CIMA F2
LONG TERM FINANCE (Chaps 1 & 2) (15%)
CHAPTER 1
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Equity Finance
Long-term Finance
Debt Finance
Sources of long term finance
If company does not have cash surplus then it might raise funds from (equity/debt):
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Capital Markets
o New Shares
o Rights Issues
o Marketable debt
Bank Borrowings (long term/short term inc. revolving (RCFs))
Government and similar sources
EQUITY
Share: fix identifiable unit of capital with (normally) fixed nominal value.
Ordinary Shares or equity shares. Pay dividends at the discretion of entity’s directors. Ordinary
shareholders are the owners of the company and they have the right to attend meetings and vote. They
are subordinated to all other finance providers.
Preference shares: pay fix dividend before ordinary share dividends. Preference shareholders are
subordinated to all other debt holders and creditors sauf ordinary. Typically do not have voting rights.
More comparable to bonds but as paid out of post-tax profits does not have tax benefit. Also company
might be given permission to avoid paying dividends in case of insufficient profit. Appealed to risk averse
investors looking for a reliable income stream. Might be redeemable (holders will be repaid capital,
usually at par). There are 4 types:
1. Cumulative preference shares. Dividends are roll forward in case of inability to pay. Pay year 2,
year 1&2 dividends.
2. Non-Cumulative preference shares. Not roll forward of dividends
3. Participating Preference Shares. Give holders fixed dividends plus extra earnings on certain
conditions
4. Convertible preference shares. Can be exchanged for a specified number of ordinary shares on
some given future date. Attractive to investors who want to participate in the rise of growth
companies while being insulated from a drop in the price if they do not live up to expectations.
Shares are listed in CAPITAL MARKETS, which are driven by supply and demand forces.
Capital Markets. Two functions.
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Primary: enable companies to raise new finance (equity or debt). In UK must be PLC.
Secondary Function: enable investors to sell their investments to other investors. Listed
companies are more attractive.
Private vs Public. Public companies means shares can be offered to the public (listed or not). Public
Cos have more strict disclosure requirements.
Limited. Both Public or Private. Liability of shareholders to creditors is limited to the capital
originally invested.
When entity obtains listing it is called floatation or IPO.
Advantages of exchange listing.
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More accurate valuation
Mechanism for buying and selling at will
Raise profile of entity
Raise capital for future investment
Makes employee share schemes more accessible.
Disadvantages:
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Costly for small entity
Loss of some control
Report requirement more onerous
Stock exchange rules can be stringent
The roles of advisors on a share issue: investment banks, stockbrokers, institutional investors, registrars
to an issue, public and investor relations, reporting accountants, underwriters (page 8)
Methods of issuing new shares.
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IPO (1st time only). Transfer of (some or all) private share to the public. The offer could be
made through Fixed Price or Tender Offer (investors suggest price).
A placing (further financing). Shares are place with certain investors on a prearranged basis.
A rights issue (further financing). Shares are offered to existing shareholders in a proportion
to the size of their shareholding (called “pre-emption rights” & are protected by law). Shares
are usually issued at a discount to market price (aprox 20%). Not too low however to avoid
price of share falling to this level and diluting EPS (eg. 1 to 4). Typically price fall after
announcement because of uncertainty and after actual issue because of the increase
number of shares at a lower price. Shareholders can sell their rights. From the company
viewpoint, a rights issue is usually successful.
DEBT Finance
Loan of funds to a business without conferring ownership rights. Interest is paid out of pre-tax profits as
an expense. It carries a risk of default if interest and principal are not met. Thus, lender will normally
require a form of security. There are two types of securities to be offered
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Fixed Charged or specific asset (preferred)
Floating charge. Underlying assets are subject to changes in quantity or value (not so strong).
Covenants. Means of limiting the risk to the lender by limiting the actions of directors through
covenants. Eg: dividend restrictions, financial ratios specifications, financial reports requirements, issue
of further debt restrictions.
