and adjusting the FEC asset or liability balance) are recognised:
x in 'profit or loss' (P/L) if it is a fair value hedge,
x in 'other comprehensive income' (OCI) if it is a cash flow hedge.
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Thus, a fair value hedge that is hedging (protecting) against the effects of changes in fair value on our
profit or loss (or other comprehensive income – see exception above) is a hedge that is trying to protect:
x a recognised asset or liability (or part thereof), or
x an unrecognised firm commitment (or part thereof),
x against changes in its fair value
x that may result from changing economic circumstances (such as fluctuations in the
exchange rates).
The value of our foreign debtor has thus dropped from R500 000 ($100 000 x R5) to R400 000
($100 000 x R4). A fair value hedge would attempt to neutralise any such decrease in value.
When accounting for a fair value hedge, we recognise the movement in the value of the hedging
instrument (e.g. a FEC) as an asset or liability and generally:
x recognise the gains or losses on the hedging instrument in profit or loss; and
x recognise the gains or losses on the hedged item in profit or loss See IFRS 9.6.5.8
There are two exceptions to the above general rules of fair value hedge accounting:
Exception 1: If the hedged item is an investment in equity instruments that is classified at fair
value through other comprehensive income (i.e. FVOCI-equity), then:
x The gains or losses on the hedging instrument must also be recognised in other
comprehensive income (not in profit or loss);
x The gains or losses on the hedged item (i.e. the equity instruments) will be recognised in
other comprehensive income (i.e. as they would normally be). See IFRS 9.6.5.8(b)
Exception 2: If the hedged item is an unrecognised firm commitment (or part thereof), then, in
addition to recognising the hedging instrument as an asset or liability, we also recognise the
movement in the value of this firm commitment (i.e. the hedged item) as an asset or liability:
x The cumulative change in the fair value of the hedged item (from the date that it was
designated as being the hedged item) is recognised as a firm commitment asset or liability
with a corresponding gain or loss in profit or loss.
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x When the firm commitment (or part thereof) finally results in the acquisition of the asset or
liability (i.e. the entity met its firm commitment, and thus no longer has the firm commitment
but has now recognised the related asset or liability), the balance on the firm commitment
asset or liability must be derecognised and recognised as an adjustment to the initial
carrying amount of this acquired asset or liability. See IFRS 9.6.5.8 (b) and IFRS 9.6.5.9
Note that the requirement of recognising hedge ineffectiveness in profit or loss is automatically
achieved with a fair value hedge, because all movements relating to a fair value hedge are
always recognised in profit or loss.
A cash flow hedge is a hedge that is protecting against x a hedge of the exposure to
x changes in cash flows of:
specific risks that could cause variability in the cash flows a recognised asset or liability; or
relating to a specific item (the item to be hedged), where of a highly probable forecast
changes in the cash flows could end up affecting profit transaction; or
a firm commitment*
or loss and where these cash flows relate to: x attributable to a particular risk; and
x a recognised asset or liability (or part thereof); or x that could affect P/L.
IFRS 9.6.5.2(b) reworded
x a highly probable forecast transaction (or part thereof);
*A hedge of a FC can only be accounted
or for as a CFH if the hedge is protecting
x a firm commitment (but only if it is being hedged the FC against foreign currency risks.
See IFRS 9.6.5.4
against foreign currency risk!). See IFRS 9.6.5.2 & .4
For example: A cash flow hedge that is being used to hedge against foreign currency risks on
an account payable (a recognised liability) is a hedge that is effectively protecting against an
increase in cash outflows due to exchange rate fluctuations.
When accounting for ‘cash flow hedges’, we recognise the change in the value of the hedging
instrument (e.g. FEC) as an asset or liability with its related gain or loss recognised in other
comprehensive income (‘fair value hedges’ recognise these gains or losses in profit or loss).
Gains or losses that accumulate in other comprehensive income are eventually reversed to profit
or loss, either by using a reclassification adjustment (affecting profit or loss directly) or a basis
adjustment (affecting profit or loss indirectly).
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Whether and when to use the basis adjustment or reclassification adjustment is decided as follows:
x The basis adjustment must be used when we have been hedging a forecast transaction that
involved a non-financial asset or liability. It is journalised when this forecast transaction:
has now resulted in the recognition of this non-financial asset or liability (e.g. plant); or
has now become a firm commitment instead and where this firm commitment is to be
accounted for as a fair value hedge.
The basis adjustment is processed directly through equity: it does not affect the amount of
other comprehensive income in the statement of comprehensive income. See IFRS 9.6.5.11(d)(i)
x The reclassification adjustment must be used in all other cases (e.g. where the underlying
transaction involves a financial asset or liability). This adjustment must be journalised when
the expected future cash flows affect profit or loss (e.g. when our forecast sale occurs or when
our forecast interest income is earned). See IFRS 9.6.5.11(d) (i) & (ii)
This is a reclassification adjustment, and is processed through other comprehensive income.
However, if the amount recognised in the cash flow hedge reserve account (OCI) is a loss that
we believe will never be recovered, this loss must be immediately reversed to profit or loss (i.e.
as a reclassification adjustment), ignoring the normal decision process above. See IFRS 9.6.5.11(d)(iii)
A slightly different approach applies if the cash flow hedge is deemed to contain what is referred
to as an 'ineffective portion' (see section 4.2.2 below).
Examples showing how to account for cash flow hedges (CFHs) without an ineffective portion:
Examples 5 – 10 show hedges of highly probable forecast transactions accounted for as CFHs
Example 7 also shows the hedge of a firm commitment accounted for as a CFH.
4.2.2 Accounting for a cash flow hedge that contains an ineffective portion
Hedges can sometimes be ineffective. It generally happens that the change in the value of a
hedged item does not match exactly the change in the value of the hedging instrument. Where
there is this 'mismatch', a part of the hedge may end up being deemed ineffective. If this happens,
the hedge is considered to be effective to the extent that it covered the hedged item's gains or
losses (the change in the item's expected cash flows) but ineffective to the extent that it covered
more than these gains or losses.
Accounting for such a hedging instrument would then be made up of two aspects – accounting
for the effective portion and ineffective portion. We would recognise the hedging instrument (e.g.
FEC) as an asset or liability as usual, but the related gains or losses would be split between gains
or losses on the effective portion and the gains or losses on the ineffective portion:
x Gains or losses on the effective portion are initially recognised in other comprehensive income
(in the 'cash flow hedge reserve account') and then subsequently accounted for using either
a basis adjustment or a reclassification adjustment. However, if the effective portion relates
to a loss that is not expected to be recovered, this loss is immediately reclassified to profit or
loss. Thus, an effective portion is accounted for in the ‘usual way’ (i.e. through other
comprehensive income) (see section 4.2.3).
x The excess (i.e. the amount by which the hedging instrument's gains or losses are bigger than
the hedged item's losses or gains), is called the ineffective portion and must be recognised
directly in profit or loss (i.e. not in other comprehensive income). See IFRS 9.6.5.11(b); (c)
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4.2.3 Calculating the effective and ineffective portions of a cash flow hedge
The portion of the gain or loss on the hedging instrument that is accounted for as being effective,
and is thus recognised in other comprehensive income, is calculated by adjusting the cash flow
hedge reserve to the lower of:
x 'The cumulative gain or loss on the hedging instrument from inception of the hedge; and
x The cumulative change in the fair value (present value) of the hedged item (i.e. the present value of
the cumulative change in the hedged expected future cash flows) from inception of the hedge.'
IFRS 6.5.11 (a) extracts and see IFRS 6.5.11 (b)
Any remaining gain or loss on the hedging instrument is considered to be ineffective and is
recognised (directly) in profit or loss. See IFRS 9.6.5.11 (c)
x Since this is a hedge of a highly probable forecast transaction, it is accounted for as a cash flow hedge.
x When accounting for a cash flow hedge, we need to ensure that it is only the gains or losses on
the effective portion that are recognised in other comprehensive income. In other words, if any part
of the hedge is ineffective, the ineffective portion must be recognised in profit or loss.
x Part (a) shows a hedge that contains an ineffective portion: the hedging instrument offsets more than
just the movement in the hedged item (i.e. it is over-effective – see workings below). Only the effective
portion may be recognised as a cash flow hedge (OCI), and the rest is recognised in P/L.
The first step is to calculate the cumulative gain or loss on the hedging instrument, which we will
recognise as an asset: R200 000
FEC Amt $100 000 x (Latest FEC rates on offer: R10 – FEC rate obtained: R8) = R200 000
The second step is to calculate the cumulative change in the fair value of the hedged item from
hedge inception:
Future foreign currency outflow: $100 000 x (Spot rate now: R8.50 – Spot rate then: R7.00) = R150 000
The third step is to compare the two amounts (in absolute terms) and choose the lower of the two
as being the effective portion (recognised in OCI) with any excess being the ineffective portion
(recognised in P/L):
Effective portion: Lower of R200 000 and R150 000 = R150 000
Ineffective portion: Total gain R200 000 – Gain on effective portion: R150 000 = R50 000
x Part (b) shows a hedge that does not contain an ineffective portion: the hedging instrument did
not move sufficiently in the opposite direction to offset the movement in the hedged item (i.e. it was
under-effective – please note that 'under-effective' is not the same as 'ineffective'!). The entire
movement in the hedging instrument may thus be recognised in other comprehensive income.
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The first step is to calculate the cumulative gain or loss on the hedging instrument, which we will
recognise as an asset: R200 000
FEC Amt $100 000 x (Latest FEC rates on offer: R10 – FEC rate obtained: R8) = R200 000
The second step is to calculate the cumulative change in the fair value of the hedged item from
hedge inception:
Future foreign currency outflow: $100 000 x (Spot rate now: R9.50 – Spot rate then: R7.00) = R250 000
The third step is to compare the two amounts (in absolute terms) and choose the lower of the two
as being the effective portion (recognised in OCI) with any excess being the ineffective portion
(recognised in P/L):
Effective portion: Lower of R200 000 and R250 000 = R200 000
Ineffective portion: Total gain R200 000 – Gain on effective portion: R200 000 = nil
FEC asset FEC Amt: $100 000 x (Latest FR on offer: 200 000
R10 – FR obtained: R8)
Cash flow hedge reserve (OCI) Lower of gain of R200 000 and movement in 150 000
hedged item of R150 000 [$100 000 x (Latest
SR: R8.50 – Previous SR: R7.00)]
Forex gain (P/L) Balancing: 200 000 – 150 000 50 000
Cash flow hedge: gain on FEC, partly recognised in OCI (effective portion:
total gain, limited to movement in hedged item) & partly recognised in P/L
(ineffective portion: the remaining 'excessive' gain)
Where an entity designates only the change in the value of the spot element as the hedging
instrument, the entity is only concerned about movements in the spot rate, and not changes due
to interest rates, which is the forward element. The difference between the forward rate and the
spot rate represents the interest differential between the two currencies, thus the forward
element can be viewed as an adjustment to the investment yield on foreign currency
assets/liabilities. This gives rise to a need to adjust profit or loss to reflect the cost of achieving
a locked-in return. See Practical Guide: General Hedge Accounting (PWC: December 2016) & IFRS 9.BC6.425
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The following example shows how the forward element (interest) and spot rate are separated.
