CPA PROGRAM
FINANCIAL
REPORTING
SIXTH EDITION
Pdf_Folio:i
Published 2022 by John Wiley & Sons Australia, Ltd,
155 Cremorne Street, Richmond Vic 3121,
on behalf of CPA Australia Ltd,
ABN 64 008 392 452
First edition published January 2010, updated July 2010, updated January 2011, reprinted July 2011, updated January 2012,
reprinted July 2012, updated January 2013, revised edition January 2013, reprinted July 2013, updated January 2014,
revised edition January 2015, updated July 2015, updated January 2016
Third edition published November 2016
Fourth edition published January 2018
Fifth edition published November 2019
Sixth edition published October 2022
© 2010–2022 CPA Australia Ltd (ABN 64 008 392 452). All rights reserved. This material is owned or licensed by CPA
Australia and is protected under Australian and international law. Except for personal and educational use in the CPA
Program, this material may not be reproduced or used in any other manner whatsoever without the express written
permission of CPA Australia. All reproduction requests should be made in writing and addressed to: Legal, CPA Australia,
Level 20, 28 Freshwater Place, Southbank, VIC 3006, or legal@cpaaustralia.com.au.
Edited and designed by John Wiley & Sons Australia, Ltd
Printed carbon neutral by Finsbury Green
ISBN 9781922690005
Authors
Nikole Gyles
Janice Loftus
Carmen Ridley
Dean Hanlon
BCom (Hons) UTas, CA, CPA
BBus NSWIT, MCom (Hons) UNSW, FCPA
BSc (Hons) Mathematics, FCA, AICD
BEc, GradDipCom, MCom (Hons), PhD Monash University, FCPA, CA
Updates to the sixth edition
Carmen Ridley
Sorin Daniliuc
Dean Hanlon
John Lourens
Sishuo Jack Liu
BSc (Hons) Mathematics, FCA, AICD
BEc (Hons) UAIC Iasi, PhD ANU, GradCertEd ANU, CPA
BEc, GradDipCom, MCom (Hons), PhD Monash University, CA, FCPA; Professor RMIT University
BBus (Acc), GradDip (Acc & Fin), MAdmin, PhD Monash University, DipEd
BCom (Acc & Fin), MBA Cornell University, CICPA, CFA, FRM
Advisory panel
Peter Gerhardy (Ernst & Young)
Shan Goldsworthy (Shans Accounting Services)
Kris Peach (KPMG)
Daen Soukseun (Department of Transport, Planning and Local Infrastructure, Victoria)
Themin Suwardy (Singapore Management University)
Anne Vuong (National Australia Bank)
Mark Shying (CPA Australia)
Ram Subramanian (CPA Australia)
David Hardidge (Telstra)
CPA Program team
Member Education, CPA Australia
Pdf_Folio:ii
ACKNOWLEDGEMENTS
This publication contains copyright © material and trademarks of the IFRS Foundation®. All rights
reserved. Used under licence from the IFRS Foundation®. Reproduction and use rights are strictly limited.
For more information about the IFRS Foundation and rights to use its material please visit www.ifrs.org.
Disclaimer: To the extent permitted by applicable law the Board and the IFRS Foundation expressly
disclaims all liability howsoever arising from this publication or any translation thereof whether in contract,
tort or otherwise (including, but not limited to, liability for any negligent act or omission) to any person
in respect of any claims or losses of any nature including direct, indirect, incidental or consequential loss,
punitive damages, penalties or costs.
Information contained in this publication does not constitute advice and should not be substituted for
the services of an appropriately qualified professional.
The IFRS Foundation logo, the IASB logo, the IFRS for SMEs logo, the “Hexagon Device”, “IFRS
Foundation”, “eIFRS”, “IAS”, “IASB”, “IFRS for SMEs”, “IASs”, “IFRS”, “IFRSs”, “International
Accounting Standards” and “International Financial Reporting Standards”, “IFRIC” and “SIC” are Trade
Marks of the IFRS Foundation.
MODULE 1
Figures 1.1–1.5, 1.7, Tables 1.2–1.6 and extracts: © 2022 CPA Australia Ltd; Figure 1.6 and extracts:
© Commonwealth of Australia 2022. All legislation herein is reproduced by permission but does not
purport to be the official or authorised version. It is subject to Commonwealth of Australia copyright.
The Copyright Act 1968 permits certain reproduction and publication of Commonwealth legislation. In
particular, s.182A of the Act enables a complete copy to be made by or on behalf of a particular person.
For reproduction or publication beyond that permitted by the Act, permission should be sought in writing
from the Commonwealth available from the Australian Accounting Standards Board. Requests in the first
instance should be addressed to the National Director, Australian Accounting Standards Board, PO Box
204, Collins Street West, Melbourne, Victoria, 8007; Table 1.1: © External Reporting Board New Zealand;
Tables 1.2–1.5, 1.7: © 2022 CPA Australia Ltd.
MODULE 2
Figures 2.1–2.6 and Tables 2.1–2.6: © 2022 CPA Australia Ltd; Extracts: © Commonwealth of Australia
2022. All legislation herein is reproduced by permission but does not purport to be the official or authorised
version. It is subject to Commonwealth of Australia copyright. The Copyright Act 1968 permits certain
reproduction and publication of Commonwealth legislation. In particular, s.182A of the Act enables a
complete copy to be made by or on behalf of a particular person. For reproduction or publication beyond
that permitted by the Act, permission should be sought in writing from the Commonwealth available
from the Australian Accounting Standards Board. Requests in the first instance should be addressed
to the National Director, Australian Accounting Standards Board, PO Box 204, Collins Street West,
Melbourne, Victoria, 8007; Extracts: © Telstra 2021, Telstra Annual Report 2021, p. 156, accessed
July 2022, https://www.telstra.com.au/content/dam/tcom/about-us/investors/pdf-g/0821-TEL-AR-2021FINAL-Interactive.pdf.
MODULE 3
Figure 3.1: © Deloitte 2018, p. 6. This is an amended version of a diagram for which the original is available
from https://dart.deloitte.com/iGAAP; Figure 3.2: © 2022 CPA Australia Ltd; Extracts: © Commonwealth
of Australia 2022. All legislation herein is reproduced by permission but does not purport to be the official
or authorised version. It is subject to Commonwealth of Australia copyright. The Copyright Act 1968
permits certain reproduction and publication of Commonwealth legislation. In particular, s.182A of the Act
enables a complete copy to be made by or on behalf of a particular person. For reproduction or publication
beyond that permitted by the Act, permission should be sought in writing from the Commonwealth
available from the Australian Accounting Standards Board. Requests in the first instance should be
addressed to the National Director, Australian Accounting Standards Board, PO Box 204, Collins Street
West, Melbourne, Victoria, 8007; Lennard, A. & Thompson, S. 1995, Provisions: Their Recognition,
Measurement and Disclosure in Financial Statements, Financial Accounting Standards Board, Norwalk,
Pdf_Folio:iii
ACKNOWLEDGEMENTS iii
paras 2.1.5–6. © Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA; © Stuart
Washington 2002.
MODULE 4
Figures 4.1–4.3, 4.5–4.7 and Tables 4.2, 4.5, 4.7–4.11, 4.14, 4.17–4.19: © 2022 CPA Australia Ltd;
Tables 4.12–4.13, 4.15–4.16 and extracts: © Amcor Limited 2018, Annual Report 2018, pp. 69, 70, 71,
accessed May 2019, https://www.amcor.com/investors/financial-information/annual-reports.
MODULE 5
Figures 5.1–5.8 and Tables 5.1, 5.4: © 2022 CPA Australia Ltd; © Commonwealth of Australia 2022. All
legislation herein is reproduced by permission but does not purport to be the official or authorised version. It
is subject to Commonwealth of Australia copyright. The Copyright Act 1968 permits certain reproduction
and publication of Commonwealth legislation. In particular, s.182A of the Act enables a complete copy
to be made by or on behalf of a particular person. For reproduction or publication beyond that permitted
by the Act, permission should be sought in writing from the Commonwealth available from the Australian
Accounting Standards Board. Requests in the first instance should be addressed to the National Director,
Australian Accounting Standards Board, PO Box 204, Collins Street West, Melbourne, Victoria, 8007.
MODULE 6
Figure 6.1 and extracts: © Commonwealth of Australia 2022. All legislation herein is reproduced by
permission but does not purport to be the official or authorised version. It is subject to Commonwealth of Australia copyright. The Copyright Act 1968 permits certain reproduction and publication
of Commonwealth legislation. In particular, s.182A of the Act enables a complete copy to be made
by or on behalf of a particular person. For reproduction or publication beyond that permitted by the
Act, permission should be sought in writing from the Commonwealth available from the Australian
Accounting Standards Board. Requests in the first instance should be addressed to the National Director,
Australian Accounting Standards Board, PO Box 204, Collins Street West, Melbourne, Victoria, 8007;
Figures 6.2–6.3, 6.5, 6.7 and Tables 6.1–6.2: © 2022 CPA Australia Ltd; Figures 6.4, 6.6: © MNP
2016, An overview of IFRS 9 Financial Instruments vs. IAS 39 Financial Instruments: Recognition
and Measurement, January, pp. 6, 13, accessed August 2022, https://www.mnp.ca/-/media/files/mnp
/pdf/_mgtn/siteassets/media/pdfs/apsg/2020-12-ifrs-9-vs-ias-39-guide--final.pdf; Figure 6.8: © KPMG
2013, First impressions: IFRS 9 (2013) – Hedge accounting and transition, December, p. 33, accessed
August 2022, https://assets.kpmg/content/dam/kpmg/pdf/2013/12/First-Impressions-IFRS9-2013–Hedge
-accounting-and-transition-O-201312.pdf; Figure 6.9: Reproduced by permission of EYGM Limited. ©
2014 EYGM Limited. All Rights Reserved; Extracts: © National Australia Bank 2021, Annual Financial
Report 2021, p. 135, accessed August 2022, https://www.nab.com.au/content/dam/nab/documents/reports
/corporate/2021-annual-financial-report.pdf; © BHP Group 2021, Annual Report 2021, pp. 164–165, 169,
accessed August 2022, https://www.bhp.com/-/media/documents/investors/annual-reports/2021/210914_
bhpannualreport2021.pdf.
MODULE 7
Figures 7.1, 7.3–7.5 and Tables 7.2, 7.10–7.12: © 2022 CPA Australia Ltd; Figure 7.2: © Wiley 2020;
Extracts: © Commonwealth of Australia 2022. All legislation herein is reproduced by permission but does
not purport to be the official or authorised version. It is subject to Commonwealth of Australia copyright.
The Copyright Act 1968 permits certain reproduction and publication of Commonwealth legislation.
In particular, s.182A of the Act enables a complete copy to be made by or on behalf of a particular
person. For reproduction or publication beyond that permitted by the Act, permission should be sought
in writing from the Commonwealth available from the Australian Accounting Standards Board. Requests
in the first instance should be addressed to the National Director, Australian Accounting Standards Board,
PO Box 204, Collins Street West, Melbourne, Victoria, 8007; © Woolworths Group 2021, 2021 Annual
Report, p. 104, accessed July 2022, https://www.woolworthsgroup.com.au/content/dam/wwg/investors/
reports/2021/195984_annual-report-2021.pdf; © Australian Securities & Investments Commission 2019,
2022; © PwC 2022.
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iv ACKNOWLEDGEMENTS
SUGGESTED ANSWERS
Extracts: © Commonwealth of Australia 2022. All legislation herein is reproduced by permission but does
not purport to be the official or authorised version. It is subject to Commonwealth of Australia copyright.
The Copyright Act 1968 permits certain reproduction and publication of Commonwealth legislation. In
particular, s.182A of the Act enables a complete copy to be made by or on behalf of a particular person.
For reproduction or publication beyond that permitted by the Act, permission should be sought in writing
from the Commonwealth available from the Australian Accounting Standards Board. Requests in the
first instance should be addressed to the National Director, Australian Accounting Standards Board, PO
Box 204, Collins Street West, Melbourne, Victoria, 8007.
Pdf_Folio:v
ACKNOWLEDGEMENTS v
BRIEF CONTENTS
Subject Outline
xiii
Module 1: The Role and Importance of Financial Reporting 1
Module 2: Presentation of Financial Statements 59
Module 3: Revenue from Contracts with Customers; Provisions, Contingent Liabilities and Contingent
Assets 117
Module 4: Income Taxes 159
Module 5: Business Combinations and Group Accounting 219
Module 6: Financial Instruments 305
Module 7: Impairment of Assets 375
Appendix: Techworks Ltd Case Study
Glossary 459
Suggested Answers 465
Index 545
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415
CONTENTS
Subject Outline xiii
MODULE 1
The Role and Importance of
Financial Reporting 1
Preview 2
1.1 The role and importance of financial
reporting 2
The role of financial reporting 2
The importance of financial reporting 3
Understanding the International Financial
Reporting Standards 5
Interaction between financial reporting
and the regulatory environment — who
must prepare general purpose
financial reports? 7
International initiatives to decrease financial
reporting complexity 9
International initiatives toward
sustainability-related financial
reporting 11
1.2 The Conceptual Framework for
Financial Reporting 12
The purpose and application of the
Conceptual Framework 13
Objectives and limitations of general
purpose financial reporting 14
Principles established in the Conceptual
Framework 15
1.3 Qualitative characteristics of useful
financial information 16
Fundamental qualitative characteristics 16
Enhancing qualitative characteristics 18
The cost constraint on useful financial
reporting 20
Application of qualitative characteristics in
the International Financial Reporting
Standards 21
1.4 The elements of financial statements 21
Defining the elements of financial
statements 21
Criteria for recognising elements of financial
statements 25
Derecognition of assets and liabilities 26
Constraints on international consistency of
the application of recognition criteria
established by the Conceptual
Framework 27
1.5 Measurement of elements of financial
statements 27
Cost-based and value-based measures
used in the International Financial
Reporting Standards 28
Present value as a valuation technique 36
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1.6
Application of measurement principles
in the International Financial
Reporting Standards 38
Leases 38
Employee benefits 45
Accounting for share-based payments 49
Investment property 51
Professional judgement 52
Disclosures 53
Review 56
References 57
Optional reading 57
MODULE 2
Presentation of Financial
Statements 59
Preview 60
Part A: Presentation of Financial Statements 62
Introduction 62
2.1 Complete set of financial statements 63
Components of a complete set of financial
statements 63
Segment reporting 65
Fair presentation and compliance with
International Financial Reporting
Standards 66
Other general features 66
2.2 Accounting policies 69
Selection of accounting policies 69
Consistency of accounting policies 70
Disclosure of accounting policies 70
Changes in accounting policies 71
2.3 Revision of accounting estimates and
correction of errors 74
Accounting estimates 74
Changes in accounting estimates 74
Material errors in a prior period 75
2.4 Events after the reporting period 76
Types of events after the reporting
period 77
Adjusting events 77
Non-adjusting events 78
Dividends declared after reporting
period 80
Going concern issues after reporting
period 80
2.5 The impact of technological
advancements on the presentation
of financial statements 80
Summary 81
Part B: Statement of Profit or Loss and Other
Comprehensive Income 83
Introduction 83
2.6 Presentation of comprehensive income 83
2.7 The concept of other comprehensive
income and total comprehensive
income 84
2.8 IAS 1 — Disclosures and classification 85
Single statement (statement of P/L
and OCI) 85
Two statements (a statement of P/L and a
statement of comprehensive income) 86
2.9 Tips on how to analyse the statement
of profit or loss and other
comprehensive income 90
Summary 91
Part C: Statement of Changes in Equity 92
Introduction 92
2.10 IAS 1 Presentation of Financial
Statements: disclosures of changes
in equity 92
Summary 93
Part D: Statement of Financial Position 95
Introduction 95
2.11 Format of the statement of
financial position 95
2.12 Presentation of assets and liabilities 96
Current assets and current liabilities 96
2.13 IAS 1 Presentation of Financial
Statements: disclosures in the notes
to the statement of financial position 98
2.14 Tips on how to analyse a statement of
financial position 99
Summary 99
Part E: IAS 7 Statement of Cash Flows 101
Introduction 101
2.15 How does a statement of cash
flows assist users of the financial
statements? 101
2.16 Information to be disclosed 102
Cash and cash equivalents 102
Classification of cash flows 102
2.17 Common methods adopted on how
to prepare a statement of cash flows 104
Formula method 105
Reporting cash flows on a net basis 106
Other information to be disclosed in the
statement of cash flow or notes 106
Consolidated financial statements 107
2.18 Tips on how to analyse the statement
of cash flows 107
Summary 108
Review 109
Case study data: Webprod Ltd 110
Section 1: Information relating to prior
reporting periods 110
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viii CONTENTS
Section 2: Information relating to the
manufacturing process of
Webprod Ltd 111
2.1
Retail inventory 111
2.2
Manufacturing inventory 111
Section 3: Non-current assets 112
3.1
Acquisitions and disposals 112
3.2
Depreciation and amortisation 112
3.3
Revaluation of land and
buildings 112
Section 4: Wages and salaries 113
Section 5: Borrowing costs 113
Section 6: Change in accounting policy 113
Section 7: Revenue 113
7.1
Revenue recognition policy 113
7.2
Research and advisory services 113
7.3
Grants 113
Section 8: 30 June 20X7 trial balance 113
Assumed knowledge review questions 115
References 116
MODULE 3
Revenue from Contracts with
Customers; Provisions,
Contingent Liabilities and
Contingent Assets 117
Preview 118
Part A: Revenue from Contracts with
Customers 119
Introduction 119
Overview of IFRS 15 Revenue from
Contracts with Customers 119
3.1 Recognition of revenue 122
Step 1: Identify the contract(s) with the
customer 122
Step 2: Identify the performance
obligation(s) in the contract 125
Step 3: Determine the transaction price of
the contract 127
Step 4: Allocate the transaction price to
each performance obligation 132
Step 5: Recognise revenue when each
performance obligation is satisfied 135
3.2 Contract costs 137
Incremental costs of obtaining
a contract 138
Costs to fulfil a contract 138
Amortisation and impairment 139
3.3 Disclosure 139
Contracts with customers 139
Significant judgements in the application of
IFRS 15 Revenue from Contracts
with Customers 141
Assets recognised from
contract costs 141
Summary 142
Part B: Provisions 143
Introduction 143
Scope of IAS 37 Provisions, Contingent
Liabilities and Contingent Assets 143
Definition of provisions 144
3.4 Recognition of provisions 144
3.5 Measurement of provisions 146
Discounting 147
3.6 IAS 37 Provisions, Contingent Liabilities
and Contingent Assets: disclosure 148
Provisions 148
Exemptions 150
3.7 Provisions and professional judgement 150
Summary 151
Part C: Contingent Liabilities and Contingent
Assets 152
Introduction 152
3.8 Contingent assets 152
3.9 Contingent liabilities 153
Liabilities versus contingent liabilities 155
3.10 Contingencies and professional
judgement 155
Summary 156
Review 156
References 157
MODULE 4
Income Taxes
159
Preview 160
Part A: Income Tax Fundamentals 161
Introduction 161
4.1 Tax expense 162
4.2 Current tax 163
Calculating current tax 163
Recognition of current tax 164
4.3 Deferred tax 165
Step 1: Determining the tax base of assets
and liabilities 168
Step 2: Compare the tax base to the
carrying amount to determine temporary
differences 170
Step 3: Measure deferred tax assets and
deferred tax liabilities 173
Summary 177
Part B: Recognition of Deferred Tax Assets
and Liabilities 180
Introduction 180
4.4 Recognition of deferred tax liabilities 180
Initial recognition of goodwill arising from a
business combination (IAS 12,
para. 15(a)) 180
Initial recognition of other assets or liabilities
not in a business combination transaction
(IAS 12, para. 15(b)) 181
4.5 Recognition of deferred tax assets 181
Recognition of deferred tax 185
Recognition rules for unused tax losses and
unused tax credits 186
4.6 Recovery of tax losses 188
Reassessment of the carrying amounts of
deferred tax assets and liabilities 192
Summary 192
Part C: Special Considerations for Assets
Measured at Revalued Amounts 194
Introduction 194
4.7 Assets carried at revalued amounts 194
4.8 Recognition of deferred tax on
revaluation 195
Recovery of revalued assets through use or
through sale 196
Additional guidance on recovery of
non-depreciable assets 199
Summary 199
Part D: Financial Statement Presentation
and Disclosure 201
Introduction 201
4.9 Presentation of current tax and
deferred tax 201
Offsetting tax assets and liabilities 203
4.10 Major components of tax expense 203
4.11 Relationship between tax expense
(income) and accounting profit 204
4.12 Information about each type of
temporary difference 207
Summary 209
Part E: Comprehensive Example 210
Introduction 210
4.13 Case study: AAA Ltd 210
Background to AAA Ltd 210
Deferred tax 211
Other deferred tax assets and
liabilities 213
Taxable profit and current tax expense 214
Illustrative disclosures 215
Summary 216
Review 216
References 217
MODULE 5
Business Combinations and
Group Accounting 219
Preview 220
Part A: Business Combinations 224
Introduction 224
5.1 Identifying a business combination 225
5.2 The acquisition method 226
(A) Identifying the acquirer 226
(B) Determining the acquisition date 228
(C) Recognising and measuring the
identifiable assets acquired, the liabilities
assumed and any non-controlling interest
in the acquiree 229
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CONTENTS ix
(D) Recognising and measuring goodwill or
a gain from a bargain purchase 231
5.3 Applying the acquisition method to
different forms of business
combinations 235
1. Direct acquisition: purchase of assets
and liabilities of a business 235
2. Indirect acquisition: purchase of shares
(i.e. equity interests) of an entity 236
5.4 Deferred tax arising from a business
combination 237
Deferred tax related to assets and liabilities
acquired in a business combination 237
Deferred tax related to tax losses in a
business combination 238
5.5 Disclosures: business combinations 240
Summary 241
Part B: Consolidated Financial Statements 243
Introduction 243
5.6 Introduction to consolidated financial
statements 244
5.7 The group 245
Defining the group 245
Concept of control 245
5.8 Preparation of consolidated financial
statements 250
Parent with an equity interest in a
subsidiary 252
Revaluation of assets 253
Depreciation adjustments related to
revaluation of depreciable assets 256
Transactions within the group 258
Non-controlling interest 265
5.9 Disclosures: consolidated financial
statements 278
Consolidated statement of financial
position 278
Consolidated statement of profit or loss and
other comprehensive income 278
Consolidated statement of changes
in equity 278
Consolidated statement of cash flows 279
Notes including accounting policies and
explanatory notes 279
Summary 279
Part C: Investments in Associates 282
Introduction 282
5.10 Identifying associates 282
5.11 Use of equity method 283
5.12 Basis of equity method 284
5.13 Application of the equity method 286
Basic features 286
Identifying the share of the associate that
belongs to the investor 287
Recognising the initial investment
at cost 288
Recognising the dividends provided by
the associate 290
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x CONTENTS
Recognising the investor’s share of the
associate post-acquisition other
comprehensive income 291
Transactions between associate and
investor (or its subsidiaries) 294
Investor’s share of losses 295
5.14 Disclosures for associates 296
Summary 297
Part D: Joint arrangements — overview 299
Review 300
Case studies 302
Assumed knowledge review 303
References 304
MODULE 6
Financial Instruments
305
Preview 305
Part A: What are Financial Instruments? 307
Introduction 307
6.1 Definition of a financial instrument 307
Financial assets 307
Financial liabilities 309
6.2 Liability or equity? 310
6.3 Contracts to buy or sell non-financial
items 311
6.4 Derivative financial instruments 311
Forward contracts 312
Futures contract 313
Option contract 314
Swap contracts 314
Interest rate swaps 314
Cross-currency swaps 315
Summary 315
Part B: Recognition and Derecognition of
Financial Assets and Financial
Liabilities 317
Introduction 317
6.5 Recognition of financial assets and
financial liabilities 317
6.6 Derecognition of financial assets and
financial liabilities 317
Derecognising financial assets 318
Transfers of financial assets 318
6.7 Derecognition of a financial liability 323
Summary 326
Part C: Classification of Financial Assets and
Financial Liabilities 327
Introduction 327
6.8 Classification of financial assets 327
Business model for managing financial
assets 328
Contractual cash flows that are solely
payments of principal and interest on the
principal amount outstanding 330
6.9
Classification of financial liabilities 331
Option to designate a financial liability at fair
value through profit or loss 332
Embedded derivatives 332
6.10 Reclassification 334
Summary 334
Part D: Measurement 336
Introduction 336
6.11 Initial measurement 336
6.12 Subsequent measurement of financial
assets 337
Impairment of financial assets carried at
amortised cost 337
Reclassification of financial assets 340
6.13 Subsequent measurement of financial
liabilities 340
6.14 Recognising gains and losses on
the subsequent measurement
of financial assets and liabilities 342
6.15 Investments in equity instruments 343
6.16 Liabilities designated at fair value
through profit or loss 343
6.17 Compound financial instruments 344
Summary 346
Part E: Hedge Accounting 348
Introduction 348
6.18 Hedging relationships 348
Hedging instruments 348
6.19 Accounting for hedging relationships 351
Types of hedges 352
6.20 Special accounting rules 359
Accounting for the time value
of options 359
6.21 Assessing hedge effectiveness 359
6.22 Discontinuing hedge relationships 360
6.23 Increased disclosures 360
Summary 360
Part F: Disclosure Issues 362
Introduction 362
6.24 Scope and level of disclosure 362
6.25 Significance of financial instruments
for financial position and
performance 362
6.26 Statement of financial position 362
6.27 Statement of profit or loss and other
comprehensive income 364
Other disclosures 365
Nature and extent of risks arising from
financial instruments 366
Credit risk 367
Liquidity risk 369
Market risk 370
Transfers of financial assets 371
Summary 371
Review 372
References 373
Optional reading 374
MODULE 7
Impairment of Assets
375
Preview 376
Part A: Impairment of Assets — an Overview 377
Introduction 377
7.1 Basic principles of impairment
of assets 377
Overview of impairment requirements 377
Why is impairment important
for users? 378
Key definitions 378
Scope of IAS 36 Impairment of Assets 379
7.2 Identifying assets that may be impaired 379
General requirements for an impairment
test 379
Specific requirements for certain intangible
assets and goodwill 380
Impairment indicators 381
Summary 383
Part B: Impairment of Individual Assets 384
Introduction 384
7.3 Measurement of recoverable amount 384
7.4 Fair value less costs of disposal 386
7.5 Value in use 387
Step 1: Estimating expected future
cash flows 387
Step 2: Determining an appropriate
discount rate 393
7.6 Recognising and measuring an
impairment loss 395
7.7 Reversals of impairment losses 395
Summary 397
Part C: Impairment of Cash-Generating Units 399
Introduction 399
7.8 Recoverable amount: individual
asset or cash-generating unit? 399
7.9 Identifying cash-generating units 400
7.10 Recoverable amount and carrying
amount of a cash-generating unit
(impairment of cash-generating units) 401
Allocating goodwill to cash-generating
units 402
Allocating corporate assets to
cash-generating units 404
Impairment testing for cash-generating
units with goodwill 405
Timing of impairment tests for
cash-generating units with goodwill 405
Identifying and allocating an impairment
loss for cash-generating units with
goodwill 406
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CONTENTS xi
Impairment testing for intangible
assets 408
Reversal of impairment losses
on cash-generating units 408
Summary 409
Part D: IAS 36 Impairment of
Assets — Disclosure 411
Introduction 411
7.11 Disclosures of impairment losses and
reversals 411
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xii CONTENTS
7.12 Disclosures of estimates used to
measure recoverable amounts in
cash-generating units 412
Summary 412
Review 413
References 413
Appendix: Techworks Ltd Case Study 415
Glossary 459
Suggested Answers 465
Index 545
SUBJECT OUTLINE
INTRODUCTION
The purpose of this subject outline is to:
• provide important information to assist you in your studies
• define the aims, content and structure of the subject
• outline the learning materials and resources provided to support learning
• provide information about the exam and its structure.
The CPA Program is designed around five overarching learning objectives to produce future CPAs
who will:
• be technically skilled and solution driven
• be strategic leaders and business partners in a global environment
• be aware of the social impacts of accounting
• be adaptable to change
• be able to communicate and collaborate effectively.
BEFORE YOU BEGIN
Important Information
Please refer to the CPA Australia website for dates, fees, rules and regulations, and additional learning
support at www.cpaaustralia.com.au/become-a-cpa.
SUBJECT DESCRIPTION
Financial Reporting
Financial Reporting is designed to provide you with financial reporting and business skills that are
applicable in an international professional environment. The subject is based on the International Financial
Reporting Standards (IFRSs), which are issued by the International Accounting Standards Board (IASB).
Many international jurisdictions have adopted or are progressively adopting the IFRSs.
In a competitive international environment, financial reporting provides users with information to
formulate corporate strategies, business plans and leadership initiatives. There is also a common acceptance
of IFRSs for communicating financial information, because they are internationally understood. This
reduces the cost of capital for the international reporting entities.
Financial reporting provides information for corporate leadership. Members of the accounting
profession with financial reporting skills and knowledge provide business advice to board directors,
analysts, shareholders, creditors, colleagues and other stakeholders. Members of the accounting profession
who provide assurance services for financial reports also require a good understanding of the IFRSs.
Directors are also required to state that the financial statements are fairly stated. These examples reinforce
the importance of financial reporting. In addition to the completion of this subject, CPA Australia
encourages continuous professional learning in financial reporting, which is constantly evolving.
This subject’s technical content includes linkages with the other subjects in the CPA Program. Financial
reporting is a significant part of an entity’s governance and accountability process, issues that are covered
in the subject Ethics and Governance. Compliance with the IFRSs is important because it results in the
presentation of fairly stated financial statements. This presentation outcome is also the aim of audit and
assurance services. The assurance knowledge and audit skills are taught in the subject Advanced Audit and
Assurance. While taxation is covered in the subject Australia Taxation – Advanced, and while it is distinct
from financial reporting, the accounting for tax is recognised as material information and therefore included
in this subject. Financial reporting provides information about the business operations and the financial
results. As a result, there is a relevant topical link with the subject Contemporary Business Issues.
Subject Aims
The aims of the subject are to:
• demonstrate IFRSs requirements for the preparation of a full set of general purpose financial statements
• demonstrate IFRSs requirements for the recognition, measurement and disclosure of specific elements
of general purpose financial statements.
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SUBJECT OUTLINE xiii
SUBJECT OVERVIEW
General Objectives
On completion of this subject, you should be able to:
• explain the application and basis of selected IFRSs issued by the IASB
• apply IFRSs in the preparation of general purpose financial statements
• explain details relating to general purpose financial statements
• prepare general purpose financial statements for designated entities, including the exercise of professional judgement.
STUDY GUIDE
Module Descriptions
The subject is divided into seven modules. A brief outline of each module is provided below.
Module 1: The Role and Importance of Financial Reporting
This module considers the role and importance of financial reporting, particularly the need for
general purpose financial statements (GPFSs), and discusses the application of financial reporting in
an international context. It then discusses the role that the IASB Conceptual Framework for Financial
Reporting (Conceptual Framework) plays in financial reporting, including a discussion on the objective
and limitations of GPFSs as identified in the Conceptual Framework.
The module discusses the qualitative characteristics of financial information and the definitions,
recognition criteria and measurement of financial reporting items as outlined in the Conceptual Framework. The concept of materiality and how it is applied to financial reporting is also addressed. This module
also examines the application of the measurement principles in International Financial Reporting Standards
(IFRSs) in the context of selected issues. IFRSs are developed based on the Conceptual Framework as a
consistent language for reporting that ensures financial statements are understandable and can be compared
among entities.
IFRSs are the global language of accounting standards. Measurement is a complex and controversial
aspect of accounting. In this module, alternative measurement bases are studied, and the application of the
mixed measurement model (based on cost and fair value) is examined. Measurement issues are considered
in the context of leases, employee benefits, share-based payments and investment properties. The module
also explores the importance of professional judgement in the reporting process.
Module 2: Presentation of Financial Statements
This module covers the specific components and overall considerations that should be used when preparing
a full set of financial statements as required in IAS 1 Presentation of Financial Statements. Part A of this
module discusses events after the reporting period and briefly outlines the requirements of IAS 34 Interim
Financial Reporting and IFRS 8 Operating Segments. This module also considers IAS 8 Accounting
Policies, Changes in Accounting Estimates and Errors as preparers of financial statements must choose
accounting policies that are both relevant to decision making and reliable. Accounting policy choices
have a major influence on the results and financial position reported by an entity, and it is important for
comparability reasons that users are able to determine differences in financial performance or position,
due to the adoption of alternative accounting policies.
An important principle when preparing financial statements is that they must be prepared on the basis
of conditions in existence at the end of the reporting period. In the time between the end of the reporting
period and completion of the financial statements, events can occur that either:
• clarify or confirm conditions that existed at the end of the reporting period, or
• give rise to new conditions.
IAS 10 Events after the Reporting Period deals with how to treat these events when preparing the
financial statements. In some cases, an event after the reporting period will mean adjustments to the
financial statements are required. In other circumstances, an event after the reporting period may lead
to separate disclosure in the notes to the financial statements. Such note disclosures are necessary when
the information could influence the decisions of financial statement users.
Part B focuses on the reporting requirements of the individual financial statements that must be included
in the set of financial statements, beginning with the statement of P/L and OCI.
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xiv SUBJECT OUTLINE
In relation to the statement of P/L and OCI, this module considers the requirements of IAS 1, which
specifies both:
• how an entity determines comprehensive income
• the information to be presented in the statement of P/L and OCI or in the notes to the financial statements.
Part C discusses the statement of changes in equity, which discloses changes in each component of
equity and reconciles the opening and closing balances of the components. Changes in equity will include
comprehensive income and transactions with owners in their capacity as owners.
Part D deals with the statement of financial position. IAS 1 prescribes:
• how assets and liabilities must be presented
• how assets, liabilities and equity items must be classified
• which disclosures must be made on the face of the statement of financial position and in the notes to the
financial statements.
Finally, part E looks at the statement of cash flows, which helps users assess the entity’s ability to
generate cash flows and the timing and certainty of their generation (IAS 7, ‘Objective’). IAS 7 Statement of
Cash Flows deals with the preparation and presentation of a statement of cash flows and covers issues such
as the definition of cash and cash equivalents, classification of cash inflows and outflows, reconciliations
required and disclosure of information about cash flows.
Module 3: Revenue from Contracts with Customers; Provisions, Contingent Liabilities and
Contingent Assets
Module 3 considers IFRS 15 Revenue from Contracts with Customers as well as accounting for provisions,
contingent liabilities and contingent assets. Part A discusses the five-step model of revenue recognition
capable of general application to a variety of transactions and the required disclosures as outlined in
IFRS 15.
Part B discusses the requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
Accounting for provisions raises a number of recognition and measurement issues, particularly in relation
to the present obligation and reliable measurement criteria. Further, for provisions extending over more
than one reporting period, the issue of discounting future cash flows introduces further measurement issues,
including the appropriateness of the discount rate used.
Part C of this module discusses the recognition and measurement requirements in relation to contingent
assets and contingent liabilities. Although IAS 37 indicates that neither may be recognised in the statement
of financial position (with the exception of some contingent liabilities in a business combination), it
clarifies the nature of these potential obligations and benefits, and outlines disclosure requirements.
Overall, the main aim of IFRS 15 and IAS 37 is to ensure that the financial reporting of revenue
from contracts with customers, provisions, contingent liabilities and contingent assets is informative for
financial statement users. For example, the revenue-related disclosures under IFRS 15 provide users with
an understanding of the revenue practices of the entity. This understanding extends to how recognised
revenue is earned, at what stage of the activity the revenue is earned and when payment is typically received,
as well as to when and how remaining revenue from existing contracts will be recognised in the future.
IAS 37 ensures that appropriate recognition criteria and measurement principles are applied to provisions
recognised in financial statements. The standard also ensures that disclosures are sufficient to enable users
to understand the nature, timing and amount of provisions, contingent liabilities and contingent assets.
Module 4: Income Taxes
Module 4 begins with part A discussing the fundamentals of income tax as prescribed in IAS 12 Income
Taxes. The accounting treatment for income taxes is based on the balance sheet method, which focuses on
balance sheet items and requires consideration of the difference between the carrying amounts of those
items (as recognised in the balance sheet) and their underlying tax bases (as determined according to the
tax rates and tax laws enacted in the relevant jurisdiction). This difference gives rise to tax effects deferred
for the future, which should be recognised together with the current tax effects.
Part B examines the separate recognition rules (and limited recognition exceptions) for the recognition
of deferred tax assets and deferred tax liabilities in the financial statements.
Part C focuses on the special considerations for assets measured at revalued amounts and deals with the
recognition and measurement of deferred tax liabilities that arise from asset revaluations.
Part D illustrates the disclosure requirements that enables users of the financial statements to understand
and evaluate the impact of current tax and deferred tax on the financial position and performance of the
entity.
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SUBJECT OUTLINE xv
Part E Comprehensive example contains a comprehensive example illustrating the application of
IAS 12.
Module 5: Business Combinations and Group Accounting
The module begins by focusing on the general accounting principles and requirements applicable to
IFRS 3 Business Combinations where an investor acquires one or more businesses or obtains control
of other entities (i.e. establishing a parent–subsidiary relationship). IFRS 3 requires that all business
combinations within the scope of the standard, no matter the form, be accounted for using the acquisition
method, which involves the following four steps:
1. identifying the acquirer
2. determining the acquisition date
3. recognising and measuring the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree
4. recognising and measuring goodwill or a gain from a bargain purchase.
Part B of this module focuses on additional accounting requirements prescribed in IFRS 10 Consolidated
Financial Statements for those investments where the investor obtains control of other entities, giving rise
to parent–subsidiary relationships. The additional requirements addressed relate to the acquirer’s need to
prepare consolidated financial statements to show the financial performance, position and cash flows of the
acquirer/parent and the subsidiary from the perspective of the reporting entity created. The consolidated
financial statements reflect the economic impact of transactions where the economic entity as a whole
is involved with external parties, but does not include the effect of transactions within the economic
entity — because the users of financial statements need to know how well the entity is doing externally.
The accounting requirements from IFRS 3 described in part A are applicable in the preparation of the
consolidated financial statements in accordance with IFRS 10.
Part C focuses on investments where the investor obtains significant influence over the investee
(associate). It addresses two issues in accordance with IAS 28:
1. determining whether or not that relationship exists
2. specifying the requirements for applying the equity method to account for investments in associates.
Part D of this module provides a brief overview of the general principles and requirements for those
investments where the investor has joint control over a joint arrangement, distinguishing between joint
operations and joint ventures (IFRS 11).
Module 6: Financial Instruments
Module 6 mainly examines the following accounting standards related to the accounting for financial
instruments:
• IFRS 9 Financial Instruments — the recognition, derecognition and measurement of financial
instruments, including hedge accounting
• IAS 32 Financial Instruments: Presentation — the appropriate presentation of the financial instruments,
once recognised
• IFRS 7 Financial Instruments: Disclosure — the appropriate information to disclose for both recognised
and unrecognised financial instruments.
It is not necessary to understand every aspect of these standards. The focus of this module is to highlight
the general principles of these standards so users and preparers of financial statements have a common
frame of reference when analysing the implications of financial instruments on an entity’s financial
position, performance and long-term survival.
This module begins by defining ‘financial instruments’, and then addresses the recognition and
measurement of financial instruments. The following section discusses the appropriate presentation of
financial instruments. The module concludes with a brief review of disclosure requirements relating to
financial information.
Module 7: Impairment of Assets
This module discusses the requirements of IAS 36 Impairment of Assets, which specifically prescribes that
the carrying amount of an asset must not exceed it recoverable amount (the higher of an asset’s ‘fair value
less costs of disposal and it value in use’). IAS 36 requires an ‘impairment test’ be applied to compare an
asset’s carrying amount and its recoverable amount at a particular point in time.
Part A provides an overview of IAS 36, including the basic principles relating to the impairment of
assets and how to identify assets that may be impaired. Part B addresses the impairment of individual
assets, including (where required) the measurement of their recoverable amount. Part C considers the
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xvi SUBJECT OUTLINE
impairment of groups of assets, or cash-generating units (CGUs), including how to identify CGUs and
apply the impairment requirements of IAS 36 to CGUs. Finally, in part D, the disclosure requirements of
IAS 36 are considered.
Module Weightings and Study Time Requirements
Total hours of study for this subject will vary depending on your prior knowledge and experience of the
course content, your individual learning pace and style, and the degree to which your work commitments
allow you to work intensively or intermittently on the materials. You will need to work systematically
through the study guide and readings, attempt all the questions, and revise the learning materials for the
exam. The workload for this subject is the equivalent of that for a one-semester postgraduate unit.
An estimated 15 hours of study per week through the semester will be required for an average candidate.
Additional time may be required for revision. The ‘Weighting’ column in the following table provides an
indication of the emphasis placed on each module in the exam, while the ‘Recommended proportion of
study time’ column is a guide for you to allocate your study time for each module.
Do not underestimate the amount of time it will take to complete the subject.
TABLE 1
Module weightings and study time
Recommended
proportion
of study time (%)
Weighting (%)
1. The Role and Importance of Financial Reporting
10
10
2. Presentation of Financial Statements
14
14
3. Revenue from Contracts with Customers; Provisions,
Contingent Liabilities and Contingent Assets
10
10
4. Income Taxes
18
18
5. Business Combinations and Group Accounting
24
24
6. Financial Instruments
14
14
7. Impairment of Assets
10
10
Module
LEARNING MATERIALS
Module Structure
The study guide is your primary examinable resource and contains all the knowledge you need to learn
and apply to pass the exam. The Financial Reporting study guide includes a number of features to help
support your learning. These include the following.
Learning Objectives
A set of objectives is included for each module in the study guide. These objectives provide a framework
for the learning materials and identify the main focus of the module. The objectives also describe what
candidates should be able to do after completing the module.
Examples
Examples are included throughout the study materials to demonstrate how concepts are applied to realworld scenarios.
Questions (and Suggested Answers)
Questions provide you with an opportunity to assess your understanding of the key learning points. These
questions are an integral part of your study and should be fully utilised to support your learning of the
module content.
Key Points
The key points feature relates the content covered in the section to the module’s learning objectives.
Review
The review section places the module in context of the other modules studied and summarises the
main points.
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SUBJECT OUTLINE xvii
References
The reference list details all sources cited in the study guide. You are not expected to follow up this
source material.
My Online Learning and Your eBook
My Online Learning is CPA Australia’s online learning platform, which provides you with access to a
variety of resources to help you with your study.
You can access My Online Learning from the CPA Australia website: www.cpaaustralia.com.au.
eBook
An interactive eBook version of the study guide will be available through My Online Learning. The eBook
contains the full study guide and features instructional media and interactive questions embedded at the
point of learning. The media content includes animations of key diagrams from the study guide and video
interviews with leading business practitioners.
IFRS Compilation Handbook
Throughout this subject, we mostly apply the accounting standards, interpretations, supporting documents
as well as the Conceptual Framework for Financial Reporting as presented in the 2022 IFRS Standards
(Red Book) and at times the more current version of the IFRS Standards, interpretations, and the supporting
documents.
All the relevant extracts from the IFRSs that are required for your study and exam purposes are presented
in this study guide. It is not compulsory to access, print or buy the IFRSs for your study or exam. If you
would like to explore the standards in more detail, you may consult the digital copy of the relevant IFRSs
provided on My Online Learning as the IFRS Compilation Handbook. All the relevant standards that have
been applied in this Study Guide have been collated in the IFRS Compilation Handbook. You are advised
against viewing the IFRSs from other sources.
CPA Australia encourages you to access the IASB’s website regularly, as it contains many relevant
resources for continuing professional development. However, the IFRSs on the IASB’s website may not
be aligned with the version of the IFRSs used for your study materials, due to frequent amendments to the
standards. You will be examined on the version of the standards used in this study guide, which are aligned
with IFRS Compilation Handbook provided on My Online Learning.
The IFRS Compilation Handbook is presented as a compilation and combination of the two parts
(outlined below) of the IFRS Red Book.
• Part A includes the Conceptual Framework, as well as all of the accounting standards and interpretations.
• Part B includes all of the supporting documents for the Conceptual Framework, accounting standards
and interpretations. These supporting documents include the basis of conclusions and, for some
accounting standards, the dissenting opinions, implementation guidance, details of amendments and
impacts on other accounting standards illustrative examples.
Rounding
In this subject, the questions and examples are sometimes rounded to the nearest dollar or thousands of
dollars. In financial reporting, rounding is used in preparing financial statements, but any requirement to
round is jurisdiction-specific and is not a requirement of the IFRSs. In this subject, where decimal places
are used, all rounding should be to two decimal places unless otherwise stated.
GENERAL EXAM INFORMATION
All information regarding the Financial Reporting exam can be found on My Online Learning.
The study guide is your central examinable resource. Where advised, relevant sections of the CPA
Australia Members’ Handbook and legislation are also examinable.
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xviii SUBJECT OUTLINE
MODULE 1
THE ROLE AND
IMPORTANCE OF
FINANCIAL REPORTING
LEARNING OBJECTIVES
After completing this module, you should be able to:
1.1 explain the role and importance of financial reporting
1.2 explain the role of the IASB Conceptual Framework in financial reporting and accounting standards
1.3 describe the objective and limitations of general purpose financial reporting as identified in the
Conceptual Framework
1.4 explain the definitions of the elements of financial statements and recognition criteria adopted by the
Conceptual Framework
1.5 explain the application of the standards to the financial reporting process and apply specific standards
1.6 discuss and demonstrate the importance of professional judgement in the financial reporting process
1.7 explain the implications of using cost and fair value accounting
1.8 explain how materiality is assessed and determine the materiality of transactions.
ASSUMED KNOWLEDGE
It is assumed that, before commencing your study in this module, you are able to:
• explain the four primary financial statements, including their purpose and interrelationship
• prepare each of the four primary financial statements using the accrual method of accounting
• read and interpret International Financial Reporting Standards (IFRSs).
LEARNING RESOURCES
International Financial Reporting Standards (IFRSs), with a particular focus on the IASB Conceptual Framework
for Financial Reporting:
• IASB Conceptual Framework for Financial Reporting (2018)
• IFRS 2 Share-based Payment
• IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
• IFRS 9 Financial Instruments
• IFRS 13 Fair Value Measurement
• IFRS 16 Leases
• IAS 1 Presentation of Financial Statements
• IAS 2 Inventories
• IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
• IAS 16 Property, Plant and Equipment
• IAS 19 Employee Benefits
• IAS 36 Impairment of Assets
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets
• IAS 40 Investment Property.
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PREVIEW
Financial reporting is the process of documenting an entity’s financial status in the form of financial
reports/statements. The entity uses the prepared financial reports as a communication tool to assist users
with their decision making. There is a broad range of users, including shareholders, banks and other
creditors, competitors, employees and financial analysts — and they may have different information needs.
Therefore, to assist users in their decision making, it is critical that financial statements are prepared in
accordance with a financial reporting framework that recognises and endeavours to satisfy the needs of
these users.
This module considers the role and importance of financial reporting, particularly the need for
general purpose financial statements (GPFSs), and discusses the application of financial reporting in
an international context. It then discusses the role that the IASB Conceptual Framework for Financial
Reporting (Conceptual Framework) plays in financial reporting, including a discussion on the objective
and limitations of GPFSs as identified in the Conceptual Framework.
The module discusses the qualitative characteristics of financial information and the definitions, recognition criteria and measurement of financial reporting items as outlined in the Conceptual Framework.
The concept of materiality and how it is applied to financial reporting is also addressed. This module also
examines the application of the measurement principles in International Financial Reporting Standards
(IFRSs) in the context of selected issues. IFRSs are developed based on the Conceptual Framework
as a consistent language for reporting that ensures that financial statements are understandable and can
be compared among entities. IFRSs are the global language of accounting standards. Measurement is
a complex and controversial aspect of accounting. In this module, alternative measurement bases are
studied, and the application of the mixed measurement model (based on cost and fair value) is examined.
Measurement issues are considered in the context of leases, employee benefits, share-based payments
and investment properties. The module also explores the importance of professional judgement in the
reporting process.
1.1 THE ROLE AND IMPORTANCE OF
FINANCIAL REPORTING
Financial reporting is a process that provides entities with an important communication tool to reach
out to external stakeholders (users) interested in their financial information for decision making. That
communication tool is represented by the GPFSs prepared in accordance with the Conceptual Framework
and the accounting standards developed based on the framework. These financial statements provide users
with financial information about the entity, including its financial position, financial performance and
cash flows.
THE ROLE OF FINANCIAL REPORTING
The role of financial reporting is to provide users with information to enable them to achieve effective
decision making. It also provides a stewardship or accountability role by requiring managers to give an
account of how they have used the resources provided by those users. The stewardship role is particularly
important when there is a separation between ownership and management in an entity.
Effective financial reporting communicates the ‘story’ of the entity during the period so that the users
can understand what the entity has achieved and how it has achieved it. Improving the communication
effectiveness of financial statements is one of the central themes of the IASB’s standard-setting work
(IFRS Foundation 2016).
The objective of general purpose financial reporting is to provide financial information about the
reporting entity that is useful to its primary users for making decisions about providing resources to the
entity. These decisions include:
• buying, selling or holding equity and debt instruments;
• providing or settling loans and other forms of credit; or
• exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the
entity’s resources (Conceptual Framework, para. 1.2).
Identification of the primary users of financial reports is crucial in determining the information that
should be disseminated through the financial reports to effectively satisfy their decision-making needs.
The IASB identifies primary users as those that provide equity or debt finance to the entity. Specifically,
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2 Financial Reporting
the primary users of an entity’s financial information are existing and potential investors, lenders and other
creditors that must rely on general purpose financial reports for much of the information they need as
they may be unable to command information from an entity directly (Conceptual Framework, paras 1.2
and 1.5). General purpose financial reports are directed to those primary users to provide information about
the economic resources of the entity, claims against the entity, and changes in those resources and claims,
which is necessary for these users to assess the entity for their decision making (Conceptual Framework,
para. 1.4).
Financial reports provide information about an entity’s financial position at a point in time. They also
provide information about an entity’s financial performance as a result of transactions and other events that
change the financial position during a reporting period (Conceptual Framework, paras 1.12–1.16). More
specifically, the statement of financial position (or balance sheet) provides information about the financial
position (i.e. the assets, liabilities and equity) of the entity at a point in time. The statement of profit or
loss and other comprehensive income (the statement of P/L and OCI) (also referred to as the ‘statement
of financial performance’ or just ‘profit or loss statement’) reports on the financial performance (i.e. the
income, expenses and profitability) for a reporting period on an accrual basis. The statement of cash flows
reports on the cash inflows and outflows of the entity for a reporting period on a cash basis. Changes
in the net assets, or equity, are reported in the statement of changes in equity. All individual financial
reports are prepared by an entity as at a particular point in time or for a particular reporting period, but the
presentation of financial reports is prescribed to ensure that they are comparable with the entity’s previous
financial statements and with the financial statements of other entities (IAS 1, para. 1).
Financial reporting via general purpose financial statements should not be seen as the only way for an
entity to communicate to external users. Other types of reporting, including investor updates, sustainability
reporting, corporate governance reporting and other prospective, or forward-looking, information, should
be considered as well. For example, when an entity is intending to list on a stock exchange, it would
normally be required to provide some forward-looking information to potential investors to help them
make their investment decision.
Technology advancements provide opportunities for various other methods of information dissemination
that, together with financial reporting via GPFSs, can be incorporated into a whole suite of reporting tools
to properly and efficiently address the information needs of users.
THE IMPORTANCE OF FINANCIAL REPORTING
Financial reporting is important because of the often significant level of resources under the responsibility
of managers and the financial impact of the decisions that users make from relying on the information provided in financial reports. This importance is reflected in company regulators and stock exchanges around
the world requiring financial statements to be prepared by entities as part of their reporting obligations.
The types of decisions that financial statements might be used for are highlighted in figure 1.1.
FIGURE 1.1
Financial statement user decisions
Shareholders
Competitors
Should I invest money
in the company?
How has the company
performed in
comparison to its
competitors?
?
Suppliers
Banks
Should I sell goods
to the company?
Should I lend money
to the company?
Source: CPA Australia 2022.
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MODULE 1 The Role and Importance of Financial Reporting 3
Information Needs of the User
As previously mentioned, the primary users of financial information are existing and potential investors,
lenders and other creditors (Conceptual Framework, para. 1.5). Management of an entity also require
financial information for decision making, but they can obtain whatever information they need internally
and do not need to rely on general purpose financial reports (Conceptual Framework, para. 1.9). Other
users of financial information include regulators and members of the public, such as community groups
and potential employees; however, general purpose financial reports are not primarily directed to these
users (Conceptual Framework, para. 1.10). In the Conceptual Framework, it is the primary users that are
the focus of general purposes financial reports. Entities are required to prepare general purpose financial
reports specifically to assist their primary users in their decision making. However, the decisions facing
the primary users may give rise to varying or even conflicting information needs.
Consider, for example, lenders as users of financial statements. Lenders are interested in making an
assessment of an entity’s capacity to meet its interest and principal repayment obligations and the level
of risk associated with a loan. As investors invest equity, they are also interested in the assessment of risk
and the ability of the entity to service its debt, so that the entity can continue its operations and provide a
return to investors.
These varying information needs and the resulting information demands may give rise to different
preferences for the measurement of assets or the timing of the recognition of revenue. For example, lenders
may prefer a measure of the net realisable value of certain assets provided as security to assess whether
the security is sufficient in the event that the entity defaults on repayment. However, investors may prefer
measurement of those assets based on their value in use, which provides a better indication of the expected
benefits to be derived from the continued use of the assets.
The IASB’s approach to resolving conflicting user information needs is to provide the information
that will meet ‘the needs of the maximum number of primary users’ (Conceptual Framework, para. 1.8).
However, according to the IASB, focusing on common information needs does not prevent an entity from
providing additional information that may be useful to another sub-group of primary users (Conceptual
Framework, para. 1.8). It should also be noted that trying to meet the needs of the maximum number of
primary users may have different implications depending on the context. For example, for some entities,
investors may be the largest group of primary users, but for other entities, the largest group of primary
users may be lenders.
Conflicting information needs are shown in figure 1.2. The grey shaded area represents the common
information needs of the primary user groups. Conflict arises where the information needs do not overlap
(the navy shaded areas) or where the information needs of only two user groups are shared (the gold shaded
areas). The navy and gold shaded areas depict differing information needs, where choices made by standard
setters and preparers may result in the needs of some primary users being met at the expense of the needs
of other primary users.
FIGURE 1.2
Maximising the number of primary users whose information needs are met
Investors
Lenders
Other creditors
Source: Adapted from IFRS Foundation 2022, Conceptual Framework for Financial Reporting, paras 1.5–1.8, IFRS Foundation,
London, p. A18. © CPA Australia 2022.
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4 Financial Reporting
QUESTION 1.1
According to the Conceptual Framework, who are the primary users of general purpose financial
reports, and why do you think they are regarded as the primary users?
QUESTION 1.2
Consider the following statement.
By focusing on the information needs of investors, lenders and other creditors, financial
reporting will not be useful for other users.
Do you agree or disagree? Give reasons for your answer.
UNDERSTANDING THE INTERNATIONAL FINANCIAL
REPORTING STANDARDS
In this module, the terms ‘financial reports’ and ‘financial reporting’ refer to general purpose financial
reports and general purpose financial reporting unless otherwise noted. GPFSs such as the statement
of P/L and OCI, statement of financial position, statement of changes in equity, and the statement of
cash flows and the notes make up the body of general purpose financial reports that are prepared for
external users.
The information included in GPFSs must comply with the International Financial Reporting Standards
(IFRSs) and achieve fair presentation in accordance with the definition and recognition criteria in the
Conceptual Framework. The Conceptual Framework is not a standard itself; therefore, it will not override
any IFRSs. If a conflict is identified between provisions of an IFRS and the Conceptual Framework, the
IFRS will take precedence. If any new provisions in the IFRSs depart from the Conceptual Framework,
the IASB will explain the departure in the Basis for Conclusions of the relevant standard. The IFRSs
are an internationally recognised set of accounting standards ‘that bring transparency, accountability and
efficiency to financial markets around the world’ (IFRS Foundation 2022a). IFRSs are used by most
publicly listed companies in over 140 jurisdictions. The Australian Accounting Standards Board adopted
the IFRSs for Australian entities required to report under the Corporations Act 2001 (Cwlth) (Corporations
Act) for annual reporting periods beginning on or after 1 January 2005.
There are two series of international accounting standards. The first series, the International Accounting
Standards (IASs), are those standards issued from 1973 to 2001, before the new International Accounting
Standards Board (IASB) was formed. The second series, the International Financial Reporting Standards
(IFRSs), are those standards issued under the IASB since 2001 and reflect the changes in accounting and
business practices since that date. Some IASs are still relevant today and have therefore remained under
their original IAS heading. An example is IAS 1 Presentation of Financial Statements.
AASB standards are the accounting standards developed by the Australian Accounting Standards Board
for all economic sectors in Australia. A specific numbering system has been used for the AASBs to identify
their connection to the international accounting standards. AASB standards numbered by using one or
two digits (from 1 to 99) are the equivalent of IFRSs. AASB standards numbered by using three digits
(from 101 to 999) are the equivalent of IASs; and AASB standards numbered with four digits (from 1001
onwards) have no international equivalent (AASB 2021). The AASBs, whilst complying with the IFRSs,
sometimes include additional paragraphs where reporting requirements differ for specific entities such as
Australian not-for-profit entities. These paragraphs have the prefix ‘AUS’ and generally begin with words
that highlight their limited applicability. For example: ‘Notwithstanding paragraphs xx, in respect of notfor-profit entities . . . ’.
Each standard includes a statement at the beginning referring to its structure, main principles and terms,
and the context in which the standard should be read. Example 1.1 shows this statement as is included at
the beginning of IFRS 16 Leases.
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MODULE 1 The Role and Importance of Financial Reporting 5
EXAMPLE 1.1
Statement from IFRS 16 Leases
International Financial Reporting Standard 16 Leases (IFRS 16) is set out in paragraphs 1–106 and
Appendices A–D. All the paragraphs have equal authority. Paragraphs in bold type state the main
principles. Terms defined in Appendix A are in italics the first time that they appear in the Standard.
Definitions of other terms are given in the Glossary for International Financial Reporting Standards. The
Standard should be read in the context of its objective and the Basis for Conclusions, the Preface to IFRS
Standards and the Conceptual Framework for Financial Reporting. IAS 8 Accounting Policies, Changes
in Accounting Estimates and Errors provides a basis for selecting and applying accounting policies in the
absence of explicit guidance.
Source: IFRS Foundation 2022, IFRS 16 Leases, IFRS Foundation, London, p. A821.
Each standard begins with statements on its Objective and Scope and includes a section for its Effective
Date (ED) and whether earlier adoption is permitted. Additional sections such as the Basis for Conclusions
(BC) and the Illustrative Examples (IE) accompany the standard but are not considered to be a part of the
standard. The BC section provides detailed explanations of the IASB’s considerations when developing
and/or updating the standard. The IE section is included for those standards requiring practical explanations
and may provide examples to demonstrate the application of the main principles of the standard. The IEs
are not meant to represent the only application of a particular aspect and are not intended to be industryspecific. Example 1.2 is taken from the Illustrative Examples section of IFRS 16 Leases — it is Example 5
from that standard which works through identifying whether or not a lease exists for a truck rental contract.
When a member (or members) of the IASB does not approve the publication of a standard, that standard
will include a section called Dissenting Opinion (DO) which states the reasons for any member objections.
EXAMPLE 1.2
IFRS 16 Leases, Illustrative Example 5 — Truck Rental
Customer enters into a contract with Supplier for the use of a truck for one week to transport cargo
from New York to San Francisco. Supplier does not have substitution rights. Only cargo specified in the
contract is permitted to be transported on this truck for the period of the contract. The contract specifies
a maximum distance that the truck can be driven. Customer is able to choose the details of the journey
(speed, route, rest stops, etc.) within the parameters of the contract. Customer does not have the right to
continue using the truck after the specified trip is complete.
The cargo to be transported, and the timing and location of pick-up in New York and delivery in
San Francisco, are specified in the contract.
Customer is responsible for driving the truck from New York to San Francisco.
The contract contains a lease of a truck. Customer has the right to use the truck for the duration of the
specified trip.
There is an identified asset. The truck is explicitly specified in the contract, and Supplier does not have
the right to substitute the truck.
Customer has the right to control the use of the truck throughout the period of use because:
(a) Customer has the right to obtain substantially all of the economic benefits from use of the truck over
the period of use. Customer has exclusive use of the truck throughout the period of use.
(b) Customer has the right to direct the use of the truck because the conditions in B24(b)(i) exist. How and
for what purpose the truck will be used (i.e. the transportation of specified cargo from New York to
San Francisco within a specified timeframe) is predetermined in the contract. Customer directs the
use of the truck because it has the right to operate the truck (for example, speed, route, rest stops)
throughout the period of use. Customer makes all of the decisions about the use of the truck that can
be made during the period of use through its control of the operations of the truck.
Because the duration of the contract is one week, this lease meets the definition of a short-term lease.
Source: IFRS Foundation 2022, IFRS 16 Leases, IFRS Foundation, London, part B, illustrative examples.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should refer to IFRS 16 Leases, reading from the title page up to and
including paragraphs 1–4 of the standard. Also refer to IFRS 16 IE section for further illustrative examples on the
application of the standard.
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6 Financial Reporting
INTERACTION BETWEEN FINANCIAL REPORTING AND THE
REGULATORY ENVIRONMENT — WHO MUST PREPARE
GENERAL PURPOSE FINANCIAL REPORTS?
International Accounting Standards Board
General purpose financial reporting applies to reporting entities. The question of who must prepare general
purpose financial reports is a matter for governments and regulatory agencies of each jurisdiction that
adopts IFRS to decide. The Conceptual Framework therefore sets out a general definition of a reporting
entity at paragraph 3.10 as follows.
A reporting entity is an entity that is required, or chooses, to prepare financial statements. A reporting entity
can be a single entity or a portion of an entity or can comprise more than one entity. A reporting entity is
not necessarily a legal entity.
The IFRSs do not further clarify who must prepare general purpose financial reports. In jurisdictions
adopting IFRSs, legislation and other regulatory requirements usually require general purpose financial
reports from entities that have issued debt or equity securities traded in a public market. The IASB does
not, however, limit general purpose financial reporting to these entities. In this regard, the Conceptual
Framework indicates that a reporting entity can be any entity that has existing and potential investors,
lenders and other creditors who must rely on general purpose financial reports for much of the information
they need to make decisions about providing resources to the entity.
A reporting entity can be a for-profit entity or a not-for-profit entity. A reporting entity can operate in
the private sector or the public sector. Examples of for-profit private sector entities include companies,
partnership and trading trusts. Examples of not-for-profit entities include registered clubs, associations,
charities and government departments. A reporting entity can be one entity or a group of entities comprising
a parent and its subsidiaries (Conceptual Framework, para. 3.11).
Whilst the IFRSs and the Conceptual Framework are also applied in the not-for-profit sector in some
jurisdictions, emphasis throughout this subject is generally on for-profit private sector entities whose equity
and/or debt securities are publicly listed in financial markets.
Australian Accounting Standards Board
In Australia, for-profit private sector entities are subject to the Conceptual Framework and must prepare
financial statements that comply with Australian Accounting Standards (i.e. prepare general purpose
financial statements) when required to do so by either:
1. legislation that requires the entity to prepare financial statements in accordance with Australian
accounting standards or ‘accounting standards’
2. their constituting or other document requires the entity to prepare financial statements in accordance
with Australian Accounting Standards, provided that the relevant document was created or amended on
or after 1 July 2021.
Other for-profit private sector entities may nonetheless elect to apply the Conceptual Framework and
prepare general purpose financial reports (AASB Conceptual Framework, para. Aus1.1). The predecessor
of the Conceptual Framework, titled the Framework for the Preparation and Presentation of Financial
Statements, continues to apply to not-for-profit entities.
Legislation
Part 2M.3 (Financial Reporting) of the Corporations Act requires an entity that is a disclosing entity, public
company, large proprietary company or registered scheme to prepare an annual financial report (s. 292).
The financial report must comply with Australian Accounting Standards when they are applicable (s. 296).
A disclosing entity is an entity with enhanced disclosure securities on issue, which is similar to the
notion of public accountability (s. 111AC). A proprietary company is usually limited by shares and can
have no more than 50 shareholders. A large proprietary company is based on qualifying for two out of three
size thresholds for revenue, gross assets and number of employees (s. 45A). The thresholds are revenue of
$50 million or more, gross assets of $25 million or more, and employees of 100 or more. A public company
is a company other than a proprietary company (s. 9).
The financial reporting obligations of other types of entities are included in other federal or statebased legislation. For example, for associations, the appropriate legislation is the relevant state-based
Incorporated Associations Act.
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MODULE 1 The Role and Importance of Financial Reporting 7
Constituting or Other Document
A for-profit private sector entity may be founded on a constituting or other document, such as a partnership
agreement, trust deed or joint arrangement (AASB 2020). If that document was created or amended after
1 July 2021 and requires the entity to prepare financial statements in accordance with Australian
Accounting Standards, the entity must prepare general purpose financial reports.
If the document was created before, and has not been amended since, 1 July 2021, and requires the
entity to prepare financial statements in accordance with Australian Accounting Standards, presuming the
entity does not have a legislative requirement to prepare general purpose financial reports, it may prepare
special purpose financial reports instead. As part of its special purpose financial reports, the entity will be
required to provide additional disclosures, including the following:
• why the entity is preparing special purpose financial reports
• the material accounting policies applied in the special purpose financial reports and details on
any changes in these policies, including the nature and reasons for the change and its financial
statement impact
• whether the special purpose financial reports comply with the consolidation and/or equity accounting
requirements in Australian Accounting Standards where the entity has interest in other entities
• where a material accounting policy applied in the special purpose financial reports does not comply
with all recognition and measurement requirements in Australian Accounting Standards, an indication
of how it does not comply, and
• a statement as to whether the special purpose financial reports, overall, comply with all recognition and
measurement requirements in Australian Accounting Standards (AASB 1054, para. 9A).
Two Tiers of General Purpose Financial Reporting
The Australian Accounting Standards Board has a two-tier model of general purpose financial reporting.
The two tiers are as follows (refer AASB 1053, para. 7).
(a) Tier 1: Australian Accounting Standards; and
(b) Tier 2: Australian Accounting Standards — Simplified Disclosures.
Tier 1 general purpose financial reporting means an entity must satisfy all the recognition, measurement
and disclosure requirements in Australian Accounting Standards, which incorporates IFRSs (AASB 1053,
para. 8). Tier 1 applies to for-profit private sector entities with public accountability that are required
by legislation to prepare financial statements that comply with Australian Accounting Standards, and
Australian Governments either at the federal, state, territory or local level (AASB 1053, para. 11).
A for-profit private sector entity has public accountability if:
• it has debt or equity instruments (i.e. securities) that are traded in a public market or it is in the process
of issuing securities for such trading; or
• ‘it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses’,
for example banks, insurance companies, securities brokers/dealers and mutual funds (AASB 1053,
Appendix A).
Tier 2 general purpose financial reporting means an entity must satisfy all the recognition and
measurement requirements in Australian Accounting Standards but has substantially simplified disclosures
relative to Tier 1 (AASB 1053, para. 9). The disclosure requirements for Tier 2 entities are set out in a
separate standard, AASB 1060 General Purpose Financial Statements – Simplified Disclosures for ForProfit and Not-for-Profit Tier 2 Entities. As such, Tier 2 entities complying with the simplified disclosure
requirements of AASB 1060 are exempt from the disclosure requirements specified within other Australian
Accounting Standards.
AASB 1060 is available to a wide range of entities that are required to prepare general purpose financial
statements in both the private and public sectors (refer AASB 1053, para. 13):
(a) for-profit private sector entities that do not have public accountability;
(b) not-for-profit private sector entities; and
(c) public sector entities . . . other than the Australian Government and State, Territory and Local
Governments.
Notwithstanding that Tier 2 is available to an entity required to prepare a general purpose financial
report, it may still elect to apply Tier 1 and the full requirements of Australian Accounting Standards.
Refer to Note 1 ‘Summary of significant accounting policies’ in the notes to financial statements of
Techworks Ltd (see appendix). What type of financial statements have been prepared by Techworks Ltd?
What factors might explain the type of financial statements that have been prepared?
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8 Financial Reporting
External Reporting Board of New Zealand
The External Reporting Board (XRB) of New Zealand also has a multi-tiered accounting standards framework in which the nature of the entity determines the level of disclosure and compliance requirements.
Entities are categorised as either ‘for-profit’ entities or ‘public-benefit’ (not-for-profit) entities. Then
entities are subclassified based on whether they are publicly accountable for their financial reports, and/or
their size. This multi-tiered approach is summarised in table 1.1.
TABLE 1.1
External Reporting Board Accounting Standards Framework – tiered approach
For-profit entities
Entities
Public benefit entities (PBEs)
Accounting
Standards
Entities
Accounting
Standards
Tier 1
Publicly accountable (as
defined below); or public
sector entities with total
expenses > $30 million
(termed ‘large’)
NZ IFRS
Publicly accountable (as
defined below); or PBEs
with total expenses >
$30 million (termed ‘large’)
PBE Standards
Tier 2
Non-publicly accountable
and non-large for-profit
public sector entities which
elect to be in Tier 2
NZ IFRS
Reduced
Disclosure
Regime
(NZ IFRS RDR)
Non-publicly accountable,
not large, have total
expenses < $30 million
but > $2 million, which
elect to be in Tier 2
PBE Standards
Reduced Disclosure
Regime (PBE
Standards RDR)
Tier 3
Non-publicly accountable
with total expenses ≤
$2 million which elect to
be in Tier 3
PBE Simple Format
Reporting Standard —
Accrual (SFR-A)
Tier 4
Entities allowed by law
to use cash accounting
which elect to be in Tier 4
PBE Simple Format
Reporting Standard —
Cash (SFR-C)
Source: External Reporting Board (New Zealand) 2019, ‘Accounting Standards Framework’, accessed July 2022,
https://www.xrb.govt.nz/standards/accounting-standards/accounting-standards-framework.
The definition of public accountability is similar to that provided above, except it also includes an entity
deemed to have public accountability by the Financial Markets Authority under s. 461K and s. 461L(1)(a)
of the Financial Markets Conduct Act 2013.
Other Jurisdictions
In other jurisdictions, the appropriate legislation includes the Singapore Companies Act (Chapter 50)
2006 (Singapore) and the Companies Act 2016 (Malaysia). This legislation will specify the content
of the financial statements, the regularity of reporting and the basis on which the financial statements
are prepared.
Not all entities from jurisdictions that adopted IFRSs are required to prepare financial reports in
accordance with the IFRSs. An entity may use alternative bases for accounting if this is required or
permitted. For example, in Malaysia, eligible private entities comply with the Malaysian Private Entities
Reporting Standard (MPERS) rather than with the IFRSs. Alternatively, an entity that is not required to
report separately in accordance with the IFRSs may still need to provide information that must comply
with the IFRSs to a parent entity for inclusion in a set of consolidated financial statements. This module
and this subject will only address an entity’s obligations under the IFRSs.
INTERNATIONAL INITIATIVES TO DECREASE FINANCIAL
REPORTING COMPLEXITY
An ongoing criticism of financial reporting is the complexity of financial reports. Improving the communication effectiveness of disclosures in financial statements is a current focus of many accounting setters,
including the IASB, and there are a growing number of initiatives to help combat the issue, including:
• reducing differences in reporting standards among countries
• reducing reporting requirements of small and medium-sized entities
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MODULE 1 The Role and Importance of Financial Reporting 9
•
•
•
•
catering to the information needs of multiple stakeholders
improving the content and structure of the primary financial statements
clarifying disclosure requirements and improving the usefulness of disclosures
improving understanding of the existing requirements and helping entities make better materiality
judgements
• considering how management commentary outside the financial statements could better complement
and support the financial statements
• improving communication between preparers and users by enabling information to be delivered in an
electronic format.
IASB and other standard setters across the world made significant progress on the first three initiatives
listed — the following section provides further details.
Reducing Differences in Reporting Standards Among Countries
Overall, the complexity in financial reporting has decreased due to increased acceptance of the IFRSs in
many parts of the world. More than 140 jurisdictions worldwide require the use of the IFRSs for their
publicly listed companies.
The global acceptance of the IFRSs led to the commitment of the US Financial Accounting Standards
Board (FASB) to work with the IASB to explore the possibilities of the convergence of US Generally
Accepted Accounting Principles (GAAP) with the IFRSs. In 2007, the US Securities and Exchange
Commission (SEC) eliminated the requirement for foreign companies registered with the US SEC to
reconcile their IFRS-based financial statements to US GAAP. However, the US SEC does not permit
domestic issuers to adopt the IFRSs (SEC 2007).
Reducing Reporting Requirements of Small and Medium-sized Entities
The complexity of the full IFRSs led the IASB and accounting standards-setting bodies to specify less
complex standards for some entities. Examples of such reductions are as follows.
International Accounting Standards Board
To reduce the complexity of following the full IFRSs for small and medium-sized entities (SMEs), the
IASB has introduced the IFRS for SMEs. The IFRS for SMEs is described as being less complex than the
‘full’ IFRSs because:
• topics not relevant to SMEs, such as earnings per share, interim financial reporting and segment
reporting, are omitted
• many principles for recognising and measuring assets, liabilities, income and expenses in the full IFRSs
are simplified — for example, amortising goodwill; expensing all borrowings and development costs;
allowing the cost model for associates and jointly controlled entities; and providing undue cost or effort
exemptions for specific requirements
• significantly fewer disclosures are required (about a 90 per cent reduction)
• the standards are written in clear, easily understandable language (IFRS Foundation 2022c).
The IFRS for SMEs was first issued in 2009 and amended in 2015 following a comprehensive review.
At the time of writing, the IASB was undertaking its second comprehensive review to determine how the
IFRS for SMEs should be amended to take account of new IFRSs and amendments to existing IFRSs. The
IASB is preparing an exposure draft outlining the proposed amendments to the IFRS for SMEs which may
be released after publication (IFRS Foundation 2022d).
Australian Accounting Standards Board
The AASB has not adopted IFRS for SMEs to date, but AASB 1060 is based on the disclosure requirements
of IFRS for SMEs. In Australia, for-profit private sector entities may prepare special purpose financial
reports rather than GPFSs if legislation or their constituting or other document does not require them to
prepare GPFSs. Special purpose financial statements (SPFSs) are prepared and presented in accordance
with the specific information needs of the entity’s financial statement users.
A few selected entities can lodge SPFSs with ASIC. An entity that lodges SPFSs with the Australian
Securities and Investments Commission (ASIC) must ensure that they comply with a minimum set of
Australian Accounting Standards as follows.
• AASB 101 Presentation of Financial Statements
• AASB 107 Statement of Cash Flows
• AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors
• AASB 1048 Interpretation of Standards
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10 Financial Reporting
• AASB 1053 Application of Tiers of Australian Accounting Standards
• AASB 1054 Australian Additional Disclosures
Entities that lodge SPFSs with ASIC are also required to ensure that the financial statements give ‘a true
and fair’ view (s. 297 of the Corporations Act). In ASIC’s opinion, SPFSs can only present a true and fair
view if they apply all recognition and measurement requirements in Australian Accounting Standards
(e.g. depreciation, tax-effect accounting, leases, inventories, employee benefits) (ASIC Regulatory
Guide 85). ASIC’s Regulatory Guide does not have any legal status. Whilst some entities that lodge
SPFSs follow ASIC’s advice, others do not. In practice, there are many large proprietary companies that
choose to lodge SPFSs with ASIC based on the minimum standards approach listed in this section.
Catering to the Information Needs of Multiple Stakeholders
One aspect of the current complexity in financial reporting, which has attracted the attention of accounting
standards-setting bodies worldwide, has resulted from the need to measure ‘performance’ from multiple
perspectives. This requirement cannot be met simply by the reporting of financial statements. A company’s
performance is a multifaceted measure. Therefore, there is a need for information such as the progress of
the company — in terms of strategy and plan — rather than financial measures such as profit, assets
and liabilities. Although the reporting of the strategy and plan is material to investors, lenders and other
stakeholders, there is no requirement to report this information in the IFRSs.
The increase in the reporting of non-mandatory information in annual reports (relative to the mandated
financial information) makes financial reporting seem like a mere compliance exercise rather than an
exercise that communicates the information needs of multiple stakeholders. To address this concern, some
of the present research projects in progress across the world are as follows.
International Accounting Standards Board
To assist entities to communicate their disclosures more effectively, the IASB engaged in a research
project around a so-called ‘Disclosure Initiative’ to develop better disclosure requirements in accounting
standards, around accounting policies and in general. Following feedback from stakeholders used to inform
the IASB’s research, in March 2021 the IASB published an Exposure Draft Disclosure Requirements in
IFRS Standards – A Pilot Approach, which sets out a proposed new approach to developing and drafting
disclosure requirements in all standards starting with IAS 19 Employee Benefits and IFRS 13 Fair Value
Measurement (IFRS Foundation 2022e). This project is part of the Board’s wider series of initiatives under
the theme ‘Better Communication in Financial Reporting’ (IFRS Foundation 2022b).
Technology Advancements
Technology advancements provide opportunities for other sources and methods for information to be
provided to the primary users of general purpose financial statements. The rapid pace of technological
advancements can be, at the same time, a source of challenges and opportunities for entities preparing
financial information, users consuming information and standard setters prescribing how the information
should be prepared and disseminated. As technology progresses, new items need to be recognised in
the financial statements (e.g. crypto-assets), new avenues become available to disseminate and consume
information (e.g. electronically instead of paper-based reports) and new techniques are used to analyse the
information (e.g. big data analytics with the use of artificial intelligence). IASB recognises these broad
implications of technology for financial reporting as part of the IFRS Foundation’s Technology Incentive
announced in November 2018. This initiative seeks to develop a strategic plan to address the impact of
technological advancements on financial reporting and standard setting.
Summary
Accounting standard-setters have had a renewed focus on reducing complexity in financial reporting.
However, challenges still exist regarding the development of an overarching disclosure model to measure
performance without increasing the complexity of financial reporting.
INTERNATIONAL INITIATIVES TOWARD
SUSTAINABILITY-RELATED FINANCIAL REPORTING
In response to growing global demand for high quality and comparable disclosures by entities on matters of
sustainability, on November 3, 2021, at the 26th United Nations Climate Change Conference of the Parties
(COP26), the United Nations global summit to address climate change, the IFRS Foundation announced
the establishment of the International Sustainability Standards Board (ISSB).
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MODULE 1 The Role and Importance of Financial Reporting 11
International Sustainability Standards Board
The purpose of the ISSB is to develop a ‘comprehensive global baseline of sustainability-related disclosure
standards that provide investors and other capital market participants with information about companies’
sustainability-related risks and opportunities to help them make informed decisions’ (IFRS Foundation
2022f). Overseen by the IFRS Foundation Trustees, the disclosure standards issued by the ISSB will be
referred to as IFRS Sustainability Disclosure Standards, while the accounting standards issued by the IASB
will now be referred to as IFRS Accounting Standards.
In March 2022, the ISSB published Exposure Drafts seeking comments on its first two proposed
IFRS Sustainability Disclosure Standards: [Draft] IFRS S1 General Requirements for Disclosure of
Sustainability-related Financial Information and [Draft] IFRS S2 Climate-related Disclosures (IFRS
Foundation 2022g).
Australian Accounting Standards Board
In light of international developments, the AASB announced its intention to be responsible for developing
a reporting framework and requirements for sustainability-related matters in Australia. In particular, the
AASB’s objectives are to:
• develop reporting requirements for sustainability-related financial information in general purpose
financial reporting to meet the evolving information needs of primary users; and
• improve the consistency, completeness, comparability and verifiability of sustainability-related financial
disclosures (AASB 2022).
To meet these objectives, the AASB aims to:
• develop a separate, or independent, suite of standards that specifically address sustainability-related
financial disclosures made as part of general purpose financial reporting; and
• prioritise international alignment by using the work of the . . . ISSB as a baseline, with modifications for
Australian matters and requirements when necessary (AASB 2022).
The AASB will use the IFRS Sustainability Disclosure Standards as a baseline in developing its own
domestic standards, making modifications when deemed necessary to meet the information needs of
Australian stakeholders. When issued, these standards will require entities to provide additional disclosures
in their general purpose financial reports on sustainability-related financial matters.
1.2 THE CONCEPTUAL FRAMEWORK FOR
FINANCIAL REPORTING
In this section we examine the IASB Conceptual Framework for Financial Reporting (Conceptual
Framework).
The Conceptual Framework sets out the concepts that underlie the preparation and presentation of
financial statements for external users (Conceptual Framework, ‘Status and Purpose’).
The Conceptual Framework is structured as shown in table 1.2.
TABLE 1.2
Structure of the Conceptual Framework for Financial Reporting
Chapter
Content
Status and Purpose
• Provides a detailed description of the status and purpose of the Conceptual
Framework
1. Objective
• Sets out the objective of general purpose financial reporting
2. Qualitative
characteristics
• Provides guidance on the qualitative characteristics of useful financial information
3. Financial statements
and the reporting entity
• Describes the objective and scope of general purpose financial statements as
4. Elements of financial
statements
• Provides the definitions of the elements of financial statements
5. Recognition and
derecognition
• Sets out the recognition and derecognition criteria
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12 Financial Reporting
well as the reporting entity concept
6. Measurement
• Provides guidance on the measurement bases including historical cost and
current value
7. Presentation and
disclosure
• Provides guidance on classification, presentation and disclosure
8. Concepts of capital and
capital maintenance
• Provides guidance on the concepts of capital and capital maintenance.
Source: CPA Australia 2022.
The purpose and application of the Conceptual Framework will now be discussed, and its components
will be examined in detail.
THE PURPOSE AND APPLICATION OF THE
CONCEPTUAL FRAMEWORK
Having a common framework is an important foundation in guiding the development of accounting
standards and accounting practice. Moreover, accounting standards do not address all possible transactions
an entity may enter into. In these instances when the standards do not provide guidance, or sufficiently
specific guidance, it is the role of the Conceptual Framework to provide guidance to facilitate consistency
in the reporting of transactions and events.
The Conceptual Framework provides a formal frame of reference for:
• what types of transactions and events should be accounted for
• when the effects of transactions and events should be recognised
• how the effects of transactions and events should be measured
• how the effects of transactions and events should be summarised and presented in financial statements.
For example, IAS 36 Impairment of Assets applies the principle that the carrying amount of an asset
should not exceed its recoverable amount. This principle is consistent with the concept of an asset adopted
in the Conceptual Framework:
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 (paras 4.3–4.4).
As an asset represents a resource that has the potential to produce future benefits, the amount at which it
is reported in the statement of financial position (i.e. its carrying amount) should not exceed the expected
benefits to be derived from the asset (i.e. the recoverable amount).
The Conceptual Framework can be applied in several ways, as shown in table 1.3.
TABLE 1.3
Applying the Conceptual Framework for Financial Reporting
Who is applying the
Conceptual Framework?
How the Conceptual Framework is applied
Standard setters
To develop accounting standards
Preparers
To obtain guidance when issues that are not directly covered by a standard
or interpretation arise (specifically, IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors requires the Conceptual Framework to be
considered when there is an absence of a specific accounting standard or
interpretation (IAS 8, paras 10–11))
Auditors
To help form an opinion on compliance with an IFRS
Users
To better understand and interpret the financial reports they are reviewing
Source: CPA Australia 2022.
Where there is a conflict between an IFRS and the Conceptual Framework, the requirements of the
particular standard override those of the Conceptual Framework (para. SP1.2).
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MODULE 1 The Role and Importance of Financial Reporting 13
OBJECTIVES AND LIMITATIONS OF GENERAL PURPOSE
FINANCIAL REPORTING
The objective of general purpose financial reporting is to provide financial information to the primary
users to support their decision-making needs. In addition, general purpose financial reporting performs a
stewardship function, which involves reporting on how efficiently and effectively management has used the
resources entrusted to it (Conceptual Framework, paras 1.22–1.23). This emphasis on user decision making
in order to ascertain the information the entity should provide follows a decision-usefulness approach.
The decision-usefulness objective of financial reporting is probably the most important objective.
However, it is not possible for entities to provide all information about the financial position, performance
and changes in financial position to all users. Preparers of GPFSs are required to exercise some judgement
in deciding which information is required for the decision-usefulness objective to be met. Consider the
following problems.
• Lack of familiarity with new types of information. If users of financial statements are not familiar with an
item of information, it is difficult to assess its usefulness to their decision-making processes. Preparers
will then be faced with difficulties in trying to assess if the new item of information should be recognised
under an existing category in the financial reports or disclosed separately. Furthermore, some users may
not have the technical expertise to understand complex information; for example, information that is
based on finance principles such as present value calculations. This problem is especially relevant during
times of rapid technological advancement, where technologies may generate new items for which there
may not be sufficient guidance provided by accounting standard setters.
• Decision-usefulness may vary among users. The personal beliefs and values of users may determine the
information that they tend to use in their decision making. For example, some investors may consider
information about environmental performance to be relevant for their decision making, whereas others
might exclude it from their decision-making models. The differences in what users find relevant are also
likely to depend on the decision being made. For example, the information needs of customers deciding
whether to enter into a long-term purchase contract will differ from the needs of employee representative
groups negotiating remuneration and working conditions for employees.
• Capable of multiple interpretations. Preparers may have a different perception of what is useful
information to users than the users themselves. For example, using fair value as the measurement
basis for assets may be useful for investors to assess the entity’s future economic benefits likely to
be generated versus other entities; however, value in use may be considered by preparers as better
capturing the management’s plans and expectations regarding particular assets. These competing views
are difficult to reconcile under the currently specified decision-usefulness objective of general purpose
financial reporting.
• Time and cost constraints in preparing GPFSs. Due to time and cost constraints in preparing general
purpose financial reports, it is not possible for entities to provide all the useful information that will meet
all the varying needs of users. When a user requires specific information that has not been disclosed in
an entity’s financial reports, the IASB recommends the use of other sources such as ‘general economic
conditions and expectations, political events and political climate, and industry and company outlooks’
(Conceptual Framework, para. 1.6) to help gain a clearer understanding. The IASB also explains that
the financial reports are ‘not designed to show the value’ of the organisation but to help decision makers
make their own estimates as to its value (Conceptual Framework, para. 1.7). Nevertheless, the time and
cost constraints in preparing GPFSs can be reduced with the help of new technologies that are capable
of capturing, managing, processing and reporting on vast amounts of data.
QUESTION 1.3
Consider the following statement.
The decision-usefulness objective provides unambiguous guidance in resolving financial
reporting problems.
Do you agree? Give reasons for your answer.
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14 Financial Reporting
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 1.6–1.11 of the Conceptual Framework (in the
IFRS Compilation Handbook).
PRINCIPLES ESTABLISHED IN THE
CONCEPTUAL FRAMEWORK
There are two important assumptions established in the Conceptual Framework that form the foundation
of general purpose financial reporting. These are the assumption of the accrual basis of accounting and the
assumption that the entity is a going concern.
Accrual Basis
The accrual basis of accounting recognises the effects of transactions and other events when they occur
(which may not correspond to the time that cash is exchanged in response to a transaction) and reports
them in the financial statements in the periods to which they relate.
The accrual basis of accounting requires an entity to recognise revenues when they are earned rather
than when cash is received. Also, under the accrual basis of accounting, expenses are recognised when
they are incurred rather than when cash is paid. For example, an entity selling goods or services on credit
recognises the revenue and related expenses (cost of sales) incurred in earning that revenue when the sale
takes place, regardless of the timing of the cash inflow and cash outflow relating to that revenue and those
expenses. Also, the accrual basis requires an entity to recognise the depreciation of a non-current asset
(with a limited useful life) as the economic benefits of that asset are consumed or expire; an entity does
not account for the asset as an expense in the period in which it is acquired.
The Conceptual Framework advocates for accrual basis of accounting as it considers that it provides
a better basis for assessing the entity’s past performance and predicting future performance than relying
only on financial statements prepared on a cash basis (Conceptual Framework, para. 1.17).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 1.17–1.19 of the Conceptual Framework.
QUESTION 1.4
In its first year of operations, Tower Ltd purchased and paid for widgets costing $50 000. During that
year, Tower Ltd sold 60 per cent of the widgets. The widgets on hand at the end of the year cost
$20 000. The sales were on credit terms. Tower Ltd received $37 000 in cash from customers, and
$3000 remained uncollected at the end of the year. During the last quarter of the first year of
operations, Tower Ltd entered into a property insurance contract for losses arising from fire or
theft. The annual premium of $4000 was paid in cash and the insurance expired nine months after
the end of the reporting period.
Calculate Tower Ltd’s profit for the first year of operations on an accrual basis and on a cash
basis. Explain the difference between the two measures. Which of the two profit measures is more
useful for assessing Tower Ltd’s performance during its first year of operations? Give reasons for
your answer.
Going Concern
Financial statements prepared in accordance with the going concern assumption presume that the entity
will continue to operate for the foreseeable future. The carrying amounts of assets and liabilities in the
statement of financial position are normally based on the going concern assumption. For example, the
carrying amount of property, plant and equipment — whether measured on a cost or fair value basis —
assumes that the carrying amount will be recoverable through the entity’s continuing operations. Some
assets, such as property and plant, may be stated at amounts that exceed their disposal value because the
entity expects to obtain greater economic benefits through the continued use of such an asset.
Where the going concern assumption is not appropriate (e.g. because of the entity’s intention or need
to wind up operations), the financial statements should be prepared on some other basis. The Conceptual
Framework does not specify an alternative basis. However, one approach may be to state assets at their net
realisable value — which in the case of certain intangible assets may be negligible — and liabilities at the
amount required for their immediate settlement.
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MODULE 1 The Role and Importance of Financial Reporting 15
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraph 3.9 of the Conceptual Framework.
1.3 QUALITATIVE CHARACTERISTICS OF USEFUL
FINANCIAL INFORMATION
Chapter 2 of the Conceptual Framework focuses on the qualitative characteristics of financial information,
and it provides that in order to be useful, financial information must:
be relevant and faithfully represent what it purports to represent. The usefulness of financial information is
enhanced if it is comparable, verifiable, timely and understandable (Conceptual Framework, para. 2.4).
These qualitative characteristics are illustrated in figure 1.3.
FIGURE 1.3
Qualitative characteristics of financial information
Fundamental
qualitative
characteristics
Relevance
Faithful
representation
Comparability
Enhancing
qualitative
characteristics
Verifiability
Timeliness
Understandability
Source: CPA Australia 2022.
FUNDAMENTAL QUALITATIVE CHARACTERISTICS
Relevance
Information is relevant when it is capable of influencing the decisions of users (Conceptual Framework,
para. 2.6). This influence can occur through the predictive value or the confirmatory value of financial
information, or both. Table 1.4 shows how relevant information helps users.
TABLE 1.4
How relevant information helps users
The Conceptual Framework
requires relevant information
that helps users . . .
How this relates to
financial reporting
An example
. . . in forming expectations
about the outcomes of past,
present and future events.
This relates to the
predictive value of
financial information.
Financial information can be used to predict
the future cash flows of an entity and the
timing and uncertainty of those cash flows.
. . . in confirming or correcting
their past evaluations.
This is referred to
as feedback, or the
confirmatory value of
financial information.
Expectations of future cash flows can be
compared with actual cash flows when
financial statements relating to those future
periods are issued and the reasons for any
differences between expected cash flows and
actual cash flows are investigated.
Source: CPA Australia 2022.
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16 Financial Reporting
Materiality
Relevance also encompasses materiality. A subjective approach to materiality is adopted in the
Conceptual Framework:
Information is material if omitting, misstating or obscuring it could reasonably be expected to influence
decisions that the primary users of general purpose financial reports . . . make on the basis of those reports,
which provide financial information about a specific reporting entity (para. 2.11).
Materiality is an aspect of relevance that can be affected by the nature or the size of an item of
financial information, or both. Some information will be considered material if it refers to amounts that
are considered large enough to influence the decision making of primary users. However, deciding what
is large enough to be material is a matter of professional judgement by preparers, as the Conceptual
Framework does not prescribe quantitative thresholds for materiality because the application of the concept
of materiality is considered to be entity-specific (Conceptual Framework, para. 2.11).
Some other information may be material regardless of the amounts it refers to. Consider the following
examples.
• An entity may engage in transactions with its directors that involve amounts that are not material to
the entity. However, the disclosure of these related party transactions may be relevant to users’ needs,
irrespective of the amounts involved, because of the nature of the relationship between the directors and
the entity and their accountability to shareholders.
• An entity may engage in new activities, the results of which have little impact on profit at present.
However, the results may be relevant to the decision-making needs of users because they may affect the
users’ assessment of the entity’s future growth and risk profile.
In summary, whether information is material is a matter of judgement that depends on the facts and
circumstances of an entity. IASB Practice Statement 2 Making Materiality Judgements highlights ways in
which management can identify whether financial information is useful to the primary users (and therefore
material), and this is outlined in table 1.5.
TABLE 1.5
Identifying financial information useful to users of financial reports
Consideration
Example
User expectations
How users think the entity should be managed (i.e. stewardship) gathered through
discussions with users or from information that is publicly available
Management perspective
Changing management perspective to think about decisions from the perspective
of the user (i.e. as if they were external users themselves and did not have the
internal knowledge held by management, for example, about key risks or key
value drivers)
Observing user or market
responses to information
For example, on particular transactions or disclosures issued by the entity or on
responses by external parties such as analysts
Source: Adapted from IFRS Foundation 2022, IFRS Practice Statement 2: Making Materiality Judgements, paras 21–23, IFRS
Foundation, London, part B.
The Practice Statement is non-mandatory guidance developed by the IASB, and its application is not
required to state compliance with IFRS Standards.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 2.4–2.11 of the Conceptual Framework.
Faithful Representation
Together with relevance, faithful representation is a fundamental qualitative characteristic of useful
financial information according to the Conceptual Framework.
Faithful representation requires that financial information faithfully represent the effects of transactions
and events that they purport to represent (Conceptual Framework, para. 2.12). For example, the statement
of financial position should faithfully represent the effects of the events that give rise to assets, liabilities
and equity at a point in time, normally the end of the reporting period.
Ideally, faithful representation means that financial information is complete, neutral and free
from error. However, it is usually impractical to maximise these three characteristics simultaneously.
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MODULE 1 The Role and Importance of Financial Reporting 17
Faithful representation implies that there should be a fair representation of the economic outcomes of all
transactions and events that involve the entity. However, this assumes that there are accounting solutions
to all of the problems and financial reporting issues encountered by preparers of the financial reports.
In practice, difficulties in identifying the transactions and other events that must be accounted for, as
well as in applying or developing appropriate measurement and presentation techniques, can impede the
achievement of faithful representation.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 2.12–2.19 of the Conceptual Framework.
Application of Fundamental Qualitative Characteristics
For information to be useful, it must be both relevant and faithfully represented. This may involve
professional judgement in making a trade-off between relevance and faithful representation. For example,
information about future cash flows expected to be derived from an asset may be highly relevant, but it
may be difficult to faithfully represent this aspect of the asset because of the inherent uncertainty of future
events. Paragraph 2.21 of the Conceptual Framework suggests a process for making such judgements
as follows.
1. Identify an economic phenomenon, information about which may be useful to decision makers.
2. Identify the information that would be most relevant about this phenomenon.
3. Determine if the information is available and can provide a faithful representation of the economic
phenomenon.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 2.20–2.22 of the Conceptual Framework.
QUESTION 1.5
Coalite Ltd participates in an emissions trading scheme. It holds emission trading allowances,
which provide a permit for a specified amount of carbon emissions for the year. If its operating
processes result in carbon emissions, Coalite Ltd must deliver sufficient emission trading
allowances to the government to ‘pay’ for the amount of carbon emitted during the year. If it
does not hold enough emission trading allowances, Coalite Ltd will need to buy more to settle
its obligation to the government. If the company’s holding of trading allowances is surplus to its
needs, the allowances may be sold.
Assume that in determining how to apply the fundamental qualitative characteristics, the chief
financial officer (CFO) of Coalite Ltd has completed the first step by identifying the emission trading
allowances held as being potentially useful to the users of the company’s financial statements.
(a) Identify the type of information about emission trading allowances that would be most relevant
if it were available and could be faithfully represented.
(b) Do you think the information that you suggested is likely to be available and able to be
represented faithfully? If not, what might be the next most relevant type of information about
the emission trading allowances?
ENHANCING QUALITATIVE CHARACTERISTICS
Comparability
Comparability is one of the four enhancing qualitative characteristics of financial information prescribed
in the Conceptual Framework. Financial information is more useful if it can be compared with similar
information about the same entity for another reporting period and with similar information about other
entities. The ability to compare financial statements over time is important to enable users to identify
trends in the entity’s financial position and performance. The ability to compare the financial statements
of different entities is important in assessing their relative financial position and performance.
Comparability also enables users to recognise similarities or differences between two sets of economic
phenomena. For example, an entity with an existing investment in Company A is deciding whether
to continue to invest in Company A or to move its investment to Company B. Comparable financial
information will help the investor in making the decision.
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18 Financial Reporting
Consistency is seen as contributing to the goal of comparability. The Conceptual Framework refers to
the concept of consistency as ‘the use of the same methods for the same items’ (para. 2.26). This may be
in reference to the use of consistent methods either by different entities for the same period or by the same
entity over different periods.
Comparability is not satisfied by mere uniformity of accounting policies and methods. In fact,
the Conceptual Framework (para. 2.27) cautions against this view because it may result in dissimilar
items being treated or presented similarly. For example, assets that form part of continuing operations
differ from assets that form part of discontinued operations. Future economic benefits of assets that form
part of continuing operations are expected to be recovered mainly by the continued use in the ordinary
course of business. On the other hand, the future economic benefits of assets forming part of discontinued
operations are expected to be recovered through disposal rather than continued use. The adoption of
uniform accounting methods to represent economic information about assets that form part of continuing
operations and those that form part of discontinued operations would not enhance comparability. Such
methods would fail to reflect the differences in the way that economic benefits are expected to be derived
from the two types of assets.
Comparability of financial statements is enhanced by the disclosure of the accounting policies adopted
in preparing the financial statements and of any changes in those policies and their effects. Disclosure of
accounting policies and material accounting policies are considered further in module 2.
Verifiability
Verifiability exists if knowledgeable and independent observers can reach a consensus that the information
is faithfully represented. As shown in table 1.6, verification may be direct or indirect.
TABLE 1.6
Form of verification
Form of verification
Example
Direct
Confirming the market price used to measure the fair value of an asset that is traded in
an active market
Indirect
Checking the inputs and processes used to determine the reported information. For
example, verifying fair value with a model that checks inputs such as the contractual
cash flows and the choice of an appropriate interest rate, and the methodology or
rationale used to estimate fair value.
Consensus might refer to a range (e.g. an estimate of the fair value of a corporate
bond that is not traded in an active market as being between $940 and $970) but not
necessarily to a point estimate (e.g. the historical cost being $990). Verifiability can help
to assure users that financial information is faithfully represented.
Source: Adapted from IFRS Foundation 2022, Conceptual Framework for Financial Reporting, para. 2.31, IFRS Foundation,
London, p. A27.
Timeliness
Timeliness enhances the relevance of information in GPFSs. Undue delays in reporting information may
reduce the relevance of that information to users’ decision making. Timeliness suggests that there is a need
for financial information at regular intervals, for example, half-year and annual financial reports.
The timeliness of financial information is critical for investment decisions. Unexpected events and
delayed news that impact negatively on the financial statements will normally result in a loss of confidence
and plummeting share prices within the investment market.
To maintain the timeliness of information reported in financial statements, it may be necessary to report
on the effects of a transaction or other event before all of the required information is available. Accordingly,
it may be necessary to use estimates instead of waiting until more directly observable information becomes
available, in which case the benefits from ensuring timeliness should be weighed against the costs of the
decrease in the reliability of the information. Technological advancements have improved the timeliness of
information disclosed because new technologies capture and disseminate information more quickly than
in the past.
Understandability
Understandability requires the information in financial statements to be clearly and concisely classified,
characterised and presented (Conceptual Framework, para. 2.34).
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MODULE 1 The Role and Importance of Financial Reporting 19
Understandability cannot be interpreted independently of the inherent capability of users of the
financial statements. Users are presumed to have reasonable knowledge of business and economic
activities (Conceptual Framework, para. 2.36). This implies that, for example, the informed user should
readily understand the measurement basis adopted for a particular financial statement item.