Money Market: short term borrowing/lending market.
Revolving credit: borrower may use or withdraw funds up to a pre approved credit limit. Borrower may
repar over time or infull at any time. Flexible debt financing option that enable to minimize interest
payment as you borrow only as much as you need.
Bonds. Is a debt type security that satisfy long term funding requirements. Issuers owe principal and
obliged to pay interest (coupon) at a fixed interval. Can be traded in capital markets. They do not confer
ownership and have a maturity after which the bond is redeemed. The underwriter (generally a IB) can
place it with specific investors (bond placement) or use a medium term note (MTN) program to issue
debt securities on a regular/ continuous basis.
OTHER SOURCES of finance
Retained earnings/existing cash balances. Retained earnings =/= cash in hand. Only if cash in hand.
Sale and leaseback. Specially for retail w high street property.
Grants. By local/national governments
Debt with warrants attached. Warrant is an option to buy shares at a specified point in the future for a
specified price. Often issued with bonds as a sweetener to encourage investors to buy the bonds. Holder
can sell the warrant.
Convertible debt. Similar to warrant sauf that the option cannot be detached and trade. If the investors
choses not to exercise the option (price too low), can hold until maturity.
Venture Capital & Business Angels (focused more on small business difficult to monitor).
CHAPTER 2. Cost of Capital
WACC (weighted average cost of capital) = measures the average cost of an entity’s finance.
Average of cost of equity (Ke) and cost of debt (Kd)
Cost of Equity: rate of return expected by shareholders. Main method of calculation is Dividend
Valuation Model (with constant or growing dividends). Market price of a share is assumed to be the
present value of that future income stream.
Ke=d/Po
Po= market price of share
Ke=d(1+g)/ Po + g  Growth dividend (- could be average (historical) or – profit retention rate)
Assumptions on Growth model based on retention rate
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Entity must be equity financed
Retained profits are the only source of additional investments
Constant proportion of each year’s earnings is retained for reinvestment
Project financed from retained earnings earn a constant rate of return
Cost of debt: rate of return that debt providers require on the funds. Value of debt is assumed to be the
present value of its future cash flows. Debt is tax deductible.
Kd for bank borrowings = r ( 1 – t)
r = annual interest rate in %
T= corporate tax rate
Kd for irredeemable, undated bonds = I ( 1 – T) / Po
I= interest paid each year per $100 of bond
Po= market price of bond after coupon
IRR= discount rate which gives a zero NPV
When Can WACC be used as a discount rate?
When using NPV or IRR calculations but only if these conditions are met:
1. Capital structure is constant; if it changes, the weightings in the WACC will also change
2. The new investment does not carry a different business risk profile to existing operations
3. The new investment is marginal to the entity. If it is a small investment, then Kd, Ke and WACC
will not change materially. Otherwise, it will cause these values to change.
Yield to Maturity = effective average annual percentage return to the investor relative to the current
market value of the bond. Tax is not deducted from any interest received within YTM calculation.
CHAPTER 3: Financial Instruments
IAS 32 Financial Instruments: presentation provides the rules on classifying financial instruments as
liabilities or equity.
Financial Instrument: Any contract that gives rise to a financial asset of one entity and a financial liability
or equity instrument of another entity (IAS 32, para 11)
Entity/ Financial Asset ----------------------------contract---------------------------Entity/Financial Liability/Equity
Financial Asset:
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Cash
An equity instrument of another entity
A contractual right to receive cash or another financial asset from another entity
A contractual right to exchange financial instruments with another entity under conditions that
are potentially favorable
Financial Liability
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To deliver cash or another financial asset to another entity
To exchange financial instruments with another entity under conditions that are potentially
unfavorable
Equity: any contract that evidences a residual interest in the assets of an entity after deducting all of its
liabilities. A financial instrument is only an equity instrument if there is no such a contract obligation.