Example 3: Splitting the interest element and the spot price of a FEC
On 31 March 20X1 a South African company (functional currency is Rands: R) entered into
a FEC for $100 000 to hedge the import of a plant, expiring on 31 December 20X1.
Solution 3: Splitting the interest element and the spot price of an FEC
Comment: Note the following:
x The FEC asset & gain is still measured using forward rates: R50 000 ($100 000 x R8.5 - $100 000 xR8).
x However, the component of the gain on the cash flow hedge to be recognised in equity (OCI) is
now determined using the spot rates because the spot rates were designated as the hedging
instrument. The remaining gain is recognised in profit or loss.
Journals:
Although hedge accounting is voluntary (assuming the qualifying criteria for hedge accounting are met),
once we start hedge accounting we are actually not allowed to voluntarily stop hedge accounting.
However, we are forced to stop hedge accounting under the following circumstances:
x Hedge accounting must stop if the qualifying criteria for hedge accounting (see section 2.1)
are no longer met.
This can result in hedge accounting having to stop for either the entire hedging relationship
or just a part of it.
x Hedge accounting must stop if the hedging instrument expires or is sold, terminated or
exercised.
A replacement or rollover of a hedging instrument into another hedging instrument would be
considered to be an expiry or termination and would thus lead to the cessation of hedge
accounting, unless the replacement of rollover was part of the entity’s documented hedging
strategy, in which case hedge accounting would not stop. See IFRS 9.6.5.6
When we stop hedge accounting, we stop prospectively. In other words, we do not restate our
comparative figures. This applies to both cash flow hedges and fair value hedges.
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6.2 How to stop using cash flow hedge accounting (IFRS 9.6.5.12)
Hedge accounting is always simply stopped prospectively (see section 6.1). However, if we had
been accounting for our hedge as a cash flow hedge, the cumulative gain or loss in the cash
flow hedge reserve account (i.e. an equity account reflecting the cumulative OCI adjustments)
must somehow get released. When and how it gets released depends on our expectation of
whether the hedged future cash flows are still expected to occur.
If the hedged future cash flows are still expected to occur, the balance in the cash flow hedge
reserve account (equity) will be released and either accounted for as a basis adjustment or a
reclassification adjustment when the cash flows occur or, if it is an irrecoverable loss, it is
immediately reclassified to profit or loss (i.e. we follow the normal approach to the subsequent
accounting for any gains or losses that were recognised in OCI – see section 4.2).
However, if the hedged future cash flows are no longer expected to occur, then the entire
balance in the cash flow hedge reserve account (equity) must immediately be reclassified to
profit or loss (i.e. using the reclassification adjustment approach).
Rebalancing requires the quantities of the hedged item or hedging instrument to be adjusted in
a way that leads to the hedge ratio once again complying with the hedge effectiveness
requirements of IFRS 9.
Hedge ineffectiveness arising from a fluctuation around an otherwise valid hedge ratio cannot
be reduced by adjusting the hedge ratio, and rebalancing will not be required in this scenario.
Changes to the quantities of the designated items for any other purpose are not classified as
‘rebalancing’ adjustments.
An airline needs to buy 100 000 litres of jet fuel in 2 years. As the price of jet fuel is
constantly fluctuating, the airline wants to hedge its exposure to this risk.
Ideally, the airline would enter into a derivative related to jet fuel. However, as this derivative doesn’t
exist, the airline will to hedge its exposure by purchasing a common derivative that has an economic
relationship to jet fuel, for instance, a futures contract for crude oil (refer to chapter 21 for an
explanation of futures contracts).
However, the airline cannot buy 1 litre crude oil futures to hedge against the price fluctuation of 1 litre
of jet fuel. This is because crude oil is only one component affecting the price of jet fuel ( there are a
number of other components that will also impact the price of jet fuel, such as costs to refine the fuel).
The airline’s hedging experts determine that crude oil trades at, approximately, a 20% discount
compared to jet fuel prices. Therefore, the hedging ratio is determined to be 0.8:1. This means that, in
order to hedge its exposure to the price fluctuation of 100 000 litres of jet fuel, the airline must enter
into a futures contract to purchase 125 000 litres of crude oil. Note that these futures would be settled
net (refer to the comment below).
At the time of the hedge inception, the price of jet fuel is C15 per litre, while the futures for crude oil is
trading at C12.50 per litre.
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After 6 months, the price of jet fuel is C16.50 per litre, while the futures for crude oil is now trading at
C13.25 per litre.
x The change in the fair value of the hedged item (the jet fuel) is C150 000 ((C16.50 – C15) x 100 000)
x The change in the fair value of the hedging instrument (the futures contract) is C93 750 ((C13.25
– C12.50) x 125 000)
Given that the change in the fair value of the futures contract is C93 750, while the change in the fair
value of the jet fuel is C150 000, this hedge would be regarded as ineffective, given that only
approximately 62.5% (93 750 / 150 000) of the change in the fair value of the jet fuel is being covered
by the change in fair value of the futures contracts. The airline would need to rebalance this hedge.
To do this, the airline would purchase more crude oil futures contracts. The hedging experts have
assessed that the airline should purchase an additional 1 500 ‘1 litre crude oil’ futures contracts. The
new hedging ratio is now 0.79:1 (100 000/126 500). The airline has now rebalanced the hedging
relationship, to ensure hedge effectiveness.
Comment:
A net settled forward contract is one where actual products are not exchanged on settlement date.
Instead, on this date, parties to the contract settle the difference between the exercise price (in this
case, C12.50) and the prevailing selling price (SP) of the ‘underlying’ (oil) on settlement date. A gross
settled forward contract is one that will be settled by actually transferring the ‘underlying’ (i.e. in this
case, we would actually have to receive oil).
However, if, after trying this ‘rebalancing’ exercise, we still believe our hedging relationship no
longer meets the criteria for hedge effectiveness, we must stop hedge accounting.
7.1 Overview
Now that we have covered the theory behind what constitutes a fair value hedge and a cash flow
hedge and how to account for each, let us now apply this theory to practical examples. Our
hedging instrument in all these examples is a FEC but the principles applied would be identical
for other hedging instruments used.
As we go through these examples, you will see that we use a timeline. A timeline can be useful
because whether we account for our hedge as a cash flow hedge or fair value hedge is not only
affected by whether the hedge is protecting against changes in fair value (fair value hedge) or
changes in the cash flows (cash flow hedge), but is also affected by whether the hedged item is a
recognised asset/ liability (A/L), firm commitment (FC) or highly probable forecast transaction
(HPFT). This timeline makes it easy to identify what we are hedging at any point in time.
By constructing a timeline showing all the relevant dates and then inserting the date on which the
hedging instrument was entered into, we will be able to easily identify which of these items the
hedging instrument is currently hedging (i.e. an A/L, FC or HPFT).
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Please note:
x The two 'N/A's' on either end of the timeline indicate the fact that we may not use hedge
accounting either before a forecast transaction has become highly probable, or after the
transaction has been settled.
x A hedging instrument could be entered into at any stage during this timeline (e.g. we may
only decide to enter into a hedging relationship on or after transaction date in which case we
would only be hedging a recognised asset or liability). In other words, it does not have to be
entered into on the date that our forecast transaction becomes highly probable.
x The circumstances of our particular transaction may not necessarily involve all three phases
(e.g. we could enter into a transaction without it first going through phases where we consider it
to be a ‘highly probable forecast transaction’ and/or ‘firm commitment’).
Once we have identified the item that we are hedging by using this timeline, we need to re-look
at the relevant definitions. If we look at the definition of a fair value hedge (see section 3.1), we
see that it only refers to hedges of recognised assets or liabilities and firm commitments. On the
other hand, the definition of a cash flow hedge (see section 4.1) refers to hedges of recognised
assets or liabilities, firm commitments (in the case of foreign currency risk) and highly probable
forecast transactions. Thus, hedges of highly probable forecast transactions are always
accounted for as cash flow hedges.
These options as to how to account for the hedges can be summarised on the same timeline as follows:
Date forecast transaction Date a firm commitment Date the transaction Date the transaction is
becomes highly probable is made is recognised settled
N/A Hedge of a HP forecast transaction Hedge of a firm commitment Hedge of a recognised A/L N/A
Phase 1 Phase 2 Phase 3
CFH CFH/ FVH CFH/ FVH
Pre-transaction period Post-transaction period
Thus, we use our timeline to analyse what the hedged item is and then to consider this in context
of the definitions of a cash flow hedge and fair value hedge as follows:
x If we enter into a hedging instrument only on or after the transaction is recognised (i.e. on or
after transaction date), we will be hedging a recognised asset or liability. This hedge,
depending on the risk being hedged, may be accounted for as either a fair value hedge or
cash flow hedge. (Phase 3).
x If we enter into a hedging instrument before the transaction was recognised (before transaction
date), but a firm commitment had already been entered into by that stage, we would be hedging
a firm commitment and thus this hedge could be accounted for as either a fair value hedge or
cash flow hedge, depending again on the risk being hedged. However, the only instance when
a firm commitment will expose an entity to a cash flow risk (and thus cash flow hedge accounting
is applied) is if the firm commitment related to a foreign currency risk. (Phase 2)
x If a hedge was entered into before the transaction was recognised (i.e. before transaction
date), and no firm commitment had been entered into, this hedge would simply be hedging a
forecast transaction. If the forecast transaction was not yet probable, hedge accounting may
not be applied at all. However, if the forecast transaction was considered to be highly probable,
then the instrument would be hedging a highly probable forecast transaction and thus the
hedge would have to be accounted for as a cash flow hedge – hedges of highly probable
forecast transactions may never be accounted for as fair value hedges. (Phase 1)
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The decision on whether to apply fair value or cash flow hedge accounting is driven by the risk
we are exposed to, and thus the risk we are hedging. If we were exposed to and hedging against
changes to the item's fair value, we apply fair value hedge accounting. If we are exposed to the
variability in the cash flows associated with the item, we adopt cash flow hedge accounting. In
phase 1 we are not exposed to variations in the fair value of the item, for that reason we cannot
apply fair value hedge accounting. Consider this example: if we are certain we will purchase a
vehicle in 3 months (HPFT) and the price today is R100 000. Should the price increase to
R120 000 in 3 months, we will pay R20 000 more than if we bought the vehicle 3 months ago
(there is a cash flow risk associated with the HPFT). Once paid for, we will receive a vehicle of
a fair value of the amount we paid (R120 000). Thus, we are not exposed to fair value risk.
The dates on this timeline are also important because they trigger certain adjustments, such as
the recognition and measurement of the hedged item (e.g. a recognised liability such as a foreign
account payable) and hedging instrument (e.g. a forward exchange contract). For example: a
recognised liability such as a foreign account payable would need to be recognised and measured
on transaction date and remeasured on settlement date. An extra date that may need to be
inserted onto the timeline for measurement purposes is the reporting date (e.g. the financial year-
end), since hedged items and hedging instruments existing on this date must also be remeasured
at this point.
Please remember that hedge accounting may not be applied before a forecast transaction
becomes highly probable (even if the hedging instrument was entered into before this date).
Similarly, hedge accounting may not be applied after the transaction has been settled. In fact, it
is important to remember that hedge accounting may have to cease even earlier than this date
if the criteria for discontinuance of hedge accounting are met (see section 6).