Information is not excluded from a financial report merely because it is difficult for users to understand
(Conceptual Framework, para. 2.35). This would be inconsistent with the characteristic of completeness
incorporated in faithful representation. Technological advancements may mean that information that was
previously difficult to understand can now be analysed with the help of artificial intelligence using
applications such as machine learning, thereby making more information suitable to be disclosed.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 2.34–2.36 of the Conceptual Framework.
QUESTION 1.6
The objectives of IFRS 13 Fair Value Measurement include establishing a common definition of fair
value and common guidance for fair value measurement. The standard prescribes the following fair
value measurement hierarchy (in descending order).
Level 1 Quoted price for an identical asset or liability
Level 2 Observable prices other than those included within Level 1
Level 3 Unobservable inputs for the asset or liability.
Explain how the enhancing qualitative characteristics, comparability and verifiability, are applied
in the requirements of IFRS 13.
Application of Enhancing Qualitative Characteristics
Although enhancing characteristics improve the relevance or faithful representation of information, they
do not make irrelevant or unfaithfully represented information useful. If information were omitted from
financial statements, rendering them incomplete (not representing faithfully the effects of all transactions
and effects affecting the entity), the consistent omission of that information over multiple periods may
provide comparability, but it would not make the information useful. For example, if an entity omitted
several material subsidiaries from its consolidated financial statements, repeating this omission in each
reporting period may provide comparability. However, financial statements that do not faithfully represent
the financial position and financial performance of the group that they report on are not useful for user
decision making.
Preparers need to exercise professional judgement in balancing the qualitative characteristics and in
assessing the relative importance of enhancing characteristics in different contexts. In selecting an
appropriate accounting policy, such as a measurement attribute, preparers may need to make a tradeoff between an enhancing qualitative characteristic and another qualitative characteristic. For instance,
the preparer may need to forego the enhancing qualitative characteristic of comparability to change an
accounting policy in the interests of providing more relevant or more faithfully represented information.
For example, an entity may adopt fair value measurement in order to provide more relevant information
at the expense of comparability with previous periods. Additional disclosures, such as the reason for and
effects of the change of accounting policy, and the restatement of reported comparative amounts may
improve comparability to assist users in making decisions about the particular entity.
Module 2 considers the application of comparability in IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors in the context of disclosure requirements for changes in
accounting policies.
THE COST CONSTRAINT ON USEFUL FINANCIAL REPORTING
While the cost constraint of preparing general purpose financial statements was identified as a limitation
of GPFSs in general, the Conceptual Framework addresses this concern at the end of Chapter 2, after
describing the qualitative characteristics of financial information. More specifically, paragraph 2.39 of the
Conceptual Framework notes that a pervasive constraint on financial reporting is the balance between the
costs of providing financial information (that include the costs of collecting, processing, verifying and
disseminating information) versus the benefits derived from providing such information.
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20 Financial Reporting
Providing useful financial information facilitates the efficient functioning of capital markets and lowers
the cost of capital (Conceptual Framework, para. 2.41). The provision of relevant and faithfully represented
financial information enables users to make more informed decisions and to make their decisions more
confidently, which should generally benefit the entity providing that information. However, the cost of
meeting all information needs of all users is normally prohibitive, and therefore some information may
need to be left out from the statements. Materiality plays an important role in helping preparers and users
of financial reports decide what information needs to be provided. In addition, the IASB provides specific
exemptions within standards. For example, a lessee may elect to not apply lease recognition, measurement
and presentation requirements to leases of less than 12 months and where the asset being leased is of
low value (IFRS 16, paras 5–8). This exemption is allowed because the cost of obtaining the required
information may exceed the benefit of providing the information to users.
As technology progresses, the cost of financial reporting has the potential to decrease, while the benefits
of providing the information to users may increase as users may find new ways to analyse it. However,
the benefits of providing information via the traditional means of GPFSs may also decrease as users have
access to additional sources of relevant information. For example, new technologies may allow users to
analyse the tone of voice and facial expressions of executives at analyst or shareholders meetings to make
decisions instead of relying on potentially outdated financial information from GPFSs.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 2.39–2.43 of the Conceptual Framework.
APPLICATION OF QUALITATIVE CHARACTERISTICS IN THE
INTERNATIONAL FINANCIAL REPORTING STANDARDS
The qualitative characteristics are reflected in the underlying principles of the IFRSs. IAS 1 Presentation of
Financial Statements, paragraphs 15–24, refers to the Conceptual Framework definitions and recognition
criteria, objectives and qualitative characteristics. Specifically, IAS 1, paragraph 15, states:
Financial statements shall present fairly the financial position, financial performance and cash flows of
an entity. Fair presentation requires the faithful representation of the effects of transactions, other events
and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and
expenses set out in the [Conceptual Framework]. The application of IFRSs, with additional disclosure when
necessary, is presumed to result in financial statements that achieve a fair presentation.
1.4 THE ELEMENTS OF FINANCIAL STATEMENTS
Now that the fundamentals of financial reporting have been discussed, how the Conceptual Framework
addresses the elements that make up financial statements will be considered. The elements of financial
statements are assets, liabilities, equity, income and expenses. Figure 1.4 presents the key decisions relating
to the elements of the financial statements. The first two decisions (definition and recognition) will be
discussed in this section, while measurement and disclosure will be considered later in the module.
DEFINING THE ELEMENTS OF FINANCIAL STATEMENTS
Assets
Note that the definitions of assets and liabilities are fundamental because the definitions of the other
elements flow from them. The Conceptual Framework defines an asset 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 (paras 4.3–4.4).
The three key components of the asset definition are:
1. it is a right
2. it has the potential to produce future economic benefits
3. the asset is controlled by the entity.
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MODULE 1 The Role and Importance of Financial Reporting 21
FIGURE 1.4
Key decision areas in accounting for transactions and other events
1. Definition
• Did a past event, or events, give rise to an item that satisfies
the definition of an element of financial statements?
2. Recognition
• Does an item that meets the definition of an element need to be
incorporated in financial statements?
3. Measurement
• How to measure the items that are recognised in financial
statements?
4. Disclosure/Presentation
• How should items be disclosed or presented in financial
statements or notes to the accounts?
Source: CPA Australia 2022.
For an asset to exist, an entity must have the right to it, established by contract, legislation or other means.
The most common type of rights are the rights arising from legal ownership. While in principle, each of
an entity’s right is a separate asset, related rights are treated as a single asset (Conceptual Framework,
para. 4.11). Sometimes, it may be difficult to establish whether a right exists. In those cases, until the
existence uncertainty is clarified, it is uncertain whether an asset exists.
Only the rights that have the potential to produce future economic benefits for an entity beyond the
economic benefits available to other parties are to be treated as assets by that entity. Rights that everyone
can access and use to generate economic benefits (e.g. rights of access to public goods) cannot be
considered assets by entities that use them.
For an entity to have control, it does not necessarily follow that the entity has ownership of the asset. For
example, IFRS 16 Leases requires a right-of-use asset to be recognised for a leased asset, even though the
entity does not own the underlying asset (e.g. a building). This is because the entity controls the benefits
arising from using the asset during the lease term.
Consider the following example. A mining company has responsibility for maintaining a private road
on land over which it holds a lease. The road provides access to the mine. Recently, the company paid for
the road to be resealed (resurfaced) at a cost of $3 million. The economic benefits from the resealed road
are expected to be obtained over several accounting periods, even though the association with income can
only be broadly or indirectly determined. In accordance with IAS 16 Property, Plant and Equipment, the
expenditure on resealing the road should be capitalised as part of the road. The new road surface enhances
the economic benefits that the company expects to obtain from the use of the road. Control has been
established because the resealed road is on land over which the company has obtained control by entering
into a lease. The costs of resealing the road should then be progressively recognised over the useful life of
the road as expenses (i.e. depreciation).
Assets are considered to result from past events. A past event normally occurs when the asset is
purchased or produced. However, assets may also arise in other circumstances. For example, an asset
may be gifted to the entity as part of a government grant program. It is important to draw the distinction
between past events and transactions or events that are expected to occur in the future. Future transactions
do not give rise to assets until such time as they occur. For instance, if an entity develops an operational
plan that requires the purchase of an item of machinery in six months, the definition of an asset is not met
until such time as the machinery is purchased.
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22 Financial Reporting
It is important to note that the definition does not require the asset to be a physical asset. Many assets,
such as patents and copyrights, are intangible in nature. These assets give rise to future economic benefits
(in the form of royalties or sales) but do not have a physical form.
Liabilities
A liability is defined as:
a present obligation of the entity to transfer an economic resource as a result of past events
(Conceptual Framework, para. 4.26).
The key components of the liability definition are:
1. the requirement for the entity to have a present obligation
2. the obligation is to transfer an economic resource
3. that the present obligation exists as a result of past events.
A present obligation may be legally enforceable, or it may arise from normal business practice, custom
and a desire to maintain good business relationships or to act in an equitable manner. For example, an entity
selling goods may have a long time practice to accept the return of faulty goods for a full exchange, even
after the contractual warranty period has expired, to maintain favourable relationships with its customers.
Nevertheless, the present obligation should be strictly related to a transaction or other event that took place
in the past — in the previous example, that transaction is the sale of goods.
The transfer of economic resources is often referred to as the ‘settlement’ of a liability.
Paragraphs 4.39–4.40 of the Conceptual Framework provide examples of how a liability might be settled,
as shown in figure 1.5.
FIGURE 1.5
Examples of how a liability might be settled
Transfer of
other assets
Payment
of cash
Liability
settlement
Conversion of
the obligation
to equity
Provision
of services
Replacement
of the obligation
with another
obligation
Source: Adapted from IFRS Foundation 2022, Conceptual Framework for Financial Reporting, paras 4.39–4.40, IFRS Foundation,
London, pp. A42–A43. © CPA Australia 2022.
The conversion of an obligation to equity and the replacement of an obligation with another obligation
do not directly involve a transfer of economic resources. Consider, for example, the issue of shares to
debt-holders in settlement of a liability. The issue of shares would normally involve consideration passing
to the entity. If debt is settled by conversion to shares, the consideration ‘paid’ by the debt-holders is
the surrender of their debt claim against the entity. From the perspective of the entity issuing the shares,
the consideration is the discharge of the obligation for the debt. Instead of receiving an inflow of economic
resources in consideration for the issue of shares, it has avoided an outflow of resources. The economic
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MODULE 1 The Role and Importance of Financial Reporting 23
substance is the same as if the new shareholders had contributed cash or other economic resources for the
shares and those resources were used to settle the liability.
Liabilities only arise from a past event or transaction. For example, if an entity purchases an item of
equipment for $1 million and agrees to pay for the equipment in 90 days, the past event is purchasing the
asset (the equipment), and the entity has an obligation to pay for the equipment. It is important to note that
a decision by management to undertake a particular transaction in the future (e.g. to acquire a new item of
plant and equipment) does not, of itself, give rise to a liability.
Equity
Equity is defined as ‘the residual interest in the assets of the entity after deducting all its liabilities’
(Conceptual Framework, para. 4.63).
The definition of equity flows from the definitions of assets and liabilities. Equity is simply the
difference between assets and liabilities. Furthermore, the amount at which equity is shown in the statement
of financial position is derived from the recognition and measurement of assets and liabilities. Figure 1.6
illustrates how equity changes during the reporting period because of an entity’s financial performance
and its contributions from, and distributions to, holders of equity claims.
FIGURE 1.6
How recognition links the elements of financial statements
Statement of financial position at beginning of reporting period
Assets minus liabilities equal equity
Statement(s) of financial performance
Income minus expenses
Changes in equity
Contributions from holders of equity claims minus distributions to
holders of equity claims
Statement of financial position at end of reporting period
Assets minus liabilities equal equity
Source: IFRS Foundation 2022, Conceptual Framework for Financial Reporting, IFRS Foundation, London, diagram 5.1, p. A51.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 4.63–4.67 of the Conceptual Framework.
Income
Income is defined as:
increases in assets, or decreases of liabilities, that result in increases in equity, other than those relating to
contributions from holders of equity claims (Conceptual Framework, para. 4.68).
The two essential characteristics of income are:
1. an increase in assets or a reduction in liabilities
2. an increase in equity, other than as a result of a contribution from owners.
Income does not arise from an increase in assets if there is a corresponding increase in liabilities because
there would not be an increase in equity. For example, if an entity receives revenue in advance of services
being provided, it would recognise an increase in assets (i.e. cash) and an equivalent increase in liabilities
(i.e. unearned revenue or revenue received in advance) representing the obligation to deliver services yet
to be rendered. Income does not arise until the liability is reduced. As the services are rendered, the entity
recognises income and a corresponding reduction in the liability.
Pdf_Folio:24
24 Financial Reporting
Income refers to both revenue and gains. Revenue arises in the course of the ordinary activities of an
entity (e.g. through sales). Revenue from contracts with customers, a subset of revenue, is discussed in
module 3. Gains are those items that meet the definition of income that may or may not arise in the course
of ordinary activities of an entity (e.g. sale of a non-current asset). They are not a separate element in the
Conceptual Framework as they are not considered different in nature to revenue (Conceptual Framework,
para. 4.72).
Expenses
Expenses are defined as:
decreases in assets, or increases of liabilities, that result in decreases in equity, other than those relating to
distributions to holders of equity claims (Conceptual Framework, para. 4.69).
The two essential characteristics of an expense are:
1. a decrease in assets or an increase in liabilities
2. a decrease in equity, other than those arising from distributions to holders of equity claims.
An expense is the opposite of income. An example of an expense is wages, which involve outflows
of cash and cash equivalents to employees for the provision of services. Depreciation is an example of
an expense involving the depletion of assets. The accrual of electricity charges gives rise to an expense
involving the incurrence of a liability.
The measurement of profit or loss is determined as the difference between income and expenses.
However, under the IFRSs, not all items that meet the definitions of income and expenses are recognised
as income or expenses used in the calculation of profit. For example, revaluation gains on property, plant
and equipment under the valuation model are required to be recognised in OCI and accumulated in equity,
unless a prior downward revaluation is being reversed (IAS 16 Property, Plant and Equipment). Gains and
losses that are recognised in other comprehensive income are reported in the statement of P/L and OCI in
accordance with IAS 1 Presentation of Financial Statements (refer to module 2).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 4.68–4.72 of the Conceptual Framework.
CRITERIA FOR RECOGNISING ELEMENTS OF
FINANCIAL STATEMENTS
Recognising elements of financial statements involves capturing, in words and with a monetary amount,
the items that meet the definition of an asset, a liability, equity, income or expenses, either alone or in
combination with other items that meet the same definition. The items recognised as assets, liabilities
and equity will then be depicted in the statement of financial position, while the recognised income and
expenses will be included in the statement of financial performance. The monetary amount at which an
asset, liability or equity is recognised in the statement of financial position is referred to as its carrying
amount (Conceptual Framework, para. 5.1). However, not all items that meet the definition of elements
of financial statements are recognised.
An asset or liability is recognised only if recognition of that asset or liability and of any resulting income,
expenses or changes in equity provides users of financial statements with information that is useful
(Conceptual Framework, para. 5.7).
As mentioned in Chapter 1 of the Conceptual Framework, information is considered useful if it is
relevant and faithfully represents what it is supposed to represent. As such, the recognition of an item that
meets the definition of an element of the financial statements is considered appropriate according to the
Conceptual Framework when it provides relevant information and a faithful representation of that element.
If it is uncertain whether the element exists or if the probability of an inflow or outflow of economic
benefits is low, the information provided by recognising that element may not be relevant; therefore, the
element may not need to be recognised. If there is measurement uncertainty with regards to the amount
to be recognised for an element of financial statements or if related elements are not properly captured in
the financial statements, the information provided by recognising that element may not result in a faithful
representation of elements of financial statements; therefore, the element may not need to be recognised.
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MODULE 1 The Role and Importance of Financial Reporting 25
In recognising the elements of financial statements, the cost constraint has to be taken into consideration
as well. ‘An asset or liability is recognised in the financial statements if the benefits of the information
provided to users of financial statements by recognition are likely to justify the costs of providing and
using that information’ (Conceptual Framework, para. 5.8). If an item satisfying the definition of an asset
or liability is not recognised, an entity may still need to provide information about that item in the notes to
the financial statements (Conceptual Framework, para. 5.11). As equity is defined as the residual interest
in the assets of the entity after deducting all its liabilities, changes in equity will be recognised whenever
the change in recognised assets does not match the change in recognised liabilities.
The recognition of income and expenses is based on the recognition of assets and liabilities to which
they relate. According to the Conceptual Framework, paragraph 5.4:
(a) the recognition of income occurs at the same time as:
(i) the initial recognition of an asset, or an increase in the carrying amount of an asset; or
(ii) the derecognition of a liability, or a decrease in the carrying amount of a liability.
(b) the recognition of expenses occurs at the same time as:
(i) the initial recognition of a liability, or an increase in the carrying amount of a liability; or
(ii) the derecognition of an asset, or a decrease in the carrying amount of an asset.
It should be noted that the link between the recognition of income and expenses and the changes in assets
and liabilities does not mean that all the changes in the recognised assets and liabilities will result in income
or expenses being recognised — some of the changes in recognised assets and liabilities may be due to
contributions from equity holders or distributions made to them. Furthermore, income and expenses do
not arise when there are corresponding amounts recognised to another asset or liability account that result
in no change to equity. For example, purchase of inventory on credit terms or receipt of cash for trade
receivables.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 5.1–5.25 of the Conceptual Framework.
The definitions and recognition criteria for assets, liabilities, income and expenses set out in the
Conceptual Framework are referenced in IAS 1, paragraph 15.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 15–24 of IAS 1 Presentation of Financial
Statements.
DERECOGNITION OF ASSETS AND LIABILITIES
Derecognition is a concept that applies only to recognised assets and liabilities. According to the
Conceptual Framework, an item is normally derecognised when it no longer meets the definition of an
asset or a liability (para. 5.26):
(a) for an asset, derecognition normally occurs when the entity loses control of all or part of the recognised
asset; and
(b) for a liability, derecognition normally occurs when the entity no longer has a present obligation for all
or part of the recognised liability.
The requirements relating to derecognition are designed to ensure that the resulting information
faithfully represents any assets and liabilities retained after the transaction or other event that led to the
derecognition, as well as the change in assets and liabilities as a result of that transaction or other event
(Conceptual Framework, para. 5.27).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 5.26–5.33 of the Conceptual Framework.
Pdf_Folio:26
26 Financial Reporting
CONSTRAINTS ON INTERNATIONAL CONSISTENCY OF THE
APPLICATION OF RECOGNITION CRITERIA ESTABLISHED BY
THE CONCEPTUAL FRAMEWORK
The business and legal environments in which entities operate, and the social and political environment
within which standard setting occurs, may impose constraints on the consistent application of the
recognition criteria established in the Conceptual Framework across the world. Although the Conceptual
Framework establishes the general criteria, it does not necessarily remove the need for professional
judgement by accountants.
For technical reasons, it may not always be possible to have consistency between accounting standards
applicable in various countries and the Conceptual Framework, but inconsistency may also arise because
of the need to take economic constraints or consequences into consideration. The application of accounting
standards can have economic consequences that management and user groups consider disadvantageous.
For example, an accounting standard might prohibit the recognition of certain intangible assets, or it
might reduce the incidence of their recognition by requiring that very stringent conditions be satisfied
before such assets are recognised. Applying such an accounting standard could reduce the reported profit of
some entities and increase the volatility of the reported profit of others. In turn, this could cause share prices
of the affected entities to fall because of investors’ perceptions that the risk of investing in such entities has
increased. Moreover, if managers’ salaries are based (even in part) on share prices, their remuneration may
also decrease. Economic consequences of this kind may lead to accounting standard setters departing from
a conceptually ‘pure’ approach outlined in the framework in order to satisfy interest groups who claim that
their interests would otherwise be adversely affected.
Other types of constraints include social and political constraints. These may arise because professional
accountants feel that their ability to exercise autonomy and judgement is constrained by the framework and
related standards. Political constraints may arise as external regulators seek to impose their own desires
on how reporting is performed.
A final constraint is based on human resources and cost. A considerable amount of time and cost is
required to apply the framework, and it is necessary to work with a wide range of stakeholders. Lack of
funding and time is often a constraint in this regard.
1.5 MEASUREMENT OF ELEMENTS OF
FINANCIAL STATEMENTS
After it has been determined that an event has resulted in an item that meets the definition of an element
of financial statements (item 1 of figure 1.4) and that the recognition criteria are satisfied (item 2 of
figure 1.4), the next decision is in relation to how the item should be measured (item 3 of figure 1.4).
In relation to assets and liabilities, there are two stages of the measurement decision:
1. how to measure the asset or liability at initial recognition
2. how to measure the asset or liability subsequent to initial recognition.
Changes in assets and liabilities affect the reported income, expenses and equity. Therefore, the measurement bases chosen for assets and liabilities have clear implications for the amount of income and
expenses reported in financial statements. Different bases can be adopted in measuring the same item. For
example, the value in exchange of an asset may be measured at market price or at net realisable value.
Further, accounting measurement is problematic because various attributes of a particular element can be
measured in the same unit of measurement. For example, the value in use of an asset (an entity-specific
value) or its value in exchange can be measured using the same currency unit.
The Conceptual Framework defines measurement and identifies and describes alternative measurement
bases, before concluding with a description of the factors to consider when selecting a measurement
basis. In addition, accounting standards may state the measurement basis for a specific item; for example,
IAS 2 Inventory states the measurement basis for inventory at cost or net realisable value, whichever
is lower. Also, accounting standards may need to describe how to implement the measurement basis
prescribed in those standards (Conceptual Framework, para. 6.3).
The Conceptual Framework focuses on the following categories of measurement bases: historical cost
(including amortised cost) and current value (including fair value, value in use for assets and fulfilment
value for liabilities and current cost). The International Financial Reporting Standards refer to more
measurement bases, classified under the following categories: cost-based and value-based measures.
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MODULE 1 The Role and Importance of Financial Reporting 27
The measurement bases prescribed in IFRSs are going to be addressed next. Reference to the Conceptual
Framework will be included when the measurement bases prescribed in IFRSs overlap with those
measurement bases mentioned in this framework.
COST-BASED AND VALUE-BASED MEASURES USED IN THE
INTERNATIONAL FINANCIAL REPORTING STANDARDS
In broad terms, cost-based measures are based on entry prices. An entry price is the price paid to acquire
an asset or received to assume a liability (IFRS 13, para. 57). As such, the cost-based measures in
relation to assets include measures of the cost incurred by an entity to acquire an asset. Variations of
cost-based measures may adjust the cost for amortisation, depreciation or interest expense, as well as for
any accumulated impairment.
In relation to a liability, cost-based measures include the proceeds received in exchange for the
obligation, such as the proceeds of an issue of debentures, or the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business (e.g. provision for
annual leave).
Value-based measures broadly include those measurement bases that require some form of valuation to
be undertaken, such as fair value. In practice, the distinction between cost-based and value-based measures
may have more to do with semantics than with substance. For example, to measure the cost of acquiring
an asset, it is necessary to measure the fair value of the purchase consideration. Figure 1.7 depicts the
key cost-based and value-based measures used in IASB pronouncements. The key characteristics of the
measures applied in the IFRSs are also described.
FIGURE 1.7
Measurement bases specified under International Accounting Standards Board pronouncements
Measurement bases under IASB pronouncements
Cost-based
Value-based
Cost/historical cost
Fair value
Amortised cost
Current cost
Fair value less costs of disposal
Net realisable value
Present value
(measurement technique)
Fulfilment value
Value in use
Source: CPA Australia 2022.
Cost/Historical Cost
The first cost-based measure shown in figure 1.7 is cost/historical cost. The Conceptual Framework uses
the term ‘historical cost’ to refer to the same concept described as ‘cost’ in various IFRSs. The definition
of ‘historical cost’ of an asset in the Conceptual Framework, paragraph 6.5 is:
Pdf_Folio:28
the value of the costs incurred in acquiring or creating the asset, comprising the consideration paid to
acquire or create the asset plus transaction costs.
28 Financial Reporting
This definition is similar to the definition of cost used in a number of IASB pronouncements —
for example IAS 16 Property, Plant and Equipment, paragraph 6:
the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an
asset at the time of its acquisition or construction or, where applicable, the amount attributed to that asset
when initially recognised in accordance with the specific requirements of other IFRSs.
However, the Conceptual Framework extends its use of the concept of historical cost to liabilities, noting
that under historical cost, liabilities are recorded at:
the value of the consideration received to incur or take on the liability minus transaction costs (para. 6.5).
While cost, or historical cost, is often applied to many classes of assets, such as property, plant and
equipment and most intangible assets, other measurement bases are also in common use. Present practice
is best described as a mixed measurement accounting model.
Advantages that have been claimed for the historical cost basis of accounting include that it is:
• easily understood — by users and preparers of financial statements
• relevant to decision making — as it is the value of the consideration given or received in exchange for
an asset or a liability
• reliable — historical cost provides evidence of the value of the item based on actual transactions with
external parties
• inexpensive to implement — the measurement of historical cost is linked to the occurrence of transactions
and is therefore readily available at little or no additional cost.
The following deficiencies have been attributed to the historical cost basis of accounting.
• Limited relevance to decision making
– Historical cost is merely a historical record of the consideration paid or received, not a forwardlooking measure. Therefore, it has limited predictive value.
– Historical cost results in the distortion of performance measurement caused by old costs being
associated with current revenues. In the case of assets, some critics argue that it is better to match the
benefit received from the asset against the cost expected to replace the asset, not the historical cost.
• Undermines the faithful representation of financial reports
– Under historical cost, the increase or decrease in value of assets and liabilities are recognised when
realised (i.e. when a future transaction occurs), not when the prices or other values of assets and
liabilities change while still held by the entity. Therefore, reflecting the true value of the assets and
liabilities will be affected by the selective timing of the sale of assets.
– Historical cost for an asset must be supplemented by additional rules that check to see whether the
amount is recoverable. This is necessary to ensure that the carrying amount of the asset (i.e. the
amount at which it is recognised in the statement of financial position) does not exceed the future
economic benefits that the entity expects to derive from the asset. By contrast, realisable value reflects
the market’s assessment of the recoverable amount of an asset.
– Historical cost does not satisfactorily deal with assets acquired for significantly less than fair value.
In those cases, historical cost will probably not be indicative of the value of that asset to the entity.
– Costs incurred at various points in time are aggregated as though they are equivalent in economic
terms.
– The historical cost of some items may have resulted from an arbitrary allocation of an overall
cost to assets, liabilities and expenses; for example, allocating overhead costs across items of
inventory. These allocations may be arbitrary and may undermine the representational faithfulness of
historical cost.
• Undermines the comparability of financial reports
– In the case of self-constructed assets, the costs incurred depend on the efficiency of the entity. For
example, if two companies were building identical assets, the less efficient of the two would incur
the higher costs. Users may conclude that the company with the higher cost base is superior to the
company that incurred the lesser costs to construct the asset.
• Problems with reliability
– There can be difficulties in objectively determining the historical cost when calculating the fair value
of the purchase consideration and other incidental costs.
– Historical cost reflects, at a minimum, management expectations of the recoverability of an asset,
rather than user expectations.
Pdf_Folio:29
MODULE 1 The Role and Importance of Financial Reporting 29
Refer to Note 1 ‘Summary of significant accounting policies’ in the notes to financial statements of
Techworks Ltd (see appendix). Provide a summary of how the assets and liabilities of Techworks have
been measured.
QUESTION 1.7
The Sydney Harbour Bridge was officially opened on 19 March 1932. The total cost of the bridge
was approximately 6.25 million Australian pounds ($13.5 million) and was eventually paid off in 1988
(Sydney Online 2017).
Explain some of the limitations of using historical cost for the subsequent measurement of the
Sydney Harbour Bridge.
Amortised Cost
The second cost-based measure depicted in figure 1.7 is amortised cost. This is a measure applied to
certain financial assets and financial liabilities subsequent to initial recognition. Amortised cost is defined
in IFRS 9 Financial Instruments as:
asset or financial liability is measured at initial recognition minus the principal repayments, plus or minus
the cumulative amortisation using the effective interest method of any difference between that initial amount
and the maturity amount, and, for financial assets, adjusted for any loss allowance (IFRS 9, Appendix A).
The effective interest method uses the effective interest rate to allocate interest income or interest
expense over the effective life of a financial asset or liability. The effective interest rate is the rate that
discounts the estimated future cash receipts or payments through the expected life of a financial asset or
liability to the net carrying amount of the financial asset or liability.
The Conceptual Framework treats amortised cost as a measure under the historical cost measurement basis.
One way to apply a historical cost measurement basis to financial assets and financial liabilities is to
measure them at amortised cost. The amortised cost of a financial asset or financial liability reflects
estimates of future cash flows, discounted at a rate determined at initial recognition. For variable rate
instruments, the discount rate is updated to reflect changes in the variable rate. The amortised cost of a
financial asset or financial liability is updated over time to depict subsequent changes, such as the accrual
of interest, the impairment of a financial asset and receipts or payments (Conceptual Framework, para. 6.9).
EXAMPLE 1.3
Initial Recognition
B Ltd issues a note payable with the following terms.
• Face amount (i.e. maturity value) of $100
• Repayable at the end of Year 2
• Coupon interest at the rate of 10 per cent per period (year), which is payable at the end of each year.
The issuer of the note is obligated to pay $10 interest at the end of Year 1 (t1 ) and $110, being interest
and principal, at the end of Year 2 (t2 ).
The financial liability will be recognised in Year 0 based on the issue price, which in this case will be the
face amount (i.e. maturity value). However, it is common for debt securities like the note payable in this
exercise to be issued at an amount other than face value. If the market expects a rate of return greater
than 10 per cent for a debt security of equivalent risk, the issuer will need to discount the issue price so
that the holder effectively earns the expected rate of return.
EXAMPLE 1.4
Effective Interest Rate
Some of the facts from the previous example have been changed.
Pdf_Folio:30
30 Financial Reporting
B Ltd issues a note payable with the following terms.
Proceeds received on issue $96.62
Maturity value of $100
Repayable at the end of Year 2
Coupon interest at the rate of 10 per cent per period (year), which is payable at the end of each year.
The issuer of the note is still obligated to pay $10 interest at the end of Year 1 (t1 ) and $110, being interest
and principal, at the end of Year 2 (t2 ).
However, based on the consideration received, the market rate of interest (i.e. the effective interest rate)
demanded by purchasers of the debt security was 12 per cent. The effective interest rate is the rate at
which the present value (PV) of the contractual cash flows over the life of the debt security equals the
initial carrying amount based on the proceeds on issue of $96.62.
Based on the PV formula, the PV of the cash flows shown in this example, given an interest rate of
12 per cent per annum, can be calculated as follows.
•
•
•
•
PV =
FV
(1 + i)n
PV =
$10
$110
+
1.12 1.122
PV = $8.93 + $87.69 = $96.62
Alternatively, the formula for the PV of an annuity may be used. In this case, the interest and principal
repayment are viewed as two streams of cash flows: an annuity of $10 per annum for two years, payable
in arrears; and a payment of $100 at the end of two years. The PV of the cash flows shown in this example,
given an interest rate of 12 per cent per annum, can then be calculated as follows.
PV = CF ×
1 − 1∕ (1 + i)n
FV
+
i
(1 + i)n
PV = $10 ×
1 − 1∕1.122
$100
+
0.12
1.122
PV = $16.90 + $79.72 = $96.62
The PV of the cash flows can also be calculated using a financial calculator as follows.
Procedure
Key operation
Display
Enter cash flow data
[+/−]100 [FV]
[+/−]10 [PMT]
12 [I/Y]
2 [N]
[COMP] PV
−100 = >FV
−10 = >PMT
12 = > I/Y
2=>N
PV =
Calculate PV
−100.00
−10.00
12.00
2.00
$96.62
EXAMPLE 1.5
Amortised Cost at Reporting Date
Continuing to use the information from the previous examples, now consider amortised cost at
reporting date.
The note is carried by the issuer at amortised cost.
At t1 , when discounted at the effective rate of interest, the PV of the remaining cash flows is $98.21
($110/1.12). The discounting procedure automatically takes into account any principal repayments that
have been made (at t1 , no principal repayments have occurred in relation to the debt security) and any
cumulative amortisation of the initial discount on issue, as required by the definition of amortised cost in
IFRS 9 Financial Instruments.
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MODULE 1 The Role and Importance of Financial Reporting 31
This is illustrated by the calculation for the period ended t1 in table 1.7.
TABLE 1.7
Amortisation schedule
Date
t0
t1
t2
Total
Coupon
interest
(10%)
$
Effective
interest
(12%)
$
Discount
amortised
$
Unamortised
discount balance
$
Carrying
amount
$
10.00(b)
11.59(c)
1.59(d)
3.38(a)
1.79(e)
10.00(b)
20.00
11.79(g)
23.38
1.79(h)
3.38
96.62
98.21(f)
100.00(i)
(a) $100.00 − $96.62
(b) $100.00 × 0.10
(c) $96.62 × 0.12
(d) $11.59 − $10.00
(e) $3.38 − $1.59
(f) $96.62 + $1.59 = $100.00 − $1.79
(g) $98.21 × 0.12
(h) $11.79 − $10.00
(i) Before principal repayment
Source: CPA Australia 2022.
At the date of issue, the PV of the debt security at a discount rate of 12 per cent was $96.62. That
amount will be recognised as part of the initial recognition of the financial liability as the original carrying
amount. The unamortised discount at t0 was the difference between the maturity value of the debt, $100,
and the issue price, $96.62, as shown in the first row in the amortisation schedule.
As shown in the second row in the amortisation schedule, the coupon interest of $10 was paid during
the period ended t1 , but the effective interest expense on the amount of cash raised on issue of the debt
was $11.59 ($96.62 × 0.12). The difference between the effective interest, $11.59, and the coupon interest,
$10, was the amortised discount for the period, $1.59. The unamortised discount at t1 was $1.79, which is
the difference between the balance of the unamortised discount at t0 and the discount that was amortised
for the period ended t1 . As there were no principal repayments until t2 , the amortised cost of the debt at
t1 was $98.21 ($96.62 + $1.59). This is the amount that will be recognised as the carrying amount of the
financial liability at the end of t1 using the amortised cost measure.
Fair Value
The first value-based measure shown in figure 1.7 is fair value. This is defined in IFRS 13 Fair Value
Measurement as:
the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date (IFRS 13, para. 9).
The same definition is included in Conceptual Framework paragraph 6.12.
‘A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction
between market participants’ (IFRS 13, para. 15). The assumptions of an orderly transaction are identified
in IFRS 13 as follows.
A transaction that assumes exposure to the market for a period before the measurement date to allow for
marketing activities that are usual and customary for transactions involving such assets or liabilities; it is
not a forced transaction (e.g. a forced liquidation or distress sale) (IFRS 13, Appendix A).
The assumption of an orderly transaction is important for fair value. This enables fair value to reflect
an amount at which market participants would willingly exchange an item rather than a ‘liquidation’ or
‘fire-sale’ price that might be achieved in a forced sale if the vendor was financially distressed.
Fair value can be considered in terms of an entry price or exit price. The IFRS 13 definition, as well as the
Conceptual Framework definition, treats fair value as an exit price — the ‘price that would be received to
sell an asset or paid to transfer a liability’ (IFRS 13, Appendix A). This can be compared to an entry price,
which is the ‘price paid to acquire an asset or received to assume a liability in an exchange transaction’
(IFRS 13, Appendix A).
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32 Financial Reporting
Neither the Conceptual Framework nor IFRS 13 prescribe the use of fair value. While the Conceptual
Framework describes the factors to consider when selecting it as a measurement basis, IFRS 13 establishes
a hierarchy for the measurement of fair value when another standard prescribes or permits its use. The
hierarchy ranks the inputs to valuation techniques based on their verifiability so as to enhance comparability
and consistency. The highest rank (Level 1) is given to inputs that reflect quoted market prices for identical
assets or liabilities, and the lowest rank (Level 3) is assigned to inputs that cannot be observed in a market.
These levels are described as follows.
• Level 1 inputs: quoted price for an identical asset or liability. These inputs reflect quoted prices for
identical assets or liabilities in active markets. For example, if a blue chip ordinary share is valued, the
stock exchange price for the share is a Level 1 input. Note that the effective implementation of this level
requires careful consideration of the definition of ‘active markets’.
• Level 2 inputs: model with no significant unobservable inputs. Where Level 1 inputs are not available,
fair value is estimated using a model with no significant unobservable inputs. For example, the entity
may use quoted market prices for comparable assets, liabilities or equity instruments in active markets.
Other examples include option valuation models or PV techniques.
• Level 3 inputs: model with significant unobservable inputs. When quoted prices and other observable
inputs are not available, the entity uses inputs that are developed on the basis of the best information
available about the assumptions that market participants would use when pricing the asset or liability. For
example, unobservable inputs into a valuation model for residential mortgage-backed securities include
prepayment rates, probability of default and the severity of loss.
Fair value is considered by many to be more relevant than cost-based measures. However, fair value has
been criticised for reasons such as:
• lack of relevance to decision making — fair value is not relevant in relation to assets that the entity does
not intend to sell, such as financial instruments that the entity intends to hold to maturity
• problems with reliability — fair value is not very reliable in relation to assets that are not traded in an
active market.
QUESTION 1.8
Stanley Ltd holds a parcel of Alpha B redeemable 7 per cent cumulative preference shares issued by
Alpha Ltd. The Alpha B preference shares are unlisted. Stanley Ltd’s financial accountant measured
the value of the shares using the market price of Alpha A preference shares, which are listed,
redeemable, cumulative 5 per cent preference shares, issued by Alpha Ltd. The Alpha A preference
shares have a very similar maturity date to the Alpha B preference shares. The accountant
determined the yield of the Alpha A preference shares by reference to the quoted price and to
the timing and amount of the contractual cash flows. The accountant then applied the same yield
in a discounted cash flow model, using the contractual cash flows of Alpha B preference shares.
Which input level has the accountant used to measure the fair value of the Alpha B preference
shares? Give reasons for your answer.
Current Cost
Current cost is the second value-based measure shown in figure 1.7.
The current cost of an asset is the cost of an equivalent asset at the measurement date, comprising the
consideration that would be paid at the measurement date plus the transaction costs that would be incurred
at that date. The current cost of a liability is the consideration that would be received for an equivalent
liability at the measurement date minus the transaction costs that would be incurred at that date emphasis
added (Conceptual Framework, para. 6.21).
In relation to assets, the definition implies that there are two concepts of current cost:
1. reproduction cost — current cost of replacing an existing asset with an identical one
2. replacement cost — current cost of replacing an existing asset with an asset of equivalent productive
capacity or service potential.
The current cost of replacing or reproducing an asset is commonly interpreted as the most economic
cost to replace the asset (IASB 2005, p. 97). Therefore, reproduction or replacement cost may differ from
historical cost where an entity could, through efficiencies, reproduce or replace the service potential of an
asset for an amount that differs from the fair value of the purchase consideration given to acquire the asset.
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MODULE 1 The Role and Importance of Financial Reporting 33
Current cost (more specifically, current replacement cost) is an example of an entry price valuation
technique.
In some instances, reproduction of an existing asset, such as a brand name, may not be feasible because
of its uniqueness. Difficulties may also arise with replacing an asset with one that provides equivalent
capacity because advances in technology may mean that any available replacement asset would increase
capacity. For example, it would be difficult to replace a computer without increasing capacity or service
potential because of the rapid advances in computer technology.
Current cost has been criticised on a number of grounds, including the following.
• Lack of relevance to decision making
– Current cost is not a measure of the value received but of the amount of the sacrifice that would be
required to replace an asset, and therefore, it has limited predictive value.
– Financial information based on current cost is difficult to interpret where an entity does not intend to
replace its assets.
– Current cost’s applicability to non-renewable or irreplaceable assets such as oil and gas reserves is
questionable.
– Current cost is not an independent measurement basis. It must be supplemented by additional rules
to ensure that the amount represented by current cost is recoverable.
• Reliability problems
– Reliability may be reduced by the need to identify assets of equivalent productive capacity or service
potential and by measuring their most economic current cost.
– There may be uncertainty about the reliability of measurement because replacement cost is an entityspecific measure that depends on management’s strategies and intentions about the level of capacity
at which the asset is used.
• Comparability problems
– Management strategies and expectations with respect to the assets concerned (e.g. nature of the use
of a building and whether it is fully occupied) may change in response to changes in the business
environment or over time.
– There may be significant differences between entities in the determination of current cost.
The only IFRS that addresses the use of the current cost measurement basis is IAS 29 Financial
Reporting in Hyperinflationary Economies.
QUESTION 1.9
Refer to question 1.7 regarding the Sydney Harbour Bridge. How might using an alternative
measure, such as current cost, overcome the limitations of cost outlined in that question?
Fair Value Less Costs of Disposal
The third value-based measure shown in figure 1.7, fair value less costs of disposal, is a variant of fair
value used in some standards. For example, fair value less costs of disposal is used in IAS 36 Impairment of
Assets, which defines the recoverable amount of an asset or cash-generating unit as ‘the higher of its fair
value less costs of disposal and its value in use’ (IAS 36, para. 6). Costs of disposal are the ‘incremental
costs directly attributable to the disposal of an asset or cash-generating unit, excluding finance costs and
income tax expense’ (IAS 36, para. 6). Finance costs and income tax are similarly excluded from the
measurement of costs to sell by IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
(Appendix A).
Net Realisable Value
The fourth value-based measure shown in figure 1.7 is net realisable value. This approach measures the
economic benefits that an entity expects to derive from selling an asset in the ordinary course of business.
The use of net realisable value in financial reporting is largely restricted to its role in measuring inventories
at the lower of cost and net realisable value, in accordance with IAS 2 Inventories. Net realisable value is:
the estimated selling price in the ordinary course of business less the estimated costs of completion and the
estimated costs necessary to make the sale (IAS 2, para. 6).
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34 Financial Reporting
Applied to inventory, net realisable value is a measure of the net amount that the entity expects to derive
from the sale of the inventory in the ordinary course of business.
Net realisable value differs from fair value less costs to sell, which measures the amount that could be
obtained from selling the asset in its current state. Net realisable value measures the benefits that the entity
expects to realise from the asset in the ordinary course of business. If the inventory is in a complete state,
there is generally no difference between the two values. However, work-in-progress inventory would be
completed before being sold in the ordinary course of business. Accordingly, the net realisable value of
work-in-progress inventory usually differs from its fair value less costs to sell.
Net realisable value may also reflect entity-specific expectations regarding the estimated selling price
in the ordinary course of business, the estimated cost of completion and costs necessary to make the sale.
These expectations may not be in accordance with market expectations on which fair value would generally
be based. For example, a second-hand car dealer may sell a specific model of car for $10 000 in the normal
course of business. If the estimated costs to make the sale are nil, the net realisable value of the car to
the dealer is $10 000. The same car is available for sale on second-hand car websites for $8000, without
selling costs, through private sales, which may be used as an indicator of fair value. If the second-hand car
belongs to an entity whose main business is not to sell cars, the entity may recognise the car based on the
fair value of the car of $8000; if the second-hand car belongs to an entity whose main business is to sell
cars, the entity may recognise the car based on the net reliable value of the car of $10 000.
Fulfilment Value
The fifth value-based measurement shown in figure 1.7 is fulfilment value. It is defined in the Conceptual
Framework as follows.
Fulfilment value is the present value of the cash, or other economic resources, that an entity expects to be
obliged to transfer as it fulfils a liability. Those amounts of cash or other economic resources include not
only the amounts to be transferred to the liability counterparty, but also the amounts that the entity expects
to be obliged to transfer to other parties to enable it to fulfil the liability (para. 6.17).
The definition of fulfilment value used in the Conceptual Framework differs slightly from the concept
of the fair value of a liability described in the framework and used by the IASB in IFRS 13 Fair Value
Measurement. The fair value of a liability is the amount that would be paid to transfer a liability in an orderly
transaction between market participants at the measurement date. In contrast, the fulfilment value refers
to the amount that the entity expects to be obliged to transfer to settle the liability with the counterparty.
While fair value is determined based on market-participant assumptions, the fulfilment value of a
liability reflects entity-specific assumptions rather than assumptions by market participants, including
whether the entity should settle the liability using its own internal resources and the efficiency with which
an entity can settle a liability (which depends on the advantages and disadvantages that a particular entity
has relative to the market). In practice, there may sometimes be little difference between the assumptions
that market participants would use and those that an entity itself uses (Conceptual Framework, para. 6.19).
Value in Use
The sixth and final value-based measure shown in figure 1.7 is value in use. This measure is defined in
IAS 36 (para. 6) as ‘the present value of future cash flows expected to be derived from an asset or cashgenerating unit’. The Conceptual Framework refers to a similar definition as follows.
Value in use is the present value of the cash flows, or other economic benefits, that an entity expects to
derive from the use of an asset and from its ultimate disposal (para. 6.17).
Value in use is also frequently referred to as the ‘entity-specific value’. The value in use should reflect
the estimated future cash flows that ‘the entity expects to derive from the asset’ (IAS 36, para. 30(a)).
However, other elements of the value-in-use computation may reflect market expectations rather than the
entity’s expectations. For example, the discount rate that is applied to the expected cash flows must reflect
the current market assessment of the time value of money and the risks specific to the asset for which the
future cash flow estimates have not been adjusted (IAS 36, para. 55).
The entity-specific value-in-use measurement basis has the following advantages.
• Management is in the best position to judge the expected amount, timing and risk of future cash
flows. Accordingly, financial statements are considered to be more relevant and reliable as they reflect
management’s intentions and expectations.
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MODULE 1 The Role and Importance of Financial Reporting 35
• Management would be held more accountable against measurements that reflect entity-specific management objectives.
The criticisms of the value-in-use basis of measurement include the following.
• Reliability problems
– Because value in use is normally calculated as the discounted future cash flows derived from the use
of an asset, it is specific to each entity and to each specific use. It therefore relates to only one specific
future course of action or combination of actions.
– Value in use is subjective and is not capable of being independently verified by others.
– The application of value in use to assets that do not generate contractual cash flows is problematic.
– An individual asset may work with other assets to generate cash flows. The measurement of value in
use of each asset results in the need to allocate expected cash flows across assets. These allocations
may be arbitrary.
• Understandability
– As cash flows are based on management expectations, while the discount rate used to calculate the
present value of those cash flows is based on market conditions, there seems to be a lack of clarity
regarding whether value in use should reflect management or market expectations.
PRESENT VALUE AS A VALUATION TECHNIQUE
Figure 1.7 shows present value (PV) separately, as it is not a measurement basis; rather, it is a measurement
or valuation technique that can be used to estimate other measurement bases. For example, amortised cost
and value in use rely on present value calculations. Similarly, IFRS 13 Level 2 or Level 3 fair values may be
determined based on a present value technique (IFRS 13, para. 74). The present value technique involves
discounting a series of expected cash flows using an appropriate discount rate to control for the time value
of money and risk. As such, issues that arise in the application of the present value technique include the:
• uncertainty of future cash flows
• selection of an appropriate discount rate.
Uncertainty of Future Cash Flows
The reliable measurement of the PV of individual assets and liabilities is problematic because future cash
flows often occur under conditions of uncertainty. Even for contractual amounts, future cash flows may
differ from those originally expected.
IAS 37 Provisions, Contingent Liabilities and Contingent Assets requires that the amount recognised
as a provision must be ‘the best estimate of the expenditure required to settle the present obligation at the
end of the reporting period’ (IAS 37, para. 36). This is often expressed as the amount required to settle
the obligation immediately or to transfer it to a third party. Where the effect of the time value of money
is material, the provision is measured as the PV of the ‘expenditures expected to be required to settle the
obligation’ (IAS 37, para. 45). The role of uncertain future events must be taken into account ‘where there
is sufficient objective evidence that they will occur’ (IAS 37, para. 48) and must be based on reasonable and
supportable assumptions. For example, where there is sufficient objective evidence that imminent changes
in technology will reduce the cost of settling obligations arising from a product warranty, such changes
are taken into account in measuring the provision.
A further difficulty can arise in determining the appropriate level of aggregation of cash flows. The need
to allocate cash flows to particular items when those cash flows are produced by the interaction of more
than one factor of production may introduce additional subjectivity into PV calculations. For example,
IAS 36 Impairment of Assets contains requirements and guidance for the measurement of value in use
when assessing the recoverable amount of an asset. When it is not possible to determine the recoverable
amount of an individual asset, IAS 36 paragraph 66 requires the entity to determine the recoverable amount
for the cash-generating unit to which the asset belongs.
Selection of Appropriate Discount Rates
Another complexity in the application of the present value technique is the need to select an appropriate
discount rate. PV may be sensitive to the rate chosen for the purpose of discounting future amounts
to a PV.
According to contemporary finance theory, investors require a rate of return that is commensurate with
the systematic risk of an investment, irrespective of whether the investment is in a financial asset or a
project involving non-monetary assets. Therefore, for the purpose of project evaluation, managers should
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36 Financial Reporting
use a current, market-determined, risk-adjusted discount rate that reflects the systematic risk of the asset,
or group of assets, concerned.
The total risk of an asset comprises systematic risk and unsystematic risk. Systematic risk is sometimes
referred to as market risk or non-diversifiable risk. Systematic risk relates to the extent that the variability
of the return earned on an asset, or group of assets, is due to economy-wide factors affecting all assets. It
can be contrasted with unsystematic risk, the risk that is specific to a particular asset due to that asset’s
unique features. Investors can drive asset-specific (unsystematic) risk towards zero by holding a diversified
portfolio of assets. However, systematic risk cannot be eliminated in this manner. Because investors can
eliminate unsystematic risk, equilibrium returns reflect only the risk-free rate plus a return for bearing
systematic risk in excess of the risk-free rate.
It is important to note that this conclusion emerges from the investor’s capacity to diversify, either
directly or via a mutual fund. It is unrelated to a producing entity’s capacity, or lack of capacity, to diversify
its investment projects. As investors can diversify their investments, diversification or lack thereof by
a producer does not add or reduce value for investors. Investors will not pay any more than the price
associated with the return required to compensate for systematic risk. This means that producing entities
should accept a project that has a positive net present value when the cash flows are discounted at a rate
adjusted for the systematic risk of the project. That is, each project has its own discount rate adjusted
for systematic risk.
There is a preference in accounting pronouncements for using discount rates that are risk-adjusted when
measuring the present values. For example, IAS 19 Employee Benefits states:
The rate used to discount post-employment benefit obligations (both funded and unfunded) shall be
determined by reference to market yields at the end of the reporting period on high quality corporate bonds.
For currencies for which there is no deep market in such high quality corporate bonds, the market yields
(at the end of the reporting period) on government bonds denominated in that currency shall be used. The
currency and term of the corporate bonds or government bonds shall be consistent with the currency and
estimated term of the post-employment benefit obligations (IAS 19, para. 83).
Another issue is whether to use a current market rate (whether risk-free or risk-adjusted) or the historical
interest rate implicit in the original transaction. Historical and current rates are now considered.
Historical Rates
In the context of a historical cost system, the historical interest rate implicit in the original contract is
usually considered to be the rate at which the cash flows specified in the contract are to be discounted. At
the date of issuing a financial instrument, the discount rate implicit in the original contract is the effective
rate demanded by lenders. Where a financial instrument is traded in an active market, the discount rate
implicit in the original contract is a market-determined, risk-adjusted discount rate, current at the date of
issue of the financial instrument.
Pronouncements that require the use of historical rates include IFRS 9 Financial Instruments. Certain
financial liabilities and assets are carried at amortised cost, using the effective-interest-rate method
(IFRS 9, paras 4.1.1 and 4.2.1 and Appendix A).
IFRS 16 Leases is another example of a pronouncement that requires the use of historical rates. More
specifically, IFRS 16 requires lease liabilities and receivables to be recognised initially by lessees and
lessors by discounting the relevant cash flows to present values using the interest rate implicit in the lease
(IFRS 16, paras 26 and 68).
Current Rates
Current rates are based on a discount rate that is current at the end of the reporting period. Current rates
may be adjusted for risks (unless risks are otherwise adjusted for in the estimated cash flows) and may
be market-determined. The use of current, market based, risk-adjusted rates in determining PV is more
consistent with a fair value approach to measurement because it reflects the rate that the market would use
to discount the expected future cash flows.
Examples of pronouncements that specify the use of current rates include:
• IAS 19 Employee Benefits. The standard adopts the position that employer obligations arising from
defined benefit plans and other long-term employee benefits, such as long service leave (LSL), are
measured at their present values at the end of the reporting period. The rate used to discount such
obligations is determined by reference to market yields on high-quality corporate bonds with equivalent
terms and currency at the end of the reporting period (IAS 19, para. 83).
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MODULE 1 The Role and Importance of Financial Reporting 37
• IAS 36 Impairment of Assets. This standard requires that the discount rate used in determining value in
use be a pre-tax rate that reflects current market assessments of the time value of money and the risks
specific to the asset for which the future cash flows have not been adjusted (IAS 36, para. 55).
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The standard requires provisions to be
measured at present value using ‘. . . a pre-tax rate (or rates) that reflect(s) current market assessments
of the time value of money and the risks specific to the liability’ (IAS 37, para. 47).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 6.1–6.95 of the Conceptual Framework.
1.6 APPLICATION OF MEASUREMENT PRINCIPLES
IN THE INTERNATIONAL FINANCIAL
REPORTING STANDARDS
Accounting standards provide the practical mechanism for achieving the overall objectives of financial
reporting, as well as outlining how best to achieve as many qualitative characteristics as possible. By
specifying how accounting information should be treated and reported, different organisations can gain
considerably more consistency and understandability than would be achieved if they used their own
judgement when reporting their financial affairs. It also limits the scope for abuse and misreporting that
may arise when the economic self-interest of organisations or their managers interferes with objective
reporting. Moreover, accounting standards go beyond specifying how items must be reported; they provide
detailed discussion of why the mandated approaches are required.
This section will take a closer look at the mixed measurement model applied in the IFRSs. Mixed
measurement models are adopted in various forms with a focus on different measures and applications
to provide accounting policy choice and, in some instances, to determine the required measurement basis.
Where there is accounting policy choice, accountants have the ability to exercise judgement according to
the circumstances. At the same time, some degree of comparability in measurement is maintained through
the IFRSs.
This discussion will focus on the following selected IFRSs.
• IFRS 16 Leases
• IAS 19 Employee Benefits
• IFRS 2 Share-based Payment
• IAS 40 Investment Property
These standards have been selected because of their commercial relevance and their common application
in financial statements. The following discussion will also explain and highlight how different the
application of measurement principles can be.
LEASES
The objective of IFRS 16 Leases is to provide the principles for ‘recognition, measurement, presentation
and disclosure of leases’ in a manner that faithfully represents the effect of leases on an entity’s financial
position, financial performance and cash flows (IFRS 16, para. 1). The parties to a lease contract are the
lessee and the lessor. The lessee is the entity that obtains the right to use the asset, and the lessor is the
entity that provides the right to use the asset (IFRS 16, Appendix A).
IFRS 16 requires entities to use professional judgement when determining if a lease exists and, if it
does, the impact it will have on the financial reporting of the entity. Each contract must be assessed at
its commencement to determine if it contains a lease. A contract contains a lease if it ‘conveys the right
to control the use of an identified asset for a period of time in exchange for consideration’ (IFRS 16,
para. 9). The period of time is commonly greater than 12 months, but it may also be expressed as an
‘amount of use’. For example, the number of units produced by the underlying asset. The existence of a
lease must be reassessed each time there is a change to the terms and conditions of the contract (IFRS 16,
paras 9–11).
Professional judgement must again be used in considering whether or not a lessee is ‘reasonably certain’
to exercise specific options that will impact the lease term and the measurement criteria. For example, the
lease term includes the ‘non-cancellable period’ plus periods covered by an option to ‘extend the lease if
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38 Financial Reporting
the lessee is reasonably certain to exercise that option’ and to ‘terminate the lease if the lessee is reasonably
certain not to exercise that option’ (IFRS 16, para. 18).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 9–21 of IFRS 16.
EXAMPLE 1.6
X Ltd enters into a lease for a ‘pop-up’ retail space that includes a two-year non-cancellable period and
an option to extend the lease for another two years. Past experience indicates that X Ltd tends to occupy
retail spaces for two years, after which it moves to alternative premises.
The lease term is two years, which is the non-cancellable period of the lease. The option to extend the
lease for a further two years is not part of the lease term. This is because it cannot be concluded with
reasonable certainty that X Ltd will exercise the option to extend the lease, given past practice is for X Ltd
to occupy retail spaces for a period of time that would not require the lease to be extended.
Recognition Criteria for the Lessee
At the commencement date of a lease, the lessee recognises a right-of-use asset at cost and a lease liability
(IFRS 16, paras 22–23). A right-of-use asset is the asset specified in the lease contract that the lessee has
the right to use during the lease term. The recognition and measurement criteria for a lessee are summarised
in table 1.8.
TABLE 1.8
Recognition and measurement criteria for the lessee
Right-of-use asset†
Lease liability‡
Initial measurement
‘The cost of the right-of-use asset shall comprise:
(a) the amount of the initial measurement of the lease
liability . . .;
(b) any lease payments made on or before the
commencement date, less any lease incentives
received;
(c) any initial direct costs incurred by the lessee; and
(d) an estimate of costs to be incurred by the lessee
in dismantling and removing the underlying asset,
restoring the site on which it is located or restoring
the underlying asset to the condition required by
the terms of the lease’ (IFRS 16, para. 24).
Initial measurement
The lease liability is measured at the present value
of future lease payments, ‘discounted using the
interest rate implicit in the lease’, or using ‘the lessee’s
incremental borrowing rate’ if the implicit interest rate
cannot be easily determined (IFRS 16, para. 26).
Future lease payments include:
(a) ‘fixed payments . . . less any lease incentives
receivable;
(b) variable lease payments . . .;
(c) amounts expected to be payable by the lessee
under residual value guarantees;
(d) the exercise price of a purchase option if the lessee
is reasonably certain to exercise that option . . .; and
(e) payments of penalties for terminating the lease’
(IFRS 16, para. 27).
Subsequent measurement
Unless alternative measurement models (see
‘Alternatives’) are applied, the lessee applies the cost
model under which the right-of-use asset is measured.
To apply a cost model:
• measure at cost less accumulated depreciation and
accumulated impairment losses
• adjust for any remeasurements of the lease liability
(IFRS 16, paras 29–30).
Subsequent measurement
The lease liability is measured by:
(a) ‘increasing the carrying amount to reflect interest on
the lease liability;
(b) reducing the carrying amount to reflect the lease
payments made; and
(c) remeasuring the carrying amount to reflect any
reassessment or lease modifications . . . or to reflect
revised in-substance fixed lease payments’
(IFRS 16, para. 36).
(continued)
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MODULE 1 The Role and Importance of Financial Reporting 39
TABLE 1.8
(continued)
Right-of-use asset†
Lease liability‡
Alternatives
Other measurement models may be used under the
following circumstances:
• ‘If a lessee applies the fair value model in IAS 40
Investment Property to its investment property’, then
the fair value model is applied to the right-of-use
assets.
• The revaluation model may be applied per IAS 16
Property, Plant and Equipment if the lessee has
applied that model to a class of property, plant and
equipment to which the right-of-use asset relates
(IFRS 16, paras 34–35).
† For further exploration of this topic, read paras 23–25 and 29–35 of IFRS 16.
‡ For further exploration of this topic, read paras 26–28 and 36–43 of IFRS 16.
Source: Adapted from IFRS Foundation 2022, IFRS 16 Leases, IFRS Foundation, London.
There are two recognition exemptions available to lessees. They apply to ‘short-term leases’ and ‘low
value leases’ (IFRS 16, para. 5). A lease is considered short term if it is for no more than 12 months
(IFRS 16, Appendix A) and the short-term lease exemption can only be applied to a class of underlying
assets, not on the basis of the terms of each lease contract (IFRS 16, para. 8).
The assessment of whether the lease is a low value lease or not is based on the value of the underlying
asset when it is new (IFRS 16, Appendix B, para. B3) and cannot be applied to subleases (IFRS 16,
Appendix B, para. B7). The underlying asset is only of low value if:
(a) the lessee can benefit from use of the underlying asset on its own or together with other resources that
are readily available to the lessee; and
(b) the underlying asset is not highly dependent on, or highly interrelated with, other assets (IFRS 16,
Appendix B, para. B5).
Tablets and personal computers, telephones, and small items of office furniture are examples of
underlying assets of low value (IFRS 16, Appendix B, para. B8). The actual amount that constitutes a
low value is not specified in IFRS 16; however, paragraph BC100 of IFRS 16 states that the IASB’s view
of low value is ‘in the order of magnitude of US$5000 or less’.
QUESTION 1.10
Bronte Ltd enters into a lease agreement to lease two new personal computers for office staff from
Computer Supplies Ltd. The lease has a two-year non-cancellable period. At the commencement
of the lease, the personal computers had a value of $4000 each. While all computers are linked to
a network server, each computer can be operated by a user independently of the other computers.
Bronte Ltd pays $100 per month for the use of each personal computer.
Determine whether a recognition exemption is available to Bronte Ltd and, if so, how
Bronte Ltd would account for the monthly lease payments assuming Bronte Ltd elected to apply
the recognition exemption.
EXAMPLE 1.7
Accounting for Leases by Lessee
On 30 June 20X4, A Ltd (lessor) leased a motor vehicle to B Ltd (lessee). At that date, the fair value of the
vehicle is $68 000, its estimated residual value at the end of the lease term is $16 000 and its economic
useful life is six years. The lease is cancellable but the lessee will incur a penalty equal to 24 months of
lease payments if it chooses this option. For the purposes of this example, we will assume the lessee
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40 Financial Reporting
does not cancel the lease. There is no option for the lessee to purchase the vehicle at the end of the lease
term. The lease agreement cost A Ltd $2647 to set up and included the following details.
Annual lease payments (payable 30 June each year in advance)
Executory costs (included in annual lease payment)*
Residual value guarantee†
Unguaranteed residual value‡
Lease term
Interest rate implicit in the lease
$19 800
$ 1 800
$ 6 000
$10 000
4 years
9%
* The executory costs relate to the reimbursement of insurance and maintenance costs which will be paid annually by A Ltd.
† The residual value guarantee is the part of the estimated residual value that is guaranteed by the lessee according to the
lease agreement. It represents the value that the lessee guarantees that the underlying asset will be valued at when the lease
term ends. If the residual value of the underlying asset at the end of the lease term is below the guarantee and the asset is
to be returned to the lessor, the lessee is responsible to pay the difference to the lessor. The expected payment under the
guarantee will be included in the lease liability. As the expected payment is likely to be $nil at the beginning of the lease, no
extra payment in relation to the residual value guarantee is likely to be recognised under the lease liability at the beginning
of the lease.
‡ The unguaranteed residual value is the part of the estimated residual value of the underlying asset at the end of the lease
that is not guaranteed by the lessee, but it may be guaranteed by a party related to the lessor. As such, the unguaranteed
residual value is recognised only by the lessor as part of the lease receipts that they are expecting to collect.
The first step for the lessee, B Ltd, is to determine the value of the lease liability and of the right-of-use
vehicle to be recognised at the commencement date of the lease.
The lease liability is the present value of the future lease payments (including the guaranteed residual
value to be paid at the end of the lease term). The amount recognised for the right-of-use vehicle by
B Ltd is equal to the lease liability recognised at the commencement of the lease plus any lease payments
made at the beginning of the lease term (as there are no other costs incurred by the lessee). The present
value of the lease payments is calculated as follows.
Interest rate = 9%
Payment in advance each year for remaining 3 years
Lease liability = PV of future lease payments
Add: First payment in advance (30 June 20X4)
Cost of right-of-use asset
Add: PV of unguaranteed residual at end of 4 years
Total present value of lease
A quick reconciliation can be performed to confirm that the present value of
the lease equals the fair value of the underlying assets plus initial direct costs.
Fair value
Initial direct costs to lessor
FV + Initial direct costs
$
$
18 000
45 563†
45 563
18 000
63 563
7 084‡
70 647
10 000
68 000
2 647
70 647
† PV factor of an annuity at 9% over 3 years = 2.5313. $18 000 × 2.5313 = $45 563.
‡ PV factor of a lump sum in 4 years time at 9% = 0.7084. Unguaranteed residual of $10 000 × 0.7084 = $7084.
Once the values have been determined, the lessee can then prepare the following schedule of
lease payments.
Lease payments schedule for B Ltd (lessee)
30.06.20X4
30.06.20X5
30.06.20X6
30.06.20X7
Lease
payments†
Interest
expense‡
Reduction
in liability§
Balance
of liability||
$
$
$
$
18 000
18 000
18 000
54 000
4 101
2 850
1 486
8 437
13 899
15 150
16 514
45 563
45 563#
31 664
16 514
† Future lease payments of $18 000 payable in advance.
‡ Balance of liability each year × interest rate of 9%.
§ Lease payments less interest expense. The total must equal the initial lease liability recognised.
|| Balance of liability each year less the reduction in the liability.
# The PV of the total lease payments less any payments made at beginning of the lease term.
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MODULE 1 The Role and Importance of Financial Reporting 41
QUESTION 1.11
Using the information provided in example 1.7, prepare the journal entries to be recorded by the
lessee (B Ltd) throughout the lease term. Please provide a detailed answer.
Recognition Criteria for the Lessor
A lessor is required to classify each of its leases as either a finance lease or operating lease (IFRS 16,
para. 61). A finance lease is defined in Appendix A as ‘a lease that transfers substantially all the risks
and rewards incidental to ownership of an underlying asset’. An operating lease is defined in Appendix A
as ‘a lease which does not transfer substantially all the risks and rewards incidental to ownership of an
underlying asset’. It is the substance of the transaction rather than the form of the contract that determines
whether a lease is classified as a finance or operating lease.
Situations that lead to classification of a finance lease include:
• ownership is transferred to the lessee by the end of the lease term
• an option for the lessee to purchase the underlying asset at a price that is sufficiently lower than its fair
value ‘at the date the option becomes exercisable for it to be reasonably certain’
• the term of the lease is for the majority of the underlying asset’s economic life (Note: IFRS 16 does
not specify what constitutes the majority or ‘major part’ of the asset’s economic life. This would be a
matter of professional judgement and needs to consider the substance of the lease and whether or not
substantially all of the risks and benefits of ownership are transferred.)
• ‘the present value of the lease payments amounts to . . . substantially all of the fair value of the
underlying asset’
• the specialised nature of the underlying asset means ‘only the lessee can use it without major
modifications’
• the lease is cancellable and the lessor’s associated losses are to be incurred by the lessee thus indicating
a transfer of risks and rewards of the underlying asset to the lessee
• gains or losses from changes in the residual amount’s fair value are accrued to the lessee
• the lessee may continue the lease for another period with the rent amount ‘substantially lower’ than
market value (IFRS 16, paras 63–64).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 61–66 of IFRS 16.
Lessors of operating leases must recognise the lease payments as income on a straight-line or other
systematic basis if that is representative of the benefit pattern of the underlying asset. Initial direct
costs incurred in obtaining the operating lease are added to the carrying amount of the underlying asset
and recognised as an expense over the lease term using the same basis as the lease income (IFRS 16,
paras 81–83).
EXAMPLE 1.8
Continuing with question 1.10, further features of the lease agreement between Bronte Ltd and Computer
Supplies Ltd are as follows:
• there is no option for Bronte Ltd to purchase the computers at the end of the lease term
• ownership does not transfer to Bronte Ltd at the end of the lease term.
The personal computers were acquired by Computer Supplies Ltd just prior to entering into the lease
agreement at a cost of $4000 each. Computer Supplies Ltd hired local solicitors who charged $1000
to review the terms of the lease agreement. The estimated economic life of the computers is five years
with zero residual value at the end of five years. The depreciation policy of Computer Supplies Ltd is to
depreciate all depreciable assets on a straight-line basis.
Exercising professional judgement, it would likely be concluded that the lease is an operating lease as
the following indicators suggest that substantially all the risks and rewards of the personal computers
have not been transferred to Bronte Ltd:
• ownership does not transfer to Bronte Ltd at the end of the lease term
• Bronte Ltd does not have an option to purchase the computers at the end of the lease term
• the term of the lease is not for the majority of the computers’ economic life (i.e. two out of five years).
Pdf_Folio:42
42 Financial Reporting
QUESTION 1.12
Using the information provided in example 1.8 prepare the journal entries for Computer
Supplies Ltd for the first year of the lease.
The recognition and measurement criteria for lessors are summarised in table 1.9.
TABLE 1.9
Recognition criteria for the lessor
Finance lease†
Operating lease‡
Initial measurement
The net investment in the lease comprises:
• initial direct costs incurred by lessor ‘other than those
incurred by manufacturer or dealer lessors’ (IFRS 16,
para. 69)
• fixed payments, less lease incentives payable
• variable lease payments
• receipts expected under residual value guarantees
provided by the lessee or a third party
• exercise price of purchase option if lessee is
reasonably certain they wish to exercise that option
• payments of penalties for terminating the lease
• any unguaranteed residual value accruing to the
lessor.
Initial measurement
Lease payments received are recognised as income
on a straight-line or other systematic basis that is
representative of the pattern of benefit from the use
of the underlying asset.
Initial direct costs are added to the carrying amount of
the underlying asset and recognised as an expense
on the same basis as the lease income (IFRS 16,
paras 81–83).
The interest rate implicit in the lease is used to measure
the net investment in the lease (IFRS 16, paras 68–70).
Specific recognition criteria for manufacturer or dealer
lessors are set out in IFRS 16 (paras 71–74).
Subsequent measurement
Finance income is recognised on a systematic basis
over the lease term. Lease payments are applied
against the gross investment to reduce the principal
amount and the unearned finance income (IFRS 16,
paras 75–78).
Subsequent measurement
Depreciation is recognised as an expense in
accordance with IAS 16. The underlying asset should
be tested for impairment and any impairment loss
recognised in accordance with IAS 36 Impairment of
Assets (IFRS 16, paras 84–86).
† For further exploration of this topic, read paras 67–78 of IFRS 16.
‡ For further exploration of this topic, read paras 81–86 of IFRS 16.
Source: Adapted from IFRS Foundation 2022, IFRS 16 Leases, IFRS Foundation, London.
EXAMPLE 1.9
Accounting for Leases by Lessor
This example uses the information provided in example 1.7.
The first step for the lessor is to determine if the lease is a finance lease or an operating lease, by applying
the guidance in paragraphs 63 and 64 of IFRS 16. This is to assess if the information (individually or in
combination) satisfied the criteria for classification as a finance lease.
• The lease agreement does not include an option for B Ltd to purchase the vehicle at the end of the
lease term. Therefore, the transfer of ownership test is not satisfied.
• The vehicle is not of a specialised nature that makes it useful only for B Ltd. Therefore, the specialised
nature test is not satisfied.
• The lease term is for four years, which is 66.67 per cent of the vehicle’s useful economic life of six
years. Assuming the expected benefits of the vehicle are receivable evenly over its useful life, it could
be argued that the lease is for the majority of the underlying asset’s economic life. Therefore, the lease
term test is satisfied.
• The present value of the lease payments of $63 563 represents almost all of the fair value of the vehicle,
$68 000. Therefore, the present value test is satisfied.
• Although the lease agreement is cancellable, the monetary penalty of 24 months of lease payments, to
be incurred by B Ltd, indicates that the risks associated with the underlying asset have been transferred
to the lessee.
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MODULE 1 The Role and Importance of Financial Reporting 43
Professional judgement must be applied to determine if the listed indicators are showing if the vehicle
is under a finance or an operating lease. The main indicators are the:
• relatively low residual value at the end of the lease term
• majority of the fair value being covered in lease payments over a four-year period instead of the vehicle’s
full useful life of six years
• substantial monetary penalty for cancellation of the lease.
Without further information, it would likely be concluded that the lease is a finance lease, as substantially
all the risks and rewards of the vehicle are to be passed to B Ltd.
Assuming A Ltd classifies the lease of the vehicle as a finance lease, A Ltd can now derecognise the
underlying asset and recognise a lease receivable for the duration of the lease. To facilitate the accounting
for the lease receivable, a schedule of lease receipts is prepared. In this, the amount of lease receivable
recognised by the lessor at the start of the lease includes the present value of the unguaranteed residual
value. The calculations in example 1.7 show the present value of this amount to be $7084. Therefore, the
full amount of lease receivable at the start of the lease is $63 563 plus $7084 = $70 647.
Lease receipts schedule for A Ltd (lessor)
30/06/20X4
30/06/20X4
30/06/20X5
30/06/20X6
30/06/20X7
30/06/20X8
Lease
receipts†
Interest
revenue‡
Reduction in
receivable§
$
$
$
Balance of
receivable||
$
# 70 647
18 000
18 000
18 000
18 000
10 000
82 000
4 738
3 545
2 244
826
11 353
18 000
13 262
14 455
15 756
9 174
70 647
52 647
39 385
24 930
9 174
† Four annual receipts payable in advance. Residual value recognised as a lease receipt on last day of lease term is
the unguaranteed residual value of $10 000.
‡ Balance of receivable each year × interest rate of 9%.
§ Lease receipts less interest revenue. Total must equal the initial amount of the lease receivable.
|| Balance of receivable less the reduction in receivable.
# Initial receivable amount equals the fair value of $68 000 plus initial direct costs of $2647. This amount should also
equal the PV of the lease payments receivable (calculated in previous example) and the PV of the unguaranteed
residual value. As the unguaranteed residual value is not the responsibility of the lessee, its presence makes the
initial value of lease liability recognised by the lessee different from the initial value of lease receivable recognised
by the lessor.
QUESTION 1.13
Using the information provided in example 1.9, prepare the journal entries to be recorded by the
lessor (A Ltd) throughout the lease term. Please provide a detailed answer.
Presentation and Disclosure
There are presentation and disclosure requirements for the lessee and the lessor to assist users of financial
statements to determine the effect of leases on the entity’s financial situation. For a lessee, the right-ofuse assets and the lease liabilities shall be reported separately from other assets and liabilities in either the
financial statements or the notes. The exception to this is if the right-of-use asset is classified as investment
property, which shall be presented in the statement of financial position as investment property. Interest
incurred on the lease liability must be included as a component of finance costs and presented separately
from depreciation expense on the right-of-use asset.
Disclosure requirements for the lessor include additional qualitative and quantitative information
regarding the nature of their leasing activities and their risk management strategy for the rights they retain
in the underlying assets. These disclosure requirements are also dependent on whether the lease is classified
as a finance or operating lease.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 47–60 and 88–97 of IFRS 16.
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44 Financial Reporting
EMPLOYEE BENEFITS
IAS 19 Employee Benefits prescribes the principles of accounting for employee benefits. The standard
defines employee benefits as ‘all forms of consideration given by an entity in exchange for service rendered
by employees or for the termination of employment’ (IAS 19, para. 8). These benefits can be short-term
or long-term employee benefits.
Short-term Employee Benefits
Short-term employee benefits are defined as:
employee benefits (other than termination benefits) that are expected to be settled wholly before twelve
months after the end of the annual reporting period in which the employees render the related service
(IAS 19, para. 8).
Examples of short-term employee benefits include wages and salaries; profit-sharing and bonuses; nonmonetary benefits such as medical care; and short-term compensated absences such as annual leave and
sick leave (IAS 19, para. 9). The liability for short-term benefits should be measured at the undiscounted
amount expected to be paid on settlement of the obligation. Recognition of the liability will usually give
rise to a corresponding expense, although in some circumstances it may be included in the carrying amount
of an asset such as plant and equipment or inventory.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 9–11 of IAS 19.
Employees may be entitled to compensation for absences for a variety of reasons, including annual
leave, sick leave and long service leave (LSL). In accordance with paragraph 11 of IAS 19, short-term
compensated absences must be recognised at the undiscounted amount of employee benefit that the
entity expects to pay for the employees’ services. Compensated absences that are expected to be settled
beyond 12 months after the end of the reporting period are measured using the PV technique (IAS 19,
paras 153–155).
When compensated absences are considered, it is important to distinguish between:
• accumulating and non-accumulating benefits
• vesting and non-vesting benefits.
An accumulating compensated absence arises where the employees can carry forward their entitlements
to future periods. If the compensated absence does not accumulate, they lapse if not fully used within the
current period (IAS 19, para. 18).
An accumulating compensated absence may be vesting or non-vesting. A vesting benefit arises when
the employer is obligated to pay any unused benefits to the employee on their leaving the entity (IAS 19,
para. 15). That is, the employer is obligated to settle a vesting benefit, even if the employee resigns or their
employment is terminated. For vesting compensated absences, the employee will be paid either when the
leave is taken or on termination of employment.
If a compensated absence is non-accumulating, the cost of providing the benefit is not recognised until
the absence occurs (IAS 19, para. 13(b)). A liability is not recognised before leave is taken because the
employee’s service does not increase the amount of the leave benefit and benefits lapse as each year ends
(IAS 19, para. 18).
When a compensated absence is accumulating and vesting, a liability for accumulated compensated
absences is recognised, as employees render services that increase their entitlement to future compensation
(IAS 19, para. 13(a)). In accordance with IAS 19, the undiscounted amount of employee benefit is used
for accumulated unused compensated absence benefits that the entity expects to settle within 12 months
after the reporting period (IAS 19, paras 11–16).
For compensated absences that are accumulating but non-vesting, the employee is only compensated for
absences taken (e.g. in Australia this is usually the case with sick leave). On termination of employment, the
employee is not compensated for any unused entitlement. Despite this, it can be argued that the definition
of a liability is satisfied for unused benefits. That is, there has been a past event (rendering services) that
results in an obligation for accumulating, non-vesting compensated absences to be carried forward as part
of the employee’s benefits. However, whether a liability for an accumulating, non-vesting compensated
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MODULE 1 The Role and Importance of Financial Reporting 45
absence is recognised depends on the probability that a payment will be made. For this reason, IAS 19
specifies that entities should:
measure the expected cost of accumulating paid absences as the additional amount that the entity expects
to pay as a result of the unused entitlement that has accumulated at the end of the reporting period (IAS 19,
para. 16).
A liability for non-vesting compensated absences should be recognised only for that part of the
accumulated entitlement that is expected to result in additional payments to employees. The probability
that the leave will be taken affects the decision to recognise the liability and the amount of the liability, if
any, that is recognised.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 11–18 of IAS 19, noting in particular the
‘Example Illustrating Paragraphs 16 and 17’.
QUESTION 1.14
An entity has 500 employees who are provided with ten days sick leave for each year of service on
a non-vesting accumulating basis. At 30 June 20X6, 20 per cent of employees had taken their full
entitlement of sick leave. The remaining employees had an average of 12 days accumulated leave.
Past experience indicates that:
• 20 per cent of employees use all of their sick leave in the year in which they become entitled to
it and therefore have no accumulated sick leave at the end of the year
• 50 per cent of the entity’s employees use six days of accumulated sick leave in years subsequent
to their accumulation
• 30 per cent of employees take two days of accumulated sick leave in years subsequent to their
accumulation.
Assume that the average annual salary per employee is $40 000 and that employees have a
five-day working week.
(a) Measure the nominal amount of the provision for sick leave as at 30 June 20X6 in accordance
with IAS 19.
(b) Explain whether it is important to know the timing of the payments to employees for accumulated sick leave in future reporting periods.
Long-term Employee Benefits
As a result of providing services during a particular reporting period, employees may receive benefits
several years later. These benefits may be settled:
• while the employee is still employed or upon resignation (e.g. LSL), or
• subsequent to the employee’s employment (e.g. superannuation benefits and other post-employment
benefits).
This module focuses on LSL to illustrate the application of measurement principles and techniques to
long-term employee benefits.
Long Service Leave
In some countries, including Australia, LSL is an entitlement that accrues to employees as they provide
services to an entity. This entitlement accrues with years of service. Under some industrial laws and
employment contracts, employees are legally entitled to be paid LSL after a certain number of years
service have been completed (ten years is a typical benchmark). LSL should be recognised as a liability,
once the definition of liability has been satisfied.
In the past, some entities only recognised a liability or expense for LSL when employees became legally
entitled to LSL — that is, when the leave became vested. In effect, employees who were not legally entitled
were excluded in measuring the liability. However, consistent with the Conceptual Framework’s broader
definition of a liability, IAS 19 is based on the view that the definition of a liability or expense is satisfied
as soon as employees provide services that result in LSL entitlements. This is so, irrespective of whether
the employees are legally entitled to LSL.
LSL benefits are paid in reporting periods after the employees’ provision of services, often many years
into the future. Paragraph 155 of IAS 19 requires the amount of the liability for such long-term employee
Pdf_Folio:46
46 Financial Reporting
benefits to be measured on a net basis as the PV of the obligation at the reporting date (see IAS 19,
paras 56–98) minus the fair value at the reporting date of plan assets (if any) out of which the obligations
are to be settled directly (see IAS 19, paras 113–119). According to paragraph 8 of IAS 19, plan assets
that exist as part of an employee benefit plan comprise assets held by the plan and qualifying insurance
policies related to the plan.
Entities estimate the number of employees who may become eligible for LSL, as well as the timing and
amount of the payment. Projected salary levels (e.g. inflation, salary increase and promotions) need to be
factored into the calculation. The estimated LSL payment is discounted to its PV at the reporting date.
In Australia, it would be rare for entities to hold assets in a long-term employee benefit fund to satisfy
LSL obligations. Therefore, this module focuses on the determination of the PV of the obligation.
In essence, the Projected Unit Credit Method determines the accumulated entitlement for service on
the basis of the ratio of the period of service completed up to the reporting date, to the periods of service
required to accumulate the total entitlement. For example, if an employee has served eight of the ten years
required for entitlement to LSL, the accumulated entitlement would be 80 per cent of the total entitlement
under the Projected Unit Credit Method.
Determination of the timing and amount of future cash flows requires professional judgement and is
often based on actuarial assessment.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 56–69 of IAS 19, which describe and provide
examples of the Projected Unit Credit Method used to measure long-term employee benefits.
Many employees of an entity will have an insufficient length of service to be legally entitled to an LSL
payment at the reporting date. Nevertheless, a proportion of employees in this category will eventually
qualify for LSL. As a result, a probability assessment must be undertaken to estimate the number of
employees currently in this situation who will eventually be paid for LSL. IAS 19 provides no guidance
on this matter, leaving it to the preparer’s judgement.
Once the number of employees who will be paid LSL has been determined, the next task is to determine
the timing and amount of the payments that will result from services provided up to the reporting date.
To determine the future cash flows associated with LSL benefits, projected annual salary levels must be
estimated. The estimation of projected salaries is affected by the expected timing of payment of LSL and
involves consideration of factors such as inflation and promotions.
The estimated future LSL payments must be discounted to PV at the reporting date. The discount rate
used will have a significant effect on the measurement of an employer’s obligation for LSL. IAS 19 requires
that the discount rate used to measure LSL liabilities be determined by reference to current market yields
on high-quality corporate bonds. In currencies with no deep market for high-quality corporate bonds, the
interest rates attaching to government bonds must be used (IAS 19, para. 83). It should be noted that entities
operating in different countries will have to select discount rates appropriate to the country in which the
employee will be paid.
QUESTION 1.15
At 30 June 20X7, Maynot Ltd has 100 employees. For simplicity, assume that the employees have
the following periods of service.
Years of service
2
4
8
10
15
Number of employees
10
40
30
10
10
100
The employees of Maynot Ltd are employed under an award that provides for LSL on the basis
of 90 calendar days after 13 years of service and nine days per year of service thereafter. After
ten years of service, employees are entitled to a pro rata payment if they resign or their employment
is terminated.
Outline the steps that you would need to take and the factors that you would need to consider in
determining Maynot Ltd’s liability for LSL.
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MODULE 1 The Role and Importance of Financial Reporting 47
Example 1.10 builds on the data in question 1.15.
EXAMPLE 1.10
Calculation of an Entity’s Liability for Long Service Leave
The following estimates of the likelihood that employees of Maynot Ltd will eventually take leave have
been determined by an actuary.
Years of service
Probability that an employee will
become entitled to LSL payments
1
2
3
4
5
6
7
8
9
10
0.20
0.20
0.25
0.40
0.40
0.70
0.75
0.90
0.95
1.00
As would be expected, the closer the employee is to completing the pre-entitlement period, the higher
is the probability of payment. From the provided actuarial calculations, it has been estimated that there is
a 70 per cent probability that an employee with six years of service will be employed for a total of ten or
more years and will therefore become entitled to LSL. After nine years of service, it is estimated that there
is a 95 per cent probability that the employee will become entitled (i.e. will stay with the entity for at least
one more year).
Based on the preceding probabilities, it can be estimated that, as at 30 June 20X7, the following number
of employees will eventually be eligible for LSL.
Years of
service
Number of
employees
2
4
8
10
15
10
40
30
10
10
100
Probability
0.2
0.4
0.9
1.0
1.0
Estimated number of employees
who will become entitled to LSL
2
16
27
10
10
65
Note: Only the probabilities applicable to the current employees are used.
The next task is to determine the future payments for services performed up to the end of the reporting
period that will be made to the 65 employees who, it is estimated, will become entitled to receive LSL pay
in the future. This amount will depend on projected future wages and salaries, as well as experience with
employee departures and periods of service. It is necessary to make assumptions about when the leave
will be taken, as the payment will vary based on that, but also so that the time to settlement can be taken
into account in measuring the present value (PV) of the obligation. Employees do not necessarily take LSL
as soon as they become unconditionally entitled to do so. Some employees may be paid LSL before they
become fully entitled where the employment contract or legal environment allows for leave to be paid on
a pro rata basis if they resign or if the employment is terminated. Again, experience with leave patterns
will be a factor in estimating when LSL obligations will be settled.
Assume that the actuary has estimated that the employees who will become entitled to LSL will be paid
the following amounts in the following periods.
Pdf_Folio:48
48 Financial Reporting
Years from
30 June 20X7
Number of
employees
Amount expected
to be paid
$
2
5
10
15
15
20
20
10
65
120 000
200 000
300 000
200 000
820 000
The final issue is to determine appropriate discount rates to measure the payments at their PV.
This would involve selecting high-quality corporate bond rates with terms to maturity that match the terms
of the estimated cash payments. Again, for illustrative purposes, the discount rates in the second column
of the following table could have been made for Maynot Ltd. Each discount rate is used to determine the
relevant PV factor. The amount expected to be paid in the future is multiplied by the PV factor to calculate
the present value of the liability at the current reporting date. From the calculations shown in the following
table, an amount of $120 000 payable in two years time at a discount rate of 8 per cent has a present
value of $102 881.
Years from
30 June 20X7
Discount
rate†
2
5
10
15
0.08
0.09
0.10
0.10
Amount
expected to
be paid
$
120 000
200 000
300 000
200 000
820 000
Present
value factor‡
0.85734
0.64993
0.38554
0.23939
Present
value
$
102 881
129 986
115 662
47 878
396 407
† These discount rates are illustrative market yields on high-quality corporate bonds for the appropriate
term.
‡ The PV factor is determined by using the discount rate indicated and the number of years to the
payment. This can be calculated using the following formula: 1/(1 + r)n , where r is the interest rate
and n is the number of periods to settlement.
Therefore, Maynot Ltd would recognise a liability for LSL of $396 407 as at 30 June 20X7.
Note: The liability for LSL includes amounts expected to be paid to employees who are not yet entitled
to LSL. Whether the obligation is settled and the amount payable is actually paid depend on uncertain
future events, including whether employees will continue in employment for a sufficient period to become
eligible for LSL. The estimation of future cash flows also requires estimation of projected salary levels. The
timing of the settlement may affect the level of projected salaries, as well as the relevant discount factor
because the liability is measured using PV techniques. This further illustrates some of the difficulties with
PV techniques.
ACCOUNTING FOR SHARE-BASED PAYMENTS
Share-based payments provide an interesting illustration of the difficulty of fair value measurement and its
implications. Accounting for share-based payments falls within the scope of IFRS 2 Share-based Payment.
A share-based payment transaction is:
a transaction in which the entity
(a) receives goods or services from the supplier of those goods or services (including an employee) in a
share-based payment arrangement, or
(b) incurs an obligation to settle the transaction with the supplier in a share-based payment arrangement
when another group entity receives those goods or services (IFRS 2, Appendix A).
Share-based payment transactions may be cash-settled or equity-settled.
In a cash-settled share-based payment transaction, ‘the entity acquires goods or services by incurring
a liability to transfer cash or other assets’, the amount of which is based on the price of the entity’s equity
instruments (IFRS 2, Appendix A). For example, an entity might agree to pay a cash bonus for employees’
services of 100 times the company’s share price. A transaction may therefore be a share-based transaction
even though there is no exchange of the entity’s equity instruments.
In an equity-settled share-based payment transaction, the entity acquires ‘goods or services as
consideration for its own equity instruments, or [it] receives goods or services but has no obligation to
settle the transaction with the supplier’ (IFRS 2, Appendix A). Examples include employee shares and
executive stock options.
Goods or services acquired in a share-based payment transaction are recognised when the goods
are obtained or the services are received (IFRS 2, para. 7). For an equity-settled share-based payment
transaction, a corresponding increase in equity is recognised. For a cash-settled share-based payment
transaction, a corresponding increase in a liability is recognised.
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MODULE 1 The Role and Importance of Financial Reporting 49
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 7–9 of IFRS 2. The definitions of terms used
in the standard are provided in IFRS 2, Appendix A.
EXAMPLE 1.11
Performance Bonuses
Great Futures Ltd introduced performance-based remuneration for its senior executives as an incentive to
encourage and reward management performance and to align the interests of managers with those of the
shareholders. Subject to performance hurdles, including a return on equity of 10 per cent, employees
in the incentive scheme receive a bonus. Bonuses are payable three months after the end of the
reporting period.
For the year ended 30 June 20X9, performance hurdles were met by several executives.
The bonus payable to the chief executive officer (CEO) was determined as 1000 ordinary shares,
which vested immediately. The share price was $50 on this date. The bonuses payable to six other
executives were cash-based and calculated as 100 times the company’s average share price of $65 from
1 June 20X9 to 31 August 20X9.
The pro forma entry for the CEO’s bonus at 30 June 20X9 was as follows.
Dr
Cr
Bonus expense
Equity
50 000
50 000
The equity-settled share-based payment transaction resulted in an increase in expenses and a
corresponding increase in equity being recognised when the employee service was received.
The pro forma entry for the other executives’ bonuses at 30 June 20X9 was as follows.
Dr
Cr
Bonus expense
Liability
39 000
39 000
The cash-settled share-based payment transaction resulted in an increase in expenses and a
corresponding increase in liabilities being recognised when the employee service was received.
Measurement of Share-Based Payment Transactions
Share-based payment transactions are measured as follows.
• Equity-settled
– Measure the goods or services received and the corresponding increase in equity at the fair value of
the goods or services received, provided that the fair value can be estimated reliably. This is referred
to as directly measuring the goods and services.
– In some cases, the fair value of the goods or services received cannot be estimated reliably, such as for
transactions with employees and others providing similar services. Under these circumstances, the
fair value of the goods or services and the corresponding increase in equity are measured indirectly,
with reference to the fair value of the equity instruments granted.
• Cash-settled
– Measure the goods or services received and the liability incurred at the fair value of the liability.
– Until the liability is settled, it may be remeasured at the end of each reporting period and upon
settlement, with changes in the fair value of the liability recognised in profit or loss.
In the case of equity-settled share-based payment transactions, the fair value of the goods or services
acquired drives the measurement of equity, consistent with equity being the residual element in the
statement of financial position (i.e. the difference between assets and liabilities). However, if the fair value
of the goods or services acquired cannot be measured reliably, IFRS 2 departs from this approach and
requires indirect measurement based on the fair value of the equity instruments (IFRS 2, para. 10).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 10–13A and 30–33 of IFRS 2.
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50 Financial Reporting
INVESTMENT PROPERTY
Investment property is defined in IAS 40 Investment Property, paragraph 5, as:
property (land or a building — or part of a building — or both) held (by the owner or by the lessee as a
right-of-use asset) to earn rentals or for capital appreciation or both, rather than for:
(a) use in the production or supply of goods or services or for administrative purposes; or
(b) sale in the ordinary course of business.
Examples of investment property described in IAS 40, paragraph 8, are:
(a) land held for long-term capital appreciation rather than for short-term sale in the ordinary course
of business.
(b) land held for a currently undetermined future use.
(c) a building owned by the entity (or a right-of-use asset relating to a building held by the entity) and leased
out under one or more operating leases.
(d) a building that is vacant but is held to be leased out under one or more operating leases.
(e) property that is being constructed or developed for future use as investment property.
IAS 40 prescribes a mixed measurement model based on the purpose and nature of the asset. An
entity may:
(a) choose either the fair value model or the cost model for all investment property backing liabilities that
pay a return linked directly to the fair value of . . . specified assets including that investment property;
and
(b) choose either the fair value model or the cost model for all other investment property, regardless of the
choice made in (a) (IAS 40, para. 32A).
Both measurement bases applied in IAS 40 provide valuable information based on the different
fundamental qualitative characteristics. For example, the cost model provides faithful representation but
would, arguably, be less relevant in future reporting periods. The fair value model provides the reverse
relationship. This points to the difficulty of determining an appropriate measurement basis for assets to
provide useful financial information.
To provide some consistency in the measurement, IAS 40 requires the choice of measurement basis
(i.e. cost model or fair value model) to be applied by an entity across all of its investment property
(IAS 40, para. 30). Moreover, IAS 40 requires the entities that use the cost model for their investment
property to also disclose the fair value of that property (IAS 40, para. 32).
IAS 40 specifies the accounting for investment property as slightly distinct from property, plant and
equipment accounted for in accordance with IAS 16 Property Plant and Equipment — property, plant and
equipment being tangible assets that are used by an entity in the ‘production or supply of good or services,
for rental to others, or for administrative purposes’ (IAS 16, para. 6).
IAS 16 also permits an entity to choose either the cost model or the fair value model for property, plant
and equipment after the asset’s initial recognition. Where the fair value model is chosen, the increase in the
asset’s carrying amount is recognised in other comprehensive income (OCI) and is accumulated in equity.
However, distinct from IAS 16, the fair value model under IAS 40 results in the gains or losses arising
from a change in the fair value of investment property being recognised in profit or loss in the period in
which it arises (IAS 40, para. 35). A decrease in the carrying amount (not reversing a previous increase)
is recognised in profit or loss for both property, plant and equipment, and for investment property.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 30–35 of IAS 40.
One of the enhancing qualitative characteristics in the Conceptual Framework is comparability.
Comparability refers to information as being more useful if it can be compared with similar information
about other entities and with similar information about the same entity for a comparable reporting period.
The accounting policy choice provided in IAS 40 in relation to the measurement of investment properties
is arguably inconsistent with the qualitative characteristic of comparability, as some entities will measure
investment properties at cost, whereas other entities will measure investment properties at fair value. The
cost and fair value of an investment property could be materially different.
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MODULE 1 The Role and Importance of Financial Reporting 51
The need for consistent information is addressed by requiring entities that choose to hold their investment
properties at cost to disclose the fair value of the investment properties in the notes to the financial
statements (IAS 40, para. 79(e)). This requirement helps to ensure that users have access to comparable
information.
Another measurement issue arises with the recognition of fair value movements on investment property
through profit or loss. Valid questions are often raised about whether these unrealised gains (which adjust
the carrying amount of the investment property) satisfy the definition and recognition criteria for an ‘asset’
in the Conceptual Framework. Questions may be raised about whether it is probable that the economic
benefits will flow to the entity because these gains may be reversed before the asset is realised.
Furthermore, the usefulness of showing unrealised movements through profit or loss can be challenged,
as the result for the year is affected by fair value movements caused by factors external to the entity
(e.g. market and economic factors) rather than by the entity’s operational performance. Therefore, an
entity’s financial performance does not necessarily show the results of its operating activities.
PROFESSIONAL JUDGEMENT
Financial reporting is not just a mechanical practice based on following specified rules. It is focused on
meeting the important objective of providing useful information for decision making, and this requires
careful thought and professional judgement when deciding how to deal with particular items. Instead
of a checklist approach, judgement is required to evaluate whether the overarching objective is being
met in the most appropriate way. An example of the application of judgement includes determining
the materiality of particular items. Professional judgement may often involve making a trade-off between
relevance and faithful representation, which are two qualitative characteristics that accounting information
should possess.
Professional judgement is an important characteristic of professional practice. It requires a combination
of conceptual and practical knowledge and is described as the ability to diagnose and solve complex,
unstructured values-based problems of the kind that arise in professional practice (Becker 1982). Professionals are expected to make decisions based on an objective review of the relevant data rather than on a
choice of outcomes that suit the employer or client. In exercising professional judgement, professionals can
rely on technological advancements; for example, machine learning can be used to make quick predictions
informed by vast amounts of data and prepare and deliver relevant judgements faster and easier.
The selection and application of accounting policies, and the recording and communication of financial
information based on these decisions, are essential functions that require professional judgement. West
(2003) suggests that without judgement, accounting becomes nothing more than a book of rules for
compliance.
In general, the IFRSs reflect a principles-based approach rather than very specific rules about what must
be done. This provides significant scope for the exercise of judgement in the application of principles to
specific situations.
The Conceptual Framework and IFRSs have not been developed with the intention of eliminating
professional judgement. What frameworks do in this context is provide a coherent set of objectives,
assumptions, principles and concepts within which those judgements are made.
Accounting standards provide the principles that an entity needs to apply, but they do not provide
all of the answers as to how to apply them. For example, in accordance with IAS 16 Property, Plant
and Equipment, an entity is required to write off the cost of an asset over its useful life. Determining
what the useful life is requires professional judgement (IAS 16, para. 57). Another example is found in
IFRS 7 Financial Instruments: Disclosures, which indicates that the identification of concentrations of
risk in relation to financial instruments requires judgement that takes into account the circumstances of the
entity (IFRS 7, para. B8).
Applying Professional Judgement to Estimates and Accounting Policy
Professional judgement is particularly important in making estimates and in developing accounting
policies. In many circumstances, the exact amounts to be disclosed in the financial statements cannot
be determined and, therefore, estimates are required. This is acknowledged in paragraph 1.11 of the
Conceptual Framework, which states that ‘to a large extent, financial reports are based on estimates,
judgements and models rather than exact depictions’.
The combination of professional judgement and a disciplined approach to estimation ensures that the
information provided is still relevant and reliable (IAS 8, paras 8 and 10). This is also acknowledged in
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52 Financial Reporting
the Conceptual Framework’s discussion on faithful representation, which suggests that a representation of
an estimate:
can be faithful if the amount is described clearly and accurately as being an estimate, the nature and
limitations of the estimating process are explained, and no errors have been made in selecting and applying
an appropriate process for developing the estimate (para. 2.18).
Paragraph 2.30 of the Conceptual Framework also allows for a range of probability estimates to be
provided, rather than a single amount, and to be regarded as verifiable.
It is important that the choice of accounting policies is aligned with estimates that are focused on
providing the most accurate and faithful representation of the organisation. There may be a temptation
to select accounting policies or estimates that provide a particular viewpoint of the organisation, but
professional judgement and ethics must ensure that the selection made is the most suitable.
Preparers of financial reports need to refer to the Conceptual Framework when developing accounting
policies and estimates for which no specific accounting standard exists (IAS 8, para. 10), such as when
assessing whether a cost should be expensed or capitalised and determining the timing of recognition of
certain transactions.
DISCLOSURES
This module concludes by briefly considering the role of disclosures and how to determine when
disclosures are required. This provides a clear link to module 2, which focuses on the presentation of
the financial statements, including the disclosures required for each financial statement.
Effective disclosures play an important role in helping the decision making of users. Entities need to
ensure that their financial reporting disclosures are clear and effective in informing users as to the entity’s
financial performance during the year, as well as its financial position. Simply providing more information
to users is not sufficient to meet user needs, as disclosure overload is a concern for many users, especially
as large amounts of information are available due to technological advancements.
The Role and Purpose of Disclosures
‘Disclosure’ is a broad term and refers to items presented in the financial statements and in items disclosed
in the notes to the financial statements (IAS 1, para. 47). The role of these disclosures is linked to the
objective of financial reporting, which is to provide an account of the organisation so that users have
useful information with which to guide their decision making. The focus on disclosures transitions from
the theoretical discussion found in the Conceptual Framework to module 2 and how financial statements
are presented. The primary financial statements on their own are not sufficient for users to be able to
make informed decisions. Disclosures provide additional information and explanations to assist users in
understanding the financial statements.
Chapter 7 of the Conceptual Framework describes the general objectives and principles of disclosure,
linking disclosure back to the need to ensure that the information presented to users in the GPFSs is relevant
and provides a faithful representation of an entity’s assets, liabilities, equity, income and expenses, but also
is understandable and comparable. It also hints that IFRSs will include the specific disclosure requirements
that will need to be followed, and that those requirements will be developed to ensure a balance between:
(a) giving entities the flexibility to provide relevant information that faithfully represents the entity’s assets,
liabilities, equity, income and expenses; and
(b) requiring information that is comparable, both from period to period for a reporting entity and in a
single reporting period across entities (Conceptual Framework, para. 7.4).
