ACCA Financial Reporting (FR)
ACCA-FR
FINANCIAL REPORTING
Sunway TES
STUDY GUIDE
(Student Copy)
PART 2
March 2022
ACCA Financial Reporting (FR)
TABLE OF CONTENTS
Table of Contents
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED OPERATIONS............ 5
LEARNING OUTCOME.................................................................................................................. 5
17.1 Overview .................................................................................................................................. 6
17.2 Classification of non-current assets (or disposal groups) as held for sale ............................... 7
17.3 Measurement of non-current assets (or disposal groups) classified as held as sale ............. 11
17.4 Changes of plan to sale .......................................................................................................... 19
17.5 Presentation of non-current asset or disposal group classified as held for sale ................... 19
17.6 Discontinued Operations ....................................................................................................... 22
17.7 Non-current assets that are abandoned ................................................................................ 27
17.8 Check Understanding ............................................................................................................. 28
17.9 Chapter Summary .................................................................................................................. 29
CHAPTER 18: IFRS 16 LEASES...................................................................................................................... 30
LEARNING OUTCOME................................................................................................................ 30
18.1 The Needs for Regulatory Framework ................................................................................... 31
18.2 Definition................................................................................................................................ 33
18.3 Recognition exemption .......................................................................................................... 35
18.4 Accounting by Lessees ........................................................................................................... 36
18.5 Sale and lease back transactions............................................................................................ 38
18.6 Check Understanding ............................................................................................................. 39
18.7 Chapter 18 Summary ............................................................................................................. 52
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION .......................................................... 53
LEARNING OUTCOME................................................................................................................ 53
19.1 Overall Consideration............................................................................................................. 54
19.2 Definitions .............................................................................................................................. 55
19.3 Classification of Financial Instruments between Debt (Liability) and Equity ......................... 57
19.4 Classification of Compound Instruments by the issuer ......................................................... 58
19.5 Interest, Dividends, Losses and Gains .................................................................................... 62
19.6 Check Understanding ............................................................................................................. 63
19.7 Chapter 19 Summary ............................................................................................................. 68
CHAPTER 20: IFRS 9 FINANCIAL INSTRUMENT – RECOGNITION & MEASUREMENT ................................ 69
LEARNING OUTCOME................................................................................................................ 69
20.1 Overview ................................................................................................................................ 70
20.2 Check Understanding ............................................................................................................. 74
20.3 Chapter 20 Summary ............................................................................................................. 80
CHAPTER 21: IAS 12 INCOME TAXES .......................................................................................................... 81
LEARNING OUTCOME................................................................................................................ 81
21.1
21.2
Overview ................................................................................................................................ 82
Current Tax ............................................................................................................................. 83
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TABLE OF CONTENTS
21.3 Deferred Tax (Provision for Deferred Tax a/c) ....................................................................... 85
21.4 Permanent Differences and Temporary Differences ............................................................. 86
21.5 Determine Tax Base ............................................................................................................... 88
21.6 Deferred Tax relating to Revaluations of Non-current Asset................................................. 94
21.7 Recognition Criteria ............................................................................................................... 94
21.8 Measurement ......................................................................................................................... 94
21.9 Presentation & Disclosure ...................................................................................................... 95
21.10 Check Understanding ............................................................................................................. 96
21.11 Chapter 21 Summary ........................................................................................................... 102
CHAPTER 22: IAS 2 INVENTORIES ............................................................................................................. 103
LEARNING OUTCOME.............................................................................................................. 103
22.1 Overview .............................................................................................................................. 104
22.2 Measurement ....................................................................................................................... 105
22.3 Cost Formulas....................................................................................................................... 106
22.4 Recognition as an expense ................................................................................................... 106
22.5 Disclosure ............................................................................................................................. 107
22.6 Check Understanding ........................................................................................................... 108
22.7 Chapter 22 Summary ........................................................................................................... 110
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS ................................................ 111
LEARNING OUTCOME.............................................................................................................. 111
23.1 Overview .............................................................................................................................. 112
23.2 The Five Steps Model Framework ........................................................................................ 114
23.3 Time Value of Money ........................................................................................................... 118
23.4 Revenue Recognition ........................................................................................................... 119
23.5 Measurement of progress over time ................................................................................... 123
23.6 Recognition of Contract Costs .............................................................................................. 125
23.7 Preparing financial statement extracts for construction contracts ..................................... 127
23.8 Specific Accounting Treatment ............................................................................................ 130
Check Understanding ........................................................................................................................ 143
23.9 Chapter 23 Summary ........................................................................................................... 149
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS ................................................................................... 150
LEARNING OUTCOME.............................................................................................................. 150
24.1 Objective .............................................................................................................................. 151
24.2 Usefulness of Statement of Cash Flow (SOCF) ..................................................................... 151
24.3 Definition of Cash and Cash Equivalent ............................................................................... 151
24.4 Presentation of Cash Flow ................................................................................................... 152
24.5 Recognition .......................................................................................................................... 153
24.6 Check Understanding ........................................................................................................... 155
24.7 Chapter 24 Summary ........................................................................................................... 172
CHAPTER 25: INTERPRETATION OF FINANCIAL STATEMENTS (RATIO ANALYSIS) .................................. 173
LEARNING OUTCOME.............................................................................................................. 173
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TABLE OF CONTENTS
25.1 Overview .............................................................................................................................. 175
25.2 Types of Ratio ....................................................................................................................... 176
25.3 Interpretation of consolidated financial statements ........................................................... 187
25.4 Limitations of Financial Statement ...................................................................................... 188
25.5 Limitations of Ratio Analysis ................................................................................................ 190
25.6 Check Understanding ........................................................................................................... 191
25.7 Chapter 25 Summary ........................................................................................................... 205
CHAPTER 26: IAS 21 THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES ................................... 206
LEARNING OUTCOME.............................................................................................................. 206
26.1 Overview .............................................................................................................................. 207
26.2 Determinant for Functional Currency .................................................................................. 210
26.3 Transactions in Foreign Currency......................................................................................... 211
26.4 Check Understanding ........................................................................................................... 212
26.5 Chapter 21 Summary ........................................................................................................... 218
CHAPTER 27: IAS 41 AGRICULTURE.......................................................................................................... 219
LEARNING OUTCOME.............................................................................................................. 219
27.1 Overview .............................................................................................................................. 220
27.2 Definition.............................................................................................................................. 222
27.3 Recognition .......................................................................................................................... 222
27.4 Measurement ....................................................................................................................... 223
27.5 Government grants .............................................................................................................. 224
27.6 Check Understanding ........................................................................................................... 225
27.7 Chapter 27 Summary ........................................................................................................... 226
CHAPTER 28: IFRS 13 FAIR VALUE MEASUREMENT................................................................................. 227
LEARNING OUTCOME.............................................................................................................. 227
28.1
28.2
28.3
28.4
28.5
28.6
Relational Mapping .............................................................................................................. 228
Definition.............................................................................................................................. 228
Consistency of Accounting Policies ...................................................................................... 229
Disclosure ............................................................................................................................. 236
Check Understanding ........................................................................................................... 237
Chapter 28 Summary........................................................................................................... 238
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ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
CHAPTER 17: IFRS 5 NON-CURRENT
ASSETS HELD FOR SALE AND
DISCONTINUED OPERATIONS
LEARNING OUTCOME
At the end of the chapter, you should be able to:
TLO B9a.
Discuss the importance of identifying and reporting the results of discontinued
operations
TLO B9b.
Define and account for non-current assets held for sale and discontinued operations.
TLO B9c.
Indicate the circumstances where separate disclosure of material items of income and
expense is required
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ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
17.1
Overview
Learning Outcome (ACCA Study Guide Area B)
B9a: Discuss the importance of identifying and reporting the results of discontinued operations
An item of PPE shall be removed from the statement of financial position (i.e. derecognized) when it
is disposed of or when no future economic benefits are expected from its use or disposal (i.e.
abandoned).
The gain or loss on disposal of an item of PPE is included in the profit or loss of the period in which the
de-recognition occurs.
The process of selling an item of PPE involves the following stages:
•
•
•
Making the decision to sell the item
Putting the item on the market, agreeing the selling price and negotiating the contract for sale
Completing the sale
The issue is at what stage through this process should any gain or loss on the sale be recognized.
The objective of IFRS 5 is to specify the accounting for assets held for sale, and the presentation and
disclosure of discontinued operations. The standard requires that:
(a) Assets that meet the criteria to be classified as held for sale to be measured at the lower of
carrying amount and fair value less costs to sell, and depreciation on such assets to cease; and
(b) Assets that meet the criteria to be classified as held for sale to be presented separately in the
statement of financial position and the results of discontinued operations to be presented
separately in the statement of profit or loss.
Assets classified as non-current and acquired exclusively with a view to resale in accordance with IAS
1 Presentation of Financial Statements will only be reclassified as current assets when they meet the
criteria to be classified as held for sale in accordance with IFRS 5.
The measurement provisions of this IFRS* do not apply to the following assets, which are covered by
the IFRSs listed, either as individual assets or as part of a disposal group:
(a)
(b)
(c)
(d)
Deferred tax assets (IAS 12 Income Taxes)
Assets arising from employee benefits (IAS 19 Employee Benefits)
Financial assets within the scope of IFRS 9 Financial Instruments
Non-current assets that are accounted for in accordance with the fair value model in IAS 40
Investment Property.
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ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
17.2
Classification of non-current assets (or disposal groups) as held for sale
Learning Outcome (ACCA Study Guide Area B)
B9b: Define and account for non-current assets held for sale and discontinued operations
An entity shall classify a non-current asset (or disposal group) as held for sale if its carrying
amount will be recovered principally through a sale transaction rather than through continuing
use.
17.2.1 Classification criteria
The asset (or disposal group) must be
•
•
available for immediate sale in its present condition subject only to terms that are usual and
customary for sales of such assets (or disposal groups) and
its sale must be highly probable.
For the sale to be highly probable,
•
•
•
•
the appropriate level of management must be committed to a plan to sell the asset (or disposal
group), and
an active programme to locate a buyer and complete the plan must have been initiated. Further,
the asset (or disposal group) must be actively marketed for sale at a price that is reasonable in
relation to its current fair value.
the sale should be expected to qualify for recognition as a completed sale within one year from
the date of classification and
actions required to complete the plan should indicate that it is unlikely that significant changes to
the plan will be made or that the plan will be withdrawn.
If the sale of the asset is not completed within one year, the delay is caused by events or circumstances
beyond the entity’s control and there is sufficient evidence that the entity remains committed to its
plan to sell the asset (or disposal group) then the asset must still be classified as held for sale.
If the criteria in IFRS 5 for NCA Held For sale are met after the reporting period, an entity shall not
classify a non-current asset (or disposal group) as held for sale in those financial statements when
issued but the entity shall disclose the information in the notes.
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ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
Example 17.2.1 (a)
On 1 December 20X3, a company became committed to a plan to sell a manufacturing facility and has
already found a potential buyer. The company does not intend to discontinue the operations currently
carried out in the facility. At 31 December 20X3 there is a backlog of uncompleted customer orders.
The company will not be able to transfer the facility to the buyer until after it ceases to operate the
facility and has eliminated the backlog of uncompleted customer orders. This is not expected to occur
until spring 20X4.
Can the manufacturing facility be classified as 'held for sale' at 31 December 20X3?
Solution:
The facility will not be transferred until the backlog of orders is completed; this demonstrates that the
facility is not available for immediate sale in its present condition. The facility cannot be classified as
'held for sale' at 31 December 20X3. It must be treated in the same way as other items of property,
plant and equipment: it should continue to be depreciated and should not be separately disclosed.
Example 17.2.1 (b)
An entity is committed to a plan to sell its headquarters building and has initiated actions to locate a
buyer:
(a) "The entity intends to transfer the building to a buyer after it vacates the building. The time
necessary to vacate the building is usual and customary for sales of such assets. "
Solution:
As the facility is available for immediate sale in its present condition, the building can be classified as
held for sale.
(b) The entity will continue to use the building until construction of a new headquarters building is
completed. The entity does not intend to transfer the existing building to a buyer until after
construction of the new building is completed (and it vacates the existing building).
Solution:
The delay in the timing of transfer of the existing building imposed by the entity (seller) demonstrates
that the building is not available for immediate sale. The criteria to be held for sale would not be
met until construction of the new building is completed.
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ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
Exception to the 1 yr rule:
If the sale has not actually taken place within one year, an asset (or disposal group) can still be
classified as held for sale provided that the delay must have been caused by events or circumstances
beyond the entity's control and there must be sufficient evidence that the entity is still committed to
sell the asset or disposal group. Otherwise the entity must cease to classify the asset as held for sale.
An exception to the one-year rule shall therefore apply in the following situations:
(a) at the date an entity commits itself to a plan to sell a non-current asset (or disposal group) it
reasonably expects that others (i.e.: government) will impose conditions on the transfer of the
asset (or disposal group), and:
(i) actions necessary to respond to those conditions cannot be initiated until after a firm
purchase commitment is obtained, and
(ii) a firm purchase commitment is highly probable within one year.
(b) an entity obtains a firm purchase commitment and, as a result, a buyer or others unexpectedly
impose conditions on the transfer of a non-current asset (or disposal group), and:
(i) timely actions necessary to respond to the conditions have been taken, and
(ii) a favourable resolution of the delaying factors is expected.
(c) circumstances arise that were previously considered unlikely (i.e.: changes in market condition),
and:
(i) the entity took action necessary to respond to the change in circumstances,
(ii) the criteria are met
Example 17.2.1 (c)
An entity in the power generating industry is committed to a plan to sell a disposal group that
represents a significant portion of its regulated operations. The sale requires regulatory
approval,which could extend the period required to complete the sale beyond one year. Actions
necessary to
obtain that approval cannot be initiated until after a buyer is known and a firm
purchase commitment is obtained. However, a firm purchase commitment is highly probable within
one year.
Solution:
The conditions for an exception to the one-year requirement would be met. Therefore, the entity will
be able to continue to classify the disposal group as held for sale.
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ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
Example 17.2.1 (d)
An entity is committed to a plan to sell a manufacturing facility in its present condition and classifies
the facility as held for sale at that date. After a firm purchase commitment is obtained, the buyer's
inspection of the property identifies environmental damage not previously known to exist. The entity
is required by the buyer to make good the damage, which will extend the period required to complete
the sale beyond one year. However, the entity has initiated actions to make good the damage and
satisfactory rectification of the damage is highly probable.
Solution:
The conditions for an exception to the one-year requirement would be met. Therefore, the entity will
be able to continue to classify the facility as held for sale.
Example 17.2.1 (e)
An entity is committed to a plan to sell a non-current asset and classifies the asset as held for sale at
that date:
(a) During the initial one-year period, the market conditions that existed at the date the asset was
classified initially as held for sale deteriorate and, as a result, the asset is not sold by the end of the
period. During that period, the entity actively solicited but did not receive any reasonable offers to
purchase the asset and, in response, reduced the price
Answer:
The asset continues to be actively marketed at a price that is reasonable given the change in market
conditions. In that situation, the conditions for an exception to the one-year period are met, the asset
would continue to be classified as held for sale.
(b) During the following one-year period, market conditions deteriorate further, and the asset is not
sold by the end of the period. The entity believes that the market conditions will improve and has not
further reduced the price of the asset. The asset continues to be held for sale, but at a price in excess
of its current fair value.
Answer:
The absence of a price reduction demonstrates that the asset is not available for immediate sale. In
addition, the standard requires an asset to be marketed at a price that is reasonable in relation to its
current fair value. Therefore, the conditions for an exception to the one-year requirement would NOT
be met. The asset would be classified as held and used.
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ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
17.3
Measurement of non-current assets (or disposal groups) classified as held as sale
An entity shall measure a non-current asset (or disposal group) classified as held for sale at the
lower of its carrying amount and fair value less costs to sell.
Should be measured
at lower of
FV-CTS (NRV)
Carrying amount (CA)
Immediately before initial classification as held
for sale, the CA of the assets should re-measured
in accordance with applicable IAS/ IFRS
(E.g. PPE accounted for using Revaluation model (IAS 16)
would be revalued immediately before classification)
Impairment loss should be recog to profit/ loss where the CA > FV - CTS
Note: this is an exception to rule in IAS 36 (compared with RA)