Reminder: accounting for cash flow hedges versus fair value hedges
The main difference in accounting for cash flow hedges and fair value hedges is that:
x Fair value hedges:
The change in the value of the hedging instrument is recognised as an asset or liability (FEC A/L) and the
related gain or loss is immediately recognised in P/L.
Exception #1: If the hedged item is an investment in equity instruments on which the FV gains or losses
will be recognised in OCI (i.e. FVOCI-equity), the gains or losses on the hedging instrument must also be
recognised in OCI (not in P/L).
Exception #2: If the hedged item is a firm commitment then, in addition to the changes in the value of
the hedging instrument being recognised as an asset or liability (e.g. FEC A/L), the changes in the value of
the firm commitment must also be recognised as an asset or liability (i.e. firm commitment A/L). The gains
or losses relating to the firm commitment A/L are recognised in P/L. When the transaction date is reached
and we thus recognise the underlying asset or liability, the firm commitment A/ L is derecognised and
recognised as an adjustment to the carrying amount of this newly recognised asset or liability.
See IFRS 9.6.5.8
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7.2 Accounting for hedges involving forward exchange contracts (IFRS 9.6.5)
Section 7 involves a series of examples showing how to apply hedge accounting theory. These
examples will involve:
x the hedged item: the examples will involve a variety of hedged items
- foreign currency denominated highly probable forecast transaction (HPFT),
- firm commitment (FC) and/ or
- recognised asset or liability (recognised transaction); and
x the hedging instrument: all examples will involve the use of a forward exchange contract (FEC).
Hedges of a recognised
If a hedging instrument (e.g. FEC) is entered into (or already
A/L are accounted for:
exists) on or after the date on which the transaction is x as CFHs or FVHs
recognised (i.e. on or after transaction date) it means the
instrument is hedging a recognised asset or liability (i.e. a recognised transaction).
Depending on whether it is hedging against changes in the hedged item's fair value or cash
flows, it will be accounted for as either:
Important dates in the
x a fair value hedge; or post-transaction period:
x a cash flow hedge.
x transaction date
x settlement date
The hedged item, being the foreign currency denominated x reporting date (normally a
transaction is recognised and measured using the spot rate financial year-end)
on transaction date.
If the hedged item is a monetary item (e.g. a payable), it must be remeasured to spot rates on
any subsequent reporting date/s and again on settlement date (see chapter 20).
Example 4: FEC taken out in the post-transaction period: fair value hedge
Required:
Show all related journals. Assume all hedging requirements are met.
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FEC asset $100 000 x R10 spot rate on payment date – 50 000
Forex gain (I: P/L) $100 000 x R9.50 prior forward rate (30/6/X1) 50 000
Fair value hedge: gain/ loss on FEC recognised at payment date in P/L
Foreign creditor $100 000 x R10; Or: the creditor a/c balance: 1 000 000
Bank R915 000 + R40 000 + R45 000 1 000 000
Payment of creditor: based on the spot rate on payment date
Bank $100 000 x (R9: the FR we obtained – R10: the 100 000
spot rate on expiry date)
FEC asset Or: the FEC asset balance: R50 000 + R50 000 100 000
Receipt from the financing house on expiry of the FEC: FR versus SR
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7.4.1 Overview
If a hedging instrument (e.g. FEC) is entered into before the transaction is recognised (i.e. before
transaction date), we have begun hedging during the 'pre-transaction period'. We may apply
hedge accounting to hedges during the pre-transaction period anytime from the date on which
the forecast transaction becomes highly probable, but not before. Thus, although it is possible
for a hedging instrument (e.g. FEC) to be entered into before a forecast transaction is considered
to be highly probable, we would simply not be able to apply hedge accounting yet.
If the hedging instrument (e.g. FEC) exists in the pre-transaction period (i.e. before the
transaction date) it may be hedging one of the following (or a combination thereof):
x A forecast transaction that is not yet ‘highly probable’ (hedge accounting is not allowed); or
x A highly probable forecast transaction (phase 1); or
x A firm commitment (phase 2).
Hedges of highly probable forecast transactions (HPFT) are always accounted for as cash flow
hedges, but hedges of firm commitments could be accounted for as either fair value hedges or
cash flow hedges when foreign currency risk is being hedged against. Thus, if a hedge exists in
the pre-transaction period, we must ascertain whether a firm commitment was made before
transaction date or not.
7.4.2 Hedges in the pre-transaction period where no firm commitment was made (phase 1)
Since, hedges of HPFTs are always accounted for as cash flow hedges, gains or losses arising
on the FEC asset or liability are recognised in other comprehensive income (in the cash flow
hedge reserve account).
When the transaction is eventually entered into (i.e. Accounting for a hedge of
a highly probable forecast
transaction date), the asset or liability that was the transaction:
ultimate purpose of the forecast transaction will then be
x Must be accounted for as a CFH
recognised (e.g. purchased inventory is recognised). x Recognise an FEC asset/ liability
(measured at FEC rates) and
At this point we no longer have a highly probable forecast x Gains or losses recognised in OCI
transaction, since it has been replaced by the actual
transaction. Thus, the hedge of the highly probable forecast transaction comes to an end on
transaction date. At this point, the cumulative gains or losses in the cash flow hedge reserve
account (OCI) must now be released to profit or loss (P/L).
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After the transaction has been recognised, the hedging instrument (if it still exists) is now
hedging a recognised asset or liability. From this point onwards, the hedging instrument would
either be recognised as a cash flow hedge or a fair value hedge.
Quick explanation:
x The FEC was entered into before transaction date when there was no firm commitment, but the
forecast transaction was considered ‘highly probable’. Thus, as this started out as a hedge of a
highly probable forecast transaction it had to be accounted for as a cash flow hedge.
x Since the ultimate asset underlying this transaction is non-financial (inventory), the gain or loss in
OCI is released by way of a basis adjustment.
x From transaction date onwards, the hedge becomes a hedge of a recognised asset or liability and
could thus be accounted for either as a cash flow hedge or fair value hedge. However, it was
designated as a fair value hedge in this example.
x We will effectively pay R900 000 ($100 000 x 9) since this is the rate we committed to in the FEC.
x If we look at the spot rate on payment date, we can see that had we not taken out the FEC, we
would have had to pay $100 000 x 10 = R1 000 000.
x The FEC has therefore saved us R1 000 000 – R900 000 = R100 000.
Journals:
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Debit Credit
1 March 20X1: transaction date (TD) continued
FEC asset (A) $100 000 x R9.10 FR on TD – 10 000
Cash flow hedge reserve (OCI) $100 000 x R9 FR obtained 10 000
Cash flow hedge: gain/ loss on FEC on transaction date in OCI
Cash flow hedge reserve (Eq) 10 000
Inventory (A) 10 000
Cash flow hedge basis adjustment: this basis adjustment is processed
directly through equity
30 June 20X1: year-end (reporting date = RD)
FEC asset (A) $100 000 x R9.60 FR at year end – 50 000
Forex gain (I: P/L) $100 000 x R9.10 previous FR 50 000
Fair value hedge: gain/ loss on FEC recognised at year-end in P/L
Forex loss (E: P/L) $100 000 x R9.60 SR at year-end – 60 000
Foreign creditor (L) $100 000 x R9.00 previous SR 60 000
Foreign creditor remeasured at spot rate at year-end
7 July 20X1: payment date
FEC asset $100 000 x R10 spot rate on payment date – 40 000
Forex gain (I: P/L) $100 000 x R9.60 previous FR 40 000
Fair value hedge: gain/ loss on FEC recognised on payment date
Forex loss (E: P/L) $100 000 x R10 spot rate at year end – 40 000
Foreign creditor (L) $100 000 x R9.60 previous spot rate 40 000
Foreign creditor remeasured at spot rate on payment date
Foreign creditor $100 000 x R10 SR on pmt date; Or the creditor 1 000 000
Bank balance: (900 000 + 60 000 + 40 000) 1 000 000
Payment of creditor: based on the spot rate on payment date
Bank $100 000 x R9: the FR we obtained – 100 000
$100 000 x R10: the SR on expiry date
FEC asset Or: Balance in the FEC asset: (R10 000 + R50 000 100 000
+ R40 000)
Receipt from the financing house on expiry of the FEC: FR versus SR
15 July 20X1: on sale of inventory
Cost of sales (E: P/L) (900 000 – 10 000) x 40% 356 000
Inventory (A) 356 000
Debtor (A) Given 400 000
Sales (I: P/L) 400 000
Sale of 40% of inventory: sales and cost of sales
20 August 20X1: on sale of inventory
Cost of sales (E: P/L) (900 000 – 10 000) x 60% 534 000
Inventory (A) 534 000
Debtor (A) Given 600 000
Sales (I: P/L) 600 000
Sale of 60% of inventory: sales and cost of sales
Comment:
x The basis adjustment decreases the cost of inventory.
x This then decreases cost of sales as the inventory is sold.
x The gain that had accumulated in OCI is thus indirectly taken to profit or loss as and when the
hedged item (inventory) affects profit/ loss by way of cost of sales.
The above example shows the cash flow hedge reserve being released on transaction date
using a basis adjustment because the forecast transaction involved a non-financial asset.
However, if the forecast transaction that is being hedged involves a financial asset or liability,
then the cash flow hedge reserve is released to profit or loss using a reclassification
adjustment/s in the same period/s that the hedged expected future cash flows are expected to
affect profit or loss (e.g. when forecast interest is recognised or when a forecast sale occurs).
Example 6 shows this.
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Debit Credit
20 August 20X1: sale of hedged item
Financial asset expensed (E: P/L)* 900 000 x 60% 540 000
Financial asset * 540 000
Debtor Given 600 000
Revenue (I: P/L) 600 000
Sale of 60% of hedged item: asset is expensed and revenue is recognised
Cash flow hedge reserve (OCI) * 10 000 x 60% 6 000
FEC gain (I: P/L) * 6 000
Reclassification adjustment of the cash flow hedge: reclassifying 60%
of the OCI to P/L when 60% of the hedged item is sold
7.4.3 Hedges in the pre-transaction period where a firm commitment was made (phase 2)
If the hedging instrument (FEC) exists before transaction date, we are dealing with a hedge in
the pre-transaction period. If a firm commitment (e.g. a firm order) was made during the pre-
transaction period, this period is split into:
x before firm commitment is made: the uncommitted period (phase 1); and
x after firm commitment is made but before transaction date: the committed period (phase 2).
Pre-transaction period
Phase 1: Phase 2:
Uncommitted pre-transaction period Committed pre-transaction period
What are we hedging? What are we hedging?
A highly probable forecast A firm commitment (FC)
transaction (HPFT)
How do we account for this How do we account for this
hedge? hedge?
As a CFH (always) As a CFH or FVH
A hedging instrument (FEC) that exists before commitment date (i.e. in phase 1), could be
hedging a forecast transaction, where hedge accounting would not have applied, or be hedging
a highly probable forecast transaction, which must be accounted for as a cash flow hedge, (there
is no option here). This was explained in the previous section and in examples 5 and 6.