The Conceptual Framework also establishes the principles based on which different elements of
financial statements can be classified, offset or aggregated in a way not to negatively impact on the use of
information disclosed.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 7.1–7.22 of the Conceptual Framework.
Criteria for Determining Whether Disclosure is Required
Notwithstanding the general disclosure principles established in the Conceptual Framework, information
is included in financial statements in accordance with the disclosure requirements of the accounting
standards. These are often linked to the definitions and recognition criteria that are discussed throughout
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MODULE 1 The Role and Importance of Financial Reporting 53
this module. In addition, IAS 1 Presentation of Financial Statements, paragraph 15, notes that compliance
with the IFRSs, with additional disclosures when necessary, is presumed to result in the fair presentation
of the financial statements. This is further expanded upon in IAS 1, paragraph 17:
In virtually all circumstances, an entity achieves a fair presentation by compliance with applicable IFRSs.
A fair presentation also requires an entity:
(a) to select and apply accounting policies in accordance with IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors. IAS 8 sets out a hierarchy of authoritative guidance that management
considers in the absence of an IFRS that specifically applies to an item.
(b) to present information, including accounting policies, in a manner that provides relevant, reliable,
comparable and understandable information.
(c) to provide additional disclosures when compliance with the specific requirements in IFRSs is insufficient to enable users to understand the impact of particular transactions, other events and conditions on
the entity’s financial position and financial performance.
Management may believe that compliance with a specific requirement in an IFRS would be very
misleading. If the item is believed to be so misleading that it would conflict with the overall objective
of financial statements, the entity may depart from that requirement — that is, it may account for it in a
different manner. This departure is only permitted if the legal rules in that country or jurisdiction allow it
(IAS 1, para. 19). This situation is only considered to arise in extremely rare circumstances, and there are
specific disclosure obligations if an entity should consider this departure to be appropriate (IAS 1, para. 20).
It should be noted that, in Australia, the types of entities that are prohibited from such departures from a
requirement in an accounting standard are:
• entities for which the Corporations Act applies
• not-for-profit entities
• entities for which the simplified disclosure requirements apply (AASB 101, para. Aus19.1).
The Importance of a Consistent Approach to Disclosure
A consistent approach to disclosure can be clearly linked back to the Conceptual Framework’s qualitative
requirements of comparability and understandability.
Accounting provides powerful and useful information that can highlight managers’ poor performance
and stewardship. Organisations facing difficulty may be tempted to mask poor results by providing
information in a manner that is not easily interpreted or analysed. One method that may cause confusion
involves formally disclosing all relevant items but in such a manner that they are not easily compared to
previous periods or able to be properly understood.
This type of disclosure goes against the requirements of fair presentation and hinders the usefulness
of accounting information. Therefore, a consistent approach to disclosure must be maintained, and any
deviations should be clearly justified and carefully explained.
The key points covered in this module, and the learning objectives they align to, are as follows.
KEY POINTS
1.1 Explain the role and importance of financial reporting.
• The role of financial reporting is to provide users with information to enable them to achieve effective
decision making.
• The objective of general purpose financial reporting is to provide financial information about the
reporting entity that is useful to its primary users for making decisions about providing resources
to the entity.
• General purpose financial reporting applies to reporting entities. Reporting entities are entities that
are required, or choose, to prepare financial statements.
1.2 Explain the role of the IASB Conceptual Framework in financial reporting and accounting
standards.
• The Conceptual Framework is not a standard itself. If a conflict is identified between provisions of
an IFRS and the Conceptual Framework, the IFRS will take precedence.
• The AASB uses a two-tier model of general purpose financial reporting: Tier 1 — Australian
Accounting Standards and Tier 2 — Australian Accounting Standards with Simplified Disclosure
Requirements.
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54 Financial Reporting
1.3 Describe the objective and limitations of general purpose financial reporting as identified in the
Conceptual Framework.
• The Conceptual Framework sets out the concepts that underlie the preparation and presentation
of financial statements for external users.
• The two important assumptions established in the Conceptual Framework are accrual basis of
accounting and going concern.
• The Conceptual Framework identifies two types of qualitative characteristics of financial
information: fundamental and enhancing.
• Fundamental qualitative characteristics consist of relevance and faithful representation.
• Enhancing qualitative characteristics consist of comparability, verifiability, timeliness and
understandability.
1.4 Explain the definitions of the elements of financial statements and recognition criteria adopted
by the Conceptual Framework.
• There are five elements of the financial statements: assets, liabilities, equity, income and expenses.
• The key components of an asset are that it is a right, it has the potential to produce future economic
benefits, and it is controlled by the entity.
• The key components of a liability are the requirement for the entity to have a present obligation,
the obligation is to transfer an economic benefit, and the present obligation exists as a result of
past events.
• The definition of equity flows from the definitions of assets and liabilities. Equity is simply the
difference between assets and liabilities and is derived from the recognition and measurement
of the assets and liabilities.
• The essential characteristics of income are an increase in assets or a reduction in liabilities, and an
increase in equity, other than as a result of a contribution from owners.
• The essential characteristics of an expense are a decrease in assets or an increase in liabilities,
and a decrease in equity, other than those arising from distributions to holders of equity claims.
• The elements of the financial statements are only recognised if they provide the users of the financial
statements with information that is useful. To be considered useful, the information must be relevant
and faithfully represent what it is supposed to represent.
• Derecognition applies only to recognised assets and liabilities. Assets are normally derecognised
when the entity loses control of the recognised asset. Liabilities are normally derecognised when
the entity no longer has a present obligation for all or part of the recognised liability.
1.5 Explain the application of the standards to the financial reporting process and apply
specific standards.
• IFRSs apply a mixed measurement model to provide accounting policy choice and, in some
instances, to determine the required measurement basis.
• In applying IFRS 16 Leases, the lessee recognises a right-of-use asset and lease liability unless
recognition exemptions for short-term leases and low value leases are applied.
• In applying IAS 19 Employee Benefits, long-term employee benefits are measured at the present
value of the obligation at the reporting date less the fair value of plan assets (if any) out of which the
obligation will be directly settled. The probability of settlement is reflected in the estimate of future
cash flows. The interest rate used to discount the future cash flows is determined by reference to
current market yields on high-quality corporate bonds, unless the obligation is in a currency that
does not have a deep market for corporate bonds.
• IFRS 2 Share-based Payment distinguishes between equity-settled and cash-settled share-based
payment transactions.
• IAS 40 Investment Property prescribes a mixed measurement model, allowing a choice between
cost and fair value, based on the purpose and nature of the asset.
• Disclosures are a requirement of the accounting standards that ensure additional information and
explanations are provided to assist users in understanding the financial statements.
1.6 Discuss and demonstrate the importance of professional judgement in the financial
reporting process.
• Professional judgement may often involve making a trade-off between relevance and faithful
representation.
• Professional judgement is particularly important in making estimates and in developing
accounting policies.
• The combination of professional judgement and a disciplined approach to estimation ensures that
the information provided is still relevant and faithfully represented.
• The mixed measurement model and accounting policy choice allow accountants to exercise
professional judgement in the measurement bases used according to the circumstances.
1.7 Explain the implications of using cost and fair value accounting.
• There are two stages of measurement for assets and liabilities: initial recognition and
subsequent recognition.
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MODULE 1 The Role and Importance of Financial Reporting 55
• Categories of measurement bases include historical cost (including amortised cost) and current
value (including fair value, value in use for assets, fulfilment value for liabilities and current cost).
• The cost of an asset is the value of the costs incurred in acquiring or creating the asset, comprising
the consideration paid to acquire or create the asset plus transaction costs.
• Advantages of historical cost accounting include that the method is easily understood, relevant to
decision making, reliable and inexpensive to implement.
• Disadvantages of cost accounting include that this method has limited relevance to decision
making, undermines the faithful representation of financial reports, undermines the comparability
of financial reports and has problems with reliability.
• The fair value of an asset is the price that would be received to sell the asset in an orderly transaction
between market participants at the measurement date.
• Fair value is considered by many to be more relevant than cost-based measures.
• The criticisms of fair value include its lack of relevance to decision making in relation to assets that
the entity does not intend to sell, and its problems with reliability in relation to assets that are not
traded in an active market.
1.8 Explain how materiality is assessed and determine the materiality of transactions.
• The Conceptual Framework adopts a subjective approach to materiality by stating that information
is material if omitting, misstating or obscuring it could reasonably be expected to influence
decisions made by the primary users of general purpose financial reports.
REVIEW
This module explained the role and importance of financial reporting as a communication tool for entities to
provide information to users to help with decision making. It discussed how financial reports are accessed
by a broad range of users, including shareholders, banks, competitors, employees and financial analysts. It
also considered the importance of an internationally accepted conceptual framework in creating financial
reports that meet the information needs of users.
The use of accounting standards as a consistent language for reporting enables financial statements
to be prepared that users will understand and be able to compare between entities. The IFRSs are the
global language of accounting standards. This module considered the role and importance of financial
reporting for users and discussed the application of reporting in an international context. It then discussed
the need for GPFSs, the role that the Conceptual Framework plays in financial reporting and the limitations
of frameworks.
A conceptual framework plays a key role in assisting users in their decision making by providing
consistency in the development of accounting standards and in providing a common set of definitions,
recognition principles and measurement principles. These act as a guide in accounting for transactions not
covered by accounting standards, including emerging financial reporting issues. A conceptual framework
also provides a source of legitimacy to the standard-setting process and enhances the consistency of
accounting standards. These benefits are subject to the economic, legal, social and political constraints
that apply to conceptual frameworks. Furthermore, there is a continuing need for professional judgement
in accounting.
In this module, the IASB’s Conceptual Framework for Financial Reporting was analysed. The major
components of the Conceptual Framework, including the qualitative characteristics of useful financial
information and the elements of financial statements, were examined. This module also addressed how
technological advancements can hinder or advance the decision-usefulness of accounting information
prepared using the principles set out by the Conceptual Framework and IFRS.
This module also discussed the different approaches to measuring the elements of financial statements
and applying the measurement bases to the measurement of liabilities and expenses for leases, employee
benefits, share-based payments and investment property.
The module concluded with a consideration of the purpose of disclosure to help meet the decisionmaking needs of users. This discussion also provided a link to the module 2 discussion of the presentation
of financial statements.
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56 Financial Reporting
REFERENCES
AASB (Australian Accounting Standards Board) 2020, ‘Key facts: AASB 2020-2 Amendments to Australian Accounting
Standards – Removal of Special Purpose Financial Statements for Certain For-Profit Private Sector Entities’, accessed
July 2022, https://www.aasb.gov.au/admin/file/content102/c3/AASB2020-2_KeyFacts_03-20.pdf.
AASB (Australian Accounting Standards Board) 2021, ‘General FAQs’, accessed July 2022, https://www.aasb.gov.au/researchresources/general-faqs.
AASB (Australian Accounting Standards Board) 2022, ‘Project insights: Developing sustainability-related financial reporting
standards in Australia’, accessed July 2022, https://www.aasb.gov.au/media/hndlldgr/staffarticle_sr_australianapproach_0622.pdf.
Becker, E. A. 1982, ‘Is public accounting a profession?’, The Woman CPA, vol. 44, no. 4, pp. 2–4.
IASB (International Accounting Standards Board) 2005, Measurement Bases for Financial Reporting — Measurement on Initial
Recognition, International Accounting Standards Committee Foundation, London.
IFRS Foundation 2016, ‘IASB Chairman to prioritise communication effectiveness of financial statements during second term’,
30 June, accessed July 2022, https://www.ifrs.org/news-and-events/2016/06/iasb-chairman-prioritises-communication-infinancial-statements.
IFRS Foundation 2018, ‘The IFRS Foundation Technology Initiative’, 5 November, accessed July 2022, https://www.ifrs.org/news
-and-events/news/2018/11/the-ifrs-foundation-technology-initiative.
IFRS Foundation 2019, ‘Discussion Paper — Disclosure Initiative — Principles of Disclosure’, accessed July 2022, https://www.
ifrs.org/projects/2019//principles-of-disclosure/#published-documents.
IFRS Foundation 2021, ‘Emmanuel Faber appointed to lead the International Sustainability Standards Board’, accessed July 2022,
https://www.ifrs.org/news-and-events/news/2021/12/emmanuel-faber-appointed-to-lead-the-issb.
IFRS Foundation 2022, 2022 IFRS Standards, IFRS Foundation, London.
IFRS Foundation 2022a, ‘Who we are: Our mission statement’, accessed July 2022, https://www.ifrs.org/about-us/who-we-are.
IFRS Foundation 2022b, ‘Better communication in financial reporting’, accessed July 2022, https://www.ifrs.org/projects/bettercommunication/#projects.
IFRS Foundation 2022c, ‘The IFRS for SMEs Accounting Standard’, accessed July 2022, https://www.ifrs.org/issued-standards/
ifrs-for-smes.
IFRS Foundation 2022d, ‘Second comprehensive review of the IFRS for SMEs accounting standard’, accessed July 2022,
https://www.ifrs.org/projects/work-plan/2019-comprehensive-review-of-the-ifrs-for-smes-standard/#current-stage.
IFRS Foundation 2022e, ‘Disclosure initiative - Targeted standards-level review of disclosures’, accessed July 2022,
https://www.ifrs.org/projects/work-plan/standards-level-review-of-disclosures/#current-stage.
IFRS Foundation 2022f, ‘International Sustainability Standards Board’, accessed July 2022, https://www.ifrs.org/groups/
international-sustainability-standards-board/#about.
IFRS Foundation 2022g, ‘ISSB delivers proposals that create comprehensive global baseline of sustainability disclosures’,
accessed July 2022, https://www.ifrs.org/news-and-events/news/2022/03/issb-delivers-proposals-that-create-comprehensiveglobal-baseline-of-sustainability-disclosures.
SEC (Securities and Exchange Commission) 2007, ‘Acceptance from foreign private issuers of financial statements prepared in accordance with international financial reporting standards without reconciliation to U.S.’, GAAP, Release
Nos. 33-8879; 34-57026; International Series Release No. 1306; File No. S7-13-07, December, accessed July 2022,
http://www.sec.gov/rules/final/2007/33-8879.pdf.
Sydney Online 2017, ‘Splendour and power of the Sydney Harbour Bridge’, accessed July 2022, http://www.sydney.com.au/
bridge.htm.
West, B. P. 2003, Professionalism and Accounting Rules, Routledge, New York.
OPTIONAL READING
ICAS (Institute of Chartered Accountants of Scotland) 2016, A Professional Judgement Framework for Financial Reporting
2nd edn, ICAS, Edinburgh, accessed July 2022, https://www.icas.com/professional-resources/public-sector/support-andguidance/a-professional-judgement-framework-for-financial-reporting.
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MODULE 1 The Role and Importance of Financial Reporting 57
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MODULE 2
PRESENTATION OF
FINANCIAL STATEMENTS
LEARNING OBJECTIVES
After completing this module, you should be able to:
2.1 explain and apply the requirements of IAS 1 with respect to a complete set of financial statements and in
relation to the considerations for the presentation of financial statements
2.2 outline and explain the requirements of IAS 8 for the selection of accounting policies
2.3 explain and apply the accounting treatment and disclosure requirements of IAS 8 in relation to changes in
accounting policies, and changes in accounting estimates and errors
2.4 explain and discuss the required treatment for both adjusting and non-adjusting events occurring after the
reporting period in accordance with IAS 10
2.5 explain and apply the requirements of IAS 7 with respect to preparing a statement of cash flows
2.6 discuss how a statement of cash flows can assist users of the financial statements to assess the ability of
an entity to generate cash and cash equivalents.
ASSUMED KNOWLEDGE
It is assumed that before commencing your study in this module, you are able to:
• explain the four primary financial statements, including their purpose and interrelationship
• identify the content contained within each financial statement, including its structure and format
• identify the assumptions and doctrines underpinning the preparation and presentation of financial statements
• identify how a listed entity is required to identify and report its operating segments in the financial statements.
CASE STUDY DATA: WEBPROD LTD
Module 2 includes case study data in a separate section at the end of this module. This case study data will be
used for a number of questions throughout the module.
LEARNING RESOURCES
International Financial Reporting Standards (IFRSs):
• IAS 1 Presentation of Financial Statements
• IAS 7 Statement of Cash Flows
• IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
• IAS 10 Events after the Reporting Period
• IAS 34 Interim Financial Reporting
• IFRS 8 Operating Segments.
Other resources:
• Digital content, such as videos and interactive activities in the e-text, support this module. You can access
this content on My Online Learning.
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PREVIEW
Module 1 discussed the international financial reporting environment, including the stakeholders of
financial reports and the institutional arrangements for regulating financial reporting. As outlined in that
module, accountants often have to make decisions about how to report on complex arrangements and
transactions, such as the classification and measurement of financial instruments, revenue recognition
and accounting for business combinations. In making these decisions, accountants use the International
Financial Reporting Standards (IFRSs) and the Conceptual Framework for Financial Reporting
(Conceptual Framework) for guidance. Module 1 contained a detailed discussion of the Conceptual
Framework, as it not only underpins the development of accounting standards but is also used to make
accounting policy decisions when no guidance is available from an IFRS. Module 2 commences the
discussion of accounting standards used in the preparation and presentation of general purpose financial
statements.
As discussed in module 1, one of the qualitative characteristics that makes information useful to
users is comparability. To assess trends in an entity’s financial performance and position, users must be
able to compare the financial statements of the entity over time. Likewise, comparability is important
when evaluating the financial performance and position of an entity relative to other entities (Conceptual
Framework, para. 2.24). For this reason, module 2 commences by considering the requirements specified
in International Accounting Standard 1 Presentation of Financial Statements (IAS 1) for the preparation
and presentation of general purpose financial statements.
Paragraph 10 of IAS 1 specifies the components of a set of financial statements, which include:
• a statement of financial position
• a statement of profit or loss (P/L) and other comprehensive income (OCI)
• a statement of changes in equity
• a statement of cash flows
• explanatory notes (including accounting policies)
• comparative information with respect to the preceding period
• a statement of the financial position at the beginning of the preceding period when an accounting policy
is applied retrospectively or items in the financial statements are retrospectively restated or reclassified.
IAS 1 specifies the overall considerations that should be used when preparing financial statements.
These considerations include:
• fair presentation
• going concern
• accrual basis of accounting
• materiality and aggregation
• offsetting
• frequency of reporting
• comparative information
• consistency of presentation.
Each of these considerations is discussed later in the module.
IAS 1 requires a complete set of general purpose financial statements to disclose the accounting policies
used in preparing and presenting the financial statements. According to paragraph 10 of IAS 8 Accounting
Policies, Changes in Accounting Estimates and Errors, preparers of financial statements must choose
accounting policies that are both relevant to decision making and reliable. Accounting policy choices
have a major influence on the results and financial position reported by an entity, and it is important for
comparability reasons that users are able to determine differences in financial performance or position,
due to the adoption of alternative accounting policies. This module discusses IAS 8 as part of the overall
considerations in preparing and presenting general purpose financial statements. IAS 8 specifies how
to determine accounting policies and the disclosures required for accounting policies and changes in
accounting policies. In addition, IAS 8 deals with the accounting treatment of accounting estimates
revisions and error corrections, which can significantly affect the presentation of financial statements.
Part A of this module discusses events after the reporting period and briefly outlines the requirements
of IAS 34 Interim Financial Reporting and IFRS 8 Operating Segments.
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60 Financial Reporting
An important principle when preparing financial statements is that they must be prepared on the basis
of conditions in existence at the end of the reporting period. In the time between the end of the reporting
period and completion of the financial statements, events can occur that either:
• clarify or confirm conditions that existed at the end of the reporting period
• give rise to new conditions.
IAS 10 Events after the Reporting Period deals with how to treat these events when preparing the
financial statements. In some cases, an event after the reporting period will mean adjustments to the
financial statements are required. In other circumstances, an event after the reporting period may lead
to separate disclosure in the notes to the financial statements. Such note disclosures are necessary when
the information could influence the decisions of financial statement users.
Part B focuses on the reporting requirements of the individual financial statements that must be included
in the set of financial statements, beginning with the statement of P/L and OCI.
In relation to the statement of P/L and OCI, this module considers the requirements of IAS 1, which
specifies both:
• how an entity determines comprehensive income
• the information to be presented in the statement of P/L and OCI or in the notes to the financial statements.
Part C discusses the statement of changes in equity, which discloses changes in each component of
equity and reconciles the opening and closing balances of the components. Changes in equity will include
comprehensive income and transactions with owners in their capacity as owners.
Part D deals with the statement of financial position. IAS 1 prescribes:
• how assets and liabilities must be presented
• how assets, liabilities and equity items must be classified
• which disclosures must be made in the statement of financial position and in the notes to the financial
statements.
Finally, part E looks at the statement of cash flows, which helps users assess the entity’s ability to
generate cash flows and the timing and certainty of their generation (IAS 7, ‘Objective’). IAS 7 Statement of
Cash Flows deals with the preparation and presentation of a statement of cash flows and covers issues such
as the definition of cash and cash equivalents, classification of cash inflows and outflows, reconciliations
required and disclosure of information about cash flows.
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MODULE 2 Presentation of Financial Statements 61
PART A: PRESENTATION OF
FINANCIAL STATEMENTS
INTRODUCTION
IAS 1 prescribes the basis for the presentation of general purpose financial statements. It sets out the overall
requirements for the presentation of financial statements together with guidelines for their structure and
minimum requirements for their content (IAS 1, para. 1).
Part A provides an overview of the requirements contained in IAS 1 for an entity to prepare and present
a ‘complete set of financial statements’. The application of IAS 1 in the Australian context is explained.
The requirements in IFRS 8 for reporting entities to disclose their operations according to segments are
briefly discussed.
Part A also covers the general features of financial statements described in IAS 1, including fair
presentation and compliance with IFRS, the going concern basis, the accrual basis, materiality and
aggregation, offsetting, frequency of reporting, and comparative information. The discussion then turns to
IAS 8, which governs how an entity selects and discloses its accounting policies used in the preparation and
presentation of the financial statements. Part A concludes by examining events arising after the reporting
period. IAS 10 deals with how to treat events and transactions that occur from the end of the reporting
period to the date that the financial report is signed off by the directors.
Relevant Paragraphs
To help you achieve the objectives outlined in the module preview, you should read the relevant paragraphs
in the following accounting standards. Where specified, you will need to be able to apply the following
paragraphs.
IAS 1 Presentation of Financial Statements:
Subject
Complete set of financial statements
Fair presentation and compliance with IFRSs
Going concern
Accrual basis of accounting
Materiality and aggregation
Offsetting
Frequency of reporting
Comparative information
Consistency of presentation
Paragraphs
10–14
15–24
25–26
27–28
29–31
32–35
36–37
38–38D, 40A–44
45–46
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors:
Subject
Selection and application of accounting policies
Consistency of accounting policies
Changes in accounting policies
Disclosure of changes in accounting policies
Changes in accounting estimates
Errors
Paragraphs
7–12
13
14–27
28–31
32–40
41–42
IAS 10 Events after the Reporting Period:
Subject
Definitions
Adjusting events after the reporting period
Non-adjusting events after the reporting period
Dividends
Going concern
Disclosures
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62 Financial Reporting
Paragraphs
3
8–9
10–11
12–13
14–16
17–22
2.1 COMPLETE SET OF FINANCIAL STATEMENTS
COMPONENTS OF A COMPLETE SET OF
FINANCIAL STATEMENTS
IAS 1 applies to general purpose financial statements prepared in accordance with IFRSs. It states that:
The objective of financial statements is to provide information about the financial position, financial
performance and cash flows of an entity that is useful to a wide range of users in making economic decisions.
Financial statements also show the results of the management’s stewardship of the resources entrusted to
it (IAS 1, para. 9).
The financial statements provide the following information about an entity in order to satisfy this
stated objective:
• assets
• liabilities
• equity
• income and expenses, including gains and losses
• contributions by and distributions to owners in their capacity as owners
• cash flows.
The information in the financial statements, together with other information in the notes, assists users
to predict the entity’s future cash flows — especially the timing and certainty of cash flows.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraph 1.2 of the Conceptual Framework to remind
yourself of the objective of general purpose financial reporting as discussed in module 1. Think about the differences
between this objective and the objective outlined in paragraph 9 of IAS 1.
•
•
•
•
•
•
•
A complete set of financial statements as stated in paragraph 10 of IAS 1 contains:
a statement of financial position as at the end of the period
a statement of P/L and OCI for the period
a statement of changes in equity for the period
a statement of cash flows for the period
notes, which include accounting policies and other explanatory information
comparative information regarding the preceding period
a statement of the financial position as at the beginning of the earliest comparative period when any of
the following occurs:
– an accounting policy is applied retrospectively
– items in the financial statements are retrospectively restated
– items in the financial statements are reclassified.
Figure 2.1 illustrates the complete set of financial statements required under IAS 1.
FIGURE 2.1
A complete set of financial statements
A complete set of financial statements
under IAS 1 comprises
Statement of
profit or loss and other
comprehensive income
+
Statement of
changes in equity
+
Statement of
financial position
+
Statement of
cash flows
Notes to the accounts
Source: CPA Australia 2022.
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MODULE 2 Presentation of Financial Statements 63
Entities are permitted to use other appropriate titles for the financial statements (IAS 1, para. 10). One
example is using the title of balance sheet instead of statement of financial position. Another example is
using the title of statement of comprehensive income instead of statement of P/L and OCI.
General purpose financial statements (GPFSs) must present all the financial statements shown in
figure 2.1. In Australia, reporting entities are required to prepare and present general purpose financial
statements. However, some entities that are considered non-reporting entities because they do not have
users dependent on general purpose financial statements to satisfy their information needs are allowed
to prepare and present only special purpose financial statements (SPFSs) in accordance with the specific
information needs of the entity’s financial statement users. If these non-reporting entities lodge their SPFSs
with the Australian Securities and Investments Commission (ASIC) or with Australian Charities and
Not-for-profits Commission (ACNC), they must still apply, as a minimum, the disclosure requirements
of the following set of Australian Accounting standards:
• AASB 101 Presentation of Financial Statements
• AASB 107 Statement of Cash Flows
• AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors
• AASB 1048 Interpretation of Standards, and
• AASB 1054 Australian Additional Disclosures.
Entities that lodge special purpose financial reports with ASIC are also required to ensure that the
financial statements give ‘a true and fair’ view (Corporations Act, s. 297). According to ASIC, SPFSs can
only present a true and fair view if they apply all recognition and measurement requirements in Australian
Accounting Standards (e.g. depreciation, tax-effect accounting, leases, inventories, employee benefits).
According to paragraph 9 of AASB 1054 Australian Additional Disclosures, an entity is required to
disclose in its accounting policy note whether the financial statements are general purpose or special
purpose financial statements. As such, users should be mindful of whether they are reading general purpose
financial statements or special purpose financial statements.
An entity must give ‘equal prominence to all of the financial statements in a complete set of financial
statements’ (IAS 1, para. 11). For example, the statement of cash flows cannot be relegated to a note
disclosure or be presented as an appendix at the end of the notes. As will be discussed in further detail in
part B, IAS 1 allows alternative presentations for the statement of profit or loss and other comprehensive
income (IAS 1, para. 10A). The first alternative is a single statement with two sections, that is, one each
for the profit or loss and other comprehensive income. The second alternative is two statements, that is,
one statement for profit or loss and one statement for other comprehensive income.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 10–11 of IAS 1.
The requirements of IAS 1 for a complete set of financial statements are also relevant for interim
financial reports (IAS 34, para. 5). IAS 34 does not specify which entities have to prepare interim financial
reports as this is usually specified by governments, stock exchange requirements and other regulators
(IAS 34, para. 1). In Australia, for example, according to section 302 of Corporations Act, disclosing
entities must prepare and present half-year financial reports. A disclosing entity is defined in the
Corporations Act as an entity that issues ‘enhanced disclosure’ (ED) securities (s. 111AC). For example,
a company whose shares are listed on the ASX is a disclosing entity. As a matter of fact, the ASX Listing
Rules also require all listed entities to prepare and present half-year financial reports. A half-year report
contains condensed financial statements and substantially reduced disclosure requirements in accordance
with IAS 34.
The objective of IAS 34 is to prescribe the minimum requirements of an interim financial report to
provide timely and reliable information that ‘improves the ability of investors, creditors and others to
understand an entity’s capacity to generate earnings and cash flows and its financial condition and liquidity’
(IAS 34, ‘Objectives’). Timely and reliable financial information are concepts that were discussed in
module 1. Paragraph 19 of IAS 34 requires entities that prepare an interim financial report to disclose their
compliance with the requirements of the standard, which includes the requirement of IAS 1 to comply
with IFRSs.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read the ‘Objective’ paragraph and paragraphs 1, 5 and 19 of
IAS 34.
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64 Financial Reporting
In addition to the complete set of financial statements and the notes to the financial statements, entities
may provide additional information required by law or disclosed voluntarily. Paragraph 13 of IAS 1 notes
that many entities present a financial review by management, outside of the financial statements, to describe
the key features of an entity’s financial performance, financial position and the principal uncertainties it
faces. The review by management may include a review of:
• the main factors and influences determining an entity’s financial performance, including changes in the
environment in which the entity operates and how the entity is responding to those changes
• details about the entity’s sources of funding and its targeted ratio of liabilities to equity
• details of the entity’s resources not recognised in the financial statements.
Furthermore, many entities also present environmental reports and value-added statements that are
outside the financial statements. Reports and statements presented outside financial statements are outside
the scope of IFRSs (IAS 1, para. 14).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 13 and 14 of IAS 1 to expand on this discussion.
SEGMENT REPORTING
IFRSs also include disclosure requirements that assist users to unpack additional detail about the numbers
presented in the financial statements. Segment reporting in IFRS 8 involves presenting disaggregated
financial information in the notes to support an understanding of the aggregated financial information
in the financial statements. IFRS 8 applies to an entity that has publicly traded debt or equity instruments
on issue or that files, or is in the process of filing, its financial statements with a regulatory body for the
purpose of issuing instruments in a public market (IFRS 8, para. 2).
IFRS 8 requires an entity to disclose information that enables users of its financial statements to evaluate
the nature and financial effects of the business activities that the entity engages in and the economic
environments in which it operates (IFRS 8, para. 20).
IFRS 8 requires disclosure of the:
• factors used to identify the entity’s reportable segments including the basis of organisation
(e.g. differences in products and services, geographical areas, regulatory environments, or some
combination thereof)
• judgements made by management if operating segments have been aggregated
• types of products and services that each reportable segment derives its revenues from (IFRS 8, para. 22).
An operating segment is defined as a component of the entity that:
• undertakes business activities from which it may generate revenues and incur expenses
• has its operating result regularly reviewed by the chief operating decision maker within the entity, such
as the general manager, managing director or chief executive officer (CEO)
• has discrete financial information available (IFRS 8, para. 5).
The focus in IFRS 8, therefore, is to identify and report on operating segments effectively using the
same basis as the internal decision maker.
IFRS 8 typically requires an entity to disclose the following financial information for each reportable
segment:
• a measure of profit or loss
• a measure of total assets and liabilities
• revenues from external customers
• revenues from transactions with transactions from other operating segments
• interest revenue
• interest expense
• depreciation and amortisation
• material items of income and expense
• the interest in the profit or loss of associates and joint ventures accounted for by the equity method
• income tax expense or income
• material non-cash items other than depreciation and amortisation (IFRS 8, para. 23).
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MODULE 2 Presentation of Financial Statements 65
FAIR PRESENTATION AND COMPLIANCE WITH
INTERNATIONAL FINANCIAL REPORTING STANDARDS
IAS 1 requires financial statements to present fairly the entity’s financial performance, financial position
and cash flows (IAS 1, para. 15). Fair presentation requires faithful representation of the effects of
transactions, other events and conditions in accordance with the definitions and recognition criteria for
assets, liabilities, income and expenses set out in the Conceptual Framework. The application of IFRSs,
with additional disclosures where necessary, is presumed to result in financial statements that are fairly
presented (IAS 1, para. 15).
IAS 1 requires entities with financial statements prepared in accordance with the IFRSs to make an
explicit and unreserved statement of such compliance in the notes to the accounts. In order to make this
statement, an entity must comply with all the requirements of IFRSs (IAS 1, para. 16).
IAS 1 states that an entity is not permitted to depart from a requirement in an IFRS except in the
extremely rare circumstance in which compliance would be so misleading that it would conflict with
the objective of financial statements set out in the Conceptual Framework, that is, to provide financial
information that is relevant and faithfully represents what it purports to represent. In this rare case, an
entity departs from the requirement in an IFRS only if permitted by its regulatory framework and with full
disclosure (IAS 1, para. 19).
An entity that departs from a requirement of an IFRS must make the following disclosures:
• a statement that management believes the departure provides financial statements that present fairly the
entity’s financial position, financial performance and cash flows
• that except for departing from a particular requirement to achieve a fair presentation, it has complied
with applicable IFRSs
• the title of the IFRS from which the entity has departed, the nature of the departure, including the
treatment that the IFRS requires and the treatment adopted, and the reasons why the IFRS treatment
would be misleading in the circumstances that it would conflict with the objective of the financial
statements stated in the Conceptual Framework
• the financial impact of the departure on each item in the financial statements that would have been
reported in complying with the requirement (IAS 1, para. 20).
IAS 1 makes it clear that adopting an accounting policy that is not permitted by an IFRS and disclosing
the details in the notes to the financial statements does not overcome non-compliance with an IFRS (IAS 1,
para. 18). In the Australian context, the Corporations Act requires that the financial statements comply with
accounting standards (s. 296). Also, if compliance with accounting standards does not provide a true and
fair view, the Corporations Act requires an entity to provide additional disclosures necessary to give a ‘true
and fair’ view (s. 297).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 15–24 of IAS 1, which confirm and expand on
this discussion.
OTHER GENERAL FEATURES
In addition to requiring financial statements to be presented fairly, IAS 1 specifies a number of other general
features that must be complied with when preparing and presenting general purpose financial statements.
These include:
• going concern
• accrual basis
• materiality and aggregation
• offsetting
• frequency of reporting
• comparative information
• consistency.
Going Concern
While preparing the financial statements, management must make an assessment of an entity’s ability to
continue as a going concern. IAS 1 states as follows.
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An entity shall prepare financial statements on a going concern basis unless management either intends to
liquidate the entity or to cease trading, or has no realistic alternative but to do so (IAS 1, para. 25).
66 Financial Reporting
There is no specific requirement in IAS 1 for the entity to disclose that it is considered a going
concern. This is an implicit assumption when preparing financial statements. However, where the entity
is not considered a going concern, this must be disclosed together with the reasons why the entity is
not considered a going concern and the basis on which the financial statements are prepared. If there is
significant uncertainty as to the continuity of an entity’s operations, but the financial statements are still
prepared on a going concern basis, then details of the uncertainty must be disclosed (IAS 1, para. 25).
In assessing whether an entity is a going concern, management should consider all available information
about the future — at least up until 12 months after the end of the reporting period (IAS 1, para. 26). In
particular, management should consider whether the entity will be able to discharge its debts as and when
they fall due. Where an entity is no longer considered a going concern, the financial statements would
normally be prepared on a realisable (or liquidation) basis.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 25 and 26 of IAS 1.
Accrual Basis
IAS 1 requires that, except for cash flow information, financial statements be prepared under accrual
accounting principles (IAS 1, para. 27). The accrual basis of accounting provides users with richer
information about the financial performance and financial position of an entity that would not otherwise
be available if the cash basis were used.
Under the accrual basis, items are recognised as assets, liabilities, equity, income and expenses when
they satisfy the definitions and recognition criteria in the Conceptual Framework (IAS 1, para. 28).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 27 and 28 of IAS 1.
Materiality and Aggregation
The financial statements are derived after processing large numbers of transactions or other events that are
aggregated into classes according to their nature or function. This process of aggregation and classification
is necessary to determine the line items presented in the financial statements or notes to the financial
statements (IAS 1, para. 30).
IAS 1 uses the concept of materiality to assist preparers to decide which items can be added together
and which must be separately reported. IAS 1 requires that:
An entity shall present separately each material class of similar items. An entity shall present separately
items of a dissimilar nature or function unless they are immaterial (IAS 1, para. 29).
In applying this requirement, an entity takes into consideration all the relevant facts and circumstances
(IAS 1, para. 30A). A specific disclosure requirement of an IFRS need not be applied if the information
resulting from that disclosure is immaterial (IAS 1, para. 31).
IAS 1 explains materiality in three parts as follows.
1. Information is material if it could reasonably be expected to influence the primary users of financial
statements decision making.
2. The nature or magnitude of information, or both, can have an effect on materiality. Whether information,
either individually or in combination with other information, is material in the context of its financial
statements taken as a whole must be assessed by the entity.
3. Information is obscured if it is communicated in a way that has a similar effect to omitting or misstating
that information. Examples include:
• the language used is vague or unclear
• information is scattered throughout the financial statements
• dissimilar items, transactions or other events are inappropriately aggregated
• similar items, transactions or events are inappropriately disaggregated
• the understandability of the financial statements is reduced by material information being hidden by
immaterial information (IAS 1, para. 7).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 29–31 of IAS 1.
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MODULE 2 Presentation of Financial Statements 67
Offsetting
Offsetting, or combining the balances, of assets and liabilities or income and expenses may result in the
loss of relevant information for financial statement users. Unless it reflects economic substance, offsetting
detracts from the ability of users to understand the transactions and other events and conditions that have
occurred (IAS 1, para. 33).
IAS 1 prohibits offsetting, except where it is required or permitted by an IFRS (IAS 1, para. 32).
Examples of permissible offsetting are as follows.
• IAS 12 Income Taxes (IAS 12) permits the offsetting of current tax assets and current tax liabilities in
the statement of financial position, provided that the entity: ‘(a) has a legally enforceable right to set off
the recognised amounts; and (b) intends either to settle on a net basis, or to realise the asset and settle
the liability simultaneously’ (IAS 12, para. 71).
• IFRS 15 Revenue from Contracts with Customers requires the amount of revenue recognised to be after
any trade discounts and volume rebates the entity allows (IAS 1, para. 34).
• Foreign exchange gains and losses or gains and loss on financial instruments held for trading should be
presented on a net basis, except if such gains and losses are separately material (IAS 1, para. 35).
It should be noted that reporting assets net of valuation allowances is not offsetting and is permissible
(IAS 1, para. 33). Examples include reporting receivables net of a provision for credit loss or impairment
or inventories net of an allowance for obsolescence.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 32–35 of IAS 1.
Frequency of Reporting
An entity must present a complete set of financial statements at least annually (IAS 1, para. 36). If an
entity changes the end of its reporting period, then it may present financial statements for a shorter or
longer period than 12 months but the change, and the reason for the change, needs to be disclosed.
Entities may report using a 52-week period rather an annual period (IAS 1, para. 37). Entities such as
retailers usually prefer the 52-week period because it ensures comparability year-on-year for the number
of retail days during which they conducted their business.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 36–37 of IAS 1.
Comparative Information
Enhancing the inter-period comparability allows users of the financial statements to assess trends in
financial information for predictive purposes (IAS 1, para. 43).
An entity must present comparative information regarding the preceding period for all amounts reported
in the current period’s financial statements, except when the IFRSs permit or require otherwise (IAS 1,
para. 38). Comparative information for narrative and descriptive information is also required if it is relevant
to understanding the current period financial statements.
The requirement for comparative information means that an entity will, as a minimum, present two
statements for each of the financial statements (IAS 1, para. 38A). For example, at least two statements of
financial position should be prepared: one for the current period and one for the prior period.
IAS 1 requires the presentation of a third statement of financial position as at the beginning of the
preceding period if:
• it applies an accounting policy retrospectively, makes a retrospective restatement of items in its financial
statements or reclassifies items in its financial statements
• the retrospective application, retrospective restatement or the reclassification has a material effect on
the information in the statement of financial position at the beginning (IAS 1, para. 40A).
Where items in the financial statements are reclassified, the comparative amounts should also be
reclassified, unless it is impracticable to do so (IAS 1, para. 41). Where it is impracticable, the entity
should disclose the reasons why and the ‘nature of the adjustments that would have been made if the
amounts had been reclassified’ (IAS 1, para. 42).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 38, 38A, 38B, 40A and 41–44 of IAS 1.
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68 Financial Reporting
Consistency
Financial statements should be prepared on a consistent basis from one period to the next, as described in
paragraph 2.26 of the Conceptual Framework.
IAS 1 requires that an entity should retain the presentation and classification items in the financial
statements from one period to the next. The presentation and classification of items contained in the
financial statements should only be changed when:
• ‘a significant change’ has occurred in an entity’s operations, or after reviewing the entity’s financial
statements, management is of the opinion that a change in accounting policy is necessary to show a
more appropriate presentation or classification, or
• a change is required by an IFRS (IAS 1, para. 45).
A significant change on an entity’s operations might arise following the disposal of a major line of its
businesses (IAS 1, para. 46).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 45 and 46 of IAS 1.
2.2 ACCOUNTING POLICIES
A complete set of financial statements identified in IAS 1 includes notes that comprise ‘a summary of
significant accounting policies and other explanatory information’ (IAS 1, para. 10). For users to be able
to compare the financial statements of different entities across different reporting periods, it is important
that there is adequate disclosure of accounting policies. This will provide the necessary information for
users to make allowances for differences in the financial results that are due to different accounting policies
between different entities or differences for the same entity across time.
.......................................................................................................................................................................................
EXPLORE FURTHER
Refer to Note 1 ‘Summary of significant accounting policies’ in the notes to financial statements of Techworks Ltd.
Note how the accounting policies enable the financial statement user to determine the basis of preparation of the
financial report and the accounting policies adopted in relation to various items, such as the ‘Basis of preparation’
(Note 1(c)), ‘Significant management judgements in applying accounting policies’ (Note 1(d)), ‘Property, plant and
equipment’ (Note 1(e)(ix)) and ‘Revenue’ (Note 1(e)(i)), to give a few examples.
If you wish to explore this topic further, you should read paragraphs 2.24–2.29 of the Conceptual Framework,
which discuss the importance of the comparability characteristic.
SELECTION OF ACCOUNTING POLICIES
Accounting policies are defined as ‘the specific principles, bases, conventions, rules and practices applied
by an entity in preparing and presenting financial statements’ (IAS 8, para. 5). Examples of accounting
policies include whether to capitalise or expense borrowing costs and whether to value non-current assets
at cost or at fair value.
IAS 8 requires management to select and apply accounting policies using a hierarchy. According to
IAS 8, if an IFRS specifically applies to a transaction, other event or condition, the accounting policy
or policies applied to that item must be determined by applying the IFRS (IAS 8, para. 7). In addition,
the accounting policy must be determined by reference to any implementation guidance associated with a
relevant IFRS where it is mandatory (IAS 8, para. 9). It is important to note that IAS 8 defines IFRSs to
encompass standards and interpretations adopted by the IASB. They include:
• International Financial Reporting Standards (IFRSs)
• International Accounting Standards (IASs)
• Interpretations of accounting standards developed by the IFRSs Interpretations Committee (referred to
as IFRIC Interpretations)
• Standards Interpretations Committee Interpretations previously issued by the IASB (SIC Interpretations)
(IAS 8, para. 5).
Accordingly, an accounting policy for a particular transaction, event or condition must comply with any
relevant accounting standards (and consider any relevant implementation guidance issued by the IASB)
and IASB Interpretations.
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MODULE 2 Presentation of Financial Statements 69
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read the definition of ‘International Financial Reporting Standards’
in paragraphs 5 and 7–9 of IAS 8.
Where specific IFRSs requirements do not apply to a transaction, other event or condition, IAS 8
requires management to use professional judgement and develop and apply accounting policies that result
in information that is:
(a) relevant to the economic decision-making needs of users; and
(b) reliable, in that the financial statements:
(i) represent faithfully the financial position, financial performance and cash flows of the entity;
(ii) reflect the economic substance of transactions, other events and conditions, and not merely the
legal form;
(iii) are neutral, ie free from bias;
(iv) are prudent; and
(v) are complete in all material respects (IAS 8, para. 10).
IAS 8 provides additional guidance on the selection of appropriate accounting policies if management
has to use professional judgement. Management is required to consider the applicability of other sources
in the following priority order:
1. the requirements in the IFRSs that deal with similar and related issues
2. the Conceptual Framework’s definitions, recognition criteria and measurement concepts for assets,
liabilities, income and expenses (IAS 8, para. 11).
In making the judgement, management may also refer to the pronouncements of other standard-setting
bodies that use a similar Conceptual Framework, other accounting literature and industry practice, but only
to the extent that these are consistent with the preceding two sources of guidance (IAS 8, para. 12).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 10–12 of IAS 8.
CONSISTENCY OF ACCOUNTING POLICIES
Consistency of accounting policies allows users to compare the financial statements of an entity over time
to identify trends in financial position, financial performance and cash flows (IAS 8, para. 15).
IAS 8 requires that an entity must apply its accounting policies consistently for similar transactions, other
events and conditions unless an IFRS specifically requires or allows a categorisation of items for different
accounting policies (IAS 8, para. 13). For an example, IAS 16 Property, Plant and Equipment allows
different classes, or categories, of plant and equipment to be presented using a different measurement
basis. It is possible to recognise land and buildings using the fair value basis and office furniture using the
cost basis.
DISCLOSURE OF ACCOUNTING POLICIES
Accounting policies adopted by an entity can significantly affect the way profits and financial position
are reported. This influences economic decisions and other evaluations, including evaluations about the
discharge of managerial accountability by users of those statements. As such, it is important that users are
provided with information about those policies and changes therein.
IAS 1 requires that the notes to the financial statements present information about the specific
accounting policies used in the preparation of the financial statements (IAS 1, para. 112(a)). The latest
IAS 1 requires an entity to disclose accounting policy information that is material – ‘accounting policy
information is material if, when considered together with other information included in an entity’s financial
statements, it can be reasonably expected to influence’ the decisions of the primary users (i.e. existing and
potential investors, lenders and other creditors) of general purpose financial statements (IAS 1, para. 117).
More specifically, accounting policy information is expected to be material if users of an entity’s financial
statements need the accounting policy information to understand other material information in the financial
statements (IAS 1, para. 117B). When disclosing accounting policy information, it should be entityspecific information that focuses on how the entity has applied the requirements of the standards to its
own circumstances (IAS 1, para. 117C).
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70 Financial Reporting
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read the following paragraphs of IAS 1:
• paragraphs 112–117, which outline the requirements for the structure of the notes to the financial statements and
the disclosure requirements for accounting policies
• paragraphs 117A–117E, which expand on the requirements of paragraph 117
• paragraphs 122–124, which discuss the disclosure requirements for judgements that management has made in
determining accounting policies
• paragraphs 125–127, which discuss the disclosure requirements relating to information concerning the key
sources of estimation uncertainty at the end of the reporting period, which may require adjustments to the amount
of assets or liabilities in the next financial year.
QUESTION 2.1
(a) Refer to Note 1 of the financial statements of Techworks Ltd. Explain how the summary complies
with the requirements of paragraphs 112 and 117 of IAS 1.
(b) Refer to the ‘Case study data’ section at the end of this module. Prepare the initial section of
the accounting policy notes relating to the significant accounting policies of Webprod Ltd.
CHANGES IN ACCOUNTING POLICIES
IAS 8 permits an entity to change its accounting policies only if the change:
(a) is required by an IFRS; or
(b) results in the financial statements providing reliable and more relevant information about the effects
of transactions, other events or conditions on the entity’s financial position, financial performance or
cash flows (IAS 8, para. 14).
IAS 8 clarifies that:
[t]he following are not changes in accounting policies:
(a) the application of an accounting policy for transactions, other events or conditions that differ in
substance from those previously occurring; and
(b) the application of a new accounting policy for transactions, other events or conditions that did not occur
previously or were immaterial (IAS 8, para. 16).
Where an entity changes an accounting policy because of a new IFRS, it must apply the transitional
provisions in the IFRS (IAS 8, para. 19(a)). When there are no transitional provisions in the IFRS, or the
entity is making a voluntary change in accounting policy, the accounting policy change must be made
retrospectively (IAS 8, para. 19(b)).
Retrospective application for voluntary changes in accounting policies ensures that the prior period
comparatives are comparable to current period financial statements. Retrospective application requires that
two adjustments must be made to the financial statements. First, the opening balance of each component
of equity affected by the change must be adjusted for the earliest prior period presented in the financial
statements. Second, the other comparative amounts disclosed for each prior period presented must be
restated as if the new policy had always been applied by the entity (IAS 8, para. 22).
EXAMPLE 2.1
Change in Accounting Policy
Capricorn Ltd is an Australian diamond wholesaler. It has a financial year-end of 30 June. Due to extreme
fluctuations in the price of diamonds, which it imports from all over the world, the cost of inventory has
become extremely volatile, and this volatility is expected to continue indefinitely in the future.
Due to these circumstances, on 1 July 20X5, in accordance with IAS 2 Inventories, Capricorn Ltd has
decided to voluntarily change its inventory valuation method from weighted average cost to first-in, firstout (FIFO). The company’s directors believe that this change in accounting policy more accurately reflects
the economic substance and results in more relevant and reliable information.
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MODULE 2 Presentation of Financial Statements 71
The impact of this change in accounting policy resulted in an increase in the value of inventory on hand
by $26 000 at 30 June 20X5 and an increase of $52 000 at 30 June 20X4.
Assume that the company is unable to determine or calculate the impact of this change of accounting
policy from any date prior to 30 June 20X4.
As this represents a voluntary change in accounting policy, it must be accounted for retrospectively
(IAS 8, para. 19(b)). The first period for which retrospective application is practicable is 30 June 20X5.
For comparative figures for 30 June 20X4, this will involve restating the inventory balance upwards by
$52 000 with a corresponding change to closing inventory in the statement of P/L and OCI. This will wash
through as an adjustment to opening retained earnings in 20X5. For the year ended 30 June 20X5, closing
inventory will increase by $26 000 with a corresponding adjustment in the statement of P/L and OCI to
closing inventory. For the year ended 30 June 20X5, the effect on the change in inventory is $26 000, being
the net effect of increasing opening inventory by $52 000 and decreasing closing inventory by $26 000.
The following journal entries would need to be processed.
Dr
Inventories (Statement of financial position — 30/6/X4)
Cost of sales/Retained earnings (30/6/X4)
52 000
Cr
Inventories (Statement of financial position — 30/6/X5)
Closing inventories 30/6/X5 (Statement of P/L and OCI)
26 000
Cr
Dr
52 000
26 000
Assume that the balances before the change in accounting policy are $nil and ignore tax. The financial
effects of recognising the change in accounting policy can be summarised as follows.
20X5
20X4
Statement of financial position
Inventories
Retained earnings
26 000
26 000
52 000
52 000
Statement of P/L and OCI
Change in inventories
Profit before tax
26 000
26 000
52 000
52 000
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 14–22 of IAS 8.
IAS 8 recognises that in some cases it may be ‘impracticable’ to adjust comparative information for
one or more prior periods (IAS 8, para. 23). For example, the data are no longer available or not able to
be collected. In this case, the new accounting policy must be applied from the earliest date practicable,
which may be the current reporting period, and a corresponding adjustment must be made to each affected
component of equity (IAS 8, para. 24).
For example, if it is not possible to determine exactly when the initial transaction was recorded in the
financial statements any catch-up revenue or expense amendments could be adjusted through opening
retained earnings of the current reporting period.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read:
• paragraphs 23–27 of IAS 8
• the definition of ‘impracticable’ in paragraph 5 of IAS 8
• the guidance on impracticability in relation to the retrospective application of a new accounting policy in
paragraphs 50–53 of IAS 8
• Example 3 in the ‘Guidance on implementing IAS 8 Accounting Policies, Changes in Accounting Estimates and
Errors’ (in the IFRS Compilation Handbook), which deals with the prospective application of a change in accounting
policy when retrospective application is impracticable.
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72 Financial Reporting
Where an entity changes an accounting policy, it must not only apply the policy retrospectively (where
it is practical to do so and which involves making every reasonable effort to do so), but it must also make
several disclosures.
According to IAS 8, when the initial application of an IFRS has an effect on the current or prior period
or potentially a future period, an entity must disclose:
• the title of the IFRS
• the nature of the change in accounting policy
• for the current period and each prior period presented, the amount of the adjustment for each financial
statement item affected and the impact on earnings per share disclosures if applicable
• for periods before those presented, the amount of the adjustment to the extent practicable
• when there are transitional provisions, disclose this fact together with a description of the transitional
provisions and the effect they might have on future periods
• if retrospective application is impracticable, the circumstance that led to the existence of that condition,
and a description of how and when the change in accounting policy has been applied (IAS 8, para. 28).
According to IAS 8, when an entity makes a voluntary change in accounting policy that has an effect
on the current or prior period or potentially a future reporting period, the entity must disclose:
• the nature of the change in accounting policy
• the reasons why the change provides ‘reliable and more relevant information’
• the amount of adjustment for each financial statement item affected (current and prior period) and the
impact on earnings per share disclosures if applicable
• the amount of the adjustments relating to periods before those presented to the extent practicable
• advice (where applicable) that retrospective application is impracticable for a particular prior period or
for periods before those presented, the circumstance that led to the existence of that condition and a
description of how and from when the change has been applied (IAS 8, para. 29).
Finally, it should be noted that in some situations an entity may prepare financial statements that do
not comply with a new standard or interpretation because it is not effective until after the end of the
reporting period. In such situations, the entity should disclose this situation and provide information about
the potential impact of applying the new standard or interpretation (IAS 8, para. 30).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 28–31 of IAS 8. In addition, re-reading
paragraphs 19 and 22 of IAS 8 may be helpful.
QUESTION 2.2
Which accounting standards in the AASB series 1–100 have been identified by the directors as those
that have not been adopted? What effects did the directors expect in the future for the accounting
standards not yet adopted?
(a) Refer to note 31(e) of the financial statements of JB Hi-Fi Limited for 30 June 2018 (available at
www.asx.com.au by searching, under the ‘Markets’ drop down menu, ‘historical announcements’ released during ‘2018’ using code ‘jbh’. Scroll down to the announcement released on
14 September 2018 titled ‘Annual Report 2018 – with Chairman’s & CEO’s Report’).
(b) Under section 334(5) of the Corporations Act, Australian companies have the option of early
adopting accounting standards. These are accounting standards that have been issued by the
IASB or AASB but do not apply until a future financial reporting period. Review Note 1 ‘Summary
of significant accounting policies’ in the notes to financial statements of Techworks Ltd. Has
Techworks Ltd early adopted any AASB accounting standards?
(c) Refer to sections 5 and 6 of the ‘Case study data’ for Webprod Ltd. Prepare any disclosures
necessary to be included in the notes to the financial statements.
Refer to Note 1 ‘Summary of significant accounting policies’ in the notes to financial statements
of Techworks Ltd. What changes in accounting policies have been applied in the current year? What
significant management judgements have been made in applying the accounting policies?
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MODULE 2 Presentation of Financial Statements 73
2.3 REVISION OF ACCOUNTING ESTIMATES AND
CORRECTION OF ERRORS
ACCOUNTING ESTIMATES
An accounting policy may require financial statement items to be measured with uncertainty. That is,
the items are measured at estimated monetary amounts. These are referred to as accounting estimates,
examples of which include:
(a)
(b)
(c)
(d)
(e)
allowance for expected credit losses [also known as provision for credit loss or impairment]
the net realisable value of an item of inventory
the fair value of an asset or liability
the depreciation expense for an item of property, plant and equipment
a provision for warranty obligations (IAS 8, para. 32).
Using estimates is an essential part of the preparation of financial statements (IAS 8, para. 33). The
nature of making an estimate means that as new information is received or new developments occur, the
estimate may have to be revised.
CHANGES IN ACCOUNTING ESTIMATES
Changes in accounting estimates should be distinguished from the correction of errors because they do not
relate to a prior period (IAS 8, para. 34).
According to IAS 8, a change of accounting estimate cannot be recognised retrospectively. It must be
recognised prospectively by including it in the profit or loss in:
(a) the period of the change [the current period], if the change affects that period only; or
(b) the period of the change and future periods, if the change affects both (IAS 8, para. 36).
The IAS 8 requirements in relation to changes in estimates operate as follows.
• Income and expense adjustments as a result of the revision must be recognised in either the current
reporting period or the current and future reporting periods, depending on which periods the change of
estimate affects (IAS 8, para. 36).
• Where relevant, adjustments to assets, liabilities and equity items should be made in the reporting period
of the change of estimate (IAS 8, para. 37).
• Specific disclosures must be made of the nature and amount of the revision in the accounting estimate
where the change affects the current reporting period and, to the extent it is practicable, disclosure of
the effect on future reporting periods (IAS 8, para. 39).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 32–40 of IAS 8.
EXAMPLE 2.2
Change in an Accounting Estimate
In its accounts for the year ended 30 June 20X1, Totalconcept Ltd recorded a provision for credit loss of
$24 000 in respect of one of its major customers who was experiencing financial difficulties.
This represented 40 per cent of the total amount owing by the customer (total of $60 000). At the time of
preparing the 30 June 20X1 accounts, this provision was considered correct and reasonable. Totalconcept
Ltd’s management expected that the balance ($36 000) would be received by December 20X1.
However, by 30 September 20X1, the customer’s position had seriously deteriorated, and the management of Totalconcept Ltd decided to revise the provision for credit loss to $60 000.
This is an example of a change in an accounting estimate based on information available at the time a
transaction is recorded or reviewed. Estimating a provision for credit loss is a regular accounting exercise
and likely to be subject to later revision. There is nothing to indicate that the initial provision was due to
an error or omission made by the entity.
The increase of $36 000 in the provision for credit loss is regarded as a change in an accounting estimate
and should be adjusted prospectively (not retrospectively) in the 20X2 accounts (i.e. by debiting expected
credit loss expenses and crediting the provision for credit loss for $36 000).
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74 Financial Reporting
MATERIAL ERRORS IN A PRIOR PERIOD
From time to time, errors may arise in the recognition, measurement, presentation or disclosure in the
financial statements or notes to the financial statements (IAS 8, para. 41).
Financial statements are considered not to comply with the accounting standards if they ‘contain either
material errors or immaterial errors made intentionally to achieve a particular presentation of an entity’s
financial position, financial performance or cash flows’ (IAS 8, para. 41). Accordingly, material errors
made in a prior period must be corrected if the financial statements are to comply with IFRSs.
There may be times when a material error (i.e. a mistake) has been made in a previous financial period
that is not covered by the current financial statements (i.e. current year and previous year comparatives) but
is only discovered in the current reporting period. An example of a material error is realising in the current
period that land sold in a previous financial year was not accounted for correctly in the previous year’s
accounts. IAS 8 acknowledges that an error could include mathematical mistakes, mistakes in applying
accounting policies, oversights or misinterpretations of facts or fraud (IAS 8, para. 5).
When material errors are discovered in a reporting period subsequent to the reporting period(s) in which
the error occurred, IAS 8 requires retrospective correction of the error in the first set of financial statements
issued after the error’s discovery. The error must be corrected by either:
(a) restating the comparative amounts for the prior period(s) presented in which the error occurred; or
(b) if the error occurred before the earliest prior period presented, restating the opening balances of assets,
liabilities and equity for the earliest prior period presented (IAS 8, para. 42).
In other words, IAS 8 requires material errors relating to prior reporting periods to be corrected
retrospectively if this is practicable.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 41 and 42 of IAS 8 as well as Example 1 of the
‘Guidance on implementing IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors’ (in the IFRS
Compilation Handbook), which illustrates a retrospective restatement of errors.
As with changes to accounting policies, IAS 8 requires that a ‘catch-up’ adjustment be made starting
from the date that the error was made. If this relates to the profit or loss of a period not covered by the
financial statements, then the adjustment is made to the opening balance of retained earnings.
However, IAS 8 recognises that in some cases it may be ‘impracticable’ to adjust comparative
information for one prior period or more (e.g. the data are longer available or cannot be collected). In this
case, the adjustment is made at the beginning of the current financial reporting period (IAS 8, para. 47).
Furthermore, paragraphs 40A–40C of IAS 1 require that a three-column statement of financial position
be presented where a material error in a prior period affects the statement of financial position. The entity
must present the following statement of financial positions as at the:
• end of the current period
• end of the previous period (which is the same as the beginning of the current period)
• beginning of the earliest comparative period.
Finally, where a prior period error has been corrected in a reporting period, IAS 8 specifies disclosure
of information including:
(a) the nature of the prior period error;
(b) for each prior period presented, to the extent practicable, the amount of the correction:
(i) for each financial statement line item affected; and
(ii) if IAS 33 [Earnings per share] applies to the entity, for basic and diluted earnings per share;
(c) the amount of the correction at the beginning of the earliest prior period presented; and
(d) if retrospective restatement is impracticable for a particular prior period, the circumstances that led to
the existence of that condition and a description of how and from when the error has been corrected
(IAS 8, para. 49).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should:
• re-read the definition of ‘impracticable’ in paragraph 5 of IAS 8
• re-read the guidance on impracticability in relation to retrospective application and restatement of errors in
paragraphs 50–53 of IAS 8
• read paragraphs 43–49 of IAS 8.
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MODULE 2 Presentation of Financial Statements 75
EXAMPLE 2.3
Material Errors in a Prior Period
Mixmaster Ltd owns 10 000 shares of a company that is listed on a public stock exchange. This investment
asset is measured at fair value through profit or loss (FVPL).
During the preparation of the financial statements for the year ended 30 June 20X6, the financial
controller noted that the shares had not been marked to market (revalued) in the prior year.
Shares are held at $100 000 ($10 per share), which was the price paid when they were originally
purchased in March 20X5. The share price at 30 June 20X5 was $9.50, and the share price at
30 June 20X6 was $10.50.
This is an example of an accounting error, and therefore, a retrospective adjustment is required when
the error is discovered.
The error should be corrected by restating the comparative balances for 20X5. At 30 June 20X5, the
carrying amount of the shares was incorrectly shown as $100 000 but should have been recognised at fair
value of $95 000 (10 000 shares × $9.50). The following journal would need to be processed.
30 June 20X5
Dr
Fair value movements in listed equities
Cr
Investment in shares
5 000
5 000
A detailed note disclosure is also required to explain this adjustment.
At 30 June 20X6, the fair value of the shares increased to $10.50 per share. The fair value is now
$105 000 (10 000 shares × $10.50). The journal entry required based on this adjustment is as follows.
30 June 20X6
Dr
Investment in shares
Cr
Fair value movements in listed equities
10 000
10 000
Assume other balances are $nil beforehand and ignore tax. The financial effects of correcting the error
can be summarised as follows.
Statement of financial position
Investment in shares
Retained earnings
Statement of P/L and OCI
Fair value movement
Profit before tax
20X6
20X5
105 000
5 000
95 000
(5 000)
10 000
10 000
(5 000)
(5 000)
2.4 EVENTS AFTER THE REPORTING PERIOD
It is important that financial statements reflect conditions that existed at the end of the reporting period.
The objective of IAS 10 is to prescribe when an entity should adjust its financial statements for events
occurring after the reporting period and the disclosures it should give about such events in the notes to the
financial statements (IAS 10, para. 1).
An event after the reporting period, or a subsequent event, is defined as a favourable or unfavourable
event occurring between the end of the reporting period and the date when the financial statements have
been authorised for issue (IAS 10, para. 3).
The date of authorisation is important because events after this date do not qualify as events after the
reporting period. In the case of a company, the date of authorisation is usually the date the directors sign
a Directors’ Declaration that is attached to the financial report. If an event occurs after the directors have
signed off, then IAS 10 does not apply, and the event will be recognised in the next reporting period.
The timeline in figure 2.2 illustrates the concept of events occurring after the reporting period and the
application of IAS 10.
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76 Financial Reporting
FIGURE 2.2
Application of IAS 10 Events after the Reporting Period
IAS 10 applies
End of reporting
period
(e.g. 30 June)
IAS 10 does not apply
Date that the board/directors
‘sign off’ the financial report
(e.g. 30 September)
Source: Based on IFRS Foundation 2022, IAS 10 Events after the Reporting Period, in 2022 IFRS Standards, IFRS Foundation,
London. © CPA Australia 2022.
Events after the reporting period are only reflected in the financial statements up to the date of
authorisation for issue. Therefore, it is important that this date is disclosed together with details of who
gave the authorisation (IAS 10, para. 17).
TYPES OF EVENTS AFTER THE REPORTING PERIOD
IAS 10 provides for two types of events that can occur after the reporting period:
1. those events that provide new or further evidence of conditions that existed at the end of the reporting
period (called an adjusting event)
2. those events that reflect conditions that were not in existence at the end of the reporting period, but
which arose for the first time after the end of the reporting period (called a non-adjusting event)
(IAS 10, para. 3).
These are illustrated in figure 2.3.
FIGURE 2.3
Types of events after the reporting period
Event after the reporting period
Adjusting events
Events that require the financial
statements to be adjusted
(usually by way of a journal entry)
or
Non-adjusting events
Events that are required to be
disclosed as a note to the
financial statements
Source: CPA Australia 2022.
ADJUSTING EVENTS
An adjusting event is one that provides new or further evidence of conditions that existed at the end of
the reporting period. According to paragraph 8 of IAS 10, an entity shall adjust the financial statements to
reflect these events.
An adjusting event may provide additional information about items that existed at the end of the reporting
period, but for which the amount was uncertain and had to be estimated. The additional information after
the reporting period informs what the correct amount is for the financial statements.
Examples of adjusting events include:
• where a court case that was in existence, but had not been settled by the end of the reporting period, is
subsequently decided after the reporting period where the outcome is now known
• where an asset value has been estimated at the end of the reporting period, and further information has
become available after the reporting period that alters or changes the value of the asset — for example,
the ascertainment of selling prices for inventory items, after the reporting period, where those prices
were uncertain at the end of the reporting period, thereby affecting the determination of the carrying
amount of inventory items measured at net realisable values
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MODULE 2 Presentation of Financial Statements 77
• the determination after the reporting period of profit sharing or bonus payments, if the entity had a
present obligation for such payments arising from events occurring before the end of the reporting period
• the discovery of fraud or errors after the reporting period that reveals that the financial statements were
incorrect at the end of the reporting period.
In the case of adjusting events, IAS 10 requires an entity to update disclosures that relate to conditions
that existed at the end of the reporting period in light of the new information (IAS 10, para. 19).
If the new information relates to items presented in the financial statements, then this means posting a
journal entry to adjust the amounts recognised in the financial statements. An example is new information
about slow-selling stock that indicates the allowance for inventory obsolescence should be increased.
The entity would need to prepare a journal entry to record an increase in the allowance for inventory
obsolescence.
If the new information concerns information disclosed in the notes to the financial statements, then this
means making changes to the note disclosures. An example is a contingent liability disclosed in the notes
at the end of the reporting period for possible damages that may result from an in-progress court action by
a disgruntled customer. After the end of the reporting period but prior to the date of issue, evidence from
the court case may indicate a stronger likelihood of losing the case. The entity should update the disclosure
about the contingent liability to reflect this new information.
NON-ADJUSTING EVENTS
A non-adjusting event is one that provides new evidence of conditions that have arisen after the reporting
period. In other words, the information does not relate to a condition that existed at the end of the
reporting period.
An entity must not adjust the amounts recognised in the financial statements to reflect non-adjusting
events (IAS 10, para. 10).
Examples of non-adjusting events are:
• a decline in the market value of investments after the reporting period and the date when the financial
statements are authorised for issue. The decline in market value does not normally relate to the
condition of the investments at the end of the reporting period but reflects circumstances that have
arisen subsequently
• a major business combination change after the reporting period (e.g. acquisition or disposal of
a subsidiary)
• announcing a plan to discontinue a business unit or operation after the reporting period
• major purchases or disposal of assets, or expropriation of major assets by government
• the destruction of a major production plant by a fire after the reporting period
• announcing or commencing the implementation of a major restructuring
• major share transactions (e.g. issuing new shares, bonus share issues) after the reporting period
• changes in tax rates or tax laws enacted or announced after the reporting period date that have a
significant effect on current and deferred tax assets and liabilities
• abnormally large changes in asset prices or foreign exchange rates after the reporting period
• entering into significant commitments or contingent liabilities
• commencing major litigation that arose solely from events that occurred after the reporting period
(IAS 10, paras 11 and 22).
In the case of non-adjusting events after the reporting period that are material, an entity should disclose
in the notes to the financial statements the nature of the event and an estimate of its financial effect, or a
statement that such an estimate cannot be made (IAS 10, para. 21).
Figure 2.4 illustrates how to distinguish between the two types of events after the reporting period,
namely adjusting and non-adjusting events.
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78 Financial Reporting
Distinguishing between different types of events after the reporting period
FIGURE 2.4
Yes
No
Not an event after
reporting period
Did the event occur
after the end of the
reporting period?
No
Did the event occur
before the authorisation Yes
date of the financial
statements?
Yes
Adjusting event
Not an event after
reporting period
Did the event reflect
conditions existing at
the end of the
reporting period?
No
Non-adjusting event
Source: Based on IFRS Foundation 2022, IAS 10 Events after the Reporting Period, in 2022 IFRS Standards, IFRS Foundation,
London. © CPA Australia 2022.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 2–7 of IAS 10. Please now attempt question 2.3
to apply your knowledge of this topic.
QUESTION 2.3
The following extract is from Note 7.5 of the 2021 annual report of Telstra Corporation Limited:
On 6 August 2021, Telstra Health entered into a binding agreement to acquire 100 per cent of
the shares in Clinical Technology Holdings Pty Ltd and its subsidiaries (MedicalDirector) for
an enterprise value of $350 million (subject to completion adjustments). MedicalDirector is a
leading general practice clinical and practice management software company. The acquisition
is expected to complete in the first quarter of the financial year 2022 (Telstra Corporation
Limited 2021, p. 156).
Comment on whether the preceding event would be regarded as an ‘adjusting event after the
reporting period’ or a ‘non-adjusting event after the reporting period’.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 8–11, 19 and 21 of IAS 10 to confirm the content
of figure 2.4. Please now attempt question 2.4 to apply your knowledge of this topic.
QUESTION 2.4
Refer to Note 18 ‘Subsequent events’ in the notes to financial statements of Techworks Ltd. This
note refers to two events that have occurred after the 31 December year end (but before the signing
off of the financial report by the directors).
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MODULE 2 Presentation of Financial Statements 79
The two events disclosed in Note 18 are:
• renegotiation of the loan facility (and repayments) in February
• declaration of the dividend by the directors on 17 February.
Explain whether these two subsequent events are adjusting or non-adjusting events under
IAS 10.
DIVIDENDS DECLARED AFTER REPORTING PERIOD
Dividends may be declared after the end of the reporting period. IAS 10 requires that an entity should
not recognise those dividends as ‘a liability at the end of the reporting period’ even if the dividend was
declared from profits derived prior to the end of the reporting period (IAS 10, para. 12).
This is because such dividends fail the essential characteristic of a liability, that is, a present obligation
existing at the end of the reporting period (IAS 10, para. 13). As such, the dividends declared/payable shall
be regarded as a non-adjusting event and be disclosed in the notes to the financial statements.
GOING CONCERN ISSUES AFTER REPORTING PERIOD
IAS 10 does not permit an entity to prepare its financial statements on a going concern basis if management
determines after the reporting period that it either intends to liquidate the entity or cease trading, or has no
realistic alternative but to do so (IAS 10, para. 14).
If the event after the reporting period reveals that the entity is no longer a going concern, then the
financial statements should not be presented as if the entity is a going concern. IAS 10 effectively treats
the new information regarding going concern as an adjusting event. In this case, the financial statements
would have to be presented on the basis that the entity is not a going concern, for example, using
liquidation values.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 14–16 of IAS 10. Paragraph 22 of IAS 10 provides
several examples of non-adjusting events. If you wish to explore this topic further, you should read paragraphs 17–22.
Please now attempt question 2.5 to apply your knowledge of this topic.
QUESTION 2.5
Venturiac Holdings Ltd’s reporting period ends on 30 June, and the financial statements are
authorised for issue on 31 August. How should the following events be disclosed?
(a) On 30 July, a major drop in the price of shares means that the value of the Venturiac Holding’s
investments has declined by 25 per cent since 30 June.
(b) A debtor who owed a significant sum of money as at 30 June was declared bankrupt on
18 August.
(c) A major explosion occurred on 20 July, causing significant losses for the company.
2.5 THE IMPACT OF TECHNOLOGICAL
ADVANCEMENTS ON THE PRESENTATION OF
FINANCIAL STATEMENTS
As discussed in module 1, timeliness is an important qualitative characteristic of financial information as
stated in the Conceptual Framework. However, it is traditionally expected that producing GPFSs involves
a significant period of time, during which the information included in those GPFSs may lose its ability
to influence decisions. That is the case because the current processes necessary to produce GPFSs still
involve, to a great extent, manually assembling and reviewing the financial reports.
It is common practice for financial statements to be released three months after the end of the reporting
period. As a consequence, even more work is needed to identify and recognise the effects of adjusting
and non-adjusting events to somehow still maintain reasonable timeliness of information disclosed. This
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80 Financial Reporting
practice and the need to disclose events after the reporting period will potentially change in the near future
as technological advancements allow entities to prepare financial reports almost instantaneously with some
clever software solutions, provided that they record their data in a structured way.
Software companies like IBM, Oracle, SAP and many others are now offering powerful cloud-based
disclosure management applications that can automatically generate reports that combine an entity’s
structured financial data with narrative analysis. Those reports are not only prepared faster but can be
updated automatically as new events occur; they can also be subject to less human errors as human intervention is kept at a minimum. The solutions began by focusing on helping entities to produce digital reports
in a machine-readable format known as XBRL (see www.xbrl.org/the-standard/what/an-introductionto-xbrl), but are continuously evolving. As more entities are embracing these software solutions, users
of financial information will benefit from having access to quality reports in a timely manner. Moreover,
they will be able to use software solutions based on artificial intelligence applications like machine learning
and deep learning to perform data analysis on the vast amounts of data that will be readily available.
SUMMARY
IAS 1 specifies the components of a complete set of financial statements and the considerations that must
be taken into account when preparing the financial statements. These considerations include:
• compliance with IFRSs to present fairly the financial performance, financial position and cash flows of
an entity
• selection and disclosure of accounting policies
• assessment of whether the entity is a going concern
• use of the accrual basis of accounting
• use of materiality to determine which items should be separately disclosed
• need for consistency from one reporting period to the next
• comparative information.
This module covered the selection and disclosure of accounting policies in some detail. IAS 8 deals
with the selection of accounting policies and specifies that management should select accounting policies
that comply with standards and interpretations. Where there is no specific requirement in a standard or
interpretation, accounting policies must be selected and applied so that the resultant information is relevant
and reliable.
IAS 1 contains requirements for the disclosure of accounting policies, including:
• a description of the measurement basis or bases used
• a description of accounting policies necessary for an understanding of the financial report
• detailed information where material uncertainties exist as to whether the entity can continue as a going
concern or whether the financial report has been prepared on other than a going concern basis.
IAS 8 specifies that an entity can only change an accounting policy when this is required by a standard
or interpretation, or the change is necessary to provide reliable and more relevant information. Where
an entity changes an accounting policy because of a new standard or interpretation, it must apply the
transitional provisions of that standard or interpretation. When there are no transitional provisions in the
standard or interpretation, or the entity is making a voluntary change in accounting policy, the accounting
policy change must be made retrospectively. That is, IAS 8 requires the entity to:
• adjust the opening balance of each component of equity affected by the change for the earliest prior
period included in the financial statements
• restate any comparative amounts included in the financial statements as if the new policy had always
been applied.
Where an accounting policy change is made, the entity must disclose information — including the title
of the standard or interpretation (if a new standard or interpretation required the change), the nature of the
change, the reasons for the change and the amount of any adjustments made to the financial statements.
The final section of part A dealt with IAS 10. The standard identifies two types of events occurring after
the reporting period: adjusting and non-adjusting events. Where the event provides evidence of conditions
existing at the end of the reporting period, the financial statements must be adjusted to reflect this event.
Where the event does not relate to conditions existing at the end of the reporting period, disclosure in the
notes is only required where the information would affect the decisions of users.
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MODULE 2 Presentation of Financial Statements 81
The key points covered in this part, and the learning objectives they align to, are as follows.
KEY POINTS
2.1 Explain and apply the requirements of IAS 1 with respect to a complete set of financial
statements and in relation to the considerations for the presentation of financial statements.
• A complete set of financial statements includes a statement of financial position, statement of profit
or loss and other comprehensive income, statement of changes in equity, statement of cash flows,
notes to the financial statements, and comparative information from the preceding reporting period.
• Segment reporting involves presenting disaggregated financial information in the notes to the
financial statements to support an understanding of the aggregated financial information in the
financial statements.
• Fair presentation of the financial statements requires faithful representation of the effects of
transactions, other events and conditions in accordance with the definitions and recognition criteria
for assets, liabilities, income and expenses set out in the Conceptual Framework.
• General features that must be complied with when preparing and presenting general purpose
financial statements include going concern, accrual basis, materiality and aggregation, offsetting,
frequency of reporting, comparative information, and consistency.
2.2 Outline and explain the requirements of IAS 8 for the selection of accounting policies.
• Accounting policies are the specific principles, bases, conventions, rules and practices applied by
an entity in preparing and presenting financial statements.
• International Financial Reporting Standards (IFRSs) have priority when determining the accounting
policies to be applied.
• An entity that prepares general purpose financial reports is required to disclose its significant
accounting policies in the notes to the financial statements to assist users in their decision making.
• An entity can change its accounting policies only if the change is either required by an IFRS or
results in the financial statements providing reliable and more relevant information about the effects
of transactions, other events or conditions on the entity’s financial position, financial performance
or cash flows.
2.3 Explain and apply the accounting treatment and disclosure requirements of IAS 8 in relation to
changes in accounting policies, and changes in accounting estimates and errors.
• Changes in accounting estimates are to be distinguished from the correction of errors as they do
not relate to a prior period and cannot be recognised retrospectively.
• Material errors made in a prior period must be corrected if the financial statements are to comply
with IFRSs.
• When material errors are discovered in a reporting period subsequent to the reporting period(s)
in which the error occurred, IAS 8 requires retrospective correction of the error in the first set of
financial statements issued after the error’s discovery.
2.4 Explain and discuss the required treatment for both adjusting and non-adjusting events
occurring after the reporting period in accordance with IAS 10.
• IAS 10 distinguishes between two types of events occurring after the reporting period and before
the date of authorisation of the financial statements:
1. events that provide new or further evidence of conditions that existed at the end of the reporting
period are referred to as ‘adjusting events’
2. events that reflect conditions that were not in existence at the end of the reporting period, but
which arose for the first time after the end of the reporting period, referred to as ‘non-adjusting
events’.
• Dividends declared after the end of the reporting period are regarded as a non-adjusting event and
are to be disclosed as a note in the financial statements.
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82 Financial Reporting
PART B: STATEMENT OF PROFIT OR LOSS
AND OTHER COMPREHENSIVE INCOME
INTRODUCTION
The key indicator of a business entity’s financial performance is its reported profit or loss (P/L) figure.
Therefore, how profit is determined and the information that is disclosed concerning the determination of
profit or loss are central accounting issues. IAS 1 deals with these matters.
A more expansive notion of financial performance is total comprehensive income, which equals the
profit or loss added together with other comprehensive income (OCI) for the period.
Part B discusses the composition of the statement of P/L and OCI, including what is required to be
included in the profit or loss and what is included in other comprehensive income.
Under IAS 1, an entity has the choice of presenting either a single statement of P/L and OCI or two
statements; for example, a statement of P/L and a statement of comprehensive income.
Relevant Paragraphs
To achieve the objectives of part B outlined in the module preview, read the relevant paragraphs in the
following accounting standard. Where specified, you need to be able to apply the following paragraphs.
IAS 1 Presentation of Financial Statements:
Subject
Paragraphs
Definitions
Complete set of financial statements
Statement of profit or loss and other comprehensive income
Information to be presented in the profit or loss section or the statement of profit or loss
Information to be presented in the other comprehensive income section
Profit or loss for the period
Other comprehensive income for the period
Information to be presented in the statement(s) of profit or loss and other comprehensive
income or in the notes
7
10–10A
81A–81B
82
82A–87
88–89
90–96
97–105
2.6 PRESENTATION OF COMPREHENSIVE INCOME
IAS 1 requires an entity to prepare and include a statement of P/L and OCI for the period in its complete
set of financial statements (IAS 1, para. 10).
IAS 1 requires an entity to present either:
1. a single statement of profit or loss and other comprehensive income with two sections presented
together, the first section for the profit or loss followed by the second section for other comprehensive
income, or
2. two statements — a separate statement of profit or loss (presenting components of profit or loss) which
must be immediately followed by a separate statement presenting comprehensive income (beginning
with the profit or loss and presenting components of other comprehensive income) (IAS 1, para. 10A).
IAS 1 allows an entity to use other titles for the statements (IAS 1, para. 10). For example, the statement
of profit or loss can instead have the title ‘income statement’. Similarly, an entity can use the term ‘net
income’ to describe the profit or loss (IAS 1, para. 8).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read the definitions of ‘profit or loss’, ‘other comprehensive income’
and ‘total comprehensive income’ in paragraph 7 of IAS 1.
Figure 2.5 illustrates the:
• components of comprehensive income (items of profit or loss and items of other comprehensive income)
• relationship of the components to the presentation requirements of IAS 1
• link between comprehensive income and the statement of changes in equity (to be discussed in part C).
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MODULE 2 Presentation of Financial Statements 83
FIGURE 2.5
Components
Components of comprehensive income and their presentation
Income
Less: Expenses
= Profit or loss
(excludes other
comprehensive income)
(para. 7)
=
Total comprehensive
income –– changes in equity
other than transactions
with owners (para. 7)
Single statement of
profit or loss and other
comprehensive income
Income
Expenses
Profit or loss
Other comprehensive income
Total comprehensive income
Presentation
option 1:
para. 10A ––
single statement
Presentation
option 2:
para. 10A ––
two statements
+
Other comprehensive
income
Items of income and
expense not recognised in
profit or loss as required
or permitted by other
IFRSs (para. 7)
Separate statement
of profit or loss
Income
Less: Expenses
Profit or loss
Statement of profit or loss
and other comprehensive
income
Profit or loss
Other comprehensive income
Total comprehensive income
Statement of
changes in
equity
Statement of
changes in
equity
Source: Based on IFRS Foundation 2022, IAS 1 Presentation of Financial Statements, in 2022 IFRS Standards, IFRS Foundation,
London. © CPA Australia 2022.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read the examples on presenting total comprehensive income in
the ‘Guidance on implementing IAS 1 Presentation of Financial Statements’ (in the IFRS Compilation Handbook).
2.7 THE CONCEPT OF OTHER COMPREHENSIVE
INCOME AND TOTAL COMPREHENSIVE INCOME
‘Other comprehensive income’ comprises items of income and expense (including reclassification adjustments) that are not recognised in the profit or loss as required or permitted by IFRSs.
OCI is effectively the difference between total comprehensive income and the profit or loss for the
period. The IAS 1 definitions are as follows.
• Total comprehensive income is the change in equity during a period resulting from transactions and other
events, other than those changes resulting from transactions with owners in their capacity as owners.
• Profit or loss is the total of income less expenses, excluding the components of other comprehensive
income (IAS 1, para. 7).
IAS 1 states that the components of other comprehensive income include:
• gains and losses recognised in the revaluation surplus resulting from the revaluation of property, plant
and equipment under IAS 16 or intangible assets under IAS 38
• gains and losses from remeasurements of defined benefit plans under IAS 19
• gains and losses arising from translating the financial statements of a foreign operation under IAS 21
• gains and losses from investments in equity instruments designated as fair value through OCI under
IFRS 9
• gains and losses on other financial assets measured at fair value through OCI under IFRS 9
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84 Financial Reporting
• gains and losses on hedging instruments in a cash flow hedge and gains and losses on hedging
instruments for investments in equity instruments measured at fair value through OCI under IFRS 9
• changes in the value of the time value of options for certain option contracts designated as hedging
instruments under IFRS 9 (IAS 1, para. 7).
This study guide focuses on the following examples of other comprehensive income:
• changes in the revaluation surplus made in accordance with IAS 16 Property, Plant and Equipment
(paras 39 and 40)
• gains and losses from remeasuring equity instruments measured at fair value through OCI in accordance
with IFRS 9 Financial Instruments
• gains and losses arising from translating the financial statements of a foreign operation under IAS 21
The Effects of Changes in Foreign Exchange Rates (para. 48).
IAS 1 requires all income and expense items to be included in the determination of profit or loss for a
reporting period ‘unless an IFRS requires or permits otherwise’ (IAS 1, para. 88).
An entity recognises items outside the profit or loss of the current period in the following circumstances:
• the correction of errors or changes in accounting policies in accordance with IAS 8
• other IFRSs require or permit items of income or expense to be excluded from profit or loss even though
the items meet the Conceptual Framework definition of income or expense (IAS 1, para. 89).
As discussed in part A, IAS 8 requires the retrospective application of changes in accounting policies
and the retrospective correction of errors. The adjustments for retrospective application are excluded from
the profit or loss for the current reporting period. Although dependent on the nature of the retrospective
application, the impact on the financial statements in the current period is reflected in the statement of
changes in equity via adjustments to the opening balances of equity items (often retained earnings).
In the case of revaluations of property, plant and equipment, IAS 16 requires an increase in an asset’s
carrying amount due to a revaluation to be recognised in OCI if it is not a reversal of a previous revaluation
decrease of the same asset (IAS 16, para. 39). If it is a reversal of a previous revaluation decrease, it is to
be recognised in P/L only, to the extent that it offsets the previous decrease (IAS 16, para. 39).
Conversely, IAS 16 requires a decrease in an asset’s carrying amount due to a revaluation to be
recognised in P/L if it is not a reversal of a previous revaluation increase of the same asset (IAS 16,
para. 40). If it is a reversal of a previous revaluation increase, it is to be recognised in OCI only to the
extent it offsets the previous increase (IAS 16, para. 40).
All changes in equity other than contributions by the owners (e.g. the issue of additional shares) and
reductions in equity (e.g. share buybacks and dividends paid) shall be recognised in the statement of P/L
and OCI. In the case of contributions by the owners (e.g. the issue of additional shares) and reductions in
equity (e.g. share buybacks and dividends paid), these transactions will be reflected directly in the statement
of changes in equity rather than in the statement of P/L and OCI.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read:
• the definition and associated discussion of ‘other comprehensive income’ in paragraph 7 of IAS 1
• paragraphs 88 and 89 of IAS 1.
2.8 IAS 1 — DISCLOSURES AND CLASSIFICATION
IAS 1 allows an entity a choice in presenting either:
• a single statement of P/L and OCI, or
• two statements (e.g. a separate statement of P/L and a separate statement of comprehensive income)
(IAS 1, para. 10A).
SINGLE STATEMENT (STATEMENT OF P/L AND OCI)
Under the first option, an entity presents a single statement of P/L and OCI. Many listed Australian
companies have adopted a ‘single-statement approach’, such as The Reject Shop Limited and Southern
Cross Media Group Limited.
According to IAS 1, the single statement approach requires two sections to be presented in the statement.
The first section is for the profit or loss, and the second section is for other comprehensive income.
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MODULE 2 Presentation of Financial Statements 85
In addition to a section for the profit or loss and a section for OCI, the statement of P/L and OCI must
present the:
(a) profit or loss;
(b) total other comprehensive income;
(c) comprehensive income for the period, being the total of profit or loss and other comprehensive income
(IAS 1, para. 81A).
The ‘total comprehensive income for the period’ transferred to the statement of changes in equity is,
therefore, the sum of the totals from the two sections calculated as follows.
Total comprehensive
income
=
Profit or loss
(after tax)
+
Other comprehensive
income
Where an entity is presenting a consolidated statement of P/L and OCI, both the consolidated ‘profit or
loss’ for the period and the consolidated ‘comprehensive income’ for the period must be allocated between:
• non-controlling interests
• the parent entity’s owners.
The amounts of the allocations of consolidated profit or loss and consolidated comprehensive income
to each of these groups of shareholders must be presented as separate items (IAS 1, para. 81B).
TWO STATEMENTS (A STATEMENT OF P/L AND A STATEMENT
OF COMPREHENSIVE INCOME)
Under the second option, an entity prepares two separate statements, for example:
• a statement of P/L
• a statement of comprehensive income.
In the two-statement approach, the statement of P/L includes the entity’s incomes and expenses for
the period ending with the line ‘profit or loss for the period’. The statement of comprehensive income
commences with a line item for the profit or loss and then adds the OCI items. As in the case of the
single-statement approach, total comprehensive income is the sum of profit or loss for the period plus OCI
(IAS 1, para. 81A).
Many listed Australian companies, such as Harvey Norman Holdings Ltd, Wesfarmers Limited, Qantas
Airways Limited, Virgin Australia Holdings Limited, Woolworths Group Limited, Telstra Corporation
Limited and JB Hi-Fi Limited have adopted a two-statement approach.
In the two-statement approach, the statement of P/L must disclose the amounts for the allocation of
consolidated profit or loss between non-controlling interests and the parent entity’s owners whereas the
statement of comprehensive income must disclose the allocation for consolidated comprehensive income
(IAS 1, para. 81B).
The allocation of the consolidated profit or loss to the ownership interests of a corporate group will be
covered in module 5, which deals with consolidated financial statements.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 81A and 81B of IAS 1.
•
•
•
•
IAS 1 also contains disclosure and classification requirements for the single statement of P/L and OCI.
Next is a discussion of the following IAS 1 requirements:
information to be presented with profit or loss
classification of income and expenses
separate disclosure of material income and expense items
information to be presented with other comprehensive income.
Information Presented With Profit or Loss
The profit or loss for the period is determined as the difference between the income and expenses that must
be recognised in the profit or loss for the period.
IAS 1 specifically requires line items to be disclosed in the profit or loss section of a single-statement
P/L and OCI or in the statement of profit and loss if two statements are presented. The required line items
are listed in paragraph 82 of IAS 1 as:
Pdf_Folio:86
(a) revenue, presenting separately:
(i) interest revenue calculated using the effective interest method; and
(ii) insurance revenue (see IFRS 17);
86 Financial Reporting
(aa)
(ab)
(ac)
(b)
(ba)
(bb)
(bc)
(c)
(ca)
(cb)
(d)
(ea)
gains and losses arising from the derecognition of financial assets measured at amortised cost;
insurance service expenses from contracts issued within the scope of IFRS 17 (see IFRS 17);
income or expenses from reinsurance contracts held (see IFRS 17);
finance costs;
impairment losses (including reversals of impairment losses or impairment gains) determined in
accordance with Section 5.5 of IFRS 9;
insurance finance income or expenses from contracts issued within the scope of IFRS 17
(see IFRS 17);
finance income or expenses from reinsurance contracts held (see IFRS 17);
share of the profit or loss of associates and joint ventures accounted for using the equity method;
if a financial asset is reclassified out of the amortised cost measurement category so that it is measured
at fair value through the profit or loss, any gain or loss arising from a difference between the previous
amortised cost of the financial asset and its fair value at the reclassification date (as defined in IFRS 9);
if a financial asset is reclassified out of the fair value through other comprehensive income measurement category so that it is measured at fair value through the profit or loss, any cumulative gain or
loss previously recognised in other comprehensive income that is reclassified to profit or loss;
tax expense;
...
a single amount for the total of discontinued operations (see IFRS 5).
An entity must present additional line items, headings and subtotals when presenting the profit or loss
and other comprehensive income if such presentation is relevant to an understanding of the entity’s financial
performance (IAS 1, para. 85). As an example, a retailer would normally present line items for sales, cost
of sales and gross profit in its statement of profit or loss, or statement of P/L and OCI.
IAS 1 prohibits the presentation of extraordinary items in the ‘statement(s) presenting profit or loss and
other comprehensive income or in the notes’ (IAS 1, para. 87). Previously, an item of income or expense
was regarded as extraordinary if it was outside the ordinary activities of the entity and not recurring in
nature. These extraordinary items were then presented separately from the profit or loss. Entities often
abused this provision and applied the term ‘extraordinary’ to any major write-downs or losses (e.g. bad
news was extraordinary). For this reason, IAS 1 now prohibits such abuse.
Expenses — Nature or Function?
IAS 1 requires an entity to present an analysis of expenses recognised in the profit or loss using a
classification system based on either the nature of the expenses or their function within the entity (IAS 1,
para. 99). The classification may be presented in the financial statement(s) or in the notes to the financial
statement(s), although entities are encouraged to present the classification in the financial statement(s)
(IAS 1, para. 100).
The choice between classification of expenses by nature or function is made based on whichever system
provides information that is reliable and more relevant (IAS 1, para. 99). In effect, classification by nature
means expenses are presented descriptively (what they are), whereas classification by function means
expenses are presented purposively (what role they have to the entity’s operations).
An example of classification of expenses by nature is:
• changes in inventories of finished goods and work in process
• raw materials and consumables used
• employee benefits expense
• depreciation and amortisation expense
• other expenses (IAS 1, para. 102).
Other line items that may arise when classifying expenses by nature include the following, insurance
expense, rent expense, electricity expense, advertising expense and audit expense.
Classification by function (also known as ‘cost of sales method’) classifies expenses according to their
function as part of cost of sales or, for example, the sales or administrative activities.
An example of classification of expenses by function is:
• cost of sales
• distribution expenses
• administration expenses
• other expenses (IAS 1, para. 103).
When the expenses are classified based on the nature of the expense, employee benefit expenses would
be aggregated and presented as a single line item called, for example, ‘employee benefits expense’, which
communicates the nature of the expense to the user of the financial statements. In contrast, when expenses
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MODULE 2 Presentation of Financial Statements 87
are classified based on the function of the expense, employee benefit expenses would be allocated to the
respective functions to which the expenses relate (e.g. cost of sales, marketing expenses, administration
expenses), which communicates the function of the expense to the user of the financial statements.
The choice between nature and function is a matter of professional judgement and will depend on a
number of factors, including the nature of the entity and industry factors (IAS 1, para. 105). When expenses
are classified by function, the entity must disclose, in the notes, information about the nature of expenses,
including depreciation and amortisation expense and employee benefits expense (IAS 1, para. 104).
Separate Disclosure of Material Income and Expense Items
IAS 1 also requires an entity to separately disclose the nature and amounts of items of income and expense
that are material (IAS 1, para. 97). This additional level of disclosure assists financial report users to fully
understand the financial performance of an entity.
The determination of whether an item of income or expense is material is a matter of professional
judgement based on whether the information could reasonably be expected to influence decisions made
by the primary users of general purpose financial statements. Recall that matters of materiality require
consideration of the nature or magnitude of information, or both (IAS 1, para. 7).
IAS 1 provides examples of circumstances that would give rise to separate disclosures of material items
of income and expense:
• ‘write-downs of inventories to net realisable value’
• write-downs of property, plant and equipment to recoverable amount or reversals
• ‘restructurings of the activities of an entity and reversals of any provisions’
• disposals of property, plant and equipment
• ‘disposals of investments’
• ‘discontinued operations’
• ‘litigation settlements’
• ‘other reversals of provisions’ (IAS 1, para. 98).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read:
• paragraphs 82–87 and paragraphs 97–98 of IAS 1
• paragraphs 99–105 of IAS 1, which discuss and illustrate the classification of expenses in more detail
• the examples for the presentation of statements of P/L and OCI in the ‘Guidance on implementing IAS 1
Presentation of Financial Statements’, which illustrate the classification of expenses by function and nature
respectively (in the IFRS Compilation Handbook)
• paragraphs 110 and B87–B89 of IFRS 15, which contain the disclosure and classification requirements for revenue
• IFRS 15, Appendix A: Defined terms to compare the definitions of income and revenue.
Information Presented with Other Comprehensive Income
Information regarding other comprehensive income is presented in the second section of the single
statement of P/L and OCI or in the statement of comprehensive income if two statements are presented.
IAS 1 requires the applicable financial statement to present amounts for line items of other comprehensive income for the period as:
• items of OCI classified by nature grouped into those where the items are subsequently reclassified to
the profit or loss and those that are not
• the share of OCI of associates and joint ventures accounted for using the equity method, separated into
those where the share of items is subsequently reclassified to the profit or loss and those that are not
(IAS 1, para. 82A).
First, the nature and amount of each item of OCI must be presented separately, including the share of
OCI of equity-accounted associates and joint ventures. Second, the items must be grouped into those that
will be reclassified subsequently to profit or loss when specific conditions are met and those that will not.
Whether an item of OCI may be classified subsequently to the profit or loss is determined by the IFRS
relevant to the accounting for that item.
An example of an item of OCI that is subsequently reclassified to the profit or loss is gains/losses on
the translation of the financial statements of a foreign operation. When the foreign operation is held, the
translation gains/losses are recognised in OCI and accumulated in equity in a ‘foreign currency translation
reserve’. When the foreign operation is disposed of, IAS 21 requires the cumulative amount of exchange
differences to be reclassified from equity (OCI) to the profit or loss (IAS 21, para. 48).
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88 Financial Reporting
An example of an item of OCI that is not subsequently reclassified to the profit or loss is revaluation
gains that arise from the application of fair value measurement to plant. When an item of plant on hand
is revalued above its cost-based amount, a gain is recognised in OCI and accumulated in equity in the
revaluation surplus. When that plant is disposed of, the cumulative amount of any revaluation gains in the
revaluation surplus may be transferred to retained earnings but cannot be reclassified from equity (OCI)
to profit or loss (IAS 16, para. 41).
IAS 1 requires an entity to disclose the amount of income tax relating to each item of comprehensive
income either in the applicable financial statement or in the notes to the financial statements (IAS 1,
para. 90). Items of other comprehensive income may be presented net of related tax or gross (before tax)
with an aggregate amount of tax disclosed for the OCI items in total (IAS 1, para. 91).
When the before tax approach is used, an entity will disclose the income tax relating to each item of OCI
in the notes to the financial statements. In the financial statement, however, income tax must be allocated
between the two groupings of OCI, that is, between those items that will be subsequently reclassified to
the profit or loss and those items that will not.
When the ‘net of tax’ approach is used, the amount of income tax relating to each item of OCI may be
disclosed either in the financial statement or in the notes to the financial statement.
IAS 1 also requires an entity to disclose reclassification adjustments related to components of other
comprehensive income (IAS 1, para. 92). Reclassification adjustments may be presented in the financial
statement or in the notes the financial statements (IAS 1, para. 94).
When an unrealised gain previously recognised in OCI is subsequently reclassified as a realised gain in
profit or loss, OCI must be reduced to avoid double counting the gain in the comprehensive income of the
current and preceding reporting periods (IAS 1, para. 93).
What Happens to the Totals in the Statement of Profit or Loss and Other
Comprehensive Income?
Both the net profit after income tax figure and the other comprehensive income figures are transferred to
the statement of changes in equity.
Table 2.1 illustrates this concept.
TABLE 2.1
Relationship between statement of profit or loss and other comprehensive income and
statement of changes in equity
Net profit after income tax
Transferred to the ‘retained earnings’ column in the statement of changes in equity.
Items included in other
comprehensive income
Transferred to the ‘reserves’ column in the statement of changes in equity.
For example, if there was a revaluation of an asset, this would be transferred to
the ‘reserves’ column in the statements of changes in equity and end up in the
‘revaluation surplus’ (IAS 16, para. 39).
Similarly, any foreign exchange gains or losses arising in respect of foreign
operations would be transferred to the ‘reserves’ column in the statements of
changes in equity and end up in the ‘foreign currency translation reserve’ as per
IAS 21.
Source: CPA Australia 2022.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 82A and 90–96 of IAS 1. Also read the illustrative
statements of P/L and OCI in the ‘Guidance on implementing IAS 1 Presentation of Financial Statements’ (in the IFRS
Compilation Handbook) that demonstrate the two acceptable approaches to dealing with the disclosure of income
tax for components of OCI.
QUESTION 2.6
Refer to section 8 of the ‘Case study data’. Prepare a single statement of P/L and OCI for
Webprod Ltd in accordance with paragraphs 10A, 81A and 82 of IAS 1.
Notes:
• There was a revaluation increase of buildings by $150 000, and a revaluation decrease of the land
by $230 000. This reduced the balance of revaluation surplus of Webprod Ltd by $80 000.
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MODULE 2 Presentation of Financial Statements 89
• For the purposes of this module, ignore any tax effects of revaluations because this topic is not
dealt with until module 4.
• Question 2.8 will consider an expanded income statement, after classification and other disclosures have been discussed.
Refer to the financial statements of Techworks Ltd. Has a single statement or two statements been
used to report profit or loss and other comprehensive income? Have expenses been classified by nature
or function?