Preference shares are classified as financial liabilities. Its dividends will be charged as a finance expense
and go through P/L. Standard shares go through Retained Earnings.
Offsetting a financial asset and a financial liability. May only be offset under very limited circumstances.
Net amount may only be reported when the entity:
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Has a legally enforceable right to set off the amounts
Intends either to settle on a net basis or to realize the asset and settle the liability
simultaneously (IAS 32, para 42)
IFRS 9 provides guidance on when a financial instrument should be recognized and how they should
measured. They initially should be recognized at fair value. Subsequent measurement depends on
classification.
Financial Liabilities (Bonds/loan stock/debentures)
Par value: headline value
Coupon rate: minimum interest repayment per annun based on par value
Discount: (only) if the cash amount received is less than par value
Redemption rate: date of repayment of capital interest of loan = maturity date
Premium: extra amount repayable at redemption date
Effective interest rate: rate of interest that spreads the total finance costs, including finance costs,
premium, coupon, across the life of the loan.
Initially recognized at fair value. Then:
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Fair value through profit or loss (FPVL)
o Applies to instruments:
 Held for trading
 Derivatives
 Record at Fair Value
 Expense Transaction costs
 Restate to fair Value at each reporting date
 Any gain and loss is taken to P/L
Other Financial Liabilities (eg loan w the bank – held to maturity)
o Record at fair value less costs (fees related to issuance)
o Measured subsequently at amortized cost; ie from the value of a the liability via a
finance charge (effective interest) over the life up to its redemption amount.
Compound instrument. A financial instruments that has characteristics of both equity and liabilities. Eg.
Convertible bonds that are debt that can be converted into equity at certain point. For this priviledge
the bondholder normally have to accept a below-market interest. Upon initial recognition, IAS 32
requires it to be split into their components parts:
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a financial libiality, measured at PV of future cash flows using a discount rate that equates to the
interest rate on similar instruments without conversion rights. Subsequently it is measured at
amortized cost
an equity instrument, calculated as the balancing figure. Subsequently, it remains unchanged.
Any transaction cost would be pro-rated between equity and libilitiy.
Financial Assets (equity or debt financial assets)
IFRS 9: asset should be initially recognized at fair value (cash paid/received). Subsequent measurement
depends upon classification.
Investments in equity
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Fair value through P/L – if held for trading ordinary shares
o Transaction cost through P/L
o Revalue to fair value after
o Gain/Losses through P/L
Fair value though OCI
o Not-held for trading and irrevocable designated LT investment in ordinary shares
o Transaction costs added
o Revalue at fair value
o Gain and Losses through OCI
Debt financial asses
An entity will designate a debt financial asset as either FVOCI or amortized cost depending on two tests:
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Business model test. Keep financial assets? Sell them? Hold some and sell some?
Contractual cash flow test. Contractual terms give rise to repayments of SOLELY Principal and
Interests. If cash flows relate to anything else (eg convertible bondscompensation for low
interest in cash or shares)FV through P/L
Investments in debt
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Business model: hold until redemption // Contractual: passed
o  Amortized cost
 Initial recognition at FV
 Transaction cost added
 Subsequent at Amortized Cost
Business model: hold until redemption and sell before redemption // Contractual: passed
o FVOCI
 Transaction costs added
 Subsequent revalue to FV, gain/losses through OCI. Reclassified through P/L
on disposal
Does not pass the test (eg debt investments held for trading in short term)
o FVPL
 Initial recognition at FV
 Transaction cost through P/L
 Subsequent, revalue to FV
 Gain/Losses through P/L
Derivative Financial Instrument
IFRS 9: a derivative is an instrument that derives its value from the value of an underlying asset, price,
rate or index (equities, bonds, commodities, interest rates, exchange rates, stock market, other indices).
Examples of derivatives: futures, forward, options, interest rate and currency swaps.