This next example (example 7) shows a hedge of a HPFT (phase 1) switching into being a hedge
of a FC (phase 2), but where both these hedges are accounted for as cash flow hedges.
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The example after this (example 8) then takes it to the next level, showing how to account for a switch
from a hedge of a HPFT as a cash flow hedge to the hedge of a FC as a fair value hedge.
15 Feb 20X1 22 Feb 20X1 1 March 20X1 30 June 20X1 7 July 20X1
FEC taken out Firm commitment Transaction date Year-end Payment date
FEC rates: 9.00 9.06 9.10 9.60 N/A
Spot rates: 8.90 8.96 9.00 9.60 10.00
Required:
Show only the extra journals relating to the hedge of the firm commitment (i.e. you are not required to
repeat the journals that were given to example 5).
Assume all hedging requirements were met and no part of the hedge was considered ineffective.
Since the hedge of the HPFT (phase 1) and the hedge of the FC (phase 2) are both accounted for as
cash flow hedges, the switch on 22 Feb 20X1 from being a hedge of a HPFT to being a hedge of a FC
does not result in a journal. Thus, the journals in example 7 are identical to the journals in example 5.
As mentioned above, an entity may account for the hedge of the firm commitment (phase 2) as
a cash flow hedge or as a fair value hedge. Accounting for a hedge of
a firm commitment as a
When accounting for a hedge of a firm commitment as a FVH:
cash flow hedge, we recognise the value of the hedging x recognise an FEC asset/ liability
instrument as an asset or liability (FEC A/L) with the (measured at FEC rates) and
related gains and losses first recognised in other x recognise a FC asset/ liability
(measured at spot rates).
comprehensive income.
Gains or losses recognised in P/L
However, when accounting for the hedge of a firm commitment as a fair value hedge:
x we recognise the value of the hedging instrument as an asset or liability (FEC A/L) ; and
x we also recognise the change in the value of the hedged item as an asset or liability (this
means we must also recognise a firm commitment A/L).
Gains or losses on both the hedging instrument asset or liability (FEC A/L) as well as the hedged
item asset or liability (firm commitment A/L) are generally always recognised in profit or loss (not
in other comprehensive income, as was the case in a cash flow hedge). An exception applies if
the firm commitment involves acquiring an investment in equity instruments that the entity has
elected to measure at fair value through other comprehensive income (FVOCI-equity), in which
case all related gains or losses will be recognised in other comprehensive income.
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The firm commitment asset or liability will be derecognised and recognised as an adjustment to
the carrying amount of the asset or liability that is recognised on transaction date. See IFRS 9.6.5.8 – 10
Thus, when accounting for a hedge of a firm commitment (phase 2) as a fair value hedge:
x We recognise a hedged item asset/ liability (i.e. firm commitment asset/ liability):
We measure the firm commitment asset/ liability using the movement in the spot rates.
This is generally journalised as:
Dr/ Cr: Firm commitment asset/ liability and
Cr/ Dr Forex gains/losses (Profit or loss)
We derecognise the firm commitment asset/ liability on transaction date and recognise
the contra entry as an adjustment to the carrying amount of the asset that is acquired
(or the liability that is assumed).
x We recognise a hedging instrument asset/ liability (e.g. FEC asset/ liability):
We measure the FEC asset/ liability based on the movement in the forward rates.
This is generally journalised as:
Dr/ Cr: FEC asset/ liability and
Cr/ Dr Forex gains/losses (Profit or loss)
We derecognise the FEC asset or liability when the FEC is finally settled.
15 Feb 20X1 22 Feb 20X1 1 March 20X1 30 June 20X1 7 July 20X1
FEC taken out Firm commitment Transaction date Year-end Payment date
FEC rates: 9.00 9.06 9.10 9.60 N/A
Spot rates: 8.90 8.96 9.00 9.60 10.00
Required: Show all related journals. Assume there is no ineffective portion on the hedge.
Solution 8: FEC taken out in the pre-transaction period: firm commitment as a FV hedge
Comment:
x We start with a hedge of a highly probable forecast transaction (HPFT), which is always accounted
for as a cash flow hedge. Then it became a hedge of a firm commitment (FC), which can be
accounted for as a cash flow hedge or fair value hedge. In this example it was designated as a fair
value hedge.
x When the cash flow hedge of the HPFT switches to being a fair value hedge of a FC, we stop recognising
gains or losses on the FEC asset/liability in OCI and recognise them in P/L instead.
x When we start hedging the FC as a fair value hedge, we also recognise a FC asset or liability.
x Since the underlying transaction involves a non-financial asset (inventory), gains or losses that had
accumulated in OCI while it was a CFH will be released using a basis adjustment. This adjustment will only be
processed on transaction date (i.e. on the day we recognise the purchase of inventory).
x As with the previous examples, the FEC has saved us R100 000 (R1 000 000 – R900 000).
x The total FEC gain of R100 000 is eventually recognised in P/L: the gain on the CFH (R6 000) will
effectively be recognised in P/L when the inventory is sold; whereas the gains on the FVH will be
recognised in P/L as they arise: R4 000 on trans. date, R50 000 at yr-end and R40 000 on pmt date.
1104 Chapter 22
Gripping GAAP Financial instruments - hedge accounting
Debit Credit
22 February 20X1: firm commitment date
FEC asset $100 000 x R9.06 FR on firm commitment 6 000
Cash flow hedge reserve (OCI) date – $100 000 x R9 FR obtained 6 000
Cash flow hedge: gain/ loss on FEC on firm commitment date, in OCI
1 March 20X1: transaction date
Inventory $100 000 x R9.00 spot rate on transaction date 900 000
Foreign creditor 900 000
Inventory purchased, measured at spot rate on transaction date
Cash flow hedge reserve (Eq) 6 000
Inventory 6 000
CFH basis adjustment: processed directly through equity
FEC asset $100 000 x R9.10 FR on transaction date – 4 000
Forex gain (I: P/L) $100 000 x R9.06 previous FR 4 000
Fair value hedge: FEC: gain/ loss on FEC on transaction date, in P/L
Forex loss (E: P/L) $100 000 x R9.00 spot rate on transact. date – $100 4 000
Firm commitment liability 000 x R8.96 spot rate on firm commit. date 4 000
Fair value hedge: FC: gain/ loss on firm commit. on trans. date, in P/L
Forex loss (E: P/L) $100 000 x R9.60 spot rate at year-end – $100 000 60 000
Foreign creditor x R9.00 previous spot rate 60 000
Foreign creditor remeasured to spot rate at year-end
Forex loss (E: P/L) $100 000 x R10 spot rate on payment date – 40 000
Foreign creditor $100 000 x R9.60 previous spot rate 40 000
Foreign creditor remeasured to spot rate on payment date
Foreign creditor $100 000 x R10 SR on pmt date; Or the creditor 1 000 000
Bank balance: (900 000 + 60 000 + 40 000) 1 000 000
Payment of creditor: based on the spot rate on payment date
Bank $100 000 x (R9: the FR we obtained – R10: the SR 100 000
on expiry date)
FEC asset Or: Balance in the FEC asset: 100 000
(6 000 + 4 000 + 50 000 + 40 000)
Receipt from the financing house on expiry of the FEC: FR versus SR
Chapter 22 1105
Gripping GAAP Financial instruments - hedge accounting
Cost of sales (E: P/L) (900 000 – 6 000 – 4 000) x 60% 534 000
Inventory 534 000
Debtor Given 600 000
Sales (I: P/L) 600 000
Sale of 60% of inventory: sales and cost of goods sold
Notice: The measurement of inventory was affected by the cash flow hedge when the other
comprehensive income was reversed to inventory using the basis adjustment and also by the fair value
hedge when the firm commitment liability was reversed to inventory:
x Inventory recognised at spot rate on transaction date 100 000 x 9.00 900 000
x FVH: Firm commitment liability reversed to inventory on transaction date (4 000)
x CFH: Gains on the FEC in OCI reversed to inventory on transaction date (basis adjustment) (6 000)
890 000
1 March 20X1 15 April 20X1 30 June 20X1 20 July 20X1 31 Aug 20X1
FEC taken out Firm commitmen Year-end Transaction date Payment date
FEC rates: 9.00 9.06 9.10 9.60 N/A
Spot rates: 8.90 8.30 8.45 8.50 10.00
Required:
Show the related journals assuming that:
A. the asset that was purchased was a non-financial asset.
B. the asset that was purchased was a financial asset.
Assume all hedging requirements are met and that any portion of a CFH that may be ineffective is
immaterial. The and deferred tax implications have been ignored
Solution 9: FEC taken out in the pre-transaction period with a year-end between firm
commitment date and transaction date
Part A Part B
1 March 20X1: date FEC entered into Dr/ (Cr) Dr/ (Cr)
No entries relating to the FEC are processed
15 April 20X1: firm commitment date
FEC asset $100 000 x R9.06 FR on firm commit date – 6 000 6 000
Cash flow hedge reserve (OCI) $100 000 x R9 FR obtained (6 000) (6 000)
Cash flow hedge: gain/ loss on FEC on firm commitment date, in OCI
30 June 20X1: year-end
FEC asset $100 000 x R9.10 FR at year-end – 4 000 4 000
Forex gain (P/L) $100 000 x R9.06 previous FR (4 000) (4 000)
Fair value hedge: FEC: gain/ loss on FEC at year-end, in P/L
Forex loss (P/L) $100 000 x R8.45 SR at yr-end – 15 000 15 000
Firm commitment liability $100 000 x R8.30 SR on firm commit. date (15 000) (15 000)
Fair value hedge: FC: gain/ loss on firm commit. at year-end, in P/L
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Non-financial asset Part A: $100 000 x R8.5 SR on trans. date 850 000 N/A
Financial asset Part B: $100 000 x R8.5 SR on trans. date N/A 850 000
Foreign creditor (850 000) (850 000)
Purchase of the asset and related creditor, at spot rate on transaction date
FEC asset $100 000 x R9.6 FR on transaction date – 50 000 50 000
Forex gain (P/L) $100 000 x R9.1 previous FR (50 000) (50 000)
Fair value hedge: FEC: gain/ loss on FEC on transaction date, in P/L
Forex loss (P/L) $100 000 x R8.5 SR on trans date – 5 000 5 000
Firm commitment liability $100 000 x R8.45 prior SR (5 000) (5 000)
Fair value hedge: FC: gain/ loss on firm commit. on trans. date, in P/L
Firm commitment liability 15 000 + 5 000 20 000 20 000
Non-financial/ Financial asset (20 000) (20 000)
Fair value hedge: FC: firm commitment A/L derecognised and
recognised as an adjustment to the carrying amount of the acquired
asset on trans. date
Cash flow hedge reserve(Eq) ONLY Part A 6 000 N/A
Non-financial asset (6 000) N/A
Cash flow hedge: basis adjustment transferring the reserve to the
hedged item on transact date (this is only done if the asset acquired is
non-financial)
31 August 20X1: payment date
FEC asset $100 000 x R10 spot rate on payment date – $100 40 000 40 000
Forex gain (P/L) 000 x R9.60 previous FR (40 000) (40 000)
Fair value hedge: FEC: gain/ loss on FEC on payment date, in P/L
Forex loss (P/L) $100 000 x R10 SR on payment date – 150 000 150 000
Foreign creditor $100 000 x R8.5 previous SR (150 000) (150 000)
Foreign creditor remeasured to spot rate on payment date
Foreign creditor $100 000 x R10 SR on pmt date; Or the creditor 1 000 000 1 000 000
Bank balance: (900 000 + 60 000 + 40 000) (1 000 000) (1 000 000)
Payment of creditor: based on the spot rate on payment date
Bank $100 000 x (R9: the FR we obtained – R10: the SR 100 000 100 000
on expiry date); Or: Balance in the FEC
FEC asset asset: (6 000 + 4 000 + 50 000 + 40 000) (100 000) (100 000)
Receipt from the financing house on expiry of the FEC: FR versus SR
27 September 20X1: sale of 40% of the asset
Cash flow hedge reserve (OCI) ONLY Part B: 6 000 x 40% N/A 2 400
FEC gain (P/L) N/A (2 400)
Cash flow hedge – reclassification adjustment: reclassifying 40% of
the OCI to profit or loss when 40% of the non-financial asset is sold
Chapter 22 1107
Gripping GAAP Financial instruments - hedge accounting
Part A Part B
1 November 20X1: continued … Dr/ (Cr) Dr/ (Cr)
Cash flow hedge reserve (OCI) ONLY Part B: 6 000 x 60% N/A 3 600
FEC gain (P/L) N/A (3 600)
Cash flow hedge – reclassification adjustment: reclassifying 60% of
the OCI to profit or loss when 60% of the non-financial asset is sold
8. Tax Consequences
The current South African Income Tax Act and the IFRSs treat foreign exchange gains or losses and
forward exchange contracts in almost the same way. The Income Tax Act deals with:
x hedged items under s25D and
x hedging instruments under s24I.