QUESTION 2.7
(a) Refer to the statement of P/L and OCI prepared in answering question 2.6. Explain whether the
revaluation loss included in OCI could result in a ‘reclassification adjustment’ in future reporting
periods.
(b) Where the financial statements of a foreign operation are translated for inclusion in the financial
statements of a reporting entity, the exchange differences arising from the translation are initially
recognised in OCI and accumulated in equity. On the disposal of the investment in the foreign
operation, the total foreign currency exchange difference accumulated in equity over the life of
the foreign operation is recognised in the profit or loss.
Assume that, at the date of disposal of an investment in a foreign operation, an entity had
recognised accumulated exchange difference gains net of tax through OCI of $7000 (pre-tax of
$10 000). Of the accumulated exchange difference gains, $2800 (pre-tax of $4000) related to the
current reporting period.
Using the net of tax approach, illustrate how the preceding information would be disclosed in
the statement of P/L and OCI for the reporting period when the disposal of the investment in the
foreign operation occurred.
QUESTION 2.8
(a) Refer to section 8 of the ‘Case study data’. Explain which items you would consider for separate
disclosure in the notes to the financial statements in accordance with paragraph 97 of IAS 1.
(b) Refer to section 8 of the ‘Case study data’. Prepare a single statement of P/L and OCI for
Webprod Ltd in accordance with the presentation, disclosure and classification requirements
of IAS 1.
Assume Webprod Ltd classifies expenses according to function.
2.9 TIPS ON HOW TO ANALYSE THE
STATEMENT OF PROFIT OR LOSS AND OTHER
COMPREHENSIVE INCOME
The purpose of the statement of P/L and OCI is to summarise the entity’s income and expenses during the
reporting period. However, it also shows unrealised gains and losses arising from transactions that result
in increases or decreases to equity other than contributions or withdrawals by the owners. The figures
comprising total comprehensive income are transferred to the various reserves in the statement of changes
in equity. Some tips on how to read, analyse and interpret the statement of P/L and OCI are summarised
as follows.
1. Review the components of income. Has there been an increase or decrease in total revenue from the
previous reporting period? What are the main drivers for this increase or decrease? Refer to the notes
to the accounts for further information about income.
2. Review the components of expenses. How does the entity classify its expenses (by nature or function)?
Has there been an increase or decrease in expenses from the previous reporting period? What are the
main drivers for this increase or decrease? Are there any notable large movements or any one-off
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90 Financial Reporting
material (non-recurring) expenses, such as impairment losses? Refer to the notes to the accounts for
further information about expenses.
3. Review the profit result for the period. Has the entity made a profit or a loss? How does this result
compare to the previous reporting period? What are the main drivers for the increase or decrease
in profit?
4. Review the OCI result. Are there any significant changes in items of comprehensive income (e.g. asset
revaluations) from the previous reporting period? What are the main drivers for these changes?
5. Overall performance. In your opinion, how well is the company performing? Did it perform better or
worse than the previous reporting period?
SUMMARY
IAS 1 specifies the requirements for:
• the presentation of profit or loss and OCI for a period
• disclosures to be made in the statement of P/L and OCI or notes to the financial statements.
IAS 1 adopts an all-inclusive view of comprehensive income and provides for separate disclosure of
certain items. In relation to the profit or loss, these items include finance costs, tax expense and profit
or loss. For OCI, each component must be separately disclosed along with the income tax relating to the
component and any reclassification adjustments.
.......................................................................................................................................................................................
EXPLORE FURTHER
You should explore this topic further and review the illustrative statements of P/L and OCI (which are not part of the
standards) that are included in the ‘Guidance on implementing IAS 1 Presentation of Financial Statements’ (in the
IFRS Compilation Handbook).
The key points covered in this part, and the learning objective they align to, are as follows.
KEY POINTS
2.1 Explain and apply the requirements of IAS 1 with respect to a complete set of financial
statements and in relation to the considerations for the presentation of financial statements.
• An entity is required to present either a single statement of profit or loss and other comprehensive
income with the two sections presented together, or two statements — a separate statement of
profit or loss immediately followed by a separate statement of other comprehensive income.
• Other comprehensive income (OCI) comprises items of income and expense (including reclassification adjustments) that are not recognised in the profit or loss as required or permitted by
IFRSs. It is effectively the difference between total comprehensive income and the profit or loss for
the period.
• Examples of OCI include gains and losses from revaluing property, plant and equipment; remeasuring equity instruments measured at fair value; and from foreign currency translation of financial
statements.
• A single-statement approach for the preparation of the statement of profit or loss (P/L) and other
comprehensive income (OCI) includes separate sections for the profit or loss and the OCI and must
present separate totals for profit or loss, OCI, and comprehensive income.
• A two-statement approach requires an entity to prepare two separate statements: (1) a statement
of P/L, and (2) a statement of comprehensive income.
• IAS 1 specifies which line items are to be presented in the statement of profit or loss and OCI.
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MODULE 2 Presentation of Financial Statements 91
PART C: STATEMENT OF CHANGES
IN EQUITY
INTRODUCTION
In addition to a statement of P/L and OCI, IAS 1 requires a complete set of general purpose financial
statements to include a statement of changes in equity, which discloses:
• the changes to each equity item arising from comprehensive income, transactions with owners and
retrospective adjustments in accordance with IAS 8
• a reconciliation between the opening and closing amounts of each component of equity for the period.
Part C discusses the composition of the statement of changes in equity, including the components of
what is required to be included in this statement.
Relevant Paragraphs
To achieve the objectives of part C outlined in the module preview, read the relevant paragraphs in the
following accounting standard. Where specified, you need to be able to apply the following paragraphs.
IAS 1 Presentation of Financial Statements:
Subject
Information to be presented in the statement of changes in equity
Information to be presented in the statement of changes in equity or in the notes
Paragraphs
106
106A–110
2.10 IAS 1 PRESENTATION OF FINANCIAL
STATEMENTS: DISCLOSURES OF CHANGES
IN EQUITY
A statement of changes in equity explains and reconciles the movement in the equity (net assets) of an
entity over a reporting period. The two primary sources of change in owners’ equity (and therefore net
assets) are:
• changes resulting from transactions with owners in their capacity as owners
• the total amount of income and expenses … generated by the entity’s activities (IAS 1, para. 109).
The statement of changes in equity requires disclosure of the total comprehensive income and its impact
on each relevant equity component, as detailed information relating to income and expenses is contained
in the statement of P/L and OCI.
IAS 1 requires an entity to present a statement of changes in equity, which contains the following
disclosures:
• total comprehensive income (allocated between non-controlling interests and owners of the parent)
(IAS 1, para. 106(a))
• the effect on each component of equity of any retrospective adjustments required by IAS 8 (IAS 1,
para. 106(b))
• a reconciliation between the opening and closing balance of each component of equity, with separate disclosure of changes resulting from profit or loss, OCI and transactions with owners (IAS 1,
para. 106(d)).
An entity must present for each component of equity affected by OCI, an analysis of the item either in
the statement of changes in equity or in the notes (IAS 1, para. 106A). This would include details such as
the source of the OCI, tax relating to the items involved and any non-controlling interest portion deducted.
An entity must also present the amount of dividends recognised as distributions to owners during a
reporting period and the related amount of dividends per share. Information relating to dividends can be
disclosed either in the statement of changes in equity or in the notes (IAS 1, para. 107).
A typical tabular format for the statement of changes in equity is shown in table 2.2.
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92 Financial Reporting
TABLE 2.2
Tabular format for the statement of changes in equity
Share capital
Reserves
Retained earnings
Total
Opening balance
Opening balance
Opening balance
Opening balance
(sum of opening
balances)
+ Issue of share
capital
+ Transfers to reserves
from retained earnings
– Transfers from reserves
to retained earnings
+/– Net profit (loss) after
income tax (from income
statement)
+ Share options
exercised
+/− Gains/(losses) on
property revaluations
– Transfers to reserves from
retained earnings
+ Transfers from reserves to
retained earnings
+/– Restatement of prior period
balances (whether due to a
change in accounting policy,
adoption of new accounting
standard or a prior period
material error)
− Share buybacks/
return of capital
+/− Exchange differences on
translating foreign operations
− Dividends declared
= Closing balance
= Closing balance
= Closing balance
Closing balance
(sum of closing
balances)
Source: CPA Australia 2022.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read:
• paragraphs 106–110 of IAS 1
• the example statement of changes in equity in the ‘Guidance on implementing IAS 1 Presentation of Financial
Statements’ (in the IFRS Compilation Handbook), including the notes, which analyse the changes to equity items
as a result of OCI.
QUESTION 2.9
Refer to sections 1 and 8 of the ‘Case study data’. Prepare a statement of changes in equity in
accordance with paragraphs 106 and 107 of IAS 1 in the column format that reconciles the opening
and closing balances of each component of equity as illustrated in the ‘Guidance on implementing
IAS 1 Presentation of Financial Statements’ (in the IFRS Compilation Handbook).
SUMMARY
In addition to reconciling the opening and closing balances of each component, the statement of changes in
equity discloses all changes to each component of equity for a reporting period. This information enables
the user to understand why the equity (net assets) of an entity have increased or decreased, how much
of the change relates to comprehensive income and how much is from transactions with owners in their
capacity as owners.
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MODULE 2 Presentation of Financial Statements 93
The key points covered in this part, and the learning objective they align to, are as follows.
KEY POINTS
2.1 Explain and apply the requirements of IAS 1 with respect to a complete set of financial
statements and in relation to the considerations for the presentation of financial statements.
• The two primary sources of change in owner’s equity are changes resulting from transactions with
owners in their capacity as owners and the total amount of income and expenses generated by the
entity’s activities.
• Total comprehensive income and its impact on each relevant equity component must be presented
in the statement of changes in equity.
• For each component of equity, the entity must present the opening and closing balances and any
increases and decreases during the reporting period.
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94 Financial Reporting
PART D: STATEMENT OF
FINANCIAL POSITION
INTRODUCTION
In addition to being interested in the financial performance of an entity, financial statement users are also
interested in its financial position. Information about the financial position is contained in the statement
of financial position or, as it is often referred to, the balance sheet. IAS 1 prescribes the:
• presentation requirements for assets and liabilities
• disclosure requirements for a statement of financial position and its components.
Part D discusses the composition of the statement of financial position, including the components of
what is required to be included in this statement.
Relevant Paragraphs
To achieve the objectives of part D outlined in the module preview, read the relevant paragraphs in the
following accounting standard. Where specified, you need to be able to apply the following paragraphs.
IAS 1 Presentation of Financial Statements:
Subject
Paragraphs
Information to be presented in the statement of financial position
Current/non-current distinction
Current assets
Current liabilities
Information to be presented either in the statement of financial position or in the notes
54–59
60–65
66–68
69–76
77–80A
2.11 FORMAT OF THE STATEMENT OF
FINANCIAL POSITION
IAS 1 does not stipulate a strict format for the statement of financial position, but it does stipulate the
minimum disclosures for the line items that are included in the statement (IAS 1, para. 54).
The minimum line items are summarised in table 2.3.
TABLE 2.3
Minimum line items required in the statement of financial position
Assets
Liabilities
Equity
•
•
•
•
•
•
•
•
•
•
• Non-controlling interests
•
•
•
•
•
•
•
Property, plant and equipment
Investment property
Intangible assets
Financial assets
Insurance and reinsurance contracts
Investments accounted for using the
equity method
Biological assets
Inventories
Trade and other receivables
Cash and cash equivalents
Non-current assets classified as held
for sale
Current tax assets
Deferred tax assets
Trade and other payables
Provisions
Financial liabilities
Insurance and reinsurance
contracts
• Current tax liabilities
• Deferred tax liabilities
• Liabilities directly associated
with non-current assets
classified as held for sale
presented within equity
• Issued capital and reserves
attributable to owners of the
parent
Source: CPA Australia 2022.
The line items in table 2.3 are the minimum disclosures required by IAS 1. An entity must add additional
line items in the statement of financial position when such presentation is relevant to an understanding of
the entity’s financial position (IAS 1, para. 55).
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MODULE 2 Presentation of Financial Statements 95
An entity makes the judgement about whether to present additional line items on the basis of the:
(a) the nature and liquidity of assets;
(b) the function of assets within the entity; and
(c) the amounts, nature and timing of liabilities (IAS 1, para. 58).
An example of additional disclosures would be disaggregating the disclosure of property, plant
equipment in the statement of financial position showing separately property measured at fair value and
plant and equipment measured using the cost basis (IAS 1, para. 59).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 54–59 of IAS 1. Note that IAS 1 does not require
any particular format for a statement of financial position. The chosen format should not impair the understanding of
the information. Also refer to the illustrative statement of financial position in the ‘Guidance on implementing IAS 1
Presentation of Financial Statements’ (in the IFRS Compilation Handbook).
2.12 PRESENTATION OF ASSETS AND LIABILITIES
An entity must present current and non-current assets and current and non-current liabilities as separate
classifications in the statement of financial position except if a presentation based on liquidity provides
information that is reliable and more relevant. When the liquidity basis is applied, assets and liabilities
must be presented in the order of liquidity; for example, cash deposits would be presented before plant and
equipment (IAS, para. 60).
When an entity supplies goods and services within a clearly identifiable operating cycle, the current
and non-current classification system provides information that is reliable and more relevant because
it distinguishes between assets and liabilities circulating as working capital from those held for longterm operations (IAS 1, para. 62). In contrast, financial institutions typically use the liquidity basis of
presentation because the solvency of such institutions is critical, and they do not provide services within an
operating cycle (IAS 1, para. 63). For example, Woolworths Group Limited and Qantas Airways Limited,
two major non-financial Australian entities providing goods and services within a clearly identifiable
operating cycle, present their assets and liabilities using current and non-current categories. In contrast,
Australia & New Zealand Banking Group Ltd (ANZ) and Westpac Banking Corporation (Westpac), two
major Australian banks, use the liquidity basis.
If an entity has an asset or liability line item that combines amounts due to be recovered or settled both
within and after 12 months of the reporting period, it must disclose the amount expected to be recovered or
settled after 12 months (IAS 1, para. 61). This disclosure is required irrespective of the presentation basis
used for assets and liabilities.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 60–65 of IAS 1, which confirm and expand on
this discussion. You may also wish to read ‘Guidance on implementing IAS 1 Presentation of Financial Statements’
(in the IFRS Compilation Handbook), which provides an example of the current/non-current presentation.
CURRENT ASSETS AND CURRENT LIABILITIES
An entity must classify an asset as current when it satisfies one or more of the following criteria.
• ‘[I]t expects to realise the asset, or intends to sell or consume it, in [the entity’s] normal operating cycle’.
• It holds the asset primarily for trading purposes.
• ‘[I]t expects to realise the asset within [12] months after the reporting period’.
• ‘[T]he asset is cash or a cash equivalent (as defined in IAS 7) unless the asset is restricted from being
exchanged’ or used by the entity for a least 12 months after the reporting period (IAS 1, para. 66).
According to IAS 1, paragraph 68, the ‘operating cycle of an entity is the time between the acquisition
of assets for processing and their realisation in cash or cash equivalents’. If an entity’s operating cycle is
not clearly identifiable, it is assumed to be 12 months. If there is a clearly identifiable operating cycle that
exceeds 12 months, the assets expected to be used during this cycle are classified as current. In other words,
a current asset does not always have to be used within 12 months. For example, an entity that engages in
long-term construction contracts (large buildings, bridges or airports) may have an operating cycle that is
longer than 12 months.
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96 Financial Reporting
All assets not classified as current are to be classified as non-current assets. The term ‘non-current
assets’ is recommended, but IAS 1 permits other descriptions to be used for this category, such as ‘fixed
assets’ or ‘long-term assets’ (IAS 1, para. 67).
Examples of current assets include cash and cash equivalents, inventories, trade receivables, current
tax receivable, and prepayments. Examples of non-current assets include property, plant and equipment,
intangibles, investments and deferred tax.
An entity must classify a liability as current when it satisfies one or more of the following criteria.
• It expects to settle the liability in the entity’s normal operating cycle.
• It holds the liability primarily for trading purposes.
• The liability is due to be settled within 12 months after the reporting period.
• It does not have the unconditional right to defer settlement for at least 12 months after end of the
reporting period. Note that as part of the amendments to IAS 1, deferred until at least 1 January 2024,
the IASB has removed the requirement for a right to be unconditional – instead, IAS 1 will require that
the right to defer settlement must have substance and exist at the end of the reporting period.
According to the amendments to IAS 1, deferred until at least 1 January 2024, if an entity has a right
to defer settlement of the liability for at least 12 months after the reporting period, for that liability to be
classified as non-current:
• the right must have substance
• the right must exist at the end of the reporting period, and
• if the right is subject to the entity satisfying certain conditions beforehand, those conditions must be
satisfied by the end of the reporting period (IAS 1, para. 72A).
Whether an entity is likely, or unlikely, to exercise its right to defer settlement does not affect whether
the liability is to be classified as current or non-current (IAS 1, para. 75A). Current liabilities include
those liabilities that are required or expected to be settled within 12 months after the end of the reporting
period. The period to settle can be longer if the operating cycle exceeds 12 months. In this regard, the same
operating cycle applies to the classification of an entity’s assets and liabilities (IAS 1, para. 70). Examples
of current liabilities include a bank overdraft, trade payables, accruals for operating costs like electricity
and rent, and accruals for employee wages.
The settlement of a liability, whether within or beyond 12 months after the reporting period, takes
place when the entity transfers either of the following to the counterparty, in return for extinguishment of
the liability:
• cash or other economic resources such as goods or services
• the entity’s own equity instruments (IAS 1, para. 76A).
An entity normally includes the portion of long-term financial liabilities due for repayment within
12 months as a current liability (IAS 1, para. 71). An entity classifies its financial liabilities due to be
settled within 12 months as current even if:
(a) the original term was for a period longer than [12] months, and
(b) an agreement to refinance, or to reschedule payments, on a long-term basis is completed after the
reporting period and before the financial statements are authorised for issue (IAS 1, para. 72).
An agreement to refinance made after the reporting period, does not represent conditions that existed
at the end of the reporting period, and therefore, the amount is still current at that date. However, the
agreement may result in a disclosure in the notes as a non-adjusting event in accordance with IAS 10
(IAS 1, para. 76).
If an entity has, at the end of the reporting period, the contractual right (i.e. a right under an existing
loan facility) to roll over an obligation for at least 12 months after the reporting period, the obligation is
classified as non-current even if it is due within 12 months. If the entity has no such right to roll over, the
obligation is classified as current (IAS 1, para. 73).
In some instances, entities may breach loan conditions that cause an obligation to become due on
demand. The obligation is regarded as current even if the lender agrees not to demand repayment after
the reporting period (IAS 1, para. 74). However, before the end of the reporting period, if the lender comes
to an agreement with the entity that the lender will not demand repayment for at least 12 months after the
reporting period, the obligation can be classified as non-current (IAS 1, para. 75).
Liabilities that do not satisfy the criteria to be classified as current must be classified as non-current
liabilities (IAS 1, para. 69). Financial liabilities that provide financing on a long-term basis that are not
due for repayment within 12 months of the reporting period are non-current liabilities unless there are
unresolved breaches of covenants at the end of the reporting period (IAS 1, para. 71).
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MODULE 2 Presentation of Financial Statements 97
The introduction of IFRS 16 Leases had a significant impact on the statement of financial position of
lessees, as lessees are now required to recognise a right-of-use asset and lease liability in their statement of
financial position for all leases (other than short-term or low-value leases). As short-term leases are those
of no more than 12 months duration, a right-of-use asset is classified as a non-current asset by a lessee.
To the extent part of a lease liability satisfies one or more of the current liability criteria listed above, the
lessee classifies it as a current liability. The remaining amount of the lease liability outstanding is classified
as non-current.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 66–76A of IAS 1, which discuss the current/noncurrent presentation in more detail. In particular, note the events that would qualify for disclosure as non-adjusting
events in accordance with IAS 10 Events after the Reporting Period (IAS 1, para. 76).
2.13 IAS 1 PRESENTATION OF FINANCIAL
STATEMENTS: DISCLOSURES IN THE NOTES TO THE
STATEMENT OF FINANCIAL POSITION
An entity must disclose, either in the statement of financial position or the notes, further subclassifications
of the line items presented in a manner appropriate to an entity’s operations (IAS 1, para. 77).
The disclosure of further subclassifications depend on the size, nature and function of the amounts
involved and are usually presented in the notes. Some subclassifications are required by other accounting
standards. IAS 1 provides examples of further subclassifications as:
• items of property, plant and equipment disaggregated into classes pursuant to IAS 16 such as office
equipment and motor vehicles (para. 78(a))
• receivables disaggregated into amount due from trade customers, related parties, prepayments and other
amounts (para. 78(b))
• inventories disaggregated pursuant to IAS 2 into finished goods, work-in-process and raw materials
(para. 78(c))
• provisions disaggregated into provisions for employee benefits and other provisions (para. 78(d))
• equity capital and reserves disaggregated into paid-up capital, retained earnings and other reserves
(para. 78(e)).
Furthermore, although IAS 1 prescribes disclosures to appear in the various financial statements, it does
not prescribe detailed disclosures for each of the various line items. For example, paragraph 54(g) of IAS 1
requires that inventories be disclosed as a separate line item in the statement of financial position. However,
the detailed requirements relating to the disclosure of inventories in the notes to the accounts can be found
in paragraph 36 of IAS 2 Inventories.
IAS 1 also specifies additional disclosures for equity items, including shares issued, rights attaching to
shares and details of reserves (IAS 1, paras 79 and 80). Some items listed, such as the par value per share,
are not relevant to all jurisdictions (e.g. Australia).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 77–80 of IAS 1.
QUESTION 2.10
Refer to section 8 of the ‘Case study data’.
Prepare a statement of financial position for Webprod Ltd. You may want to refer to paragraph 54
of IAS 1 if you need to review the required line items. In addition, prepare notes to the statement of
financial position that:
• illustrate the composition of the items disclosed in the statement of financial position
• satisfy any relevant disclosure requirements. If you need to review the requirements, refer to
paragraph 79 of IAS 1.
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98 Financial Reporting
Refer to the financial statements of Techworks Ltd. What line items have been presented in the
statement of financial position? Would it have been possible for Techworks to present additional detail
in the statement of financial position?
2.14 TIPS ON HOW TO ANALYSE A STATEMENT OF
FINANCIAL POSITION
The purpose of the statement of financial position is to summarise an entity’s assets, liabilities and equity.
The format of the statement of financial position is to disclose the entity’s assets and liabilities according to
a current/non-current classification. The equity figures in the statement of changes in equity flow through
to the equivalent lines in equity at the end of the statement of financial position.
Some tips on how to read, analyse and interpret the statement of financial position are summarised
as follows.
1. Review the value of total assets. Have total assets increased or decreased from the previous reporting
period? What are the drivers behind this increase or decrease? If total assets are increasing, this indicates
that the financial position has expanded (grown). Has the change been primarily as a result of changes
in current assets or non-current assets?
2. Review the value of total liabilities. Have total liabilities increased or decreased from the previous
reporting? What are the drivers behind this increase or decrease? If total liabilities are increasing, this
indicates that the entity has taken on more debt and has increased its gearing (leverage). Has the change
been primarily as a result of changes in current liabilities or non-current liabilities?
3. Review the value of total equity (or net assets). Is total equity positive? If so, this indicates that the
company is a going concern. Has total equity increased from the previous reporting period? If so, this
indicates that the entity’s financial position has grown. The stage of the business’ life cycle will also
impact on this figure. More mature businesses are likely to have greater amount of retained earnings,
whereas start-ups may experience losses in the first years of trading.
4. Analyse the relationship between current assets and current liabilities. This is an indication of the
company’s liquidity position or the entity’s ability to be able to pay its short-term debts as and when
they fall. Are current assets greater than current liabilities? The general rule of thumb for the current
ratio is 2:1. This means that ideally current assets should be approximately two times larger than
current liabilities.
In reviewing a statement of financial position of a particular entity, it is always important to identify and
understand the risks of each asset. For example, in the case of a retailer, it is likely that inventories will
be the largest asset on the statement of financial position. In this case, the risk is one of obsolescence and
slow-moving stock.
In the case of an entity that has acquired businesses over the years and those with significant goodwill
and brand names, the impairment of intangibles is likely to be the most significant risk or concern.
Analyse the relationship between non-current liabilities and non-current assets. This provides an
indication of the entity’s gearing (leverage) position. Is the entity highly geared or lowly geared? If the
entity is highly geared (more debt than assets), this may limit the entity’s ability to borrow additional funds
to fund expansion or capital replacement requirements. If the entity has low gearing, it may be in a good
position to borrow monies from banks and financial institutions to fund expansion.
SUMMARY
IAS 1 specifies the requirements for:
• the presentation of assets and liabilities
• disclosures in either the statement of financial position or notes.
Assets and liabilities must be presented on a current/non-current basis, except where a liquidity
presentation provides information that is more relevant and reliable. Where the current/non-current
classification is used, a 12-month period after the reporting period or the entity’s operating cycle can be
used to identify current assets and liabilities.
IAS 1 contains disclosure requirements, including items that must appear in the statement of
financial position.
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MODULE 2 Presentation of Financial Statements 99
The key points covered in this part, and the learning objective they align to, are as follows.
KEY POINTS
2.1 Explain and apply the requirements of IAS 1 with respect to a complete set of financial
statements and in relation to the considerations for the presentation of financial statements.
• IAS 1 specifies the minimum disclosure requirements for the statement of financial position.
• An entity may make additional disclosures based on the nature, function and/or liquidity of assets,
and the amounts, nature and timing of liabilities.
• Assets and liabilities must be classified as current and non-current except if a presentation based
on liquidity provides information that is reliable and more relevant. If the liquidity basis is applied,
then assets and liabilities must be presented in order of liquidity.
• Further subclassifications of the line items presented in the statement of financial position are
required to be disclosed in the notes. Further disclosure depends on the size, nature and function
of the amounts involved.
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100 Financial Reporting
PART E: IAS 7 STATEMENT OF
CASH FLOWS
INTRODUCTION
Part E discusses the composition of the statement of cash flows, including the format and presentation of
the statement and the various cash flows that are required to be disclosed when presenting the statement.
An entity is required to include a statement of cash flows in its complete set of financial statements
(IAS 1, para. 10(d); IAS 7, para. 1). The content and format of a statement of cash flows are governed by
IAS 7.
The objective of the statement of cash flows is to explain the movement in an entity’s cash and cash
equivalents over the reporting period. Information about an entity’s cash flows is useful in providing users
of the financial statements with a basis to assess the entity’s ability to generate cash flows and the needs
of the entity to utilise those cash flows (IAS 7, ‘Objective’).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 4 and 5 of IAS 7.
Relevant Paragraphs
To achieve the objectives of part E outlined in the module preview, read the relevant paragraphs in the
following accounting standard. Where specified, you need to be able to apply the following paragraphs.
IAS 7 Statement of Cash Flows:
Subject
Scope
Benefits of cash flow information
Definitions
Cash and cash equivalents
Presentation of a statement of cash flows
Reporting cash flows from operating activities
Reporting cash flows from investing and financing activities
Reporting cash flows on a net basis
Interest and dividends
Taxes on income
Non-cash transactions
Changes in liabilities arising from financing activities
Components of cash and cash equivalents
Other disclosures
Paragraphs
1–3
4–5
6
7–9
10–17
18–20
21
22–24
31–34
35–36
43
44A–44E
45–47
48–52
Assumed Knowledge
You should consult the assumed knowledge review questions located at the end of this module to check
your understanding of the assumed knowledge for part E. If you need further assistance with the assumed
knowledge, you should consult the latest edition of an appropriate financial accounting text, such as
the following.
• Henderson, S., Peirson, G. et al., Issues in Financial Accounting, Pearson, Melbourne.
• Hoggett, J., Medlin, J. et al., Financial Accounting, John Wiley & Sons, Brisbane.
• Loftus, J., Leo, K. et al., Financial Reporting, John Wiley & Sons, Brisbane.
2.15 HOW DOES A STATEMENT OF CASH FLOWS
ASSIST USERS OF THE FINANCIAL STATEMENTS?
A statement of cash flows is useful for communicating information about an entity’s liquidity and solvency.
According to IAS 7, the information provided in a statement of cash flows may assist users in assessing
the ability of an entity to:
• generate cash flows in the future
• meet its financial commitments as they fall due, including the servicing of borrowings and payment
of dividends
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MODULE 2 Presentation of Financial Statements 101
• fund changes in the scope and/or nature of its activities
• obtain external finance (IAS 7, paras 4 and 5).
It has also been suggested that a statement of cash flows is useful for:
• predicting future cash flows (both inflows and outflows)
• evaluating management decisions
• determining the ability to pay dividends to shareholders and repay debt — both interest and principal
— to creditors
• showing the relationship of net profit to changes in the cash balances
• assessing the quality of revenue and earnings by reference to its realisation in cash.
Of course, to assist in a full analysis, it would be more useful to review and analyse the statement of
cash flows over a number of years to enable trends to be analysed.
2.16 INFORMATION TO BE DISCLOSED
CASH AND CASH EQUIVALENTS
Cash flows are inflows and outflows of cash and cash equivalents (IAS 7, para. 6). It is necessary therefore
to determine the components of cash and cash equivalents in order to identify the cash flows to be
disclosed in the statement.
According to IAS 7, cash and cash equivalents are determined as follows.
• Cash comprises cash on hand and demand deposits.
• Cash equivalents are short term, highly liquid investments that are readily convertible to known amounts
of cash and which are subject to an insignificant risk of changes in value (IAS 7, para. 6).
An investment normally only qualifies as a cash equivalent if it has a short maturity of three months
or less from the date of acquisition. Investments in equity securities do not qualify as cash equivalents
(IAS 7, para. 7). Bank overdrafts that are repayable on demand and fluctuate from being positive to
overdrawn are included as a component of cash and cash equivalents (IAS 7, para. 8).
The amount of cash and cash equivalents at the beginning and end of the reporting period are disclosed
in the statement of cash flows. An entity must disclose the components of cash and cash equivalents and
present a reconciliation to the amounts shown in the statement of cash flows with amounts reported in the
statement of financial position (IAS 7, para. 45).
CLASSIFICATION OF CASH FLOWS
The statement of cash flows must report cash flows during the period (both inflows and outflows) classified
by operating, investing and financing activities (IAS 7, para. 10). Figure 2.6 illustrates the classification
scheme for cash flows.
FIGURE 2.6
Classification of cash flows
Cash flows
=
Operating
Cash revenues
less cash expenses
(i.e. cash profit)
+
Investing
Movements in
non-current assets and
other investments
+
Financing
Movements in debt
and equity
Source: CPA Australia 2022.
Operating Cash Flows
Cash flows from operating activities are those that relate to the principal revenue-producing activities of
the entity and which are not from investing or financing activities (IAS 7, para. 6). Operating cash flows
‘generally result from the transactions and other events that enter into the determination of profit or loss’
(IAS 7, para. 14).
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102 Financial Reporting
Examples of cash inflows and outflows from operating activities are shown in table 2.4.
TABLE 2.4
Examples of cash inflows and outflows from operating activities
Cash inflows
Cash outflows
•
•
•
•
•
•
•
•
•
Cash receipts from the sale of goods
Cash receipts from rendering of services
Cash receipts from royalties
Cash receipts from fees, commissions and other
revenue (e.g. government grants)
• Cash receipts from contracts held for trading
• Refund of income tax
Cash payments to suppliers for goods and services
Cash payments to and on behalf of employees
Cash payments from contracts held for trading
Borrowing costs (interest paid)
Income tax paid
Source: CPA Australia 2022.
An entity must report cash flows from operating activities using either the:
• direct method — in which ‘major classes of gross cash receipts and gross cash payments are disclosed’
• indirect method whereby profit or loss is adjusted for the effects of non-cash income and expenses,
accruals and items associated with investing and financing activities (IAS 7, para. 18).
The information shown in table 2.4 is consistent with reporting operating cash flows using the
direct method.
Interest paid and dividends received are usually regarded as an operating cash inflow for financial
institutions (IAS 7, para. 33). There is no consensus however, on the classification of these cash flows
for other entities. An entity may elect to classify these cash flow items under IAS 7 as follows.
• Interest paid may be classified as either an operating cash outflow or a financing cash outflow
(para. 33).
• Interest and dividends received may be classified as either operating cash inflows or investing cash
inflows (para. 33).
• Dividends paid may be classified either as a financing cash outflow or an operating cash outflow
(para. 34).
Consistent with IAS 7, this module recognises interest paid (borrowing costs) as an operating cash
outflow (table 2.4), interest received as an investing cash inflow (table 2.5), and dividends paid as a
financing cash outflow (table 2.6).
Investing Cash Flows
Cash flows from investing activities are those that relate to ‘the acquisition and disposal of long-term
assets and other investments not included in cash and cash equivalents’ of the entity (IAS 7, para. 6). Cash
outflows from investing activities result in the recognition of assets in the statement of financial position
(IAS 1, para. 16). The assets so recognised are usually non-current assets.
Accordingly, most investing cash inflows and outflows are identified by analysing the movements in the
non-current assets accounts in the statement of financial position.
Examples of cash inflows and outflows from investing activities are shown in table 2.5.
TABLE 2.5
Examples of cash inflows and outflows from investing activities
Cash inflows
Cash outflows
• Cash receipts from sales of property, plant and
• Cash payments to acquire or self-construct property,
•
•
•
•
•
•
equipment
Cash receipts from sales of intangibles
Cash receipts from other long-term assets
Cash receipts from sales of equity and debt
instruments of other entities (if not trading)
Cash receipts from contracts for derivatives (if not for
trading or financing)
Cash receipts from repayment of advances and loans
made to other parties
Dividends received
plant and equipment
• Cash payments for intangibles including capitalised
development costs
• Cash payments for other long-term assets
• Cash payments to acquire equity or debt
instruments of other entities (if not for trading)
• Cash payments for interests in joint ventures
• Cash advances and loans made to other parties
• Cash payments from contracts for derivatives (if not
for trading or financing)
Source: CPA Australia 2022.
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MODULE 2 Presentation of Financial Statements 103
Financing Cash Flows
Cash flows from financing activities are those ‘that result in changes in the size and composition of the
contributed equity and borrowings of the entity’ (IAS 7, para. 6).
Financing cash flows relate to the providers of capital to the entity, that is, debtholders and equity
participants (IAS 7, para. 17).
Examples of cash inflows and outflows from financing activities are shown in table 2.6.
TABLE 2.6
Examples of inflows and outflows from financing activities
Cash inflows
Cash outflows
• Cash proceeds from issuing shares or other equity
• Cash payments to owners to acquire or redeem the
instruments
• Cash proceeds from issuing short- or long-term
borrowings including debentures, loans, notes, and
mortgages
• Cash repayments of amounts borrowed
• Cash payments by a lessee to reduce the
entity’s shares
outstanding amount of a lease liability
• Dividends paid
Source: CPA Australia 2022.
EXAMPLE 2.4
Illustrative Example of a Statement of Cash Flows for the Reporting
Period Ended 30 June 20X7
ZHIVAGO HOLDINGS PTY LTD
$
Cash flows from operating activities (IAS 7, paras 10, 14, 18)
Receipts from customers
Payments to suppliers and employees
Cash generated from operations
Interest paid
Income tax paid (IAS 7, para. 35)
Net cash flows from operating activities
Cash flows from investing activities (IAS 7, paras 10, 16, 21)
Interest received
Proceeds from sale of plant and equipment
Purchase of plant and equipment
Net cash flows used in investing activities
Cash flows from financing activities (IAS 7, paras 10, 17, 21)
Proceeds from borrowings
Repayment of borrowings
Dividends paid (IAS 7, para. 31)
Net cash flows used in financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at the beginning of the period
Cash and cash equivalents at the end of the period
831 083
(776 276)
54 807
(1 545)
(6 467)
46 795
57
231
(17 119)
(16 831)
141 000
(154 000)
(7 210)
(20 210)
9 754
7 572
17 326
2.17 COMMON METHODS ADOPTED ON HOW TO
PREPARE A STATEMENT OF CASH FLOWS
The statement of P/L and OCI and statement of financial position are prepared under accrual accounting
concepts. Put simply, the basic aim of a statement of cash flows is to convert the figures prepared under
accrual accounting concepts to what they would be if they were prepared on a cash basis. In substance, the
statement of cash flows explains the change in assets and liabilities (net assets) during the period that is
attributable to cash transactions.
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104 Financial Reporting
A statement of cash flows involves making adjustments from accrual-based information, de-accruing
the figures and converting them to cash-based figures. In other words, the purpose of the statement of cash
flows is to determine the cash movements during the financial year.
There are three common methods used to prepare a statement of cash flows. These methods include the:
1. worksheet method (typically prepared in a spreadsheet tool such as Excel™)
2. formula method
3. ‘T’ account reconstruction method.
The assumed knowledge for this module is that participants are able to prepare a simple statement of
cash flows. The questions in (and later answers to) the ‘Assumed knowledge review questions’ section at
the end of this module illustrate the basic principles to be used when preparing a statement of cash flows.
Because the underlying data are relatively simple, the calculations and the statement of cash flows have
been completed without the aid of a worksheet. However, in more complicated situations, a worksheet is
considered a useful means of organising the necessary procedures. For the purposes of this module, the
formula method will be used in preparing the statement of cash flows.
FORMULA METHOD
The following is a brief summary of the formulas necessary to determine individual lines in the statement of
cash flows. Once again, it needs to be remembered that the figures in the financial statements are prepared
under accrual accounting principles, while the statement of cash flows is based on cash movements
(i.e. cash inflows and outflows) during the reporting period.
Some of the more common formulas used to determine cash flows include:
Receipts from customers
Opening balance of
trade receivables
+
Sales revenue
−
Credit loss
write-off †
−
Closing balance of
trade receivables
† To determine the amount of credit loss written off, the following formula is relevant.
Credit loss write-off
Opening balance of
provision for credit
loss or impairment
+
Expected credit loss expense (from P/L)
−
Closing balance of
provision for credit
loss or impairment
+
Cost of sales (from P/L)
−
Opening balance
of inventories
−
Closing balance
of trade payables
−
Closing balance of
income tax payable
−
Opening
balance of PPE
−
Closing balance
of final dividend
payable (liability)
Inventory purchased on credit
Closing balance
of inventories
Payments to suppliers and employees
Opening balance
of trade payables
+
Expenses
(from P/L)
+
Inventory
purchased
on credit
(from formula)
Income taxes paid
Opening balance of
income tax payable
+
Income tax expense (from P/L)
Purchase of property, plant and equipment (PPE)
Closing balance of PPE
+
Disposals (at cost)
Dividends paid
Opening balance of final
dividend payable (liability)
+
Interim
dividend
+
Final dividend
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MODULE 2 Presentation of Financial Statements 105
REPORTING CASH FLOWS ON A NET BASIS
An entity must separately report major classes of gross cash receipts and gross cash payments (IAS 7,
paras 18 and 21). Normally, cash flows are reported on a gross basis; however, reporting cash flows on a
net basis is permitted in limited circumstances.
IAS 7 allows cash flows arising from operating, investing or financing activities to be reported on a net
basis as:
(a) cash receipts and payments on behalf of customers when the cash flows reflect the activities of the
customer rather than those of the entity; and
(b) cash receipts and payments for items in which the turnover is quick, the amounts are large, and the
maturities are short (IAS 7, para. 22).
Examples of cash receipts and payments on behalf of customers include funds held for customers by an
investment entity and rents collected by an agent on behalf of the owners of the properties (IAS 7, para. 23).
Examples of cash receipts and payments for items with quick turnover and short maturity are principal
amounts relating to credit card customers and the purchase and sale of investments (IAS 7, para. 23A).
IAS 7 also sets out additional circumstances for netting by financial institutions (IAS 7, para. 24).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 23 and 23A of IAS 7, which contain examples of
cash flows that can be reported on a net basis. Also relevant is paragraph 24 of IAS 7, which deals with the additional
items of cash flows that may be presented on a net basis by a financial institution.
OTHER INFORMATION TO BE DISCLOSED IN THE STATEMENT
OF CASH FLOW OR NOTES
Several other items of information must be disclosed in the statement of cash flows. These cash flow items
include interest and dividends, income taxes and loss of control of subsidiaries (IAS 7, paras 31, 35, 39
and 40).
Investing and financing transactions that do not require the use of cash (or cash equivalents) are excluded
from a statement of cash flows (IAS 7, para. 43). For example, an entity may acquire a block of land by
issuing shares. Although this involves the acquisition of an asset, it does not result in a cash outflow and,
therefore, will not be captured in the statement of cash flows. IAS 7 requires that non-cash transactions are
disclosed elsewhere in the financial statements or the notes in a way that provides all relevant information
about investing and financing activities (IAS 7, para. 44).
An entity is also required to disclose changes in liabilities arising from financing activities, including
both changes arising from cash flows and non-cash changes (IAS 7, para. 44A). The purpose of this
requirement is to ‘enable users of financial statements to evaluate changes in liabilities arising from
financing activities’ (IAS 7, para. 44A). Liabilities arising from financing activities are those whose cash
flows were, or whose future cash flows will be, classified as financing activities in the statement of cash
flows (IAS 7, para. 44C).
One way to fulfil the disclosure requirement is to provide a reconciliation between the opening and
closing balances in the statement of financial position for liabilities arising from financing activities
(IAS 7, para. 44D). This would include changes arising from cash flows, as well as non-cash changes
such as those arising from obtaining or losing control of subsidiaries or other businesses, the effect of
changes in foreign exchange rates, changes in fair values, and other changes (IAS 7, para. 44B).
An entity must also disclose the amount of significant cash and cash-equivalent balances held that are
not available for use by the group (IAS 7, para. 48). For example, there may be exchange controls or legal
restrictions in place that restrict the movement of cash (IAS 7, para. 49). This disclosure is important as
it allows users to make informed decisions regarding the liquidity of an entity. Another disclosure that is
encouraged is the amount of undrawn borrowing facilities that may be available for the future cash needs
(IAS 7, para. 50).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read the illustrative examples of IAS 7 (in the IFRS Compilation
Handbook) to gain an overview of the suggested structure of the statement of cash flows and the additional
information that is required to be presented in the financial statements institution.
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106 Financial Reporting
CONSOLIDATED FINANCIAL STATEMENTS
A parent entity in a group that is required to prepare a set of consolidated financial statements will include
a statement of cash flows that discloses the cash flows of the group. This module does not deal with the
complexities of preparing a consolidated statement of cash flows from raw data. However, please note that:
• consolidated cash flows should be reported net of cash flows among entities comprising the group
• foreign currency translation is required when a foreign subsidiary is a member of a domestic group and
a consolidated statement of cash flows is to be prepared.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 25–28 of IAS 7. Note that these paragraphs also
apply to foreign currency-denominated transactions of domestic reporting entities and to those of foreign subsidiaries
that are members of a domestic group.
QUESTION 2.11
It is important to complete all previous case study questions before attempting this question.
Refer to sections 1–5, 7 and 8 of the ‘Case study data’.
Prepare a statement of cash flows and disclosures for Webprod Ltd for the year ended 30 June
20X7, using the direct method in accordance with paragraph 18(a) of IAS 7. In addition, prepare
a reconciliation between the profit for the period and the cash from operating activities (the
indirect method).
Note: This question is a comprehensive question that combines many of the concepts discussed
in this section of the module. You can expect to take several hours to complete the set tasks.
Tip: Calculate the cash flows for each of the following activities (preferably in this order).
Cash flows from operating activities
1. Cash received from customers
2. Cash received from grants
3. Cash paid to suppliers
4. Cash paid to employees
5. Borrowing costs
6. Warranties paid
7. Income tax paid
Cash flows from investing activities
8. Interest received
9. Proceeds from sale of factory plant and equipment
10. Purchase of factory plant and equipment
11. Loan to director
12. Cash paid for product development costs
Cash flows from financing activities
13. Proceeds from funds borrowed
14. Dividends paid
15. Payment of bank loan
16. Payment of promissory notes
Refer to the financial statements of Techworks Ltd. Why does the balance of cash and cash equivalents
differ to the statement of financial position? Has interest received and interest paid been disclosed as
cash flows from operating activities, investing activities or financing activities?
2.18 TIPS ON HOW TO ANALYSE THE STATEMENT
OF CASH FLOWS
The purpose of the statement of cash flows is to analyse the movement between the opening and closing
balances of the entity’s cash and cash-equivalent accounts during the reporting period. The statement of
cash flows reveals the various sources of cash inflows and cash outflows of the entity during the reporting
period so that users can assess where the monies are coming from and where they are being spent.
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MODULE 2 Presentation of Financial Statements 107
Some tips on how to read, analyse and interpret the statement of cash flows are summarised as follows.
1. Review the cash balance at the end of the reporting period. Is this value positive? Is it greater than or
less than the balance at the beginning of the reporting period?
2. Review the cash flows from operating activities. This figure is essentially the entity’s cash profit figure.
Is this value positive? A positive value is a good sign that the entity has made a cash profit during
the reporting period. How does this value compare to the previous reporting periods’ cash flows from
operating activities? If the result for the current period is higher, this is a good sign as it indicates that the
entity’s cash profit has increased. If the cash profit figure has decreased, this would firstly indicate that
the entity has had a cash loss during the current reporting period. The entity has spent more money on
its operating day-to-day activities than it has received. This is a less positive sign, as all entities should
be looking to make an underlying cash profit from their day-to-day business operations. As a general
rule of thumb, the entity should report a positive cash flow from operating expenses, and this amount
should (in principle) be enough to cover net cash used in investing and financing activities.
3. Review the cash flows from investing activities (i.e. purchasing and disposing of non-current assets and
investments). Is this value positive or negative? If negative, this indicates that the entity has invested in
non-current assets. This could mean that the entity is expanding its operations or that the entity may be
in the start-up or growth phase of the business life cycle.
4. Review the cash flows from financing activities (i.e. is the business funding the acquisition of assets
through debt or equity?). Review the increases or decreases in external borrowings. Has the entity
borrowed or paid back funds? Review the increases and decreases in equity. Has the entity paid
dividends or issued more shares to raise capital? How does the payout of dividends compare to
the net cash flow from operating activities? Has the entity paid out a high percentage of profits to
its shareholders, or has it retained the funds to cover operating costs and repayment of financing
arrangements?
5. Review the net increase or decrease in cash and cash equivalents. Is this value positive or negative?
A positive value indicates that the entity has retained (and banked) funds for the reporting period. This
also indicates that the entity has generated substantial cash profits from operating activities. This will
be particularly pleasing for shareholders who are interested in the ability of their investment to generate
positive returns.
SUMMARY
IAS 7 specifies the requirement for the presentation of a statement of cash flows to be included in the
general purpose financial statements of an entity. The statement is to display information about cash inflows
and outflows from operating, investing and financing activities.
Gross cash flows are to be presented in the statement of cash flows. IAS 7 permits cash flow from
operating activities to be reported in the statement of cash flows using either the direct or indirect method
(although the former is preferred).
Several items of information relevant to the operating, financing and investing activities of a reporting
entity are to be separately disclosed. These are to be disclosed in the notes to the financial statements of
which the statement of cash flows forms a part.
.......................................................................................................................................................................................
EXPLORE FURTHER
Re-read the list of objectives at the beginning of this module and make sure you have mastered all of these before
moving on.
The key points covered in this part, and the learning objectives they align to, are as follows.
KEY POINTS
2.5 Explain and apply the requirements of IAS 7 with respect to preparing a statement of cash flows.
• Cash flows are inflows and outflows of cash and cash equivalents.
• Cash flows are classified into three activities: operating, investing and financing.
• Operating cash flows relate to the revenue-producing activities of the entity. They can be expressed
as ‘cash revenues less cash expenses = cash profit or loss’.
Pdf_Folio:108
108 Financial Reporting
• Investing cash flows relate to movements in non-current assets and other investments.
• Financing cash flows relate to movements in debt and equity.
• A statement of cash flows involves making adjustments from accrual-based information, deaccruing the figures and converting them to cash-based figures.
• There are three common methods used to prepare a statement of cash flows: (1) the worksheet
method, (2) the formula method, and (3) the ‘T’ account reconstruction method.
2.6 Discuss how a statement of cash flows can assist users of the financial statements to assess
the ability of an entity to generate cash and cash equivalents.
• The information provided in a statement of cash flows may assist users in assessing the ability of
an entity to generate cash flows in the future, meet its financial commitments as they fall due, fund
changes in the scope and/or nature of its activities, and obtain external finance.
REVIEW
In module 2, the discussion has centred on the issues relating to the presentation of financial statements
and the preparation of the four financial statements: the statement of P/L and OCI, the statement of changes
in equity, the statement of financial position and the statement of cash flows. The following accounting
standards were considered as part of the discussion:
• IAS 1 Presentation of Financial Statements
• IAS 7 Statement of Cash Flows
• IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
• IAS 10 Events after the Reporting Period
• IAS 16 Property, Plant and Equipment
• IAS 34 Interim Financial Reporting
• IFRS 8 Operating Segments.
Part A discussed the overall considerations in preparing financial statements and the structure and
content of particular financial statements (as contained in IAS 1). As accounting policies are a key
determinant of the content of financial statements, the focus was on the IAS 8 requirements to disclose
the accounting policies of an entity and any changes made to such policies. Part A also discussed how
to deal with information that arises from events that occur in the time between the end of the reporting
period and the date the financial statements are authorised for issue. IAS 10 makes a distinction between
events that clarify conditions that existed at the end of the reporting period (information from such events is
incorporated into the financial statements) and those that indicate conditions that arose after the reporting
period (if material, information about their nature and financial effect is disclosed in the notes).
Part B discussed the statement of P/L and OCI. IAS 1 specifies disclosure requirements for items to be
included in the statement of P/L and OCI. In addition, IAS 1 sets accounting standards for the presentation
of profit (loss) and OCI. Total comprehensive income for a period is based on an ‘all-inclusive’ view of
profit. The disclosure requirements of IAS 1 include items such as revenue, finance costs, tax expense
and profit or loss. An illustrative statement of P/L and OCI is included in the ‘Guidance on implementing
IAS 1 Presentation of Financial Statements’ (in the IFRS Compilation Handbook).
Part C dealt with the statement of changes in equity. This statement requires the disclosure of the changes
to each equity component arising from comprehensive income, transactions with owners and retrospective
adjustments made in accordance with IAS 8. The statement must also contain a reconciliation between the
opening and closing amount of each equity item for the period.
Part D considered the statement of financial position. IAS 1 prescribes standards for the classification
of assets and liabilities. In addition, IAS 1 prescribes disclosure requirements for a statement of financial
position. An illustrative statement of financial position is included in the ‘Guidance on implementing
IAS 1 Presentation of Financial Statements’ (in the IFRS Compilation Handbook).
Part E considered the statement of cash flows. IAS 7 requires this statement to display information about
cash flows from operating, financing and investing activities. IAS 7 also requires the disclosure of several
items in the notes to the statement of cash flows, including:
• information about non-cash financing and investing activities
• details of the cash unavailable for use.
Pdf_Folio:109
MODULE 2 Presentation of Financial Statements 109
CASE STUDY DATA: WEBPROD LTD
Webprod Ltd, a manufacturer of computer modems, was incorporated on 8 August 20X2. The company
also has two retail outlets through which it markets computer-related products. The accountant for
Webprod Ltd is currently preparing the company’s 20X7 financial statements.
The following sections will be referred to throughout module 2.
SECTION 1: INFORMATION RELATING TO PRIOR
REPORTING PERIODS
The statement of financial position of Webprod Ltd as at 30 June 20X6 was as follows.
$
Current assets
Bank†
Trade receivables
Less: Provision for credit loss
Secured loan to director
Raw materials (at cost)
Work in process (at cost)
Finished goods — manufactured modems (at cost)
Retail inventory (at cost)
Prepayments
Total current assets
Non-current assets
Investment in debentures
Less: Unamortised debenture discount
Secured loan to director
Patent rights
Less: Accumulated amortisation
Land (at independent valuation 20X5)
Factory buildings (at independent valuation 20X5)
Less: Accumulated depreciation
Factory plant and equipment (at cost)
Less: Accumulated depreciation
Fixtures and fittings — retail outlets (at cost)
Less: Accumulated depreciation
Total non-current assets
Total assets
Current liabilities
Trade payables
Accruals
Provision for employee benefits
Provisions for warranties
Dividend payable
Current tax payable
Bank loan — secured
Total current liabilities
Non-current liabilities
Provision for employee benefits
Provisions for warranties
Bank loan — secured‡
Promissory notes§
Preference shares||
Total non-current liabilities
Total liabilities
Net assets
Pdf_Folio:110
110 Financial Reporting
$
6 713
467 840
(15 600)
100 000
(1 713)
200 000
(30 000)
1 800 000
(200 000)
865 400
(328 000)
68 300
(23 700)
452 240
22 000
62 500
108 400
412 100
195 000
22 500
1 281 453
98 287
50 000
170 000
1 200 000
1 600 000
537 400
44 600
3 700 287
4 981 740
340 000
124 000
84 500
10 500
60 000
120 000
100 000
839 000
214 500
35 000
900 000
300 000
100 000
1 549 500
2 388 500
2 593 240
Shareholders’ equity
Share capital||
Revaluation surplus#
Retained earnings
Total shareholders equity
1 050 000
700 000
843 240
2 593 240
† Webprod Ltd has access to a bank overdraft of $200 000, which is secured by a first mortgage over Webprod Ltd’s land and
buildings. The interest rate on the overdraft is 8%.
‡ The bank loan commenced on 4 November 20X5 and is for a period of ten years at an effective interest rate of 7%. The bank loan
is secured by a first mortgage over Webprod Ltd’s land and buildings.
§ The promissory notes are backed by a bank standby facility of $200 000. The facility bears interest at 9%.
|| There are 50 000 redeemable fully paid preference shares that have been classified as debt. There are 1 500 000 fully paid ordinary
shares. Both classes of shares have no par value.
# The $700 000 revaluation surplus comprises $400 000 revaluation surplus in relation to land and $300 000 revaluation surplus in
relation to buildings.
SECTION 2: INFORMATION RELATING TO THE
MANUFACTURING PROCESS OF WEBPROD LTD
2.1 RETAIL INVENTORY
Webprod Ltd uses a perpetual inventory system for the inventory in its two retail stores. These stores stock
74 software products and 22 hardware products. Costs are assigned on a weighted-average cost basis. The
following information is relevant to the retail inventory of Webprod Ltd for the 20X7 reporting period.
• Purchases of retail inventory on credit were $2 563 200.
• Cost of retail inventory sold was $2 544 602.
• After the 30 June stocktake, a comparison of the weighted-average cost and net realisable value of each
item was undertaken. Net realisable value was estimated on the general pattern of sales and discounts.
However, because of the rapid change in the computer industry and a miscalculation in purchasing, it
was discovered that two lines of software and one line of hardware would have to be sold at substantial
discounts. As a result, these inventory items would have to be carried at net realisable value.
Retail inventory as at 30 June 20X7 was:
• at cost, $213 598
• allowance for inventory write-down, $24 921.
2.2 MANUFACTURING INVENTORY
Webprod Ltd maintains a job costing system for its manufacturing operations. Costs are assigned to
manufacturing inventory on a first-in-first-out (FIFO) basis. Raw materials on hand are carried at cost.
The cost of manufactured inventories and work in process includes an appropriate share of both variable
and fixed overheads.
Subsequent to the 30 June stocktake, a comparison of the cost and net realisable value of each item
of finished goods was undertaken. The net realisable value was estimated on the general pattern of sales
and discounts.
Information relating to manufacturing inventory for the 20X7 reporting period is set out as follows.
2.2.1 Raw Materials
Purchases of raw materials on credit amounted to $5 423 500, and raw materials on hand as at 30 June
20X7 cost $53 820.
2.2.2 Work in Process
•
•
•
•
Raw materials allocated to work in process totalled $5 432 180.
Direct labour allocated to work in process amounted to $2 494 803.
Overhead allocated to work in process totalled $1 624 487.
The cost of work in process on hand at 30 June 20X7 was $132 540.
Pdf_Folio:111
MODULE 2 Presentation of Financial Statements 111
2.2.3 Finished Goods
During the financial year ending on 30 June 20X7, $9 527 330 of work in process was transferred from
work in process to finished goods. The cost of manufacturing inventory sold totalled $9 501 630. The cost
of finished goods on hand at 30 June amounted to $437 800.
SECTION 3: NON-CURRENT ASSETS
Note: The carrying amount of each non-current asset is included in section 1.
3.1 ACQUISITIONS AND DISPOSALS
The following information relates to acquisitions and disposals of non-current assets during the 20X7
financial year.
• On 20 August 20X6, retail fixtures and fittings were purchased at a cost of $8000.
• On 1 December 20X6, factory plant and equipment with a carrying amount of $63 000 (cost $160 000)
was sold for $88 000. The profit or loss on sale is based on the carrying amount of the plant and
equipment at the start of the reporting period.
• During the 20X7 reporting period, Webprod Ltd purchased $1 084 846 of factory plant and equipment;
$30 000 of this amount is included in the liability for accruals. See also section 5.
3.2 DEPRECIATION AND AMORTISATION
The depreciation and amortisation charges of Webprod Ltd during the 20X7 financial year are listed as:
• patent rights amortisation — $85 000
• factory buildings — $100 000 (included in factory overhead); also see section 3.3
• factory plant and equipment — $121 862 (included in factory overhead)
• retail fixtures and fittings — $10 254.
3.3 REVALUATION OF LAND AND BUILDINGS
Webprod Ltd adopts a policy of revaluing both its land and factory buildings annually to fair value, in
accordance with the revaluation model under IAS 16. The $700 000 revaluation surplus (IAS 16, para. 39)
as at 30 June 20X6 comprises a $400 000 revaluation increase in relation to land and a $300 000 revaluation
increase in relation to buildings.
I. Virgo, an independent valuer, carried out the revaluation as at 30 June 20X7 on the basis of the fair
value of the land and buildings from their existing use (being the highest and best use under IFRS 13 Fair
Value Measurement). Virgo determined that the value of the land and buildings was as follows.
$
Land
Buildings
970 000
1 650 000
The buildings had been depreciated by $100 000 during the 20X7 financial year and, hence, had an
accumulated depreciation of $300 000 as at 30 June 20X7.
The revaluation of the buildings at 30 June 20X7 resulted in an increase of the buildings value by
$150 000 (i.e. the difference between $1 650 000 — the fair value of the buildings as at 30 June 20X7
and $1 500 000 — the value of the buildings of $1 800 000 – $300 000 accumulated depreciation of the
buildings as at 30 June 20X7).
The revaluation of the land resulted in a decrease of the land by $230 000 (i.e. $1 200 000 – $970 000)
as at 30 June 20X7. This required a reversal of the previous revaluation increase of land recognised in the
revaluation surplus of land (i.e. reduces the balance in the revaluation surplus of land from $400 000 as at
30 June 20X6 by $230 000, as per IAS 16, paragraph 40, giving rise to a balance in the revaluation surplus
of land as at 30 June 20X7 of $170 000).
Therefore, the revaluation of land and buildings at 30 June 20X7 resulted in a net revaluation decrease
during the year of $80 000 (i.e. buildings increased by $150 000 and land decreased by $230 000). For the
purposes of this module, ignore any tax effects of revaluations as this topic is not dealt with until module 4.
Therefore, assume the $80 000 is net of tax.
Pdf_Folio:112
112 Financial Reporting
SECTION 4: WAGES AND SALARIES
The following information is relevant in preparing the 20X7 accounts of Webprod Ltd.
• During the 20X7 financial year, the total payments for wages and salaries, including annual leave,
totalled $3 250 000. Long service leave paid during the same period amounted to $22 000. Therefore,
total employee benefits paid were $3 272 000.
• Employee benefits to the value of $665 281 were allocated to overhead.
SECTION 5: BORROWING COSTS
The following information is relevant in relation to borrowing costs incurred by Webprod Ltd during 20X7.
• On 2 February 20X7, Webprod Ltd decided to construct a major item of manufacturing plant. By
30 June 20X7, Webprod Ltd had incurred $820 000 of expenditure on the manufacturing plant and
owed creditors $30 000 for materials used in the construction process. These amounts are included in
section 3.1 and include capitalised borrowing costs paid of $10 146.
• During 20X7, Webprod Ltd also incurred borrowing costs of $103 654, all of which have been paid. An
additional $4550 was prepaid (i.e. prepaid borrowing costs).
SECTION 6: CHANGE IN ACCOUNTING POLICY
In previous financial reporting periods, Webprod Ltd expensed all borrowing costs when incurred. Assume
that during the 20X7 reporting period, IAS 23 Borrowing Costs was re-issued. As a result, Webprod Ltd
changed its accounting policy on the treatment of borrowing costs so that borrowing costs relating to
qualifying assets are now capitalised. The accounting policy change has been made in accordance with the
transitional provisions of IAS 23.
For the purposes of the case study, assume that the transitional provisions require all borrowing costs
relating to qualifying assets incurred after the date the standard is applied to be capitalised with no
adjustments to the opening balances of the financial statements.
SECTION 7: REVENUE
7.1 REVENUE RECOGNITION POLICY
Webprod Ltd has adopted the requirements of IFRS 15 Revenue from Contracts with Customers as its
accounting policy for the recognition of revenue.
7.2 RESEARCH AND ADVISORY SERVICES
The principals of Webprod Ltd and several key employees had considerable knowledge and understanding
of the history of the development of telecommunications in Australia. Therefore, the company was
successful in securing a contract to provide research and advisory services. Revenue from these services
is recorded as ‘telecommunications project revenue’. Although the money has not yet been received,
$600 000 of revenue has been recognised during the 20X7 financial year.
7.3 GRANTS
On 1 January 20X7, Webprod Ltd won a $1 million AusIndustry R&D Start Grant for a computer
software project. The revenue from the grant has been recognised, but $250 000 of the grant has not yet
been received.
SECTION 8: 30 JUNE 20X7 TRIAL BALANCE
The following is a trial balance for Webprod Ltd as at 30 June 20X7 and incorporates all information
necessary to prepare the financial report.
Pdf_Folio:113
MODULE 2 Presentation of Financial Statements 113
Sales
Cost of sales
Interest revenue
Telecommunications project revenue
Grant revenue
Profit on sale of factory plant and equipment
Loss on write-down of inventory
Under-applied overhead expense
Employee benefits — retail
Expected credit loss expense
Amortisation expense — patent
Depreciation expense — retail fixture and fittings
Borrowing costs expense
Damages expense
Warranties expense
Advertising campaign — new product
Audit fees
Consulting services — auditor
Selling expenses
Administrative expenses
Tax expense
Interim dividend
Final dividend
Current assets
Cash at bank
Trade receivables
Less: Provision for credit loss
Grant receivable
Secured loan to director
Raw materials — at cost
Work in process — at cost
Finished goods — manufactured modems — at cost
Retail inventory — at cost
Less: Allowance for inventory write-down
Prepaid borrowing costs
Prepayments
Non-current assets
Investment in debentures
Less: Unamortised debenture discount
Secured loan to director
Product development costs (R&D)
Patent rights
Less: Accumulated amortisation
Land (at independent valuation 20X7)
Factory buildings (at independent valuation 20X7)
Less: Accumulated depreciation
Factory plant and equipment (at cost)
Less: Accumulated depreciation
Fixtures and fittings — retail outlets (at cost)
Less: Accumulated depreciation
Pdf_Folio:114
Dr
Cr
$
$
19 194 434
12 046 232
12 283
600 000
1 000 000
25 000
24 921
87 500
166 320
5 400
85 000
10 254
103 654
620 000
12 300
380 000
25 000
30 000
2 415 000
3 530 077
387 018
200 000
250 000
192 173
723 210
17 200
250 000
28 000
53 820
132 540
437 800
213 598
24 921
4 550
58 800
100 000
897
50 000
380 000
200 000
115 000
970 000
1 650 000
0
1 790 246
352 862
76 300
33 954
Current liabilities
Trade payables
Accruals
Provision for employee benefits
Dividend payable
Current tax payable
Provision for warranties
Provision for damages
Bank loan — secured
342 500
163 000
110 000
250 000
387 018
11 000
620 000
100 000
Non-current liabilities
Provision for employee benefits
Provision for warranties
243 404
38 000
114 Financial Reporting
Bank loan — secured
Promissory notes
Loan — Finance Ltd
Preference shares
800 000
235 000
400 000
100 000
Shareholders’ equity
Share capital
Revaluation surplus
Retained earnings
27 689 713
1 050 000
620 000
843 240
27 689 713
Notes to trial balance:
1. On average, there is a $20 000 write-down of inventory for the annual reporting period.
2. Overhead has been under-applied in the last two reporting periods by an average of $100 000 per reporting period.
3. Share capital relates to the ordinary shares. The preference shares are classified as debt.
4. No executive of Webprod Ltd earns more than $100 000.
5. A tax rate of 30 per cent applies. Tax effect accounting has not been applied.
6. The final dividend was declared prior to the end of the reporting period and does not require shareholder approval.
7. The product development expense (non-current asset) has met the conditions of paragraph 57 of IAS 38 Intangible Assets and is
recognised as an intangible asset in the statement of financial position.
8. On 15 January 20X7, Webprod Ltd was sued for infringement of a patent right. On 20 August 20X7, Webprod Ltd settled the
lawsuit for $620 000. A liability for damages has been recognised in the statement of financial position.
ASSUMED KNOWLEDGE REVIEW QUESTIONS
This assumed knowledge review is designed to test your understanding of concepts that are fundamental to
this module. Answers to the questions are included at the end of the review. If you experience difficulties
with the questions in this review, consult the latest edition of an appropriate financial accounting textbook.
QUESTION 1
Explain how to classify the following cash flows.
(a) Interest paid and interest received
(b) Income taxes paid
The following information relates to questions 2–5. These questions review how to prepare a statement
of cash flows for a non-trading entity. Their purpose is to help you judge the extent to which you should
consult an appropriate financial accounting text prior to commencing part E of the module 2 study guide.
The examples and questions in module 2 are more complex and require a basic familiarity with preparing
a statement of cash flows for a trading enterprise. If you believe it would be advantageous to review your
understanding of statements of cash flows in the context of a trading entity, you should consult the latest
edition of an appropriate text, such as the following.
• Henderson, S. & Peirson, G. et al., 2017, Issues in Financial Accounting, 16th edn, Pearson, Melbourne.
• Hoggett, J. R. & Medlin, J. et al., 2021, Financial Accounting, 11th edn, John Wiley & Sons, Brisbane.
• Loftus, J., Leo, K. et al., 2023, Financial Reporting, 4th edn, John Wiley & Sons, Brisbane.
Before considering the questions, read paragraphs 18–20 of IAS 7 Statement of Cash Flows. Please
note that this material adopts the following disclosure approach.
• On the statement of cash flows, cash flows from operating activities will be reported using the direct
method (gross cash inflows and gross cash outflows from operating, investing and financing activities).
• The notes to the financial statements contain disclosure of the indirect method with a reconciliation
between profit for the year and cash flow from operating activities.
This approach is consistent with IAS 7, which encourages the use of the direct method (para. 19).
The following information relates to the activities of Management Services Ltd. (Note that it is an
abbreviated version of the requirements of IAS 1.)
MANAGEMENT SERVICES LTD
Statement of profit or loss and other comprehensive income
for the year ended 30 June 20X3
$
Revenues
Less: Expenses (excluding depreciation)
Depreciation expense
$
500 000
277 000
23 000
(300 000)
Pdf_Folio:115
MODULE 2 Presentation of Financial Statements 115
$
Profit before income tax
Less: Income tax expense
Net profit after income tax
$
200 000
(60 000)
140 000
MANAGEMENT SERVICES LTD
Statement of financial position
at 30 June 20X3
20X3
$
20X2
$
Change
$
Bank
Trade receivables
Prepaid expenses
Land and buildings
Less: Accumulated depreciation
Total assets
37 000
30 000
6 000
250 000
(33 000)
290 000
49 000
37 000
5 000
34 000
(10 000)
115 000
(12 000)
(7 000)
1 000
216 000
(23 000)
Trade payables and accruals
Current tax payable
Debentures
Share capital
Retained earnings
Net assets
40 000
60 000
—
40 000
150 000
290 000
6 000
14 000
15 000
40 000
40 000
115 000
34 000
46 000
(15 000)
—
110 000
QUESTION 2
Direct method of calculating and reporting cash flows from operating activities
Using the information provided for Management Services Ltd, calculate the net cash flows from operating
activities by adjusting sales, cost of sales, interest, and other items in the statement of P/L and OCI
for changes in assets and liabilities that affected the determination of profit and OCI (e.g. receivables,
payables). This is the second of the two techniques referred to in paragraph 19 of IAS 7.
The general principle that underlies the calculations is as follows. The gross cash inflow or outflow
relating to an item of revenue or expense is found by adjusting the dollar amount of items included in
the statement of P/L and OCI (excluding non-cash items, such as depreciation) by the change(s) in the
related statement of financial position item(s). The gross cash inflow or outflow may be found by direct
adjustment or by reconstruction of the related ledger accounts.
QUESTION 3
Indirect method of calculating and reporting cash flows from operating activities
Using the information provided for Management Services Ltd, reconcile the net cash provided by operating
activities to the net profit for the year. Provide brief reasons for each adjustment made to the profit for the
year. Comparative figures are not required.
QUESTION 4
Cash flows from investing activities and cash flows from financing activities
Using the information provided for Management Services Ltd, calculate the cash flows from investing
activities and the cash flows from financing activities.
QUESTION 5
Statement of cash flows
Using the information provided for Management Services Ltd, prepare a statement of cash flows using the
direct method in the form set out in the illustrative examples of IAS 7.
REFERENCES
IFRS Foundation 2022, 2022 IFRS Standards, IFRS Foundation, London.
Telstra Corporation Limited 2021, Telstra Annual Report 2021, accessed July 2022, https://www.telstra.com.au/content/dam/tcom/
about-us/investors/pdf-g/0821-TEL-AR-2021-FINAL-Interactive.pdf.
Pdf_Folio:116
116 Financial Reporting
MODULE 3
REVENUE FROM
CONTRACTS WITH
CUSTOMERS;
PROVISIONS,
CONTINGENT
LIABILITIES AND
CONTINGENT ASSETS
LEARNING OBJECTIVES
The overall aim of this module is to provide you with a working knowledge of the requirements and issues
associated with accounting for revenue from contracts with customers; provisions, and contingent liabilities and
contingent assets.
After completing this module, you should be able to:
3.1 explain and apply the requirements of IFRS 15 with respect to contract(s) with customers
3.2 determine and allocate the transaction price of a contract to the performance obligation(s) of the contract
3.3 understand, and be able to apply, IAS 37 as it relates to a provision, contingent liability and contingent
asset, and recognise how they relate to the Conceptual Framework.
ASSUMED KNOWLEDGE
Before you begin your study of this module, it is assumed that you are familiar with:
• the definitions of assets, liabilities, income and expenses in the Conceptual Framework
• the recognition criteria for assets, liabilities, income and expenses in the Conceptual Framework
• journal entries to record assets, liabilities, income and expenses.
LEARNING RESOURCES
International Financial Reporting Standards (IFRSs), with a particular focus on the IASB Conceptual
Framework for Financial Reporting (2018):
• IASB Conceptual Framework for Financial Reporting (2018)
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets
• IFRS 15 Revenue from Contracts with Customers.
Pdf_Folio:117
PREVIEW
This module examines accounting for revenue from contracts with customers, as well as accounting for
provisions, contingent liabilities and contingent assets. These items have been an area of much discussion,
not only within the accounting profession but also among financial statement users, especially in relation
to satisfying their information needs.
International Financial Reporting Standard Revenue from Contracts with Customers (IFRS 15) introduced a five-step model of revenue recognition capable of general application to a variety of transactions
and required detailed revenue-related disclosures. Part A of this module discusses the five-step model and
the disclosure requirements of IFRS 15.
The introduction of standards relating to provisions, contingent liabilities and contingent assets has also
led to a tightening of accounting practice. International Accounting Standard 37 Provisions, Contingent
Liabilities and Contingent Assets (IAS 37) significantly reduced the ability of entities to use provisions as
a means of managing the timing of the recognition of expenses, because the standard requires a present
obligation to exist before any provision (and related expense) can be recognised. Accounting for provisions
raises a number of recognition and measurement issues, particularly in relation to the present obligation and
reliable measurement criteria. Further, for provisions extending over more than one reporting period, the
issue of discounting future cash flows introduces further measurement issues, including the appropriateness
of the discount rate used. All these issues related to accounting for provisions are discussed in part B of
this module.
Part C of this module discusses the recognition and measurement requirements in relation to contingent
assets and contingent liabilities. Although IAS 37 indicates that neither may be recognised in the statement
of financial position (with the exception of some contingent liabilities in a business combination and
contingent assets that are considered virtually certain), it clarifies the nature of these potential obligations
and benefits, and outlines disclosure requirements.
Overall, the main aim of IFRS 15 and IAS 37 is to ensure that the financial reporting of revenue
from contracts with customers, provisions, contingent liabilities and contingent assets is informative for
financial statement users. For example, the revenue-related disclosures under IFRS 15 provide users with
an understanding of the revenue practices of the entity. This understanding extends to how recognised
revenue is earned, at what stage of the activity the revenue is earned and when payment is typically received,
as well as when and how remaining revenue from existing contracts will be recognised in the future.
IAS 37 ensures that appropriate recognition criteria and measurement principles are applied to provisions
recognised in financial statements. The standard also ensures that disclosures are sufficient to enable users
to understand the nature, timing and amount of provisions, contingent liabilities and contingent assets.
Pdf_Folio:118
118 Financial Reporting
PART A: REVENUE FROM CONTRACTS
WITH CUSTOMERS
INTRODUCTION
Part A reviews the recognition and disclosure requirements of IFRS 15 Revenue from Contracts with
Customers. IFRS 15 establishes principles for reporting useful information to financial statement users
about the nature, amount, timing and uncertainty of revenue and cash flows from an entity’s contracts with
customers. The aim of these principles is to provide a framework of broad revenue recognition concepts
that can be consistently applied to a wide range of transactions and industries. The IFRS 15 principles also
aim to provide important information for financial statement users to make an informed assessment of an
entity’s revenue-earning capabilities.
A key indicator of an entity and its management’s current performance is the revenue generated from its
activities. Moreover, revenue that is to be generated in future periods acts as a signal of future performance.
Providing information about an entity’s current and future revenue from contracts with customers allows
users to understand how the entity is currently performing and its performance capacity in the future.
Existing and potential investors in an entity, for example, require information on an entity’s revenueearning capacity to evaluate their potential return on investment and decide whether to buy, hold or sell
shares in the entity. Lenders may also rely on information about the entity’s revenue to assess the ability
of the entity to pay back its loans. Accordingly, it is critical that users have information on an entity’s
revenue-earning activities. By unifying the revenue recognition practices of entities and requiring detailed
disclosures of revenue earned in the current period and revenue from existing contracts to be earned in
future periods, IFRS 15 helps financial statement users to not only make more informed assessments of an
entity’s revenue-earning capabilities, but also of an entity’s performance relative to other entities.
Part A begins with an overview of IFRS 15, including an outline of its scope and effective date. The
recognition of revenue under IFRS 15 is then discussed, with an emphasis on the prescribed revenue
recognition model, which entities are to apply in determining the timing and amount of revenue to be
recognised. Part A concludes with a discussion on disclosure requirements relating to revenue from
contracts with customers.
Relevant Paragraphs
To assist in understanding of certain sections in this part, you may be referred to relevant paragraphs in
IFRS 15. You may wish to read these paragraphs as directed.
IFRS 15 Revenue from Contracts with Customers:
Subject
Paragraphs
Objective
Scope
Identifying the contract
Combination of contracts
Contract modifications
Identifying performance obligations
Satisfaction of performance obligations
Determining the transaction price
Allocating the transaction price to performance obligations
Changes in the transaction price
Contract costs
Disclosure
1–4
5–8
9–16
17
18–21
22–30
31–43
47–72
73–86
87–90
91–104
110–129
OVERVIEW OF IFRS 15 REVENUE FROM CONTRACTS
WITH CUSTOMERS
The purpose of IFRS 15 is to provide a comprehensive single model for revenue recognition that can be
consistently applied by all entities to their contracts with customers. For example, consider an entity that
enters into a contract with a customer for the sale of goods that allows the customer for a specified period a
right of return of the goods purchased. In accounting for the sales contract, the entity needs to consider not
only when to recognise revenue, but also the amount to be recognised as revenue, because the customer
is expected to exercise, to some degree, its right of return. Another example refers to software providers
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and other entities in the continuously growing technology sector where the previous revenue standards did
not provide clear guidance on the timing of revenue recognition, particularly in cases where those entities
provide multiple services to customers.
IFRS 15 was introduced to improve the financial reporting of revenue by:
(a) providing a robust framework for addressing revenue recognition issues;
(b) improving comparability of revenue recognition practices across entities, industries, jurisdictions and
capital markets;
(c) simplifying the preparation of financial statements by reducing the amount of guidance to which entities
must refer; and
(d) requiring enhanced disclosures to help users of financial statements better understand the nature,
amount, timing and uncertainty of revenue that is recognised (IFRS 15 Basis for Conclusions,
para. BC3).
To assist entities in applying IFRS 15, the standard provides guidance on how to account for numerous
contract types and their elements, including:
• contracts with a right of return period
• contracts providing goods or services with warranties
• contracts in which a third party provides the goods or services to the customer (principal versus agent
considerations)
• contracts with options for customers to purchase additional goods or services at a discount or free
of charge
• customer prepayments and payment of non-refundable upfront fees
• licensing and repurchase agreements
• consignment and bill-and-hold arrangements.
Scope of IFRS 15
IFRS 15 applies to all contracts with customers, except those contracts that are (in their entirety or in part):
(a) lease contracts within the scope of IFRS 16 Leases;
(b) contracts within the scope of IFRS 17 Insurance Contracts. However, an entity may choose to apply
[IFRS 15] to insurance contracts that have as their primary purpose the provision of services for a fixed
fee in accordance with paragraph 8 of IFRS 17;
(c) financial instruments and other contractual rights or obligations within the scope of IFRS 9 Financial
Instruments, IFRS 10 Consolidated Financial Statements, IFRS 11 Joint Arrangements, IAS 27
Separate Financial Statements and IAS 28 Investments in Associates and Joint Ventures; and
(d) non-monetary exchanges between entities in the same line of business to facilitate sales to customers
or potential customers (IFRS 15, para. 5).
A contract with a customer may be partially within the scope of IFRS 15 and partially within the scope
of one of the above standards. In such cases, IFRS 15 applies as follows.
• If the other standards specify how to separate or initially measure one or more parts of the contract, then
an entity shall apply those separation or measurement requirements first. The transaction price of the
contract is then reduced by the amounts initially measured under the other standards, with the remaining
transaction price being accounted for under IFRS 15. The term ‘transaction price’ is discussed shortly.
• If the other standards do not specify how to separate or initially measure one or more parts of the contract,
then an entity shall apply IFRS 15 to the contract (IFRS 15, para. 7).
EXAMPLE 3.1
Scope of IFRS 15
An entity enters into a lease agreement (as the lessor) with another entity (the lessee) for the lease of
equipment. The annual payments made by the lessee include lease payments and a fee for ongoing service
and maintenance of the equipment, as provided by the lessor. From the perspective of the lessor, the
contract with the lessee is partially within the scope of IFRS 16 Leases (in relation to the lease payments)
and partially within IFRS 15 (in relation to the service and maintenance fee).
In accordance with paragraph 7 of IFRS 15, the lessor shall apply IFRS 16 first to measure the lease
receivable arising from the lease payments. This amount is deducted from the transaction price of the
lease agreement and the remaining amount, being the service and maintenance fee, is accounted for by
the lessor applying the revenue recognition model in IFRS 15.
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The scope of IFRS 15 also extends to the recognition and measurement of gains and losses on the sale
of non-financial assets that are not an output of an entity’s ordinary activities. As such, IFRS 15 applies to
the sale of assets previously governed by IAS 16 Property, Plant and Equipment, IAS 38 Intangibles and
IAS 40 Investment Property.
Impact of IFRS 15
The impact of IFRS 15 varies by industry. For entities in some industries, IFRS 15 resulted in just a
little change in the traditional timing and amount of revenue recognised. For entities in other industries,
however, significant changes occurred compared to traditional practice. Entities in the technology sectors
were particularly affected, making IFRS 15 a prime example of the IASB’s response to how various aspects
of technological advancements impact on the accounting profession — in this case, by providing clear
guidance to entities responsible for technological advancements on how to account for their complex
transactions. For example, telecommunications entities may provide customers with a ‘free’ handset that
they can use in return for entering into a monthly payment plan for a minimum period. The previous
revenue standard, IAS 18 Revenue, provided little guidance on how to recognise revenue from contracts for
the bundled offer of a good and service. As a result, some telecommunication entities recognised revenue
from the sale of the monthly plans when the service was provided and treated the cost of the handsets
as a marketing expense. Others treated the handset as a cost of acquiring the customer and amortised it
over the minimum contract period. Neither of these options is permitted under IFRS 15, and as a result,
telecommunication entities must allocate the total contract price between the sale of the handset and the
monthly plan. This changed the timing of the recognition of revenue, with revenue allocated to the handset
now being recognised earlier (i.e. at the time of its sale).
Similar to entities in the telecommunications industry, those in the software development and technology
industries also need to allocate the contract price between the goods and/or services in a bundled offer.
Software entities may enter into contracts with customers for the implementation, customisation and testing
of software, with post-implementation support. Under IAS 18, software entities would have recognised
revenue by reference to the stage of completion of the transaction, including post-implementation services.
Under this approach, software entities would not have been required to allocate the total contract price
between each of the services provided. Rather, the revenue would have been recognised according to the
percentage of completion of the services as a whole. IFRS 15, however, requires the contract price to be
allocated to each distinct service, with revenue recognised when that service is completed. This altered the
timing of revenue recognised by software entities.
IFRS 15 also contains detailed requirements related to when a change in the terms of a contract should
be treated as a separate contract or as a modification to an existing contract. IAS 18, however, did not
provide such guidance, resulting in entities accounting for contract modifications differently. For entities
such as manufacturers, whose contracts can be modified to require the delivery of additional goods or
services to the customer at an increased price, IFRS 15 has the potential to change how they account for
revenue when a contract is modified.
Finally, IFRS 15 imposes stringent requirements that must be satisfied before revenue can be recognised
progressively over time. This has a particular impact on entities that have previously recognised revenue
on long-term contracts over time, such as various providers of enterprise technology solutions for their
licence revenue. If the IFRS 15 requirements are not satisfied, these entities would recognise revenue at a
point in time, for example, when the service is complete.
Overall, the practical implications of IFRS 15 are that the timing and amount of revenue recognised
from contracts with customers have changed for some entities that have been applying previous revenue
standards (i.e. IAS 18 and IAS 11 Construction Contracts). This is because some entities are required to
alter their accounting treatment of items such as contracts for bundled goods and services, contract modifications and contracts that are satisfied over time. The additional requirements contained in IFRS 15 over
the previous revenue standards might be seen as having increased the workload of accountants trying to
recognise revenues from contracts with customers, but entities can mitigate this effect by implementing
effective technology solutions built on customer relationship management (CRM) systems to track revenue
streams, recognise revenue from multiple sources and automate allocations of transaction price, costs and
discounts to different customers and services provided.
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 121
3.1 RECOGNITION OF REVENUE
IFRS 15 establishes a framework for determining when to recognise revenue and how much revenue to
recognise. Within that framework, the core principle of IFRS 15 is that an entity should recognise ‘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’ (IFRS 15, para. 2). To
meet this core principle, an entity needs to adopt a five-step recognition model for each customer, as
illustrated by figure 3.1.
FIGURE 3.1
IFRS 15 Revenue from Contracts with Customers five-step model
Step 1
Identify the contract(s) with the customer
Step 2
Identify the performance obligation(s) in the contract
Step 3
Determine the transaction price of the contract
Step 4
Allocate the transaction price to each performance obligation
Step 5
Recognise revenue when (or as) each performance
obligation is satisfied
Source: Deloitte 2018. This is an amended version of a diagram for which the original is available from
https://www.iasplus.com/en/publications/global/guides/a-guide-to-ifrs-15.
Step 1, step 2 and step 5 refer to recognition requirements, while step 3 and step 4 cover measurement
requirements. As such, these steps are not presented sequentially in IFRS 15, because in a manner
consistent with other IFRSs, IFRS 15 presents the requirements related to recognition, measurement,
presentation and disclosure sequentially.
When applying the five-step model, the entity must consider the terms of each contract and all relevant
facts and circumstances. The entity must also apply the five-step model consistently to contracts that are
similar in character and circumstance (IFRS 15, para. 3).
This section now looks at each step in detail.
STEP 1: IDENTIFY THE CONTRACT(S) WITH THE CUSTOMER
In carrying out step 1, an entity must identify its customers and then the contracts it has with its customers.
First, IFRS 15 defines a customer as ‘a party that has contracted with an entity to obtain goods or services
that are an output of the entity’s ordinary activities in exchange for consideration’ (IFRS 15, Appendix A).
Under this definition, not all parties with whom the entity enters into a contract are customers for IFRS 15
purposes: the definition is limited to those parties that obtain, in exchange for consideration, the output of
the entity’s ordinary activities. If the counterparty to a contract is not a customer, the contract is outside the
scope of IFRS 15. Second, a contract is ‘an agreement between two or more parties that creates enforceable
rights and obligations’ (IFRS 15, Appendix A). The agreement can be written, oral or implied by an entity’s
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122 Financial Reporting
customary business practices. Provided the contract is within the scope of IFRS 15 (see ‘Scope of IFRS 15’
in the part A ‘Introduction’ section of this module), an entity shall apply the requirements of IFRS 15 to
each contract that has all of the following attributes:
• the parties have approved the contract and are committed to perform their obligations
• the entity can identify each party’s rights regarding, and the payment terms for, the goods or services to
be transferred
• the contract has ‘commercial substance’ (i.e. should have an effect on future cash flows of the entity)
• it is probable that the entity will collect the consideration that it is entitled to in exchange for the goods
or services that it transfers to the customer (IFRS 15, para. 9).
Once the entity has established that a contract has all the above attributes, it needs to apply IFRS 15 and
is not required to reassess whether these attributes remain present for the duration of the contract unless
there is an indication that the facts and circumstances have changed significantly. If the contract does not
have all of the above attributes, IFRS 15 does not apply. Under such circumstances, however, the entity
must continually reassess the contract to determine whether all attributes are subsequently present. If they
are all present, the entity can then proceed to step 2 of the five-step model for the contract in question.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 9–14 of IFRS 15.
EXAMPLE 3.2
Counterparty to a Contract is Not a Customer
A research centre enters into an agreement with a grantor that provides grants and sponsorship for
research activity. The agreement states the grantor cannot specify how any output from the research
activity will be used. This agreement is not a contract with a customer under IFRS 15 because the grantor
is not a customer of the research centre. As the grantor cannot specify how the output from the research
activity can be used, the grantor does not obtain the output of the research centre’s ordinary activities in
exchange for consideration (see IFRS 15, para. 6).
QUESTION 3.1
Consider whether the following constitutes a contract with a customer under IFRS 15, and explain
why it does or does not.
• A construction company enters into a three-year agreement with a property developer for
the construction of a shopping centre. After 12 months, the property developer experiences
significant financial difficulties and is unlikely to meet future commitments.
Combining Multiple Contracts
Paragraph 17 of IFRS 15 requires an entity to combine two or more contracts entered into at or near the
same time with the same customer and to account for them as one contract if at least one of the following
criteria is met:
• ‘the contracts are negotiated as a package with a single commercial objective’
• the consideration ‘to be paid in one contract depends on the price or performance of the other
contract’, or
• ‘the goods or services promised in the contracts (or some goods or services promised in each of the
contracts) are a single performance obligation’ (see ‘Step 2: Identify the performance obligation(s) in
the contract’ for the definition of a performance obligation).
However, if the entity reasonably expects that the financial statement effects of accounting for multiple
contracts as a single contract will be materially different from accounting for the contracts individually,
the entity is not required to combine multiple contracts into one contract (IFRS 15, para. 4).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 4 and 17 of IFRS 15.
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 123
Contract Modifications
A contract modification is a change in the scope or price (or both) of a contract that is approved by both
contracting parties. A contract modification exists when the contracting parties approve a modification that
creates new, or changes existing, enforceable rights and obligations of the parties. Like the contract itself,
the modification can be written, oral or implied by customary business practices (IFRS 15, para. 18).
Modification Accounted for as a Separate Contract
If the modification has been approved by both contracting parties, it shall be accounted for as a separate
contract if both of the following conditions are met:
• ‘the scope of the contract increases because of the addition of promised goods or services that are
distinct’ (IFRS 15, para. 20(a)) (see ‘Step 2: Identify the performance obligation(s) in the contract’
to understand what is meant by ‘distinct’ in this context)
• ‘the price of the contract increases by an amount of consideration that reflects the entity’s stand-alone
selling prices of the additional promised goods or services and any appropriate adjustments to that price
to reflect the circumstances of the particular contract’ (IFRS 15, para. 20(b)). An example of price
adjustment is when discounts are provided to customers.
If both of these conditions are met, the entity will apply the remaining steps of the five-step model to the
contract modification, starting with step 2. The existing contract is unaffected by the contract modification,
as the revenue recognised to date under the existing contract (being the amounts associated with those
performance obligations already completed) is not adjusted. Future revenues related to the remaining
performance obligations under the existing contract will be accounted for under the existing contract.
Future revenues associated with the performance obligations remaining under the contract modification
will be accounted for separately.
Modification Not Accounted for as a Separate Contract
If neither of the conditions for a separate contract is met, how the contract modification is accounted
for depends on whether the remaining goods or services to be transferred under the existing contract are
distinct from those goods or services that were already transferred before the contract modification. The
three accounting approaches are outlined in the following scenarios:
1. If they are distinct, the contract modification is accounted for as a replacement of the existing contract
with the creation of a new contract.
2. If they are not distinct, the contract modification is accounted for as part of the existing contract.
3. If they are a combination of 1 and 2, the contract modification is accounted for as partly the creation of
a new contract and partly the modification of the existing contract (IFRS 15, para. 21).
These distinction scenarios determine whether an entity is required to adjust previously recognised
revenue because of the contract modification. Under scenario 1, revenue recognised to date under the
existing contract is not adjusted. After the modification, the consideration promised by the customer under
the existing contract that has yet to be recognised as revenue plus the consideration promised under the
contract modification are allocated to the remaining performance obligations in both the existing contract
and the contract modification. Remaining revenue is then recognised on a ‘prospective’ basis when these
performance obligations are completed.
Under scenario 2, the entity retrospectively adjusts recognised revenue to reflect the contract modification’s effect on the transaction price and the entity’s progress towards completing the performance
obligation. This retrospective adjustment to recognised revenue would typically arise when the existing
contract relates to a single performance obligation that is partially satisfied at the time of the modification.
Depending on the modification’s effect on the transaction price and the extent of progress, the adjustment
may either increase or decrease recognised revenue. After the modification, revenue is recognised
according to the satisfaction of the single performance obligation.
Scenario 3 applies when an entity modifies an existing contract in which some of the remaining goods
or services to be transferred are distinct from those that have already been transferred. If this is the case,
the entity would adopt a combination of scenarios 1 and 2. In particular, the entity applies scenario 1 to
those goods or services that are distinct and scenario 2 to those that are not.
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EXAMPLE 3.3
Contract Modification
An entity promises to sell 100 widgets to a customer over 12 months for a transaction price of $8000
($80 per widget). The customer obtains control of each widget at the time they take possession of the
widgets. After six months, the entity had transferred control of 45 widgets to the customer under the
existing contract. The contract is modified as follows.
Scenario A: Contract Modification that is a Separate Contract
Require the delivery of an additional 40 widgets at an additional price of $3000 ($75 per widget).
The contract modification is a new contract that is separate from the existing contract. The scope of the
contract has increased due to the promise of additional widgets that are distinct from the existing widgets
(IFRS 15, para. 20(a)). Moreover, the price of the additional widgets reflects their stand-alone selling price
at the time of the modification (IFRS 15, para. 20(b)).
Under IFRS 15, no adjustment is made to revenue recognised on the 45 widgets that have been transferred to the customer ($3600). Following the modification, the entity will recognise revenue separately
for the 55 widgets remaining under the existing contract ($4400) and the 40 widgets remaining under the
additional contract ($3000).
Scenario B: Contract Modification that is Not a Separate Contract
Require the delivery of an additional 40 widgets. The entity agrees to a reduced price for $70 per widget
for the additional 40 widgets and all remaining widgets on the original contract. This price reflects the
higher volume purchased when considering both the original contract and the additional order.
The contract modification is not accounted for as a separate contract because it fails to meet the
conditions in IFRS 15, paragraph 20. The entity determines that the negotiated price of $70 per widget for
the additional widgets does not reflect the stand-alone selling price of the additional 40 widgets, which is
$80 per widget. Because the remaining widgets to be delivered are distinct from those already transferred,
the entity applies the requirements in IFRS 15, paragraph 21(a) and accounts for the modification as a
termination of the original contract and the creation of a new contract.
Consequently, the amount recognised as revenue for the remaining widgets is $3850 ($70 × 55 widgets
not yet transferred under the original contract) + $2800 ($70 × 40 widgets to be transferred under the
contract modification).
Source: Based on IFRS Foundation 2022, IFRS 15 Revenue from Contracts with Customers, IFRS Foundation, London,
p. A761.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 18–22 of IFRS 15.
STEP 2: IDENTIFY THE PERFORMANCE OBLIGATION(S) IN
THE CONTRACT
Once the contract has been identified, the entity’s next step is to identify the performance obligation(s)
within the contract. This is done at the beginning of the contract and requires the entity to identify each
contractual promise to deliver goods or services to the customer. A promise constitutes a performance
obligation if it is for the transfer of either:
(a) a good or service (or a bundle of goods or services) that is distinct; or
(b) a series of distinct goods or services that are substantially the same and that have the same pattern of
transfer to the customer (IFRS 15, para. 22).
Provided it is considered distinct, any good or service promised to a customer as a result of a contract
gives rise to a performance obligation. This applies whether the promise is explicit within the contract
or implied by the entity’s customary business practices. Promised goods or services may give rise to
a performance obligation even if the promise is incidental or part of an entity’s marketing campaign.
Examples include ‘free’ handsets provided by telecommunication entities, ‘free’ services promised as part
of a licence contract by a software developer (e.g. customisation, installation, customer support, updates,
cloud services) and customer loyalty points awarded by supermarkets, airlines and hotels.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 22, 24 and 25 of IFRS 15.
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 125
Determining What is Meant by ‘Distinct’
A good or service is considered distinct when:
(a) the customer can [derive] benefit from the good or service either on its own or together with other
resources that are readily available to the customer; and
(b) the entity’s promise to transfer the good or service to the customer is separately identifiable from other
promises in the contract (IFRS 15, para. 27).
Customer Deriving Benefit from the Good or Service
IFRS 15 states a customer can benefit from a good or service through its use, consumption or sale (for an
amount greater than its scrap value) or if it is otherwise held in a way that generates economic benefits.
A customer may be able to benefit from the good or service on its own or in conjunction with other readily
available resources. A readily available resource is a good or service that is acquired separately from the
entity or another party or a resource that the customer has already obtained from the entity under the
contract or from other transactions or events (IFRS 15, para. 28).
Separately Identifiable Promise to Transfer a Good or Service
For a good or service to be distinct, the promise to transfer the good or service must be separable from
other promises in the contract. A promise is separable if the nature of the promise, within the context of the
contract, is to transfer goods or services individually rather than as inputs to a combined item (or items).
Indicators that two or more promises to transfer goods or services are not separable include, but are not
limited to, the following:
(a) ‘the entity provides a significant service of integrating the goods or services with other goods or
services promised in the contract’ into a combined item or items (IFRS 15, para. 29(a)).
(b) ‘one or more of the goods or services significantly modifies or customises, or is significantly modified
or customised by, one or more of the other goods or services promised in the contract’ (IFRS 15,
para. 29(b)).
(c) ‘the goods or services are highly interdependent or highly interrelated’ (IFRS 15, para. 29(c)).
When the customer can derive benefit from a good or service that is separately identifiable, as per
IFRS 15, paragraphs 27(a) and 27(b), the good or service is considered to be distinct. The entity has a
separate performance obligation for each distinct good or service within the contract.
If either criterion under paragraph 27 is not satisfied, the good or service is not distinct. The entity will
then combine the good or service with other promised goods or services until the entity identifies a bundle
of goods or services that are distinct. This could include combining a good or service that is not considered
distinct with another good or service that could be considered distinct on its own.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 26–30 of IFRS 15.
EXAMPLE 3.4
Identifying Whether a Good or Service is Distinct
An entity enters into a contract to construct a library for a customer. As part of the contract, the entity is
responsible for providing various goods and services, including engineering, site clearance, material and
labour for the construction of the library, and overall project management services.
Given the entity (or its competitors) can sell many of these goods or services separately to other
customers, it is likely the customer can benefit from the goods or services either on their own or
together with other readily available resources. As such, paragraph 27(a) of IFRS 15 is met. However,
paragraph 27(b) of IFRS 15 is not met because the individual goods and services are not distinct. This
is because the entity’s promise to transfer individual goods or services in the contract is not separately
identifiable from other promises in the contract; the entity ‘provides a significant service of integrating the
goods and services’ into a combined output — the library. As such, the goods and services constitute a
distinct bundle of goods and services, and the entity has a single performance obligation to construct the
library as per paragraph 29 of IFRS 15.
Source: Based on IFRS Foundation 2022, IFRS 15 Revenue from Contracts with Customers, IFRS Foundation, London,
p. A764.
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QUESTION 3.2
A software developer enters into a contract with a customer to transfer a software licence,
provide an installation service, and provide software updates and technical support for a threeyear period. The entity also sells each of these components separately. Although unique to each
customer, the installation service does not significantly modify the software. The software functions
without the updates and the technical support.
Identify the performance obligation(s) within this contract.
Source: Based on IFRS Foundation 2022, IFRS 15 Revenue from Contracts with Customers, IFRS Foundation, London,
pp. A764–A765.
Series of Distinct Goods and Services that are Substantially the Same and
have the Same Pattern of Transfer
IFRS 15 permits an entity to account for a series of distinct goods or services that are substantially the same
and have the same pattern of transfer as a single performance obligation, provided the following criteria
are met:
• each distinct good or service in the series that the entity promises to transfer to the customer represents
a performance obligation to be satisfied over time
• the entity uses the same method to measure its progress towards satisfaction of the performance
obligation for each distinct good or service in the series (IFRS 15, para. 23).
As stated, these requirements apply to goods or services that are delivered consecutively rather than
concurrently. For example, they would apply to repetitive service contracts such as cleaning contracts
and contracts to deliver utilities such as electricity and gas. The concept of satisfaction of a performance
obligation is discussed in ‘Step 5: Recognise revenue when each performance obligation is satisfied’.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should re-read paragraph 22 and read paragraph 23 of IFRS 15.
STEP 3: DETERMINE THE TRANSACTION PRICE OF
THE CONTRACT
Determining the total transaction price of a contract is an important part of the five-step model. This
is because once the transaction price is determined, it is allocated among the performance obligations
within the contract (i.e. step 4) and is recognised as revenue when those performance obligations are
satisfied (i.e. step 5).
The transaction price is ‘the amount of consideration to which an entity expects to be entitled in
exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf
of third parties’ (IFRS 15, para. 47). It is the amount to which an entity expects to be entitled that constitutes
the transaction price. As such, it excludes amounts collected on behalf of another party, such as sales taxes
or in Australia, the GST (Goods and Services Tax).
The transaction price may be affected by the nature, timing and amount of consideration promised by a
customer. When determining the transaction price, an entity shall consider the effects of:
• variable consideration, including any constraining estimates of that consideration
• the ‘existence of a significant financing component in the contract’
• non-cash consideration
• consideration that is payable to a customer (IFRS 15, para. 48).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 46–49 of IFRS 15.
Variable Consideration
The consideration promised in a contract with a customer may include fixed amounts, variable amounts or
both. If the consideration includes a variable amount, an entity ‘shall estimate the amount of consideration
to which [it] will be entitled in exchange for transferring the promised goods or services to a customer’
(IFRS 15, para. 50).
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 127
Paragraph 51 of IFRS 15 specifies examples of when consideration may vary. These include:
• discounts, rebates, refunds, credits and price concessions (whether explicit in the contract or implied
from an entity’s customary business practices, published policies or statements to the customer) offered
to customers, or
• incentives or performance bonuses offered to the entity on the occurrence of a future event, or penalties
imposed on the entity on the occurrence of a future event.