NCA held for sale should NOT be depreciated, even if they are still being used by the entity
Immediately before the initial classification of the asset (or disposal group) as held for sale, the
carrying amounts of the asset (or all the assets and liabilities in the group) shall be measured in
accordance with applicable IFRSs.
i. Recognition of impairment losses and reversals
An entity shall recognise an impairment loss for any initial or subsequent write-down of the asset (or
disposal group) to fair value less costs to sell.
An entity shall recognise a gain for any subsequent increase in fair value less costs to sell of an asset,
but not in excess of the cumulative impairment loss that has been recognised either in accordance
with this IFRS or previously in accordance with IAS 36 Impairment of Assets.
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ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
The impairment loss (or any subsequent gain) recognised for a disposal group shall reduce (or
increase) the carrying amount of the non-current assets in the group that are within the scope of the
measurement requirements of this IFRS, in the order of allocation set out below.
The allocation of disposal-group impairment losses under IFRS 5 is different from that specified by IAS
36. Disposal-group impairment losses can only be allocated between the scoped-in non-current
assets, whereas impairment losses recognised under IAS 36 may, in principle, be allocated between
all assets of a cash-generating unit. Further, the purpose of the restricted references to IAS 36 is to
make clear that, unlike IAS 36, IFRS 5 does not establish a limit below which the carrying amount
cannot be reduced. Accordingly, it is possible for a scoped-in non-current asset within a disposal group
to be written down to a lower amount than would result if IAS 36 alone were applied.
The order of allocation of impairment losses under IFRS 5 is therefore:
• First, to reduce the carrying amount of any goodwill allocated to the disposal group;
• Then, to the other non-current assets subjected to IFRS 5 measurement rules (scoped-in noncurrent assets) in the disposal group, pro-rata on the basis of the carrying amount of each of
those assets.
An entity shall not depreciate (or amortise) a non-current asset while it is classified as held for sale or
while it is part of a disposal group classified as held for sale. Interest and other expenses attributable
to the liabilities of a disposal group classified as held for sale shall continue to be recognised.
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ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
Example 17.3.1
Non-current asset held for sale: Cost Model
An item of PPE was acquired on 1 January 20X4 at a cost of $150,000. The asset has a residual value
of $30,000 and a useful life of 6 years. On 1 January 20X6 the asset was classified as held for sale. Its
fair value was estimated at $60,000 and the cost to sell at $4,000. The asset was sold on 30 September
20X6 for $63,000.
Solution:
Carrying amount at 1 January 20X6:
Fair value less cost to sell:
Extracts of statement of profit or loss will be recognised on 30 September 20X6
31 Dec X4
31 Dec X5
31 Dec X6
31 Dec X4
$
1 Jan X6
$
31 Dec X6
$
Depreciation charge
Impairment loss
Gain on disposal
Extracts of statement of financial position
NCA
PPE
CA
NCA Held for sale
Journal entry to record the classification as held for sale
As at 1 January 20X6
$
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$
ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
Example 17.3.2
Continuing from example above, except that on classification as held for sale - the fair value was
estimated at $120,000 with cost to sell at $5,000. The asset was sold for $120,000 on 30 th June 20X6.
Solution:
Carrying amount at 1 January 20X6
Fair value less cost to sell
Since the carrying amount is lower than the fair value less cost to sell, there will be no impairment loss
at the time of classification. The carrying amount will be used to classify the asset as held for sale.
Journal entry as at 1 January 20X6:
A gain on disposal of $10,000 will be reported on 30th June 20X6.
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ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
Example 17.3.3
Non-current asset held for sale: Revaluation Model
Bon Plc acquired a machine on 1 January 20X6 at a cost of $30,000, has an estimated useful life of 10
years was revalued to $36,000 on 1 January 20X7. On 1 January 20X9 the asset was classified as held
for sale. Its fair value was estimated at $29,000 and the costs to sell at $3,000. On 30th September
20X9 the asset is sold for $31,000. Bon plc’s year end is 31st December.
Solution:
31st December 20X6
The asset’s carrying amount would be as follows:
1 January 20X7
Revaluation was carried out:
Fair value less carrying amount = Gain on property revaluation (OCI)
=
1 January 20X9
The asset is reclassified to be held for sale:
Carrying amount as at 1st January 20X9 =
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ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
The asset’s carrying amount will be updated in accordance with the accounting policy chosen by Bon
plc which is to revalue the asset as per IAS 16. Therefore, immediately before classification as held for
sale, the asset’s carrying amount of $28,000 will be compared to its fair value of $29,000 giving a
gain of $1,000 recorded in other comprehensive income and accumulated in revaluation surplus
except to the extent it reverses a loss previously charged to the statement of profit or loss. But if there
is a loss on revaluation it will be charged in the statement of profit or loss (except to the extent it
reverses a gain previously recognised in other comprehensive income and held in revaluation surplus.
So the asset’s carrying amount of $29,000 will be compared with its fair value less cost to sell of
$26,000 ($29,000 - $3,000) and the difference of $3,000 which is the cost to sell will be charged as an
impairment loss. The lower amount of $26,000 will be used to classify the asset as held for sale.
Extracts of statement of profit or loss for the year ended 31 December 20X9
$
Impairment loss
Gain on disposal
Profit for the year
Other comprehensive income:
Gain on property revaluation
Total comprehensive income
The remaining balance on revaluation surplus will be transferred to retained earnings in the statement
of changes in equity.
Retained
Revaluation
Earnings
Surplus
Brought forward balance
TCI
Transfers
Carried forward balance
The asset will not be shown in the statement of financial position as it has been disposed of by the
year end.
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ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
Example 17.3.4
Melvin Ltd has a 30 June year end. On 1 October 20x3 it classified one of its freehold properties as
held for sale. At that date the property had a carrying amount of $98,500 and had been accounted for
according to the cost model. Its fair value was estimated at $120,100 and the costs of disposal at
$2,500.
On 15 June 20x4 the property was sold for $115,500.
In accordance with IFRS 5 what amounts should be recognized as gain on reclassification and gain on
disposal in profit or loss for the year ended 30 June 20x4?
Solution:
On 1 October 20x3, when the property is classified as held for sale, it is valued at the lower of carrying
amount and fair value less cost to sell. Since the property is valued using the cost model it will be
valued at the lower of carrying amount $98,500.
This treatment will only recognised gain when the asset is actually derecognised (i.e. sold). Hence the
only gain recognised is that on sale of $17,000 (115,500 – 98,500) in profit for the year ended 30 June
20x4.
Example 17.3.5
Dove Ltd has a 30 June year end. On 1 June 20x5 it classified one of its freehold properties as held for
sale. At that date the property had a carrying amount of $567,000 and had been accounted for
according to the revaluation model. Its fair value was estimated at $725,000 and the costs of disposal
at $3,000.
On 15 March 20x6 the property was sold for $726,000 and the cost of disposal at $3,500.
In accordance with IFRS 5 what amounts should be recognized in the financial statement for the year
ended 30 June 20x5 and 30 June 20x6?
Solution:
Where an asset has been held under the revaluation model and is subsequently classified as held for
sale the asset must be revalued to fair value immediately before the reclassification. Any gain will be
taken to the revaluation surplus and any loss to profit or loss (except to the extent that it reverses a
gain held in the revaluation surplus). So here, a revaluation gain is recognised of $158,000
(725,000 – 567,000) for year ended 30 June 20x5.
Once revalued in this way, the measurement is then adjusted to the normal basis for held for sale
assets, so fair value less costs to sell. The effect is that the costs to sell (here $3,000) are recognised
in profit or loss as an impairment loss charged to profit or loss for year ended 30 June 20x5.
On disposal at 15 March 20x6:
Net proceed
Carrying value
Gain on disposal recognized in profit or loss
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ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
Exercise 1
An entity plans to dispose of a group of its assets. The assets form a disposal group, and are measured
as follows:
Goodwill
PPE (carried at revalued amount)
PPE (carried at cost)
Inventory
Total
CA at Y/E before
classification as
held for sale ($)
1,500
4,600
5,700
2,400
14,200
CA as remeasured immediately
before classification as held for
sale ($)
1,500
4,000
5,700
2,200
13,400
The entity recognises the impairment loss $800 ($14200 - $13400) immediately before classifying the
disposal group as held for sale.
Solution:
After classification as held for sale (IFRS 5)
Subsequently the entity estimates that the FV - costs to sell of the disposal group amounts to $11,500.
Disposal group classified as held for sale is measured at the lower of its:
Carrying Value (CV)
= 13400
Fair Value - Cost to sell (net realizable value)
= 11500
Recognise an impairment loss of _____ when the group is initially classified as held for sale.
The allocation can be illustrated as follows:
CA as remeasured
immediately
before
classification as
held for sale
($)
Goodwill
PPE (carried at revalued amount)
PPE (carried at cost)
Inventory
Total
18
Allocation of
impairment loss
($)
CA after allocation
of impairment loss
($)
ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
17.4
Changes of plan to sale
If an entity has classified an asset (or disposal group) as held for sale, but if the criteria of held for sale
are no longer met (for example, because the sale has not taken place within one year), the entity shall
cease to classify the asset (or disposal group) as held for sale. The non-current asset that is no longer
classified as held for sale is measured at the lower of:
(a) Its carrying amount before it was classified as held for sale, adjusted for any depreciation that
would have been charged had the asset not been held for sale
(b) Its recoverable amount at the date of the decision to sell
Example - Changes of a plan to sale
1.
2.
3.
4.
5.
6.
Carrying amount at HFS date is $1,000.
If it had not been held for sale, it would have depreciated by 50.
The additional depreciation of 50 must now be charged to continuing operations.
The revised carrying amount at the date it ceased HFS classification will be 950 (1000-50).
The recoverable amount at the date it ceased HFS classification is 820
Compare 950 and 820, measure at lower of 820, therefore loss of 130 will be accounted for as
impairment loss.
17.5
Presentation of non-current asset or disposal group classified as held for sale
Learning Outcome (ACCA Study Guide Area B)
B9c: Indicate the circumstances where separate disclosure of material items of income and
expense is required
Non-current assets and disposal group classified as held for sale should be presented separately from
other assets in the SOFP. The liabilities of a disposal group should be presented separately from other
liabilities in the SOFP.
(a) Assets and liabilities held for sale should not be offset
(b) The major classes of assets and liabilities held for sale should be separately disclosed either on
the face of the SOFP or in the notes
Additional disclosures
(c) Assets and liabilities held for sale should not be offset
In the(d)
period
in which
a non-current
asset
(or disposal
group)
has been
either classified
as held
foron
The major
classes
of assets and
liabilities
held for
sale should
be separately
disclosed
either
sale or sold
the
following
should
be
disclosed.
the face of the balance sheet or in the notes
(a)
(b)
(c)
(d)
A description of the non-current assets (or disposal group)
A description of the facts and circumstances of the disposal
Any gain or loss recognised when the item was classified as held for sale
If applicable, the segment in which the non-current asset (or disposal group) is presented in
accordance with IFRS 8 Operating Segments
Where an asset previously classified as held for sale is no longer held for sale, the entity should disclose
a description of the facts and circumstances leading to the decision and its effects on results.
19
ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
Example 17.5
At the end of 20X5, an entity decides to dispose of part of its assets (and directly associated liabilities).
The disposal, which meets the criteria to be classified as held for sale, takes the form of two disposal
groups, as follows:
Carrying amount after classification as held for sale
Disposal group 1
Disposal Group 2
$
$
1,700
Property, Plant & Equipment
4,900
IIE financial asset*
1,400
(900)
Liabilities
(1,400)
Net carrying amount to disposal group
4,900
800
* An amount of $400 relating to these assets has been recognised directly in equity.
20
ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
Solution:
21
ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
17.6
Discontinued Operations
Learning Outcome (ACCA Study Guide Area B)
B9b: Define and account for non-current assets held for sale and discontinued operations
17.6.1 Definition
15.1.1
A discontinued operation is a component of an entity that either has been disposed of, or is
classified as held for sale, and
(a) represents a separate major line of business or geographical area of operations,
(b) is part of a single coordinated plan to dispose of a separate major line of business or
geographical area of operations or
(c) is a subsidiary acquired exclusively with a view to resale.
Component of an entity is a part of the overall business which can be clearly distinguished
(separate out) operationally and for financial reporting purposes.
17.6.2 Presenting discontinued operations
17.6.3
15.1.2
An
entity shall disclose:
I. a single amount in the statement of profit or loss & other comprehensive income comprising the
total of:
➢ the post-tax profit or loss of discontinued operations, and
➢ the post-tax gain or loss recognised on the measurement to fair value less costs to sell or on
the disposal of the assets or disposal group(s) constituting the discontinued operation
II. an analysis of the single amount in (a) into:
➢ the revenue, expenses and pre-tax profit or loss of discontinued operations;
➢ the related income tax expense as required by IAS 12;
➢ the gain or loss recognised on the measurement to fair value less costs to sell or on the
disposal of the assets or disposal group(s) constituting the discontinued operation; and
➢ the related income tax expense as required by IAS 12.
The analysis may be presented in the notes or in the statement of profit or loss. If it is presented
in the statement of profit of loss it shall be presented in a section identified as relating to
discontinued operations, i.e. separately from continuing operations.
III. the net cash flows attributable to the operating, investing and financing activities of discontinued
operations. These disclosures may be presented either in the notes or in the financial statements.
An entity shall re-present the disclosures for prior periods presented in the financial statements
so that the disclosures relate to all operations that have been discontinued by the end of the
reporting period for the latest period presented.
22
ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
23
ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
Example 17.6.2 (a)
Toy Plc manufactures toys and models. In the current year, it classified its soft toy division as held for
sale. The division has been loss making for some time due to severe competition. The divisions
operations represent in 20X9 5% of revenue, 15% of cost of sales, 10% of distribution costs and 20%
administrative expenses.
Ignore tax.
The following balances represent the total for the respective costs and income of Toy Plc for the year
ended 31 December 20X9.
Revenue
Cost of sales
Distribution costs
Administrative expenses
$
35,000
10,000
2,000
3,000
Solution:
Statement of profit or loss for the year ended 31 December 20X9
Continuing Operations
Revenue
Cost of Sales
Gross Profit
Distribution Costs
Administrative Expenses
Profit for the year from continuing operation
Loss for the year from discontinued operation
Profit for the year
$
Notes:
Discontinued operation
$
Sales Revenue
Cost of sales
Gross Profit
Distribution cost
Administration expenses
Loss for year on discontinued operation
24
ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
Exercise 17.6.2 (b)
Valentine Co produced cards & sold roses. However, half way through the year ended 30 September
2010, the rose business was closed and the assets sold off, incurring losses on disposal of fixed assets
of $76,000 and redundancy costs of $37,000. The directors reorganised the continuing business at a
cost of $98,000
Trading results are summarised as follows:
Revenue
COS
Administrative Expense
Distribution Cost
Interest Expense
Income Tax Expense
Cards ($'000)
650
320
120
30
Rose ($'000)
320
150
110
90
Total ($'000)
17
31
Required: Draft the SOPL for the year ended 30 September 2010.
Solution:
SOPL for the y/e 30 Sep 2010
Revenue
COS
GP
Admin exp
Dist cost
Reorganisation cost
Fin cost
PBT
Income tax exp
Profit for the year from continuing operations
Discontinued operations
Loss for the year from discontinued operations
Profit/ (loss) for the year
Notes to the FS
Analysis of Discontinued operations
Revenue
COS
GP
Admin exp
Dist cost
Loss on disposal
Redundancy costs
Loss for the year from discontinued operations
25
ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
17.6.4 Presenting discontinued operations Separate Presentation for Discontinued Operations
17.6.5
There
are few reasons for separate presentation for discontinued operations. The reasons are as
15.1.3
follows:
i. users of the FS to evaluate the financial effects of discontinued operations and disposals of
noncurrent assets or disposal groups.
This allows users to distinguish between operations which will continue in the future and those
which will not, and makes it more possible to predict future results (i.e.: only the result of
continuing operation should be used in forecasting future results, P/L from discontinued operation
will not be repeated)
improve the predictive usefulness of FS.
ii. Information on discontinued operations can help to assess mgt's strategy (i.e.: one would expect
loss-making actv to be sold/ closed down, but selling a profitable actv may indicate that a co has
liquidity/ debt problems)
26
ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
17.7
Non-current assets that are abandoned
An entity shall not classify as held for sale a non-current asset (or disposal group) that is to be
abandoned. This is because its carrying amount will be recovered principally through continuing use.
However, if the disposal group to be abandoned meets the criteria for discontinuing operation, the
results and cash flows of the disposal group will be presented as discontinued operations at the date
on which it ceases to be used. Abandoned assets include non-current assets (or disposal groups) that
are to be used to the end of their economic life and non-current assets (or disposal groups) that are to
be closed rather than sold.
An entity shall not account for a non-current asset that has been temporarily taken out of use as if it
had been abandoned.
Example 17.7.1:
On 20 October 20X3 the directors of a parent company made a public announcement of plans to close
a steel works. The closure means that the group will no longer carry out this type of operation, which
until recently has represented about 10% of its total revenue. The works will be gradually shut down
over a period of several months, with complete closure expected in July 20X4. At 31 December output
had been significantly reduced and some redundancies had already taken place. The cash flows,
revenues and expenses relating to the steel works can be clearly distinguished from those of the
subsidiary's other operations.
How should the closure be treated in the FS for the year ended 31 December 20X3?
Solution:
Because the steel works is being closed, rather than sold, it cannot be classified as 'held for sale'. In
addition, the steel works is not a discontinued operation. Although at 31 December 20X3 the group
was firmly committed to the closure, this has not yet taken place nor can its assets be classified as
held for sale, therefore the steel works must be included in continuing operations. Information about
the planned closure could be disclosed in the notes to the FS.
Example 17.7.2:
In October 2005 an entity decides to abandon all of its cotton mills, which constitute a major business.
All works stops at the cotton mills during the year ended 31 December 2006.
Solution:
Because the cotton mills are being abandoned, rather than sold, they cannot be classified as `held for
sale'.
In the FS for the y/e 31 December 2005, results and cash flows of the mills are treated as continuing
operations. However, in the FS for the y/e 31 December 2006, the results and cash flows of the cotton
mills are treated as discontinued operations with appropriate disclosures.
27
ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED
OPERATIONS
17.8
Check Understanding
Question 1 (LO A1a)
On 1 January 20X1, Michelle Co bought a chicken-processing machine for $20,000. It has an expected
useful life of 10 years and a nil residual value. On 30 September 20X3, Michelle Co decides to sell the
machine and starts actions to locate a buyer. The machines are in short supply, so Michelle Co is
confident that the machine will be sold fairly quickly.
Its market value at 30 September 20X3 $13,500 and it will cost $500 to dismantle the machine and
make it available to the purchaser. The machine has not been sold at the year-end.
At what value should the machine be stated in Michelle Co's SOFP at 31 December 20X3?
Solution:
The machine qualifies as held for sale on 30 Sep 20X3, therefore should be stated at lower of its:
fair value - cost to sell (net realizable
value)
=
carrying amount (CA)
=
recognise an impairment loss of _______to SOPL.
Extract of SOPL for the Y/E 31 Dec 20X3
Depreciation
Impairment loss
$
Extract of SOFP as at 31 Dec 20X3
Current Assets
Machine held for sale
$
28
ACCA Financial Reporting (FR)
CHAPTER 17: IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED OPERATIONS
17.9
Chapter Summary
Diagram 17.9.: Summary of IFRS 5 NCA Held for sale & Discontinued operation
29
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
CHAPTER 18: IFRS 16 LEASES
LEARNING OUTCOME
At the end of the chapter, you should be able to:
TLO B6a.
Account for right of use assets and lease liabilities in the records of the lessee
TLO B6b.
Explain the exemption from the recognition criteria for leases in the records of the
lessee
TLO B6c.
Account for sale and leaseback agreements
30
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
18.1
The Needs for Regulatory Framework
Under the previous guidance in IAS 17, Leases, a lessee had to make a distinction between a finance
lease (recognized in SOFP) and an operating lease (not recognized in SOFP).
An operating lease contract confers a valuable right to use a leased item. This right meets the
Conceptual Framework's definition of an asset, and the liability of the lessee to pay rentals meets the
Conceptual Framework's definition of a liability. However, the right and obligation are not recognised
for operating leases i.e. no recognition of assets & liabilities (Off balance sheet financing).
The absence of information about leases on the balance sheet meant that investors and analysts did
not have a complete picture of the financial position of a company, and were unable to properly
compare companies that borrow to buy assets with those that lease assets, without making
adjustments.
The need to classify a lease as an operating or finance lease has a considerable impact on the financial
statements (particularly the financial statement of the lessee), most notably on indebtedness, gearing
ratios, ROCE and interest cover.
The IASB issued IFRS 16 Leases in January 2016. IFRS 16 will replace IAS 17 Leases. The objective of
the standard is to specify the rules for recognition, measurement, presentation and disclosure of
leases, for both parties to a contract i.e. the customer (lessee) and the supplier (lessor).
IFRS 16 is effective from January 2019, but Companies can opt for earlier adaptation only if companies
also apply IFRS 15.
31
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
Diagram 18.1.2
32
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
18.2
Definition
A contract between lessor (the legal owner of the asset) & the lessee (right to use the asset). Lessor
gives the lessee the right to control the use of asset for a period of time in exchange for consideration.
The legal ownership remains with the lessor.
18.2.1 Determining whether a contract contains a lease
Foundation
15.1.4
At inception of a contract, an entity shall determine whether the contract is, or contains a lease, by
assessing:
i.
ii.
▪
▪
▪
▪
Whether the fulfilment of the contract depends on the use of an identified asset; and
Whether the customer (lessee) controls the use of the identified asset throughout the period
of use.
Identified Asset
The asset is being specified in a contract
The supplier of the asset must not have the substantive right to substitute the asset for
an alternative asset throughout its period of use and it does not take into account
protective rights or substitution due to repair or technical update
Right to use
Right to direct how and for what purpose the asset is used throughout its period of use
Obtain substantially all the economic benefits from that use
33
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
Example 18.2.1 (a) - Identified Asset
Under a contract between a local government authority (L) and a private sector provider (P),
P provides L with 20 trucks to be used for refuse collection on behalf of L for a six-year period. The
trucks, which are owned by P, are specified in the contract.
L determines how they are used in the refuse collection process. When the trucks are not in use, they
are kept at L’s premises. L can use the trucks for another purposes if it so chooses. If a particular truck
needs to be serviced or repaired, P is required to substitute a truck of the same type. Otherwise, and
other than on default by L, P cannot retrieve the trucks during the six-year period.
In context of IFRS 16:
The contract is a lease. L has the right to use the 20 trucks for six years which are identified and
explicitly specified in the contract. Once delivered to L, the trucks can be substituted only when they
need to be serviced or repaired.
Example 18.2.1 (b) - The right to direct the use of an asset
A customer (C) enters into a contract with a road haulier (H) for the transportation of goods from on
a specified truck. The truck is explicitly specified in the contract and H does not have substitution
rights.
H operates and maintains the truck and is responsible for the safe delivery of the goods. C is prohibited
from hiring another haulier to transport the goods or operating the truck itself.
In context of IFRS 16:
This contract does not contain a lease.
There is an identified asset. The truck is explicitly specified in the contract and H does not have the
right to substitute that specified truck.
C does have the right to obtain substantially all of the economic benefits from use of the truck over
the contract period. Its goods will occupy substantially all of the capacity of the truck, thereby
preventing other parties from obtaining economic benefits from use of the truck.
However, C does not have the right to control the use of the truck because C does not have the right
to direct its use. C does not have the right to direct how and for what purpose the truck is used. How
and for what purpose the truck will be used (i.e. the transportation of specified goods from London to
Edinburgh within a specified timeframe) is predetermined in the contract. C has the same rights
regarding the use of the truck as if it were one of many customers transporting goods using the truck.
34
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
IFRS 16 applies to all lease contracts except for:
• Leases to explore for or use minerals, oil, natural gas and similar non re-generative resources
•
Leases of biological assets within the scope of IAS 41, Agriculture, held by lessees
•
Licences of intellectual property granted by a lessor within the scope of IFRS 15, Revenue from
contracts with customers
•
Rights held by lessee under licensing agreements within the scope of IAS 38 Intangible assets,
for items such as motion picture films, video recordings, plays, manuscripts, patents and
copyrights. Beside these intangibles, a lessee may choose to apply IFRS 16 to leases of
intangibles asses
18.3 Recognition exemption
Learning Outcome (ACCA Study Guide Area B)
B6b: Explain the exemption from the recognition criteria for leases in the records of the lessee
Lessee may elect to account for a lease payment as an expense on a straight-line basis over the lease
term or another systematic basis for the following types of lease:
a. Leases with a lease term of 12 months or less (short term) and containing no purchase option
b. Leases where the underlying asset has a low value when new (such as personal computers or
small items of office furnishing)
35
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
18.4 Accounting by Lessees
Learning Outcome (ACCA Study Guide Area B)
B6a: Account for right of use assets and lease liabilities in the records of the lessee
18.4.1 Initial measurement
Initial
measurement
1.
Right of use (ROU) asset
Lease liability
COST:
Present value of lease payment that
are not paid at inception of lease
Initial measurement of lease liability
Lease payment at inception:
1.
2. Any payments made to the lessor at, or
before, the commencement date of the
lease, less any lease incentives received.
2.
3. Any initial direct costs incurred by the
lessee.
3.
4.
4. An estimate of any costs to be incurred by
the lessee in dismantling and removing the
underlying asset, or restoring the site on
which it is located
36
5.
Fixed payment including insubstance fixed payment less
any lease incentives.
Variable lease payments that
depends on an index of rate
Guaranteed residual value
Exercise price of a purchase
option if lessee is reasonably
certain to exercise that option
Penalties for terminating the
lease if the lease term reflects
lessee exercising an option to
terminate the lease
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
18.4.2 Subsequent measurement
Subsequent
measurement
Right of use (ROU) asset
Lease liability
Treated as a financial liability
ROU asset is subsequently depreciated
over the shorter of the EUL and the lease
term
which is measured at amortised cost
(ACM), using the rate of interest implicit
in the lease if readily determinable
otherwise, incremental borrowing rate
of lessee
If lessee has the option to extend lease,
and it is reasonable to do so, depreciated
over the extended lease term
Unless the title to the asset transfers at
the end of the lease term, then
depreciation is over its EUL
Lease payment in arrears
Lease payment in advance
37
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
18.5 Sale and lease back transactions
Learning Outcome (ACCA Study Guide Area B)
B6c: Account for sale and leaseback agreements
A sale and leaseback transaction involves the sale of an asset and leasing the same asset back.
In this situation, a seller becomes a lessee and a buyer becomes a lessor.
Accounting treatment of sale and leaseback transactions depends on the whether the transfer of an
asset is a sale under IFRS 15.
IF A TRANSFER IS A SALE
IF A TRANSFER IS NOT A SALE
The seller (lessee) accounts for the
right-of-use (ROU) asset at the
proportion of the previous carrying
amount related to the right-of-use
retained.
The seller (lessee) keeps recognizing
transferred asset and accounts for
the cash received as for a financial
liability under IFRS 9 Financial
Instruments. (e.g. secured loan)
Gain or loss is recognized only to the
extend related to the rights
transferred.
The buyer recognizes a financial asset
under IFRS 9 amounting to the cash
paid.
The buyer (lessor) accounts for a
purchase of an asset under applicable
standards and for lease under IFRS 16.
38
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
18.6 Check Understanding
Question 1
On 1 October 2009 Alpine Ltd entered into an agreement to lease a machine for 10 months with
monthly rentals of $500, payable quarterly in advance from 1 October 2009. The machine is expected
to have a nil residual value at the end of its life. The machine had a fair value of $50,000 at the
inception of the lease.
How should the lease be accounted for in the FS of Alpine for the year end 30 April 2010?
SOPL for the year ended 30 Apr 2010
SOFP as at 30 Apr 2010
Question 2
A Co entered into an agreement to lease an equipment on 1 April 2009 for a fixed period of 10 months.
As an incentive to enter into the lease, a first month rent-free period was included in the agreement
after which A Co is required to pay a monthly rental of $1,000.
How should the lease be accounted for in the year ended 30 September 2009?
SOPL for the year ended 30 Sep 2009
SOFP as at 30 Sep 2009
39
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
Question 3
On 1 Jan 20X1, Mac Co entered into 2 years lease for a lorry. The contract contains an option to extend
the lease term for another year. Mac believes that it is reasonably certain that the option will be
exercised, and all lorries has a EUL of 10 years.
Lease payments are $10,000 per year for the initial term and $15,000 per year for the option period.
All payments are due at the end of the year. To obtain the lease, Mac incurred initial direct cost of
$3,000. The lessor then reimburses $1,000 of these costs.
The rate of interest implicit in the lease is 5%.
How should the lease be accounted for in the FS of Mac for year ended 31 Dec 20X1 to 20X3?
Solution:
Year
Cash flows
($)
DF @
5%
PV of liability
($)
1
2
3
Yr
Op bal
FC @ 5%
Cash outflow
Cl balance
NCL
CL
Extract of SOPL for the year ended 31 Dec
Depreciation
Finance cost
x1
x2
x3
Extract of SOFP as at 31 Dec
NCA
Right of use (ROU) asset
x1
x2
x3
NCL
Lease liability
CL
Lease liability
40
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
Question 4
On 1 Jan 20X0, ABC Co lease a machine from DEF Co for 4 years. The initial measurement of the
machine and lease liability was $7,710 (include deposit payment). The contract required the
immediate payment of $2,000 deposit with the annual instalments of $2,000 p.a. commencing on 31
Dec 20X0. The implicit interest is 15%.
How should the lease be accounted for in the FS of ABC Co for year ended 31 Dec 20X0 to 20X3?
Solution:
Yr
X0
X1
X2
X3
Op bal
FC @ 15%
Cash outflow
Cl bal
NCL
CL
Extract of SOPL for the year ended 31.12
Depreciation
Finance cost
X0
X1
X2
X3
Extract of SOFP at 31.12
NCA
Right of use (ROU) asset
X0
X1
X2
X3
NCL
Lease liability
CL
Lease liability
41
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
Question 5
A lessee enters into 5 years lease of a building which has a remaining UL of 10 years. Lease payments
are $50,000 p.a. payable at the beginning of each year. The lessee incurs initial direct costs of $20,000
and receives lease incentives of $5,000. There is no transfer of the asset at the end of the lease and
no purchase option. The interest implicit in the lease is 5%.
How should the lease be accounted for in the FS for the year 1 to year 5?
Solution:
Year Cash flows
($)
0
1
2
3
4
Yr
1
2
3
4
5
Op bal
DF @
5%
PV of liability
($)
Cash flow Cl cap
FC @ 5%
Cl bal
NCL:cap
CL:cap
CL:int
Extract of SOPL for the year ended 31.12
Depreciation
Finance cost
X1
X2
X3
X4
X5
Extract of SOFP at 31.12
NCA
Right of use (ROU) asset
X1
X2
X3
X4
X5
NCL
Lease liability
CL
Lease liability
- Principal
- Interest
42
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
Question 6
P Ltd enters into 5 years lease on 1 Jan X3 for a machine with initial measurement of $20,000. The PV
of lease payment are $20,000. Lease payment are $5,200 p.a. payable in advance.
The interest implicit in the lease is 15.15%.
How should the lease be accounted for in the FS for the year 1 to year 5?
Lease Liability
Yr Op bal
1
2
3
4
5
Cash flow Cl cap FC @ 15.15%
Cl bal
NCL:cap
CL:cap
CL:int
Extract of SOPL for the year ended 31.12
Depreciation
Finance cost
X3
X4
X5
X6
X7
Extract of SOFP at 31.12
NCA
Right of use (ROU) asset
X3
X4
X5
X6
X7
NCL
Lease liability
CL
Lease liability
- Principal
- Interest
43
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
Question 7
Calvin Co entered into a sale and leaseback on 1 April 20X7. It sold a machine with a carrying amount
of $300,000 for $400,000 (FV equivalent) and leased it back for a period of 5 years. The transaction
constitutes a sale in accordance to IFRS 15.
The lease provided 5 annual payments in arrears of $90,000. The implicit interest rate in the lease is
5%.
What are the amounts to be recognised in the FS at 31 March 20X8 in respect of this transaction?
Solution:
Year
Cash flows ($)
DF @
5%
PV of liability ($)
1
2
3
4
5
Right of use asset recognised = previous carrying amount x Lease liability =
Fair value
Gain / (Loss) = FV – Carrying amount =
Gain/ (Loss) relating to rights retained = Total G/(L) x Lease Liability =
Fair Value
Gain/ (Loss) recognised relating to rights transferred =
Initial measurement @ 1 April 20X7
44
ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
Question 8
A Ltd sold an item of machinery and leased it back over a five-year lease. The sale took place on 1 Jan
20X4 and the company has a 31 Dec year end. The transaction does not constitute a sale in accordance
to IFRS 15. The details of the scheme are as follows:
$
1,000,000
750,000
277,409
5 years
12%
Proceeds of sale
Carrying value of asset at date of sale
Annual lease payments in arrears
Remaining useful life of the machinery
Implicit rate of interest
Prepare the extract of SOPL & SOFP for year ended 31 Dec 20X4 to 20X8.
Lease liability
Yr
1
2
3
4
5
Op bal
FC @ 12%
Cash outflow
Cl bal
NCL
CL
Extract of SOPL for the Y/E 31 Dec
Depreciation
Finance cost
X4
X5
X6
X7
X8
Extract of SOFP as at 31 Dec
NCA
PPE
X4
X5
X6
X7
X8
NCL
Lease liability
CL
Lease liability
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ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
Question 9
On 1 October 2008 Number Co entered into an agreement to lease a machine. The lease period is four
years with annual rentals of $10,000 payable in advance from 1 October 2008. Initial measurement
for the ROU asset and the lease liability are $35,000. The implicit interest rate is 10% per annum.
How should the lease be accounted for in the financial statements of Number Co for the year end
31 March 2010?
Solution:
Lease liability
Year
1/10/08-31/3/09
1/4/09-31/3/10
1/4/10-31/3/11
FC to 30/9 Bal at 1/10 CF @ 1/10 Cap at 1/10 FC to 31/3 Bal at 31/3
Extract of SOPL for the year ended 31 March
2010
$
Depreciation
Finance costs
Extract of SOFP at 31 March
NCA
Right of use (ROU) asset
2010
NCL
Lease liability
CL
Lease liability - principal
- interest
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ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
Question 10
Bowtock has leased an item of plant under the following terms:
•
Commencement of the lease was 1 January 20X2
•
Term of lease 5 years
•
Annual payments in advance $12,000
•
Present value of lease liability - $52,000 at 1 January 20X2
•
Implicit interest rate within the lease (as supplied by the lessor) 8% per annum (to be
apportioned on a time basis where relevant).
Prepare Extracts of the SOPL and SOFP for Bowtock for the year to 30 September 20X3 for the
above lease.
Year
FC to 31/12
Bal at 1/1
CF @ 1/1
Cap at 1/1
FC to 30/9
Bal at 30/9
30 Sep X2
30 Sep X3
30 Sep X4
Extract of SOPL for the year ended 30.9
X3
$
Depreciation
Finance costs
Extract of SOFP at 30.9
NCA
Right of use (ROU) asset
X3
NCL
Lease liability
CL
Lease liability
- principal
- interest
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ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
Question 11
The following list of account balances relates to Winnie at 31 March 20X1.
$'000
Sales revenue (note a)
Cost of sales
Distribution costs
Administration expenses
Lease rentals (note b)
Loan interest paid
Dividend paid
Property at cost (note c)
Plant and equipment cost
Depreciation 1 April 20X0 - plant and equipment
Development expenditure (note d)
Profit on disposal of non-current assets
Trade accounts receivable
Inventories: 31 March 20X1
Cash and bank
Trade accounts payable
Taxation: over provision in year to 31 March 20X0
Equity shares of 25c each
8% loan notes (issued in 20W8)
Retained earnings 1 April 20X0
$'000
358,450
185,050
28,700
15,000
20,000
2,000
12,000
200,000
154,800
34,800
30,000
45,000
55,000
28,240
10,660
741,450
29,400
2,200
150,000
50,000
71,600
741,450
The following notes are relevant:
(a) Included in sales revenue is $27 million, which relates to sales made to customers under sale or
return agreements. The expiry date for the return of these goods is 30 April 20X1. Winnie has
charged a mark-up of 20% on cost for these sales.
(b) A lease rental of $20 million was paid on 1 April 20X0. It is the first of five annual payments in
advance for the rental of an item of equipment that has an initial measurement of $80 million.
The implicit interest rate in the lease as 12% per annum. Leased assets should be depreciated on
a straight-line basis over the life of the lease.
(c) On 1 April 20X0 Winnie acquired a new property at a cost of $200 million. For the purpose of
calculating depreciation only, the asset has been separated into the following elements.
Separate asset Cost $'000
Land
50000
Heating system
20000
Lifts
30000
Building
100000
Life
freehold
10 years
15 years
50 years
The depreciation of the elements of the property should be calculated on a straight-line basis.
Plant and machinery is depreciated at 20% on the reducing balance basis.
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CHAPTER 18: IFRS 16 LEASES
(d) The figure for development expenditure in the list of account balances represents the amounts
deferred in previous years in respect of the development of a new product. Unfortunately, during
the current year, the government has introduced legislation which effectively bans this type of
product. As a consequence of this the project has been abandoned. It now has no effective value.
(e) A provision for income tax for the year to 31 March 20X1 of $15 million is required.
Required:
(i) Prepare Winnie's statement of profit or loss for the year to 31 March 20X1, along with the
changes in retained earnings from the statement of changes in equity.
(9 marks)
(ii) Prepare a statement of financial position as at 31 March 20X1 in accordance with International
Financial Reporting Standards as far as the information permits.
(11 marks)
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ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
Question 12
The following trial balance relates to Peter at 31 March 20X9:
Leasehold property - at valuation 31 March 20X8 (note (i))
Plant and equipment (owned) - at cost (note (i))
Right of use asset - at cost (note (i))
Accumulated depreciation at 31 March 20X8:
Owned plant and equipment
Right of use asset
Brand - at cost 1 April 20X8 (note (iii))
Accumulated amortisation - 1 April 20X8
Lease payment (paid on 31 March 20X9) (note (i))
Lease liability at 1 April 20X8 (note (i))
Inventory at 31 March 20X9
Trade receivables
Bank
Trade payables
Revenue
Cost of sales
Distribution costs
Administrative expenses
Preference dividend paid
Equity dividend paid
Equity shares of 50 cents each
6% redeemable preference shares at 31 March 20X8
Retained earnings at 31 March 20X8
Current tax (note (ii))
$'000
25,200
46,800
20,000
$'000
12,800
5,000
30,000
9,000
6,000
15,600
28,200
33,100
5,500
33,400
310,000
234,500
19,500
27,500
2,400
8,000
45,100
41,600
14,900
700
487,400
487,400
The following notes are relevant:
(a) Non-current assets:
The 15-year leasehold property was acquired on 1 April 20X7 at cost $30 million. The company
policy is to revalue the property at market value at each year end. The valuation in the trial balance
of $25.2 million as at 31 March 20X8 led to an impairment charge of $2.8 million which was
reported in profit or loss in the previous year (i.e. year ended 31 March 20X8). At 31 March 20X9
the property was valued at $24.9 million.
Owned plant is depreciated at 25% per annum using the reducing balance method.
The leased plant was acquired on 1 April 20X7. The rentals are $6 million per annum for four years
payable in arrears on 31 March each year. The interest rate implicit in the lease is 8% per annum.
Leased plant is depreciated at 25% per annum using the straight-line method.
No depreciation has yet been charged on any non-current assets for the year ended 31 March
20X9. All depreciation is charged to cost of sales.
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ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
(b) The directors have estimated the provision for income tax for the year ended 31 March 20X9
at $4.5 million. The balance of current tax in the trial balance represents the under provision
of the income tax liability for the year ended 31 March 20X8.
(c) Peter's brand in the trial balance relates to a product line that received bad publicity during
the year which led to falling sales revenues. An impairment review was conducted on 1
October 20X8 which concluded that, based on estimated future sales, the brand had a value
in use of $12 million and a remaining life of only three years. However, on the same date as
the impairment review, Peter received an offer to purchase the brand for $15 million. Prior
to the impairment review, it was being depreciated using the straight-line method over a 10year life.
No amortisation has yet been charged on any intangible assets for the year ended 31 March
20X9. All amortisation is charged to cost of sales.
Required
(i)
Prepare the statement of profit or loss for the year ended 31 March 20X9.
(ii)
Prepare the statement of financial position as at 31 March 20X9.
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ACCA Financial Reporting (FR)
CHAPTER 18: IFRS 16 LEASES
18.7 Chapter 18 Summary
Diagram 18.7.: Summary of IFRS 16 Leases
52
ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
CHAPTER 19: IAS 32 FINANCIAL
INSTRUMENTS – PRESENTATION
LEARNING OUTCOME
At the end of the chapter, you should be able to:
TLO B5a.
Explain the need for an accounting standard on financial instruments
TLO B5b.
Define financial instruments in terms of financial assets and financial liabilities
TLO B5c.
Explain and account for the factoring of receivables
TLO B5e.
Distinguish between debt and equity capital
TLO B5f.
Apply the requirements of relevant accounting standards to the issue and finance
costs of:
i)
equity
ii)
redeemable preference shares and debt instruments with no conversion
rights (principle of amortised cost)
iii)
convertible debt
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ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
19.1
Overall Consideration
Learning Outcome (ACCA Study Guide Area B)
B5a: Explain the need for an accounting standard on financial instruments
IAS 32 Financial Instruments – Presentation outlines the accounting requirements for the presentation
of financial instruments, particularly as to the classification of such instruments into the financial
assets, financial liabilities and equity instruments. The standard also provides guidance on the
classification of related interest, dividends and gains/losses, and when financial liabilities can be
offset.
19.1.1 Needs for A Standards on Financial Instruments (FI)
Over the years there has been rapid international expansion in the use of Financial Instrument (FI).
More and more instruments emerging today are no longer simple equity or debt instruments. In
recent years there has been a huge growth worldwide in the variety and complexity of FI in
international financial markets, issuing bonds with warrants and convertible securities and derivatives
instrument
Thus a need for a standard in FI and other reasons identify the concerns included as follows:
▪
▪
▪
▪
▪
there had been significant growth in the number and complexity of FI
accounting standards had not developed in line with the growth in instruments, there had
been a particular problem with derivatives (i.e. forwards, futures, swaps, etc.)
unrealised gains/losses on many financial instruments were not recognised
companies could choose when to recognised profits on instruments in order to smooth profits
There have been recent high-profile disasters involving derivatives which, while not caused
by accounting failures, have raised questions about accounting and disclosure practices.
Three accounting standards deal with FI:
▪
IAS 32 Financial instruments: Presentation
[Scope, definition of FI, FI. A, FI. L, Equity, Derivatives, Presentation in SOFP, SOPL OCI, SOCIE,
Critical event to classify as Liability/Equity, Compound FI and A-L approach etc.]
▪
IFRS 9 Financial instruments
[Financial Asset and Financial Liability recognition, measurement, de-recognise, impairment of
Financial Asset, derivatives]
▪
IFRS 7 Financial instruments: Disclosure
[Risk of FI, Qualitative disclosure, Quantitative disclosure]
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ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
19.2
Definitions
Learning Outcome (ACCA Study Guide Area B)
B5b: Define financial instruments in terms of financial assets and financial liabilities
19.2.1 Financial Instrument
Instruments
Financial instrument is any contract that gives rise to BOTH a financial asset of one entity and a
financial liability or equity instrument of another entity.
Example:
Issuer: Co A
Dr Bank 100
Cr OSC 100
Co A issues 100 OS of $1 each
Co B buys all the shares
Investor: Co B
Dr Investment in OSC 100
Cr Bank
100
19.2.2 Financial Asset
Financial asset is any asset that is:
•
•
•
Cash
Equity instruments of another entity
(e.g. investment in shares)
Contractual right
o To receive cash or another financial asset from another entity (e.g. receivable);
o To exchange financial assets or financial liabilities with another entity under
potentially favourable conditions to the entity (e.g. investment in convertible
bond/redeemable preference shares)
19.2.3 Financial Liability
Financial liability is any liability that is contractual obligation;
o
o
To deliver cash or another financial asset to another entity (e.g. payables, loan);
To exchange financial assets or financial liabilities with another entity under potentially
unfavourable conditions to the entity (e.g. issuer of convertible loan, redeemable preference
shares)
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ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
19.2.4 Equity Instrument
Equity Instrument is any contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities (e.g. A-L = NA / C+R)
Exercise:
Identify which of the following are financial assets:
1.
Inventories
2.
PPE, leased assets
3.
Intangible assets
4.
Investment in ordinary shares (equity instruments)
5.
Investment in 10% loan notes (debt instruments)
6.
Loans to other companies
7.
Trade receivables
8.
Prepayments for goods or services
Identify which of the following are financial liabilities:
1.
Liability for income taxes
2.
10% loan notes (debt instruments) issued by the company
3.
Loans from other companies
4.
Trade payables
5.
Debentures loan payable
6.
Redeemable preference shares
7.
A share option [obligation to issue its own shares]
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ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
19.3
Classification of Financial Instruments between Debt (Liability) and Equity
Learning Outcome (ACCA Study Guide Area B)
B5e: Distinguish between debt and equity capital
B5f: Apply the requirements of relevant accounting standards to the issue and finance costs of:
I.
Equity
II.
redeemable preference shares and debt instruments with no conversion rights (principle
of amortised cost)
Classification should be based on the substance and the definitions of the FI [not based on the legal
form]
SIGNIFICANCE
The determination has an immediate effect and significant impact on the entity’s reported result and
financial position. Liability classification affects gearing ratio and results in any payments treated as
interest and charged to earnings. Equity classification avoids these impacts but may be perceived
negatively be investors if it is seen as diluting their existing equity interest.
CLASSIFICATION
Determine the following:
SOFP
Liability
Equity
Critical feature
Mandatory redemption
Contractual Obligation
Choice of payment
No choice but to pay
Discretionary payment
NO Contractual
Obligation
May avoid payment
Contingent
settlement
Outcome beyond control of BOTH the issuer and
holder,
or within control of holder
Within control of
issuer
19.3.1 Redeemable Preferences Share
Redeemable Preference share may be a:
Equity Instrument
If the redemption is solely at the discretion of the issuer (e.g. the option to redeem held by the
issuer), the shares does not satisfy the definition of financial liability as the issuer does not have a
present obligation to transfer the fin assets to the holders of preference shares.
Financial Liability
- When the preference shares provide for a mandatory (compulsory) redemption by the issuer
for a fixed/ determinable amount at a fixed/ future date or gives the holder the right to
acquire the shares of the issuer at/ after a particular date.
- If preference shares are issued in such a way that they may have contractually provided for
an accelerating dividend (dividend yield is scheduled to be so high), this implied that the
issuer will be economically compelled to redeem the preference shares.
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ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
19.3.2 Irredeemable Preference Share
Share
When preference shares are not redeemable at the option of the holder, the classification depends
on other terms related to the preference shares, in particular the rights to dividends
Equity Instrument
When the distribution of dividends to holders at the discretion of the issuer, means the issuer has no
contractual obligation to deliver cash or other financial assets for the payment of dividends.
Financial Liability
When the distribution of dividends to holders are mandatory by the issuer and cumulative, means
the issuer does not have an unconditional right to avoid the obligation to pay dividends.
Equity Instrument
If the accumulated dividends can be deferred indefinitely even until the company is liquidated and
there is no other feature of the preference shares that would indicate that in substance it is a liability.
19.4
Classification of Compound Instruments by the issuer
Learning Outcome (ACCA Study Guide Area B)
B5f:
Apply the requirements of relevant accounting standards to the issue and finance costs of:
iii.
Convertible debts
The issuer of a Financial Instrument that contains both a liability and an equity component should
classify them separately and present them separately in the Financial Statements.
E.g. Convertible bonds – create primary liability and also grant on option to the holder to convert into
equity at future date.
Diagram 19.4.1
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ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
Example 19.4.1
Rathbone Co issues 2,000 convertible bonds at the start of 20X1. The bonds have a three-year term
and are issued at par with a face value of $1,000 per bond, giving total proceeds of $2,000,000. Interest
is payable annually in arrears at a nominal annual interest rate of 6%. Each $500 bond is convertible
into 250 $1 ordinary shares. Conversion or redemption at par takes place on 31 Dec 20X3. When the
bonds are issued, the prevailing market interest rate for similar debt without conversion options is
9%.
What is the value of the equity component in the bond?
Solution:
The liability component is valued first, and the difference between the proceeds of the bond issue and
the FV of liability is assigned to equity component. The PV of the liability component is calculated using
a discount rate of 9%, the market interest rate for similar bonds having no conversion rights, as shown:
Calculation of liability component
Year
1
2
3
Cash flows
Interest
Interest
Interest + capital
Equity component = Proceeds of the bond issue – liability
=
=
Double entry – initial measurement
59
DF @ 9%
0.917
0.842
0.772
PV of liability
ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
Amortisation cost table
Opening
Year
balance
1
2
3
Finance Cost
(9%)
Cash outflow
Closing
balance
--> paid / converted
Extract of SOPL for the Y/E 31 Dec
Finance costs
X1
X2
X3
Extract of SOFP as at 31 Dec
Equity attributable to equity holders
Equity option
X1
X2
X3
Non-current liabilities
Liability component of convertible bond
Current liabilities
Liability component of convertible bond
At 31 December 20X3, if:
CONVERTED
All holders elect for conversion
No of OSC issued:
REDEEMED
No holders elect for conversion
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ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
Example 19.4.2
A company issues $20m of 4% convertible loan notes at par on 1 January 2009. The loan notes are
redeemable for cash or convertible into equity shares on the basis of 20 $1 shares per $100 of debt
at the option of the loan note holder on 31 December 2011. Similar but non-convertible loan notes
carry an interest rate of 9%. The PV of $1 receivable at the end of the year based on discount rates
of 4% and 9% can be taken as:
4%
9%
$
$
End of year
1
0.96
0.92
2
0.93
0.84
3
0.89
0.77
Cumulative
2.78
2.53
Show how these loan notes should be accounted for in the FS
Calculation of liability component
Year
1
Interest
2
Interest
3
Interest + capital
Cash flows
DF @ 9%
PV of liability
Equity component = Proceeds of the bond issue – liability
SUBSEQUENT MEASUREMENT – AT YEAR END
Amortisation cost table
Year
Op bal
1
2
3
FC (9%)
Cash outflow
Cl bal
--> paid / converted
Extract of SOPL for the Y/E 31 Dec
Finance costs
2009
2010
2011
Extract of SOFP as at 31 Dec
Equity attributable to equity holders
Equity option
2009
2010
2011
Non-current liabilities
Liability component of 4$ convertible bond
Current liabilities
Liability component of 4% convertible bond
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ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
At 31 December 2011, if:
CONVERTED
All holders elect for conversion
No of OSC issued:
19.5
REDEEMED
No holders elect for conversion
Interest, Dividends, Losses and Gains
IAS 32 also considers how Financial Instruments affect the SOPL & OCI (and changes in equity). The
treatment varies according to whether interest, dividends, losses or gains relate to a financial liability
or an equity instrument:
a. Interest, dividends, losses and gains relating to a financial liability
• Recognise as income or expense in profit or loss [e.g. dividend on redeemable preference
shares - treat as an FC]
b. Distributions to holders of equity instrument (e.g. dividends to ordinary shareholders)
• Debited directly to equity by the issuer, appear in the SOCIE
c. Transaction costs of an equity transaction (e.g. issue cost of OSC)
• Deduct from equity, usually debited to the share premium account
Example 19.5.1
Co A issued 10,000 OSC of $1 at $2.50 and incurred issue cost of $4,500.
$
Proceeds of OS issue
Less: Cost of issue
Double entry:
Dr Bank
Cr OSC
Cr Other Equity
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ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
19.6
Check Understanding
Question 1
Bertrand issued $10 million convertible loan notes on 1 October 2010 that carry a nominal interest
(coupon) rate of 5% per annum. They are redeemable on 30 September 2013 at par for cash or can
be exchanged for equity shares in Bertrand on the basis of 20 shares for each $100 of loan. A similar
loan note, without the conversion option, would have required Bertrand to pay an interest rate of
8%.
When preparing the draft financial statements for the year ended 30 September 2011, the directors
are proposing to show the loan note within equity in the statement of financial position, as they
believe all the loan note holders will choose the equity option when the loan note is due for
redemption. They further intend to charge a finance cost of $500,000 ($10 million x 5%) in the SOPL
for each year up to the date of redemption. The present value of $1 receivable at the end of each year,
based on discount rates of 5% and 8%, can be taken as:
End of year
1
2
3
5%
0.95
0.91
0.86
8%
0.93
0.86
0.79
Required:
a. (i) Explain why the nominal interest rate on the convertible loan notes is 5%, but for nonconvertible loan notes it would be 8%.
(ii) Briefly comment on the impact of the directors’ proposed treatment of the loan notes on
the financial statements and the acceptability of this treatment.
b. Prepare extracts to show how the loan notes and the finance charge should be treated by
Bertrand in its financial statements for the year ended 30 September 2011.
Solution:
(a) (i) The interest rate (5%) for the convertible loan notes is lower because of the potential value of
the conversion option. The cost of equivalent loan notes without the option is 8%, the
difference is mainly due to the market expectation of the higher worth of Bertrand’s equity
shares (compared to the cash alternative) when the loan notes are due for redemption. From
the entity’s viewpoint, the conversion option means lower payments of interest (to help cash
flow), but it will eventually cause a dilution of earnings.
(ii) If the directors’ treatment were acceptable, the use of the conversion option (compared to
issuing non-convertible loans) would improve profit and earnings per share because of lower
interest rates (and hence interest charges) and the company’s gearing would be lower as the
loan notes would not be shown as debt. However, this proposed treatment is not acceptable.
A convertible loan note is a compound financial instrument and IFRS requires that the proceeds of
the issue should be allocated between equity and debt and the finance charge should be based on
that of an equivalent non-convertible loan (8% in this case).
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ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
(b) Calculation of liability component
Year
Cash flows ($’000)
1
Interest
2
Interest
3
Interest + capital
DF @ %
PV of liability ($’000)
Equity component = Proceeds of the bond issue – liability =
SUBSEQUENT MEASUREMENT – AT YEAR END
Amortisation cost table
Year
Op bal
1
FC ( %)
Cash outflow
Cl bal
Extract of SOPL for the Y/E 31 Dec 2011
Finance costs
($’000)
Extract of SOFP as at 31 Dec 2011
Equity attributable to equity holders
Equity option
($’000)
Non-current liabilities
Liability component of 5% convertible bond
Question 2
On 1 April 20X5 Peterlee issued an 8% $5 million convertible loan at par. The loan is convertible in
three years’ time to ordinary shares or redeemable at par in cash. The directors decided to issue a
convertible loan because a non-convertible loan would have required an interest rate of 10%. The
directors intend to show the loan at $5 million under non-current liabilities. The following discount
rates are available:
Year 1
Year 2
Year 3
8%
0.93
0.86
0.79
10%
0.91
0.83
0.75
Describe (and quantify) how Peterlee should treat the above in its financial statements for the
year ended 31 March 20X6 commenting on the directors' views where appropriate.
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CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
Solution:
According to IAS 32, a convertible loan is a compound financial instrument and IFRS requires that the
proceeds of the issue should be allocated between equity and debt and the finance charge should be
based on that of an equivalent non-convertible loan (10% in this case). Therefore, the directors'
intention to show the loan at $5m under NCL is not acceptable.
Calculation of liability component
Year
Cash flows ($’000)
1
Interest
2
Interest
3
Interest + capital
DF @ %
PV of liability ($’000)
Equity component = Proceeds of the bond issue – liability =
SUBSEQUENT MEASUREMENT – AT YEAR END
Amortisation cost table
Year
Op balance
FC (%)
Cash outflow
Cl balance
1
Extract of SOPL for the Y/E 31 Mar 20x6
($’000)
Finance costs
Extract of SOFP as at 31 Mar 20x6
($’000)
Equity attributable to equity holders
Equity option
Non-current liabilities
Liability component of 8% convertible bond
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ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
Question 3
On 1 January 20X0, Jedders issued $15m of 7% convertible loan notes at par. The loan notes are
convertible into equity shares in the company, at the option of the note holders, five years after the
date of issue (31 December 20X4) on the basis of 25 shares for each $100 of loan stock. Alternatively,
the loan notes will be redeemed at par.
Jedders has been advised by Fab Factors that, had the company issued similar loan notes without the
conversion rights, then it would have had to pay interest of 10%; the rate is thus lower because the
conversion rights are favourable.
Fab Factors also suggest that, as some of the loan note holders will choose to convert, the loan notes
are, in substance, equity and should be treated as such on Jedders' statement of financial position.
Thus, as well as a reduced finance cost being achieved to boost profitability, Jedders' gearing has been
improved compared to a straight issue of debt.
The present value of $1 receivable at the end of each year, based on discount rates of 7% and 10%
can be taken as:
End of year
1
2
3
4
5
7%
0.93
0.87
0.82
0.76
0.71
10%
0.91
0.83
0.75
0.68
0.62
In relation to the 7% convertible loan notes, calculate the finance cost to be shown in the SOPL &
SOFP extracts for the year to 31 December 20X0 for Jedders and comment on the advice from Fab
Factors.
66
ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
Solution:
According to IAS 32, a convertible loan notes is a compound financial instrument and IFRS requires
that the proceeds of the issue should be allocated between equity and debt and the finance charge
should be based on that of an equivalent non-convertible loan (10% in this case). Therefore, the Fab
Factors' advise to show the convertible loan notes of $15m under equity is not acceptable.
Calculation of liability component
Year
Cash flows ($’000)
DF @ %
PV of liability ($’000)
1
2
3
4
5
Equity component = Proceeds of the bond issue – liability =
SUBSEQUENT MEASUREMENT – AT YEAR END
Amortisation cost table
Year
Op balance
1
FC (%)
Cash outflow
Cl balance
Extract of SOPL for the Y/E 31 Dec 20x0
Finance costs
($’000)
Extract of SOFP as at 31 Dec 20x0
Equity attributable to equity holders
Equity option
Non-current liabilities
Liability component of 8$ convertible bond
($’000)
67
ACCA Financial Reporting (FR)
CHAPTER 19: IAS 32 FINANCIAL INSTRUMENTS – PRESENTATION
19.7
Chapter 19 Summary
Diagram 19.7.: Summary of IAS 32 Financial Instrument – Presentation
68
ACCA Financial Reporting (FR)
CHAPTER 20: IFRS 9 FINANCIAL INSTRUMENT – RECOGNITION & MEASUREMENT
CHAPTER 20: IFRS 9 FINANCIAL
INSTRUMENT – RECOGNITION &
MEASUREMENT
LEARNING OUTCOME
At the end of the chapter, you should be able to:
TLO B5d. Indicate for the following categories of financial instruments how they should be measured
and how any gains and losses from subsequent measurement should be treated in the
financial statements:
i.
ii.
iii.
amortised cost
fair value through other comprehensive income (including where an irrecoverable election
has been made for equity instruments that are not held for trading)
fair value through profit or loss
69
ACCA Financial Reporting (FR)
CHAPTER 20: IFRS 9 FINANCIAL INSTRUMENT – RECOGNITION & MEASUREMENT
20.1
Overview
Learning Outcome (ACCA Study Guide Area B)
B5d: Indicate for the following categories of financial instruments how they should be measured
and how any gains and losses from subsequent measurement should be treated in the
financial statements:
i.
ii.
iii.
amortised cost
fair value through other comprehensive income (including where an irrecoverable
election has been made for equity instruments that are not held for trading)
fair value through profit or loss
The purpose of IFRS 9 is to establish the principles by which financial assets and financial liabilities
should be recognized and measured in financial statements.
A financial instrument should initially be measured at fair value, usually including transaction costs.
The standard also provides guidance on classification of financial assets and financial liabilities that
will have an impact on the measurement of its carrying value.
To establish principles for the financial reporting [recognition, de-recognition and measurement] of
financial assets and financial liabilities that will present relevant and useful information to users of
FS for their assessment of the amounts, timing and uncertainty of an entity’s future cash flows.
20.1.1 Recognition criteria
A financial asset or financial liability should be recognised in the SOFP when:
- the reporting entity becomes a party to the contractual provisions of the instrument
(i.e.: at the commitment date)
20.1.2 De-recognition
Financial Asset
Financial liability
De-recognise when:
▪ the contractual rights to cash flows from the
financial asset expire; or
▪ it transfers substantially all the risks and
rewards and control of ownership of the
financial asset to another party.
De-recognise when:
it is EXTINGUISHED; when obligation is:
▪ discharged (paid); or
[Dr Fin L, Cr Bank]
▪ cancelled by lender; or
[Dr Fin L, Cr SOPL] - gain to borrower
▪ expires (not exercised; gain to issuer) 
[Dr Fin L, Cr SOPL]
70
ACCA Financial Reporting (FR)
CHAPTER 20: IFRS 9 FINANCIAL INSTRUMENT – RECOGNITION & MEASUREMENT
20.1.3 Initial measurement
BUY financial asset
FV of consideration paid (outflow)
Issuing (sell) FI
FV of consideration received (inflow)
Transaction cost (outflow)
Transaction cost (outflow)