The Income Tax Act measures the cost of a foreign-denominated item, (e.g. imported plant), the hedged
item, at the spot rate on transaction date (s25D). This is the same spot rate used to measure the item in
terms of IFRSs and thus there are generally no temporary differences on initial recognition of the hedged
item (e.g. plant) as the carrying amount and tax base would be the same.
As we know, foreign exchange gains or losses can arise on both hedged items and hedging instruments.
The Income Tax Act taxes all foreign exchange gains and deducts all foreign exchange losses. However,
if the foreign exchange gain or loss relates to a hedging instrument, the inclusion of the related gain or
loss in the calculation of taxable profit may be deferred. This happens when the gain or loss on the
instrument arises before the hedged item has been recognised. This is explained below.
An 'affected FEC' is an FEC taken before transaction date (e.g. a cash flow hedge of a forecast
transaction or firm commitment or a fair value hedge of a firm commitment).
x By definition, this means that if we have an 'affected FEC', the hedged item will obviously not
have been recognised. This means that the foreign exchange gains or losses from the time
the ‘affected FEC’ (the hedging instrument) was taken until transaction date could thus not
be offset by foreign exchange gains or losses on the hedged item.
x In order to avoid this mismatch, the Income Tax Act defers all foreign exchange gains or losses
on the 'affected FEC' until transaction date. To calculate the taxable profit in this case, we simply
reverse the gains or losses included in profit or loss if they relate to 'affected FECs'. When the
hedged item is eventually recognised on transaction date, the FEC will no longer be an 'affected
FEC', from which point the tax rules relevant to a basic 'FEC' will apply.
x For IFRS purposes, the affected FEC in the pre-transaction period is accounted for using the
forward rates available on translation date (e.g. reporting date). Thus, the carrying amount of
the FEC on reporting date will differ from its tax base and deferred taxation will be recognised.
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Gripping GAAP Financial instruments - hedge accounting
Disclosure requirements for hedges are set out in IAS 32, IFRS 7 and IAS 1.
x An entity shall describe its financial risk management objectives and policies including its
policy for hedging each main type of forecast transaction that is accounted for as a hedge.
x An entity shall disclose the following for designated fair value and cash flow hedges:
a description of the hedge;
a description of the financial instruments designated as hedging instruments and their
fair values at the end of the reporting period;
the nature of the risks being hedged; and
for cash flow hedges: the periods in which the cash flows are expected to occur, when
they are expected to affect profit or loss and a description of any forecast transaction
for which hedge accounting had been used but which is no longer expected to occur.
x When a gain or loss on a hedging instrument in a cash flow hedge has been recognised in
other comprehensive income, an entity shall disclose the amount that was:
recognised in other comprehensive income during the period;
reclassified from OCI and included in P/L for the period (reclassification adjustment); or
removed from OCI during the period and included in the initial measurement of the
acquisition cost or carrying amount of a non-financial asset or liability (basis adjustment).
x The tax consequences of all items in OCI must be disclosed, including the tax effect of
reclassification adjustments. Items presented in OCI may be presented net of their related
tax effects or before their related tax effects, with one amount shown for the aggregate
amount of income tax relating to all items in OCI. IAS 1.91 (slightly reworded)
Required: Show the disclosure for Apple Limited's year ended 30 June 20X2 (ignore tax) assuming:
A The asset that was acquired was non-financial and thus the basis adjustment was used.
B The asset that was acquired was financial and thus the reclassification adjustment was used.
Comment: Note that this example ignores the effects of current and deferred tax. However, amounts
that are supposed to be presented net of current and deferred tax have been identified as such.
Apple Limited
Statement of comprehensive income 20X2 20X1
For the year ended 30 June 20X2 Notes C C
Total comprehensive income for the year 111 000 595 000
Chapter 22 1109
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Apple Limited
Statement of changes in equity (extracts)
For the year ended 30 June 20X2
Retained Cash flow Total
earnings hedges
C C C
Balance 1/7/20X0 xxx 0 xxx
Total comprehensive income 589 000 6 000 595 000
Balance 30/6/20X1 xxx 6 000 xxx
Total comprehensive income 111 000 0 105 000
Basis adjustment 0 (6 000)
Balance 30/6/20X2 xxx 0 xxx
Apple Limited
Notes to the financial statements (extracts)
For the year ended 30 June 20X2
20X2 20X1
C C
10. Profit before tax
This is stated after taking into account the following separately disclosable (income)/ expense items:
x Foreign exchange gain 20X2: 50 000 + 40 000 (90 000) (4 000)
x Foreign exchange loss 20X2: 5 000 + 150 000 155 000 15 000
* The tax effect should be presented, but this example has ignored tax.
The differences from 10A are highlighted with asterisks so that you can compare 10A and 10B easier.
Apple Limited
Statement of comprehensive income
For the year ended 30 June 20X2
Notes 20X2 20X1
C C
Revenue 1 000 000 600 000
Expense of the hedged item 20X2: 332 000 + 498 000 * (830 000) (0)
Foreign exchange gain 20X2: 50 000 + 40 000 10 90 000 4 000
Foreign exchange reclassification adj. 20X2: 2 400 + 3 600 10 *6 000 0
Other expenses 20X2: 5 000 + 150 000 10 (155 000) (15 000)
Profit before tax 10 111 000 589 000
Tax expense (ignored) 0 0
Profit for the year 111 000 589 000
Other comprehensive income for the year 11 (6 000) 6 000
x Items that may never be reclassified to profit or loss 0 0
x Items that may be reclassified to profit or loss:
- Gain on cash flow hedge, (net of tax and reclassification adjustment) (6 000) 6 000
Total comprehensive income for the year 105 000 695 000
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Apple Limited
Statement of changes in equity (extracts)
For the year ended 30 June 20X2
Retained Cash flow Total
earnings hedges
C C C
Balance 1/7/20X0 xxx 0 xxx
Total comprehensive income 589 000 6 000 595 000
Balance 30/6/20X1 xxx 6 000 xxx
Total comprehensive income 111 000 (6 000) 105 000
Balance 30/6/20X2 xxx 0 xxx
Apple Limited
Notes to the financial statements (extracts)
For the year ended 30 June 20X2
Notes 20X2 20X1
C C
10. Profit before tax
This is stated after taking into account the following separately disclosable (income)/ expense items
x Foreign exchange gain 20X2: 50 000 + 40 000 (90 000) (4 000)
x Foreign exchange loss 20X2: 5 000 + 150 000 155 000 15 000
x FEC gain: reclassification adjustment 20X2: 2 400 + 3 600 (6 000) 0
* The tax effect should be presented (either on the face or in the notes), but this example ignored tax.
10. Summary
Chapter 22 1111
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Types of Hedges:
1112 Chapter 22
Gripping GAAP Share capital: equity instruments and financial liabilities
Chapter 23
Share Capital: Equity Instruments and Financial Liabilities
Reference: Companies Act of 2008, Companies Regulations of 2011, IFRS 7, IFRS 9, IAS 32 (including
amendments to 1 December 2019)
Contents: Page
1. Introduction 1114
2. Ordinary shares and preference shares 1114
2.1 Ordinary share and preference shares on liquidation 1114
2.2 Ordinary dividends and preference dividends 1114
Worked example 1: Dividend obligations – proposal vs declaration dates 1115
Example 1: Preference dividend 1115
2.3 Redeemable and non-redeemable preference shares 1116
2.3.1 Overview 1116
2.3.2 Redeemable preference shares 1116
2.3.3 Non-redeemable preference shares 1116
Example 2: Issue of non-redeemable preference shares 1117
Example 3: Issue of non-redeemable preference shares 1119
2.4 Participating and non-participating preference shares 1121
Example 4: Participating dividend 1121
3. Changes to share capital 1123
3.1 Par value and no par value shares 1123
Example 5: Issue at par value and above par value 1123
Example 6: Issue of ordinary shares 1124
3.2 Share issue costs and preliminary costs 1124
Example 7: Share issue costs and preliminary costs 1124
3.3 Conversion of shares 1125
Example 8: Converting ordinary shares into preference shares 1125
3.4 Rights issue 1125
Example 9: Rights issue 1126
3.5 Share splits 1126
Example 10: Share split 1126
3.6 Share consolidations (Reverse share split) 1126
Example 11: Share consolidation 1127
3.7 Capitalisation issue 1127
Example 12: Capitalisation issue 1127
3.8 Share buy-backs (treasury shares and other distributions made by the company 1128
Example 13: Share buy-back 1129
3.9 Redemption of preference shares 1130
3.9.1 Overview 1130
3.9.2 Financing of the redemption 1131
Example 14: Redemption at issue price – share issue is financing of last resort 1131
3.9.3 Redemption at a premium 1132
Example 15: Redemption at premium –shares were recognised as equity 1132
Example 16: Redemption at a premium – shares were recognised as a liability 1133
3.10 Companies Act requirements relating to distributions 1136
3.10.1 Overview 1136
3.10.2 Requirements relating to distributions to shareholders 1136
3.10.3 Solvency and liquidity test 1136
3.10.4 Requirements relating to share buy-backs 1136
4. Summary 1137
Chapter 23 1113
Gripping GAAP Share capital: equity instruments and financial liabilities
1. Introduction
An entity requires funding to start and continue running. This funding can be obtained from
any of the following:
x Raising funds from owners (shares, an external source);
x Making profits (an internal source); and
x Borrowing through loans or debentures (an external source).
In the case of a partnership the owners would be referred to as partners. In the case of a
close corporation, the owners would be referred to as members (please note that close
corporations still exist but are being phased out since the introduction of the new Companies
Act of 2008). In the case of companies, the owners would be referred to as shareholders.