Characteristics:
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Its value changes in response to changes in underlying asset
Requires little or no investment
Settle in future date
All derivatives are accounted at FV through PL and subsequently revalued through PL at each reporting
date.
Types of derivatives: Forward, Forward rate agreement, future (standardized), swaps, options
CHAPTER 4: Earning Per Share (IAS 33)
EPS is widely regarded as the most important indicator of company’s performance.
EPS= Earnings / Number of shares
Earnings = net profit attributable to ordinary shareholders of the parent entity of the parent (group
profit after tax, less profit attributable to non-controlling and irredeemable preference share dividends).
Number of shares =Weighted number of ordinary shares on a time weighted basis.
Issues at full market price: Bring additional resources. Impact on earnings from the time of issue
number of shares are time apportioned.
Bonus Issue/Scrip issues. Issues of shares to current shareholders, based upon the shareholder’s current
shareholding (no cash raised, shareholder own the same proportion of shares before and after
issuance). Bonus shares are reflected for the full period (no time apportioned). Comparative figures are
also restated to include bonus shares.
Rights issues: Combine characteristics of full-market (raise capital, time apportioned) and Bonus
issuance (priced below market). To arrive to weighted average capital, must adjust by 1) bonus element
2) time apportioned.
Diluted EPS. Increase in the number of shares in issue without a proportionate increase in resources
(exercise of options, convertible bonds/shares). IAS 33 requires an entity to disclose DEPS as well as
basic EPS with current earnings and worse possible future dilution scenario.
Interest on bonds is tax deductible but preference dividends are not.
Options or warrants. Give the holder the right to buy shares at some time in the future at a
predetermined price. Cash received by co will be less than selling those shares at market price.
Therefore the total number of shares issue on the exercise of an option or warrant is split in two: 1)
number of shares that would have been issue if cash received had been used to buy shares at market
price (using average price) 2) remainder, treated like a bonus and added to the weighted number of
shares issued when calculating DEPS.
CHAPTER 5: Leases (IFRS 16)
IFRS 16, appendix A
A lease is a contract, or part of a contract, that conveys the right to use an asset (the underlying asset)
for a period of time in exchange for consideration.
The lessor is the entity that provides the right to use the underlying asset in exchange for consideration
The lessee is the entity that obtains the right to use an underlying asset in exchange for consideration
A right to use asset represents the lessee’s right to use an underlying asset in exchange for consideration
A right-of-use asset represents the lessee’s rights to use an underlying asset for the lease team.
The lessor must classify its leases as Finance (a lease that transfers all the risks and rewards of
ownership. Title may or may not be transferred) or Operating leases (other than finance leases)
Indications of a finance lease. Substance of the agreement should be considered. One or more should
apply:
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Ownership is transferred to the lessee at the end of the lease
The lease has the option to purchase the asset for a price substantially below the fair value of
the asset and it is reasonably certain the option will be exercised.
The lease term is for the major part of the asset’s useful life.
The present value of the minimum lease payments amounts to substantially all of the fair value
of the asset.
The leased assets are of such a specialized nature that only the lessee can use them without
major modification
The lessee bears losses arising from cancelling the lease
Lessee has ability to continue the lease for a secondary period a rate below market rent.
Accounting treatment for an Operating lease
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Lease receipts are shown as income in the statement of P/L on a straight line basis over the term
of the lease, unless another systematic basis is more appropriate
Any difference between amounts charged and amounts paid will be recognized as accrued
income or deferred income in the statement of financial position (SFP)
Finance leases
At the inception of a lease, lessors present assets held under a finance lease as a receivable
Net investments of the lease: The finance lease receivable is equal to the net investment of the lease.