Except for FI carried at FV through P/L (FVTPL), these trans costs are
EXCLUDED from FV at initial recognition  should expense off to SOPL
Example 20.2.1 [Initial measurement]
A debt security that is classified as FVTPL is purchased for $6,000, trans costs are $500.
Solutions:
The initial carrying amount $6,000 and the trans costs of $500 are expensed off.
Example 20.2.2 [Initial measurement]
A bond classified as FVTOCI is purchased for $5,600 and trans costs are $700.
Solutions:
The initial carrying amount = $6,300 (e.g. amount paid + trans costs)
71
ACCA Financial Reporting (FR)
CHAPTER 20: IFRS 9 FINANCIAL INSTRUMENT – RECOGNITION & MEASUREMENT
20.1.4 Subsequent measurement
Note: Even if an investment in debt instrument passed both tests, it is still possible to designate as
FVTPL if doing so eliminates or significantly reduces a measurement/ recg inconsistency. (i.e.: to
reduce accounting mismatch)
72
ACCA Financial Reporting (FR)
CHAPTER 20: IFRS 9 FINANCIAL INSTRUMENT – RECOGNITION & MEASUREMENT
73
ACCA Financial Reporting (FR)
CHAPTER 20: IFRS 9 FINANCIAL INSTRUMENT – RECOGNITION & MEASUREMENT
20.2 Check Understanding
Question 1
How to classify the following financial assets?
Financial assets
i. Investments held for trading purposes.
ii. Interest-bearing debt instruments that will be redeemed in 5
yrs. Brenda intends to collect the contractual cash flows which
consist solely of repayments of interest & capital.
iii. A trade receivable.
iv. Derivatives held for speculation purposes.
v. Equity shares that Brenda has no intention of selling.
Classification / Measurement
vi. A convertible bond which is due to be converted into equity
shares in 3 years’ time.
Question 2
A company invests $5,000 in 10% loan notes. The loan notes are repayable at a premium after 3 years.
The effective rate of interest is 12%. The company intends to collect the contractual cash flows which
consist solely of repayments of interest and capital and have therefore chosen to record the financial
asset at amortised cost.
What amounts will be shown in the SOPL and SOFP for the financial asset for years 1-3?
Solution:
The fin instrument appears to be a debt instrument which passed both BMT & CCT. It must be
measured at amortised cost.
Amortisation cost table
Yr
1
2
3
Op bal
FC @
Cash outflow
Cl bal
Extract of SOPL for the Y/E 31 Dec ($'000)
Investment/ finance income
1
2
3
Extract of SOFP as at 31 Dec ($'000)
NCA
Investment
1
2
3
74
ACCA Financial Reporting (FR)
CHAPTER 20: IFRS 9 FINANCIAL INSTRUMENT – RECOGNITION & MEASUREMENT
Question 3
A company invested in 20,000 shares of a listed company in October 2007 at a cost of $3.40 per share.
At 31 December 2007 the shares have a market value of $3.80. The company are not planning on
selling these shares in the short term.
Prepare extracts of SOPL and SOFP for the financial asset for the Y/E 31 Dec 2007.
Solution:
This investment in equity instrument is not held for trading purposes. It can be designated upon initial
recognition to be FVTOCI.
Extract of SOPL & OCI for the Y/E 31 Dec 2007
OCI
Gain on valuation of investment at FVTOCI
$
Extract of SOFP as at 31 Dec 2007
NCA
Investment at FVTOCI
$
Equity
FVTOCI reserves
Question 4
A company invested in 10,000 shares of a listed company in November 2007 at a cost of $4.20 per
share. At 31 December 2007 the shares have a market value of $4.90. The company are planning on
selling these shares in April 2008.
Prepare extracts of SOPL and SOFP for the financial asset for the Y/E 31 Dec 2007.
Solution:
Extract of SOPL for the Y/E 31 Dec 2007
Gain on valuation of investment at FVTPL
$
Extract of SOFP as at 31 Dec 2007
CA
Investment
$
75
ACCA Financial Reporting (FR)
CHAPTER 20: IFRS 9 FINANCIAL INSTRUMENT – RECOGNITION & MEASUREMENT
Question 5
A company invested in 20,000 shares of a listed company in October 2007 at a cost of $3.40 per share
and paid transaction cost of $1,000. At 31 December 2007 the shares have a market value of $3.80.
The company sells the shares for $4.00 per shares just after the year end.
Solution:
If measured at FVTPL:
Extract of SOPL & OCI
Trans cost
Investment/ Finance income
Gain on disposal
Initial
measurement
Subs measurement
Derecognition
Initial
measurement
Subs measurement
Derecognition
Extract of SOFP
NCA
Investment
If measured at FVTOCI:
Extract of SOPL & OCI
Gain on disposal
OCI:
Gain on valuation of invst
Extract of SOFP
NCA
Investment
-
Equity
FVTOCI reserves
-
76
ACCA Financial Reporting (FR)
CHAPTER 20: IFRS 9 FINANCIAL INSTRUMENT – RECOGNITION & MEASUREMENT
Question 6
Galaxy Co issues a bond for $503,778 on 1 January 20X2. No interest is payable on the bond, but it will
be held to maturity and redeemed on 31 December 20X4 for $600,000. The bond has not been
designated as at fair value through profit or loss. The effective interest rate is 6%.
Solution:
The bond has not been designated as at FVTPL. Therefore, it will be measured at amortised cost
Initial measurement = FV of consd recd - trans cost
Amortisation cost table
Yr
1
2
3
Op bal
FC @
Cash outflow
Extract of SOPL for the Y/E 31 Dec
Fin costs
1
2
3
Extract of SOFP as at 31 Dec
NCL: Loan notes
1
2
3
CL: Loan notes
77
Cl bal
ACCA Financial Reporting (FR)
CHAPTER 20: IFRS 9 FINANCIAL INSTRUMENT – RECOGNITION & MEASUREMENT
Question 7
A company issues 3% bonds with a nominal value of $150,000. The loan notes are issued at a discount
of 10% and issue costs of $11,455 are incurred. The loan notes will be repayable at a premium of
$10,000 after 4 years. The effective rate of interest is 10%.
What amount will be recorded as a financial liability when the loan notes are issued?
What amounts will be shown in the SOPL & SOFP for years 1-4?
Solution:
Initial measurement = FV of consd recd - trans cost
Amortisation cost table
Yr
1
2
3
4
Op bal
FC @
Cash outflow
Cl bal
Extract of SOPL for the Y/E 31 Dec
Fin costs
1
2
3
4
Extract of SOFP as at 31 Dec
NCL: Bonds
1
2
3
4
CL: Bonds
78
ACCA Financial Reporting (FR)
CHAPTER 20: IFRS 9 FINANCIAL INSTRUMENT – RECOGNITION & MEASUREMENT
Question 8
A company issues 4% loan notes with a nominal value of $20,000. The loan notes are issued at a
discount of 2.5% and $534 of issue costs are incurred. The loan notes will be repayable at a premium
of 10% after 5 years. The effective rate of interest is 7%.
What amount will be recorded as a financial liability when the loan notes are issued?
What amounts will be shown in the SOPL & SOFP for years 1-5?
Solution:
Initial measurement = FV of consd recd - trans cost
When loan notes are issued:
Dr Bank
$
Cr Loan notes
$
Amortisation cost table
Yr
Op bal
1
2
3
4
5
FC @7%
Cash outflow
Cl bal
Extract of SOPL for the Y/E 31 Dec
Fin costs
1
2
3
4
5
Extract of SOFP as at 31 Dec
NCL: 4% Loan notes
1
2
3
4
5
CL: 4% Loan notes
79
ACCA Financial Reporting (FR)
CHAPTER 20: IFRS 9 FINANCIAL INSTRUMENT – RECOGNITION & MEASUREMENT
20.3 Chapter 20 Summary
Diagram 20.3.: Summary of IFRS 9 Financial Instrument – Recognition & Measurement
80
ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
CHAPTER 21: IAS 12 INCOME TAXES
LEARNING OUTCOME
At the end of the chapter, you should be able to:
TLO B8a.
Accounting for current taxation in accordance with relevant accounting standards
TLO B8b.
Explain the effect of taxable temporary differences on accounting and taxable profits
TLO B8c.
Compute and record deferred tax amounts in the financial statements
81
ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
21.1
Overview
IAS 12 prescribes the accounting treatment for income taxes. Income taxes include all domestic and foreign
taxes that are based on taxable profits.
IAS 12 requires an entity to recognise a deferred tax liability or (subject to specified conditions) a deferred
tax asset for all temporary differences, with some exceptions. Temporary differences are differences
between the tax base of an asset or liability and its carrying amount in the statement of financial position.
The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.
21.1.1 Relationship between IAS 12 & IAS 1
SOPL & OCI
Revenue
x
PBT
Income tax expense
Profit for the year
x
100
xx
OTHER COMPREHENSIVE INCOME:
Gain on property revaluation
Deferred tax on revaluation
x
(x)
Notes to the FS
Tax provision for current year
Under/(over) provision of tax for previous year
Transfer to/(from) deferred tax
SOFP
NCL: Deferred tax
CL: Current tax payable
$
80
(20)
40
100
 Closing balance of Deferred Tax
 Closing balance of Corporate Tax
(Tax provision for current year)
82
ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
21.2
Current Tax
Learning Outcome (ACCA Study Guide Area B)
B8a: Accounting for current taxation in accordance with relevant accounting standards
B8b: Explain the effect of taxable temporary differences on accounting and taxable profits
The amount of income taxes payable (recoverable) in respect of the taxable profit (tax loss) for a period.
[i.e. Tax rate % x taxable profits]
Accounting profit ≠ Taxable profits
is profit or loss for a period
before deducting tax expense
determined in advanced with
rules established by the
accounting standards
The profit (loss) for a period, determined in accordance
with rules established by the taxation authorities, upon
which income taxes are payable (recoverable) (based on
tax rules)
Current year tax is paid in the following year (E.g. 7 months after year end)


Dr Income tax expense (SOPL) Cr Current tax payable (SOFP)
Double entries
a. When provision for current year tax is made
Dr Income tax expense (SOPL)
Cr Current tax payable (SOFP)
b. When payment of tax
Dr Current tax payable (SOFP)
Cr Cash/ Bank
c.
Under Provision = Actual tax payment > provision of last year tax
Dr Income tax expense (SOPL)
Cr Current tax payable (SOFP)
d. Over Provision = Actual tax payment < provision of last year tax
Dr Current tax payable (SOFP)
Cr Income tax expense (SOPL)
83
ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
Example 21.2.1
Calculate current year tax, tax paid, provision of tax and complete the Financial Statement of the company
Profit before tax
Taxable profit
Tax rate
Tax paid
2011
$
100,000
85,000
25%
-
2012
$
250,000
210,000
25%
20,000
2013
$
180,000
125,000
25%
55,000
Solution:
Current year tax
Under/(over) provision of tax
Current tax payable
Extract of SOPL & OCI for year ended 31 December
2011
2012
2013
2011
2012
2013
Profit before tax
Income tax expense
Profit for the year
Extract of SOFP as at 31 December
Current Liability
Current tax payable
84
ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
21.3
Deferred Tax (Provision for Deferred Tax a/c)
Learning Outcome (ACCA Study Guide Area B)
B8c: Compute and record deferred tax amounts in the financial statements
Transfer to / (from) deferred tax (compare op bal to cl bal of DT)
Increase in DT
Dr Inc tax exp (SOPL)
Cr Deferred tax (SOFP)
Decrease in DT
Dr Deferred tax (SOFP)
Cr Inc tax exp (SOPL)
Note: Movement goes to SOPL, closing balance goes to SOFP as NCL
21.3.1 Definition
Deferred tax is the income tax relating to a particular year which could become payable / recoverable
sometime in the future.
Tax rules indicates that the tax is
payable / recoverable in the future
[E.g. when the cash income is
received in future]
Accountants follow accrual concept /IAS/
IFRS
e.g. as long as income earned during the
current year, must be recognised in profit
Resulted in taxable profit is lower than accounting profit

ITE charges to SOPL will be lower = income tax % x taxable profit

resulted in profit overstated
Cannot avoid obligation to pay tax in future when income is received

Recognised liability in the current year it arises

Must create a Provision for DT
Dr ITE
Cr DTL

Increase the income tax charge to SOPL

Deferred taxation is a means of allocating tax charges fairly to particular accounting period

Failure to allow for DT liability will lead to overstatement of profit which can lead to:
•
Over-optimistic dividend payments based on inflated profits
•
Distortion of EPS & P/E ratio
•
Shareholders being misled
85
ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
21.4
Permanent Differences and Temporary Differences
Due to difference between accounting rules & tax rules

Give rise to temporary different & permanent different

Resulting in different computation of accounting profit & taxable profit
Permanent different
Temporary different (TD)
Tax rules - disallow it as an expense
Accounting rules - allow it as an expense
[E.g. fines, tax fees, entertainment]
or
Tax rules  not recognised income
Accounting rules  taxable income
[E.g. capital gain]

Permanent diff will never be resolved

IAS 12 Rule
Permanent different are IGNORED in
calculation of Deferred Tax
Accounting rules & tax rules may coincide
but will be taxable / recoverable in diff
accounting period or amount [E.g.
depreciation vs cap allowance]

Resulted in carrying value of asset/ liability
≠Tax Base of an asset / Liability
E.g. Accounting rule - allow expense in 2009
Tax rule - allow expense in 2010

TD will result in income tax becoming
payable / recoverable in the future
Must PROVIDE for Deferred tax
Taxable TD
Deductible TD


(DTL) (Cr)
DTA (Dr)
Offset according to IAS 12
**
• DTA = Deferred tax asset
• DTL = Deferred tax liability
Closing balance of Deferred Tax
86
ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
Example 21.4.1: temporary differences
Co purchase a NCA
Acc rule: HC $100, EUL 5 yrs, ERV=nil
Tax rule: Capital allowance @ 50% for 2 yrs
Taxable profit before depreciation for year 1 to 5 = $100
Accounting profit before depreciation for year 1 to 5 = $100
Accounting base (AB)
Year
NCA
Historical cost
Acc depn
NBV (AB)
1
2
3
4
5
100
(20)
80
100
(40)
60
100
(60)
40
100
(80)
20
100
(100)
0
1
2
3
100
(50)
50
100
(100)
0
100
(100)
0
Taxable profit be4 CA
Cap allowance
Taxable profit
tax rate
tax prov for the year
100
100
100
100
100
Year
Acc pft be4 depn
depn
PBT
Inc tax exp:
1
100
2
100
3
100
4
100
5
100
Tax base (TB)
NCA
Historical cost
Acc capital allowance
TB
4
derecognise
100
(100)
0
5
100
(100)
0
TTD
DTL (tax rate @ 20%)
Movement in DT
Tax prov for crn year
Inc/(Dec) in DT
Profit for the year
Conclusion:
For ASSETS
AB > TB
TTD
Create a DTL
87
Dr Inc tax exp (SOPL)
Cr DTL (SOFP)
ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
21.5
Determine Tax Base
Rule to Calculate DTA and DTL for All Assets and Liabilities:
Diagram 21.5
Taxable
temporary
difference
(TTD)
AB>TB
TB>AB
Assets
Liabilities
Deductible
temporary
difference
(DTD)
TB>AB
AB>TB
DTL:
TTD x CT%
DTA:
DTD x CT%
Cl. balance for DT
x
(x)
xx
Deferred tax is calculated using the SOFP / Liability method

by reference to the Tax Base (TB) of an Asset /Liability compared to its Carrying Amount (AB)