This chapter concentrates on the acquisition of funds by a company through its shareholders.
The company’s Memorandum of Incorporation must specify each class Shares must
of shares, the description of each class and the maximum number of be authorised
shares within each class that the company is authorised to issue. Only before they may
authorised shares may be issued to shareholders. See Co’s Act s36 & s38 be issued. See Co’s Act s38
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It is important to note that a dividend to a shareholder should only be recognised when the
company has a present obligation to pay the dividend (i.e. when this obligation occurs, we will
recognise the liability and the dividend: credit liability and debit equity).
A dividend only becomes a present obligation once it has been appropriately authorised and is
no longer at the discretion of the entity. This obligation generally arises when the dividends are
declared: dividends are first proposed in a meeting and if the proposal is accepted, the entity will
then declare the dividend. Declaring a dividend means publicly announcing that the dividend will
be paid on a specific date in the future. In some jurisdictions, a declaration may need further
approval before the entity becomes obligated (e.g. although it may be declared by the board of
directors, there may be a requirement that the directors’ declaration still needs to be approved
by the shareholders). See IFRIC 17.10 & IAS 10.13 & Co’s Act s46
In this case, only the interim dividend is recognised during the 20X2 financial period because it was
only this dividend that was declared, creating an obligation during 20X2. The fact that the final
dividend was proposed before the end of 20X2 does not lead to an obligation during 20X2.
For ordinary shareholders, there is no certainty that they will receive a dividend, or portion
thereof, as this is decided on by the directors of entity, who consider a variety of factors,
including the entity’s profitability and liquidity. In contrast, preference shareholders are often
offered fixed dividends, calculated based on a coupon rate. While these dividends may not be
issued in one year, because the entity does not meet the regulatory requirements necessary to
pay out the dividend, the entity has an obligation to pay these dividends in future.
The terms of the preference share could indicate that the preference dividend is:
x discretionary (i.e. the company can choose whether to pay the dividend or not), or
x non-discretionary (i.e. mandatory) (i.e. the company must pay the dividends).
If the preference dividend is discretionary, the dividend is only recognised once it has been
declared (i.e. it is recognised in the same way as an ordinary dividend).
However, if the dividend is non-discretionary (i.e. mandatory), then the company has created an
obligation to pay all future preference dividends from day one. In other words, the company has
created a liability for all future preference dividends on the day the preference share is issued.
This liability must be recognised on the day the preference share is issued and will be measured
at the present value of these future preference dividends. These preference dividends will be
recognised as an interest expense, through the process of unwinding the discount, rather than
as a distribution to equity shareholders.
Chapter 23 1115
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Non-cumulative preference dividends are dividends that, if not declared in a particular year, need never
be declared in future. In other words, if the entity does not declare the preference dividend, the
preference shareholder's right to the dividend falls away on the date that it should have been declared.
Cumulative preference dividends are dividends that, if not declared in a particular year, will have
to be declared in a following year if an ordinary dividend is ever to be declared. In other words,
the entity is not allowed to declare a dividend to the ordinary shareholders until such time as all
cumulative dividends promised to the preference shareholder have been declared.
However, it is important to note that, even though the dividend may be cumulative, it does not
mean that the entity has an obligation to pay that dividend – whether or not the company has an
obligation (and thus whether it should recognise a liability for the dividend) depends on whether
or not the dividend is non-discretionary (i.e. mandatory).
To redeem
2.3 Redeemable and non-redeemable preference shares means:
x to return capital
2.3.1 Overview
Some preference shares are redeemable, and some are non-redeemable. Redeeming a
preference share means returning the capital to the preference shareholder. Although shares
are equity from a legal point of view, we must classify them based on their substance rather
than their legal form. Thus, whether the shares are redeemable or non-redeemable will affect
whether the shares are to be classified as equity instruments or financial liabilities.
If a preference share is redeemable, the first thing we must ascertain is whether the future
redemption will be at the discretion of the entity or not.
If the redemption is at the issuing entity’s discretion (i.e. the entity can choose not to redeem the
shares), this entity can avoid the redemption. If it can avoid the redemption, it does not have a
present obligation and so this aspect of the shares represents equity. See IAS 32.AG25
However, if the redemption is non-discretionary (i.e. the issuing entity does not have the right to
choose whether to redeem the shares or not), then the issuing entity has created an obligation
on the date that it issues the shares and so it must recognise a liability. The redemption would
be considered to be non-discretionary (i.e. mandatory) if the terms of the preference share
stipulate either that the:
x shareholder has the option to choose whether or not the shares should be redeemed; or
x redemption must take place on a specific future date.
If the shares are non-redeemable, the classification as equity or liability depends on the other
rights attached to the shares.
x If the preference share comes with the right to receive dividends but where the payment of
these dividends is at the discretion of the issuing entity, then the share is classified as an
equity instrument. See IAS 32.AG26
x If the payment of dividends is not at the entity’s discretion (i.e. the payment of dividends is
mandatory), then the share issue is classified as a financial liability. See IAS 32.AG6
Non-redeemable preference shares that offer mandatory dividends effectively provide the
shareholder with a ‘contractual right to receive payments on account of interest at fixed
dates extending into the indefinite future’. This is referred to as a ‘perpetual annuity’ and the
shares would be referred to as a ‘perpetual instrument’. See IAS 32.AG6
In this case, the shareholder has a financial asset (contractual right to receive cash) and the
issuer has a financial liability (contractual obligation to deliver cash). See IAS 32.AG6
1116 Chapter 23
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Assuming this financial liability (preference share liability) is classified at amortised cost
(see chapter 21):
- The liability would be measured at the present value of the future dividend payments
(a perpetual annuity: calculated at the coupon rate applied to the face value of the
shares), discounted at the market interest rate.
- The mandatory dividends would be recognised as an interest expense in profit or
loss, calculated on the effective interest rate method.
Glow Limited
Statement of financial position (extracts)
At 31 December 20X3
Note 20X3 20X2 20X1
Equity and Liabilities C C C
Issued share capital and reserves
Ordinary share capital Journals / SOCIE 3 350 000 350 000 350 000
Preference share capital Journals / SOCIE 4 100 000 100 000 100 000
Current liabilities
Preference shareholders for dividends Journals 10 000 0 0
Chapter 23 1117
Gripping GAAP Share capital: equity instruments and financial liabilities
Glow Limited
Statement of changes in equity (extracts)
For the year ended 31 Dec 20X3
Ordinary Preference Retained Total
share capital share capital earnings
C C C C
Opening balance – 20X3 350 000 (1) 100 000 (2) xxx xxx
Ordinary dividends declared (xxx) (xxx)
Preference dividends declared (10 000) (10 000)
Total comprehensive income xxx
Closing balance – 20X3 350 000 100 000 xxx xxx
Calculations: (1) ordinary shares: 100 000 shares x C3,50 each (2) preference shares: 50 000 x C2
Glow Limited
Notes to the financial statements (extracts)
For the year ended 31 December 20X3
20X3 20X2 20X1
3. Ordinary share capital Number Number Number
Authorised:
Ordinary shares of no-par value Comment 200 000 200 000 200 000
Issued:
Shares in issue: opening balance 100 000 100 000 0
Issued during the year 0 0 100 000
Shares in issue: closing balance 100 000 100 000 100 000
Comment: All shares in South Africa are now issued at no-par value (see section 3.1). However, IAS 1
requires disclosure of whether the shares have a par value or not. In this regard, please note that some
companies in South Africa will still be disclosing shares that have a par value: these will be the shares
that were issued by South African companies prior to the SA Companies Act of 2008. See IAS 1.79(a)(iii)
1118 Chapter 23
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Chapter 23 1119
Gripping GAAP Share capital: equity instruments and financial liabilities
Effective interest rate: Interest is calculated using the effective interest rate = 12,93699016% (given)
This rate could have been calculated as the internal rate of return using a financial calculator:
PV = 100 000 (C2 x 50 000 shares) FV = -110 000 (C2,20 x 50 000 shares)
PMT = -10 000 (50 000 x C2 x 10%) n=3
COMP i = 12,93699016%
Company name
Statement of financial position (extracts)
As at 31 December 20X2
Note 20X2 20X1
Equity and Liabilities C C
Issued share capital and reserves 570 000 xxx
Ordinary share capital From SOCIE 3 350 000 350 000
Retained earnings From SOCIE 220 000 xxx
Non-current liabilities
Redeemable preference shares W1 or Journals 4 0 102 937
Current liabilities
Redeemable preference shares W1 or Journals 4 106 254 0
For your interest: If the dividend for 20X1 had been declared before year-end but only paid after year-end, the
total liability balance at 31 December 20X1 would have been C112 937 (C102 937 + C10 000), instead of
C102 937, but the C10 000 dividend payable would be presented as a ‘current liability’.
Company name
Statement of changes in equity (extracts)
For the year ended 31 December 20X2
Ordinary Retained Total
share capital earnings
C C C
Opening balance – 20X2 Given 350 000 150 000 500 000
Total comprehensive income From SOCIE 80 000 80 000
Ordinary dividends declared Journals (10 000) (10 000)
Closing balance – 20X2 350 000 220 000 570 000
Comment relating to statement of changes in equity:
x The preference shares are not presented in the statement of changes in equity since they are included
as a liability in the statement of financial position.
x Similarly, the preference dividends are not presented in the statement of changes in equity since they
are included as finance charges in the statement of comprehensive income.
1120 Chapter 23
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Company name
Statement of comprehensive income (extracts) 20X2 20X1
For the year ended 31 December 20X2 C C
Profit before finance charges xxx xxx
Finance charges W1 or Journals (13 317) (12 937)
Profit before tax xxx
… xxx xxx
Total comprehensive income for the year 80 000 xxx
Company name
Notes to the financial statements (extracts)
For the year ended 31 December 20X2
2. Accounting policies
2.8 Preference shares Preference shares that are mandatorily redeemable on a specific date, or at the
option of the shareholder, are recognised as liabilities, because, in substance, they are borrowings. The
dividends on these preference shares are mandatory and thus the mandatory dividend stream is also
recognised as a liability. This means these dividends are included in profit or loss as part of the interest
expense that is recognised when unwinding both these liabilities using the effective interest rate method.
20X2 20X1
3. Ordinary share capital Number Number
Authorised:
Ordinary shares of no-par value 120 000 120 000
Issued:
Shares in issue: opening balance 100 000 0
Issued during the year 0 100 000
Shares in issue: closing balance 100 000 100 000
20X2 20X1
4. Redeemable preference share liability Number Number
Authorised:
10% redeemable preference shares 100 000 100 000
Issued:
Shares in issue: opening balance 50 000 0
Issued during the year 0 50 000
Shares in issue: closing balance 50 000 50 000
The redeemable preference shares, of no-par value, are compulsorily redeemable on 31 December 20X3 at a
premium of C0,20 per share.
The 10% preference dividend is cumulative and mandatory and calculated on a deemed value of C2 per share.
The effective interest rate is 12,93699016%. Per IFRS 7.6 and IFRS 7 Appendix B3
For the purposes of the rest of this chapter, you may assume, unless specifically stated
otherwise, that the preference shares are non-redeemable and the related preference dividends
are discretionary and thus that the preference shares are classified as equity.