This is calculated as the PV of all unreceived
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Fixed rental payments
Variable rental payments
Residual guarantees (amounts the lessee guarantees that the lease asset will be worth at the
end of the lease
Unguaranteed residual values
Termination penalties
Payments are discounted at the rate implicit in the lease. Record interest income in P/L
Subsequent the carrying amount of the lease is:
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Increased by the finance income
Decrease by the cash receipts
CHAPTER 6: Revenue from contracts with customers (IFRS 15)
Revenue: Income arising in the course of an entity’s ordinary activities (IFRS, Appendix A)
Revenue does not include:
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Proceeds from sale of non-current assets
Sales tax and other similar
Other amounts collected on behalf of others. Eg agency commission
Revenue recognition: 5 step process (COPAR acronym)
1. Identify the Contract.
Contract is an agreement between two or more parties that creates rights and obligations (does
not need to be written). An entity can only account for revenue if the contract meets the following
criteria:
- The parties to the contract have approved and are committed to fulfilling the contract
- Each party’s rights can be identified
- The payment terms can be identified
- The contract has commercial substance
- It is probable that the entity will be paid
2. Identify the separate performance Obligations within the contract
Performance obligations are promises to transfer distinct goods or services to a customer. Some
contracts contain more than one performance obligation. For example: provide a course of 5
lectures as well as provide a textbook the first dat. Different performance obligations must be
identified. An entity must decide if the nature of a performance obligation is: to provide the
specified goods or services itself or to arrange for another party to provide those. If an entity is an
agent, revenue is recognized in the form of commission.
3. Determining the transaction Price
Price: Amount of consideration an entity expects in exchange for satisfying a performance
obligation. The following must be considered:
- Variable consideration: eg a bonus based on the delivery of the contract. It shall be
included in the transaction price if it is highly probably that a significant reversal in the
amount of cumulative revenue will not occur when the uncertainty is resolved (IFRS 15
p56). If a product is sold with a right of return, then it is considered to be variable and the
entity must estimate the likelihood of return and record revenue below this figure (eg
96%)
- Significant financing components: The existence of a financing element to the sale can be
indicated by:
o A difference between the amount paid and the cash selling price
o An extended time period between the transfer of the goods/services and the
payment date.
If there is a significant financing component, then the consideration receivable needs to be
discounted to present value using the rate at which the customer would borrow.
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Non-cash consideration: Customer may by using shares, options, or other assets. Any noncash consideration should be valued at fair value
- Consideration payable to a customer: Sometimes amounts are paid to customers as part of
the contract. These payments are often an incentive to encourage completion of the sale.
If consideration is paid to a customer in exchange for a distinct good or service (eg
suppliers sell to supermarkets but also pay them for shelf space) then it is essentially a
purchase transaction and should be accounted for in the same way as other purchasers
from suppliers. If the consideration paid to customer is not in exchange for a distinct good
or service, an entity should account for it as a reduction of the transaction price.
4. Allocate de transaction price. Contracts can include a number of performance obligations. E.g. sales
of products including warranty periods. Prices should be allocated to each separate performance
obligation within a contract (in proportion to stand alone selling prices). The best evidence is the
observable selling price of goods or services sold separately. If a stand-alone selling price is not
observable, then the entity estimates the stand-alone selling price. In relation to a bundle sale, any
discount should generally be allocated to a specific individual component of the transaction if that
component is regularly sold separately at a discount.
5. Recognize revenue: revenue is recognized when the entity satisfies a performance obligation by
transferrin a promised good or service to a customer (IFRS 15, para 31). For each performance
obligation identified, an entity must determine whether it satisfies the performance obligation:
a. At a point in time. Is satisfied when a customer obtains control of a promised asset.
Control of an asset refers to the ability to direct the use of, and obtain substantially all
of, the remaining benefits from the asset. Control includes the ability to prevent other
entities from obtaining benefits from an asset (i.e. an entity can restrict the assets use).
