HOOFSTUK
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Index of
Accounting Standards
Publication
Conceptual
Framework
IAS
IAS
IAS
IAS
1
2
7
8
IAS 10
IAS 12
IAS 16
IAS 19
IAS 20
IAS 21
IAS 23
IAS 24
IAS 26
IAS 27
IAS 28
IAS 29
IAS 32
IAS 33
IAS 34
IAS 36
IAS 37
IAS 38
IAS 39
IAS 40
IAS 41
Title
Accounting framework
The Conceptual Framework for Financial Reporting 2010
International Accounting Standard (IAS)
Presentation of Financial Statements
Inventories
Statement of Cash Flows
Accounting Policies, Changes in Accounting Estimates and
Errors
Events after the Reporting Period
Income Taxes
Property, Plant and Equipment
Employee Benefits
Government Grants and Government Assistance
The Effects of Changes in Foreign Exchange Rates
Borrowing Costs
Related Party Disclosures
Accounting and reporting by retirement benefit plans
Consolidated and Separate Financial Statements
Investments in Associates and Joint Ventures
Hyperinflationary Economies
Financial Instruments: Disclosure and Presentation
Earnings per Share
Interim Financial Reporting
Impairment of Assets
Provisions, Contingent Liabilities and Contingent Assets
Intangible Assets
Financial Instruments: Recognition and Measurement
Investment Property
Agriculture
xi
Chapter
2
3
4
5
6
7
8
9
10
–
11
12
13
–
24
25
–
20
–
–
14
15
16
–
17
–
xii Descriptive Accounting
Publication
IFRS 1
IFRS 2
IFRS 3
IFRS 4
IFRS 5
IFRS 6
IFRS 7
IFRS 8
IFRS 9
IFRS 10
IFRS 11
IFRS 12
IFRS 13
IFRS 15
IFRS 16
IFRS 17
SIC 7
SIC 10
SIC 25
SIC 29
SIC 32
IFRIC 1
IFRIC 2
IFRIC 5
IFRIC 6
IFRIC 7
IFRIC 10
IFRIC 12
IFRIC 14
IFRIC 16
IFRIC 17
IFRIC 19
Title
International Financial Reporting Standards (IFRS)
First-time adoption of International Financial Reporting
Standards
Share-based Payment
Business Combinations
Insurance contracts
Non-current Assets Held for Sale and Discontinued
Operations
Exploration for and evaluation of mineral resources
Financial Instruments: Disclosure
Operating Segments
Financial Instruments
Consolidated Financial Statements
Joint Arrangements
Disclosure of Interests in Other Entities
Fair Value Measurement
Revenue from Contract with Customers
Leases
Insurance Contracts
Interpretations
Introduction of the Euro
Government assistance – no specific relation to operating
activities
Income taxes – changes in the tax status of an entity or its
shareholders
Service concession arrangements: disclosures
Intangible assets – web site costs
Changes in existing decommissioning, restoration and
similar liabilities
Members shares in co-operative entities and similar
instruments
Rights to interests arising from decommissioning
restoration and environmental rehabilitation funds
Liabilities arising from participating in a specific market –
Waste electrical and electronic equipment
Applying the restatement approach under IAS 29
Interim financial reporting and impairment
Service Concession arrangements
(Updated to July 2008)
The limit on a defined benefit asset, minimum funding
requirements and their interaction
Hedges of a net investment in a foreign operation
Distributions of non-cash assets to owners
Extinguishing financial liabilities with equity instruments
Chapter
–
18
26
–
19
–
20
–
20
24
27
24, 25, 27
21
22
23
–
–
–
–
16
20
9, 15
–
15
15
15
–
–
10
–
–
20
Index of Accounting Standards xiii
Publication
IFRIC 21
FRG 1
FRG 2
FRG 3
IFRS for SMEs
Title
Changes in existing decommissioning, restoration and
similar liabilities
Chapter
15
Financial Reporting Guides (FRG)
Substantively Enacted Tax Rates and Tax Laws
Accounting for black economic empowerment (BEE)
transactions
18
IAS 19 (AC 116) The limit on a defined benefit asset,
minimum funding requirements and their interaction in the
South African Pension Fund environment
10
Small and Medium-sized entities
IFRS for Small and Medium-sized entities
28
8
CHAPTER
1
The South African
regulatory framework
Contents
1.1
1.2
1.3
1.4
Background .......................................................................................................
The due process of the IASB ............................................................................
1.2.1 Introduction .............................................................................................
1.2.2 Exposure Drafts .....................................................................................
1.2.3 Finalising a Standard ..............................................................................
1.2.4 Publication ..............................................................................................
Accounting publications .....................................................................................
1.3.1 IFRSs/IASs .............................................................................................
1.3.2 IFRICs/SICs ............................................................................................
1.3.3 IFRS for SMEs ........................................................................................
Regulatory requirements for financial reporting in South Africa ........................
1.4.1 The Companies Act, 2008 ......................................................................
1.4.2 The King IV Report .................................................................................
1.4.3 The JSE Limited Listings Requirements .................................................
1.4.4 The Financial Reporting Investigation Panel ..........................................
1
2
2
2
2
3
3
3
3
3
4
4
4
5
5
6
2 Descriptive Accounting – Chapter 1
1.1 Background
South Africa fully harmonised the South African Statements of Generally Accepted
Accounting Practice (SA GAAP) with the International Financial Reporting Standards (IFRS)
in 1995, effective 2003. Since then, the Accounting Practices Board (APB), a private
accounting standard-setting body established in South Africa in 1973, has issued IFRS
without amendments as SA GAAP. All companies, listed and unlisted, in South Africa were
required to use SA GAAP (which was identical to IFRS) as their reporting framework. Since
SA GAAP is identical to IFRS, SA GAAP was withdrawn as a reporting framework in South
Africa for all companies with reporting periods commencing on or after 1 December 2012.
The JSE Limited has, since 1 January 2005, required all listed companies to use IFRS as a
reporting framework.
Financial reporting standards, in terms of the Companies Act 71 of 2008 (Companies Act,
2008), allows companies to adopt either IFRS or IFRS for Small and Medium-sized entities
(IFRS for SMEs) depending on whether they meet the scope requirements of the respective
frameworks.
The Financial Reporting Standards Council (FRSC) was established in 2011 in terms of the
Companies Act, 2008. The FRSC is now South Africa’s constituted governmental
accounting standard-setter, and is responsible for advising the Minister on matters relating
to financial reporting standards.
1.2 The due process of the IASB
1.2.1 Introduction
The IASB is the accounting standard-setting body of the IFRS Foundation. The IFRS
Foundation is governed by a body of trustees that in turn is monitored and reports to the
Monitoring Board, a body representing the public authorities that oversee the standard
setters. The IASB has a mandate from the IFRS Foundation to develop and publish IFRS
and IFRS for SMEs. In order to fulfil its mandate, the IASB follows a transparent and
comprehensive due process to develop new Standards or amend existing Standards. The
due process of the IASB is based on the principle of transparency and protects the integrity
of accounting standard-setting.
The requirements of the due process of accounting standard-setting are contained in the
Due Process Handbook of the IASB. The handbook specifies the minimum steps the IASB
must take to ensure the development of quality Standards. The handbook also prescribes
the thorough consultation process that the IASB must follow when developing a new
Standard or amending a Standard.
The publication of an Exposure Draft on a proposed or amended Standard represents an
important step in the consultative arrangements of the due process of the IASB.
1.2.2 Exposure Drafts
An Exposure Draft (ED) is generally set out in the same format as the proposed or amended
Standard. An ED is the IASB’s principal attempt to consult the public on a proposed or
amended Standard. When the IASB publishes an ED, it normally allows a minimum period
of 120 days for the public to comment. At the same time, SAICA also publishes the ED in
South Africa to invite comments from interested parties, who thus have the option of raising
their views on an ED in either a comment letter to SAICA or directly to the IASB.
The South African regulatory framework 3
Once the comment period ends, the IASB analyses and summarises the main points raised
by the interested parties in their comment letters. Any technical matters arising from the
comment letters are addressed by the IASB and resolved through a consultative process. If
the IASB is satisfied that all technical matters relevant to the ED are resolved, the new
Standard is finalised and prepared for balloting. If the IASB is not satisfied that all technical
matters are resolved, or concludes that fundamental changes to the ED are required, based
on the comments received, it has to publish a revised ED for public comment.
1.2.3 Finalising a Standard
All finalised Standards should include at least the following:
ƒ the defined terms used in the Standard;
ƒ the principles and an application guidance; and
ƒ the effective date of the Standard and transitional provisions.
A Standard, or an amendment thereto, has an effective date to allow the various
jurisdictions time to prepare for the implementation of the new Standard or amendment.
Transitional provisions are generally included in a new Standard to provide preparers with
the procedure to follow to account for any change in accounting policy due to the initial
application of the Standard.
In addition to the above, each Standard also includes a table of contents, an introduction,
the Basis of Conclusions, and dissenting opinions, where applicable.
1.2.4 Publication
A new Standard is published as an IFRS. The publication of an IFRS or amendment to an
existing IFRS is accompanied by a press release and various communication materials. If
necessary, the IASB will embark on educational initiatives to ensure that a new IFRS is
implemented and applied consistently.
1.3 Accounting publications
1.3.1 IFRSs/IASs
The IASB publishes accounting standards called IFRSs. IFRSs deal with recognition,
measurement, presentation and disclosure requirements in general purpose financial
statements, namely those that are directed towards the common information needs of a
wide range of users such as shareholders, creditors, employees and the public at large. In
order to achieve consistent and logical formulation, IFRSs are based on the Conceptual
Framework for Financial Reporting (discussed in chapter 2). Requirements for transactions
and events in specific industries are, however, sometimes also addressed. IFRSs apply to
the financial reporting of all profit-oriented entities, such as those engaged in commercial,
industrial, financial and similar activities, regardless of whether they are organised in
corporate or other forms.
IASs are the Standards issued from 1973 to 2001 by the IASB’s predecessor, the
International Accounting Standards Committee (IASC). The IASs continue to be designated
as part of IFRSs.
1.3.2 IFRICs/SICs
The IASC set up the Standing Interpretations Committee (SIC) to issue interpretations of
IASs. These interpretations are known as SIC Interpretations. During March 2002, the SIC
was replaced by the International Financial Reporting Interpretations Committee (IFRIC), a
committee of the IASB. The committee is currently referred to as the IFRS Interpretations
Committee.
4 Descriptive Accounting – Chapter 1
IFRIC Interpretations provide guidance on the application of IFRSs and on financial
reporting issues not specifically addressed in IFRSs. IFRIC Interpretations do not change or
conflict with IFRSs, but promote the rigorous and uniform application of IFRSs. Since IFRIC
Interpretations form part of IFRSs, they must be ratified by the IASB.
1.3.3 IFRS for SMEs
The IASB issued the IFRS for SMEs, which is intended for use by small and medium-sized
entities that do not have public accountability and publish general purpose financial
statements for external users. The IFRS for SMEs can be described as a scaled down
version of the complete IFRSs.
1.4 Regulatory requirements for financial reporting in South Africa
There are various regulatory requirements that govern and monitor financial reporting in
South Africa. A brief explanation of the relevant legislation is provided below.
1.4.1 The Companies Act, 2008
The Companies Act, 2008 was signed by the President in April 2009 and became effective
on 1 May 2011. In terms of the Act, two categories of companies are recognised, namely
profit companies and non-profit companies.
1.4.1.1 Profit companies
Profit companies are defined as companies incorporated for the purpose of financial gain for
their shareholders, and include the following categories of companies:
ƒ State-owned company (SOC Ltd):
A company that falls within the meaning of ‘state-owned enterprise’ or is owned by a
municipality.
ƒ Private company ((Pty) Ltd):
A company that is neither a state-owned company nor a personal liability company. Its
Memorandum of Incorporation (MOI) also prohibits it from offering its securities to the
public and restricts the transferability of those securities.
ƒ Personal liability company (Inc.):
A private company, whose MOI states that it is a personal liability company.
ƒ Public company (Ltd):
A profit company that is not a state-owned company, a private company or a personal
liability company. A public company can either be listed on the JSE Limited or it can be a
non-listed entity.
1.4.1.2 Non-profit companies
A non-profit company (NPC) is incorporated for public benefit or for an object relating to
social or cultural activities. Its income and property are not distributable to its members,
incorporators, directors, officers or related persons. This category of company may be
regarded as the successor of the former Section 21 Company.
The South African regulatory framework 5
1.4.1.3 Financial reporting of respective companies
The respective financial reporting frameworks applicable to the different categories of profit
companies are as follows:
Category of profit company
Financial reporting framework
State-owned companies (SOCs) and nonprofit companies that require an audit.
IFRS (but should there be any conflict with the
Public Finance Management Act 1 of 1999, the
latter prevails).
Listed public companies.
IFRS.
Public companies not listed.
IFRS or IFRS for SMEs.
Profit companies, other than SOCs or public
companies.
IFRS or IFRS for SMEs.
Profit companies, other than SOCs or public
companies, whose public interest score is
less than 100, and whose financial
statements are internally compiled.
The financial reporting standards as determined
by the company for as long as no financial
reporting standards are prescribed.
In all cases, a company can choose to comply with a ‘higher’ level of financial reporting
framework (i.e. applying IFRS even if IFRS for SMEs was allowed). Companies that apply
IFRS for SMEs may only do so if the company meets the scoping requirements of IFRS for
SMEs.
1.4.2 The King IV Report
The King Committee issued a third edition of the King Report on 1 September 2009. King III
has been revised to bring it up to date with international governance codes and best
practice. King IV was released on 1 November 2016. The King Code and Report on
Governance for South Africa (King IV) is effective from 1 April 2017. In terms of the JSE
Limited’s Listings Requirements, all listed companies have to comply with the King Report.
All other companies and other business entities incorporated in, or resident in, South Africa
are strongly encouraged to apply the principles in this Code, irrespective of their manner or
format of incorporation or establishment and should also consider the best practice
recommendations in the King Report.
In terms of reporting and disclosure, King III requires the board of directors of a company to
prepare an integrated report that should be integrated with the company’s financial
reporting. The integrated report should be prepared annually and should present financial
information with sustainability issues of social and environmental impacts. The board of
directors is also required to comment on the financial results and disclose whether the
company is a going concern. The integrated report should be independently assured.
1.4.3 The JSE Limited Listings Requirements
In terms of section 8.62 of the JSE Limited Listings Requirements, the annual financial
statements of listed companies must be prepared in accordance with the national law
applicable to a listed company and in accordance with IFRSs and South African accounting
standards. The financial statements should also be audited in accordance with International
Standards on Auditing.
Furthermore, the financial statements of a listed company with subsidiaries should usually
be in consolidated form, but the listed company’s own financial statements must also be
published if they contain significant additional information. Financial statements must also
fairly present the financial position, changes in equity, results of operations and cash flows
of the group.
6 Descriptive Accounting – Chapter 1
In addition to complying with IFRSs and the Companies Act, 2008, section 8.63 of the
Listings Requirements requires companies to provide a narrative statement in their financial
statements of their compliance with the principles of the King Report. Section 8.63 also
requires other extensive information to be disclosed on specific aspects in both the annual
report and the annual financial statements.
1.4.4 The Financial Reporting Investigation Panel
The Financial Reporting Investigation Panel (FRIP), previously known as the GAAP
Monitoring Panel (GMP), is an advisory panel first formed in 2002 as a joint initiative
between SAICA and the JSE Limited. The role of the Financial Reporting Investigation
Panel (the Panel) is to investigate and advise the JSE Limited about alleged cases of noncompliance with financial reporting standards in annual and interim reports and any other
company publication.
It is important to note that the Panel’s authority is limited to companies listed on the JSE
Limited, and other companies in the same group.
In order to further improve market securities regulation, the JSE Limited announced, in
February 2010, their decision to proactively monitor the financial statements of all listed
companies, in a bid to pick up any non-compliance with IFRS. This means that all company
results could be proactively reviewed and possibly investigated at any time. Under the
proactive review and monitoring process, the financial statements of every listed company
will be reviewed at least once every five years, in addition to any other queries arising from
public or other complaints. Previously, reviews were conducted on the JSE Limited’s own
initiative or upon the JSE Limited receiving a query or complaint from an investor.
CHAPTER
2
The Conceptual Framework
(Conceptual Framework for Financial
Reporting 2018)
Contents
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
2.10
Background .......................................................................................................
2.1.1 The Conceptual Framework project .......................................................
2.1.2 The purpose of the Conceptual Framework ...........................................
The objective of general purpose financial reporting .........................................
Qualitative characteristics of useful financial information ..................................
2.3.1 Fundamental qualitative characteristics .................................................
2.3.2 Enhancing qualitative characteristics .....................................................
2.3.3 The cost constraint on useful financial reporting ....................................
Financial statements and the reporting entity....................................................
2.4.1 Objective and scope of financial statements ..........................................
2.4.2 Reporting period .....................................................................................
2.4.3 Perspective .............................................................................................
2.4.4 Going concern assumption .....................................................................
2.4.5 The reporting entity .................................................................................
The elements of financial statements ................................................................
2.5.1 Assets .....................................................................................................
2.5.2 Liabilities .................................................................................................
2.5.3 Unit of account ........................................................................................
2.5.4 Equity ......................................................................................................
2.5.5 Income ....................................................................................................
2.5.6 Expenses ................................................................................................
Recognition and derecognition ..........................................................................
2.6.1 Recognition .............................................................................................
2.6.2 Derecognition..........................................................................................
Measurement ....................................................................................................
2.7.1 Measurement bases ...............................................................................
2.7.2 Factors to consider when selecting a measurement basis .....................
2.7.3 Measurement of equity ...........................................................................
Presentation and disclosure ..............................................................................
2.8.1 Classification...........................................................................................
2.8.2 Aggregation ............................................................................................
Concepts of capital and capital maintenance ....................................................
Overview of the Conceptual Framework ...........................................................
7
8
8
9
9
10
10
12
13
13
13
13
14
14
14
14
15
15
16
17
17
17
17
18
19
19
19
21
22
22
22
23
23
25
8 Descriptive Accounting – Chapter 2
2.1 Background
2.1.1 The Conceptual Framework project
During 1989, the then International Accounting Standards Committee (IASC) issued a
statement entitled Framework for the Preparation and Presentation of Financial Statements,
which was formally adopted in 2001 by its successor body, the International Accounting
Standards Board (IASB) as the Framework. This document was based on the American
Financial Accounting Standards Board’s (FASB) conceptual framework.
In 2004, the FASB and the IASB initiated a joint project to develop a common conceptual
framework. The existing frameworks of the IASB and FASB served as the point of departure
for the development of the new conceptual framework. The joint project was to be
conducted in a number of phases and Phase A – Objectives and Qualitative Characteristics
was finalised in 2010, and published as chapters 1 and 3 of The Conceptual Framework for
Financial Reporting 2010.
The Conceptual Framework (2010) contained the following:
ƒ Chapter 1: The objective of general purpose financial reporting.
ƒ Chapter 2: The reporting entity (to be added).
ƒ Chapter 3: Qualitative characteristics of useful financial information.
ƒ Chapter 4: The Framework (1989): The remaining text.
Chapters 1 and 3 replaced the relevant paragraphs in the Framework for the Preparation
and Presentation of Financial Statements of 1989 (Framework). Although the Framework
was partially replaced by certain chapters in the Conceptual Framework (2010), the
International Financial Reporting Standards (IFRS), and specifically the older Standards (the
International Accounting Standards (IAS), are still based on the concepts contained in the
Framework. These Standards will therefore, in many instances, still refer to the concepts
and principles contained in the Framework (1989).
The joint framework project was suspended in 2010 but ‘resumed’ in 2012 as an IASB-only
project. The IASB issued a revised Conceptual Framework in 2018. This Conceptual
Framework (2018) is effective immediately for the IASB and effective for annual periods
beginning on or after 1 January 2020 for preparers who develop accounting policies based
on the Conceptual Framework.
The revised Conceptual Framework introduces new concepts and guidance on
measurement, presentation and disclosure, and derecognition. It has also updated the
definitions of the elements of financial statements and the recognition criteria. Further, it has
clarified the concepts of prudence, stewardship, measurement uncertainty, and substance
over form.
The revised Conceptual Framework (2018), entitled “Conceptual Framework for Financial
Reporting” contains the following chapters:
ƒ Chapter 1: The objective of general purpose financial reporting;
ƒ Chapter 2: Qualitative characteristics of useful financial information;
ƒ Chapter 3: Financial statements and the reporting entity;
ƒ Chapter 4: The elements of financial statements;
ƒ Chapter 5: Recognition and derecognition;
ƒ Chapter 6: Measurement;
ƒ Chapter 7: Presentation and disclosure; and
ƒ Chapter 8: Concepts of capital and capital maintenance.
The Conceptual Framework 9
2.1.2 The purpose of the Conceptual Framework
The Conceptual Framework serves primarily to assist the IASB in developing and revising
Standards that are based on consistent concepts and also discusses the factors the IASB
needs to consider in making judgements when application of the concepts does not lead to
a single answer. In addition, the Conceptual Framework also assists preparers of financial
reports in developing consistent accounting policies for transactions or other events when
no Standard applies or a Standard allows a choice of accounting policies. Further, it aims to
assist all parties understand and interpret Standards. The Conceptual Framework, therefore,
provides the foundation for Standards that:
ƒ contribute to transparency;
ƒ strengthen accountability; and
ƒ contribute to economic efficiency.
While the Conceptual Framework provides concepts and guidance that underpin the
decisions the IASB makes when developing Standards, the Conceptual Framework is not a
Standard. The Conceptual Framework does not override any Standard or any requirement
in a Standard and any revision of the Conceptual Framework will not automatically lead to
changes in the Standards.
2.2 The objective of general purpose financial reporting
This chapter was issued in 2010. The Conceptual Framework (2010) established the
purpose of financial reporting and not just the objective of financial statements, which
was the objective addressed in the Framework (1989). This chapter was not
fundamentally reconsidered in the Conceptual Framework (2018).
The Conceptual Framework defines the objective of general purpose financial reporting as:
To provide financial information about the reporting entity that is useful to existing
and potential investors, lenders and other creditors in making decisions about
providing resources to the entity.
These decisions include decisions about 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
economic resources. These decisions depend on the returns that the potential investors,
lenders and other creditors expect from their investment. Expectations about returns are
based on an assessment of the amount, timing and uncertainty of future net cash inflows to
the entity as well as an assessment of management’s stewardship of the entity’s economic
resources. Thus, existing and potential investors, lenders and other creditors need
information that will help them to make these assessments. Therefore, information is
needed about the economic resources of the entity and the claims against the entity
(financial position) as well as changes in those resources and claims (resulting from the
entity’s financial performance or other events (such as issuing debt or equity instruments)).
Further, information is needed about how efficiently and effectively the entity’s
management have discharged their responsibilities to use the entity’s economic resources.
Information in financial reports is often based on estimates, judgements and models, rather
than exact calculations. The Conceptual Framework establishes certain concepts that
underlie those estimates, judgements and models.
Information about a reporting entity’s economic resources and claims, and changes in its
economic resources and claims, during a period, provides a better basis for assessing the
entity’s past and future performance, than information solely about cash receipts and
payments during that period. Therefore, accrual accounting is applied in financial reports.
Accrual accounting depicts the effects of transactions and other events and circumstances
10 Descriptive Accounting – Chapter 2
on a reporting entity’s economic resources and claims in the periods in which those occur,
even if the resulting cash receipts and payments occur in a different period.
The primary users of financial reports are identified as existing and potential investors,
lenders and other creditors. The term ‘primary users’ refers to those users who are not in a
position to demand specific information from the entity. They have to rely on the general
purpose financial reports as their main source of information. General purpose financial
reports are not primarily intended for the use of management and regulators. General
purpose financial reports are not intended to provide information about the value of a
reporting entity but to provide information to the users in order for them to be able to
estimate the value of the entity. General purpose financial reports do not and cannot
provide all of the information that users need. The IASB, in developing financial reporting
standards, has as its objective the provision of information that will meet the needs of the
maximum number of users. Users, however, also need to consider information from
other sources, including the conditions of the general economic environment in which the
reporting entity operates, political events, and industry- and company-related matters.
2.3 Qualitative characteristics of useful financial information
The qualitative characteristics in the Framework (1989) were relevance, reliability,
understandability and comparability. The chapter as it is now, was issued in 2010. This
chapter was not fundamentally reconsidered in the Conceptual Framework (2018).
To achieve the objective of financial reporting, the information contained in the financial
reports must have certain qualitative characteristics. The qualitative characteristics are
the attributes that increase the usefulness of the information provided in the financial
reports.
The Conceptual Framework distinguishes between fundamental and enhancing qualitative
characteristics. For information to be useful, it needs to be both relevant and faithfully
represented. These qualitative characteristics are fundamental to ensuring useful
information is provided during financial reporting.
The usefulness of financial information is further enhanced when it is comparable,
verifiable, timely and understandable.
Timely information
Financial reporting
Relevant information
Faithful representation
Understandable information
Comparable information
Verifiable information
2.3.1 Fundamental qualitative characteristics
2.3.1.1 Relevance
Relevant information is information that is useful and has the ability to make a difference to
the decisions made by users. Such information can enable users to make more accurate
forecasts regarding specific future events, or can supply feedback on previous expectations.
The Conceptual Framework 11
Relevant information, therefore, has one or both of the characteristics of predictive value or
confirmatory value. Financial information has predictive value if it can be used as an input
to processes employed by users to predict future outcomes. Financial information has
confirmatory value if it provides confirmation about previous evaluations.
Materiality plays an important role when evaluating the relevance of information.
Information is considered to be material if its omission or misstatement could influence the
decisions made by users based on this information. Materiality is an entity-specific aspect,
based on the nature or magnitude of the items.
Financial reports provide information about the reporting entity’s economic resources, claims
against the reporting entity, and the effects of transactions and other events and conditions
that change those resources and claims (economic phenomena) in words and numbers. For
financial reports to be useful, the financial information contained in them must not only be
relevant, it must also be a faithful representation of the substance of the events (and not
merely the legal form) it purports to represent.
2.3.1.2 Faithful representation
The Conceptual Framework indicates that the following three characteristics would ensure
faithful representation:
ƒ completeness;
ƒ neutrality; and
ƒ free from error.
ƒ Completeness
Information included in the financial reports is complete when it includes all the
necessary information that a user would need to be able to understand the economic
phenomena being presented. This should include all necessary descriptions and
explanations.
ƒ Neutrality
Faithfully represented information should be neutral in that it should not present
information in a manner that will achieve a predetermined result. A neutral presentation
is without bias when selecting or presenting financial information. A neutral depiction is
not slanted, weighted, emphasised or de-emphasised or otherwise manipulated to
increase the probability that information will be received favourably or unfavourably.
Neutrality is supported by the exercise of prudence. Prudence is the exercise of caution
when making judgements under conditions of uncertainty. Prudence does not allow for
overstatement or understatement of assets, liabilities, income or expenses.
ƒ Free from error
Faithful representation of information does not imply that the information is absolutely
accurate. It does, however, imply that the description of the event and/or transaction
(economic phenomena) is free from error or omissions and that the process followed to
provide the reported information was selected and applied without errors.
When monetary amounts in financial reports cannot be observed directly and need to be
estimated, measurement uncertainty exists. The use of estimates is an essential part of
the preparation of financial information. The estimates do not undermine the usefulness
if the information if they are clearly and accurately described and explained.
2.3.1.3 Applying the fundamental qualitative characteristics
For information to be useful, it must be both relevant and faithfully represented. Users
cannot make good decisions based on either a faithfully represented but irrelevant event or
transaction, or an unfaithfully represented relevant event or transaction. However, a faithful
representation by itself does not necessarily result in useful information. If something is not
12 Descriptive Accounting – Chapter 2
considered relevant, then the view taken is that the item does not really need to be
disclosed, perhaps regardless of whether it can be faithfully represented. However, if an
event or transaction is considered to be relevant to the users of the financial statements, it
would be important to represent the information faithfully. In some cases a trade-off between
the fundamental qualitative characteristics may need to be made.
The Conceptual Framework suggests the following steps as the most efficient and effective
process when applying the fundamental qualitative characteristics:
Step 1: identify an economic phenomenon that has the potential to be useful to users.
Step 2: identify the type of information about that phenomenon that would be most relevant.
Step 3: determine whether that information is available and can be faithfully represented.
Once this process has been followed, the process ends and the relevant information is
presented faithfully in the financial report. Should any of the steps be impossible to perform,
the process is repeated from the start.
2.3.2 Enhancing qualitative characteristics
The usefulness of information that is already relevant and faithfully represented can further
be enhanced by applying the following enhancing qualitative characteristics to it:
ƒ comparability;
ƒ verifiability;
ƒ timeliness; and
ƒ understandability.
2.3.2.1 Comparability
To meet their decision-making needs, users of financial information should be given
comparable information in order to identify trends over time and between similar companies.
This means that the accounting treatment should be consistent for:
ƒ the same items over time;
ƒ the same items in the same period; and
ƒ similar items of different but similar companies over time and in the same period.
Consistency is not the same as comparability. Consistency helps to achieve the goal of
comparability.
The most visible example of comparability is the comparative amounts included in the
financial statements, as required by IAS 1. The disclosure of accounting policies in financial
statements also assists readers of such statements to compare the financial statements of
different entities. The accounting policy notes indicate the accounting treatment of specific
items; thus it is possible to compare such treatment with the treatment of similar items in
different entities. The financial statements of different but similar entities can therefore be
appropriately analysed in order to evaluate a particular entity’s performance relative to the
performance of its peers.
It is undesirable to permit alternative accounting methods for the same transactions or
events, because comparability and other desirable qualities such as faithful representation
and understandability may be diminished. Nevertheless, comparability should not be
pursued at all costs. Where new accounting standards are introduced, or when the
application of a more appropriate accounting policy becomes necessary, the current
accounting policy should be changed. In such circumstances, there are measures to ensure
the highest possible degree of comparability, but absolute and complete comparability are
sometimes not achieved.
The Conceptual Framework 13
2.3.2.2 Verifiability
Verifiability is a characteristic of financial information that enables users to confirm that the
presented information does in fact faithfully present the events or transactions it purports to
present.
When different knowledgeable and independent observers can reach consensus on whether
a specific event or transaction is faithfully presented, the information would be deemed
verifiable.
2.3.2.3 Timeliness
Information can influence the decision of users when it is reported timeously (in a timely
manner). Usually, older information is less useful, but some information could still be useful
over a longer period of time when it is used for purposes of identifying and assessing certain
trends.
2.3.2.4 Understandability
To achieve the stated objective of financial reporting, the financial statements should be
understandable to the average user who has a reasonable knowledge of business and a
willingness to review and analyse the information with the necessary diligence. In order to
achieve understandability, information should clearly and concisely be classified,
characterised and presented.
2.3.2.4 Applying the enhancing qualitative characteristics
According to the Conceptual Framework, the application of the enhancing qualitative
characteristics should be maximised to the extent possible. It is, however, very important to
note that the enhancing characteristics cannot make information useful if it is not already
relevant and faithfully represented.
2.3.3 The cost constraint on useful financial reporting
A pervasive constraint on the presentation of financial information is the cost involved in
supplying the information. Reporting financial information imposes costs, and it is important
that those costs are justified by the benefits of reporting that information.
2.4 Financial statements and the reporting entity
This chapter is new and was not included in the Framework (1989) or the Conceptual
Framework (2010).
2.4.1 Objective and scope of financial statements
Financial statements are a particular form of general purpose financial reports. Financial
statements provide information about economic resources of the reporting entity, claims
against the entity, and changes in those resources and claims, that meet the definitions of
the elements of financial statements.
The objective of financial statements is to provide financial information about the entity’s
assets, liabilities and equity (in the statement of financial position) and income and
expenses (in the statement(s) of financial performance) that is useful to users of financial
statements on assessing the prospects for future net cash inflows to the reporting entity and
in assessing management’s stewardship of the entity’s economic resources. Information can
also be provided in other statements or notes.
2.4.2 Reporting period
Financial statements are prepared for a specific period of time (this is the reporting period)
and provide information about:
ƒ assets and liabilities and equity that existed at the end of the reporting period, or during
the reporting period; and
ƒ income and expenses for the period.
14 Descriptive Accounting – Chapter 2
Forward looking information is provided if it relates to these items and is useful to the users
of financial statements. Information about transactions and other events that have occurred
after the end of the reporting period is provided if it is necessary to meet the objective of
financial statements.
Comparative information is provided for at least one preceding reporting period.
2.4.3 Perspective
Financial statements provide information about transactions and other events viewed from
the perspective of the reporting entity as a whole, not from the perspective of any particular
group of the entity’s existing or potential investors, lenders or other creditors. This is
important for matters such as non-controlling interests in a group.
2.4.4 Going concern assumption
Financial statements are prepared on the assumption that the reporting entity is a going
concern and will continue in operation for the foreseeable future and has neither the
intention or the need to enter liquidation or cease trading. If this assumption is not valid, the
financial statements may have to be prepared on a different basis.
2.4.5 The reporting entity
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 (such as a branch or activities
within a defined region) or more than one entity. A reporting entity is not necessarily a legal
entity.
Where one entity has control over another entity, a parent-subsidiary relationship exists. If
the reporting entity is the parent alone, the financial statements are referred to as
‘unconsolidated’ (other Standards use the term separate financial statements). If the
reporting entity comprises both the parent and the subsidiary, the financial statements are
referred to as ‘consolidated’. If the reporting entity comprises two or more entities that are
not all linked by a parent-subsidiary relationship, the financial statements are referred to as
‘combined’.
Determining the boundary of a reporting entity can be difficult if the reporting entity is not a
legal entity and does not comprise only of legal entities linked by a parent-subsidiary
relationship. The boundary is driven by the information needs of the users of the reporting
entity’s financial statements. To achieve this:
ƒ the boundary of a reporting entity does not include arbitrary or incomplete information;
ƒ the set of economic activities within the boundary of a reporting entity includes neutral
information; and
ƒ an explanation is provided as to how the boundary was determined and what constitutes
the reporting entity.
2.5 The elements of financial statements
The definitions of an asset and a liability have been refined in the Conceptual
Framework (2018) and the definitions of income and expenses have been updated to
reflect this refinement.
The elements of financial statements in the Conceptual Framework are:
ƒ assets, liabilities and equity, which relate to a reporting entity’s financial position; and
ƒ income and expenses, which relate to a reporting entity’s financial performance.
The elements are linked to economic resources, claims and changes in economic resources
and claims.
The Conceptual Framework 15
2.5.1 Assets
Previous definition (1989 and 2010)
New definition (2018)
A resource controlled by the entity as a
result of past events and from which
future economic benefits are expected to
flow to the entity
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
Main changes in the definition of an asset:
ƒ separate definition of an economic resource – to clarify that an asset is the economic
resource, not the ultimate inflow of economic benefits.
ƒ deletion of ‘expected flow’ – it does not need to be certain, or even likely, that economic
benefits will arise. A low probability of economic benefits might affect recognition
decisions and the measurement of the asset.
2.5.1.1 Rights
An economic resource is not seen as an object as a whole, but as a set of rights. These
rights could include rights that correspond to an obligation of another party (such as rights to
receive cash), and rights that do not correspond to an obligation of another party (such as
rights over a physical object). Rights are established by contract, legislation, or other means.
In principle, each right could be a separate asset. However, to present the underlying
economics, related rights will be viewed collectively as a single asset that forms a single unit
of account. Legal ownership of a physical object may, for example, give rise to several
rights, such as the right to use, the right to sell, the right to pledge the object as security, and
other undefined rights. Describing the set of rights as the physical object will often provide a
faithful representation of those rights.
2.5.1.2 Potential to produce economic benefits
It is necessary for the right to already exist and that, in at least one circumstance, it would
produce for the entity economic benefits beyond those available to all other parties. An
economic resource derives its value from its present potential to produce future economic
benefits. The economic resource is the present right that contains that potential. The
economic resource is not the future economic benefit that the right may produce.
2.5.1.3 Control
Control links a right (in other words the economic resource) to an entity. Control
encompasses both a power and a benefits element: an entity must have the present ability
to direct how a resource is used, and be able to obtain the economic benefits that may flow
from that resource.
2.5.2 Liabilities
Previous definition (1989 and 2010)
New definition (2018)
A present obligation of the entity arising
from past events, the settlement of which
is expected to result in an outflow from the
entity of resources embodying economic
benefits
A present obligation of the entity to
transfer an economic resource as a result
of past events
An obligation is a duty or responsibility
that the entity has no practical ability to
avoid
Main changes in the definition of a liability:
ƒ economic resource – to clarify that a liability is the obligation to transfer the economic
resource, not the ultimate outflow of economic benefits.
16 Descriptive Accounting – Chapter 2
ƒ deletion of ‘expected flow’ – it does not need to be certain, or even likely, that economic
benefits will be required to transfer the economic resource. A low probability might affect
recognition decisions and the measurement of the liability.
ƒ Introduction of the ‘no practical ability to avoid’ criterion to the definition of obligation.
2.5.2.1 Obligation
Many obligations are established by contract, legislation or similar means and are legally
enforceable by the party to whom they are owned. Obligations can also arise from an
entity’s customary practices, published policies or specific statements, if the entity has no
practical ability to act in a manner inconsistent with those practices, policies or statements
(constructive obligation). If the duty or responsibility is conditional on a particular future
action that the entity itself may take, the entity has an obligation if it has no practical ability to
avoid taking that action.
The factors used to assess whether an entity has the practical ability to avoid transferring an
economic resource may depend on the nature of the entity’s duty or responsibility.
2.5.2.2 Transfer of an economic resource
It is necessary that the obligation already exists and that, in at least one circumstance, it
would require the entity to transfer an economic resource.
2.5.2.3 Present obligation as a result of past events
A present obligation exists as a result of past events only if:
ƒ the entity has already obtained economic benefits (for example goods or services), or
taken an action (for example constructing an oil rig in the ocean); and
ƒ as a consequence, the entity will or may have to transfer an economic resource that it
would not otherwise have had to transfer (for example the oil rig needs to be removed
and the ocean bed restored in the future).
2.5.3 Unit of account
Unit of account affects decisions about recognition, derecognition, measurement as well as
presentation and disclosure.
The unit of account is the right or group of rights, the obligation or group of obligations, or
the group of rights and obligations, to which the recognition criteria and measurement
concepts are applied.
A unit of account is selected to provide useful information, which means that the information
about the asset or liability and about any related income and expenses must be relevant and
must faithfully represent the substance of the transaction or other event from which they
have arisen. Treating a set of rights and obligations that arise from the same source and
that are interdependent and cannot be separated as a single unit of account, is not the same
as offsetting.
In terms of the cost constraint, it is important to consider whether the benefits of the
information provided to users of financial statements by selecting that unit of account are
likely to justify the costs of providing and using that information.
2.5.3.1 Executory contracts
An executory contract is a contract that is equally unperformed. It establishes a combined
right and obligation to exchange economic resources.
2.5.3.2 Substance of contractual rights and contractual obligations
In some cases, the substance of the rights and obligations is clear from the legal form of the
contract. In other cases, the terms of the contract or a group or series of contracts require
analysis to identify the substance of the rights and obligations. Explicit and implicit terms in a
contract, that have substance (have an effect on the economics of the contract), are
considered.
The Conceptual Framework 17
A group or series of contracts may be designed to achieve an overall commercial effect. To
report the substance of such contracts, it may be necessary to treat rights and obligations
arising from that group or series of contracts as a single unit of account.
A single contract may, however, create two or more sets of rights or obligations that may
need to be accounted for as if they arose from separate contracts, in order to faithfully
represent the rights and obligations.
2.5.4 Equity
The definition of equity – the residual interest in the assets of the entity after deduction all its
liabilities – is unchanged (E = A – L). The IASB has, however, already expressed their
intention to update this definition.
Equity claims are claims against the entity that do not meet the definition of a liability.
Different classes of equity claims, such as ordinary shares and preference shares, may
confer on their holders different rights.
2.5.5 Income
Income is increases in assets, or decreases in liabilities, that result in increases in equity,
other than those relating to contributions from holders of equity claims.
2.5.6 Expenses
Expenses are decreases in assets, or increases in liabilities, that result in decreases in
equity, other than those relating to distributions to holders of equity claims.
2.6 Recognition and derecognition
The previous recognition criteria required that an entity should recognise an item that
meets the definition of an element, if it was probably that economic benefits would flow,
and if the item had a cost or value that could be measured reliably. The revised
recognition criteria refer to the qualitative characteristics of useful information.
Derecognition has not been previously covered by the Framework or Conceptual
Framework.
Recognition is the process of capturing for inclusion in the statement of financial position or
the statement(s) of financial performance an item that meets the definition of an asset,
liability, equity, income or expense.
In addition to meeting the definition of an element, items are only recognised when their
recognition provides users of financial statements with information about the items that is
both relevant and can be faithfully represented.
Recognition involves depicting the item in the financial statements – either alone or in
aggregation with other items – in words and by a monetary amount, and including that
amount in one or more totals in the financial statements.
This chapter of the Conceptual Framework provides a high-level overview of how different
types of uncertainty (e.g. existence, outcome and measurement) could affect the recognition
decisions.
Derecognition is the removal of all or part of a recognised asset or liability from an entity’s
statement of financial position.
Derecognition aims to faithfully represent both:
ƒ any assets and liabilities retained after the transaction or other event that led to the
derecognition (this represents a control approach); and
ƒ the change in the entity’s assets and liabilities as a result of the transaction or other
event (this represents a risks-and-rewards approach).
18 Descriptive Accounting – Chapter 2
2.6.1 Recognition
Recognition links the elements of financial statements (Diagram 5.1 in the Conceptual
Framework (2018)):
Statement of financial position at beginning of reporting period
Assets minus liabilities equal equity
+
Statement(s) of financial performance
Income minus expenses
+
Contributions from holders of equity claims minus distributions to
holders of equity claims
Changes
in equity
=
Statement of financial position at end of reporting period
Assets minus liabilities equal equity
2.6.1.1 Relevance
Recognition of a particular asset or liability and any resulting income, expenses or changes
in equity, may not always provide relevant information, for example if:
ƒ it is uncertain whether an asset or liability exists (existence uncertainty); or
ƒ an asset or liability exists, but the probability of an inflow or outflow of economic benefits
is low.
2.6.1.2 Faithful representation
Whether a faithful representation can be provided may be affected by the level of
measurement uncertainty (uncertainty that arises when monetary amounts in financial
reports cannot be observed directly and must instead be estimated).
The use of reasonable estimates is an essential part of the preparation of financial
information and does not undermine the usefulness of the information if the estimates are
clearly and accurately described and explained. However, in some cases, the level of
uncertainty involved in estimating a measure of an asset of liability may be so high that it
may be questionable whether the estimate would provide a sufficiently faithful
representation of that asset and of any resulting income, expenses or changes in equity.
This could be the case, for example, if the range of possible outcomes is exceptionally wide
and the probability of each outcome is exceptionally difficult to estimate (outcome
uncertainty is uncertainty about the amount or timing of any inflow or outflow of economic
benefits that will result from an asset or liability).
2.6.1.3 Other factors
ƒ It is important to consider whether related assets and liabilities are recognised. If they
are not recognised, recognition may create a recognition inconsistency (accounting
mismatch).
ƒ Whether or not the asset or liability is recognised, explanatory information about the
uncertainties associated with it may need to be provided in the financial statements.
ƒ The simultaneous recognition of income and related expenses is sometimes referred to
as the matching of costs with income. However, matching is not an objective in the
Conceptual Framework.
ƒ In terms of the cost constraint, it is important to consider whether 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.
The Conceptual Framework 19
2.6.2 Derecognition
For an asset, derecognition normally occurs when the entity has lost control of all or part of
the recognised asset. For a liability, derecognition normally occurs when the entity no longer
has a present obligation for all or part of the recognised liability.
In some cases, an entity might appear to transfer an asset or liability, but that asset or
liability might nevertheless remain an asset or liability of the entity, and therefore
derecognition of that asset or liability may not be appropriate. Appropriate presentation and
disclosure may be required in such cases.
2.7 Measurement
The Framework 1989 and the Conceptual Framework (2010) included little guidance on
measurement. The revised Conceptual Framework (2018) describes what information
measurement bases provide and explains the factors to consider when selecting a
measurement basis.
Measurement is quantifying, in monetary terms, elements that are recognised in financial
statements. To measure is the result of applying a measurement basis to an asset or liability
and related income and expenses.
A measurement basis is an identified feature – for example, historical cost or current value –
of an item being measured. The Conceptual Framework does not favour one basis over the
other, but notes that under some circumstances one may provide more useful information
than the other.
When selecting a measurement basis, it is important to consider the nature of the
information that the measurement basis will produce in both the statement of financial
position and the statement(s) of financial performance and the confirmatory or predictive
value of that information. The information provided by the measurement basis must be
useful to users of financial statements. The information must be relevant, must faithfully
represent what it purports to represent and be, as far as possible, comparable, verifiable,
timely and understandable.
The choice of measurement basis for an asset or liability and the related income and
expenses, is determined by considering both initial and subsequent measurement.
2.7.1 Measurement bases
2.7.1.1 Historical cost
Historical cost measures are entry values and provide monetary information about assets,
liabilities and related income and expenses, using information derived, at least in part, from
the price of the transaction or other event that gave rise to them. Transaction costs are
taken into account if they are incurred in the transaction or other event giving rise to the
asset or liability:
Dr Asset / liability
Cr
Bank
The historical cost of an asset is updated over time to depict, if applicable:
ƒ The consumption of part or all of the economic resources that constitutes the asset
(depreciation);
ƒ Payments received that extinguish part or all of the asset;
ƒ The effect of events that cause part or all of the historical cost of the asset to be no
longer recoverable (impairment); and
ƒ Accrual of interest to reflect any financing component of the asset.
20 Descriptive Accounting – Chapter 2
The historical cost of a liability is updated over time to depict, if applicable:
ƒ Fulfilment of part or all of the liability;
ƒ The effect of events that increase the value of the obligation to transfer the economic
resources needed to fulfil the liability to such an extent that the liability becomes onerous
(it is onerous if the historical cost is no longer sufficient to depict the obligation to fulfil the
liability); and
ƒ Accrual of interest to reflect any financing component of the liability.
For financial assets and financial liabilities, a way to apply the historical cost basis, is to
measure the items at amortised cost. The amortised cost of a financial asset or financial
liability is updated over time to depict subsequent changes.
2.7.1.2 Current value
Current value measures provide monetary information about assets, liabilities and related
income and expenses, using information updated to reflect conditions at the measurement
date.
Current value measurement bases include:
Fair value
The price that would be received to sell an asset, or paid to
transfer a liability, in an orderly transaction between market
participants at the measurement date. An exit value.
Reflects market participants’ current expectations about
the amount, timing and uncertainty of future cash flows. In
some cases it can be determined directly by observing
prices in an active market. In other cases it is determined
indirectly by using measurement techniques. Transaction
costs are excluded.
Value in use (assets)
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. An exit value.
Determined by using cash-flow-based measurement
techniques. Transaction costs incurred on acquiring the
asset are excluded. Takes into account transaction costs
expected on ultimate disposal.