QUESTION 3.3
Consider whether the following performance payments constitute consideration of a fixed amount,
variable amount or a combination of both, and justify your answer.
• A construction company enters into a contract with a customer to build an office block. The
consideration promised by the customer is $1 500 000 with a $350 000 performance bonus if the
office block is completed within 18 months.
• A construction company enters into a contract with a customer to build a warehouse for
$500 000. The contract specifies that the warehouse is to be completed by 30 June 20X6, and
that if it is not completed by 31 August 20X6, the construction company incurs a $50 000 penalty.
Estimating Variable Consideration
An entity shall estimate variable consideration using either the ‘expected value’ or the ‘most likely amount’
method. An entity should choose the method that better predicts the amount of consideration to which it
will be entitled. An entity must apply the chosen method to that type of variable consideration consistently
throughout the contract. An entity is also required to apply the chosen method consistently to similar types
of variable consideration in other contracts. However, an entity is permitted to choose different methods
for estimating different types of variable consideration within one contract.
Under the expected-value method, the expected value of variable consideration is the sum of probabilityweighted amounts in a range of possible consideration amounts. This method requires an entity to
identify: (1) the possible outcomes of a contract; (2) the probability of each outcome occurring; and
(3) the consideration amount it is entitled to under each outcome. The sum of each probability-weighted
consideration amount the entity is entitled to under each outcome is the expected value of variable
consideration. The expected-value method may better predict variable consideration if the entity has a
large number of contracts with similar characteristics. The IFRS 15 Basis for Conclusions indicates that an
entity is not required to consider all possible outcomes because it may be costly to do so. Rather, a limited
number of discrete outcomes and their probabilities of likelihood can provide a reasonable estimate of
the expected value of variable consideration.
Under the most likely amount method, the expected value of variable consideration is the consideration
amount the entity is entitled to under the ‘most likely’ possible outcome of a contract. This amount is not
probability-weighted. Rather, an entity determines, from a range of possible outcomes, the outcome that is
most likely to occur. The consideration amount the entity is entitled to under this outcome is the expected
value of variable consideration. This method may be a better predictor of variable consideration than the
expected-value method if the contract has only two possible outcomes (e.g. an entity either achieves a
performance bonus or not).
IFRS 15 states:
An entity shall recognise a refund liability if the entity receives consideration from a customer and expects
to refund some or all of that consideration to the customer. A refund liability is measured at the amount
of consideration received (or receivable) for which the entity does not expect to be entitled (IFRS 15,
para. 55).
This refund liability amount is not included in the transaction price (IFRS 15, para. 55).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 50–55 of IFRS 15.
Constraining Estimates of Variable Consideration
On estimating the amount of variable consideration within the transaction price, an entity needs to consider
the likelihood that this amount will be realised. Variable consideration that is too uncertain should not be
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128 Financial Reporting
included in the transaction price. Variable consideration is included in the transaction price ‘only to the
extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised
will not occur when the uncertainty associated with the variable consideration is subsequently resolved’
(IFRS 15, para. 56).
‘Highly probable’ is defined as being ‘significantly more likely than probable’ (as defined in IFRS 5
Non-current Assets Held for Sale and Discontinued Operations, Appendix A). A significant reversal in the
amount of cumulative revenue recognised refers to a significant downward adjustment in the amount of
previously recognised revenue. When it is highly probable that a significant reversal will not subsequently
occur, variable consideration is included in the transaction price.
In assessing whether it is highly probable that a significant revenue reversal will not occur in
a subsequent reporting period, an entity should consider both the likelihood and magnitude of the
revenue reversal.
If the entity assesses that it is highly probable that including its variable consideration estimate will not
result in a significant revenue reversal, the amount is included in the transaction price. This assessment
must be done for each performance obligation that contains variable consideration. Further, the magnitude
of a possible revenue reversal should be assessed relative to the total consideration for each performance
obligation. For example, if the consideration for a single performance obligation includes both a fixed
and variable amount, the entity would assess the magnitude of a possible revenue reversal of the variable
amount relative to the total consideration (i.e. variable plus fixed consideration).
At the end of each reporting period, an entity must update the transaction price to reflect the amount
of consideration to which it expects to be entitled. This includes a reassessment of whether the variable
consideration is constrained and, if so, by what amount. After the reassessment, if it is highly probable that
a significant revenue reversal of all or some of the variable consideration will occur when the uncertainty
associated with the variable consideration is resolved in future periods, this amount is excluded from the
transaction price. This highly probable and significant reversal of the variable consideration requires a
change to the transaction price and any cumulative revenue recognised.
Similarly, at the end of each reporting period, an entity must adjust the refund liability amount for
changes in expectations about the amount of refunds. The corresponding adjustment is recognised as
revenue (or a decrease in revenue) if the refund liability amount decreases (or increases).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 56–58 of IFRS 15.
EXAMPLE 3.5
Estimating Variable Consideration and Determining Whether it is
Included in the Transaction Price
An entity enters into a contract with a customer to provide 100 gadgets at a price of $35 per gadget. Cash
is received when control of a gadget transfers. The contract explicitly states that the customer has the
ability to return any unused gadgets within 30 days of transfer and receive a full refund. As the gadgets are
specific to the customer, the entity cannot resell the returned gadgets to another customer. The contract
will be completed before the end of the current reporting period. Based on past experience, the entity
attaches the following probabilities to the estimated number of gadgets the customer will return.
Gadgets returned
Probability
of outcome
0
10%
1
20%
2
50%
3
10%
4
10%
Estimated variable consideration (probability-weighted)
Consideration entitled to
100 gadgets × $35 × 10% = $ 350
99 gadgets × $35 × 20% = $ 693
98 gadgets × $35 × 50% = $1 715
97 gadgets × $35 × 10% = $ 340
96 gadgets × $35 × 10% = $ 336
$3 434
Despite having a fixed price ($35 per gadget), the consideration is variable because the contract allows
the customer to return the gadgets. In estimating the amount of variable consideration, the entity would
use the expected-value method. Given there are more than two possible outcomes, the expected-value
method better predicts the amount of consideration to which the entity would be entitled in comparison
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 129
to the most likely amount method. As shown in the previous table, the expected-value method provides
an estimated variable consideration of $3434.
Whether the estimated amount of consideration is included in the transaction price depends on whether
it is highly probable that a significant revenue reversal will occur. Although the returns are outside the
entity’s influence, the entity has significant experience in estimating gadgets likely to be returned by this
customer. Also, the uncertainty will be resolved within a short time frame (i.e. 30 days). As such, the entity
concludes it is highly probable that a significant revenue reversal for the cumulative amount of revenue
recognised (i.e. $3434) will not occur when the uncertainty is resolved (i.e. over the 30-day return period).
Therefore, the transaction price is $3434. On transfer of control of the 100 gadgets, the entity recognises
revenue of $3434 and a refund liability of $66 ($3500 – $3434). At the end of the reporting period, the
entity will assess the number of gadgets actually returned and make a corresponding adjustment to the
amount of the refund liability and revenue recognised.
Although the entity would use the expected-value method given the circumstances that there are more
than two possible outcomes, the most likely amount method would have produced a similar result. The
most likely outcome is that the customer will return two gadgets, being 50 per cent, which is the highest
probability outcome as shown above. Based on this outcome, the transaction price is $3430 (98 gadgets
× $35). On transfer of control of the 100 gadgets, the entity would recognise revenue of $3430 and a
refund liability of $70 ($3500 – $3430).
Source: Based on IFRS Foundation 2022, IFRS 15 Revenue from Contracts with Customers, IFRS Foundation, London,
pp. A771–A773.
Significant Financing Component in the Contract
The payment of consideration by a customer may not occur at the same time the entity transfers the
good or service to the customer. The consideration may be paid before or after the transfer occurs. When
consideration is paid in advance, the entity receives (from the customer) the benefit of financing the transfer
of the good or service. Alternatively, when consideration is paid in arrears, the customer receives (from
the entity) the benefit of financing the transfer.
When the benefit of financing is ‘significant’, the contract contains a significant financing component.
When a contract contains a significant financing component, the entity adjusts the promised amount of
consideration (and, therefore, the transaction price of the contract) for the effects of the time value of
money. A significant financing component may exist irrespective of whether the promise of financing is
explicitly stated in the contract or implied by the payment terms of the contract (IFRS 15, para. 60).
Under IFRS 15, an entity must assess, first, whether a contract contains a financing component and,
second, if it does, whether that component is significant to the contract. This assessment, however, is not
required when the period between the entity transferring a promised good or service to a customer and the
customer paying for the good or service is one year or less. If the assessment is not required, the financing
component (if any) is automatically considered to be not significant (IFRS 15, para. 63).
For those contracts in which the period between the transfer of the good or service and the payment
of consideration is greater than one year, the entity must consider all relevant facts and circumstances in assessing whether the contract contains a significant financing component. These facts and
circumstances include:
• the difference, if any, between the amount of promised consideration and the price that a customer would
have paid for the good or service if the customer had paid cash for the good or service at the time of
transfer (i.e. the cash selling price)
• the combined effect of: (1) the ‘expected length of time between when the entity transfers the promised
good or service to the customer and when the customer pays for the good or service’; and (2) ‘the
prevailing interest rates in the relevant market’ (IFRS 15, para. 61).
If the financing component is not considered to be significant, no adjustment is made to the transaction
price of the contract. If the financing component is considered to be significant, the entity adjusts the
amount of the promised consideration for the effects of the time value of money. This is achieved by
discounting the nominal amount of promised consideration to the cash selling price at the discount rate
that would be used if the entity and customer entered into a separate financing transaction. The discount
rate reflects ‘the credit characteristics of the party receiving financing in the contract’ (IFRS 15, para. 64).
In effect, if a contract contains a significant financing component, the contract conceptually consists of
two transactions: one for the exchange of a good or service and another for the financing of that good or
service. In this case, IFRS 15 requires each transaction to be accounted for separately. The entity recognises
revenue from contracts with customers as the portion of promised consideration that equals the cash selling
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130 Financial Reporting
price. The entity recognises the difference between the nominal amount of promised consideration and the
cash selling price as interest revenue (if the entity benefits from financing) or interest expense (if the
customer benefits from financing). Revenue recognised from customers and interest revenue or interest
expense shall be presented separately in the statement of profit or loss and other comprehensive income
(statement of P/L and OCI). ‘Interest revenue or interest expense is recognised only to the extent that
a contract asset (or receivable) or a contract liability is recognised in accounting for a contract with a
customer’ (IFRS 15, para. 65).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 60, 61, 63–65 of IFRS 15.
EXAMPLE 3.6
Accounting for a Significant Financing Component in a Contract
A property developer enters into a contract with a customer to sell land, with control of the land transferring
to the customer when the contract is signed. The customer has no right to return the land once the contract
is signed. The cash selling price of the land is $50 000, which is the amount the customer would have paid
for the land if payment was required at the time of transfer. Payment, however, is required 24 months after
transfer at an amount of $57 781. The amount of $57 781 is the promised consideration of the contract.
Given the difference between the amount of promised consideration and the cash selling price ($7781 =
$57 781 − $50 000), the length of time between transfer and payment (24 months), and prevailing market
interest rates, the contract includes a significant financing component in accordance with paragraph 61
of IFRS 15. The contract includes an implicit interest rate of 7.5 per cent, which the entity considers
commensurate with the rate ‘that would be reflected in a separate financing transaction between the
entity and its customer at contract inception’ (IFRS 15, para. 64).
The entity recognises revenue when control of the land transfers to the customer, as the entity does not
expect to refund some or all of that consideration to the customer. At the time of transfer, the journal entry
would be as follows.
Dr
Cr
Receivable
Revenue
50 000
50 000
The interest revenue will be recognised over the next 24 months as interest receivable at the end of
each year as follows.
Dr
Cr
End of Year 1.
Dr
Cr
End of Year 2.
Interest receivable
Interest revenue
3 750
Interest receivable
Interest revenue
4 031
3 750
4 031
The final journal entry at the end of year 2, when the amount of $57 781 is received, should be as follows.
Dr
Cr
Cr
Cash
Receivable
Interest receivable
57 781
50 000
7 781
Source: Based on IFRS Foundation 2022, IFRS 15 Revenue from Contracts with Customers, IFRS Foundation, London,
pp. A772–A773.
Non-cash Consideration
Customer consideration might be in the form of goods, services or other forms of non-cash consideration.
When a customer promises consideration in a form other than cash, the non-cash consideration should be
measured at fair value according to IFRS 13 Fair Value Measurement and included in the transaction price.
When fair value cannot be reasonably estimated, the non-cash consideration is measured as the stand-alone
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 131
selling price of the goods or services promised to the customer in exchange for the consideration (IFRS 15,
paras 66 and 67).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 66–69 of IFRS 15.
Consideration Payable to a Customer
Consideration may be payable by entities to their customers:
• in exchange for a distinct good or service that the customer transfers to the entity, or
• as an incentive provided by the entity to the customer to encourage the customer to purchase a good
or service from the entity (e.g. a credit, coupon, voucher, or free product or service that can be applied
against amounts owed to the entity).
Consideration payable to a customer in exchange for a distinct good or service is accounted for in the
same way that the entity accounts for other purchases from suppliers. However, when the consideration
payable exceeds the fair value of the distinct good or service, the entity accounts for the excess as a
reduction of the transaction price owed to the entity. If the entity cannot reasonably estimate the fair value of
the distinct good or service, all the consideration payable is accounted for as a reduction of the transaction
price owed to the entity. The effect of a reduced transaction price is a reduction in the revenue ultimately
recognised by the entity.
Consideration payable to encourage the customer to purchase a good or service is accounted for as a
reduction of the transaction price owed to the entity. This reduction will reduce the revenue recognised
by the entity from its contract with the customer by the amount of consideration that is payable to
the customer.
Consideration is considered payable to the customer when the recipient of the consideration is another
party that purchased the entity’s goods or services from the customer. For example, a car manufacturer
that offers final consumers 12 months of free car servicing would account for this as a reduction of the
transaction price of the contract with the car dealer that sold the car to the final consumer.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 70–72 of IFRS 15.
EXAMPLE 3.7
Consideration Payable to a Customer
An entity that produces breakfast cereals enters into a one-year contract to sell boxes of cereal to a
customer that is a large supermarket chain. The customer commits to buying $5 000 000 worth of cereal
during the year. The contract requires the entity to make a non-refundable payment of $500 000 to the
customer at the inception of the contract to compensate the customer for the changes it needs to make
to its shelving to accommodate the cereal boxes.
The $500 000 payment is not made in exchange for a distinct good or service that the customer transfers
to the entity. As such, in accordance with paragraph 70 of IFRS 15, the $500 000 payment is a reduction
of the transaction price. The transaction price is therefore $4 500 000 ($5 000 000 – $500 000), which
will be recognised as revenue on satisfaction of the performance obligation(s) (see ‘Step 4: Allocate the
transaction price to each performance obligation’ and ‘Step 5: Recognise revenue when each performance
obligation is satisfied’).
STEP 4: ALLOCATE THE TRANSACTION PRICE TO EACH
PERFORMANCE OBLIGATION
Under this step, the transaction price of the contract (as determined under step 3) is allocated to each
separate performance obligation in the contract (as determined under step 2). For contracts with a single
performance obligation, the allocation process is simple: the entire transaction price relates to the single
performance obligation. It is when the contract contains more than one performance obligation that the
apportionment of the transaction price to each separate performance obligation is necessary.
Recall that each separate performance obligation in a contract relates to a distinct good or service.
An entity shall allocate the transaction price to each performance obligation based on the stand-alone
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132 Financial Reporting
selling price of the distinct good or service. To do this, an entity determines the stand-alone selling price
of each distinct good or service underlying each performance obligation in the contract. Once all standalone selling prices have been determined, the entity allocates the transaction price in proportion to those
stand-alone selling prices (IFRS 15, para. 76).
The stand-alone selling price is the price (at the time of entering into the contract) for which an entity
would sell the distinct good or service separately to a customer. The ‘best evidence’ of the stand-alone
selling price is ‘the observable price’ from stand-alone sales of that good or service to similar customers
(IFRS 15, para. 77). If a stand-alone selling price is not directly observable, entities must estimate that
price. IFRS 15 does not preclude or prescribe any particular method for estimating the stand-alone selling
price. The estimation method, however, must provide a faithful representation of the price at which the
entity would sell the distinct good or service separately to the customer. When estimating a stand-alone
selling price:
. . . an entity shall consider all information (including market conditions, entity-specific factors and
information about the customer or class of customer) that is reasonably available to the entity. In doing
so, an entity should maximise the use of observable inputs and apply estimation methods consistently in
similar circumstances (IFRS 15, para. 78).
Under paragraph 79 of IFRS 15, the three suitable estimation methods (illustrated in figure 3.2)
include the following.
• Adjusted market assessment approach: An entity evaluates the market in which it sells goods or
services and estimates the price customers would be willing to pay for those goods or services, whether
provided by the entity or a competitor. Under this approach, an entity focuses on market conditions,
including supply of and customer demand for, the good or service; competitor pricing for the same or
similar good or service; and the entity’s share of the market.
• Expected cost plus a margin approach: An entity forecasts its expected costs of satisfying a
performance obligation and then adds an appropriate margin for that good or service. Under this
approach, the entity primarily focuses on entity-specific factors, including its internal cost structure
and pricing strategies and practices.
• Residual approach: An entity estimates the stand-alone selling price as the total transaction price less
the sum of the observable stand-alone selling prices of other goods or services promised in the contract.
Under this approach, when all but one of the stand-alone selling prices of promised goods or services
is directly observable, the stand-alone selling price of the good or service that is not observable is the
difference between the total transaction price and the sum of directly observable stand-alone selling
prices. An entity, however, may only use the residual approach for a good or service with a highly
variable selling price. Otherwise, the selling price is uncertain because the good or service has not
previously been sold on a stand-alone basis.
FIGURE 3.2
Suitable methods for estimating the stand-alone selling price of a good or service
(a) Suitable methods for estimating the stand-alone selling price of a good or service
Adjusted market
assessment approach
Expected cost plus
a margin approach
Residual approach
Evaluate the market
Forecast expected
costs of satisfying a
performance obligation
Estimate the standalone selling price
Estimate the price
customers would pay
Add an
appropriate margin
Calculate total transaction
price less the sum of
the observable standalone selling prices
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 133
FIGURE 3.2
(continued)
(b) Factors that influence the stand-alone selling price estimate under each method
Adjusted market
assessment approach
Expected cost plus
a margin approach
Residual approach
Market conditions,
supply and demand,
competitor pricing,
market share
Entity-specific factors
such as internal cost
structure and pricing
High variable
selling price
Source: CPA Australia 2022.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 76–79 of IFRS 15.
Allocation of a Discount
A discount exists when the sum of the stand-alone selling prices of the distinct goods or services in the
contract exceeds the promised consideration in a contract. Consistent with the proportionate allocation of
the transaction price to each performance obligation in the contract (as discussed previously), an entity
must allocate a discount proportionately to all performance obligations in the contract. However, if the
entity has observable evidence that the entire discount relates to one or more, but not all, performance
obligations in a contract, it will allocate the entire discount to those specific performance obligations only
(i.e. not to all obligations). The entity has observable evidence when both of the following criteria are met.
• The entity regularly sells each (or bundles of each) distinct good or service in the contract on a standalone basis and regularly at a discount to the stand-alone selling price.
• The discount in the contract is substantially the same as the discount regularly given on a standalone basis.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 81 and 82 of IFRS 15.
EXAMPLE 3.8
Allocating a Discount
An entity regularly sells scarves, gloves and woollen hats individually, thereby establishing the following
stand-alone selling prices.
$
Scarves
Gloves
Hats
Total
40
55
45
140
In addition, the entity regularly sells gloves and hats together for $60.
The entity enters into a contract with a customer to sell all three products in exchange for $100. The entity
will satisfy the performance obligations of each of the products at different times. The contract includes a
discount of $40 on the overall transaction. Because the entity regularly sells gloves and hats together for
$60 and scarves for $40, it has observable evidence that the entire discount should be allocated to the
promises to transfer the gloves and hats (as per IFRS 15, para. 82).
If the entity transfers control of the gloves and hats at the same time, the entity could account for the
transfer of these products as a single performance obligation. As such, the entity could allocate $60 of
the transaction price to the single performance obligation and recognise revenue of $60 when the gloves
and hats simultaneously are transferred to the customer. When the entity transfers control of the scarves,
the entity can allocate $40 of the transaction price to this performance obligation and recognise revenue
of $40 at this time.
Pdf_Folio:134
134 Financial Reporting
If the contract requires the entity to transfer control of the gloves and hats at different times, then the
allocated amount of $60 is allocated to the gloves and hats individually, based on their stand-alone selling
price. The amount of $40 is also allocated to the stand-alone selling price of the scarves. Allocations are
as follows.
Product
Allocated transaction price
$
Gloves
Hats
Scarves
Total
33
27
40
100
($55/$100 stand-alone selling price × $60)
($45/$100 stand-alone selling price × $60)
Source: Based on IFRS Foundation 2022, IFRS 15 Revenue from Contracts with Customers, IFRS Foundation,
London, pp. A776–A777.
Allocation of Variable Consideration
Generally speaking, an entity is to allocate the variable consideration in a transaction price proportionately
to all performance obligations in the contract. IFRS 15, however, acknowledges that this may not always be
appropriate (IFRS 15, para. 84). For example, consider an entity that enters into a contract with a customer
to provide two distinct goods at different times. Each distinct good constitutes a separate performance
obligation. A bonus is payable by the customer to the entity on timely delivery of the second good. The
bonus constitutes variable consideration, and it would be inappropriate to allocate it to both performance
obligations given that it relates to the second performance obligation only.
STEP 5: RECOGNISE REVENUE WHEN EACH PERFORMANCE
OBLIGATION IS SATISFIED
Recall that, under step 4, an entity allocates the transaction price of the contract to each separate
performance obligation in the contract. Under step 5, the portion of the transaction price allocated to
a performance obligation is recognised as revenue when (or as) the entity satisfies that performance
obligation. Under IFRS 15, a performance obligation is satisfied when a promised good or service is
transferred to the customer. A good or service is considered to be transferred when the customer ‘obtains
control’ of that good or service (IFRS 15, para. 31). According to IFRS 15, a good or service is an asset
to a customer: the standard states, ‘control of an asset refers to the ability to direct the use of, and obtain
substantially all of the remaining benefits from, the asset’ (IFRS 15, para. 33). The benefits of an asset are
the potential cash inflows or savings in cash outflows obtained directly or indirectly from the asset.
Transferring control of a promised good or service (and, therefore, concurrently satisfying a performance
obligation) could occur over time or at a point in time. At the time of entering into a contract, an entity
must determine whether it will satisfy the performance obligation over time or at a point in time. If a
performance obligation will not meet the criteria to be satisfied over time, it is considered to be satisfied
at a point in time.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 31–33 of IFRS 15.
Performance Obligations Satisfied Over Time
A performance obligation is satisfied 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;
(b) the entity’s performance creates or enhances an asset 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 (IFRS 15, para. 35).
If any of these three criteria are met, the entity transfers control of the good or service over time while
concurrently satisfying the performance obligation. The transaction price allocated to the performance
obligation is recognised as revenue gradually as the performance obligation is increasingly completed
over time. Each criterion will now be examined in turn.
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 135
Customer Simultaneously Receives and Consumes the Benefits of the Entity’s Performance
This criterion implies that the entity’s performance creates an asset only momentarily, as the asset is
simultaneously created, received and consumed by the customer while the entity performs. As such, this
criterion applies only to services and not goods, as a customer cannot simultaneously receive and consume
a good while it is being produced. Not all service-type performance obligations, however, provide benefits
that are simultaneously received and consumed by the customer while the entity performs. For instance,
asset managers are unlikely to recognise performance fees in full until they are crystallised or no longer
subject to claw-back. In those types of situations, this criterion does not apply.
For some service-type performance obligations, the customer’s receipt and simultaneous consumption
of the benefits of the entity’s performance can be readily identified. Examples include performance
obligations where routine or recurring services are promised, such as cleaning services or transaction
processing services (IFRS 15, para. B3). For other service-type performance obligations, it may be unclear
whether the customer simultaneously receives and consumes the benefits of the entity’s performance over
time. If unclear, the entity will determine whether another entity would need to substantially re-perform
the work it has completed to date if that other entity were to fulfil the remaining performance obligation
to the customer. If substantial re-performance is not required, the performance obligation is satisfied over
time (IFRS 15, para. B4).
Customer Controls the Asset as it is Being Created or Enhanced
Under this criterion, control of an asset is transferred over time if the entity’s performance creates or
enhances an asset that a customer controls as the asset is created or enhanced. The meaning of ‘control’ is
the same as that discussed earlier. The asset being created or enhanced can be either tangible or intangible.
For example, an entity enters into a contract with a single performance obligation to construct a building
on the customer’s land. In that case, the customer generally controls any work in progress as the building
is constructed. Because the customer controls the work in progress, it is obtaining benefits of the goods
and services the entity is providing. As a result, the performance obligation is satisfied over time.
Entity’s Performance does not Create an Asset with an Alternative Use, and the Entity has a Right to
Payment for Performance Completed to Date
This criterion has two components: (1) the entity’s performance does not create an asset with an alternative
use to the entity; and (2) the entity has an enforceable right to payment for performance completed to date.
Both components must be present for this criterion to be met. Each component will now be considered
in turn.
Alternative use
When the entity’s performance creates an asset with an alternative use to the entity, the entity could direct
the asset to another customer. The customer does not control the asset as it is being created because it
cannot restrict the entity from directing that asset to another customer. An example of alternative use
is the production of identical inventory items that the entity can substitute across different contracts
with customers.
The entity is less likely to have an alternative use for a highly customised asset that is created for a
customer. The entity would likely need to incur significant costs to rework the asset for another customer,
or need to sell it at a significantly reduced price. As a result, control of the asset could be considered to be
transferred over time (provided the entity also has a right to payment for performance completed to date).
Right to payment
Once it has been established that the asset does not have an alternative use to the entity, the entity must
have a right to payment for performance completed to date. An entity has a right to payment if it is entitled
to an amount that compensates it for its performance completed to date should the customer or another
party terminate the contract for reasons other than the entity’s failure to perform as promised.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 35–37 of IFRS 15.
Measuring Progress on Performance Obligations Satisfied Over Time
When an entity determines that a performance obligation is satisfied over time (i.e. any of the three criteria
in IFRS 15, paragraph 35, are met), the entity ‘shall recognise revenue over time by measuring the progress
towards complete satisfaction of that performance obligation’ (IFRS 15, para. 39). An entity applies a
single method of measuring progress for each performance obligation, with the chosen method being the
one that best depicts the ‘entity’s performance in transferring control of goods or services promised to a
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136 Financial Reporting
customer’ (IFRS 15, para. 39). According to paragraph 40 of IFRS 15, once the method has been chosen,
an entity cannot change the method of measuring progress and must apply it consistently from inception
until complete satisfaction of the performance obligation.
IFRS 15 specifies two types of methods of measuring progress on performance obligations that are
satisfied over time: output methods and input methods. In choosing an appropriate method for measuring
progress, an entity must consider the nature of the good or service that it promised to transfer to the
customer (IFRS 15, para. 41). Output methods recognise revenue based on direct measurements of
the value (to the customer) of the goods or services transferred to date relative to the remaining goods
or services promised under the contract. Examples of output methods include surveying performance
completed to date, appraising results or milestones achieved, determining time elapsed under the contract
and measuring units produced or delivered to date (IFRS 15, para. B15).
Input methods recognise revenue based on the entity’s efforts or inputs towards satisfying a performance obligation relative to the total expected inputs to satisfy the performance obligation. Examples of
input methods include measuring (to date) resources consumed, labour hours expended, costs incurred,
time elapsed under the contract or machine hours used (IFRS 15, para. B18).
Using the chosen output or input method, at the end of each reporting period, an entity measures its
progress towards complete satisfaction of a performance obligation satisfied over time. When an entity
is closer to completely satisfying the performance obligation than the previous period, the change in the
measure of progress is recognised as revenue in the current reporting period. The change in the measure of
progress is also disclosed as a change in estimate in accordance with IAS 8 Accounting Policies, Changes
in Accounting Estimates and Errors.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 39–43 of IFRS 15.
Performance Obligations Satisfied at a Point in Time
If none of the three criteria for recognising revenue over time are met, an entity must recognise revenue
at a point in time. The time to recognise revenue is when the entity transfers control of the asset to the
customer. The meaning of ‘control’ is the same as that discussed earlier. At the time control is transferred,
the performance obligation is satisfied.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraph 38 of IFRS 15.
EXAMPLE 3.9
Determining Whether a Performance Obligation is Satisfied Over Time
or at a Point in Time
An entity enters into a contract with a customer to provide a consulting service on how to improve
production process efficiency and, on completing the consultation, a final recommendation. The payment
is due after the final recommendation. The consulting service with final recommendation constitutes
a single performance obligation. The customer benefits from the entity’s performance once complete
and the final recommendation is made; benefit does not occur while the entity performs. As such, the
customer does not simultaneously receive and consume the benefits provided by the entity’s performance
as the entity performs, per paragraph 35(a) of IFRS 15. Also, the entity’s performance does not create
or enhance an asset that the customer controls, per paragraph 35(b). Moreover, the entity does not
have an enforceable right to payment for performance completed before the final recommendation, per
paragraph 35(c). As none of the criteria in paragraph 35 are met, the performance obligation is not satisfied
over time but, rather, at a point in time. The entity recognises revenue on completing the consultation.
3.2 CONTRACT COSTS
In certain instances, IFRS 15 permits an entity to recognise the following as assets:
1. the incremental costs of obtaining a contract with a customer
2. the costs to fulfil a contract with a customer.
Each of these types of contract costs will now be considered in turn.
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 137
INCREMENTAL COSTS OF OBTAINING A CONTRACT
Under paragraph 91 of IFRS 15, the incremental costs of obtaining a contract shall be recognised as an asset
if the entity expects to recover those costs. There are two aspects to this recognition requirement. First,
the costs of obtaining a contract are ‘incremental’ and, second, the entity expects to recover these costs.
Costs of obtaining a contract are incremental if they would not have been incurred had the contract not
been obtained (IFRS 15, para. 92), while recovery of these costs may be either direct (i.e. reimbursement
by the customer under the terms of the contract) or indirect (i.e. incorporated into the profit margin of the
contract). Costs of obtaining a contract that are not incremental (i.e. costs incurred regardless of whether
the contract was obtained) are recognised as an expense when incurred, unless they are chargeable to the
customer regardless of whether the contract is obtained (IFRS 15, para. 93).
For expediency, IFRS 15 permits an entity to recognise the incremental costs of obtaining a contract as
an expense when those costs are incurred, even though they would otherwise qualify for asset recognition
if the asset’s amortisation period is up to one year (IFRS 15, para. 94).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 91–94 of IFRS 15.
QUESTION 3.4
A consulting services entity wins a tender process to provide consulting services to a new customer.
The contract is for two years with an option for the entity to extend the contract for another year.
The entity intends on exercising this option. The entity incurs the following costs to obtain the
contract.
$
Legal fees to lodge tender
Travel costs to deliver proposal
Sales commission to employees for obtaining the contract
Total costs incurred
25 000
20 000
12 500
57 500
As part of the agreement with the lawyer involved in preparing the tender, $10 000 is payable
regardless of whether the tender is successful. The remaining $15 000 in legal fees becomes
payable on the success of the tender. All legal fees are borne by the entity and not recoverable
from the customer. What amount should the entity recognise as an asset for the incremental costs
of obtaining the contract?
Source: Based on IFRS Foundation 2022, IFRS 15 Revenue from Contracts with Customers, IFRS Foundation, London,
pp. A778–A779.
COSTS TO FULFIL A CONTRACT
In determining the accounting treatment for costs incurred in fulfilling a contract with a customer, an entity
must first establish whether these costs are within the scope of another standard. If the costs incurred
are within the scope of another standard, IFRS 15 states that an entity shall account for those costs in
accordance with that standard (IFRS 15, para. 96). IFRS 15 provides examples of other standards that may
apply to costs incurred in fulfilling a contract, including IAS 2 Inventories, IAS 16 Property, Plant and
Equipment and IAS 38 Intangible Assets.
If the costs incurred are not within the scope of another standard, an entity recognises an asset from the
incurred costs only if all of the following criteria are met:
• the costs ‘relate directly to a contract or to an anticipated contract that the entity can specifically identify’
(e.g. direct labour, direct materials, allocation of overheads that relate directly to the contract, costs
explicitly chargeable to the customer under the contract, and other costs that are incurred only because
an entity entered into the contract)
• the costs ‘generate or enhance resources of the entity that will be used in satisfying . . . performance
obligations in the future’
• the costs ‘are expected to be recovered’ (IFRS 15, para. 95).
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138 Financial Reporting
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 95–98 of IFRS 15.
AMORTISATION AND IMPAIRMENT
Under IFRS 15, an asset recognised from the incremental costs of obtaining a contract or from the costs
to fulfil a contract is subject to amortisation and impairment. Amortisation shall occur ‘on a systematic
basis that is consistent with the transfer to the customer of the goods or services to which the asset relates’
(IFRS 15, para. 99). Generally speaking, unless the asset relates to a particular performance obligation
within the contract, the amortisation period will be the life of the contract. When there is a significant
change in the entity’s expected timing of transfer to the customer of the goods or services to which the
asset relates, the entity updates the amortisation to reflect the change. This may arise, for example, if the
entity renews a contract for an additional period that was not anticipated at contract inception. This type
of change is accounted for as a change in accounting estimate under IAS 8 (IFRS 15, para. 100).
An entity recognises an impairment loss to the extent that the carrying amount of the asset that is
recognised exceeds ‘the remaining amount of consideration that the entity expects to receive in exchange
for the goods or services to which the asset relates’, less the yet-to-be-incurred costs ‘that relate directly
to providing those goods or services’ (IFRS 15, para. 101). When an entity determines the amount of
consideration it expects to receive, the principles for determining the transaction price are to be used (see
‘Step 3: Determine the transaction price of the contract’).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 99–102 of IFRS 15.
EXAMPLE 3.10
Determining the Amortisation Period of an Asset Recognised for
Contract Costs
Based on the information provided in question 3.4, the amortisation period for the asset recognised is
three years. This is consistent with the transfer of services to the customer to which the asset relates, as
the entity intends on extending the contract at contract inception. Given the asset amount ($12 500) and
amortisation period (three years), amortisation is $4167 per year.
If the entity does not exercise the option to extend the contract at the end of the second year,
the remaining unamortised amount will be amortised immediately and accounted for as a change in
accounting estimate under IAS 8.
3.3 DISCLOSURE
The objective of the IFRS 15 disclosure requirements is:
. . . for an entity to disclose sufficient information to enable users of financial statements to understand the
nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers
(IFRS 15, para. 110).
To achieve this objective, IFRS 15 requires an entity to disclose qualitative and quantitative information
about all of the following:
• its contracts with customers
• the significant judgements, and changes in judgements, made in applying IFRS 15 to those contracts
• any assets recognised from the incremental costs of obtaining a contract or the costs to fulfil a contract.
Each of these disclosure requirements is now examined in turn.
CONTRACTS WITH CUSTOMERS
The majority of the disclosures required under IFRS 15 relate to an entity’s contracts with customers. In
relation to contracts with customers, an entity must disclose disaggregated revenue from contracts with
customers, contract balances, performance obligations and the transaction price allocated to remaining
performance obligations.
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 139
Disaggregation of Revenue
Under IFRS 15, an entity must disclose revenue recognised from contracts with customers that has been
disaggregated into categories ‘that depict how the nature, amount, timing, and uncertainty of revenue
and cash flows are affected by economic factors’ (IFRS 15, para. 114). IFRS 15 provides guidance on
how entities might disaggregate revenue for financial statement users to assist users in understanding
the composition of revenue from contracts with customers that is recognised in the current period. This
guidance includes the following examples of categories:
(a)
(b)
(c)
(d)
(e)
(f)
type of good or service (for example, major product lines);
geographical region (for example, country or region);
market or type of customer (for example, government and non-government customers);
type of contract (for example, fixed-price and time-and-materials contracts);
contract duration (for example, short-term and long-term contracts);
timing of transfer of goods or services (for example, revenue from goods or services transferred to
customers at a point in time and revenue from goods or services transferred over time); and
(g) sales channels (for example, goods sold directly to consumers and goods sold through intermediaries)
(IFRS 15, para. B89).
Contract Balances
In relation to contract balances, an entity must disclose all of the following:
• ‘the opening and closing balances of receivables, contract assets and contract liabilities from contracts
with customers’
• revenue recognised in the reporting period that was included in the contract liabilities opening balance
• revenue recognised in the reporting period from performance obligations that were either completely or
partially satisfied in previous periods (IFRS 15, para. 116).
A contract liability arises when an entity has received consideration (or has an unconditional right to
receive consideration) from the customer before the entity transfers a good or service to the customer. It is
the obligation to transfer the good or service that is a contract liability.
The unconditional right to receive compensation from a customer constitutes a receivable. Further,
‘[a] right to consideration is unconditional if only the passage of time is required before payment of that
consideration is due’ (IFRS 15, para. 108). This is distinct from a contract asset, which is ‘[a]n entity’s
right to consideration in exchange for goods or services that the entity has transferred to a customer
when that right is conditioned on something other than the passage of time (for example, the entity’s
future performance)’ (IFRS 15, Appendix A). IFRS 15 makes the distinction between receivables and
contract assets to enable users to differentiate between an unconditional and conditional right to receive
consideration.
Disclosures about an entity’s contract balances help users understand the relationship between the
revenue recognised and changes in the balances of an entity’s contract assets and liabilities during a
reporting period (IFRS 15 Basis for Conclusions, para. BC341). For example, disclosing the opening
balances of contract liabilities will help users understand the amount of revenue that will be recognised
during the current period, while disclosing the opening balances of contract assets will provide them with
an understanding of the amounts that will be transferred to accounts receivable or collected as cash during
the period (IFRS 15 Basis for Conclusions, para. BC343).
Performance Obligations
In relation to performance obligations, an entity must disclose a description of all of the following:
• ‘when the entity typically satisfies its performance obligations’ (e.g. on shipment, on delivery, as services
are rendered or when they are completed)
• ‘the significant payment terms’ (e.g. when payment is due, whether the contract includes a significant
financing component, and whether the amount of consideration is variable or its estimate is constrained)
• ‘the nature of the goods or services that the entity has promised to transfer’
• ‘obligations for returns, refunds and other similar obligations’
• ‘types of warranties and related obligations’ (IFRS 15, para. 119).
Transaction Price Allocated to Remaining Performance Obligations
The final disclosure requirement related to contracts with customers requires an entity to disclose the
amount of the transaction price that is allocated to the unsatisfied performance obligations in a contract
(whether partial or complete) at the end of the reporting period. An entity must also provide an explanation
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140 Financial Reporting
of when it expects to recognise as revenue the transaction price amount allocated to the unsatisfied
performance obligations. This explanation can be either quantitative (e.g. amounts to be recognised as
revenue according to specified time bands) or qualitative (IFRS 15, para. 120).
These disclosure requirements provide users with information about the amount and timing of revenue
that an entity expects to recognise from the remaining performance obligations in its existing contracts
with customers (IFRS 15 Basis for Conclusions, para. BC350).
EXAMPLE 3.11
Disclosure of the Transaction Price Allocated to Remaining
Performance Obligations
On 30 June 20X6, an entity enters into a three-year contract with a customer to provide office maintenance
services. The services are to be provided as and when needed, capped at a maximum of two visits per
month over the next three years. The customer pays a fixed amount of $300 per month for the services. The
transaction price of the contract is $10 800. The performance obligation under the contract is satisfied
over time, and the entity uses a time-based output method in measuring progress towards complete
satisfaction of the performance obligation.
In accordance with paragraph 120 of IFRS 15, the entity is required to disclose at the end of each
reporting period the amount of the transaction price allocated to the unsatisfied performance obligation,
which is yet to be recognised as revenue. The entity chooses to explain when it expects to recognise the
amount as revenue using quantitative time bands. As such, for the reporting period ending 31 December
20X6, the following information is disclosed.
Revenue expected to be recognised on this contract
as of 31 December 20X6
20X7
$
20X8
$
20X9
$
Total
$
3 600†
3 600†
1 800‡
9 000
† $300 per month × 12 months
‡ $300 per month × 6 months
Source: Based on IFRS Foundation 2022, IFRS 15 Revenue from Contracts with Customers, IFRS Foundation, London,
pp. A784–A785.
SIGNIFICANT JUDGEMENTS IN THE APPLICATION OF IFRS 15
REVENUE FROM CONTRACTS WITH CUSTOMERS
An entity is required to disclose and explain the judgements and changes in judgements used to determine the:
• ‘timing of satisfaction of performance obligations’
• ‘transaction price and amounts allocated to performance obligations’ (IFRS 15, para. 123).
Disclosure of the estimates and judgements made by an entity in determining the transaction price,
allocating the transaction price to performance obligations, and determining when performance obligations
are satisfied allows users to assess the quality of earnings reported by the entity.
ASSETS RECOGNISED FROM CONTRACT COSTS
In relation to assets recognised from the costs to obtain or fulfil a contract with a customer, an entity must:
• provide a description of the judgements made in determining the amount of the costs, and of the
amortisation method used for each reporting period
• disclose the closing balances of the assets recognised
• disclose the amount of amortisation and any impairment losses recognised in the reporting period
(IFRS 15, paras 127 and 128).
Refer to Note 2 ‘Income’ in the notes to financial statements of Techworks Ltd. What is the
disaggregated revenue of Techworks?
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 141
SUMMARY
This part focused on accounting for revenue from contracts with customers under IFRS 15.
As a key indicator of an entity’s, and management’s, performance is the revenue it generates, it is
important for users and preparers of financial statements to have an understanding of how revenue is
to be measured and recognised in the entity’s financial statements. By introducing a five-step model of
revenue recognition capable of general application to a variety of transactions and by requiring more
detailed revenue-related disclosures, IFRS 15 enhances the financial reporting of revenue.
IFRS 15 establishes principles for reporting useful information to financial statement users about the
nature, amount, timing and uncertainty of revenue and cash flows from an entity’s contracts with customers.
These principles provide a framework of broad revenue recognition concepts that can be consistently
applied across entities and encourage providing information to users so that they can make informed
assessments of an entity’s performance relative to other entities.
The key points covered in this part, and the learning objectives they align to, are as follows.
KEY POINTS
3.1 Explain and apply the requirements of IFRS 15 with respect to contract(s) with customers.
• The core principle of IFRS 15 is that an entity should recognise 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.
• The five-step recognition model for revenue from contracts with customers is as follows.
– Step 1: Identify the contract(s) with the customer.
– Step 2: Identify the performance obligation(s) in the contract.
– Step 3: Determine the transaction price of the contract.
– Step 4: Allocate the transaction price to each performance obligation.
– Step 5: Recognise revenue when each performance obligation is satisfied.
• Assets recognised from the incremental costs of obtaining a contract or from the costs to fulfil a
contract are subject to amortisation and impairment.
• The objective of disclosure requirements under IFRS 15 is for an entity to disclose sufficient
information to enable users of financial statements to understand the nature, amount, timing and
uncertainty of revenue and cash flows arising from contracts with customers.
3.2 Determine and allocate the transaction price of a contract to the performance obligation(s) of
the contract.
• The transaction price is the amount of consideration an entity expects to be entitled to in exchange
for transferring promised goods or services to a customer.
• The transaction price excludes amounts collected on behalf of third parties, such as the Goods
and Services Tax in Australia.
• The transaction price may be affected by the nature, timing and amount of consideration promised
by a customer. The following can affect the transaction price: variable consideration, the existence
of a significant financing component in the contract, non-cash consideration, and the consideration
that is payable to a customer.
• There are three methods suitable for estimating the stand-alone selling price: adjusted market
assessment approach; expected cost plus a margin approach; and residual approach.
• Output methods and input methods are the two types of methods of measuring progress on
performance obligations that are satisfied over a period of time.
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142 Financial Reporting
PART B: PROVISIONS
INTRODUCTION
Part B reviews issues relating to the recognition, measurement and disclosure of provisions, including the
requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets. IAS 37 outlines specific
existence, recognition and measurement criteria to be applied to provisions; it also requires extensive
disclosures. The recognition of provisions, and the disclosure of information about their nature and the
timing, amount and likelihood of any resulting outflows, provides financial statement users with a greater
understanding of an entity’s existing obligations. However, opportunities exist for managers to exploit the
uncertainty and subjectivity of provisions when recognising and measuring them, in order to manipulate
reported accounting numbers.
This part begins with the definition of a provision, followed by a discussion on key aspects of
the recognition of provisions. Measurement issues are then discussed, including how to deal with risks
and uncertainties, as well as the use of probability in measurement. Part B concludes with a discussion on
disclosure requirements relating to provisions.
Relevant Paragraphs
To assist in understanding of certain sections in this part, you may be referred to relevant paragraphs in
IAS 37. You may wish to read these paragraphs as directed.
IAS 37 Provisions, Contingent Liabilities and Contingent Assets:
Subject
Paragraphs
Scope
Definitions
Recognition
Measurement
Disclosure
1–9
10–13
14–35
36–52
84–92
SCOPE OF IAS 37 PROVISIONS, CONTINGENT LIABILITIES
AND CONTINGENT ASSETS
IAS 37 applies to all provisions (and to contingent liabilities and contingent assets discussed in part C)
other than those that:
• result from executory contracts, except for onerous contracts
• are covered by another standard (IAS 37, para. 1).
Executory contracts are ‘contracts under which neither party has performed any of its obligations or
both parties have partially performed their obligations to an equal extent’ (IAS 37, para. 3).
Importantly, IAS 37 ‘does not apply to financial instruments (including guarantees) that are within the
scope of IFRS 9 Financial Instruments’ (IAS 37, para. 2). Financial instruments are covered in module 6.
Other provisions, contingent liabilities and contingent assets that are covered by other standards are:
• income taxes (IAS 12 Income Taxes)
• leases (IFRS 16 Leases), except any lease that becomes onerous before its commencement date,
or short-term leases and leases where the underlying asset is of low value and that the lease has
become onerous
• employee benefits (IAS 19 Employee Benefits)
• insurance contracts within the scope of IFRS 17 Insurance Contracts. For example, product warranties
issued by another party for goods sold by a manufacturer, dealer or retailer (IFRS 17, para. B26(g))
• contingent consideration of an acquirer in a business combination (IFRS 3 Business Combinations)
• revenue from contracts with customers (IFRS 15 Revenue from Contracts with Customers) (IAS 37,
para. 5).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 1–9 of IAS 37.
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 143
DEFINITION OF PROVISIONS
Provisions are a subset of liabilities; therefore, to properly understand provisions, it is helpful to revisit
the definition of a liability. The IASB Conceptual Framework for Financial Reporting (Conceptual
Framework) defines a liability as:
. . . a present obligation of the entity to transfer an economic resource as a result of past events (Conceptual
Framework, para. 4.26).
A provision is defined in IAS 37 as a ‘liability of uncertain timing or amount’ (IAS 37, para. 10). A key
aspect of this definition is the requirement that uncertainty exists. However, not all uncertainties give rise
to a provision. An estimate of timing or amount does not automatically result in uncertainty.
When there is a significant level of certainty (i.e. an insignificant level of uncertainty), the amount is
not recognised as a provision but as a liability. Examples of these types of liabilities are borrowings, trade
creditors and accruals.
In cases where the degree of uncertainty in relation to the timing or amount of the liability cannot be
measured with sufficient reliability, the amount is classified as a contingent liability (discussed in part C
of this module).
QUESTION 3.5
With reference to the scope of IAS 37 and the definition of a provision, identify which of the following
is likely to be a provision within the scope of IAS 37, and which is likely to be another form of liability
and explain why.
• An obligation to repair or replace goods sold if they are determined to be faulty
• A warranty provided for a television sold by a retailer
• Annual leave
3.4 RECOGNITION OF PROVISIONS
IAS 37 requires the following conditions to be met for a provision to be recognised:
(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required to settle the
obligation; and
(c) a reliable estimate can be made of the amount of the obligation (IAS 37, para. 14).
Present Obligation and Past Event
The first recognition criterion in paragraph 14 of IAS 37 requires the entity to have a present obligation
‘as a result of a past event’. The importance of this recognition criterion was outlined by the G4+1 Group
of accounting standard setters:
If the trigger point for recognition is set too early, the result would be to recognise a liability and an expense
where none exist, thus reducing the relevance and reliability of the financial statements. A provision could
be recognised for expenditures that, in the event, are never made. The effect would be to misstate both the
entity’s financial position (by recording a liability that does not actually exist) and its financial performance
(by recognising an expense in one accounting period and income in another in relation to amounts that are
never actually paid or received).
Conversely, it would be incorrect not to provide for expenditures that are clearly unavoidable, result
from past events, and are measurable with a high degree of reliability simply on the grounds that the
outflow of cash or other resources will not occur until a future date. Failure to recognise a provision in
such circumstances would result in the financial statements not portraying faithfully either the expenses
incurred in the accounting period or the liabilities of the entity at the statement of financial position date.
Source: Lennard, A. & Thompson, S. 1995, Provisions: Their Recognition, Measurement and Disclosure in Financial Statements,
Financial Accounting Standards Board, Norwalk, paras 2.1.5–6. © Financial Accounting Foundation, 401 Merritt 7, Norwalk,
CT 06856, USA. Reproduced with permission.
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144 Financial Reporting
The standard setters believed that it will normally be clear whether a past event has given rise to a present
obligation that should be recognised in the statement of financial position. However, in rare cases it may
not be clear whether a present obligation exists. In such cases, IAS 37 provides the following guidance:
[A] past event is deemed to give rise to a present obligation if, taking account of all available evidence, it
is more likely than not that a present obligation exists at the end of the reporting period (IAS 37, para. 15).
Such evidence is not limited only to what is available at the reporting date; it specifically includes
information from events that may occur between the end of the reporting period and the time of completion
of the financial report.
The Conceptual Framework notes that an obligation ‘is a duty or responsibility that an entity has no
practical ability to avoid’ (Conceptual Framework, para. 4.29). Obligations may be legally enforceable as
a consequence of a binding contract or statutory requirement (Conceptual Framework, para. 4.31). The
obligation must involve another party to whom the obligation is owed — that is, a third party. For a present
obligation to exist, the entity must have no realistic alternative to settling the obligation created by the
event (IAS 37, para. 17).
The most common form of present obligation is a legal obligation, in which an external party has a
present legal right to force the entity to pay or perform. However, it may also be a constructive obligation
to the extent that there is a valid expectation in other parties that the entity will discharge the obligation.
Consistent with the Conceptual Framework definition of a liability, a constructive obligation is defined in
IAS 37 as:
. . . an obligation that derives from an entity’s actions where:
(a) by an established pattern of past practice, published policies or a sufficiently specific current statement,
the entity has indicated to other parties that it will accept certain responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of those other parties that it will
discharge those responsibilities (IAS 37, para. 10).
By including constructive obligations as a form of present obligation, the Conceptual Framework
extends the definition of liabilities beyond the issue of legal enforceability (Conceptual Framework,
para. 4.31). The definition includes liabilities arising from normal business practice or custom, a desire to
maintain good business relations or a desire to act in an equitable manner (e.g. habitually providing staff
with bonus payments or performing environmental remediation to a standard higher than that required by
law), but not from a contractual agreement with another entity.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 15–22 of IAS 37, as well as the implementation
guidance — ‘Guidance on Implementing IAS 37’, ‘C. Examples: recognition’, ‘Example 2B. Contaminated land and
constructive obligation’ — in the IFRS Compilation Handbook.
Probable Outflow of Economic Benefits
The second criterion in paragraph 14 of IAS 37 for the recognition of provisions is that ‘it is probable that
an outflow of resources embodying economic benefits will be required to settle the obligation’. This occurs
when the outflow of resources or another event is more likely than not to occur. That is, ‘the probability
that the event will occur is greater than the probability that it will not’ (IAS 37, para. 23). Where there
are a number of similar obligations, such as warranty obligations arising from product sales, the class of
obligations is considered as a whole in determining whether an outflow of resources is probable (IAS 37,
para. 24).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 23 and 24 of IAS 37.
Reliable Measurement
The third recognition criterion in paragraph 14 of IAS 37 is that ‘a reliable estimate can be made
of the amount of the obligation’. IAS 37 notes that:
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. . . except in extremely rare cases, an entity will be able to determine a range of possible outcomes and can
therefore make an estimate of the obligation that is sufficiently reliable to use in recognising a provision
(IAS 37, para. 25).
MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 145
Consequently, a provision is considered to be capable of being reliably measured even if a number of
possible outcomes exist.
The use of reasonable estimates is an essential part of the preparation of financial statements and does
not undermine the usefulness of the statements (Conceptual Framework, para. 5.19).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 25 and 26 of IAS 37.
QUESTION 3.6
A manufacturer gives warranties at the time of sale to purchasers of its product. Under the
terms of the contract for sale, the manufacturer undertakes to remedy, by repair or replacement,
manufacturing defects that become apparent within three years from the date of sale. As this is the
first year that the warranty has been available, there is no data from the entity to indicate whether
there will be claims under the warranties. However, industry research suggests that it is likely such
claims will be forthcoming.
Should the manufacturer recognise a provision in accordance with the requirements of IAS 37?
Why or why not?
3.5 MEASUREMENT OF PROVISIONS
One of the more difficult aspects of accounting for provisions is determining the amount to be recognised
in the financial statements given the inherent uncertainty surrounding provisions.
As the actual amount of sacrifice of economic resources is often not known with certainty (by definition),
estimates of the provisions are required to be made.
IAS 37 requires that:
. . . the amount recognised as a provision shall be the best estimate of the expenditure required to settle the
present obligation at the end of the reporting period (IAS 37, para. 36).
The best estimate is the amount that an entity would rationally pay either to settle the obligation at
that date or to transfer it to a third party at that time. The estimation requirements differ depending on
whether the provision involves a large population of items or a single obligation, and are outlined in IAS 37
as follows.
• ‘Where the provision being measured involves a large population of items, the obligation is estimated by
weighting all possible outcomes by their associated probabilities. The name for this statistical method
of estimation is “expected value”’ (IAS 37, para. 39).
• ‘Where a single obligation is being measured, the individual most likely outcome may be the best
estimate of the liability’ (IAS 37, para. 40).
With regard to determining best estimates, IAS 37 suggests that the most appropriate estimate of the
provision is determined by using:
. . . the judgement of the management of the entity, supplemented by experience of similar transactions and,
in some cases, reports from independent experts. The evidence considered includes any additional evidence
provided by events after the reporting period (IAS 37, para. 38).
IAS 37 states that ‘where there is a continuous range of possible outcomes, and each point in that range
is as likely as any other, the mid-point of the range is used’ (IAS 37, para. 39).
These criteria are consistent with the enhancing qualitative characteristic of verifiability. As noted in
paragraph 2.30 of the Conceptual Framework, ‘quantified information need not be a single point estimate
to be verifiable. A range of possible amounts and the related probabilities can also be verified’.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 36–40 of IAS 37.
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146 Financial Reporting
EXAMPLE 3.12
Calculation of Best Estimate
Part A: Large Population of Items
An entity faces 100 warranty claims relating to a faulty widget. The entity’s management has determined
there is 30 per cent likelihood that each of these claims is unsubstantiated and will not cost the entity
anything. There is 70 per cent likelihood that the cost of each claim will be $100.
According to the expected value method, the best estimate of the provision can be calculated as
100 × (30% × $0 + 70% × $100) = $7000.
Part B: Single Obligation
Now assume that the same entity is facing a single warranty claim with the same probabilities as in
part A. In such circumstances, IAS 37 requires the individual most likely outcome be used to calculate the
amount of the provision. In this example, the most likely outcome is that $100 will be paid to settle the
warranty claim. As such, the cost of $100 is the most likely outcome because it has a 70 per cent chance
of occurring, whereas there is a 30 per cent chance of no payout being required.
Therefore, $100 would be the amount required to be recognised in accordance with IAS 37.
DISCOUNTING
Example 3.12 ignored the effect of discounting. However, IAS 37 requires that:
. . . where the effect of the time value of money is material, the amount of a provision shall be the present
value of the expenditures expected to be required to settle the obligation (IAS 37, para. 45).
Consequently, provisions are discounted when the effect of this discounting is material. The discount
rate should be a pre-tax rate that reflects ‘current market assessments of the time value of money and the
risks specific to the liability. The discount rate(s) shall not reflect risks for which the future cash flow
estimates have been adjusted’ (IAS 37, para. 47).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 45–47 of IAS 37.
IAS 37 also notes that risks and uncertainties should be taken into account in reaching the best estimate
of a provision. It cautions, however, that ‘uncertainty does not justify the creation of excessive provisions
or a deliberate overstatement of liabilities’ (IAS 37, para. 43).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 42–44 of IAS 37.
It should be noted that when the sacrifice of economic resources depends on the use of technology
(e.g. for cleaning up a site in the future), the estimated amount should be based on the existing technology
(IAS 37, para. 49). Even if the technology is normally expected to improve over time and new technologies
will likely decrease the costs necessary to perform a specific action required, IAS 37 does not allow
entities to estimate the amount recognised for provisions based on expected costs to be incurred with
technologies that do not exist at the time the estimation is made.
QUESTION 3.7
Refer to the background material in question 3.6.
The entity has now been operating its warranty for five years, and reliable data exists to suggest
the following.
• If minor defects occur in all products sold, repair costs of $2 million would result.
• If major defects are detected in all products, costs of $5 million would result.
• The manufacturer’s past experience and future expectations indicate that each year 80 per cent
of the goods sold will have no defects, 15 per cent of the goods sold will have minor defects, and
5 per cent of the goods sold will have major defects.
Calculate the expected value of the cost of repairs in accordance with the requirements of IAS 37.
Ignore both income tax and the effect of discounting.
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 147
3.6 IAS 37 PROVISIONS, CONTINGENT LIABILITIES
AND CONTINGENT ASSETS: DISCLOSURE
PROVISIONS
IAS 37 includes a number of disclosure requirements relating to provisions, which assist financial
statement users to understand the reasons, uncertainty and subjectivity behind the recognised end-ofperiod carrying amount. As discussed in greater detail shortly, subjectivity in recognising and measuring
provisions makes them a potential tool for entities to manage their earnings, where earnings management
is the manipulation of revenue and expense to smooth out profit fluctuations or to achieve a predetermined
(and often an overstated) profit result. The disclosure requirements of IAS 37 aim to reduce the ability of
entities to use provisions as a means of earnings management. The key disclosures required by IAS 37
relating to provisions are outlined as follows.
For each class of provision, an entity shall disclose:
(a) the carrying amount at the beginning and end of the period;
(b) additional provisions made in the period, including increases to existing provisions;
(c) amounts used (i.e. incurred and charged against the provision) during the period;
(d) unused amounts reversed during the period; and
(e) the increase during the period in the discounted amount arising from the passage of time and the effect
of any change in the discount rate.
Comparative information is not required.
An entity shall disclose the following for each class of provision:
(a) a brief description of the nature of the obligation and the expected timing of any resulting outflows of
economic benefits;
(b) an indication of the uncertainties about the amount or timing of those outflows. Where necessary to
provide adequate information, an entity shall disclose the major assumptions made concerning future
events, as addressed in paragraph 48; and
(c) the amount of any expected reimbursement, stating the amount of any asset that has been recognised
for that expected reimbursement (IAS 37, paras 84 and 85).
Question 3.8 requires a review of the provisions disclosures included in the notes of an entity’s financial
statements.
QUESTION 3.8
Review Note 14 ‘Provisions’ of the Spring Valley Ltd’s financial statements. Focusing on the
Provision for warranties class of provisions, highlight how Spring Valley Ltd has complied with
the requirements of paragraph 85 of IAS 37 in this disclosure.
14. Provisions
Current
Provision for warranties
Provision for legal claim
Provision for restructuring
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148 Financial Reporting
20X2
$’000
20X1
$’000
670
2 500
564
3 734
492
0
0
492
Provision for
warranties
$’000
Gross carrying amount
Balance at 1 July 20X1
Charged/(credited) to profit or loss:
• Additional provisions recognised
• Unwinding of discount
Amounts used during the year
Balance at 30 June 20X2
Gross carrying amount
Balance at 1 July 20X0
Charged/(credited) to profit or loss:
• Additional provisions recognised
• Unwinding of discount
Amounts used during the year
Balance at 30 June 20X1
Provision for
legal claim
$’000
Provision for
restructuring
$’000
Total
provisions
$’000
492
0
0
492
385
23
(230)
670
2 500
564
0
2 500
0
564
436
0
0
436
405
21
(370)
492
0
0
0
0
0
0
0
0
405
21
(370)
492
3 449
23
(230)
3 734
Spring Valley Ltd — Notes to the financial statements for the year ended 30 June 20X2
Provision for warranties
Provision is made for estimated warranty claims in respect of products sold which are still under
warranty at the end of the reporting period.
These claims are expected to be settled in the next financial year.
Management estimates the provision based on historical warranty claim information and any
recent trends that may suggest future claims could differ from historical amounts.
Provision for legal claim
A provision for legal claim has been recognised for damages payable to a customer of the
production division, following an unfavourable judgment handed down against the group by
the New South Wales Supreme Court in May 20X2.
Provision for restructuring
The reduced demand for products and services in regional and remote areas required a reassessment of the size and geographic distribution of staff and facilities, resulting in a loss of jobs. The provision for restructuring includes costs associated with the voluntary redundancy compensation
package of $564 367 and other direct costs associated with closure of premises. The provision
remaining on the statement of financial position at balance date is expected to be fully utilised
before 30 June 20X3.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 84 and 85 of IAS 37.
QUESTION 3.9
Consider the following quote.
At present, banks create provisions to meet the costs of . . . restructuring. When analysts
analyse these, they classify them as significant items so that they appear below the operating
profit line; this ensures the cost of these provisions disappears from their calculations of the
operating profit. By over-provisioning with below-the-line significant items in a good year, the
company can use the over-provisions during a bad year when there are additional write-offs.
The write-offs do not appear in the operating profit (Washington 2002, p. 74).
Explain how the disclosure requirements contained in IAS 37 reduce the ability of entities
to engage in earnings management through the increase and then subsequent write-back
of provisions.
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 149
EXEMPTIONS
Although the disclosure requirements of IAS 37 are more extensive than many entities would like, the
standard does provide some relief from compliance with the requirements. This relief includes when:
. . . disclosure of some or all of the information required . . . can be expected to prejudice seriously the
position of the entity in a dispute with other parties on the subject matter of the provision, contingent
liability or contingent asset (IAS 37, para. 92).
IAS 37 notes that this exemption would occur only in extremely rare cases and, therefore, cannot be
used to circumvent the disclosure requirements. Also, even when the exemption is applicable, the general
nature of the dispute, together with the fact and reason why that information has not been disclosed, must
be stated.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraph 92 of IAS 37.
3.7 PROVISIONS AND PROFESSIONAL JUDGEMENT
An entity’s accountant is required to exercise professional judgement in determining whether an obligation
constitutes a provision. If it is a provision, professional judgement is also required in measuring the
provision. As mentioned in module 1, professional judgement is likely to be easier to exercise in the future
as technological advancements ensure that the accountants have the necessary information to make proper
judgements. Nevertheless, the need for professional judgement introduces discretion and subjectivity into
financial reporting, which creates potential pressures from management for the accountant to manipulate
reported accounting numbers, including engaging in earnings management.
For example, a distinguishing feature between provisions and other types of liabilities, such as trade
payables, is the degree of uncertainty in the timing or amount of the obligation. Recall that it is when the
level of uncertainty is significant that the obligation is recognised as a provision. When deciding on the
degree of uncertainty, an accountant is required to exercise professional judgement.
Professional judgement is also required in the measurement of provisions. Recall that IAS 37 states
that the best estimate is to be used to measure provisions. The best estimate includes the use of either the
‘expected-value’ method or the ‘most likely outcome’ method. The inputs used to derive the best estimate
under either method, namely the likelihood of an outcome or outcomes occurring, are often subject to the
discretion of an entity’s management. Management may exploit this discretion to understate provisions,
and thereby reduce the entity’s total liabilities. An accountant must exercise professional judgement in
ensuring that these inputs can be verified.
EXAMPLE 3.13
Discretion in the Calculation of Best Estimate
Continuing on from example 3.12, now assume that management has revised its estimates so that there
is 45 per cent likelihood that each of the warranty claims is unsubstantiated and 55 per cent likelihood
that the cost of each claim will be $100.
According to the expected-value method, the best estimate of the provision is now $5500 (100 × (55%
× $100 + 45% × $0) = $5500), which is $1500 lower compared with the original estimate in example 3.12.
The use of professional judgement in recognising and measuring provisions not only enables manipulation of reported liabilities in the statement of financial position, but also creates opportunities for earnings
management. This is because the understatement of provisions also results in an understatement of
the corresponding expense, and in so doing, overstates reported profit for the current period. Using
example 3.13 to illustrate this, both the warranty provision and warranty expense would be $1500 lower
compared with their original amounts in example 3.12 due to management’s revised estimates. Exercising
discretion in the recognition and measurement of provisions, therefore, simultaneously affects an entity’s
reported financial position and its profit. Nevertheless, technological advancements that involve the use of
artificial intelligence (AI), machine learning and deep learning, coupled with vast amounts of data that will
be available to users to perform AI-assisted data analytics, will probably limit the opportunities for earnings
management as the users will automatically detect any potential misstatements or manipulations.
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150 Financial Reporting
SUMMARY
This part focused on accounting for provisions under IAS 37.
IAS 37 outlines specific criteria to be applied to provisions in their recognition and measurement
and requires extensive disclosures. The recognition of provisions provides financial statement users with
an understanding of the entity’s existing obligations. The disclosure of information about the nature of
provisions and the timing, amount and likelihood of any resulting outflows assists users to understand
the reasons, uncertainty and subjectivity behind the recognised end-of-period carrying amount. It is the
presence of this uncertainty and subjectivity that enables managers to manipulate reported accounting
numbers. The discretion exercised in measuring provisions creates opportunities for managers to understate
provisions in the statement of financial position and the corresponding expense, thereby, overstating
reported profit. While the measurement of provisions is subject to an entity’s accountant verifying that
management’s estimates are neutral and free of error, financial statement users should be mindful of
subjectivity in the measurement of provisions.
The key points covered in this part, and the learning objective they align to, are as follows.
KEY POINTS
3.3 Understand, and be able to apply, IAS 37 as it relates to a provision, contingent liability and
contingent asset, and recognise how they relate to the Conceptual Framework.
• The level of uncertainty in the timing or amount determines whether a ‘provision’ or a ‘liability’ is
recognised.
• A provision is recognised when an entity has a present obligation as a result of a past event, it is
probable that an outflow of economic benefits will be required to settle the obligation, and a reliable
estimate can be made of the amount of the obligation.
• The amount to be recognised as a provision shall be the best estimate of the expenditure required
to settle the present obligation at the end of the reporting period.
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets outlines specific disclosure requirements for each class of provision.
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 151
PART C: CONTINGENT LIABILITIES AND
CONTINGENT ASSETS
INTRODUCTION
Part C reviews the requirements of IAS 37 in relation to contingent liabilities and contingent assets. The
objective of the standard is to assist users in assessing the nature and amount of contingent assets and
contingent liabilities, as well as the uncertainties that are expected to affect their outcomes. The standard’s
ultimate aim is to ensure consistent reporting practices, even though recognition of contingent liabilities
and contingent assets is prohibited in the financial statements and note disclosure is generally required.
Relevant Paragraphs
To assist in understanding of certain sections in this part, you may be referred to relevant paragraphs in
IAS 37. You may wish to read these paragraphs as directed.
IAS 37 Provisions, Contingent Liabilities and Contingent Assets:
Subject
Scope
Definitions
Recognition
Disclosure
Paragraphs
1–9
10–13
16–35
86–92
3.8 CONTINGENT ASSETS
The definition of contingent assets in IAS 37 is based on the definition of assets provided in the
Conceptual Framework. However, the definition overcomes some of the difficulties associated with the
recognition criteria.
A contingent asset is defined in IAS 37 as:
. . . a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity
(IAS 37, para. 10).
An example of a contingent asset provided by IAS 37 is ‘a claim that an entity is pursuing through legal
processes, where the outcome is uncertain’ (IAS 37, para. 32). Another example is a buyer entitled to a
full cash refund for faulty products purchased, who has made a refund claim during the warranty period,
but the supplier is disputing the claim, and the dispute is being decided by an independent arbiter. Until
the dispute has been settled, the buyer has a contingent asset.
Contingent assets are not recognised in the statement of financial position, unless the inflow of benefits
is virtually certain. Nevertheless, they are disclosed in the notes to the financial statements.
A possible asset is identified and disclosed in accordance with IAS 37. It is a contingent asset if, after
all the available evidence has been considered, the existence of an asset is still unclear and will not be
clarified until an uncertain future event that is not wholly within the control of the entity occurs or fails to
occur. In relation to the second part of the definition — dealing with probability — IAS 37 only requires
disclosure when the inflow of economic benefits is probable.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 31–35 of IAS 37.
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Table 3.1 summarises the key requirements of IAS 37 in relation to contingent assets.
TABLE 3.1
Application of probability criteria to contingent assets
Probability of inflow of
economic benefits
Accounting treatment in accordance with IAS 37 Provisions, Contingent
Liabilities and Contingent Assets
Virtually certain
It is appropriate to recognise the asset where the realisation of income is virtually
certain as the asset is not a contingent asset (IAS 37, para. 33).
Probable but not
virtually certain
If there is a possible asset for which future benefits are probable, but not virtually
certain, no asset is recognised (IAS 37, para. 31), but a contingent asset is
disclosed (IAS 37, para. 89).
Not probable
If there is a possible asset for which the probability that future benefits will
eventuate is not probable, no asset is recognised (IAS 37, para. 31) and no
disclosure is required for the contingent asset (IAS 37, para. 89).
Source: Adapted from IFRS Foundation 2022, IAS 37 Provisions, Contingent Liabilities and Contingent Assets, IFRS Foundation,
London, pp. A1484–A1485.
.......................................................................................................................................................................................
EXPLORE FURTHER
The section titled ‘A. Tables — Provisions, contingent liabilities, contingent assets and reimbursements’ under
’Guidance on Implementing IAS 37’ in the IFRS Compilation Handbook provides a useful summary of these
requirements.
If you wish to explore this topic further, you should read this section of ‘Guidance on Implementing IAS 37’ (focusing
on the contingent assets portion) in the IFRS Compilation Handbook.
QUESTION 3.10
Identify two further examples of contingent assets. For each example, explain why the item would
be a contingent asset rather than be recognised as an asset. Do you believe that the reporting
of contingent assets affects the decisions of equity investors or other finance providers? Why or
why not?
IAS 37 requires disclosure of the nature of the contingent assets at the end of the reporting period and,
where practicable, an estimate of their financial effect. Estimates of contingent assets are measured using
the principles set out for the measurement of provisions in paragraphs 36–52 of IAS 37 (IAS 37, para. 89).
3.9 CONTINGENT LIABILITIES
IAS 37 adopts a broad concept of contingent liabilities. Contingent liabilities are defined as:
(a) a possible obligation that arises from past events and whose existence will be confirmed only by the
occurrence or non-occurrence of one or more uncertain future events not wholly within the control of
the entity; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be required to
settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability (IAS 37, para. 10).
IAS 37 explains that only those contingent liabilities described under (a) in the definition provided in
paragraph 10 of the standard are entirely contingent in nature. However, the standard setters have adopted
the view that it is useful to treat present obligations that may not result in a probable outflow of resources
or for which an amount cannot be measured reliably as contingent liabilities.
Contingent liabilities, like contingent assets, are not recognised in the statement of financial position.
IAS 37 requires the disclosure of contingent liabilities unless the possibility of an outflow of resources is
remote (IAS 37, para. 28).
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 153
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 12–13 and 27–30 of IAS 37 and the section titled
‘A. Tables — Provisions, contingent liabilities, contingent assets and reimbursements’ (focusing on the provisions and
contingent liabilities portion) under ‘Guidance on Implementing IAS 37’ in the IFRS Compilation Handbook.
Table 3.2 summarises the key requirements of IAS 37 in relation to provisions and contingent liabilities.
TABLE 3.2
Application of probability criteria to provisions and contingent liabilities
Obligation and probability of outflow
of economic benefits
Accounting treatment in accordance with IAS 37
Provisions, Contingent Liabilities and Contingent Assets
Present obligation that probably requires an
outflow of resources
A provision is recognised (IAS 37, para. 14). Disclosures are
required for the provision (IAS 37, para. 84–85)
Possible obligation or present obligation that
may, but probably will not, require an outflow
of resources
No provision is recognised (IAS 37, para. 27). Disclosed as a
contingent liability (IAS 37, para. 86)
Possible obligation or present obligation where
the likelihood of outflow of resources is remote
No provision is recognised (IAS 37, para. 27). No disclosure is
required (IAS 37, para. 86)
Extremely rare case where there is a liability,
but it cannot be measured reliably
No provision is recognised (IAS 37, para. 27). Disclosed as a
contingent liability (IAS 37, para. 86)
Source: Adapted from IFRS Foundation 2022, IAS 37 Provisions, Contingent Liabilities and Contingent Assets, IFRS Foundation,
London, pp. A1479–A1484.
Remember from the definition in paragraph 10 of IAS 37, a contingent liability will exist in the
event of:
1. a possible obligation to be confirmed by uncertain future events
2. a present obligation where the future sacrifice of economic benefits is not probable, or
3. a present obligation with a probable future sacrifice of economic benefits that is not reliably measurable.
It is only when the probability of future sacrifice is higher than remote that the contingent liability will
be disclosed in a note to the financial statements. In the context of event (3), this is satisfied as the future
sacrifice is probable. For events (1) and (2), however, an assessment must be made as to the degree to
which the future sacrifice is unlikely. If it is remote, then no disclosure is required.
A provision, however, exists in the event of a present obligation with a probable future sacrifice of
economic benefits, where a reliable estimate of the amount of the obligation can be made. A provision
is clearly distinct from event (1), which relates to a possible obligation, and event (2), where the future
sacrifice is not probable. As such, a provision most closely resembles event (3). The distinction, however,
is whether the estimate is sufficiently reliable to warrant recognition. If the answer is ‘yes’, it is a provision.
If the answer is ‘no’, as per event (3), it is disclosed as a contingent liability.
EXAMPLE 3.14
Determining When to Disclose a Contingent Liability
Legal proceedings are commenced seeking damages from an entity due to food poisoning, possibly
caused by products sold by the entity. The entity disputes liability, and the entity’s lawyers initially advise
that it is probable that the entity will not be found liable. At this point in time, a possible obligation (as per
contingent liability event (1)) exists that will be disclosed as a contingent liability unless the probability of
future sacrifice is remote.
If, however, owing to developments in the case it becomes probable that the entity will be found liable,
but the amount of damages to be awarded cannot be measured with sufficient reliability, a contingent
liability still exists (as per event (3)). Disclosure will be required as the future sacrifice is probable and,
thus, cannot be considered remote.
To extend this example, if a reliable estimate could be made of the damages to be awarded, the present
obligation would no longer be a contingent liability under event (3), but rather would be recognised as
a provision.
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154 Financial Reporting
‘Guidance on Implementing IAS 37’ in the IFRS Compilation Handbook provides a decision tree that
clearly differentiates between the requirements for the recognition of an item as a provision, disclosure of
the item as a contingent liability or non-disclosure of the item.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read ‘Guidance on Implementing IAS 37’ in the IFRS
Compilation Handbook.
LIABILITIES VERSUS CONTINGENT LIABILITIES
When it is determined whether a liability or a contingent liability exists, it will normally be clear whether
a past event has given rise to a present obligation. In rare cases where there is uncertainty, the entity must
consider all available evidence, including, where necessary, the opinions of experts. This will also include
information from events occurring between the end of the reporting period and the time the financial
statements are completed. Where the existence of a present obligation is still unclear — and this will only
be confirmed by the occurrence or non-occurrence of some future event outside the control of the entity —
a possible obligation is identified and treated as a contingent liability.
For a past event to give rise to an obligation, the Conceptual Framework requires the entity to have no
practical ability to avoid the obligation. This is normally the case where the settlement of the obligation
is legally enforceable as a consequence of a binding contract or statutory requirement. An obligation may
also arise as a result of custom, a desire to maintain good business relations or a desire to act in an equitable
manner. These obligations arise where valid expectations that the entity will discharge the obligation are
created in other parties.
3.10 CONTINGENCIES AND PROFESSIONAL
JUDGEMENT
An accountant must exercise professional judgement in determining whether an item should be recognised
as a financial statement element or whether it constitutes a contingency. For example, an accountant must
assess whether, after all available evidence has been considered, it is clear that an asset exists. If it is
clear, the asset must be recognised in the statement of financial position in accordance with IFRSs/IASs
and the Conceptual Framework. However, if the existence of the asset is uncertain, the accountant must
then exercise professional judgement in determining whether the inflow of economic benefits is probable,
which then requires disclosure of the contingent asset.
Similarly, professional judgement is required by an accountant in concluding whether a liability or
contingent liability exists, and if it is a contingent liability, whether the liability is to be disclosed. An
accountant must decide whether an obligation is a possible or present obligation. If it is a possible
obligation, a contingent liability exists and must be disclosed. If it is a present obligation, the accountant
must determine whether an outflow of resources is probable and whether the amount of the obligation is
reliably measurable. When an outflow is probable and the amount is reliably measurable, a liability must
be recognised. However, when an outflow is not probable or the amount cannot be measured reliably,
the obligation is a contingent liability that must be disclosed provided the likelihood of future sacrifice
is higher than remote. When deciding on the nature of the obligation, the probability of an outflow
occurring and whether the amount of an obligation is reliably measurable, an accountant is required to
exercise professional judgement. The consequence of exercising this judgement is whether the obligation
is recognised, disclosed or not reported.
When a contingency is required to be disclosed, an accountant must also exercise discretion in deciding
the extent to which potentially sensitive information is made public. For example, an entity subject to
a strong legal claim that has been brought against it, where the outcome is uncertain, has a contingent
liability. In applying the disclosure requirements of paragraph 86 of IAS 37, the entity must disclose a
brief description of the legal claim and, where practicable, best estimate of the amount required to settle
the claim, an indication of any uncertainties surrounding the amount or timing of the settlement, and the
possibility of reimbursement through insurance. An entity, however, will be reluctant to give extensive
details about the legal claim for fear of prejudicing the outcome or jeopardising settlement negotiations.
Moreover, while an entity has commercial reasons for disclosing confidence in their ability to defend
the claim, this may be misleading to financial statement users. An accountant must, therefore, exercise
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 155
professional judgement in ensuring IAS 37 disclosure requirements are met, but not at the cost of releasing
sensitive information that would prove harmful to the entity.
SUMMARY
This part reviewed the requirements of IAS 37 in relation to contingent liabilities and contingent assets.
The objective of IAS 37 is to assist users in assessing the nature and amount of contingent assets
and contingent liabilities of an entity. Through the disclosure of information on contingent assets and
contingent liabilities, financial statement users are made aware of assets and liabilities that, while not
recognised in the entity’s financial statements, may affect an entity’s financial position in the future, and,
in so doing, enable users to make more informed decisions.
The key points covered in this part, and the learning objective they align to, are as follows.
KEY POINTS
3.3 Understand, and be able to apply, IAS 37 as it relates to a provision, contingent liability and
contingent asset, and recognise how they relate to the Conceptual Framework.
• Contingent assets and contingent liabilities are not recognised in the statement of financial position
but are disclosed in the notes to the financial statements, except for some contingent liabilities in
a business combination and contingent assets which are considered to be virtually certain.
• The probability criteria to be applied to contingent assets considers the probability of an inflow of
economic benefits to the entity. There are three levels of probability: virtually certain; probable but
not virtually certain; and not probable.
• The probability criteria to be applied to contingent liabilities considers the type of obligation and the
probability of an outflow of economic benefits from the entity. There are four levels of probability:
– present obligation that probably requires an outflow of resources
– possible obligation or present obligation that may, but probably will not, require an outflow
of resources
– possible obligation or present obligation where the likelihood of outflow of resources is remote
– extremely rare case where there is a liability, but it cannot be measured reliably.
REVIEW
This module examined the requirements of both IFRS 15, in relation to the recognition of revenue from
customers, and IAS 37, in relation to accounting for provisions, contingent liabilities and contingent assets.
In part A, the five-step model for revenue recognition was discussed, beginning with a discussion on
identifying whether a contract with a customer exists. Given the presence of such a contract, part A then
explored identifying the performance obligation(s) within the contract and quantifying the transaction price
of the contract. How to allocate the transaction price to each performance obligation was then considered,
followed by when to recognise revenue under the contract. Finally, the accounting treatment of contract
costs and the disclosure requirements of IFRS 15 were reviewed — the aim of the disclosures under
IFRS 15 being to provide financial statement users with an understanding of the revenue practices of
the entity.
In part B, provisions were discussed and identified as a subset of liabilities. The definition and
recognition criteria for liabilities were reviewed as a basis for understanding the requirements for the
recognition of provisions. The disclosures relating to provisions were described, as well as how they assist
users in understanding the reasons behind, and the uncertainty of, the recognised amount.
Contingent liabilities and contingent assets were covered in part C. The relationship between assets
and contingent assets was explored, and a summary of the requirements for the disclosure of contingent
assets was provided. Contingent assets are not recognised in the statement of financial position (unless
they are considered virtually certain) but are disclosed in the notes if the inflow of future economic
benefits is probable. Contingent liabilities were also discussed. IAS 37 prohibits the recognition of
contingent liabilities in the statement of financial position, but they should be disclosed in the notes
unless the probability of any outflow in settlement is remote. These disclosures provide users with a better
understanding of the assets, whether recognised or contingent, and liabilities, whether arising from possible
or present obligations, of an entity.
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156 Financial Reporting
REFERENCES
Deloitte 2018, Revenue from contracts with customers: A guide to IFRS 15, March, accessed 13 July 2022, www.iasplus.com/en/
news/2018/03/deloittes-guide-to-ifrs-15.
IFRS Foundation 2022, 2022 IFRS Standards, IFRS Foundation, London.
Lennard, A. & Thompson, S. 1995, Provisions: Their recognition, measurement and disclosure in financial statements, Financial
Accounting Standards Board, Norwalk.
Washington, S. 2002, ‘Smooth accusations’, Business Review Weekly, 24 October, pp. 74–75.
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MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 157
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MODULE 4
INCOME TAXES
LEARNING OBJECTIVES
After completing this module, you should be able to:
4.1 explain the terms ‘taxable temporary differences’ and ‘deductible temporary differences’
4.2 apply the requirements of IAS 12 with respect to current and deferred tax assets and liabilities
4.3 apply the tax rates and tax bases that are consistent with the manner of recovery or settlement of an asset
or liability
4.4 apply the probability recognition criterion for deductible temporary differences, unused tax losses and
unused tax credits
4.5 account for the recognition and reversal of deferred tax assets arising from deductible temporary
differences, unused tax losses and unused tax credits
4.6 determine the deferred tax consequences of revaluing property, plant and equipment
4.7 apply the requirements of IAS 12 with respect to financial statement presentation and disclosure
requirements.
ASSUMED KNOWLEDGE
It is assumed that, before commencing your study of this module, you are able to:
• explain the difference between cash and accrual methods of accounting
• prepare each of the four primary financial statements using the accrual method of accounting.
LEARNING RESOURCES
International Financial Reporting Standards (IFRSs):
• IAS 1 Presentation of Financial Statements
• IAS 12 Income Taxes
• IAS 16 Property, Plant and Equipment.
Other resources:
• Comprehensive example: To explain the rationale and application of IAS 12, there is a comprehensive example
in part E. You should familiarise yourself with the data in this example.
• Digital content, such as videos and interactive activities in the e-text, support this module. You can access
this task on My Online Learning.
Unless otherwise indicated, a tax rate of 30 per cent has been adopted throughout this module.
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PREVIEW
Income taxes are incurred by entities in most countries according to the tax rates and tax laws of the
relevant jurisdiction.
Income taxes normally give rise to an income tax expense and some related income tax assets and
liabilities that should be recognised in the financial statements. As those items can be significant for many
entities, it is important for users and preparers of financial statements to have a clear understanding of the
way they are calculated and recognised in the financial statements. Due to technological advancements
and the development of powerful software programs for accounting and taxation, most of the procedures
that will be described in this module are automated. However, it is still paramount for users and preparers
to understand the principles and the processes used in the calculation of income tax to be able to use the
information provided by the computer software to make decisions.
The accounting treatment for income taxes is prescribed in IAS 12 Income Taxes and is based on the socalled ‘balance sheet method’. The name of this method comes from the fact that it focuses on balance
sheet (or statement of financial position) items (i.e. assets and liabilities) and requires consideration of
the difference between the carrying amounts of those items (as recognised in the statement of financial
position) and their underlying tax bases (as determined according to the tax rates and tax laws enacted in
the relevant jurisdiction). This difference gives rise to tax effects deferred for the future, which should be
recognised together with the current tax effects.
In general terms, the use of the balance sheet method of accounting for income taxes will result in the
entity recognising the current and future tax consequences of:
• transactions and other events of the current period that are recognised in an entity’s financial statements
• the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in an
entity’s statement of financial position.
This module discusses the rationale underpinning the balance sheet method of accounting for income
tax and examines the fundamentals of this approach. More specifically, the module provides guidance and
illustrative examples as to the recognition and measurement of tax consequences in current and deferred
tax expense (tax income), tax assets and tax liabilities.
The following is a brief overview of the structure of the module.
• Part A: Income tax fundamentals — discusses the core principle of IAS 12 and explores the nature of the
income tax items recognised in the financial statements and the practical approach to their determination.
• Part B: Recognition of deferred tax assets and liabilities — examines the separate recognition rules (and
limited recognition exceptions) for the recognition of deferred tax assets and deferred tax liabilities in
the financial statements.
• Part C: Special considerations for assets measured at revalued amounts — deals with the recognition
and measurement of deferred tax liabilities that arise when assets are carried at revalued amounts.
• Part D: Financial statement presentation and disclosure — illustrates the disclosure requirements that
enable users of the financial statements to understand and evaluate the impact of current tax and deferred
tax on the financial position and performance of the entity.
• Part E: Comprehensive example — contains a comprehensive example illustrating the application
of IAS 12.
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160 Financial Reporting
PART A: INCOME TAX FUNDAMENTALS
INTRODUCTION
Part A of this module examines the fundamentals of accounting for income tax under IAS 12.
As explained in the Preview to the module, the core principle of IAS 12 is that the financial statements
should recognise the current and future tax consequences of:
(a) the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in an
entity’s statement of financial position; and
(b) transactions and other events of the current period that are recognised in an entity’s financial statements
(IAS 12, ‘Objective’).
These current and future tax consequences are reflected in the financial statements as ‘current tax
liability’, ‘current tax assets’, ‘deferred tax assets’, ‘deferred tax liabilities’ and ‘tax expense (tax income)’.
The definition of those items as provided in IAS 12 are included in table 4.1, while table 4.2 presents an
example of those items disclosed in the financial statements.
TABLE 4.1
Income tax line items in financial statements
Current tax liability
The amount of tax payable to the taxation authorities for current and prior periods,
to the extent unpaid at the end of the financial year (IAS 12, para. 12).
Current tax asset
The amount of tax already paid in respect of current and prior periods that exceeds
the amount due for those periods (IAS 12, para. 12).
Deferred tax assets
The ‘amounts of income taxes recoverable in future periods in respect of:
(a) deductible temporary differences [which are future deductible amounts that will
result from the realisation of assets or the settlement of liabilities];
(b) the carryforward of unused tax losses; and
(c) the carryforward of unused tax credits’ (IAS 12, para. 5).
Deferred tax liabilities
The ‘amounts of income taxes payable in future periods in respect of taxable
temporary differences [which are future taxable amounts that will result from the
realisation of assets or the settlement of liabilities]’ (IAS 12, para. 5).
Tax expense (tax income)
The ‘aggregate amount included in the determination of profit or loss for the period
in respect of current tax and deferred tax’ (IAS 12, para. 5).
Source: Adapted from IFRS Foundation 2022, IAS 12 Income Taxes, para. 5, IFRS Foundation, London, pp. A1096, A1098.
TABLE 4.2
Financial statement extracts
Statement of profit or loss and other comprehensive income
for the year ended 30 June 20X1
Income
Expenses
Profit before income tax
Tax expense
Profit for the year
20X1
$
20X0
$
975 000
(325 000)
650 000
(195 000)
455 000
857 000
(232 000)
625 000
(187 500)
437 500
20X1
$
20X0
$
433 500
375 500
143 000
216 000
Statement of financial position
at 30 June 20X1
Current assets
Cash
Trade and other receivables
Non-current assets
Property, plant and equipment
Deferred tax assets
Total assets
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1 450 000
15 000
2 274 000
1 410 000
13 500
1 782 500
(continued)
MODULE 4 Income Taxes 161
TABLE 4.2
(continued)
Current liabilities
Trade and other payables
Current tax liability
Provisions
Non-current liabilities
Borrowings
Deferred tax liabilities
Provisions
Total liabilities
Net assets
20X1
$
20X0
$
115 000
191 500
35 000
95 000
185 000
30 000
500 000
65 000
15 000
921 500
1 352 500
500 000
60 000
15 000
885 000
897 500
Source: CPA Australia 2022.
Part A explores the nature of these income tax items recognised in the financial statements and
the practical approach to their determination. The fundamentals outlined in part A are essential to
understanding the more advanced concepts addressed in parts B–E.
Relevant Paragraphs
To assist in achieving the objectives of part A outlined in the module preview, you may wish to read
the following paragraphs of IAS 12. Where specified, you need to be able to apply these paragraphs as
referenced in this module.
Subject
Paragraphs
Definitions
Tax base
Recognition of current tax liabilities and current tax assets
Recognition of deferred tax liabilities and deferred tax assets
Deductible temporary differences
Measurement
Recognition of current and deferred tax
Illustrative Examples (in the IFRS Compilation Handbook)
5–6
7–11
12–14
15–18
24–25, 26(a), 26(b), 26(d), 27–31
46–56
57–60
Part A (paragraphs 1–11)
Part B (paragraphs 1–8)
Part C (paragraphs 1–4)
Example 2
4.1 TAX EXPENSE
As illustrated in the financial statement extracts in table 4.2, tax expense is presented as a separate line item
in the statement of profit or loss and other comprehensive income (statement of P/L and OCI). Tax expense
comprises two components (i.e. ‘current tax expense’ and ‘deferred tax expense’). Each component is
calculated separately and then aggregated to determine ‘tax expense’ for the reporting period. It is possible
for the amounts recognised under tax expense (current, deferred or total) to be negative, in which case they
are described as tax income.
This is illustrated in figure 4.1.
FIGURE 4.1
Tax expense (income)
Tax expense
(Tax income)
=
Current tax expense
(Current tax income)
Amount of income tax
payable for the period
(determined from tax
return) recognised in
profit or loss
Source: CPA Australia 2022.
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162 Financial Reporting
+
Deferred tax expense
(Deferred tax income)
Movement in deferred
tax assets and
liabilities for the
period recognised
in the profit or loss
As outlined in the Objective of IAS 12, the rationale for the recognition of ‘deferred tax expense’ (in
addition to the recognition of ‘current tax expense’), together with the associated ‘deferred tax assets’ and
‘deferred tax liabilities’, is that:
• It is inherent in the recognition of an asset or liability that the reporting entity expects to recover or settle
the carrying amount of that asset or liability.
• If it is probable that recovery or settlement of that carrying amount will make future tax payments larger
(smaller) than they would be if such recovery or settlement were to have no tax consequences, this
Standard requires an entity to recognise a deferred tax liability (deferred tax asset), with certain limited
exceptions (IAS 12, ‘Objective’).
From a conceptual perspective, recognising the future tax consequences of the expected recovery
(settlement) of the carrying amounts of assets (liabilities) recognised in the statement of financial position,
together with the current tax consequences of any transactions or events that took place during the current
period, provides a more complete picture of the financial position and financial performance of the entity.
A detailed discussion of the determination of current tax and deferred tax (and the associated deferred
tax assets and deferred tax liabilities) is contained in the following sections.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read the definitions of the following terms in paragraphs 5 and 6
of IAS 12: tax expense (tax income), current tax, deferred tax liabilities and deferred tax assets.
4.2 CURRENT TAX
As illustrated in figure 4.1, the first component of tax expense (income) is current tax.
Current tax is the ‘amount of income taxes payable (recoverable) in respect of taxable profit (tax loss)
for the period’ (IAS 12, para. 5).
The key steps for accounting for current tax are shown in table 4.3.
TABLE 4.3
Key steps in accounting for current tax
Step 1
Calculate the ‘amount expected to be paid to (recovered from) the taxation authorities, using
the tax rates (and tax laws) that have been enacted or substantively enacted by the end of the
reporting period’ (IAS 12, para. 46).
Step 2
Recognise the amount of current tax in profit or loss for the period, in OCI, or directly in equity, as
appropriate (IAS 12, para. 58(a)).
Source: Adapted from IFRS Foundation 2022, IAS 12 Income Taxes, paras 46, 58, IFRS Foundation, London, pp. A1112, A1117.
Each step will now be discussed.
CALCULATING CURRENT TAX
From a practical perspective, taxable profit (tax loss) is generally calculated:
• directly, by applying the relevant tax laws to the transactions and other events of the current reporting
period to determine the difference between assessable income and allowable deductions, or
• indirectly, by adjusting the accounting profit of the current reporting period for differences between
accounting and tax treatments of items recognised in the accounting profit.
The indirect approach of adjusting the accounting profit to determine taxable profit (tax loss) is the more
common approach used in practice.
After determining the taxable profit (tax loss), the current tax is determined by simply multiplying it
with the relevant tax rate. The calculation of the current tax, starting with the calculation of the taxable
profit using the indirect approach, is illustrated in example 4.1.
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MODULE 4 Income Taxes 163
EXAMPLE 4.1
Calculate Taxable Profit by Adjusting the Accounting Profit for the
Reporting Period
The statement of P/L and OCI of Hi-sales Ltd (Hi-sales) for the financial year ending 30 June 20X0 included
the following items.
$
Income
Sales
Expenses
Cost of sales
Depreciation — equipment
Other expenses
Profit before tax
$
2 540 000
1 735 000
12 000
40 000
(1 787 000)
753 000
Some additional information is provided as follows.
• For tax purposes, depreciation on the plant and equipment for the current period is $14 000.
• ‘Other expenses’ of $40 000 includes entertainment expenses that are not deductible for tax purposes
of $3000.
The taxable profit of Hi-sales can be calculated as follows.
$
Profit before tax
Add:
Non-deductible entertainment expenses†
753 000
3 000
756 000
Less:
Excess of tax depreciation deduction over accounting depreciation expense‡
Taxable profit
2 000
754 000
† The entertainment expense of $3000 is non-deductible and will not be included when determining taxable profit. This is
an example of a non-temporary difference, which must be added back to accounting profit.
‡ Depreciation expense for accounting purposes is $12 000 but for tax purposes the tax depreciation is $14 000. Therefore,
an additional $2000 of depreciation must be deducted from accounting profit in calculating taxable profit.
Assume that the tax rate is 30 per cent. We calculate current tax by multiplying taxable profit by the tax
rate ($754 000 × 30% = $226 200). The journal entry for current tax liability is as follows.
Dr
Cr
Current tax expense
Current tax payable
226 200
226 200
RECOGNITION OF CURRENT TAX
Current tax is normally recognised as income or as an expense in profit or loss. More specifically, IAS 12
(para. 58) states the following with regards to the recognition of current (and deferred) tax.
Current and deferred tax shall be recognised as income or an expense and included in profit or loss for the
period, except to the extent that the tax arises from:
(a) a transaction or event which is recognised, in the same or a different period, outside profit or loss, either
in other comprehensive income or directly in equity; or
(b) a business combination (other than the acquisition by an investment entity, as defined in IFRS 10
Consolidated Financial Statements, of a subsidiary that is required to be measured at fair value through
profit or loss) (IAS 12, para. 58).
For transactions and any other event that generate items recognised outside profit or loss, IAS 12
(para. 61A) requires that the current and deferred tax consequences shall be recognised outside of profit
or loss as well. Current tax and deferred tax that relates to such items are recognised:
• in OCI where the item is recognised in OCI
• directly in equity where the item is recognised directly in equity (IAS 12, para. 61A).
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164 Financial Reporting
The accounting treatment of tax effects arising from a business combination will be discussed in
module 5.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 58 and 61A of IAS 12.
In addition to recognising the amount of current tax in profit or loss for the period, in OCI, or directly in
equity (as discussed), an entity must also recognise the amount payable to (refundable from) the taxation
authorities as an asset or liability, as follows.
12 Current tax for current and prior periods shall, to the extent unpaid, be recognised as a liability. If the
amount already paid in respect of current and prior periods exceeds the amount due for those periods,
the excess shall be recognised as an asset.
13 The benefit relating to a tax loss that can be carried back to recover current tax of a previous period
shall be recognised as an asset (IAS 12, paras 12, 13).
This is illustrated in example 4.2.
EXAMPLE 4.2
Recognition of a Current Tax Liability
Using the data from example 4.1, current tax of Hi-sales Ltd (Hi-sales) for the financial year ending 30 June
20X0 was determined to be $226 200. Assume that, in addition to the information provided, the relevant
tax laws required Hi-sales to pay tax instalments during the financial year ending 30 June 20X0 based on
Hi-sales’ estimate of its taxable profit for the year. Based on Hi-sales’ estimate of its taxable profit for the
financial year ending 30 June 20X0, instalments amounting to $185 000 were paid to the relevant taxation
authority prior to 30 June 20X0.
Using the provided information, the current tax liability recognised by Hi-sales in the statement of
financial position at 30 June 20X0 would be $41 200 ($226 200 – $185 000).
Dr
Current tax expense
Cr
Cash
Journal entry for instalments paid.
Dr
Current tax expense
Cr
Current tax liability
Journal entry for current tax liability.
185 000
185 000
41 200
41 200
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 12–14 of IAS 12.
4.3 DEFERRED TAX
As illustrated in figure 4.1, the second component of tax expense (income) is deferred tax, which
is capturing the movement in deferred tax assets and deferred tax liabilities for the reporting period
recognised in profit or loss.
In principle, deferred tax represents the future tax consequences (as distinct from current tax consequences) of the future recovery of assets and the future settlement of liabilities (IAS 12, ‘Objective’).
As such, the recognition and measurement of deferred tax requires an assessment of those future tax
consequences.
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MODULE 4 Income Taxes 165
The key steps required to recognise and measure deferred tax are shown in table 4.4.
TABLE 4.4
Key steps for calculating deferred tax
Step 1
Determine the tax base of assets and liabilities (IAS 12, paras 7–11).
Step 2
Compare the tax base with the carrying amount of assets and liabilities to determine taxable
temporary differences and deductible temporary differences (IAS 12, para. 5).
Step 3
Measure deferred tax assets (arising from deductible temporary differences) and deferred tax liabilities
(arising from taxable temporary differences) (IAS 12, paras 46–56).
Step 4
Recognise the movement in the deferred tax assets (arising from deductible temporary differences)
and deferred tax liabilities (arising from taxable temporary differences) as deferred tax, taking into
account the limited recognition exceptions (IAS 12, paras 15–45).
Source: Adapted from IFRS Foundation 2022, IAS 12 Income Taxes, IFRS Foundation, London, pp. A1096–A1117.
Each of these steps is discussed in turn. Steps 1 to 3 are discussed in the remainder of part A, and step 4
is discussed in part B.
In order to implement these steps, it is important to understand the terms ‘carrying amount’, ‘tax base’,
‘temporary difference’, ‘deferred tax assets’ and ‘deferred tax liabilities’. Except for carrying amount,
these terms are defined in paragraph 5 of IAS 12. Their basic meanings are as follows.
Carrying Amount
The carrying amount is the amount at which an asset or liability is recognised in the statement of financial
position. For an asset, this is the amount which is recognised ‘after deducting any accumulated depreciation
and accumulated impairment losses’ (IAS 16, para. 6).
Tax Base
‘The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes’
(IAS 12, para. 5). The tax base can also be described as the written-down value, or carrying amount, of the
asset or liability for tax purposes. To assist with understanding the term, it may be helpful to assume the
existence of a hypothetical statement of financial position for tax purposes.
For example, assume that an entity acquires an item of equipment for $10 000, and the applicable tax
laws allow the entity to claim future tax deductions equal to the $10 000 original cost of the equipment
(by way of tax-deductible depreciation). Under this scenario, at the date of acquisition the tax base of the
equipment is $10 000.