The following are indicators of control:
i. The entity has a present right to payment for the asset
ii. The customer has legal title to the asset
iii. The entity has transferred physical possession of the asset
iv. The customer has the significant risk and rewards of ownership of the asset
v. The customer has accepted the asset (IFRS, para 38)
Specific Applications:
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Consignment inventory. Inventory legally owned by one party but held by another
party, on terms which give the holder the right to sell the inventory in the normal
course of business or, at the holder’s option, to return it to the legal owner. Type of
arrangement common in the motor trade.
Inventory is legally owned by the manufacturer until 1) the dealer sells the inventory
to a third party or 2) the dealer’s right to return expires and the inventory is still not
sold.
Particular attention should be paid to the need for the customer to hold the risks
and rewards of ownership. If the risk and rewards are transferred to the customer,
the sale is recorded. Otherwise, the opposite is true. If sale is not recorded at date
of delivery, the manufacturer continues to include goods in inventory and the dealer
makes no entries on their books.
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Sale and repurchase agreements. A sale and repurchase agreement is where an
entity sells an asset but retains a right to repurchase the asset at some point in the
future. Sale and repurchase agreements are common in property developments and
in maturing inventories such as whisky or cheese. The asset has been legally sold but
there is either a commitment or an option to repurchase the asset at a later date.
The point in time at which to recognize revenue depends upon whether the control
has transferred to the customer.
Factors to consider when determining who has control of the asset:
o
o
o
o
o
o
Has the entity transferred the all of risks and benefits of the asset (and
therefore control)? Can the entity still use the asset? Does the entity bear
costs associated with the asset?
Was the asset sold at a price different to market value?
Is the entity obliged to repurchase the asset?
If the entity has the option to repurchase the asset are they likely to
exercise this option?
Is the sale is to a bank or financing company?
Is repurchase at a fix price or market value?
If asset has been sold, sale must be recorded. Otherwise it is recorded as a loan.
(see case study 4, page 154)
b. Satisfying a performance obligation over time. If one of the following criteria is met:
i. The customer simultaneously received and consumes the benefits provided by
the entity’s performance as the entity performs (i.e. the entity provides a
services, classroom courses).
ii. The entity’s performance creates or enhances an asset (for example, work in
progress) that a customer controls as the asset is created or enhanced. (i.e
construction work to create a building on land owned by customer.
iii. The entity’s performance does not create an asset with an alternative use to the
entity and the entity has an enforceable right to payment for performance
completed to date. i.e. construction of highly specialized assets.
For each performance obligation satisfied over time, an entity shall recognize the
revenue over time by measuring the progress towards complete satisfaction of that
performance obligation (IFRS, para 39). Methods for measuring performance include:
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Output methods (such as surveys of performance or time elapsed as a proportion of
total contract price/time).
Input methods (such as costs incurred to date as a proportion of total expected
costs)
This is typical in construction companies building an asset. As long as the construction
company is not able to use the asset and has a right to payment for work to date,
revenue would be recognized over time. In calculating the entries to be made for such
contracts, the following 4-step approach can be helpful:
1. Calculate overall profit or loss. If expected profitrevenue and cost should
be recognized according to progress of the contract. If expected lossthe
whole loss should be recognized immediately creating a provision as per IAS
37. If outcome is unknown (early stages)revenue should be recognized
only to the level of recoverable costs incurred.
2. Determining the progress of a contract. Two acceptable methods: 1) Input
based on costs incurred/total costs=% complete 2) Output: based on
performance completed (work certified/contract price = % of complete.
3. Statement of profit or loss (from step 1)
4. Statement of financial position. Some contracts where performance
obligations are satisfied over time will be large scale projects and can span a
number of years. Billing is difficult to keep accurate as progress continues.
As a result, the full amount of work performed may not have been billed or
amounts in excess of the work performed may have been billed to the
customer. At the year end, this discrepancy in billing will create a contract
asset or liability. IFRS is not prescriptive about this. As alternatives to the
term “contract asset”, IFRS also allow the terms receivable and work-inprogress to be used. If revenue exceeds cash received, this could be
included within trade receivables. If cost to date exceed cost of sales, this
could be included within inventory as work in progress. If cash received
exceeds the revenue recognized to date, there will be a contract
liability/provision (acting as deferred income). If contract is loss making,
there will be a provision recorded to recognize the full loss under the
onerous contract per IAS 37.