Participating preference shares are those where the shareholders receive, in addition to the fixed
annual dividend, a fluctuating dividend, based on the ordinary dividend.
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The ordinary dividend declared is C0,10 per share. There are 1 000 ordinary shares in issue.
The ordinary dividends and preference dividends were declared on 25 December 20X5.
Required: Journalise the ordinary and preference dividends.
Note 1: Non-redeemable are classified based on the other rights attaching to them:. If their divs:
x are discretionary: the share remains equity and the dividend is an equity distribution; or
x are mandatory: the share is a perpetual debt instrument and so it is a L & the dividend is interest. See IAS32.AG26
See IAS32.AG26
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The separate Regulations (which accompany this Companies Act) explain that, with the exception
of banks, companies that had par value shares in existence at effective date must deal with their
par value shares as follows:
x If the company had an authorised class of par value shares, where none had been issued by
the effective date, those shares could not be issued until they had been converted into ‘no par
value shares’. The same applies for any class of shares where all those shares had been
issued but since been re-acquired by the company by the effective date. Regulations 31 (3) reworded
x If the company had authorised par value shares, only some of which had been issued at
effective date (i.e. outstanding issued shares), the company may continue to issue the
unissued authorised par value shares until the company publishes a proposal to convert these
shares into no par value shares, but it may not increase the
number of these authorised shares. Regulations 31 (5) reworded With the new Co’s Act:
x only no-par value shares can be
Since the intention is that all shares in future be ‘no par value issued; but
shares’, this text focuses on no par value shares. However, since x par value shares still exist
par value shares still exist in South Africa and in many countries around the world, a brief
explanation and example is included to show how par value shares are accounted for (see
example 5).
Shares with a par value (in countries where par value shares are issuable) may be issued:
x at their par value (in which case there would be no share premium);
x above their par value (in which case there would be a share premium); or
x below their par value (often subject to certain conditions laid down in that country’s legislation).
Chapter 23 1123
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X Limited
Statement of changes in equity (extracts)
For the year ended …
Ordinary shares Share premium Retained earnings Total
C C C C
Opening balance 0 0 xxx xxx
Ordinary shares issued 100 10 110
Total comprehensive income xxx xxx
Closing balance 100 10 xxx xxx
3.2 Share issue costs and preliminary costs (IAS 32.37 and IAS 38.69)
Share issue costs and preliminary costs are not the same thing.
x Share issue costs (also called transaction costs) are the costs incurred in issuing shares.
These must be set-off against the equity account, unless the issue of shares is abandoned, in
which case the share issue costs will be expensed in profit or loss. This is in terms of IAS 32.
However, please note that IAS 32 does not specify which equity account must be used to
absorb the share issue costs and thus the entity should choose which equity account it will use
(i.e. as an accounting policy) and must apply it consistently. See IAS 32.37
x Preliminary costs (also called start-up costs) is an initial cost incurred in starting up a
business, an example being ‘legal and secretarial costs incurred in establishing a legal
entity’. These costs are accounted for in the same way that we account for most other such
costs incurred in start-up activities, which is to expense them in profit or loss. see IAS 38.69
1124 Chapter 23
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Wallington Limited
Statement of changes in equity
For the year ended 31 December 20X1
Ordinary Retained Total
share capital earnings C
C C
Opening balance 0 0 0
Ordinary shares issued 200 000 0 200 000
Share issue costs set-off (2 000) 0 (2 000)
Total comprehensive income W1 110 000 110 000
Closing balance 198 000 110 000 308 000
W1: Corrected total comprehensive income: Given: C120 000 – preliminary costs expensed: C10 000 = C110 000
Shares of one class may be converted into shares of another class (for example, preference
shares may be converted into ordinary shares, or vice versa).
Craig Limited
Statement of changes in equity
For the year ended 31 December 20X2
Ordinary Preference Retained Total
share capital share capital earnings
C C C C
Opening balance 1 200 0 Xxx xxx
Conversion of ordinary shares to preference shares (600) 600 0
Total comprehensive income Xxx xxx
Closing balance 600 600 Xxx xxx
Notice: The net balance on these equity accounts remains at C1 200 and total equity is not affected.
Also note that such a change in the company’s share capital has no impact on cash reserves.
Chapter 23 1125
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The lower price provides an incentive to these shareholders to invest more capital in the
company. Note that shareholders are not obliged to purchase the shares offered.
A share split involves the company splitting its authorised and issued share capital into more
shares. This has the effect of reducing the market value per share, since there are suddenly
more shares on the market, while the net asset value of the company has not changed. A
company may perform a share split if it feels that its share price is too high, because a lower
price may attract new investors and increase the liquidity of its shares.
This is the opposite of a share split and is often implemented when the company believes its
share price is too low: the company reduces the number of authorised and issued shares. This
should increase the market value per share, as there are now fewer shares on the market, yet
the company’s net asset value remains the same.
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Other terms for a capitalisation issue include ‘bonus issue’, ‘scrip issue’ (or scrip dividends) or ‘fully
paid up’ shares. The most important feature of a capitalisation issue is that the shareholder does
not pay for the shares they receive (i.e. it does not involve the flow of cash).
So, if no cash is involved, you may be wondering how the issue would be journalised. It depends
on the purpose behind the capitalisation issue:
x A company could issue capitalisation shares if it is short of cash but needs to declare a
dividend to keep its shareholders happy (i.e. it give its shareholders shares instead of a cash
dividend… shareholders who need cash can then sell these shares). This is called a scrip
dividend and would be journalised as: debit dividends declared; credit share capital.
x A company could also issue capitalisation shares simply to make use of the company’s idle
reserves (i.e. they could issue capitalisation shares in addition to a cash dividend purely to
restructure, or ‘tidy up’, its reserves). Since no cash is involved, the share issue is ‘funded’ by
converting reserves into share capital e.g. debit retained earnings and credit share capital).
The Companies Act s40 requires authorised shares (including capitalisation issues) to be issued
for ‘adequate consideration’. In many instances the market price of a share is ‘adequate
consideration’ for the purposes of measuring the amount of the capitalisation issue journal.
However, it is up to the directors’ judgement to determine the ‘adequate consideration’ for the
capitalisation journal.
Although capitalisation issues often occur because a company is short of cash, the company might offer
their shareholders a choice between cash and a capitalisation share. However, this optional cash
payment may only be offered if it complies with the solvency and liquidity test in s46 of the Companies
Act. This section must be applied before making any distribution (the definition of which includes,
amongst other things, dividends and payments in lieu of a capitalisation issue). The application of this
section (s46) requires that the solvency and liquidity test would be satisfied immediately after the
capitalisation issue takes place assuming all shareholders opted to receive the cash payment (see
section 3.10 for a more detailed discussion about s46 and the solvency and liquidity test). See s47 (1) and (2)
Chapter 23 1127
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Company name
Statement of changes in equity
For the year ended …
Ordinary Retained Total
share capital earnings
C C C
Opening balance 1 500 800 2 300
Capitalisation issue 600 (600) 0
Total comprehensive income 150 150
Closing balance 2 100 350 2 450
Note: there is no change in either the total equity or the cash resources of the company.
Shares that are bought back by the entity are called treasury shares. Treasury shares have no
rights attached to them, which means that the holder of a treasury share (i.e. the entity itself) will
have no voting rights and will not receive dividends. A company buying back its own shares can
signal to the market that management (knowing the real value of their company) believes the
share is under-priced. Treasury shares may be re-issued (sold) at a later date.
Issued shares
Treasury shares (i.e. shares that an entity holds in itself) are refers to the:
commonly described as ‘issued shares that are not outstanding x Total shares
shares’. The term ‘outstanding shares’ is used to describe shares issued by the company,
that are held by investors (as opposed to shares now held by the including treasury shares.
issuing entity itself). Outstanding shares
x Issued shares held by
Although treasury shares are referred to as ‘issued shares that are not shareholders, excluding
treasury shares.
outstanding’, please note that, legally, they ‘have the same status as See Co’s Act s35
shares that have been authorised but not issued’. See Cos’ Act s35
In South Africa, a company may buy back its shares only if the Companies Act requirements are met:
x The buy-back must satisfy the requirements of s46 of the Companies Act (which includes the
requirement to meet the solvency and liquidity test in s4: see section 3.10 for details); and
x After the buy-back, there must be shares in existence other than:
- shares that are owned by one or more of its subsidiaries; or
- convertible or redeemable shares. See Co’s Act s48
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The reason for these restrictions is that both the cash reserves and capital base of the company
are diminished through a share buy-back – putting other shareholders and creditors at risk.
Thus, the solvency and liquidity test helps to protect their financial interests in the entity.
IAS 1 requires that, when an entity holds its own shares, the treasury ‘shares’ must be separately
disclosed. However, it is not clear from the wording of IAS 1 whether it is the number of treasury
shares or the amount allocated to the treasury shares that is required disclosure, or both. That
said, IAS 32 requires that ‘the amount of treasury shares’ be disclosed, and the wording of this
standard seems to suggest that IAS 1 was also referring to the amount of treasury shares.
However, for the purposes of our users, who need to know the number of issued shares for
purposes of ratio analysis (i.e. they need to know the number of shares held by shareholders
rather than the total shares issued, including shares held by the entity), it is submitted that we
should ideally disclose both the amount allocated to treasury shares and the number of treasury
shares held. Disclosure could be made on the face of the statement of financial position,
statement of changes in equity or in the notes to the financial statements. IAS 1.79(a)(vi) and IAS 32.34
IAS 32 explains that when buying back shares, the consideration paid for these shares must be
debited directly to equity and no gain or loss may be recognised in profit or loss.
Although IAS 32 requires that a buy-back of shares be debited to equity, it does not specify which
equity accounts should be debited. For example, it could be debited to share capital directly or
could be debited to a separate treasury share account (a negative equity account). In this textbook
we will use a treasury account. See IAS 32.33
Petal Limited
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 C C
Petal Limited
Statement of changes in equity (extract)
For the year ended 31 December 20X2
Ordinary share Treasury Retained Total
capital shares earnings C
C C C
Opening balance 1 500 0 80 000 81 500
Treasury shares (share buy-back) (s48) (750) (750)
Total comprehensive income 5 000 5 000
Closing balance 1 500 (750) 85 000 85 750
Chapter 23 1129
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Petal Limited
Notes to the financial statements (extracts)
For the year ended …
Although preference shares that are either ‘mandatorily redeemable’ or ‘redeemable at the option
of the holder’ are recognised as liabilities, they are still considered to be shares from a legal point
of view and, thus, their redemption must still comply with the Companies Act requirements.
The Companies Act requirements exist because, when a The S&L test
company redeems shares, both its capital and cash reserves must be satisfied before
are reduced (debit shares and credit cash), which could put preference shares can be redeemed.
the other remaining shareholders and creditors at risk.
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To reduce this risk, the Companies Act requires the company to meet the solvency and liquidity
test and other requirements before the redemption takes place (these requirements are contained
in s46 and s4 of the Companies Act: see section 3.10 for more detail).
How the payment is made is referred to as the ‘financing of the redemption’. A company may
finance the redemption of shares by, for example, issuing new shares, issuing debentures,
raising a loan or an overdraft.