is the amount attributed to an Asset /Liability for tax purpose
Amount attributable to an asset/
liability under accounting rule
21.5.1 Asset
The tax base of an asset is the amount that will be deductible for tax purposes against any taxable
economic benefit that will flow to an enterprise when it recovers the carrying amount of the asset. If those
economic benefits will NOT be taxable, the tax base of the asset is equal to its carrying amount.
Example 21.5.1 (Assuming income tax rate is 20%)
(a)
A machine cost $10,000. For tax purposes, the tax depreciation of $3,000 has already been deducted
in the current and prior periods. The carrying amount is $9,000.
SOFP
AB
TB
SOPL
PPE
Depreciation
88
Accounting Taxable
Profit (AP) Profit (TP)
ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
(b)
Interest receivable has a carrying amount of $1,000. The related interest revenue will be taxed on
a cash basis.
SOFP
AB
TB
SOPL
Interest
receivable
(c)
Interest
income
AB
TB
SOPL
CA:
Receivable
AP
TP
Revenue
A loan receivable has a carrying amount of $1 m. The repayment of the loan will have no tax
consequences.
SOFP
AB
TB
SOPL
CA: Loan
Receivable
(e)
Taxable
Profit (TP)
Trade receivables have a carrying amount of $10,000. The related revenue has already been
included in taxable profit (tax loss).
SOFP
(d)
Accounting
Profit (AP)
AP
TP
Loan receivable
Dividends receivable from a subsidiary have a carrying amount of $100. The dividends are not
taxable.
SOFP
AB
TB
SOPL
CA: Dividend
receivable
Dividend income
89
AP
TP
ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
(f)
Research costs of $1,000 are recognised as an expense in the period in which they are incurred but
not permitted as a deduction in determining taxable profit (tax loss) until a later period.
SOFP
CA: Research cost
AB
TB
-
1,000
SOPL
Research expense
AP
TP
(1,000)
-
AB<TB = DTD of $1,000 x 20% = DTA of $200
(g)
Development costs of $1,000 may be capitalised and amortised over future periods in determining
accounting profit but deducted in determining taxable profit in the period in which they are
incurred.
SOFP
NCA: Development
cost
AB
1,000
TB
SOPL
Development
expense
-
AP
TP
-
1,000
AB>TB = TTD of $1,000 x 20% = DTL of $200
(h)
Inventory with a cost of $1,000 and net realisable value of $800. The write down of the inventory
is ignored for tax purposes until the goods are sold.
SOFP
AB
TB
CA: Inventory
800
1,000
SOPL
AP
TP
Inventories
written off
200
-
AB<TB = DTD of $200 x 20% = DTA of $40
(i)
A machine with a carrying amount of $10,000 and recoverable amount of $7,000. For tax purposes,
impairment loss is not deductible until the asset is sold.
SOFP
NCA: PPE
AB
TB
7,000
10,000
SOPL
Impairment loss
AB<TB = DTD of $3,000 x 20% = DTA of $600
90
AP
TP
3,000
-
ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
(j)
A non-taxable government grant of $100 related to an asset of $1,000 is deducted in arriving at the
carrying amount of the asset but, for tax purposes, is not deducted from the asset's depreciable
amount.
SOFP
AB
TB
NCA: PPE
900
1,000
Permanent differences as amortisation of government grant will never be taxable in calculation of
taxable profit. Therefore, assuming AB=TB, no deferred tax.
(a) An entity intends to use an asset which cost 1,000 throughout its useful life of five years and then
dispose of it for a residual value of nil. Depreciation of the asset is not deductible for tax purposes.
On disposal, any capital gain would not be taxable and any capital loss would not be deductible.
21.5.2 Liabilities
The tax base of a liability is its carrying amount less any amount that will be deductible for tax purposes in
respect of that liability in the future periods. In the case of revenue which is received in advance, the tax
base of the resulting liability is its carrying amount, less any amount of the revenue that will not be taxable
in the future periods.
Example 21.5.2
(a)
Current liabilities include accrued expenses with a carrying amount of $1,000. The related expense
be deducted for tax purposes on a cash basis.
SOFP
AB
TB
SOPL
CL: Accruals
Expenses
91
AP
TP
ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
(b)
Current liabilities include interest revenue received in advance, with a carrying amount of $10,000.
The related interest revenue was taxed on a cash basis.
SOFP
AB
TB
SOPL
CL: Deferred inc
(c)
Interest income
AB
TB
SOPL
CL: Accruals
AP
TP
Expenses
Current liabilities include accrued fines and penalties with a carrying amount of $100. Fines and
penalties are not deductible for tax purposes.
SOFP
AB
TB
SOPL
CL: Accruals
(e)
TP
Current liabilities include accrued expenses with a carrying amount of $2,000. The related expense
already been deducted for tax purposes.
SOFP
(d)
AP
AP
TP
Expenses
A loan payable has a carrying amount of $1 m. The repayment of the loan will have no tax
consequences.
SOFP
AB
TB
SOPL
CL: Loan pay
1m
1m
Loan repayment
AP
TP
no impact
no impact
No difference between accounting rules & tax rules as loan repayment will not affect both
accounting profit & tax profit.
Therefore, AB=TB, no deferred tax.
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ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
(f)
A provision for product warranty costs has a carrying amount of $500. For tax purposes, the
product warranty costs will not be deductible until the entity pays the warranty claims.
SOFP
AB
TB
CL: Provision
500
-
SOPL
AP
TP
Warranty cost
500
-
AB>TB = DTD of $500 x 20% = DTA of $100
(g)
A government grant of $5,000 was recognised as deferred income and to be amortised as an
income over future periods in determining accounting profits. For tax purposes, the government
grant is not taxable.
SOFP
NCL&CL: Def income
AB
TB
5000
-
Permanent differences as amortisation of govt grant will never be taxable in calculation of taxable
profit. Therefore, assuming AB=TB, no deferred tax.
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ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
21.6
Deferred Tax relating to Revaluations of Non-current Asset
Accounting Rule
Revaluation model applied (IAS 16)
Tax Rule
Revaluation Surplus (RS) is taxable on disposal in the future and since
revaluation surplus is recognised in OCI the deferred tax pertaining to the
surplus is also recognised in OCI
IAS 12 – Deferred tax pertaining to 'surplus' on revaluation
Dr OCI & RS (Surplus on revaluation x CT%)
Cr DTL
21.7
Recognition Criteria
21.7.1 Deferred Tax Liability
DTL shall be recognised for all taxable temporary differences (TTD) except for initial recognition of
goodwill arising in a business combination.
21.7.2 Deferred Tax Asset
DTA shall be recognised for:
a. Deductible temporary differences
b. Carry forward of unused tax losses
c. Carry forward of unused tax credits
To the extent that it is probable that future taxable profit will be available to utilise the deductible
temporary difference.
21.8
Measurement
DTA & DTL should be measured based on tax rate that are expected to apply when the asset / liability
will be realised / settled.
Normally, current tax rate will be used because it is too unreliable to estimate future tax rate.
DTA & DTL represent future taxes, but IAS 12 does NOT permit discounting of DT because it is highly
complex & subjective.
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ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
21.9
Presentation & Disclosure
The tax expense (income) related to profit (or loss) from ordinary activities should be presented on
the face of the statement of profit or loss and other comprehensive income.
The following are the main items that should be disclosed separately:
•
•
•
•
•
•
•
•
•
Current tax expense (income)
Any adjustments recognised in the period for current tax of prior periods
The amount of deferred tax expense (income) relating to temporary differences
The amount of deferred tax expense (income) relating to changes in tax rates or the imposition
of new taxes
Prior period deferred tax or current tax adjustments
The aggregate current and deferred tax relating to items that are charged or credited to equity
An explanation of the relationship between tax expense (income) and accounting profit which
can be done in either (or both) of the following ways :
A numerical reconciliation between tax expense and the product of accounting profit
multiplied by the applicable tax rate(s), disclosing also the basis on which the
applicable tax rate(s) is (are) computed; or
A numerical reconciliation between the average effective tax rate and the applicable
tax rate, disclosing also the basis on which the applicable tax rate is computed.
An explanation of changes in the applicable tax rate(s) compared to the previous accounting
period
The amount of deductible temporary differences, unused tax losses, and unused tax credits
for which no deferred tax asset is recognised in the statement of financial position.
21.9.1 Disclosure in statement of financial position
Tax assets and tax liabilities should be presented separately from other assets and liabilities in the
statement of financial position. Deferred tax assets and liabilities should be distinguished from current
tax assets and liabilities.
Deferred tax assets (liabilities) should not be classified as current assets (liabilities).
There is no requirement in IAS 12 to disclose the tax base of assets and liabilities on which deferred
tax has been calculated.
Offsetting
Where appropriate deferred tax assets and liabilities should be offset in the statement of financial
position.
An entity should offset deferred tax assets and deferred tax liabilities if, and only if:
•
The entity has a legally enforceable right to set off current tax assets against current tax
liabilities
•
The deferred tax assets and the deferred tax liabilities relate to income taxes levied by the same
taxation authority.
There is no requirement in IAS 12 to provide an explanation of assets and liabilities that have been
offset.
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CHAPTER 21: IAS 12 INCOME TAXES
21.10 Check Understanding
Question 1
Extract of trial balance as at 30 September 2010:
Dr ($'000)
Deferred tax
Current tax
Cr ($'000)
4,000
900
A provision for income tax for the year ended 30 September 2010 of $5·6 million is required. The
balance on current tax represents the under/over provision of the tax liability for the year ended 30
September 2009. At 30 September 2010 the balance of deferred tax is $3.75 million.
Requirement:
i.
Extract of SOPL and income tax expense computation
ii.
Extract of SOFP
Solution:
Extract of SOPL
Income tax expense (W1)
$'000
Extract of SOFP
NCL: Deferred tax
$'000
CL: Current tax payable
W1: Income tax expenses computation:
Tax provision for current year
Under/(over) provision of tax for previous year
Transfer to/(from) deferred tax
$'000
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ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
Question 2
Z Co owns a property which has a carrying value at the beginning of 20X9 of $1,500,000. At the year
end, the Co revalue its property it the market value of $1,800,000. The tax rate is 30%.
How will this be shown in the financial statements?
Solution:
Extract of SOPL & OCI
Profit for the year
$'000
Other comprehensive income:
Gains on property revaluation
Deferred tax on revaluation
Other comprehensive income for the year net of tax
Extract of SOFP
NCA : PPE
$'000
Equity : RS
NCL : DTL
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CHAPTER 21: IAS 12 INCOME TAXES
Question 3
Extract of trial balance for Highwood as at 31 March 2011:
Freehold property – at cost 1 April 2005 (land element $25 million)
Accumulated depreciation – 1 April 2010 – building
Current tax
Deferred tax
Dr ($'000) Cr ($'000)
75,000
10,000
800
2,600
On 1 April 2010 Highwood decided for the first time to value its freehold property at its current value.
A qualified property valuer reported that the market value of the freehold property on this date was
$80 million, of which $30 million related to the land. At this date the remaining estimated life of the
property was 20 years. Highwood does not make a transfer to retained earnings in respect of excess
depreciation on the revaluation of its assets.
The balance on current tax represents the under/over provision of the tax liability for the year ended
31 March 2010. The required provision for income tax for the year ended 31 March 2011 is $19·4
million. The difference between the carrying amounts of the net assets of Highwood (including the
revaluation of the property) and their (lower) tax base at 31 March 2011 is $27 million. Highwood’s
rate of income tax is 25%.
Solution:
Extract of SOPL & OCI
Depn
Income tax exp
$'000
Other comprehensive income:
Gain on revaluation of property
Deferred tax on revaluation
Other comprehensive income for the year net of tax
Extract of SOFP
NCA
Freehold prop
$'000
Equity
RS
NCL
DTL
CL
Tax payable
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CHAPTER 21: IAS 12 INCOME TAXES
Question 4
Julian recognised a deferred tax liability for the year end 31 December 20X3 which related solely to
accelerated tax depreciation on property, plant and equipment at a rate 30%. The net book value of
the property, plant and equipment at that date was $310,000 and the tax written down value was
$230,000.
The following data relates to the year ended 31 December 20X4:
(i)
At the end of the year the carrying value of property, plant and equipment was $460,000 and
their tax written down value was $270,000. During the year some items were revalued by
$90,000. No items had previously required revaluation. In the tax jurisdiction in which Julian
operates revaluations of assets do not affect the tax base of an asset or taxable profit. Gains due
to revaluations are taxable on sale.
(ii) Julian began development of a new product during the year and capitalised $60,000 in
accordance with lAS 38. The expenditure was deducted for tax purposes as it was incurred. None
of the expenditure had been amortised by the year end.
(iii) Julian's statement of profit or loss showed interest income receivable of $55,000, but only
$45,000 of this had been received by the year end. Interest income is taxed on a receipts basis.
(iv) During the year, Julian made a provision of $40,000 to cover an obligation to clean up some
damage caused by an environmental accident. None of the provision had been used by the year
end. The expenditure will be tax deductible when paid.
The corporate income tax rate recently enacted for the following year is 30% (unchanged from the
previous year). The current tax charge was calculated for the year as $45,000.
Current tax is settled on a net basis with the national tax authority.
Required:
(a) Prepare a table showing the carrying values, tax bases and temporary differences for each for the
items above at 31 December 20X4.
Solution:
AB
i.
ii.
iii.
iv.
TB
PPE
Development
Interest recv
Provision
Cl bal of DTL =
99
TTD/(DTD)
ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
(b) Prepare the extract of SOPL & OCI and SOFP relating to deferred tax for the year ended 31
December 20X4.
Solution:
Extract of SOPL &OCI
Income tax expense:
i. Tax provision for current year
ii. Under/(over) provision of tax for previous year Transfer to/(from) deferred
iii. tax
$
OCI:
Gain on revaluation of property
Deferred tax on revaluation
Extract of SOFP
Eq: RS
NCL: Deferred tax
CL: Current tax payable
Question 5
The following information related to Aswin Co as at 31 Dec 2010:
Accounting
base (CA) ($)
Assets
Motor vehicles
200,000
Plant and machinery (note i)
63,000
Land (note ii)
200,000
Trade receivables (note iii)
50,000
Interest receivables (note iv)
1,000
Liabilities
Fine (note v)
Accrued entertainment (note vi)
Interest payable (note iv)
Tax base
($)
175,000
10,000
10,000
2,000
Additional information:
i.
The plant and machinery cost $70,000 at the start of the year. It is being depreciated on a 10%
SLM for accounting purposes. The company can claim $42,000 accelerated depreciation as a
taxable expense in this year's tax computation.
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CHAPTER 21: IAS 12 INCOME TAXES
ii.
iii.
The land has been revalued during the year in accordance with IAS 16. It originally cost
$150,000.
The trade receivables balance in the accounts is made up as follows:
Balances
$55,000
Receivable allowances ($5,000)
$50,000
Receivable allowances are deductible for tax purposes only when the debtor enters insolvent
liquidation.
iv.
Interest is taxed on cash basis.
v.
Fines are not tax deductible.
vi.
Entertainment expense are only 40% tax deductible when paid
vii.
The deferred tax balances as at 1 Jan 2010 was $1,200. The tax rate is 30%
Calculate the deferred tax provision required at 31 Dec 2010 and the charge to SOCI for the period.
Solution:
Accounting
base (CA)
($)
Assets
Motor vehicles
Plant and machinery (note i)
Land (note ii)
Trade receivables (note iii)
Interest receivables (note iv)
200,000
63,000
200,000
50,000
1,000
Liabilities
Fine (note v)
Accrued entertainment (note vi)
Interest payable (note iv)
10,000
10,000
2,000
Tax base ($)
Tax rate
Cl bal of deferred tax
Op bal of deferred tax
Transfer to / (from) deferred tax
101
TTD
/(DTD)
($)
30%
ACCA Financial Reporting (FR)
CHAPTER 21: IAS 12 INCOME TAXES
21.11 Chapter 21 Summary
Diagram 21.11.: Summary of IAS 12 Income Taxes
102
ACCA Financial Reporting (FR)
CHAPTER 22: IAS 2 INVENTORIES
CHAPTER 22: IAS 2 INVENTORIES
LEARNING OUTCOME
At the end of the chapter, you should be able to:
TLO B4a.
Describe and apply the principles of inventory valuation
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ACCA Financial Reporting (FR)
CHAPTER 22: IAS 2 INVENTORIES
22.1
Overview
The objective of IAS 2 Inventories is to prescribe the accounting treatment for inventories. In
particular, it provides guidance on the determination of cost and its subsequent recognition as an
expense, including any write-down to net realisable value.
IAS 2 applies to all inventories except the following:
• Work in progress under construction contracts
•
Financial instruments (e.g. shares, bonds)
•
Biological assets
Certain inventories are exempt from the standard's measurement rules, i.e. those held by:
• Producers of agricultural, forest and mineral products
•
Commodity-broker traders
22.1.1 Definition
Inventories – assets that are:
a. held for sale in the ordinary course of business;
b. in the process of production for such sale; or
c. in the form of materials or supplies to be consumed in the production process or in the
rendering of services.
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CHAPTER 22: IAS 2 INVENTORIES
22.2
Measurement
Learning Outcome (ACCA Study Guide Area B)
B4a: Describe and apply the principles of inventory valuation
Inventories shall be measured at the lower of cost and net realisable value.
Cost of Inventories
The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs
incurred in bringing the inventories to their present location and condition.
Examples of costs excluded from the cost of inventories and recognised as expenses in the period in which
they are incurred are:
▪
▪
▪
▪
abnormal amounts of wasted materials, labour or other production costs;
storage costs, unless those costs are necessary in the production process before a further
production stage;
administrative overheads that do not contribute to bringing inventories to their present location
and condition; and
selling costs.
Net realisable value (NRV)
Is the estimated selling price less the estimated costs of completion and the estimated costs necessary
to make the sale?
Inventories are written down to NRV on the basis that assets should not be carried in excess of amounts
expected to be realised from their sale or use. Reason for inventories to be written down:
▪
goods are damaged (become worthless)
▪
goods are obsolete / out of fashion
▪
increase in costs or a fall in selling price
Inventories are usually written down to NRV on an item by item basis, unless it is more appropriate to
group similar or related items. This may be the case with items of inventory relating to the same product
line that have similar purposes or end uses, are produced and marketed in the same geographical area,
and cannot be practicably evaluated separately from other items in that product line
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CHAPTER 22: IAS 2 INVENTORIES
22.3
Cost Formulas
An entity shall use the same cost formula for all inventories having a similar nature and use to the
entity. For inventories with a different nature or use, different cost formulas may be justified.
The cost of inventories of items that are not ordinarily interchangeable and goods or services
produced and segregated for specific projects shall be assigned by using specific identification of their
individual costs.
In all other cases, the cost of inventories should be measured using:
WEIGHTED AVERAGE COST (AVCO)
the cost of each item is determined from
the weighted average of the cost of
similar items at the beginning of a period
and the cost of similar items purchased
or produced during the period. The
average may be calculated on a periodic
basis, or as each additional shipment is
received, depending upon the
circumstances of the entity.
FIRST IN, FIRST-OUT (FIFO)
assumes that the items of inventory that
were purchased or produced first are
sold first, and consequently the items
remaining in inventory at the end of the
period are those most recently purchased
or produced.
The LIFO (last in, first out) formula is not permitted by the revised IAS 2.
22.4
Recognition as an expense
i. When inventories are sold, the carrying amount of those inventories shall be recognised as an
expense in the period in which the related revenue is recognised.
ii. The amount of any write-down of inventories to net realisable value and all losses of inventories
shall be recognised as an expense in the period the write-down or loss occurs.
The amount of any reversal of any write-down of inventories, arising from an increase in net
realisable value, shall be recognised as a reduction in the amount of inventories recognised as an
expense in the period in which the reversal occurs.
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CHAPTER 22: IAS 2 INVENTORIES
22.5
Disclosure
In the notes to FS:
a. the accounting policies adopted in measuring inventories, including the cost formula used
b. the total carrying amount of inventories and the carrying amount in classifications appropriate to
the entity;
c. the carrying amount of inventories carried at fair value less costs to sell;
d. the amount of inventories recognised as an expense during the period;
e. the amount of any write-down of inventories recognised as an expense in the period
f. the amount of any reversal of any write-down that is recognised as a reduction in the amount of
inventories recognised as expense in the period;
g. the circumstances or events that led to the reversal of a write-down of inventories; and the carrying
amount of inventories pledged as security for liabilities.
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CHAPTER 22: IAS 2 INVENTORIES
22.6
Check Understanding
Question 1
A manufacturing business incurs the following expenditures:
Include in cost
of inventory
Recognised as
expenses
incurred
Supplier’s gross price for raw material
Quantity discounts allowed by supplier
Purchase taxes and duties charged by supplier &
recoverable from taxing authorities
Costs of transporting materials to the business premises
Labour costs directly incurred in the processing of R/M
Variable costs, such as power, incurred in the processing of
raw material (R/M)
Fixed production costs such as rent, in the processing
Costs of holding finished goods in inventory to trade
receivables
Costs of accounts department
Head office costs relating to the overall management of
the business
Identify in the table above the expenditures to be included in the cost of inventories and those to
be recognized as an expenses as incurred.
Question 2
A retailer identifies inventory at the end of an accounting period as follows:
Department A: Inventory with a selling price of $30,000. This department makes a 25% gross profit on
its sales.
Department B: Inventory with a selling price of $21,000. This department sets its selling prices at cost
plus 50%.
Calculate the value of inventory in each department
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CHAPTER 22: IAS 2 INVENTORIES
Solution:
Question 1
Include in cost
of inventory
Supplier’s gross price for raw material
Quantity discounts allowed by supplier
Purchase taxes and duties charged by supplier &
recoverable from taxing authorities
Costs of transporting materials to the business premises
Labour costs directly incurred in the processing of R/M
Variable costs, such as power, incurred in the processing of
raw material (R/M)
Fixed production costs such as rent, in the processing
Costs of holding finished goods in inventory to trade
receivables
Costs of accounts department
Head office costs relating to the overall management of
the business
Question 2
Dept A = 30,000 x 75% / 100% = 22,500
Dept B = 21,000 x 100%/150% = 14,000
109
Recognised as
expenses
incurred
√
√
X
X
√
√
√
√
√
√
√
ACCA Financial Reporting (FR)
CHAPTER 22: IAS 2 INVENTORIES
22.7
Chapter 22 Summary
Diagram 22.7.: Summary of IAS 2 Inventories
110
ACCA Financial Reporting (FR)
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
CHAPTER 23: IFRS 15 REVENUE FROM
CONTRACTS WITH CUSTOMERS
LEARNING OUTCOME
At the end of the chapter, you should be able to:
TLO B10a.
Explain and apply the principles of recognition of revenue:
(i)
Identification of contracts
(ii)
Identification of performance obligations
(iii)
Determination of transaction price
(iv)
Allocation of the price to performance obligations
(v)
Recognition of revenue when/as performance obligations are satisfied
TLO B10b.
Explain and apply the criteria for recognising revenue generated from contracts where
performance obligations are satisfied over time or at a point in time
TLO B10c.
Describe the acceptable methods for measuring progress towards complete
satisfaction of a performance obligation
TLO B10d.
Explain and apply the criteria for the recognition of contract costs
TLO B10e.
Apply the principles of recognition of revenue, and specifically account for the
following types of transaction
i)
principal versus agent
ii)
repurchase agreements
iii)
bill and hold agreements
iv)
consignments
TLO B10f.
Prepare financial statements extracts for contracts where performance obligations are
satisfied over time
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CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
23.1
Overview
Financial statements are prepared on the underlying assumption of the accrual basis of accounting,
whereby effects of transactions are recognised when they occur and not when the cash associated with
them is received or paid.
But this raises questions about when a transaction 'occurs':
•
•
•
Is it when the buyer takes possession of the goods, in circumstances where the contract for sale
contains clauses that seek to ensure that ownership does not pass to the customer until the seller
has been paid in full?
Is it when services are provided, in circumstances where the seller undertakes to come back to do
additional work without charge if needed, e.g. remedial work carried out by a building contractor?
When does the profit arise on a contract for the provision of services to a customer over time, such
as under a maintenance contract of two years' duration? Only at the start, only in the middle, only
at the end, or over the period of two years?
In addition, there are issues about which costs to include in the carrying amount for inventories, in the
statement of financial position:
•
•
Should the amount include only those variable costs that are incurred in the manufacture? After
all, fixed costs are incurred regardless of volume of activity and perhaps should be recognised in
profit or loss as incurred.
Or should the amounts include fixed costs? And if so, which? Should general administration costs
be included?
The timing of the recognition of revenue is critical to the timing of profits, while the amount of year end
inventories has a corresponding effect on the profits earned in the period. So, the way these are
calculated is vital to any real understanding of the financial performance in the period.
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CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
23.1.1 Objective
15.1.5
The objective of IFRS 15 is to establish the principles that an entity shall apply to report useful information
to users of financial statement (f/s) about the nature, amount, timing, and uncertainty of revenue and cash
flows arising from a contract with a customer.
Income is defined in the IASB’s Conceptual Framework as 'increases in economic benefits in the form of
inflows or enhancements of assets or decreases of liabilities that result in increases in equity.' Revenue is
simply income arising in the ordinary course of an entity's activities and it may be called different names
such as:
•
•
•
•
•
Sales
Turnover
Interest
Dividends
Royalties
Revenue is defined as income arising from an entity’s ordinary activities.
23.1.2 Scope of IFRS 15
15.1.6
•
•
•
•
•
IFRS 15 applies to all contracts with customers except:
Leases within the scope of IFRS 16
Insurance contracts within the scope of IAS 4
Financial instruments and other contractual rights and obligations within the scope of IFRS 9, IFRS 10,
IFRS 11, IAS 27 or IAS 28.
Non-monetary exchanges between entities in the same line of business
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CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
23.2
The Five Steps Model Framework
Learning Outcome (ACCA Study Guide Area B)
B10a: Explain and apply the principles of recognition of revenue:
i.
ii.
iii.
iv.
v.
Identification of contracts
Identification of performance obligations
Determination of transaction price
Allocation of the price to performance obligations
Recognition of revenue when/as performance obligations are satisfied
The core principle of IFRS 15 is that an entity will recognize revenue to depict the transfer of promised goods
or services to customers in an amount that reflects the consideration to which the entity expects to be
entitled in exchange for those goods or services.
Under IFRS 15 revenue is recognized and measured using a five steps model.
Step 1 – identify the contract(s) with the customer.
A contract is an agreement between two or more parties that creates enforceable rights and obligations.
A company would apply IFRS 15 to each contract with a customer if the following conditions are met:
•
The contract has been approved by the parties to the contract
•
Each party’s rights in relation to the goods or services to be transferred can be identified
•
The payment terms for the goods or services to be transferred can be identified
•
The contract has commercial substance, i.e. risk, timing, amount of the entity’s future cash flows is
expected to change as a result of the contract, and,
•
It is probable that the company will collect the consideration to which it will be entitled in exchange
for the promised goods or services.
Step 2 – identify the performance obligations in the contract.
Performance obligations (PO) are promises in a contract to transfer to a customer goods or services that
are distinct.
A good or service is distinct if:
• the customer can benefit from the good or service on its own or together with other resources that are
readily available to the customer.
• the entity’s promise to transfer the good or service is separately identifiable from other promises in the
contract.
For example, a customer could benefit separately from the supply of bricks and the supply of construction
labour. However, those items would not be distinct if the company is providing the bricks and construction
labour to the customer as part of its promise in the contract to construct a brick wall for the customer.
In this case, the company has a single performance obligation to construct a brick wall. The bricks and
construction labour would not be distinct goods or services because those items are used as inputs to
produce the output for which the customer has contracted.
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CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
Step 3 – determine the transaction price.
The transaction price (TP) is the amount of consideration to which a company expects to be entitled in
exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf
of third parties e.g. Sales tax or value added tax, import or export duties.
Usually, the transaction price is a fixed amount of customer consideration. Sometimes, the transaction price
includes estimates of consideration that is variable or consideration in a form other than cash.
Step 4 – allocate the transaction price.
If the contract has more than one PO, an entity would allocate the transaction price to each PO on the basis
of the relative stand-alone selling prices (SASP) of each distinct good or service.
If a SASP is not observable, the company would estimate it.
SASP is defined as the price at which an entity would sell a promised good or service separately to a
customer.
Step 5 – recognise revenue when a performance obligation is satisfied.
A company would recognise revenue when (or as) it satisfies a PO by transferring a promised good or
service to a customer (which is when the customer obtains control of that good or service.).
Performance obligation is defined as a promise in a contract with a customer to transfer to the customer
either:
• A good or service (or a bundle of goods or services) that is distinct; or
•
A series of distinct goods or services that are substantially the same and that have the same pattern
to transfer to the customer.
A PO may be satisfied at a point in time (typically for promises to transfer goods to a customer) or over time
(typically for promises to transfer services to a customer).
For a PO satisfied over time, a company would select an appropriate measure of progress to determine how
much revenue should be recognised as the PO is satisfied.
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CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
Example 23.2.1 – Five step model in revenue recognition
Johnny enters into a 12 months’ telecom plan with a local mobile operator ABC. The terms of the plan are
as follows:
• Johnny’s monthly fixed fee is $100.
•
Johnny receives a free handset at the inception of the plan.
ABC sells the same handsets for $300 and the same monthly prepayment plans without handset for
$80/month.
How should ABC recognise the revenues from this plan in line with IFRS 15?
Solution:
According to IFRS 15, ABC should:
Step 1: Identify the contract with a customer. A contract can be written, oral or implied by customary
business practices:
Step 2: identify the performance obligation (PO) from the contract which are 2 distinct performance
obligations:
Note: the obligation to deliver a handset would not be a distinct performance obligation if the handset
could not be sold separately, but it is in this case because the handsets are sold separately.
Step 3: determine the transaction price. This is the amount to which the entity expects to be ‘entitled’:
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Step 4: ABC needs to allocate the transaction price of $1,200 to the individual PO under the contract
based on their relative stand-alone selling price (SASP) or their estimates if SASP in not
observable
PO
Stand-alone Selling price (SASP)
$
Revenue (=relative selling price)
$
Handset
Network services
Total
Step 5: recognise revenue when ABC satisfied the PO, that is when ABC transfers a promised good or
service to a customer
When ABC gives the handset to Johnny, it needs to recognise the revenue of $____ (revenue recognised at
a point in time)
When ABC provides network services to Johnny, it needs to recognise the total revenue of $_____ (revenue
recognised over time). It’s practical to do it once the billing to Johnny normally on a monthly basis.
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23.3
Time Value of Money
The transaction price will be adjusted for the effects of time value of money if the contract includes a
significant financing component. The objective when adjusting the promised amount of consideration for
a significant financing component is for an entity to recognise revenue at an amount that reflects the price
that a customer would have paid if the customer had paid cash for those goods or services when they
transfer to the customer i.e. the cash selling price.
An entity is not required to assess whether the arrangement contains a significant financing component
unless the period between the customer’s payment and the entity’s transfer of the goods or services is
greater than 1 year.
Example 23.3.1
A car retailer sells its new cars by requiring 20% deposit followed by no further payments until the full
amount is due after 2 years. The price of the cars is calculated using a 10% pa finance charge. A customer
took delivery of a car costing $20,000 on 1 January 2014.
Show the extract of financial statement (f/s) on how revenue should be recognised in the 2 years ended
31 December 2014 & 2015.
Solution:
Initial measurement at 1 January 2014:
Cash received:
Cash receivables: Present value of future cash flow =
Dr
Dr
Cr
Bank
Trade receivable
Sales revenue
Subsequent measurement at year ended 31 Dec:
Extract of SOPL for the y/e 31 Dec
Revenue
Interest income
2014($)
2015($)
Extract of SOFP as at 31 Dec
Current asset
Trade receivables
2014($)
2015($)
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23.4
Revenue Recognition
Learning Outcome (ACCA Study Guide Area B)
B10b: Explain and apply the criteria for recognising revenue generated from contracts where
performance obligations are satisfied over time or at a point in time
23.4.1 Performance Obligations (PO) Satisfied Over Time
An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation
and recognises revenue over time, if one of the following criteria is met:
(a) the customer simultaneously receives and consumes the benefits provided by the entity’s performance
as the entity performs, example cleaning services;
(b) the entity’s performance creates or enhances an asset (for example, work in progress) that the customer
controls as the asset is created or enhanced or
(c) 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.
For example, when a company constructs or develops an asset so specific for the customer that it would
be very costly or impracticable to transfer to other customer (e.g. building with highly customized
specification). At the same time, customer is obliged to pay for work completed to date in the reasonable
amount.
Alternatively, ‘no alternative use’ can be achieved contractually, meaning that the contract prevents
directing the asset to another customer.
It’s crucial to assess whether the property developer has an enforceable right to payment for performance
completed to date and asset has no alternative use. If the specific contract does not meet these criteria,
then revenue is recognised at the point of time, i.e. when an asset is delivered to customer.
23.4.2 Performance Obligations Satisfied at a Point in Time
If a performance obligation is not satisfied over time, an entity satisfies the performance obligation at a
point in time. To determine the point in time at which a customer obtains control of a promised asset and
the entity satisfies a performance obligation, (revenue is satisfied when control is transferred).
An entity shall consider indicators of the transfer of control, which include, but are not limited to, the
following:
(a) The entity has a present right to payment for the asset, i.e. if a customer is presently obliged to pay for
an asset.
(b) The customer has legal title to the asset.
(c) The entity has transferred physical possession of the asset.
(d) The customer has the significant risks and rewards of ownership of the asset.
(e) The customer has accepted the asset
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Example 23.4.2 (a) – PO satisfied over time
Andy, is developing a multi-unit residential complex. A customer enters into a binding sales contract with
Andy for a specified unit that is under construction. The contract has the following terms:
•
•
•
The customer pays a non-refundable deposit upon entering the contract.
The customer has to make progress payments on completion of each stage of construction of the unit
The terms of the contract prevent Andy from being able to direct the unit to another customer.
Solution:
PO is satisfied over time due to:
•
•