CHAPTER 7: Provisions, contingent liabilities and contingent assets (IAS 37)
Before IAS 37, provisions were a result of the intention to make an expenditure and not the obligation to
do so. With this, entities would smooth profits (reduce profits in good times, increase in bad), aggregate
several provisions as an exceptional item (“big bath”).
IAS 37 introduced a set of criteria that must be satisfied before a provision can be recognized.
A provision is a liability of uncertain timing or amount. A liability is a present obligation of the entity
arising from past events, the settlement of which is expected to result in an outflow from the entity fo
resources embodying economic benefits. (IAS 37, para 10).
Recognition criteria. Only when ALL of the following conditions are met (otherwise no):
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An entity has a present obligation (legal –contract, legislation, operation of law- or constructive
–pattern of past practice, published policy) as a result of a past event
It is probable (more likely than not) that an outflow of resources embodying economic benefits
will be required to settle the obligation, and
A reliable estimate can be made of the amount of the obligation. Estimate should be prudent
and discounted when it is material. Rare cases exist when these can’t be done.
Specific Applications
Future operating losses. The do not meet the definition of liability (are an expectation and not an
obligation. A provision cannot be made.
Onerous contracts. An onerous contract is a contract in which the unavoidable costs of meeting the
obligation under the contract exceed the economic benefits expected to be received under it. A
provision is required for the cheapest option of exiting the contract: cost of fulfilling the contract or any
compensation/penalties payable for failing to fulfill it
Restructuring. Program planned and controlled by management that materially changes the scope of
business undertaken or the way the business is conducted. A provision can be made if:
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The entity has a detailed formal plan AND
has raised a valid expectation, in those affected that it will carry out the restructuring by starting
to implement it or announcing it.
A provision can then only be made for cost that are:
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Necessarily by the restructuring and
Not associated with the ongoing activities of the entity. Cost specifically not allowed include:
retraining/relocation of existing staff, marketing and investment in new systems.
Provisions for dismantling/decommissioning costs. When a facility such as an oil well or mine is
authorized by the government, the license normally includes a legal obligation for the entity to
decommission the facility at the end of its useful life. IAS 37 requires a provision to be recognized for the
decommissioning costs. These form part of the cost of the asset and are therefore capitalized and
expensed over the life of the asset (as part of the depreciation charge). The provision is only recorded
once damage has been incurred to the land upon which the oil well or mine will be located. The
obligation to incur the decommission costs is only created at the point damage/changes to the land
occurs.
Contingent liabilities and assets
A contingent liability is a possible obligation that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly
within the control of the entity, or
A present obligation that arises from past events but is not recognized because:
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It is not probable that an outflow of resources embodying economic benefits will be required to
settle the obligation, OR
The amount of the obligation cannot be measured with sufficient reliability (IAS 37, para 10)
Accounting for a contingent liability. According to IAS 37, it is not recognized AND should be disclosed
in a note, unless the possibility of outflow is remote.
A contingent asset is defined as a possible asset that arises from past events and whose existence will
be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the entity (IAS 37, para 10).
Accounting for contingent asset is not recognized and disclosed in a note, if an inflow is considered
probable.
According to IAS 37 the following will be disclosed for contingent liabilities and assets:
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Description of contingent liability/asset
An estimate of its financial effect
An indication of uncertainties relating to amount or timing of outflow/inflow
For contingent liabilities, the possibility of any reimbursement
Degree of probability of an
outflow/inflow
Virtually certain
Probable
Possible
Remote
Liability
Recognize
Provide
Disclosed by note
No disclosure
Asset
Recognize
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CHAPTER 8: IAS 38 Intangible Assets
An intangible asset is an identifiable non-monetary asset without physical substance (IAS 38, para 8)
Intangible assets include items such as: licenses and quotas, intellectual property e.g. patents and
copyrights, grand names, trademarks
An asset is identifiable if it is both:
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separable (can be bought and sold separately) AND
arrives from contractual or other legal rights (IAS 38,p12)
Goodwill arising from the acquisition of a business cannot be sold individually and is not accounted as
intangible asset.