Fulfilment value
(liabilities)
Present value of the cash flows, or other economic
resources, that an entity expects to be obliged to transfer
as it fulfils a liability. An exit value. Reflects entity-specific
current expectations about the amount, timing and
uncertainty of future cash flows. Determined by using
cash-flow-based measurement techniques. Transaction
costs incurred on taking on the liability are excluded.
Takes into account transaction costs expected on fulfilling
the liability.
Current cost (assets)
Cost of an equivalent asset at the measurement date,
comprising the consideration that would be paid plus the
transaction costs that would be incurred at that date. An
entry value. Reflects conditions at the measurement date.
In some cases, cannot be determined directly and must be
determined indirectly.
Current cost (liabilities)
Consideration that would be received for an equivalent
liability minus the transaction costs that would be incurred
at that date. An entry value. Reflects conditions at the
measurement date. In some cases, cannot be determined
directly and must be determined indirectly.
The Conceptual Framework 21
Cash-flow-based measurement techniques:
When measuring an asset or liability by reference to estimates of uncertain future cash
flows, a factor to consider is possible variations in the estimated amount or timing of those
cash flows. Those variations are considered in selecting a single amount from within the
range of possible cash flows.
2.7.2 Factors to consider when selecting a measurement basis
2.7.2.1 Relevance
The relevance of information provided by a measurement basis for an asset or liability and
for the related income and expenses is affected by:
ƒ the characteristics of the asset or liability (for example, the variability of cash flows and
whether the value of the asset or liability is sensitive to market factors or other risks); and
ƒ how the asset or liability contributes to future cash flows (for example, whether cash
flows are produced directly or indirectly in combination with other economic resources,
and the nature of the business activities conducted by the entity).
2.7.2.2 Faithful representation
Whether a measurement basis can provide a faithful representation is affected by:
ƒ measurement inconsistency (accounting mismatch) (using different measurement bases
for assets and liabilities that are related); and
ƒ measurement uncertainty (when a measure cannot be determined directly by observing
prices in an active market and must instead be estimated).
2.7.2.3 Enhancing qualitative characteristics and the cost constraint
In terms of the cost constraint, it is important to consider whether the benefits of the
information provided to users of financial statements by that measurement basis are likely to
justify the costs of providing and using that information.
Consistently using the same measurement bases for the same items, either from period to
period within a reporting entity, or in a single period across entities, can help make financial
statements more comparable.
A change in measurement basis can make financial statements less understandable.
Therefore, if a change is made, users of financial statements may need explanatory
information to enable them to understand the effect of that change.
Verifiability is enhanced by using measurement bases that result in measures that can be
independently corroborated either directly (for example by observing prices) or indirectly (for
example by checking inputs into a model).
Timeliness has no specific implications for measurement.
2.7.2.4 More than one measurement basis
In most cases, the most understandable way is to:
ƒ use a single measurement basis for both the asset or liability in the statement of financial
position and for related income and expenses in the statement(s) of financial
performance; and
ƒ provide in the notes additional information applying a different measurement basis (if
more than one measurement basis is needed in order to provide relevant information
that faithfully represents both the entity’s financial position and its financial performance).
However, in some cases, different measurement bases are used in the statement of
financial position and statement of profit or loss.
22 Descriptive Accounting – Chapter 2
2.7.3 Measurement of equity
The total carrying amount of equity is not measured directly. It equals the total of the
carrying amounts of all recognised assets less the total of the carrying amounts of all
recognised liabilities.
The total carrying amount of an individual class of equity or component of equity is normally
positive, but can be negative in some circumstances.
2.8 Presentation and disclosure
This chapter is new and was not included in the Framework (1989) or the Conceptual
Framework (2010). This chapter includes concepts that describe how information should
be presented and disclosed in financial statements, and guidance on including income
and expenses in the statement of profit or loss and other comprehensive income.
Information about assets, liabilities, equity, income and expenses is communicated through
presentation and disclosure in the financial statements of a reporting entity. Effective
communication of information in financial statements makes that information more relevant
and contributes to a faithful representation. Including presentation and disclosure objectives
in Standards can support effective communication because it helps entities identify useful
information and to decide how to communicate that information in the most effective
manner.
In terms of the cost constraint, it is important to consider whether the benefits provided to
users of financial statements by presenting or disclosing particular information are likely to
justify the costs of providing and using that information.
2.8.1 Classification
Classification is the sorting of assets, liabilities, equity, income or expenses on the basis of
shared characteristics for presentation and disclosure purposes. Classifying dissimilar items
together (for example offsetting assets and liabilities) can obscure relevant information,
reduce understandability and comparability, and may not provide a faithful representation of
what it purports to represent.
2.8.1.1 Classification of assets and liabilities
Classification is applied to the unit of account. Sometimes it may be appropriate to separate
an asset or liability into components, and to classify those components separately (for
example current and non-current components).
Offsetting occurs where an entity recognises and measures both an asset and liability as
separate units of account, but groups them into a single net amount in the statement of
financial position.
2.8.1.2 Classification of equity
It may be necessary to classify equity claims separately if those claims have different
characteristics. It may also be necessary to classify components of equity separately if those
components are subject to particular legal, regulatory or other requirements.
2.8.1.3 Classification of income and expenses
Classification is applied to income and expenses resulting from the unit of account selected
for an asset or liability; or components of such income and expenses, if those components
have different characteristics that are identified separately.
Income and expenses are classified and included either:
ƒ in the statement of profit or loss; or
ƒ in other comprehensive income.
The Conceptual Framework 23
The statement of profit or loss is the primary source of information about an entity’s financial
performance for the reporting period. In principle, all income and expense items are included
in that statement. The IASB may, however, decide in exceptional circumstances that income
or expenses arising from a change in the current value of an asset or a liability are to be
included in other comprehensive income (in the statement of other comprehensive
income), when doing so would result in the statement of profit or loss providing more
relevant information or providing a more faithful representation of the entity’s performance
for that period. This discretion applies only to the IASB. Preparers of financial statements
will not be able to choose to exclude items from profit or loss when using the Conceptual
Framework to develop accounting policies.
In principle, income and expenses included in other comprehensive income in one period
are reclassified from other comprehensive income into the statement of profit or loss in a
future period, when doing so results in the statement of profit or loss providing more relevant
information or providing a more faithful representation of the entity’s performance for that
future period. Only in exceptional circumstances may the IASB decide that income and
expenses will not be reclassified to profit or loss.
2.8.2 Aggregation
Aggregation is the adding together of assets, liabilities, equity, income or expenses that
have shared characteristics and are included in the same classification. Different levels of
aggregation may be needed in different parts of financial statements, for example the
statement of financial position provides summarised information and more detailed
information is provided in the notes.
2.9 Concepts of capital and capital maintenance
This chapter has remained unchanged from the Framework (1989) to the Conceptual
Framework (2010) and the Conceptual Framework (2018).
The concept of capital maintenance relates to the capital that an entity strives to maintain
and also serves as a point of departure for the measurement of profit.
Two different concepts of capital are identified in the Conceptual Framework – a financial
concept of capital, and a physical concept of capital.
ƒ According to the financial concept of capital, capital is equal to the net assets or equity
of an entity.
ƒ In terms of the physical concept of capital, capital is equal to: the production capacity/
physical productive capacity/operating capability/resources or funds needed to achieve
that capability, of an entity – for example, the number of units produced per day.
The selection of the appropriate concept of capital by an entity should be based on the
needs of the users of its financial statements. In South Africa, most entities adopt a financial
concept of capital, but if the main consideration of users is to maintain operating capacity,
the physical concept of capital is selected.
Capital maintenance is linked to the concepts of capital:
ƒ In terms of the financial concept of capital, capital is maintained if net assets at the
beginning of a period are equal to net assets at the end of that period after excluding any
distributions to or contributions by owners of the entity during the period. In other words,
the financial concept of capital states that profit is only earned if the financial (or money)
amount of the net assets at the end of a period exceed the financial (or money) amount
of the net assets at the beginning of that period. Measurement is done in nominal
monetary units (without taking inflation into account) or in units of constant purchasing
power.
24 Descriptive Accounting – Chapter 2
Should capital be measured using nominal monetary units, profit represents an
increase in the nominal monetary capital over a period. Increases in the values of assets
held during a period are known as holding gains, but nevertheless remain profits from a
conceptual point of view.
Should capital be measured in units of constant purchasing power, profit is
represented by an increase in invested purchasing power over a period. Consequently,
only the portion of the increase in the prices of assets that exceeds the general level of
price increases would represent profits. The rest are considered to be capital
maintenance adjustments and form part of equity, not profits.
ƒ In terms of the physical concept of capital, capital is maintained if the physical
production capacity of an entity at the beginning of a period is equal to the physical
production capacity at the end of the period after excluding any distributions to or
contributions by owners of the entity during the period. Consequently, profit under the
physical concept of capital is only earned if the physical production capacity at the end of
a period exceeds the physical production capacity at the beginning of the period.
Measurement takes place on a current cost basis.
All price changes in the assets and liabilities of the entity are considered to be changes
in the measurement of the physical production capacity of the entity. These changes are
consequently accounted for as capital maintenance adjustments against equity, and are
not recognised as profits.
Example 2.1
2.1
Capital maintenance
A company has net assets of R3 000 at the beginning of the year and R4 500 at the end of the
year. Assume that net assets of R3 750 are required to maintain the company’s physical capacity
and that the general price level increased by 10% during the year.
The income under the various capital maintenance options will be as follows:
Financial capital maintenance:
Money maintenance: R4 500 – R3 000 = R1 500
General purchasing power maintenance: R4 500 – (R3 000 + (R3 000 × 10%)) = R1 200
Physical capital maintenance:
Productive capacity maintenance: R4 500 – R3 750 = R750
The Conceptual Framework 25
2.10 Overview of the Conceptual Framework
The objective of general purpose
financial reporting is to provide
useful financial information
Qualitative characteristics of
useful financial information
ƒ fundamental
ƒ enhancing
Reporting entity is
required to or
chooses to prepare
financial statements
Financial statements are a
particular form of general
purpose financial report
Concepts of capital
and capital
maintenance adopted
in preparing financial
statements
The elements of financial
statements
ƒ Assets
ƒ Liabilities
ƒ Equity
ƒ Income
ƒ Expenses
Recognition
Derecognition
Measurement
Presentation
Disclosure
CHAPTER
3
Presentation of financial statements
(IAS 1 and IFRIC 17)
Contents
3.1
3.2
3.3
3.4
3.5
3.6
Overview of IAS 1 Presentation of Financial Statements ..................................
Background .......................................................................................................
Objective and components of financial statements ...........................................
General features ................................................................................................
3.4.1 Fair presentation and compliance with IFRSs ........................................
3.4.2 Going concern ........................................................................................
3.4.3 Accrual basis ..........................................................................................
3.4.4 Materiality and aggregation ....................................................................
3.4.5 Offsetting ................................................................................................
3.4.6 Frequency of reporting ...........................................................................
3.4.7 Comparative information ........................................................................
3.4.8 Consistency of presentation ...................................................................
Structure and content ........................................................................................
3.5.1 Identification of financial statements .......................................................
3.5.2 Statement of financial position ................................................................
3.5.3 Statement of profit or loss and other comprehensive income ................
3.5.4 Statement of changes in equity ..............................................................
3.5.5 Statement of cash flows .........................................................................
3.5.6 Notes ......................................................................................................
Statutory reporting requirements .......................................................................
27
28
29
30
31
31
33
33
33
34
34
34
36
36
36
38
44
49
51
51
55
28 Descriptive Accounting – Chapter 3
3.1 Overview of IAS 1 Presentation of Financial Statements
PRESENTATION OF FINANCIAL STATEMENTS
Purpose of
IAS 1
Prescribes the basis for preparation of general purpose financial statements.
Sets out minimum requirements for presentation as well as guidelines for
structure and content of financial statements.
Objective of
financial
statements
To provide useful information about the financial position, financial performance
and cash flows of an entity to a wide range of users for making economic
decisions.
Complete set of
financial
statements
Structure and content
Statement of
financial
position (SFP)
ƒ Certain line items should be presented on the face of the SFP (e.g.
property, plant and equipment, inventories, provisions, etc.).
ƒ Certain information should be presented either on the face of the SFP or in
the notes (e.g. sub-classifications of line items and details regarding share
capital).
ƒ Assets and liabilities should be presented as either current or
non-current, unless presentation is based on liquidity.
Statement of
profit or loss
and other
comprehensive
income
(SPLOCI)
ƒ All income and expense items recognised in a period are presented as
either:
– a single statement of profit or loss and other comprehensive income;
OR
– two separate statements (one displaying profit or loss and the other
displaying other comprehensive income together with profit or loss as an
opening amount).
ƒ Expenditure items should be classified either by their function or their
nature.
ƒ Specific line items are required to be presented in the profit or loss section
(e.g. revenue, finance cost, tax expense, share of profit of associates and
joint ventures, etc.).
ƒ The nature and amount of material items to be presented either on the face
of the SPLOCI or separately in the notes.
ƒ Other comprehensive income items to be classified as either:
– items that will not be classified subsequently to profit or loss; OR
– items that will subsequently be reclassified to profit or loss.
ƒ Items of other comprehensive income must be presented as either:
– net of related tax effects; OR
– before related tax effects, with one amount shown for the aggregate
amount of income tax relating to those items.
ƒ Reclassification adjustments relating to components of other
comprehensive income need to be disclosed, either on the face, or in the
notes.
ƒ The notion of extraordinary items has been abandoned.
continued
Presentation of financial statements 29
Statement of
changes in
equity
ƒ Reconciliation of equity at the beginning of the reporting period with equity
at the end of the reporting period.
ƒ Includes:
– total comprehensive income for the period, separated between amounts
attributable to the owners of the parent and non-controlling interests;
– effect of retrospective restatements; and
– transactions with owners in their capacity as owners (e.g. issue of
shares, dividends paid).
ƒ Dividends paid and the related dividends per share should be presented
either on the face, or in the notes.
Statement of
cash flows
ƒ Refer to chapter 5.
Notes
General
features for the
presentation of
financial
statements
ƒ
ƒ
ƒ
ƒ
ƒ
ƒ
ƒ
Basis of preparation of the financial statements.
Specific accounting policies applied.
Present information required by IFRS not already presented elsewhere.
Supporting information for items presented in the financial statements.
Additional information on items not presented in the financial statements.
Sources of estimation uncertainty.
Disclosures regarding capital.
ƒ Fair presentation and compliance with IFRSs.
ƒ Financial statements are prepared on the going concern assumption.
ƒ Items recognised on the accrual basis (i.e. when items satisfy the
definitions and recognition criteria of the Conceptual Framework for
Financial Reporting).
ƒ Materiality and aggregation (present each material class of similar items
separately).
ƒ Offsetting (not allowed unless required/permitted by an IFRS).
ƒ Frequency of reporting (at least annually).
ƒ Comparative information (in respect of preceding period for all amounts
presented and for the beginning of the earliest period presented where
prior year numbers have been restated).
ƒ Consistency of presentation (retain presentation and classification between
periods).
3.2 Background
The aim of IAS 1 is:
ƒ to set out guidelines for the structure and content of financial statements;
ƒ to set out the overall requirements for the presentation of financial statements; and
ƒ to establish certain underlying assumptions.
This Standard provides guidance on the overall presentation by setting out the basic
requirements for general purpose financial statements. Other IFRSs set out specific
disclosure requirements which should be added to the basic general purpose financial
statements as required by IAS 1 Presentation of Financial Statements.
Although the scope of IAS 1 applies to all general purpose financial statements, the
terminology is more suited to profit-oriented entities. It may therefore be necessary to
amend descriptions and line items in the financial statements when IAS 1 is applied to
30 Descriptive Accounting – Chapter 3
non-profit organisations and to entities other than companies, such as sole traders,
partnerships and close corporations.
General purpose financial statements are those statements that are intended to satisfy
the needs of the group of interested parties who are not in a position to demand that
financial statements should be specifically compiled for their purposes. Non-controlling
shareholders and creditors are examples of interested parties who must depend on general
purpose financial statements. In contrast, members of management can ensure that
management information is compiled in such a way that their needs are adequately
addressed. IAS 1 attempts to serve the interests of the former group.
IAS 1 applies to financial statements in documents such as prospectuses, but not to
condensed interim financial statements. Condensed interim financial statements fall under
the scope of IAS 34 Interim Financial Reporting. IAS 1 also applies to both separate and
consolidated financial statements in accordance with IFRS 10, Consolidated Financial
Statements.
3.3 Objective and components of financial statements
The objective of financial statements is:
ƒ to provide information;
ƒ about the financial position, financial performance and cash flows of an entity;
ƒ that is useful to a wide range of users;
ƒ in making economic decisions.
A complete set of financial statements comprises (IAS 1.10):
ƒ a statement of financial position as at the end of the period;
ƒ a statement of profit or loss and other comprehensive income for the period;
ƒ a statement of changes in equity for the period;
ƒ a statement of cash flows for the period;
ƒ notes to the financial statements, including a summary of significant accounting policies;
ƒ comparative information in respect of the preceding period; and
ƒ a statement of financial position as at the beginning of the preceding period when an entity
applies an accounting policy retrospectively or makes a retrospective restatement of
items in its financial statements, or when items in the financial statements were reclassified
(refer to section 3.4.7.1).
An entity may use titles for the components of financial statements other than those used in
IAS 1.
A single statement of profit of loss and other comprehensive income may be presented, with
profit or loss and other comprehensive income presented in two separate sections. In this
single statement, the two sections will be presented together, with the profit or loss section
presented immediately before the other comprehensive income section. The profit or loss
section may, however, be presented in a separate statement of profit or loss.
When a statement of profit or loss is presented separately, it is part of the complete set of
financial statements and should be displayed immediately before the statement presenting
comprehensive income. The statement presenting comprehensive income should begin with
the profit or loss amount.
IAS 1 acknowledges that preparers of financial statements do provide additional information,
such as a value added statement and environmental reports, if required by users. A financial
overview of the entity’s activities can also be provided to include the following information:
ƒ the main factors that influenced the performance of the entity in the current period and
will continue to do so in future periods;
ƒ the entity’s policy regarding the maintenance and enhancement of performance;
Presentation of financial statements 31
ƒ its policy in respect of dividends;
ƒ the sources of funding and the policies on gearing and risk management;
ƒ the strengths and resources of the entity that are not reflected in the statement of
financial position; and
ƒ the changes in the environment within which the entity functions, how it reacts to the changes
and the effect thereof on its performance.
The content and format of these reports falls outside the scope of IAS 1.
3.4 General features
The following general features for the presentation of financial statements are identified in
IAS 1.15 to .46:
ƒ fair presentation and compliance with IFRSs;
ƒ going concern;
ƒ accrual basis of accounting;
ƒ materiality and aggregation;
ƒ offsetting;
ƒ frequency of reporting;
ƒ comparative information; and
ƒ consistency of presentation.
Each of these concepts is discussed below.
3.4.1 Fair presentation and compliance with IFRSs
3.4.1.1 Fair presentation
The concept of fair presentation is not new to accounting literature, yet it is one that is, by its
very nature, one of the most difficult to apply. IAS 1.15 states that financial statements
should present the financial position (referring to the statement of financial position), the
financial performance (referring to the statement of profit or loss and other comprehensive
income) and the cash flows (referring to the statement of cash flows) of an entity fairly.
IAS 1 states that fair presentation is achieved by faithful representation of the effects of
transactions, other events and conditions in accordance with the definitions and recognition
criteria for assets, liabilities, equity, income and expenses as set out in the Conceptual
Framework.
Concepts of the Conceptual Framework are employed in an attempt to describe the rather
difficult term ‘fair presentation’. These concepts are:
ƒ faithful representation;
ƒ definitions of elements (assets, liabilities, equity, income and expenses) of financial
statements; and
ƒ recognition criteria for elements of financial statements.
Faithful representation refers to that characteristic of financial reports that will reassure
users of such reports that they can rely on the information contained therein to faithfully
represent the economic circumstances and events that it purports to represent or would
reasonably be expected to represent. Users of financial statements are assured that all
items that impact on the financial position, financial results and cash flows of an entity are
represented appropriately. At a practical level, this means that, for example, the item
‘inventories’ in the statement of financial position actually represents those units and only
those units that qualify for inclusion as inventory (and would therefore meet the definition of
assets), appropriately recognised and measured in accordance with the relevant
Standards.
32 Descriptive Accounting – Chapter 3
By complying with the Standards and Interpretations of the IASB, and fairly presenting the
effects of transactions and other events in accordance with the definitions and recognition
criteria for assets, liabilities, equity, income and expenses as set out in the Conceptual
Framework, fair presentation in the financial statements is usually accomplished. It should
be stated in financial statements that they comply with IFRSs. However, unless compliance
with all applicable IFRSs, as well as each applicable approved Interpretation has been
achieved, the statement should not be included. IFRSs include all Standards of the IFRS
series and IAS series and all applicable Interpretations, IFRIC, or the SIC series.
3.4.1.2 Non-compliance with IFRSs
IAS 1 recognises that there may be rare circumstances where compliance with a particular
requirement of a Standard or Interpretation may be misleading and in conflict with the
objectives of financial statements as set out in the Conceptual Framework. In such
extremely rare cases, the entity shall depart from the requirement in the Standard if the
relevant regulatory framework requires or does not otherwise prohibit such a departure.
When assessing whether a specific departure is necessary, consideration is given to the
following:
ƒ why the objective of financial statements is not achieved in the particular circumstances;
and
ƒ the way in which the entity’s circumstances differ from those of other entities that follow
the requirement. There is a rebuttable presumption that if other entities in similar
circumstances comply with the requirement, the entity’s compliance with the requirement
would not be so misleading that it would conflict with the objective of financial statements
as set out in the Conceptual Framework. The entity departing from the particular
requirement will therefore have to motivate and justify the departure.
Where departure from a requirement in IFRSs is deemed necessary in order to achieve fair
presentation, and where the regulating authority permits departure from a requirement in a
Standard, the following are disclosed (IAS 1.20):
ƒ the fact that management has concluded that the financial statements fairly present the
entity’s financial position, financial performance and cash flows;
ƒ the fact that the financial statements comply in all material respects with the applicable
Standards and Interpretations, except for the departure in question;
ƒ the Standard or Interpretation from which the entity has departed;
ƒ the nature of the departure, including the treatment that the Standard would require;
ƒ the reason why the treatment would be so misleading in the circumstances that it would
conflict with the objective of financial statements as set out in the Conceptual
Framework;
ƒ the treatment adopted; and
ƒ the financial impact of the departure on each item in the financial statements that would
have been reported in compliance with the requirement, for each period presented.
If an entity departed from a Standard or Interpretation in a previous year and the departure
still affects amounts recognised in the financial statements, the information in the last five
bullet points above must be disclosed.
Should management conclude that compliance with a requirement in a Standard or an
Interpretation would be misleading, but the regulatory authority under which the entity
operates prohibits departure from the requirement, the entity is required to reduce the
perceived misleading aspects to the maximum extent possible by disclosing (IAS 1.23):
ƒ the title of the Standard or Interpretation requiring the entity to report information concluded
to be misleading;
Presentation of financial statements 33
ƒ the nature of the requirement;
ƒ the reason why management has concluded that complying with that requirement is
misleading and in conflict with the objective of financial statements as set out in the
Conceptual Framework; and
ƒ for each period presented, the adjustments to each item in the financial statements that
management has concluded would be necessary to achieve fair presentation.
In assessing fair presentation, the management of a reporting entity should also consider the
definitions of elements, as well as the recognition criteria in the Conceptual Framework, as
discussed in chapter 2.
3.4.2 Going concern
In terms of this concept, it is assumed that the entity will continue to exist in the foreseeable
future. More specifically, it means that the statement of profit or loss and other
comprehensive income, and the statement of financial position are drafted on the
assumption that there is no intention or need to cease or materially curtail operations.
This concept has an effect on the valuation of assets and liabilities. If the entity is no longer
a going concern, IFRS does not prescribe the basis under which the financial statements
should be prepared. Consideration should be given to the use of the liquidation valuation
method, while provision could also be made for liquidation expenses. These facts, with the
basis used and the reason why the entity is no longer a going concern, should be disclosed.
When management assesses whether the going concern assumption is appropriate, it takes
all appropriate information for at least 12 months from the end of the previous reporting
period into account. The existence of material uncertainties about the possibility of a going
concern problem should be disclosed. How an entity applies this disclosure requirement
requires the exercise of professional judgement as IAS 1 does not provide detailed
disclosure requirements.
3.4.3 Accrual basis
Financial statements (except the statement of cash flows) are prepared on an accrual basis.
This implies that transactions are accounted for when they occur and not when the related
cash is received or paid (i.e. when the items satisfy the definitions and recognition criteria for
those items as per the Conceptual Framework). In terms of the accrual concept, only the
value that has been earned during a specified period may be recognised in profit
calculations, irrespective of when the revenue was received.
In addition, only the cost that has been incurred within the same specified period may be
recognised as expenses in the profit calculation, irrespective of when payment took place.
3.4.4 Materiality and aggregation
According to IAS 1.29, each material class of similar items should be presented
separately in the financial statements. Items of a dissimilar nature or function should be
presented separately, unless they are immaterial. For example, a single event that leads to
the write-off of 85% of the inventories is shown separately and not merely aggregated with
other instances of the routine write-off of assets.
A line item may not be sufficiently material to warrant disclosure in the statement of profit or
loss and other comprehensive income, but it can be material enough to warrant inclusion in
the notes to the financial statements. A user of the financial statements usually regards an
item as being material if its non-disclosure may lead to a different decision.
Materiality is established with reference to both the nature and the size of an item. Individual
items belonging to the same category (nature) are aggregated, even though they may all be
of large amount (size). Items belonging to different categories are not aggregated.
34 Descriptive Accounting – Chapter 3
3.4.5 Offsetting
IAS 1.32 to .35 states that:
ƒ assets and liabilities may not be offset against one another, except when such offsetting
is required or permitted by a Standard or Interpretation;
ƒ income and expenditure items should likewise not be offset against one another, except
when a Standard or Interpretation requires or permits it;
ƒ offsetting of profits, losses and related expenditure is allowed when amounts are not
material and relate to similar items; and
ƒ offsetting is also permitted where set-off is required to reflect the substance of the
transaction or event (in such cases, the amounts are aggregated and indicated on a net
basis).
Examples of offsetting are the sale of equipment as well as gains and losses in respect of
foreign currency, in which event only the net amount of the gains or losses is included in the
profit or loss section of the statement of profit or loss and other comprehensive income.
When income and expenditure are offset against one another, the entity should, in the light
of the materiality thereof, nevertheless consider disclosing the amounts that were offset
against one another in the notes to the financial statements.
Assets measured net of valuation allowances, such as obsolescence allowances on
inventories and allowance for credit losses on receivables, are not regarded as offsetting.
Gains and losses on the disposal of other non-current assets, including investments, are
reported by deducting the carrying amount of the asset and related selling expenses from
the proceeds on disposal. Expenditure related to a provision that is recognised in
accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets and
reimbursed under a contractual arrangement with a third party (e.g. a supplier’s warranty
agreement) may be netted against the related reimbursement (refer to chapter 19).
3.4.6 Frequency of reporting
A complete set of financial statements should be published at least annually (IAS 1.36). In
exceptional cases, in which an entity’s reporting date changes, with the result that the
financial statements are presented for a period shorter or longer than one year, the following
additional information should be provided:
ƒ the reason why the reporting period is not one year; and
ƒ the fact that the comparative amounts in the various components of the financial
statements (statement of profit or loss and other comprehensive income, statement of
cash flows, statement of changes in equity and related notes) are not entirely comparable.
3.4.7 Comparative information
All numerical information presented in financial statements should be accompanied by a
comparative amount for the preceding period, unless a Standard or Interpretation permits
otherwise (IAS 1.38). Even narrative and descriptive information should be accompanied
by comparative information if it is necessary for the understanding of the current period’s
financial statements.
It is of vital importance that users of financial statements should be able to discern trends in
financial information. Consequently, comparative information should be structured in such a
way that the usefulness of the financial statements is enhanced.
When presenting comparative information, an entity shall present as a minimum
(IAS 1.38A):
ƒ two statements of financial position;
ƒ two statements of profit or loss and other comprehensive income;
ƒ two separate statements of profit of loss (if presented);
Presentation of financial statements 35
ƒ two statements of cash flows;
ƒ two statements of changes in equity; and
ƒ related notes.
In addition to the above minimum requirements, an entity may present additional
information. This additional information need not consist of a full set of financial statements,
but must be prepared in accordance with IFRSs (IAS 1.38C and .38D).
3.4.7.1 Change in accounting policy, retrospective restatements or reclassification
An entity must present a third statement of financial position as at the beginning of the
preceding period (this is in addition to the minimum comparative financial statements
required, as mentioned above) under the following circumstances:
ƒ the retrospective application of a change in accounting policy;
ƒ the retrospective restatement of items in financial statements; or
ƒ the reclassification of items in financial statements.
This additional statement of financial position is only required if the application, restatement
or reclassification is considered to have a material effect on the information included in the
statement of financial position at the beginning of the preceding period.
The date of this third statement of financial position should be the beginning of the
preceding period, regardless of whether earlier periods are being presented. IAS 8
Accounting Policies, Changes in Accounting Estimates and Errors lists the full disclosure
requirements when an entity changes an accounting policy or corrects an error (refer to
chapter 6).
Example 3.1
3.1
Third statement of financial position
During the audit of the financial statements for the year ended 31 December 20.15, the auditors of
Olympics Ltd detected a material error that was made during the financial year ended
31 December 20.13. Olympics Ltd will have to restate the amounts in its financial statements
retrospectively to correct this error, in accordance with IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors. In accordance with IAS 1, the following periods will have to be
presented in the statement of financial position (SFP) of Olympics Ltd for the year ended
31 December 20.15, provided that full retrospective adjustment is possible in terms of IAS 8:
SFP
31 December 20.15
Current period
31 December 20.14
Preceding period
1 January 20.14
Beginning of preceding period
Where there is a change in the presentation and classification of items in the current period,
comparatives should be amended accordingly wherever possible, for example by
reclassifying the comparative amounts (including as at the beginning of the preceding
period). The following disclosure is called for in such cases:
ƒ the nature of the reclassification;
ƒ the amount of each item or class of items that is reclassified; and
ƒ the reason for the reclassification.
However, where such reclassifications are impracticable, they need not be made, but the
following should be disclosed:
ƒ the reasons why they were not changed; and
ƒ the nature of the changes that would have been effected had the comparatives indeed
been reclassified.
IAS 1.7 has introduced the notion of impracticability. It defines a requirement as
impracticable when an entity cannot apply it after making every reasonable effort to do so.
36 Descriptive Accounting – Chapter 3
An example is where the data may not have been collected in the prior period in a way that
allows for reclassification. Clearly, the preferred treatment is to reclassify comparative
information wherever possible.
3.4.8 Consistency of presentation
In terms of the consistency concept, there should be consistency of the presentation and
classification of like items within each accounting period, and from one period to the next.
Consistency has therefore two aspects: consistency over time and consistency of disclosure
of similar items.
IAS 1.45 states that the presentation and classification of items in the financial statements
should be retained from one period to the next, unless:
ƒ a significant change in the nature of the operations has taken place; or
ƒ upon a review of its financial statement presentation, it was decided that the change in
presentation or classification is necessary for more appropriate disclosure; or
ƒ a Standard or an Interpretation requires a change in presentation.
In such circumstances, comparative amounts should be restated.
Where a Standard requires or permits separate categorisation or measurement of items, a
different, allowed, alternative accounting policy may be applied to each category, and this
policy should then be consistently applied, unless the circumstances described in the
previous paragraph are present. Where separate categorisation of items is not allowed or
permitted by a Standard, the same accounting policy should be applied to all similar
items. For example, in IAS 2 Inventories (refer to chapter 4) separate classifications of
inventories and separate disclosure of the different classifications are allowed. Consequently,
a separate cost allocation method may be employed for each separate classification of
inventory.
3.5 Structure and content
Information may be disclosed on the face of the statement of financial position, statement of
profit or loss and other comprehensive income, statement of changes in equity, or in the
notes. IAS 1, together with other Standards, identifies specifically which disclosures should
be on the face of the financial statements.
3.5.1 Identification of financial statements
Financial statements should be clearly distinguished and identified separately from other
information that forms part of the annual report. The following information should be
indicated prominently, preferably on each page of the financial statements (IAS 1.51):
ƒ the name of the reporting entity or any other form of identification, as well as any change
since the previous reporting date to the name of the reporting entity;
ƒ whether the financial statements cover an individual entity or a group of entities;
ƒ the date of the end of the reporting period or period covered by the report, whichever
is applicable to the particular financial statements;
ƒ the relevant component of the financial statements, for example statement of cash flows
or statement of financial position;
ƒ the currency used in the financial statements; and
ƒ the level of precision of the amounts presented, for example that the amounts have been
rounded off to the nearest thousand or million.
Presentation of financial statements 37
Example 3.2
3.2
Identification of financial statements
The following points out the application of the requirements of IAS 1.51 regarding the identification
of financial statements:
London Ltd Group1
Consolidated statement of financial position4 as at 31 December 20.143
Company2
Group2
20.14
20.13
20.14
20.13
R’0005
R’000
R’0005
R’000
1
2
3
4
5
Name of the reporting entity.
Whether the information is for a single company or a group of entities.
Date of the end of the reporting period.
The component of the financial statements.
The currency used and precision of amounts presented.
The structure of financial statements can be illustrated as follows:
Statement of profit or
loss and other
comprehensive income
Statement of changes in
equity
Profit or loss section (P/L)
• income/expenses
Retained earnings
Choice to
present as
one or two
separate
statements
Other comprehensive
income (OCI) section
• items not reclassified
to P/L and
• items reclassified to
P/L.
Recognise directly in
equity: mark-to-market
reserve, revaluation
surplus, cash-flow hedge
reserve
Statement of
financial position
Assets – Liabilities
= Equity
Transactions with owners
in their capacity as
owners:
dividends,
share capital issues,
transfers between
reserves
38 Descriptive Accounting – Chapter 3
3.5.2 Statement of financial position
According to IAS 1.60, an entity should present current and non-current assets, and
current and non-current liabilities, as separate classifications on the face of its
statement of financial position, except when a presentation based on liquidity provides
information that is reliable and more relevant. When this exception applies, all assets and
liabilities should be presented broadly in order of liquidity. For some entities, such as
financial institutions, a presentation of assets and liabilities in increasing or decreasing order
of liquidity provides information that is reliable and more relevant than a current/non-current
presentation, because the entity does not supply goods or services within a clearly
identifiable operating cycle.
An entity is permitted to present some of its assets and liabilities using a current/non-current
classification, and others in order of liquidity when this provides information that is reliable
and more relevant. The need for a mixed basis of presentation may arise when an entity has
diverse operations (IAS 1.64).
Regardless of which method of presentation is being applied, each asset or liability line item
should be separated between:
ƒ the amount that is expected to be recovered or settled after more than 12 months after
the end of the reporting period (non-current); and
ƒ the amount that is expected to be recovered or settled within 12 months after the end of
the reporting period (current).
Disclosure of the expected realisation of assets and liabilities is also useful, as it allows
users to assess the liquidity and solvency of the entity.
3.5.2.1 Current assets and current liabilities
An asset is classified under current assets if it satisfies the following criteria (IAS 1.66):
ƒ it is expected to be realised in, or is intended for sale or consumption in, the entity’s
normal operating cycle;
ƒ it is held primarily for the purpose of being traded;
ƒ it is expected to be realised within 12 months after the end of the reporting period; or
ƒ it is cash or a cash equivalent, unless it is restricted from being exchanged or used to
settle a liability for at least 12 months after the end of the reporting period.
All other assets, including tangible, intangible and financial assets, are classified as
non-current assets.
The operating cycle of an entity is the average time that elapses from the acquisition of raw
material or inventories until they have been sold and converted into cash.
A liability is classified under current liabilities if it satisfies the following criteria (IAS 1.69):
ƒ it is expected to be settled in the entity’s normal operating cycle;
ƒ it is held primarily for the purpose of being traded;
ƒ it is due to be settled within 12 months after the end of the reporting period; or
ƒ the entity does not have an unconditional right to defer settlement of the liability for
at least 12 months after the end of the reporting period.
All other liabilities are classified as non-current liabilities. Certain liabilities, such as trade
payables, are part of the working capital of the entity and are classified as current liabilities,
even if they are settled more than 12 months after the end of the reporting period. Other
current liabilities include financial liabilities held for trading, bank overdrafts, dividends
payable, income taxes and the current portion of non-current financial liabilities.
Presentation of financial statements 39
Note that the same normal operating cycle applies to the classification of an entity’s assets
and liabilities. When the entity’s normal operating cycle is not clearly identifiable, its duration
is assumed to be 12 months.
An entity classifies its financial liabilities as current when they are due to be settled within
12 months after the end of the reporting period, even if:
ƒ the original repayment term was for a period longer than 12 months; and
ƒ an agreement to refinance, or to reschedule, payments on a long-term basis, is
completed after the end of the reporting period and before the financial statements are
authorised for issue (IAS 1.72).
The determining factor for classification of liabilities as current or non-current is whether
the conditions existed at end of the reporting period. Information that becomes available
after the reporting period is not adjusted, but may qualify for disclosure in the notes, in
accordance with IAS 10 Events after the Reporting Period (refer to chapter 7).
If an entity expects, and has the discretion, to refinance or roll-over an obligation for at
least 12 months after the reporting period under an existing loan facility, it classifies the
obligation as non-current, even if it would otherwise be due within a shorter period.
However, when refinancing or rolling-over the obligation is not at the discretion of the
entity (e.g., there is no agreement to refinance), the potential to refinance is not considered
and the obligation is classified as current (IAS 1.73).
If an entity breaches an undertaking under a long-term loan agreement on or before the
end of the reporting period, with the effect that the liability becomes payable on demand, the
liability is classified as a current liability. This applies even if the lender has agreed, after
the reporting period and before the authorisation of the financial statements for issue, not
to demand payment as a result of the breach. The liability is classified as a current liability
because, at the end of the reporting period, the entity does not have an unconditional right
to defer its settlement for at least 12 months after the reporting date (IAS 1.74).
However, the liability is classified as a non-current liability if the lender agreed by the end of
the reporting period to provide a period of grace, ending at least 12 months after the end of
the reporting period, within which the entity can rectify the breach and during which the
lender cannot demand immediate repayment (IAS 1.75).
40 Descriptive Accounting – Chapter 3
The following diagram gives an indication of the classification of liabilities in circumstances
where a long-term refinancing agreement has been concluded or is being contemplated:
Current liability
Concluded after
end of reporting
period
Concluded before
end of reporting
period
Long-term
refinancing
agreement
Expected
YES
NO
Current
liability
Example 3.3
3.3
Discretion
of entity?
Reclassify as
non-current
liability
Classification of financial liabilities
Sport Ltd has a 30 June year end and its financial statements are authorised for issue on
30 September of each year.
During the year ended 30 June 20.15, Sport Ltd purchased a piece of land from Team Ltd. The
land was registered in the name of Sport Ltd on 1 January 20.15. Sport Ltd financed the purchase
of the land with a loan from ABC Bank on 1 January 20.15. The loan is repayable in full on
31 December 20.15. In terms of the loan agreement, refinancing of the obligation is not at the
discretion of Sport Ltd.
On 31 May 20.15, Sport Ltd applied to the bank for the refinancing of the loan. On
15 August 20.15, ABC Bank agreed to refinance the loan. In terms of the refinancing granted, the
loan is now only repayable in full on 31 December 20.16.
Discussion
According to IAS 1.73, if an entity expects, and has the discretion, to refinance or roll-over an
obligation for at least 12 months after the reporting period under an existing loan facility, it
classifies the obligation as non-current, even if it would otherwise be due within a shorter period.
However, when refinancing or rolling-over the obligation is not at the discretion of the entity, the
potential to refinance is not considered and the obligation is classified as current.
Consequently, Sport Ltd will classify the loan from ABC Bank as current in the statement of
financial position as at 30 June 20.15, even though refinancing for a period longer than 12 months
after the end of the reporting period was granted before the financial statements were authorised
for issue. The determining factor for classification of liabilities as current or non-current is whether
the conditions existed at the end of the reporting period. On 30 June 20.15, Sport Ltd did not
have the discretion to refinance the loan.
Sport Ltd will have to disclose the refinancing of the loan as a non-adjusting event after the end
of the reporting period in terms of IAS 10.4.
Presentation of financial statements 41
If, for loans classified as current liabilities, the following events occur between the end of the
reporting period and the date on which the financial statements are authorised for issue, these
events qualify for disclosure as non-adjusting events in accordance with IAS 10 Events after
the Reporting Period:
ƒ refinancing on a long-term basis;
ƒ rectification of a breach of a long-term loan agreement; and
ƒ the receipt from the lender of a period of grace to rectify a breach of a long-term loan
agreement ending at least 12 months after the end of the reporting period (IAS 1.76).
3.5.2.2 Items presented on the statement of financial position
IAS 1 does not prescribe the format or order of items to be presented on the statement of
financial position. The statement of financial position should however, present at least the
following line items:
ƒ property, plant and equipment;
ƒ investment property;
ƒ intangible assets;
ƒ financial assets (excluding investments accounted for using the equity method, trade and
other receivables, and cash and cash equivalents);
ƒ investments accounted for using the equity method;
ƒ biological assets;
ƒ inventories;
ƒ trade and other receivables;
ƒ cash and cash equivalents;
ƒ total assets classified as held for sale, and assets included in disposal groups in
accordance with IFRS 5, Non-current Assets Held for Sale and Discontinued Operations;
ƒ trade and other payables;
ƒ liabilities and assets for current tax;
ƒ deferred tax liabilities and deferred tax assets;
ƒ provisions;
ƒ financial liabilities (excluding trade and other payables, and provisions);
ƒ liabilities included in disposal groups classified as held for sale in accordance with
IFRS 5;
ƒ issued capital and reserves attributable to owners of the parent; and
ƒ non-controlling interests presented within equity.
Assets held for sale, or assets and liabilities forming part of discontinued operations, are
included as separate line items on the statement of financial position. Additional line items,
headings and subtotals should also be presented on the face of the statement of financial
position when such presentation is relevant to an understanding of the entity’s financial
position.
When an entity presents current and non-current assets and current and non-current
liabilities as separate classifications on the face of its statement of financial position, it
should not classify deferred tax assets (liabilities) as current assets (liabilities) (IAS 1.56).
Line items are included if the size, nature or function of an item or the composition of
similar items is such that separate disclosure is appropriate to understanding the financial
42 Descriptive Accounting – Chapter 3
position of the entity and to supplying information necessary to understand the financial
position. The descriptions and order of the items or aggregation of separate items are
adapted in accordance with the nature of the entity and its transactions.
The following criteria are applied in deciding whether an item should be disclosed separately:
ƒ the nature and liquidity of the assets, leading to a distinction between, for example, longterm assets and liabilities, tangible and intangible assets, monetary and non-monetary
items, and current assets and liabilities;
ƒ the function of the relevant items, leading to a distinction between, for example,
operating assets and financial assets; and
ƒ the amount, nature and settlement date of liabilities, leading to a distinction between, for
example, interest-bearing and non-interest-bearing liabilities and provisions.
3.5.2.3 Items presented on the statement of financial position or in the notes
Sub-classifications of items presented (see above), appropriately classified, are provided in
either the statement of financial position or in the notes. The requirements of IFRSs would
supply the detail that is required under these sub-classifications. The details would also
depend on the function, size and nature of the amounts involved.
For share capital, in particular, the following are disclosed for each class (IAS 1.79):
ƒ the number of authorised shares;
ƒ the number of shares issued and fully paid;
ƒ the number of shares issued but not fully paid;
ƒ the par value per share, or that the shares have no par value;
ƒ a reconciliation of the number of shares outstanding at both the beginning and the end of
the period;
ƒ the rights, preferences and restrictions applicable to each category, including restrictions
on the distribution of dividends and the repayment of capital;
ƒ the shares in the entity held by the entity or its subsidiaries or associates; and
ƒ the shares reserved for issuance under options and sales contracts, including the terms
and amounts thereof.
Furthermore, a description of the nature and purpose of each reserve that forms part of
equity is required. Entities without share capital, for example partnerships and trusts, should
disclose, to the extent applicable, information equivalent to the above. Movements during the
accounting period in each category of equity interest and the rights, preferences and
restrictions attached to each category of equity interest should be duly disclosed.
The timing and reasons for reclassification between financial liabilities and equity should be
disclosed. Reclassifications include puttable financial instruments classified as equity and
instruments providing a pro rata share of net assets on liquidation classified as equity.
Presentation of financial statements 43
Example 3.4
3.4
Presentation of the statement of financial position
The following is the trial balance of the Ngwenya Ltd Group. The group has a 31 December year end.
The information will be used to prepare a consolidated statement of financial position.
Ngwenya Ltd Group
Consolidated trial balance on 31 December 20.15
Advertising costs
Delivering costs
Income tax expense
Profit on expropriation of land
Dividends paid
Dividends received
Rental received
Share of profit of associate/joint venture
Goodwill – impairment loss
Cost of sales
Non-controlling interests in profit for the year
Interest paid
Salaries
Administrative personnel
Sales agents
Stationery
Sales
Depreciation
Delivery vehicles
Office buildings
Bank
Investment in associate/joint venture
Debtors
Property, plant and equipment
Goodwill
Investments in equity instruments
Other intangible assets
Creditors
Current portion of long-term borrowings
Non-controlling interests (cumulative)
Long-term borrowings
Retained earnings (1.1.20.14)
Revaluation surplus (net of tax) (20.13: Rnil) (parent only)
Revaluation surplus (net of tax) (20.13: Rnil) (associate/joint venture)
Cash flow hedge reserve (net of tax) (20.13: Rnil) (parent only)
Issued ordinary share capital
Deferred tax (cumulative)
Preference share capital
Inventories (20.13 – R160 400)
Raw materials (20.13 – R43 000)
Consumables (20.13 – R8 400)
Work-in-progress (20.13 – R57 800)
Finished goods (20.13 – R51 200)
Dr
R
29 600
44 200
687 190
Cr
R
100 000
160 000
14 000
6 000
300 000
12 000
2 093 200
90 200
66 600
356 000
187 600
168 400
22 000
4 022 400
69 800
53 400
16 400
805 010
586 000
90 000
550 000
96 000
113 600
50 000
51 000
40 000
189 450
404 000
600 000
32 750
10 000
28 400
200 000
3 000
110 000
189 600
46 000
10 000
71 200
62 400
6 111 000
6 111 000
continued
44 Descriptive Accounting – Chapter 3
Ngwenya Ltd Group
Consolidated statement of financial position as at 31 December 20.15
Assets
Non-current assets
Property, plant and equipment
Goodwill
Investment in associate/joint venture
Investment in equity instruments
Other intangible assets
R
550 000
96 000
586 000
113 600
50 000
1 395 600
Current assets
Inventories
Trade receivables
Cash and cash equivalents
189 600
90 000
805 010
1 084 610
Total assets
2 480 210
Equity and liabilities
Equity attributable to owners of the parent
Share capital (200 000 + 110 000)
Retained earnings (600 000 (opening balance) + 971 610 (refer to Example 3.5
for the consolidated statement of profit or loss and other comprehensive income)
– 160 000 (dividends paid))
Other components of equity (32 750 + 10 000 + 28 400)
1 411 610
71 150
Non-controlling interests
1 792 760
189 450
Total equity
Non-current liabilities
Long-term borrowings
Deferred tax
310 000
1 982 210
404 000
3 000
407 000
Current liabilities
Trade payables
Current portion of long-term borrowings
51 000
40 000
91 000
Total liabilities
Total equity and liabilities
498 000
2 480 210
3.5.3 Statement of profit or loss and other comprehensive income
All income and expense items recognised in a period should be presented in either a single
statement of profit or loss and other comprehensive income, or in two separate
statements, where one statement displays the items of profit or loss (statement of profit or
loss) and the other displays the items of comprehensive income together with the total profit
or loss as an opening amount.