Example 14: Redemption at issue price – share issue is financing of last resort
A company must redeem all its preference shares at their original issue price of C2.
It prefers not to have to issue any further ordinary shares unless absolutely necessary but if
such an issue is necessary, these ordinary shares will be issued at C6 each.
x The company has C80 000 in the bank. The directors feel that only C30 000 of this should be used
for the redemption.
x Any further cash required should be acquired via an issue of up to 10 000 debentures at C1 each
(redeemable after 3 years at C1 each).
x If further cash is still required, a bank loan of up to C40 000 (repayable after 4 years) may be raised.
x There is a balance of C150 000 in the retained earnings account.
Consider the following scenarios:
x Scenario (i): there are 10 000 preference shares to be redeemed
x Scenario (ii): there are 35 000 preference shares to be redeemed
x Scenario (iii): there are 70 000 preference shares to be redeemed
Required: For each of the scenarios listed above:
A. Calculate the number of ordinary shares that would need to be issued to finance the redemption.
B. Show all related journal entries.
Chapter 23 1131
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A redemption that requires a company to pay the preference shareholder an amount in excess of
its issue price is referred to as a redemption at a premium.
x If the preference share was mandatorily redeemable, the original share issue would have been
recognised as a preference share liability and the mandatory premium would have been
included in the measurement of this liability balance (furthermore, irrespective of whether the
liability was measured at amortised cost or at fair value through profit or loss (FVPL), the
premium will have been included in the interest expense, and this will have automatically
reduced retained earnings).
x If the preference share was not mandatorily redeemable, the original share issue would have
been recognised as equity. In this case, if a premium is paid on redemption, the amount paid
will exceed the amount originally recognised in the share capital equity account when the
shares were issued. Thus, when these shares are redeemed, we will have to first debit the
share capital equity account, bringing it to zero, and then the extra premium paid will need to
be debited to another distributable reserve equity account, such as retained earnings.
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The redeemable preference shares were compulsorily redeemable on 31 December 20X3 at a premium of
C0,20 per share. The 10% preference dividend is mandatory and cumulative and is based on a deemed
value of C2 per share. The effective interest rate is 12,93699016%. Per IFRS 7.6 and IFRS 7 Appendix B3
Chapter 23 1135
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3.10 Companies Act requirements relating to distributions (s4, s46 & s48)
3.10.1 Overview
In South Africa, the Companies Act has several provisions that control distributions from a
company to its shareholders. These legislative requirements exist because, when a company
makes a distribution to its shareholders, both its equity and assets are reduced (e.g. in the case
of a redemption of shares, we would debit shares and credit cash), thus potentially putting
shareholders and/ or creditors at risk. It is this risk that the legislative requirements are designed
to reduce. We will now consider the requirements in s46, s4 and s48.
The S&L test
3.10.2 Requirements relating to distributions to shareholders (s46) helps to protect:
the financial interests of
shareholders with smaller
In South Africa, the Companies Act (section 46) states that a company
shareholdings, and creditors
may not make any proposed distribution to shareholders (such as a
dividend payment, a redemption of preference shares or a buy-back of ordinary shares) unless:
x The distribution is:
- pursuant to an existing legal obligation of the company, or
- pursuant to a court order; or
- the board of the company, by resolution, has authorised the distribution; and
x It reasonably appears that the company will satisfy the solvency and liquidity test (per s4 of
the Companies Act) immediately after completing the proposed distribution; and
x The board of the company, by resolution, has acknowledged that it has applied the solvency
and liquidity test, and concluded that the company will satisfy the solvency and liquidity test
immediately after completing the proposed distribution. Significantly summarised - see Companies Act s46
A S&L test means
3.10.3 Solvency and liquidity test (s4) satisfying tests of:
x solvency = A(FV) ≥ L(FV)
The solvency and liquidity test (s4) will be satisfied at a certain point
x liquidity = ability to pay
in time if, considering all reasonably foreseeable information: current debts as and when
x The company’s assets (fairly valued) equal or exceed its liabilities they fall due See Co’s Act s4
(fairly valued); and
x It appears that the company will be able to pay its debts as they become due in the ordinary
course of business for a 12-month period after the test or, in the case of a distribution, for a
12-month period following that distribution. Significantly summarised - see Companies Act s4
In the case of a share buy-back (section 3.8), the company would have to comply not only with
s46 and s4 of the Companies Act, but also s48, which requires that, after the buy-back, there
must be shares in existence other than:
x shares that are owned by one or more of its subsidiaries; or
x convertible or redeemable shares. Significantly summarised - see Companies Act s48
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4. Summary
Note 1: Non-redeemable PS are classified based on the other rights attaching to them. So, if their divs are:
x discretionary: the share remains equity and the dividend is an equity distribution; or
x mandatory: the share is effectively a perpetual debt instrument and is thus recognised as a liability
& the dividend is recognised as an interest expense. See IAS32.AG26
Share
Share splits Share issue Share buy-back
consolidation
x for value: mkt price existing shares reduce equity e.g.
existing shares split
x for free: cap issue combined into fewer dr treasury shares & cr
into more shares
x combo: rights issue shares bank
No journal No journal
Journals
Share issue:
x Issue at mkt price: Normal issue: Proceeds on issue (Dr Bank and Cr Ord SC)
x Issue for free: Cap issue: Amt of reserves to be capitalised (Dr RE Cr Ord SC)
x Combination issue: Rights issue: Proceeds on issue (Dr Bank and Cr Ord SC) (i.e. same a
for an issue at mkt price)
Share buy-back: Payment made (Cr Bank; Dr Treasury shares) (never recognise a P/L!)
Transaction costs and preliminary expenses:
Share issues are often accompanied by certain costs such as transaction costs and
preliminary costs:
x Transaction costs (Cr Bank and Dr Stated capital) –
x Preliminary costs are always expensed (Cr Bank and Dr Prelim cost expense (P/L))
Chapter 23 1137
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Chapter 24
Earnings per Share
Reference:
IAS 33; Circular 4/2018, IAS 10 and IFRIC 17 (incl. any amendments to 10 December 2019)
Contents: Page
1. Introduction 1140
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7. Summary 1177
Chapter 24 1139
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1. Introduction
‘Earnings per share’ is essentially a ratio used in the financial analysis of a set of financial
statements and therefore falls under the chapter on financial analysis as well. It takes into
account the number of shares in issue, and is thus a comparable, relative measure. This ratio
is, however, so useful and popular that the standard, IAS 33, had to be developed to control
the method of calculation thereof. This standard sets out how to calculate:
x the numerator: earnings; and
x the denominator: the number of shares
for each class of equity share (where each class has a varying right to receive dividends).
IAS 33 refers to two different types of earnings per share: basic earnings per share and
diluted earnings per share. It allows other variations of earnings per share to be presented as
well (although these other per share figures may not be presented on the face of the
statement of comprehensive income, but may only be presented in the notes). In South
Africa, companies wishing to be listed or to remain listed on the JSE Exchange must comply
with the JSE Listing Requirements, which requires that headline earnings per share be
presented. The various earnings per share figures can be summarised as follows:
The ‘basic earnings per share’ figure may be extremely volatile since all items of income and
expenses are included in the calculation thereof. In order to compensate for this volatility, the
calculation of ‘headline earnings per share’ has been introduced, which excludes income and
expenses of a capital nature and those that are ‘highly abnormal’. Headline earnings are
therefore a better indicator of ‘maintainable earnings’. ‘Diluted earnings per share’ is also
covered by IAS 33. This is covered later in this chapter.
2. Types of Shareholders
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x If the preference dividend is mandatory it means that the entity cannot avoid paying it with
the result that this aspect of the share represents a liability to the entity. In other words,
on the date the shares are issued, the entity has an obligation to pay all future dividends.
Thus, the entity recognises the present value of the future dividend stream as a liability on
the day the shares are issued. These dividends will then be recognised as an interest
expense as the present value of the dividends unwinds.
x If the preference dividend is discretionary it means the entity can choose whether or not
to pay it. Since there is no obligation to pay a discretionary dividend, this is recognised as
a distribution of equity in the same way as ordinary dividends. In other words, it will only
be recognised as a distribution of equity once the dividend has been appropriately
authorised and is no longer at the discretion of the entity. Therefore, it is only recognised
once the entity has created for itself an obligation to pay the dividend (in most
jurisdictions, this is the date that the dividends are publicly declared). See IAS 10.13 & IFRIC 17.10
Chapter 24 1141
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3.1 Overview
IAS 33 states that 'the objective of basic earnings per share information is to provide a
measure of the interests of each ordinary share of a parent entity in the performance of the
entity over the reporting period’.IAS 33.11 In other words, we disclose the basic earnings per
share to show users how much of the earnings for the period ('performance') belongs to each
share We can disclose earnings per share for every entity, but if the entity is part of a group of
entities, it need only be provided for the parent entity (i.e. the entity with ultimate control).
In the event that the entity reports a loss instead of a profit, the earnings per share will be
reported as a loss per share instead. See IAS 33.69
In order to calculate the earnings attributable to the ordinary shareholders, one should start
with the ‘profit for the period’ per the statement of comprehensive income and deduct the
profits attributable to the preference shareholders that are classified as equity.
Basic Earnings C
Profit (or loss) for the period (after tax) xxx
Less fixed preference dividend (coupon rate) (equity distributions only) NOTE 1 (xxx)
Less variable div: share of profits belonging to participating preference shareholders (xxx)
= Earnings attributable to ordinary shareholders xxx
Note 1: Preference dividends are, in fact, not always deducted. As explained already, some
dividends represent liabilities and are thus recognised as interest expense whereas other
dividends represent equity and are thus recognised as distributions of equity (true dividends).
We only deduct preference dividends if they are recognised as distributions of equity. If these
true preference dividends are not declared, they would obviously not be recognised.
However, if they are cumulative it means that ordinary shareholders will not be able to receive
a dividend until these arrear dividends are paid. Thus, when calculating the basic earnings
belonging to ordinary shareholders, we must remember to deduct any undeclared preference
dividends that are cumulative. In summary, when dealing with preference dividends that are
recognised as distributions of equity:
x if the dividends are non-cumulative, deduct only the preference dividends that
are declared in respect of that period; and
x if the dividends are cumulative, deduct the total required preference dividends for the
period (in accordance with the preference share’s coupon rate), regardless of whether or
not these dividends have been declared. See IAS 33.14
When preference dividends represent liabilities, they are recognised as interest expense. In
this case, they will have already been deducted in the calculation of ‘profit or loss for the
period’ and thus they must obviously not be deducted again when calculating ‘earnings
attributable to the ordinary shareholders’.
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If there are only ordinary shareholders, it stands to reason that the entire profit or loss of the
company belongs to the ordinary shareholders (owners).
Profit (or loss) for the year (per the statement of comprehensive income) 100 000
Less fixed preference dividends (0)
Less share of profits belonging to participating preference shareholders (0)
Earnings belonging to ordinary shareholders 100 000
If there are both ordinary and preference shareholders, and if these preference dividends are
classified as equity, we will need to set aside the portion of the profit for the year that belongs
to these preference shareholders (i.e. the portion needed to cover the p