Temporary Difference
A temporary difference is the difference ‘between the carrying amount of an asset or liability in the
statement of financial position and its tax base’ (IAS 12, para. 5). These differences will reverse over time
and, as they increase or decrease, they will affect deferred tax balances.
A temporary difference reflects the future tax consequences of realising an asset or settling a liability
(i.e. the extent to which the realisation of an asset or the settlement of a liability will result in future taxable
income or future tax deduction).
For example, assume that the carrying amount of an item of equipment is $10 000, and the tax base
(determined under the applicable tax laws) is $8000. Under this scenario, the temporary difference is
$2000 ($10 000 – $8000). This reflects that there are future tax consequences of realising the carrying
amount of the asset (i.e. future taxable amounts will occur).
Temporary differences are classified as either ‘deductible temporary differences’ or ‘taxable temporary
differences’. These terms are defined as follows.
Taxable Temporary Difference
Taxable temporary differences ‘are temporary differences that will result in taxable amounts in
determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is
recovered or settled’ (IAS 12, para. 5).
For example, assume that the carrying amount of land is $750 000, and its tax base (determined under
the applicable tax laws) is $500 000. Under this scenario, the temporary difference is $250 000. As this
temporary difference will result in taxable amounts of a future period (when the asset is realised), because
the entity creates taxable income, the temporary difference is classified as ‘taxable temporary difference’.
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166 Financial Reporting
Deductible Temporary Difference
Deductible temporary differences ‘are temporary differences that will result in amounts that are
deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the asset
or liability is recovered or settled’ (IAS 12, para. 5).
For example, assume that the carrying amount of an employee benefit liability is $120 000, and its tax
base is $nil (determined under the applicable tax laws). Under this scenario, the temporary difference
is $120 000. As this temporary difference will result in deductible amounts in a future period (when the
liability is settled), because the entity is entitled to deduct the amounts from taxable income (reduce taxable
income), the temporary difference is classified as a ‘deductible temporary difference’.
Deferred Tax Assets
These are amounts of income taxes recoverable in future periods. They arise from deductible temporary
differences and the carry-forward of unused tax losses or tax credits (IAS 12, para. 5). This reflects the net
difference between the accounting treatment and tax treatment of transactions.
Deferred Tax Liabilities
These are amounts of income taxes payable in the future and arise from taxable temporary differences
(IAS 12, para. 5).
These definitions lead to the formulas shown in figure 4.2.
FIGURE 4.2
Temporary differences and deferred tax assets/liabilities
Temporary
differences
=
Carrying amount of
assets or liabilities
–
Tax bases of assets
or liabilities
Deferred tax
assets/liabilities
=
Temporary
differences
×
Tax rate
Source: CPA Australia 2022.
Example 4.3 provides an illustration of those concepts, following the steps described in table 4.4 in
calculating and recognising deferred tax.
EXAMPLE 4.3
Calculating and Recognising the Deferred Tax Related to Settling a
Liability in the Future
An entity recognises a liability and related expense for employee benefits in 20X1 of $20 000, which
remains unsettled at the end of the financial year (30 June 20X1), and the entity will obtain a tax deduction
for the $20 000 expense at the time of settlement (i.e. when paid in cash in a future period).
Step 1: Determining the tax base of the liability.
No amount is attributed to the employee benefit liability for tax purposes because the tax deduction is
based on cash outgoings. Therefore, the tax base of the employee benefit liability is $nil.
Step 2: Compare the tax base of the liability with the carrying amount to determine any
temporary differences.
The carrying amount of the employee benefit liability is $20 000. Therefore, a temporary difference of
$20 000 arises between the carrying amount and the tax base of the employee benefit liability. The
temporary difference is a deductible temporary difference because the future settlement of the employee
benefit liability will result in a future deductible amount.
Step 3: Measure the deferred tax asset arising from the deductible temporary difference.
There is a deferred tax asset of $6000 equal to the deductible temporary difference of $20 000 multiplied
by the tax rate of 30 per cent.
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MODULE 4 Income Taxes 167
Step 4: Recognise the deferred tax asset as deferred tax.
The deferred tax asset arising from the deductible temporary difference for the employee benefit liability
will be recognised at the end of the 20X1 period together with other temporary differences. If it is the only
temporary difference, then the journal entry is as follows.
Dr
Cr
Deferred tax asset
Deferred tax income
6 000
6 000
From the perspective of the statement of financial position, at 30 June 20X1, the entity will recognise
the employee benefit liability of $20 000 and a deferred tax asset of $6000. In combination, this reflects
the ‘after tax’ effect of the transaction on the financial position of the entity.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read the definitions of ‘tax base’, ‘temporary differences’, ‘deferred
tax assets’ and ‘deferred tax liabilities’ in paragraph 5 of IAS 12.
While working through the remainder of this module, it is useful to keep in mind that the objective of
calculating the tax base is to determine, for each item concerned, whether a deferred tax amount arises.
As noted previously, the fundamental principle for determining whether deferred tax amounts arise is
as follows.
[A]n entity shall, with certain limited exceptions, recognise a deferred tax liability (asset) whenever
recovery or settlement of the carrying amount of an asset or liability would make future tax payments
larger (smaller) than they would be if such recovery or settlement were to have no tax consequences
(IAS 12, para. 10).
STEP 1: DETERMINING THE TAX BASE OF ASSETS
AND LIABILITIES
The Tax Base of Assets
The tax base of an asset is ‘the amount that will be deductible for tax purposes against any taxable
economic benefits that will flow to an entity when it recovers the carrying amount of the asset. If those
economic benefits will not be taxable, the tax base of the asset is equal to its carrying amount’ (IAS 12,
para. 7).
Figure 4.3 illustrates the formula that can be applied in calculating the tax base of an asset.
FIGURE 4.3
Tax base of an asset
1. Future economic benefits are taxable
2. Future economic benefits are not taxable
Tax base = future deductible amount
Tax base = carrying amount
Source: CPA Australia 2022.
Example 4.4 outlines two scenarios for calculating the tax base of an asset.
EXAMPLE 4.4
Calculating the Tax Base of Assets
Scenario 1 (IAS 12, para. 7, example 1)
A machine costs $100. Depreciation of $30 has already been expensed for accounting purposes and
deducted for tax purposes in the current and prior periods — that is, the accounting treatment and tax
treatment are the same.
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168 Financial Reporting
In this scenario, when the entity uses the asset it generates economic benefits in the form of revenue.
The revenue generated by using the machine is taxable.
Future deductible amounts are calculated as original cost less accumulated tax depreciation deductions
($100 – $30 = $70). This remaining cost of $70 will be tax deductible in future periods, either as depreciation
or through a deduction on disposal.
Therefore, as the future economic benefits, in the form of revenue, are taxable, the tax base of the
machine is determined as follows.
[1] Tax base = Future deductible amount = $70
The carrying amount is calculated as original cost ($100) less accumulated accounting depreciation
($30) = $70. This is the net amount that would be recorded in the financial statements. Therefore, in this
scenario, the tax base is equal to the carrying amount of the asset.
Scenario 2
An item of plant was purchased two years ago for $100. This plant is being depreciated on a straight-line
basis for accounting purposes over a four-year period and on a straight-line basis for tax purposes over a
five-year period. There is no residual value for either tax or accounting purposes. The income generated
by the plant is included in taxable profit (loss), and tax depreciation is deductible for tax purposes.
In this scenario, when the entity uses the asset, it generates economic benefits in the form of revenue.
The revenue generated by using the plant is taxable.
Future deductible amounts are amounts that were not yet claimed as deductions out of the original
cost and they will be calculated as original cost ($100) less accumulated tax depreciation deductions
($100/5 × 2 = $40) = $60.
Therefore, as the future economic benefits, in the form of revenue, are taxable, the tax base of the plant
is determined as follows.
[1] Tax base = Future deductible amount = $60
The carrying amount is calculated as original cost ($100) less accumulated accounting depreciation
($100/4 × 2 = $50) = $50. This is the net amount that would be recorded in the financial statements.
Therefore, in this scenario, the tax base is not equal to the carrying amount of the asset.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read examples 2–5 in paragraph 7 of IAS 12.
QUESTION 4.1
Calculate the tax base for the following assets.
(a) An item of inventory was purchased during the year for $250. The cost of the inventory for
both accounting and tax purposes is $250. The tax cost of the inventory will be included in the
determination of taxable profit (tax loss) as a deduction when the inventory is sold. The income
from the sale of inventory is taxable when the inventory is sold.
(b) Trade receivables have a carrying amount of $250 with no provision for credit loss. The related
revenue has already been included in taxable profit (tax loss).
The Tax Base of 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 future periods. In the case of revenue which is received in advance, the tax
base of the resulting liability is its carrying amount, less any amount of the revenue that will not be taxable
in future periods’ (IAS 12, para. 8).
The formulas in figure 4.4 may be helpful in performing the calculation to determine the tax base of a
liability. (These formulas are based on the method described in IAS 12, para. 8.)
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MODULE 4 Income Taxes 169
Tax base of a liability
FIGURE 4.4
Tax base of a
liability that is not
revenue received
in advance
=
Carrying
amount
–
Future
deductible
amounts
Tax base of
revenue received
in advance
=
Carrying
amount
–
Amount of
revenue not taxable
in the future
Source: Adapted from IFRS Foundation 2022, IAS 12 Income Taxes, para. 8, IFRS Foundation, London, pp. A1097–A1098.
For example, if a current liability with a carrying amount of $100 relates to expenses that will be
deductible for tax purposes when settled (i.e. when paid), the tax base of the current liability is $nil.
Tax base
Nil
=
Carrying
amount
100
–
Future deductible
amounts
100
An example of revenue received in advance is interest revenue received in advance with a carrying
amount of $50. The related interest revenue is taxed on a cash basis (i.e. when received). The tax base of
the interest revenue received in advance is $nil. The $50 is not taxable in the future because it was already
taxed when the cash was received.
Tax base
Nil
=
Carrying
amount
50
–
Amount of revenue
not taxable in the future
50
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read examples 2–5 in paragraph 8 of IAS 12.
QUESTION 4.2
Calculate the tax base for the following liabilities.
(a) Employee benefits have a carrying amount of $100. The employee benefits are deductible on a
cash basis (i.e. when paid).
(b) A loan payable has a carrying amount of $250. The repayment of the loan will have no tax
consequences.
(c) Revenue received in advance has a carrying amount of $400. The amount was taxed on a cash
basis (i.e. when received).
STEP 2: COMPARE THE TAX BASE TO THE CARRYING
AMOUNT TO DETERMINE TEMPORARY DIFFERENCES
A temporary difference is the ‘difference between the carrying amount of an asset or liability in the
statement of financial position and its tax base’ (IAS 12, para. 5).
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170 Financial Reporting
This is illustrated in figure 4.5.
FIGURE 4.5
Calculating the temporary difference
Temporary
difference
=
Carrying
amount
Tax base
–
Source: CPA Australia 2022.
Therefore, temporary differences are identified by:
• comparing the carrying amount (in the statement of financial position) of each asset and liability with
its tax base
• identifying all items that have a carrying amount of $nil (i.e. are not reported in the statement of financial
position) but have a tax base. For example, research costs that are expensed when incurred (i.e. no asset
is recorded) but which are deductible for tax purposes in a subsequent reporting period.
Using a worksheet format to present the statement of financial position and tax base will assist in
identifying taxable and deductible temporary differences. This is illustrated in table 4.5.
TABLE 4.5
Illustrative worksheet extract
Carrying
amount
$
Assets and liabilities
Cash
Trade receivables
Inventories
Plant and equipment
Trade payables
Provisions
Borrowings
10 000
75 000
115 000
1 250 000
60 000
5 000
750 000
Taxable
temporary
difference
$
Tax
base
$
10 000
80 000
115 000
1 050 000
60 000
nil
750 000
—
—
—
200 000
—
—
—
Deductible
temporary
difference
$
—
5 000
—
—
—
5 000
—
Source: CPA Australia 2022.
The term temporary refers to the fact that such differences originate in a reporting period and reverse
in one or more later reporting periods. All temporary differences reverse over time. For example, using
the data included in table 4.5, the deductible temporary difference of $5000 that arises in relation to the
provision will reverse when the provision is settled.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraph 17 of IAS 12, and Illustrative Examples (in the IFRS
Compilation Handbook) part A (paragraphs 1–11), part B (paragraphs 1–8) and part C (paragraphs 1–4) of IAS 12.
Table 4.6 summarises the relationship between the carrying amounts of assets and liabilities, the tax
base, and deferred tax assets and liabilities.
TABLE 4.6
Relationship between carrying amount, tax base and temporary differences
Statement of financial position
Asset
Liability
Carrying amount > tax base
1
Taxable temporary difference
4
Deductible temporary difference
Carrying amount < tax base
2
Deductible temporary difference
5
Taxable temporary difference
Carrying amount = tax base
3
None
6
None
Source: Adapted from CPA 2016.
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MODULE 4 Income Taxes 171
To understand the rationale for the six relationships in table 4.6, it is necessary to recall some of the key
concepts already discussed. We will explore these concepts further and begin by considering relationships
between the carrying amount and the tax base for assets (cases 1 to 3 in table 4.6).
Assets
The first three relationships outlined in table 4.6 in regard to assets are explained in table 4.7.
TABLE 4.7
Assets — relationship between carrying amount, tax base and temporary differences
Assets
Is there a difference between
the carrying amount and the tax
base?
What are the future tax consequences of recovering the asset
at its carrying amount?
Do the future tax consequences give
rise to a temporary difference?
1. Carrying amount > tax base
The future taxable amounts from
recovery of the asset (through use
or sale, discussed later) exceed
future deductible amounts.
Yes. A taxable temporary difference
arises.
2. Carrying amount < tax base
The future deductible amounts
exceed the future taxable amounts
from recovery of the asset (through
use or sale).
Yes. A deductible temporary
difference arises.
3. Carrying amount = tax base
Either there are no future tax
consequences, or the future
deductible and future taxable
amounts are equal.
No temporary difference arises.
Source: CPA Australia 2022.
‘The tax base of an asset is the amount that will be deductible for tax purposes against any taxable
economic benefits that will flow to an entity when it recovers the carrying amount of the asset’ (IAS 12,
para. 7). When an entity recovers the carrying amount of the item by using an asset, it generates revenue
that is taxable. If the tax base is lower than the carrying amount, then the entity will be expected to pay tax
on that difference in the future; therefore, a taxable temporary difference exists, giving rise to a deferred
tax liability. If the tax base is greater than the carrying amount, then the entity will be expected to enjoy
deductions greater than the taxable amounts in the future; therefore, a deductible temporary difference
exists, giving rise to a deferred tax asset.
For example, assume that the taxable amount estimated to be generated by the entity in the future when
the carrying amount of an asset is recovered is $80 (equal to its carrying amount). If the total depreciation
that it will be able to deduct from this amount for tax purposes (i.e. the tax base) is only $70, the entity
will still pay income tax with respect to the difference of $10 when it recovers the carrying amount of the
asset. Therefore, a taxable temporary difference of $10 exists as the carrying amount of the asset is greater
than the tax base ($80 > $70).
This relationship can be viewed as follows.
Tax base
70
=
Future deductible
amounts
70
Temporary
difference
10
=
Carrying
amount
80
–
Tax base
70
As an extension of this analysis, paragraph 7 of IAS 12 explains that where the future economic benefits
from recovering an asset are not taxable, the tax base of the asset is equal to its carrying amount. In such
circumstances, there is no temporary difference. For example, where the recovery of an asset such as a
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172 Financial Reporting
loan receivable does not have any future tax consequences (i.e. the recovery of the principal is not taxable
and there are no future deductions), a temporary difference does not exist.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraph 7 of IAS 12 and refer to example 5 (which is
below paragraph 7).
Liabilities
The tax base of a liability is its carrying amount less future deductible amounts arising from the liability.
Therefore, if the settlement of the amount of the liability is fully tax deductible in the future, the tax base
will be $nil.
Table 4.8 explains the second set of relationships outlined in table 4.6 (numbers 4 to 6) in relation
to liabilities.
TABLE 4.8
Liabilities — relationship between carrying amount, tax base and temporary differences
Liabilities
Is there a difference between
the carrying amount and the tax
base?
What are the future tax consequences of settling the liability at
its carrying amount?
Do the future tax consequences give
rise to a temporary difference?
4. Carrying amount > tax base
There will be future deductible
benefits from settling the liability.
Yes. A deductible temporary
difference arises.
5. Carrying amount < tax base
There will be future taxable amounts
arising when the liability is settled.
Yes. A taxable temporary difference
arises.
6. Carrying amount = tax base
Either there are no future tax
consequences, or the future
deductible and future taxable
amounts are equal.
No temporary difference arises.
Source: CPA Australia 2022.
For example, if a liability with a carrying amount of $100 is deductible for tax purposes at the time of
settlement, the liability has a tax base of $nil. Given the carrying amount of $100 > tax base of $nil, there
will be future deductible benefits from settling the liability and a deductible temporary difference arises.
STEP 3: MEASURE DEFERRED TAX ASSETS AND DEFERRED
TAX LIABILITIES
Once temporary differences have been determined, the related deferred tax assets and deferred tax
liabilities can be calculated using the appropriate tax rate as shown in figure 4.6.
FIGURE 4.6
Calculating deferred tax asset and deferred tax liability
Deductible
temporary
difference
×
Tax rate
=
Deferred
tax asset
Taxable
temporary
difference
×
Tax rate
=
Deferred
tax liability
Source: CPA Australia 2022.
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MODULE 4 Income Taxes 173
The deductible temporary differences will give rise to deferred tax assets as the entity will be able to
enjoy tax benefits in the form of tax deductions, while taxable temporary differences will give rise to
deferred tax liabilities because the entity will have more tax liabilities in the future.
In some cases, determining the tax base for assets or liabilities and their related temporary differences
may not be straightforward. As a consequence, it would be difficult to calculate any deferred tax assets
or liabilities. To deal with those cases, IAS 12, paragraph 10 recommends that entities consider the
fundamental principle upon which IAS 12 is based: ‘that an entity shall, with certain limited exceptions,
recognise a deferred tax asset (liability) whenever recovery or settlement of the carrying amount of an
asset or liability would make future tax payments smaller (larger) than they would be if such recovery or
settlement were to have no tax consequences’.
This fundamental principle can be expressed in simple terms to mean that:
• if an asset or liability has an expected future taxable amount greater than the future deductions that
can be claimed against it, a taxable temporary difference exists for which a deferred tax liability will
be recognised
• if an asset or liability has an expected future taxable amount lower than the future deductions that
can be claimed against it, a deductible temporary difference exists for which a deferred tax asset will
be recognised.
Calculating the temporary differences and the amounts to be recognised under the related deferred tax
assets and liabilities in this way removes the need for performing step 1 in the calculation of deferred tax
(i.e. determining the tax bases).
QUESTION 4.3
Refer to IAS 12, paragraph 7, example 3.
Assume that the carrying amount of the trade receivables in the example is $80. The $80 is net of
an expected credit loss of $20.
(a) Use the fundamental principle from paragraph 10 of IAS 12 to explain why a deferred tax asset
arises for this transaction.
(b) What is the amount of the temporary difference implied by your answer to requirement (a)?
(c) Explain which cell of table 4.6 this amended example falls into.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 15–17 of IAS 12, noting that for the time being
we will defer discussion of the exceptions mentioned in paragraph 15. You should also read items 4 and 5 of part A
of Illustrative Examples to IAS 12 (in the IFRS Compilation Handbook).
QUESTION 4.4
Part A (adapted from part A of the Illustrative Examples to IAS 12)
(a) Using the fundamental principle from paragraph 10 of IAS 12, explain why a deferred tax liability
should be recognised in relation to the following scenarios.
Development costs
Development costs of $1000 that are recognised as an asset (i.e. capitalised) and will be
amortised to the statement of P/L and OCI. The costs were deducted in determining taxable
profit when they were incurred (i.e. when the cash was paid).
Prepaid expenses
Prepaid expenses (recognised as an asset for accounting purposes) of $1000 that have already
been deducted in determining the taxable profit in the period in which they were paid.
(b) Using the relevant formulas, determine the tax base, the temporary difference and the deferred
tax asset or liability associated with the items in requirement (a).
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174 Financial Reporting
Part B
A liability that was to be settled in units of a foreign currency was recognised in the reporting
currency financial statements of an entity at $100. Due to movements in the exchange rate between
the reporting currency and the foreign currency, the liability was remeasured by $20 to $120.
The increase in the carrying amount of the liability was taken into account as a foreign exchange
loss when measuring accounting profit before tax for the current year. However, the loss is not
deductible against taxable profit until foreign currency is acquired to settle the liability in future.
(a) Use the fundamental principle from paragraph 10 of IAS 12 to explain why a deferred tax asset
arises for this transaction.
(b) What is the amount of the temporary difference implied by your answer to requirement (a)?
(c) Apply the relevant formulas to calculate the tax base for this liability after its remeasurement
and the temporary difference created.
(d) Apply the relevant formula to calculate the deferred tax asset created as the result of the
remeasurement of the liability.
Refer to Note 5 ‘Income tax’ in the notes to financial statements of Techworks Ltd. What items in the
statement of financial position give rise to deferred tax? Explain how the deferred tax arises.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read example 2 ‘Deferred tax assets and liabilities’ under ‘Illustrative
computations and presentations’ in part C of the Illustrative Examples in IAS 12 (in the IFRS Compilation Handbook).
Appropriate Tax Rates to be Used in the Calculation of Deferred Tax Assets
and Liabilities
According to IAS 12, the measurement of deferred tax assets and deferred tax liabilities (which arise from
deductible temporary differences and taxable temporary differences) must reflect the expected manner of
the recovery (settlement) of the underlying asset (liability) and the tax rates that will apply in the period
when the underlying asset (liability) is realised (settled).
The relevant requirements of IAS 12 that give effect to this principle are as follows.
47 Deferred tax assets and liabilities shall be measured at the tax rates that are expected to apply to the
period when the asset is realised or the liability is settled, based on tax rates (and tax laws) that have
been enacted or substantively enacted by the end of the reporting period.
51 The measurement of deferred tax liabilities and deferred tax assets shall reflect the tax consequences
that would follow from the manner in which the entity expects, at the end of the reporting period, to
recover or settle the carrying amount of its assets and liabilities (IAS 12, paras 47, 51).
IAS 12 does not define, or specify, the conditions for substantive enactment of tax rates. Rather,
paragraph 48 of IAS 12 states that:
Current and deferred tax assets and liabilities are usually measured using the tax rates (and tax laws)
that have been enacted. However, in some jurisdictions, announcements of tax rates (and tax laws) by
the government have the substantive effect of actual enactment, which may follow the announcement by a
period of several months. In these circumstances, tax assets and liabilities are measured using the announced
tax rate (and tax laws).
Accordingly, substantive enactment is determined by the legal framework of a jurisdiction.
Further, paragraph 51A of IAS 12 explains that, in some tax jurisdictions, the amount of tax ultimately
payable or recoverable may depend on the manner in which an entity recovers (settles) the carrying amount
of an asset (liability). The manner of recovery (settlement) may affect either or both of:
(a) the tax rate that is to be applied, or
(b) the tax base of the item.
In such cases, IAS 12 requires an entity to measure the deferred tax liability or deferred tax asset using
the tax rate and the tax base that are consistent with the expected manner of recovery or settlement.
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MODULE 4 Income Taxes 175
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 46 to 51A of IAS 12.
These concepts are illustrated in examples 4.5 and 4.6.
EXAMPLE 4.5
The Manner of Recovery Affects the Tax Rate
Entity D owns an item of plant and equipment that has a carrying amount of $100 000 and a tax base of
$60 000. In the tax jurisdiction of Entity D, a tax rate of 20 per cent applies if the plant and equipment is
sold, and a tax rate of 30 per cent applies to other income (i.e. if the asset is recovered through use). Entity
D would recognise a deferred tax liability of:
• $8000 ($40 000 × 20%) if it expects to sell the plant and equipment (without further use), or
• $12 000 ($40 000 × 30%) if it expects to recover the carrying amount of the plant and equipment
through use.
It is possible to have different tax consequences for an asset, depending on whether an asset is
expected to be held for use or sold without further use. Capital tax consequences such as those arising
from sale of plant and equipment (without further use) are often referred to as capital gains tax (CGT).
The CGT consequences may differ from income tax consequences — that is, the CGT cost base may be
different from the tax base of the asset if it is recovered through use. The CGT cost base may also be
different from the cost of the asset recognised for accounting purposes. Any difference between the CGT
cost base and the carrying amount of an asset affects the tax base of an item, and therefore also has an
impact on the calculation of deferred tax consequences.
EXAMPLE 4.6
The Manner of Recovery Affects the Tax Base
Entity F owns a building. The building was originally purchased by Entity F for $100 000. For accounting
purposes, the building is depreciated on a straight-line basis over five years, and for tax purposes, the
building is depreciated on a straight-line basis over four years. Tax depreciation is deductible each year.
The building has no residual value.
In the jurisdiction in which Entity F operates, the CGT cost base of the building (the amount deductible
against any taxable proceeds on sale) is $120 000.
Scenario 1 — Asset to be Held for Use
At the end of year one, the entity expects to continue to use the asset for the next four years. Entity F
would then record the following balances.
Cost
Less: Accumulated depreciation
Carrying amount/Tax base
Accounting
$’000
Tax
$’000
100
20
80
100
25
75
Assuming that Entity F expects to continue to use the asset, the revenue generated through the use of
the asset will be taxable. At the end of year one, the tax base of the building can be calculated as follows
(refer to figure 4.3).
Pdf_Folio:176
176 Financial Reporting
Tax base
of an asset
=
Future
deductible amounts
75
=
75
Scenario 2 — Asset to be Sold
At the end of year one, the entity expects to sell the asset in year three. At the end of the year,
Entity F would then record the following balances (assuming that the depreciation deductions reduce
the CGT cost base of the asset).
Cost
Less: Depreciation
Carrying amount/Tax base
Accounting
$’000
Tax
$’000
100
20
80
120
25
95
(CGT cost base)
Assuming that Entity F expects to sell the asset, the revenue generated through the sale of the asset
will be taxable. At the end of year one the tax base of the building can be calculated as follows (refer
to figure 4.3).
Tax base
of an asset
=
Future
deductible amounts
95
=
95
Discounting of Deferred Tax Assets and Deferred Tax Liabilities is
Not Permitted
Deferred tax assets and deferred tax liabilities are expected to be recovered or settled at dates in the
future. It may seem appropriate that these amounts should be discounted to their present values at each
reporting date; however, IAS 12 does not permit such discounting (IAS 12, para. 53) for the reasons given
in paragraph 54, such as the requirement for ‘detailed scheduling of the timing of the reversal of each
temporary difference’. Nevertheless, where the carrying amount of an asset or liability is determined on
a discounted basis, any temporary difference together with the related deferred tax asset or deferred tax
liability will be determined based on those discounted amounts. The temporary difference, and therefore
the deferred tax asset or deferred tax liability, is to be determined on the basis of the discounted values
recognised in the carrying amount of the asset or liability.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 53 and 54 of IAS 12.
SUMMARY
The core principle of IAS 12 is that the financial statements should recognise the current and future tax
consequences of:
• transactions and other events of the current period that are recognised in an entity’s financial statements
• the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in an
entity’s statement of financial position.
These current and future tax consequences are reflected in the financial statements as ‘current tax
liability’, ‘current tax assets’, ‘deferred tax assets’, ‘deferred tax liabilities’ and ‘tax expense (income)’
(refer back to table 4.1 earlier in the module).
Tax expense (income) for a period comprises current tax expense (income) together with deferred tax
expense (income). Current tax expense (income) is the portion of current tax payable (recoverable) that is
recognised in the current period. Deferred tax expense (income) reflects movement in deferred tax assets
and deferred tax liabilities recognised in the statement of profit or loss and other comprehensive income.
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MODULE 4 Income Taxes 177
A taxable temporary difference is a temporary difference that will result in taxable amounts in the future
when the carrying amount of an asset or liability is recovered or settled. As such, future tax payments are
larger, resulting in the recognition of a deferred tax liability.
A deductible temporary difference is a temporary difference that will result in deductible amounts in
the future when the carrying amount of an asset or liability is recovered or settled. As such, future tax
payments are smaller, resulting in the recognition of a deferred tax asset.
A deferred tax liability arises when recovery or settlement of the carrying amount of an asset or liability
will have tax consequences that cause future tax payments to be larger than they would have been in the
absence of those tax consequences.
A deferred tax asset arises when recovery or settlement of the carrying amount of an asset or liability
will have tax consequences that cause future tax payments to be smaller than they would have been in the
absence of those tax consequences.
The key points covered in this part, and the learning objectives they align to, are as follows.
KEY POINTS
4.1 Explain the terms ‘taxable temporary differences’ and ‘deductible temporary differences’.
• Income tax expense is the aggregate amount included in the determination of profit or loss for the
period in respect of current tax and deferred tax.
• Current tax is the amount of income taxes payable (recoverable) in respect of taxable profit (tax loss)
for the period.
• Deferred tax is the movement in deferred tax assets and liabilities for the period recognised in the
profit or loss.
• Taxable temporary differences are the temporary differences that will result in taxable amounts in
determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability
is recovered or settled.
• Deductible temporary differences are the temporary differences that will result in amounts that are
deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the
asset or liability is recovered or settled.
4.2 Apply the requirements of IAS 12 with respect to current and deferred tax assets and liabilities.
• The core principle of IAS 12 Income Taxes is that the financial statements should recognise the
current and future tax consequences of:
– the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in
an entity’s statement of financial position
– transactions and other events of the current period that are recognised in an entity’s financial
statements.
• Taxable profit (tax loss) can be calculated directly by applying the relevant tax laws to the transactions
and other events of the current reporting period to determine the difference between assessable
income and allowable deductions.
• Taxable profit (tax loss) can be calculated indirectly by adjusting the accounting profit of the current
reporting period for differences between accounting and tax treatments of items recognised in the
accounting profit.
4.3 Apply the tax rates and tax bases that are consistent with the manner of recovery or settlement
of an asset or liability.
• Key steps in accounting for current tax are as follows.
– Step 1: Calculate the amount expected to be paid to (recovered from) the taxation authorities,
using the tax rates (and tax laws) that have been enacted or substantively enacted by the end of
the reporting period.
– Step 2: Recognise the amount of current tax in profit or loss for the period, in OCI, or directly in
equity, as appropriate.
• Key steps for calculating deferred tax are as follows.
– Step 1: Determine the tax base of assets and liabilities.
– Step 2: Compare the tax base with the carrying amount of assets and liabilities to determine
taxable temporary differences and deductible temporary differences.
– Step 3: Measure deferred tax assets (arising from deductible temporary differences) and deferred
tax liabilities (arising from taxable temporary differences).
– Step 4: Recognise the movement in the deferred tax assets (arising from deductible temporary
differences) and deferred tax liabilities (arising from taxable temporary differences) as deferred
tax, taking into account the limited recognition exceptions, in profit or loss for the period, in OCI,
or directly in equity, as appropriate.
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178 Financial Reporting
• The tax base of a liability that is not in the nature of unearned income is the carrying amount, less
any amount that will be deductible for tax purposes in respect of that liability in future periods.
• The tax base of a liability that is in the nature of unearned income is the carrying amount less any
amount that will not be included in taxable profit in future periods.
• The tax base of an asset is the amount that will be deductible for tax purposes against any
taxable economic benefits that will flow to an entity when it recovers the carrying amount of the
asset. If those economic benefits will not be taxable, the tax base of the asset is equal to its
carrying amount.
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MODULE 4 Income Taxes 179
PART B: RECOGNITION OF DEFERRED TAX
ASSETS AND LIABILITIES
INTRODUCTION
As outlined in table 4.4 in part A, there are four key steps required to recognise and measure deferred tax.
Part B of the module discusses step 4.
IAS 12 requires an entity to recognise deferred tax assets and deferred tax liabilities, with certain limited
exceptions. IAS 12 also prescribes separate recognition rules (and limited recognition exceptions) for
deferred tax assets and deferred tax liabilities.
Each will be discussed and considered in this part of the module.
Relevant Paragraphs
To assist in achieving the objectives of part B, you may wish to read the following paragraphs of IAS 12.
Where specified, you need to be able to apply these paragraphs as referenced in this module.
Subject
Recognition of deferred tax liabilities and deferred tax assets
Initial recognition of an asset or liability
Deductible temporary differences
Unused tax losses and unused tax credits
Reassessment of unrecognised deferred tax assets
Measurement
Recognition of current tax and deferred tax
Paragraphs
15–16
22(c)
24–25, 26(a), 26(b), 26(d), 27–31
34–36
37
46–56
57–60
4.4 RECOGNITION OF DEFERRED TAX LIABILITIES
As explained in paragraph 15 of IAS 12, a deferred tax liability must be recognised for all taxable temporary
differences, except for certain limited exceptions that will be discussed in this section.
Under the IAS 12, paragraph 15 exceptions, deferred tax liabilities are not recognised when they
arise from:
(a) the initial recognition of goodwill; or
(b) the initial recognition of an asset or liability in a transaction which:
(i) is not a business combination;
(ii) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss); and
(iii) at the time of the transaction, does not give rise to equal taxable and deductible temporary
differences.
However, for taxable temporary differences associated with investments in subsidiaries, branches and
associates, and interests in joint arrangements, a deferred tax liability shall be recognised in accordance
with paragraph 39 (IAS 12, para. 15).
Each of these two recognition exceptions is now discussed.
INITIAL RECOGNITION OF GOODWILL ARISING FROM A
BUSINESS COMBINATION (IAS 12, PARA. 15(A))
Goodwill arising from a business combination is recognised and measured in accordance with IFRS 3
Business Combinations.
Many taxation authorities do not allow reductions in the carrying amount of goodwill as a deductible
expense in determining taxable profit. Moreover, in such jurisdictions, the cost of goodwill is often not
deductible when a subsidiary disposes of its underlying business. In such jurisdictions, goodwill has a tax
base of nil. Any difference between the carrying amount of goodwill and its tax base of nil is a taxable
temporary difference. However, [IAS 12] does not permit the recognition of the resulting deferred tax
liability because goodwill is measured as a residual and the recognition of the deferred tax liability would
increase the carrying amount of goodwill (IAS 12, para. 21).
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180 Financial Reporting
INITIAL RECOGNITION OF OTHER ASSETS OR LIABILITIES
NOT IN A BUSINESS COMBINATION TRANSACTION (IAS 12,
PARA. 15(B))
A temporary difference may arise on initial recognition of an asset or liability if, for example, part or all
of the cost of an asset will not be deductible for tax purposes.
[I]f the transaction is not a business combination, affects neither accounting profit nor taxable profit and
does not give rise to equal taxable and deductible temporary differences, an entity would, in the absence
of the exemption provided by paragraphs 15 and 24, recognise the resulting deferred tax liability or asset
and adjust the carrying amount of the asset or liability by the same amount. Such adjustments would make
the financial statements less transparent. Therefore, this Standard does not permit an entity to recognise the
resulting deferred tax liability or asset, either on initial recognition or subsequently (see example below).
Furthermore, an entity does not recognise subsequent changes in the unrecognised deferred tax liability or
asset as the asset is depreciated (IAS 12, para. 22(c)).
For example, an entity purchases an item of machinery for $100; however, the maximum deduction
available for items of machinery of this type has been limited by the taxation authority to $60 per item
of machinery.
As a result of the recognition exemption contained in paragraph 15(b), deferred tax liabilities are not
recognised and the journal entry to record the acquisition of the item of machinery is as follows.
Dr
Cr
Machinery (property, plant and equipment)
Cash/Accounts payable
100
100
In the absence of the exemption contained in paragraph 15(b), the journal entry to record the acquisition
of the item of machinery would have been as follows.
Dr
Cr
Cr
Machinery (property, plant and equipment)
(Cost $100 + Deferred tax ($40 × 30%))
Deferred tax liability ($40 × 30%)
Cash/Accounts payable
112
12
100
However, IAS 12, paragraph 22(c) does not permit an entity to recognise the resulting deferred tax
liability or asset, either on initial recognition or subsequently, as such adjustments would make the financial
statements less transparent and potentially misleading.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraph 22(c) of IAS 12, including the related example.
Paragraph 39 of IAS 12 also includes an exemption for a deferred tax liability for taxable temporary
differences associated with investments in subsidiaries, branches and associates, and interests in joint
arrangements in certain circumstances. Understanding this exemption is outside the scope of this module.
4.5 RECOGNITION OF DEFERRED TAX ASSETS
Deferred tax assets may arise from:
• deductible temporary differences
• unused tax losses and unused tax credits.
As explained in paragraph 24 of IAS 12, a deferred tax asset must be recognised for all deductible
temporary differences to the extent that it is probable that taxable profit will be available against which
the deductible temporary difference can be utilised, except for certain limited exclusions.
Similarly, paragraph 34 of IAS 12 explains that a deferred tax asset shall be recognised for the carryforward of unused tax losses and unused tax credits to the extent that it is probable that future taxable profit
will be available against which the unused tax losses and unused tax credits can be utilised.
These recognition rules (and the limited recognition exceptions) are now discussed.
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MODULE 4 Income Taxes 181
Recognition Rules for Deductible Temporary Differences
When applying the recognition criteria to deferred tax assets arising from deductible temporary differences
(IAS 12, para. 24) consideration must be given to:
• whether any of the specific recognition exceptions apply
• the probability that taxable profit will be available against which the deductible temporary difference
can be utilised.
Each of these matters is now discussed separately.
Recognition Exceptions
In specified circumstances, deferred tax assets may not be recognised for certain deductible temporary
differences. Specifically, deferred tax assets are not recognised when the related deductible temporary
differences arise from the initial recognition of an asset or liability in a transaction that:
(a) is not a business combination;
(b) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss); and
(c) at the time of the transaction, does not give rise to equal taxable and deductible temporary differences.
However, for deductible temporary differences associated with investments in subsidiaries, branches and
associates, and interests in joint arrangements, a deferred tax asset shall be recognised in accordance with
paragraph 44 (IAS 12, para. 24).
These restrictions mirror the restrictions that apply to the recognition of deferred tax liabilities under
paragraph 15(b) of IAS 12. For example, an entity purchases an asset at a cost of $1000. For tax purposes,
on initial recognition, the asset has a tax base of $1200 (under the relevant tax laws). As a result of the
recognition exemption contained in paragraph 24, the entity does not recognise a deferred tax asset for the
difference between the initial carrying amount of the asset and the tax base.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraph 33 of IAS 12, including the related example.
Paragraph 44 of IAS 12 also includes an exemption for a deferred tax asset for deductible temporary
differences associated with investments in subsidiaries, branches and associates, and interests in joint
arrangements in certain circumstances — similar to paragraph 39 for deferred tax liabilities. Again,
understanding this exemption is outside the scope of this module.
Application of the Probable Criterion
A deferred tax asset arising from a deductible temporary difference is recognised only if it is probable
that future economic benefit associated with the item will flow to the entity. The probability of the flow
of economic benefits to the entity from the reversal of deductible temporary differences is dependent on
the probability of future taxable profits, against which the related deductible temporary difference can be
deducted (IAS 12, paras 24 and 27).
IAS 12 does not include a definition of ‘probable’. Guidance on the generally accepted meaning
of ‘probable’ is contained in IAS 37 Provisions, Contingent Liabilities and Contingent Assets, which
states that:
. . . an outflow of resources or other event is regarded as probable if the event is more likely than not
to occur, [that is,] the probability that the event will occur is greater than the probability that it will not
(IAS 37, para. 23).
IAS 37 indicates that the definition in paragraph 23 is not necessarily applicable to other standards.
However, the appendix A of IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
also contains a similar definition, identifying probable to mean ‘more likely than not’. As such, it is
reasonable to use this definition to assist in understanding the application of paragraphs 24 and 27 of
IAS 12. Therefore, a deferred tax asset will be recognised for a deductible temporary difference if it is
more likely than not that the entity will earn sufficient taxable profits against which the related deductible
temporary difference can be deducted in the future.
To determine whether the probable criterion is satisfied, the preparers will need to exercise professional
judgement. As described in module 1, the reliability of the professional judgement by preparers can be
improved with the help of artificial intelligence and other technological advancements. Deep learning
software can be used to analyse thousands of transactions to instantly and accurately identify the likelihood
of incurring future tax liabilities or benefitting from future tax deductions.
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182 Financial Reporting
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 24, 25 and 27 of IAS 12 to review the deferred
tax asset recognition requirements.
Paragraph 28 of IAS 12 explains that a primary source of taxable profit is the reversal of taxable
temporary differences. When a taxable temporary difference reverses, taxable amounts arise and are
included in taxable profit. A deductible temporary difference can then be used against the resulting
taxable profit.
Further guidance is contained in paragraph 29 of IAS 12, which explains that when there are insufficient
taxable temporary differences, the deferred tax asset is recognised to the extent that:
• it is probable that there will be other taxable profit, after allowing for future taxable profit required in
order to utilise future deductible temporary differences, or
• the entity can create taxable profit by using tax planning opportunities.
Tax planning opportunities are ‘actions that the entity would take to create or increase taxable income
in a particular period before the expiry of a tax loss or tax credit carry-forward’ (IAS 12, para. 30).
This relationship is shown diagrammatically in figure 4.7.
FIGURE 4.7
Tax planning relationships
Yes
Are there sufficient taxable temporary differences?
No
Yes
Is it probable that there will be other taxable profit available?
No
Yes
Can the entity create taxable profit by using tax planning opportunities?
No
Recognise deferred
tax asset
Do NOT recognise deferred tax asset
Source: Based on IAS 12, para. 36. © CPA Australia 2022.
Accounting treatment for an entity with a history of tax losses is discussed later in this module when
addressing the recognition rules related to unused tax losses and unused tax credits in IAS 12.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 28–31 of IAS 12 to confirm your understanding
of when the probability recognition criterion is satisfied for deferred tax assets.
Examples 4.7 and 4.8 illustrate how the ‘probability criterion’ would be satisfied for the recognition of
the deferred tax asset arising from a deductible temporary difference.
EXAMPLE 4.7
Probability of the Future Utilisation of Deductible Temporary Differences
(Scenario 1)
The records of HIJ Investments PLC as at 31 December 20X1 show the following.
Warranty Obligations — Deductible Temporary Difference
• A deductible temporary difference of $60 000 relating to warranty obligations, which was expected to
reverse in the future reporting periods, as follows.
– $20 000 in 20X2 (i.e. leaving a remaining deductible temporary difference of $40 000)
– $40 000 in 20X3 (i.e. leaving a $nil remaining deductible temporary difference)
Receivables — Taxable Temporary Difference
• A taxable temporary difference of $100 000, relating to a receivable for credit sales that were recognised
in the measurement of accounting profit in the year ended 31 December 20X1. The receivable is
recognised for accounting purposes when the performance obligation is satisfied by the transfer of
control of the promised goods to the customer. For the purposes of this illustration, we will assume that
the income is taxed when the cash is received.
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MODULE 4 Income Taxes 183
• It was expected that this taxable temporary difference of $100 000 would reverse on receipt of cash in
future reporting periods, as follows.
– $45 000 in 20X2 (i.e. leaving a remaining taxable temporary difference of $55 000)
– $55 000 in 20X3 (i.e. leaving a $nil remaining taxable temporary difference)
• There were no other transactions in 20X1, 20X2 and 20X3.
• Taxable profit for the year ended 31 December 20X1 was $nil.
• The entity does not have a history of tax losses.
Recognising a Deferred Tax Asset
The deductible temporary difference originating during the period ended 31 December 20X1 gives rise to
a deferred tax asset of $18 000 ($60 000 × 30%). Applying the requirements of paragraph 24 of IAS 12,
this deferred tax asset should be recognised in full if ‘it is probable that taxable profit will be available
against which the deductible temporary difference can be utilised’.
Year
Reversal of deductible
temporary difference
Reversal of taxable
temporary difference
20X2
20X3
Total
20 000
40 000
60 000
45 000
55 000
100 000
Result
DTD < TTD
DTD < TTD
The analysis here shows that the expected reversals of the taxable temporary difference in years
20X2 ($45 000) and 20X3 ($55 000) are greater than the expected reversals of the deductible temporary
difference in each of these years ($20 000 and $40 000 respectively).
This means that the expected taxable profits in each of 20X2 and 20X3, arising from the reversal of the
taxable temporary difference, are sufficient to absorb the amounts of the deductible temporary difference
that reverses in each period. As a consequence, HIJ Investments PLC should recognise a deferred tax
asset of $18 000 ($60 000 × 30%) as at 31 December 20X1.
Using the language of paragraph 28(a) of IAS 12, it is probable that sufficient taxable profit will
be available, because there are ‘sufficient taxable temporary differences relating to the same taxation
authority and the same taxable entity which are expected to reverse in the same period as the expected
reversal of the deductible temporary difference’.
EXAMPLE 4.8
Probability of the Future Utilisation of Deductible Temporary Differences
(Scenario 2)
It should be noted that this example adopts very similar data to that used in example 4.7. The key points
of difference are that the data for this example assumes that the deductible temporary difference will be
reversed in full in 20X2 and an additional $55 000 is expected as future deductible expenses in 20X3.
The records of HIJ Investments PLC as at 31 December 20X1 show the following.
Warranty Obligations — Deductible Temporary Difference
• A deductible temporary difference of $60 000 relating to warranty obligations, which was expected to
reverse in full in 20X2 (i.e. leaving a $nil remaining deductible temporary difference).
Receivables — Taxable Temporary Difference
• A taxable temporary difference of $100 000, relating to a receivable for credit sales that were recognised
in the measurement of accounting profit in the year ended 31 December 20X1. The receivable is
recognised for accounting purposes when the performance obligation is satisfied. For the purposes
of this illustration, we will assume that the income is taxed when the cash is received.
• It was expected that the taxable temporary difference would reverse on receipt of cash in future reporting
periods, as follows.
– $45 000 in 20X2 (i.e. leaving a remaining taxable temporary difference of $55 000)
– $55 000 in 20X3 (i.e. leaving a $nil remaining taxable temporary difference)
• Other expenses that were expected to be deductible for tax purposes during 20X3 were $55 000.
• There were no other transactions in 20X1, 20X2 and 20X3.
• Taxable profit for the year ended 31 December 20X1 was $nil.
• Tax losses can be carried forward for offset against future taxable income for only one year. The
carry-back of tax losses is not permitted.
• HIJ Investments PLC does not have a history of tax losses.
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184 Financial Reporting
Recognising a Deferred Tax Asset
In this case, the deductible temporary difference of $60 000 is expected to reverse in full in 20X2. However,
the amount of taxable profit arising from the reversal of the taxable temporary difference in 20X2 is only
$45 000, and the reversal of the taxable temporary differences in 20X3 is equal to the other deductible
expenses in 20X3 (i.e. taxable profit for 20X3 is expected to be $nil). Therefore, the expected taxable
profit in 20X2 and 20X3 is not sufficient to absorb the full amount of the deductible temporary difference.
On this basis, paragraph 24 of IAS 12 has not been satisfied.
As only $45 000 of the deductible temporary difference can be used against the taxable temporary
difference in 20X2, and there are no taxable temporary differences in excess of the future deductions in
20X3, the amount of the deferred tax asset that can be recognised at 31 December 20X1 is restricted
to $13 500 ($45 000 × 30%), leaving $15 000 ($60 000 – $45 000) of the deductible temporary difference
unrecognised.
QUESTION 4.5
(a) Using the data and analysis in example 4.8, present the income tax journal entries for
31 December 20X1.
(b) Assume that the tax legislation allows for the carrying back of tax losses for deduction from
taxable income of the three years before the year of the tax loss. Explain whether or not you
would recognise the full amount of the deferred tax asset as at 31 December 20X1.
RECOGNITION OF DEFERRED TAX
Deferred tax expense (income) arises from the recognition of the movement in deferred tax assets and
deferred tax liabilities in step 4, recognising deferred tax.
As discussed in part A of this module (in relation to the recognition of current tax), the principle adopted
by IAS 12 (para. 12) to account for the tax effects of a transaction or other event (e.g. the recognition of
current tax and deferred tax) is that accounting for tax should be consistent with the accounting treatment
of the transaction or event itself.
For example, deferred tax is recognised in profit or loss (i.e. included in the amount of tax expense (tax
income) for the reporting period) to the extent that it relates to items of income and expense recognised in
profit or loss for the reporting period.
However, deferred tax can also relate to gains or losses recognised in OCI, items recognised directly
in equity or business combination transactions. In these circumstances, deferred tax is recognised in OCI,
directly in equity or as part of accounting for the business combination respectively, to the extent that it
relates to such items or transactions.
Paragraphs 58 to 68C of IAS 12 describe this principle, with the main requirements contained in
paragraph 58 and 61A as discussed with regards to the recognition of current tax in part A of this module.
The recognition of deferred tax outside of profit or loss will be discussed further in part C of this module.
Business combinations and investment entities are covered in module 5.
QUESTION 4.6
Lowsales Ltd (Lowsales) has the following extract from its statement of financial position as at
30 June 20X1.
$
Cash
Accounts receivable (net)
Prepaid rent
Inventory
Equipment (net)
Total assets
97 000
234 000
4 000
228 000
48 000
611 000
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MODULE 4 Income Taxes 185
$
Accounts payable
Revenue received in advance
Bank loan
Foreign currency loan payable
Employee benefits liability
Total liabilities
67 000
18 000
100 000
32 000
65 000
282 000
The following information is relevant for Lowsales.
1. Revenue received in advance is recognised in the statement of financial position of Lowsales
and will be recognised in the statement of P/L and OCI in a later reporting period (i.e. as the
revenue is earned). It is included in taxable profit in 20X1 (i.e. it is taxed on a cash basis).
2. The employee benefits liability increases with additional employee expenses and decreases
when the liability is paid. Lowsales receives a tax deduction when employee benefits are paid.
3. For tax purposes, deductions can only be claimed for credit loss written off. At 30 June 20X1,
the provision for credit loss was $11 000. Expected credit loss expense was $5000 for the year
ended 30 June 20X1. The revenue relating to the accounts receivable has already been taxed.
4. The equipment was originally purchased four years ago for $80 000. The equipment is being
depreciated for tax purposes over eight years and for accounting purposes over ten years.
5. The foreign currency loan payable was originally drawn down at $33 000. The $1000 foreign
exchange gain included in the statement of P/L and OCI is not included in taxable profit until
the loan is settled.
6. Prepaid rent has increased by $2000 during the year. This additional outlay can be claimed as a
tax deduction as incurred (i.e. when it is paid).
7. There are no future tax consequences associated with the cash, accounts payable or inventory
assets.
Assume that Lowsales has an opening deferred tax asset balance of $16 200 and opening deferred
tax liability balance of $2400. Lowsales’ taxable profit for the financial year ending 30 June 20X1 is
$331 000. Assume a tax rate of 30 per cent.
(a) Calculate the relevant tax bases for assets and liabilities for Lowsales for the financial year
ended 30 June 20X1.
(b) Prepare the deferred tax worksheet (deferred tax assets, liabilities and expense) for Lowsales
for the financial year ended 30 June 20X1.
(c) Prepare the income tax journal entry for Lowsales for the financial year ended 30 June 20X1.
RECOGNITION RULES FOR UNUSED TAX LOSSES AND
UNUSED TAX CREDITS
Deferred tax assets also arise when the taxation legislation within a particular jurisdiction allows an entity
to carry forward unused tax losses and tax credits for use against later years’ profits — that is, to use prior
period tax losses and tax credits to reduce tax payable in future periods.
The taxation legislation usually contains several provisions and exceptions, which would need to be
carefully considered to determine the extent to which unused tax losses and unused tax credits may be
carried forward and utilised against future taxable profit.
Deferred tax assets arising from unused tax losses and unused tax credits should be recognised on the
same basis as other deferred tax assets. That is, to the extent that ‘it is probable that future taxable profit
will be available against which the unused tax losses and unused tax credits can be utilised’ (IAS 12,
para. 34).
When applying the probability criterion to unused tax losses or tax credits, IAS 12 states that the
existence of unused tax losses is strong evidence that future taxable profit may not be available. In this
regard, IAS 12 explains further that ‘when an entity has a history of recent losses, the entity recognises
a deferred tax asset arising from unused tax losses or tax credits only to the extent that the entity has
sufficient taxable temporary differences or there is convincing other evidence that sufficient taxable profit
will be available against which the unused tax losses or unused tax credits can be utilised by the entity’
(IAS 12, para. 35).
When assessing the probability that taxable profit will be available against which the unused tax losses
or unused tax credits can be utilised, IAS 12 requires that an entity considers:
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186 Financial Reporting
(a) whether the entity has sufficient taxable temporary differences relating to the same taxation authority
and the same taxable entity, which will result in taxable amounts against which the unused tax losses
or unused tax credits can be utilised before they expire;
(b) whether it is probable that the entity will have taxable profits before the unused tax losses or unused
tax credits expire;
(c) whether the unused tax losses result from identifiable causes which are unlikely to recur; and
(d) whether tax planning opportunities (see paragraph 30) are available to the entity that will create taxable
profit in the period in which the unused tax losses or unused tax credits can be utilised.
To the extent that it is not probable that taxable profit will be available against which the unused tax losses
or unused tax credits can be utilised, the deferred tax asset is not recognised (IAS 12, para. 36).
Examples 4.9 and 4.10 use two different scenarios to illustrate the assessment of whether it is probable
there will be sufficient future taxable profit available to utilise unused tax losses.
EXAMPLE 4.9
Assessing the Probability of Future Utilisation of Unused
Tax Losses (Scenario 1)
An entity’s taxable profit for 20X2, and expected taxable profit for 20X3, are as set out in the
following table.
Taxable profit
Taxable income
Allowable deductions
Settlement of warranty obligations
Other
Taxable profit (loss)
Expected taxable
profit 20X3
$
Actual taxable
profit 20X2
$
75 000
80 000
(35 000)
(40 000)
nil
(95 000)
(15 000)
The table shows a tax loss for 20X2 of $15 000. This example assumes that tax losses can be
carried forward for offset against future taxable profit for only one year and carry-back of tax losses is
not permitted.
On this basis, a deferred tax asset can be recognised for the $15 000 tax loss in 20X2 at 31 December
20X2 to the extent that it is probable that taxable profit will be available during the one-year tax loss
carry-forward period (i.e. by 31 December 20X3).
However, as illustrated by the table, the expected taxable profit for 20X3 is $nil. Although the tax loss is
available for carrying forward, there is insufficient expected taxable profit during the carry-forward period
against which to use the tax loss from 20X2.
Therefore, no deferred tax asset can be recognised for the $15 000 tax loss at 31 December 20X2.
EXAMPLE 4.10
Assessing the Probability of Future Utilisation of Unused
Tax Losses (Scenario 2)
Use the same assumptions as example 4.9, but now assume that the allowable deductions for 20X3 are
only due to the settlement of warranty obligations of $35 000. There are no other allowable deductions in
20X3. Given the amended assumption for this entity, taxable profit for 20X2, and expected taxable profit
for 20X3, are as set out in the following table.
Taxable profit
Taxable income
Allowable deductions
Settlement of warranty obligations
Taxable profit (loss)
Less: Credit for tax loss carried forward
Taxable profit after carrying forward tax losses
Expected taxable
profit 20X3
$
Actual taxable
profit 20X2
$
75 000
80 000
(35 000)
40 000
(15 000)
25 000
(95 000)
(15 000)
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MODULE 4 Income Taxes 187
This table shows a tax loss for 20X2 of $15 000. As outlined in example 4.9, this example assumes that
tax losses can be carried forward for offset against future taxable profit for only one year and carry-back
of tax losses is not permitted.
On this basis, a deferred tax asset arising from the $15 000 tax loss in 20X2 can be recognised at
31 December 20X2 to the extent that it is probable that taxable profit will be available during the one-year
tax loss carry-forward period.
As illustrated in the table for this scenario, the expected taxable profit for 20X3 is $40 000 and this is
sufficient to use the $15 000 tax loss from 20X2. Therefore, a deferred tax asset should be recognised for
the $15 000 tax loss at 31 December 20X2.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 34–36 of IAS 12.
4.6 RECOVERY OF TAX LOSSES
The previous section of this module discussed the recognition of a deferred tax asset arising from a tax
loss in the year in which the tax loss was generated.
This section discusses the accounting treatment of the subsequent recovery of tax losses (i.e. utilising
carry-forward tax losses to reduce taxable profit in subsequent reporting periods).
The core principle of IAS 12 is that the accounting treatment of the recovery of tax losses must be
consistent with the accounting treatment applied in the tax loss period. More specifically, the accounting
treatment of the recovery of tax losses is dependent on whether or not the tax losses were previously
recognised as a deferred tax asset.
The practical application of this core principle is that when tax losses are recovered, the benefit from
the recovery of those losses is allocated:
• first to tax losses for which no deferred tax asset was previously recognised (which, in effect, results in
the recognition of tax income)
• second to tax losses for which a deferred tax asset was previously recognised (which, in effect, results
in the reduction of the previously recognised deferred tax asset).
These principles are illustrated in table 4.9 and in examples 4.11 and 4.12.
TABLE 4.9
Recognising and recovering tax losses
Probability criterion
satisfied?
Probability criterion
for recognition is not
satisfied
See example 4.11
Probability criterion
for recognition is
satisfied (either by
taxable temporary
differences or other
sources)
See example 4.12
Source: CPA Australia 2022.
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188 Financial Reporting
Pro forma journal entry for
recovery of tax losses
Recognition
Recovery
A deferred tax asset is
not recognised in the
loss year, as it is not
probable that there
would be sufficient
taxable profit against
which the unused
tax losses could be
utilised.
On recovery of the tax
loss, the current tax
income and associated
DTA are recognised,
simultaneous with the
derecognition of the DTA
and associated deferred
tax expense. The entry
is usually presented as a
combined journal entry,
omitting the offsetting
entries to recognise and
derecognise the DTA.
Dr
A deferred tax asset is
recognised in the year
of the loss.
The deferred tax asset
is realised when the tax
losses are recovered.
Therefore, the benefit of
the tax losses recovered,
the savings in the outflow
of resources for tax
payments, is recognised
as a reduction in the
deferred tax asset.
Dr
Cr
Deferred tax expense
Current tax income
Cr
Deferred tax expense
Deferred tax asset
It should be noted that the journal entry for recovery of tax losses in the first scenario (i.e. probability
criterion not satisfied) can be seen as the net of two journal entries as follows.
Dr
Deferred tax asset
Cr
Current tax income
Initial recognition of the deferred tax asset.
Dr
Deferred tax expense
Cr
Deferred tax asset
Subsequent realisation of the deferred tax asset.
As both of these journal entries would be recognised in the same period, there is no requirement to
separately recognise the debit (Dr) and credit (Cr) to the deferred tax asset.
EXAMPLE 4.11
Probability Recognition Criterion Not Satisfied
The following assumptions are applicable for TL Ltd.
(a) The tax return of TL Ltd for the period ended 30 June 20X1 revealed a tax loss of $60 000.
(b) Tax losses were available for carry-forward for an indefinite period for use against future taxable profit.
(c) As at 30 June 20X1, there is no convincing evidence that there would be future taxable profits against
which the $60 000 tax loss can be utilised during the tax loss carry-forward period.
(d) Taxable profit for the period ended 30 June 20X2 was $100 000.
(e) There were no movements in temporary differences during the years ended 30 June 20X1 and
30 June 20X2.
(f) The tax rate is 30 per cent.
(g) Reconciliations between accounting profit before tax and taxable profit (loss) for the periods ended
30 June 20X1 and 30 June 20X2 were as follows.
Accounting profit (loss) before tax
Adjustments for movements in non-temporary
differences and excluded temporary differences
Statutory fines for breaching environmental laws
Exempt dividends
Adjustments for movements in
temporary differences
Taxable profit (loss) before utilising tax losses
Tax losses recovered
Taxable profit (loss) after utilising tax losses
Year ended
30 June 20X2
$
Year ended
30 June 20X1
$
110 000
(65 000)
5 000
(10 000)
—
100 000
(60 000)
40 000
—
(60 000)
(60 000)
Tax Loss Reporting Period Ended 30 June 20X1
As at 30 June 20X1 there were no taxable temporary differences against which the tax losses could be
used. Nor was there convincing other evidence that there would be sufficient taxable profits arising from
other sources during the tax loss carry-forward period. Therefore, under paragraph 34 of IAS 12, the entity
is unable to recognise a deferred tax asset as at 30 June 20X1.
Recovery Period Ended 30 June 20X2
During the year ended 30 June 20X2, taxable profit before utilising tax losses was $100 000. As the
probability criterion for recognition of the deferred tax asset was not satisfied for the reporting period
ended 30 June 20X1, the entity recognises the benefit of any tax losses recovered as current tax income.
The journal entries at 30 June 20X2 are:
• Tax losses recovered of $60 000, which would give rise to the following entry.
Dr
Cr
Deferred tax expense
Current tax income
18 000
18 000
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MODULE 4 Income Taxes 189
• Taxable profit of $40 000, which would give rise to the following entry.
Dr
Cr
Current tax expense
Current tax payable
12 000
12 000
Combining these two entries would give the following.
Dr
Cr
Tax expense
Current tax payable
12 000
12 000
As explained in part A of this module, and illustrated in figure 4.1, ‘tax expense’ is the sum of ‘current tax’
and ‘deferred tax’ recognised in the profit or loss for the period. In this example, tax expense of $12 000
(illustrated by combining the two entries) is the net amount of deferred tax expense of $18 000 (from the
first entry), current tax income of $18 000 (from the first entry) and current tax expense of $12 000 (from
the second entry). The tax expense of $12 000 comprises deferred tax expense of $18 000 and net current
tax income of $6000 because the current tax expense is offset against the current tax income.
EXAMPLE 4.12
Probability Recognition Criterion Satisfied
This example uses the same facts outlined in example 4.11 but assumes there is convincing evidence
that there would be sufficient taxable profits arising during the tax loss carry-forward period to use the
carry-forward tax losses.
Tax Loss Reporting Period Ended 30 June 20X1
As at 30 June 20X1, it was probable that there would be sufficient taxable profits during the tax loss carryforward period to use any carry-forward tax losses in the future. Paragraph 34 of IAS 12 allows the entity
to recognise a deferred tax asset of $18 000 ($60 000 × 30%) on that date.
The journal entry required at 30 June 20X1 is as follows.
Dr
Cr
Deferred tax asset
Current tax income
18 000
18 000
The credit entry is against ‘current tax income’ rather than ‘deferred tax income’, as the tax income
arises as a consequence of the tax loss from the calculation of current tax payable (refundable).
Recovery Period Ended 30 June 20X2
During the period ended 30 June 20X2, taxable profit (loss) before utilising tax losses was $100 000.
Consequently, the 20X1 tax loss of $60 000 was recovered in full.
Recall that when tax losses are recovered, the benefit from the recovery of those losses is allocated:
• first to tax losses for which no deferred tax asset was previously recognised
• second to tax losses for which a deferred tax asset was previously recognised.
In this example, a deferred tax asset was previously recognised for the whole of the tax losses that
were incurred during the year ended 30 June 20X1. Since the deferred tax asset has been realised in full,
$18 000 is credited to the deferred tax asset balance. The corresponding debit is to deferred tax expense.
Taxable profit for the period ended 30 June 20X2, after taking into account the tax losses recovered,
was $40 000, giving rise to tax payable and current income tax expense of $12 000 ($40 000 × 30%).
The journal entries required are shown as follows.
• Tax losses recovered were $60 000, which would give rise to the following entry.
Dr
Cr
Deferred tax expense
Deferred tax asset
18 000
18 000
• Taxable profit was $40 000, which would give rise to the following entry.
Dr
Cr
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190 Financial Reporting
Current tax expense
Current tax payable
12 000
12 000
Combining these two entries would give the following.
Dr
Cr
Cr
Tax expense
Deferred tax asset
Current tax payable
30 000
18 000
12 000
As explained in part A of this module, and illustrated in figure 4.1, ‘tax expense’ is the sum of ‘current
tax’ and ‘deferred tax’ recognised in the profit or loss for the period. In this example, tax expense of
$30 000 (illustrated by combining the two entries) is the sum of deferred tax expense of $18 000 (from the
first entry) and current tax expense of $12 000 (from the second entry).
Question 4.7 deals with a more complicated set of circumstances than those discussed in examples 4.11
and 4.12.
QUESTION 4.7
This is a very challenging question. It is recommended that you have a good understanding of the
concepts discussed earlier in this module before attempting this question.
Using the following data, prepare tax-effect journal entries for Bayside Ltd for each of the years
ended 30 June 20X9, 30 June 20Y0 and 30 June 20Y1.
Prior to the beginning of the 20X9 financial year, Bayside Ltd had recognised a deferred tax liability
of $600 relating to a taxable temporary difference of $2000. The taxable temporary difference is the
cumulative difference between the amounts of accelerated depreciation deducted for tax purposes
and the amounts of straight-line depreciation expense for accounting purposes.
Summary of key amounts for the years ended 30 June 20X9 – 30 June 20Y1:
1. Accounting profit (loss) before
income tax
2. Less: Additional tax depreciation
3. Taxable profit (loss) before utilising
unused tax losses
4. Less: Tax losses recovered this period
5. Taxable profit (loss)
6. Current tax payable
Year ended
30 June 20X9
$
Year ended
30 June 20Y0
$
Year ended
30 June 20Y1
$
(1)
(2)
(3)
(6 000)
(1 000)
2 800
(800)
7 700
(700)
(7 000)
0
(7 000)
0
2 000
2 000
0
0
7 000
5 000
2 000
600
The following key items are provided in the table.
• Bayside Ltd incurred a tax loss of $7000 during the period ended 30 June 20X9 (row 3 of
column 1).
• The differences between accounting profit (loss) before income tax and taxable profit (loss)
arise from using accelerated depreciation for tax purposes and straight-line depreciation for
accounting purposes. The extra amounts of tax depreciation allowed each year are deducted
in row 2.
• Row 3 of column 2 shows that for the year ended 30 June 20Y0, taxable profit, before utilising
unused tax losses, was $2000. The corresponding amount for the year ended 30 June 20Y1
was $7000.
• The taxable temporary differences that arose from the additional tax depreciation, shown in
row 2 for each of the three years, were expected to reverse before the end of the seven-year
tax loss carry-forward period that commenced on 30 June 20X9.
For 30 June 20X9 and 30 June 20Y0, Bayside was unable to establish that it was probable that
there would be future taxable profits in excess of taxable profits from the reversal of taxable
temporary differences.
The taxation legislation does not provide for the carry-back of tax losses.
The tax rate is 30 per cent.
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MODULE 4 Income Taxes 191
REASSESSMENT OF THE CARRYING AMOUNTS OF
DEFERRED TAX ASSETS AND LIABILITIES
IAS 12 contains several requirements relating to the reassessment of the carrying amounts of deferred tax
assets and liabilities.
First, ‘[t]he entity recognises a previously unrecognised deferred tax asset to the extent that it has become
probable that future taxable profit will allow the deferred tax asset to be recovered’ (IAS 12, para. 37).
Second, IAS 12, paragraph 56 explains that the carrying amount of a deferred tax asset should be reduced
to the extent that it is no longer probable that there will be sufficient taxable profit to allow realisation of
the asset. A reduction is reversed to the extent that it has subsequently become probable that there will be
sufficient taxable profit to allow realisation of the asset.
Paragraph 60 of IAS 12 states that the carrying amount of a deferred tax asset may change following a
reassessment of the expected recoverability of the item. Paragraph 60 also states that the carrying amounts
of deferred tax assets and deferred tax liabilities may change following:
(a) a change in tax rates or tax laws;
(b) a reassessment of the recoverability of deferred tax assets; or
(c) a change in the expected manner of recovery of an asset (IAS 12, para. 60).
When the balances of deferred tax assets and liabilities change, deferred tax income or expense arises.
The resulting deferred tax income or expense should be recognised in profit or loss, unless it relates to
items previously recognised in OCI or directly recognised in equity.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 37, 56 and 60 of IAS 12.
QUESTION 4.8
An entity is finalising its financial statements for the year ended 30 June 20Y0. Before 30 June 20Y0,
the government announced that the tax rate was to be amended from 40 per cent to 45 per cent of
taxable profit from 30 September 20Y0.
The legislation to amend the tax rate has not yet been approved by the legislature. However, the
government has a significant majority and it is usual, in the tax jurisdiction concerned, to regard
an announcement of a change in the tax rate as having the substantive effect of actual enactment
(i.e. it is substantively enacted).
After performing the income tax calculations at the rate of 40 per cent, the entity has the following
temporary differences and deferred tax asset and deferred tax liability balances.
$
Aggregate deductible temporary differences
Deferred tax asset
Aggregate taxable temporary differences
Deferred tax liability
200 000
80 000
150 000
60 000
Of the deferred tax liability balance, $28 000 ($70 000 × 40%) related to a taxable temporary
difference of $70 000. This associated deferred tax expense had previously been recognised in OCI.
The entity reviewed the carrying amount of the asset in accordance with paragraph 56 of IAS 12
and determined that it was probable that sufficient taxable profit to allow utilisation of the deferred
tax asset would be available in the future.
Present the journal entries necessary to give effect to paragraph 60 of IAS 12.
SUMMARY
Part B of this module discussed the recognition of deferred tax assets and deferred tax liabilities.
Deferred tax liabilities are recognised for all taxable temporary differences, with certain limited
exceptions, as described in IAS 12, paragraphs 15 and 39.
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192 Financial Reporting
Deferred tax assets are recognised to the extent that it is probable that future taxable profit will be
available against which the deferred tax asset can be used, with certain limited exceptions, as described in
IAS 12, paragraphs 24, 34 and 44.
A primary source of taxable profit against which the deferred tax asset can be used is the taxable amounts
that arise when taxable temporary differences reverse. Therefore, a deferred asset is normally recognised if
there are sufficient taxable temporary differences against which the deferred asset (arising from deductible
temporary differences or unused tax losses and credits) can be used.
When an entity does not have sufficient taxable temporary differences, recognition of the deferred tax
asset depends on the probability of future taxable profits in excess of profits arising from the reversal of
existing future taxable temporary differences.
The key points covered in this part, and the learning objectives they align to, are as follows.
KEY POINTS
4.4 Apply the probability recognition criterion for deductible temporary differences, unused tax
losses and unused tax credits.
• Deferred tax liabilities must be recognised for all taxable temporary differences, except for certain
limited exceptions.
• Exceptions to the recognition of deferred tax liabilities include the initial recognition of goodwill and
the initial recognition of an asset or liability in a transaction that is not a business combination, does
not affect the accounting or taxable profit and does not give rise to equal taxable and deductible
temporary differences.
• Deferred tax assets may arise from deductible temporary differences, unused tax losses and unused
tax credits.
• A deferred tax asset must be recognised for all deductible temporary differences to the extent that
it is probable that taxable profit will be available against which the deductible temporary difference
can be utilised, except for certain limited exclusions.
• Exceptions to the recognition of deferred tax assets include the initial recognition of an asset or
liability in a transaction that is not a business combination, does not affect the accounting or taxable
profit and does not give rise to equal taxable and deductible temporary differences.
• Deferred tax assets arising from unused tax losses and unused tax credits should be recognised to
the extent that it is probable that future taxable profit will be available against which the unused tax
losses and unused tax credits can be utilised.
4.5 Account for the recognition and reversal of deferred tax assets arising from deductible
temporary differences, unused tax losses and unused tax credits.
• Deferred tax expense (income) arises from the recognition and movement in deferred tax assets and
deferred tax liabilities.
• When tax losses are recovered, the benefit from the recovery of those losses is allocated:
– first to tax losses for which no deferred tax asset was previously recognised (which, in effect,
results in the recognition of tax income)
– second to tax losses for which a deferred tax asset was previously recognised (which, in effect,
results in the reduction of the previously recognised deferred tax asset).
• An entity recognises a previously unrecognised deferred tax asset to the extent that it has become
probable that future taxable profit will allow the deferred tax asset to be recovered.
• The carrying amount of a deferred tax asset should be reduced to the extent that it is no longer
probable that there will be sufficient taxable profit to allow realisation of the asset.
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MODULE 4 Income Taxes 193
PART C: SPECIAL CONSIDERATIONS
FOR ASSETS MEASURED AT
REVALUED AMOUNTS
INTRODUCTION
Recall from part A of this module that temporary differences are determined by comparing the carrying
amount of assets and liabilities to the tax base. Part C of this module deals with temporary differences that
arise when assets are carried at revalued amounts and the tax base is not adjusted by an amount equivalent
to the revaluation.
Relevant Paragraphs
To assist in achieving the objectives of part C, you may wish to read the following paragraphs of IAS 12
and IAS 16 Property, Plant and Equipment. Where specified, you need to be able to apply these paragraphs
as referenced in this module.
Subject
IAS 12
Taxable temporary differences
Measurement
Recognition of current and deferred tax
Illustrative Examples (in the IFRS Compilation Handbook)
Paragraphs
18(b), 20, 26(d)
51, 51A, 51B
58, 61A, 62(a)
Part A (items 10, 11)
Part B (item 8)
IAS 16
Revaluation model
39–40
4.7 ASSETS CARRIED AT REVALUED AMOUNTS
International Financial Reporting Standards (IFRSs) permit a range of assets to be carried at fair value or
revalued amount. For example, according to paragraph 31 of IAS 16, after the initial recognition, an item
of property, plant and equipment may ‘be carried at a revalued amount, being its fair value at the date of
revaluation, less any subsequent accumulated depreciation and subsequent impairment losses’.
Paragraph 20 of IAS 12 explains that whether a temporary difference arises when an asset is revalued
depends on how a revaluation is treated in the relevant tax jurisdiction.
As discussed earlier in this module, the difference between the carrying amount of a revalued asset and
its tax base is a taxable or deductible temporary difference that gives rise to a deferred tax liability or
deferred tax asset.
When an asset is revalued, there are two possibilities.
1. The tax base of the asset is adjusted by the same amount as the change in the carrying amount of the
asset. Therefore, no temporary difference arises because of the revaluation.
2. The tax base of the asset is not adjusted, or it is adjusted by an amount that differs from the amount by
which the asset was revalued. In this case, a taxable or deductible temporary difference arises.
This is illustrated in example 4.13.
EXAMPLE 4.13
The Effects of a Revaluation
Assume that prior to an upwards revaluation, the tax base and the carrying amount of an asset are each
$100. The asset is revalued upwards to its fair value of $180 for accounting purposes, and the tax base
is adjusted by the same amount (in accordance with the tax laws of the relevant jurisdiction). The tax rate
is 30 per cent.
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194 Financial Reporting
As the tax base is adjusted by the revaluation amount, no temporary difference arises. The temporary
difference immediately before and after the revaluation is $nil, as shown in the following illustration.
Carrying amount
Tax base
Temporary difference
Before revaluation
$
After revaluation
$
100
100
nil
180
180
nil
QUESTION 4.9
Using the same facts as example 4.13, assume that in the tax jurisdiction concerned, the amount of
the tax deduction is not altered in response to a revaluation. Therefore, the tax base is not adjusted
and remains at $100.
Calculate the taxable temporary difference immediately before and after the revaluation.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 18(b), 20 and 26(d) of IAS 12. Note that the
circumstances in question 4.9, where the tax base is not adjusted by the revaluation amount, are consistent with the
requirements of paragraph 26(d).
The module will now address the requirements for accounting for deferred tax arising from both a
revaluation increase and decrease.
4.8 RECOGNITION OF DEFERRED TAX
ON REVALUATION
As discussed in part B of this module, the principle adopted by IAS 12 to account for the tax effects of a
transaction or other event (e.g. the recognition of current tax and deferred tax) is that accounting for tax
should be consistent with the accounting treatment of the transaction or event itself.
In this regard, paragraph 58(a) of IAS 12 requires that current or deferred tax be recognised as income
or expense, except when the tax relates to items that are credited or charged either to OCI or directly to
equity. When the tax relates to items that are recognised in OCI, the current and deferred tax is recognised
in OCI. Similarly, paragraph 61A of IAS 12 requires that where the current and deferred tax relates to
items that are recognised directly in equity, current and deferred tax is recognised directly in equity.
None of the examples in this module relate to items recognised directly in equity. The examples relate
to the revaluation of assets that are recognised in OCI and accumulated in equity.
The required accounting treatment following a revaluation is outlined in paragraphs 39 and 40
of IAS 16.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 39 and 40 of IAS 16.
Following the requirements of paragraph 39 of IAS 16, a revaluation increase should be recognised as an
increase in OCI and accumulated in equity as a revaluation surplus, unless it reverses a previous decrement
in respect of that asset previously recognised in profit or loss.
Using the same facts as question 4.9, the revaluation increase would be recognised in OCI (and
accumulated in equity as a revaluation surplus), while considering the tax effect as follows.
Dr
Asset
Cr
Other comprehensive income — revaluation surplus
To recognise the revaluation increment before tax effects.
80
80
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MODULE 4 Income Taxes 195
Dr
Other comprehensive income — revaluation surplus
Cr
Deferred tax liability
To recognise the tax effect of the revaluation as deferred tax in other
comprehensive income ($80 × 30% tax rate = $24).
24
24
Note the after-tax amount of the revaluation recognised in the revaluation surplus is $80 – $24 = $56.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 58, 61A and 62(a) of IAS 12. You should also
read items 10 and 11 in part A and item 8 of part B of the Illustrative Examples to IAS 12 (in the IFRS Compilation
Handbook).
It should be noted that IAS 16 offers entities the option to transfer to retained earnings a part of the
revaluation surplus recognised for their revalued assets as they are used in the business (IAS 16, para. 41).
In terms of the tax effect of this treatment, paragraph 64 of IAS 12 states that:
IAS 16 does not specify whether an entity should transfer each year from revaluation surplus to retained
earnings an amount equal to the difference between the depreciation or amortisation on a revalued asset
and the depreciation or amortisation based on the cost of that asset. If an entity makes such a transfer, the
amount transferred is net of any related deferred tax. Similar considerations apply to transfers made on
disposal of an item of property, plant or equipment.
RECOVERY OF REVALUED ASSETS THROUGH USE OR
THROUGH SALE
Following the requirements of paragraph 51 of IAS 12, calculating the tax base is based on how an
‘entity expects, at the end of the reporting period, to recover or settle the carrying amounts of its assets
and liabilities’. For an asset, the expectation may be to hold the asset (e.g. using an item of plant
in manufacturing operations) or sell the asset (e.g. disposing of plant that is no longer required for
manufacturing operations). In some jurisdictions, there are differences between the tax treatment of assets
held for use in the business and assets held for sale; consequently, in those jurisdictions, the tax base and
the related temporary differences may differ based on the method chosen to generate future economic
benefits from the asset. This is illustrated in example 4.14, in relation to determining the amount of the
temporary difference arising from the revaluation of a depreciable asset.
EXAMPLE 4.14
The Amount of the Temporary Difference Impacted by the Expected
Manner of Recovery of a Revalued Depreciable Asset
A depreciable asset, with an initial cost of $100, is revalued to a new carrying amount of $150. Immediately
prior to the revaluation, the carrying amount of the asset was $80 and the future deductible amount
on recovery of the asset was the tax written-down amount of $70 (cost of $100 less $30 cumulative
depreciation previously allowed for tax purposes). The capital gains tax cost base (future taxable amount
if recovery of the asset is by sale) is $120 (where applicable).
Note: The capital gains tax cost base of $120 has been provided for illustrative purposes only — it is
not necessary to know how the capital gains tax base was determined. The capital gains tax cost base
is applicable where the expected recovery of the carrying amount is through sale and capital gains tax is
applicable. If the carrying amount of the asset is recovered by use, then capital gain is not applicable.
Recovery of Carrying Amount by Using the Revalued Asset to the End of its Useful Life
Recall that the ‘tax base of an asset is the amount that will be deductible for tax purposes against any
taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset’
(IAS 12, para. 7). Refer to figure 4.3 for the formula for calculating the tax base of an asset.
When an entity first purchases an asset, it will recognise it with a tax base often equal to the initial cost.
The entity will then depreciate the asset for tax purposes based on the cost, claiming tax depreciation
every period as a tax deduction. These deductions reduce the tax base of the asset so that the tax base
at the end of every period reflects what was not yet claimed as a tax deduction out of the initial cost of the
asset (i.e. the initial cost less the cumulative amount already claimed as deductions for tax depreciation).
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196 Financial Reporting
When the carrying amount is expected to be recovered by using the asset to provide goods and services
for resale, the entity is likely to generate future taxable income through use equal to the revalued carrying
amount (i.e. $150 in this exercise). The future amount deductible against that taxable income is the tax
base of $70 (tax written-down amount). The tax base is not affected by the revaluation in this case.
The difference between expected future taxable income and future deductions will give rise to a taxable
temporary difference of $80.
The carrying amount of the asset, together with the tax base and the temporary difference are presented
in the following formulas.
Tax base
of an asset
=
Future
deductible
amounts
70
=
70
Carrying
amount
–
Tax base
=
Temporary
difference
150
–
70
=
80
The entity would recognise a deferred tax liability of $24 ($80 × 30%) for the taxable temporary difference
presented if it expects to recover the carrying amount by using the asset.
In accordance with paragraph 61A of IAS 12, only the amount of deferred tax relating to the revaluation
is recognised in OCI. If the asset had not been revalued, the deferred tax liability would have been $3
(relating to the taxable temporary difference that existed prior to revaluation between the carrying amount
($80) and tax base ($70)). The increase in deferred tax liability from $3 to $24 is due to the revaluation;
therefore, $21 is recognised as deferred tax in OCI, while the original deferred tax ($3) based on the taxable
temporary difference prior to revaluation would have been recognised in profit or loss.
Recovery of Carrying Amount by Selling the Revalued Asset
When the carrying amount is expected to be recovered by selling the asset, the entity may sell the asset
for more than the tax base, in which case it will recover some, if not all, of the previously deducted tax
depreciation. In general, if the asset is sold for more than its initial cost, the entity is essentially recovering
all the tax deductions previously claimed. In many jurisdictions, the proceeds of sale are taxable to the
extent that they reflect tax depreciation recovered. In this example, the entity has claimed deductions for
tax depreciation of $30. If the entity expects to sell the asset for $150 (the revalued amount), the entity will
in effect fully ‘recover’ the $30 tax depreciation previously claimed as tax deductions and will be taxed on
that amount of $30. However, capital gains tax may also apply and will be discussed next.
Capital gains reflect the excess of the sale proceeds over the initial cost of an asset. Basically, the
proceeds on sale of an asset can be divided into a capital gain component and a recovery of cost
component. If the asset is sold for the revalued amount of $150, the capital gain is $50 and the rest
is the recovery of cost component.
Where an entity expects to recover the carrying amount by selling the asset, there are two possible
scenarios as follows.
1. There is no capital gains tax applicable; therefore, if the asset will be sold for the revalued amount of
$150, the capital gain of $50 (the excess of the sale proceeds of $150 over the initial cost of $100) will
be exempt from income tax.
2. Capital gains tax applies; therefore, if the asset will be sold for the revalued amount of $150, the capital
gain of $30 (the excess of the sale proceeds of $150 over the capital gains tax cost base of $120) will
be subject to income tax.
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MODULE 4 Income Taxes 197
As described above, if capital gains tax applies, the tax will be applicable to the difference between
the sale proceeds and the capital gains tax cost base. Determining the capital gains tax cost base, which
might be different from initial cost, is beyond the scope of this module.
Each of these scenarios is now considered.
Note: In both scenarios, the asset remains on hand; the scenarios only assume that the expected
recovery of the carrying amount is through sale. If the asset had been sold, the asset no longer exists and
the tax base and carrying amount will both be $nil and any pre-existing deferred tax liability is reversed.
1. Capital Gains Tax Not Applicable
In a regime in which there is no capital gains tax, if the asset is sold for the revalued amount of $150,
the capital gain of $50 (the excess of the sale proceeds of $150 over the initial cost of $100) is exempt
from income tax. In other words, the tax rate applicable to sale proceeds in excess of the initial cost is,
in substance, $nil. The other component of the sale proceeds (i.e. the recovery of cost) is taxed at the
normal tax rate.
As such, when the carrying amount is expected to be recovered by selling the asset and capital gains
taxes are not applicable, the entity is likely to generate future taxable income through sale equal to the
initial cost (i.e. $100 in this exercise). The future amount deductible against that taxable income is the
tax deductions that were not yet claimed as tax depreciation (i.e. $70). The difference between expected
future taxable income and future deductions will give rise to a taxable temporary difference of $30 ($100
initial cost less $70 written-down amount).
Therefore, the deferred tax liability is $30 × 30% = $9. This represents, in essence, the tax payable in
the future due to the recovery through sale of the tax depreciation claimed as deductions.
This may be contrasted with the treatment on recovery of the carrying amount by using the asset. In that
case, as shown earlier, the deferred tax liability was $24 as the related temporary difference was based
on the total gain on revaluation of the asset and not just on the initial cost.
2. Capital Gains Tax Applicable
In a regime where capital gains tax applies, if the asset is sold for the revalued amount of $150, the total
capital gain is $50; however, only the excess of the sale proceeds of $150 over the capital gains tax cost
base of $120 is taxable. In addition to the capital gain, the fact that this is also a depreciable asset means
that any tax depreciation recovered on the sale of the asset is also taxable. In this example, $30 of the
capital gain and $30 of tax depreciation recovered are taxable.
Therefore, the $150 sales proceeds from the asset (equal to the revalued carrying amount of the asset)
can be divided into:
• a taxable capital gain component of $30 (being the difference between the sales proceeds of $150 and
the capital gains tax cost base of $120)
• an exempt capital gain component of $20 (being the difference between the original cost of $100 and
CGT cost base of $120)
• a recovery of the original cost of $100.
As such, when the carrying amount is expected to be recovered by selling the asset and capital gains
taxes are applicable, the entity is likely to generate future taxable income through sale equal to the taxable
capital gain component of $30 plus the initial cost of $100. The future amount deductible against that
taxable income is the tax deductions that were not yet claimed as tax depreciation (i.e. $70). The difference
between expected future taxable income and future deductions will give rise to a taxable temporary
difference of $60.
As a result, the deferred tax liability is $60 × 30% = $18. This represents, in essence, the tax payable in
the future due to the recovery through sale of the tax depreciation claimed as deductions ($30), together
with the capital gains tax payable ($150 – $120 = $30).
QUESTION 4.10
Present the journal entry required to recognise the deferred tax liability applicable to the revaluation
recognised in example 4.14, under the assumption that the revaluation increase was credited to OCI
and accumulated in equity as a revaluation surplus, if:
(a) the carrying amount of the asset was recovered by using the asset to the end of its useful life
(b) the carrying amount of the asset was recovered by selling the asset and capital gains tax
is applicable.
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198 Financial Reporting
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraph 51A, example B, in IAS 12. This example is
intended to illustrate how the expected manner of recovery of the carrying amount of an item of property, plant and
equipment may affect the tax rate applicable when an entity recovers the carrying amount and the amount of tax that
is ultimately payable or recoverable.
ADDITIONAL GUIDANCE ON RECOVERY OF
NON-DEPRECIABLE ASSETS
As discussed, the amount of tax payable is affected by the manner of recovery of an asset. An entity
may realise the future economic benefits of an asset either through use or through sale. Nevertheless,
paragraph 51B of IAS 12 states that, in relation to a non-depreciable asset revalued in accordance with
IAS 16, the tax consequences to consider (including the tax rates to apply to calculate the deferred tax)
are those that would follow from the recovery of the carrying amount of that asset through sale. This is
illustrated in example 4.15, in relation to determining the amount of the temporary difference arising from
the revaluation of a non-depreciable asset.
EXAMPLE 4.15
The Amount of the Temporary Difference Impacted by the Expected
Manner of Recovery (Non-depreciable Asset)
A piece of land, which is held for use, has a carrying amount and cost of $100. The land is revalued by
$50 to $150. The tax law specifies that the tax rate applicable to the taxable amount derived from sale is
20 per cent. The tax rate applicable to the taxable amount derived from using the asset is 30 per cent.
As the revalued land is a non-depreciable asset, the tax rate that is applicable when calculating any
deferred tax implications is the tax rate applicable from sale (i.e. 20 per cent).
As the economic benefits are taxable, the tax base can be calculated as follows.
Tax base
of an asset
100
=
Future
deductible
amounts
100
The future deductible amounts are $100, being the initial cost of the asset. After the revaluation, the
resulting temporary difference is taxed at a rate of 20 per cent. This is summarised in the following table.
Deferred tax liability after revaluation
Carrying amount of land
Tax base
Temporary difference
Tax rate
Deferred tax liability
$
150
(100)
50
20%
10
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraph 51B of IAS 12.
SUMMARY
Whether a temporary difference arises when an asset is revalued depends on how a revaluation increase or
decrease is treated in the relevant tax jurisdiction.
A taxable or deductible temporary difference arises when the tax base is not adjusted or is adjusted by
an amount that differs from the amount by which the asset was revalued.
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MODULE 4 Income Taxes 199
The accounting treatment of deferred tax resulting from a revaluation follows the treatment of the
revaluation surplus. A revaluation amount may be treated either as income or expense, or as a credit or
debit to OCI and accumulated in equity as a revaluation surplus. IAS 12 requires that:
current tax and deferred tax that relates to items that are recognised, in the same or a different period:
(a) in other comprehensive income, shall be recognised in other comprehensive income
(b) directly in equity, shall be recognised directly in equity (IAS 12, para. 61A).
The manner of recovery of an asset may affect the tax rate and/or the temporary differences recognised at
the end of a period for that asset. IAS 12 requires that deferred tax assets and liabilities should be measured
using the tax rates and temporary differences that are consistent with the expected manner of recovery of
the entity’s assets.
The key points covered in this part, and the learning objective they align to, are as follows.
KEY POINTS
4.6 Determine the deferred tax consequences of revaluing property, plant and equipment.
• There are two possibilities when an asset is revalued as follows.
1. The tax base of the asset is adjusted by the same amount as the change in the carrying amount
of the asset. Therefore, no temporary difference arises because of the revaluation.
2. The tax base of the asset is not adjusted, or it is adjusted by an amount that differs from
the amount by which the asset was revalued. In this case, a taxable or deductible temporary
difference arises.
• IAS 12 requires that current or deferred tax be recognised as income or expense, except when the
tax relates to items that are credited or charged either to OCI or directly to equity. Therefore, if the
revaluation of the asset is recognised in OCI, then the related deferred tax is recognised in OCI.
Pdf_Folio:200
200 Financial Reporting
PART D: FINANCIAL STATEMENT
PRESENTATION AND DISCLOSURE
INTRODUCTION
As discussed in part A of this module, the application of the principles for accounting for income taxes
prescribed by IAS 12 will result in the entity recognising the current and future tax consequences of:
• transactions and other events of the current period that are recognised in an entity’s financial statements
• the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in an
entity’s statement of financial position.
The objective of the presentation and disclosure requirements of IAS 12 is to disclose information that
enables users of the financial statements to understand and evaluate the impact of current tax and deferred
tax on the financial position and performance of the entity.
The presentation and disclosure requirements of IAS 12 focus primarily on the presentation of tax
balances in the statement of financial position and the disclosure of information about the following
matters:
• major components of tax expense (tax income)
• relationship between tax expense (tax income) and accounting profit
• particulars of temporary differences that give rise to the recognition of deferred tax assets and the
deferred tax liabilities
• particulars of temporary differences, unused tax losses and unused tax credits for which no deferred tax
asset was recognised (i.e. because the probability criterion was not satisfied).
Relevant Paragraphs
To assist in achieving the objectives of part D, you may wish to read the following paragraphs of IAS 1
and IAS 12. Where specified, you need to be able to apply these paragraphs as referenced throughout
the module.
Subject
Paragraphs
IAS 1
Information to be presented in the statement of financial position
Disclosure
IAS 12
Presentation
Disclosure
54, 56
82
71–77
79–88
4.9 PRESENTATION OF CURRENT TAX AND
DEFERRED TAX
Current tax assets and liabilities and deferred tax assets and liabilities are presented in separate line items
in the statement of financial position as required by paragraphs 54(n) and 54(o) of IAS 1 Presentation of
Financial Statements.
This is illustrated in the financial statement extract in table 4.10.
TABLE 4.10
Financial statement extract showing current and deferred tax assets and liabilities
Statement of financial position at 30 June 20X1
Current assets
Cash
Trade and other receivables
Non-current assets
Property, plant and equipment
Deferred tax assets
Total assets
20X1
$
20X0
$
433 500
375 500
143 000
216 000
1 450 000
15 000
2 274 000
1 410 000
13 500
1 782 500
(continued)
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MODULE 4 Income Taxes 201
TABLE 4.10
(continued)
20X1
$
Current liabilities
Trade and other payables
Current tax liabilities
Provisions
Non-current liabilities
Borrowings
Deferred tax liabilities
Provisions
Total liabilities
Net assets
20X0
$
(115 000)
(191 500)
(35 000)
(95 000)
(185 000)
(30 000)
(500 000)
(65 000)
(15 000)
(921 500)
1 352 500
(500 000)
(60 000)
(15 000)
(885 000)
897 500
Source: CPA Australia 2022.
Further, paragraph 56 of IAS 1 prohibits the classification of deferred tax assets and deferred tax
liabilities as current assets or liabilities.
Example 4.16 illustrates the presentation of tax liabilities in the statement of financial position.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 54, 56 and 82 of IAS 1.
EXAMPLE 4.16
Presentation of Tax Liabilities in the Statement of Financial Position
The following assumptions are relevant when preparing the disclosures for ABC Ltd.
(a) ABC Ltd received a statutory fine of $50 000 for a violation of environmental laws. This fine is nondeductible in the relevant tax jurisdiction.
(b) A receivable of $100 000 for accrued interest revenue, associated with loans advanced to borrowers,
was recognised in the statement of financial position of ABC Ltd as at 30 June 20X9. The revenue
is taxable when received in cash during the year ended 30 June 20Y0. This advance gave rise to a
temporary difference in 20X9, which is reversed in 20Y0.
(c) Other information about taxable profit and accounting profit before tax was as follows.
Year ended
30 June 20Y0
$
Year ended
30 June 20X9
$
750 000
100 000
600 000
(100 000)
850 000
255 000
50 000
550 000
165 000
Accounting profit before tax
Add/(less): Interest revenue
Add: Amounts in addition to the interest revenue recognised
in the measurement of accounting profit before tax
Statutory fines for violation of environmental laws
Taxable profit
Current tax payable (taxable profit × 30%)
Using this information, the amounts of the current tax liability and the deferred tax liability presented in
the statement of financial position are as follows.
Statement of financial position extracts
Tax liabilities
Current liabilities
Current tax payable
Non-current liabilities
Deferred tax liability
Pdf_Folio:202
202 Financial Reporting
30 June 20Y0
$
30 June 20X9
$
255 000
165 000
0
30 000
OFFSETTING TAX ASSETS AND LIABILITIES
Although current tax assets and liabilities are separately recognised and measured, they are required to be
presented as a single net amount (i.e. net asset or net liability) in the statement of financial position when
certain specified criteria are satisfied (as follows).
IAS 12 requires that current tax assets (tax recoverable from the taxation authority) and current tax
liabilities (tax payable) are offset when the entity:
(a) has a legally enforceable right to set off the recognised amounts; and
(b) intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously
(IAS 12, para. 71).
Similar requirements also apply to the presentation of deferred tax assets and liabilities in the statement
of financial position (as follows).
IAS 12 requires deferred tax assets and deferred tax liabilities to be offset when:
(a) the entity has a legally enforceable right to set off current tax assets against current tax liabilities
[discussed in the previous section]; and
(b) the deferred tax assets and the deferred tax liabilities relate to income taxes levied by the same taxation
authority (IAS 12, para. 74).
In all other circumstances the amounts must be presented in the statement of financial position on a
gross basis (i.e. the statement of financial position will include two separate line items — ‘deferred tax
assets’ and ‘deferred tax liabilities’).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 71–77 of IAS 12.
4.10 MAJOR COMPONENTS OF TAX EXPENSE
Tax expense (tax income) is presented as a single line item in the profit and loss section of the statement
of P/L and OCI as required by paragraph 82(d) of IAS 1.
This is illustrated in the financial statement extract in table 4.11.
TABLE 4.11
Financial statement extract showing tax expense line item
Statement of profit or loss and other comprehensive income
for the year ended 30 June 20X1
Income
Expenses
Profit before income tax
Tax expense
Profit for the year
20X1
$
20X0
$
975 000
(325 000)
650 000
(195 000)
455 000
857 000
(232 000)
625 000
(187 500)
437 500
Source: CPA Australia 2022.
In order to provide more useful information to the users of financial statements, paragraph 79 of IAS 12
requires the major components of tax expense (tax income) to be disclosed separately. This information is
usually disclosed in the notes to the financial statements.
Examples of components of tax expense (tax income) are included in paragraph 80 of IAS 12.
An example of the note disclosure of the major components of tax expense (income) is shown in
table 4.12.
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MODULE 4 Income Taxes 203
TABLE 4.12
Major components of income tax expense (income)
Income tax expense for the year
US$ million
Current tax (expense)/benefit
Current period
Adjustments to current tax expense relating to prior periods
Tax losses, tax credits and temporary differences not recognised for book in
prior years now recouped [i.e. recovered]
Total current tax (expense)/benefit
Deferred tax (expense)/benefit
Origination and reversal of temporary differences
Adjustments to deferred tax expense relating to prior period
Tax losses and credits derecognised
Change in applicable tax rates
Total deferred tax (expense)/benefit
Total income tax (expense)/benefit
2018
2017
(223.6)
22.9
(177.8)
(3.6)
8.4
(192.3)
3.4
(178.0)
10.2
(15.8)
(5.2)
57.8
47.0
(145.3)
35.7
6.7
(15.4)
0.7
26.3
(151.7)
Source: Amcor Limited 2018, Annual Report 2018, p. 69, accessed May 2019, https://www.amcor.com/investors/financialinformation/annual-reports.
The extract from the Amcor Limited 2018 Annual Report discloses the major components of income
tax expense for the 2018 reporting period (and the comparative reporting period) and further distinguishes
between ‘current tax’ and ‘deferred tax’, which together make up the aggregate tax expense for the
reporting period.
The disclosure of the major components of tax expense (tax income) is illustrated in example 4.17.
EXAMPLE 4.17
Disclosing the Major Components of Tax Expense (Income)
This example uses the data outlined in example 4.12.
On the basis of the data outlined in example 4.12, and applying the requirements of paragraph 79 of
IAS 12, the major components of tax expense (income) for the financial year ended 30 June 20Y0 are
as follows.
Major components of tax income
Major components of tax expense (income)
Current tax expense (income)
Tax on taxable profit
Tax benefit from recovery of previously unrecognised tax
losses (IAS 12, para. 80(e))
Current tax expense (income) (IAS 12, para. 80(a))
Deferred tax expense (income)
Deferred tax expense (income) relating to origination and reversal of temporary
differences (IAS 12, para. 80(c))
Deferred tax expense relating to recovery of previously unrecognised tax losses
Deferred tax expense relating to recovery of previously recognised tax losses
Deferred tax expense (income) on recognition of deferred tax assets
Tax benefit arising from previously unrecognised tax losses reducing deferred tax
expense (IAS 12, para. 80(f))
Deferred tax expense (income)
Tax expense (income)
30 June 20Y0
$
12 000
—
12 000
—
—
18 000
—
—
18 000
30 000
4.11 RELATIONSHIP BETWEEN TAX EXPENSE
(INCOME) AND ACCOUNTING PROFIT
As noted and illustrated previously, profit or loss for the reporting period and tax expense (tax income) are
presented as single line items in the statement of P/L and OCI as required by paragraph 82(d) of IAS 1.
Pdf_Folio:204
204 Financial Reporting
In order to fully understand the financial performance of the entity, it is important for users of the
financial statements to understand the relationship between tax expense (income) and profit or loss for the
reporting period (i.e. accounting profit).
Accordingly, paragraph 81(c) of IAS 12 requires that an explanation of the relationship between tax
expense (income) and accounting profit be provided in the notes to the financial statements.
An example of the note disclosure of the relationship between tax expense (income) and accounting
profit is shown in table 4.13.
TABLE 4.13
Relationship between tax expense (income) and accounting profit
Numerical reconciliation of income tax expense to prima facie tax payable
US$ million
Profit before related income tax expense
Tax at the Australian tax rate of 30% (2017: 30%)
Tax effect of amounts which are not deductible/(taxable) in calculating
taxable income:
Net items non-deductible/non-assessable for tax
Previously unrecognised tax losses, tax credits and temporary differences now
used to reduce income tax expense
Tax losses and credits derecognised
Effect of local tax rate change
Underprovision in prior period
Foreign earnings taxed at rates other than 30%
Total income tax expense
2018
2017
880.7
(264.2)
765.7
(229.7)
7.6
12.2
8.4
(5.2)
57.8
7.1
43.2
(145.3)
3.4
(15.4)
(0.7)
3.1
75.4
(151.7)
Source: Amcor Limited 2018, Annual Report 2018, p. 70, accessed May 2019, https://www.amcor.com/investors/financialinformation/annual-reports.