The statement of profit or loss and other comprehensive income therefore consists of the
following two sections:
ƒ profit or loss for the year; and
ƒ other comprehensive income for the year.
In addition to the above, the statement of profit or loss and other comprehensive income
should also present:
ƒ profit or loss;
Presentation of financial statements 45
ƒ total other comprehensive income; and
ƒ comprehensive income for the period, being the total of profit or loss and other
comprehensive income.
On the face of the statement of profit or loss and other comprehensive income (or on the
statement of profit or loss) profit or loss for the year should be allocated as follows:
ƒ attributable to owners of the parent; and
ƒ attributable to non-controlling interests.
On the face of the statement presenting comprehensive income, total comprehensive
income for the year should be allocated as follows:
ƒ attributable to owners of the parent; and
ƒ attributable to non-controlling interests.
All income and expense items are recognised in profit or loss for a specific accounting
period, unless a Standard requires or permits otherwise. This implies that the effect of
changes in accounting estimates is also included in the determination of profit or loss.
Only in a limited number of circumstances may particular items be excluded from profit or
loss for the period. These circumstances include the correction of errors and the effect of
changes in accounting policies in terms of IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors (IAS 8.14 to .31 and .41 to .48).
There are a number of items (including reclassification adjustments) that meet the
Conceptual Framework’s definitions of income or expense, but are excluded from the
determination of profit or loss and presented separately as items of other comprehensive
income. Examples of items of other comprehensive income include the following:
ƒ revaluation surpluses and deficits against existing revaluation surpluses;
ƒ remeasurements of defined benefit plans;
ƒ gains and losses arising from the translation of the financial statements of a foreign
entity;
ƒ gains or losses on remeasuring equity instruments classified as financial assets at fair
value through other comprehensive income;
ƒ gains and losses on cash flow hedges;
ƒ changes in credit risk based on changes in fair value for liabilities held at fair value
through profit or loss; and
ƒ share of other comprehensive income of associates or joint ventures.
The profit or loss section of the statement of profit or loss and other comprehensive income
may be presented in two ways: either by classifying expenditure in terms of the functions
that give rise to them, or by classifying expenditure in terms of their nature (IAS 1.99). Note
that expenses are sub-classified in terms of frequency, potential for gain or loss, and
predictability.
When items of profit or loss are classified in terms of the functions that give rise to them,
additional information about the nature of the expenditure should be provided in the notes to
the statement of profit or loss and other comprehensive income, including:
ƒ depreciation;
ƒ amortisation; and
ƒ employee benefit expense.
The above additional disclosure is required in the case of a presentation of items of profit or
loss in terms of function because the nature of expenses is useful in predicting future cash
flows. The method selected should be the one most suitable to the entity, depends on
historical and industry factors, and should be consistently applied.
46 Descriptive Accounting – Chapter 3
3.5.3.1 Information to be presented in the profit or loss section or the statement of
profit or loss
In addition to items required by other IFRSs, the profit or loss section, or the statement of
profit or loss, should include the following line items as a minimum (IAS 1.82):
ƒ revenue;
ƒ gains and losses arising from the derecognition of financial assets measured at
amortised cost;
ƒ finance cost;
ƒ the share of the profit or loss of associates and joint ventures accounted for using the
equity method;
ƒ when a financial asset is reclassified so that it is measured at fair value, any gain or loss
arising from a difference between the previous carrying amount and its fair value at the
reclassification date (refer to IFRS 9, Financial Instruments);
ƒ a single amount for the total of discontinued operations (refer to IFRS 5 Non-current
Assets Held for Sale and Discontinued Operations);
ƒ income tax expense (this line item includes only taxes that are income taxes within the
scope of IAS 12 Income Taxes discussed);
ƒ a single amount comprising the total of:
– the post-tax profit or loss of discontinued operations; and
– the post-tax gain or loss recognised on the measurement to fair value less costs to
sell or on the disposal of the assets or disposal group(s) constituting the discontinued
operation; and
ƒ profit or loss.
Additional line items, headings and subtotals should be added where required by a Standard
or where it is in the interest of fair presentation, for example in the case of a material item, or
when such presentation is relevant to an understanding of the entity’s financial performance.
Factors considered include materiality and the nature of the components of income and
expenses. Descriptions are adapted to suit the activities of the reporting entity. It is important
to note that the notion of extraordinary items has been abandoned, and no disclosure
whatsoever of such an item is allowed. An entity is also no longer required to present a line
item headed results from operating activities but it can do so voluntarily or if local regulation
requires such disclosure. The selection of the items that make up operating activities requires
professional judgement as IFRS does not provide specific guidance.
3.5.3.2 Information to be presented in the other comprehensive income section
The other comprehensive income section shall present line items for each component of
other comprehensive income, classified by nature, and grouped into the following categories,
in accordance with other IFRSs:
ƒ items that will not subsequently be reclassified to profit or loss; and
ƒ items that will subsequently be reclassified to profit or loss when specific conditions are met.
An entity should also disclose the amount of income tax relating to each item of other
comprehensive income, including reclassification adjustments, in the statement of profit or
loss and other comprehensive income, or in the notes.
Each item of other comprehensive income is shown:
ƒ net of the related tax effects; or
ƒ before the related tax effect, with a separate line item for the aggregate amount of
income tax relating to those items.
When an entity presents an amount showing the aggregate tax amount, this tax amount
should also be grouped into items that will not subsequently be reclassified to profit or loss
and those that will subsequently be reclassified to profit or loss.
Presentation of financial statements 47
Reclassification adjustments are amounts that are reclassified to profit or loss in the
current period that were previously recognised in other comprehensive income in the current
or previous periods. These adjustments may be presented in the statement of profit or loss
and other comprehensive income, or in the notes. When presented in the notes, the items of
other comprehensive income are presented after any related reclassification adjustments.
3.5.3.3 Information to be presented in the statement of profit or loss and other
comprehensive income, or in the notes
Items of such material size, nature or incidence that the users of financial statements should
be specifically referred to them to ensure that they are able to assess the performance of
the entity, should be disclosed separately. The following are examples of items that will
probably require specific separate disclosure in particular circumstances (IAS 1.98):
ƒ the write-down of inventories to net realisable value, or of property, plant and equipment
to the recoverable amount, as well as the reversal of such write-downs;
ƒ the restructuring of the activities of an entity and the reversal of any provisions for the
cost of restructuring;
ƒ the disposal of property, plant and equipment;
ƒ the disposal of investments;
ƒ discontinued operations;
ƒ the settlement of litigation; and
ƒ other reversals of provisions.
Example 3.5
3.5
Presentation of the statement of profit or loss and other comprehensive
income
The following is an example of the presentation of a single statement of profit or loss and other
comprehensive income in which income and expenditure are presented in terms of their function,
using the same trial balance as given in Example 3.4:
Ngwenya Ltd Group
Consolidated statement of profit or loss and other comprehensive income
for the year ended 31 December 20.15
R
Revenue
4 022 400
Cost of sales
(2 093 200)
Gross profit
Other income (100 000 + 14 000 + 6 000)
Distribution costs (168 400 + 53 400 + 44 200 + 29 600)
Administrative expenses (187 600 + 16 400 + 22 000)
Other expenses
Finance costs
Share of profit of associate/joint venture
1 929 200
120 000
(295 600)
(226 000)
(12 000)
(66 600)
300 000
Profit before tax
Income tax expense
1 749 000
(687 190)
Profit for the year
1 061 810
Other comprehensive income, after tax:
Items that will not be reclassified to profit or loss:
Revaluation surplus
Share of other comprehensive income of associate/joint venture
32 750
10 000
continued
48 Descriptive Accounting – Chapter 3
R
Items that may subsequently be reclassified to profit or loss:
Cash flow hedges
Other comprehensive income for the year, net of tax
Total comprehensive income for the year
Profit attributable to:
Owners of the parent
Non-controlling interests
28 400
71 150
1 132 960
971 610
90 200
1 061 810
Total comprehensive income attributable to:
Owners of the parent
Non-controlling interests
1 042 760
90 200
1 132 960
The following is an example of the presentation of a single statement of profit or loss and other
comprehensive income in which income and expenditure are presented in terms of their nature:
Ngwenya Ltd Group
Consolidated statement of profit or loss and other comprehensive income
for the year ended 31 December 20.15
R
Revenue
4 022 400
Other income (100 000 + 14 000 + 6 000)
120 000
Changes in inventories of finished goods and work-in-progress
(62 400 + 71 200 – 57 800 – 51 200)
24 600
Raw materials and consumables used
(43 000 + 8 400 – 46 000 – 10 000 + 2 093 200 – 160 400 + 189 600)
(2 117 800)
Employee benefits expense
(356 000)
Depreciation
(69 800)
Impairment loss on goodwill
(12 000)
Other expenses (29 600 + 44 200 + 22 000)
(95 800)
Finance costs
(66 600)
Share of profit of associate/joint venture
300 000
Profit before tax
Income tax expense
1 749 000
(687 190)
Profit for the year
1 061 810
Other comprehensive income, after tax:
Items that will not be reclassified to profit or loss:
Revaluation surplus
Share of other comprehensive income of associate/joint venture
Items that may subsequently be reclassified to profit or loss:
Cash flow hedge
28 400
Other comprehensive income for the year, net of tax
71 150
Total comprehensive income for the year
Profit attributable to:
Owners of the parent
Non-controlling interests
32 750
10 000
1 132 960
971 610
90 200
1 061 810
continued
Presentation of financial statements 49
R
Total comprehensive income attributable to:
Owners of the parent
Non-controlling interests
1 042 760
90 200
1 132 960
3.5.4 Statement of changes in equity
A statement of changes in equity forms part of a minimum set of financial statements.
Essentially what is required is a reconciliation of equity at the beginning of the reporting
period with equity at the end of the reporting period.
3.5.4.1 Information to be presented in the statement of changes in equity
The statement should include the following information:
ƒ the total comprehensive income for the period, showing separately the total amounts
attributable to owners of the parent and to non-controlling interests;
ƒ the effect of retrospective application or restatement as a result of changes in accounting
policy and the correction of errors for each component of equity (refer to IAS 8
Accounting Policies, Changes in Accounting Estimates and Errors); and
ƒ for each component of equity, a reconciliation between the carrying amount at the
beginning and the end of the period, separately disclosing movements resulting from:
– profit or loss;
– other comprehensive income; and
– transactions with owners in their capacity as owners, showing contributions by and
distributions to owners separately, and including the following:
• issue of shares;
• buy back of shares;
• dividends paid;
• transfers between reserves; and
• changes in ownership interests in subsidiaries that do not result in a loss of control.
3.5.4.2 Information to be presented in the statement of changes in equity or in the
notes
An entity shall present, either in the statement of changes in equity or in the notes, an
analysis of each item of other comprehensive income.
Dividends declared or declared and paid for the period, and related dividends per share can
be disclosed either on the face of the statement of changes in equity, or in the notes
(IAS 1.107).
Example 3.6
3.6
Presentation of statement of changes in equity in columnar format
The following information relates to the Umbaba Ltd Group for the year ended 31 December 20.15:
1. The balances of the capital accounts and reserves of Umbaba Ltd (parent) on 31 December
20.14 were as follows:
R
Ordinary share capital (1 550 000 shares)
2 350 000
Redeemable preference share capital (200 000 shares)
200 000
Revaluation surplus
–
Retained earnings
1 200 000
continued
50 Descriptive Accounting – Chapter 3
2. On 1 January 20.15, Umbaba Ltd’s property was revalued upwards by R50 000 (net amount).
The revaluation reserve is realised through the use of the asset. The revaluation resulted in an
increase in the annual depreciation charge of R5 000.
3. On 31 March 20.15, Umbaba Ltd issued 100 000 ordinary shares at R1,20 per share.
4. On 30 June 20.15, the total preference share capital of Umbaba Ltd was redeemed. Shares
were not issued to fund this redemption.
5. On 15 July 20.15, a material error amounting to R32 500 (net amount) was discovered in the
books of Umbaba Ltd, relating to the 20.14 financial year. This error was corrected during
20.15 (increase in net profit), by restating the 20.14 amounts.
6. Umbaba Ltd acquired a controlling interest in a subsidiary during the 20.15 financial year. The
equity of the subsidiary only comprised share capital and retained earnings at acquisition date.
The subsidiary has no other components of equity. The subsidiary did not declare any
dividends during the 20.15 financial year. The fair value of the non-controlling interests at
acquisition date was R25 000, correctly calculated.
7. Consolidated profit for the year amounted to R110 000 (non-controlling interests R17 400).
Dividends amounting to R35 000 were declared and paid by Umbaba Ltd on
31 December 20.15. It is the accounting policy of Umbaba Ltd to present dividends per share
in the statement of changes in equity.
8. On 31 December 20.145, the cash flow hedge reserve of Umbaba Ltd amounted to R40 000.
Umbaba Ltd Group
Statement of changes in equity for the year ended 31 December 20.15
Share
capital
R
Balance at
31 Dec 20.14
Correction of error
2 550 000
–
Restated balance
2 550 000
Changes in equity
for 20.15
Issue of ordinary
share capital
120 000
Redemption
of preference shares (200 000)
Acquisition of
subsidiary
Dividends
–
Total comprehensive
income
–
Profit for the year
Other comprehensive
income
Revalua- Cash flow
tion
hedge
surplus
reserve
R
R
–
–
R
Total
R
Noncontrolling
interests
R
Total
equity
R
1 200 000 3 750 000
32 500
32 500
–
–
3 750 000
32 500
1 232 500 3 782 500
–
3 782 500
–
–
–
120 000
–
120 000
–
–
–
(200 000)
–
(200 000)
–
–
50 000
–
–
–
50 000
Realisation of
revaluation surplus to
retained earnings
–
Balance at
31 Dec 20.15
2 470 000
(5 000)
Dividend per share
(35 000 / 1 650 000)
–
–
Retained
earnings
45 000
40 000
–
40 000
–
(35 000)
(35 000)
25 000
–
92 600
182 600
17 400
200 000
92 600
92 600
17 400
110 000
–
90 000
–
90 000
5 000
–
40 000 1 295 100 3 850 100
–
25 000
(35 000)
–
42 400 3 892 500
20.14
R
0,02
(2,12 cents)
Comment
¾ IAS 1.107 does not specify whether the number of shares to be used to calculate the
dividends per share should be the actual number of shares outstanding as at the date the
dividend is declared, the actual number of shares outstanding as at the reporting date, or the
weighted average number of shares used to calculate earnings per share. A reporting entity
should develop an appropriate accounting policy and apply it consistently.
Presentation of financial statements 51
3.5.5 Statement of cash flows
The statement of cash flows provides the users of financial statements with useful
information regarding the historical changes in cash and cash equivalents of the entity, and
enables the users to formulate an opinion and make a better estimate of the cash
performance of an entity. IAS 7 Statement of Cash Flows sets out the presentation and
disclosure requirements of cash flow information. Refer to chapter 5 in this regard.
3.5.6 Notes
The notes to the financial statements provide additional information on items that are
presented in the financial statements in order to ensure fair presentation. The notes are
presented systematically, with cross-references to the financial statements. The following is
the usual sequence in which the notes are presented:
ƒ a statement that the financial statements comply with the International Financial Reporting
Standards;
ƒ a statement in which the basis of preparation and accounting policies are set out;
ƒ supporting information on items that are presented in the statement of financial position,
statement of profit or loss and other comprehensive income, statement of changes in
equity, or statement of cash flows;
ƒ additional information on items that are not presented in the statement of financial
position, statement of profit or loss and other comprehensive income, statement of
changes in equity, or statement of cash flows; and
ƒ other disclosures, such as contingencies, commitments and disclosures of a financial and a
non-financial nature, for example financial risk management targets.
The sequence may vary according to circumstances. In some cases, the notes on
accounting policies are presented as a separate component of the financial statements.
3.5.6.1 Accounting policies
The notes on accounting policy should disclose the following:
ƒ The measurement basis used in the compilation of the financial statements, for example
historical cost, current cost, net realisable value, fair value and recoverable amount.
Where more than one measurement basis is used, for example when particular classes
of assets are revalued, an indication is given of only the categories of assets and
liabilities to which each measurement basis applies.
ƒ Each specific accounting policy matter that is relevant to an understanding of the
financial statements. Management has to decide whether disclosure of a particular
accounting policy would assist users in understanding how transactions, other events
and conditions are reflected. Disclosure of accounting policies is especially important
where the Standards allow alternative accounting treatments, for example whether an
entity applies the cost model or the fair value model of IAS 40 Investment Property to its
investment property.
Accounting policies relating to at least the following, but not limited thereto, should be
disclosed:
ƒ revenue recognition;
ƒ consolidation principles;
ƒ application of the equity method of accounting for investments in associates or joint
ventures;
ƒ business combinations;
ƒ joint arrangements;
ƒ recognition and depreciation/amortisation of tangible and intangible assets;
52 Descriptive Accounting – Chapter 3
capitalisation of borrowing costs and other expenditure;
construction contracts;
investment properties;
financial instruments and investments;
leases;
inventories;
taxes, including deferred taxes;
provisions;
employee benefit costs;
foreign currency entities and transactions;
definitions of business and geographical segments, and the basis for the allocation of
costs between segments;
ƒ government grants; and
ƒ definitions of cash and cash equivalents.
Each entity is expected to disclose the accounting policies that are applicable to it, even if
the amounts shown for current and prior periods are not material – the accounting policy
may still be significant.
In its choice of appropriate accounting policy, the management of an entity often makes
judgements when formulating a particular policy, for example when determining whether
financial assets should be classified as at amortised cost or not. In order to enable the users
of financial statements to better understand the accounting policies and be able to make
comparisons between entities, those judgements that have the most significant effect on the
amounts of items recognised in the financial statements are disclosed in the summary of
significant accounting policies (when accounting policies are disclosed in a separate
summary) or in the notes to the financial statements (IAS 1.122). Some of these judgements
are required disclosures in terms of other Standards.
ƒ
ƒ
ƒ
ƒ
ƒ
ƒ
ƒ
ƒ
ƒ
ƒ
ƒ
3.5.6.2 Sources of estimation uncertainty
In the determination of the carrying amounts of certain assets and liabilities, it is often necessary
for management to estimate the effects of uncertain future events. Management has to
make certain assumptions about these uncertain future events in order to be able to
determine the carrying amounts of assets and liabilities that are influenced by such events.
The following are examples of items that are influenced by such uncertain future events that
management is called upon to assess:
ƒ the absence of recent market prices in thinly-traded markets used to measure certain assets;
ƒ the recoverable amount of property, plant and equipment;
ƒ the rate of technological obsolescence of inventories;
ƒ provisions subject to the effects of future litigation or legislation; and
ƒ long-term employee benefit liabilities, such as pension obligations.
Factors that should be taken into account in making the judgement on the carrying amounts
of these items include assumptions about future interest rates, future changes in salaries,
the expected rate of inflation, and discount rates. Disclosure of estimates is, however, not
required if assets and liabilities are measured at fair value based on a quoted price in an
active market for an identical asset or liability at the end of the reporting period (refer to
IFRS 13, Fair Value Measurement). It is also not necessary to disclose information on
budgets and forecasts.
In order to enhance the relevance, reliability and understandability of the information reported
in the financial statements, entities are required to disclose (see IAS 1.125 and .129):
ƒ information regarding key assumptions about the future (such as interest rates, future
changes in salaries and the expected rate of inflation); and
Presentation of financial statements 53
ƒ other sources of measurement uncertainty at the end of the reporting period that
have a significant risk of causing a material adjustment to the carrying amounts of
assets and liabilities within the next reporting period. In respect of such assets and
liabilities, details should be disclosed about:
– the nature of the asset or liability;
– the nature of the assumption or estimation uncertainty; and
– their carrying amounts as at the end of the reporting period, for example:
• the sensitivity of carrying amounts to the methods, assumptions and estimates
underlying their calculation, including the reasons for the sensitivity;
• the expected resolution of an uncertainty and the range of reasonably possible
outcomes within the next reporting period in respect of the carrying amounts of the
assets and liabilities affected; and
• an explanation of changes made to past assumptions concerning those assets and
liabilities, if the uncertainty remains unresolved;
ƒ when it is impracticable to disclose the possible effects of key assumptions or other
sources of measurement uncertainty, the entity discloses:
– the nature and carrying amount of the asset or liability affected; and
– a statement that it is reasonably possible, based on existing knowledge, that changes
in conditions within the next reporting period may require a material adjustment to the
carrying amount of the asset or liability affected.
In certain IFRSs, disclosure of estimates is already required, for example the major
assumptions on future events which affect classes of provisions (IAS 37 Provisions,
Contingent Liabilities and Contingent Assets) and the disclosure of assumptions when
measuring the fair values of assets and liabilities that are carried at fair value (IFRS 13 Fair
Value Measurement).
Note that IAS 1 defines impracticability as instances when the entity cannot apply a
requirement after making every reasonable effort to do so. Note further that key sources of
estimate uncertainty should not be confused with the judgements of management made in
the process of selecting an accounting policy (which are disclosed in terms of
paragraph 122).
3.5.6.3 Capital disclosure
The purpose of the capital disclosure is to enable users to assess the objectives, policies
and processes of the entity relating to the management of its capital (IAS 1.134). The
following should be disclosed:
ƒ The entity discloses qualitative information on:
– how it manages its capital;
– any external capital requirements (such as regulatory or legislative requirements); and
– a performance assessment on the meeting of its objectives.
ƒ The quantitative information disclosed includes:
– the level of capital;
– the definition applied to capital;
– changes during the previous period; and
– the extent of compliance to externally imposed capital requirements.
Note that IAS 1 does not specifically require quantification of externally imposed capital
requirements. The disclosure focuses instead on the extent of compliance with such
externally imposed requirements. If an entity does not comply with such requirements, the
consequences of non-compliance should be disclosed. This assists users to evaluate the
risk of breaches of capital requirements.
54 Descriptive Accounting – Chapter 3
Although some industries may also have specific capital requirements, IAS 1 does not
require disclosure of such requirements because of the different practices among industries
that will affect the comparability of the information. Similarly, an entity may have internally
imposed capital requirements. IAS 1 also does not require disclosure of such capital targets,
or the extent or consequences of any non-compliance.
3.5.6.4 Dividends
In accordance with IAS 1.107, the entity must disclose the amount of dividends recognised
as distributions to equity-holders, as well as the dividends per share, in the statement of
changes in equity or in the notes to the financial statements.
In addition, IAS 1.137 requires that the entity should disclose the dividends proposed or
declared before the financial statements are authorised for issue, but after the end of the
reporting period, and the related dividend per share in the notes to the financial statements.
In terms of the definition of a liability in the Conceptual Framework, a dividend declared after
the end of the reporting period may not be recognised as a liability, because no current
obligation exists at the end of the reporting period, yet such declaration provides useful
information to users and should therefore be disclosed.
The entity should also disclose any cumulative preference dividends that may be in arrears
and have therefore not been recognised in the financial statements.
IAS 1 does not, however, address how an entity should measure distributions of assets
other than cash when it pays dividends to its owners. As a result of a significant diversity in
practice in this respect, IFRIC 17 Distributions of Non-cash Assets to Owners was issued.
IFRIC 17 applies to the entity making the distribution, not to the recipient. It applies when
non-cash assets are distributed to owners or when the owner is given a choice of taking
cash in lieu of the non-cash assets. IFRIC 17 clarifies that:
ƒ a dividend payable must be recognised when the dividend is appropriately authorised
and is no longer at the discretion of the entity;
ƒ the dividend payable must be measured at the fair value of the net assets to be
distributed;
ƒ if owners are given a choice of receiving either a non-cash asset or a cash alternative, the
entity must estimate the value of the dividend payable by considering both the fair value of
each alternative as well as the associated probability of owners selecting each alternative;
ƒ the liability must be remeasured at each reporting date and at settlement, with changes
recognised directly in equity;
ƒ the difference between the dividend paid and the carrying amount of the net assets
distributed must be recognised in profit or loss, and must be disclosed as a separate line
item; and
ƒ additional disclosures must be provided if the net assets being held for distribution to
owners meet the definition of a discontinued operation.
IFRIC 17, Distributions of Non-cash Assets to Owners, applies to pro rata distributions of
non-cash assets (all owners are treated equally) but does not apply to common control
transactions.
Presentation of financial statements 55
Example 3.7
3.7
Distribution of non-cash assets to owners
Spitfire Ltd is a mining company with a 31 December year end. Spitfire Ltd declared a dividend to
its 100 shareholders of either a cash payment of R600 or 1 oz of gold. At 31 December 20.14, the
dividend was appropriately authorised and no longer at the discretion of the entity.
At 31 December 20.14, management estimated that 50% of the shareholders would take the cash
option and 50% of shareholders would take the gold. At 31 December 20.14, the fair value of 1 oz
of gold was R900 and the carrying value was R500. On 28 February 20.15, the actual distribution
of the dividend occurred. On 28 February 20.15, the fair value of 1 oz gold is R750 and 40% of the
shareholders took the gold as a dividend.
Spitfire Ltd accounted for the dividend at 31 December 20.14 and 28 February 20.15 as follows:
Dr
Cr
31 December 20.14
R
R
Equity (Dividends declared)
75 000
Liability (Dividends payable)
75 000
Recording of the distribution at expected fair value of R75 000
((50 × R600) + (50 × R900))
28 February 20.15
Liability (Dividends payable)
Equity (Dividends declared)
Remeasurement of liability to fair value of R66 000
((60 × R600) + (40 × R750)) directly in equity
Liability (Dividends payable)
Cash
Inventories (500 x 40)
Fair value gain (P/L)
Extinguishment of liability and de-recognition of cash (60 × R600) and
de-recognition of inventories of gold (40 × R500) and recognition of
fair value gain in relation to gold ((40 × R750) – (40 × R500)).
9 000
9 000
66 000
36 000
20 000
10 000
3.5.6.5 Other disclosures
The following additional information should be provided unless it is already contained in the
information that is published with the financial statements:
ƒ the domicile of the entity;
ƒ the legal form of the entity;
ƒ the country of incorporation;
ƒ the address of the registered office (or principal place of business, if it is different from
the registered office);
ƒ a description of the nature of the entity’s operations and its principal activities;
ƒ the name of the parent and the ultimate parent entity of the group; and
ƒ if it is a limited life entity, details regarding the length of its life.
3.6 Statutory reporting requirements
In addition to the requirements of the Standards and Interpretations of IFRS and the
requirements of the Companies Act 71 of 2008 (the Companies Act, 2008/the Act), the
financial statements of companies listed on the JSE Limited should also meet the disclosure
requirements of the JSE Limited.
The annual financial statements must (in terms of The Listing Requirements,
paragraph 8.62):
ƒ be drawn up in accordance with the national law applicable to a listed company;
56 Descriptive Accounting – Chapter 3
ƒ be prepared in accordance with International Financial Reporting Standards and the
Financial Reporting Pronouncements (FRPs) (previously AC 500 Standards) issued by
the Financial Reporting Standards Council (FRSC);
ƒ be audited in accordance with International Standards on Auditing or, in the case of
overseas companies, in accordance with national auditing standards acceptable to the
JSE Limited;
ƒ be in consolidated form if the listed company has subsidiaries, unless the JSE Limited
otherwise agrees, but the listed company’s own financial statements must also be
published if they contain significant additional information;
ƒ fairly present the financial position, changes in equity, results of operations and cash flows of
the group;
ƒ comply with the Companies Act, 2008; and
ƒ comply with the requirements of the King Code on corporate governance (including the
requirement to prepare an integrated report that replaces the annual report and
sustainability report).
The JSE Limited requires that the annual reports of companies listed on the JSE Limited
should disclose at least the following (Listing Requirements, paragraph 8.63):
ƒ a narrative statement of how the company has applied the principles set out in the King
Code, providing explanations that enable its shareholders to evaluate how the principles
have been applied; and
ƒ a statement about the extent of the company’s compliance with the King Code and the
reasons for non-compliance with any of the principles therein, specifying whether the
company has complied throughout the accounting period with all the provisions of the
King Code, and indicating for what part of the period any non-compliance occurred.
CHAPTER
4
Inventories
(IAS 2 and Circular 09/2006)
Contents
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
4.10
4.11
4.12
Overview of IAS 2 Inventories ...........................................................................
Background .......................................................................................................
Nature of inventories .........................................................................................
Measurement of inventories ..............................................................................
Cost of inventories .............................................................................................
4.5.1 Introduction .............................................................................................
4.5.2 Allocation of overhead costs ...................................................................
Application of cost allocation techniques and cost formulas .............................
4.6.1 Standard cost..........................................................................................
4.6.2 Retail method..........................................................................................
4.6.3 Cost formulas..........................................................................................
4.6.4 Other cost formulas ................................................................................
Determining net realisable value .......................................................................
Lower of cost and net realisable value ..............................................................
4.8.1 General rule ............................................................................................
4.8.2 Exceptions ..............................................................................................
Recognition of an expense ................................................................................
Taxation implications .........................................................................................
Disclosure ..........................................................................................................
Comprehensive example ...................................................................................
57
58
59
60
60
60
60
64
67
68
68
68
71
71
72
72
74
76
77
78
79
58 Descriptive Accounting – Chapter 4
4.1
Overview of IAS 2 Inventories
The scope of IAS 2:
Includes:
ƒ held for sale in the ordinary course of business;
ƒ in the process of production for such sales; and
ƒ to be consumed in the production of goods and services
for sale.
Excludes:
ƒ work-in-progress arising from construction contracts;
ƒ financial instruments; and
ƒ biological assets to point of harvest.
Partially excludes:
ƒ mineral and mineral products;
ƒ commodity brokers; and
ƒ producers of agricultural and forest products after harvest.
Cost
Use either:
ƒ FIFO;
ƒ weighted average;
ƒ identification, only where
goods have been
manufactured for specific
purposes and are normally
not interchangeable;
ƒ standard costs; or
ƒ retail method, only if the
results obtained approximate
the lower of costs and NRV.
Measure at lower of cost
and net realisable value
(Evaluation of total inventories
is unacceptable if it results in
the netting of losses against
unrealised profits.)
(Note the exclusions in
section 4.2, as well as the fact
that certain inventories are
disclosed at fair value less
costs to sell rather than at net
realisable value.)
Net realisable value
(The estimated selling price in the ordinary course of business
less costs of completion and less costs necessary to make
the sale.)
ƒ Based on reliable evidence of expected realisation values
available at the time of making the estimates.
ƒ Write-down by item or by group of similar items, applied
consistently.
ƒ Where inventory is being kept in terms of a firm sales
contract, still to be delivered, NRV based on contracted
price.
ƒ In the case of materials, no write-down to NRV from cost
takes place if materials form part of finished goods that are
expected to realise their cost or more.
The historical cost of inventories includes:
Costs of purchasing
Costs of purchasing
includes:
ƒ import duties and other
taxes; and
ƒ any other directly
attributable costs of
acquisition less rebates,
discounts and subsidies
on purchases.
Conversion costs
ƒ Variable production
overheads.
ƒ Fixed production
overheads allocated,
based on normal
capacity of production
facilities.
ƒ Excludes abnormal
spillage.
Other costs
ƒ To bring the inventories to their
present location and condition.
ƒ Expenses incurred in respect of
the design of a specific product
for a particular customer.
ƒ Include borrowing cost if IAS 23
requires capitalisation.
ƒ Normally excludes administration
and selling expenses.
Inventories 59
4.2 Background
Inventories, one of the two main components of non-monetary assets, represent a material
portion of the assets of numerous entities. The measurement of inventories can have a
significant impact on determining and presenting the financial position and results of the
operations of entities. Inventories should also be presented and disclosed in such a way that
the information is faithful and relevant to the users of financial statements. It is, therefore,
clear that the objective of IAS 2 is twofold, namely to prescribe:
ƒ how the cost of inventories is determined; and
ƒ what useful and understandable information should be provided in the financial
statements.
There are two categories of exclusion from the requirements of IAS 2, namely those
categories of inventories that are excluded from the scope of IAS 2 entirely, and those that
are excluded from the measurement requirements of IAS 2 only.
IAS 2 does not apply to the following categories of inventories:
ƒ work-in-progress under construction contracts (IFRS 15), including directly related
service contracts;
ƒ agricultural produce at the point of harvest, and biological assets related to agricultural
activity (IAS 41); and
ƒ financial instruments (IAS 32, IFRS 9 and IFRS 7).
IAS 2 applies only partially to certain inventories, as the measurement requirements do
not apply to:
ƒ producers of agricultural and forestry products, agricultural produce after harvest, and
minerals and mineral products. These inventories are measured at net realisable value in
accordance with well-established practices in those industries. When such inventories
are measured at net realisable value, changes in that value are recognised in profit or
loss in the period of the change; and
ƒ commodity brokers/traders, who measure their inventories at fair value less costs to sell.
In such instances, changes in the fair value less costs to sell of the inventories are
recognised in profit or loss for the period of the change.
Note that there is a difference between net realisable value and fair value less costs to
sell. Net realisable value uses, as point of departure, the entity-specific amount to be
realised from the sale of inventories in the ordinary course of business. Fair value less
costs to sell is not entity-specific but market-specific, and uses, as point of departure,
the price that would be received to sell the same inventories in an orderly transaction
between market participants. Please refer to the meaning of fair value in terms of IFRS 13 in
chapter 21.
The inventories of producers of agricultural and forestry products are often measured at net
realisable value at certain stages of production (rather than at the lower of cost and net
realisable value), for example when an active market exists and there is a negligible risk of
failure to sell, as crops have been harvested or minerals have been extracted. This can also
occur when a sale is assured under a forward contract or a government guarantee. Once
agricultural produce is harvested and measured on initial recognition at fair value less costs
to sell in terms of IAS 41, the requirements of IAS 2, excluding the measurement
requirements, apply, and the fair value less costs to sell becomes the cost in terms of IAS 2.
Brokers/traders typically buy or sell commodities for others or on their own account with the
purpose of selling such commodities in the short-term and generating a profit due to
fluctuations in price or brokers/traders’ margins. Consequently, these inventories are often
measured at fair value less costs to sell, and they are therefore also excluded from the
measurement requirements of IAS 2 only.
60 Descriptive Accounting – Chapter 4
Note that IAS 2.3 requires changes in the value of any inventories excluded from its
measurement requirements (discussed earlier) to be recognised in profit or loss for the
period of the change.
4.3 Nature of inventories
Inventories include all assets, both tangible and intangible:
ƒ held for sale in the ordinary course of business, for example fuel at a petrol station and
sweets sold by a café;
ƒ in the process of production for such sale, for example a partly completed piece of
furniture (work-in-progress) of a furniture manufacturer;
ƒ consumed during the production of saleable goods or services, for example materials such
as rivets used during the manufacture of a bus or supplies such as shampoo used in a
hair salon; and
ƒ the cost of labour and other related expenses such as supervision and other attributable
overhead costs of a service provider not yet invoiced, for example the cost of interim
audit work not yet invoiced.
The decision whether a certain item, for example a motor vehicle, is classified as inventory,
relates to its purpose to the entity. Should the entity be a motor vehicle dealer and the
motor vehicle be used by the financial manager for travelling purposes, the vehicle would be
classified as a non-current asset and not as inventory. If the motor vehicle is placed in the
showroom so that it can be sold to the public, then the motor vehicle is classified as
inventory within current assets. From this it is evident that neither the item itself nor the kind
of entity in which it is being utilised determines whether it should be classified as inventories,
but rather the abovementioned criteria referred to in IAS 2.6.
4.4 Measurement of inventories
Inventories are measured at the lower of cost and net realisable value. The measurement of
inventories for financial reporting entails the following steps:
ƒ determining the cost;
ƒ applying a cost allocation technique to measure the cost of inventories;
ƒ determining the net realisable value;
ƒ recognising the inventories at the lower of cost and net realisable value in the annual
financial statements; and
ƒ disclosing of inventories in the notes to the financial statements.
Each of these aspects is now discussed.
4.5 Cost of inventories
4.5.1 Introduction
The historical cost of inventories includes:
ƒ purchasing costs;
ƒ conversion costs; and
ƒ other costs incurred in bringing inventories to their present location and condition.
The cost of inventories excludes:
ƒ abnormal spillage of raw materials, labour and other production costs incurred during the
production process, for example production labour hours lost due to a natural disaster;
ƒ fixed production costs that are not allocated to production on the grounds that normal
capacity, instead of actual capacity, was used as the basis of allocation. The portion not
allocated is written-off in the profit and loss section (within cost of sales) of the statement
of profit or loss and other comprehensive income;
Inventories 61
ƒ storage costs, unless such costs are necessary in the production process prior to a
further production stage, for example incomplete goods in a production process that
should first be frozen before the goods can proceed to the next process;
ƒ administrative expenses not related to bringing the inventories to their present location
and condition; and
ƒ selling expenses (IAS 2.16).
It is important at this stage to emphasise that IAS 2 relates directly to inventories and
indirectly to cost of sales. This is reflected in the Standard’s name, namely ‘Inventories’,
and not ‘Cost of sales’. Therefore, although abnormal spillage and under- or over-allocated
fixed overheads are excluded from the closing inventories, they are included in cost of sales.
4.5.1.1 Purchasing costs
These costs include the following:
ƒ the purchase price of finished goods or raw materials;
ƒ import duties and other taxes, other than those subsequently recoverable from the taxing
authorities, such as VAT if the buyer is registered for VAT purposes;
ƒ transport costs;
ƒ handling costs; and
ƒ other costs directly attributable to the acquisition of the inventories.
From these costs, the following are deducted if included:
ƒ trade discounts (and cash and settlement discounts in terms of CC 09/06); and
ƒ rebates and other similar items, such as subsidies and ‘kick-backs’ on purchases.
Imported inventories settled in foreign currency are recognised at the spot rate ruling at the
transaction date, in terms of IAS 21. Exchange differences due to fluctuations in exchange
rates do not form part of the cost of inventories. If, in terms of IAS 39 (hedge accounting is
at present not covered by IFRS 9, but by IAS 39), the purchase qualifies as a forecast
transaction or unrecognised firm commitment that is covered by a fair value hedge (see
paragraph 89(b) of IAS 39) or a cash flow hedge (see paragraph 98(b)), the exchange
fluctuation on the hedging instrument (underlying derivative) before the transaction date may
form part of the cost of the inventories.
Example 4.1
Purchasing costs
Alpha Ltd was recently incorporated and registered for VAT. Goods were purchased on two
occasions during its first month of business. The details of these purchase transactions are as
follows:
Transaction 1
Goods were purchased from a supplier who wants to establish a long-term business relationship
with Alpha Ltd. With this in mind, the following terms were laid down:
ƒ The purchase price of the goods before any rebates or discount is R703 703,70 (including VAT
levied at 15%).
ƒ Alpha Ltd will receive a 10% volume rebate on the purchase price of the goods.
ƒ Alpha Ltd will receive a further 10% settlement discount if the outstanding amount it is settled
within 30 days.
Transaction 2
Goods were purchased from a foreign supplier (the transaction was denominated in rand) for
R400 000 (excluding VAT). Ownership of the goods was transferred to Alpha Ltd upon delivery at
the harbour. Alpha Ltd entered into a contract with an independent transport company to transport
the goods from the harbour to the entity’s premises at a cost of R50 000.
continued
62 Descriptive Accounting – Chapter 4
When the goods were inspected by Alpha Ltd’s foreman, it was discovered that 30 of the 300
containers had suffered water damage during shipping to South Africa. Following negotiations with
the supplier, it was agreed that the goods would be returned to the supplier.
The cost of the two purchase transactions will be calculated as follows:
Transaction 1
Purchase price
VAT input (recoverable taxes) (703 703,70 × 15/115)
R
703 703,70
(91 787.44)
Purchase price (excluding VAT)
Volume rebate – deducted from the cost of inventories and not recognised as other
income (Circular 9/2006) (611 916.26 × 10%)
611 916.26
Amount payable to supplier (excluding VAT)
Settlement discount – the entity has the intention of settling the outstanding
amount within 30 days. Therefore, the discount should be estimated and deducted
from the cost of inventory and not recognised as other income when the creditor
is paid (550 824.64 × 10%)
550 724.64
Amount to be recognised as the cost of the inventories
495 652.18
Transaction 2
Purchase price (excluding VAT)
Delivery cost
400 000,00
50 000,00
(61 191.62)
(55 072.46)
Amount to be recognised as the cost of the inventories
When goods are returned, the cost of inventories is reduced by the initial
cost thereof – note that the delivery cost will not be refunded.
Cost of goods returned (30/300 × 400 000)
450 000,00
Amount to be recognised as the cost of the inventories
410 000,00
(40 000,00)
4.5.1.2 Conversion costs
Conversion costs are costs incurred in converting raw materials into finished products ready
for sale. They include the following:
ƒ direct labour;
ƒ variable production overhead costs; and
ƒ fixed production overhead costs based on normal capacity.
IAS 2 adopts, in effect, the full absorption cost approach, on the assumption that a clear
distinction between fixed and variable cost exists.
IAS 2 defines normal capacity in paragraph 13 as the production expected to be achieved on
average over a number of periods or seasons under normal circumstances, taking into
account the normal loss of capacity resulting from planned maintenance. The cost of
normal spillage also forms part of conversion costs.
The production process may sometimes produce two or more products simultaneously, for
example in a chemical process. These are called joint products. If the costs of the
conversion of the joint products cannot be identified separately, a rational and consistent
cost allocation basis should be used. The relative sales value of the products, either at the
stage in production where they originate, or at the stage of completion, may be appropriate
(see paragraph 14).
If the production process results in main products and a by-product, the value of the latter is
usually immaterial. Consequently, no cost is usually allocated to the by-product and it is
carried at its net realisable value – this is an exception to the general rule of net realisable
value (refer to paragraph 4.7). The net realisable value of the by-product is deducted from
the cost of the main product or from the joint costs before it is allocated to the main products.
Inventories 63
Example 4.2
Main products and by-products
Delta Ltd is a pharmaceutical company. The company uses two raw materials (X and Y) in equal
portions in a chemical process that produces two main products, Headeze en Headache, and a
by-product, Calc, which is sold to fertiliser manufacturers. Costs to sell are immaterial.
One production cycle produces:
Headeze:
3 000 units
Headache:
1 000 litres
Calc:
2 000 litres
The sales price for Headeze is R25,00 per unit, for Headache it is R15,00 per litre and for Calc it is
R1,50 per litre. The total cost of production (joint costs) is R60 000 per cycle. You may assume
that the value of the Calc inventory is immaterial.
The relative sales value of the main products and the by-product can be calculated as follows:
Sales value:
R
Percentage
Headeze
3 000 × R25,00
75 000
83,33%
Headache
1 000 × R15,00
15 000
16,67%
90 000
Calc
2 000 × R1,50
100%
3 000
93 000
The cost of production of the joint main products is allocated on the basis of sales value. The net
realisable value of the by-product is deducted from the main products.
Allocation of costs:
Gross
R
Headeze
(R60 000 – R3 000) × 83,33%
47 500
Headache
(R60 000 – R3 000) × 16,67%
9 500
Calc
3 000
Total cost
60 000
Comment
¾ By-products that are not material (as in most cases) may be measured at net realisable value.
This may result in by-products being valued at above cost, if net realisable value is higher than
actual cost – if it can be determined. This is a departure from the basic rule that inventory
should be measured at the lower of cost and net realisable value. It seems, however, that the
objective of IAS 2 is to provide an expedient and cost-effective solution, and recognise a
generally accepted practice in the measuring of by-products. This departure can also be
justified, as International Financial Reporting Standards are applicable to material items only,
and the by-product amounts are normally not material.
4.5.1.3 Other costs
Included in these costs are all other costs incurred in bringing the inventories to the present
location and condition. Examples are:
ƒ costs of designing products for a particular customer;
ƒ borrowing costs relating to inventories where substantially necessary long ageing periods
are required, as in the case of wine; and
ƒ necessary storage costs in the production process where products are to be kept at a
certain temperature.
Where an entity purchases inventories on deferred settlement terms, and the arrangement
effectively contains a financing element, that element is recognised as interest expense over
the period of the financing, and is therefore not included in the cost of the inventories
(IAS 2.18).
64 Descriptive Accounting – Chapter 4
Example 4.3
Deferred settlement terms
A supplier agrees to supply inventories with a cash price of R12 000. This amount will however
only be payable twelve months after delivery. The supplier’s normal interest-free credit term is one
month. Assume that an interest rate of 18,37% per annum (compounded monthly) is similar to the
market rate on similar credit arrangements. In terms of IAS 2.18, read with Circular 9/2006
paragraph 30, the purchaser should recognise the inventories at the present value of the amount
payable in 12 months’ time, assuming that the time value of money is material. Assuming that the
time value of money is material in this instance, the R12 000 should be discounted to a present
value at 18,37% per annum compounded monthly. The calculation of the cost of the inventories
will be as follows: FV = 12 000; i = 18,37 (P/YR = 12); n = 12 months, and then PV = 10 000. The
inventories purchased must therefore be recognised at R10 000. The difference between the cash
purchase price and the final payment of R12 000 must be recognised as a finance cost, using the
effective interest method (IFRS 9). Note that Circular 9/2006 requires that the normal credit term
should be included in the period over which the amount is discounted, as it forms part of the
financing that is provided to the purchaser.
The general rule applicable in determining the cost of the inventories is therefore that all costs
incurred in bringing the inventories to their present location and condition are included.
The theoretical basis for this is that all costs of inventories in the statement of financial
position are expensed in the following accounting period when the related revenue is
recognised.
4.5.1.4 Costs of service providers
The treatment costs of service providers are now dealt with in pargraphs 91-104 of IFRS 15,
Revenue from contracts with customers as it is now seen as contract costs. Please refer to
chapter 22.
4.5.2 Allocation of overhead costs
The determination of cost can be subject to manipulation in practice, especially in respect of
the allocation of production and other overhead costs, and the application of cost formulas.
The choice of cost formula may result in significantly different outcomes that impact on the
profit for the year as well as the earnings per share.
Overheads are sometimes also referred to as indirect costs. For the purposes of this
discussion, a distinction is made between production overhead costs and other overhead
costs:
ƒ Production overhead costs are those costs incurred in the manufacturing process
which do not form part of the direct raw material or direct labour costs – for example
indirect materials and indirect labour, rates and taxes of a factory, depreciation on
production machinery, administration of a factory, insurance of plant, etc. These items
are included in what is referred to as ‘product cost’.
ƒ Other overhead costs are those costs that do not relate to the production process, and
are normally incurred in running the operations of the entity – for example office rental,
salaries of administrative personnel, selling and marketing costs, etc. These items are
often referred to as ‘expenses’ or ‘period costs’.