The unit does not have an alternative use to Andy because the contract precludes Andy from
transferring the specified unit to another customer.
Andy has right to payment for performance completed to date, as the customer has to make progress
payments on completion of each stage of construction of the unit
Example 23.4.2 (b) – PO satisfied at a point in time
Andy, is developing a multi-unit residential complex. A customer enters into a binding sales contract with
Andy for a specified unit that is under construction. The contract has the following terms:
•
•
•
The customer pays a deposit upon entering into the contract that is refundable if Andy fails to
complete the unit.
The remaining balance of the purchase price is due only upon completion of the unit.
If the customer default on the contract before completion, Andy only has the right to retain the deposit
Solution
The PO is at a point in time due to:
•
•
The customer does not have control of the unit until it’s completion, and transfer of the property by
Andy.
Andy does not have an enforceable right to payment for performance completed to date.
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Exercise 23.4.2 (d) – PO satisfied over time & at a point in time
On 1 July 20X3, Company A signs a contract with a customer under which Company A delivers an ‘off the
shelf IT system on that date and then provides support services for the next 3 years. The contract price is
$940,000 and full payment is collected upfront. The cost of the support services is estimated at $60,000
p.a. and Company A normally makes a profit margin of 25% on such work without IT system and sells the
same IT system for $800,000 separately to customer. Company A makes up financial statement (f/s) to 31
December.
What is the amount of revenue Company A should recognise in the f/s ending 31 Dec 20X3?
Solution:
Allocate TP to individual PO under the contract based on their relative stand-alone selling price (SASP)
PO
Stand-alone Selling price (SASP)
$ ‘000
Revenue allocated
$’000
IT System
Support service
Total
Dr Bank
Cr Revenue
Cr Contract liability
(obligation to transfer G/S to a customer for which the entity has received consideration)
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Exercise 23.4.2 (e)
W plc enters into a franchise arrangement with X plc on 1 January 20X4 to use and market its patented
fried chicken products. The arrangement calls for payment of $10 million upfront to cover initial supply of
equipment plus technical support and services for 5 years.
The estimate of the cost to provide the technical support and services, based on the company’s similar
franchise arrangements in the past, is about $2 million and it is considered that 50% mark up on cost is a
reasonable profit for services without the equipment and the same equipment is normally sold for $8.5m
separately to customer.
Explain how the $10m franchise fee should be recognised as revenue in the accounts of W for the year
ended 31 Dec 20X4.
Solution:
Allocate TP to individual PO under the contract based on their relative stand-alone selling price (SASP)
PO
Stand-alone Selling price (SASP)
$ ‘m
Equipment (given)
Support service
Total
Dr
Bank
Cr
Revenue
Cr
Contract liability
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Revenue allocated
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23.5
Measurement of progress over time
Learning Outcome (ACCA Study Guide Area B)
B10c: Describe the acceptable methods for measuring progress towards complete satisfaction of a
performance obligation
For each PO satisfied over time, an entity shall recognise revenue over time by measuring the progress
towards complete satisfaction of that PO to determine the timing of revenue recognition.
Methods of measuring progress (previously known as percentage of completion/ stage of completion)
a. Output method (previously known as work certified/proportion of sales value).
Recognise revenue on the basis of direct measurements of the value to the customer of the goods or
services (G/S) transferred to date relative to the expected contract value:
Value of G/S transferred to date (previously known as value of work certified)
Total contract value
b. Input method (previously known as proportion of cost basis)
Recognise revenue on the basis of the entity’s efforts or inputs to the satisfaction of a PO (for example,
resources consumed, labour hours expended, costs incurred, or machine hours used relative to the
total expected inputs to the satisfaction of that PO:
Contract costs incurred to date
Total estimated contract costs (TCC)
Outcome CANNOT be measured reasonably
An entity may not be able to reasonably measure the outcome of a PO (i.e. in the early stages of a contract),
but the entity expects to recover the costs incurred in satisfying the PO. In these circumstances, the entity
shall recognise revenue only to the extent of the costs incurred until such time that it can reasonably
measure the outcome of the PO (no gain no loss approach.)
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Example 23.5
The following information relates to a construction contract:
$’000
800
Estimated contract revenue
Costs to date
320
Estimated further costs to complete
280
Estimated stage of completion
60%
a. What amounts of revenue, costs and profit should be recognised in the SOPL?
b. Using the same information above, but assume that the business is not able to reliably estimate the
outcome of the contract although it is believe that all costs incurred will be recoverable from the
customer. What amounts should be recognised for revenue, costs and profit in the SOPL?
Solution:
Extract of SOPL
a.
($)
b.
($)
Revenue
COS
Gross profit
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23.6
Recognition of Contract Costs
Learning Outcome (ACCA Study Guide Area B)
B10d: Explain and apply the criteria for the recognition of contract costs
If the costs incurred in fulfilling a contract with a customer are not within the scope of another Standard
(for example, IAS 2 Inventories, IAS 16 PPE or IAS 38 Intangible Assets), an entity shall recognise an asset
from the costs incurred to fulfil a contract only if those costs meet all of the following criteria:
a. the costs relate directly to a contract that the entity can specifically identify
b. the costs generate or enhance resources of the entity that will be used in satisfying (or in continuing to
satisfy) performance obligations (PO) in the future; and
c. the costs are expected to be recovered.
Costs that relate directly to a contract (or a specific anticipated contract) include any of the following:
• Direct labour (i.e. salaries & wages of employees who provide the promised services directly to the
customer)
• Direct materials (. i.e. supplies used in providing the promised services to a customer)
• Allocations of costs that relate directly to the contract (i.e. costs of contract management and
supervision, insurance and depreciation of tools & equipment used in fulfilling the contract)
• Costs that are explicitly chargeable to the customer under the contract and
• Other costs that are incurred only because an entity entered into the contract (i.e. payments to
subcontractors)
• Incremental costs of obtaining a contract (i.e. sales commission) that would not have been incurred if
the contract had not been obtained.
An entity shall recognise the following costs as expenses when incurred:
General & administrative costs (unless those costs are explicitly chargeable to the customer under the
contract.
Costs of wasted materials, labour or other resources to fulfil the contract (i.e. abnormal loss) that were not
reflected in the price of the contract.
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Example 23.6.1
Centrepoint have a fixed price contract to build a tower block. The initial amount of revenue agreed is
$220m. At the beginning of the contract on 1 January 20X6 the initial estimate of the contract costs is
$200m. At the end of 20X6 the estimate of the total costs has risen to $202m.
During 20X7 the customer agrees to a variation which increases expected revenue from the contract by
$5m and causes additional costs of $3m. At the end of 20X7 there are material stored on site for use during
the following period which cost $2.5m.
Centrepoint have decided to measure the progress of completion of the contract by calculating the
proportion that contract costs incurred for work to date bear to the latest estimated total contract costs
(input method). The contract costs incurred at the end of each year were 20X6: $52.52, 20X7: $154.2m
(including materials in store), 20X8: $205m. The performance obligations (PO) under the contract will be
satisfied over time.
Calculate and determine the amount of revenue, costs and profits that will be recognised in each year.
Solution:
20X6
$m
20X7
$m
20X8
$m
Total contract revenue
Total estimated contract costs
Contract costs incurred to date
Progress of completion (input method)
= Contract costs incurred to date
Total estimated contract costs
Revenue, expenses and profit that will be recognised in P/L as follows:
20X6
Revenue
COS
GP
20X7
Revenue
COS
GP
20X8
Revenue
COS
GP
Cumulative to date
Recognised in prior years
$m
$m
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Recognised in current year
P/L
$m
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23.7
Preparing financial statement extracts for construction contracts
Learning Outcome (ACCA Study Guide Area B)
B10f: Prepare financial statements extracts for contracts where performance obligations are satisfied
over time
Steps in preparing financial statement (F/S) extracts for construction contracts
Step 1:
Compare the contract value and the total costs expected to be incurred on the contract. If a loss is foreseen,
then it must be recognised immediately in full.
Step 2:
Calculate the progress/stage of completion.
Step 3:
‘Build’ up the SOPL:
Cumulative to date
Revenue
COS
GP
(-)
Recognised in prior years =
$
$
POC% x contract value = X
Cost incurred to date = (X)
XX
X
(X)
XX
Recognised in current year
P/L
$
X
(X)
Step 4:
Calculate contract asset/contract liability (unbilled revenue):
Revenue recognised to date
X
- progress billlings / amount invoiced
(X)
Contract asset / (liability)
XX Show under current asset/liability
Step 5:
Receivables (unpaid billed revenue) = progress billings – cash received
Extract of SOPL
Revenue (S3)
COS (S3)
Gross profit (S3)
Extract of SOFP
Current asset
Contract asset (S4)
Receivables (S5)
$
x
(x)
xx
Revenue earned but not yet invoiced
Revenue has been invoiced but not yet received
Current liability
Contract liability (S4)
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Example 23.7.1 (Output/Work certified method)
ABC is a construction company that prepares its f/s to 31 Dec each year. During the year ended 31 Dec
20X8, the company commenced a contract that is expected to take more than one year to complete. The
PO under the contract will be satisfied over time. The contract summary at 31 Dec 20X8 is as follows:
Right to payment for performance completed to date/progress payments
Contract price
Value of construction satisfied to date/work certified complete
Contract costs incurred to date
Estimated total cost at 31 Dec 20X8
$000
1,400
2,736
1,824
1,780
2,520
The percentage of completion is calculated as the value of work satisfied to date compared to the
contract price (output method).
Show extracts from the SOPL & SOFP at 31 Dec 20X8 for the above contract.
Solution:
Extract of SOPL (S3)
Revenue
COS
Gross profit
$000
Extract of SOFP
Current assets
Contract asset
S1: Compare the contract value & the total costs expected to be incurred on the contract.
$’000
Total contract price
- Total contract costs
Expected total profit/(loss)
S2: % of completion/progress of completion of PO
=
Work satisfied to date
Contract price
=
S4: Calculate contract asset/liability:
$’000
Revenue recognised to date
- Progress billings
Contract asset/(liability)
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Example 23.7.2 (Input/Cost proportion method):
GE is a construction company that prepares its f/s to 31 Dec each year. During the year ended 31 Dec 20X8,
the company commence a contract that is expected to take more than one year to complete. The PO under
the contract will be satisfied over time. The contract summary at 31 Dec 20X8 is as follows:
$000
3,780
4,500
3,600
1,200
Progress payments
Contract price
Contract costs incurred to 31 Dec 20X8
Estimated cost to complete at 31 Dec 20X8
The percentage of completion of this contract is to be based on the costs to date compared to the estimated
total contract costs (input method).
Show extracts from the SOPL & SOFP at 31 Dec 20X8 for the above contract.
Solution:
Extract of SOPL (S3)
Revenue
COS
Gross profit
$000
Extract of SOFP
Current liabilities
Contract liability
S1: Compare the contract value & the total costs expected to be incurred on the contract.
$’000
Total contract price
- Total contract costs
Expected total profit/(loss)
S2: % of completion/progress of completion of PO
=
S4: Calculate contract asset/liability:
$’000
Revenue recognised to date
- Progress billings
Contract asset/(liability)
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23.8
Specific Accounting Treatment
Learning Outcome (ACCA Study Guide Area B)
B10e: Apply the principles of recognition of revenue, and specifically account for the following types of
transaction
i.
ii.
iii.
iv.
B5c:
principal versus agent
repurchase agreements
bill and hold agreements
consignments
Explain and account for the factoring of receivables
23.8.1 Principal versus Agent Considerations
When another party is involved in providing goods or services (G/S) to a customer, the entity shall
determine whether the nature of its promise is a PO to provide the specified G/S itself (i.e. the entity is a
principal) or to arrange for the other party to provide those G/S (i.e. the entity is an agent).
An entity is a principal if the entity controls a promised G/S before the entity transfers the G/S to a
customer. However, an entity is not necessarily acting as a principal if the entity obtains legal title of a
product only momentarily before legal title is transferred to a customer. An entity that is a principal in a
contract may satisfy a PO by itself or it may engage another party (for example a subcontractor) to satisfy
some or all of a PO on its behalf.
An entity is an agent if the entity’s performance obligation is to arrange for the provision of goods or
services by another party.
Indicators that an entity is an agent (and therefore does not control the good or service before it is provided
to a customer) include the following:
(a) another party is primarily responsible for fulfilling the contract;
(b) the entity does not have inventory risk before or after the goods have been ordered by a customer,
during shipping or on return;
(c) the entity does not have discretion in establishing prices for the other party’s goods or services and,
therefore, the benefit that the entity can receive from those goods or services is limited;
(d) the entity’s consideration is in the form of a commission; and
(e) the entity is not exposed to credit risk for the amount receivable from a customer in exchange for the
other party’s goods or services
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Revenue recognition
The principal is required to satisfy a PO and therefore recognises revenue in the gross amount of
consideration to which it expects to be entitled in exchange for those G/S transferred.
The agent satisfied a PO on behalf of its principal, the agent recognises revenue in the amount of any fee
or commission to which it expects to be entitled in exchange for arranging for the principal to provide its
G/S.
Example 23.8.1(a)
Map sells 2 types of product to Web, the gigi & the gaga. Web sells the gigi as an agent of Map receiving
commission of 15% on selling price. Web sells the gaga as principal at a gross margin of 30%.
The following information relates to the year ended 30 September 20X8.
Revenue
Gross profit
Gigi ($)
Gaga ($)
200,000
60,000
75,000
22,500
Determine the amount of revenue recognise by Web on the sale of gigi & gaga for the year ended 30
September 20X8.
Solution:
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Example 23.8.1 (b)
On 1 December in the current year, an internet travel agent accepts a payment by credit card of $1,000 in
respect of a hotel booking for the following February. The travel agent confirms the booking and issues the
customer with an appropriate receipt. In due course, the internet travel agent will pay $900 to the hotel.
Having received $1,000 from the customer, the internet travel agent immediately recognised the full
amount as revenue by debiting the bank and crediting sales revenue with $1,000. In addition, it recorded
a liability to pay the hotel by crediting payable and debited expenses with $900. The internet travel agent
has a financial year end of 31 December.
Required:
Advise the internet travel agent on the appropriate accounting treatment for the above transaction.
Solution:
It appears that the internet travel agent is merely acting as an agent. All it has done is to provide an
introduction. It has not actually been responsible for the provision of a bed room for the customer.
The entry required would be to recognise the commission received $100 as an income
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23.8.2 Consignment Arrangements (Goods Sold On Sale or Return Basis)
When an entity delivers a product to another party (such as a dealer or a distributor) for sale to the
customers, the entity shall evaluate whether the other party has obtained control of the product at that
point in time.
If the dealer/distributor has not obtained control of the product, the entity shall not recognise revenue upon
delivery of a product to the dealer/distributor.
Indicators that an arrangement is a consignment arrangement include, but not limited to the following:
•
•
•
•
•
•
The product is controlled by the entity until the sale of the product to a customer or until a specified
period expires;
The entity is able to require the return of the product or transfer the product to a third party (such
as another dealer) and
The dealer does not have an unconditional obligation to pay for the product (although it might be
required to pay a deposit).
No penalty/cost for the dealer to return the product;
Insurance and maintenance of the product are borned by the entity;
Gain or loss on price fluctuation of the product is borned by the entity.
Example 23.8.2
Angelino is a motor car dealer selling vehicles to the public. Most of its new vehicles are supplied on
consignment by two manufacturers, Monza and Capri, who trade on different terms.
Monza supplies cars on terms that allow Angelino to display the vehicles for a period of three months from
the date of delivery or when Angelino sells the cars on to a retail customer if this is less than three months.
Within this period Angelino can return the cars to Monza or can be asked by Monza to transfer the cars to
another dealership (both at no cost to Angelino). Angelino pays the manufacturer’s list price at the end of
the three-month period (or at the date of sale if sooner). In recent years Angelino has returned several cars
to Monza that were not selling very well and has also been required to transfer cars to other dealerships
at Monza’s request.
Capri’s terms of supply are that Angelino pays 10% of the manufacturer’s price at the date of delivery and
1% of the outstanding balance per month as a display charge. After six months (or sooner if Angelino
chooses), Angelino must pay the balance of the purchase price (manufacturer’s price at the date of delivery)
or return the cars to Capri.
If the cars are returned to the manufacturer, Angelino has to pay for the transportation costs and forfeits
the 10% deposit. Because of this Angelino has only returned vehicles to Capri once in the last three years.
Discuss the accounting treatment?
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Solution:
Contract with Monza
•
•
•
Angelino can return cars to manufacturer at no cost/without penalty. This indicate that the
manufacturer bears the risk of slow moving/obsolete cars.
Manufacturer can ask to transfer the cars to another dealer. This indicate control of the car is with
the manufacturer.
Angelino pays to manufacturer the list price at the end of the 3 months or date of sale if earlier.
This indicate manufacturer bear the risk of price fluctuation.
In conclusion, Angelino has not obtained control of the cars. The cars that have been delivered to Angelino
are just held in a consignment arrangement. Therefore, the cars remain the assets of Monza and Monza
shall not recognise any revenue upon delivery of the cars and any unsold cars should not appear as
inventory in the f/s of Angelino.
Contract with Capri
•
•
•
Angelino pays 10% of the manufacturer’s price at the date of delivery not at the date of sale and
balance at manufacturer’s price at date of delivery. This indicate Angelino bear the risk of price
fluctuation.
If Angelino return cars to manufacturer, Angelino has to pay for transportation cost and the
forfeiture of 10% deposits. This indicate that it’s unlikely Angelino will return the car due to
commercial penalties, and evidence by only 1 return of the car in the last 3 years.
Angelino has to pay 1% of the outstanding balance per month for display which indicate that in
substance Angelino is financing the cost of holding inventory.
In conclusion, Angelino has obtained control of the cars upon delivery and therefore should capitalised the
cars in inventory and set up a trade payable for the list price, less the deposit paid. The 1% display charge
will be recognised as an operating expense or maybe presented as a finance cost.
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23.8.3 Bill and Hold Arrangements
A bill and hold arrangement is a contract under which an entity bills a customer for a product but the entity
retains physical possession of the product until it is transferred to the customer at a point in time in the
future (i.e. a customer may request an entity to enter into such a contract because of the customer’s lack
of available space for the product or because of delays in the customer’s production schedules.
In this case, the customer has the ability to use and obtain benefits from the product (control) even though
it has decided not to exercise its right to take physical possession of that product.
For a customer to have obtained control of a product in a bill and hold arrangement, all of the following
criteria must be met:
1. The reason for the bill and hold arrangement must be substantive (for example, the customer has
requested the arrangement)
2. The product must be identified separately as belonging to the customer
3. The product currently must be ready for physical transfer to the customer and
4. The entity cannot have the ability to use the product or to direct it to another customer.
Met all conditions
Does not meet all conditions
The substance is that the entity does not
control the product. Instead, the entity
provides custodial services to the customer
over the customer’s asset.
The substance is that the entity still
obtained control of the goods,
means there has been no sale and
the goods remain the asset of the entity
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23.8.4 Repurchase Agreements
A repurchase agreement is a contract in which an entity sells an asset and also promises or has the option
to repurchase the asset.
Repurchase agreements generally come in three forms:
(a) an entity’s obligation to repurchase the asset (a forward);
(b) an entity’s right to repurchase the asset (a call option); and
(c) an entity’s obligation to repurchase the asset at the customer’s request (a put option).
A forward or a call option
If an entity has an obligation or a right to repurchase the asset (a forward or a call option), a customer does
not obtain control of the asset because the customer is limited in its ability to direct the use of, and obtain
substantially all of the remaining benefits from, the asset even though the customer may have physical
possession of the asset.
Therefore, the entity shall account for the contract as either:
A Lease (IFRS 16)
A financing arrangement (secured loan)
Repurchase price < original selling price
repurchase price = or > original SP
•
•
•
Continue to recognise the asset
Also recognise a financial liability for
the consideration received.
Accrued interest expense
136
ACCA Financial Reporting (FR)
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
A put option
If an entity has an obligation to repurchase the asset at the customer’s request (a put option) the entity
shall consider at contract inception whether the customer has a significant economic incentive to exercise
that right
Yes
Repurchase price is > the expected
market value.
No
Repurchase price is = or < the expected
market value
The entity shall account for the contract
as either:
Account for as if it were the sale of a
product with a right of return.
1. A lease if repurchase price < original SP
2. A financing arrangement if repurchase
price = or > original selling price (SP)
137
ACCA Financial Reporting (FR)
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
Example 23.8.4 (a)
On 1 April 20X6 Forest had an inventory of cut seasoning timber which had cost $12m two years ago. Due
to shortages of this quality timber its value at 1 April 20X6 had risen to $20m. It will be a further 3 years
before this timber is sold to a manufacturer of high classes furniture. On 1 April 20X6 Forest entered into
an arrangement to sell the timber to BC Bank for $15m. Forest has a call option to buy back the timber at
any time within the next three years at a cost of $15m plus accumulated interest at 2% per annum above
base rate. This will be charged from the date of the original sale. The base rate for the period of the
transactions is expected to be 8%. Forest intends to buy back the timber on 31 March 20X9 and sell it the
same day for an expected price of $25m.
Required:
Assuming the above transactions take place as expected, prepare extracts of SOPL & SOFP for the years to
31 March 20X7, 20X8 and 20X9 to reflect the transaction at those year ends:
a. If Forest treated the transactions in their legal form;
b. If the substance of the transaction is recorded.
Solution:
a. Legal form
Extract of SOPL for the y/e 31 March ($m)
Revenue
COS
Gross profit
Extract of SOFP as at 31 March ($m)
Inventory
20X7
20X8
20X9
Total
20X7
Derecognise
20X8
20X9
Total
Liabilities
Not recognised!
b. Based on SOF
Extract of SOPL for the y/e 31 March ($m)
Revenue
COS
Gross profit
Finance cost
Net profit/(loss)
20X7
20X8
20X9
Total
Extract of SOFP as at 31 March ($m)
Inventory
20X7
20X8
20X9
Total
NCL: Secured loan
CL: Secured loan
138
ACCA Financial Reporting (FR)
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
Example 23.8.4 (b)
Atkins bought 5 identical plots of development land for $2m in 2013. On 1 October 2015 Atkins sold 3 of
the plots of land to an investment company, Landbank, for a total of $2.4m. The terms of the sale contained
a clause stating that on 1 October 2018, Landbank has the put option to require Atkins to repurchase the
properties for $3.2m, which is believed to be more than the expected market value. You may assume that
Landbank seeks a return on its investment of 10% per annum.
Discuss the substance of the above transaction and prepare extracts of the SOPL and SOFP (ignore cash)
of Atkins for the year to 30 September 2016.
Solution:
Although Atkins has legally sold the land to Landbank and legal title of the land is transfer to Landbank, the
substance of this transaction is that of a secured loan. Since the repurchase price of $3.2m is above the
market value, it indicates that Landbank plc has a significant economic incentive (i.e. highly likely) to
exercise its put option to require a repurchase.
When this is understood, it becomes clear that the difference between the ‘sale price’ (the amount of the
loan) of $2.4m and the repurchase price of $3.2m (repayment of principal & interest) represents a finance
charge on a secured loan.
The arrangement is secured loan (based on substance):
Extract of SOPL for year ended 30 September 2016
Finance cost on loan
$000
Extract of SOFP at 30 September 2016
NCA
Development land
$000
NCL
Secured loan
139
ACCA Financial Reporting (FR)
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
23.8.5 Factoring of Receivables
This is an arrangement where an entity sell its receivables (recv) to another company (a factor) for
management & collection in return, receives an advance on the value of those receivables.
Illustration
Transfer legal title of receivables to bank for advance cash
Co A
Bank / Factor
Collect cash from receivables to
recover cash advanced and interest.
May receive balance paid by receivables
after factor has recovered cash advanced
& interest
Accounting issue: Who should recognise receivables as a current asset in SOFP?
ASSETS OF THE SELLER
NOT THE ASSETS OF THE SELLER
There is full recourse to the seller for
losses
There is no recourse to the seller for
losses.
(i.e.: Factor cannot proceed against the
seller for non-payment by the recv)
(i.e.: Factor can proceed against the seller
for non-payment by the recv)
Risk, rewards & Control
transferred to the factor
Risk, rewards & Control
remains with the entity
There is a genuine sale of recv
In substance, the Co actually obtained a
LOAN on the security of recv
Accounting treatment
 Continues to recog recv in the SOFP
 Recog the secured loan as liab in SOFP
Dr Bank
Cr Loan (SOFP) - recog FC by y/end
Accounting treatment
 The co derecg the recv
Dr Bank
Cr Recv
 G/(L) can be recg = SP - CV of recv
140
ACCA Financial Reporting (FR)
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
Example 23.8.5 (a)
P Ltd entered into an agreement with Q Ltd whereby the title of recv were transfer to Q Ltd on the
following terms:
•
P Ltd to receive an immediate payment of 90% of net receivables (recv) balance.
•
P Ltd has the right to receive further sum, the amount depends on whether and when the recv would
pay.
•
The position at year end was that title has been transferred to the factor with an invoice value at $15m
less receivables allowance of $0.6m
Prepare extract of SOPL & SOFP assuming that:
a) Q Ltd has full recourse against P Ltd
b) Q Ltd has no recourse against P Ltd.
Solution:
a. Full recourse
b. No recourse
No transfer of control – continue to recog recv.
Control transferred – derecg recv.
Extract of SOFP
$
CA: Net recv
CL: Loan/Debt factoring
Derecognised
141
ACCA Financial Reporting (FR)
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
Example 23.8.5 (b)
On 1 September 20X3, LP sold $2m of its trade receivables to a factor, EasyFinance. LP received an
immediate payment of $1.8m and credited this amount to receivables and charged $200,000 to
administrative expenses. LP will receive further amounts from EasyFinance depending on how quickly
EasyFinance collects the amount from receivables.
EasyFinance will charge a monthly administration fee of $10,000 and 2% per month on its outstanding
balance with LP. Any receivables not collected after four months would be sold back to LP; however, LP
expects all customers to settle in full within this period. None of the receivables were due or had been
collected by 30 September 20X3.
Explain & quantify where appropriate, how LP should account for the above issue in its f/s for the year
ended 30 September 20X3.
Solution:
When dealing with factoring of receivables, an important aspect of the transaction is which party bears
the risk of any non-payment by the receivables (irrecoverable debts). In this case, LP, is bearing the risk as
it will have to ‘buy back’ any receivables not settled within four months of their ‘sale’ (full recourse). Thus
EasyFinance is acting as an administrator (for a fee of $10,000 per month) and as a provider of finance
(charging 2% interest per month)
LP should not ‘derecognise’ receivables. The correction entries will be ($’000):
142
ACCA Financial Reporting (FR)
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
Check Understanding
Question 1
Hindberg is a car retailer. On 1 April 2014, Hindberg sold a car to Latterly on the following terms:
The selling price of the car was $25,300. Latterly paid $12,650 (half of the cost) on 1 April 2014 and would
pay the remaining $12,650 on 31 March 2016 (two years after the sale). Hindberg’s cost of capital is 10%
per annum.
What is the total amount which Hindberg should credit to profit or loss in respect of this transaction in
the year ended 31 March 2015?
A $23,105
B $23,000
C $20,909
D $24,150
Question 2
The main business of Santolina Co is construction contracts. The performance obligations under the
contract will be satisfied over time. At the end of September 20X3 there is an uncompleted contract on the
books, details of which are as follows:
CONTRACT B
Date commenced
Expected completion date
Final contract price
Costs to 30.9.X3
Value of work certified to 30.9.X3
Progress billings to 30.9.X3
Cash received to 30.9.X3
Estimated costs to completion at 30.9.X3
Revenue recognised in previous year
Cost recognised in previous year
1/4/20X1
23.12.X3
$ 290,000
$ 210,450
$ 230,000
$ 210,000
$ 194,000
$ 20,600
$ 110,000
$ 98,000
Santolina calculates % completion based on work certified/contract price.
Prepare calculations showing the amount to be included in the statement of profit or loss and
statement of financial position at 30 September 20X3 in respect of the above contract.
143
ACCA Financial Reporting (FR)
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
Solution:
Extract of SOPL for the year ended 30 Sep 20X3 (S3)
Revenue
COS
Profit
Extract of SOFP as at 30 Sep 20X3
Current assets
Contract asset
Receivables
Steps:
S1: Compare the contract value & the total costs expected to be incurred on the contract.
$
Total contract price
- Total contract costs
Expected total profit/(loss)
S2: % of completion/progress of completion of PO
=
S4: Calculate contract asset/liability:
$’000
Revenue recognised to date
- Progress billings
Contract asset/(liability)
144
ACCA Financial Reporting (FR)
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
Question 3
Softfloor House Limited build cafe bars. The projects generally take a number of months to complete. The
performance obligations under the contract will be satisfied over time. The company has three contracts
in progress at the year ended 30 April.
Costs incurred to date
Costs to complete
Contract price
Progress billings
A
$'000
200
200
600
40
B
$'000
90
110
300
70
C
$'000
600
200
750
630
Softfloor calculates the percentage of completion by using the costs incurred compared to the total costs.
Calculate the effects of the above contracts upon the financial statements.
Solution:
Extract of SOPL
Revenue
COS
Profit
A
$’000
B
$’000
C
$’000
A
$’000
B
$’000
C
$’000
Extract of SOFP
Current assets
Contract asset
Current liabilities
Contract liability
S1: Total expected profit/(loss)
Total contract price
- Total contract costs
Total contract profit
S2: % of completion
Contract costs incurred to date
Total estimated contract costs (TCC)
S3: Contract asset / liability:
Revenue recognised to date
- Progress billings
Contract asset/(liability)
145
Total
$’000
ACCA Financial Reporting (FR)
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
Question 4
On 1 October 20X6 Beckwood entered into a construction contract that was expected to take 27 months
and therefore be completed on 31 December 20X8. The performance obligations under the contract will be
satisfied over time. Details of the contract are:
$’000
25,000
11,000
Agreed contract price
Estimated total cost of contract (excluding plant)
Plant for use on the contract was purchased on 1 January 20X7 (three months into the contract as it was
not required at the start) at a cost of $16 million. The plant has a four-year life and after two years, when
the contract is complete, it will be transferred to another contract at its carrying amount. Annual
depreciation is calculated using the straight-line method (assuming a nil residual value) and charged to the
contract on a monthly basis at 1/12 of the annual charge.
The correctly reported SOPL results for the contract for the year ended 31 March 20X7 were:
Revenue recognised
Contract expenses recognised
Profit
$’000
8,000
7,380
620
Details of the progress of the contract at 31 March 20X8 are:
$’000
Contract costs incurred to date (excluding depreciation)
Agreed value of work completed
Work billed to date
Total cash received to date (payments on account)
9,600
16,250
14,800
14,150
The percentage of completion is calculated as the agreed value of work completed as a percentage of the
agreed contract price.
Prepare the SOPL and SOFP extracts for Beckwood for the year ended 31 March 20X8.
Solution:
Extract of SOPL
Revenue
COS
Profit
$'000
Extract of SOFP
Non-current assets
Plant
Current assets
Contract asset
Receivables
146
$'000
$'000
ACCA Financial Reporting (FR)
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
S1: Total expected profit/(loss)
Total contract price
- Total contract costs
Total contract profit
S2: % of completion
Value of work certified
Total contract price (TCP)
S3: Contract asset / liability:
Revenue recognised to date
- Progress billings
Contract asset/(liability)
Question 5
The following details are as at the 31 December 20X5.
Contract
1
Contract value
120,000
Costs to date
48,000
Estimated costs to completion
48,000
Progress payments received
50,400
Date started
Estimated completion date
% complete (Output method)
Contract
2
72,000
8,000
54,000
-
Contract
3
240,000
103,200
160,800
76,800
Contract
4
500,000
299,600
120,400
345,200
1.3.20X5
30.6.20X6
15.10.20X5
15.9.20X6
1.7.20X5
30.11.20X6
1.6.20X4
30.7.20X6
45%
10%
35%
70%
The performance obligations under the contract will be satisfied over time.
The statement of profit or loss for the previous year showed revenue of $225,000 and expenses of
$189,000 in relation to contract 4.
The company considers that the outcome of a contract cannot be estimated reliably until a contract is
25% complete. It is, however, probable that the customer will pay for costs incurred so far.
Calculate the amounts to be included in the statement of profit or loss for the year ended 31
December 20X5 and the statement of financial position as at that date.
147
ACCA Financial Reporting (FR)
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
Solution:
Extract of SOPL
Revenue
COS
Profit
Contract 1
$
Contract 2
$
Contract 3
$
Contract 4
$
Contract 1
$
Contract 2
$
Contract 3
$
Contract 4
$
Extract of SOFP
Current assets
Contract asset
Current liabilities
Contract liability
S1: Total expected profit/(loss)
Total contract price
- Total contract costs
Total contract profit
S2: % of completion
S3: Contract asset / liability:
Revenue recognised to date
- Progress billings
Contract asset/(liability)
148
ACCA Financial Reporting (FR)
CHAPTER 23: IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
23.9
Chapter 23 Summary
Diagram 23.10.: Summary of IFRS 15 Revenue from contract with customers
149
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
CHAPTER 24: IAS 7 STATEMENT OF
CASH FLOWS
LEARNING OUTCOME
At the end of the chapter, you should be able to:
TLO C3d.
Compare the usefulness of cash flow information with that of a statement of profit or
loss and other comprehensive income.
TLO C3e.
Interpret a statement of cash flows (together with other financial information) to
assess the performance and financial position of an entity
TLO D1c.
Prepare a statement of cash flows for a single entity (not a group) in accordance with
relevant accounting standards using the indirect method
150
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
24.1
Objective
▪ To provide information to users about the entity's ability to generate cash and cash equivalents, as
well as indicating the needs for cash.
▪ To provide historical information about the changes in cash and cash equivalent by means of SOCF
▪ To classify cash flows between operating, investing and financing activities
24.2
Usefulness of Statement of Cash Flow (SOCF)
Learning Outcome (ACCA Study Guide Area C)
C3d: Compare the usefulness of cash flow information with that of a statement of profit or loss
and other comprehensive income.
▪ Prepare on cash basis, easier to understand than SOPL as SOPL are subjected to accrual accounting
▪ Enhance comparability, as opposed to SOPL and SOFP which are subject to manipulation by the
use of different accounting policies.
▪ Enable users to assess the liquidity and solvency (i.e.: the company's ability to repay its debt) as
healthy liquidity is vital to a company’s going concern