This extract from the Amcor Limited 2018 Annual Report discloses the relationship between tax
expense and accounting profit by presenting a reconciliation from accounting profit (described as ‘profit
before related income tax expense’) to total income tax expense. Please note that the amounts included in
the reconciliation are presented on a ‘tax effective basis’ (i.e. at the 30% Australian tax rate).
The determination of the relevant information to be disclosed in the notes to the financial statements to
explain the relationship between tax expense (income) and accounting profit is commonly undertaken as
a two-step process, as shown in table 4.14.
TABLE 4.14
Key steps for preparing the tax reconciliation
Step 1
Reconcile accounting profit to taxable profit (i.e. understand the differences between the accounting treatment
and the tax treatment).
Step 2
Determine and present the relationship between tax expense (income) and accounting profit.
Source: CPA Australia 2022.
These two steps are illustrated in examples 4.18 and 4.19.
EXAMPLE 4.18
Reconcile Accounting Profit to Taxable Profit
Using the data from example 4.16, a reconciliation of accounting profit to taxable profit is shown in the
first two columns of the accompanying table.
This reconciliation helps to identify and understand the differences between accounting treatment and
tax treatment in order to prepare the explanation of the relationship between tax expense and accounting
profit. Column (3) shows the effect of the tax rate on each of the figures in column (2). These are described
in column (4). The initial focus will be on columns (1) and (2).
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MODULE 4 Income Taxes 205
Year ended 30 June 20X9
$
(2)
(2) × 30%
$
(3)
600 000
180 000
50 000
15 000
650 000
195 000
Tax expense
(100 000)
550 000
(30 000)
165 000
Deferred tax expense
Current tax expense†
(1)
Accounting profit before tax
Tax effect of expenses that are not deductible
in determining taxable profit:
Add: Non-deductible statutory fines
Accounting profit adjusted for nondeductible expenses
Movements in temporary differences
Less: Interest revenue
Taxable profit
(4)
Prima facie tax
† Tax expense – Deferred tax expense = Current tax expense.
As indicated by the descriptions in column (1), the reconciliation begins by adding back to (deducting
from) accounting profit before tax any items of income or expense that cause taxable profit to be greater
(less) than accounting profit.
In relation to the final two columns, it is convenient to first check that the amount shown in column (3)
for tax expense does satisfy the definition of this item. This can be done by reading column (3) from the
bottom upwards and seeing that tax expense of $195 000 is the sum of current tax expense of $165 000
and deferred tax expense of $30 000, as defined earlier. Note that the numerical value of tax expense is
the result of the tax rate and accounting profit before tax adjusted for non-temporary differences, although
tax expense is not defined in this way. These relationships will always apply, except when tax losses are
involved. This complication will be dealt with later.
Reading down column (3), the tax expense of $195 000 is $15 000 greater than the prima facie tax
of $180 000 (where ‘prima facie’ tax is calculated as the accounting profit before tax multiplied by the
30 per cent applicable tax rate), as a consequence of the non-deductibility of the statutory fines.
EXAMPLE 4.19
Presenting the Relationship Between Tax Expense and Accounting Profit
IAS 12 requires the:
explanation of the relationship between tax expense (income) and accounting profit be provided in
either or both of the following two forms:
(i) a numerical reconciliation between tax expense (income) and the product of accounting profit
multiplied by the applicable tax rate(s), disclosing also the basis on which the applicable tax rate(s)
is (are) computed; or
(ii) 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 (IAS 12, para. 81(c)).
Using the data from example 4.16, this example illustrates the two methods of presentation.
Presentation Method 1: Reconciliation Between Tax Expense and the Product of
Accounting Profit Multiplied by the Applicable Tax Rate
30 June 20Y0
$
30 June 20X9
$
750 000
225 000
600 000
180 000
—
225 000
15 000†
195 000
Accounting profit before tax
Tax at the applicable tax rate of 30%
Tax effect of expenses that are not deductible in
determining taxable profit:
Statutory fines
Tax expense
† Amount of the statutory fine × the applicable income tax rate = $50 000 × 30%.
The applicable tax rate is the notional income tax rate of 30 per cent.
Pdf_Folio:206
206 Financial Reporting
Presentation Method 2: Reconciliation Between the Average Effective Tax Rate and
the Applicable Tax Rate
30 June 20Y0
%
30 June 20X9
%
30.0
30.0
—
30.0
2.5†
32.5‡
Applicable tax rate
Tax effect of expenses that are not deductible in
determining taxable profit:
Statutory fines
Average effective tax rate
† Tax effect/accounting profit before tax = $15 000/$600 000.
‡ Tax expense/accounting profit before tax = $195 000/$600 000.
The applicable tax rate is the notional income tax rate of 30 per cent.
4.12 INFORMATION ABOUT EACH TYPE OF
TEMPORARY DIFFERENCE
As discussed in part A of this module, temporary differences result in the recognition of deferred tax assets
and deferred tax liabilities in the statement of financial position, and the movement in deferred tax assets
and liabilities is included as a component of tax expense (income) for the reporting period.
Accordingly, it is important for the users of the financial statements to understand the nature and amount
of each type of temporary difference.
Recognised Deferred Tax Assets and Deferred Tax Liabilities
IAS 12 requires the following information to be disclosed in respect of each type of temporary difference:
(i) the amount of the deferred tax assets and liabilities recognised in the statement of financial position
for each period presented;
(ii) the amount of the deferred tax income or expense recognised in profit or loss, if this is not apparent
from the changes in the amounts recognised in the statement of financial position (IAS 12, para. 81(g)).
An example note disclosure is shown in table 4.15.
TABLE 4.15
Information about each type of temporary difference
Deferred tax assets and liabilities reconciliation
Deferred tax relates to the following:
US$ million
Property, plant and equipment
Impairment of trade receivables
Intangibles
Valuation of inventories
Employee benefits
Provisions
Financial instruments at fair value and net investment hedges
Tax losses carried forward
Accruals and other items
Deferred tax (expense)/benefit
Net deferred tax assets/(liabilities)
Statement of
financial position
Income statement
2018
2017
2018
2017
(205.9)
4.3
(63.4)
5.8
56.4
5.2
17.7
32.2
50.7
(239.3)
6.4
(133.2)
5.3
93.0
45.1
2.2
24.5
47.3
33.4
(2.1)
69.0
0.5
(28.3)
(39.7)
7.7
8.2
(1.7)
47.0
15.3
2.8
24.6
(3.7)
(3.5)
16.3
4.5
(9.4)
12.0
26.3
(97.0)
(148.7)
Source: Amcor Limited 2018, Annual Report 2018, p. 71, accessed May 2019, https://www.amcor.com/investors/financialinformation/annual-reports.
This extract from the Amcor Limited 2018 Annual Report discloses information about each temporary
difference that resulted in the recognition of deferred tax assets and deferred tax liabilities for 2018
Pdf_Folio:207
MODULE 4 Income Taxes 207
(and for the comparative financial year). For example, looking at the first line of the note disclosures
in table 4.15, temporary differences arising from property, plant and equipment resulted in the recognition
of a deferred tax liability of $205.9 million for 2018 (and $239.3 million for 2017).
Example 4.20 illustrates the recognition of taxable temporary differences.
EXAMPLE 4.20
Recognising Taxable Temporary Differences
Using the data from example 4.16, the amounts of deferred tax assets and deferred tax liabilities
recognised in the statement of financial position would be as follows.
30 June 20Y0
$
30 June 20X9
$
0
0
30 000
30 000
Taxable temporary differences
Interest receivable
Deferred tax liability
Unrecognised deferred tax assets and deferred tax liabilities
Paragraph 81(e) of IAS 12 requires the disclosure of ‘the amount (and expiry date, if any) of deductible
temporary differences, unused tax losses, and unused tax credits for which no deferred tax asset is
recognised in the statement of financial position’.
An example note disclosure is shown in table 4.16.
TABLE 4.16
Unrecognised deferred tax assets and deferred tax liabilities
US$ million
recognised(1)
Unused tax losses for which no deferred tax asset has been
Potential tax benefits on unused tax losses at applicable rates of tax
Unrecognised tax credits
Deductible temporary differences not recognised
Total unrecognised deferred tax assets
2018
2017
820.0
214.8
48.0
7.3
270.1
716.4
207.9
25.9
21.4
265.2
(1) Unused tax losses have been incurred by entities in various jurisdictions. Deferred tax assets have not been recognised in
respect of these items because it is not probable that future taxable profit will be available in those jurisdictions against which
the Group can utilise the benefits.
Source: Amcor Limited 2018, Annual Report 2018, p. 71, accessed May 2019, https://www.amcor.com/investors/financialinformation/annual-reports.
The following extract from the Amcor Limited 2018 Annual Report (p. 71) discloses information
about unrecognised deferred tax assets and deferred tax liabilities for 2018 (and for the comparative
financial year).
A deferred tax liability on differences that result from translating financial statements of the Group’s
subsidiaries only arises in the event of a disposal. It is not expected in the foreseeable future to dispose
of any subsidiary or associate and no such deferred tax liability is therefore recognised.
When retained earnings of subsidiaries are distributed upstream to Amcor Limited or other parent
entities, withholding taxes may be payable to various foreign countries. These amounts are not expected to
be significant and the Group controls when and if this deferred tax liability arises. No significant deferred
tax liabilities are thus recognised on unremitted earnings.
The note indicates that Amcor Limited had unused tax losses of $820.0 million for 2018 for which a
deferred tax asset was not recognised. In this regard, the footnote explains that the unused tax losses were
not recognised as a deferred tax asset ‘because it is not probable that future taxable profit will be available
. . . against which the Group can utilise the benefits’ (Amcor Limited 2018, p. 71).
It should be noted that the disclosure requirements with regards to income tax are numerous and, coupled
with the strict requirements in terms of measuring and recognising income tax items, makes the process
of achieving compliance by preparers a bit challenging. Implementing technologies like Ernst & Young
(EY)’s Automated Ledger Review Tool (https://www.ey.com/uk/en/services/tax/ey-alert-compliancetransformation) may allow entities to capture and present the tax-related information more efficiently,
more accurately and ensuring a high level of compliance.
Pdf_Folio:208
208 Financial Reporting
SUMMARY
The objective of the presentation and disclosure requirements of IAS 12 is to disclose information that
enables users of the financial statements to understand and evaluate the impact of current tax and deferred
tax on the financial position and performance of the entity.
IAS 12 requires the presentation and disclosure of several items of information about income tax. The
presentation and disclosures discussed in part D included:
• major components of tax expense (tax income)
• relationship between tax expense (tax income) and accounting profit
• particulars of temporary differences that give rise to the recognition of deferred tax assets and the
deferred tax liabilities
• particulars of temporary differences, unused tax losses and unused tax credits for which no deferred tax
asset was recognised (i.e. because the ‘probability criterion’ was not satisfied).
The key points covered in this part, and the learning objective they align to, are as follows.
KEY POINTS
4.7 Apply the requirements of IAS 12 with respect to financial statement presentation and
disclosure requirements.
• Current tax assets and liabilities and deferred tax assets and liabilities are presented in separate
line items in the statement of financial position.
• Current tax assets and liabilities can be presented as a single net amount (i.e. net asset or net
liability) in the statement of financial position when the following criteria are satisfied.
– The entity has a legally enforceable right to set off the recognised amounts.
– The entity intends to settle on a net basis, or to realise the assets and settle the liability
simultaneously.
• Deferred tax assets and liabilities can be offset in the statement of financial position when:
– 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.
• The major components of tax expense (tax income) are to be disclosed separately in the notes to
the financial statements.
• An explanation of the relationship between accounting profit and tax expense (income) must be
provided in the notes to the financial statements.
• IAS 12 requires particular disclosures to be included in the notes to the financial statements for
each type of temporary difference.
• IAS 12 also requires the disclosure of the amount (and expiry date, if any) of deductible temporary
differences, unused tax losses, and unused tax credits for which no deferred tax asset is recognised
in the statement of financial position.
Pdf_Folio:209
MODULE 4 Income Taxes 209
PART E: COMPREHENSIVE EXAMPLE
INTRODUCTION
Part E of this module looks at a comprehensive example illustrating the application of IAS 12. A thorough
understanding of parts A–D is required before beginning part E.
.......................................................................................................................................................................................
EXPLORE FURTHER
Digital content, such as videos and interactive activities in the e-text, support this module. You can access this content
on My Online Learning.
4.13 CASE STUDY: AAA LTD
The AAA Ltd case study is a comprehensive example that deals with an entity over a three-year period:
20X0, 20X1 and 20X2. The comprehensive example covers the concepts addressed in this module. Specific
considerations covered include:
• recognition and measurement of deferred tax assets and liabilities
• recognition of deferred tax on revaluation
• goodwill
• tax losses, and recovery of tax losses
• presentation and disclosure requirements.
Relevant Paragraphs
To assist in achieving the objectives of part E, you may wish to read the following paragraphs of IAS 1,
IAS 12 and IAS 16. Where specified, you need to be able to apply these paragraphs as referenced in
this module.
Subject
Paragraphs
IAS 1
Information to be presented in the statement of financial position
Disclosure
IAS 12
Definitions
Tax base
Recognition of current tax liabilities and current tax assets
Recognition of deferred tax liabilities and deferred tax assets
Taxable temporary differences
Initial recognition of an asset or liability
Deductible temporary differences
Unused tax losses and unused tax credits
Reassessment of unrecognised deferred tax assets
Measurement
Recognition of current tax and deferred tax
Items recognised outside profit or loss
Presentation
Disclosure
IAS 16
Revaluation model
54, 56
82
5–6
7–11
12–14
15–17
18(b), 20
22(c)
24–25, 26(a), 26(b), 26(d), 27–31
34–36
37
46–56
57–60
61A, 62(a)
71–77
79–88
39–40
BACKGROUND TO AAA LTD
The records of AAA Ltd as at 31 December 20X0 – 31 December 20X2 revealed the following.
(a) A deferred tax liability of $30 000 relating to a taxable temporary difference of $100 000. The
temporary difference related to a receivable that was recognised in the measurement of accounting
profit in the year ended 31 December 20X0. It was expected that the temporary difference would
reverse on receipt of cash in future reporting periods, as follows.
20X1
20X2
Pdf_Folio:210
210 Financial Reporting
$45 000
$55 000
(b) A deductible temporary difference of $15 000 relating to warranty obligations, which was expected to
reverse in the future reporting periods, as follows.
20X1
20X2
$ 5 000
$10 000
(c) During the year ended 31 December 20X0, AAA Ltd received a statutory fine of $6000 for a violation
of environmental laws. This fine was non-deductible in the relevant tax jurisdiction. The fine was paid
in the year ended 31 December 20X1.
(d) On 1 January 20X0, AAA Ltd purchased buildings at cost of $40 000. The tax base of the buildings
before depreciation was also $40 000.
(e) Buildings were depreciated at 20 per cent per year on a straight-line basis for accounting purposes and
at 25 per cent per year on a straight-line basis for tax purposes. The carrying amount of the buildings
was expected to be recovered through use.
(f) On 1 January 20X2, the building was revalued to $45 000 and the entity estimated that the remaining
useful life of the building was five years from the date of the revaluation. The revaluation did not affect
the taxable profit in 20X2, and the tax base of the building was not adjusted to reflect the revaluation.
(g) The entity did not have a history of losses.
(h) AAA Ltd had recognised goodwill of $10 000 in its statement of financial position. Goodwill would
only be expensed if impaired.
(i) Accounting profit was as follows.
20X0
20X1
20X2
$ 75 000
$ 95 000
$110 000
(j) There were no other transactions in 20X0, 20X1 and 20X2.
(k) The tax rate was 30 per cent.
(l) The entity also had the following assets and liabilities, with their tax bases equal to the accounting
carrying amounts.
Inventory
Investments
Plant and equipment
Accounts payable
Long-term debt
20X2
$
20X1
$
20X0
$
2 000
33 000
10 000
500
20 000
2 000
33 000
10 000
500
20 000
2 000
33 000
10 000
500
20 000
DEFERRED TAX
The first step in determining the deferred tax effects is to calculate the deferred tax liability associated with
the buildings. Using the information in the ‘Background to AAA Ltd’ section discussed earlier in part E,
the deferred tax liability can be calculated for the periods ending 31 December 20X0 and 31 December
20X1. This calculation is as follows.
Calculation of Deferred Tax Liability on Buildings
Date
1/01/X0
31/12/X0
31/12/X1
Carrying
amount
$
40 000
32 000
24 000
Tax base
$
Taxable
temporary
difference
$
Deferred tax
liability
$
Deferred
tax expense
(income)
$
40 000
30 000
20 000
0
2 000
4 000
0
600
1 200
0
600
600
Pdf_Folio:211
MODULE 4 Income Taxes 211
This calculation may also be demonstrated as follows.
31/12/X0
$
Carrying amount
Less: Tax base — Cost
— Tax depreciation
Taxable temporary difference
$
32 000
40 000
(10 000)
(30 000)
2 000
Multiplying the taxable temporary difference of $2000 by 30 per cent tax rate, the deferred tax liability
is $600.
31/12/X1
$
Carrying amount
Less: Tax base — Cost
— Tax depreciation
Taxable temporary difference
$
24 000
40 000
(20 000)
(20 000)
4 000
By multiplying the taxable temporary difference of $4000 by the tax rate of 30 per cent, it is determined
that the deferred tax liability increases to $1200. The movement for the year is $600, which is reflected in
deferred tax expense.
At 1 January 20X2, the building was revalued and the estimated useful life adjusted (see note (f) in
the ‘Background to AAA Ltd’ section). Following the revaluation, the deferred tax liability calculation is
shown in table 4.17.
TABLE 4.17
Calculation of deferred tax liability following revaluation
Date
1/01/X2
31/12/X2
Carrying
amount
$
45 000
36 000
Tax base
$
Taxable
temporary
difference
$
Deferred tax
liability
$
Deferred
tax expense
(income)
$
20 000
10 000
25 000
26 000
7 500
7 800
6 300†
300†
† On 1 January 20X2, the building was revalued from its carrying amount of $24 000 to $45 000 — a revaluation increase of $21 000
resulting in a movement of $6300 in deferred tax liability and deferred tax expense (recognised in other comprehensive income
(OCI)). The deferred tax expense of $6300 (recognised in OCI) is calculated as the tax rate of 30 per cent multiplied by the
revaluation increase of $21 000. Recall from part C, in accordance with paragraph 61 of IAS 12, the $6300 will be debited to OCI
and accumulated in equity.
Source: CPA Australia 2022.
This calculation may also be demonstrated as follows.
31/12/X2
Carrying amount
Less: Tax base — Cost
— Tax depreciation
Taxable temporary difference
$
$
36 000
40 000
(30 000)
(10 000)
26 000
By multiplying the taxable temporary difference of $26 000 by the 30 per cent tax rate, it is determined
that the deferred tax liability is $7800. Therefore, the deferred tax liability has increased by $300 since the
beginning of the year. This is recognised in deferred tax expense.
Confirm that the total deferred tax liability of $7800 at 31 December 20X2 will reverse over the
remaining four-year useful life of the asset.
QUESTION 4.11
Assume that the carrying amount and the recoverable amount through sale is $45 000 as at
31 December 20X2. Using the information in table 4.17 as at 31 December 20X2, outline how the
calculations would differ if:
(a) the asset was expected to be recovered through sale and capital gains tax was not applicable
(b) the asset was expected to be recovered through sale and capital gains tax was applicable.
Pdf_Folio:212
212 Financial Reporting
OTHER DEFERRED TAX ASSETS AND LIABILITIES
This module has stated that, to implement the balance sheet method of accounting for income tax, all
taxable and deductible temporary differences are identified by:
• comparing carrying amount of each asset and liability from the statement of financial position with its
tax base
• identifying all items that have a carrying amount of $nil in the statement of financial position but
nevertheless have a tax base.
Table 4.18 illustrates one method of identifying all taxable and deductible temporary differences.
The table lists the carrying amounts of the assets and liabilities, their tax bases and the two temporary
differences: taxable and deductible. Reference to table 4.6 may assist with the determination of the
relationship between the carrying amount and the tax base. The bottom section of the table shows the
calculation of the deferred tax asset and liability for the year.
TABLE 4.18
AAA Ltd’s deferred tax assets and liabilities as at 31 December 20X0
Receivable
Inventory
Investments
Buildings
Plant and equipment
Goodwill†
Accounts payable
Fines payable‡
Warranty obligations
Long-term debt
Total temporary differences
Deferred tax liability (taxable temporary
differences × 30% tax rate)
Deferred tax asset (deductible temporary
differences × 30% tax rate)
Carrying
amount
$
Tax
base
$
100 000
2 000
33 000
32 000
10 000
10 000
500
6 000
15 000
20 000
—
2 000
33 000
30 000
10 000
10 000
500
6 000
—
20 000
Taxable
temporary
difference
$
Deductible
temporary
difference
$
100 000
2 000
15 000
102 000
15 000
30 600
4 500
† IAS 12 Income Tax does not permit the recognition of a deferred tax liability relating to goodwill (IAS 12, para. 15(a)). Therefore,
no taxable or deductible temporary difference should be recognised for goodwill.
‡ The fine is not deductible for tax purposes; therefore, the tax base is equal to its carrying amount.
Source: CPA Australia 2022.
You can confirm the tax bases listed in the second column of the table by referring to paragraphs 7
and 8 of IAS 12 or to the examples in this module. At the same time, you can confirm the taxable temporary
difference for buildings as outlined in tables 4.7 and 4.8. Also note that there are no opening deferred tax
asset or deferred tax liability balances. If such balances did exist at the beginning of the year, these would
need to be considered when constructing the statement of financial position.
QUESTION 4.12
Part A
Construct a table identifying all taxable and deductible temporary differences for AAA Ltd for
the year ending 31 December 20X1, and a table identifying all taxable and deductible temporary
differences for AAA Ltd for the year ending 31 December 20X2.
The tables should include the carrying amounts of the assets and liabilities, their corresponding
tax bases and the two types of temporary differences: taxable and deductible. The bottom section
of the table should illustrate the calculation of the deferred tax asset and liability for the year.
Part B
How would the answer for the year ended 31 December 20X2 differ if the tax rate changed from
30 per cent to 25 per cent in 20X2?
Pdf_Folio:213
MODULE 4 Income Taxes 213
TAXABLE PROFIT AND CURRENT TAX EXPENSE
Having calculated the deferred tax for each of the three years, it is now possible to perform the current tax
expense calculation, as shown in table 4.19.
TABLE 4.19
Calculation of current tax expense
Period ended 31 December 20X0
(1)
Accounting profit before tax
Adjustment for non-temporary
differences and excluded temporary
differences
Statutory fines
Accounting profit adjusted for nontemporary and excluded temporary
differences
Movements in temporary differences
Add: Warranty obligations
Accounting depreciation
Less: Receivables
Tax depreciation
Taxable profit (loss)
$
(2)
(2) × 30%
$
(3)
75 000
22 500
6 000
1 800
81 000
24 300
15 000
8 000
(100 000)
(10 000)
(6 000)
(26 100)
(1 800)
(4)
Prima facie tax
Tax expense
Deferred tax expense
Current tax income
For the period ended 31 December 20X0, a taxable loss results. A deferred tax asset may be recognised to
the extent that it is probable that future taxable profit will be available against which the deferred tax asset can be
used. A primary source of taxable profit is the reversal of taxable temporary differences.
In this example, the expected reversal of the taxable temporary difference in each of years 20X1 and 20X2 is
greater than the expected reversals of the deductible temporary difference in each of these years. This means that
the expected taxable profits in each of 20X1 and 20X2, arising from the reversal of the taxable temporary differences,
are sufficient to absorb the amounts of the deductible temporary differences that reverse in each period. As a
consequence, AAA Ltd should recognise a deferred tax asset of $1800 ($6000 × 30%) as at 31 December 20X0.
Period ended 31 December 20X1
(1)
Accounting profit before tax
Adjustment for non-temporary
differences and excluded temporary
differences
Accounting profit adjusted for nontemporary and excluded temporary
differences
Movements in temporary differences
Add: Receivable
Accounting depreciation
Less: Warranty obligations
Tax depreciation
Recovery of previously recognised
tax losses
Taxable profit (loss)
Pdf_Folio:214
214 Financial Reporting
$
(2)
(2) × 30%
$
(3)
95 000
28 500
—
—
95 000
28 500
Tax expense
9 600
38 100
Deferred tax income
Current tax expense
(4)
Prima facie tax
45 000
8 000
(5 000)
(10 000)
(6 000)
127 000
Period ended 31 December 20X2
(1)
Accounting profit before tax
Adjustment for non-temporary
differences and excluded temporary
differences
Accounting profit adjusted for nontemporary and excluded temporary
differences
Movements in temporary differences
Add: Receivable
Accounting depreciation
Less: Warranty obligations
Tax depreciation
Taxable profit (loss)
$
(2)
(2) × 30%
$
(3)
110 000
33 000
—
—
110 000
33 000
Tax expense
55 000
9 000
(10 000)
(10 000)
154 000
13 200
46 200
Deferred tax income
Current tax expense
(4)
Prima facie tax
Note that this table does not include the tax effects of items recognised in OCI. In this example, the revaluation
of the building on 1 January 20X2 increased deferred tax liability by $6300 and the corresponding deferred tax
expense was recognised in OCI. As the revaluation is not recognised in profit or loss, the tax effect of the revaluation
is not included in the amount for deferred tax income.
At 31 December 20X2, the net movement in deferred tax liability is $6900 ($14 700 – $7800). However, it has two
parts: deferred tax expense recognised in OCI $6300 (Dr) and deferred tax income recognised in profit or loss of
$13 200 (Cr).
Source: CPA Australia 2022.
QUESTION 4.13
How would the answer for the year ended 31 December 20X0 in table 4.19 differ if the entity had a
history of losses?
ILLUSTRATIVE DISCLOSURES
Major Components of Tax Expense (Income)
The disclosures required by IAS 12, paragraphs 79 and 80, are illustrated as follows.
Major components of tax expense (income)
Current tax expense (income)
Deferred tax expense (income) relating to the
origination and reversal of temporary differences
Tax expense
31 Dec 20X2
$
31 Dec 20X1
$
31 Dec 20X0
$
46 200
38 100
(1 800)
(13 200)
33 000
(9 600)
28 500
26 100
24 300
Statement of Financial Position
The disclosures required by paragraph 54(n) and 54(o) of IAS 1 are illustrated as follows.
Statement of financial position extracts
Tax liabilities
Current tax payable
Deferred tax liability
Tax assets
Deferred tax asset
Pdf_Folio:215
31 Dec 20X2
$
31 Dec 20X1
$
31 Dec 20X0
$
46 200
7 800‡
38 100
17 700
30 600
—
3 000
6 300†
† The $6300 includes the $1800 deferred tax asset resulting from the tax losses and the $4500 deferred tax asset from the deductible
temporary difference related to warranty obligations.
‡ The $7800 includes the $1200 deferred tax liability existing at 31 December 20X1 arising from depreciation differences between
accounting and tax for the building, the $6300 additional deferred tax liability arising on revaluation of the building (30%
× $21 000 revaluation increase) and the additional $300 deferred tax liability arising from depreciation differences between
accounting and tax for the year ended 31 December 20X2. Recall from part C, in accordance with paragraph 61 of IAS 12, the
$6300 additional deferred tax liability arising from the revaluation of the asset will be debited to OCI accumulated in equity in
the revaluation surplus.
MODULE 4 Income Taxes 215
Relationship Between Tax Expense and Accounting Profit
The disclosures required by IAS 12, paragraph 81(c)(i), are illustrated as follows.
Relationship between tax expense and
accounting profit
Accounting profit before tax
Tax at the applicable tax rate of 30%
Tax effect of expenses that are not deductible in
determining taxable profit
Statutory fines
Tax expense
31 Dec 20X2
$
31 Dec 20X1
$
31 Dec 20X0
$
110 000
33 000
95 000
28 500
75 000
22 500
0
33 000
0
28 500
1 800
24 300
IAS 12, paragraph 81(c)(ii), allows that this disclosure may alternatively be made on a percentage basis.
Information About Each Type of Temporary Difference
Since the amount of deferred tax income and expense recognised in profit or loss for the current year
is apparent from changes in the amounts recognised in the statement of financial position, the following
information satisfies the disclosure requirements of IAS 12, paragraph 81(g).
The amounts of deferred tax assets and deferred tax liabilities recognised in the statement of financial
position would be as follows.
Taxable temporary differences
Buildings
Receivable
Deferred tax liability
Deductible temporary differences
Warranty obligations
Carry-forward tax losses
Deferred tax asset
31 Dec 20X2
$
31 Dec 20X1
$
31 Dec 20X0
$
7 800‡
0
7 800
1 200
16 500
17 700
600
30 000
30 600
0
0
0
3 000‡
0
3 000
4 500†
1 800
6 300
† Refer to table 4.18 for calculation.
‡ Refer to question 4.12 suggested answer for calculation.
SUMMARY
Part E of this module has worked through a comprehensive example that illustrates the specific applications
of IAS 12, including:
• recognition and measurement of deferred tax assets and liabilities
• recognition of deferred tax on revaluation
• goodwill
• tax losses and recovery of tax losses
• presentation and disclosure requirements.
.......................................................................................................................................................................................
EXPLORE FURTHER
Digital content, such as videos and interactive activities in the e-text, support this module. You can access this content
on My Online Learning.
REVIEW
This module focused on accounting for income tax under IAS 12.
Income taxes normally give rise to an income tax expense and some related income tax assets and
liabilities that should be recognised in the financial statements. As those items can be significant for many
entities, it is important for users and preparers of financial statements to have a clear understanding of the
way they are calculated and recognised in the financial statements.
Pdf_Folio:216
216 Financial Reporting
The accounting treatment for income taxes prescribed in IAS 12 is based on the balance sheet method.
The name of this method comes from the fact that it focuses on balance sheet (or statement of financial
position) items (i.e. assets and liabilities) and requires consideration of the difference between the carrying
amounts of those items (as recognised in the statement of financial position) and their underlying tax bases
(as determined according to the tax rates and tax laws enacted in the relevant jurisdiction). This difference
gives rise to tax effects deferred for the future, which should be recognised together with the current
tax effects.
As discussed in part A of this module, the core principle of IAS 12 is that the financial statements should
recognise the current and future tax consequences of:
• transactions and other events of the current period that are recognised in an entity’s financial statements
• the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in an
entity’s statement of financial position.
From a conceptual perspective, the recognition of the current tax consequences, together with future
tax consequences of the expected recovery (settlement) of the carrying amounts of assets (liabilities)
recognised in the statement of financial position provides a more complete picture of the financial position
and financial performance of the entity.
These current and future tax consequences are reflected in the financial statements, as shown in
table 4.1 earlier in the module; refer back to table 4.1 to refresh your memory on income tax line items in
financial statements.
As discussed in part B of this module, IAS 12 requires an entity to recognise deferred tax assets and
deferred tax liabilities, with certain limited exceptions.
In accordance with these recognition rules (and limited recognition exceptions):
• a deferred tax liability must be recognised for all taxable temporary differences, except for certain
limited exclusions
• a deferred tax asset must be recognised for all deductible temporary differences to the extent that it is
probable that taxable profit will be available against which the deductible temporary difference can be
utilised, except for certain limited exclusions.
As discussed in part D of this module, the presentation and disclosure requirements of IAS 12 focus
primarily on the presentation of tax balances in the statement of financial position and the disclosure of
information about the following matters:
• major components of tax expense (tax income)
• relationship between tax expense (tax income) and accounting profit
• particulars of temporary differences that give rise to the recognition of deferred tax assets and deferred
tax liabilities
• particulars of temporary differences, unused tax losses and unused tax credits for which no deferred tax
asset was recognised (i.e. because the probability criterion was not satisfied).
The objective of the presentation and disclosure requirements of IAS 12 is to disclose information that
enables users of the financial statements to understand and evaluate the impact of current tax and deferred
tax on the financial position and performance of the entity.
REFERENCES
Amcor Limited 2018, Annual Report 2018, accessed May 2019, www.amcor.com/investors/financial-information/annual-reports.
CPA 2016, ‘IAS 12 Income Taxes: Fact sheet’, accessed August 2022, http://www.cpaaustralia.com.au/tools-and-resources/
financial-reporting/ifrs-resources.
IFRS Foundation 2022, 2022 IFRS Standards, IFRS Foundation, London.
Pdf_Folio:217
MODULE 4 Income Taxes 217
Pdf_Folio:218
MODULE 5
BUSINESS
COMBINATIONS AND
GROUP ACCOUNTING
LEARNING OBJECTIVES
After completing this module, you should be able to:
5.1 identify a business combination, discuss the forms that it may take and analyse issues relating to different
business combinations
5.2 discuss and apply the acquisition method to a business combination, including the IFRS 3 requirements
for recognising and measuring goodwill
5.3 apply the accounting for the deferred taxation impact of a business combination
5.4 explain the concept of control and analyse specific scenarios to outline how the existence of control
is determined
5.5 explain and prepare consolidation worksheet entries, including the revaluation of assets subject to
depreciation and transactions within the group
5.6 explain the concept of ‘non-controlling interest’ and prepare a consolidation worksheet that includes the
appropriate adjustment entries and allows for non-controlling interests
5.7 explain and apply the disclosure requirements of both IAS 1 Presentation of Financial Statements for
consolidated financial statements and IFRS 12 Disclosure of Interests in Other Entities for interests in
subsidiaries, associates and joint arrangements
5.8 determine whether significant influence exists in specific scenarios and evaluate whether consolidation
is required
5.9 account for associates using the equity method
5.10 define a joint arrangement and explain the accounting requirements of IFRS 11.
ASSUMED KNOWLEDGE
It is assumed that before commencing your study of this module, you are able to:
• understand the concept of cost of acquisition
• apply the cost method to a single asset, or a number of assets (but not a business)
• understand the concept of consolidated financial statements
• understand the design and purpose of a consolidation worksheet (Note: A consolidation worksheet is prepared each financial year using the financial information of the parent entity and its subsidiaries. Accordingly,
the adjustment entries in the consolidation worksheet do not carry over from period to period and must be
determined and incorporated into the consolidation worksheet each financial year)
• determine whether an acquisition of a subsidiary involves purchased goodwill or a gain on bargain purchase
(Note: Only purchased goodwill will be addressed in this module)
• prepare a consolidation pre-acquisition elimination entry at the acquisition date that involves the revaluation
of assets and recognition of goodwill.
To help you test your understanding of some aspects of assumed knowledge, two questions are included in
the ‘Assumed knowledge review’ at the end of this module. It is strongly recommended that you answer these
questions when directed to do so.
The concepts considered as assumed knowledge are examinable.
Pdf_Folio:219
LEARNING RESOURCES
International Financial Reporting Standards (IFRSs):
• IFRS 3 Business Combinations
• IFRS 10 Consolidated Financial Statements
• IFRS 11 Joint Arrangements
• IFRS 12 Disclosure of Interests in Other Entities
• IAS 1 Presentation of Financial Statements
• IAS 2 Inventories
• IAS 12 Income Taxes
• IAS 16 Property, Plant and Equipment
• IAS 27 Separate Financial Statements
• IAS 28 Investments in Associates and Joint Ventures
• IAS 36 Impairment of Assets
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets
• IAS 38 Intangible Assets.
Other resources:
• Digital content, such as videos and interactive activities in the e-text, support this module. You can access
this task on My Online Learning.
PREVIEW
As part of their strategic objectives, many entities are involved in investment activities to grow or diversify
their operations. Their investments can include:
• acquiring a business or some businesses of other entities (e.g. on 1 June 2022, National Australia
Bank Ltd (National Australia Bank) acquired the consumer business of Citigroup Pty Ltd (Citigroup),
a Sydney-based commercial bank, ultimately owned by Citigroup Inc.)
• establishing relationships with other entities through:
– acquiring shares in other entities (e.g. on 1 November 2021, Nick Scali Ltd (Nick Scali) acquired the
entire share capital of Plush-Think Sofas Pty Ltd (Plush-Think Sofas), a Melbourne-based furniture
store operator)
– setting up joint arrangements (e.g. on 14 January 2020, I-MED Network Ltd, a provider of diagnostic
imaging services, and Harrison-AI Pty Ltd, a software developer, formed a joint venture to allow
radiologists and AI engineers to develop prediction engines to assist radiologists to diagnose diseases
and injuries).
Each of those options comes with its own advantages and disadvantages. To ensure that the strategic
objectives of the investment can be achieved, due diligence must be performed when making such
investment decisions. For example, acquisition of a business with all its assets and liabilities may be the
most appropriate investment for an investor that needs to use the acquired assets in its own business.
Acquiring shares in other entities operating in growth markets with high barriers to entry may be
the most appropriate way for investors to gain exposure to those markets, with the level of exposure
sought influencing the level of equity interest acquired. Finally, setting up joint arrangements may be an
appropriate way to share scarce resources among business partners in search of a common goal, while
protecting themselves against a high level of risks. These investments are particularly popular during
times of rapid technological advancements when entities engage in acquisitions or joint arrangements
with entities that developed new technologies; thus, preserving or enhancing their competitive advantage
by allowing quick access to those technologies, rather than waiting for them to be developed in-house.
When an entity has grown or diversified through either of these means, based on the underlying principle
of accounting it will need to prepare financial statements for users to be able to understand the financial
impact of those investments on the entity’s financial position, performance and cash flows. In preparing
the financial statements, alternative accounting treatments are required, both at the time of the initial
investment and subsequently, according to the type of investment undertaken.
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220 Financial Reporting
If these investments involve acquiring a business or some businesses of other entities, the investor will
directly get ownership over the assets and liabilities of the acquired businesses; as such, the accounting
treatment at the time of the initial investment and subsequently will involve recognising those items in the
investor’s own financial statements, together with any other of its own assets and liabilities. For example,
after National Australia Bank acquired the Australian consumer banking business of Citigroup, National
Australia Bank recognised the assets and liabilities acquired in its own financial statements. Figure 5.1
shows a company acquiring two businesses that become integral parts of the acquirer’s businesses.
FIGURE 5.1
Acquisition of multiple businesses by a company
Business
A
Company
Business
A
Company
Business
B
Business
B
Source: CPA Australia 2022.
If the investor establishes relationships with other entities through acquiring shares in other entities or
setting up a joint arrangement as a joint venture, the investor, in essence, is acquiring a single asset: the
investment account. As such, the accounting treatment at the time of the initial investment will involve
recognising the investment account in the investor’s financial statements based on the consideration
transferred. For example, after Nick Scali acquired the share capital of Plush-Think Sofas, Nick Scali
recognised its investment in Plush-Think Sofas in an investment asset account based on how much it paid
for the shares acquired.
If the investor establishes relationships with other entities through setting up a joint arrangement as a
joint operation, it essentially acquires a share of the individual accounts of the joint operation. As such, the
accounting treatment at the time of the initial investment will involve recognising in the investor’s financial
statements the investor’s share of the individual accounts of the joint operation. For example, if two entities
establish a 50:50 joint operation that gives them joint control over the assets and liabilities contributed to
that operation, and one entity contributes cash of $1 000 000 while the other entity contributes plant and
equipment recognised at its fair value of $1 000 000, each entity will recognise its share (50 per cent) of
the individual assets of the joint operation in their own financial statements (i.e. cash of $500 000 and plant
and equipment of $500 000).
The subsequent accounting treatment of the relationships established with other entities is dependent
upon the type of relationship created. This module considers three types of relationships established by
the investor with other entities (shown in figure 5.2):
1. parent–subsidiary relationship, established through investments where the investor (parent) obtains
control over other entities (i.e. wholly and partially owned subsidiaries, depending on whether the parent
has 100 per cent of the shares in the subsidiary or less)
2. investor–associate relationship, established through investments where the investor obtains significant
influence over other entities (i.e. associates)
3. joint arrangements, established through investments where the investor obtains joint control over other
entities (i.e. joint operations and joint ventures, depending on whether the investor has joint rights over
the assets and liabilities of the arrangement or only over the net assets).
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MODULE 5 Business Combinations and Group Accounting 221
FIGURE 5.2
Types of relationships established by a company with other entities
Company
Associate
Control
Wholly owned
subsidiary
Partially owned
subsidiary
Joint control
Significant
influence
Joint
venture
Joint
operation
Source: CPA Australia 2022.
There are eight international financial reporting standards that provide guidance on various aspects of
accounting for these investment activities.
1. IFRS 3 Business Combinations — specifies the accounting requirements for acquisitions of one or more
businesses and for investments where the investor obtains control over other entities.
2. IFRS 9 Financial Instruments — specifies the accounting requirements for investments in shares and
other financial instruments not covered by other accounting standards that deal with specific types of
investments (as listed in points 3, 4 and 6). (Note: IAS 32 Financial Instruments: Presentation and
IFRS 7 Financial Instruments: Disclosures are also relevant to the presentation and disclosures relating
to investments in this category.)
3. IFRS 10 Consolidated Financial Statements — specifies the additional accounting requirements for the
preparation of consolidated financial statements for investments where the investor obtains control over
other entities.
4. IFRS 11 Joint Arrangements — specifies the accounting requirements for investments where the
investor obtains joint control over a joint arrangement that is either a joint operation or a joint venture.
5. IFRS 12 Disclosure of Interests in Other Entities — specifies the disclosure of information relating to
investments in subsidiaries, associates, joint arrangements and unconsolidated structured entities.
6. IAS 24 Related Party Disclosures — specifies the disclosure of information about relationships
and transactions with related parties including, among other parties, subsidiaries, associates and
joint arrangements.
7. IAS 27 Separate Financial Statements — specifies the accounting requirements for investments in
subsidiaries, associates and joint ventures when the investor prepares separate financial statements.
8. IAS 28 Investments in Associates and Joint Ventures — specifies the accounting requirements for
investments in entities over which the investor has either significant influence (associates) or that are
regarded as joint ventures in IFRS 11.
IFRS 9 will be dealt with in module 6. The remaining accounting standards from the preceding list are
addressed in this module, with discussion of the overriding principles on which these accounting standards
were developed. IAS 24 requires disclosures regarding the effect of transactions between related parties
(e.g. between parent and subsidiary, investor and associate) to enable users to better assess the investor’s
operations and the risks and opportunities it may face, but it will not be discussed further as it is beyond
the scope of this material.
Part A of this module focuses on the general accounting principles and requirements applicable,
according to IFRS 3, to those investments where an investor acquires one or more businesses (e.g. National
Australia Bank acquiring the Australian consumer banking business of Citigroup) or obtains control
of other entities (i.e. establishing a parent–subsidiary relationship). Those investments are denoted as
business combinations.
The remaining parts of this module focus solely on those relationships established by a company with
other entities, as per figure 5.2. Part B of this module focuses on additional accounting requirements
prescribed in IFRS 10 for those investments where the investor obtains control of other entities, giving rise
Pdf_Folio:222
222 Financial Reporting
to parent–subsidiary relationships. The additional requirements addressed in part B relate to the acquirer’s
need to prepare consolidated financial statements to show the financial performance, position and cash
flows of the acquirer/parent and the subsidiary from the perspective of the reporting entity created. The
Conceptual Framework states that ‘a reporting entity can be a single entity or a portion of an entity or can
comprise more than one entity’ (para. 3.10). The Conceptual Framework further states that ‘if a reporting
entity comprises both the parent and its subsidiaries, the reporting entity’s financial statements are referred
to as ‘consolidated financial statements’ (para. 3.11). The consolidated financial statements reflect the
economic impact of transactions where the economic entity as a whole is involved with external parties,
but does not include the effect of transactions within the economic entity — because the users of financial
statements need to know how well the entity is doing externally. Note that the accounting requirements
from IFRS 3 described in part A are applicable in the preparation of the consolidated financial statements
in accordance with IFRS 10.
Part C focuses on investments where the investor obtains significant influence over the investee
(associate). It addresses two issues in accordance with IAS 28:
1. determining whether or not that relationship exists
2. specifying the requirements for applying the equity method to account for investments in associates.
Part D of this module provides a brief overview of the general principles and requirements for those
investments where the investor has joint control over a joint arrangement, distinguishing between joint
operations and joint ventures (IFRS 11).
Parts B, C and D also address the disclosure requirements for investors that have an investment
in subsidiaries, associates and joint arrangements, respectively. These requirements are included in
IFRS 12.
Table 5.1 provides a summary of the accounting treatment requirements for all the investment types
discussed previously (and illustrated by figures 5.1 and 5.2), both at the time of the initial investment
and after.
TABLE 5.1
Accounting treatment of different investment types
Investment type
Accounting rules
addressing this
type of investment
At the time of
initial investment
After the initial
investment
Section(s)
addressing
this type of
investment
Acquiring assets
and liabilities
that constitute
a business
IFRS 3
Recognise the assets
and liabilities of the
business acquired in
the investor’s accounts
Recognise the assets
and liabilities of the
business acquired
in the investor’s
accounts
A
Obtaining control
over other entities
IFRS 3, 10, 12;
IAS 24
Recognise an
investment asset in the
investor’s accounts
Prepare consolidated
financial statements
A, B
Obtaining
significant
influence over
other entities
IAS 24, 28
Recognise an
investment asset in the
investor’s accounts
Use the equity
method of accounting
to recognise
changes in the
investment account
C
Setting up a
joint venture
IFRS 11, 12;
IAS 24, 28
Recognise an
investment asset in the
investor’s accounts
Use the equity
method of accounting
to recognise
changes in the
investment account
D
Setting up a
joint operation
IFRS 11, 12;
IAS 24
Recognise the investor’s
share of the assets
and liabilities of the
joint operation
Recognise the
investor’s share of the
assets and liabilities
of the joint operation
D
Source: CPA Australia 2022.
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MODULE 5 Business Combinations and Group Accounting 223
PART A: BUSINESS COMBINATIONS
INTRODUCTION
Many entities, no matter how big or small, at some point will try to expand by obtaining control over other
businesses, including whole entities, that is, via business combinations. Due to legal, tax, regulatory or
other reasons, a business combination may be structured in a variety of ways, including the following.
• An entity acquires the assets and liabilities of a business of another entity.
• An entity obtains control of another entity through the purchase of shares (equity interests) in that entity.
• An entity obtains control of another entity through other means than the purchase of shares (equity
interests) in that entity (e.g. by contract alone).
• A new entity is formed to obtain control through the purchase of shares in other entities.
• A stapled entity is listed on the securities exchange. A stapled entity comprises several legal entities that
are stapled (combined) together so that purchasers of the ‘stapled’ shares become investors in all the
legal entities (e.g. Westfield Group, which staples together Westfield Holdings shares, Westfield Trust
units and Westfield America Trust units).
• Dual-listed entities where the operations of two entities listed on different securities exchanges are
combined and managed via a contractual arrangement so that investors in each of the entities share in
the performance of the combined operations of both entities (e.g. Rio Tinto Ltd in Australia and Rio
Tinto plc in the United Kingdom).
This module considers the first two bullet points specified in the preceding list, as these are two of the
most common scenarios. As in figure 5.3, these two types of business combinations are categorised as:
1. direct acquisition: acquiring the assets and liabilities (i.e. net assets) of another business that does
not represent a separate legal entity or subsequently ceases to exist as a separate legal entity (e.g. the
acquisition by National Australia Bank of the Australian consumer banking business of Citigroup)
2. indirect acquisition: acquiring the shares of another separate legal entity in order to obtain control over
that entity, in which case a parent–subsidiary relationship arises (e.g. the acquisition by Nick Scali of
the entire share capital of Plush-Think Sofas).
FIGURE 5.3
Business combinations
Business combinations
Investor acquires the assets and
Investor acquires shares in another
liabilities of one or more businesses
entity and obtains control
Direct acquisition
Indirect acquisition
Source: CPA Australia 2022.
According to IFRS 3, where a business combination occurs, it is very important to first identify the
acquirer (i.e. the entity that obtains control, whether directly or indirectly), as it has to disclose information
that enables users to assess the nature and financial impact of the acquisition (in our examples, the acquirers
are National Australia Bank and Nick Scali). Hence, IFRS 3 requires an acquirer to be identified and the
combination to be accounted for using the acquisition method. This method results in information that
shows the financial impact of the business combination on the acquirer by identifying what was acquired
in exchange for the consideration transferred. More specifically, under this method, an acquirer recognises
the identifiable assets acquired, liabilities assumed and any non-controlling interests in the acquiree, and
then identifies any difference at acquisition date between:
(a) the fair value of the consideration transferred plus any non-controlling interest plus the fair value of
any previously held equity interest in the acquiree
(b) the fair value of the identifiable net assets acquired (IFRS 3, para. 32).
This difference will be recognised as goodwill if the amount in (a) is greater than the amount in (b). If
the opposite situation arises, the difference is considered to be a gain on bargain purchase and recognised
as part of profit or loss. As the latter is not common in practice, this module will only focus on situations
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224 Financial Reporting
where goodwill arises as a result of a business combination. IFRS 3 specifies measurement and disclosure
requirements for goodwill, both at the acquisition date and subsequently.
Note that the preceding formula for the calculation of goodwill essentially applies only in the case of
an indirect acquisition; in the case of a direct acquisition, there won’t be any non-controlling interest or
previously held equity interest in the acquiree, and therefore the goodwill can be calculated as the simple
difference between the acquisition-date fair values of:
(a) the consideration transferred
(b) the identifiable net assets acquired.
When a business combination is an indirect acquisition (i.e. it involves a purchase of shares that leads
to a parent–subsidiary relationship), in accordance with the requirements of IFRS 10, a set of consolidated
financial statements must be prepared that include the aggregated (combined) financial performance,
financial position and cash flows of the parent and its subsidiary/ies.
The additional requirements related to the preparation of the consolidated financial statements are
considered in part B of this module.
Relevant Paragraphs
To assist in understanding the material presented in part A, you may wish to read the following paragraphs
of IFRS 3. Where specified, you need to be able to apply these paragraphs referenced in this module.
Subject
Paragraphs
Objective
Scope
Identifying a business combination
The acquisition method
Identifying the acquirer
Determining the acquisition date
Recognising and measuring the identifiable assets acquired, liabilities assumed
and any non-controlling interest in the acquiree
Recognising and measuring goodwill or a gain from a bargain purchase
Measurement period
Determining what is part of the business combination transaction
Subsequent measurement and accounting
Disclosures
Defined terms
1
2
3
4–53
6–7
8–9
10–31
32–40
45–50
51–53
54–57
59–63
Appendix A
5.1 IDENTIFYING A BUSINESS COMBINATION
A business combination is ‘[a] transaction or other event in which an acquirer obtains control of one or
more businesses’ (IFRS 3, Appendix A). Business combinations can be as simple as buying a franchise
from the franchisor, but also include transactions referred to as ‘true mergers’ or ‘mergers of equals’.
The business/es over which the acquirer obtains control is (are collectively) referred to as the acquiree.
A business is defined in Appendix A of IFRS 3 as ‘[a]n integrated set of activities and assets that is capable
of being conducted and managed for the purpose of providing goods or services to customers, generating
investment income (such as dividends or interest) or generating other income from ordinary activities’.
It is important to note that the integrated set of assets and processes is required to be capable of resulting
in economic benefits to be recognised as a business and not actually required to produce these benefits yet.
For example, a start-up entity that is still developing a product or is trying to find a market for its products
can still be classified as a business. Also, the assessment of whether the assets and liabilities acquired
constitute a business is based on the situation existing at acquisition date; instances where those assets and
liabilities are then sold to other parties (i.e. essentially breaking up the business after acquisition) do not
indicate that a business combination did not take place at acquisition date, they just show that the business
combination was short-lived.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read the definitions of ‘acquirer’, ‘acquiree’, ‘business’, ‘business
combination’ and ‘equity interests’ in IFRS 3, Appendix A, and ‘control’ in paragraphs 6–8, and ‘control of an investee’
in IFRS 10, Appendix A.
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MODULE 5 Business Combinations and Group Accounting 225
QUESTION 5.1
Indicate which of the following acquisitions represent a business combination. Select one or more
options from the following list. Justify your answer for each option.
(a) A Ltd acquires inventory from B Ltd on a regular basis.
(b) A Ltd acquires plant and equipment from B Ltd as a one-off transaction.
(c) A Ltd acquires some inventory from B Ltd that it then sells to C Ltd and some plant and
equipment that it then sells to D Ltd.
(d) A Ltd acquires a bundle of assets from B Ltd that includes, among others, cash, inventories,
a brand name, plant and equipment, land and buildings that are used together to produce and
market a blood pressure monitor.
(e) A Ltd acquires the entire share capital of B Ltd from its old shareholders.
5.2 THE ACQUISITION METHOD
IFRS 3 requires that all business combinations within the scope of the standard, no matter the form,
be accounted for using the acquisition method. That is because the substance of these transactions
(i.e. obtaining control over other businesses) is the same; only the form varies. A business combination
involving businesses or entities under common control is not subject to the acquisition method because it
is not within the scope of the standard (IFRS 3, para. 2).
The acquisition method is applied at acquisition date. As outlined in IFRS 3, paragraph 5, the application
of the acquisition method involves four steps:
(a) identifying the acquirer;
(b) determining the acquisition date;
(c) recognising and measuring the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree; and
(d) recognising and measuring goodwill or a gain from a bargain purchase.
It should be noted here that the acquisition method is consistent with the way accounting in general
deals with transactions in which assets are acquired and liabilities are assumed or incurred (IFRS 3,
para. BC24).
(A) IDENTIFYING THE ACQUIRER
The financial impact of a business combination is likely to be more significant for the entity that obtains
control in such a transaction or event, so the users of financial information need to focus on the acquirer.
Consequently, the acquisition method views the business combination from the acquirer’s perspective, so
it is fitting that the first step in applying this method is identifying the acquirer. In the case of a direct
acquisition, the acquirer is the entity that receives the assets and liabilities acquired. In the case of an
indirect acquisition, the guidance in IFRS 10 related to the concept of control is used to identify the acquirer
(IFRS 3, para. 7). As such, IFRS 10, paragraph 7 specifies the essential criteria of control that must be
satisfied by the acquirer (investor) in order to be considered as having control over the acquiree (investee),
that is:
(a) power over the investee;
(b) exposure, or rights, to variable returns from its involvement with the investee; and
(c) the ability to use its power over the investee to affect the amount of the investor’s returns.
It should not automatically be assumed that an investor has control over the investee when it holds
more than 50 per cent of the equity interests that carry voting rights in the investee. Previously, such an
assumption was often presented as a ‘rule of thumb’ indicating the existence of control. However, this ‘rule
of thumb’ is now regarded as an inappropriate, outdated and outmoded concept. On one hand, control can
exist even when the investor holds a lower percentage of those equity interests (e.g. when the investor
holds 49 per cent of the equity interests that carry voting rights in the investee, while the other 51 per cent
is held by a few hundred individual shareholders, each holding less than 1 per cent, who do not regularly
attend meetings where voting rights can be exercised). On the other hand, holding more than 50 per cent
of the equity interests that carry voting rights in an investee may indicate the existence of control, but
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226 Financial Reporting
this would need to be established on a case by case basis in light of available evidence. The concept of
control, and its application, is discussed in more detail in part B of this module in the context of whether
a parent–subsidiary relationship exists.
Based on the guidance provided in IFRS 10 with regards to the criteria of control, determining which
entity is the acquirer in an indirect acquisition is a matter of professional judgement. When the application
of the guidance on control in IFRS 10 does not clearly indicate which entity is the acquirer in an indirect
acquisition, IFRS 3 includes additional guidance in paragraphs B14–B15 (see table 5.2).
TABLE 5.2
Identifying an acquirer
Business combination effected
The acquirer is usually
• primarily by transferring cash or other assets
• the entity that transfers the cash or other assets
• by incurring liabilities
• the entity that incurs the liabilities
• primarily by exchanging equity interests
• the entity that issues the equity interests
Source: Adapted from IFRS Foundation 2022, IFRS 3 Business Combinations, paras B14–B15, IFRS Foundation, London,
pp. A219–A220.
IFRS 3 states that if a business combination involves an exchange of equity interests, the entity issuing
shares is normally the acquirer (IFRS 3, para. B15). Since this may not always be the case, as in a reverse
acquisition, all the facts and circumstances must be considered in assessing who is the acquirer in a business
combination.
Note: This module does not deal with accounting for reverse acquisitions considered in IFRS 3,
paragraph B19.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraph B15 of IFRS 3 to expand on the facts and
circumstances that should also be considered in identifying the acquirer in a business combination effected by
exchanging equity interests.
IFRS 3, paragraphs B16 and B17 provide some additional guidance to assist in identifying the acquirer
in a business combination, including consideration of:
• the relative size of the combining entities, with the largest party normally being the acquirer (e.g. when
a large player in an industry decides to combine its business with one of its competitors of considerably
smaller size, it is normally assumed that the larger entity is the acquirer, taking over the ‘little guy’)
• the entity that initiated the combination.
Further guidance in paragraph B18 specifies that a ‘new entity formed to effect a business combination
is not necessarily the acquirer’ because this entity was created to manage the combined entities and did
not play any part in the negotiations between the combining entities; instead, one of the combining entities
should be identified as the acquirer.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read the following paragraphs of IFRS 3:
• B16–B18
• BC93–BC101, which discuss the IASB’s Basis for Conclusions on IFRS 3 in relation to identifying the acquirer
(in the IFRS Compilation Handbook).
QUESTION 5.2
Refer to the following business combinations and discuss the factors that need to be taken into
account when determining the acquirers in the combinations.
(a)
A Ltd
B Ltd
A Ltd acquired 90%
of the shares and
voting rights in
B Ltd for cash.
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MODULE 5 Business Combinations and Group Accounting 227
(b)
D Ltd
100%
100%
100%
A Ltd
B Ltd
C Ltd
A new entity, D Ltd, was formed and acquired all
the shares in A Ltd, B Ltd and C Ltd by issuing
shares in D Ltd.
(c)
100%
A Ltd
B Ltd
Prior to the acquisition of shares in B Ltd, A Ltd had 500 000 shares on issue
(fair value of $5) and B Ltd had 400 000 on issue (fair value of $10).
To acquire the shares in B Ltd, A Ltd issued 800 000 shares to the shareholders of B Ltd.
(B) DETERMINING THE ACQUISITION DATE
The acquisition date is the date on which the acquirer obtains control of the acquiree (IFRS 3, para. 8).
For a direct acquisition, that may be the date when the contract of the sale of the business by the acquiree
is signed. For an indirect acquisition, that may be the date when enough shares in the acquiree that give
majority voting power are held by the acquirer.
EXAMPLE 5.1
Determining the Acquisition Date
As part of the history of the acquisition of B Ltd (B) by A Ltd (A), the following information is available
(assume that all the shares in B carry voting rights).
• On 15/08/20X1, A acquired 3.6 per cent of the shares in B.
• On 31/08/20X2, A acquired a further 18.9 per cent interest in B.
• On 17/11/20X3, A managed to convince a major shareholder in B to sell its ownership interest of
35.5 per cent to A, with the shares being transferred to A on that day.
• A has established that holding 50 per cent of the shares in B would be sufficient to exercise control
over B.
On 15/08/20X1, A had only 3.6 per cent of the voting rights in B, while on 31/08/20X2, the voting
rights held by A increased to 22.5 per cent, which is still not enough to suggest the existence of control.
However, on 17/11/20X3, the interest by A becomes 58 per cent, enough to give A control over B. As such,
the acquisition date is 17/11/20X3. Figure 5.4 shows the timeline of the events related to the acquisition
of B’s shares by A and the total ownership interest by A at specific times.
FIGURE 5.4
Timeline for A’s acquisition of B’s shares
3.6%
01/01
20X1
22.5%
01/01
20X2
58%
01/01
20X3
01/01
20X4
Source: CPA Australia 2022.
In the further examples and questions contained in this module, the acquisition date will always
be provided.
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228 Financial Reporting
(C) RECOGNISING AND MEASURING THE IDENTIFIABLE
ASSETS ACQUIRED, THE LIABILITIES ASSUMED AND ANY
NON-CONTROLLING INTEREST IN THE ACQUIREE
Recognition
In order to be recognised in a business combination, an identifiable asset or liability normally needs to be
one that is capable of being individually identified and separately recognised in the statement of financial
position because it meets the following recognition criteria.
• It meets, at the acquisition date, the definition of an asset or liability in the Conceptual Framework
according to IFRS 3, paragraph 11.
• It must be part of what the acquirer and the acquiree exchanged in the business combination transaction,
rather than a result of separate transactions.
A number of exceptions to this principle are discussed shortly.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 10–14 of IFRS 3.
Identifiable assets acquired may include items such as inventory, receivables, property, plant and
equipment and intangible assets. If an acquired asset cannot be individually identified and recognised
(e.g. customer satisfaction or employees’ satisfaction), by definition it is regarded as part of the goodwill
of the acquired business, which will be recognised in step 4 of the acquisition method.
Identifiable liabilities assumed may include, among others, items such as accounts payable, loans and
taxes payable.
Note that the recognition of the identifiable assets acquired and liabilities assumed is not limited to
the identifiable assets and the liabilities that were previously recognised by the acquiree. Given that the
acquisition method views the acquisition from the acquirer’s perspective, additional identifiable assets
or liabilities may be recognised in this step. For example, the acquiree may have some intangible assets
that were generated internally — according to IAS 38, they may not be able to be recognised by the
acquiree prior to the business combination; however, they should be recognised by the acquirer as part of
the identifiable assets acquired as long as they satisfy either a:
• separability criterion, or
• contractual-legal criterion.
The separability criterion is fulfilled if the intangible asset can be separated from the entity and sold,
rented, transferred, licensed or exchanged. The contractual-legal criterion relates to control over the asset
via contractual or legal rights, regardless of whether or not the rights are transferable or separable from the
entity or other rights (IAS 38, para. 12; IFRS 3, para. B32).
EXAMPLE 5.2
Recognising the Identifiable Assets Acquired and Liabilities Assumed
Assume that A Ltd (A) acquired the business of B Ltd (B), which ran a store in a sought-after location that
ensured customers enjoy shopping there. At acquisition date, the fair values of the assets and liabilities
presented in the statement of financial position prepared by B are:
• accounts receivable — $400 000
• inventory — $600 000
• plant and equipment — $2 000 000
• land and buildings — $7 000 000
• accounts payable — $500 000
• bank loan — $4 500 000.
In addition, A identified that B had a trademark with a fair value of $1 000 000 not recognised in its
financial statements. Also, customer satisfaction with B was extremely good due to the after-sale service
that B provided, and customers were willing to pay more for a product sold by B, even though there were
cheaper options available on the market.
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MODULE 5 Business Combinations and Group Accounting 229
When recognising the identifiable assets acquired and liabilities assumed, A will recognise the various
assets and liabilities already recorded by B prior to the acquisition, as well as the trademark not previously
recognised. The location of the store and the customer satisfaction may bring economic benefits, but
they cannot be separately identified and recognised; therefore, they may only be included in the goodwill
recognised on acquisition.
QUESTION 5.3
The managing director of a company subject to a takeover offer argued that the price offered by
the potential acquirer was inadequate because it did not reflect the value of some items such as
the company’s brands, competitive position and market strength.
Which of these items could be recognised as an identifiable asset and which would form part of
‘goodwill’ in accordance with IFRS 3?
The non-controlling interest is the equity in the acquiree/subsidiary that is not controlled by the
acquirer/parent. For example, a non-controlling interest would exist where the acquirer owns 70 per
cent of the issued capital of the acquiree. In this example, the non-controlling interest shareholders own
30 per cent of the share capital of the acquiree. Note that the non-controlling interest in the acquiree is
only recognised in business combinations structured as indirect acquisitions.
Measurement
IFRS 3 requires that identifiable assets acquired and liabilities assumed are measured at their acquisitiondate fair values (IFRS 3, para. 18). Adoption of this measurement basis by IFRS 3 is necessary in order
to capture the future cash flow potential resulting from the acquisition and to provide more relevant
information to users of financial statements. For example, if an identifiable asset acquired is measured
based on its original cost to the acquiree, it may not reflect the true value of the asset from the perspective of
the acquirer (i.e. the amount it is willing to pay for it, which approximates the amount of future economic
benefits expected to be extracted from it); as such, the users may be misled in their assessment of the
potential benefits brought by the assets acquired.
Measurement of some identifiable assets acquired at fair value may be difficult. For example, acquisitions of businesses that developed new technologies and are at the forefront of the recent rapid
technological advancements may involve the need to recognise and measure a large amount of unique
intangible assets for which the fair value cannot be easily determined. The measurement of those
assets will require professional judgement based on all the facts and circumstances that existed at
acquisition date.
An acquirer is allowed a measurement period not exceeding 12 months to obtain information concerning
all the facts and circumstances that existed at acquisition date. An acquirer must report provisional amounts
for items where the accounting is still incomplete at a reporting date (IFRS 3, para. 45).
Exceptions
IFRS 3 includes a number of exceptions to the recognition or measurement principles presented in the
preceding paragraphs. These are summarised in table 5.3. Note that an understanding of the specific
recognition and measurement requirements for each of these exceptions is not required for this module.
TABLE 5.3
Exceptions to recognition or measurement principles
Exceptions to the recognition principle
IFRS 3 requirements
Contingent liabilities
The acquirer shall recognise a contingent liability if it is a
present obligation that arises from past events and its fair
value can be measured reliably, even if it is not probable.
These requirements are contrary to IAS 37 Provisions,
Contingent Liabilities and Contingent Assets.
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230 Financial Reporting
Exceptions to the measurement principles
IFRS 3 requirements
Reacquired rights
Measured on the basis of the remaining contractual term
of the related contract, regardless of whether market
participants would consider potential contractual renewals.
Share-based payment awards
Measured in accordance with the method in IFRS 2 Sharebased Payment.
Assets held for sale
Measured in accordance with IFRS 5 Non-current Assets
Held for Sale and Discontinued Operations.
Exceptions to both the recognition and
measurement principles
IFRS 3 requirements
Income taxes
Recognised and measured in accordance with the
requirements of IAS 12 Income Taxes.
Employee benefits
Recognised and measured in accordance with the
requirements of IAS 19 Employee Benefits.
Indemnification assets
Recognised and measured on the same basis as the
indemnified item.
Leases in which the acquiree is the lessee
Recognised and measured in accordance with the
requirements of IFRS 16 Leases.
Source: Adapted from IFRS Foundation 2022, IFRS 3 Business Combinations, IFRS Foundation, London, pp. A197–A200.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 21–31 of IFRS 3.
EXAMPLE 5.3
Recognising and Measuring the Identifiable Assets Acquired and
Liabilities Assumed
In addition to the facts presented in example 5.2, A Ltd (A) assumed a contingent liability disclosed in the
notes of the financial statements of B Ltd (B). This contingent liability related to a lawsuit by a customer
who fell in the store due to a slippery floor. Even though it was probable that the lawsuit would be won
as it was discovered that the customer was not paying attention to the hazard signs erected at the time
of the accident, A needed to recognise it as part of the liabilities assumed as a result of the acquisition.
The measurement of it would be based on an estimation of potential damages awarded to the customer
by the court.
QUESTION 5.4
Would all identifiable assets and liabilities recognised by an acquirer be included in the statement
of financial position of the acquiree prior to acquisition?
(D) RECOGNISING AND MEASURING GOODWILL OR A GAIN
FROM A BARGAIN PURCHASE
Goodwill is measured at acquisition date as the fair value of the consideration transferred plus the amount
of any non-controlling interest, plus the fair value of any previously held equity interest in the acquiree, less
the fair value of the identifiable net assets acquired (IFRS 3, para. 32). It represents future economic benefits
other than those expected to arise from the identifiable assets acquired and comprises assets that cannot
be separately recognised and/or sold (i.e. unidentifiable assets). In the cases of business combinations
involving businesses at the forefront of technological advancements, the amount of goodwill that will be
recognised by the acquirer can be quite substantial given the amount of know-how and technical skills of
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MODULE 5 Business Combinations and Group Accounting 231
the human capital present in the acquired business that may not be able to be separately identified as an
identifiable asset.
Note that the existence of any previously held equity interest in the acquiree implies an acquisition made
in stages. While this module does not subsequently address accounting for acquisitions made in stages,
you need to be able to determine goodwill where there is a previously held equity interest.
QUESTION 5.5
Provide examples of unidentifiable assets that may contribute to the goodwill of a business.
Identifying and Measuring Consideration
IFRS 3, paragraph 37 discusses how consideration transferred in a business combination is measured at
fair value, calculated as the acquisition-date fair values of the:
• assets transferred by the acquirer
• liabilities incurred by the acquirer with respect to the former owners of the acquiree
• equity interests issued by the acquirer.
Any acquisition-related costs incurred in a business combination are not considered part of the
consideration transferred. That is because these costs are incurred in separate transactions that involved
entities other than the acquiree or its owners. Those costs are required to be accounted for as expenses in
the period in which the costs are incurred — with the exception of costs to issue debt or equity securities,
which are recognised in accordance with IAS 32 and IFRS 9. Acquisition-related costs include finder’s
fees; advisory, legal, accounting, valuation and other professional or consulting fees; general administrative
costs, including the costs of maintaining an internal acquisitions department; and costs of registering and
issuing debt and equity securities (IFRS 3, para. 53).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read:
• paragraph 53 of IFRS 3, which discusses acquisition-related costs
• the definition of ‘fair value’ in IFRS 3, Appendix A.
EXAMPLE 5.4
Identifying and Measuring Consideration
Assume that A Ltd (A) acquired all the assets and liabilities that constitute a business from B Ltd (B). As
part of the consideration transferred, A transferred:
• $1 000 000 in cash, with $400 000 raised from a debt issue that attracted 5 per cent interest per year
• other assets previously recorded by A at $300 000, but with a fair value of $500 000 at acquisition date
• shares in A that it issued with a value of $700 000, incurring $50 000 as share issue costs.
Note that A used the services of a financial adviser to help in the negotiations with B and paid $150 000
for those services.
To identify and measure the consideration transferred, A needed to separate it from the acquisitionrelated costs. In this case, those costs were:
• interest incurred on the debt issue, which would be treated as a part of finance expenses
• share issue costs, which would be treated as a reduction in share capital
• remuneration of the financial adviser, which would be treated as part of expenses for the period.
In turn, consideration transferred would be recognised at fair value of $2 200 000, calculated as:
• $1 000 000 in cash
• $500 000 in other assets
• $700 000 in shares.
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232 Financial Reporting
QUESTION 5.6
(a) If an entity has an acquisitions department, would the costs associated with running the
department be included in the cost of a business combination?
(b) On 1 April 20X5, Investor Ltd (Investor) signed an agreement to acquire all the shares of Investee
Ltd and, in return, to issue 100 000 of its own shares. The terms of the agreement were fulfilled
on 30 June 20X5, when the shares were transferred. Consulting fees relating to the combination
were $10 000. These costs were paid by Investor.
The last sale of Investor shares took place in December 20X4 at a price of $4.50 per share.
The estimated fair value of the shares at 30 June 20X5 was $5.00 per share.
(i) Calculate the consideration transferred for the investment acquired by Investor, explaining
your reasoning.
(ii) Provide pro forma journal entries for Investor to account for the acquisition of the investment
and the payment of the costs attributable to the investment.
Identifying and Measuring Non-controlling Interest
As previously discussed, non-controlling interest is the equity in the acquiree not owned by the acquirer.
It represents an ownership interest in the acquiree by shareholders other than the acquirer.
IFRS 3, paragraph 19 allows an accounting policy choice, on an acquisition-by-acquisition basis, for
the measurement of a non-controlling interest in the acquiree. There are two options available to measure
the non-controlling interest in the acquiree at acquisition date:
1. ‘full goodwill’ method — at the fair value of the equity interests that the non-controlling interest has in
the acquiree
2. ‘partial goodwill’ method — at the non-controlling interest’s proportionate share of the fair value of the
acquiree’s identifiable net assets.
The measurement of the non-controlling interest at the fair value of the shares held by the non-controlling
interest shareholders is known as the ‘full goodwill’ method. The reason for this is that in the calculation
of goodwill, the total fair value of the acquiree (i.e. subsidiary), being the fair value of the consideration
transferred by the acquirer plus the fair value of the non-controlling interest plus the fair value of any
previously held interest by the acquirer, is compared with the total fair value of the identifiable net assets
in the acquiree. The difference is ‘full goodwill’. In essence, this method measures the total goodwill of
the business combination at acquisition date, including:
• goodwill for the acquirer, calculated as the fair value of the consideration transferred by the acquirer
plus the fair value of any previously held interest by the acquirer minus the acquirer’s proportionate
share of the fair value of the acquiree’s identifiable net assets
• goodwill for the non-controlling interest, calculated as the fair value of the equity interests that the noncontrolling interest has in the acquiree minus the non-controlling interest’s proportionate share of the
fair value of the acquiree’s identifiable net assets.
Where the non-controlling interest is measured using its proportionate share of the acquiree’s identifiable
net assets, essentially only the acquirer’s share of the goodwill is recognised in the business combination
(see preceding ‘goodwill for the acquirer’ bullet point for a discussion of calculation). For this reason, this
second choice is referred to as the ‘partial goodwill’ method. Under this method, the value assigned to the
non-controlling interest is lower than under the full goodwill method because it does not recognise any
goodwill for the non-controlling interest.
It is important to note that the per-share fair value of the non-controlling interest in the acquiree cannot be
measured based on the per-share fair value of the consideration transferred by the acquirer at acquisition
date. The per-share fair value of the consideration transferred by the acquirer at acquisition date may
include a control premium that the acquirer is willing to pay on top of the normal per-share fair value
of the shares in the acquiree to gain control; alternatively, the per-share fair value of the non-controlling
interest in the acquiree may include a discount, as those shares do not give control as control rests with the
acquirer (IFRS 3, para. B45).
Example 5.5 illustrates how goodwill is calculated with a non-controlling interest applying the two
options permitted by IFRS 3, paragraph 19.
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MODULE 5 Business Combinations and Group Accounting 233
EXAMPLE 5.5
Calculation of Goodwill with Non-controlling Interest
On 1 July 20X7, Entity A acquired 30 per cent of the shares in Entity B for $30 000. On 1 July 20X8,
Entity A acquired a further 50 per cent interest in Entity B for $77 000, which gave it control. Entity B has
140 000 shares issued, with a fair value of $1 per share. At 1 July 20X8, the fair value of Entity B’s identifiable
net assets is $110 000.
Goodwill at 1 July 20X8 is calculated as follows.
NCI calculated
at fair value of
equity interests
held (full goodwill)
$
Fair value of consideration transferred by acquirer
Non-controlling interest (20%)†
Fair value of previously held interest by acquirer (30%)
Fair value of identifiable net assets in Entity B
Goodwill
†
‡
§
||
77 000
28 000‡
42 000||
147 000
110 000
37 000
NCI calculated
as a percentage
of fair value of
identifiable net assets
(partial goodwill)
$
77 000
22 000§
42 000||
141 000
110 000
31 000
NCI = non-controlling interest
The NCI at 1 July 20X8 is 20% given that Entity A has an 80% interest (30% previously held plus 50% acquired on 1 July
20X8) in Entity B.
Under the full goodwill method, the NCI is measured as the fair value of the equity interests that the NCI has in Entity B:
20% × 140 000 shares @ $1 per share = $28 000.
Under the partial goodwill method, the NCI is measured as the proportionate share of the fair value of Entity B’s
identifiable net assets (20% × $110 000 = $22 000).
The fair value at 1 July 20X8 of the previously held interest of 30% that Entity A had in Entity B is 30% × 140 000 shares
@ $1 per share = $42 000.
Under the partial goodwill method, goodwill can also be calculated as follows.
NCI calculated
as a percentage
of fair value of
identifiable net assets
(partial goodwill)
$
Fair value of consideration transferred by acquirer
Fair value of previously held interest by acquirer (30%)
Fair value of identifiable net assets in Entity B
Interest held by the acquirer (30% + 50%)
Goodwill
77 000
42 000
119 000
110 000
80%
88 000
31 000
Example 5.5 demonstrates how goodwill can differ, depending on the method used to measure the
non-controlling interest. In this case, the difference between goodwill recognised under the full goodwill
method (i.e. $37 000) versus the partial method (i.e. $31 000) is $6000, which also represents the difference between the fair value of the equity interests that the non-controlling interest has in the
acquiree (i.e. $28 000) and the non-controlling interest’s proportionate share of the fair value of the
acquiree’s identifiable net assets (i.e. $22 000) — this difference is essentially the goodwill for the noncontrolling interest.
Note also that the per-share fair value of the non-controlling interest (i.e. $1.00) is different from the
per-share fair value of the consideration transferred by the acquirer (i.e. $77 000/(50% × 140 000) = $1.10)
as the consideration transferred includes a control premium of $0.10 per share.
Non-controlling interest is addressed in more detail later in part B of this module when IFRS 10 is
discussed. For the remainder of part A, goodwill is calculated as the consideration transferred less the fair
value of the identifiable net assets acquired.
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234 Financial Reporting
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read IFRS 3:
• paragraphs 32–33
• paragraphs B44 and B45, which expand on the discussion regarding the acquiree’s non-controlling interest.
Measurement and Recording of Goodwill Subsequent to the Date
of Purchase
Goodwill is not permitted to be amortised and, instead, it is required to be tested annually for impairment in
accordance with IAS 36. As a consequence, subsequent to the date of purchase, goodwill will be adjusted
for impairment losses (IFRS 3, para. B63(a)). Impairment of goodwill is discussed in module 7.
5.3 APPLYING THE ACQUISITION METHOD TO
DIFFERENT FORMS OF BUSINESS COMBINATIONS
It is important to note that the form of business combination creates accounting differences when applying
the acquisition method, as the subsequent discussion will highlight.
1. DIRECT ACQUISITION: PURCHASE OF ASSETS AND
LIABILITIES OF A BUSINESS
Acquiring assets and liabilities constituting a business results in transferring these items directly to the
acquirer, which can use them in its own business, generally without any restrictions imposed by other
parties. As such, the acquirer will need to recognise them in its financial statements in a similar way
to an acquisition of individual assets. One distinction, however, is when the business acquired includes
unidentifiable assets like customer relationships or employee morale — unidentifiable assets can only
be recognised if acquired as part of a business, in which case they will be collectively recognised under
goodwill acquired.
As previously mentioned, it is important to note that the assets and liabilities acquired as part of a
business may also include identifiable assets and liabilities previously not recognised by the acquiree. From
the acquirer’s perspective, those assets and liabilities represent items that it now owns and, therefore, they
need to be separately recognised.
EXAMPLE 5.6
Applying the Acquisition Method for a Direct Acquisition
Refer to the data in example 5.2. Assuming that the consideration transferred by A Ltd (A) to acquire all
the assets and liabilities in B Ltd (B) was $8 000 000 paid in cash, A would have to recognise goodwill
(presumably attributable to B’s store location and customer satisfaction) as the difference between the
fair value of consideration transferred and the fair value of the identifiable net assets in B. The fair value
of the identifiable net assets in B would be calculated as follows.
Fair value of total identifiable assets recorded by B
Add: Fair value of identifiable assets not previously recorded by B
Less: Fair value of total identifiable liabilities in B
Fair value of total identifiable net assets of B
Therefore, the goodwill on acquisition is:
Fair value of consideration transferred by acquirer
Less: Fair value of total identifiable net assets in B
Goodwill
$10 000 000
1 000 000
(5 000 000)
$ 6 000 000
$8 000 000
(6 000 000)
$2 000 000
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MODULE 5 Business Combinations and Group Accounting 235
The journal entry posted by A in its own records to recognise the acquisition of all the assets and
liabilities of B would be as follows.
Dr
Dr
Dr
Dr
Dr
Dr
Cr
Cr
Cr
Accounts receivable
Inventory
Plant and equipment
Land and buildings
Trademark
Goodwill
Accounts payable
Bank loan
Bank
400 000
600 000
2 000 000
7 000 000
1 000 000
2 000 000
500 000
4 500 000
8 000 000
QUESTION 5.7
Using the same data as in example 5.6 and assuming that a contingent liability for a damages claim
exists in the notes of B as suggested in example 5.3 (A measures it at the fair value of $1 000 000),
prepare and explain the journal entry posted by A to recognise the acquisition of the assets and
liabilities of B. Assume no tax effect.
2. INDIRECT ACQUISITION: PURCHASE OF SHARES
(I.E. EQUITY INTERESTS) OF AN ENTITY
Acquiring the equity interests of another entity that gives the acquirer control over that other entity results
in the acquirer, in essence, purchasing a single asset: an investment in the shares of the acquiree. As such,
the acquirer can only recognise this new asset in its financial statements. However, this type of acquisition
results in a parent–subsidiary relationship, with the acquirer being the parent and the acquiree being the
subsidiary. This relationship gives rise to the need to prepare a set of consolidated financial statements for
the group of entities, which includes the parent and its subsidiary, to provide users with information about
the combined financial performance, position and cash flows of the group. The consolidated financial
statements will include the assets and liabilities of the subsidiary in a similar way as they would have been
recognised in the acquirer’s statements if they were directly acquired by the acquirer. That means that the
consolidated financial statements need to recognise:
• any unidentifiable assets like customer relationships or employee morale as goodwill acquired
• any identifiable assets and liabilities previously not recognised by the acquiree.
If the acquirer in an indirect acquisition is required to present separate financial statements, IAS 27,
paragraph 10 states that the investment in the shares of the acquiree should be accounted in the financial
statements of the acquirer/parent either:
(a) at cost;
(b) in accordance with IFRS 9; or
(c) using the equity method as described in IAS 28.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read IAS 27:
• paragraph 4, the definition of ‘separate financial statements’
• paragraph 10 (assume that the investment is not classified as held for sale).
The examples and questions in module 5 assume that the parent carries the investment in its financial
statements at cost.
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236 Financial Reporting
EXAMPLE 5.7
Applying the Acquisition Method for an Indirect Acquisition
Using the same data as in example 5.6, but assuming that A Ltd (A) acquired all the shares in B Ltd (B)
instead of directly acquiring the assets and liabilities, the journal entry posted by A in its own accounts to
recognise the business combination would be as follows.
Dr
Cr
Investment in B
Bank
8 000 000
8 000 000
Note that the amounts recognised under the acquisition method for all the identifiable assets and
liabilities of B at acquisition date and for the goodwill will be exactly the same as in example 5.6. However,
only the consolidated financial statements, where those items will be recognised, will reflect those values;
A cannot recognise those items in its separate financial statements as it did not acquire them directly —
A only directly acquired the investment in shares.
QUESTION 5.8
Refer to the journal entries posted in examples 5.6 and 5.7. Discuss the impact of those entries of the
individual accounts of A and identify which one provides more information to the users interested
in B.
Please note that notwithstanding these differences discussed in points 1 and 2 of this section, both
forms of business combinations still comply with the requirement in IFRS 3 to account for a business
combination, no matter its form, by applying the acquisition method. Those differences just mean that the
acquisition method is applied:
• in the acquirer’s own financial statements in the case of a direct acquisition
• in the consolidated financial statements in the case of an indirect acquisition.
5.4 DEFERRED TAX ARISING FROM A
BUSINESS COMBINATION
DEFERRED TAX RELATED TO ASSETS AND LIABILITIES
ACQUIRED IN A BUSINESS COMBINATION
As discussed, IFRS 3 requires identifiable assets and liabilities acquired in a business combination to be
measured at fair value at acquisition date. As such, temporary differences arise when the tax base of the
asset acquired or liability assumed is either not affected, or is affected differently compared to the carrying
amount, by the business combination (IAS 12, para. 19). For example, in an indirect acquisition, assume
equipment of the acquiree/subsidiary is recognised at its fair value of $100 000 at acquisition date. The
carrying amount and tax base prior to the acquisition were $70 000, and the tax base does not change
as a result of the revaluation on acquisition. This would give rise to a taxable temporary difference of
$30 000 at acquisition date calculated as the difference between the new carrying amount and the tax
base (the concepts of tax base and temporary difference were discussed in module 4). As a result, the
acquirer would recognise a deferred tax liability of $9000 (assuming a tax rate of 30 per cent) as part of
the liabilities assumed. As another example, in a direct acquisition this time, an acquirer recognises an
assumed provision for warranty expenses from an acquired business. The fair value of this provision is
$50 000, which is recognised as the carrying amount in the statements of the acquirer. For tax purposes,
the warranty costs will only be deductible when the entity pays the claims, and therefore, the tax base is
nil. Compared to the carrying amount, this gives rise to a deductible temporary difference of $50 000, for
which the acquirer will have to recognise a deferred tax asset of $15 000 as part of the assets acquired
(assuming a tax rate of 30 per cent).
Recognising additional deferred tax assets and liabilities in a business combination affects the amount
of goodwill recognised (IAS 12, paras 19 and 66). The fair value of the identifiable net assets will increase
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MODULE 5 Business Combinations and Group Accounting 237
(if a deferred tax asset is recognised) or decrease (if a deferred tax liability is recognised). This impacts on
the goodwill — that is, the difference between the fair value of the consideration transferred and the fair
value of the identifiable net assets.
While deferred tax assets and liabilities can arise from measuring identifiable assets and liabilities at fair
value in a business combination, IAS 12 prohibits the recognition of a deferred tax liability arising from
goodwill (IAS 12, paras 15 and 21). This is because goodwill is a residual, and, as such, creates a mutual
dependence between the recognition of a deferred tax liability relating to it and its measurement. As a
deferred tax liability is an identifiable liability, recognition of a deferred tax liability for goodwill would
decrease the fair value of the identifiable net assets by the amount of the deferred tax liability, which
then increases the amount of goodwill. This would create the need to reassess the amount of deferred tax
liability relating to goodwill and so on in an endless loop.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 15, 19, 21 and 66 of IAS 12.
DEFERRED TAX RELATED TO TAX LOSSES IN A
BUSINESS COMBINATION
As a result of a business combination, the acquirer may recognise a deferred tax asset for tax losses that it
had previously considered not recoverable. For example, tax losses of the acquirer may now be able to be
offset against future taxable profit of the acquiree. As it relates to tax losses of the acquirer, the deferred
tax asset recognised cannot be identified as part of the assets acquired and, therefore, does not impact on
goodwill (IAS 12, para. 67).
At the date of a business combination, an acquiree may have potential benefits from tax losses or
other deferred tax assets. If the acquirer considers it is probable that these benefits will be realised, it
will recognise them as part of the assets acquired; hence, they are taken into account when determining
goodwill. However, if the acquirer considers that it is not probable that those potential tax benefits
of the acquiree would be realised after acquisition, it won’t recognise them as part of the business
combination. Nevertheless, if those unrecognised tax benefits of the acquiree are eventually realised after
acquisition, IAS 12, paragraph 68(b) requires the acquirer to recognise them in profit or loss (P/L) (or in
other comprehensive income (OCI) if those tax benefits relate to items recognised in OCI according to
paragraph 61A).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 66–68 of IAS 12. Note: You will not be required
to deal with the application of the requirements of paragraph 68 for deferred tax assets not recognised at the
acquisition date.
EXAMPLE 5.8
Purchase of a Business from Another Entity with No Deferred Tax Effects
On 1 January 20X9, Large Ltd (Large) agreed to purchase the assets and liabilities of Small Ltd (Small)
for $400 000 cash plus 50 000 ordinary shares in Large. The shares of Large were currently traded on the
stock exchange for $4.50 each. It was not expected that the proposed issue would affect this price. The
statement of financial position for Small at the date of purchase is presented here.
SMALL LTD
Statement of financial position
as at 1 January 20X9
$’000
Assets
Trade receivables
Inventory
Land and buildings
(net of accumulated depreciation)
100
220
630
950
Pdf_Folio:238
238 Financial Reporting
Liabilities
Bank overdraft
Trade payables and loans
Equity
Retained earnings
Issued capital
$’000
$’000
30
400
430
420
100
520
950
To determine goodwill, it is first necessary to measure the fair value of the consideration transferred. In
this case, that is equal to $625 000 calculated as follows.
$’000
Cash
Fair value of shares issued (50 000 @ $4.50)
Fair value of consideration transferred
400
225
625
Next, the acquisition-date fair values of the identifiable assets acquired and liabilities assumed are
considered. Large has determined the following fair values.
$’000
Trade receivables
Inventory
Land and buildings
Bank overdraft
Trade payables and loans
Fair value of identifiable net assets
95
200
700
(30)
(400)
565
As the assets were acquired by Large in a direct acquisition, it is assumed that the amount they were
initially recognised at establishes their tax base for Large. In addition, it is assumed that there are no
taxable or deductible temporary differences arising from the acquired liabilities, as their tax base and fair
value (i.e. carrying amount) are equal due to their nature. Hence, Large does not need to recognise a
deferred tax asset or liability from the business combination.
The goodwill purchased by Large can now be measured in accordance with IFRS 3, paragraph 32
as follows.
$’000
Fair value of consideration transferred
Less: Fair value of identifiable net assets
Goodwill
625
(565)
60
The goodwill of $60 000 will be recognised in the statement of financial position of Large as a
non-current asset.
QUESTION 5.9
Prepare a pro forma general journal entry to reflect the acquisition of Small’s assets and liabilities
by Large, based on the data in example 5.8.
In example 5.8, the tax bases of each of the assets were considered to be equal to their fair values and
there were no taxable or deductible temporary differences arising from the acquired liabilities given their
nature, so no tax effect was recorded. Example 5.9 deals with a scenario where the tax bases differ from
the fair values of the net assets acquired.
EXAMPLE 5.9
Purchase of a Business from Another Entity with Deferred Tax Effects
On 1 July 20X9, High Ltd (High) purchased the business of Low Ltd (Low). The consideration transferred
was $2 800 000 in cash.
Low disclosed in the notes to its financial statements a contingent liability with a fair value of $300 000.
The liability was contingent as it was not probable that an outflow of resources would occur and, therefore,
was not recognised as a liability prior to the acquisition. On acquisition, in accordance with IFRS 3, High
recognised a liability for this contingent liability in its statement of financial position even though it was
not probable. In addition, as the tax base of this liability was $nil (carrying amount $300 000 less future
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MODULE 5 Business Combinations and Group Accounting 239
deductible amount of $300 000), there was a deductible temporary difference of $300 000. Therefore, a
deferred tax asset of $90 000 ($300 000 × 30%) also had to be recognised by High in relation to this
provision as part of the accounting for the business combination.
Apart from the contingent liability and the related deferred tax asset, High had determined that the fair
values of the other identifiable net assets of Low at the acquisition date included the following.
$’000
Trade receivables
Inventory
Plant and equipment
Trade payables
Loans
200
850
2 600
(100)
(890)
2 660
It is assumed that on the acquisition of the previously recognised assets, the tax base will be equal to
their fair values and no deferred assets or liabilities will be recognised in relation to them. Also, there are
no taxable or deductible temporary differences arising from the acquired liabilities that were previously
recognised by Low given their nature.
Therefore, the fair value of the identifiable net assets in Low at the acquisition date would be determined
as follows.
$’000
Fair value of previously recognised identifiable net assets
Less: Fair value of contingent liability
Add: Deferred tax asset relating to contingent liability
Fair value of identifiable net assets in the acquiree
2 660
(300)
90
2 450
The goodwill would be calculated as follows.
$’000
Fair value of the consideration transferred
Less: Fair value of identifiable net assets in the acquiree
Goodwill
2 800
(2 450)
350
QUESTION 5.10
Based on the data in example 5.9, prepare a pro forma journal entry for High to reflect the acquisition
of Low’s assets and liabilities.
5.5 DISCLOSURES: BUSINESS COMBINATIONS
IFRS 3 includes extensive disclosure requirements to enable financial statement users to evaluate the
financial effects of the acquirer’s business combinations that occur either during the current reporting
period, or after the end of the reporting period but before the financial statements are authorised for
issue. IFRS 3, paragraph 61 also requires disclosures to enable ‘users to evaluate the financial effects of
adjustments recognised in the current reporting period that relate to business combinations that occurred
in the period or previous reporting periods’.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 59–63 and B64–B67 of IFRS 3, which detail the
specific disclosure requirements of IFRS 3.
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240 Financial Reporting
SUMMARY
IFRS 3 specifies the requirements for accounting for business combinations that involve an acquirer
obtaining control of another business (or businesses). This part of the module considered two common
approaches to undertaking a business combination:
1. direct acquisition: purchasing the assets and liabilities that constitute a business from another entity
2. indirect acquisition: acquiring the shares of another entity to obtain control over the assets and liabilities
or business of that entity.
In accordance with IFRS 3, all business combinations must be accounted for by using the acquisition
method, which involves four steps:
1. identifying the acquirer
2. determining the acquisition date
3. recognising and measuring the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree
4. recognising and measuring goodwill or a gain from a bargain purchase.
The acquisition method requires the acquirer of a business to recognise the assets acquired and liabilities
assumed at their acquisition-date fair values. If the combination involves acquiring control of another entity
via the acquisition of shares in that entity (i.e. indirect acquisition) and the acquirer does not acquire all
of the shares in the subsidiary, the non-controlling interest also needs to be measured at acquisition date.
IFRS 3 permits the non-controlling interest to be measured either at fair value or by using its proportionate
share of the subsidiary’s identifiable net assets.
After measuring the identifiable net assets acquired and the non-controlling interest, the acquirer
measures the difference between:
• the acquisition-date fair value of the consideration transferred plus any non-controlling interest plus the
acquisition-date fair value of any previously held equity interest in the acquiree, and
• the acquisition-date fair value of the identifiable net assets in the acquiree.
While the difference will generally be recognised as goodwill, in rare instances there may be a gain from
a bargain purchase that must be recognised in profit or loss.
When a combination involves a purchase of assets and liabilities that constitute a business (i.e. direct
acquisition), IFRS 3 is to be applied in the acquirer’s financial statements. When a combination involves
a purchase of shares that leads to a parent–subsidiary relationship (i.e. indirect acquisition), a set of
consolidated financial statements must be prepared in accordance with the requirements of IFRS 10.
IFRS 10 is dealt with in part B. IFRS 3 is to be applied in the consolidated financial statements.
Deferred tax effects can arise as a result of a business combination due to:
• the revaluation of identifiable assets and liabilities to fair value at acquisition date
• the recognition of recoverable tax losses or other tax credits.
IFRS 3 includes disclosure requirements to enable financial statement users to evaluate the financial
effects of the acquirer’s business combinations that occurred during the reporting period, or after the end
of the reporting period but before the financial statements are authorised for issue.
The key points covered in this part, and the learning objectives they align to, are as follows.
KEY POINTS
5.1 Identify a business combination, discuss the forms that it may take and analyse issues relating
to different business combinations.
• A business combination is a transaction or other event in which an acquirer obtains control of one
or more businesses.
• Business combinations include buying a franchise from the franchisor, true mergers or mergers
of equals.
5.2 Discuss and apply the acquisition method to a business combination, including the IFRS 3
requirements for recognising and measuring goodwill.
• The acquisition method is applied at the acquisition date and involves four steps as follows.
1. Identifying the acquirer.
2. Determining the acquisition date.
3. Recognising and measuring the identifiable assets acquired, the liabilities assumed and any
non-controlling interest in the acquiree; and
4. Recognising and measuring goodwill or a gain from a bargain purchase.
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MODULE 5 Business Combinations and Group Accounting 241
• Direct acquisition method: transferring the assets and liabilities acquired directly to the acquirer.
Unidentifiable assets acquired are recognised under goodwill.
• Indirect acquisition method: Acquiring the equity interests of another entity that gives the acquirer
control over that other entity. This method results in a parent-subsidiary relationship between the
entities and requires consolidated financial statements to be prepared for the group of entities.
• Consolidated financial statements need to recognise any unidentifiable assets like customer
relationships or employee morale as goodwill acquired, and any identifiable assets and liabilities
previously not recognised by the acquiree.
5.3 Apply the accounting for the deferred taxation impact of a business combination.
• Identifiable assets and liabilities acquired in a business combination are to be measured at fair
value at acquisition date.
• Temporary differences arise when the tax base of the asset acquired or liability assumed is either not
affected, or is affected differently compared to the carrying amount, by the business combination.
• IAS 12 prohibits a deferred tax liability arising from goodwill.
• As a result of a business combination, the acquirer’s tax losses may be able to be offset against
future taxable profit of the acquiree.
5.7 Explain and apply the disclosure requirements of both IAS 1 Presentation of Financial
Statements for consolidated financial statements and IFRS 12 Disclosure of Interests in Other
Entities for interests in subsidiaries, associates and joint arrangements.
• IFRS 3 includes extensive disclosure requirements to enable financial statement users to evaluate
the financial effects of the acquirer’s business combinations that occur either during the current
reporting period, or after the end of the reporting period but before the financial statements are
authorised for issue.
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242 Financial Reporting
PART B: CONSOLIDATED FINANCIAL
STATEMENTS
INTRODUCTION
Part A of this module dealt with the accounting requirements for business combinations in general
(i.e. arising from direct and indirect acquisitions). Part B deals with the specific case of an indirect
acquisition and examines additional accounting requirements for the preparation of consolidated financial
statements. It examines IFRS 10 and the disclosure requirements for interests in subsidiaries contained in
IFRS 12.
IFRS 10 is concerned with establishing the principles for the preparation and presentation of financial
statements of a group when an investment by the investor in another entity creates a parent–subsidiary
relationship. These consolidated financial statements present the assets, liabilities, equity, income,
expenses and cash flows of the parent and its subsidiaries as those of a single economic entity (as opposed
to legal entity) (IFRS 10, para. 1 and definition of ‘consolidated financial statements’ in Appendix A).
Consolidated financial statements are useful to various financial statement users, both internal and
external to the economic entity. Senior management and directors of the parent entity are interested
in understanding the contribution of the acquiree’s (i.e. subsidiary’s) activities to group performance.
Consolidated financial statements provide this information by reporting the post-acquisition results of
the subsidiary and the complete results of the acquirer (i.e. the parent). External users, such as existing and
potential investors, analysts and creditors, are also interested in understanding the subsidiary’s contribution
to group performance. Such interest might be particularly so in the first year or two after acquisition.
IFRS 12 applies to entities that have an interest in one of the following: subsidiaries, joint arrangements,
associates or unconsolidated structured entities (IFRS 12, para. 5). If an entity has an interest in
subsidiaries, the standard requires the entity to disclose information that enables users ‘to evaluate (a) the
nature of, and risks associated with, its interests in the subsidiaries; and (b) the effects of those interests on
its financial position, financial performance and cash flows’ (IFRS 12, para. 1). To achieve this objective,
IFRS 12 requires disclosure of information concerning:
• significant judgements and assumptions in determining that the entity has control of another entity
• details of an entity’s interests in subsidiaries, which include details such as the composition of the group
and non-controlling interests’ share of the group’s performance and cash flow.
Relevant Paragraphs
To assist you in achieving the objectives for part B of this module, you may wish to read the following
paragraphs of IFRS 10 and IFRS 12. Where specified, you need to be able to apply these paragraphs.
Subject
Paragraphs
IFRS 10 Consolidated Financial Statements
Objective
Scope
Control
Power
Returns
Link between power and returns
Accounting requirements
Determining whether an entity is an investment entity
Investment entities: Exception to consolidation
Defined terms
Application guidance
Assessing control
Consolidation procedures
Uniform accounting policies
Measurement
Potential voting rights
Reporting date
Non-controlling interests
1–3
4
5–9
10–14
15–16
17–18
19–24
27–30
31–33
Appendix A
Appendix B
B2–28, B34–50, B55–B72
B86
B87
B88
B89–B91
B92–B93
B94–B95
(continued)
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MODULE 5 Business Combinations and Group Accounting 243
(continued)
Subject
IFRS 12 Disclosure of Interests in Other Entities
Objective
Scope
Significant judgements and assumptions
Interests in subsidiaries
Application guidance
Paragraphs
1–4
5
7–9
10–19
B10
5.6 INTRODUCTION TO CONSOLIDATED
FINANCIAL STATEMENTS
The purpose of consolidated financial statements is to disclose the financial performance, financial position
and cash flows of a group of interrelated entities that operate as a single economic entity (but not a
single legal entity). IFRS 10 is primarily concerned with establishing the principles for the preparation
of consolidated financial statements. A group is defined in IFRS 10, Appendix A, as a ‘parent and
its subsidiaries’.
According to the Conceptual Framework, a reporting entity ‘can be a single entity or a portion of an
entity or can comprise more than one entity . . . not necessarily a legal entity’ (para. 3.10). When a parent
entity has control over a subsidiary entity the reporting entity consists of both the parent and its subsidiaries
and the financial statements prepared by the reporting entity are referred to as ‘consolidated financial
statements’ (para. 3.11).