The main distinction is that production overhead costs are included in the cost of the
inventories, while the other overhead costs are recognised as expenses and only included in
the costs of inventory in exceptional instances.
Inventories 65
4.5.2.1 Production overhead costs
The general principle is that only those production overheads involved in bringing the
inventories to their present location and condition should be included in the costs. Both fixed
and variable production overhead costs are included in terms of the full absorption cost
approach prescribed in IAS 2.
Variable overhead costs can be allocated to inventories with reasonable ease, as the costs
are normally directly related to the production volumes. The actual number of units
manufactured serves as the basis for allocating such costs.
Fixed production overhead costs are not allocated directly to a product with the same
ease. IAS 2.13 provides the following guidelines in this respect:
ƒ The normal capacity of the production plant is used as the basis for allocation, not the
actual production levels. ‘Normal capacity’ can refer to either the average normal
production volume over a number of periods, or to the maximum production which is
practically attainable. IAS 2 adopts the first meaning.
ƒ The actual capacity may only be used when it approximates normal capacity or when
the number of units manufactured is substantially higher than the normal capacity (see
the fourth bullet in this list).
ƒ The interpretation of the concept ‘normal capacity’ is determined in advance, and should
be applied consistently, unless other considerations of a permanent nature result in
increasing or decreasing production levels.
ƒ If the production levels are particularly high in a certain period, the fixed overhead recovery
rate should be revised, to ensure that inventories are not measured above cost
(allocated based on actual capacity).
ƒ If the production levels are lower than normal capacity, the fixed overhead recovery rate
is not adjusted (allocated based on normal capacity), and the under-recovered portion is
charged directly to the profit or loss section of the statement of profit or loss and other
comprehensive income, forming part of the cost of sales expense.
The large degree of judgement involved in the calculations may result in numerous practical
problems arising from the allocation of fixed overhead production costs. Nevertheless, it is
imperative that a regulated allocation of both variable and fixed production costs be included in
the costs of inventories, in order to achieve the best possible measurement of the asset.
Example 4.4
4.4
Normal versus actual capacity
Echo Ltd’s budgeted and actual fixed production cost is R100 000 and the normal capacity is
regarded as 10 000 units per annum. What amount will be allocated to finished goods in respect of
fixed costs for the following two cases?
Case 1: Actual capacity 5 000 units
Case 2: Actual capacity 20 000 units
Case 1
Normal capacity will be used to calculate the fixed overhead rate for measuring inventory costs:
R10 per unit (R100 000/10 000 units).
The under-recovered fixed production costs of R50 000 (100 000 – (10 × 5 000)) shall be
recognised as an expense under cost of sales.
Comment
¾ The actual rate is R20 per unit (R100 000/5 000) and cannot be used for the measurement of
inventory. The measurement of inventory cannot be ‘increased’ by under-performance.
continued
66 Descriptive Accounting – Chapter 4
Case 2
The actual capacity will be used to calculate the fixed overhead rate for measuring inventory costs:
R5 per unit (R100 000/20 000 units).
Comment
¾ The normal rate cannot be used, as R10 per unit is higher than the actual cost of R5 per unit.
Inventory should be measured at the lower of cost or net realisable value.
4.5.2.2 Other overhead costs
Costs that are not related to the production function of an entity, such as those of
administrative personnel, research and development, financial management and marketing,
are part of other overhead costs. They form a significant part of the expenses of an entity,
and without them there can be no successful production. The relationship between the
production function and the other functions is an indirect connection; therefore other
overhead costs do not normally form part of the cost of inventories. This stipulation is based
on the premise that such costs cannot be seen as being directly related to, or necessary in
bringing inventories into their present location or condition and should be seen as period
costs or expenses.
Certain exceptions to the abovementioned rule exist, namely:
ƒ other overhead costs that clearly relate to bringing inventories to their present location
and condition, for example design costs, some research and development, etc.;
ƒ borrowing costs that have been capitalised in respect of inventories where long ageing
processes are required to bring them to their saleable condition, for example wine and
spirits; and
ƒ storage costs that are necessary in the production process prior to the further production
stage, for example the maturation of cheese or the freezing storage that is necessary in
a manufacturing process.
Example 4.5
4.5
Allocation of overheads
Lima Ltd manufactures electrical motors. The normal capacity of the company is 50 000 units per
annum. If the actual capacity of the company is:
(1) 70 000 units per year (very high level of production); or
(2) 40 000 units per year,
calculate the fixed and variable overheads in the closing balance of finished goods and the
overhead expense in the statement of profit or loss and other comprehensive income.
The following information is available:
ƒ Fixed overheads amount to R7 500 000 per annum.
ƒ Variable production overheads amount to R200 per unit.
ƒ The closing balance of finished goods is 15 000 units. Assume that there was no opening balance.
continued
Inventories 67
Closing inventories:
Case 1
15 000 × R200
R7 500 000/70 000 × 15 000
Case 2
15 000 × R200
R7 500 000/50 000 × 15 000
Expenses (cost of sales):
Case 1
(70 000 – 15 000)(sold) × R200
(70 000 – 15 000) × R107,14 (7 500’/70’) (allocated)
Case 2
(40 000 – 15 000)(sold) × R200
(40 000 – 15 000) × R150 (7 500’/50’) (allocated)
R7 500 000 – R6 000 000 (40 000 × R150) (under-recovery)
Variable
overheads
R’000
Fixed
Total
overheads overheads
R’000
R’000
3 000
1 607
4 607
2 250
5 250
5 893
16 893
3 750
1 500
10 250
3 000
11 000
5 000
Comment
¾ Fixed overheads are usually allocated to cost of conversion using normal capacity (50 000 units
in this example). However, if the actual capacity is substantially higher than normal capacity,
actual capacity is used in order to prevent inventories from being measured above cost.
¾ Note that actual capacity may be used in cases where it approximates normal capacity –
however, this is not the case in this example.
¾ The under-recovered fixed overhead (Case 2) shall be recognised as an expense (Cost of
sales).
The principles regarding the allocation of production overhead costs can be presented
diagrammatically as follows:
TOTAL OVERHEAD COSTS
Production overheads
Variable
Fixed
Always allocated based on
actual production
Allocation based on normal
capacity (note exceptions)
Other overheads
Allocated in exceptional
cases only
Basic principle: Allocate costs if they are related (and necessary) to bring the inventories to
their present location and condition.
4.6 Application of cost allocation techniques and cost formulas
Other than the actual cost of inventories (discussed above), various other techniques can be
used to calculate the cost of inventories. The following are possibilities:
ƒ the standard cost method; and
ƒ the retail method.
68 Descriptive Accounting – Chapter 4
4.6.1 Standard cost
This method involves working with expected costs, based on normal levels of operations
and operating efficiency measures, and entails the application of predetermined information.
This method allows management to monitor and control costs. Standard costs can be used for
convenience as long as the measurement of inventory determined in this way approximates
cost. A regular review of the standard costs is required where conditions change, for
example in times of rising costs.
4.6.2 Retail method
This method is particularly suitable for entities that do not maintain complete records of
purchases and inventories. Inventory is measured at the end of the reporting period by
determining the selling price of the inventory, which is reduced by the average gross profit
margin, to determine the approximate cost. Suppose, for example, that the inventories of a
sports shop valued at selling price amounted to R980 000 on a particular date. If the owner
normally adds a mark-up of 25% to the cost price of his products, the retail method is
applied as follows to calculate the approximate cost of the inventories:
100
R980 000 ×
= R784 000
125
This basis can be applied only if the gross profit margins of homogenous groups of products
are known. If certain inventory items are marked at reduced selling prices as a result of
special offers, the gross profit margins on these items are determined individually. As with
standard costs, this basis may be applied only if the results obtained approximate cost.
4.6.3 Cost formulas
According to IAS 2.23 to .27, the cost of inventories is determined by using one of the
following cost formulas:
ƒ first-in, first-out (FIFO); or
ƒ weighted average costs; or
ƒ specific identification.
Note that last-in, first out (LIFO) is not allowed in terms of IAS 2. See section 4.6.4.
4.6.3.1 First-in, first-out (FIFO)
On this basis, inventories are measured in accordance with the assumption that the entity
will sell the items of inventory in the order in which they were purchased; that is, first the old
inventory items and then the new items. The ‘oldest’ prices are debited first to the statement
of profit or loss and other comprehensive income, forming part of the cost of sales expense.
This method is normally appropriate to interchangeable items of large volumes and is
currently the most popular method used by listed companies in South Africa.
4.6.3.2 Weighted average method
The word ‘weighted’ refers to the fact that the number of items is also taken into account
when calculating cost. The weighted average is calculated either after each purchase, or
periodically, depending on the particular circumstances. This basis, just as in the case of
FIFO, is appropriate to interchangeable inventory items, usually of large volumes.
Inventories 69
Example 4.6
4.6
Weighted average calculation
Assume that an entity purchases 100 units @ R16 each and purchases a further 300 units
@ R16,50 each. The average price is not R16,25 [(R16 + R16,50) ÷ 2]. It should rather be
weighted, as follows:
R
100 @ R16
1 600
300 @ R16,50
4 950
400
6 550
Weighted average price = R16,375 (R6 550/400)
Example 4.7
4.7
Application of cost formulas for perpetual and periodic inventory
recording systems
Romeo Ltd has incurred the following inventory transactions during the month of October 20.14:
Units
R/U
01.10 Opening balance
200
20
02.10 Sales
120
40
05.10 Purchases
300
24
15.10 Sales
200
48
20.10 Purchases
150
30
25.10 Sales
150
50
The cost price of inventory is determined using
(1) the FIFO method; and
(2) the weighted average method
First-in, first-out method:
31.10 Inventory on hand (200 – 120 + 300 – 200 + 150 – 150) = 180 units
R
Cost price 150 × R30 4 500 (from the purchase of 150 units @ R30/unit)
30 × R24
720 (left from the first purchase of 300 units @ R24/unit)
180
5 220
Comment
¾ Both the perpetual and the periodic inventory recording systems result in the same cost for inventory.
continued
70 Descriptive Accounting – Chapter 4
Weighted average method:
31.10
Inventories on hand
Perpetual inventory recording system:
180 units
Units
1.10
2.10
Opening balance
Sales
5.10
Purchases
15.10
Sales
20.10
Purchases
25.10
200
(120)
80
300
380
(200)
180
150
330
(150)
Sales
Closing balance
180
Cost price
per unit
R
20
20
Total
cost price
R
24
23,16 *
23,16 *
30
26,27 **
26,27
26,27
4 729
Calculations:
*80 × R20
300 × R24
380
R8 800/380
**180 × R23,16
150 × R30
330
R8 669/330
= R1 600
= R7 200
R8 800
= R23,16
= R4 169
= R4 500
R8 669
= R26,27
Periodic inventory recording system:
Units
Opening balance
Purchases
Purchases
200
300
150
650
Weighted average cost price (R15 700/650)
Closing inventories (180 × R24,15)
Comment
R24,15
Cost price
per unit
R
20
24
30
Total
cost price
R
4 000
7 200
4 500
15 700
4 347
¾ The cost of inventory calculated using weighted average differs under the perpetual and the
periodic inventory recording systems, as different averages are used.
4.6.3.3 Specific identification
According to IAS 2, this basis allocates costs to separately identified items of inventory,
usually of high value. It is particularly appropriate for items acquired or manufactured for a
specific project and items that are normally not interchangeable. This basis is generally not
suitable for large volumes of interchangeable items, and should not be used as a means of
manipulating profits.
4.6.3.4 Cost formulas in general
It is clear from the above discussion that there is a variety of measurement bases for
determining the costs of inventories. These valuation bases necessarily result in different
operating results and different statement of financial position amounts.
Inventories 71
IAS 2.25 requires that the same cost formula be used for inventories having the same
nature and use for the entity. Where the nature or use of groups of items differs from
others, the application of different methods is allowed. This means that if a group of
companies owns materials with different uses, they may be measured by using different cost
formulas. Where inventories are similar in nature and use, and held in different geographical
locations, different cost formulas may not be applied. For example, where different metals
are used in a production process, the average method is appropriate. However, where
inventories are used on an item-for-item basis in the production process, the FIFO formula is
more appropriate. However, in the computerised environment of costing systems, any cost
formula is appropriate and with even price increases will always produce the same result.
4.6.4 Other cost formulas
Other cost formulas that are sometimes encountered in practice are the LIFO (last-in,
first-out) formula and the formula based on latest purchase price, neither of which is
sanctioned by IAS 2.
The LIFO formula is the opposite of the FIFO formula, inasmuch as it assumes that the unit
of inventory that was purchased last will be the first to be sold. The result is that current
costs are recognised against current revenue in the statement of profit or loss and other
comprehensive income, leading to an improvement in the quality of reported earnings.
However, in the statement of financial position, inventories are reflected at prices that
prevailed long ago, with little or no relationship to current costs.
As IFRS is more focused on the statement of financial position and not on the statement of
profit and loss and other comprehensive income, the measurement of inventories at the
latest purchase price is unacceptable, since such a valuation bears no relationship to the
actual cost at which the inventories were purchased.
4.7 Determining net realisable value
Net realisable value (NRV) is the estimated selling price that could be realised in the
normal course of business, less the estimated costs to be incurred in order to complete the
product and make the sale. Such estimates will take into account changes in prices and cost
changes after the reporting date, in accordance with the requirements of IAS 10, to the
extent that events confirm conditions existing at the end of the reporting period. The diagram
below illustrates net realisable value:
NET REALISABLE VALUE
Estimated selling price in the
normal course of business
Less
Costs to make the sale,
namely:
ƒ costs to complete the inventories
(if cost elements are not fully
completed, e.g. work in progress);
ƒ trade and other discounts allowed;
ƒ advertising;
ƒ sales commission;
ƒ packaging; and
ƒ transport costs.
As the determination of net realisable value entails the use of estimates, an element of
judgement is involved, and the necessary caution should be exercised when making use of
these estimates. It is often difficult to determine the net realisable value of a product, due to a
72 Descriptive Accounting – Chapter 4
lack of information regarding the costs necessary to make the sale. In such cases, the current
replacement value can be used as a possible solution (especially for raw materials) (refer to
IAS 2.32). After having taken everything into consideration, estimates of the NRV should be
based on the most reliable information available at the time of making the estimate.
If the inventories are held in terms of a binding sales contract in terms of which the
inventories will be delivered at a later date, the NRV of these inventories should be based
on the contract price. If the contract quantities are less than the total inventories for this
particular item, the net realisable value of the non-contracted inventories is based on
normal selling prices. Any expected losses on firm sales contracts in excess of the inventory
quantities held are dealt with by IAS 10.
If inventory quantities are less than quantities required for firm purchase contracts, onerous
contracts may arise and the provisions of IAS 37 will apply.
4.8 Lower of cost and net realisable value
4.8.1 General rule
The requirement by IAS 2 that inventories be reflected at the lower of cost or net realisable
value (NRV) is the application of a measure of conservatism when exercising judgement in
making estimates under uncertain conditions.
In accordance with this rule, inventories are measured at cost at the end of an accounting
period and are carried over to the following accounting period. This cost should, however,
not exceed the net amount, which, according to estimates, will be realised from the sales.
Should the cost exceed the NRV, it implies that the inventories are expected to be sold at an
estimated loss. This estimated loss should be recognised in accordance with the
characteristic of faithful representation as soon as it is probable that the loss will occur and it
can be measured. The cost is then reduced to the net realisable value and the write-off is
recognised and shown as a loss in the profit or loss section of the statement of profit or loss
and other comprehensive income as part of the cost of sales line item. If such inventories
are still unsold at the end of the following accounting period, the cost is compared with the
latest NRV, and the carrying amount is adjusted accordingly.
Inventories are written-down to net realisable value on an item-by-item basis, or (where
appropriate) a group-by-group basis. In cases where items relate to the same product
range, have similar purposes or end uses, and are marketed in the same geographical area,
they cannot be evaluated separately; therefore, the items belonging to the range are
grouped together in assessing NRV. It should be noted that ‘finished goods’ or ‘inventory of
shoes’ are probably not product ranges.
Example 4.8
4.8
Net realisable value per item and per group
The following schedules reflect the inventory values of Juliet Ltd on 31 December 20.14:
Net
Lowest
realisable
value
Cost
value
per item
R’000
R’000
R’000
Wall tiles
Hand-painted
6 000
7 500
6 000
Normal process
10 000
9 000
9 000
*16 000
16 500
15 000
continued
Inventories 73
R’000
Net
realisable
value
R’000
Lowest
value
per item
R’000
48 000
53 000
16 000
36 000
58 000
20 000
36 000
53 000
16 000
117 000
114 000
105 000
133 000
130 500
120 000
Cost
Bricks
A Type
B Type
C Type
Total inventory
According to IAS 2.29, inventories can be measured as follows:
Item-by-item:
R15 million + R105 million = R120 million or
Per group (if conditions were met): R16 million* + R114 million = R130 million
Comment
¾ A comparison of the total cost (R133 million) of the inventories with the total net realisable value
(R130,5 million) is not permitted by IAS 2, because unrealised profits and losses may not be
netted against each other.
A new assessment of net realisable value is made in each financial year. Indicators of
possible adjustments to net realisable value may include:
ƒ damaged inventories;
ƒ wholly or partially obsolete inventories;
ƒ declines in selling prices;
ƒ increases in estimated costs to completion; and
ƒ increases in selling costs.
When there is clear evidence of an increase in net realisable value because of changed
economic circumstances, or because the circumstances that previously caused inventories
to be written-down below cost no longer exist, the amount of the write-down is reversed, but
the amount of the reversal is limited to the amount of the original write-down, as assets may
not be restated above their original cost. The new carrying amount is again the lower of the
cost and the (revised) net realisable value. This may, for example, occur when an item of
inventory that is carried at net realisable value, because its selling price has declined, is still
on hand in a subsequent period, and its selling price has now increased. This will occur in
extremely rare cases, as inventory is normally sold in the subsequent accounting period.
Example 4.9
4.9
Reversal of previous net realisable value adjustment
Pappa Ltd purchases and distributes a medical product, Hasim. On 30 June 20.14, Pappa Ltd had
1 500 units of Hasim on hand. These units were purchased at a cost of R50 each. Two weeks
before the end of the reporting period, an announcement was made in the press that Hasim
contains some ingredients which may have harmful side-effects for users. Management decided
that this product would not be sold until further research into the possible side-effects had been
done. A company that manufactures bathroom cleaner advised that Hasim can be used in its
manufacturing process, and made a public offer to buy the product from Pappa Ltd at a price of
R20 per unit. For accounting purposes, the inventories on hand on 30 June 20.14 should be
written-down as follows:
R
Cost per unit
50
Net realisable value per unit
20
Write-down per unit
Total write-down recognised by Pappa Ltd (1 500 × R30)
30
45 000
continued
74 Descriptive Accounting – Chapter 4
Pappa Ltd decided not to sell the product until the results of the research were known. During
December 20.14, the results of the research indicated that there are no harmful side-effects from
the use of Hasim. The market was, however, still sceptical, and as a result sales were slow. On
30 June 20.15, Pappa Ltd still had 600 of the units that had been on hand on 30 June 20.14 on
hand. The market selling price had however increased to R70 per unit.
In terms of IAS 2, Pappa Ltd has to reverse the previous write-offs on Hasim to the net realisable
value on 30 June 20.15. The write-off is limited to the original cost of the inventory. In this case,
the lower of cost (R50) and net realisable value (R70) would be the original cost of R50 per unit.
Note that the reversal can only be done for the 600 units still on hand on 30 June 20.15.
The reversal of write-off for the year ended 30 June 20.15 would amount to R18 000, namely
(600 × (R50 – R20)).
4.8.2 Exceptions
One exception to the general rule that inventories must be valued at the lower of cost and
net realisable value is mentioned in IAS 2.32. In accordance with this stipulation, raw
materials or supplies that will be incorporated in the finished product are not written-down
below cost if the finished product is expected to be sold at or above cost. In the authors’
opinion, IAS 2 gives insufficient guidance in cases where the finished product sells at less
than the cost. By implication, it appears that the raw materials and other supplies should be
written-down to NRV in these cases.
Example 4.10
4.10
Raw materials: Replacement value vs NRV
Consider the following two cases:
NRV of finished product
Cost per unit of finished product
Raw materials @ cost
Labour
Overheads
Profit/(loss) per product
Replacement value of raw material component of finished product
Case A
R
190
190
Case B
R
189
190
100
65
25
100
65
25
–
(1)
80
80
Comment
¾ IAS 2.32 states that the replacement value of the materials may be the best indicator of the
NRV of the materials. In this example it is assumed to be R80.
¾ If the current instructions per IAS 2.32 are strictly adhered to, then the raw material component
in Case A should be reflected at R100 per unit in the statement of financial position, while in
Case B it should be reflected at R80 (lower of cost and NRV), if the replacement cost is used as
the net realisable value.
¾ It is apparent that, as a result of a drop of only R1 in the selling price of the finished product, raw
materials must be written down by R20 per unit. Alternatively stated, although R1 of the
historical cost is irrecoverable, R20 of the costs should be recognised immediately in the current
period’s statement of profit or loss and other comprehensive income.
¾ In Case B, the authors propose that the raw material component should be reflected at R99.
The net realisable value of R99 is calculated as the selling price of the finished products, less
costs to sell (given as R189 in Case B), less costs to complete of R90 (R65 + R25).
The principles applicable in this case may be summarised as follows:
– Costs should be deferred only to the extent to which they are expected to be recovered from
the inflow of future revenues.
continued
Inventories 75
– Where materials will be realised, not through direct sale, but through the sale of the finished
product in which the materials are used, the NRV of the materials should be seen as that
amount which will be realised from the sale of the particular finished product ‘in the normal
course of business’.
¾ To complicate the matter further, IAS 2.32 states that the replacement value of the materials
may be the best indicator of the NRV of the materials. The authors, however, abide by the
alternative approach, namely of assessing the realisation value of the finished goods in order to
determine whether raw materials should be impaired.
Example 4.11
4.11
Net realisable value
Beta Limited completed 100 000 units, whilst 20 000 units are 60% completed in respect of
conversion costs. 85 000 units were sold during the year. At reporting date, 16 000 kgs of raw
material were on hand. There were no opening inventories.
Estimated selling price of a completed product
R
200
Raw material 2 kg @ R50
Labour
Production overhead
100
65
25
Unit cost of the completed product
190
Calculate the net realisable value if the expected selling cost is 20%
Net realisable value per unit:
Completed goods: 200 – 10% = R180 per unit
Raw material: 180 – 25 – 65 = R90. Per raw material unit: 90/2 = R45
Completed goods:
At cost: (100 000 – 85 000) × 190
At net realisable value (15 000 × 180)
Net realisable value is the lowest
R’000
2 850
2 700
Comment
¾ Seeing that the net realisable value of the completed goods is lower than the cost, the net
realisable value of raw material should also be tested. The work in progress should also be
adjusted accordingly.
Raw material
At cost: (100/2 = R50 per kg, 16 000 × 50)
At net realisable value: (R45 (above) × 16 000)
800
720
continued
76 Descriptive Accounting – Chapter 4
Work in progress
At cost:
Raw material (100 × 20 000)
Labour and production overhead ((65 + 25) × 20 000 × 60%)
2 000
1 080
3 080
At net realisable value:
Net realisable value if completed (180 × 20 000)
Less: Cost to complete ((65 + 25) × 20 000 × 40%)
3 600
(720)
2 880
Alternatively: 20 000 × 90 + 20000 × 60% × (65 + 25) = R2 880 000
Comment
¾ If the net realisable value of the completed goods is lower then the cost, both the raw materials
and the work in progress should be adjusted accordingly.
Caution should be applied in cases where the NRV of the raw material component drops
below the cost, particularly where the raw materials form a significant part of the finished
product. This could mean that the selling price of the finished product will also have to drop,
particularly in cases where the selling price of a product reacts sensitively to changes in the
cost of the raw material components.
A further exception to the general rule stated in IAS 2.14 relates to by-products. As
mentioned previously, by-products are the inevitable result of a production process directed
at the production of another (primary) product. The costs of the primary product, which
consist of raw material, labour and allocated production overhead costs, are allocated to the
primary product in total. The by-product normally has no cost price and should be valued at
net realisable value, as long as this value is deducted from the joint costs of primary
products before being allocated to the individual products.
A further exception exists in respect of inventories acquired for the construction of own plant
and equipment of the entity. In this case, the principle that applies is that such inventories
are written-down only as the plant and equipment depreciate, after the costs of these
inventories have been incorporated into the cost of the plant and equipment.
4.9 Recognition of an expense
The carrying amount of inventories is recognised as an expense when the inventories are
sold and the revenue is recognised. The sales and corresponding expenses may be
recognised throughout the period if the entity uses a perpetual inventory system. The
expense is recognised only at the end of the period if a periodic inventory recording system
is used.
Any write-down of inventories to NRV for damages, obsolescence or fluctuations in costs or
selling prices forms part of the cost of sales expense, but is written off and recognised
directly in the profit or loss section of the statement of profit or loss and other
comprehensive income.
These write-downs are, however, disclosed separately in the financial statements. It is
important to distinguish between write-downs that should be disclosed and inventory losses
that do not have to be disclosed separately. Inventory losses arise typically when the
physical inventories on hand differ from the inventory records.
Where write-downs of inventories are reversed due to subsequent increases in NRV, the
amount is recognised as a reduction in the cost of sales expense in the profit or loss section
of the statement of profit or loss and other comprehensive income. The reversal of any
write-downs should also be disclosed separately.
Inventories 77
Example 4.12
4.12
Composition of the cost of sales expense
The cost of sales expense of a manufacturing company may include the following expenses:
Cost of inventories (finished products sold) (calc 1) (allocated costs)
Abnormal spillage of raw material, labour and other production costs (not allocated)
Under- or over-allocation of fixed production overheads (not allocated) (calc 4)
Inventory write-downs (inventories losses)
Inventory write-downs to NRV
Recovery of NRV write-down
Cost of sales
(1) Cost of inventories (finished products sold)
Opening inventories (finished products)
Transferred from work-in-progress (calc 2)
Closing inventories (finished products)
Cost of inventories (sold)
(2) Work-in-progress
Opening inventories (work-in-progress)
Direct raw materials (calc 3)
Direct labour
Variable production overheads (allocated)
Fixed production overheads (allocated)
Closing inventories (work-in-progress)
R
xxx xxx
xxx xxx
xxx xxx
xxx xxx
xxx xxx
(xxx xxx)
xxx xxx
xxx xxx
xxx xxx
(xxx xxx)
xxx xxx
xxx xxx
xxx xxx
xxx xxx
xxx xxx
xxx xxx
(xxx xxx)
Transferred to finished products
xxx xxx
(3) Direct raw materials
Opening inventories
Purchases
xxx xxx
xxx xxx
Cost
Other purchase costs
xxx xxx
xxx xxx
Abnormal spillage
Closing inventories
Transferred to work-in-progress
(4) Under-/over-allocated fixed production overheads
Incurred
Allocated (actual units produced × rate based on normal capacity)
Under-/over-allocation of fixed production overheads
(xxx xxx)
(xxx xxx)
xxx xxx
xxx xxx
(xxx xxx)
xxx xxx
4.10 Taxation implications
The tax aspects of trading stock are contained in sections 11(a), 22 and 22A of the Income
Tax Act 58 of 1962. Although the details are too extensive for the purposes of this
paragraph, the most important aspects are detailed below:
ƒ Trading stock may be shown at the lower of cost and net realisable value. However,
financial assets, such as shares, held as inventories may not be written down to their net
realisable value.
ƒ The LIFO cost formula may not be applied for tax purposes when determining the value
of the inventories (and is also not allowed under IAS 2).
ƒ Any inventories acquired free of charge must be included at the market value on the
date of acquisition. Special rules apply to inventories received from schemes of
arrangement, reconstruction and amalgamation.
78 Descriptive Accounting – Chapter 4
ƒ Trading stock includes all inventories, according to IAS 2. Spares and consumables such
as unused stationery, maintenance spares, fuel, lubricants and cleaning agents kept by
an entity to be utilised in operation, are also included in the definition of trading stock.
From the above it would appear that there are minimal differences between inventories as
defined for accounting purposes, and trading stock for tax purposes. If differences occur,
their nature should be determined, because deferred tax may have to be provided for on
such differences.
4.11 Disclosure
The following disclosure requirements regarding inventories are prescribed by IAS 2.36
to .39:
ƒ the accounting policy pertaining to the measurement and the cost formula used;
ƒ the total carrying amount of inventories in classifications suitable for the entity, for example:
– materials (materials and spares included);
– finished goods;
– merchandise shown under appropriate subheadings;
– consumable goods (including maintenance spares);
– work-in-progress (including the inventory of a service provider); and
– work-in-progress – construction work;
ƒ the carrying amount of inventories carried at fair value less costs to sell of commodity
brokers/traders;
ƒ the amount of inventories recognised as an expense during the period;
ƒ the amount of any write-down of inventories recognised as an expense;
ƒ if such a write-down is reversed in a subsequent period, the amount reversed and the
circumstances which resulted in the reversal; and
ƒ the carrying amount of any inventories pledged as security.
Note that the disclosure of the carrying amount of inventories carried at net realisable value
is not required, but that the amount of any write-down of inventories should be disclosed,
typically in the note on profit before tax. Note also that disclosure of the carrying amount of
inventories carried at fair value less costs to sell is required, for example in the case of
commodity brokers/traders.
In terms of IAS 1, the format of the profit or loss section of the statement of profit or loss and
other comprehensive income may be dictated by the nature or the function of expenses. In
accordance with the functional approach, the cost of sales will be disclosed as a line item
and the disclosure requirements of IAS 2 will be met, provided that separate disclosures of
write-downs and the reversals of write-downs and their circumstances are given.
Entities using the nature of expenses approach will disclose operating costs such as raw
materials, labour costs, other operating costs and the net movement in finished goods and
work-in-progress, where applicable. To comply with IAS 2, the cost of such expenses will
have to be disclosed elsewhere in the financial statements. The disclosure of the cost of
sales expense does allow for the calculation of the gross profit margin, but the calculation may
not support comparison with other entities, as the composition of the amounts may differ.
Inventories 79
Example 4.13
4.13
Disclosure of the statement of profit or loss and other comprehensive
income using function or nature
Assume that the following are the details for the calculation of the profit before tax of a
manufacturing entity for the year ended 31 December 20.14:
R
Revenue
7 500 000
Cost of finished goods sold
3 995 100
Direct materials used
Labour
Variable production overhead costs allocated
Fixed production overhead costs allocated
Packing material
910 100
1 200 000
800 000
845 000
310 000
Cost of finished goods manufactured
Opening inventory: finished goods
Closing inventory: finished goods
4 065 100
70 000
(140 000)
Selling and administrative expenses
Write-down of cost of materials to net realisable value
Over-recovery of fixed production overhead costs
Abnormal spillage of materials
1 735 000
25 000
(41 000)
15 000
This will be disclosed as follows in the first part of the statement of profit or loss and other
comprehensive income:
Statement of profit or loss and other comprehensive income
for the year ended 31 December 20.14
If by function:
Revenue
7 500 000
Cost of sales (3 995 100 + 25 000 – 41 000 + 15 000)
(3 994 100)
Gross profit
Other expenses
Profit before tax
3 505 900
(1 735 000)
1 770 900
OR
If by nature:
Revenue
Changes in inventories (140 000 – 70 000)
Direct material used (910 100 + 310 000 + 15 000 + 25 000)
Labour costs
Other expenses
Production overhead costs:
Variable
Fixed (845 000 – 41 000)
Selling and administrative expenses
Profit before tax
7 500 000
70 000
(1 260 100)
(1 200 000)
(800 000)
(804 000)
1 735 000
1 770 900
4.12 Comprehensive example
Inyati Ltd’s inventories consist of the following:
Raw materials
Work-in-progress
Finished goods
Packaging materials
Opening
inventories
R’000
35 000
15 000
40 000
1 750
Closing
inventories
R’000
15 000
25 500
20 500
1 600
Net realisable
value
R’000
14 500
20 000
30 000
1 135
80 Descriptive Accounting – Chapter 4
The following information is available for the year ended 31 December 20.14:
R’000
275 000
75 000
90 000
250
50 250
41 500
2 750
Sales
Administrative expenses
Raw material purchases
Transport costs – raw materials
Variable production overhead costs, including direct labour
Fixed production overhead costs, including indirect labour
Selling expenses
Inyati Ltd measures raw materials and work-in-progress using the first-in, first-out method. Finished
goods and consumables are measured using the weighted average method. Fixed production
overhead costs are allocated at R40 per unit on the basis of a normal capacity of 1 million units.
Inyati Ltd
Extract from the statement of financial position as at 31 December 20.14
Note
Assets
Current assets
Inventories
3
R’000
62 135
Inyati Ltd
Extract from the statement of profit or loss and other comprehensive income
for the year ended 31 December 20.14
R’000
275 000
(211 465)
Revenue
Cost of sales
Gross profit
63 535
Inyati Ltd
Extract from the notes for the year ended 31 December 20.14
1. Accounting policy
1.1 Inventories
Inventories are measured at the lower of cost and net realisable value using the following
valuation methods:
Raw materials and work-in-progress: first-in, first-out method
Finished goods and consumables: weighted average method
2. Profit before tax
Profit before tax includes the following item:
Consumables written off to net realisable value (1 600 – 1 135)
3. Inventories
Raw materials
Work-in-progress
Finished goods
Consumables
R’000
465
15 000
25 500
20 500
1 135
62 135
Calculations
Inventories
Opening inventories
Plus purchases/transfers received
Plus other costs
Less transfers/sales
Closing inventories
Raw
materials
R’000
Work in
progress
R’000
Finished
goods
R’000
35 000
90 000
250
(110 250)
15 000
110 250
*90 250
(190 000)
40 000
190 000
–
(209 500)
15 000
25 500
20 500
* 50 250 000 + (40 × 1 000 000)
continued
Inventories 81
Cost of sales
Cost of inventories (finished goods) sold
Fixed production overhead costs – under-recovery (41 500 000 – 40 000 000)
Consumables written off to net realisable value**
R’000
209 500
1 500
465
211 465
**
Raw materials, work-in-progress and other supplies held for use in the production of inventories are not
written-down below cost if the finished products in which they will be incorporated are expected to be sold at
or above cost. The consumables are however written down to their net realisable value.
CHAPTER
5
Statement of cash flows
(IAS 7)
Contents
5.1
5.2
5.3
5.4
5.5
5.6
5.7
Overview of IAS 7 Statement of Cash Flows ....................................................
Background .......................................................................................................
Objective of the statement of cash flows ...........................................................
Elements of cash flows ......................................................................................
5.4.1 Cash and cash equivalents ....................................................................
5.4.2 Cash flows from operating activities .......................................................
5.4.3 Cash flows from investing activities ........................................................
5.4.4 Cash flows from financing activities ........................................................
5.4.5 Net increase or decrease in cash and cash equivalents ........................
Specific aspects ................................................................................................
5.5.1 Group statements ...................................................................................
5.5.2 Interest and dividends ............................................................................
5.5.3 Taxes ......................................................................................................
5.5.4 Value-added tax (VAT) ...........................................................................
5.5.5 Gross figures ..........................................................................................
5.5.6 Foreign currency cash flows ...................................................................
5.5.7 Leases ....................................................................................................
5.5.8 Discontinued operations .........................................................................
Disclosure ..........................................................................................................
Comprehensive example ...................................................................................
83
84
85
85
86
86
87
89
92
92
93
93
98
98
99
100
101
103
103
103
104
84 Descriptive Accounting – Chapter 5
5.1 Overview of IAS 7 Statement of Cash Flows
Objectives of the statement of cash flows
ƒ to provide users with useful information in respect of historical changes in cash and cash
equivalents of an entity; and
ƒ to enable the users to formulate an opinion and make a better estimate of the cash
performance of an entity.
Cash and cash equivalents
ƒ Cash consists of cash on hand and demand deposits.
ƒ Cash equivalents consist of short-term (<3 months) highly liquid investments that are readily
convertible to known amounts of cash.
Elements of
cash flow:
Cash flows are
divided into
three
categories.
There is a
mathematical
relationship
between these
categories.
Cash flows from operating activities
ƒ Chief revenue-producing activities.
ƒ Cash effect of transactions that are used in determining profit or loss.
ƒ Present in one of two ways: Indirect method or Direct method.
+/–
Cash flows from investing activities
ƒ Activities which relate to the acquisition and disposal of long-term assets
and other investments.
ƒ Distinguish between maintenance of operating capacity and increase in
operating capacity.
ƒ Present gross receipts and gross payments.
+/–
Cash flows from financing activities
ƒ Activities that result in changes in size and composition of the borrowings
and contributed equity.
ƒ Present gross receipts and gross payments.
=
Net movement in cash and cash equivalents.
Specific aspects
ƒ Group statements: control gained or lost in a subsidiary = single line item in consolidated
statement of cash flows as part of investing activities.
ƒ Interest and dividends paid and received are disclosed separately.
ƒ Taxes:
– Taxation paid is normally shown separately as cash flows relating to operating activities.
– Deferred tax is not a cash flow.
– The cash flow effect of VAT is disclosed under cash generated from operating activities.
ƒ Foreign currency cash flows:
– Unrealised foreign exchange gains and losses do not represent cash flows.
– Realised foreign exchange gains and losses are viewed as cash flows.
– Exchange gains or losses relating to cash and cash equivalents must be reported separately.
ƒ Repayments of a lease for the lessee are divided between capital and interest portions:
– Interest = classified as operating activities.
– Capital = classified as financing activities.
ƒ Cash flows from discontinued operations should be disclosed under each category of cash
flows.
ƒ Additional disclosure requirements:
– Information on non-cash financing and investing activities;
– Components of cash and cash equivalents;
– Reconciliation of cash and cash equivalents in the statement of cash flows and the
corresponding items in the statement of financial position;
– Cash and cash equivalents not available for use by the group; and
– Accounting policy for composition of cash and equivalents.
Statement of cash flows 85
5.2 Background
In terms of IAS 1.9 and .10, a statement of cash flows is one of the components of a
complete set of financial statements prepared by entities that provide information about the
financial position, performance and changes in financial position of such entities. A
statement of cash flows is presented in accordance with IAS 7.
For cash flows, the activities of an entity are categorised into three main classes (IAS 7.10):
ƒ operating activities (activities that are revenue-producing);
ƒ investing activities (activities that are needed to support the income-generating
process, e.g. investing in fixed and other long-term assets); and
ƒ financing activities (activities that have as their objective the organising of the financing
requirements of the entity, e.g. obtaining loans and issuing shares).
Non-cash transactions are not included in the statement of cash flows (IAS 7.43). Where
an asset is, for example, acquired via mortgage bond financing, no cash changes hands and
the transaction is therefore not reflected in the statement of cash flows. This also applies
where assets are exchanged, shares are issued to acquire another entity, or where liabilities
are converted to equity. These transactions are, however, disclosed in the notes to the
financial statements, so that all relevant information is supplied to the users of the statements.
In reality, the statement of cash flows represents a summary of the movement of the cash
and bank balances (cash and cash equivalents) of entities for the period under review.
‘Cash’ refers to cash on hand and demand deposits, while ‘cash equivalents’ refers to shortterm highly liquid investments that are readily convertible to known amounts of cash and are
subject to an insignificant risk of changes in value.
5.3 Objective of the statement of cash flows
The objective of the statement of cash flows is:
ƒ to provide useful information on how an entity generates cash and how an entity
utilises cash;
ƒ in respect of the historical changes;
ƒ in cash and cash equivalents.
The statement of cash flows enables the users of financial statements to formulate an opinion
and make a better estimate of the cash performance of an entity. The users may find the
information useful for the following purposes:
ƒ to formulate an opinion regarding the risk profile of an entity by paying particular
attention to the ability of the entity to:
– pay interest and dividends;
– make capital repayments on borrowed funds; and
– access the appropriate sources of financing to finance the activities of the entity;
ƒ to forecast the cash that will probably be available in the future to finance expansions;
ƒ to determine which sources of cash have been used to finance operating and investing
activities;
ƒ to evaluate whether the entity is capable of generating sufficient cash flows from
operating activities for a part thereof to be ploughed back into the entity;
ƒ to evaluate the timing and certainty of generated cash in order to assess the ability of the
entity to adapt to changing circumstances;
ƒ to enhance the comparability of the operating results of different entities by eliminating
the effects of different accounting policies; and
ƒ to determine the relationship between the profitability and cash flows of the entity.
86 Descriptive Accounting – Chapter 5
The provision of cash flow information is primarily aimed at more effectively informing users
about the liquidity and solvency of the entity. This information is of the utmost importance,
as a cash deficit could result in financial failure. A statement of cash flows could timeously
identify possible problems in this regard, as it provides quality information about the timing
and amounts of the cash flows of an entity.
IAS 7 is applicable to all entities, even financial institutions where cash is viewed as
inventories of the entity. To accommodate financial institutions such as banks and
investment companies, IAS 7 allows certain cash flows to be reported on a net basis.
Remember that financial statements (except the statement of cash flows) are prepared on
an accrual basis, namely accounting for transactions when they occur. However, the
statement of cash flows presents the actual cash receipts and cash payments of the
transactions for the period.
5.4 Elements of cash flows
Cash flows in the statement of cash flows are divided into three categories as follows:
ƒ cash flows from operating activities;
ƒ cash flows from investing activities; and
ƒ cash flows from financing activities.
There is a mathematical relationship between these three categories, in that cash retained
from operating activities plus the cash proceeds of financing activities is used in investing
activities. Conversely, cash retained from operating activities may be utilised for both
investing and financing activities. Other combinations also exist.
IAS 7.11 does not prescribe a specific format for the statement of cash flows but suggests
instead that the format most appropriate to the entity’s business be used to present the cash
flows from operating, investing and financing activities.
The classification of cash flows by activity may result in cash flows originating from one
transaction being disclosed under two activities. For instance, the repayment of a loan is
shown under financing activities, while the payment of interest is shown under operating
activities. Furthermore, items such as interest and dividends may be shown under operating,
investing or financing activities (IAS 7.31).
5.4.1 Cash and cash equivalents
Cash consists of cash on hand and demand deposits, while cash equivalents consist of
short-term highly liquid investments that are readily convertible to known amounts of cash
that are subject to an insignificant risk of changes in value (IAS 7.6).
Short-term is usually viewed as three months or less from the date of acquisition. Equity
investments are usually not classified as cash equivalents, while bank overdrafts normally
are. Bank borrowings are generally considered to be financing activities. Cash movements
between cash and cash equivalents are not reflected separately, as they are part of the
normal cash management activities of the entity to which the statement of cash flows
reconciles.
The reporting entity discloses the accounting policy for determining cash and cash
equivalents and discloses a reconciliation of the components to the equivalent items in the
statement of financial position (IAS 7.45 and .46). If the policy adopted for determining
components is changed by the entity, it is accounted for in accordance with IAS 8
Accounting Policies, Changes in Accounting Estimates and Errors.
If cash and cash equivalents are held in a foreign currency and are subsequently
converted to the reporting currency, the effect of the changes in foreign currency exchange
rates is reported in the statement of cash flows in order to reconcile cash and cash
equivalents at the beginning and the end of the period. This amount should be disclosed
separately from cash flows from operating, investing and financing activities (IAS 7.28).
Statement of cash flows 87
5.4.2 Cash flows from operating activities
Operating activities are normally the principal revenue-producing activities of the entity,
and include other activities that do not constitute investing or financing activities (IAS 7.14).
The cash generated from operating activities (or conversely, the cash deficit from operating
activities) is normally the cash effect of transactions and other events that is used in
determining profit or loss. This represents the difference between the cash received from
customers during the period and cash paid in respect of goods and services. It also
includes the following:
ƒ cash receipts from royalties, fees, commissions and other revenue;
ƒ cash payments to and on behalf of employees (such as contributions to pension funds);
ƒ cash payments or refunds of income taxes (unless they can be specifically linked to
financing and investing activities); and
ƒ cash receipts and payments from contracts held for dealing or trading purposes, since
such contracts constitute the inventories of the particular entity (IAS 7.14).
The amount of cash flows from operating activities enables the users of the financial
statements to evaluate the cash component of the normal operating activities for the period,
and in doing so, to assess the quality of the earnings. It also gives an indication of the
extent to which the operations of the entity have generated sufficient cash flows to repay
loans, maintain the operating capability of the entity, pay dividends and make new
investments without having to resort to external sources of financing.
Cash generated from operations is calculated in one of two ways (IAS 7.18) i.e.:
ƒ the indirect method; or
ƒ the direct method,
and is disclosed as such in the statement of cash flows.
Although IAS 7.19 encourages entities to use the direct method to report cash flows from
operating activities, no prescriptive guidance is given in IAS 7 about the circumstances
under which the respective methods should be used. This situation calls for the application
of consistency in terms of IAS 8 Accounting Policies, Changes in Accounting Estimates
and Errors. If a Standard allows a choice of accounting policy, but is silent on the manner of
exercising that choice, one is chosen and applied consistently. Here the entity should
choose between the direct or indirect method, and the chosen method should be applied
consistently from year to year.
5.4.2.1 The indirect method
Under the indirect method (IAS 7.18(b)), cash generated by operations comprises two
disclosable components, namely profit before working capital changes, and changes in
working capital.
ƒ Profit before working capital changes: This amount is calculated by adjusting the
profit before tax for investment income and interest charges (because investment
income and interest charges are disclosed separately as components of cash flow from
operating activities) and for those items that do not involve a flow of cash. Examples of
the latter include the following:
– depreciation charges;
– gains or losses on disposal of property, plant and equipment;
– impairment losses;
– unrealised foreign exchange gains or losses;
– fair value adjustments;
– undistributed profits of associates/joint ventures; and
– non-controlling interests.
88 Descriptive Accounting – Chapter 5
ƒ Changes in working capital: Movements in working capital, in other words, changes in
current assets and current liabilities, are taken into consideration in determining the cash
generated from operations. Examples of the latter include the following:
– inventories;
– receivables;
– payables;
– provisions;
– income received in advance;
– expenses payable; and
– prepaid expenses.
However, tax and dividends payable are excluded, as these are dealt with individually in the
statement of cash flows. In addition, cash at bank, cash on hand and cash equivalents such
as money market instruments are also excluded from the calculation, as these represent the
opening and closing balances respectively of the statement of cash flows.
5.4.2.2 The direct method
In accordance with the direct method (IAS 7.18(a)), cash generated from operations is
disclosed as being the difference between the following two items:
ƒ gross cash receipts from customers; and
ƒ gross cash paid to suppliers and employees.
Only the major classes of gross cash receipts and gross cash payments are disclosed in
accordance with this method. These two amounts cannot be deduced directly from the profit
or loss section of the statement of profit or loss and other comprehensive income, and they
therefore provide additional useful information that can be used in estimating future cash
flows.
The amounts are determined either by referring to the entity’s accounting records, or making
the necessary additional calculations. For a trader, these ‘additional calculations’ entail
adjusting sales and cost of sales for changes in inventories, receivables, payables and other
non-cash items, and other items for which the cash effects are investing or financing cash
flows.
The following example illustrates the difference between disclosures using the indirect and
direct methods.