▪ Difficult to manipulate cash flows as they are real and possess the qualitative characteristic of
objectivity (as opposed to subjective profits)
▪ Assist to highlight where the cash is being generated (i.e.: from the core activities, or non-operating
activities)
▪ Cash flow (CF) information of historical nature can be used as an indicator of amount, timing and
certainty of future CF
24.3
Definition of Cash and Cash Equivalent
Cash
➢ Cash on hand (including overdrafts) and demand deposits.
Cash Equivalents
➢ Short-term, highly liquid investments that are readily convertible into known amounts of cash
(normally matured within 3 months) and are subject to an insignificant risk of changes in
value.
151
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
24.4
Presentation of Cash Flow
Learning Outcome (ACCA Study Guide Area D)
D1c: Prepare a statement of cash flows for a single entity (not a group) in accordance with
relevant accounting standards using the indirect method
IAS 7 required SOCF to classify into:
Cash Flows from operating activities
CF derived from main revenue producing /operating/ trading activities.
Examples are:
(a)
(b)
(c)
(d)
Cash receipts from the sale of goods and the rendering of services
Cash receipts from royalties, fees, commissions and other revenue
Cash payments to suppliers for goods and services
Cash payments to and on behalf of employees
2 methods of presenting
▪
Direct (preferred method)
▪
Indirect method (exam focus)
Cash flows from investing activities
Cash flow related to the acquisition or disposal of any long-term assets or investments together with
returns received in cash from investments.
Examples are:
(a)
(b)
(c)
Cash payments to acquire PPE, intangible assets, shares or debentures (investment) of other
entities
Cash receipts from sales of PPE, intangible assets, shares or debentures (investment) of other
entities
Dividends or interest received as a return from investments
Cash flows from financing activities
Receipts from or repayments that resulted in changes in equity capital and borrowings
Examples are:
(a)
(b)
(c)
(d)
Cash proceeds from issuing shares
Cash payments to owners to acquire or redeem the entity's shares
Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or longterm borrowings
Principal repayments of amounts borrowed under leases
152
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
24.5
Recognition
STATEMENT OF CASH FLOWS FOR YEAR ENDED
Cash flows from operating activities (Indirect method)
Profit before taxation
Adjustments for:
$
xx
+ Depreciation on PPE
+ Amortisation of IA
- Amortisation of government grant
- Profit / (loss) on disposal of NCA
+ Increase / (decrease) in provision
x
x
(x)
(x)/x
x/(x)
+ Interest expense /finance costs
- Interest income / dividend income
Operating profit before working capital changes
+ Decrease / (Increase) in inventories
+ Decrease / (Increase) in trade receivables
+ Increase / (Decrease) in trade payables
Cash generated from operations
- Interest paid
- Income taxes paid
Net cash from / (used) in operating activities
x
(x)
xx
x/(x)
x/(x)
x/(x)
xx
(x)
(x)
A
Cash flows from investing activities
- Capitalised development expenditure
- Purchase of PPE / long term investment
+ Proceeds from sale of PPE / long term investment
+ Interest received
+ Dividend received
Net cash from / (used) in investing activities
Cash flows from financing activities
+ Proceeds from issue of shares
+ Raising of long term loan / debentures
- Repayment/ redemption of debentures
- Payment of lease liabilities (capital portion only)
- Dividends paid (can be shown under operating CF)
Net cash from / (used) in financing activities
Net increase /(decrease) in cash and cash equivalents
+ Cash and cash equivalents at beginning of period
Cash and cash equivalent at end of period
153
(x)
(x)
x
x
x
B
x
x
(x)
(x)
(x)
C
A+B+C
D
E
Non-cash items
not part of the cash
generated from
operations
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
Non-current assets - NBV
Op NBV
Disposal - NBV
Disposal (trade in)
Depn
NCA on lease
Revaluation surplus
Bank
xx Cl NBV
Non-current assets - Accumulated depreciation
Disposal - acc depn
Revaluation surplus
Cl acc depn
Op acc depn
Depn
xx
Deferred development expense
Op bal
Bank
SOPL - amortization
xx Cl bal
Retained earnings
xx Op bal
NP for the year
Divd paid
Cl bal
Deferred income - government grant
SOPL - amortization
xx Op bal - CL & NCL
Cl bal - CL & NCL
Bank
xx
xx
xx
Lease liabilities (capital portion only)
Bank
xx Op bal - CL & NCL
Cl bal - CL & NCL
NCA on lease
Bank
Cl bal - Current tax
- Deferred tax
Bank
Cl accruals
Income tax expense
xx Op bal - Current tax
- Deferred tax
SOPL
Dividend/ Interest expense
xx Op accruals
SOPL
154
xx
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
24.6
Check Understanding
Question 1
Traffold, a limited liability company, is preparing its statement of cash flows for the year ended 31
May 2008.
Traffold
Statements of financial position as at 31 May
Assets
Non-current assets
Cost
Accumulated depreciation
Current assets
Inventory
Trade receivables
Bank
Total assets
Equity and liabilities
Capital and reserves
$1 Ordinary share capital
Share premium
Revaluation reserve
Retained earnings
Non-current liabilities
9% loan notes
Current liabilities
Trade payables
Taxation
Total equity and liabilities
155
2008
$'000
2007
$'000
65,251
(14,798)
50,453
53,525
(12,509)
41,016
16,503
6,214
595
23,312
73,765
14,563
8,664
536
23,763
64,779
21,000
7,892
7,454
19,979
56,325
17,000
6,425
4,092
18,190
45,707
6,734
8,825
9,505
1,201
10,706
73,765
8,951
1,296
10,247
64,779
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
SOPL for the year ended 31 May 2008
Sales revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Profit from operations
Interest received
Finance cost
Profit before tax
Taxation
Profit for the period
$'000
28,775
(14,821)
13,954
(4,908)
(3,410)
5,636
57
(794)
4,899
(1,570)
3,329
Additional information
i.
ii.
iii.
iv.
v.
Dividends paid during the year were $1,540,000.
There were no amounts outstanding in respect of interest payable or receivable as at either
year end.
Total depreciation for the year was $2,487,000.
The only revaluation of non-current assets was of a piece of freehold land.
During the year, the company sold equipment for $766,000 realising a profit of $66,000.
Prepare a statement of cash flows for Traffold for the year ended 31 May 2008 in accordance with
IAS 7 – Statement of Cash Flows, using the indirect method.
156
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
Solution:
Traffold
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 MAY 2008
Cash flows from operating activities
Profit before taxation
Adjustments for:
+ Finance costs
- Interest received
+ Depreciation expenses
- Gain on disposal of equipment
Operating profit before working capital changes
+ Decrease / (Increase) in inventories
+ Decrease / (Increase) in trade receivables
+ Increase / (Decrease) in trade payables
Cash generated from operations
- Interest paid
+ Interest received
- Income taxes paid
Net cash from / (used) in operating activities
Cash flows from investing activities
Proceeds from sale of equipment
Purchase of PPE
Net cash from / (used) in investing activities
Cash flows from financing activities
Repayment of loan note
Dividend paid
Issue of shares
Net cash from / (used) in financing activities
Net increase /decrease in cash and cash equivalents
+ Cash and cash equivalents at beginning of period
Cash and cash equivalent at end of period
157
$'000
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
Question 2:
Below are the statements of financial position of Dickson as at 31 March 20X8 and 31 March 20X7,
together with the statement of profit or loss and other comprehensive income for the year ended 31
March 20X8.
Non-current assets
Property, plant and equipment
Goodwill
Development expenditure
Current assets
Inventories
Trade receivables
Investments
Cash
Equity
Share capital - $1 ordinary shares
Share premium
Revaluation surplus
Retained earnings
Non-current liabilities
6% debentures
Lease liabilities
Deferred tax
Current liabilities
Trade payables
Lease liabilities
Current tax
Debenture interest
Bank overdraft
158
20X8
$'000
20X7
$'000
825
100
290
1,215
637
100
160
897
360
274
143
29
806
2,021
227
324
46
117
714
1,611
500
350
152
237
1,239
400
100
60
255
815
150
100
48
298
100
80
45
225
274
17
56
5
132
484
2,021
352
12
153
54
571
1,611
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
Revenue
Cost of sales
Gross profit
Other expenses
Finance costs
Profit before tax
Income tax expense
Profit for the year
Other comprehensive income:
Gain on revaluation of property, plant and equipment
Total comprehensive income for the year
$,000
1,476
(962)
514
(157)
(15)
342
(162)
180
100
280
Notes
(1) Goodwill arose on the acquisition of unincorporated businesses. During 20X8 expenditure on
development projects totalled $190,000.
(2) During 20X8 items of property, plant and equipment with a net book value of $103,000 were
sold for $110,000. Depreciation charged in the year on property, plant and equipment totalled
$57,000. Dickson transfers extra depreciation on revalued property, plant and equipment to
retained earnings as allowed by IAS 16.
Depreciation based on historical cost in 20X8 is $49,000. Dickson purchased $56,000 of
property, plant and equipment by means of leases, payments being made in arrears on the last
day of each accounting period.
(3) The current asset investments are government bonds and management has decided to class
them as cash equivalents.
(4) During the year Dickson made a 1 for 8 bonus issue capitalising its retained earnings followed
by a rights issue.
Prepare a statement of cash flows in accordance with IAS 7 using the indirect method.
159
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
Solution:
DICKSON
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 MARCH 20X8
Cash flows from operating activities
Profit before taxation
Adjustments for:
+ Finance costs
+ Depreciation expenses
- Gain on disposal PPE
+ Amortization of development expenditure
Operating profit before working capital changes
+ Decrease / (Increase) in inventories
+ Decrease / (Increase) in trade receivables
+ Increase / (Decrease) in trade payables
Cash generated from operations
- Interest paid
- Income taxes paid
Net cash from / (used) in operating activities
Cash flows from investing activities
Development expenditure
Proceeds from sale of PPE
Purchase of PPE
Net cash from / (used) in investing activities
Cash flows from financing activities
Issue of 6% debenture
Rights issue
Dividend paid
Repayment of lease liabilities
Net cash from / (used) in financing activities
Net increase /decrease in cash and cash equivalents
+ Cash and cash equivalents at beginning of period
Cash and cash equivalent at end of period
160
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
Question 3
The statements of financial position of Nedburg include the following extracts:
Statements of financial position as at 30 September
20X2
$’m
20X1
$’m
Non-current liabilities
Deferred tax
310
140
Current liabilities
Taxation
130
160
The tax charge in the statement of profit or loss for the year ended 30 September 20X2 is $270 million.
What amount of tax was paid during the year to 30 September 20X2?
A
B
C
D
$300 million
$140 million
$200 million
$130 million
Question 4
A business has made a profit of $8,000 but its bank balance has fallen by $5,000. This could be due
to:
A
B
C
D
depreciation of $3,000 and an increase in inventories of $10,000
depreciation of $6,000 and the repayment of a loan of $7,000
depreciation of $12,000 and the purchase of new non-current assets for $25,000
the disposal of a non-current asset for $13,000 less than its book value
Question 5
The following information is available for Fry as at 30 September:
Property, plant and equipment at carrying amounts
2014
$23.4 million
2013
$14.4 million
The following items were recorded during the year ended 30 September 2014:
(i)
(ii)
(iii)
(iv)
Depreciation charge of $2·5 million
An item of plant, with a carrying amount of $3 million, was sold for $1·8 million
A property was revalued upwards by $2 million
Environmental provisions of $4 million relating to property, plant and equipment were capitalised
during the year
What amount would be shown in Fry’s statement of cash flows for purchase of property, plant and
equipment for the year ended 30 September 2014?
A $8·5 million
B $12·5 million
C $7·3 million
D $10·5 million
161
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
Question 6
The financial statements of Nedberg for the year to 30 September 20X2 together with the comparative
statement of financial position for the year to 30 September 20X1 are shown below:
SOPL - year to 30 September 20X2
Revenue
Cost of sales (note 1)
Gross profit for period
Operating expenses (note 1)
Profit from operations
Interest - Loan note
Profit before tax
Taxation
Profit for the year
Other comprehensive income:
Revaluation gain
Total comprehensive income
$'m
3,820
(2,620)
1,200
(280)
920
(30)
890
(270)
620
Statements of financial position as at 30 September:
Non-current assets
Property, plant and equipment
Intangible assets (note 2)
20X2
$m
1,890
670
2,560
20X1
$m
1,830
300
2,130
1,420
990
70
2,480
5,040
940
680
nil
1,620
3,750
750
350
140
1,910
3,150
500
100
nil
1,600
2,200
300
260
310
870
100
300
140
540
200
820
Current assets
Inventory
Receivables
Cash
Total assets
Equity and liabilities
Ordinary shares of $1 each
Share premium
Revaluation
Retained earnings (note 3)
Non-current liabilities
10% Loan note
Government grants
Deferred tax
162
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
Current liabilities
Trade payables
Bank overdraft
Loan interest accrual
Taxation
875
nil
15
130
1,020
5,040
Total equity and liabilities
730
115
5
160
1,010
3,750
Notes to the financial statements:
1. Cost of sales includes depreciation of property, plant and equipment of $320 million and a loss on
the sale of plant of $50 million. It also includes a credit for the amortisation of government grants.
2. Intangible non-current assets:
20X2
$m
470
200
670
Deferred development expenditure
Goodwill
20X1
$m
100
200
300
3. Extract from statement of changes in equity - Movement on retained earnings:
20X2
$m
1,600
620
(320)
10
1,910
Opening balance
Profit for the year
Dividends - interim
Transfer from revaluation reserve
Closing balance
20X1
$m
1,000
800
(200)
1,600
The following additional information is relevant:
i.
The company successfully completed the development of a new product during the current
year, capitalising a further $500 million before amortisation charges for the period.
163
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
ii.
Property, plant and equipment/ revaluation reserve:
- The company revalued its buildings by $200 million on 1 October 20X1. The surplus was
recorded as other comprehensive income and credited to a revaluation reserve.
- New plant was acquired during the year at a cost of $250 million and a government grant of
$50 million was received for this plant.
- On 1 October 20X1 a bonus issue of 1 new share for every 10 held was made from the
revaluation reserve.
- $10 million has been transferred from the revaluation reserve to realised profits as a year-end
adjustment in respect of the additional depreciation created by the revaluation.
- The remaining movement on property, plant and equipment was due to the disposal of
obsolete plant.
iii.
Share issues:
In addition to the bonus issue referred to above Nedberg made a further issue of ordinary
shares for cash.
Prepare a statement of cash flows for Nedbergfor the year to 30 September 20X2 prepared in
accordance with IAS 7.
164
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
Question 7
Bigwood, a public company, is a high street retailer that sells clothing and food. The managing director
is very disappointed with the current year's results. The company expanded its operations and
commissioned a famous designer to restyle its clothing products. This has led to increased sales in
both retail lines, yet overall profits are down. Details of the financial statements for the two years to
30 September 20X4 are shown below.
SOPL & OCI
Year to
Year to
30 September 20X4 30 September 20X3
$000
$000
16,000
15,600
7,000
4,000
23,000
19,600
Revenue - clothing
- food
Cost of sales- clothing
-food
14,500
4,750
19,250
12,700
3,000
15,700
Gross profit
Other operating expenses
Operating profit
Interest expense
Profit before tax
Income tax expense
Profit for period
3,750
(2,750)
1,000
(300)
700
(250)
450
3,900
(1,900)
2,000
(80)
1,920
(520)
1,400
165
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
Statements of financial position
as at
Year to
Year to
30 September 20X4 30 September 20X3
$000
$000
17,000
9,500
(5,000)
(3,000)
12,000
6,500
Property, plant and equipment at cost
Accumulated depreciation
Current Assets
Inventory
- clothing
- food
Trade receivables
Bank
Total assets
Equity and liabilities
Issued ordinary capital ($1 shares)
Share premium
Retained earnings
Non-current liabilities
Long-term loans
Current liabilities
Bank overdraft
Trade payables
Current tax payable
2,700
200
100
Nil
3,000
15,000
1,360
140
50
450
2,000
8,500
5,000
1,000
1,750
7,750
3,000
Nil
1,900
4,900
3,000
1,000
930
3,100
220
4,250
15,000
Nil
2,150
450
2,600
8,500
Note: The directors have signalled their intention to maintain annual dividends at $600,000 for the
foreseeable future.
The following information is relevant:
(i) The increase in property, plant and equipment was due to the acquisition of five new stores and
the refurbishment of some existing stores during the year. The carrying value of fixtures scrapped
at the refurbished stores was $1.2 million; they had originally cost $3 million. Bigwood received no
scrap proceeds from the fixtures, but did incur costs of $50,000 to remove and dispose of them.
The losses on the refurbishment have been charged to operating expenses.
Prepare, using the indirect method, a statement of cash flows for Bigwood for the year to 30
September 20X4.
166
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
Solution:
Question 1
Traffold
Statement of Cash Flows for the year ended 31 May 2008
Cashflows from operating activities
$'000
Profit before taxation
4899
Adjustments:
+ Finance costs
794
- Interest received
-57
+ Depreciation expenses
2487
- Gain on disposal of equipment
-66
8057
Operating profit before working capital changes
Increase in inventory
-1940
Decrease in receivables
2450
Increase in payables
554
Cash generated from operation
9121
- Interest paid
-794
+ Interest received
57
- Tax paid
-1665
Net cash from / (used in) operating
activities
6719
b/d
OCI, RS
Cash
NCA-NBV
41016 Depr
3362 Disposal
9262 c/d
2487
700
50453
c/d
OSC
b/d
21000 Cash
17000
4000
c/d
SP
b/d
7892 Cash
6425
1467
RS
c/d
Cashflows from investing activities
Proceeds from sale of equipment
Purchase of PPE
Net cash from / (used in) investing activities
Cashflows from financing activities
Repayment of loan notes
Dividend paid
Issue of shares
Net cash from / (used in) financing activities
Net increase in cash and cash equivalents
Opening cash and cash equivalents
Closing cash and cash equivalents
766
-9262
-8496
-2091
-1540
5467
1836
59
536
595
167
Div paid
c/d
Cash
c/d
b/d
Gain on
7454 revl
RE
1540 b/d
19979 PAT
Tax payable
1665 b/d
1201 ITE
4092
3362
18190
3329
1296
1570
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
Question 2
Dickson
Statement of Cash Flows for the year ended
31 March 20X8
Cashflows from operating activities
Profit before taxation
Adjustments:
+ Finance costs
+ Depreciation expenses
- Gain on disposal of PPE
+ Amortisation of development expenditure
Operating profit before working capital
changes
Increase in inventory
Decrease in receivables
Decrease in payables
Cash generated from operation
- Interest paid
- Tax paid
Net cash from / (used in) operating activities
Cashflows from investing activities
Development expenditure
Proceeds from sale of equipment
Purchase of PPE
Net cash from / (used in) investing activities
Cashflows from financing activities
Issue of 6% debentures
Proceeds from rights issue
Dividend paid
Repayment of lease liabilities
Net cash from / (used in) financing activities
Net decrease in cash and cash equivalents
Opening cash and cash equivalents
Closing cash and cash equivalents
$'000
342
15
57
-7
60
467
-133
50
-78
306
-10
-256
40
-190
110
-192
-272
50
300
-156
-31
163
-69
109
40
b/d
OCI,RS
ROU A
Cash
PPE
637 Depr
100 Disposal
56
192 c/d
b/d
Cash
Dev exp
160 Amrtz
190 c/d
60
290
c/d
OSC
b/d
RE (BI)
500 Cash
400
50
50
c/d
SP
b/d
350 Cash
100
250
RE
c/d
RS
8 b/d
152 PPE
60
100
OSC (BI)
Div paid
c/d
RE
50 b/d
156 PAT
237 RS
255
180
8
Cash
c/d
LL (NCL + CL)
31 b/d
117 ITE
Cash
c/d
Cash
c/d
168
Tax payable
166
5 b/d
120
1 ITE
Interest payable
10 b/d
5 ITE
57
103
825
92
56
129
6
157
0
15
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
Question 3
D
Question 4
C
Question 5
A
169
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
Question 6
Nedberg
Statement of Cash Flows for the year ended 30 Sep 20X2
Cashflows from operating activities
$'000
Profit before taxation
890
Adjustments:
+ Interest - loan note
30
+ Depreciation expense
320
+ Loss on disposal
50
+ Amortisation of development expenditure
130
- Amortisation of government grant (income)
-90
Operating profit before working capital changes
Increase in inventory
Increase in receivables
Cash generated from operation
- Interest paid
- Tax paid
Net cash from / (used in) operating activities
b/d
OCI RS
Cash
Amrtz
130
Cash
500
c/d
470
145
b/d
500
685
-20
-130
RS
Cash
50
200
b/d
Cash
100
250
b/d
PPE
0
200
b/d
PAT
RS
1600
620
10
OSC
c/d
50
20
750
SP
c/d
Net cash from / (used in) investing activities
320
70
1890
100
-500
-250
Receipt of government grant
Sales proceeds from disposal of plant
Depr
Disp
c/d
IA - dev exp
535
Cashflows from investing activities
Development expenditure
Purchase of new plant
1830
200
250
b/d
1330
-480
-310
Increase in payables
PPE
350
RS
RE
OSC
10
50
-680
c/d
140
200
-320
450
Div paid
c/d
Cashflows from financing activities
RE
Issue of new loan note
Dividend paid
Issue of shares
Net cash from / (used in) financing activities
320
1910
330
GG / Def inc
Net increase in cash and cash equivalents
Opening cash and cash equivalents
185
-115
Closing cash and cash equivalents
SOPL -inc
c/d
90
260
b/d
Cash
300
50
70
Int payable
Cash
20
c/d
15
b/d
FC
SOPL
5
30
Tax payable
Cash
c/d
170
130
130
b/d
ITE
160
100
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
Question 7
Bigwood
Statement of Cash Flows for the year ended 30 Sep 20X4
Cashflows from operating activities
$'000
Profit before taxation
700
Adjustments:
+ Finance costs
300
+ cost of removal (non-operating)
50
+ Loss on disposal of PPE
1200
+ Depreciation expenses
3800
Operating profit before working capital changes
6050
Increase in inventory
-1400
Increase in receivables
-50
Increase in payables
950
Cash generated from operation
5550
- Interest paid
-300
- Tax paid
-480
Net cash from / (used in) operating activities
4770
b/d
Cash
PPE-cost
9500 Disp
10500 c/d
c/d
PPE-AD
1800 b/d
Depr
5000
c/d
OSC
b/d
5000 Cash
Disposal
3000
17000
3000
3800
3000
2000
SP
Cashflows from investing activities
Cost of removal of PPE
Purchase of PPE
Net cash from / (used in) investing activities
-50
-10500
-10550
Cashflows from financing activities
Issue of loans
Dividend paid
Issue of shares
Net cash from / (used in) financing activities
2000
-600
3000
4400
Net decrease in cash and cash equivalents
Opening cash and cash equivalents
Closing cash and cash equivalents
-1380
450
-930
171
c/d
b/d
1000 Cash
0
1000
Div paid
c/d
RE
600 b/d
1750 PAT
1900
450
Cash
c/d
Tax payable
480 b/d
220 ITE
450
250
ACCA Financial Reporting (FR)
CHAPTER 24: IAS 7 STATEMENT OF CASH FLOWS
24.7
Chapter 24 Summary
Diagram 24.7.: Summary of IAS 7 Statement of Cash Flows
172
ACCA Financial Reporting (FR)
CHAPTER 25: INTERPRETATION OF FINANCIAL STATEMENTS (RATIO ANALYSIS)
CHAPTER 25: INTERPRETATION OF
FINANCIAL STATEMENTS (RATIO
ANALYSIS)
LEARNING OUTCOME
At the end of the chapter, you should be able to:
TLO C1a. Indicate the problems of using historic information to predict future performance and
trends
TLO C1b. Discuss how financial statements may be manipulated to produce a desired effect (creative
accounting, window dressing)
TLO C1c. Explain why figures in a statement of financial position may not be representative of
average values throughout the period for example, due to:
i.
seasonal trading
ii.
major asset acquisitions near the end of the accounting period
TLO C1d. Explain how the use of consolidated financial statements might limit interpretation
techniques
TLO C2a. Define and compute relevant financial ratios
TLO C2b. Explain what aspects of performance specific ratios are intended to assess
173
ACCA Financial Reporting (FR)
CHAPTER 25: INTERPRETATION OF FINANCIAL STATEMENTS (RATIO ANALYSIS)
TLO C2c. Analyse and interpret ratios to give an assessment of an entity’s/group’s performance and
financial position in comparison with:
i.
previous period’s financial statements
ii.
another similar entity/group for the same reporting period
iii.
industry average ratios
TLO C2d. Interpret financial statements to give advice from the perspectives of different
stakeholders
TLO C2e. Discuss how the interpretation of current value based financial statements would differ
from those using historical cost-based accounts.
TLO C3a. Discuss the limitations in the use of ratio analysis for assessing corporate performance
TLO C3b. Discuss the effect that changes in accounting policies or the use of different accounting
polices between entities can have on the ability to interpret performance
TLO C3c. Indicate other information, including non-financial information, that may be of relevance
to the assessment of an entity’s performance
TLO C4a. Explain how the interpretation of the financial statement of a specialised, not for-profit or
public sector organisations might differ from that of a profit making entity by reference to
the different aims, objectives and reporting requirements
174
ACCA Financial Reporting (FR)
CHAPTER 25: INTERPRETATION OF FINANCIAL STATEMENTS (RATIO ANALYSIS)
25.1
Overview
Accounting ratios help to summarise and present financial information in a more understandable
form. They assist in assessing the performance of a business by identifying significant relationships
between different figures.
Ratios are used as a basis for comparison such as:
• Previous years
• Other companies
• Industry averages budgeted or forecast vs actual.
Ratios do not provide answers but help to focus attention on important areas, therefore minimising
the chance of failing to identify a significant trend or weakness.
Ratios are divided into the following main areas:
• Performance
• Short term liquidity / Long term solvency
• Efficiency (asset and working capital)
• Investors’ ratios.
How to analyse the financial statements of the company?
(i)
Vertical / trend analysis
- compared to its previous result
(ii)
Horizontal analysis
- compared to other companies in the same industry and similar sized
(iii)
Industry average comparison
- compared to a compilation of the average of many other similar types of companies
175
ACCA Financial Reporting (FR)
CHAPTER 25: INTERPRETATION OF FINANCIAL STATEMENTS (RATIO ANALYSIS)
25.2
Types of Ratio
Learning Outcome (ACCA Study Guide Area C)
C2a: Define and compute relevant financial ratios
C2b:
Explain what aspects of performance specific ratios are intended to assess
25.2.1 Profitability and return
(I)
RETURN ON CAPITAL EMPLOYED (ROCE)
Profit before interest and tax
x 100
Capital employed
CE
= Ordinary Share Capital + Reserves + Preference shares + Non-current liability, or
= Total assets – Current Liability
Purpose 
A primary measurement of profitability to measure how efficiently a
business is using its resources
Consideration:
 should always higher than the company's borrowing rates
 should meet the target return set by investors
Possible interpretations:
High ROCE
▪
▪
▪
▪
▪
Low ROCE
▪
due to higher profit before interest
and tax
better use of assets
due to inflation
book values of assets understated
 depreciation understated
due to the effect of not replacing noncurrent asset
 non- current asset value drop
 depreciation drop
due to disposal of non- current asset
 non- current asset value drop, gain
on disposal increase profit before
interest and tax
176
▪
▪
▪
due to decrease in profit before
interest and tax
poor use of assets / not fully utilised
due to gain on revaluation of noncurrent asset
 revaluation reserve increased
 Capital employed increased
due to purchase of new assets during
the year
 did not contribute to full year profit
 there will be time lag for new assets
to reach its full beneficial effect
ACCA Financial Reporting (FR)
CHAPTER 25: INTERPRETATION OF FINANCIAL STATEMENTS (RATIO ANALYSIS)
(II)
GROSS PROFIT (GP) MARGIN
Gross profit x 100
Sales
Possible interpretations:
High GP margin
▪ Increase in selling price/ in a position to exploit market
▪ Receive trade discount for bulk purchasing (cost of sales reduced)
▪ Reduction in manufacturing cost
▪ Stocktaking errors. (e.g. closing stocks overstated  cost of sales understated  GP
overstated)
▪ Changes in sales mix (e.g. sell more items of higher margins/ mark up)
Low GP margin
▪ Decrease in selling price may be due to price wars/ to boost sales/ greater competition in
the market
▪ Due to written down of inventories that are obsolete/ damage
▪ Large proportion of sales coming from sales made at a reduced price
▪ Higher manufacturing cost/ cost of purchasing
▪ Due to expansion costs (e.g. launching new product) or trying to increase market share
▪ Other costs (e.g. research and development expenditure) being allocated to the cost of sales
 increase in cost of sales
(III)
OPERATING PROFIT (NET PROFIT) MARGIN
Profit before interest and tax x 100%
Sales
Possible interpretations:
High OP margin
▪ Reduction in general overheads costs
▪ Disposal of non-current asset  reduce the depreciation charges
▪ Gain on disposal
▪ Restructuring  reduce the staff costs
▪ Better control of administration & distribution expenses
Low OP margin
▪ General overheads have increased (e.g. due to increase in advertisement cost to attract
sales)
▪ Purchase of new assets  increase the depreciation charges
Linkage:
If GP margin increase, profit before interest and tax margin decrease  bad control over expenses/
due to one off loss
177
ACCA Financial Reporting (FR)
CHAPTER 25: INTERPRETATION OF FINANCIAL STATEMENTS (RATIO ANALYSIS)
(VI)
NET ASSET /ASSET TURNOVER
Sales
Capital employed
x 100
Purpose  to measure how efficiently a business is using its assets to generate sales
Possible interpretations:
High asset turnover:
▪ Generating lots of sales (check is it due to lower selling price  reducing gross profit margin)
▪ Non-current asset might be old/ undervalued  lower non-current asset value  lower CE
▪ Company might be using assets which are not on the statement of financial position (e.g.
leased assets)
▪ Due to disposal of non-current asset  non-current asset drop --> CE drop
Low asset turnover:
▪ Due to raising of finance via issue of shares  CE increase
▪ Due to gain on revaluation of non-current asset  revaluation reserve increase  CE
increase
▪ Decrease in sales volume / goods sold at lower prices
▪ Due to new assets  non-current asset increase  CE increase
▪ Too low might be an indication of over investment in assets
Notes:
ROCE = Asset turnover x Gross/ Operating profit margin
Profit before interest and tax = __
Sales
x Profit before interest and tax
Capital employed
Capital employed
Sales
If operating profit margin is higher
 Selling price is high and a strong possibility that sales volumes will be depressed causing a low asset
turnover
If operating profit margin is low
 Selling price is low and a strong possibility that sales volumes will be increased causing a high asset
turnover
178
ACCA Financial Reporting (FR)
CHAPTER 25: INTERPRETATION OF FINANCIAL STATEMENTS (RATIO ANALYSIS)
(V)
RETURN ON OWNER'S EQUITY (ROOE)
Profit After Tax - preference dividends
Owner equity (exclude preference shares)
x 100%
Purpose  to determine the returns due to ordinary shareholders
Consideration
▪
Should meet the target return set by investors
Not very important ratio as there are more useful ratios that give an indication of the return to
shareholders (e.g. Earnings Per Share, Dividends Per Share which cover under Return on Owner’s
equity (ROOE)
25.2.2 Liquidity / Short term
solvency
(I)
CURRENT RATIO
Current assets
Current liabilities
Purpose  Measure the company’s ability to use its current assets to pay off its short-term liabilities
Consideration  Ratio of 1 to 2:1 is acceptable but varies between businesses/industries.
Possible interpretations:
High current ratio
▪ Stocks too high, possibly due to slow moving stocks / obsolescence
▪ Receivables too high, possibly due to poor credit controls or may lead to bad debts
▪ Company may be paying payables quickly to enjoy the cash discount
▪ Indication of funds are tied up in cash which could be earning money elsewhere
 not efficiently utilising its surplus fund available
Low current ratio
▪ Current liabilities are too high  company might face difficulties paying to payables or
overdraft
▪ Receivables decrease due to good credit control but might lose customers
▪ Payables are too high, possibly loss of goodwill with suppliers / suppliers might raise price
▪ Company has relied on extended credit from suppliers to finance further sales
▪ Indication of poor liquidity positions / facing liquidity problems
(Check if the company is in overdraft position --> if yes, further support liquidity problems)
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(II)
QUICK / ACID TEST RATIO
Current Assets - Inventory
Current liabilities
Purpose:
 To measure the company's ability to use its most liquid assets to pay off its short-term liability
 To remove slower moving item (inventory) from current assets to measure real short-term liquidity
Consideration  Ratio of 0.8 to 1:1 is acceptable but varies between businesses/industries.
Possible interpretations:
High current ratio
Same as current ratio except items involving inventory
High current ratio
Same as current ratio
25.2.3 Efficiency/Working capital
(I)
ACCOUNTS RECEIVABLE COLLECTION PERIOD / DEBTORS DAY
Trade receivables x 365 days
Credit sales
Purpose  To measure average length of time it takes for customers of a company to pay what they
owe/ credit period taken by the customers
Possible interpretations:
High accounts receivable collection period / debtors day
▪ Poor credit control management
▪ Company's policy to extend credit periods to customers to encourage higher sales
▪ Receivables allowances under-estimated resulted in receivables overvalued
▪ Might resulted in liquidity problems
Low accounts receivable collection period / debtors day
▪ Good credit control management
▪ Higher cash sales
▪ Credit period offered is too short, possibly lose customers to competitors
▪ Too high estimation of receivable allowances resulted in receivables undervalued
▪ May indicate factoring of receivables due to declining liquidity
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(II)
INVENTORY TURNOVER PERIOD
Inventory
Cost of sales
x 365 days
Cost of sales = no of times
Inventory
or
Purpose  to measure average number of days that items of inventory are held for
Possible interpretations:
High inventory turnover period
▪ Poor sales achievement / slowdown in trading (check if sales drop)
▪ Excessive investment in inventory  may lead to high storage costs
▪ A lot of slow moving / obsolete stocks
▪ Sales fallen due to recession but the company has been slow to cut back on production
causing build-up of stocks
▪ Indication of cash being tied up in stocks
Low inventory turnover period
▪ Suppliers are reliable, hold less stocks
(Check if payment period drops  if yes, indicate prompt delivery with prompt payment)
▪ Company adopts just in time (JIT) policy
▪ Risks of suffering from stock outs as inventory level are low
▪ Purchase value may be low due to bulk purchasing  decrease inventory value
▪ Products is perishable in nature
(III)
ACCOUNTS PAYABLE PAYMENT PERIOD / CREDITORS DAY
____Trade payables_________ x 365 days
Credit purchases /cost of sales
Purpose  to measure the credit period the company has taken from suppliers
Possible interpretations:
High accounts payable payment period / creditors day
▪ Lack of long-term finance resulted in using extended credit periods to finance expansion
▪ Indication of liquidity problems
▪ Might resulted in damaging relationship with creditors, future renewal of credit is
questionable
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Low accounts payable payment period / creditors day
▪ Company has sufficient cash reserves to pay debts on time
▪ Due to unrecorded payables  payables understated
▪ Due to company's purchases primarily in cash
▪ Company should able to bargain for lower prices or better credit terms
25.2.4 Financial stability/ Long term
solvency
(I)
GEARING / LEVERAGE
Preference shares + Long term liability x 100%
Capital Employed
also knowns as prior charge capital (means carries a right to fixed rate of return regardless of
profit)
or
Preference shares + Long term liability x 100%
Owner equity (exclude preference shares)
Purpose  To measure the level of risk for shareholders
 the higher the gearing, the greater the risk that less profits will be available to be
distributed as ordinary dividend (after paying interest & preference dividend)
Possible interpretations:
High gearing / leverage
▪
▪
▪
▪
▪
Greater risks that little profits will be available to distribute as dividend to shareholders
High borrowings, possibly due to low borrowing rates
Might affect liquidity because the company needs to pay huge interests, thus reduce cash flow
Indication of future borrowings might be difficult & expensive
In a bad year when profits are low, may face difficulties as fixed interest charges must be paid
regardless of profit, might left nothing to pay to shareholders
▪ If money borrowed is invested by the company which produce higher return than the rate of
borrowing, gearing will increase the equity earnings which are beneficial to the shareholders
but comes with higher risk (e.g. compare ROCE % with finance interest %)
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Low gearing / leverage
▪
▪
▪
▪
Low borrowings
Due to repayment of borrowings during the year
Finance through issue of shares
Due to gain on revaluation of non-current asset  owner's equity increase
Example 25.2.4
OSC
Reserves
Shareholder's equity
10% preference shares
Co A ($)
100,000
100,000
200,000
100,000
300,000
Co B ($)
50,000
50,000
100,000
200,000
300,000
Gearing ratio:
Pref shares + Long term liab
Owner equity (exclude pref shares)
%
= 100k/200k
= 50%
%
= 200k/100k
= 200%
Profit made by CO A & B are as follows:
Profit for period 1
Profit for period 2
50,000
20,000
ROOE for period 1:
PAT-pref divd
Owner equity (exclude pref shares)
%
= (50k-10k)/200k
= 20%
50,000
20,000
%
= (50k-20k)/100k
= 30%
When profit is high, a high geared company will give a higher return to its shareholders.
ROOE for period 2:
PAT-pref divd
Owner equity (exclude pref shares)
%
= (20k-10k)/200k
= 5%
%
= (20k-20k)/100k
= 0%
When profit is low, the shareholders of company B assume greater risks and losses.
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(II)
INTEREST COVER
Profit before interest and tax = number of times
Interest charges
Purpose:
▪ to determine whether the company is earning enough profit before interest and tax to pay its
finance costs comfortably
▪ to determine whether a fall in profit before interest and tax will have significant effect on
profit available for ordinary shareholders
Consideration:
Generally, 2-3 times is considered reasonable, 1.5 should be minimum but no fixed answer
Possible interpretations:
High interest cover:
▪ means sufficient profits to meet interest payments
▪ due to low borrowings (company is funded primarily by share capital)
▪ due to borrowings for investment / expansion have helped to generate high profits
Low interest cover:
▪ due to high borrowings (company is possibly over dependant on borrowings for funding)
▪ due to low profit before interest and tax, possibly due to high general overheads costs
▪ indications of increasing risk to lenders that interest payments will not be met
▪ predictor of business failure
▪ vulnerable to small change in operating activities (i.e.: if sales drop, operating expenses
Increase --> result in losses and interest charges would not be covered)
25.2.5 Shareholder’s Investment Ratio
(I)
EARNINGS PER SHARE (EPS)
Net profit - preference dividends
No of ordinary shares
= $x per share