In essence, the overriding principle that applies in the preparation of consolidated financial statements
is that these statements need to show how the financial position, financial performance and cash flows of
the group are impacted by transactions with other entities. As the entities within the group are considered
an integral part of the group, the investments between themselves and the effect of transactions between
them (i.e. intra-group transactions) should be eliminated. A group can be thought of as similar to a single
company that has numerous departments. As the company does not disclose in its financial statements,
the effect of transactions between internal departments, a group should not disclose, for example, intragroup investments, intra-group receivables and payables or intra-group profits and losses. This is because,
as a single entity, the group cannot have investments in itself, receivables from itself, payables to itself
or profits and losses generated from within. The consolidated financial statements should recognise the
assets, liabilities, equity, income, expenses and cash flows of all the entities within the group as they are
impacted by transactions with external parties only.
The consolidated financial statements are prepared in order to provide easy-to-access information about
the group’s risks and opportunities that would otherwise be difficult to assess if only the separate financial
statements of the entities within the group were prepared. Also, by eliminating the effects of intra-group
transactions that may not be at arm’s-length prices (instead at prices that may benefit an entity in the group
to the detriment of the other in order to shift some income, expenses, assets or liabilities), external parties
looking to transact with an entity get a better understanding of the true financial position and performance
of the group. For example, lenders to an entity within the group may not only be interested in the financial
position and performance of that entity, but may also be interested in the financial position and performance
of the whole group to assess whether the borrower will be able to pay back the debts when they fall due.
In this regard, debts incurred by an entity in the group are often subject to cross-guarantees from the other
entities within the group.
.......................................................................................................................................................................................
EXPLORE FURTHER
For the purpose of this module, the terms ‘economic entity’ and ‘group’ have the same meaning and are
interchangeable. If you wish to explore this topic further, you should read paragraphs 1–3 of IFRS 10, which discuss
the objective of the standard. You may also wish to review the following definitions in IFRS 10, Appendix A:
• parent
• subsidiary
• group
• consolidated financial statements.
In determining which entities are part of a group, the standard relies on the criterion of control. If one
entity controls another entity, a ‘parent–subsidiary’ relationship is deemed to exist. IFRS 10 requires parent
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244 Financial Reporting
entities to prepare a single set of consolidated financial statements for the group unless it satisfies certain
restrictive conditions that are outlined in paragraph 4 of the standard.
Broadly, IFRS 10 is concerned with two issues:
1. defining the group
2. preparing consolidated financial statements.
As indicated in part A of this module, IFRS 3 is relevant to the second of these issues.
5.7 THE GROUP
DEFINING THE GROUP
Where one entity controls another entity, this gives rise to a parent–subsidiary relationship and establishes
a group for financial reporting purposes (IFRS 10, Appendix A ‘Defined terms’).
The focus of reporting (the group or economic entity) can be visualised as in figure 5.5.
FIGURE 5.5
Concept of the group
Group
Parent
entity
Controls
Subsidiary
entity
Source: CPA Australia 2022.
A group can be of different shapes and sizes and, while it may include a minimum of two entities, there
is no upper limit of how many entities can form a group. The entities within the group may be listed on a
stock exchange or not.
As indicated in the diagram, ‘control’ is used to define the group. Specifying control as the criterion for
the need to prepare consolidated financial statements has several important consequences, including:
• the legal form of the members of the economic entity is irrelevant
• equal applicability in both the public and the private sectors
• a broad concept of group (the nature of the entity or lack of ownership rights is not a limiting factor).
It should not be inferred that the use of control implies that information concerning ownership interest
lacks relevance to users. For this reason, information concerning the levels of equity attributable to the
ownership group of the parent entity and to the non-controlling interest is disclosed.
CONCEPT OF CONTROL
IFRS 10 requires that consolidated financial statements be prepared where a parent entity controls an
investee (i.e. a subsidiary entity). IFRS 10 (para. 7) specifies the three essential criteria of control, all of
which must be satisfied by the investor in order to be considered to have control over the investee:
(a) power over the investee;
(b) exposure, or rights, to variable returns from its involvement with the investee; and
(c) the ability to use its power over the investee to affect the amount of the investor’s returns (IFRS 10,
para. 7).
Figure 5.6 demonstrates the concept of control.
FIGURE 5.6
The essential attributes of control
Ability to use power to affect the
investor’s variable returns
Power
Variable returns
Source: CPA Australia 2022.
Professional judgement has to be exercised when assessing whether or not control exists, and the
assessment must take into account all facts and circumstances (IFRS 10, para. 8). Significant judgements
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MODULE 5 Business Combinations and Group Accounting 245
and assumptions made in determining whether control exists must be disclosed in accordance with
paragraph 7(a) of IFRS 12.
IFRS 10 provides detailed guidance to help the investor make an assessment of the existence of control.
Only the key aspects of this guidance will be discussed.
Power Over an Investee
Appendix A of IFRS 10 defines power as the current ability to direct the activities that significantly affect
the investee’s returns. Those activities are denoted as relevant activities (Appendix A) and include a
range of operating and financial activities, such as selling and purchasing goods and services, acquiring
and disposing of assets, and determining a funding structure (IFRS 10, para. B11). Relevant activities may
change over time and depend on the purpose and design of the investee.
The ability to direct the relevant activities of an investee arises from existing rights (IFRS 10, para. 11),
and these rights can be:
• voting rights
• rights to ‘appoint, reassign or remove [the] investee’s key management personnel’
• contractual rights (IFRS 10, para. B15).
The rights must be substantive in that the investor has the practical ability to exercise the rights when
decisions about relevant activities are being made. A right is not substantive if there are barriers to
exercising the right, such as legal or regulatory requirements (IFRS 10, paras B22 and B23). Examples
of such barriers include restrictive terms and conditions attached to the rights that make them unlikely to
be exercised. Also, rights that are purely protective — that is, rights that just protect the interest of the
holder (e.g. the right of a secured creditor to take possession of the assets over which the debt is secured
if the borrower (investee) fails to pay back the debt when it falls due) — cannot be considered as giving
power over the investee.
Importantly, the investor has to have the current ability to direct the relevant activities for power to exist
(IFRS 10, para. 12), but that does not mean that it has to be exercised; the fact that the investor does not
exercise its current ability to direct the relevant activities of the investee does not mean that power does
not exist.
In many cases, the assessment of power will be straightforward. For example, in most circumstances,
the relevant activities of the investee are directed by the board of directors of the investee. If the investor
holds the majority of the voting shares in an investee (more than 50 per cent), the investor may have the
ability to appoint the directors of the investee, who in turn direct the investee’s relevant activities (IFRS 10,
para. B35). In such cases, the investor has power over the investee. However, there are other circumstances
where the relevant activities of the investee are directed by the government or a liquidator (IFRS 10,
para. B37) and, therefore, the investor may have the majority of voting rights but may not have power.
For example, when an entity is not able to pay its debts when they fall due and cannot be saved by an
administrator appointed by the court or its creditors, the entity needs to be placed under the control of a
liquidator. In those cases, the directors relinquish their decision-making powers, and so does the investor
that had a controlling interest (i.e. the majority of voting rights) before the liquidation proceedings started.
Just as an investor that holds the majority of the voting shares in an investee may not have power, there
may be cases where an investor that holds less than the majority of the voting shares is considered to have
power when other factors are taken into account. These factors (IFRS 10, para. B38) could include:
• the investor’s contractual arrangements with other vote holders which give the investor power (IFRS 10,
para. B39). For example, an investor holding 40 per cent of the voting rights in an investee may have a
current contractual agreement with another voting rights holder that has 15 per cent of the voting rights;
if that contractual agreement establishes that the other vote holder will always vote with the investor in
meetings where decisions are made about relevant activities of the investee, the investor is considered
to control the investee
• the investor’s rights from other contractual arrangements (e.g. contractual rights to direct certain relevant
activities) (IFRS 10, para. B40). For example, if an investor has a contractual right to direct a type of
relevant activity, an assessment has to be made about whether the relevant activity significantly affects
the investee’s returns. If so, the investor is deemed to have control over the investee
• the size of the investor’s voting rights relative to the size and dispersion and apathy of other vote holders
(IFRS 10, paras B41–B45). For example, if an investor holds 40 per cent of the voting rights in an
investee and all the other voting rights holders each hold less than 0.1 per cent and do not normally
attend meetings where decisions about relevant activities are made, the investor may have control
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246 Financial Reporting
• the investor’s potential voting rights (IFRS 10, paras B47–B50). For example, an investor may have
control over an investee if it holds 30 per cent of the voting rights in the investee and also options that
can be exercised currently to increase its percentage of voting rights to a level where control exists
• a combination of the previous four factors.
Therefore, it is important to consider all the facts and circumstances when assessing the existence
of power, including performing a detailed analysis of voting rights held by other parties and existing
contractual arrangements (IFRS 10, para. 11).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 10–14, B9–B18 and B34–B50 of IFRS 10.
Exposure, or Rights, to Variable Returns from an Investee
The second essential criterion for control is that the investor must be ‘exposed, or has rights, to variable
returns from its involvement with the investee’. In essence, this requires that the investor’s returns (either
positive or negative) have the potential to vary with the performance of the investee (IFRS 10, para. 15).
Examples of such returns include:
• dividends that will vary with the investee’s profit
• changes in value of investor’s investment
• performance fees or remuneration for managing the investee’s assets
• other returns from the investor and investee combining operating functions, such as economies of scale,
cost savings and access to intellectual property (IFRS 10, para. B57).
It should be noted that other parties, apart from the investor that has control, can also share in the returns
of the investee (IFRS 10, para. 16). For example, where an investee is only partly owned by an investor
(e.g. the investor holds 60 per cent of the ownership interest that carries voting rights), both the investor
and the holders of the remaining interest (i.e. non-controlling interest shareholders) share in the returns of
the investee. However, in order to have control, the other attributes of control have to exist (e.g. the party
that shares in the returns of the investee must also have power over the investee arising from substantive
rights and the ability to affect the returns (see below)).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 15–16 and B55–B57 of IFRS 10.
Link Between Power and Variable Returns
The final essential criterion for control to exist is that the investor should be able to use its power to
affect the variable returns it receives from its involvement with the investee (IFRS 10, para. 17). That is,
the investor can use its current ability to direct the investee’s relevant activities so that it receives greater
positive returns or limits negative returns.
This link between power and returns is necessary to distinguish an investor that has control over an
investee from an agent with decision-making rights over an investee that is acting on behalf of an investor
(IFRS 10, para. 18). An agent is a party engaged to act on behalf of another party (i.e. the principal) who
will benefit from the agent’s activities. As such, an agent cannot control an investee (IFRS 10, para. B58).
However, if an investor has delegated decision-making rights to an agent, the investor must treat these
rights as if they were its own rights when determining whether it has control over an investee (IFRS 10,
para. B59). IFRS 10, paragraph B60, specifies that the following factors should be considered when a
decision maker determines whether it is a principal or an agent:
• ‘the scope of its decision-making authority over the investee’ (e.g. discretion over various relevant
activities)
• ‘rights held by other parties’ (e.g. do other parties have the right to remove the decision maker?)
• entitlements to remuneration (e.g. the more the remuneration varies with the performance of the investee,
the more likely it is that the decision maker is a principal)
• exposure of the decision maker to variability of returns from other interests held in the investee (i.e. the
greater the size and variability of return associated with the interests of the investor, the more likely it
is that the decision maker is a principal).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 17–18 and B58–B72 of IFRS 10.
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MODULE 5 Business Combinations and Group Accounting 247
Exception to Consolidation of Subsidiaries — Investment Entities
IFRS 10 includes an exemption for a parent that is an investment entity from consolidating its subsidiaries
or applying IFRS 3. Instead of consolidating the subsidiary, the investment entity needs to measure its
investment in the subsidiary at fair value, with changes in fair value being included in the P/L in accordance
with IFRS 9 (IFRS 10, para. 31). The reason for this exception is that these entities acquire the shares of
other entities mainly in order to benefit from the increase in the value of those shares and are not interested
in exercising the control rights obtained through the investment. These investments are normally held for
sale, so it is fitting they be recognised at fair value as that represents the economic benefit to be extracted
from them, with any increases recognised directly in the P/L.
To determine whether a parent is an investment entity, IFRS 10 provides guidance in the form of a
definition and a discussion of typical characteristics of such entities.
IFRS 10, paragraph 27 defines an investment entity as an entity that:
• acquires funds from investors for the purpose of providing investment management services to those
investors
• has an objective to invest funds for its investors to solely provide returns from investment income, capital
appreciation, or both
• primarily measures and assesses performance of its investments on a fair value basis.
Typical characteristics of an investment entity include:
• having more than one investment
• having more than one investor
• investors are not related to the investment entity
• ownership interests are in the form of equity or similar interests (IFRS 10, para. 28).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 4B and 27–33 of IFRS 10.
Investor Control and Professional Judgement
When IFRS 10 was first issued by the IASB, it redefined the way in which investor control over an investee
was to be characterised and assessed.
Previously, investor control was defined in terms of the power of an investor to govern the financial and
operating policies of an investee so as to obtain benefits from its activities. For its part, IFRS 10 retained
the notion of ‘power and returns’ in its definition of control. But there was a major difference between the
old definition and the new IFRS 10 definition. Rather than emphasise an investor’s ability to govern the
financial and operating policies of an investee, the new definition focused on the ability of an investor to
direct the activities of the investee that most affect the returns of the investor.
When IFRS 10 was issued, some commentators predicted the new standard was unlikely to affect the
scope of consolidation in simple situations. Specifically, they predicted that the scope of consolidation
would remain largely unchanged in situations involving control through ownership of a majority of the
voting power in an investee. However, it was felt that more complex and borderline control assessments
would need to be reviewed and, in some cases, possibly revised. The passage of time has borne out these
predictions.
As noted in part B of this module, the IFRS 10 definition of control is underpinned by three
assessment criteria:
1. the investor must have ‘power over the investee;’
2. the investor must have ‘exposure, or rights, to variable returns from its involvement with the
investee; and’
3. the investor must have ‘the ability to use its power over the investee to affect the amount of the investor’s
returns’ (IFRS 10, para. 7).
The three criteria are interrelated, and all must be present to confer investor control. Furthermore, the
criteria imply that careful analysis and professional judgement are now required in order to determine
whether an investor with a significant minority of voting or other rights can exercise control over an
investee. By their very nature, such situations are complex, challenging and not always easy to assess
in terms of investor control. Consider the three examples that follow.
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EXAMPLE 5.10A
Franchise Business
Both the franchisor and the franchisee of franchise entity XYZ have rights to variable returns, and both
have decision-making rights over some activities.
The franchisor owns the business trade name and the intellectual property pertaining to the business
model used. The franchisor has received an initial franchise fee from the franchisee, and is entitled to
ongoing royalties as well as fees for advertising and other services. In addition, the franchisor also sets the
selling price for core products, determines branding requirements, maintains a list of approved suppliers
for key food supplies and negotiates the prices paid to suppliers.
For its part, the franchisee has the exclusive right to operate the franchise business in a specified
location for five years. This exclusive right to operate is renewable at the discretion of the franchisee. The
franchisee is entitled to all residual profits after paying all fees required by the franchisor.
The franchisee is responsible for financing the franchise, fitting out the premises (subject to franchisor
approval), purchasing equipment, negotiating the lease for the premises, hiring employees, negotiating
wages, establishing terms of employment, determining detailed operating procedures and organising local
advertising promotions.
As explained in part B of this module, substantive rights, as opposed to protective rights, are the
rights that define investor control. In the case of a franchise business, protective rights held by a
franchisor are designed to protect the franchise brand against adverse actions by a franchisee. However,
assessing whether rights are purely protective often requires judgement, taking into account all facts
and circumstances.
In the current example, both the franchisor and the franchisee have rights to variable returns and
have decision-making rights over some activities. The franchisor’s decision-making rights may extend
beyond simple brand protection because, for example, they include rights over input and output prices. An
assessment is therefore needed as to which activities have the greatest effect on returns. If it is determined
that the most relevant activities are staffing, financing the franchise and renewal, then the franchisee would
have control of the business. If this is considered not to be the case, the franchisor would have control of
the business. The final determination is thus a matter that requires professional judgement.
EXAMPLE 5.10B
Special Project Company
Investor A and Investor B have formed a new company to carry out a special project. Each investor holds
50 per cent of the voting share capital of the new company, but there is no formal agreement between the
two investors establishing joint control.
The special project company has a 10-member Board of Directors. Investor A and Investor B can each
appoint four directors. Two independent directors make up the remainder of the Board.
In this example, it is not clear which of the two investors has control over the investee. Resolving this
issue would require professional judgement taking into account all relevant facts and circumstances.
EXAMPLE 5.10C
Minority Shareholding in an Investee
Investor P holds 45 per cent of the voting share capital of public company, Excelsior Company. Ten other
investors each hold 5 per cent of the voting share capital. The remaining five per cent of the voting share
capital is held by investors each having a shareholding less than one per cent of Excelsior’s voting share
capital. None of the shareholders has contractual arrangements to consult any of the others or make
collective decisions.
Based on the above details, the distribution of voting rights is inconclusive. Other facts and circumstances would need to be considered in order to assess whether Investor P has control over Excelsior
Company. In this example, it is not clear whether the 45 per cent shareholding of Investor P would
be sufficient to confer investor control over Excelsior. Professional judgement is required to determine
whether Investor P has control.
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MODULE 5 Business Combinations and Group Accounting 249
Concluding Comment
Establishing the presence of investor power over an investee does sometimes require professional judgement. The clear implication is that professional judgement has an important role to play in determining
whether an investor ultimately controls an investee.
QUESTION 5.11
(a) ‘X Ltd (X) owns 60 per cent of the share capital of Y Ltd (Y). Thus, Y is a subsidiary of X.’ Explain
whether you agree with this statement, providing reasons for your answer.
(b) ‘X has 44 per cent of the voting rights in Y. The other 56 per cent of voting rights in Y are
held by several hundred shareholders who are geographically dispersed. No other shareholder
owns more than 1 per cent of the voting rights in Y. In general, few of the other shareholders
attend annual general meetings. There are no arrangements between shareholders for making
collective decisions.’ Explain whether X is likely to control Y.
(c) Would it make any difference to your answer to (b), if, apart from X, there were only two other
shareholders in Y, each with a 28 per cent shareholding interest?
(d) Provide two examples of where an investor could have the majority of voting rights but no power.
5.8 PREPARATION OF CONSOLIDATED
FINANCIAL STATEMENTS
In essence, a set of consolidated financial statements is prepared to provide information concerning the
combined financial performance, financial position and cash flows of the group of entities. Consolidated
financial statements are prepared by aggregating the financial statements of each of the entities in the
group, subject to a series of adjustments required by IFRS 10. The reasons behind those adjustments stem
from the fact that the consolidated financial statements should regard the group of entities as a separate
economic entity for which the investment in itself and transactions between internal parts of it should not
be considered as having an impact on its financial performance, financial position and cash flows.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read the scope exclusions contained in paragraph 4 of IFRS 10.
Combining the financial statements of separate entities (through what is known as the consolidation
process) is usually not a simple matter. Numerous issues have to be addressed before the consolidated
financial statements can be prepared. Consideration of these issues often results in a series of adjustments
being carried out in the first two stages of the consolidation process.
The initial stage involves adjusting the financial statements of individual entities where they have not
been prepared on a common basis. In particular, adjustments at this stage are required where the individual
entities used dissimilar:
• accounting policies, or
• reporting period ending dates.
These adjustments are necessary because the information that is to be aggregated needs to be comparable
to ensure that the end-of-period aggregation is meaningful and not misleading. As with individual financial
statements, the consolidated financial statements reflect income, expenses and cash flows for a particular
accounting period and assets, liabilities and equity as at the end of a particular accounting period. If the end
of the accounting period considered by a parent is different from that considered by a subsidiary within
the group, without an adjustment to unify reporting dates the carrying amount of assets and liabilities
will be measured at, and income, expenses and cash flows measured over, different points in time, which
may mislead users. If the individual entities used different accounting policies to account for similar
transactions, similar items may be treated differently (one entity may measure the cost of inventories using
the first-in, first-out formula, while the other entity may use the weighted average cost formula) and the
aggregated amounts will be difficult to interpret.
Pdf_Folio:250
250 Financial Reporting
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 19, B87, B92 and B93 of IFRS 10, which discuss
the adjustments required to the financial statements of entities within the group prior to consolidation. Note that
for the purposes of this module, it will be assumed that subsidiaries have prepared their financial statements using
uniform accounting policies and reporting periods ending on the same date as the group. Hence, no adjustments will
be required for dissimilar accounting policies or reporting periods ending on different dates.
The second stage combines the financial statements of the individual entities in order to present the
information as it would have been prepared for a single economic entity. After adjusting for differences in
reporting dates and accounting policies, the financial statements of individual entities must be combined to
reflect the financial performance and position of the group (IFRS 10, para. B86(a)). This is carried out using
a consolidation worksheet, which is not only a means of aggregation but also permits further adjustments
to be made. The worksheet adjustments are necessary to refocus the accounting entity perspective from the
individual entities (the initial data) to the group as a separate entity (the consolidated financial statements).
However, it should be noted that the worksheet is separate from the records of the individual entities and
the financial statements of the individual entities will not be affected by it. The reason for using a separate
worksheet is that the individual entities are still separate legal entities from the other entities within the
group and their records should still include the results of transacting with those other entities.
Adjustments at this stage are required where:
(a) the parent entity holds an equity interest in a subsidiary, recognised in an investment account in the
parent’s financial statement
(b) the subsidiary’s identifiable assets or liabilities were not recorded at fair value at acquisition date in
the subsidiary’s accounts and they still exist as at the beginning of the current period
(c) transactions have taken place between members of the group and their financial effects are still
recognised in the assets, liabilities, income or expenses of the individual entities during the
current period.
The adjustments required in the preceding points (a) and (b) are referred to in this module as the
pre-acquisition entries because they are adjustments affecting items present at acquisition date. These
adjustments will also include an adjustment to the pre-acquisition equity recorded by the subsidiary (as
the fair value adjustments are recognising the true value of the subsidiary’s net assets at acquisition), out
of which the parent share will next be eliminated, together with the parent investment in the subsidiary. A
detailed explanation of the need to eliminate the pre-acquisition equity of the subsidiary on consolidation
is included next.
It should be noted that before starting to prepare journal entries to record the adjustments required in
points (a) and (b), a so-called ‘acquisition analysis’ can be undertaken that mirrors step (c) and step (d) of
the acquisition method (discussed under the subheading ‘The acquisition method’ in part A of this module)
by calculating/measuring at acquisition date the:
• fair value of the identifiable net assets in the subsidiary
• fair value of consideration transferred
• fair value of the previously held interest by the parent in the subsidiary (if any)
• value of the non-controlling interest in the subsidiary (if any), and, as a result,
• value of goodwill.
Example 5.11 relates to a simple case where the acquisition analysis does not need to address the
calculation of the fair value of the previously held interest or the value of the non-controlling interest,
as the acquirer acquired its entire ownership interest of 100 per cent of the shares in the subsidiary at
acquisition date. It is based on data from case study 5.1. If you wish to explore this topic further, you may
now read points 1–3 of case study 5.1 in the ‘Case studies’ section.
EXAMPLE 5.11
Acquisition Analysis
In case study 5.1, the consideration transferred is $230 000. This must be compared with the fair
values of the identifiable assets acquired and liabilities assumed to determine whether there is any
goodwill acquired.
Point 2 of case study 5.1 is the equity section of Subsidiary Ltd (Subsidiary), which will also be
encountered in subsequent examples in this module. The purpose of this information is twofold.
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MODULE 5 Business Combinations and Group Accounting 251
1. It provides the carrying amount of the net assets (i.e. assets minus liabilities) recorded by Subsidiary
(by definition, this is equal to the amount of equity), which is then adjusted for the recognition of
previously unrecognised identifiable assets and liabilities (net of tax), fair value adjustments (net of
tax) and adjustments for recognised goodwill from previous acquisitions to calculate the fair value
of identifiable net assets and in determining goodwill.
2. It provides the pre-acquisition equity accounts recorded by Subsidiary that must be eliminated
(together with the business combination reserve recorded in the consolidation worksheet to recognise
fair value adjustments other than those posted directly in the subsidiary’s accounts) as part of the
pre-acquisition elimination entry.
In case study 5.1, the carrying amount of the net assets of Subsidiary, derived from the carrying
amount of the equity, is $180 000. It is assumed that Subsidiary does not have any goodwill previously
recorded (from any previous acquisitions where it acted as an acquirer), meaning that all its net assets are
identifiable. Also, it is assumed that all identifiable assets are recorded by Subsidiary in its own accounts
prior to the acquisition. With these assumptions in place, the carrying amount of equity of $180 000 is
equal to the carrying amount of identifiable net assets. However, this amount includes plant recorded at
acquisition date at its carrying amount ($60 000), not its fair value ($80 000). As discussed in part A of this
module, the revaluation of the plant by $20 000 in a business combination will give rise to a deferred tax
liability of $6000 ($20 000 × 30%). This is because, from a group’s perspective, the carrying amount of
the plant will be increased by $20 000, but its tax base will remain constant, and this results in a taxable
temporary difference of $20 000 and a deferred tax liability of $6000.
Therefore, the fair value of the identifiable assets acquired less the liabilities assumed for Subsidiary is
calculated as follows.
$
Carrying amount of identifiable net assets of Subsidiary
Add: Increase in plant to fair value
Less: Deferred tax liability — revaluation of plant
Fair value of identifiable net assets of Subsidiary
180 000
20 000
(6 000)
194 000
As this example considers that the parent acquired 100 per cent of the shares in Subsidiary in one
transaction, there is no non-controlling interest or previously held interest. The goodwill is then simply
calculated by comparing the fair value of the consideration transferred ($230 000) with the fair value of the
identifiable net assets of Subsidiary ($194 000). Therefore, the goodwill acquired by the group is $36 000.
PARENT WITH AN EQUITY INTEREST IN A SUBSIDIARY
Where the parent entity has an equity interest representing shares acquired in the subsidiary, the parent
will recognise in its own accounts an investment asset account based on the consideration transferred for
those shares. This asset must be eliminated in full on consolidation, together with the parent’s share of
the subsidiary’s pre-acquisition equity (IFRS 10, para. B86(b)). The elimination of the investment in the
subsidiary recognised as an asset in the parent’s accounts is necessary because, from the group’s perspective
as a separate economic entity, the group’s assets cannot recognise investments in itself.
An explanation for the elimination of the parent’s share of the subsidiary’s pre-acquisition equity comes
from the fact that profits and other comprehensive income (recognised in reserves) from an investment
can only be earned after the investment occurs, and therefore, only the post-acquisition changes in the
subsidiary’s equity can be included in the consolidated equity.
If the parent owns 100 per cent of the share capital in the subsidiary, the equity of the group at acquisition
date should be equal only to the equity of the parent at acquisition date.
Example 5.12, based on data from case study 5.1 in the ‘Case studies’ section, demonstrates that in the
absence of non-controlling interest in the subsidiary, the consolidated equity of the group at the acquisition
date should be equal to the equity of the parent.
EXAMPLE 5.12
Consolidated Equity at Acquisition Date when Parent has Full Ownership
Interest in the Subsidiary
In addition to the data in case study 5.1, this example assumes that the following information is recorded
in the individual statements of financial position of Parent Ltd (Parent) and Subsidiary Ltd (Subsidiary).
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252 Financial Reporting
• For Parent: the total assets were recorded as $1 230 000 (that includes the amount for its investment
in Subsidiary, i.e. $230 000) and total liabilities as $400 000, resulting in total equity of $830 000
(i.e. $1 230 000 – $400 000).
• For Subsidiary: the total assets were recorded as $500 000 and total liabilities as $320 000, resulting
in total equity of $180 000 (i.e. $500 000 – $320 000), recognised as issued capital of $100 000 and
retained earnings of $80 000.
If we want to calculate the equity of the group and demonstrate that it is equal to the equity of Parent
only, we first calculate the consolidated assets and consolidated liabilities, with the difference giving us
the consolidated equity.
In terms of consolidated assets, we can start by adding together the total assets of Parent plus the
total assets of Subsidiary (i.e. $1 230 000 + $500 000 = $1 730 000). This amount should be adjusted
as it includes the intra-group investment recognised by Parent based on the consideration transferred
of $230 000. This amount should also be adjusted for the fair value adjustment regarding the plant of
Subsidiary undervalued at acquisition date (i.e. by adding $20 000) and for the goodwill on acquisition
(i.e. by adding a further $36 000, the goodwill determined in example 5.11). Therefore, the consolidated
assets amount is $1 556 000 ($1 730 000 – $230 000 + $20 000 + $36 000 = $1 556 000).
In terms of consolidated liabilities, we can start by adding together the total liabilities of Parent plus the
total liabilities of Subsidiary (i.e. $400 000 + $320 000 = $720 000). This amount should be adjusted for
the deferred tax liability (a part of the liabilities of the group) that arise from the revaluation of the plant on
consolidation of $6000 (30% × $20 000). Therefore, the consolidated liabilities amount is $726 000, and as
the equity is the residual of assets after subtracting liabilities, the consolidated equity is equal to $830 000
($1 556 000 – $726 000), which is equal to Parent’s equity only.
Remember that consolidation starts by adding together the items of the individual entities within the
group — that applies to the equity accounts as well. While the equity of Subsidiary at acquisition date
can be added to the equity of Parent, the preceding result shows that it should then be eliminated as part
of the consolidation adjustment so that at acquisition date the consolidated equity only recognises the
equity of Parent.
.......................................................................................................................................................................................
EXPLORE FURTHER
As stated in the ‘Assumed knowledge’ section, it is assumed that, from your undergraduate knowledge, you can
prepare a basic pre-acquisition elimination entry.
Finally, to ensure that you can prepare a pre-acquisition elimination entry at the acquisition date that deals with the
revaluation of non-current assets and goodwill, please refer to the ‘Assumed knowledge review’ at the end of this
module and attempt question 1.
REVALUATION OF ASSETS
When the parent gains control of another entity, the group is deemed to have acquired the net assets of
that entity. Hence, IFRS 3 needs to be applied in the consolidated financial statements. As a consequence,
the identifiable assets and liabilities of the subsidiary should be reflected in the consolidated financial
statements at fair value at the acquisition date.
If the identifiable assets and liabilities are not recorded in the subsidiary’s financial statements at
fair value at acquisition date, fair value adjustments should normally be recorded in the consolidation
worksheet. For some assets, accounting standards may allow fair value adjustments to be recorded in
the subsidiary’s accounts at acquisition date instead (e.g. non-current assets like plant and equipment,
where revaluation can be recorded according to IAS 16 Property, Plant and Equipment). For other assets
(e.g. current assets like inventory), fair value adjustments should be recorded in the consolidation
worksheet. For example, paragraph 9 of IAS 2 Inventories requires the inventory to be recorded at the
lowest of the cost and the net realisable value, where net reliable value is the fair value minus the costs
to sell. If the fair value of the subsidiary’s inventory at acquisition date is greater than the value of the
inventory recorded by the subsidiary according to IAS 2, the adjustment cannot take place in the financial
statements of the subsidiary because IAS 2 will be contravened, and therefore, it will be recognised in the
consolidation worksheet instead.
Note: As discussed in part A of this module, measuring an asset or liability in a business combination at
fair value with no equivalent adjustment to its tax base leads to an additional temporary difference and the
recognition of an increase in a deferred tax asset or liability. This tax effect should be recognised no matter
whether fair value adjustments were posted in the subsidiary’s accounts or in the consolidation worksheet.
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MODULE 5 Business Combinations and Group Accounting 253
EXAMPLE 5.13A
Revaluation of Assets
On 1 March 20X3, Holding Ltd (Holding) signed an agreement with the shareholders of Subsidiary Ltd
(Subsidiary) to acquire the entire issued capital (12 000 shares, at $1.00 per share) of that company.
Holding agreed to issue five Holding shares for every two Subsidiary shares. Subsidiary was to continue
to operate its business as a subsidiary of Holding.
The terms of the agreement were fulfilled on 30 June 20X3 when the share transfer took place.
Immediately prior to settlement, the statements of financial position for the companies involved were
as follows.
Issued capital
Retained earnings
Liabilities
Current assets
Non-current assets
Holding
$’000
Subsidiary
$’000
80
140
50
270
40
230
270
12
83
25
120
30
90
120
At 30 June 20X3, it was determined that the fair values and the tax bases of the net assets of Subsidiary
were as follows.
Current assets
Non-current assets
Liabilities
Fair value
$’000
Tax base
$’000
40
110
(25)
125
30
90
(25)
95
The non-current assets were revalued to their individual fair values in the accounting records of
Subsidiary at the same date. The current assets were revalued to their individual fair values in the
consolidation worksheet.
At 30 June 20X3, the shares issued by Holding to the shareholders of Subsidiary traded on the securities
exchange at $5.00 per share.
QUESTION 5.12
Using the data from example 5.13A:
(a) calculate the fair value of the consideration transferred
(b) provide a pro forma journal entry for Holding to account for the acquisition of Subsidiary’s
shares
(c) provide a pro forma journal entry for Subsidiary for the revaluation of its non-current assets to
fair value and a consolidation journal entry for the revaluation of the current assets of Subsidiary
to fair value
(d) explain whether the group has purchased goodwill and, if so, calculate the amount of purchased
goodwill
(e) provide the pre-acquisition elimination entry.
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254 Financial Reporting
EXAMPLE 5.13B
Revaluation of Assets
If Holding prepared a consolidation worksheet on 30 June 20X3, after the pro forma journal entries referred
to in question 5.12 had been processed, it would appear as follows.
Consolidation worksheet (30 June 20X3)
Eliminations &
adjustments
Holding
$’000
Subsidiary
$’000
Dr
$’000
Issued capital
Retained earnings
Revaluation surplus
Business combination reserve
Deferred tax liability
Liabilities
230†
140
12
83
14‡
12
83
14
7
Current assets
Investment in Subsidiary
Non-current assets
Goodwill
40
150
230
110
420
140
Accounts
†
‡
50
420
6‡
25
140
30
Cr
$’000
230
140
7‡
3‡
10‡
150
34
160
Consolidated
$’000
160
9
75
454
80
—
340
34
454
Original issued capital ($80 000) plus shares issued at fair value to the shareholders of Subsidiary (30 000 @ $5.00 per
share = $150 000).
As the non-current assets were revalued in the subsidiary’s accounts, a revaluation surplus and a related deferred tax
liability were recorded in the subsidiary’s financial statements. As the current assets were revalued in the consolidation
worksheet, the current assets still appear as $30 000 in the subsidiary’s account, but the increase in their value and a related
business combination reserve, together with the associated deferred tax liability, were recorded into the worksheet.
The worksheet illustrates that:
• the acquirer, Holding, includes its interest in the acquiree in its own financial statements as an asset
called ‘Investment in Subsidiary’
• the identifiable net assets of the subsidiary are recorded at their individual fair values in the consolidated
column, as a result of the revaluation being posted either in the subsidiary’s accounts (for non-current
assets in this example) or as an adjustment in the consolidation worksheet (for current assets in
this example)
• a deferred tax liability is recognised due to temporary differences arising on the revaluation of the net
assets of the subsidiary
• on acquisition of the subsidiary, goodwill has been treated as a consolidated adjustment as it is the
group that has acquired the business of the subsidiary
• the ‘Investment in Subsidiary’ account is eliminated, together with the elimination of the shareholder’s
equity of the subsidiary at acquisition date (that includes the revaluation surplus and the business
combination reserve recognised on revaluation of the identifiable net assets of the subsidiary) and the
recognition of goodwill.
Note: The examples in the remainder of this topic will assume that all revaluations of subsidiary assets
where their carrying amounts were different from their fair value at acquisition date are posted in the
consolidation worksheet and not in the subsidiary’s accounts.
QUESTION 5.13
Using the information in case study 5.1 and example 5.11, prepare a consolidation worksheet
adjusting entry as at the acquisition date to record the elimination of the investment account and
of the pre-acquisition equity of the subsidiary. Explain the rationale for your entries.
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MODULE 5 Business Combinations and Group Accounting 255
DEPRECIATION ADJUSTMENTS RELATED TO REVALUATION
OF DEPRECIABLE ASSETS
When, in accordance with IFRS 3, a depreciable non-current asset has to be revalued to fair value
at the acquisition date in the consolidation worksheet, further consolidation adjustments will have to
be undertaken in subsequent reporting periods to adjust the depreciation charges. The subsidiary’s
depreciation expense will be based on the amount of the asset recorded in its financial statements. However,
the group will need to recognise a consolidation depreciation expense based on the fair value of the
non-current asset recorded in the consolidated financial statements (IFRS 10, para. B88), and therefore,
an adjustment to depreciation expense will be needed. As this adjustment will impact total expenses
recognised by the group and, therefore, consolidated profit, a tax effect adjustment will also need to be
posted. In other words, as the upwards revaluation reverses through depreciation adjustments, so too does
the associated deferred tax liability.
The adjustments to depreciation expense and the related tax effect need to take into account the current
period adjustments and the previous period adjustments that will be recorded against retained earnings. In
addition, the gain or loss recorded in the financial statements of the subsidiary, when the asset is disposed of,
should be adjusted, on consolidation, to reflect the gain or loss to the group (again, a tax effect adjustment
will have to be prepared).
Example 5.14 relates to the pre-acquisition entries in the case of an acquisition that involved revaluation
of depreciable assets and depreciation adjustments after the acquisition date. It is based on data from case
study 5.1. If you wish to explore this topic further, you may now read point 4 of case study 5.1, which
relates to the depreciation of the plant. Think about the depreciation expense that would be recorded in the
financial statements in Subsidiary and the depreciation expense that should be recorded by the group.
EXAMPLE 5.14
Depreciation Adjustments Related to Revaluation of Depreciable Assets
Consider the data from case study 5.1. As discussed in the answer to question 5.13, based also
on case study 5.1, the pre-acquisition elimination entry at acquisition date has resulted in the plant
of Subsidiary Ltd (Subsidiary) being measured at fair value of $80 000 in the consolidated financial
statements. Subsequent consolidation adjustments in the next periods will have to take into account the
fact that the amount of depreciation recorded by Subsidiary (based on the cost of the asset to Subsidiary)
will differ from the depreciation that will have to be recorded by the group (based on the fair value of the
asset at acquisition).
Subsidiary estimates the remaining useful life of the plant to be five years, with a $nil scrap value at the
end of this time. The group will have the same estimate of useful life and residual value as Subsidiary.
Like Subsidiary, the group will also use the straight-line depreciation method for this type of plant, as the
manner in which Subsidiary uses up the service potential of the asset also reflects the way the group is
using it up. Therefore, the depreciation expense for the plant in the financial statements of Subsidiary
is $12 000 per year ($60 000/5 years), while in the consolidated statement of profit or loss and other
comprehensive income (statement of P/L and OCI) of the group, the required depreciation expense is
$16 000 ($80 000/5 years). As a result, the consolidation adjustment after the acquisition date will have to
allow for this increase in depreciation expense every year.
In the statement of financial position of Subsidiary prepared at 30 June 20X1 (i.e. one year after the
acquisition date), the plant is recorded at historical cost to that entity ($100 000) less related accumulated
depreciation ($52 000 = $40 000 + $12 000). This information is entered into the consolidation worksheet
used to prepare the financial statements of the group. A consolidation adjustment is required so that
the consolidated financial statements reflect the cost of the plant to the group ($80 000) and the related
accumulated depreciation for the group ($16 000 — it does not include the accumulated depreciation
recorded prior to the acquisition as it was considered to be written off when revalued at acquisition date).
Therefore, the consolidation worksheet entries for 30 June 20X1 would be as follows.
1. Revaluation of plant to fair value (same as the entry at acquisition date)
Dr
Cr
Cr
Cr
Pdf_Folio:256
256 Financial Reporting
Accumulated depreciation
Plant
Deferred tax liability
Business combination reserve
40 000
20 000
6 000
14 000
At the acquisition date (1 July 20X0):
• the financial statements of Subsidiary recorded plant at cost of $100 000, less accumulated
depreciation of $40 000. See point 3 of case study 5.1.
• Parent Ltd (Parent) considered that the plant owned by Subsidiary had a fair value of $80 000.
In accordance with IFRS 3, the plant must be initially measured at $80 000 (i.e. fair value) in the
consolidated financial statements. See point 3 of case study 5.1.
Therefore, the consolidation worksheet entry (consolidation adjustment) prepared at acquisition date
must decrease the gross carrying value of the plant by $20 000 (i.e. from $100 000 down to $80 000)
and decrease accumulated depreciation by $40 000 (i.e. from $40 000 down to $nil). This is reflected in
the consolidation worksheet entry (consolidated adjustment) as a debit to accumulated depreciation of
$40 000 and a credit to the gross carrying value of plant of $20 000. As this entry posted at acquisition
date does not carry over to other periods, given it does not affect the individual statement of the
subsidiary, it needs to be repeated at 30 June 20X1 to make sure the asset value is adjusted to fair value
in the consolidated statements. However, a further adjustment is needed for the year since acquisition
date to the depreciation expense recognised by the subsidiary.
2. Depreciation entry and associated tax effect
Dr
Cr
Dr
Cr
Depreciation expense
Accumulated depreciation
Deferred tax liability
Income tax expense
4 000
4 000
1 200
1 200
The adjustment to the depreciation expense for the current year ended 30 June 20X1 ensures that:
• the depreciation expense is recorded in the consolidated financial statements as $16 000, being
the amount of $12 000 recognised by the subsidiary plus the debit adjustment now posted against
depreciation expense of $4000
• the accumulated depreciation is also recorded from the group’s perspective as $16 000, being the
amount of $52 000 recognised by the subsidiary minus the debit adjustment of $40 000 from the first
entry above recognising the revaluation of plant to fair value plus the credit adjustment now posted
against accumulated depreciation of $4000.
The increase of $4000 in depreciation reduces the group’s profit before tax. Hence, the income tax
expense of the group has to be reduced by $1200 ($4000 × 30%). The deferred tax liability of the group
is reduced by $1200, from $6000, recognised in the first entry above for the revaluation of the plant
to $4800, as the taxable temporary difference relating to the plant at 30 June 20X1 is now $16 000.
That is, the carrying amount of the plant for the group at 30 June 20X1 is $64 000 (cost of $80 000
less accumulated depreciation of $16 000), while, if it is assumed that the tax depreciation is equal
to the accounting depreciation for this plant, its tax base is $48 000 (the future deductible amount
via Subsidiary). As the asset is used in the business, the additional future taxable economic benefits
recognised on revaluation (i.e. $20 000) remaining are decreased (by 1 divided by the asset’s useful life,
i.e. 1/5 of $20 000 = $4000) and, with that, so are the related future tax effects (i.e. $4000 × 30%).
A consolidation worksheet would reveal, in part, the following.
Eliminations &
adjustments
Accounts
Plant
Less: Accumulated depreciation
Depreciation expense
Parent
Subsidiary
Dr
Cr
$’000
$’000
$’000
$’000
100
(52)
48
12
40
Consolidated
$’000
20
4
80
(16)
64
16
4
Please note that the preceding consolidation worksheet only presents the adjustments that impact
on plant, accumulated depreciation and depreciation expense accounts. A full worksheet is not
prepared as further information is not provided about the other accounts of Parent and Subsidiary
that will be needed in the preparation of that worksheet.
3. Pre-acquisition elimination entry
Dr
Dr
Dr
Dr
Cr
Issued capital
Retained earnings (opening balance)
Business combination reserve
Goodwill
Investment in Subsidiary
100 000
80 000
14 000
36 000
230 000
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MODULE 5 Business Combinations and Group Accounting 257
The preceding entry eliminates the investment by the parent in the subsidiary and the pre-acquisition
equity of the subsidiary at acquisition date (that includes the business combination reserve recognised
on revaluation of plant) and recognises the goodwill on acquisition. Even though this is the entry that
would be prepared at acquisition date, it is repeated unchanged at 30 June 20X1 because:
• the entry prepared at acquisition date does not carry over
• there are no movements that affect the accounts originally included in the entry.
QUESTION 5.14
(a) Using points 3 and 4 of case study 5.1 and the information from example 5.11, prepare a
consolidation worksheet adjusting entry for the year ended 30 June 20X2. Explain the rationale
for account(s) that differ(s) from the 30 June 20X1 entry discussed previously.
(b) Refer to point 5 of case study 5.1, which relates to the sale of the plant. Prepare a consolidation
adjusting entry for the year ending 30 June 20X3. Explain the rationale for accounts debited and
credited that differ from (a).
(c) Provide the consolidation adjusting entry that would be necessary in years subsequent to the
year ended 30 June 20X3. Explain the rationale for accounts debited and credited that differ
from (b).
.......................................................................................................................................................................................
EXPLORE FURTHER
Digital content, such as videos and interactive activities in the e-text, support this module. You can access this content
on My Online Learning.
TRANSACTIONS WITHIN THE GROUP
The content of consolidated financial statements is determined by focusing on the group as a single
economic entity. IFRS 10, paragraph B86(c) reinforces the financial accounting concept that requires that
before preparing consolidated financial statements, the scope or boundary of the entity for which they
are prepared (i.e. the group) must first be determined. Such denotations limit the content of the resulting
financial reports to reflect only transactions involving the group and parties external to it. Internal events
are ignored.
From the individual entity’s point of view, a transaction involving another member of the group is an
external event to be reported in the financial statements of that entity. From the perspective of the group, the
same transaction is an ‘internal’ one and should be eliminated from the consolidated financial statements.
An intra-group transaction is, from the perspective of the group, a similar transaction as a transaction
between two departments of a single entity. Figure 5.7 illustrates these important consolidation concepts.
FIGURE 5.7
Transactions within the group
Group
External
transaction ––
included in
group financial
statements
Internal
transactions —
eliminate
Parent
Subsidiary
External
transaction ––
included in
group financial
statements
Source: CPA Australia 2022.
Therefore, as part of the consolidation process, after the initial adjustments are made in the preacquisition entries discussed previously, the group must eliminate in full all the effects of intra-group
transactions. That may involve adjusting the amounts recognised for assets, liabilities, income and expenses
Pdf_Folio:258
258 Financial Reporting
to reflect only the impact of transactions with external parties. Eliminating the effects of intra-group
(internal) transactions is achieved via adjusting entries in the consolidation worksheet. In essence, this
worksheet adjustment reverses the effect of the original entries processed by the individual entities involved
in those transactions so that the consolidated financial statements reflect only transactions between the
group and parties external to the group.
It should be noted that the effects of a transaction ‘within the group’ may carry forward in the individual
statements of the parties involved to future periods that come after the period when the original intragroup transaction took place. Therefore, an intra-group transaction from a period may not only require
adjusting entries in the consolidation worksheet prepared at the end of that period, but also in the subsequent
accounting periods, to eliminate any account balances still affected. That is because the worksheet
adjustment from one period does not carry over to the next, as at the end of each period, the consolidation
process starts with adding together the financial statements of the group entities that are not affected by
prior periods’ consolidation adjustments. For example, if an intra-group loan from a previous period is still
unpaid at the end of the current period, the balance of the loan still needs to be eliminated on consolidation
from the loan receivable and loan payable.
However, the general accounting requirement that income and expense accounts are closed to retained
earnings at the end of the period may help eliminate the need for further consolidation adjustments related
to some intra-group transactions. For example, the interest expense and interest revenue on an intra-group
loan for the current period will need to be eliminated on consolidation, but the interest expense and interest
revenue from previous periods will not. This is because they are already eliminated by aggregating the
retained earnings accounts of the entities that recognised a decrease and an increase in retained earnings,
respectively, for the interest expense and interest revenue on the loan, which were closed to retained
earnings at the end of the previous periods.
Realisation of Profit or Loss by Group
Some intra-group transactions, such as the sale of inventory or non-current assets, may involve eliminating
profits or losses recorded by the parent or subsidiary. That is because those profits or losses are unrealised
from the group’s perspective. Those profits or losses would be recognised as realised by the group when
the assets involving the intra-group profits or losses were either sold to a party external to the group or
when the group consumed a part of the future economic benefits of the assets and recognised that via
depreciation or amortisation. Therefore, profit from some intra-group transactions will be recognised in
the financial statements of the individual entities within the group in reporting periods that may differ from
when that profit is eventually recognised in the consolidated financial statements.
The central focus of this recognition test is the direct, or indirect, involvement of a party external to
the group. In relation to inventory, a direct involvement occurs when the inventory is subsequently sold
to that external party. For example, if some inventory was sold intra-group for $20 000, while the original
cost paid to an external supplier was $15 000, to the extent that this inventory is still with the group, the
profit of $5000 is considered unrealised from the group’s perspective. However, once the inventory is sold
to external parties, let’s say for $22 000, the group should recognise a profit of $7000 (i.e. $22 000 – the
original cost of $15 000), which can be seen to comprise the unrealised intra-group profit of $5000 plus an
additional $2000 recognised when the intra-group buyer sells the inventory to external parties (i.e. $22 000
– $20 000). As such, the profit on the intra-group profit is now realised from the group’s perspective.
With depreciable assets transferred within the group, external parties are involved indirectly when the
goods or services produced by the asset are sold outside the group. As the depreciation is supposed to reflect
the use of the depreciable assets to produce goods or services that will be sold to external parties, it is said
that the unrealised profit of intra-group transfers of depreciable assets is realised through depreciation. In
essence, as the depreciated part of the asset cannot be used in the business any more, it is equivalent to
having been sold to external parties, and therefore, the part of the intra-group profit proportional to how
much of the asset was depreciated since it was sold intra-group is now considered to be realised.
For example, if a depreciable non-current asset purchased from an external entity for $100 000 is sold
immediately intra-group for $130 000, the intra-group profit of $30 000 is considered unrealised from
the group’s perspective. However, assuming that the useful life of the asset is five years, with economic
benefits from the asset to be consumed evenly, at the end of one full year after the intra-group sale, onefifth of the asset’s economic benefits have been consumed. As such, profit of $6000 ($30 000/5 years)
each year can be considered realised and recognised in the group’s accounts. Note that the group does not
recognise this as directly affecting profit; rather, the depreciation expense recognised by the intra-group
buyer of $26 000 ($130 000/5 years), being overstated from the point of view of the group (which will
Pdf_Folio:259
MODULE 5 Business Combinations and Group Accounting 259
only recognise $20 000, based on the original cost of $100 000/5 years), will be adjusted on consolidation,
resulting in a decrease in depreciation expense by $6000 that will indirectly affect the profit, increasing it
by $6000 ($26 000 – $20 000) each year.
Not all intra-group transactions generate unrealised profits from the group’s perspective. Intra-group
transactions that result in an equal and offsetting amount recognised in the current period under revenue and
expense items do not have a net impact on the profit or loss obtained. As such, there is no unrealised profit
that needs to be eliminated on consolidation, but that does not mean that there won’t be any eliminations
required. The individual expense and revenue accounts will still need to be adjusted to eliminate the intragroup amounts.
For example, when management services are provided within the group for $40 000, the provider entity
recognises revenue of $40 000, while the entity receiving the services records an expense for the same
amount. If the provider and receiving entity recognise profits for the whole period of $100 000 and $80 000
respectively, inclusive of those intra-group revenues and expenses, the aggregated amount for profit will be
$180 000. To eliminate the effects of the intra-group transaction, the adjusted profits of the entities would
be $60 000 (i.e. $100 000 – $40 000) and $120 000 ($80 000 + $40 000) and aggregating those amounts
would give us the same result as before. As such, it is said that the aggregated profit of $180 000 does not
include unrealised profits. Nevertheless, adjustments will still be required in the current period to make
sure that the revenues and expenses are not overstated from the group’s perspective.
Other transactions in this category include intra-group dividends and interest.
Table 5.4 summarises the accounting treatment of intra-group transactions.
TABLE 5.4
Accounting treatment of intra-group transactions
Original transaction
Intra-group sale
of inventory
Unrealised profit (recognised by
legal entity)
Profit recognised by group
Eliminate unrealised intra-group profit
or loss in the period of sale and any
remaining unrealised profit in later
reporting periods while the inventory
remains in the group.
If held as inventory by the purchaser
within the group — recognise profit or
loss when the inventory is sold to party
external to group.
Eliminate unrealised intra-group profit
or loss in the period of sale and any
remaining unrealised profit in subsequent
reporting periods while the asset remains
in the group.
If used as depreciable asset by the
purchaser within the group — recognise
profit or loss consistent with the
depreciation allocation of asset.
Intra-group provision
of services
No unrealised profit. Eliminate relevant
income and expense items.
Not applicable.
Payment of dividend
by subsidiary
Eliminate dividend income and retained
earnings appropriation.
Not applicable.
Intra-group interest
No unrealised profit. Eliminate relevant
income and expense items.
Not applicable.
Intra-group sale of
depreciable asset
If held as depreciable asset by the
purchaser within the group — recognise
profit or loss consistent with the
depreciation allocation of asset.
If the depreciable asset becomes
inventory for the purchaser within the
group — recognise profit or loss when
the inventory is sold to party external
to group.
Source: CPA Australia 2022.
However, the examples in table 5.4 are conventions that help explain the shortcuts that can be applied
in preparing the adjusting entries for intra-group transactions. It is important to note that unrealised profits
arise only from intra-group sales of assets for a profit. After such an intra-group transaction, the amount
recognised by the entity holding the assets within the group is overstated from the group’s perspective. That
is because when an asset is sold within the group for a profit, it will be recorded in the financial statements
of the individual entity holding the asset at an amount that differs from the amount that should be recorded
in the consolidated financial statements, being the original cost to the group, adjusted for depreciation
Pdf_Folio:260
260 Financial Reporting
(if applicable) based on that cost. The difference will be equal to the unrealised profit. When eliminating
an unrealised profit, it is important to make sure that the value of the asset incorporating that profit is
adjusted for the unrealised amount.
.......................................................................................................................................................................................
EXPLORE FURTHER
This module assumes you can prepare consolidation elimination entries that deal with intra-group transactions
excluding tax effects.
To test your understanding of intra-group transactions consolidation elimination entries, you should attempt
question 2 of the ‘Assumed knowledge review’ at the end of the module. If you wish to explore this topic further, you
should read paragraph B86(c) of IFRS 10.
Tax Effects of Intra-group Transactions
One consideration when eliminating transactions within the group is whether there are any tax effects
to be accounted for in accordance with IAS 12 (discussed in module 4). Profit from some intra-group
transactions will be recognised in the financial statements of the individual entities within the group in
reporting periods that may differ from when that profit is eventually recognised in the consolidated financial
statements. This suggests the need for tax adjustments from the group’s perspective. If a profit is recognised
in a period by an individual entity and not by the group, that results in an income tax expense recognised by
the individual entity that should be eliminated on consolidation. Also, in that case, as the individual entity
pays the tax on this profit, that represents a prepayment of tax from the group’s perspective. Therefore,
when the profit is eventually realised in the future by the group, the tax will not have to be paid again. That
is equivalent to having a tax benefit deferred for the future until the profit becomes realised. The deferred
tax benefit will be recognised by the group as a deferred tax asset when eliminating the income tax expense
on the unrealised profit.
For example, if inventory is sold intra-group at a profit of $20 000, the seller will recognise that profit
in its individual records, and it will pay tax of $6000 on it (assuming the tax rate of 30 per cent). However,
as long as the entire inventory is still on hand with the intra-group buyer, from the group’s perspective,
the tax should not have been paid yet and should be recognised as a prepayment of tax that will bring tax
benefits in the future.
Therefore:
• the income tax expense recognised by the intra-group seller will be eliminated on consolidation as it
was not yet incurred from the group’s perspective
• a deferred tax asset will be recognised to show that when the profit is realised from the group’s
perspective, the tax on it will not have to be paid again. That is, a deductible temporary difference
originates when the intra-group seller pays tax, which subsequently reverses when the group realises
profit on the sale of inventory.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraph B86(c) of IFRS 10.
Example 5.15 relates to case study 5.2. Example 5.15 demonstrates the application of the principles
of accounting for intra-group transactions in the context of the sale of inventory within the group. These
principles include the need to:
• eliminate intra-group profits or losses until realised via the involvement of a party external to the group
• measure the asset transferred within the group at the cost to the group
• account for deferred tax assets or deferred tax liabilities arising from measuring assets transferred within
the group at the cost to the group.
EXAMPLE 5.15
Intra-group Transactions — Sale of Inventory
In case study 5.2, the parent entity sold inventory to a subsidiary for $40 000 on 1 June 20X3. The cost of
the inventory to the parent was $30 000.
As previously discussed, for a proper understanding of the consolidation adjustment necessary to
eliminate the effects of the intra-group transaction, it is important to understand what the effects really
are. To achieve this, first consider the entries that were posted in the individual financial records of the
parent entity and the subsidiary as a result of this transaction.
Pdf_Folio:261
MODULE 5 Business Combinations and Group Accounting 261
Entry processed by the parent (1 June 20X3):
Dr
Dr
Cr
Cr
Bank
Cost of sales
Sales
Inventory
40 000
30 000
40 000
30 000
Entry processed by the subsidiary (1 June 20X3):
Dr
Cr
Inventory
Bank
40 000
40 000
The entry processed by the parent records both the sale of inventory at the selling price (Dr Bank
$40 000 and Cr Sales $40 000) and the outflow of inventory at the cost price (Dr Cost of sales $30 000 and
Cr Inventory $30 000). The entry processed by the subsidiary records the cash purchase of inventory from
the parent at the price charged by the parent (Dr Inventory $40 000 and Cr Bank $40 000). From a group
perspective, starting with the Bank account, given that a credit and a debit was recognised in the individual
accounts for the same amount, the net effect is $nil and, therefore, there is no need for adjustment. Next,
the cost of sales and sales revenue need to be eliminated in full, which results in an overall decrease
in profit of $10 000 (the elimination of cost of sales decreases the expenses, which increases the profit
by $30 000, but the elimination of sales revenue decreases the profit by $40 000). The decrease in profit
has tax effects that will be recognised by decreasing the income tax expense and recognising a deferred
tax asset for the deductible temporary difference arising from the tax paid by the parent on the unrealised
intra-group profit. With regards to the inventory account, the parent recognises that it transferred the items
to the subsidiary, so that inventory will disappear from its accounts and appear in the subsidiary accounts,
but the amount recognised is $40 000 (the price paid intra-group). However, if this transaction did not take
place from the group’s perspective, that means that the inventory should still be recorded at the original
cost of $30 000. As such, the inventory is overstated (by $10 000, being the unrealised profit) and should
be adjusted. These consolidation adjustments are presented as follows.
Consolidation journal entries (1 June 20X3):
Dr
Cr
Cr
Dr
Cr
Sales
Cost of sales
Inventory
Deferred tax asset
Income tax expense
40 000
30 000
10 000
3 000
3 000
These adjustments can also be visualised in the following consolidation worksheet, which includes only
the affected accounts (a tax rate of 30 per cent is used).
Consolidation worksheet (1 June 20X3)
Eliminations &
adjustments
Accounts
Parent
$
Statement of profit or loss
Sales
Less: Cost of sales
Gross profit
40 000
(30 000)
10 000
Profit before tax
Income tax expense
Profit after tax
10 000
(3 000)
7 000
Statement of financial position
Inventory
Deferred tax asset
Subsidiary
$
Dr
$
Cr
$
40 000
40 000
30 000
—
—
—
3 000
—
—
—
10 000
3 000
Consolidated
$
30 000
3 000
Notes
• The consolidated statement of P/L and OCI does not include the sales revenue and cost of sales that
did not result from a transaction with parties external to the group.
Pdf_Folio:262
262 Financial Reporting
• Inventory is measured in the consolidated statement of financial position at the original cost to the
group, and not at the cost to the subsidiary, which is based on the price paid intra-group and includes
the profit recognised by the parent from the sale within the group.
• As the profit on the sale is not recognised by the group, this requires the income tax expense of the
group to be reduced (a credit of $3000: 30% of the unrealised profit of $10 000).
• The group has recognised a ‘deferred tax asset’ because the tax expense on the unrealised profit is a
prepaid tax that will give rise to a tax benefit in the future when the profit will be realised from the point
of view of the group.
In case study 5.2, the inventory was still on hand at the end of the financial year 30 June 20X3, so there
are no other transactions that may be impacted by this original intra-group transaction. Note that if the
inventory was sold to an external party, the entries processed by the subsidiary to recognise the external
sale would consider the cost of sales based on the price paid intra-group, so cost of sales would also be
affected by the intra-group sale and therefore would need to be adjusted.
If, for example, 50 per cent of the inventory was sold by the subsidiary to an external party for $24 000
by 30 June 20X3, the subsidiary would record the following additional entry.
Dr
Dr
Cr
Cr
Bank
Cost of sales
Sales
Inventory
24 000
20 000
24 000
20 000
As the Bank and Sales accounts recognise the proceeds received from an external party, they do not
need to be adjusted. However, from the group’s perspective, the cost of sales now should only recognise
the cost of the inventory sold to external parties based on the original cost of that inventory prior to the
intra-group transfer (i.e. 50% of $30 000 = $15 000). Therefore, the adjustment on consolidation will initially
just need to reverse the debit to cost of sales and the credit to inventory by $5000 ($20 000 – $15 000).
However, as that adjustment will increase the profit before tax (and knowing that the intra-group profit has
been realised in proportion of 50 per cent), a tax effect adjustment entry will also need to be posted on
consolidation to reverse the tax effect for the realised profit. In particular, the tax effect adjustment entry
records the partial reversal of the deductible temporary difference that arose from the intra-group sale,
as profit has now been realised from the sale of inventory to an external party. These adjustments can be
visualised in the following consolidation worksheet, which also includes the previous adjustments posted
to eliminate the initial effects of the intra-group transaction.
Consolidation worksheet (30 June 20X3)
Eliminations &
adjustments
Accounts
Parent
$
Statement of profit or loss
Sales
Less: Cost of sales
40 000
(30 000)
24 000
(20 000)
Gross profit
10 000
4 000
Profit before tax
Income tax expense
Profit after tax
10 000
(3 000)
7 000
4 000
(1 200)
2 800
Statement of financial position
Inventory
Deferred tax asset
Subsidiary
$
20 000
Dr
$
Cr
$
40 000
Consolidated
$
24 000
30 000
5 000
(15 000)
9 000
1 500
3 000
9 000
(2 700)
6 300
5 000
3 000
10 000
1 500
15 000
1 500
Notes
• The consolidated statement of P/L and OCI includes only the sales revenue from the external sale
($24 000) and cost of sales to external parties based on the original cost of that inventory to the group
(50% of $30 000).
• Inventory remaining is measured in the consolidated statement of financial position at the original cost
to the group (50% of $30 000), and not at the cost to the subsidiary, which is based on the price paid
intra-group and includes the profit recognised by the parent from the sale within the group and not
yet realised.
• As the profit is recognised by the group as $9000, this requires the income tax expense of the group to
be $2700.
Pdf_Folio:263
MODULE 5 Business Combinations and Group Accounting 263
• The group has recognised a ‘deferred tax asset’ because the tax expense on the unrealised profit is a
prepaid tax that will give rise to a tax benefit in the future when the profit will be realised from the point
of view of the group (50% of the original deferred tax asset of $3000).
Note that when some of the inventory previously sold intra-group is then sold to external parties, there
are two sets of adjustments posted in the consolidation worksheet:
• adjustments for the initial intra-group transaction
• adjustments for the external transaction recorded based on the prices paid intra-group.
These adjustments can be combined into only one set of adjustments by aggregating the amounts that
both the parent and subsidiary would have recorded in the accounts affected as a result of both internal
and external transactions and then adjusting the aggregated amounts, if needed, to the amounts that
should be reported in the consolidated financial statements from the group’s perspective.
The aggregated amount in the Bank line item recognises the price received from an external party and,
therefore, there is no adjustment needed. The aggregated amount in the Sales line item reflects the amount
of sales recorded by the parent from the intra-group sale ($40 000) and the amount of sales recorded
by the subsidiary from the external sale ($24 000). As only the external sales should be recognised in
the consolidated financial statements, the Sales line item should be decreased by the amount of intragroup sales (Dr Sales $40 000). Also, from the group’s perspective, the Cost of sales line item should only
recognise the cost of the inventory sold to external parties based on the original cost of that inventory prior
to the intra-group transfer (i.e. 50% of $30 000 = $15 000). As the parent recorded $30 000 as the cost of
sales from the intra-group sale, while the subsidiary also recorded $20 000 as the cost of sales from the
external sale, the aggregated amount recognised by the parent and subsidiary will be $50 000. Therefore,
in order to make sure the consolidated Cost of sales line item only reflects the cost to the group of inventory
sold externally of $15 000, a consolidation adjustment is needed to decrease the aggregated amount by
$35 000 (Cr Cost of sales $35 000). The aggregated amount remaining in Inventory will only include the
amount recognised for inventory still held by the subsidiary, but that will be based on the price paid intragroup for that inventory ($20 000). As the inventory remaining inside the group should be recorded from the
group’s perspective based on the initial cost (50% × $30 000 = $15 000), an adjustment on consolidation
is needed to bring the aggregated amount to the correct consolidated amount (Cr Inventory $5000). As the
adjustments to Sales and Cost of sales will effectively reduce the profit by $5000 (i.e. the unrealised profit,
50% × $10 000), a tax effect adjustment entry will also need to be posted on consolidation to recognise
that the tax paid on the unrealised profit is essentially a tax prepayment from the group’s perspective
(Dr Deferred tax asset $1500; Cr Income tax expense $1500). These adjustments are presented as follows,
both as consolidation entries and as part of the consolidation worksheet.
Consolidation journal entries (30 June 20X3):
Dr
Cr
Cr
Dr
Cr
Sales
Cost of sales
Inventory
Deferred tax asset
Income tax expense
40 000
35 000
5 000
1 500
1 500
Consolidation worksheet (30 June 20X3)
Eliminations &
adjustments
Accounts
Parent
$
Statement of profit or loss
Sales
Less: Cost of sales
Gross profit
40 000
(30 000)
10 000
24 000
(20 000)
4 000
Profit before tax
Income tax expense
Profit after tax
10 000
(3 000)
7 000
4 000
(1 200)
2 800
Statement of financial position
Inventory
Deferred tax asset
Pdf_Folio:264
264 Financial Reporting
Subsidiary
$
Dr
$
Cr
$
40 000
20 000
35 000
24 000
(15 000)
9 000
1 500
9 000
(2 700)
6 300
5 000
1 500
Consolidated
$
15 000
1 500
QUESTION 5.15
(a) Refer to case study 5.2 and use assumption 1. Prepare pro forma consolidation worksheet
entries for the year ended 30 June 20X4. Explain the rationale for your entries.
(b) Refer to case study 5.2 and use assumption 2. Prepare pro forma consolidation worksheet
entries for the year ended 30 June 20X4. Explain the rationale for your entries.
(c) Assume that on 1 July 20X2, a subsidiary sold to its parent entity an item of plant for $50 000.
The plant had cost the subsidiary $100 000 and had a carrying amount of $40 000. While the
subsidiary had depreciated the plant using the reducing-balance method at a rate of 30 per
cent, the parent entity is depreciating the plant on a straight-line basis over five years with a
$nil scrap value at the end of its useful life.
Prepare pro forma consolidation worksheet entries for the financial years ending 30 June
20X3 and 30 June 20X4 to account for this transaction from the group’s point of view. Assume a
tax rate of 30 per cent and explain the rationale for your pro forma entries. (Hint: First think about
the entries that would be processed in the accounting records of the parent and subsidiary as
a result of the transaction.)
.......................................................................................................................................................................................
EXPLORE FURTHER
Digital content, such as videos and interactive activities in the e-text, support this module. You can access this content
on My Online Learning.
NON-CONTROLLING INTEREST
So far, the discussion has focused primarily on the preparation of consolidated financial statements for
parent entities that have 100 per cent ownership interest in a subsidiary. Another situation is when a parent
entity owns less than the total issued capital of a subsidiary. In this situation, a non-controlling interest
exists that should be recognised in the consolidated financial statements.
For example, a non-controlling interest would exist where the parent entity owned 70 per cent of the
issued capital of a subsidiary. The equity participants (i.e. the shareholders or owners) in the parent entity
have an interest in the group through their direct interest in the parent and an indirect interest (via the
investment) in the subsidiary. The holders of the other 30 per cent of the issued capital of the subsidiary
have an interest in the group through their investment in the subsidiary. This is illustrated in figure 5.8.
FIGURE 5.8
Non-controlling interest
Parent entity
owners
Non-controlling
interest
100%
Group
30%
Parent entity
70%
Subsidiary
Source: CPA Australia 2022.
Although not explicitly stated, IFRS 10 uses the ‘entity concept’ (also referred to as ‘economic entity
concept’) of consolidation, and as a consequence, a non-controlling interest is classified as part of
consolidated equity. This module does not discuss the alternative concepts of consolidation. However, you
should appreciate that historically there has been debate about whether non-controlling interest should be
classified as equity or liabilities.
The important features of the entity concept of consolidation are:
• all assets, liabilities, income and expenses of a similar nature in the financial statements of entities within
the group are combined, subject to any required consolidation adjustments
• the effects of transactions within the group are eliminated in full
• the non-controlling interest is classified as an equity participant in the group
Pdf_Folio:265
MODULE 5 Business Combinations and Group Accounting 265
• the non-controlling interest is entitled to the respective proportionate interest in the equity of the
subsidiary after making adjustments for unrealised profits and losses of the subsidiary arising from
intra-group transactions.
The first two features listed have already been discussed in this module. Using the entity concept of
consolidation, the existence of a non-controlling interest requires three modifications to the consolidation
process. These affect:
1. the pre-acquisition elimination entry
2. the treatment of dividends paid by the subsidiary
3. the measurement and disclosure of the non-controlling interest in the consolidated financial statements.
1. Pre-acquisition Elimination Entry
Where the parent entity acquires less than a 100 per cent interest in the subsidiary, the consolidation
pre-acquisition elimination entry should eliminate the carrying amount of the parent’s investment in
the subsidiary and the parent’s portion of equity in the subsidiary at the acquisition date (IFRS 10,
para. B86(b)). The elimination of the investment in the subsidiary recognised as an asset in the parent’s
accounts is necessary because, from the group’s perspective as a separate economic entity, the group’s
assets cannot recognise investments in itself. The reason for the elimination of the parent’s share of the
subsidiary’s equity was discussed earlier in this module under the subheading ‘Parent with an equity
interest in a subsidiary’.
The pre-acquisition equity balances of the subsidiary not eliminated on consolidation represent the noncontrolling interest in the fair value of the net assets of the subsidiary at the acquisition date and form part
of its equity in the group.
Example 5.16 illustrates the pre-acquisition elimination entry where the parent entity acquires less than a
100 per cent interest in the subsidiary. The purpose of this example is to demonstrate the key consolidation
principle that the parent entity’s share of equity of the subsidiary at acquisition date must be eliminated
as part of the pre-acquisition elimination entry. This principle is applied both at acquisition date and
in subsequent reporting periods. The amount of pre-acquisition equity of the subsidiary remaining after
this elimination entry is the non-controlling interest’s share of the equity of the group at acquisition date
(ignoring intra-group transactions — to be discussed shortly).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraph B86(b) of IFRS 10.
EXAMPLE 5.16
Non-controlling Interest — Consolidation Pre-acquisition
Elimination Entry
On 1 July 20X2, Parent Ltd (Parent) purchased 70 per cent of the shares of Subsidiary Ltd (Subsidiary) for
$160 000. At the acquisition date, the equity section of Subsidiary contained the following accounts.
$
Issued capital
Retained earnings
100 000
100 000
200 000
Assuming that all the assets and liabilities of Subsidiary recognised prior to the acquisition are
identifiable and are recorded at fair value, the goodwill on consolidation would be calculated as follows.
$
Consideration transferred
Non-controlling interest (30% of $200 000)
Less: Fair value of identifiable net assets
Goodwill
Pdf_Folio:266
266 Financial Reporting
160 000
60 000
220 000
(200 000)
20 000
The non-controlling interest in the group at the acquisition date is measured as its share of the fair
value of the identifiable net assets of Subsidiary. Hence, the non-controlling interest equals 30 per cent of
$200 000 or $60 000.
The pre-acquisition entry to eliminate the parent’s share of the subsidiary’s pre-acquisition equity is
presented as follows.
Dr
Dr
Dr
Cr
Issued capital
Retained earnings
Goodwill
Investment in Subsidiary
70 000
70 000
20 000
160 000
The following worksheet illustrates this pre-acquisition entry and the allocation of consolidated equity
between the non-controlling interest and parent equity interest. For the purpose of the worksheet, it has
been assumed that, at the acquisition date, the equity of Parent was as follows.
$
Issued capital
Retained earnings
300 000
200 000
500 000
Eliminations &
adjustments
Parent
Subsidiary
Dr
Cr
Consolidated
Noncontrolling
interest
$’000
$’000
$’000
$’000
$’000
$’000
$’000
Issued capital
Retained earnings
300
200
500
100
100
200
70
70
330
230
560
30
30
60
300
200
500
Other net assets
Investment in
Subsidiary
Goodwill
340
200
Accounts
540
160
500
160
200
Parent
equity
interest
20
160
160
—
20
560
Notes
• The pre-acquisition entry eliminates the investment account recognised by the parent and the parent
entity’s share of pre-acquisition equity in the subsidiary at the acquisition date, as well as recognising
goodwill on consolidation.
• The amount of the net assets of the group is $560 000, which includes the goodwill of $20 000.
• There are two groups of shareholders who have an interest in the group: the parent shareholders and
the non-controlling interest. At the acquisition date, the parent shareholders’ interest in the consolidated
net assets is the equity of Parent, $500 000. The non-controlling interest’s share of the consolidated net
assets is reflected in its 30 per cent interest in the equity of Subsidiary — that is, 30 per cent of $200 000
or $60 000. This amount reflects its share of the fair value of the net assets of Subsidiary. Remember,
Parent’s share of the equity of Subsidiary at the acquisition date has been eliminated on consolidation.
QUESTION 5.16
To extend example 5.16, assume that:
(a) during the 20X3 financial year, Parent and Subsidiary recorded profits of $100 000 and $50 000,
respectively
(b) neither company paid, nor declared, a dividend during the 20X3 financial year — the increase in
each company’s retained earnings during this year is equal to its 20X3 profit.
Pdf_Folio:267
MODULE 5 Business Combinations and Group Accounting 267
Complete the following consolidation worksheet.
Eliminations &
adjustments
Accounts
Issued capital
Retained earnings
Other net assets
Investment in
Subsidiary
Goodwill
Parent
Subsidiary
Dr
Cr
Consolidated
Noncontrolling
interest
$’000
$’000
$’000
$’000
$’000
$’000
300
300
600
440
100
150
250
250
Parent
equity
interest
$’000
160
600
250
Example 5.16 accounted for the business combination at the acquisition date by applying the acquisition
method in accordance with IFRS 3. That is:
• the identifiable net assets of the subsidiary were measured at their acquisition-date fair values (IFRS 3,
para. 18)
• the non-controlling interest was measured at its proportionate share of the fair value of the subsidiary’s
identifiable net assets at the acquisition date (IFRS 3, para. 19)
• goodwill was measured at the acquisition date as the difference between the fair value of the consideration transferred by the parent plus the non-controlling interest in the subsidiary less the fair value of the
identifiable net assets of the subsidiary (IFRS 3, para. 32).
In example 5.16, the net assets of the subsidiary were measured at fair value on the acquisition
date. Where the net assets of the subsidiary are not measured at fair value at acquisition date, consolidation adjustment entries are required to achieve this. After accounting for any tax effects by
recognising a deferred tax liability, the after-tax consolidation revaluation is recognised in a business
combination reserve.
In earlier examples, the pre-acquisition entry eliminated the business combination reserve in full, as the
parent owned 100 per cent of the equity of the subsidiary. Where there is a non-controlling interest, the
pre-acquisition entry eliminates the parent’s share of the business combination reserve. The remainder of
the reserve is included in the non-controlling interest’s share of the consolidated equity. That is, at the
acquisition date, the non-controlling interest is equal to its share of the subsidiary’s recorded equity plus
its share of the business combination reserve. This is equal to the non-controlling interest in the fair value
of the identifiable net assets of the subsidiary at the date of the acquisition (IFRS 3, para. 19).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 18, 19 and 32 of IFRS 3. For the purposes of
this module, assume that where a non-controlling interest is involved, the net assets of the subsidiary are measured
at their fair values at the acquisition date.
2. Dividends Paid by Subsidiary
This consolidation adjustment entry will only eliminate the dividend paid/payable within the group
(i.e. by the subsidiary to the parent), as only that represents intra-group dividends. The proportion of
dividend paid/payable by the subsidiary to the non-controlling interest shareholders will not be eliminated
because a party external to the group is involved. Elimination entries 6 and 7 of example 5.18, which
follows shortly, illustrate the elimination entries required where a final dividend is payable by a subsidiary
and there is a non-controlling interest involved.
Pdf_Folio:268
268 Financial Reporting
3. Measurement of Non-controlling Interest
The presentation of any non-controlling interest in the consolidated statement of financial position within
equity is required by paragraph 22 of IFRS 10 and paragraph 54(q) of IAS 1. The non-controlling interest
must be presented separately from the equity of the owners of the parent.
Paragraph 81B of IAS 1 requires the profit or loss and other comprehensive income to be allocated to
the owners of the parent and to the non-controlling interest.
The non-controlling interest in the net assets of consolidated subsidiaries should consist of:
• the amount of the non-controlling interest at the date of the original combination calculated in
accordance with IFRS 3 (i.e. pre-acquisition equity)
• the non-controlling interest’s share of changes in equity since the date of the combination (i.e. postacquisition changes in equity).
At acquisition, the non-controlling interest is measured at its share of the fair value of the identifiable
net assets of the subsidiary (one available option in accordance with IFRS 3, para. 19). IFRS 10 does not
indicate how to measure the non-controlling interest’s share of movements in equity. However, the general
principle is that the non-controlling interest should be measured as its portion of the aggregate amount of
the equity of the subsidiaries adjusted for unrealised profits or losses of subsidiaries.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you should read paragraphs 22 and B94 of IFRS 10.
The rationale for requiring a non-controlling interest to be adjusted for the unrealised profits or losses
of a subsidiary stems from the entity concept of consolidation, which sees a non-controlling interest as an
owner in the group. Determining a non-controlling interest focuses on its share of the equity of the group,
not its share of the equity recorded in the financial statements of the subsidiary. The equity of the group
is affected by the elimination of intra-group profits or losses. As such, the calculation of a non-controlling
interest must also be adjusted for unrealised profits or losses relevant to it. To determine which intragroup transactions affect the measurement of a non-controlling interest, there are two important points
to remember.
First, as a non-controlling interest has an interest in the group via the subsidiary, only intra-group
transactions that affect the subsidiary’s equity require adjustment. Thus, the original intra-group transaction
leading to unrealised profits or losses must have been from the subsidiary. For example, if the subsidiary
sold plant at a profit to the parent, the profit would be reflected in profit or loss and retained earnings of
the subsidiary. However, from the group’s perspective, this profit is unrealised and should be eliminated.
Thus, the profit or loss and relevant income and expense items in the financial statements of the subsidiary
must be adjusted for the unrealised profit on the plant to reflect the profit recognised by the group.
This adjusted subsidiary profit then forms the basis of calculation for the non-controlling interest. It
is important to remember that if the intra-group transaction has been a sale of plant from the parent
to the subsidiary, there is no effect on the equity of the subsidiary (only on the equity of the parent),
and the non-controlling interest has no interest in the parent. Therefore, for the intra-group transactions
from the parent to the subsidiary, no adjustments are required to the subsidiary equity-account balances to
enable the non-controlling interest to be calculated.
The second point to note is the requirement to understand which transactions lead to unrealised profits
or losses from the perspective of the group. As previously discussed, unrealised profits or losses only arise
through an intra-group sale of assets such as inventory, plant and land. Profits or losses from the intragroup sale of those assets are realised by the group when a party external to the group is involved. For
other intra-group transactions (interest and services), it is assumed, from a practical viewpoint, that the
profits or losses are realised immediately as the net effect of those transactions on the consolidated profit
is nil.
In summary, measuring the amount of non-controlling interest in a consolidated equity item involves
applying the relevant non-controlling interest percentage to the carrying amount of the subsidiary equity
account involved, adjusted where relevant for realised/unrealised profits/losses that resulted from a sale
of an asset from the subsidiary to the parent.
Example 5.17 demonstrates the application of this measurement principle where there is an intra-group
sale of inventory resulting in an unrealised profit. Question 5.17, following example 5.17, applies the
measurement principle for non-controlling interests in the subsequent reporting period when the inventory
is sold to parties external to the group and the profit is realised.
Pdf_Folio:269
MODULE 5 Business Combinations and Group Accounting 269
Example 5.17 relates to case study 5.3 contained in the ‘Case studies’ section and focuses on the data
for the year ended 30 June 20X4.
EXAMPLE 5.17
Measurement of Non-controlling Interest
Example 5.17 is concerned with measuring the non-controlling interest in the following consolidated items:
opening retained earnings, profit for the year and closing retained earnings.
As the parent owns 70 per cent of the shares in the subsidiary, the non-controlling interest is entitled to
30 per cent of the subsidiary’s equity as it is reflected in the consolidated equity.
To determine the non-controlling interest in the consolidated opening retained earnings, the starting
point is the opening retained earnings of Subsidiary Ltd (Subsidiary). The next consideration is to
determine whether there have been any transactions that have impacted on the opening retained earnings
of Subsidiary but have been eliminated on consolidation. In case study 5.3, there are no fair value
adjustments for assets or liabilities not recorded at fair value at acquisition date and no unrealised
profits/losses carried forward from the year ended 30 June 20X3. Hence, there is no need to make any
adjustments to the opening retained earnings in the financial statements of Subsidiary.
Non-controlling interest in opening retained earnings account:
= 30% of opening retained earnings balance in financial statements of Subsidiary
= 30% of $40 000
= $12 000
To measure the non-controlling interest in the consolidated profit, the starting point is again the relevant
item in the financial statements of Subsidiary, that is, the profit of Subsidiary. Then, it is necessary to
determine whether there have been any transactions that have affected the profit of Subsidiary but have
been eliminated on consolidation.
Case study 5.3 contains three intra-group transactions for the year ended 30 June 20X4. Both the sale
of the inventory from Subsidiary to Parent Ltd (Parent) and the sale of the plant from Parent to Subsidiary
would require the elimination of unrealised profits from the group’s perspective. There is no unrealised
profit on the provision of management services. From Subsidiary’s point of view, the profit on the sale
of inventory is the only one of the three transactions that has impacted on its 20X4 profit but not on the
consolidated profit. Hence, this item should be taken into account when calculating the non-controlling
interest in the consolidated profit. The non-controlling interest has an interest in the consolidated profits
via the profits of Subsidiary, but the profit on the sale of inventory to Parent has been eliminated by the
group. The non-controlling interest can only receive its share of the profit of Subsidiary when it is included
in the consolidated profit of the group.
Non-controlling interest in profit:
= 30% of (Profit in financial statements of Subsidiary – Unrealised after-tax profits made by Subsidiary)
= 30% of (Profit in financial statements of Subsidiary – Unrealised profit on sale of inventory + Tax effect
of unrealised profit)
= 30% of ($200 000 – $40 000 + $12 000)
= 30% of $172 000
= $51 600
As the unrealised profit on the sale of inventory from Subsidiary to Parent has been eliminated from the
consolidated profit, it must have also been eliminated from the consolidated closing retained earnings.
Hence, the unrealised profit must be taken into account when determining the non-controlling interest’s
share of the consolidated closing retained earnings.
Non-controlling interest in closing retained earnings:
= 30% of (Closing retained earnings of Subsidiary – Unrealised after-tax profits made by Subsidiary)
= 30% of (Closing retained earnings of Subsidiary – Unrealised profit on sale of inventory + Tax effect
of unrealised profit)
= 30% of ($140 000 – $40 000 + $12 000)
= 30% of $112 000
= $33 600
An alternative way of reconciling the non-controlling interest in closing retained earnings is by using the
individual items making up the balance:
= Non-controlling interest in opening retained earnings + Non-controlling interest in profit – Noncontrolling interest in dividends
= $12 000 + $51 600 – $30 000 (30% of $100 000)
= $33 600
Pdf_Folio:270
270 Financial Reporting
QUESTION 5.17
Refer to case study 5.3. Using data for the year ended 30 June 20X5, measure the non-controlling
interest in the following: opening retained earnings, profit and closing retained earnings.
.......................................................................................................................................................................................
EXPLORE FURTHER
Digital content, such as videos and interactive activities in the e-text, support this module. You can access this content
on My Online Learning.
Example 5.18 relates to case study 5.4. You should read the data in case study 5.4 in the ‘Case studies’
section.
The purpose of example 5.18 is to provide an overview example that demonstrates the application of
the following consolidation principles:
• elimination of the investment in the subsidiary and the parent’s share of the equity of the subsidiary at
acquisition date
• elimination in full of all intra-group assets, liabilities, revenues and expenses including profits or losses
on the transfer of assets within the group
• measurement of non-controlling interest by applying the non-controlling interest percentage to the
carrying amount of the subsidiary equity adjusted for unrealised/realised profits or losses from the sale
of an asset from the subsidiary to the parent.
EXAMPLE 5.18
Comprehensive Consolidation
The first task is to analyse the case study 5.4 data and prepare consolidation elimination entries. The
elimination entries and their rationale are outlined here.
1. On 1 July 20X0, Parent Ltd (Parent) purchased 70 per cent of the issued capital of Subsidiary Ltd
(Subsidiary) for $120 000. An extract from the equity section of the statement of financial position of
Subsidiary at the acquisition date reveals the following.
$
Issued capital
Retained earnings
100 000
50 000
150 000
At the acquisition date, the identifiable net assets of Subsidiary were recorded at fair value. Thus, the
fair value of identifiable net assets at the acquisition date is equal to the value of total equity recorded
in the statement of financial position of Subsidiary (assuming no goodwill previously recorded). The
value of non-controlling interest at acquisition date is calculated based on the proportionate share of
identifiable net assets.
Goodwill on consolidation would be calculated as follows.
$
Fair value of consideration transferred
Non-controlling interest (30% of $150 000)
120 000
45 000
165 000
(150 000)
15 000
Less: Fair value of identifiable net assets
Goodwill
In accordance with IFRS 10, paragraph B86(b), the investment in the subsidiary must be eliminated
in full, together with the parent’s share of the subsidiary’s equity. Therefore, the following pre-acquisition
elimination entry (1) is required.
Dr
Dr
Dr
Cr
Issued capital
Retained earnings (opening balance)
Goodwill
Investment in Subsidiary
70 000
35 000
15 000
120 000
Pdf_Folio:271
MODULE 5 Business Combinations and Group Accounting 271
2. During the financial year ended 30 June 20X1, Parent sold inventory with a cost of $5000 to Subsidiary
for $9000. The inventory was still on hand as at 30 June 20X1.
The entry processed by Parent for the sale of the inventory would be as follows.
Dr
Dr
Cr
Cr
Bank
Cost of sales
Sales
Inventory
9 000
5 000
9 000
5 000
The entry processed by Subsidiary for the purchase of the inventory would be as follows.
Dr
Cr
Inventory
Bank
9 000
9 000
From the group’s perspective, these entries do not relate to parties external to the group and, hence,
the effect should not be reflected in the consolidated financial statements. That is, the intra-group sale
and cost of sales must be eliminated (which eliminates the profit on the transaction) and the inventory
must be restated to the cost to the group. Therefore, the following consolidation elimination entry (2a)
is required.
Dr
Cr
Cr
Sales
Cost of sales
Inventory
9 000
5 000
4 000
To explain each line of this entry, the debit to Sales eliminates the credit to Sales recorded by Parent
upon the sale of inventory to Subsidiary. Similarly, the credit to Cost of sales eliminates the debit to
Cost of sales previously recorded by Parent at the time of sale. The credit to Inventory of $4000 offsets
the ‘net’ debit to Inventory recorded by both Parent and Subsidiary at the time of sale (i.e. $9000 debit
recorded by Subsidiary minus $5000 credit recorded by Parent equals $4000 ‘net’ debit) and makes
sure that inventory is recorded at the original cost to the group. No entry is required for Bank as the debit
recorded by Parent at the time of sale has already been offset by the credit recorded by Subsidiary.
This consolidation elimination entry requires the following tax effect entry (2b).
Dr
Cr
Deferred tax asset
Income tax expense
1 200
1 200
As the group has eliminated $4000 of unrealised profit (i.e. by debiting Sales of $9000 and crediting
Cost of sales of $5000), the income tax expense of the group must be reduced by $1200 (30% of
$4000). As such, the unrealised after-tax profit on sale of inventory is $2800 ($4000 – $1200). The
deferred tax asset of $1200 arises because the tax paid on the intra-group profit by the parent is a
prepayment of tax from the group’s perspective, giving rise to a tax benefit available for the future
(i.e. the group will not have to pay tax again when profit will be realised for the group).
3. Over the financial year, Parent had charged Subsidiary $3000 for services rendered. The services had
not been paid for by the end of the financial year.
Parent processed the following entry for the services rendered.
Dr
Cr
Trade receivables
Other income
3 000
3 000
Subsidiary processed the following entry for the services received.
Dr
Cr
Expenses
Trade payables
3 000
3 000
From the group’s perspective, this transaction is an internal one and must be eliminated. Therefore,
the following consolidation elimination entries (3 and 4) are required.
Consolidation elimination entry 3:
Dr
Cr
Pdf_Folio:272
272 Financial Reporting
Other income
Expenses
3 000
3 000
Consolidation elimination entry 4:
Dr
Cr
Trade payables
Trade receivables
3 000
3 000
Note: There is no tax effect for these elimination entries, as they do not have any net impact on
the consolidated profit. This is because the amount of ‘Other income’ eliminated equals the amount of
‘Expenses’ eliminated, meaning that the effect of these elimination entries on consolidated profit is nil.
4. On 30 June 20X1, Subsidiary sold plant to Parent for $16 000 at a loss of $4000. The plant had a
remaining useful life of two years with a scrap value of $2000 at the end of that time.
Subsidiary processed the following entry for the sale of the plant.
Dr
Dr
Cr
Bank
Other income (loss)
Plant
16 000
4 000
20 000
Note: The plant was sold for $16 000 at a loss of $4000. The carrying amount of the plant
in Subsidiary’s statements was, therefore, $20 000 (Carrying amount $20 000 – Sale price $16 000
= $4000 loss).
Parent processed the following entry for the purchase of the plant.
Dr
Cr
Plant
Bank
16 000
16 000
From the group’s perspective, the intra-group loss on the sale of the plant should be eliminated
and the amount of the plant should be increased to the cost to the group. Therefore, the following
consolidation elimination entry (5a) is required.
Dr
Cr
Plant
Other income
4 000
4 000
In this entry, the debit to Plant of $4000 offsets the ‘net’ credit to Plant recorded by both Parent and
Subsidiary at the time of sale (i.e. $20 000 credit recorded by Subsidiary minus $16 000 debit recorded
by Parent equals $4000 ‘net’ debit) and brings the Plant to the original carrying amount. The credit to
Other income eliminates the debit to Other income previously recorded by Subsidiary at the time of
sale to recognise the loss. No entry is required for Bank as the debit recorded by Parent at the time of
sale has already been offset by the credit recorded by Subsidiary.
The preceding elimination entry requires the following tax effect entry (5b).
Dr
Cr
Income tax expense
Deferred tax liability
1 200
1 200
As the group has eliminated the unrealised loss of $4000, the consolidated profit increases and the
income tax expense of the group must be increased by $1200 (30% of $4000). As such, the unrealised
after-tax loss on plant is $2800 ($4000 – $1200). In addition, the group has a deferred tax liability of
$1200. That is, the group does not have to pay the tax itself, but the individual entities will pay it when
their profit does not include this loss. In other words, as a result of the increase in the carrying amount
of Plant in elimination entry (5a), a taxable temporary difference arises and, consequently, gives rise to
a deferred tax liability.
The elimination of an intra-group profit or loss on sale of plant usually also gives rise to a
consolidation depreciation adjustment. However, a depreciation adjustment is not required in this
example because the plant was transferred at the end of the reporting period and, therefore, it was
not yet subject to a depreciation that would have been affected by the intra-group sale. A depreciation
adjustment will be required in the next reporting period when the plant is used by the entity that
purchased it intra-group.
5. On 30 June 20X1, Subsidiary declared a final dividend of $10 000. Parent recognises dividend income
when it is receivable.
Subsidiary processed the following entry for the dividend declared.
Dr
Cr
Final dividend (retained earnings)
Final dividend payable
10 000
10 000
Pdf_Folio:273
MODULE 5 Business Combinations and Group Accounting 273
Parent processed the following entry in relation to the dividend declared by Subsidiary.
Dr
Cr
†
Dividend receivable
Dividend income†
7 000
7 000
Parent owns 70% of the shares in Subsidiary and, therefore, is entitled to 70% of the final dividend
declared by Subsidiary. The remaining 30% is owned by the non-controlling interest shareholders.
From the group’s perspective, the effects of the intra-group dividend should be eliminated.
Therefore, the following consolidation elimination entries (6 and 7) are required.
Consolidation elimination entry 6:
Dr
Cr
Dividend income
Final dividend (retained earnings)
7 000
7 000
Consolidation elimination entry 7:
Dr
Cr
Final dividend payable
Dividend receivable
7 000
7 000
There are no tax consequences for these consolidation elimination entries related to the dividend
because the dividend is tax-free to Parent, and the income tax expense of Parent will reflect this. Note
that entry 7 does not eliminate the non-controlling interest’s share in the dividend (i.e. 30% × $10 000
= $3000) because this relates to shareholders external to the group.
After determining the consolidation elimination entries for this comprehensive example that were
discussed on the preceding pages, these can now be processed in the consolidation worksheet.
The following consolidation worksheet is prepared and includes the non-controlling interest allocation
(the calculation of non-controlling interest is discussed after the worksheet). The financial statement
amounts of Parent and Subsidiary are pre-determined. Notes in the worksheet refer to the numbered
consolidation elimination entries in bold that were discussed in the preceding pages.
Eliminations &
adjustments
Parent Subsidiary
Accounts
Sales
Less: Cost of
sales
Gross profit
Less: Expenses
Dividend income
Other income
Profit before tax
Less: Income tax
expense
Profit for the year
Retained earnings
1 July 20X0
Less: Final
dividend
Retained earnings
30 June 20X1
Issued capital
Total equity
Pdf_Folio:274
274 Financial Reporting
$’000
$’000
Dr
Cr
Consolidated
Noncontrolling
interest
$’000
$’000
$’000
$’000
9(2a)
320
95
(150)
170
(80)
90
7
3
100
(35)
60
(16)
44
(30)
70
(12)
28
1.2(5b)
220
290
50
78
35(1)
(20)
(10)
270
68
400
100
(4)
40
3(3)
4(5a)
1.2(2b)
7(6)
70(1)
$’000
406†
5(2a)
7(6)
3(3)
Parent
equity
interest
(180)
226
(93)
133
—
—
133
(42)
91
9.24
81.76
235
326
15
24.24
220
301.76
(23)
(3)
(20)
303
21.24
281.76
430
733
30
51.24
400
681.76
Liabilities
Trade payables
Final dividend
payable
Other
Deferred tax
liability
Total equity and
liabilities
Current assets
Dividend
receivable
Trade
receivables
Inventory
Other
Non-current
assets
Plant (net)
Other
Investment in
Subsidiary
Goodwill
Deferred tax
asset
Total assets
†
20
11
3(4)
28
20
84
10
50
7(7)
23
134
1.2(5b)
794
239
919.2
7(7)
7
35
60
100
14
25
30
250
222
100
70
3(4)
4(2a)
4(5a)
15(1)
239
1.2(2b)
5.4(2a)
—
46
81
130
354
292
120(1)
120
794
1.2
155.4
—
15
1.2
919.2
Parent’s sales of $320 000 + Subsidiary’s sales of $95 000 – Elimination (debit) of $9000 = Consolidated sales of
$406 000. This approach is applicable throughout the worksheet based on normal debit and credit rules.
Calculation of Non-controlling Interest
• Non-controlling interest in Subsidiary’s opening retained earnings:
= 30% of opening retained earnings balance in financial statements of Subsidiary
= 30% of $50 000
= $15 000
The opening retained earnings of Subsidiary represents the balance of this item at the acquisition
date. No intra-group transactions from Subsidiary to Parent had taken place.
• Non-controlling interest in Subsidiary’s profit after tax for the year (adjusted for profit or loss on intragroup transactions):
= 30% of (Profit for the year in financial statements of Subsidiary – (+) Unrealised after-tax profits (losses)
made by Subsidiary + (–) Realised after-tax profits (losses) made by Subsidiary)
= 30% of (Profit for the year in financial statements of Subsidiary + Unrealised after-tax loss on plant)
= 30% of ($28 000 + ($4000 – $1200))
= 30% of $30 800
= $9240
Remember that the measurement of non-controlling interest involves applying the relevant noncontrolling interest percentage to the carrying amount of the subsidiary equity adjusted for unrealised/
realised profits/losses that resulted from a sale of an asset from the subsidiary to the parent. For the
comprehensive example, the relevant non-controlling interest percentage is 30 per cent. The focus is
on the non-controlling interest share of profit and, therefore, the appropriate starting point is the profit
for the year in the financial statements of the subsidiary ($28 000).
However, the profit of Subsidiary includes the after-tax loss on the sale of the plant by Subsidiary
to Parent. From the group’s perspective, this was an internal transaction and the unrealised loss and
associated tax effects were eliminated (refer to entries 5a and 5b in the consolidation worksheet). As the
group has not recognised the loss (net of tax), the non-controlling interest should not be allocated a share
of this item. The profit of Subsidiary is adjusted by adding back the unrealised loss and eliminating the
associated tax effects that resulted from the sale of the plant by Subsidiary to Parent.
Note: Even though the intra-group sale of inventory is reflected in the statement of financial position
of Subsidiary, Parent recorded the profit on the sale. Hence, the non-controlling interest shareholders of
Subsidiary have no interest in this profit or its elimination.
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MODULE 5 Business Combinations and Group Accounting 275
• Non-controlling interest in Subsidiary’s closing retained earnings:
This amount can be calculated in two ways:
1. The calculations of the individual items making up the closing balance of retained earnings:
= Non-controlling interest in Subsidiary’s opening retained earnings + Non-controlling interest in
Subsidiary’s profit after tax (adjusted for profit or loss on intra-group transactions) – Noncontrolling interest in final dividend declared by Subsidiary:
= $15 000 + $9240 – (30% of $10 000)
= $15 000 + $9240 – $3000
= $21 240
2. Using the closing balance of the retained earnings of Subsidiary – (+) Any after-tax unrealised profits
(losses) made by Subsidiary:
= 30% of ($68 000 + ($4000 – $1200))
= 30% of ($68 000 + $2800)
= 30% of $70 800
= $21 240
• Non-controlling interest in Subsidiary’s issued capital:
= 30% of $100 000
= $30 000
• Non-controlling interest in statement of financial position:
= Non-controlling interest in Subsidiary’s issued capital (refer to prior calculation) + Non-controlling
interest in Subsidiary’s closing retained earnings (refer to prior calculation) + Non-controlling
interest in Subsidiary’s reserves
= $30 000 + $21 240 + $0
= $51 240
Note that as the net assets of Subsidiary were recorded at fair value, there is no business combination
reserve. If there was, the non-controlling interest share of this item would also have to be taken into
account.
QUESTION 5.18
Question 5.18 extends example 5.18. One year later, on 30 June 20X2, the following information and
worksheet data were available for Parent and Subsidiary.
Required
(a) Complete the consolidation worksheet. (Note: Remember to use any relevant information
relating to the 20X1 year from the comprehensive example (example 5.18).)
(b) Explain how the non-controlling interest was arrived at.
Additional information
1. During the financial year ended 30 June 20X2, half of the inventory sold by Parent to Subsidiary in
the previous financial year was sold to parties external to the group. On 15 June 20X2, Subsidiary
sold inventory to Parent for $8000 that had cost $4000. Parent still had this inventory on hand at
the end of the financial year.
2. Over the financial year, Parent had charged Subsidiary $4000 for services rendered; $1000 of the
services had not been paid for by the end of the financial year.
3. The plant sold by Subsidiary to Parent on 30 June 20X1 was depreciated by $7000 in the financial
statements of Parent during the 20X2 financial year. That is, a straight-line basis of depreciation
was adopted.
4. During the financial year, Subsidiary paid an interim dividend of $10 000. On 30 June 20X2,
Subsidiary declared a final dividend of $10 000. Parent recognises dividend income when it
is receivable.
5. The directors of Parent and Subsidiary decided to transfer $20 000 and $10 000 respectively from
their respective pre-acquisition retained earnings to a general reserve.
6. Assume a tax rat