Example 5.1
Indirect and direct method
Indirect method:
Cash flows from operating activities
Profit before tax
Adjustments:
– Depreciation
– Gain on disposal of equipment
– Investment income
– Finance costs
Net changes in working capital
Cash generated from operations
R
250 000
15 000
(2 500)
(5 000)
20 000
3 000
280 500
continued
Statement of cash flows 89
R
Direct method:
Cash flows from operating activities
Cash receipts from customers
Cash paid to suppliers and employees
Cash generated from operations
950 000
(669 500)
280 500
5.4.3 Cash flows from investing activities
Investing activities are activities that relate to the acquisition and disposal of long-term
assets and other investments which do not fall within the definition of cash equivalents.
The separate disclosure of cash flows arising from investing activities is important because
the cash flows represent the extent to which expenditures have been made for resources
intended to generate future income and cash flows. Only expenditure that results in a
recognised asset in the statement of financial position is recognised under investing
activities.
In IAS 7.16, the following examples of cash flows arising from investing activities are given:
ƒ cash payments to acquire property, plant and equipment, including capitalised
development costs and self-constructed property, plant and equipment, intangible assets
and other long-term assets;
ƒ cash receipts from the disposal of property, plant and equipment, intangible assets and
other long-term assets;
ƒ cash payments to acquire or cash receipts to dispose of equity or debt instruments of
other entities and interests in joint ventures;
ƒ cash advances and loans to other parties (other than financial institutions), or cash receipts
from their repayment; and
ƒ cash payments or receipts for financial futures contracts, forward contracts, options and
swap contracts, except where these are held for speculative purposes, or if they are
classified as financing activities.
Cash flows of a hedging instrument are classified in the statement of cash flows in the same
way as the hedged item (IAS 7.16).
It should be remembered that movements in property, plant and equipment and investments
may not, in all instances, result in a flow of cash. Amongst such non-cash transactions are
internal transactions such as revaluations, impairments, the scrapping of assets, and
routine depreciation charges. Certain external transactions, such as the purchase of assets
financed by a mortgage bond, via an equity issue or a lease arrangement, will also not
lead to cash flows.
90 Descriptive Accounting – Chapter 5
Example 5.2
Assets acquired without cash outflows or via indirect cash flows
Case 1: Asset acquisition financed via a mortgage bond
A Ltd purchased a piece of land on 1 December 20.17 for R600 000 and financed this transaction
by way of a mortgage bond.
The journal entry to account for this transaction would be as follows:
Dr
Cr
1 December 20.17
R
R
Land
600 000
Mortgage bond
600 000
Recognise asset financed by way of mortgage bond
This journal entry illustrates the fact that no direct cash flows took place on acquisition of the
asset.
On 31 December 20.17, the following line items will appear in the financial statements of A Ltd in
respect of the above transaction:
Extract from statement of financial position as at 31 December 20.17
R
Assets
Non-current assets
Property, plant and equipment
600 000
Equity and liabilities
Non-current liabilities
Mortgage bond
600 000
For the purposes of the statement of cash flows, this transaction would have no cash flow effect
(it is neither an investing activity nor a financing activity) and the fact that the asset was acquired
by way of a mortgage bond will be disclosed in the notes to the financial statements.
Case 2: Asset acquired in exchange for shares issued
A Ltd acquires a machine with a fair value of R500 000 on 1 December 20.17 in exchange for
100 000 ordinary shares at a fair value of R500 000.
The journal entry to account for this transaction would be as follows:
Dr
Cr
1 December 20.17
R
R
Machine at cost
500 000
Share capital
500 000
Recognise asset acquired in exchange for shares issued at fair value
in terms of IAS 16 Property, Plant and Equipment.
From the above journal entry it is clear that there was no cash flow involved in this transaction.
At 31 December 20.17, the following line items will appear in the financial statements of A Ltd in
respect of the above transaction:
Extract from the statement of financial position as at 31 December 20.17
R
Assets
Non-current assets
Property, plant and equipment
Equity and liabilities
Equity
Share capital
500 000
500 000
continued
Statement of cash flows 91
When the statement of cash flows is prepared, it should be borne in mind that an increase in
property, plant and equipment took place that did not result in a cash outflow. Similarly, there
would be an increase in share capital that did not result in a cash inflow. These asset and
equity movements for the year must thus be excluded from the amounts that will be presented in
the financing and investing sections of the statement of cash flows. The fact that there was no
direct cash flow involved with the acquisition of the asset is disclosed elsewhere in the notes to
the financial statements.
Case 3: Asset acquired under a lease agreement
A Ltd entered into a lease agreement with Bank B on 1 December 20.17 to acquire a machine.
The fair value of the machine as well as the present value of the minimum lease payments
amounts to R400 000 on 1 December 20.17.
The journal entry to account for this transaction is the following:
Dr
Cr
1 December 20.17
R
R
Machine under lease arrangement
400 000
Finance lease obligation
400 000
Recognise asset acquired by way of a lease agreement
in terms of IFRS 16 Leases.
This journal entry clearly illustrates that the transaction has no cash flow implications.
At 31 December 20.17, the following line items will appear in the financial statements of A Ltd in
respect of the above transaction:
Extract from the statement of financial position as at 31 December 20.17
R
Assets
Non-current assets
Property, plant and equipment
400 000
Equity and liabilities
Non-current liabilities
Lease obligation
400 000
For the purpose of preparing the statement of cash flows, it must be borne in mind that there is an
increase in property, plant and equipment that did not result in a cash outflow. The same
applies in the respect of the increase in the lease obligation that also did not result in a cash
inflow. The increase in property, plant and equipment and increase in the lease obligation are
excluded from the amounts that will be presented in the financing and investing sections of the
statement of cash flows.
It is important to the users of financial statements to evaluate whether the entity’s reinvestment
(i.e. the amount ploughed back) is sufficient for achieving the following objectives:
ƒ the maintenance of operating capacity; and
ƒ the increase in operating capacity.
For this reason, a distinction should be made as far as practically possible between investing
activities to replace property, plant and equipment (maintaining operating capacity), and the
cash used in investing activities to expand investments in property, plant and equipment
(purchasing additional items to increase operating capacity) (IAS 7.51).
The major classes of gross cash receipts and gross cash payments arising from investing
activities are reported separately in the statement of cash flows. Refer to section 5.5.5 for an
exception to this rule where cash flows are reported on a net basis.
92 Descriptive Accounting – Chapter 5
5.4.4 Cash flows from financing activities
Financing activities are activities that result in changes in the size and composition of the
borrowings and contributed equity of the entity. These activities include raising new
borrowings, the repayment of existing borrowings, and the issuing and redemption of shares
or other equity instruments. Paragraph 18 of IAS 32 Financial Instruments: Presentation
may have an impact on the equity and liability classifications of certain items.
Cash flows arising from financing activities include (IAS 7.17):
ƒ proceeds from the issuing of shares or other equity instruments;
ƒ payments to acquire or redeem shares of the entity;
ƒ proceeds from the issuing of debentures, loans, notes, bonds, mortgages and other
short- and long-term borrowings;
ƒ repayments in respect of amounts borrowed; and
ƒ payments by a lessee to reduce the liability resulting from a lease.
The major classes of gross cash receipts and gross cash payments arising from financing
activities are shown in the statement of cash flows.
Example 5.3
Financing section of the statement of cash flows
The following is an illustration of the possible line items that will appear in the financing activities
section of the statement of cash flows:
Extract from the statement of cash flows of A Ltd for the year ended 31 December 20.17:
R
Cash flows from financing activities
(150 000)
Ordinary shares issued
Redemption of redeemable preference shares
Repayment of mortgage bond
Long-term loan obtained during the year
Lease agreement entered into (refer to Example 5.2)
Lease repayments
100 000
(200 000)
(300 000)
400 000
–
(150 000)
Cash flows as well as non-cash flow related changes in liabilities arising from financing
acivities should be disclosed (IAS 7.44A). This enables users to evaluate changes in liabilities.
The Standard recommends a reconciliation between the opening and closing balances for
liabilities arising from financing activities. In the issued amendments to IAS 7, an illustrative
example is available for this specific disclosure. The effective application date is for annual
periods beginning on or after 1 January 2017. Non-cash flow changes include:
ƒ financing changes;
ƒ changes from obtaining or losing control of subsidiaries;
ƒ foreign exchange changes;
ƒ fair value changes; and
ƒ any other changes.
5.4.5 Net increase or decrease in cash and cash equivalents
In this single line, the net cash result of the operating, investing and financing activities is
aggregated. This amount is used to reconcile the cash and cash equivalents at the
beginning of the year with the cash and cash equivalents at the end of the year, as reported
in the statement of financial position.
Statement of cash flows 93
Example 5.4
Reconciliation between cash and cash equivalents at the beginning
and end of the year
The following is an extract from the statement of financial position of P Ltd, as it appears in the
published financial statements for the year ended 31 December 20.17:
20.17
20.16
R
R
Assets
Current assets
Cash and cash equivalents
–
150 000
Equity and liabilities
Current liabilities
Overdrawn bank account
(100 000)
–
The following extract from the statement of cash flows for the year ending 20.17 illustrates the
reconciliation between cash and cash equivalents at the beginning and the end of the year as it
will appear at the end of the statement of cash flows:
Extract from the statement of cash flows for the year ended 31 December 20.17
R
Cash flows from operating activities*
Cash flows from investing activities*
Cash flows from financing activities*
300 000
(350 000)
(200 000)
Net decrease in cash and cash equivalents
Cash and cash equivalents at the beginning of the year
(250 000)
150 000
Cash and cash equivalents at the end of the year
(100 000)
* Note that a comprehensive statement of cash flows will have several line items under the above
sections of cash flows from operating activities, investing activities and financing activities.
5.5 Specific aspects
5.5.1 Group statements
When control in a subsidiary is obtained or lost, the resultant cash flows are reflected as a
single line item in the consolidated statement of cash flows as part of the investing
activities. Details regarding the assets and liabilities acquired are disclosed by means of a
note (IAS 7.40). In this note, a distinction is made between cash, cash equivalents and other
assets and liabilities. The consideration paid or received for subsidiaries is therefore treated
in the same way for statement of cash flow purposes as the sale of any other investments.
Where cash or cash equivalents are obtained or lost as part of obtaining or losing control of
an investment in a subsidiary, the amounts are not reflected as part of the cash flow
resulting from the transaction – only the net figures are reflected in the statement of cash
flows.
The following information is disclosed in aggregate in a note:
ƒ the total consideration paid or received;
ƒ the cash and cash equivalents portion of the total consideration paid or received;
ƒ the amount of cash and cash equivalents in the subsidiary over which control is obtained
or lost; and
ƒ the amount of assets and liabilities other than cash or cash equivalents in subsidiaries or
other businesses over which control is obtained or lost per major category (IAS 7.40).
94 Descriptive Accounting – Chapter 5
Cash flows that arise from changes in owner's equity in a subsidiary that do not result in a
loss of control are:
ƒ classified as cash from financing activities (IAS 7.42A); and
ƒ accounted for as equity transactions (IAS 7.42B).
Where the equity method or cost method of accounting is applied to an investment, only the
cash flow between the company and the investment should be included in the statement of
cash flows, as it is only this amount that represents a flow of cash (IAS 7.37).
Examples are dividends and advances. These dividends are disclosed with other investment
income in the statement of cash flows.
A pure and consistent application of the technique as proposed by IAS 7 for the preparation
of statements of cash flows may result in cash flows that were not actual cash flows for any
of the respective entities being consolidated being reported as cash flows. The same
argument can be applied to many other aspects of group statements. The fundamental
reason for this is that group statements are not prepared for a single entity, but rather for a
number of entities, and the combined entities consequently take on the status of a separate
accounting entity.
Example 5.5
Consolidated statement of cash flows
The following are extracts from the statements of financial position of two companies, P Ltd and
S Ltd, as at 31 December:
P Ltd
Assets
Investment in S Ltd at fair value
Property, plant and equipment
Trade receivables
Cash
Equity and liabilities
Share capital
Retained earnings
Trade payables
S Ltd
Assets
Property, plant and equipment
Trade receivables
Cash
Equity and liabilities
Share capital
Retained earnings
Trade payables
20.17
R’000
88
420
90
80
20.16
R’000
88
250
80
50
20.15
R’000
–
200
70
50
678
468
320
250
350
78
250
150
68
250
20
50
678
468
320
100
55
50
80
40
20
20
30
30
205
140
80
50
110
45
50
60
30
50
10
20
205
140
80
continued
Statement of cash flows 95
P Ltd obtained control over S Ltd with the acquisition of an 80% interest in S Ltd on
31 December 20.16 for a cash amount of R88 000. On the acquisition date of S Ltd, no
unidentified assets or liabilities existed and the fair value of all the assets and liabilities was
considered to be equal to the carrying amount thereof. P Ltd elected to measure the noncontrolling interests at the proportionate share of the acquiree’s identifiable net assets at the
acquisition date. No dividends have been paid for the years ended 31 December 20.16 and 20.17.
Assume there are no intragroup transactions and no other comprehensive income items. The
consolidated financial statements for the year ended 31 December 20.17 will be prepared as
follows:
P Ltd Group
Extract from the consolidated statement of profit or loss and other comprehensive income
for the year ended 31 December 20.17
20.17
20.16
R’000
R’000
Profit for the year (350(P) – 150(P)) + (110(S) – 60(S)); (150(P) – 20(P))
250
130
Other comprehensive income for the year
–
–
Total comprehensive income for the year
250
130
Total comprehensive income and profit for the year attributable to:
Owners of the parent
Non-controlling interests [20% × (110(S) – 60(S))]
240
10
130
–
250
130
P Ltd Group
Consolidated statement of financial position as at 31 December 20.17
20.17
R’000
Assets
Non-current assets
Property, plant and equipment (420(P) + 100(S)); (250(P) + 80(S))
Current assets
Trade receivables (90(P) + 55(S)); (80(P) + 40(S))
Cash and cash equivalents (80(P) + 50(S)); (50(P) + 20(S))
20.16
R’000
520
330
145
130
120
70
275
190
Total assets
795
520
Equity and liabilities
Equity attributable to owners of the parent
Share capital
Retained earnings (350(P) + (110(S) – 60(S) – 10(NCI))
250
390
250
150
Non-controlling interests (20% × 160); (20% × 110 (50 + 60))
640
32
400
22
Total equity
Current liabilities
Trade payables (78(P) + 45(S)); (68(P) + 30(S))
672
422
123
98
Total equity and liabilities
795
520
continued
96 Descriptive Accounting – Chapter 5
P Ltd Group
Extract from the consolidated statement of changes in equity
for the year ended 31 December 20.17
Balance at 31 December 20.15
Changes in equity for 20.16
Total comprehensive income for the year
Share
capital
Retained
earnings
R’000
250
R’000
20
Noncontrolling
interests
R’000
–
–
130
22
Profit for the year (150 – 20)
Other comprehensive income for the year
–
–
130
–
–
–
Balance at 31 December 20.16
Changes in equity for 20.17
Total comprehensive income for the year
250
150
22
–
240
10
Profit for the year
Other comprehensive income for the year
–
–
240
–
10
–
Balance at 31 December 20.17
250
390
32
P Ltd Group
Consolidated statement of cash flows for the year ended 31 December 20.17
20.17
20.16
R’000
R’000
Cash flows from operating activities (see calculation below)
250
138
Cash flows from investing activities
(190)
(118)
Obtaining control of a subsidiary (see note 1)/(88 – 20)
Addition to property, plant and equipment
(520(GS) – 330(GS)); (330(GS) – 200(P) – 80(S))
Cash flow from financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of year
–
(68)
(190)
(50)
–
60
70
–
20
50
130
70
P Ltd Group
Notes to the consolidated cash flow statement for the year ended 31 December 20.17
20.17
20.16
R’000
R’000
1. Obtaining control of a subsidiary
Property, plant and equipment (specify)
–
80
Receivables
–
40
Payables
–
(30)
Cash
–
20
Net asset value
Non-controlling interests (110 000 × 20%)
–
–
110
(22)
Total consideration paid in cash
Cash of subsidiary
–
–
88
(20)
Net cash flow at acquisition of subsidiary
–
68
continued
Statement of cash flows 97
Calculations
1. Cash flow from operating activities
Profit for the year
Change in operating capital:
Increase in receivables (145(GS) – 120(GS)); (120(GS) – 70(P) – 40(S))
Increase in payables (123(GS) – 98(GS)); (98(GS) – 50(P) – 30(S))
20.17
R’000
20.16
R’000
250
130
(25)
25
(10)
18
250
138
Comment
¾ Due to limited information provided, the full disclosure of the operating activities section cannot
be presented.
2. Analysis of owners’ equity of S Ltd
At acquisition (31 Dec 20.16)
Share capital
Retained earnings
Total
R’000
50
60
P Ltd
At
R’000
40
48
Equity represented by goodwill
110
–
88
–
22
–
Consideration and NCI
110
88
22
Since acquisition
• Current year
Profit for the year (110 – 60)
80%
Since
R’000
20%
NCI
R’000
10
12
50
40
10
160
40
32
Comment
¾ The calculation of the change in the receivables and payables for the year ended
31 December 20.16 includes the effect (acquisition) of the subsidiary from the date on which
control was obtained, to the reporting date. In the period since control of the subsidiary was
acquired, during 20.17, there is no additional effect of the subsidiary on the receivables and
payables as the subsidiary is already included in the consolidated statement balances.
¾ The calculation for the 20.16 year can be explained as follows:
Receivables
Opening balance
Acquisition of subsidiary
Bank (balancing amount)
R’000
70
40
10
120
R’000
Closing balance (80(P) + 40(S))
120
120
¾ The opening balance represents only the receivables amount for P Ltd, as at the beginning of
the 20.16 financial year the P Ltd Group did not exist. However, at year end (31 December
20.16) P Ltd acquired control of S Ltd and thereby formed the P Ltd Group. The closing balance
used at year end is a consolidated amount of R120 000, which includes the receivables of both
P Ltd and S Ltd. The acquisition of the subsidiary during the year needs to be taken into
account before the cash movement can be calculated. This results in a cash flow movement of
R10 000, and not R50 000. The same approach will be followed for PPE and payables.
continued
98 Descriptive Accounting – Chapter 5
¾ The calculation for the 20.17 year can be explained as follows:
Receivables
Opening balance (80(P) + 40(S))
Bank (balancing amount)
R’000
120
25
145
R’000
Closing balance (90(P) + 55(S))
145
145
¾ During the 20.17 financial year there were no acquisitions or disposals of subsidiaries, therefore
the consolidated amounts as per the P Ltd Group’s records can be used in the opening and
closing balances.
5.5.2 Interest and dividends
Payments to the suppliers of finance, and amounts received on investments, are disclosed
separately in the statement of cash flows. Accrued and unpaid amounts are not included
here and the necessary adjustments must therefore be made to the amounts reflected in the
statement of profit or loss and other comprehensive income and the statement of financial
position.
In terms of IAS 7.31, cash flows associated with interest and dividends paid and received
must be disclosed separately and classified on a consistent basis, as operating, investing
or financing activities. Since there is no consensus regarding the classification of these
items, consistency in the treatment of these items is encouraged.
Some argue that these items are the fruits of financing and/or investing activities and should
therefore be disclosed under operating activities. Alternatively, it may be argued that
dividends and interest received are the result of investing activities, or that dividends and
interest paid are the result of financing activities; therefore the items should be disclosed
accordingly. Interest and dividends are treated as operating activities in this chapter.
Note that interest paid and capitalised in terms of IAS 23 Borrowing Costs will be shown in
the statement of cash flows. The fact that the interest is capitalised does not have a direct
impact on the cash flow associated with it.
The effect of the application of IAS 32 Financial Instruments: Presentation on the
classification of items as either equity or liabilities also impacts on the resulting classification
of associated statement of profit or loss and other comprehensive income items.
Consequently, it also has an impact on the statement of cash flows.
Dividends paid to shareholders or any other distributions to owners are also shown
separately, under cash flows from operating activities. This could provide users with an
indication of the entity’s ability to pay dividends out of operating cash flows.
5.5.3 Taxes
As the principle of the statement of cash flows is to show the flow of cash and cash
equivalents, the proper ‘matching’ of cash inflows with the relevant cash outflows cannot
always occur. This is particularly true of taxes, where the tax arising from items reflected in
the current statement of cash flows is shown only in the next statement of cash flows, as the
tax is only paid after the date of the current statement of cash flows. For this reason, it is
difficult to conceive that the tax cash flows related to items reflected in the statement of cash
flows can be matched against the relevant items.
To illustrate this point, suppose that the sale of depreciable assets results in the recoupment
of tax allowances, and thus in a tax expense. In the profit or loss section of the statement of
profit or loss and other comprehensive income, the tax expense could be connected to the
gain on the disposal of the asset and be disclosed as such. In the statement of cash flows,
Statement of cash flows 99
this would not be possible, as the actual tax paid is only reflected in the statement of cash
flows of the ensuing year, even though the proceeds from the disposal of the asset are
reflected under investing activities in the current year’s statement of cash flows.
For this reason, IAS 7.35 and .36 state that taxes paid are normally shown as cash flows
relating to operating activities. However, when it is practicable to match the tax cash flow
with an individual transaction classified as an investing or financing activity, the tax cash
flow should also be classified as an investing or financing activity. Taxes paid, such as
transfer duty on property, stamp duty on shares and tax on dividends (where appropriate)
can normally be linked to the appropriate investment or activity. If the tax cash flows are
allocated over more than one activity, the total amount of taxes paid is disclosed in the
notes.
The tax charges in the statement of profit or loss and other comprehensive income often
include an amount in respect of deferred tax. The annual charge for deferred tax is not a
flow of cash and must therefore not be reflected in the statement of cash flows.
5.5.4 Value-added tax (VAT)
The treatment of VAT in a statement of cash flows is not addressed in IAS 7. Entities should
however disclose whether they present their gross cash flows as inclusive or exclusive of
VAT.
Example 5.6
Treatment of VAT
S Ltd is a registered vendor for VAT purposes and all purchases and sales are subject to VAT of
15%. Gross cash flows are disclosed excluding VAT. The following extract was obtained from the
trial balance of S Ltd:
20.17
20.16
Debits
Trade receivables
18 300
22 650
Inventories
19 300
21 850
VAT control account
80
100
Cost of sales
62 400
52 300
Other expenses
8 594
6 700
Credits
Trade payables
25 870
27 500
Revenue
96 000
89 650
By using the direct method, disclose “the cash flow generated from operations” section in the
statement of cash flows for the year ending 31 March 20.17.
The cash flow generated from operations will be disclosed as follows in the statement of cash flows:
S Ltd
Extract from the statement of cash flows for the year ended 31 March 20.17
(Direct method)
R
Cash flows from operating activities
Cash receipts from customers (calc 1)
Cash payments to suppliers and employees (calc 2)
VAT cash in/(out)flow (calc 3)*
Cash generated from operations
99 783
(69 861)
374
30 296
*The cash flow from VAT may also be presented in the tax note to the statement of cash flows if
the indirect method is used.
continued
100 Descriptive Accounting – Chapter 5
Calculations
1. Cash receipts from customers (net of VAT)
Revenue
Decrease in trade receivables ((22 650 – 18 300) x 100/115)
R
96 000
3 783
99 783
Comment
The accounting treatment for the total sales for the year is recorded as follows:
Dr
R
110 400
Trade receivables
Revenue
VAT control account
Cr
R
96 000
14 400
Alternative reconstruction of the general ledger for illustrative purposes:
Trade receivables
Opening balance
Revenue
Net
19 696
96 000
VAT
2 954
14 400
Gross
22 650 Bank
110 400 Closing balance
Net
99 783
15 913
VAT
Gross
14 967 114 750
2 387 18 300
133 050
133 050
Trade receivables movement net of VAT: 19 696 – 15 913 = 3 783 (rounding difference)
2. Cash payments to suppliers and employees (net of VAT)
Cost of sales
Other expenses
Changes in working capital:
Decrease in trade payables ((27 500 – 25 870) × 100/115)
Decrease in inventories (21 850 – 19 300)
R
(62 400)
(8 594)
(1 417)
2 550
(69 861)
3. VAT cash inflow
Decrease in VAT control account (100 – 80)
VAT included in decrease of trade receivables ((22 650 – 18 300) × 15/115)
VAT included in decrease of trade payables ((27 500 – 25 870) × 15/115)
R
20
567
(213)
374
5.5.5 Gross figures
In terms of IAS 7.21, information relating to investing and financing activities is reflected at
gross rather than at net amounts. This reduces the potential loss of important information
as a result of disclosing net figures. Expenditure on new investments is therefore shown
separately from the proceeds on disposal of investments, and the repayment of borrowings
is shown separately from newly-obtained borrowings.
The following exceptions to the general rule are however permitted by IAS 7.22 and .23:
ƒ cash receipts and payments on behalf of customers when these cash flows reflect the
cash flows of the customer rather than the cash flows of the entity, for example:
– the acceptance and repayment of demand deposits of a bank;
– funds held for customers by an investment entity; and
– rent collected on behalf of and paid over to the owners of properties; and
ƒ cash receipts and payments for items of which the turnover is quick, the amounts are
large, and the maturities are short, for example:
– capital amounts in respect of credit card customers; and
– the purchase and disposal of investments and short-term borrowings.
Statement of cash flows 101
5.5.6 Foreign currency cash flows
Foreign currency transactions are converted into the reporting entity’s functional currency
(in South Africa, this is the Rand) for disclosure in the statement of cash flows. Only if such
transactions result in a flow of cash will the cash flow be translated at the exchange rate
applicable on the date of the transaction and disclosed as such (IAS 7.25). The cash flows
of a foreign subsidiary are translated at the exchange rates between the reporting entity’s
functional currency and the foreign currency on the dates of the cash flows (IAS 7.26). A
weighted average rate may also be used if it approximates the actual rate.
Unrealised gains and losses on foreign exchange transactions do not represent cash
flows and will therefore not be reflected in the statement of cash flows. Only the actual cash
flows in the functional currency are therefore shown.
There is one exception to this rule: Where cash and cash equivalents are held in foreign
currency at the end of a period, or are payable in foreign currency, these items are
translated at the exchange rate ruling at the reporting date. This results in an associated
foreign exchange gain or loss on the reporting date. In order to reconcile the cash and cash
equivalents at the beginning and the end of the current reporting period, this foreign
exchange gain or loss will appear in the statement of cash flows. IAS 7.28 requires that this
difference be reported separately from cash flows from operating, investing and financing
activities.
Realised foreign exchange gains and losses are therefore viewed as cash flows.
Unrealised exchange differences arising due to translations on the reporting date are simply
added back. Only translation differences relating to cash and cash equivalents are not
added back; instead, they are disclosed separately in the statement of cash flows.
Example 5.7
Foreign currency transactions
A Ltd has entered into a number of foreign currency transactions. Indicate how the transactions
will be treated in the statement of cash flows for the year ended 30 September 20.17:
Transaction 1:
Acquired inventories from abroad on 1 September 20.17 for FC5 000. Paid
creditor on 15 October 20.17.
Transaction 2:
Raised a long-term loan abroad of FC15 000 on 1 September 20.17. Interest is
payable quarterly in arrears at 5% per annum.
Transaction 3:
Acquired machinery from abroad at FC10 000 on 15 September 20.17 and
took out forward exchange cover on the same day for payment on
30 September 20.17.
Transaction 4:
A foreign currency bank account is used to deposit any receipts in foreign
currency. The account had a balance of FC500 000 on 1 September 20.17.
Only one amount was deposited into the account during the year – a customer
deposited FC100 000 on 30 September 20.17. Therefore, on 30 September 20.17,
the balance amounted to FC600 000.
The following exchange rates apply:
Spot rate Forward rate
20. 17
FC1 = R
FC1 = R
01 September
2,00
15 September
2,20
2,30
30 September
2,25
Average rate for September
2,18
continued
102 Descriptive Accounting – Chapter 5
Transaction 1
The cash flow takes place on 15 October 20.17, when the creditor is paid and the transaction is
then reflected in the cash flows from operating activities section. At 30 September 20.17, the
creditor (a monetary liability) is remeasured and an exchange difference is recognised:
R
01 September FC5 000 × 2,00
10 000
30 September FC5 000 × 2,25
(11 250)
Foreign exchange loss
(1 250)
The unrealised foreign exchange loss is reflected in the profit or loss section of the statement
of profit or loss and other comprehensive income as unrealised, and under the indirect method is
added back to profit for the year as a non-cash item. No flow of cash is therefore recognised in
the statement of cash flows for the year ended 30 September 20.17.
Transaction 2
A cash flow takes place when the loan is raised on 1 September 20.17 at:
FC15 000 × 2,00 = R30 000
The cash flow is shown under the cash flows from financing activities section as a loan raised. At
30 September 20.17, the loan is remeasured, the interest accrued and an exchange difference is
recognised in the statement of profit or loss and other comprehensive income (profit or loss):
Capital:
R
01 September
30 000
30 September FC15 000 × 2,25
(33 750)
Foreign exchange loss
(3 750)
Interest: 30 September 5% × FC15 000 × 1/12 × 2,18 = R136
The interest is not yet paid; therefore no cash flow is shown as interest paid under operating
activities for the year. The expense in the statement of profit or loss and other comprehensive
income (profit or loss) is raised via the creditor. As the unrealised exchange loss is also a
non-cash transaction, the amount is added back against profit for the year in the statement of
cash flows.
A reconciliation disclosing the movement of cash and non-cash changes in the liabilities arising
from finance activities is required (IAS 7.44A–D). This reconciliation includes the cash inflow
related to the newly acquired loan as well as the non-cash flow change related to the foreign
exchange difference.
Transaction 3
Investing activities reflect the acquisition of machinery at the cash flow amount of:
FC10 000 × 2,30 = R23 000
The exchange difference is realised and is not adjusted against profit for the year in the
statement of cash flows. The forward cover contract of 15 September does not result in a flow of
cash and is therefore not shown in the statement of cash flows.
Comment
¾ If the creditor in transaction 3 was paid after the reporting date, the machinery acquisition is
reflected net of the creditor, while the unrealised exchange difference on the creditor is added
back to profit for the year as a non-cash flow item. It is recommended that the machinery
acquisition be disclosed in the notes to the statement of cash flows.
Transaction 4
The reconciliation between the opening and closing balances of cash and cash equivalents will be
as follows:
R
Opening balance (500 000 × 2,00)
1 000 000
Closing balance (600 000 × 2,25)
1 350 000
Total movement for the year
350 000
Exchange differences (500 000 × (2,25 – 2,00))
Change in cash and cash equivalents (100 000 × 2,25)
125 000
225 000
IAS 7.28 requires the movement in cash and cash equivalents and related exchange differences to
be disclosed separately.
Statement of cash flows 103
5.5.7 Leases
When the lessee repays a lease instalment, the payments are divided into capital and
interest portions. The capital portion is the repayment of a loan that is classified under
financing activities, while the interest is shown with other interest cash flows, probably under
operating activities. When the lease is initially recognised, there is no flow of cash and
therefore no entry in the statement of cash flows (refer to Example 5.2). The transaction
should, however, be reflected in the notes to the statement of cash flows.
5.5.8 Discontinued operations
The cash flows from discontinued operations are not specifically addressed in IAS 7. The
cash flows from discontinued operations of an entity should be disclosed separately for
operating, investing and financing activities (IFRS 5 Non-current Assets Held for Sale and
Discontinued Operations paragraph 33(c)). These disclosures may be presented either in
the notes or in the financial statements. This enables the users to differentiate between
streams of cash, namely those that are likely to continue and those that will discontinue. The
predictive value of the information is thus enhanced. Comparative amounts in the statement of
cash flows should be restated accordingly.
5.6 Disclosure
The following is a summary of the disclosure requirements of IAS 7:
ƒ Cash flows from operating activities are shown using either the direct or the indirect
method. In both cases, the disclosure of the following is required:
– cash flow generated by operations, which, in terms of the direct method, is merely
the difference between cash receipts from customers and cash paid to suppliers and
employees. In accordance with the indirect method, this constitutes a reconciliation of
the profit before tax as reflected in the profit or loss section of the statement of profit or
loss and other comprehensive income and the cash generated by operations (this
reconciliation is carried out by adjusting the profit before tax for the non-cash items
appearing in the profit or loss section of the statement of profit or loss and other
comprehensive income, and for movements in working capital, excluding movements
in cash and cash equivalents); and
– interest paid, dividends and taxation, except in cases where interest paid and dividends
are shown as part of investing and financing activities.
ƒ Cash flows from investing activities, distinguishing as far as possible between the main
categories, gross cash receipts and gross cash payments, except where gross disclosure
is not required (refer to section 5.5.5).
ƒ Cash flows from the acquisition and disposal of subsidiaries and other entities are
shown separately under investing activities (refer to section 5.5.1).
ƒ Cash flows from financing activities, distinguishing as far as possible between the main
categories, gross cash receipts and gross cash payments, except where gross disclosure
is not required (refer to section 5.5.5).
The following additional disclosures are recommended in appropriate circumstances:
ƒ the policy followed in determining the composition of cash and cash equivalents;
ƒ the components of cash and cash equivalents;
ƒ a reconciliation between the amounts of cash and cash equivalents in the statement of
cash flows and the corresponding items in the statement of financial position;
ƒ the amount of significant cash and cash equivalent balances held by the entity and not
available for use by the group, with commentary from management – for example where a
subsidiary operates in a country where exchange controls or other legal restrictions apply;
ƒ information on non-cash financing and investing transactions;
104 Descriptive Accounting – Chapter 5
ƒ a reconciliation of liabilities arising from financing activities, presenting cash flow and
non-cash flow movements (IAS 7.44D);
ƒ the amount of the undrawn borrowing facilities available for future operating activities and
to settle capital commitments, with an indication of any limitations on the use of such
facilities; and
ƒ the aggregate amount of cash flows that represent increases in operating capacity
separately from those cash flows that are required to maintain operating capacity.
Furthermore, an entity is required to disclose the following in terms of the Standard on
discontinued operations for each discontinued operation (IFRS 5.33(c)) during the current
financial reporting period:
ƒ the amounts of net cash flows attributable to:
– operating activities;
– investing activities; and
– financing activities.
5.7 Comprehensive example
The following are the draft annual financial statements of Alfa Ltd for the year ended 30 June 20.17:
Alfa Ltd
Revenue
Cost of sales
Statement of profit or loss and other comprehensive income
for the year ended 30 June 20.17
20.17
R’000
4 830
(2 898)
20.16
R’000
4 643
(3 186)
Gross profit
Other income
1 932
660
1 457
20
660
–
(390)
(480)
–
20
(125)
(360)
100
220
20
100
20
20
90
210
20
–
–
40
Profit before tax
Income tax expense
1 722
(500)
992
(100)
Profit for the year
Other comprehensive income
Items that will not be reclassified to profit or loss
Gain on property revaluation
Income tax on other items of comprehensive income
1 222
892
2 000
(448)
–
(–)
Total comprehensive income for the year
2 774
892
– Gain on disposal of land
– Reduction in allowance for credit losses
Distribution costs
Other expenses
– Audit fees
– Depreciation
– machinery
– furniture
– Allowance for credit losses
– Loss on disposal of machinery
– Finance costs
Statement of cash flows 105
Alfa Ltd
Statement of financial position as at 30 June 20.17
Assets
Non-current assets
Property, plant and equipment
Land at valuation
Land at cost
Machinery
Cost price
Accumulated depreciation
Furniture
Cost price
Accumulated depreciation
Current assets
Inventories
Debtors
Cash on deposit
Bank
Total assets
20.17
R’000
4 920
20.16
R’000
4 000
–
800
1 600
(800)
120
200
(80)
2 000
–
1 240
660
1 400
(740)
100
160
(60)
4 920
2 000
3 200
4 400
600
480
2 800
3 600
200
–
8 680
6 600
13 600
8 600
Alfa Ltd
Statement of financial position as at 30 June 20.17
20.17
R’000
20.16
R’000
Equity and liabilities
Share capital – ordinary
Retained earnings
Other components of equity
– Revaluation surplus
3 300
690
1 460
700
1 552
–
Total equity
5 542
2 160
Non-current liabilities
Long-term borrowings
Deferred tax
2 200
610
2 000
40
2 810
2 040
2 800
1 200
38
1 200
10
–
3 200
200
100
800
–
100
5 248
4 400
8 058
6 440
13 600
8 600
Current liabilities
Creditors
Current portion of long-term borrowings
Tax payable: South African Revenue Service (SARS)
Shareholders for dividends
Unclaimed dividends
Bank overdraft
Total liabilities
Total equity and liabilities
106 Descriptive Accounting – Chapter 5
Alfa Ltd
Statement of changes in equity for the year ended 30 June 20.17
Share
capital
Balance at 30 June 20.15
Changes in equity for 20.16
Preference dividend
Ordinary dividend
Total comprehensive income for the year
Profit for the year
Other comprehensive income, net of tax
Balance at 30 June 20.16
Changes in equity for 20.17
Ordinary shares issued
Preference dividend
Ordinary dividend
Total comprehensive income for the year
R’000
1 460
–
–
–
–
–
1 460
Revaluation Retained
surplus
earnings
R’000
Total
R’000
640
R’000
2 100
–
–
–
–
–
(32)
(800)
892
(32)
(800)
892
892
–
892
–
–
700
2 160
–
(32)
(1 200)
1 222
1 840
(32)
(1 200)
2 774
1 222
1 552
–
–
–
–
1 552
–
Profit for the year
Other comprehensive income, net of tax
1 840
–
–
–
–
–
1 552
1 222
–
Balance at 30 June 20.17
3 300
1 552
690
5 542
Additional information
1. Land at a cost of R540 000 was sold during the year and new land was acquired. This was not
done to replace the land that was sold.
2. Machinery with a cost of R400 000 was purchased on 31 October 20.16 to replace existing
machinery which cost R200 000 and was sold on 1 July 20.16.
3. Depreciation on machinery and furniture is calculated at 15% per annum and 10% per annum
respectively on the straight-line basis.
4. Furniture with a cost of R40 000 was purchased on 1 July 20.16, as a replacement of old furniture.
The statement of cash flows using the indirect method will be prepared as follows:
Statement of cash flows 107
Alfa Ltd
Statement of cash flows for the year ended 30 June 20. 17
(Indirect method)
Notes
Cash flows from operating activities
Profit before tax
Adjusted for:
Gain on disposal of land
Depreciation (220 + 20)
Increase in the allowance for credit losses
Loss on disposal of machinery
Interest paid
20.17
R’000
(1 540)
1 722
(660)
240
100
20
20
Operating profit before changes in working capital
Changes in working capital
1 442
(1 700)
Increase in inventory (3 200 – 2 800)
Increase in debtors (4 400 + 100 – 3 600)
Decrease in creditors (2 800 – 3 200)
(400)
(900)
(400)
Cash generated from operations
Interest paid
Tax paid (4)
Dividends paid (800 + 1 232 (1 200 + 32) – 1 210 (1 200 + 10))
(258)
(20)
(440)
(822)
Cash flows from investing activities
(520)
Investments to maintain operating capacity
(440)
Replacement of machinery (given)
Replacement of furniture (given)/(200 – 160)
(400)
(40)
Investments to expand operating capacity
(80)
Additions to land (1 240 – 540 + 2 000 – 4 000)
Proceeds on disposal of land (540 + 660)
Proceeds on disposal of machinery (– 740 – 220 + 800 + 200 – 20) or (see (5))
(1 300)
1 200
20
Cash flows from financing activities
3 040
Proceeds from long-term borrowings ((2 200 + 1 200) – (2 000 + 200))
Proceeds from issue of share capital (3 300 –1 460)
4
2
1 200
1 840
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of year
1
980
100
Cash and cash equivalents at end of year
1
1 080
Notes to the financial statements (limited to cash flow items)
1. Cash and cash equivalents
Cash and cash equivalents consist of cash on deposit and bank account balances. Cash and cash
equivalents included in the statement of cash flows comprise the following statement of financial
position amounts:
20.17
20.16
R’000
R’000
Cash on deposit
600
200
Bank balances
480
(100)
1 080
100
108 Descriptive Accounting – Chapter 5
2. Issuing of share capital
20.17
R’000
During the period, additional share capital was issued as follows:
1 840 000 ordinary shares (assumption)
1 840
1 840
3. Reconciliation from liabilities arising from financing activities
20.16
Cash flows
Non-cash changes
R’000
Foreign
Fair value
exchange
changes
Loans
2 200
–
1 200
20.17
R’000
–
3 400
The statement of cash flows using the direct method will differ from that using the indirect method in
one respect only: ‘Cash generated from operations’ will be reflected as follows:
Alfa Ltd
Statement of cash flows for the year ended 30 June 20. 17
(Direct method)
Note
Cash receipts from customers (4 830 – 900 (4 400 + 100 – 3 600)(1))
Cash paid to suppliers and employees
(3 698 (3) + 390 (distribution costs) + 100 (audit fees))
or (2 898 (cost of sales) + 390 + 100 + 400 (inventory) + 400 (creditors))
Cash generated from operations
R’000
3 930
(4 188)
1
(258)
Comment
¾ Cash receipts from customers and cash paid to suppliers and employees, are calculated as
follows:
Calculations
(1)
Debtors
Opening balance
Sales
R’000
3 600
4 830
Bank (Balancing amount)
Allowance for credit losses
Closing balance
8 430
(2)
Opening balance
Payables (Balancing amount)
8 430
Inventories
R’000
2 800
3 298
Cost of sales
Closing balance
6 098
(3)
Bank (Balancing amount)
Closing balance
R’000
3 930
100
4 400
R’000
2 898
3 200
6 098
Creditors
R’000
3 698
2 800
6 498
Opening balance
Inventories (2)
R’000
3 200
3 298
6 498
continued
Statement of cash flows 109
(4)
SARS
R’000
Bank (Balancing amount)
Closing balance
440
38
Opening balance
Income tax expense
590
R’000
100
378
478
Deferred tax
R’000
610
Closing balance
Opening balance
Revaluation on property
Income tax expense (Balancing
amount)
610
R’000
40
448
122
610
Income tax expense
SARS
Deferred tax
Statement of profit or loss
R’000
378
122
500
(5) Alternative calculation for proceeds on disposal of machinery:
Carrying amount of machine on date of disposal (calculated below)
Loss on disposal of machine (given – statement of profit or loss)
R’000
40
(20)
Proceeds on disposal of machine – to disclose in statement of cash flows
20
Carrying amount of machine on date of disposal
40
Cost (given)
Accumulated depreciation (–740 – 220 + 800)
200
(160)
The following note will accompany the statement of cash flows when prepared in accordance with the
direct method, in addition to the notes already indicated above:
Notes to the financial statements
1. Reconciliation of profit before tax with cash generated from operations
Profit before tax
Adjusted for:
Gain on disposal of land
Depreciation (220 + 20)
Increase in allowance for credit losses
Loss on disposal of machinery
Interest paid
Working capital changes:
20.17
R’000
1 722
(660)
240
100
20
20
1 442
(1 700)
Increase in inventory (3 200 – 2 800)*
Increase in debtors(4 400 + 100 – 3 600)
Decrease in creditors(2 800 – 3 200)*
(400)
(900)
(400)
Cash generated from operations
(258)
continued
110 Descriptive Accounting – Chapter 5
Comment
¾ When the inventory balance increases from the prior period, it is an indication that the company
purchased more inventory in the current year; therefore there will be a cash outflow in the
statement of cash flows for the current period.
¾ When the creditors (trade payables) balance decreases from the prior period, it is an indication
that the company settled more of their outstanding debt in the current year, instead of obtaining
credit from their suppliers. Therefore there will be a cash outflow in the statement of cash flows
for the current period. The counter-arguments will also hold.
CHAPTER
6
Accounting policies, changes in
accounting estimates and errors
(IAS 8)
Contents
6.1
6.2
6.3
6.4
6.5
6.6
6.7
Overview of IAS 8 Accounting Policies, Changes in Accounting Estimates
and Errors ..........................................................................................................
Background .......................................................................................................
Accounting policies ............................................................................................
6.3.1 Selection of accounting policies .............................................................
6.3.2 Consistency of accounting policies .........................................................
Changes in accounting policies .........................................................................
6.4.1 Schematic representation of changes in accounting policies .................
6.4.2 Changes in accounting policy due to the initial application of
a Standard or Interpretation ....................................................................
6.4.3 Voluntary change in accounting policy ...................................................
6.4.4 Disclosure requirements in case of non-application of a new
Standard or Interpretation .......................................................................
Changes in accounting estimates .....................................................................
6.5.1 Disclosure requirements .........................................................................
6.5.2 Example in respect of change in accounting estimate ...........................
Errors .................................................................................................................
6.6.1 Prior period errors ...................................................................................
6.6.2 Material prior period errors .....................................................................
6.6.3 Disclosure requirements .........................................................................
6.6.4 Example in respect of a material prior period error ...............................
Impracticability of retrospective application and retrospective restatement ......
111
112
112
112
113
113
114
116
117
117
123
123
125
125
127
127
128
130
131
138
112 Descriptive Accounting – Chapter 6
6.1 Overview of IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors
Accounting policies
Initial decision
Application of accounting policy
should be consistent from
period to period and for all
similar transactions.
If no Standard or Interpretation
exists, management should
apply its judgement.
Accounting policies are only
changed if:
ƒ required by an
Accounting Standard or
Interpretation; or
ƒ the change will provide
more relevant and
reliable information.
Accounting policy changes
must be applied in terms of
the transitional provisions of a
new Accounting Standard, or
retrospectively
(including all comparative
periods shown and their
opening balances).
Changes in estimates
Changes are applied
prospectively, namely
current reporting period and
future periods (where
appropriate).
Prior period errors
Determined by Accounting
Standards and
Interpretations.
Corrections are made
retrospectively as if the
error was never made.
Restate comparative amounts
and opening balances, where
appropriate.
Changes in accounting policy
should be appropriately
disclosed.
Changes in estimates
should be appropriately
disclosed, including the
effect of the change on
future reporting periods
(where appropriate).
Corrections must be
appropriately disclosed.
Note that only corrections
of prior period errors are
disclosed.
6.2 Background
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors prescribes the
criteria for selecting and changing accounting policies, together with the accounting
treatment and disclosure of such changes as well as changes in accounting estimates and
corrections of prior period errors in the entity’s financial statements. The objective of IAS 8 is
to enhance the relevance and reliability of an entity’s financial statements as well as the
comparability of those financial statements over time and with the financial statements of
other entities (IAS 8.1).
6.3 Accounting policies
IAS 8 addresses the selection, adoption and consistent application of accounting policies
and the required and voluntary changes in accounting policies.
Accounting policies, changes in accounting estimates and errors 113
Accounting policies are defined in IAS 8.5 as the specific principles, bases, conventions,
rules and practices adopted by an entity in preparing and presenting financial statements.
These principles, bases, conventions, rules and practices are found in the Standards and
Interpretations of the International Accounting Standards Board (IFRSs).
6.3.1 Selection of accounting policies
Management must select and apply an entity’s accounting policies so that the financial
statements comply with all the requirements of each applicable Standard and Interpretation.
Accounting policies prescribed by the Standards need not be applied when the effect of
applying them is immaterial. An item would be material if it might influence the economic
decisions of the users of the financial statements (also refer to sections 3.4.4 and 6.6.2).