Purpose  help to assess the investment potential of a company's share --> it has major influence
on the company share price movements
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(II)
PRICE / EARNINGS (P/E) RATIO
Share price
Earnings per share
Purpose:
▪ to measure how many times, the earnings the investors are willing to pay for the company’s
shares
▪ represents number of years it would take to recover the cost of investment based on the
earning
Possible interpretations:
High P/E:
▪ indication of strong investor confidence in the company and its future
▪ investors expect the co to perform well in the future/ indication of significant growth
prospects
▪ company shares may be overvalued
Low P/E:
▪ investors lack confidence in the long-term prospects of the company
▪ company shares may be undervalued
(III)
DIVIDEND PER SHARE (DPS)
Ordinary dividend payables + paid
No of ordinary shares
(IV)
DIVIDEND YIELD
Dividend per share
Share price (ex-dividend)
x 100%
Purpose  to measure the return a shareholder is expecting on the share of the company
Possible interpretations:
High dividend yield:
▪ high dividend payout to please the investors or attempt to boost the share price rather than
fund future growth
▪ due to low share price because lack of investor confidence
Low dividend yield:
▪ funds are being retained for expansion or for more profitable investments
▪ share price is high in anticipation of future growth / expansion
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(V)
DIVIDEND COVER
EPS = number of times
DPS
Purpose:
▪ to measure number of times the current year’s dividend could have been paid out of the
current year's earnings
▪ it is a measure of security for the ordinary shareholder
Possible interpretations:
High dividend cover:
▪ high security--> the company's profit in future years could fall substantially and still
maintain its dividend policy
▪ due to low dividend payout policy, possibly profits are retained for future investment/
expansion
Low dividend cover:
▪ due to low profitability --> may be caused by high geared company --> high interest cost
▪ low security to ordinary shareholder
▪ due to high dividend payout policy, possibly the co does not any future expansion plan
▪ if < 1 times means previous years retained earnings were used to pay current year’s
dividend
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25.3
Interpretation of consolidated financial statements
Learning Outcome (ACCA Study Guide Area C)
C2c:
Analyse and interpret ratios to give an assessment of an entity’s/group’s performance and
financial position in comparison with:
i.
ii.
iii.
C2d:
previous period’s financial statements
another similar entity/group for the same reporting period
industry average ratios.
Interpret financial statements to give advice from the perspectives of different stakeholders
When producing a discussion on the performance or position of the consolidated FS, consideration
must be given to the impact of the subsidiary on the FS.
If a subsidiary has been acquired in the year, the following impacts should be considered:
•
•
•
•
•
•
The current year’s financial statements will contain an entity which was not included in the
previous period, so income, expenses, assets and liabilities are all likely to rise following the
consolidation
If the subsidiary has been acquired during the year, it is unlikely to have contributed a full year’s
results in the statement of profit or loss. This could affect ratios such as return on capital
employed or working capital ratios at the year end, as the full assets and liabilities are included
in the statement of financial position, only the post-acquisition income and expenses are included
in the statement of profit or loss
The new subsidiary is likely to have different margins to the rest of the group which will impact
on the interpretation
The new subsidiary Is likely to have different customers, suppliers and inventory, so the working
capital cycle is likely to be different
Acquisition- related costs may have been included in the current period which will not be
repeated in future periods.
A new subsidiary may result in shared assets and synergies occurring within the group, for
example, departments and properties may be merged.
If a subsidiary has been disposed of during the year, the following impacts should be considered:
•
•
•
•
•
Any prior year statement or profit or loss will involve a full year’s results from the subsidiary,
while the current year will not
Any prior year statement on financial position will contain the assets and liabilities relating to the
subsidiary, whereas the current year will not
The statement of profit or loss figures may contain the profit or loss on disposal of the subsidiary,
and the subsidiary’s results up to the date of the disposal
The statement of profit or loss may also contain some one-off costs relating to the disposal of the
subsidiary, such as professional costs or redundancies
The group may lose benefits from the subsidiary, such as supplies to the group, or skills held by
the senior management of the subsidiary.
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25.4
Limitations of Financial Statement
Learning Outcome (ACCA Study Guide Area C)
C1a: Indicate the problems of using historic information to predict future performance and
trends
C1b: Discuss how financial statements may be manipulated to produce a desired effect (creative
accounting, window dressing)
C1c:
Explain why figures in a statement of financial position may not be representative of
average values throughout the period for example, due to:
i.
seasonal trading
ii.
C1d:
major asset acquisitions near the end of the accounting period
Explain how the use of consolidated financial statements might limit interpretation
techniques
(I)
PROBLEMS OF HISTORICAL COST INFORMATION
Historical cost info is reliable and can be verified, but it becomes less relevant as time goes by. In the
time of inflation, Assets in statement in profit or loss are understated  corresponding depreciation
also understated  overstatement of profit
(II)
CREATIVE ACCOUNTING
Listed companies like to produce financial statements which show analysts what they are expecting
to see. For example:
▪
▪
▪
▪
(III)
using provisions to smooth out the profits (big bath provisions) - refer to IAS 37
delaying or advancing invoicing or manipulating cut-offs or accruals
assets can be `sold' under a sale and leaseback agreement, which is in effect a disguised loan
window dressing - loans repaid just before year end and then reversed in the following period
THE EFFECT OF RELATED PARTIES
It is common for entities to carry on activities with or through subsidiaries and associates, or
occasionally to engage in transactions with directors or their families.
Such transactions cannot be assumed to have been engaged in `at arm's length' or in the best interests
of the entity itself. (e.g. transfer pricing can be used to transfer profit from one company to another
and intercompany loans and transfers of non-current asset can also be used in the same way)
(IV)
SEASONAL TRADING
Many companies whose trade is seasonal, position their year-end after their busy period, so that
inventory levels are lower than usual and to minimise time spent on the inventory count. At this point
in time, the statement of financial position will show a healthy level of cash and/or receivable and a
low level of trade payables (assuming most of them have been paid). Thus the position is reported at
the moment when the company is at its most solvent.
A statement of financial position drawn up at a different period in time may give a very different
picture.
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(V)
ASSET ACQUISITIONS
Major asset acquisitions just before the end can also distort results. statement of financial position
will show an increased level of assets and corresponding liabilities (e.g. loan or lease payables), but
the income which will be earned from utilisation of the asset will not yet have materialised. This will
adversely affect the company's ROCE.
(VI)
ONLY INCLUDE QUANTITATIVE FACTORS
Only quantitative factors are taken into account in the financial statements. Qualitative factors such
as reputation & prestige of the business with the public, the efficiency and loyalty of employees, etc.
do not appear in the financial statements.
(VII)
ITEMS BASED ON ESTIMATION TECHNIQUES
In the financial statements, many items are based on estimation techniques (i.e.: depreciation charges
(estimated residual value, estimated useful life), net realisable value of inventory, % of receivables
allowances, etc.). Therefore, financial statements might not be correct and accurate.
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25.5
Limitations of Ratio Analysis
Learning Outcome (ACCA Study Guide Area C)
C2e: Discuss how the interpretation of current value based financial statements would differ from
those using historical cost-based accounts.
C3a: Discuss the limitations in the use of ratio analysis for assessing corporate performance
C3b: Discuss the effect that changes in accounting policies or the use of different accounting polices
between entities can have on the ability to interpret performance
(I)
THE USE OF 'NORMS' CAN BE MISLEADING
A current ratio of 2:1 may be considered ideal, but would be very high ratio for a retailer with few
accounts receivables, while it is very low for a construction company that will have high levels of work
in progress.
(II)
ONE OFF EVENT MAY DISTORT THE RATIOS
Large sales of non-current asset may temporarily boost the current year's profit, but this is not an
indication of sustainable profitability, and could in fact lead to problems in the future.
(III)
DIFFERENT ACCOUNTING POLICIES BETWEEN DIFFERENT COMPANIES
A company adopting a revaluation policy on its non-current asset will have a lower ROCE than a
company that depreciates its non-current asset at historical cost.
(IV)
DIFFERENT ACCOUNTING PRACTICES BTW DIFFERENT COMPANIES
A company that chooses to adopt debtor factoring will have a shorter accounts receivable collection
period than a company that collects its accounts receivable conventionally.
(V)
STATEMENT OF FINANCIAL POSITION AVERAGE
Many ratios are calculated based on year end statement of financial position items when they should
in fact be based on the average throughout the year (e.g. debtor’s day). This can be especially
misleading for companies that have seasonal trading.
(VI)
INFLATION CAN DISTORT TREND ANALYSIS
Inflation will cause comparisons over time to be distorted (e.g. ROCE of a company will improve over
time as revenues continue to rise gradually while statement of financial position items often remains
at book value).
(VII)
DIFFERENT DEFINITIONS OF RATIOS BETWEEN COMPANIES
Ratios are often calculated differently and this may not be apparent, particularly when compared
against industry indexes.
(VIII)
RATIOS ON THEIR OWN ARE MEANINGLESS
Ratios often raise more questions than they provide answers. They are only helpful if looked at in
conjunction with other qualitative methods of analysis (e.g. considering info such as material
disclosures in the financial statement, management's intention and future plan, etc.).
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25.6
Check Understanding
Question 1
Reactive is a publicly listed company that assembles domestic electrical goods which it then sells to
both wholesale and retail customers. Reactive's management were disappointed in the company's
results for the year ended 31 March 20X5. In an attempt to improve performance, the following
measures were taken early in the year ended 31 March 20X6:
•
A national advertising campaign was undertaken,
•
Rebates to all wholesale customers purchasing goods above set quantity levels were introduced,
•
The assembly of certain lines ceased and was replaced by bought in completed products. This
allowed Reactive to dispose of surplus plant.
Reactive's summarised financial statements for the year ended 31 March 20X6 are set out below:
STATEMENT OF PROFIT OR LOSS
Revenue (25% cash sales)
Cost of sales
Gross profit
Operating expenses
$million
4,000
(3,450)
550
(370)
180
40
(20)
200
(50)
150
Profit on disposal of plant (note (i))
Finance charges
Profit before tax
Income tax expense
Profit for the year
STATEMENT OF FINANCIAL POSITION
$million
Non-current assets
Property, plant and equipment (note (i))
Current assets
Inventory
Trade receivables
Bank
Total assets
$million
550
250
360
nil
Equity and liabilities
Equity shares of 25 cents each
Retained earnings
$million
191
610
1,160
$million
100
380
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ACCA Financial Reporting (FR)
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Non-current liabilities
8% loan notes
Current liabilities
Bank overdraft
Trade payables
Current tax payable
Total equity and liabilities
200
10
430
40
480
1,160
Below are ratios calculated for the year ended 31 March 20X5
Return on year end capital employed (profit before interest and tax
over total assets less current liabilities)
Net asset (equal to capital employed) turnover
Gross profit margin
Net profit (before tax) margin
Current ratio
Closing inventory holding period
Trade receivables' collection period
Trade payables' payment period
Dividend yield
Dividend cover
28.1%
4 times
17.0%
6.3%
1.6:1
46 days
45 days
55 days
3.8%
2 times
Notes:
(i)
Reactive received $120 million from the sale of plant that had a carrying amount of $80 million
at the date of its sale.
(ii) The market price of Reactive's shares throughout the year averaged $3.75 each.
(iii) There were no issues or redemption of shares or loans during the year.
(iv) Dividends paid during the year ended 31 March 20X6 amounted to $90 million, maintaining the
same dividend paid in the year ended 31 March 20X5.
Required:
(a)
(b)
Calculate ratios for the year ended 31 March 20X6 (showing your workings) for Reactive,
equivalent to those provided above.
Analyse the financial performance and position of Reactive for the year ended 31 March
20X6 compared to the previous year.
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Solution:
(a)
20X6
Return on year end capital employed (profit before interest and tax over
total assets less current liabilities)
Net asset (equal to capital employed) turnover
Gross profit margin
Net profit (before tax) margin
Current ratio
Closing inventory holding period
Trade receivables' collection period
Trade payables' payment period
Dividend yield
Dividend cover
20X5
28.1%
4 times
17.0%
6.3%
1.6:1
46 days
45 days
55 days
3.8%
2 times
(b) Analysis of the comparative financial performance and position of Reactive for the year ended 31
March 20X6
Profitability
The first thing to notice about Reactive's results. is that the ROCE has increased by 4.2 percentage
points, from 28.1 to 32.3. On the face of it, this is impressive. However, we have to take into
account the fact that the capital employed has been reduced by the plant disposal and the net
profit has been increased by the profit on disposal. So the ROCE has been inflated by this
transaction and we should look at what the ROCE would have been without the disposal. Taking
out the effects of the disposal gives us the following ratios:
ROCE =180/ (680 + 80) x 100 = 23.7%
Net asset turnover = 4,000/760 = 5.3 times
Net profit margin = 160/4,000 x 100 = 4%
Comparing these ratios to those for the period ended 31 March 20X5 we can see that ROCE has
fallen. This fall has been occasioned by a fall in the net profit margin. The asset turnover has
improved on the previous year even after adding back the disposal.
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The net profit margin can be analysed into two factors - the gross profit margin and the level of
expenses. The gross profit percentage is 3.2% down on the previous year. This is probably due to
the rebates offered to wholesale customers, which will have increased sales at the expense of
profitability. The replacement of some production lines by bought in products will probably also
have reduced profit margins. Sales may have been increased by the advertising campaign, but this
has been additional expense charged against net profit. It looks as if management have sought to
boost revenue by any available means. The plant disposal has served to mask the effect on profits.
Liquidity
Reactive's liquidity has also declined over the current year. The current ratio has gone down from
1.6 to 1.3. However, there has also been a sharp decline in the inventory holding period, probably
due to holding less raw material for production. It could be that the finished goods can be delivered
direct to the wholesalers from the supplier. This will have served to reduce the current ratio. The
receivables collection period has remained fairly constant but the payables payment period has
gone down by 10 days. It looks as if, in return for prompt delivery, the finished goods supplier
demands prompt payment. This fall in the payables period will have served to improve the current
ratio. We do not have details of cash balances last year, but Reactive currently has no cash in the
bank and a $10m overdraft. Without the $120m from the sale of plant the liquidity situation would
obviously have been much worse.
Investment ratios
The dividend yield has increased from 3.75% to 6%, which looks good as far as potential investors
are concerned. But we are told that the dividend amount is the same as last year. As there have
been no share issues, this means that the dividend per share is the same as last year. Therefore,
the increase in dividend yield can only have come about through a fall in the share price. The
market is not that impressed by Reactive's results. At the same time the dividend cover has
declined. So the same dividend has been paid on less profit (last year's dividend cover was 2.0, so
profit must have been $180m). Management decided it was important to maintain the dividend,
but this was not sufficient to hold the share price up.
Conclusion:
To conclude, we can say that Reactive's position and performance is down on the previous year
and any apparent improvement is due to the disposal of plant.
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Question 2
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Notes
(i) Both companies operate from similar premises.
(ii) Additional details of the two companies’ plant are:
Grappa
$’000
8,000
nil
Owned plant – cost
Leased plant – original fair value
Merlot
$’000
10,000
7,500
There were no disposals of plant during the year by either company.
(iii) The interest rate implicit within Merlot’s finance leases is 7·5% per annum. For the purpose of calculating
ROCE and gearing, all finance lease obligations are treated as long-term interest bearing borrowings.
(iv) The following ratios have been calculated for Grappa and can be taken to be correct:
Return on year end capital employed (ROCE)
(capital employed taken as shareholders’ funds plus long-term
interest bearing borrowings – see note (iii) above)
Pre-tax return on equity (ROE)
Net asset (total assets less current liabilities) turnover
Gross profit margin
Operating profit margin
Current ratio
Closing inventory holding period
Trade receivables’ collection period
Trade payables’ payment period (using cost of sales)
Gearing (see note (iii) above)
Interest cover
Dividend cover
14·8%
19·1%
1·2 times
12·5%
10·5%
1·2:1
70 days
73 days
108 days
35·3%
6 times
3·6 times
Required:
(a) Calculate for Merlot the ratios equivalent to all those given for Grappa above. (8 marks)
(b) Assess the relative performance and financial position of Grappa and Merlot for the year ended 30
September 2008 to inform the directors of Victular in their acquisition decision. (12 marks)
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Solution:
(a) Equivalent ratios from the financial statements of Merlot (workings in $’000)
Return on year-end capital employed (ROCE)
Pre-tax return on equity (ROE)
Net asset (total assets less current liabilities) turnover
Gross profit margin
Operating profit margin
Current ratio
Closing inventory holding period
Trade receivables’ collection period
Trade payables’ payment period (using cost of sales)
Gearing (see note (iii) above)
Interest cover
Dividend cover
(b) Assessment of the relative performance and financial position of Grappa and Merlot for the year
ended 30 September 2008.
Introduction
This report is based on the draft financial statements supplied and the ratios shown in (a) above.
Although covering many aspects of performance and financial position, the report has been
approached from the point of view of a prospective acquisition of the entire equity of one of the
two companies.
Profitability
The ROCE of 20·9% of Merlot is far superior to the 14·8% return achieved by Grappa. ROCE is
traditionally seen as a measure of management’s overall efficiency in the use of the finance/assets
at its disposal. More detailed analysis reveals that Merlot’s superior performance is due to its
efficiency in the use of its net assets; it achieved a net asset turnover of 2·3 times compared to only
1·2 times for Grappa. Put another way, Merlot makes sales of $2·30 per $1 invested in net assets
compared to sales of only $1·20 per $1 invested for Grappa. The other element contributing to the
ROCE is profit margins. In this area Merlot’s overall performance is slightly inferior to that of
Grappa, gross profit margins are almost identical, but Grappa’s operating profit margin is 10·5%
compared to Merlot’s 9·8%. In this situation, where one company’s ROCE is superior to another’s
it is useful to look behind the figures and consider possible reasons for the superiority other than
the obvious one of greater efficiency on Merlot’s part.
A major component of the ROCE is normally the carrying amount of the non-current assets.
Consideration of these in this case reveals some interesting issues. Merlot does not own its
premises whereas Grappa does. Such a situation would not necessarily give a ROCE advantage to
either company as the increase in capital employed of a company owning its factory would be
compensated by a higher return due to not having a rental expense (and vice versa). If Merlot’s
rental cost, as a percentage of the value of the related factory, was less than its overall ROCE, then
it would be contributing to its higher ROCE. There is insufficient information to determine this.
Another relevant point may be that Merlot’s owned plant is nearing the end of its useful life
(carrying amount is only 22% of its cost) and the company seems to be replacing owned plant with
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leased plant. Again this does not necessarily give Merlot an advantage, but the finance cost of the
leased assets at only 7·5% is much lower than the overall ROCE (of either company) and therefore
this does help to improve Merlot’s ROCE. The other important issue within the composition of the
ROCE is the valuation basis of the companies’ non-current assets. From the question, it appears
that Grappa’s factory is at current value (there is a property revaluation reserve) and note (ii) of
the question indicates the use of historical cost for plant. The use of current value for the factory
(as opposed to historical cost) will be adversely impacting on Grappa’s ROCE. Merlot does not
suffer this deterioration as it does not own its factory.
The ROCE measures the overall efficiency of management; however, as Victular is considering
buying the equity of one of the two companies, it would be useful to consider the return on equity
(ROE) – as this is what Victular is buying. The ratios calculated are based on pre-tax profits; this
takes into account finance costs, but does not cause taxation issues to distort the comparison.
Clearly Merlot’s ROE at 50% is far superior to Grappa’s 19·1%. Again the issue of the revaluation of
Grappa’s factory is making this ratio appear comparatively worse (than it would be if there had not
been a revaluation). In these circumstances it would be more meaningful if the ROE was calculated
based on the asking price of each company (which has not been disclosed) as this would effectively
be the carrying amount of the relevant equity for Victular.
Gearing
From the gearing ratio it can be seen that 71% of Merlot’s assets are financed by borrowings (39%
is attributable to Merlot’s policy of leasing its plant). This is very high in absolute terms and double
Grappa’s level of gearing. The effect of gearing means that all of the profit after finance costs is
attributable to the equity even though (in Merlot’s case) the equity represents only 29% of the
financing of the net assets. Whilst this may seem advantageous to the equity shareholders of
Merlot, it does not come without risk. The interest cover of Merlot is only 3·3 times whereas that
of Grappa is 6 times. Merlot’s low interest cover is a direct consequence of its high gearing and it
makes profits vulnerable to relatively small changes in operating activity. For example, small
reductions in sales, profit margins or small increases in operating expenses could result in losses
and mean that interest charges would not be covered.
Another observation is that Grappa has been able to take advantage of the receipt of government
grants; Merlot has not. This may be due to Grappa purchasing its plant (which may then be eligible
for grants) whereas Merlot leases its plant. It may be that the lessor has received any grants
available on the purchase of the plant and passed some of this benefit on to Merlot via lower lease
finance costs (at 7·5% per annum, this is considerably lower than Merlot has to pay on its 10% loan
notes).
Liquidity
Both companies have relatively low liquid ratios of 1·2 and 1·3 for Grappa and Merlot respectively,
although at least Grappa has $600,000 in the bank whereas Merlot has a $1·2 million overdraft. In
this respect Merlot’s policy of high dividend payouts (leading to a low dividend cover and low
retained earnings) is very questionable. Looking in more depth, both companies have similar
inventory days; Merlot collects its receivables one week earlier than Grappa (perhaps its credit
control procedures are more active due to its large overdraft), and of notable difference is that
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Grappa receives (or takes) a lot longer credit period from its suppliers (108 days compared to 77
days). This may be a reflection of Grappa being able to negotiate better credit terms because it has
a higher credit rating.
Summary
Although both companies may operate in a similar industry and have similar profits after tax, they
would represent very different purchases. Merlot’s sales revenues are over 70% more than those
of Grappa, it is financed by high levels of debt, it rents rather than owns property and it chooses to
lease rather than buy its replacement plant.
Also its remaining owned plant is nearing the end of its life. Its replacement will either require a
cash injection if it is to be purchased (Merlot’s overdraft of $1·2 million already requires serious
attention) or create even higher levels of gearing if it continues its policy of leasing.
In short although Merlot’s overall return seems more attractive than that of Grappa, it would
represent a much riskier investment. Ultimately the investment decision may be determined by
Victular’s attitude to risk, possible synergies with its existing business activities, and not least, by
the asking price for each investment (which has not been disclosed to us).
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Question 3
The summarised consolidated financial statements for the year ended 30 September 20X5 (and the
comparative figures) for the Tangier group are shown below.
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At 1 October 20X4, the Tangier group consisted of the parent, Tangier Co, and two wholly owned
subsidiaries which had been owned for many years. On 1 January 20X5, Tangier Co purchased a third
100% owned investment in a subsidiary called Raremetal Co. The consideration paid for Raremetal Co
was a combination of cash and shares.
The cash payment was partly funded by the issue of 10% loan notes. On 1 January 20X5, Tangier Co
also won a tender for a new contract to supply aircraft engines which Tangier Co manufactures under
a recently acquired long-term licence. Raremetal Co was purchased with a view to securing the supply
of specialised materials used in the manufacture of these engines.
The bidding process had been very competitive and Tangier Co had to increase its manufacturing
capacity to fulfil the contract.
Required:
(a) Comment on how the new contract and the purchase of Raremetal Co may have affected the
comparability of the consolidated financial statements of Tangier Co for the years ended 30
September 20X4 and 20X5. (5m)
(b) Calculate appropriate ratios and comment on Tangier Co’s profitability and gearing. Your analysis
should identify instances where the new contract and the purchase of Raremetal Co have limited
the usefulness of the ratios and your analysis. (12m)
Note: Your ratios should be based on the consolidated financial statements provided and you should
not attempt to adjust for the effects of the new contract or the consolidation. Working capital and
liquidity ratios are not required.
(c) Explain what further information you might require to make your analysis more meaningful.(3m)
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Solution:
(a) Note: References to ‘20X5’ are in respect of the year ended 30 September 20X5 and ‘20X4’ refers
to the year ended 30 September 20X4.
The key matter to note is that the ratios for 20X4 and 20X5 will not be directly comparable because
two significant events, the acquisition of Raremetal Co and securing the new contract, have
occurred between these dates. This means that the underlying financial statements are not directly
comparable. For example, the 20X4 statement of profit or loss (SOPL) will not include the results
of Raremetal Co or the effect of the new contract. However, the 20X5 SOPL will contain nine
months of the results of Raremetal Co (although intra-group transactions will have been
eliminated) and nine months of the effects of the new contract (which may have resulted in either
a net profit or loss). Likewise, the 20X4 statement of financial position does not contain any of
Raremetal Co’s assets and liabilities, whereas that of 20X5 contains all of the net assets of
Raremetal Co and the cost of the new licence. This does not mean that comparisons between the
two years are not worthwhile, just that they need to be treated with caution. For some ratios, it
may be necessary to exclude all of the subsidiaries from the analysis and use the single entity
financial statements of Tangier Co as a basis for comparison with the performance of previous
years. Similarly, it may still be possible to compare some of the ratios of the Tangier group with
those of other groups in the same sector although not all groups will have experienced similar
acquisitions.
Assuming there has been no impairment of goodwill, the investment in Raremetal Co has resulted
in additional goodwill of $30 million which means that the investment has cost more than the
carrying amount of Raremetal Co’s net assets. Although there is no indication of the precise cost,
it is known to have been achieved by a combination of a share exchange (hence the $180 million
new issue of shares) and a cash element (funded from the proceeds of the loan issue and the
decrease in the bank balance). Any intra-group sales have been eliminated on consolidation and it
is not possible to determine in which individual company any profit on these intra-group sales will
be reported; it is therefore difficult to measure any benefits of the investment. Indeed, the benefit
of the investment might not be a financial one but merely to secure the supply of raw materials. It
would be useful to establish the cost of the investment and the profit (if any) contributed by
Raremetal Co so that an assessment of the benefit of the investment might be made.
(b)
Relevant ratios:
ROCE
Gross profit margin
Operating profit margin
Net asset turnover
20X5
Debt/equity
Interest cover
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All of the issues identified in part (a) make a comparison of ratios difficult and, if more information
was available, then some adjustments may be required. For example, if it is established that the
investment is not generating any benefits, then it might be argued that the inclusion of the goodwill
in the ROCE and asset turnover is unjustified (it may be impaired and should be written off). Goodwill
has not been excluded from any of the following ratios.
The increase in revenues of 48·4% (880/1,820 x 100) in 20X5 will be partly due to the consolidation of
Raremetal Co and the revenues associated with the new contract. Yet, despite these increased
revenues, the company has suffered a dramatic fall in its profitability. This has been caused by a
combination of a falling gross profit margin (from 40% in 20X4 to only 30% in 20X5) and markedly
higher operating overheads (operating profit margin has fallen from 21·9% in 20X4 to 8·7% in 20X5).
Again, it is important to note that some of these costs will be attributable to the consolidation of
Raremetal Co and some to the new contract.
It could be speculated that the 73% increase in administrative expenses may be due to one-off costs
associated with the tendering process (consultancy fees, etc.) and the acquisition of Raremetal Co and
the 77% increase in higher distribution costs could be due to additional freight/packing/insurance cost
of the engines, delivery distances may also be longer (even to foreign countries) (although some of
the increase in distribution costs may also be due to consolidation).
This is all reflected in the ROCE falling from an impressive 61·7% in 20X4 to only 19·5% in 20X5 (though
even this figure is respectable). The fall in the ROCE is attributable to a dramatic fall in profit margin
at operating level (from 21·9% in 20X4 to only 8·7% in 20X5) which has been compounded by a
reduction in the asset turnover, with only $2·24 being generated from every $1 invested in net assets
in 20X5 (from $2·82 in 20X4).
The information in the question points strongly to the possibility (even probability) that the new
contract may be responsible for much of the deterioration in Tangier Co’s operating performance. For
example, it is likely that the new contract may account for some of the increased revenue; however,
the bidding process was ‘very competitive’ which may imply that Tangier Co had to cut its prices (and
therefore its profit margin) in order to win the contract.
The costs of fulfilling the contract have also been heavy: investment in property, plant and equipment
has increased by $370 million (at carrying amount), representing an increase of 61% (no doubt some
of this increase will be due to the acquisition of Raremetal Co). The increase in licence costs to
manufacture the new engines has cost $200 million plus any amortisation and there is also the
additional goodwill of $30 million.
An eight-fold increase in finance cost caused by the increased borrowing at double the interest rate
of the borrowing in 20X4 and (presumably) some overdraft interest has led to the dramatic fall in the
company’s interest cover (from 79·6 in 20X4 to only 5·9 in 20X5). The finance cost of the new $300
million 10% loan notes to partly fund the investment in Raremetal Co and other non-current assets
has also increased debt/equity (one form of gearing measure) from 18·3% in 20X4 to 49·7% in 20X5
despite also issuing $180 million in new equity shares. At this level, particularly in view of its large
increase from 20X4, it may give debt holders (and others) cause for concern as there is increased risk
for all Tangier Co’s lenders. If it could be demonstrated that the overdraft could not be cleared for
some time, this would be an argument for including it in the calculation of debt/equity, making the
20X5 gearing level even worse. It is also apparent from the movement in the retained earnings that
Tangier Co paid a dividend during 20X5 of $55 million (295,000 + 135,000 – 375,000) which may be a
questionable policy when the company is raising additional finance through borrowings and
contributes substantially to Tangier Co’s overdraft. Overall, the acquisition of Raremetal Co to secure
supplies appears to have been an expensive strategy, perhaps a less expensive one might have been
to enter into a long-term supply contract with Raremetal Co.
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(c) Further information which would be useful to obtain would therefore include:
(i) The cost of the investment in Raremetal Co, the carrying amount of the assets acquired and
whether Tangier Co has carried out a goodwill impairment test as required under IFRS.
(ii) The benefits generated from the investment; for example, Raremetal Co’s individual financial
statements and details of sales to external customers (not all of these benefits will be
measurable in financial terms).
(iii) The above two pieces of information would demonstrate whether the investment in Raremetal
Co had been worthwhile.
(iv) The amount of intra-group sales made during the year and those expected to be made in the
short to medium term.
(v) The pricing strategy agreed with Raremetal Co so that the effects on the profits reported in the
individual financial statements of Raremetal Co and Tangier Co can be more readily determined.
(vi) More information is needed to establish if the new contract has been detrimental to Tangier
Co’s performance. The contract was won sometime between 1 October 20X4 and 1 January
20X5 and there is no information of when production/sales started, but clearly there has not
been a full year’s revenue from the contract. Also there is no information on the length or total
value of the contract.
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25.7
Chapter 25 Summary
Diagram 25.7.: Summary of Interpretation of Financial Statement
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CHAPTER 26: IAS 21 THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
CHAPTER 26: IAS 21 THE EFFECTS OF
CHANGES IN FOREIGN EXCHANGE
RATES
LEARNING OUTCOME
At the end of the chapter, you should be able to:
TLO B12a. Explain the difference between functional and presentation currency and why
adjustments for foreign currency transactions are necessary.
TLO B12b. Account for the translation of foreign currency transactions and monetary/nonmonetary foreign currency items at the reporting date.
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26.1
Overview
Learning Outcome (ACCA Study Guide Area B)
B12a: Explain the difference between functional and presentation currency and explain why
adjustments for foreign currency transactions are necessary
Business go global in two ways:
▪
▪
have individual transactions in foreign currencies, or;
when they grow bigger, they often set up foreign operations (separate business abroad)
An entity may carry on foreign activities in either of the two ways:
a. An entity which buys or sells goods overseas, priced in a foreign currency for example, a UK company
might buy materials from Canada, pay for them in US dollars, then sell its finished goods in Germany,
receiving payment in Euros or some other currency. This is foreign currency transactions.
b. The translation of foreign currency subsidiary financial statements prior to consolidation.
A UK company might have a subsidiary abroad (i.e. a foreign entity that it owns), and the subsidiary
will trade in its own local currency. The subsidiary will keep books of account and prepare its annual
financial statements in its own currency. However, at the year end, the parent company must
'consolidate' the results of the overseas subsidiary into its group accounts. Therefore, the assets
and liabilities and the annual profits of the subsidiary must be translated from the foreign currency
into pounds sterling.
The objective of IAS 21 is to produce rules that entities should follow in the translation of foreign
currency activities.
26.1.1 Scope of IAS 21
IAS 21 applies in the following cases:
• In accounting for transactions and balances in foreign currencies except for those derivative
transactions and balances that are within the scope of IFRS 9 Financial Instruments
• In translating the results and financial position of foreign operations that are included in the
financial statements of the entity by consolidation or the equity method
• In translating an entity's results and financial position into a presentation currency
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26.1.2 Definition
Closing rate is the spot exchange rate at the SOFP date