Recognition of intangible assets
To be recognized in the financial statement, an intangible asset must meet
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the definition of intangible asset AND
meet the recognition criteria of the framework IAS 38, para 18
INTANGIBLE ASSETS (recognition criteria)
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Internally generated. Cannot be capitalized as they cannot be identified separately from the
cost associated with running the business. Not capable of reliable measurement. Can never be
recognized: goodwill, brands, publishing titles, newspapers mastheads, customer lists,
intellectual property. This approach can greatly undervalue certain entities (creative design ind)
o Goodwill: should not be recognized, non identifiable and not capable of reliable
measurement.
o Other: record at cost if recognition criteria met
Purchased
o Separately: record at cost if recognition criteria met.
o As part of business combination. Record at FV assuming asset is identifiable and FV is
reliable. Otherwise included in goodwill
The cost comprises:
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Its price to purchase, included import duties, and non-refundable taxes on
acquisition, after deducting discounts and rebates.
any directly attributable cost of preparing the assets for its intended use
Subsequent measurement of intangible assets:
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the cost model:
o Finite useful life: the intangible asset should be carried at cost less amortization and any
impairment losses. This model is more commonly used in practice. The intangible is
amortized over the useful life, normally straight-line, with the annual expense shown on
P/L
o Indefinite useful life (no foreseeable limit to asset cash flow generation): should not be
amortized and be tested for impairment annually (and more often if there is indication).
Amortization should start from the date is available for use. The method of amortizing
should reflect the pattern in which the economic benefits are expected to be consumed. If
that is difficult, straight line is acceptable. The residual value of the intangible should be zero
unless there is a commitment from a third party to purchase the asset or the entity intends
to sell and there is market. The useful life and amortization method should be reviewed
annually and change as soon as identified the need for current and future periods.
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the revaluation model: intangible assets may be revalue to fair value. The fair value should be
determined by an active market. An active market exist if ALL the following: items traded in the
market are homogenous, willing buyers and sellers can be found at any time, prices are available
to the public. The markets are rare according to IAS 38. Certain licenses or quotas (e.g. taxi cab
licenses and farm milk quotas) may fit this model and could possibly be revalued, but most
intangibles will not.
Derecognition of intangible assets: an intangible asset is derecognized on 1) on diposal; or 2) when
no future benefit are expected from it. A again or loss on disposal is recorded in P/L, being the
difference between the proceeds on disposal and the carrying amount. They are not part of
revenue.
Research and development. R&D will extend to any industry (pharma, education, construction, etc)
and business operations (prod devel, recruitment, etc)
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Research: investigation undertaken to gain new knowledge and understanding. Its
expenditure is recognize as an expense when incurred.
Development: Application of research findings or other knowledge to produce new or
substantially improved products. Consider criteria:
o intention to use/sell
o Intend to complete
o Reliable measurement of costs
o Technically feasible to complete project
o Adequate resources to complete the project exists
o Probable future benefits
 Criteria met? Yes  capitalized | Noexpense
Only expenditure incurred AFTER recognition criteria have been met, which
should be recognized as an asset. If an item of a plant is used in the
development process, the depreciation on the plant is added to the
development costs in intangible assets during the period that it meets the
development criteria. That is because the economic benefits from the plan is
only realized when the development project is complete and production under
way. The depreciation will eventually take part of the amortization of the
development cost when the project is under way.
Development expenditure should be amortized over it useful life as soon as
commercial production begins.