However, it is inappropriate to make, or leave uncorrected, immaterial departures from
IFRSs to achieve a particular presentation of an entity’s financial position, financial
performance or cash flows (IAS 8.8). The Conceptual Framework requires that financial
information should be a faithful representation and be neutral.
Where there is no specific IFRS that applies to a specific transaction or event, management
must use its judgement to develop and apply accounting policies to ensure that the financial
statements provide information that is:
ƒ relevant to the decision-making needs of users; and
ƒ reliable, in that the financial statements:
– faithfully present the financial position, financial performance and cash flows of the
entity;
– reflect the economic substance of transactions, events and conditions and not merely
the legal form;
– are neutral, that is, free from bias;
– are prudent; and
– are complete in all material aspects (IAS 8.10).
In making this judgement, management must refer to, and consider the applicability of, the
following sources (in descending order):
ƒ the requirements and guidance in Standards and Interpretations dealing with similar and
related issues; and
ƒ the definitions, recognition criteria and measurement concepts for assets, liabilities, income
and expenses in the Conceptual Framework for Financial Reporting (the Conceptual
Framework) (IAS 8.11).
Management may also consider the most recent pronouncements of other standard-setting
bodies that use a similar conceptual framework to develop accounting standards, other
accounting literature and accepted industry practices, to the extent that these do not conflict
with the sources above (IAS 8.12).
6.3.2 Consistency of accounting policies
In terms of the consistency concept (that also implies comparability) (also refer to chapters 2
and 3), there must be consistent accounting treatment of like items within each accounting
period, and from one period to the next. Consistency has two aspects: consistency over time
and consistency of disclosure of similar items.
IAS 1.45 states that the presentation and classification of items in the financial statements
should be retained from one period to the next, unless:
ƒ a significant change in the nature of the entity’s operations has taken place, or upon a
review of its financial statement presentation, it was decided that another presentation or
classification would be more appropriate; or
ƒ a Standard or Interpretation requires a change.
114 Descriptive Accounting – Chapter 6
In such circumstances, comparative amounts are restated.
IAS 8.13 requires that accounting policies must be applied consistently for similar
transactions, events and conditions, unless a Standard or Interpretation specifically requires
or permits categorisation of items for which different policies may be appropriate. If a
Standard or Interpretation requires or permits categorisation of items, an appropriate
accounting policy is selected and applied consistently to each category. For example,
different accounting policies may be chosen for different categories of property, plant and
equipment in terms of IAS 16 Property, Plant and Equipment (e.g. at cost or revalued
amounts). Once the appropriate policy has been chosen, however, it is applied consistently
to the particular category.
However, where separate categorisation of items is not allowed or permitted by a Standard,
the same accounting policy must be applied to all similar items (e.g. where the same
model is required for all investment properties – refer to chapter 17).
A chosen accounting policy must be maintained unless a significant change in the nature of
the entity’s activities has occurred, a review of its presentation indicates that a change in
presentation will provide a more faithful representation of the transactions, events or
conditions, or if a change in presentation is required by an Accounting Standard or
Interpretation.
6.4 Changes in accounting policies
Changes in accounting policies are not expected to occur often. One of the enhancing
qualitative characteristics prescribed by the Conceptual Framework for the financial
statements is comparability, requiring that the financial statements of the same entity of one
year can be compared to the results in subsequent years in order to identify trends. If
changes in accounting policy take place too often, this goal is negated.
A change in accounting policy can take place in terms of IAS 8.14 only if:
ƒ it is required by a Standard or an Interpretation; or
ƒ the change results in the financial statements providing reliable and more relevant
information about the effects of transactions, events or conditions on the entity’s financial
position, financial performance or cash flows.
The first instance mentioned arises from where particular reporting practices were used that
are now prohibited by law or a new Standard. In these instances, it is necessary to
incorporate the change in accounting policy in the statements in order to comply with the
newly accepted reporting method.
If an entity enters into a new type of transaction, or transactions that differ in substance from
those previously entered into, it requires the adoption of a new accounting policy. However,
this does not constitute a change in accounting policy (IAS 8.16). The initial adoption of a
policy to carry assets at revalued amounts constitutes a change in accounting policy in terms
of IAS 8.17, but must be accounted for in accordance with IAS 16 Property, Plant and
Equipment (refer to chapter 9) and IAS 38 Intangibles (refer to chapter 16), and not in
accordance with IAS 8.
IAS 8 requires that changes in accounting policies must be applied retrospectively, unless
the transitional provisions of a Standard prescribed otherwise. In extraordinary
circumstances where it is not practicable to apply the policy retrospectively, the policy may
be applied prospectively.
Disclosures regarding changes in accounting policies need only be presented in the year of
the change and not in subsequent periods.
Accounting policies, changes in accounting estimates and errors 115
IAS 1 Presentation of Financial Statements has introduced a requirement to include a third
statement of financial position (as at the beginning of the preceding period) whenever an
entity:
ƒ retrospectively applies an accounting policy;
ƒ makes a retrospective restatement of items in its financial statements; or
ƒ reclassifies items in its financial statements; and
such adjustments have a material effect on the information in the statement of financial
position at the beginning of the preceding period (IAS 1.40A).
In the above circumstances, an entity is required to present, as a minimum, three
statements of financial position. A statement of financial position must be prepared as at:
ƒ the end of the current period;
ƒ the end of the preceding period; and
ƒ the beginning of the preceding period.
Disclosure in terms of IAS 8 (see below) is specifically required, but the other related notes
to the statement of financial position as at the beginning of the preceding period are not
required.
116 Descriptive Accounting – Chapter 6
6.4.1
Schematic representation of changes in accounting policies
Change in Accounting Policy IAS 8.14 to .27
Initial application of a new
Standard or
Interpretation
(paragraphs 7 and 14(a))
Is a new Standard being
applied or will the
proposed change in policy
achieve more reliable or
relevant information?
Voluntary change to achieve
reliable and more relevant
information
(paragraphs 10 and 14(b))
NO
Apply transitional
provisions in Standard
or Interpretation
(paragraph 19(a))
A change in accounting
policy may not be made
If there are no transitional
provisions (paragraph 19(b))
Refer to:
ƒ Other Standards or
Interpretations (on similar and
related issues)
ƒ Conceptual Framework
ƒ Pronouncements by other
standard-setting bodies (with a
similar conceptual framework)
ƒ Other accounting literature
ƒ Accepted industry practices
(paragraphs 11 and 12)
Apply retrospectively as if
new policy has always been
applied
(paragraph 22)
If application is impracticable
or partially impracticable
(paragraph 23)
The cumulative effect of the change
in accounting policy is known
(paragraph 24)
Cumulative effect is not known at
beginning of current period
(paragraph 25)
Determine period-specific effects
(paragraph 24)
Apply new policy prospectively from earliest
date practical in determining the cumulative
effect
Apply new policy to earliest period practical
for retrospective application
(including the current period)
Accounting policies, changes in accounting estimates and errors 117
6.4.2 Changes in accounting policy due to the initial application of a Standard
or Interpretation
If the change in accounting policy is necessary due to the adoption of a new Standard or
Interpretation, the treatment follows the transitional provisions contained in the respective
Standard (IAS 8.19(a)). Where there are no such transitional provisions, a retrospective
change in accounting policy shall be effected (IAS 8.19(b)). This entails adjusting the
opening balances of each affected component of equity for the earliest (and each) prior
period presented, as if the new accounting policy had always been applied (IAS 8.22).
There is an exemption clause in IAS 8 that allows comparative amounts not to be restated if
doing so is not practicable in terms of IAS 8.23 to .27. When it is impracticable to calculate
the period-specific effects of applying the change in policy to comparatives, the entity
applies the new accounting policy to the carrying amounts of assets and liabilities at the
beginning of the earliest period presented where retrospective application is possible (which
may be the current period). A corresponding adjustment is made to the opening balances of
each affected component of equity for that period.
If it is impracticable to calculate the cumulative effect of the change in accounting policy at
the beginning of the current period for all prior periods, the entity will apply the policy
prospectively from the earliest date from which it is practicable to determine the cumulative
effect. This implies that in certain instances the cumulative effect of changes in accounting
policies will only be partially recognised if it is impracticable to recognise it fully (i.e. it is not
possible to calculate it).
6.4.2.1 Disclosure requirements in case of the initial application of a Standard
or Interpretation (IAS 8.28)
When a change in accounting policy results from the initial application of a Standard or
Interpretation, the following must be disclosed:
ƒ the title of the Standard or Interpretation;
ƒ when applicable, that the change in accounting policy is made in accordance with its
transitional provisions;
ƒ the nature of the change in accounting policy;
ƒ when applicable, a description of the transitional provisions;
ƒ when applicable, the transitional provisions that may have an effect on future periods;
ƒ for the current period and each prior period presented, to the extent practicable, the
amount of the adjustment for each financial statement line item affected;
ƒ the amount of the adjustment relating to periods before those presented, to the extent
practicable (i.e., the cumulative adjustment against the opening balance of retained
earnings); and
ƒ if retrospective application is impracticable for a particular prior period, or for periods
before those presented, the circumstances that led to the existence of that condition and
a description of how and from when the change in accounting policy has been applied.
6.4.3 Voluntary change in accounting policy
When the management of an entity decides voluntarily to adopt a new accounting policy in
terms of IAS 8.14(b), the change of policy is applied retrospectively. A policy is only
changed voluntarily if it results in reliable and more relevant information about the
transactions, events or conditions reported in the financial statements.
If, however, it is impracticable, the comparatives need not be restated retrospectively. In
such instances, the new accounting policy is applied prospectively, subject to the
requirement addressed above in section 6.4.2. The reason for not applying the policy
retrospectively must be stated in the notes to the financial statements.
118 Descriptive Accounting – Chapter 6
A voluntary change in accounting policy takes place because the new policy will result in a
fairer presentation of the events and transactions in the financial statements, but it can also
lead to misuse. It is, for example, possible that certain changes in accounting policies can
be adopted in practice with the particular aim of manipulating the reported profit figures.
Only by applying professional judgement and ensuring that the financial statements comply
with the qualitative characteristics of financial statements as per the Conceptual Framework
can such manipulation be prevented.
6.4.3.1 Retrospective application of a change in accounting policy
A retrospective application of a change in accounting policy results in financial statements
that are adjusted to show the new accounting policy being applied to events and
transactions as if the new accounting policy had always been in use – in other words,
applied since the founding of the entity. This implies that the financial statements, including
the comparative amounts, must be adjusted to reflect the new policy. If the change in
accounting policy affects periods prior to the comparative period, a cumulative adjustment is
made to the opening balance of the retained earnings in the comparative year, or the
earliest period presented if more than one year’s comparative amounts are given. Note that
IAS 8 allows for partial recognition, subject to the limitations on retrospective application, as
discussed earlier.
6.4.3.2 Disclosure requirements in case of voluntary change in accounting policy
(IAS 8.29)
In addition to presenting a third statement of financial position (as discussed above in
section 6.4), when a voluntary change in accounting policy takes place, the following must
be disclosed:
ƒ the nature of the change in accounting policy;
ƒ the reasons why applying the new accounting policy provides reliable and more relevant
information;
ƒ for the current period and each prior period presented, to the extent practicable, the
amount of the adjustment for each financial statement line item affected;
ƒ the amount of the adjustment relating to periods before those presented, to the extent
practicable (i.e., the cumulative adjustment against the opening balance of retained
earnings); and
ƒ if retrospective application is impracticable for a particular prior period, or for periods
before those presented, the circumstances that led to the existence of that condition and
a description of how and from when the change in accounting policy has been applied.
Example 6.1
Change in accounting policy (retrospective restatement)
Comment
¾ A suggested method to approach the current and retrospective adjustments to the financial
statements resulting from an entity’s change in accounting policy, as well as the required
disclosure in the notes, is as follows:
¾ Calculate the current and retrospective cumulative and period-specific effects. (Be aware of
any possible impracticable retrospective applications (refer to section 6.7)).
¾ Prepare the applicable journals to account for the current and retrospective application of the
new accounting policy.
¾ Apply these journals to each individual line item affected in the financial statements.
¾ Disclose the effect of the changes to each financial statement line item in the notes to the
financial statements.
The preliminary statement of profit or loss and other comprehensive income and other information
of Gazelle Ltd for the year ended 31 December 20.19 is provided:
continued
Accounting policies, changes in accounting estimates and errors 119
20.19
R
1 401 000
(1 000 500)
20.18
R
1 000 000
(700 000)
Opening inventory
Purchases
300 000
1 100 500
200 000
800 000
Closing inventory
1 400 500
(400 000)
1 000 000
(300 000)
400 500
(100 500)
300 000
(100 000)
Profit before tax
Income tax expense (only current tax)
300 000
(84 000)
200 000
(56 000)
Profit for the year
216 000
144 000
Revenue
Cost of sales
Gross profit
Other expenses
Retained earnings at the beginning of the year:
20.18: R150 000
20.19: R294 000
In 20.19, the company decided to change the method used to value its inventories from the weighted
average cost method to the first-in, first-out cost method. Management is of the opinion that this
would result in a fairer presentation of the financial position and operating results because of
fluctuations in inventory prices. The closing inventories valued in accordance with the new basis are as
follows:
31 December 20.17 R240 000
31 December 20.18 R390 000
31 December 20.19 R480 000
The normal income tax rate is 28%. There are no temporary differences other than those arising from
the above information. The South African Revenue Service (SARS) accepted the new valuation
method of inventories on 31 December 20.19.
Comment
¾ It is important to note that the opening and closing inventory as included in the preliminary cost
of sales above are based on the old method. Both these amounts should be adjusted to reflect
the new valuation method.
The change in accounting policy will be disclosed in the financial statements of Gazelle Ltd as follows:
Gazelle Ltd
Extract from the statement of financial position as at 31 December 20.19
20.19
20.18
20.17
Note
R
R
R
Assets
Current assets
Inventories
3
480 000
390 000
240 000
continued
120 Descriptive Accounting – Chapter 6
Revenue
Cost of sales
Gazelle Ltd
Statement of profit or loss and other comprehensive income
for the year ended 31 December 20.19
20.19
Note
R
1 401 000
(1 010 500) 1
Gross profit
Other expenses
20.18
R
1 000 000
(650 000) 2
390 500
(100 500)
350 000
(100 000)
290 000
(81 200) 3
250 000
(70 000) 4
Profit for the year
Other comprehensive income
208 800
–
180 000
–
Total comprehensive income for the year
208 800
180 000
Profit before tax
Income tax expense
1
2
3
4
2
R1 000 500 + R10 000 (Jnl 4) = R1 010 500
R700 000 – R50 000 (Jnl 2) = R650 000
R84 000 – R2 800 (Jnl 5) = R81 200
R56 000 + R14 000 (Jnl 3) = R70 000
Gazelle Ltd
Extract from the statement of changes in equity
for the year ended 31 December 20.19
Note
Balance at 1 January 20.18
Change in accounting policy (R40 000 – R11 200) (Jnl 1)
Balance at 1 January 20.18 – restated
Changes in equity for 20.18
Total comprehensive income for the year
3
Retained
earnings
R
150 000
28 800
178 800
180 000
Profit for the year
Other comprehensive income
180 000
–
Balance at 31 December 20.18 – restated (R294 000 + R64 800)
Changes in equity for 20.19
Total comprehensive income for the year
358 800
208 800
Profit for the year
Other comprehensive income
208 800
–
Balance at 31 December 20.19
567 600
Gazelle Ltd
Notes for the year ended 31 December 20.19
1. Accounting policy
1.1 Inventories
Inventories are valued at the lower of cost and net realisable value according to the first-in,
first-out cost method. This represents a change in accounting policy (refer to note 3).
2. Income tax expense
Major components of tax expense:
Current tax expense (2) (20.18: R200 000 × 28%)
Deferred tax expense (3) (20.18: Jnl 3)
Tax expense
20.19
R
106 400
(25 200)
20.18
R
56 000
14 000
81 200
70 000
continued
Accounting policies, changes in accounting estimates and errors 121
3. Change in accounting policy
During the year, the company changed its accounting policy in respect of the valuation of inventories
from the weighted average cost method to the first-in, first-out cost method. Management is of the
opinion that the new valuation method for inventories will result in a fairer presentation of the financial
position and operating results since there have been fluctuations in the market prices. This change in
accounting policy has been accounted for retrospectively and the comparative amounts have been
restated. The effect of this change in accounting policy is as follows:
20.19
20.18
20.17
R
R
R
(Increase)/Decrease in cost of sales
(10 000)
50 000
Decrease/(Increase) in tax expense
2 800
(14 000)
(Decrease)/Increase in profit for the year
(7 200)
36 000
Increase in inventories
(Increase)/Decrease in current tax owing
(R106 400 (2) – R84 000 given)
(Increase)/Decrease in deferred tax liability
80 000
90 000
40 000
(25 200)
(11 200)
28 800
(22 400)
Increase/(Decrease) in equity (retained earnings)
57 600
64 800
Increase in retained earnings – beginning of year
64 800
28 800
Calculations
1. Effect of change in accounting policy
CumuPeriodlative
specific
20.19
20.19
R
R
SFP
P/L
Weighted average (old policy)
(400 000)
First-in, first-out (new policy)
480 000
Increase in inventory* per SFP
Increase/(Decrease) in profit before tax
Tax @ 28%
80 000
Cumulative
20.18
R
SFP
(300 000)
390 000
Periodspecific
20.18
R
P/L
90 000
(22 400)
(10 000)
2 800
57 600
(7 200)
Cumulative
20.17
R
SFP
(200 000)
240 000
40 000
(25 200)
50 000
(14 000)
(11 200)
64 800
36 000
28 800
* An increase in closing inventories = decrease in cost of sales = increase in profit
2. Calculation of current tax expense
Reported profit (adjusted) (R300 000 – R10 000 (Jnl 4))
Temporary differences
20.19
R
290 000
90 000
Opening inventories – new policy (per accounting as restated)
– old policy (per taxation – not restated)
390 000
(300 000)
Taxable income
380 000
Current tax expense (R380 000 × 28%)
106 400
continued
122 Descriptive Accounting – Chapter 6
20.19
R
Alternative calculation for the current tax expense in 20.19:
Revenue – taxable in full
Cost of sales
Opening inventory
(old basis, as SARS accepted new basis for closing inventory)
Purchases
Closing inventory (new basis)
1 401 000
(920 500)
300 000
1 100 500
(480 000)
Other expenses – deductible in full
(100 500)
Taxable income
380 000
Current tax expense (R380 000 × 28%)
106 400
3. Calculation of deferred tax
Carrying
amount
Deferred Movement
Temporary
tax – SFP
to P/L
differences
@ 28%
@ 28%
Dr/(Cr)
Dr/(Cr)
R
R
R
R
200 000
40 000
(11 200) 11 200
300 000
90 000
(25 200) 14 000
480 000
–
–
(25 200)
Tax
base
R
20.17 – Restated
240 000
20.18
390 000
20.19
480 000
Comment
¾ SARS does not normally go back to previous years and re-open assessments for changes in
accounting policies. This means that the tax base of inventories in prior years will be determined
using the ‘old’ method of valuation. IAS 8 however, requires that the carrying amounts of
inventories in the financial statements be changed retrospectively so that the prior years’ values
will be in accordance with the ‘new’ basis of valuation. This gives rise to a temporary difference for
deferred tax purposes.
4. Journal entries to account for the change in accounting policy
The full cumulative and period-specific effect for all comparative periods are available as is evident
from the calculation above; therefore the amounts in the financial statements for the year ended
31 December 20.18 (comparative period) can be restated for the cumulative effect of the change
in accounting policy on all prior periods, assuming that the comparative period can be re-opened
for purposes of processing these journals. Full retrospective application is therefore practicable.
Dr
Cr
R
R
Journal 1
1 January 20.18
Inventories (SFP)
40 000
Deferred tax (SFP)
11 200
Retained earnings – opening balance (Equity)
28 800
Restate the earliest period presented for the cumulative effect of the
change in accounting policy (change in the 20.17 closing inventories
balance) (R240 000 – R200 000); (R40 000 × 28%)
Journal 2
31 December 20.18
Inventories (SFP)
Cost of sales (P/L)
Account for the period-specific effect of 20.18
50 000
Journal 3
31 December 20.18
Income tax expense (P/L)
Deferred tax (SFP)
Tax effect for the period-specific effect of 20.18
14 000
50 000
14 000
continued
Accounting policies, changes in accounting estimates and errors 123
Dr
R
Journal 4
31 December 20.19
Cost of sales (P/L)
Inventories (SFP)
Account for the period-specific effect of 20.19
Journal 5
31 December 20.19
Income tax expense (P/L)
Current tax payable (SFP) (R80 000 × 28%) (note 3)
Deferred tax (SFP) (3)
Income tax expense (P/L)
Tax effect for the period-specific effect of 20.19
Cr
R
10 000
10 000
22 400
22 400
25 200
25 200
Comment
¾ The cumulative effect of Journals 1 and 2 is an increase in the inventories balance of R90 000
at the end of 20.18, which is in line with the calculations above.
¾ The cumulative effect of Journals 1, 2 and 4 is an increase in the inventories balance of
R80 000 at the end of 20.19, which is in line with the calculations above.
6.4.3.3 Prospective application of a change in accounting policy
Prospective application of changes in accounting policy should only be used when the
amount of the adjustment to the opening balance of the retained earnings cannot be
determined reliably, or if the transitional provisions of a new Standard specify such
treatment.
A prospective application of a change in accounting policy means that the new policy is only
applied to transactions, events and conditions after the date of implementation of the new
policy. Retrospective adjustments are not made, as is in the case of a retrospective change
in accounting policy, and the comparative amounts are not changed, nor are any
adjustments made to retained earnings. The new policy is applied only to new transactions,
events and conditions.
6.4.4 Disclosure requirements in case of non-application of a new Standard
or Interpretation
When the IASB issues a new or revised Standard or Interpretation, it will specify an effective
future date for it. When an entity has not applied a new Standard or Interpretation that has
been issued but is not yet effective, the entity must disclose:
ƒ this fact; and
ƒ known or reasonably estimable information relevant to assessing the possible impact
that application of the new Standard or Interpretation will have on the entity’s financial
statements in the period of initial application. The information disclosed must include:
– the title of the Standard or Interpretation;
– the nature of the impending changes in policy;
– the date by which the application of the Standard or Interpretation is required;
– the entity’s expected application date; and
– a discussion of the expected impact of the initial application, or if not known, a
declaration to that effect.
6.5 Changes in accounting estimates
Estimates are commonly used to measure the carrying amounts of assets and liabilities,
such as provisions, allowance for credit losses on debtors, depreciation, impairment losses, etc.
124 Descriptive Accounting – Chapter 6
Some items in the financial statements cannot be measured precisely due to uncertainties
inherent in business activities. The use of estimates is thus necessary which involves
professional judgement based on the latest reliable information available at the time the
estimate is made. As professional judgement is often used in preparing financial statements,
it is possible that the exercise of judgement may prove to have been incorrect at a later
date. This does not imply, however, that an error was made. The preparer of the financial
statements merely used the information available at the date of estimation with reasonable
care in order to come to a conclusion that subsequent events proved to be incorrect. An
example is the estimate of the useful life of a depreciable asset. On the date of acquisition of
a depreciable asset, the expected useful life is estimated, based on the facts available at
that date. If the estimate proves to be incorrect at a later stage due to changes in
circumstances, new information or more experience, steps are taken to correct the estimate.
The correction of the estimate is called a ‘change in accounting estimate’, and takes place
continually. The financial statements are not less accurate as a result of the changes in
estimates. The use of reasonable estimates is an essential part of the preparation of
financial statements and does not undermine the faithful representation thereof.
A change in accounting estimates is either an adjustment of:
ƒ the carrying amount of an asset or a liability; or
ƒ the amount of the periodic consumption of an asset,
that results from the assessment of the present status of, and expected future benefits and
obligations associated with, assets and liabilities. Changes in accounting estimates are not
the same as the corrections of errors, as these changes result from new information or new
developments that became available, and are not the result of fixing mistakes, omissions,
misuse of information, etc.
Examples of the adjustment of the carrying amount of an asset or liability are the estimates
involved in determining the recoverable amount of an asset (e.g. value in use or net realisable
value) and determining the balance of a provision (e.g. a provision for environmental
restoration – also refer to IFRIC 1, which is addressed in chapter 15). The effect of the
changes in these estimates is recognised merely by adjusting the carrying amount of the
asset or liability. Estimates relating to the periodic consumption of an asset are made for the
residual value, pattern of economic benefits and useful life of the asset. The effect of the
changes in these estimates is recognised in profit or loss by changing the amount of the
depreciation expense to be recognised for the current (and future) period.
Changes in accounting estimates affect only the current period, or the current and future
periods. This implies that changes in estimates are recognised and disclosed prospectively,
in the periods affected by the change. An example of a change in estimate that affects only
the current period is a change in the allowance for credit losses (adjustment of the carrying
amount of receivables). Such a change in estimate is merely included in the profit or loss of
the current period and, if material, is disclosed as an item requiring specific disclosure in terms
of IAS 8, unless it is impracticable to do so. Even if the item does not have a material effect
on the results of the current period, but is expected to have a material effect in the future,
the item is disclosed separately as an item requiring disclosure in the current period in terms
of IAS 8, unless estimating it is impracticable.
Changes in the useful life, residual value and the depreciation method of a depreciable
asset are examples of items which affect both the current and future periods. The change of
estimate applicable to the current period is included in profit or loss. Once again, if the
amount is material in relation to the results of the current period or is expected to have a
material effect on future periods, the item will be disclosed in accordance with the specific
disclosure requirements of IAS 8, unless estimating it is impracticable, in which instance this
fact is disclosed in the financial statements.
A change of estimate made in the current period need not again be disclosed separately in
future periods.
Accounting policies, changes in accounting estimates and errors 125
In the exceptional instance where it is not possible to distinguish whether a transaction,
event or condition is a change in estimate or a change in accounting policy, then IAS 8
recommends that it be treated as a change in estimate.
6.5.1 Disclosure requirements
The following must be disclosed in respect of material changes in accounting estimates:
ƒ the nature of the change;
ƒ the amount of the change; and
ƒ the effect on future periods (if practicable to estimate) or else a statement that the future
effect is impracticable to estimate.
6.5.2 Example in respect of changes in accounting estimate
Example 6.2
Change in accounting estimate: Depreciation pattern
The following information was obtained in respect of the equipment of Londo Ltd for the year
ended 31 December 20.13:
The original cost of the equipment was R125 000 on 1 January 20.11.
According to the company’s management, the accounting estimate in respect of the depreciation
of equipment has changed, as the previous pattern of depreciation differed from the actual pattern
of economic benefits from depreciable assets. The reducing balance method is applied from 20.13
at 20% per annum, instead of the straight-line method over five years. The depreciation for the
20.13 financial year was calculated on the reducing balance method, as follows:
R’000
Balance at beginning of year – carrying amount of asset (R125 000 – R25 000 – R25 000)
75
Depreciation for the year (R75 000 × 20%)
(15)
Balance at end of year
60
Comment
¾ The depreciation for the current year should reflect the newest estimate (of the pattern of
economic benefits). The approach is then to start with the carrying amount of the asset at the
beginning of the current year and to apply the newest estimates to it.
¾ Changes to the estimates that relate to the consumption of the future economic benefits
embodied in a depreciable asset affect the depreciation expense for the current year (refer to
IAS 8.38). As such, the newest estimates are used to calculate the depreciation expense for
the current year, irrespective of when the estimates change (i.e. at the beginning of, during, or
at the end of the year).
¾ The same approach would also have been followed, if, for example, the estimates for the
residual value and/or the useful life of the depreciable asset were changed as is illustrated in
the next example.
continued
126 Descriptive Accounting – Chapter 6
The change in accounting estimate will be disclosed in the notes to the financial statements of
Londo Ltd as follows:
Londo Ltd
Notes for the year ended 31 December 20.13
1. Property, plant and equipment
Equipment
Equipment
20.13
20.12
R’000
R’000
Carrying amount at the beginning of the year
75
100
Cost
Accumulated depreciation
125
(50)
125
(25)
Depreciation for the year
(15)
(25)
60
75
125
(65)
125
(50)
Carrying amount at the end of the year
Cost
Accumulated depreciation
2. Profit before tax
The following items are included in profit before tax:
20.13
R’000
20.12
R’000
15
25
Expenses:
Depreciation
A change in the method of determining depreciation, from the straight-line method to the reducing
balance method, resulted in a change in estimate, which decreased depreciation on equipment for
the year by R10 000 (R25 000 – R15 000). The effect on future periods is an increase in the total
depreciation expense of R10 000 for the remaining useful life (1).
Comment
¾ The actual amount of depreciation (R15 000) is presented in the notes for property, plant and
equipment and profit before tax. Furthermore, IAS 8 requires disclosure of the amount of the
change itself (R10 000). IAS 8 does not specify where (in which note) such disclosure is to be
made.
Calculations
1. Change in accounting estimate
Effect of change in estimate on future periods
Depreciation expense still to be written-off – old basis (R75 000 – (R125 000/5))
Depreciation expense still to be written-off – new basis (given)
Increase in depreciation
Example 6.3
R’000
50
60
10
Change in accounting estimates: Useful life and residual value
Wifi Ltd bought a new item of plant on 1 January 20.11 at a total cost of R1 000 000. The plant
was depreciated evenly over its useful life of 6 years, with a residual value of R100 000.
New technology became available on 1 January 20.14. Wifi Ltd realised that the plant would need
to be replaced sooner than expected. On 1 January 20.14 the remaining useful life was estimated
to be 2 years (the new total useful life was considered to be 5 years), with a residual value of
R50 000.
continued
Accounting policies, changes in accounting estimates and errors 127
The depreciation for the year ended 31 December 2014 is calculated as follows:
Cost of the plant
Accumulated depreciation at 1 January 2014
((R1 000 000 – R100 000)/6 × 3 years)
Carrying amount of the plant at the beginning of the year
Depreciation for the year ((R550 000 – R50 000)/2 years remaining from the
beginning of the current year)
Carrying amount at the end of the year
R
1 000 000
(450 000)
550 000
(250 000)
300 000
Comment
¾ The depreciation for the current year should reflect the newest estimates (of the useful life and
residual value). The approach is then to start with the carrying amount of the asset at the
beginning of the current year and to apply the newest estimates to it.
¾ The estimates are changed as a result of new information (new technology) that became
available. This does not represent a prior period error.
¾ The effect of the change in the estimates for the periodic consumption of the plant (i.e. how
depreciation is calculated based on the new estimates for the useful life and residual value) to
be disclosed in the notes is:
Depreciation based on new estimates
R250 000
Depreciation based on previous estimates
(R150 000)
Effect of the change in the accounting estimates
R100 000
Also refer to chapter 9 for more examples on the changes in estimates of the periodic
consumption of assets.
6.6 Errors
Errors can arise in respect of the recognition, measurement, presentation or disclosure of
elements of financial statements. Financial statements do not comply with IFRSs 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.
Errors discovered in the current period (and relating to it) are corrected before the financial
statements are authorised for issue and therefore do not require special treatment or
disclosure. Errors are, however, sometimes not discovered until a subsequent period, and
are called prior period errors. They may need special treatment, depending on the
materiality thereof.
6.6.1 Prior period errors
Prior period errors are omissions from, and misstatements in, the entity’s financial
statements for one or more prior periods arising from a failure to use (or misuse of) reliable
information that was available when the financial statements for those periods were
authorised for issue and could reasonably be expected to have been obtained and taken
into account in the preparation and presentation of those financial statements. Such errors
include the effects of mathematical mistakes, mistakes in applying accounting policies,
oversights or misinterpretations of facts, and fraud.
An example of an error made in the application of an accounting policy is the incorrect
application of the calculation of the recoverable amount of an asset that is possibly impaired
as required by IAS 36 Impairment of Assets. According to IAS 36, the recoverable amount of
an asset is the higher of its value in use and its fair value less costs of disposal. Should an
entity have used the lower of the two amounts when calculating the impairment loss in a
128 Descriptive Accounting – Chapter 6
prior period, the resultant impairment loss would have been incorrect and it would constitute
an error that should be corrected retrospectively in accordance with IAS 8.
It is important to note that a change in an accounting estimate is not a correction of an error,
as a change in estimate results from new information, more experience or a change in
circumstances, whereas the correction of an error relates to information that was available in
prior periods. A change in estimate is inherent in accounting and will therefore not result in
financial statements that are incorrect or unreliable as is the case with errors. For example,
a gain or loss recognised on the outcome of a contingency is a change in estimate (based
on new information) and not an error.
6.6.2 Material prior period errors
Prior period omissions or misstatements of items are material if they could, individually or
collectively, influence the economic decisions of users made on the basis of the financial
statements. Materiality depends on the size and/or nature of the omission or misstatement
judged in the surrounding circumstances. The size, or nature of the item, or a combination of
both, could be the determining factor. An entity should correct material prior period errors
retrospectively in the first set of financial statements authorised for issue after the
discovery of the error. By the retrospective restatement or correction of an error, an entity
corrects the recognition, measurement and disclosure of amounts of the relevant element of
the financial statements as if the prior period error had never occurred.
Retrospective correction of a material prior period error involves (IAS 8.42):
ƒ restating the comparative amounts for the prior period(s) presented in which the error
occurred; or
ƒ 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.
Example 6.4
6.4
Retrospective correction of material prior period errors
The preliminary financial statements of Oops Ltd for the three years ended 31 December 20.18,
before any of the additional information below has been taken into account, reflected the following
items:
20.18
20.17
20.16
R
R
R
Assets:
Building – cost
1 000 000
1 000 000
1 000 000
Prepaid expense
–
50 000
–
Equity:
Retained earnings:
Balance at the beginning of the year
4 700 000
3 800 000
3 000 000
Profit for the year
1 020 000
900 000
800 000
Balance at the end of the year
5 720 000
4 700 000
3 800 000
Additional information
After reviewing the preliminary financial statements, the new financial director discovered the following
prior period errors. Both errors are regarded as material.
1. Oops Ltd acquired a new building on 1 January 20.14 at a cost of R1 000 000. The accountant
forgot to recognise any depreciation on the building.
The building should have been depreciated on the straight line basis over 10 years, with no residual
value.
continued
Accounting policies, changes in accounting estimates and errors 129
2. During 20.17, the company paid its annual insurance premium of R50 000 and incorrectly
recognised it as a prepaid expense. The insurance premium should have been expensed
during 20.17 in full.
Ignore any taxes.
The material prior period errors will be corrected retrospectively in the prior periods as follows:
Oops Ltd
Extract from statement of financial position as at 31 December 20.18
20.18
20.17
20.16
R
R
R
Assets as at the end of the year:
Building – cost
1 000 000
1 000 000
1 000 000
1
1
1
Accumulated depreciation
(500 000)
(400 000)
(300 000)
2
Prepaid expense
–
–
–
Equity:
Retained earnings (see below)
5 170 000
4 250 000
3 500 000
Oops Ltd
Extract from statement of changes in equity for the year ended 31 December 20.18
20.18
20.17
R
R
Retained earnings:
Balance at the beginning of the year
4 250 000
3 500 000
As presented previously
Correction in respect of depreciation
Correction in respect of prepaid expenses
Profit for the year
4 700 000
(400 000)
(50 000)
6
920 000
As presented previously
Correction in respect of depreciation
Correction in respect of prepaid expenses
Balance at the end of the year
3 800 000
3
(300 000)
–
750 000
4
5 170 000
900 000
(100 000)
5
(50 000)
4 250 000
1 The annual depreciation on the building was recognised against accumulated depreciation:
20.16: (R1 000 000/10 × 3 years)
20.17: (R1 000 000/10 × 4 years)
20.18: (R1 000 000/10 × 5 years)
2 The prepaid expense has now been corrected to reflect no prepaid expenses anymore.
3 20.17: The cumulative effect of the annual depreciation of R100 000 for 20.14, 20.15 and 20.16 is
corrected to the retained earnings as at the beginning of 20.17: R100 000 × 3 years = R300 000.
4 The annual depreciation for each period after 20.14 would also be corrected with R100 000. As
the error relates to the prior period presented, the comparative amounts for 20.17 are restated.
5 The error in respect of the insurance premium is corrected in the year in which it occurred (i.e.
20.17). As the error relates to a prior period presented (20.17), the comparative amounts for
20.17 are restated.
6 The financial statements for the current year (20.18) were not yet published. It is therefore not
needed to show the effect of the correction separately. The amount for the profit for the year is
corrected as: R1 020 000 – R100 000 = R920 000.
continued
130 Descriptive Accounting – Chapter 6
Comment
¾ IAS 1.40A requires a third statement of financial position to be presented where a prior period
error was restated retrospectively. Therefore, 20.16 and 20.17 are presented as prior periods in
the statement of financial position.
¾ A third statement of changes in equity is not required (IAS 1.38A). Therefore, only the
comparative amounts for 20.17 are presented.
¾ The error relating to the depreciation that was not recognised occurred (in 20.14) before the
earliest prior period presented. Therefore, the opening balance for retained earnings3 for the
earliest prior period presented (i.e. 20.17) is restated with the cumulative effect of R300 000
(R100 000 for each of 20.14, 20.15 and 20.16).
¾ The comparative amounts for the prior period presented (20.17) are also restated with the
depreciation expense4 corrected.
¾ The comparative amount for the ‘profit for the year’ for 20.17 is restated for the insurance
premium5 that was now recognised as an expense in 20.17.
¾ The purpose of this example was to illustrate where the cumulative effect and period-specific
effect of the prior period errors are to be corrected. Full disclosure for prior period errors is
illustrated in the next example.
When a retrospective correction of a material prior period error is required, it may happen
that it is impracticable to determine either the period-specific effects (i.e. the effect for a
specific period) or the cumulative effect of the error (IAS 8.43 to .45). Should the
impracticability relate to period-specific effects on comparative information for one or more
prior periods presented, determine the earliest period for which retrospective restatement is
practicable. The necessary adjustment is then made against the opening balance of each
affected component of equity for that specific period, after which restatement will commence
from that period onwards. If it is impracticable to determine the cumulative effect of the error
on all prior periods at the beginning of the current period, comparative information should be
restated prospectively from the earliest date practicable. The cumulative restatement of
assets, liabilities and equity arising before that specific date is then disregarded. Note that
the above treatment is identical to the treatment of a change in accounting policy where
retrospective application of such a change is impracticable.
6.6.3 Disclosure requirements
Disclosures in respect of the correction of prior period errors will only be presented in the
year of the correction of the error and not in subsequent periods. The following information
regarding the correction of errors must be disclosed in the financial statements:
ƒ the nature of the prior period error;
ƒ for each prior period presented, to the extent practicable, the amount of the correction:
– for each financial statement line item affected; and
– for basic and diluted earnings per share, if presented;
ƒ the amount of the correction at the beginning of the earliest prior period presented
(i.e., the cumulative correction against the opening balance of retained earnings); and
ƒ 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.
The requirement of IAS 1 to present a third statement of financial position (as discussed
above in section 6.4) also applies where a prior period error was restated retrospectively.
Accounting policies, changes in accounting estimates and errors 131
6.6.4 Example in respect of a material prior period error
Example 6.5
6.5
Prior period error and reclassification
The preliminary statements of profit or loss and other comprehensive income of Badger Ltd for the
three years ended 31 December 20.19, before any of the additional information below has been
taken into account, are provided:
20.19
20.18
20.17
R
R
R
Revenue
2 778 000
2 095 000
1 790 000
Cost of sales
(1 348 000)
(869 000)
(800 000)
Gross profit
Other expenses
1 430 000
(662 000)
1 226 000
(672 000)
990 000
(545 000)
Profit before tax
Income tax expense
768 000
(215 040)
554 000
(155 120)
445 000
(124 600)
– Current tax
– Deferred tax
(227 040)
12 000
(116 120)
(39 000)
(116 600)
(8 000)
552 960
398 880
320 400
Profit for the year
Additional information
1. Retained earnings on 1 January 20.17 was R763 000.
2. During the preparation of the financial information for the year ended 31 December 20.19, the
accountant established that a material error had been made in the published financial
statements for the years ended 31 December 20.17 and 20.18.
On 1 January 20.17, Badger Ltd purchased computer equipment for R800 000. The computer
equipment was installed at a cost of R110 000 and was available for use as intended by
management on 1 February 20.17. There is no residual value, and management estimated the
useful life to be 4 years. Depreciation is calculated on the straight-line basis.
During the year ended 31 December 20.17, when the asset was accounted for, only the
R800 000 was capitalised and the R110 000 was expensed (as professional fees paid).
3. The accountant immediately informed the South African Revenue Services (SARS) of the
error. SARS agreed to re-open the 20.17 and 20.18 tax assessments and make the necessary
adjustments. The tax rate has remained unchanged at 28%. No penalties were levied.
4. Assume SARS allowed a tax allowance on computer equipment as a straight-line deduction
over three years, without apportionment for parts of a year.
5. The following items are included in other expenses:
20.19
20.18
20.17
R
R
R
Depreciation (computer equipment and other items)
230 000
230 000 210 000
Professional fees paid
–
– 110 000
Staff costs
180 000
175 000
40 000
Distribution costs
97 000
77 000
–
Administrative expenses
155 000
190 000 185 000
662 000
672 000
545 000
Assume that the depreciation, professional fees and staff costs are correctly classified as
‘other expenses’. During 20.19, the accountant also realised that the distribution costs and
administrative expenses should be presented separately in the statement of profit or loss and
other comprehensive income.
6. Badger Ltd has not paid a dividend for the last 3 years.
continued
132 Descriptive Accounting – Chapter 6
The financial statements and the relevant notes of Badger Ltd for the year ended
31 December 20.19 will be prepared as follows:
Badger Ltd
Extract from the statement of financial position as at 31 December 20.19
Notes
20.19
20.18
R
R
Assets
Non-current assets
Property, plant and equipment
Computer equipment
Other items
Equity
Retained earnings
Revenue
Cost of sales
20.17
R
246 458
xx
473 958
xx
701 458
xx
2 056 689
1 523 528
1 144 450
Badger Ltd
Statement of profit or loss and other comprehensive income
for the year ended 31 December 20.19
20.19
Notes
R
2 778 000
(1 348 000)
Gross profit
Distribution costs
Administrative costs
Other expenses (4)
20.18
R
2 095 000
(869 000)
1 430 000
(97 000)
(155 000)
(437 500)
1 226 000
(77 000)
(190 000)
(432 500)
740 500
(207 339)
526 500
(147 422)
Profit for the year
Other comprehensive income
533 161
–
379 078
–
Total comprehensive income for the year
533 161
379 078
Profit before tax
Income tax expense
3
Badger Ltd
Extract from the statement of changes in equity
for the year ended 31 December 20.19
Balance at 1 January 20.18 – as presented previously (R763 000 + R320 400)
Correction of error (note 1)
Balance at 1 January 20.18 – restated (8)
Changes in equity for 20.18
Total comprehensive income for the year – restated
Profit for the year (R398 880 – R19 802)
Other comprehensive income
Balance at 31 December 20.18 – restated
Changes in equity for 20.19
Total comprehensive income for the year
Profit for the year (R552 960 – R19 799)
Other comprehensive income
Balance at 31 December 20.19
Retained
earnings
R
1 083 400
61 050
1 144 450
379 078
379 078
–
1 523 528
533 161
533 161
–
2 056 689
continued
Accounting policies, changes in accounting estimates and errors 133
Badger Ltd
Notes for the year ended 31 December 20.19
1. Prior period error
In 20.17, an error was made in the calculation of property, plant and equipment. Installation costs for
computer equipment were expensed instead of being capitalised. The depreciation, tax allowances,
income tax expense and deferred tax were incorrectly calculated. The comparative amounts for 20.18
have been restated. The effect of the restatement on the financial statements is summarised below.
20.18
20.17
R
R
(Increase)/Decrease in other expenses * (4)
(27 500)
84 791
(Increase)/Decrease in income tax expense * (7)
7 698
(23 741)
(Decrease)/Increase in total comprehensive income for the year *
(19 802)
61 050
(Decrease)/Increase in property, plant and equipment – cost *
(Increase)/Decrease in accumulated depreciation *
110 000
(52 709)
110 000
(25 209)
(Decrease)/Increase in property, plant and equipment *
Decrease/(Increase) in deferred tax liability *
Decrease/(Increase) in current tax owing *
1
Increase in equity *
4
Increase in retained earnings – opening balance *
2
3
57 291
(5 775)
(10 268)
41 248
1
2
3
84 791
(3 207)
(20 534)
61 050
61 050
1 20.17: (R701 458 (2) – R616 667 (2)) = R84 791 (R110 000 – R25 209 (Jnl 1))
20.18: (R473 958 (2) – R416 667 (2)) = R57 291 or cumulative change amount at end of 20.18 =
R84 791 – R27 500 (cumulative change at end of 20.17) = R57 291 (period change for 20.18);
2 Calc 6.3 or R5 775 is the cumulative change to end of 20.18: [R3 207 cumulative for 20.17
(calc 6.4) + period change of R2 568 for 20.18 (calc 6.4) = R5 775)]; [R3 207 (Jnl 1) + R2 568
(Jnl 3) = R5 775]
20.17: R3 207 (Jnl 1) and calc 6.3;
3 20.18: R10 268 is the cumulative change to end of 20.18: [(R20 534) cumulative for 20.17 +
period change of R10 266 for 20.18 = (R10 268)]; [R20 534 (Jnl 1) – R10 266 (Jnl 3) =
R10 268]
20.17: R20 534 (Jnl 1) and calc 5;
4 Proof: R61 050 (cumulative change 20.17) – R19 802 (period change 20.18) = R41 248
(cumulative change 20.18); [R61 050 (Jnl 1) – R27 500 (Jnl 2) + R10 266 (Jnl 3) – R2 568 (Jnl 3)
= R41 248]
Comment
¾ IAS 1.40A requires that when an entity retrospectively restates items in its financial statements
as a result of the correction of an error and the restatement has a material effect on the
information in the statement of financial position at the beginning of the previous year, it shall
present, as a minimum, three statements of financial position.
¾ In this case, the restatement resulting from the correction of the error affects 20.18 and 20.17.
Disclosure in terms of IAS 8 is required, whereby the comparative amounts (for 20.18) are
restated (IAS 8.42(a); 49(b)) and the opening retained earnings is adjusted with the cumulative
effect (for 20.17) (IAS 8.42(b); 49(c)). In terms of IAS 1.40C detailed notes for the statement of
financial position as at 1 January 20.18 (end of 20.17) are not required. A statement of profit or
loss and other comprehensive income for 20.17 is also not required (comparative amounts are only
required for one year (IAS 1.38)). Therefore, full disclosure of the amounts for 20.17 in the note for
the prior period error above, may perhaps not be needed, but were given for illustrative purposes.
¾ The effect on each of the line items in the statement of financial position that make up the net
effect on equity must be indicated.
continued
134 Descriptive Accounting – Chapter 6
¾ According to IAS 8.49(b), an entity shall disclose* for each prior period presented, the amount
of the correction for each financial statement line item affected. This prior period error note
therefore has to indicate the effect of the correcting journal entry on all the financial statement
line items and not only those directly affected as a result of the prepared journal entry.