Exchange difference is the different resulting from translating a given number of units of one currency
into another currency at different exchange rate.
Exchange rate is the ratio of exchange for two currencies
Foreign currency is a currency other than the functional currency
Functional currency is the currency of the primary economic environment (PEE) in which the entity
operates
Presentation currency is the currency in which the financial statements are presented
26.1.3 Scope of IAS 21
The objective of IAS 21 The Effects of Changes in Foreign Exchange Rates is to prescribe:
▪
▪
How to include foreign currency transactions and foreign operations in the financial statements
of an entity; and
How to translate financial statements into a presentation currency.
Functional vs Presentation Currency
is the currency of the primary economic
environment in which the entity operates
All other currencies are “foreign currencies”
208
Is the currency in which
the FS are presented
ACCA Financial Reporting (FR)
CHAPTER 26: IAS 21 THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
Sources: www.ifrsbox.com
In most cases, functional and presentation currencies are the same.
However, an entity can decide to present its financial statements in a currency different from its
functional currency, when preparing consolidation reporting package for its parent in a foreign
country.
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26.2
Determinant for Functional Currency
The most important factor in determining the functional currency is the entity’s primary economic
environment in which it operates.
currency in which the entity primarily generates and expends cash
INDICATORS OF FUNCTIONAL CURRENCY
▪
▪
▪
▪
What currency that mainly influence sales prices for goods and services?
In what currency are the labour, material and other costs denominated and settled?
In what currency are funds from financing activities generated (loans, issued equity
instruments)?
In what currency in which receipts from operating activities are usually retained?
Sometimes, sales prices, labour and material costs and other items might be denominated in various
currencies and therefore, the functional currency is not obvious.
In this case, management must use its judgment to determine the functional currency that most
faithfully represents the economic effects of the underlying transactions, events and conditions.
How to Report Foreign Exchange Differences
All exchange rate differences shall be recognized in profit or loss, with the following exceptions:
Exchange rate gains or losses on non-monetary items are recognized consistently with the recognition
of gains or losses on an item itself.
For example, when an item is revalued with the changes recognized in OCI, then also exchange rate
component of that gain or loss is recognized in OCI, too.
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CHAPTER 26: IAS 21 THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
26.3
Transactions in Foreign Currency
Learning Outcome (ACCA Study Guide Area B)
B12b: Account for the translation of foreign currency transactions and monetary/non-monetary
foreign currency items at the reporting date
Co A (Reporting entity)
Functional currency = USD
buy/ sell
Co B (foreign co)
Other / Foreign currency
Co A is exposed to exchange rate risk only if
transaction is fixed in 'foreign currency'
Cash Transaction
Translate ONCE at Historical rate (HR)
(Spot rate (SR) at the date of transaction)
Credit Transaction
Date of transaction Date of settlement
GAP
No exchange G/ (L)
E.g. Cash sales RM100,000
Functional currency USD
1 USD = RM4
within the year
Trans entered &
settled in SAME YR
Trans entered &
settled in FUTURE YR
next year
DOT
Initial at HR
DOS
Subsq at SR
DOT
Initial at HR
Year End at DOR
Subsq at CR
DOS
Subsq at SR
Exchange G/(L) recog to SOPL in current yr
or over many years (if settled in future yr)
Year End at DOR
t Items
Monerary
No of units of currency is fixed/ constant
Non-monetary items
Prices/ values will fluctuate
NCA & Inventory
Translate ONCE at Historical rate (HR)
Do not retranslate at DOR
Assets other than
NCA & Inventory
Exception to basic rule
Remeasurement (E.g. Revl model) give
rise to Exchange G/(L)
All liability
are monetary
E.g. 1. Cash and bank balances
2. Receivables and payables
3. Loan receivables and payables
Translate stage by stage
(Retranslate using CR - give rise to exchange G/ (L)
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CHAPTER 26: IAS 21 THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
26.4
Check Understanding
Question 1
On 1 May 20X6, an entity with a functional currency of $ sold goods to a German entity for €48,000.
On this date, the rate of exchange was $1=€3.2.
Initial measurement
The sale is translated into ___________ currency using exchange rate at the DOT.
Workings:
Subsequent measurement
At DOR of 31 July 20X6, the invoice had not been settled. The exchange date of DOR was $1=€3.4.
Receivables are an______________ item so must be ______________ into functional currency using
____________ rate.
Receivables at year end = $______________
Question 2
An entity has a functional currency of $, accounts for land using Cost Model in IAS 16. On 1 July
20X6, the entity purchased a plot of land in another country for 1.2m dinars.
Relevant exchange rate:
1 July 20X6 (DOT)
30 June 20X7 (DOR)
$1 = 4 Dinars
$1 = 3 Dinars
Initial measurement
The land is translated into ___________ currency using exchange rate at the DOT (purchase date).
Workings:
Subsequent measurement
At the DOR 30 June 20x7, the land is not retranslated as land is a _____________________.
Therefore, the land will be remained at $_____________.
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CHAPTER 26: IAS 21 THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
Question 3
An entity has a functional currency of $, accounts for land using Revaluation Model in IAS 16. On 1
July 20X6, the entity purchased a plot of land in another country for 1.2m dinars. At 30 June 20X7,
the FV of the land was 1.5m dinars.
Relevant exchange rate:
1 July 20X6 (DOT)
30 June 20X7 (DOR)
$1 = 4 Dinars
$1 = 3 Dinars
Initial measurement
The land is translated into ___________ currency using exchange rate at the DOT (purchase date).
Workings:
Subsequent measurement
At the DOR 30 June 20x7, the land's COST is not retranslated as land is a ________________
This mean the land will be revalued to $________________.
Workings:
Question 4
An entity, Butler, has a reporting date of 31 December and functional currency of USD. On 27
November 20X6, Butler plc buys goods from a Swedish supplier for SWK 324,000
On 19 December 20X6, Butler plc pays the Swedish supplier in full.
Exchange rates were as follows:
27 November 20X6 $1 = SWK 11.15
19 December 20X6 $1 = SWK 10.93
Show how the expense and liability, together with the exchange difference arising, should be
accounted for in the financial statements.
(i) 27 November 20X6 $1 = SWK 11.15
(ii) 19 December 20X6 $1 = SWK 10.93
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CHAPTER 26: IAS 21 THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
Question 5
An entity, Waiter, which has a reporting date of 31 December and the dollar ($) as its functional
currency borrows in the foreign currency of the Kram(K). The loan of K120,000 was taken out on 1
January 20X7. A repayment of K40,000 was made on 1 March 20X7.
The following rates of exchange are relevant:
1 January 20X7
1 March 20X7
31 December 20X7
K1 to $
K1: $2
K1: $3
K1: $3.5
Prepare the SOPL and SOFP extracts for the year ended 31 Dec 20X7.
Solution:
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CHAPTER 26: IAS 21 THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
Question 6
An entity, Attendant, which has a reporting date of 31 December, has the dollar $ as its functional
currency purchased a plot of land overseas on 1 March 20X0. The entity paid for the land in the
currency of the Rylands (R). The purchase cost of the land at was R60,000. The value of the land at
the reporting date was R80,000.
The following rates of exchange are relevant:
1 March 20X0
31 December 20X0
R8:$1
R10:$1
Prepare the SOPL &OCI and SOFP extracts for year ended 31 Dec 20X0 if the land is measured at:
(a)
Cost
(b)
Fair value
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CHAPTER 26: IAS 21 THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
Question 7
Highlight is an entity whose functional currency is $. On 1 Jul 20X6, Highlight purchased a plant &
equipment on credit for Dn400,000. On 1 Nov 20X6, Highlight made a payment of Dn180,000 to the
supplier. The balance of the invoice remains outstanding.
Highlight using cost model for PPE and depreciating using 20% p.a. The P&E has no residual value at
the end of its useful life.
The following rates of exchange are relevant:
1 Jul 20X6
1 Nov 20X6
31 Dec 20X6
$1=
Dn10
Dn7.2
Dn8
Prepare the SOPL &OCI and SOFP extracts for the year ended 31 Dec 20X6.
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CHAPTER 26: IAS 21 THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
Question 8
Highlighter is an entity whose functional currency is $. On 1 Nov 20X6, Highlighter made a credit sale
to Eraser for Dn360,000.
On 1 Dec 20X6, Highlighter made further credit sales to Eraser for Dn540,000.
By 31 Dec 20X6, Highlighter had received no payment from Eraser.
The following rates of exchange are relevant:
1 Nov 20X6
1 Dec 20X6
31 Dec 20X6
$1=
Dn7.2
Dn9
Dn8
Prepare the SOPL and SOFP extracts for the year ended 31 Dec 20X6.
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CHAPTER 26: IAS 21 THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
26.5
Chapter 21 Summary
Diagram 26.5.: Summary of IAS 21 The effect of changes in foreign exchange rate
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CHAPTER 27: IAS 41 AGRICULTURE
CHAPTER 27: IAS 41 AGRICULTURE
LEARNING OUTCOME
At the end of the chapter, you should be able to:
TLO B4b.
Apply the requirements of relevant accounting standards for biological assets
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CHAPTER 27: IAS 41 AGRICULTURE
27.1
Overview
IAS 41 Agriculture sets out the accounting for agricultural activity – the transformation of biological
assets (living plants and animals) into agricultural produce (harvested product of the entity's biological
assets). The standard generally requires biological assets to be measured at fair value less costs to sell.
IAS 41 was originally issued in December 2000 and first applied to annual periods beginning on or after
1 January 2003.
27.1.1 Scope
To prescribe the accounting treatment and disclosures related to agricultural activity.
27.1.2 Scope
This standard shall be applied to account for the following when they relate to agricultural activity:
(a) biological assets excluding bearer plants;
(b) agricultural produce at the point of harvest; and
(c) Government grants
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The table below provides examples of biological assets, agricultural produce, and products that are
the result of processing after harvest:
This standard is applied to agricultural produce, which is the harvested product of the entity's
biological assets, up to the point of harvest. Thereafter, IAS 2 Inventories or another applicable
standard is applied. Accordingly, this standard does not deal with the processing of agricultural
produce after harvest; for example, the processing of grapes into wine by a vintner who has grown
the grapes.
While such processing may be a logical and natural extension of agricultural activity, and the events
taking place may bear some similarity to biological transformation, such processing is not included
within the definition of agricultural activity in this standard.
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27.2
Definition
Agricultural activity
The management by an entity of the biological transformation and harvest of biological assets for
sale or for conversion into agricultural produce, or into additional biological assets.
is the harvested
product of the
entity's biological
assets.
comprises the processes of
growth, degeneration,
production, and procreation
that cause qualitative or
quantitative changes in a
biological asset
is a living
animal or
plant
Biological transformation results in the following types of outcomes:
a. asset changes through
(i) growth (an increase in quantity or improvement in quality of an animal or plant),
(ii) degeneration (a decrease in the quantity or deterioration in quality of an animal or plant), or
(iii) procreation (creation of additional living animals or plants); or
b. production of agricultural produce such as latex, tea leaf, wool, and milk.
The fair value of an asset is based on its present location and condition. As a result, for example, the
fair value of cattle at a farm is the price for the cattle in the relevant market less the transport and
other costs of getting the cattle to that market.
27.3
Recognition
An entity shall recognise a biological asset or agricultural produce when, and only when:
(a)
(b)
(c)
the entity controls the asset as a result of past events;
it is probable inflow of future economic benefits
the fair value or cost of the asset can be measured reliably
The Conceptual Framework 2018 defines Assets as ‘A present economic resource controlled by the
entity as a result of past events. An economic resource is a right that has the potential to produce
economic benefits’.
**It is important to note that the definition of asset in this standard was not revised following the
revision of the definition of an asset in the Conceptual Framework for Financial Reporting issued in
2018.
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27.4
Measurement
Learning Outcome (ACCA Study Guide Area B)
B4B: Apply the requirements of relevant accounting standards for biological assets
A biological asset shall be measured on initial recognition and at the end of each reporting period at
its fair value less costs to sell.
Agricultural produce harvested from an entity's biological assets shall be measured at its fair value
less costs to sell at the point of harvest.
Gains and losses
A gain or loss arising on initial recognition of a biological asset and agricultural produce at fair value
less costs to sell and from a change in fair value less costs to sell of a biological asset shall be included
in profit or loss for the period in which it arises.
Inability to measure fair value reliably
There is a presumption that fair value can be measured reliably for a biological asset. However, that
presumption can be rebutted only on initial recognition for a biological asset for which marketdetermined prices or values are not available and for which alternative estimates of fair value are
determined to be clearly unreliable. In such a case, that biological asset shall be measured at its cost
less any accumulated depreciation and any accumulated impairment losses.
Once the fair value of such a biological asset becomes reliably measurable, an entity shall measure it
at its fair value less costs to sell. Once a non-current biological asset meets the criteria to be classified
as held for sale (or is included in a disposal group that is classified as held for sale) in accordance with
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations, it is presumed that fair value
can be measured reliably.
In all cases, an entity measures agricultural produce at the point of harvest at its fair value less costs
to sell. This standard reflects the view that the fair value of agricultural produce at the point of harvest
can always be measured reliably.
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CHAPTER 27: IAS 41 AGRICULTURE
27.5
Government grants
An unconditional government grant related to a biological asset measured at its fair value less costs
to sell shall be recognised in profit or loss when, and only when, the government grant becomes
receivable.
If a government grant related to a biological asset measured at its fair value less costs to sell is
conditional, including when a government grant requires an entity not to engage in specified
agricultural activity, an entity shall recognise the government grant in profit or loss when, and only
when, the conditions attaching to the government grant are met.
Example
A grant may require an entity to farm in a particular location for five years and require the entity to
return all of the grant if it farms for a period shorter than five years. In this case, the grant is not
recognised in profit or loss until the five years have passed. However, if the terms of the grant allow
part of it to be retained according to the time that has elapsed, the entity recognises that part in profit
or loss as time passes.
If a government grant relates to a biological asset measured at its cost less any accumulated
depreciation and any accumulated impairment losses, IAS 20 Accounting for Government Grants and
Disclosure of Government Assistance is applied.
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27.6
Check Understanding
Question 1
What are the recognition criteria’s for recognising a biological asset?
(a)
(b)
(c)
Question 2
When should an unconditional and conditional government grant related to biological asset
measured at fair value less cost to sell be recognised in the SOPL?
Question 3
At what measurement should a biological asset be measured at on initial recognition, at the point
of harvest and at the end of each reporting period?
Solution:
Question 1
(a) The entity controls the assets as a result of past events
(b) There is probable inflow of future economic benefits
(c) The fair value or cost of the asset can be measured reliably
Question 2
Unconditional grant – when the grant becomes receivable
Conditional grant – when the conditions are met
Question 3
Fair value less costs to sell on initial recognition, at the point of harvest and at the end of each
reporting period
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CHAPTER 27: IAS 41 AGRICULTURE
27.7
Chapter 27 Summary
Diagram 27.7.: Summary of IAS 41 Agriculture
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ACCA Financial Reporting (FR)
CHAPTER 28: IFRS 13 FAIR VALUE MEASUREMENT
CHAPTER 28: IFRS 13 FAIR VALUE
MEASUREMENT
LEARNING OUTCOME
At the end of the chapter, you should be able to:
TLO 28a.
Understand the principles and apply ‘fair value’ measurement for assets and liabilities
presented in the financial statements.
TLO 28b.
Determine and measurement of fair value using the ‘fair value hierarchy’.
TLO 28c.
Discuss and apply the principles of highest and best use, most advantageous and
principal market.
TLO 28d.
Explain the circumstances where an entity may use a valuation technique.
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CHAPTER 28: IFRS 13 FAIR VALUE MEASUREMENT
28.1
Relational Mapping
28.2
Definition
That definition of fair value emphasises that fair value is a market-based measurement, not an entityspecific measurement.
When measuring fair value, an entity uses the assumptions that market participants would use when
pricing the asset or liability under current market conditions, including assumptions about risk. As a
result, an entity’s intention to hold an asset or to settle or otherwise fulfil a liability is not relevant
when measuring fair value.
For some assets and liabilities, observable market transactions or market information might be
available. For other assets and liabilities, observable market transactions and market information
might not be available, hence, unobservable inputs may be used.
When a price for an identical asset or liability is not observable, an entity measures fair value using
another valuation technique that maximises the use of relevant observable inputs and minimises
the use of unobservable inputs.
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28.3
Consistency of Accounting Policies
The IFRS explains that a fair value measurement requires an entity to determine the following:
(i) the particular asset or liability being measured;
(ii) the market in which an orderly transaction would take place for the asset or liability;
(iii) for a non-financial asset, the highest and best use of the asset; and
(iv) the appropriate valuation technique(s) to use when measuring fair value.
28.3.1 The particular asset or liability being measured
15.1.7
A fair value measurement is for a particular asset or liability.
Therefore, when measuring fair value an entity shall take into account the characteristics of the asset
or liability if market participants would take those characteristics into account when pricing the
asset or liability at the measurement date. Such characteristics include, the following:
a. the condition and location of the asset; and
b. restrictions, if any, on the sale or use of the asset.
The effect on the measurement arising from a particular characteristic will differ depending on how
that characteristic would be taken into account by market participants.
The asset or liability measured at fair value might be either of the following:
a. a stand-alone asset or liability (e.g. a financial instrument or a non-financial asset); or
b. a group of assets, a group of liabilities or a group of assets and liabilities (e.g. a cash-generating
unit or a business).
Whether the asset or liability is a stand-alone asset or liability, a group of assets, a group of liabilities
or a group of assets and liabilities (cash generating units) for recognition or disclosure purposes
depends on its unit of account.
*Unit of account: The level at which an asset or a liability is aggregated or disaggregated in an
IFRS for recognition purposes.
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28.3.2 The market in which an orderly transaction would take place for the asset or liability
15.1.8
A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes
place either:
a) in the principal market for the asset or liability;
*principal market: The market with the greatest volume and level of activity for the asset or
liability.
b) in the absence of a principal market, in the most advantageous market for the asset or liability.
*most advantageous market: The market that maximises the amount that would be received
to sell the asset or minimises the amount that would be paid to transfer the liability, after
taking into account transaction costs and transport costs.
The market in which the entity would normally enter into a transaction to sell the asset or to transfer
the liability is presumed to be the principal market or, in the absence of a principal market, the most
advantageous market.
If there is a principal market for the asset or liability, the fair value measurement shall represent the
price in that market (whether that price is directly observable or estimated using another valuation
technique), even if the price in a different market is potentially more advantageous at the
measurement date.
i)
Market Participant
An entity shall measure the fair value of an asset or a liability using the assumptions that market
participants would use when pricing the asset or liability, assuming that market participants act in
their economic best interest.
Buyers and sellers in the principal (or most advantageous) market for the asset or liability that have
all of the following characteristics:
1. They are independent of each other, E.g. they are not related parties as defined in IAS 24,
although the price in a related party transaction may be used as an input to a fair value
measurement if the entity has evidence that the transaction was entered into at market terms.
2. They are knowledgeable, having a reasonable understanding about the asset or liability and the
transaction using all available information, including information that might be obtained through
due diligence efforts that are usual and customary.
3. They are able to enter into a transaction for the asset or liability.
4. They are willing to enter into a transaction for the asset or liability, i.e. they are motivated but
not forced or otherwise compelled to do so.
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ii) The Price
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction in the principal (or most advantageous) market at the measurement date under current
market conditions (E.g. an exit price) regardless of whether that price is directly observable or
estimated using another valuation technique.
* exit price: The price that would be received to sell an asset or paid to transfer a liability.
The price in the principal (or most advantageous) market used to measure the fair value of the asset
or liability shall not be adjusted for transaction costs.
Transaction costs do not include transport costs.
If location is a characteristic of the asset (as might be the case, for example, for a commodity), the
price in the principal (or most advantageous) market shall be adjusted for the costs, if any, that
would be incurred to transport the asset from its current location to that market.
Example 28.2 1
An asset is sold in two different active markets at different prices. An entity enters into transactions
in both markets and can access the price in those markets for the asset at the measurement date. In
Market A, the price that would be received is $26, transaction costs in that market are $3 and the
costs to transport the asset to that market are $2 (i.e. the net amount that would be received is $21).
In Market B, the price that would be received is $25, transaction costs in that market are $1 and the
costs to transport the asset to that market are $2 (i.e. the net amount that would be received in
Market B is $22).
If Market A is the principal market for the asset (i.e. the market with the greatest volume and level of
activity for the asset), the fair value of the asset would be measured using the price that would be
received in that market, after taking into account transport costs ($24).
If neither market is the principal market for the asset, the fair value of the asset would be measured
using the price in the most advantageous market. The most advantageous market is the market that
maximises the amount that would be received to sell the asset, after taking into account transaction
costs and transport costs (i.e. the net amount that would be received in the respective markets).
Because the entity would maximise the net amount that would be received for the asset in Market B
($22), the fair value of the asset would be measured using the price in that market ($25), less transport
costs ($2), resulting in a fair value measurement of $23. Although transaction costs are taken into
account when determining which market is the most advantageous market, the price used to measure
the fair value of the asset is not adjusted for those costs (although it is adjusted for transport costs).
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28.3.3 For a non-financial asset, the highest and best use of the asset
15.1.9
A fair value measurement of a non-financial asset takes into account a market participant’s ability to
generate economic benefits by using the asset in its HIGHEST AND BEST USE or by selling it to another
market participant that would use the asset in its highest and best use.
The use of a non-financial asset by market participants that would maximise the value of the asset or
the group of assets and liabilities (e.g. a business) within which the asset would be used.
The highest and best use of a non-financial asset (i.e.: land) takes into account the followings:
i.
ii.
iii.
i)
Physically possible
takes into account the physical characteristics of the asset that market participants would
take into account when pricing the asset (e.g. the location or size of a property)
Legally permissible
takes into account any legal restrictions on the use of the asset that market participants
would take into account when pricing the asset (e.g. the zoning regulations applicable to a
property).
Financially feasible
takes into account whether a use of the asset that is physically possible and legally
permissible generates adequate income or cash flows (taking into account the costs of
converting the asset to that use) to produce an investment return that market participants
would require from an investment in that asset put to that use.
Valuation premise
The highest and best use of a non-financial asset establishes the valuation premise used to measure
the fair value of the asset. In other words, in determining whether the asset should be valued on:
a. a stand-alone basis, or
b. as a group in combination with other assets (or with other assets and liabilities)
Highest and best use is determined from the perspective of market participants, even if the entity
intends a different use.
However, an entity’s current use of a non-financial asset is presumed to be its highest and best use
unless market or other factors suggest that a different use by market participants would maximise
the value of the asset.
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Example 28.2.3 (a)
To protect its competitive position, or for other reasons, an entity may intend not to use an acquired
non-financial asset actively or it may intend not to use the asset according to its highest and best use.
For example, that might be the case for an acquired intangible asset that the entity plans to use
defensively by preventing others from using it.
Nevertheless, the entity shall measure the fair value of a non-financial asset assuming its highest and
best use by market participants.
Example 28.2.3 (b) (Asset group)
An entity acquires assets and assumes liabilities in a business combination. One of the groups of assets
acquired comprises Assets A, B and C. Asset C is billing software integral to the business developed by
the acquired entity for its own use in conjunction with Assets A and B (i.e. the related assets). The
entity measures the fair value of each of the assets individually, consistently with the specified unit of
account for the assets.
The entity determines that the highest and best use of the assets is their current use and that each
asset would provide maximum value to market participants principally through its use in combination
with other assets or with other assets and liabilities (i.e. its complementary assets and the associated
liabilities). There is no evidence to suggest that the current use of the assets is not their highest and
best use.
In this situation, the entity would sell the assets in the market in which it initially acquired the assets
(i.e. the entry and exit markets from the perspective of the entity are the same). Market participant
buyers with whom the entity would enter into a transaction in that market have characteristics that
are generally representative of both strategic buyers (such as competitors) and financial buyers (such
as private equity or venture capital firms that do not have complementary investments) and include
those buyers that initially bid for the assets.
Although market participant buyers might be broadly classified as strategic or financial buyers, in
many cases there will be differences among the market participant buyers within each of those
groups, reflecting, for example, different uses for an asset and different operating strategies.
As discussed below, differences between the indicated fair values of the individual assets relate
principally to the use of the assets by those market participants within different asset groups:
a. STRATEGIC BUYER ASSET GROUP.
The entity determines that strategic buyers have related assets that would enhance the value of
the group within which the assets would be used (i.e. market participant synergies). Those assets
include a substitute asset for Asset C (the billing software), which would be used for only a limited
transition period and could not be sold on its own at the end of that period.
Because strategic buyers have substitute assets, Asset C would not be used for its full remaining
economic life. The indicated fair values of Assets A, B and C within the strategic buyer asset group
(reflecting the synergies resulting from the use of the assets within that group) are $360, $260
and $30, respectively. The indicated fair value of the assets as a group within the strategic buyer
asset group is $650.
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b. FINANCIAL BUYER ASSET GROUP.
The entity determines that financial buyers do not have related or substitute assets that would
enhance the value of the group within which the assets would be used. Because financial buyers
do not have substitute assets, Asset C (i.e. the billing software) would be used for its full
remaining economic life.
The indicated fair values of Assets A, B and C within the financial buyer asset group are $300,
$200 and $100, respectively. The indicated fair value of the assets as a group within the financial
buyer asset group is $600.
The fair values of Assets A, B and C would be determined on the basis of the use of the assets as a
group within the strategic buyer group ($360, $260 and $30). Although the use of the assets within
the strategic buyer group does not maximise the fair value of each of the assets individually, it
maximises the fair value of the assets as a group ($650).
28.3.4 Valuation techniques to measure FV
15.1.10
An entity shall use valuation techniques that are appropriate in the circumstances and for which
sufficient data are available to measure fair value, maximising the use of relevant observable inputs
and minimising the use of unobservable inputs.
The assumptions that market participants would use when pricing the asset or liability, including
assumptions about risk.
Inputs may be observable or unobservable.
*Observable: Inputs that are developed using market data, such as publicly available information
about actual events or transactions, and that reflect the assumptions that market participants would
use when pricing the asset or liability.
*Unobservable: Inputs for which market data are not available and that are developed using the
best information available about the assumptions that market participants would use when pricing
the asset or liability.
Three widely used valuation techniques are:
Valuation
technique
Definition
Typical inputs
(assumptions)
Specific valuation
methods
Market approach
A valuation technique
that uses price& other
relevant information
generated by market
transactions involving
identical or
comparable assets,
liabilities or a group of
assets & liabilities such
as a business
The FV & yield to
maturity on a corporate
bond on an active
market that has a similar
credit quality to the
instrument being valued
Example are matrix
pricing & market
pricing based on
recent transactions
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Items that may be
valued using this
technique
•
Real estate
•
Financial
instrument such
as swaps, debt
securities/ equity
instruments
•
Intangibles that
has an active
market for a
homogenous
asset e.g. taxi
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CHAPTER 28: IFRS 13 FAIR VALUE MEASUREMENT
Cost approach
A valuation technique
that reflects the
amount that would be
required currently to
replace the service
capacity of an asset
(referred to as current
replacement cost)
Estimated costs using
quantity surveyors &
builders, remaining
useful life estimates
reflecting physical &
economic/technological
factors
Depreciated
replacement cost
method
Valuation
technique
Definition
Typical inputs
(assumptions)
Specific valuation
methods
Income approach
Valuation technique
that convert future
amounts (e.g. cash
flows or income &
expenses) to a single
current (i.e.
discounted) amount.
The FV measurement
is determined on the
basis of the value
indicated by current
market expectations
about those future
amounts.
Discount rate, income
stream (e.g. rental,
royalties, sales,
remaining economic
life).
For a financial
instrument, inputs may
include current share
price, risk free interest
rate, time until option
expiration and option
strike price.
•
•
Tangible assets
such as plant &
equipment
Infrastructure
assets e.g.
bridges
Items that may be
valued using this
technique
Example discounted •
A cash generating
cash flow method &
unit.
multi period excess •
Intangible assets
earnings. Black
that generate an
Scholes Merton
income stream
option pricing model
e.g. royalties
ii) Fair value hierarchy
To increase consistency and comparability in fair value measurements and related disclosures, this
IFRS establishes a fair value hierarchy that categorises into three levels the inputs to valuation
techniques used to measure fair value.
The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for
identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3
inputs):
a. Level 1 inputs
Quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity
can access at the measurement date. A quoted price in an active market provides the most
reliable evidence of fair value and shall be used without adjustment to measure fair value
whenever available.
b. Level 2 inputs
Inputs other than quoted prices included within Level 1 that are observable for the asset or
liability, either directly or indirectly. Level 2 inputs include the following:
▪
quoted prices for similar assets or liabilities in active markets.
▪
quoted prices for identical or similar assets or liabilities in markets that are not active
▪
inputs other than quoted prices that are observable for the asset or liability (E.g. interest
rates and yield curves observable at commonly quoted interval).
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▪
market-corroborated inputs (E.g. Inputs that are derived principally from or corroborated
by observable market data by correlation or other means)
c. Level 3 inputs
Unobservable inputs for the asset or liability. Unobservable inputs shall be used to measure
fair value to the extent that relevant observable inputs are not available, thereby allowing for
situations in which there is little, if any, market activity for the asset or liability at the
measurement date.
An entity shall develop unobservable inputs using the best information available (i.e.: from the
market participant's perspective) in the circumstances, which might include the entity’s own data.
28.4
Disclosure
An entity shall disclose information that helps users of its financial statements assess both of the
following:
a. for assets and liabilities that are measured at fair value on a recurring or non-recurring basis in
the statement of financial position after initial recognition, the valuation techniques and inputs
used to develop those measurements.
b. for recurring fair value measurements using significant unobservable inputs (Level 3), the effect
of the measurements on profit or loss or other comprehensive income for the period.
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28.5
Check Understanding
Question 1
Yanong owns several farms and also owns a division which sells agricultural vehicles. It is considering
selling this agricultural retail division and wishes to measure the fair value of the inventory of vehicles
for the purpose of the sale. Three markets currently exist for the vehicles. Yanong has transacted
regularly in all three markets. At 30 April 2015, Yanong wishes to find the fair value of 150 new
vehicles, which are identical. The current volume and prices in the three markets are as follows:
Sales price per vehicle
Historical
volume vehicles sold by
Yanong
$
Unit
Unit
$
$
Europe
40,000
6,000
150,000
500
400
Asia
38,000
2,500
750,000
400
700
Africa
34,000
1,500
100,000
300
600
Market
Total volume of
vehicles sold in
market
Transaction
costs - per
vehicle
Transport cost to the
market - per vehicle
Yanong wishes to value the vehicles at $39,100 per vehicle as these are the highest net proceeds per
vehicle, and Europe is the largest market for Yanong’s product.
Yanong would like advice as to whether this valuation would be acceptable under IFRS 13 Fair Value
Measurement.
Solution:
In Yanong’s case, Asia would be the principal market as this is the market in which the majority of
transactions for the vehicles occur. As such, the fair value of the 150 vehicles would be $5,595,000
($38,000 – $700 = $37,300 x 150). Actual sales of the vehicles in either Europe or Africa would result
in a gain or loss to Yanong when compared with the fair value, i.e. $37,300. The most advantageous
market would be Europe where a net price of $39,100 (after all costs) would be gained by selling there
and the number of vehicles sold in this market by Yanong is at its highest. Yanong would therefore
utilise the fair value calculated by reference to the Asian market as this is the principal market.
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28.6
Chapter 28 Summary
Diagram 28.6.: Summary of IFRS 13 FV Measurement
238