2. Reclassification
A portion of other expenses was reclassified to distribution costs and administrative expenses
during the current and comparative financial years. The separate disclosure of these items is
required by IFRSs. The comparative amounts have been restated accordingly as follows
(IAS 1.41):
20.18
R
Decrease in other expenses (Jnl 6)
(267 000)
Increase in distribution costs (Jnl 6)
77 000
Increase in administrative expenses (Jnl 6)
190 000
3. Income tax expense
Major components of tax expense:
Current tax expense (5)
(R227 040 – R10 267 (Jnl 5)); (R116 120 – R10 266 (Jnl 3))
Deferred tax expense (6.4)
((R12 000) + R2 566 (Jnl 5)); (R39 000 + R2 568 (Jnl 3))
Tax expense (7)
20.19
20.18
R
R
216 773
(9 434)
207 339
105 854
41 568
147 422
Calculations
1. Journal entries
To account for prior period error, assuming that the comparative period can be re-opened for
purposes of processing these journals:
Dr
Cr
R
R
Journal 1
1 January 20.18
Property, plant and equipment (SFP) (given)
110 000
Accumulated depreciation (SFP) (R208 542 – R183 333) (2)
25 209
Current tax payable (SFP) (5)
20 534
Deferred tax liability (SFP) (6.3)
3 207
Retained earnings – opening balance (Equity)
61 050
((R110 000 – R25 209) × 72%)
Restate earliest period presented for the cumulative effect of the
correction of the prior period error
Journal 2
31 December 20.18
Other expenses (Depreciation) (P/L) (R227 500 – R200 000)
Accumulated depreciation (SFP)
Account for the period-specific of the correction of prior period error
for 20.18
27 500
27 500
continued
Accounting policies, changes in accounting estimates and errors 135
Dr
R
Journal 3
31 December 20.18
Deferred tax expense (P/L) (6.4)
Deferred tax liability (SFP)
Current tax expense (P/L) (7)
Current tax receivable (SFP)
Account for the tax effects of the period-specific effect of the
correction of prior period error for 20.18
Journal 4
31 December 20.19
Other expenses (Depreciation) (P/L)
Accumulated depreciation (SFP)
Account for the period-specific effect of the correction of prior period
error for 20.19
Journal 5
31 December 20.19
Deferred tax expense (P/L) (6.4)
Deferred tax liability (SFP)
Current tax expense (P/L) (7)
Current tax receivable (SFP)
Account for the tax effects of the period-specific effect of the
correction of prior period error for 20.19
To account for reclassification:
Journal 6
31 December 20.18
Distribution costs (P/L)
Administrative expenses (P/L)
Other expenses (P/L)
Reclassification of expense items
Cr
R
2 568
2 568
10 266
10 266
27 500
27 500
2 566
2 566
10 267
10 267
77 000
190 000
267 000
2. Depreciation of computer equipment
Cost
Depreciation 20.17 (R800 000/4 × 11/12); (R910 000/4 × 11/12)
Before
correction
of error
R
800 000
(183 333)
Carrying amount 31/12/20.17
Depreciation 20.18 (R800 000/4); (R910 000/4)
616 667
(200 000)
701 458
(227 500)
Carrying amount 31/12/20.18
416 667
473 958
(200 000)
(227 500)
216 667
246 458
Depreciation 20.19 (R800 000/4); (R910 000/4)
Carrying amount 31/12/20.19
After
correction
of error
R
910 000
(208 542)
continued
136 Descriptive Accounting – Chapter 6
3. Tax allowances of computer equipment
Cost
Tax allowance 20.17 (R800 000/3); (R910 000/3)
Before
correction
of error
R
800 000
(266 667)
After
correction
of error
R
910 000
(303 333)
Tax base 31/12/20.17
Tax allowance 20.18 (R800 000/3); (R910 000/3)
533 333
(266 667)
606 667
(303 333)
Tax base 31/12/20.18
Tax allowance 20.19 (R800 000/3); (R910 000/3)
266 666
(266 666)
303 334
(303 334)
–
–
Tax base 31/12/20.19
4. Other expenses
Amount disclosed in preliminary financial
statements (before correction of error)
Adjustments needed for corrected error
Professional fees that should have been
capitalised to the cost of asset
Depreciation correction
Reclassification – Distribution costs and
Administrative expenses
20.19
R
20.18
R
662 000
27 500
672 000
27 500
545 000
(84 791)
–
27 500
(110 000)
2
25 209
1
3
–
27 500
4
(267 000)
(185 000)
437 500
432 500
275 209
5. Current tax
Adjustments needed for corrected error
(36 668)
(36 666)
73 334
Professional fees incorrectly expensed
Tax allowance adjustments (3)
–
2
(36 668)
–
1
(36 666)
110 000
1
(36 666)
Thus adjustment to current tax expense
(decrease)/increase at 28%
(10 267)
(10 266)
20 534
Comprehensive calculation of current tax:
Amount as given before correction of error
227 040
116 120
116 600
Thus taxable income (R227 040/28%);
(R116 120/28%); (R116 600/28%)
Adjustments needed for corrected error
810 857
(36 668)
414 714
(36 666)
416 429
73 334
1
2
3
4
(252 000)
1
20.17
R
20.18 and 20.19: R227 500 – R200 000 = R27 500
20.17: R208 542 – R183 333 = R25 209
20.19: (R97 000 + R155 000)
20.18: (Jnl 6) or (R77 000 + R190 000)
Professional fees incorrectly expensed
Tax allowance adjustments (3)
2
–
(36 668)
1
–
(36 666)
1
110 000
(36 666)
Adjusted taxable income
774 189
378 048
489 763
Current tax at 28% thereof (new)
Current tax (old)
Thus adjustment to current tax expense
(decrease)/increase
216 773
(227 040)
105 854
(116 120)
137 134
(116 600)
(10 267)
(10 266)
20 534
1 20.17 and 20.18: R303 333 – R266 667 = R36 666
2 20.19: R303 334 – R266 666 = R36 668
continued
Accounting policies, changes in accounting estimates and errors 137
6. Deferred tax relating to computer equipment
6.1 Before error was corrected
Carrying
amount
Tax
base
Temporary
differences
R
Deferred Movement
tax – SFP
to P/L
@ 28%
@ 28%
Dr/(Cr)
Dr/(Cr)
R
R
–
–
(23 334)
23 334
R
R
31/12/20.16
31/12/20.17
–
616 667
–
533 333
–
83 334
31/12/20.18
416 667
266 666
150 001
(42 000)
18 666
31/12/20.19
216 667
216 667
(60 667)
18 667
6.2 After error was corrected
31/12/20.16
31/12/20.17
–
701 458
–
606 667
–
94 791
–
(26 541)
–
26 541
31/12/20.18
473 958
303 334
170 624
(47 775)
21 234
31/12/20.19
246 458
246 458
(69 008)
21 233
20.19
R
(60 667)
69 008
20.18
R
(42 000)
47 775
20.17
R
(23 334)
26 541
8 341
5 775
3 207
Movement before correction of error (6.1)
Movement after correction of error (6.2)
20.19
R
(18 667)
21 233
20.18
R
(18 666)
21 234
20.17
R
(23 334)
26 541
Thus increase in deferred tax expense
Deferred tax expense given in P/L
2 566
(12 000)
2 568
39 000
3 207
8 000
(9 434)
41 568
11 207
20.19
R
215 040
(7 701)
20.18
R
155 120
(7 698)
20.17
R
124 600
23 741
2 566
(10 267)
2 568
(10 266)
3 207
20 534
207 339
147 422
148 341
–
–
6.3 Adjustments needed to deferred tax balance
Deferred tax balance before error corrected
Deferred tax balance after error corrected
Increase/(Decrease)
6.4 Effect on deferred tax movement – tax expense
Adjusted deferred tax expense amount
7. Income tax expense (Test calculation))
Total tax expense given in P/L
Total adjustment
Increase in deferred tax expense (6.4)
(Decrease)/Increase in current tax expense (5)
Comment
¾ Due to the effect of the rounding on the various individual calculations that is included in the
calculations above, the total tax adjustment is not always exactly 28% of the adjustments made to
profit or loss. For example, the depreciation of 20.19 is adjusted with R27 500 and the tax effect is
expected to have been R7 700 (R27 500 × 28%).
continued
138 Descriptive Accounting – Chapter 6
8. Retained earnings 1/1/20.18
Balance given as at 1/1/20.17
Total comprehensive income for 20.17 before correction of error (given)
Correction of error:
Decrease in other expenses (4)
Increase in income tax expense (7)
20.17
R
763 000
320 400
84 791
(23 741)
1 144 450
6.7 Impracticability of retrospective application and retrospective
restatement
The retrospective application for changes in accounting policies or the restatement of
amounts for prior period errors cannot be achieved in all circumstances. In certain instances,
it is impracticable to restate comparatives, as the information of previous periods is
unavailable, not collected or not available in a format that allows for restatement. IAS 8
defines impracticable as when an entity cannot apply a requirement after making every
reasonable effort to do so. For retrospective application or restatement, it includes:
ƒ the effects of retrospective application (change of policy) or retrospective restatement
(errors) are not determinable;
ƒ the retrospective application or retrospective restatement requires assumptions about
what management's intent would have been in a prior period;
ƒ the retrospective application or retrospective restatement requires significant estimates
of amounts and it is not possible to objectively distinguish information about those
estimates that:
– provides evidence of circumstances that existed at the initial date the amounts were
recognised, measured or disclosed; and
– would have been available when the financial statements were authorised for issue,
from other information.
Consequently, the determination of estimates such as fair values of assets that are not
based on market values of recognised securities exchanges is probably impracticable to
determine. It is important to note that when determining the estimates, the information
available on the date of the transaction, event or condition should be considered in the
measurement, but the benefits of hindsight should not be considered. For example, the
classification of a financial asset may not be changed if, with the knowledge of hindsight, it
was found that management changed the classification in subsequent years.
Example 6.6
6.6
Impracticability of retrospective restatement
On the date of incorporation, namely 1 January 20.11, Bella Ltd acquired an item of property, plant
and equipment at a cost of R2 250 000 with an estimated insignificant residual value. The asset is
depreciated on the straight-line method over its estimated useful life of 15 years. All estimates
were revised annually and it was deemed that no change was necessary in any financial year. At
the end of each year, an impairment loss was recognised on this asset. The asset was written
down to its fair value. Value in use was never calculated and costs of disposal were never taken
into account. The current financial year end is 31 December 20.16. The error in the calculation of
the recoverable amount and the resultant impairment loss was only discovered in the current
financial year. Ignore any tax implications.
continued
Accounting policies, changes in accounting estimates and errors 139
Comment
¾ In this scenario the recoverable amount was only based on the fair value of the asset. In terms
of IAS 36, the recoverable amount should have been the higher of the fair value less costs of
disposal, and value in use.
The following information is available:
Carrying amount at the beginning of the financial year
(based on incorrect recoverable amount)
Less: depreciation for the year (R1 402 500/11); (R1 602 000/12)
20.15
Comparative
year
1 402 500
End of
20.14*
1 602 000
(127 500)
(133 500)
Carrying amount before impairment loss
Less: impairment loss
1 275 000
(45 000)
1 468 500
(66 000)
Recoverable amount at end of financial year (based on fair value)
1 230 000
1 402 500
Correct recoverable amount a
1 245 000
?b
ƒ Fair value less costs of disposal
(R1 230 000 – R18 000)
ƒ Value in use
1 212 000
?
1 245 000
?
* End of 20.14 is opening balance of comparative year (20.15)
a Based on the higher of fair value less costs of disposal and value in use (IAS 36.6).
b It is not possible to go back to previous years and determine the cash flows, discount rates and
related costs of disposal in order to calculate the correct recoverable amount. The first time it
was possible to calculate these amounts was on 31 December 20.15. Therefore the cumulative
effect of the error is only determinable at the end of the comparative year (20.15). It is however
not possible to calculate the correct impairment loss that should be recognised in profit or loss
of the 20.15 financial year, as the cumulative effect of the error is the result of an incorrect
impairment loss and resultant depreciation recognised in all previous years. The full cumulative
effect of the error cannot be recognised in one year’s profit or loss. Full retrospective
restatement is therefore not possible, as the prior year’s period-specific effect is not
known.
Journal entry to account for the correction of the prior period error:
Because the period-specific effect of the 20.15 comparative year cannot be determined, the
opening balances of the 20.16 financial year is the earliest period for which retrospective
restatement is practicable. (Refer to IAS 8.44, which states ‘When it is impracticable to determine
the period-specific effects of an error on comparative information for one or more periods
presented, the entity shall restate the opening balances of assets, liabilities and equity for the
earliest period for which retrospective restatement is practicable (which may be the current
period).’)
The following journal entry will therefore be applicable:
1 January 20.16
Property, plant and equipment (SFP) (R1 245 000 – R1 230 000)
Retained earnings – opening balance (Equity)c
Correction of error at the beginning of the year
Dr
R
15 000
Cr
R
15 000
c Previous years’ adjustments should have been made to all previous impairment losses and all
previous depreciation amounts (had the information been available to do these adjustments).
The effect of previous years’ incorrect impairment losses and depreciation would have
accumulated in retained earnings. Since the period specific effect could not be determined, the
full cumulative effect is adjusted against retained earnings.
continued
140 Descriptive Accounting – Chapter 6
In calculating the depreciation for the 20.16 financial year, the entity will start with the correct
carrying amount of R1 245 000 and depreciate that over the remaining useful life of ten years. If,
at the end of the year, there is an indication of possible impairment, the entity will test for
impairment by calculating the recoverable amount (being the higher of fair value less costs of
disposal and value in use) and compare that to the correct carrying amount at the end of the
year.
Restate the line items in the financial statements for the effect of the correction of the prior
period error, as follows:
Bella Ltd
Statement of changes in equity year ended 31 December 20.16
Retained
earnings
Note
R
Balance at 31 December 20.15 – as presented previously
xxx
Correction of prior period error (Jnl 1)
5
15 000
Restated balance
Changes in equity for 20.16
Total comprehensive income for the year
Profit for the year
Other comprehensive income
xxx + 15 000
xxx
xxx
xxx
Dividends
(xx)
Balance at 31 December 20.16
xxx
Disclose the effect of the prior period error in the notes:
Bella Ltd
Notes for the year ended 31 December 20.16
5. Prior period error
The carrying amount of property, plant and equipment has been restated for the effect of a prior
period error. The recoverable amount of the item was incorrectly calculated as its fair value without
comparing it to its value in use and using the higher of fair value less costs of disposal and value in
use. The effect of the error could not be restated retrospectively, because the cash flows, discount
rates and related costs of disposal needed to calculate the correct recoverable amount were not
available for prior periods. The cumulative effect could be calculated for the first time on
31 December 20.15. This effect was accounted for by adjusting the opening balances of assets
and equity in the current financial year.
Comment
¾ The disclosure requirements for a prior period error (IAS 8.49) require that the amount of the
correction for each financial statement line item affected for each prior period presented
should be disclosed. Due to the impracticability of full retrospective adjustment in this example,
none of the prior period amounts have been adjusted. Consequently, there are no line items to
disclose.
The statement of changes in equity for the year ended 31 December 20.16 (refer above) and
the note for property, plant and equipment will however indicate the amount of the adjustment
as a restatement to the opening retained earnings and the opening carrying amount of the
property, plant and equipment, which will be cross-referenced to this note.
¾ If the period-specific effect for the financial year ended 31 December 20.15 could have been
determined, the correcting journal entries would have adjusted the amounts included in the
financial statements for the year ended 31 December 20.15, provided that the accounting
system can be re-opened for the purpose of processing these journals. The prior period error
note would then have indicated the effect of the correction on all applicable line items in the
financial statements of the prior period presented.
CHAPTER
7
Events after the reporting period
(IAS 10)
Contents
7.1
7.2
7.3
7.4
7.5
7.6
7.7
7.8
7.9
Overview of IAS 10 Events after the Reporting Period .........................................
Background ..........................................................................................................
Date of authorisation of the issue of financial statements ....................................
Adjusting events ...................................................................................................
Non-adjusting events ............................................................................................
Dividends ..............................................................................................................
Going concern ......................................................................................................
Presentation and disclosure .................................................................................
Examples ..............................................................................................................
141
142
142
142
143
143
144
144
144
145
142 Descriptive Accounting – Chapter 7
7.1 Overview of IAS 10 Events after the Reporting Period
EVENTS AFTER THE REPORTING PERIOD
Events that occur after the reporting period are those favourable or unfavourable events that occur
between the end of the reporting period and the date of authorisation of the financial statements for
issue.
ADJUSTING EVENTS
ƒ Provide evidence of conditions that existed
at the end of the reporting period;
ƒ Irrespective of whether the fact was
actually known at the end of the reporting
period;
ƒ Update the relevant amounts in financial
statements to reflect adjusting events.
NON-ADJUSTING EVENTS
ƒ Indicative of conditions that arose after the
reporting period;
ƒ Unrelated to conditions that existed at the
end of the reporting period;
ƒ Disclose in note to the financial
statements, if material:
– nature of events;
– financial effect or a statement that the
financial effect cannot be determined.
SPECIFIC ISSUES
Dividends
Declared after the reporting period:
ƒ not a present obligation at reporting period;
ƒ therefore do not recognise at reporting
period;
ƒ disclose in note to financial statements
(IAS 1).
Going concern
Financial statements must not be prepared
on the basis of a going concern if:
ƒ entity plans to go into liquidation; or
ƒ ceases its commercial activities; or
ƒ if there is no realistic alternative but to
liquidate.
7.2 Background
Events that occur after the reporting period are both favourable and unfavourable events
that occur between the end of the reporting period and the date of authorisation of the
financial statements for issue. Two types of events can therefore be identified, namely:
ƒ those that provide additional evidence of the conditions that existed at the end of the
reporting period (adjusting events); and
ƒ those that are indicative of conditions that arose after the reporting period (nonadjusting events).
These two categories require different accounting treatments. The alternatives are:
ƒ inclusion in the financial statements as adjustments to assets and liabilities and
accompanying income and expense items; or
ƒ no accounting recognition, but, if material, disclosure in the notes.
7.3 Date of authorisation of the issue of financial statements
The date on which the financial statements are authorised for issue is the date on which the
board of directors approves the financial statements.
In all cases, the date that is used for purposes of this Standard is the date on which the full
board authorises the statements for issue, even if a supervisory board of non-executive
directors subsequently still has to peruse the statements.
Events after the reporting period 143
The date on which authorisation for issue was given, together with an indication of the
identity of the authorising body, must be disclosed in the financial statements by means of a
note. This is important information for the users of financial statements, because it gives an
indication of the date until which information has been included in the financial statements.
In terms of IAS 10.17, if the owners of the entity have the power to change the financial
statements after they have been issued, this fact must be disclosed.
7.4 Adjusting events
Events that provide additional information on the conditions that existed at the end of the
reporting period are included as adjustments to the amounts in the financial statements,
irrespective of whether the fact was actually known at the end of the reporting period.
An example of an adjusting event is where evidence that a trade debtor was insolvent at the
end of the reporting period was only received after the reporting period. This would require
the principles of impairment in respect of financial assets carried at amortised cost be
applied at the end of the reporting period. If, however, a catastrophe affected the debtor
after the reporting period, resulting in the debtor being declared insolvent, the catastrophe
does not refer to conditions that prevailed at the end of the reporting period, and therefore
not an adjusting event.
The following are examples of adjusting events (IAS 10.9):
ƒ Obligations: the settlement after the reporting period of a court case that confirms that
the entity had a present obligation at the end of the reporting period.
ƒ Assets/Investments: the receipt of information after the reporting period indicating that an
asset/investment was impaired at the end of the reporting period, or that the amount of a
previously recognised impairment loss for that asset/investment needs to be adjusted.
ƒ Inventory: the sale of inventories after the reporting period may give evidence about their
net realisable value at the end of the reporting period.
ƒ Assets: the determination after the reporting period of the cost of assets purchased, or
the proceeds from assets sold, before the end of the reporting period.
ƒ Profit-sharing or bonus payments: the determination after the reporting period of the
amount of profit-sharing or bonus payments, if the entity had an obligation at the end of
the reporting period to make such payments.
ƒ Fraud or errors: the discovery of fraud or errors that show that the financial statements
are incorrect.
7.5 Non-adjusting events
Events that refer to conditions that arise after the reporting period require no accounting
recognition, except when the going concern concept no longer applies as a result of the
event. Such material events that are not recognised, but whose non-disclosure may be
relevant to users of these financial statements, may warrant certain disclosure in the notes.
The following examples of non-adjusting events will normally lead to disclosure
(IAS 10.22):
ƒ A large business combination or, conversely, the sale of a subsidiary after the reporting
period.
ƒ Discontinuation of operations, sale of assets or liabilities as a result of operations that
are being discontinued, conclusion of binding agreements on the sale of such assets or
the settlement of such liabilities.
ƒ Substantial purchase or sale of assets, or expropriation of major assets by the government.
ƒ Destruction of a major plant after the reporting period.
144 Descriptive Accounting – Chapter 7
Plans for restructuring.
Issue of shares and debentures after the reporting period.
Abnormal changes in the value of assets or exchange rates after the reporting period.
Changes in tax rates or tax legislation that were promulgated after the reporting period
and that will have a major impact on the figures for tax and deferred tax reflected in the
financial statements.
ƒ Conclusion of material commitments, for instance issuing of material warranties.
ƒ Litigation as a result of events that occurred after the reporting period.
ƒ
ƒ
ƒ
ƒ
7.6 Dividends
Dividends declared after the end of the reporting period, but before the financial statements
are authorised for issue, may not be recognised as a liability at the reporting period, as no
present obligation to pay the dividend existed at the end of the reporting period. Such a
dividend is nevertheless, in terms of IAS 1, disclosed in the notes to the financial
statements.
The following must be disclosed in the notes to the financial statements:
ƒ the amount of dividends proposed or declared before the financial statements were
authorised for issue but not recognised as a distribution to equity holders during the
period; and
ƒ the related amount per share.
7.7 Going concern
The rules that apply to the going concern assumption are not the same as those that pertain
to events after the reporting period.
IAS 10.14 requires that financial statements must not be prepared on the basis of a going
concern if the entity plans to go into liquidation, or cease its commercial activities, or if there
is no realistic alternative but to liquidate.
When financial statements are prepared in accordance with liquidation principles, specific
additional disclosures in terms of IAS 1.25 are required. Refer to chapter 3 for an
explanation in this regard.
7.8 Presentation and disclosure
In terms of IAS 10 the following information must be disclosed:
ƒ Authorisation of the issue of financial statements
– the date when the financial statements were authorised for issue;
– who gave the authorisation;
– if the entity’s owners or others have the power to amend the financial statements after
issue, that fact should be disclosed.
ƒ Adjusting events
– update the relevant amounts and other disclosures to reflect the new information.
ƒ Non-adjusting events
– nature of events
– financial effect or a statement that the financial effect cannot be determined.
Events after the reporting period 145
In terms of IFRIC 17, the following information must be disclosed:
IFRIC 17 determines that if an entity declares a dividend after the end of the reporting period
but before the financial statements are authorised for issue, and the dividend takes the form
of a distribution of a non-cash asset, the following should be disclosed:
ƒ nature of the non-cash asset to be distributed;
ƒ carrying amount of the non-cash asset at the end of the reporting period;
ƒ fair value of the non-cash asset at the end of the reporting period if it is different from the
carrying amount at that date;
ƒ information about the method used to measure the fair value of the asset.
7.9 Examples
Example 7.1
Events after the reporting period
In the schematic exposition below, position (1) represents the first day of the financial year of
Alpha Ltd, namely 1 January 20.12; position (2) represents the last day of the financial year (end of
the reporting period), namely 31 December 20.12, and position (3) represents the date of the
authorisation of the financial statements for issue, namely 31 March 20.13. The dotted lines A to E
represent conditions that should probably be accounted for, where the beginning of the dotted line
represents the commencement of the condition and the end of the dotted line represents the final
achievement of clarity on all uncertainty, and confirmation that the condition must have been
accounted for at its commencement, if no uncertainties had existed.
Reporting period
(1)
Authorisation date
(2)
1 January 20.12
(3)
31 December 20.12
31 March 20.13
A
B
C
D
E
Assume that each of the dotted lines A to E refers to a material debtor who is experiencing
financial problems. Whereas it is uncertain at the outset whether the debt will be recovered (start of
the dotted line), it subsequently becomes certain that the debtor is insolvent and that the account
must therefore be impaired (end of the dotted line).
Case A
Case A does not present a problem. Since the uncertainty about the possible recovery of the debt
is resolved before the end of the reporting period, the impairment can take place in 20.12.
Case B
Case B is an uncertain situation that exists at the end of the reporting period (31 December 20.12)
and the outcome of the situation will only become known at a later date. In this example,
uncertainty exists about the collectability (measurement uncertainty) of the debt prior to the end of
the reporting period, but the final confirmation of the recoverability of the debt is only received after
the reporting period. At the end of the reporting period an allowance for expected credit losses will
be recognised.
continued
146 Descriptive Accounting – Chapter 7
Case C
Case C is classified as an event after the reporting period, because it did indeed take place after
the end of the reporting period. However, it differs from Case B, because the uncertain
circumstances arose only after the reporting period, whereas in Case B, the uncertain
circumstances arose before the end of the reporting period. In this scenario, Alpha Ltd’s debtor
encountered problems only after the reporting period. It is therefore apparent that there are two
categories of events: those presenting additional information on uncertain conditions that existed
at the end of the reporting period (Case B) and those that only arose after the reporting period
(Case C). Events such as those in Case C must not be recognised in the current financial year
(20.12), because they do not refer to conditions that existed at the end of the reporting period. The
circumstances and events must, however, be disclosed in a note if it is relevant.
Case D
As Case D does not refer to circumstances that existed prior to the end of the reporting period, it is
not recognised in the current financial year (20.12). As with Case C, disclosure of the information
in a note must be considered, but measurement uncertainty exists as the confirmed event only
took place after the authorisation date.
Case E
Case E refers to circumstances that already existed prior to the end of the reporting period. There is
no fundamental difference between Case E and Case B. The only difference is that, in Case B, there
is no measurement uncertainty at authorisation date.
Example 7.2
7.2
Events after the reporting period
In all the examples mentioned below, the end of the reporting period of Beta Ltd is 31 December 20.12
and the annual financial statements are authorised for issue on 30 March 20.13. Ignore taxation.
(i) Inventories destroyed
On 15 February 20.13, half of the inventories of Beta Ltd was destroyed by a fire, which resulted in
a loss of R250 000 to the company. Of the inventories destroyed, R120 000 was on hand on
31 December 20.12. Since the event does not refer to a condition that existed at the end of the
reporting period, it will not be accounted for in the financial year ended 31 December 20.12. If,
however, the loss of R250 000 was material, disclosure could be required. If the company was no
longer a going concern as a result of the loss, the loss must be provided, but not in accordance
with the rules governing events after the reporting period.
Extract from the notes for the year ended 31 December 20.12
37. Events after the reporting period
On 15 February 20.13, half of the inventories of entity was destroyed by a fire. The amount of the
loss of inventories is estimated at R250 000.
(ii) Insolvency of debtor
On 5 January 20.13, one of Beta Ltd’s significant debtors was liquidated. On 31 December 20.12,
the carrying amount of debtors in the financial records of Beta Ltd included an amount of
R600 000 relating to this debtor. Beta Ltd will only be entitled to a liquidation dividend of R100 000.
Closer investigation revealed that the debtor was experiencing financial difficulties for quite some
time, but this was covered by means of inappropriate accounting practices. The conditions that
lead to the weakened financial position of the debtor already existed on 31 December 20.12,
although Beta Ltd only came to know of it five days later. This event must therefore be recognised
in the financial statements for the year ended 31 December 20.12 as an adjusting event.
continued
Events after the reporting period 147
Extract from the financial statements of Beta Ltd for the year ended 31 December 20.12
Extract from the statement of profit or loss and other comprehensive income
for the year ended 31 December 20.12
Other expenses (xxx + (600 000 – 100 000))
xxx
Profit before tax (xxx – 500 000)
xxx
Extract from the statement of financial position as at 31 December 20.12
Assets
Current assets
xxx
Trade receivables (xxx – 500 000)
xxx
Total assets
xxx
(iii) Decrease in market value of investment
On 31 December 20.12, Beta Ltd has an investment of R10 million in a listed company. On
15 January 20.13, the market value of the investment was R6 million. On 15 March 20.13, the
market value showed no sign of recovery. As the event does not refer to circumstances that
existed at the end of the reporting period, it is categorised as a non-adjusting event. The loss of
R4 million appears to be material and must therefore be disclosed as follows in the financial
statements:
Extract from the notes for the year ended 31 December 20.12
37. Events after the reporting period
The market value of an investment of R10 million in a listed company declined to R6 million during
January 20.13. The investment has not yet shown any sign of recovery, and the company could
consequently suffer a loss of R4 million.
(iv) Dividends declared
Before the end of the reporting period (31 December 20.12), the board of directors proposed a
dividend of R100 000, subject to approval at the annual general meeting. The annual general
meeting was held on 25 March 20.13 and the proposed dividends were declared at that meeting –
the financial statements were authorised for issue on 30 March 20.13.
As no obligating event had taken place by 31 December 20.12, there is no present obligation and
recognition of a liability at the end of the reporting period – the obligating event is the approval by
shareholders at the annual general meeting. The disclosure is as follows:
Extract from the notes for the year ended 31 December 20.12
38. Dividends declared after the reporting period
An ordinary dividend of R100 000 related to 20.12 was proposed before the end of the reporting
period and declared after the reporting period at the annual general meeting held on
25 March 20.13. The related dividend per share is Rx,xx.
CHAPTER
8
Income taxes
(IAS 12, FRG 1, IFRIC 23)
Contents
8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
8.9
8.10
8.11
8.12
8.13
8.14
Overview of IAS 12 Income Taxes ....................................................................
Background .......................................................................................................
Recognition and measurement of current tax ...................................................
8.3.1 Current income tax on companies ..........................................................
8.3.2 Capital Gains Tax on companies ............................................................
Nature of deferred tax .......................................................................................
Temporary differences ......................................................................................
8.5.1 Tax base .................................................................................................
8.5.2 Taxable temporary differences ...............................................................
8.5.3 Deductible temporary differences ...........................................................
8.5.4 Assessed tax losses ...............................................................................
Recognition of deferred tax assets – specific aspects ......................................
Enacted or substantively enacted tax rates and tax laws..................................
Recognition and measurement of deferred tax .................................................
8.8.1 Reversal of deferred tax .........................................................................
8.8.2 Measuring of deferred tax in case of change in tax rate .........................
8.8.3 Measuring of deferred tax allowing for the expected manner
of recovery ..............................................................................................
Dividend tax .......................................................................................................
Foreign tax ........................................................................................................
Consolidation and equity method ......................................................................
Uncertainty over Income Tax treatments ..........................................................
Presentation and disclosure ..............................................................................
8.13.1 Statement of profit or loss and other comprehensive
income and notes .................................................................................
8.13.2 Statement of financial position and notes .............................................
Comprehensive example ...................................................................................
149
150
150
152
152
152
155
157
158
162
166
170
173
184
185
185
188
190
198
198
200
202
203
204
204
205
150 Descriptive Accounting – Chapter 8
8.1 Overview of IAS 12 Income Taxes
Current tax
Amount of income tax payable on taxable profit for a period based on tax law
Measurement:
R
Accounting profit
Add back:
Accounting items
(e.g. depreciation)
xx
Include tax treatment
(e.g. tax allowance)
xx
Taxable profit
xx
Current tax @ 28%
xx
xx
Recognition:
Current tax expense
Liability
Tax expense usually in
P/L, but recognises tax
consequence where item
was recognised
(P/L, OCI, Equity)
Dr
R
xx
Cr
R
xx
Deferred tax
Recovery or settlement of carrying amount of assets and liabilities will make future tax payments
larger or smaller than they would have been if they had no tax consequence
= recognised deferred tax, with limited exceptions
Carrying
amount
–
Tax base
Some temporary
differences are exempt: No
deferred tax
=
Temporary
difference
Taxable:
Deferred tax liability
Measurement:
ƒ Tax rate expected to apply when
temporary differences reverse;
ƒ Based on manner in which carrying
amount expected to be recovered or
settled.
Deductible: Deferred tax asset
(to the extent probable that could utilise)
Recognition:
Movement in deferred tax
balance usually in P/L, but
recognises tax consequence
where item was recognised
(P/L, OCI, Equity)
Detailed
disclosure
8.2 Background
IAS 12 Income Taxes is applicable to:
ƒ South African taxes that are levied on taxable profits;
ƒ foreign taxes levied on taxable profits obtained from foreign sources (refer to
section 8.10) (IAS 12.2); and
ƒ withholding taxes payable by an entity on distributions to them (refer to section 8.9).
Income taxes 151
The objective of the requirements of IAS 12 is to ensure that the appropriate amount of tax
is recognised and disclosed in the financial statements of an entity. The tax expense
(/income) in the statement of profit or loss and other comprehensive income comprises of
both current tax and deferred tax (IAS 12.6). The Standard therefore prescribes the accounting
treatment of both current and deferred tax.
The principal issue in accounting for incomes taxes is how to account for the current and
future tax consequences of items in the financial statements. The accounting profit is
determined by applying IFRSs, while the taxable income is determined by applying the
Income Tax Act 58 of 1962 (the Income Tax Act). As such, IAS 12 defines the taxable profit
(/loss) as the profit (/loss) for a period, determined in accordance with the rules established
by the taxation authority (i.e. the South African Revenue Service (SARS)), upon which
income taxes are payable (/recoverable). The taxable income is normally calculated by
adjusting the accounting profit for the reporting period with certain items that are treated
differently for tax purposes. The current tax expense (/payable) is then based on the taxable
income for the applicable year. Current tax is discussed in section 8.3 below.
The amount of tax that is payable by an entity in a specific accounting period is often out of
proportion to the reported accounting profit before tax for the period. The reason for this
difference is that the basis used for establishing the accounting profit often differs from the
rules used to determine the taxable profits (and thus the tax payable).
These differences mainly arise from the following circumstances:
ƒ the carrying amount of assets in the accounting records differs from the tax base of the
assets, or amounts are expensed for accounting purposes in a particular period and
deducted for income tax purposes in a different period;
ƒ the carrying amount of assets and accounting expenses are not deductible for income
tax purposes;
ƒ the carrying amount of liabilities in the accounting records differs from the tax base thereof;
ƒ the carrying amount of liabilities in the accounting records is not deductible for income tax
purposes;
ƒ income that is not taxable, or income that is recognised for accounting purposes in a
specific accounting period and taxed for income tax purposes in another;
ƒ income tax losses are set-off against taxable income in later years, thereby disturbing
the relationship between the accounting profit and the taxable income; and
ƒ adjustments relating to the correction of errors and/or changes in accounting policies are
either taken into account in different periods for income tax and accounting purposes, or
are excluded because they are neither taxable nor deductible.
The abovementioned items are commonly known as non-taxable, non-deductible and
temporary differences. They are discussed in more detail later in this chapter. The nontaxable and non-deductible differences are never accounted for in the financial statements
or they are never taken into account in determining the taxable income (e.g. dividends that
are not taxable). These differences are merely explained in the financial statements
(normally in the tax (rate) reconciliation in the note for the income tax expense). Deferred tax
is recognised on the other (temporary) differences. Deferred tax is discussed in detail in
section 8.4 below. These differences can be summarised as follows:
Differences between accounting profit and taxable income
Non-taxable and non-deductible differences
Temporary differences
Explained in tax reconciliation in notes
Deferred tax recognised
152 Descriptive Accounting – Chapter 8
8.3 Recognition and measurement of current tax
In South Africa, current tax and capital gains tax (CGT) are raised on the taxable income and
capital gains of entities.
8.3.1 Current income tax on companies
Current income tax is the amount of income tax payable (recoverable) in respect of the
taxable profit (tax loss) of a company or close corporation for a tax period (IAS 12.5). The
taxable profit is determined in accordance with the Income Tax Act. The taxable income is
normally calculated by adjusting the accounting profit for the reporting period with certain
items that are treated differently for tax purposes. There may be various non-taxable and nondeductible differences that are never accounted for in the financial statements or are never
taken into account in determining the taxable income (e.g. dividends that are not taxable,
donations that are not deductible, etc.). As a result of these differences, the income tax
expense may not be in proportion (28%) to the accounting profit. Consequently, these
differences are explained in the financial statements (normally in the tax reconciliation in the
note for the income tax expense). Deferred tax is recognised on the other (temporary)
differences between the accounting and tax treatments of items, as will be indicated in the
following sections.
Companies are provisional tax payers and are required to make provisional tax payments
in terms of the Income Tax Act. Provisional payments are merely advance payments of the
company’s estimated liability for normal tax for a particular year of assessment (refer to the
first two journal entries in Example 8.1 below for the recognition of provisional tax). Unpaid
current tax for the current and preceding periods is recognised as a current liability (refer to
the third journal entry in Example 8.1 below for the recognition of current tax in respect of a
financial year/year of assessment). Where the tax for the current and previous periods is
paid in advance, a current asset is recognised (IAS 12.12).
Current tax liabilities (assets) for the current and preceding periods must be measured at the
amount that is expected to be paid to or recovered from SARS, using the tax rates and tax
laws that have been enacted or substantively enacted at the reporting date (IAS 12.46) (also
refer to section 8.7).
The amount of current tax remains an accounting estimate, which may change once the tax
return is finally received. The correction of the accounting estimate takes place in the period
in which the tax return is received and is shown as an under- or over-provision for current
tax in the tax expense of the current year. This correction must, in terms of IAS 12.80(b), be
disclosed separately (refer to the comprehensive example at the end of this chapter for an
illustration).
For accounting purposes, the current income tax in respect of a transaction or event is
treated in the same manner as the relevant transaction or event (IAS 12.57). This implies,
for example, that current tax will be charged to other comprehensive income in cases in
which the underlying transaction or event is accounted for in other comprehensive income.
A similar treatment applies to deferred tax, which is explained by means of an example in
section 8.8 dealing with recognition and measurement of deferred tax.
Penalties and interest paid in respect of tax payments are not included in the tax expense of
an entity. These items do not fall under the scope of IAS 12 as it does not represent a tax
levied on taxable profit. These items would probably be presented as ‘other expenses’ in the
statement of profit or loss and other comprehensive income.
8.3.2 Capital Gains Tax on companies
Capital Gains Tax (CGT) (part of current tax) is payable on capital gains after 1 October 2001,
unless ‘roll-over’ relief is applicable. The capital gain is calculated as the difference between
the proceeds on disposal of an asset and the ‘base cost’ of the asset as defined in the
Income Tax Act. The inclusion rate of capital profits is currently 80% for companies. This
Income taxes 153
means that the total gain on disposal of an asset may be partly taxable and partly exempt. If
the portion is a loss, it may be set-off against other capital gains during that financial year. If
the sum of all the capital gains and losses for the financial year results in a capital gain, 80%
thereof must be included in the company’s taxable income and subjected to tax at a rate of
28%. The effect is thus an effective tax rate of 22,4%. If the sum of all capital gains and
losses for the financial year results in a capital loss, that loss must be carried forward to the
following year of assessment. (Refer to section 9.10.4 of chapter 9, Property, plant and
equipment, for the accounting treatment and disclosure of CGT, as well as section 8.8.3
below).
Example 8.1
Current tax
The accounting profit of Blom Ltd for the year ended 31 December 20.15 amounted to R2 106 500
before any items for which the accounting and tax treatment differs (see items below), were taken
into account.
The final accounting profit of Blom Ltd for the year ended 31 December 20.15 amounted to
R2 000 000 after all items were correctly accounted for. The following differences between the
accounting and tax treatment were identified:
•
During the current year, Blom Ltd received a dividend of R80 000 that is not taxable.
•
Blom Ltd also incurred research costs of R100 000 during the current year and correctly
expensed it. Assume that 150% of this amount is deductible for tax purposes for the current
year.
• Included in Blom Ltd’s other expenses are a tax penalty and donations paid to the amount of
R24 000 that were not allowed as tax deductions during the current year.
• Blom Ltd acquired an item of plant on 1 January 20.15 at a cost of R500 000. The plant is
depreciated evenly over 8 years with no residual value. For tax purposes, a 40/20/20/20 tax
allowance is applied.
The normal income tax rate is 28%.
Blom Ltd made two provisional tax payments of R230 000 and R250 000 respectively during the
year.
Calculation of accounting profit and current tax for the year ended 31 December 20.15:
Accounting
Taxable income
profit
R
R
Gross amount (balancing)
2 106 500
2 106 500
Dividends received
80 000
–
Research costs
(100 000)
(150 000)
Tax penalty and donations
(24 000)
–
Plant: Depreciation (R500 000/8 years);
(62 500)
(200 000)
Tax allowance (R500 000 × 40%)
Accounting profit and taxable income
2 000 000
1 756 500
Comment
¾ This example illustrates the calculation of the taxable income and the current tax payable on it.
The calculation above may typically not be done too often, but is given here to highlight and
illustrate the differences between the accounting and tax treatment of these items. The taxable
income is usually calculated by adjusting the accounting profit for the reporting period with certain
items that are treated differently for tax purposes, as is done below.
continued
154 Descriptive Accounting – Chapter 8
Calculation of current tax for the year ended
31 December 20.15 by starting with the accounting profit:
Accounting profit
Non-taxable items and additional deductions:
Dividends received – accounting income reversed
Extra research costs deductible (R100 000 × 50%)
Accounting expense reversed
Tax deduction claimed (R100 000 × 150%)
Non-deductible expenses (tax penalties and donations)
Gross
amount
R
2 000 000
(80 000)
(50 000)
Tax at 28%
R
560 000
(22 400)
(14 000)
100 000
(150 000)
24 000
6 720
1 894 000
530 320
Temporary differences*:
Depreciation and tax allowance on plant
(137 500)
(38 500)
Depreciation on plant reversed (R500 000/8 years)
Tax allowance on plant claimed (R500 000 × 40%)
62 500
(200 000)
Taxable income and current tax payable
Journal entries:
Current tax payable (SFP)
Bank
Recognition of first provisional payment
1 756 500
Dr
R
230 000
491 820
Cr
R
230 000
Current tax payable (SFP)
Bank
Recognition of second provisional payment
250 000
Income tax expense (P/L)
Current tax payable (SFP)
Recognition of current tax payable to SARS
Income tax expense (P/L)
Deferred tax* (SFP)
Recognition of movement in deferred tax* for the current year
491 820
250 000
491 820
38 500
38 500
Notes
2. Current tax payable (current liability)
Total current tax payable
Provisional tax payments made (R230 000 + R250 000)
Amount payable as at 31 December 20.15
R
491 820
(480 000)
11 820
7. Income tax expense
Major components of tax expense
Current tax expense
Deferred tax expense*
491 820
38 500
Tax expense
530 320
continued
Income taxes 155
The tax reconciliation# is as follows:
Accounting profit
R
2 000 000
Tax at the standard tax rate of 28% (R2 000 000 × 28%)
Dividends received (R80 000 × 28%)
Extra research costs deductible (R50 000 × 28%)
Non-deductible expense (tax penalty and donations) (R24 000 × 28%)
560 000
(22 400)
(14 000)
6 720
Tax expense
530 320
Effective tax rate (R530 320/R2 000 000 × 100)
26,52%
Comment
Comment
¾ Certain differences (such as the dividend received or the penalty and donations paid) are not
included in, or deducted from the taxable income, based on the rules of the Income Tax Act.
Other differences (such as the extra 50% of the research costs that are deductible for tax
purposes) are not included in the accounting profit in accordance with IFRSs. These differences
caused the total tax expense to be out of proportion (28%) to the accounting profit. The effect of
these differences are explained to the users of financial statements by the reconciliation
between the expected tax expense (R560 000) on the accounting profit and the actual tax
expense (R530 320). Refer to IAS 12.81(c), and .84 to .86.
¾ The tax reconciliation# could also be done by reconciling the applicable tax rate to the effective
tax rate (as percentages), as is illustrated in the comprehensive example (see section 8.13).
¾ Other differences (such as the depreciation and tax allowance on the plant) are only of a
temporary nature. The entire cost of the plant will be depreciated for accounting purposes and
will be claimed as a tax deduction over time. The period (timing) in which it will be included in
the accounting profit and taxable income may differ. Deferred tax is recognised on such
temporary differences. The nature of temporary differences* and the recognition of deferred
tax* will be explained in detail in the remainder of this chapter.
¾ The format used for the calculation of the current tax illustrates the amounts disclosed in the
note for the income tax expense.
8.4 Nature of deferred tax
Deferred tax arises as a result of differences between the carrying amounts of assets and
liabilities presented in the statement of financial position determined in accordance with the
International Financial Reporting Standards (IFRSs), and their carrying amounts (referred to
as ‘tax bases’) determined in accordance with the Income Tax Act. Deferred tax is regarded
as an obligation/asset that will be payable or recoverable at a future date when the carrying
amount of the asset/liability is recovered/settled.
A deferred tax liability is the amount of income tax payable in future periods in respect of
taxable temporary differences (IAS 12.5). A deferred tax asset is the amount of income tax
that will be recoverable in future periods in respect of:
ƒ deductible temporary differences;
ƒ the carryforward of unused tax losses; and
ƒ the carryforward of unused tax credits (IAS 12.5).
It is inherent in the recognition of an asset or liability that an entity expects to recover or
settle the carrying amount of that asset or liability (refer to the concept of the ‘future
economic benefits’ in the definitions of assets or liabilities in the Conceptual Framework for
Financial Reporting). 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, IAS 12 requires an entity to recognise a deferred tax
liability (deferred tax asset), with certain limited exceptions.
156 Descriptive Accounting – Chapter 8
The concept of deferred tax can simplistically be explained as follows (IAS 12.16 and .25):
Example 8.2
Basic explanation of the concept of deferred tax
Deferred tax liability:
A company bought an item of plant for R120 000 at the beginning of the year. Assume
depreciation for the year amounted to R20 000 and the tax allowance amounted to R40 000. At
the end of the year, the carrying amount is R100 000 (R120 000 – R20 000) and the tax base is
R80 000 (R120 000 – R40 000).
Following from the definition of an asset (see the Conceptual Framework), the plant is an
economic resource that has the potential to produce economic benefits. The company expects to
receive future economic benefits of R100 000 from this asset. When it receives these benefits, the
company will receive tax allowances of R80 000 (the remaining balance) in total. This implies that
the company will have a taxable profit of R20 000 (R100 000 – R80 000) on which R5 600
(R20 000 × 28%) tax would be payable. Thus the net future economic benefits of the company is
only R94 400 (R100 000 – R5 600). The company cannot then recognise an asset at R100 000
from which net economic benefits of R94 400 is expected to flow to the company itself.
To achieve the correct effect in the statement of financial position, the company would recognise a
deferred tax liability of R5 600, resulting in an asset of R100 000 and a liability of R5 600. The
net amount (R94 400) reflects the future expected benefits of R94 400 as calculated above.
Deferred tax asset:
The company also recognised a liability for accrued leave of R5 000 at the end of the year which
will be settled in cash during the next year. Assume the payment for the accrued leave will be
deductible for tax purposes during the next year.
Following from the definition of a liability (see the Conceptual Framework), the settlement of the
liability will result in the transfer an economic resource from the entity. When it settles the leave
liability, the company will receive a tax deduction of R5 000. This implies that the company will
save R1 400 (R5 000 × 28%) on the tax payment. Thus the net outflow of economic resources is
only R3 600 (R5 000 – R1 400). The company cannot then recognise a liability at R5 000 which
will only result in an outflow of net economic benefits of R3 600.
To achieve the correct effect in the statement of financial position, the company would have to
recognise a deferred tax asset of R1 400, resulting in a liability of R5 000 and an asset of R1 400.
The net amount (R3 600) reflects the expected future net outflow of R3 600 as calculated above.
Comment
¾ The fundamental principle of IAS 12 is that an entity must recognise a deferred tax liability or
asset whenever recovery or settlement of the carrying amount of an asset or liability would make
future tax payments larger or smaller than they would be if such recovery or settlement were to
have no tax consequences.
¾ The recovery of the carrying amount of the plant will make future tax payments larger (by R5 600)
than they would be if such recovery were to have no tax consequences. Therefore, a deferred tax
liability is recognised.
¾ The settlement of the carrying amount of the liability for the accrued leave will make future tax
payments smaller (by R1 400) than they would be if such settlement were to have no tax
consequences. Therefore, a deferred tax asset is recognised.
To calculate and recognise deferred tax, an entity needs to determine the following:
ƒ the carrying amount of the asset or liability;
ƒ the tax base thereof;
ƒ the difference between the carrying amount and the tax base and whether this temporary
difference is taxable (a deferred tax liability is recognised), deductible (a deferred tax
asset is recognised if it is recoverable) or exempt (no deferred tax is recognised);
ƒ the applicable measurement of the deferred tax balance; and
Income taxes 157
ƒ the movement between the newly calculated deferred tax balance and the balance at the
end of the preceding period.
The resultant deferred tax movement is accounted for in the same way as the transaction
or event was recognised. For example, if the transaction was recognised within profit or loss
(e.g., the depreciation and leave expenses in the previous Example), the tax consequence
is also recognised within profit or loss, and if the transaction was recognised within other
comprehensive income (e.g., a revaluation of land – refer to Example 8.24), the tax
consequence is also recognised within other comprehensive income. All these concepts are
discussed in detail below.
8.5 Temporary differences
In terms of IAS 12, the recognition of deferred tax, either as a deferred tax liability or as a
deferred tax asset, is based on temporary differences. Temporary differences are
differences between the tax base of an asset or liability and its carrying amount in the
statement of financial position (IAS 12.5). At the end of each financial period, these
differences are used to determine the deferred tax liability or asset in the statement of
financial position.
The recognition of deferred tax can be explained schematically as follows:
Carrying amount
of asset/liability
LESS
Tax base of
asset/liability
=
Temporary difference
Temporary
difference
MULTIPLIED
BY
Tax rate
=
Deferred tax balance (asset/liability) in
statement of financial position
LESS
Deferred
tax balance
(asset/liability)
of Year 1
=
Movement in deferred tax
in statement of profit or loss and other
comprehensive income or equity
Deferred
tax balance
(asset/liability)
of Year 2
Temporary differences are divided into two main categories, namely taxable temporary
differences, and deductible temporary differences. The fundamental principle that
underlies the determination of all temporary differences is that an entity must 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. It follows that deferred tax is not
recognised when the recovery or settlement of the carrying amount of an asset or liability
will have no effect on the future tax payments. In such cases, the taxable or deductible
temporary differences are exempt from the recognition of deferred tax.
158 Descriptive Accounting – Chapter 8
Temporary differences can be explained schematically as follows:
TEMPORARY DIFFERENCE
TAXABLE
temporary difference
DEDUCTIBLE
temporary difference
Recognise deferred tax liability (income tax
payable in future periods)
Assets:
Carrying amount > Tax base
Liabilities:
Carrying amount < Tax base
Recognise deferred tax asset (income tax
recoverable in future periods)
Assets:
Carrying amount < Tax base
Liabilities:
Carrying amount > Tax base
Some taxable or deductible temporary differences are exempt
and a deferred tax liability or asset is not recognised.
The chapter continues with a discussion and examples of the identification of the tax base of
assets and liabilities, followed by a discussion of taxable temporary differences and
deductible temporary differences.
8.5.1 Tax base
Temporary differences are differences that arise between the tax base and the carrying
amount of assets and liabilities on the reporting date. It is therefore important to be able to
determine the tax base of both assets and liabilities. The tax base of an asset or a liability is
the amount attributed to that asset or liability for tax purposes (IAS 12.5).
The tax base can be explained schematically as follows:
TAX BASE
Tax base of
ASSET
Amount deductible for tax purposes against
future economic benefits (when carrying
amount of the asset is recovered).
If economic benefits are not taxable:
tax base = carrying amount.
Tax base of
LIABILITY
Carrying amount less amount deductible
for tax purposes in future periods.
Revenue received in advance:
Carrying amount less revenue not taxable
in future periods.
8.5.1.1 Assets
The tax base of an asset is dependent on whether the future economic benefits arising from
the recovery of the carrying amount of the asset are taxable, or not. If the future economic
benefits are taxable, the tax base is the amount that will be deductible for tax purposes.
Where the economic benefits are not taxable, the tax base of the asset is equal to its
carrying amount, for example, trade receivables where the sales have already been taxed
(IAS 12.7).
Income taxes 159
Example 8.3
Tax base of property, plant and equipment
At the end of the reporting period, a company has plant with a cost of R200 000 and accumulated
depreciation of R40 000. For tax purposes, the SARS has permitted a tax allowance of R50 000
on the plant.
Carrying amount
Tax base
Temporary difference
R
R
R
Plant (*)
160 000
150 000
10 000
(*) (R200 000 – R40 000); (R200 000 – R50 000)
Comment
¾ The income generated by the plant as it is used (carrying amount recovered) will be taxable in
the future and if the plant is sold at a profit, the profit will also be taxable to the extent that it
represents a recoupment of the tax allowances, and capital gains tax (CGT) is applicable. The
effect of CGT on the measurement of deferred tax is discussed in section 8.8.3.
¾ The remaining tax base of the plant is deductible as a tax allowance and/or a scrapping
allowance in future periods against taxable income.
Example 8.4
Tax base of dividends receivable
A company recognises a debit account (Dividends receivable) in the statement of financial position
for dividends of R60 000 receivable from a listed investment. Dividends are not taxable.
Carrying amount
Tax base
Temporary difference
R
R
R
Dividends receivable
60 000
60 000
–
Comment
¾ When the dividend receivable is recovered (i.e., cash received), the amount is not taxable.
Therefore, the tax base of the asset equals the carrying amount. Thus no temporary difference
arises.
Example 8.5
Tax base of trade receivables
A company’s trade receivables balance at the end of the reporting period amounted to R86 000.
Carrying amount
Tax base
Temporary difference
R
R
R
Trade receivables
86 000
86 000
–
Comment
¾ When the carrying amount of the receivables is recovered (i.e., received in cash), the amount
will not be taxable since it was already taxed when the revenue was recognised (sales). As the
future economic benefits are not taxable, the tax base equals the carrying amount.
160 Descriptive Accounting – Chapter 8
Example 8.6
Tax base of capitalised development costs
A company capitalised development costs of R320 000 during the year. An amount of R50 000
was recognised as an amortisation expense. Assume SARS will allow the capitalised cost to be
written-off over a period of 4 years as a tax allowance. The temporary difference is calculated as
follows at the end of the reporting period:
Carrying amount
Tax base
Temporary difference
R
R
R
Development costs (*)
270 000
240 000
30 000
(*) (R320 000 – R50 000); (R320 000 – (R320 000 × 25%))
Comment
¾ The development costs will generate taxable economic benefits as the carrying amount is
recovered.
¾ The balance of the tax base will be deductible for tax purposes over the remaining three years.
Some items are not recognised as assets in the statement of financial position, because
they have already been written-off as expenses, but these items may still have a tax base
that results in a temporary difference (IAS 12.9).
Example 8.7
Tax base of items not recognised as assets
During the year, a company incurred costs of R10 000 in cash and immediately recognised it as
an expense. Assume SARS allows such costs to be deducted over three years on a 50/30/20
basis.
Carrying amount
Tax base
Temporary difference
R
R
R
Costs incurred (*)
–
5 000
(5 000)
(*) (R10 000 – (R10 000 × 50%))
Comment
¾ The temporary difference arose because the total expense is not immediately deductible for tax
purposes. The tax base is the amount that is deductible against future taxable income, namely
(30% + 20%) × R10 000.
8.5.1.2 Liabilities and revenue received in advance
The tax base of a liability is:
ƒ the carrying amount (for accounting purposes) less any amount that will be deductible in
future periods for tax purposes in respect of that liability (IAS 12.8).
The tax base of revenue received in advance is:
ƒ its carrying amount less any amount of the revenue that will not be taxable in future
periods (thus revenue already taxed or revenue that will never be taxed) (IAS 12.8).
Example 8.8
Tax base of a long-term loan and interest accrued
A company received a 12% long-term loan of R800 000 at the beginning of the year. At the end of
the reporting period, no capital has been repaid and no interest has been paid.
Carrying amount
Tax base
Temporary difference
R
R
R
Loan (capital)
(800 000)
(800 000)
–
Interest expense accrual
(96 000)
(96 000)
–
continued
Income taxes 161
Comment
¾ The repayment of the loan does not have tax implications, therefore there is nothing to be
deducted from the carrying amount to determine its tax base (carrying amount of R800 000 less
an amount of Rnil deductible in future).
¾ Interest is deductible for tax purposes as it is actually incurred during the current reporting
period. Thus there will be no future tax deduction (carrying amount of R96 000 less an amount
of Rnil deductible in future).
Example 8.9
Tax base of liabilities
A company recognised the following items at the reporting date:
Water and electricity accrual
R1 250
Leave pay accrual
R4 500
The expenditure for the water and electricity is deductible for tax purposes during the current year
as it actually incurred. The company has an unconditional obligation to pay for the consumption of
such items (even though the cash payment may only occur in the following period).
The leave pay accrual was created for the first time in the current year, and SARS only allows the
expense when it is paid in cash to employees (i.e. during the next period).
Carrying amount
Tax base
Temporary difference
R
R
R
Water and electricity accrual
(1 250)
(1 250)
–
Leave pay accrual
(4 500)
–
(4 500)
Comment
¾ The water and electricity expense has already been allowed as a deduction for income tax
purposes in the current year, because the service has already been provided to the company.
(It is in the tax year in which the liability for the expenditure is incurred, and not in the tax year
in which it is actually paid (if paid the subsequent year), that the expenditure is actually incurred
for the purposes of section 11(a) of the Income Tax Act.) Consequently, no further amounts will
be deductible for tax purposes in future periods. The tax base is therefore equal to the carrying
amount (carrying amount of R1 250 less an amount of Rnil deductible in future).
¾ The leave pay accrual is only deductible for tax purposes once it has been paid. The tax base
is therefore R4 500 – R4 500 = R0, or the carrying amount less the amount that will be
deductible for tax purposes in future.
Example 8.10
Tax base of revenue received in advance
At the reporting date, a company created a current liability of R380 for subscriptions received in
advance. The subscriptions are taxed immediately because they have been received in cash by
the company.
Carrying amount
Tax base
Temporary difference
R
R
R
Subscriptions received in advance
(380)
–
(380)
Comment
¾ The tax base of the subscriptions received in advance is R380 – R380 = R0, or the carrying
amount of the liability less any amount of the revenue that will not be taxable in future periods
(i.e., the full amount in this instance as the amount was already taxed in the current year).
162 Descriptive Accounting – Chapter 8
Example 8.11
Tax base of trade receivables after allowance for credit losses
A company’s trade receivables balance at the end of the reporting period amounted to R74 000
after an allowance for credit losses of R12 000. Assume SARS allows a deduction of 25% of the
doubtful debts (credit losses).
Carrying amount
Tax base
Temporary difference
R
R
R
Trade receivables
74 000
83 000
(9 000)
Gross amount
Allowance for credit losses (*)
86 000
(12 000)
86 000
(3 000)
–
(9 000)
(*) (R12 000 × 25%)
Comment
¾ When the carrying amount of the trade receivables is recovered (i.e., received in cash), the
amount will not be taxable, since it was already taxed when the revenue was recognised. As
the future economic benefits are not taxable, the tax base equals the carrying amount.
¾ The carrying amount of the allowance is R12 000. The tax base of the allowance is R3 000
(carrying amount of R12 000 less amount of R9 000 deductible in future). The temporary
difference is therefore 75% of the allowance, which is deductible against future taxable income
when the full allowance realises.
In group statements, temporary differences are determined by comparing the carrying
amounts of assets and liabilities in the consolidated financial statements with the
appropriate tax bases. The tax bases are determined by referring to the tax returns of the
individual companies in the group (IAS 12.11). Specific adjustments, for example for
intragroup transaction, may be needed on consolidation (refer to Example 24.11).
8.5.2 Taxable temporary differences
Taxable temporary differences are those temporary differences that will result in taxable
amounts in the determination of the taxable profit or tax loss for future periods when the
carrying amount of the asset or liability is recovered or settled (IAS 12.5). A deferred tax
liability is recognised in respect of all taxable temporary differences. There are, however, a
few exceptions to this rule (IAS 12.15).
Taxable temporary differences arise in respect of assets when the carrying amount is
greater than the tax base.
An inherent aspect of the recognition of an asset is that the carrying amount will be
recovered in the form of economic benefits that will flow to the entity in future periods.
Where the carrying amount of the asset exceeds the tax base, the amount of taxable
economic benefits exceeds the amount that is deductible for tax purposes. The difference is
a taxable temporary difference and the obligation to pay the resulting income tax in future
periods is a deferred tax liability. As the entity recovers the carrying amount of the asset,
the taxable temporary difference reverses and the entity recognises the taxable income,
which will result in the payment of income tax (IAS 12.16).
Income taxes 163
Example 8.12
Taxable temporary difference
Taxable temporary differences will give rise to the recognition of a deferred tax liability in the
statement of financial position at the reporting date. Using the temporary differences illustrated in
Examples 8.3 to 8.6 and a normal income tax rate of 28%, the deferred tax liability to be
recognised will be calculated as follows:
Deferred tax Movement
Carrying
Temporary
– SFP
to P/L
Tax base
amount
differences
@ 28%
@ 28%
Dr/(Cr)
Dr/(Cr)
R
R
R
R
R
8.3 Plant
160 000
150 000
10 000
(2 800)
2 800
8.4 Dividends receivable
60 000
60 000
–
–
–
8.5 Trade receivables
86 000
86 000
–
–
–
8.6 Development costs
270 000
240 000
30 000
(8 400)
8 400
(11 200)
11 200
Comment
¾ Taxable temporary differences arise in respect of assets when the carrying amount is greater
than the tax base.
¾ The entity will recognise a deferred tax liability of R11 200. The movement of the deferred tax
balance (opening balance assumed to Rnil) in this case also amounts to R11 200.
The journal entry for the initial recognition of the deferred tax
liability will be as follows:
Income tax expense (P/L)
Deferred tax (SFP)
Recognition of movement in deferred tax for the current year
Dr
R
4 340
Cr
R
4 340
In exceptional circumstances, taxable temporary differences arise in liabilities and revenue
received in advance where the tax base is larger than the carrying amount. An example
is found in construction contracts.
IAS 12.15 also identifies circumstances in which a temporary difference may exist but the
deferred tax liability is not recognised. These exceptions include deferred tax liabilities
that arise from taxable temporary differences on:
ƒ the initial recognition of goodwill (refer to the comment below); or
ƒ the initial recognition of an asset or a liability in a transaction which:
– is not a business combination; and
– at the time of the transaction, affects neither accounting profit nor taxable profit (tax
loss).
Comment
¾ Goodwill is not an allowable deduction for tax purposes; consequently, the tax base of the
goodwill is R0. Although this gives rise to a temporary difference between the carrying amount
of goodwill and its tax base, this temporary difference is not recognised in terms of IAS 12.15
because of the interdependent nature of the relationship between the determination of goodwill
and the calculation of any deferred tax thereon. Any deferred tax recognised will reduce the
identifiable net assets of the subsidiary at acquisition, which in turn will increase the amount of
goodwill.
continued
164 Descriptive Accounting – Chapter 8
¾ It is important to note that it is only temporary differences that arise on initial recognition of
assets or liabilities that are exempt from the recognition of deferred tax (refer to the next
example for the temporary differences that arose on the initial recognition of the land and
administrative buildings for which no tax allowances can be claimed). Temporary differences
arising from subsequent remeasurement of assets or liabilities (e.g. revaluation of property,
plant and equipment, as is illustrated in Example 8.24) are not exempt.
¾ Furthermore, temporary differences arising from a business combination are not exempt and
deferred tax shall be recognised on all such temporary differences (refer to section 26.5 for
more information on deferred taxes relating to business combinations).
Example 8.13
Exemption from recognising a deferred tax liability
Tango Ltd is a manufacturing entity, which has diversified its operations, and now owns a
shopping mall and an apartment block. The final accounting profit of Tango Ltd for the year ended
31 December 20.19 amounted to R2 000 000 after all items were correctly accounted for.
Details of the property owned by Tango Ltd for the year ended 31 December 20.19 are as follows:
Land at
Building
Date brought
Building use
cost
at cost
into use
R
R
Stand 502, Brenton
100 000
270 000
1 Jan 20.15
Administrative
Stand 503, Brenton
110 000
330 000
1 Jan 20.15
Manufacturing
Stand 1112, Bodmin
50 000
180 000
1 Jan 20.15
Commercial
Stand 844, Seadune
120 000
420 000
1 Jan 20.19
Residential
380 000
1 200 000
1. Land is not depreciated.
2. Tango Ltd depreciates buildings on a straight-line basis over 30 years. There are no residual
values.
3. The tax allowances are as follows:
SARS does not allow a deduction on land, nor is a deduction claimable on the administrative
building (purchased 31 December 20.14). Tango Ltd can claim a tax allowance of 5% on the
cost of the manufacturing building in terms of section 13(1), not apportioned for part of the year
(construction completed 31 December 20.14).
Tango Ltd can claim a tax allowance of 5% on the cost of the commercial building in terms of
section 13quin, as the building is mainly used for the purpose of producing taxable income.
Tango Ltd can claim a tax allowance of 5% on the cost of the apartment block (residential units)
as it qualifies in terms of section 13sex for the allowance (construction completed
1 January 20.19).
4. The deferred tax liability at 31 December 20.18 was R9 520.
5. The normal income tax rate is 28% and the carrying amount of all buildings will be recovered
through use.
continued
Income taxes 165
The deferred tax balance on 31 December 20.19 will be calculated as follows:
Land
Administration building
Manufacturing building
Residential building
Opening balance at
1 January 20.19
Land
Administration building
Manufacturing building
Commercial building
Residential building
Deferred
Movement
Carrying
Temporary tax balance for the year
Tax base
amount
difference
@ 28%
in P/L
Dr/(Cr)
Dr/(Cr)
R
R
R
R
R
380 000
–
380 000
Exempt
234 000
–
234 000
Exempt
286 000 264 000
22 000
(6 160)
156 000 144 000
12 000
(3 360)
(9 520)
380 000
225 000
275 000
150 000
406 000
–
–
247 500
135 000
399 000
380 000
225 000
27 500
15 000
7 000
Balance at 31 December 20.19
Exempt
Exempt
(7 700)
(4 200)
(1 960)
(13 860)
4 340
Journal entry
Income tax expense (P/L)
Deferred tax (SFP)
Recognition of movement in deferred tax for the current year
Dr
R
4 340
Cr
R
4 340
Comment
Comment
¾ The tax base of the land is Rnil as SARS does not allow a deduction on land. However, the
deferred tax has not been recognised, because the temporary difference arises from the initial
recognition of an asset which is not a business combination and which, at the time of the
transaction, affected neither the accounting profit nor the taxable profit (IAS 12.15). The
temporary difference is exempt. (The same result for the deferred tax on land would be
achieved if the tax base is measured at the cost of land, namely R380 000. IAS 12.51B
assumes that the carrying amount of non-depreciable assets (measured using the revaluation
model in IAS 16 – refer to Example 8.24) will be recovered through sale. The cost of the land
would be deductible against the proceeds when the land is sold. In this example, the land was
not revalued.)
¾ The carrying amount of the administration building is R225 000 (270 000 – 45 000
(270 000/30 × 5)) and the tax base = R0 as no amount is deductible in future. However, the
deferred tax has not been recognised, because the temporary difference arises from the initial
recognition of an asset which is not a business combination and which, at the time of the
transaction, affected neither the accounting profit nor the taxable profit (IAS 12.15). The
temporary difference is exempt. There is no tax allowance granted on this administrative
building, while the depreciation is recognised for accounting purposes. This difference is also
explained in the tax reconciliation (see below).
¾ The carrying amount of the manufacturing building is calculated as R275 000 (330 000 –
55 000 (330 000/30 × 5)). The tax base is R247 500 (330 000 – 82 500 (330 000 × 5% × 5)).
¾ The carrying amount of the commercial building is R150 000 (180 000 – 30 000
(180 000/30 × 5)). The tax base is R135 000 (180 000 – 45 000 (180 000 × 5% × 5).
¾ In the first year, the entity depreciates the residential building by R14 000 (420 000/30). The tax
base of the building is calculated as R399 000 (420 000 – 21 000 (420 000 × 5%)).
continued
166 Descriptive Accounting – Chapter 8
Calculation of current tax for the year ended
31 December 20.19 by starting with the accounting profit:
Accounting profit
Non-taxable items and additional deductions:
Depreciation: Administrative building
Temporary differences*:
Depreciation and tax allowance on buildings:
Depreciation on manufacturing building (330 000/30)
Tax allowance on manufacturing building (330 000 × 5%)
Depreciation on commercial building (180 000/30)
Tax allowance on commercial building (180 000 × 5%)
Depreciation on residential building (420 000/30)
Tax allowance on residential building (420 000 × 5%)
Taxable income and current tax payable
Gross
amount
R
2 000 000
Tax at 28%
R
560 000
9 000
2 520
2 009 000
562 520
(15 500)
11 000
(16 500)
6 000
(9 000)
14 000
(21 000)
(4 340)
1 993 500
558 180
The tax expense will be disclosed as follows in the notes:
Notes
7. Income tax expense
Major components of tax expense
Current tax expense
Deferred tax expense (see journal above)
558 180
4 340
Tax expense
562 520
The tax reconciliation is as follows:
Accounting profit
2 000 000
Tax at the standard tax rate of 28% (R2 000 000 × 28%)
Non-deductible depreciation on administrative building (R9 000 × 28%)
560 000
2 520
Tax expense
562 520
Effective tax rate (R562 520/R2 000 000 × 100)
28,13%
Comment
¾ There is no tax allowance granted on the administrative building in this example. However, the
accounting depreciation is indeed deducted in determining the accounting profit. This difference
caused the total tax expense to be out of proportion (28%) to the accounting profit. The effect of
this difference is explained to the users of financial statements by the reconciliation between
the expected tax expense (R560 000) on the accounting profit and the actual tax expense
(R562 520).
Taxable temporary differences may also arise from differences in investments in subsidiaries,
branches and associates, interests in joint ventures and in business combinations. These
temporary differences are addressed in the relevant chapters.
8.5.3 Deductible temporary differences
Deductible temporary differences are those temporary differences that will result in amounts
that are deductible in the determination of the taxable profit (tax loss) in future periods when
the carrying amount of the asset or liability is recovered or settled (IAS 12.5). A deferred tax
asset is recognised for all deductible temporary differences to the extent that it is
probable that future taxable profits will be available against which the deductible temporary
differences can be utilised (IAS 12.24).
Income taxes 167
IAS 12.28 indicates that it is probable that future taxable profits will be available for
utilisation against a deductible temporary difference when:
ƒ sufficient taxable temporary differences relating to the same tax authority and the same
taxable entity are expected to reverse in the same period as the deductible temporary
differences; or
ƒ sufficient taxable temporary differences relating to the same tax authority and the same
taxable entity reverse in the periods in which a tax loss arising from the deferred tax
asset can be carried forward.
Where there are insufficient taxable temporary differences, the deferred tax asset is only
recognised to the extent that:
ƒ it is probable that the entity will have sufficient taxable profits in the same periods in
which the reversal of the deductible temporary differences occurs; or
ƒ there are tax planning opportunities available to the entity that will create taxable profit in
the appropriate periods (IAS 12.29).
These aspects are discussed in more detail in section 8.6. Deferred tax assets can also
arise from the carryforward of unused tax losses and unused tax credits. These types of
deferred tax assets are described in section 8.5.4.
Deductible temporary differences arise in respect of liabilities and revenue received in
advance when the carrying amount is larger than the tax base. When these economic
resources flow from the entity, part or all of the amount may be deductible in the
determination of taxable income in periods that follow the periods in which the liability is
recognised. In such instances, a temporary difference arises between the carrying amount
of the liability and the tax base. A deferred tax asset arises in respect of the income tax
that will be recoverable in future periods when that part of the liability is allowed as a
deduction in the determination of the taxable profit.
Example 8.14
Deductible temporary differences
Deductible temporary differences will give rise to the recognition of a deferred tax asset in the
statement of financial position at the reporting date. Using the temporary differences illustrated in
Examples 8.7 to 8.11 and a normal income tax rate of 28%, the deferred tax asset to be
recognised will be calculated as follows:
Deferred Movement
Temporary
Carrying
Tax
tax – SFP
for the
differamount
base
@ 28% year in P/L
ences
Dr/(Cr)
Dr/(Cr)
R
R
R
R
R
8.7 Costs incurred
–
5 000
(5 000)
1 400
(1 400)
8.8 Loan (capital)
(800 000) (800 000)
–
–
–
8.8 Interest expense accrual
(96 000)
(96 000)
–
–
–
8.9 Water and electricity accrual
(1 250)
(1 250)
–
–
–
8.9 Leave pay accrual
(4 500)
–
(4 500)
1 260
(1 260)
8.10 Subscriptions received in
advance
(380)
–
(380)
106
(106)
8.11 Trade receivables
74 000
83 000
(9 000)
2 520
(2 520)
5 286
(5 286)
Comment
¾ Deductible temporary differences arise in respect of assets and expenses when the tax base is
larger than the carrying amount.
¾ Deductible temporary differences also arise in respect of liabilities and revenue received in
advance when the carrying amount is larger than the tax base.
¾ A deferred tax asset of R5 286 should be created if the debit balance will be recovered in future
by means of sufficient taxable profits being earned to utilise the benefit.
continued
168 Descriptive Accounting – Chapter 8
The journal entry for the initial recognition of the deferred tax
asset will be as follows:
Deferred tax (SFP)
Income tax expense (P/L)
Recognition of movement in deferred tax for the current year
Dr
R
5 286
Cr
R
5 286
In IAS 12.24, circumstances are identified in which a deferred tax asset is not recognised.
These exemptions include deferred tax assets which arise from:
ƒ the deductible temporary difference on the initial recognition of an asset or liability in a
transaction which:
– is not a business combination; and
– at the time of the transaction, affects neither accounting profit nor taxable profit (tax
loss).
Example 8.15
Non-taxable government grant
A company receives a non-taxable government grant of R20 000 on an asset with a cost price of
R100 000. The grant is presented as a deduction from the asset in terms of IAS 20.
Carrying amount
Tax base
Temporary difference
R
R
R
Asset
80 000
100 000
(20 000) #
Comment
¾ For accounting purposes, the carrying amount of the asset is shown at R80 000, which is net of
the government grant of R20 000.
¾ The tax base is larger than the carrying amount and results in a deductible temporary
difference. This deductible temporary difference is, however, not recognised,# because the
difference arose upon the initial recognition of the asset and does not affect the accounting or
the taxable profit.
¾ The reversal of this difference is also not recognised. Also refer to IAS 12.33 in this regard.
¾ Government grants may also be recognised as deferred income, in which case the difference
between the deferred income and its tax basis of Rnil is a deductible temporary difference.
Whichever method of presentation an entity adopts, the entity does not recognise the resulting
deferred tax asset.
Example 8.16
Comprehensive example: Temporary difference over years
Alpha Ltd purchased a new machine on 1 January 20.11 and brought it into use immediately. The
machine is depreciated at 25% per annum on the straight-line basis with no residual value. For tax
purposes, a 40/20/20/20 tax allowance is applied. The reporting date of the company is
31 December. The normal income tax rate is 28%. The profits before tax (after taking depreciation
into account) for each of the four years were as follows:
20.11
R80 000
20.12
R100 000
20.13
R110 000
20.14
R130 000
continued
Income taxes 169
Calculations in respect of the asset
1 January 20.11
Cost
31 December 20.11 Depreciation/tax allowance
Accounting
R
10 000
(2 500)
R
10 000
(4 000)
Tax
31 December 20.12
Depreciation/tax allowance
7 500
(2 500)
6 000
(2 000)
31 December 20.13
Depreciation/tax allowance
5 000
(2 500)
4 000
(2 000)
31 December 20.14
Depreciation/tax allowance
2 500
(2 500)
2 000
(2 000)
–
–
Tax calculation
Accounting profit
Depreciation
Tax allowance
20.11
R
80 000
2 500
(4 000)
20.12
R
100 000
2 500
(2 000)
20.13
R
110 000
2 500
(2 000)
20.14
R
130 000
2 500
(2 000)
Taxable income
78 500
100 500
110 500
130 500
Current tax @ 28%
21 980
28 140
30 940
36 540
Deferred tax calculation
Deferred
Movement
Temporary tax balance for the year
difference
@ 28%
in P/L
Dr/(Cr)
Dr/(Cr)
R
R
R
1 500
(420)
420
Carrying
amount
Tax
base
20.11
R
7 500
R
6 000
20.12
5 000
4 000
1 000
(280)
(140)
20.13
2 500
2 000
500
(140)
(140)
–
–
20.14
–
–
(140)
Dr
R
Cr
R
Journal entries
20.11
Income tax expense (P/L)
Deferred tax (SFP)
Recognition of movement in deferred tax for the current year
20.12
Deferred tax (SFP)
Income tax expense (P/L)
Recognition of movement in deferred tax for the current year
20.13
Deferred tax (SFP)
Income tax expense (P/L)
Recognition of movement in deferred tax for the current year
20.14
Deferred tax (SFP)
Income tax expense (P/L)
Recognition of movement in deferred tax for the current year
420
420
140
140
140
140
140
140
continued
170 Descriptive Accounting – Chapter 8
The above information will be disclosed as follows in the financial statements:
Statement of profit or loss and other comprehensive income
20.11
20.12
20.13
R
R
R
Profit before tax
80 000
100 000
110 000
Income tax expense
(22 400)
(28 000)
(30 800)
Profit for the year
57 600
72 000
Statement of financial position
20.11
20.12
R
R
20.14
R
130 000
(36 400)
79 200
93 600
20.13
R
20.14
R
Equity and liabilities
Non-current liabilities
Deferred tax
420
280
140
–
Current liabilities
Tax owing*
21 980
28 140
30 940
36 540
* This would be the balance after the deduction of any provisional tax paid. Assume for the
purposes of this illustration that no provisional tax was paid.
Notes
2. Income tax expense
20.11
20.12
20.13
20.14
R
R
R
R
Major components of tax expense
Current tax expense
21 980
28 140
30 940
36 540
Deferred tax expense
420
(140)
(140)
(140)
Tax expense
22 400
28 000
30 800
36 400
Comment
¾ The tax expenses in Years 20.11, 20.12, 20.13 and 20.14 are in line (28%) with the profit before tax
amount to which they relate.
¾ Each year, the deferred tax liability (or asset) is calculated, and the change in the balance from
the preceding year to the current year is recognised in the profit or loss section of the statement
of profit or loss and other comprehensive income. This is done as the item that created the
temporary difference (annual depreciation amount differs from tax allowance) was recognised
in profit or loss.
8.5.4 Assessed tax losses
A deferred tax asset represents the income tax amounts that are recoverable in future
periods in respect of:
ƒ deductible temporary differences (section above);
ƒ the carryforward of unused tax losses (assessed tax losses); and
ƒ the carryforward of unused tax credits.
An assessed tax loss is the amount by which the tax deductions exceed the taxable
income of a company for a particular year of assessment. Such a tax loss can be carried
forward to the next year of assessment and can be deducted from the taxable income in the
next year of assessment. This implies that an assessed tax loss can be regarded as a
specific type of deductible temporary difference. The principles underpinning the
accounting treatment of deductible temporary differences also apply to assessed tax losses.
In terms of IAS 12.34, a deferred tax asset is recognised for the carryforward of unused tax
losses (assessed tax losses) and unused tax credits to the extent that it is probable that
there will be taxable profit in future against which the unused tax losses and unused tax
credits may be utilised. The requirements in respect of the creation of deferred tax assets
resulting from deductible temporary differences also apply to unused tax losses and tax
Income taxes 171
credits. However, where unused tax losses arise as a result of recent operating losses, it
may indicate that future taxable profits may not be available in the future to utilise these tax
losses (IAS 12.35). Other indications that future taxable profits may not be available are an
entity’s history of unused or expired tax losses and tax credits, as well as management’s
expectation of future operating losses. There should be convincing evidence that sufficient
taxable income will be available to utilise the asset in future periods.
IAS 12.36 proposes the following criteria for assessing the probability that sufficient taxable
profits will be generated in future in order to utilise unused tax losses and credits:
ƒ the entity has sufficient taxable temporary differences relating to the same tax authority
and the same taxable entity to provide taxable amounts against which the unused tax
losses or unused tax credits may be utilised;
ƒ it is probable that the entity will have taxable profits before the unused tax losses or
unused tax credits expire;
ƒ the unused tax losses result from identifiable causes which are unlikely to recur; and
ƒ the entity has tax planning opportunities (discussed in section 8.6 below) available that
will create taxable profits in the period in which the unused tax losses or unused tax
credits may be utilised.
Example 8.17
Assessed tax losses
The following information is available for a newly-formed company, Omega Ltd. The normal
income tax rate is 28%. The information is for the first two consecutive years:
Year 1
Year 2
R
R
Accounting profit for the year:
52 000
100 000
Temporary differences arose as follows:
Property, plant and equipment (cost of R800 000):
Carrying amount
(800 000 – 50 000 depreciation); (750 000 – 118 000 depreciation)
750 000
632 000
Tax base
(800 000 – 107 000 allowance); (693 000 – 63 000 allowance)
(693 000) (630 000)
Temporary difference (taxable)
57 000
2 000
Therefore movement on temporary differences
57 000
(55 000)
Year 1
R
52 000
(57 000)
50 000
(107 000)
Year 2
R
100 000
55 000
118 000
(63 000)
(Assessed tax loss)/Taxable income for the year
Assessed tax loss brought forward from previous year
(5 000)
–
155 000
(5 000)
(Assessed tax loss)/Taxable income
(5 000)
150 000
Tax calculation
Accounting profit before tax
Movement in temporary differences
Depreciation
Tax allowance
Current tax payable (at a tax rate of 28%)
–
42 000
continued
172 Descriptive Accounting – Chapter 8
Deferred tax
Year 1
Property, plant and equipment
Assessed tax loss
Carrying
amount
Tax
base
Temporary
difference
R
R
R
750 000
–
693 000
(5 000)
Deferred tax liability
Deferred
tax @
28%
Dr/(Cr)
R
57 000
(5 000)
(15 960)
1 400
52 000
(14 560)
Movement in statement of profit or loss and other comprehensive income
(R14 560 – Rnil = R14 560 Dr)
Year 2
Property, plant and equipment
Assessed tax loss
Carrying
amount
Tax
base
Temporary
difference
R
R
R
632 000
–
630 000
–
Deferred tax liability
Deferred
tax @
28%
Dr/(Cr)
R
2 000
–
(560)
–
2 000
(560)
Movement in statement of profit or loss and other comprehensive income
(R560 – R14 560 = R14 000 Cr)
In Year 2, no assessed tax loss exists since it has been fully utilised in the current tax calculation
of Year 2.
Deferred tax account
Tax expense1
Balance c/f
R
1 400
14 560
Year 1
Opening balance
Tax expense2
R
–
15 960
15 960
Tax expense3
Balance c/f
15 400
560
15 960
Year 2
Balance b/d
Tax expense4
14 560
1 400
15 960
1
2
3
4
15 960
Assessed tax loss (deferred tax asset fully recognised) (R5 000 × 28%)
Temporary differences – Property, plant and equipment (R57 000 × 28%)
Temporary differences – Property, plant and equipment ((R57 000 – R2 000) × 28%)
Assessed tax loss utilised
The statement of profit or loss and other comprehensive income reflects the following:
Year 1
R
Profit before tax
52 000
(14 560)
Income tax expense
Profit for the year
37 440
Year 2
R
100 000
(28 000)
72 000
continued
Income taxes 173
The notes will reflect the following:
2. Income tax expense
Year 1
R
Year 2
R
Major components of tax expense
Current tax expense
Deferred tax expense*
–
14 560
42 000
(14 000)
Accelerated tax allowances for tax purposes (15 960 – 0); (560 – 15 960)
Assessed loss (0 – 1 400); (1 400 – 0)
15 960
(1 400)
(15 400)
1 400
Tax expense
14 560
28 000
Effective tax rate
28%
28%
(Year 1: R14 560/R52 000 = 28% effective tax rate)
(Year 2: R28 000/R100 000 = 28% effective tax rate)
No current tax was provided for in Year 1, since the company had an assessed tax loss.
3. Deferred tax
Year 1
Year 2
R
R
Analysis of temporary differences
Accelerated tax allowances for tax purposes
15 960
560
Assessed loss
(1 400)
–
Deferred tax liability
14 560
560
Comment
¾ Because the amount of the deferred tax expense for the various categories of temporary
differences is apparent from the changes in the deferred tax balance in the statement of
financial positions (note 3), there is no need to disclose the categories of temporary differences
in the note for the income tax expense* (note 2) (IAS 12.81(g)(ii)). The categories of temporary
differences were presented for the sake of completeness.
¾ Because the effective tax rate and the standard tax rate are the same, a reconciliation of the
tax rate is not required.
8.6 Recognition of deferred tax assets – specific aspects
A deferred tax asset (on deductible temporary differences and assessed tax losses, as was
discussed in the preceding sections) should be created only to the extent that it will be
utilised in future by means of taxable temporary differences, or when acceptable evidence
exists to indicate that sufficient taxable income will be available against which the deductible
temporary differences can be utilised. In essence, the realisation of future taxable income is
largely dependent on the future profitability of the entity. The criteria given for the recognition
of a deferred tax asset in IAS 12 are aimed at establishing whether the entity will be
profitable in future.
It is apparent that a certain measure of professional judgement should be exercised in
recognising deferred tax assets, especially in instances in which the amount of the taxable
temporary differences is smaller than the amount of the deductible temporary differences. A
deferred tax asset may then be recognised to the extent (IAS 12.29) that:
ƒ it is probable that the entity will have sufficient taxable profits relating to the same tax
authority and the same taxable entity in the same period as the reversal of the deductible
temporary difference (including assessed tax losses carried forward); or
ƒ the entity has tax planning opportunities available that will create taxable profits in the
period in appropriate periods.
174 Descriptive Accounting – Chapter 8
Tax planning opportunities arise when the entity institutes measures to create or increase
taxable income in specific periods in order to utilise deductible temporary differences, tax
losses and tax credits. The following examples of tax planning opportunities are presented
in IAS 12.30:
ƒ the entity defers the claim for certain tax deductions from taxable income;
ƒ the entity sells, and possibly leases back, assets that have appreciated in value, but for
which the tax base has remained constant; and
ƒ the entity sells an asset that generates non-taxable revenue in order to purchase another
investment that generates taxable revenue.
An important aspect to consider in the creation of deferred tax assets is timing. The first
step for the recognition of a deferred tax asset in an entity is that taxable temporary
differences which create taxable income, or taxable income itself, will be available against
which the unused losses may be utilised. The second step is to ensure that the timing of the
reversal, realisation and utilisation of these items correspond. If it is assumed that a tax loss
expires or that deductible temporary differences reverse in the near future, but that taxable
temporary differences only reverse several years later (creating taxable income), the
deferred tax asset may not be recognised. An important matter addressed in IAS 12 is the
manner in which deferred tax assets and deferred tax liabilities are recovered or settled.
This aspect influences the assessment of when deductible temporary differences will
reverse and when tax losses and tax credits will be utilised. The deferred tax asset is only
recognised to the extent that it is probable that there will be taxable income in these periods.
Deferred tax assets and liabilities are calculated separately. All deferred tax liabilities are
recognised, but deferred tax assets are only recognised to the extent that it is probable that
taxable income will be available in future, when the unused tax losses and unused tax
credits are utilised.
In instances in which the deferred tax asset cannot be utilised fully, IAS 12 permits the
partial recognition of the deferred tax asset, which is obviously limited to the amount of
expected future taxable profits.
The extent to which deferred tax assets are not recognised in the statement of financial
position should be disclosed in a note to the statement of financial position (IAS 12.81(e)).
The utilisation of previously unrecognised deferred tax assets in the current year should be
disclosed separately as a component of the tax expense (IAS 12.80(e) and (f)).
Income taxes 175
Example 8.18
.18
Deferred tax asset recognised
The following information regarding a newly-formed company, Charlie Ltd, is available. The normal
income tax rate is 28%. The information is for two consecutive years.
Year 1
Year 2
R
R
Accounting (loss)/profit for the year:
(5 000)
155 000
Temporary differences are as follows:
Property, plant and equipment
(see detail in deferred tax calculation below):
Carrying amount
750 000
680 000
Tax base
(805 000)
(700 000)
Temporary difference (deductible)
(55 000)
(20 000)
Thus movement in temporary differences
(55 000)
35 000
(5 000)
55 000
160 000
(105 000)
155 000
(35 000)
70 000
(105 000)
Taxable income
50 000
120 000
Current tax payable (@ 28%)
14 000
33 600
Tax calculation
Accounting (loss)/profit before tax
Movement in temporary differences
Depreciation
Tax allowances
The calculation of deferred tax is as follows:
Property, plant and equipment: Cost
Movement for Year 1 – temporary
differences
Year 1 balance
Movement for Year 2 – temporary
differences
Year 2 balance
Carrying
amount
Tax
base
Temporary
difference
R
910 000
R
910 000
R
(160 000)
750 000
(105 000)
805 000
(70 000)
680 000
Deferred
tax @28%
Dr/(Cr)
R
(55 000)
(55 000)
15 400
15 400
(105 000)
35 000
(9 800)
700 000
(20 000)
5 600
Assume that it is probable at the end of Year 1 that sufficient taxable income will be earned
in Year 2 and thereafter.
Deferred tax account
R
Tax expense1
15 400
R
Year 1
Opening balance
Balance c/f Year 1
15 400
Balance b/f
15 400
15 400
Year 2
Tax expense1
Balance c/f Year 2
15 400
1
–
15 400
9 800
5 600
15 400
Temporary differences – Property, plant and equipment
continued
176 Descriptive Accounting – Chapter 8
The statement of profit or loss and other comprehensive income reflects the following:
Year 1
Year 2
R
R
(Loss)/profit before tax
(5 000)
155 000
Income tax expense
1 400
(43 400)
(Loss)/profit for the year
(3 600)
111 600
Notes
2. Income tax expense
Year 1
R
Major components of tax expense
Current tax expense
Deferred tax expense
Tax expense
Year 2
R
14 000
(15 400)
33 600
9 800
(1 400)
43 400
Effective tax rate
(Year 1: R1 400/R5 000 = 28% effective tax rate)
(Year 2: R43 400/R155 000 = 28% effective tax rate)
3. Deferred tax
Analysis of temporary differences:
Tax allowances on property, plant and equipment
28%
28%
(15 400)
(5 600)
Deferred tax asset recognised
(15 400)
(5 600)
The company has recognised a deferred tax asset in respect of deductible temporary differences
on its property, plant and equipment. Management believes that it is probable that sufficient future
taxable profits will be earned to utilise the deductible temporary differences, as the company has
signed various new contracts from which significant profits are expected (IAS 12.82).
Comment
¾ In this example, it is probable that the debit balance on the deferred tax account will realise.
Consequently, the effect of the deductible temporary difference is recognised in full in Year 1.
During Year 2, a portion of the debit balance is utilised due to the reversal of temporary
differences of R35 000. At the end of Year 2, the deferred tax account has a debit balance of
R5 600 ((700 000 – 680 000) × 28%) presented under non-current assets in the statement of
financial position.
Income taxes 177
Example 8.19
Deferred tax asset not recognised
Refer once again to the information in the previous example for Charlie Ltd. The normal income
tax rate is 28%.
The probability that taxable profit will be earned for Year 2 and thereafter is remote (as at
every year end).
The calculation of deferred tax is as follows:
Deferred
Carrying
Tax
Temporary
tax @28%
amount
base
difference
Dr/(Cr)
R
R
R
R
Property, plant and equipment
(refer to detail in preceding example):
Year 1 balance
750 000
805 000
(55 000)
15 400
Deferred tax asset not recognised
(15 400)
Balance of deferred tax asset
recognised
Year 2:
Previously unrecognised asset utilised
against tax expense of current year
(see comment below)
Movement for Year 2 –
temporary differences
(70 000)
(105 000)
35 000
(9 800)
Year 2 balance
680 000
700 000
(20 000)
5 600
–
15 400
Deferred tax asset not recognised
Balance of deferred tax asset
recognised
(5 600)
–
Deferred tax account
R
Tax expense 1
–
Balance c/f Year 1
–
Balance c/f Year 2
–
Year 1
Opening balance
R
–
–
Year 2
Balance b/f
Tax expense 2
–
–
–
–
1
Temporary differences – Property, plant and equipment (R15 400 limited to R0)
Temporary differences – Property, plant and equipment (R9 800 limited to R0) or (R15 400
unrecognised from preceding year, now utilised – R9 800 movement for current year – R5 600
unrecognised for current year)
The statement of profit or loss and other comprehensive income reflects the following:
Year 1
Year 2
R
R
(Loss)/profit before tax
(5 000)
155 000
Income tax expense
(14 000)
(33 600)
2
(Loss)/profit for the year
(19 000)
121 400
continued
178 Descriptive Accounting – Chapter 8
Notes
2. Income tax expense
Year 1
R
Major components of tax expense
Current tax expense (calculated in previous example)
Deferred tax expense
(Originating)/reversing deductible temporary differences*
Deferred tax assets not recognised*
Previously unrecognised deferred tax asset utilised in current year
to reduce tax expense (IAS 12.80(e) and (f))*
Year 2
R
14 000
–
33 600
–
(15 400)
15 400
9 800
5 600
–
(15 400)
Tax expense
14 000
33 600
The tax reconciliation is as follows:
Accounting profit
(5 000)
155 000
(1 400)
43 400
Tax at the standard tax rate of 28% (R5 000 × 28%); (R155 000 × 28%)
Effect of debit balance on deferred tax account not recognised
(movement for the year) (R55 000 × 28%); (R35 000 × 28%) or
(R5 600 – R15 400)
15 400
(9 800)
Tax expense
14 000
33 600
– 280%
21,68%
15 400
(15 400)
–
5 600
(5 600)
–
Effective tax rate
(Year 1: R14 000/(R5 000) = 280% effective tax rate)
(Year 2: R33 600/R155 000 = 21,68% effective tax rate)
3. Deferred tax
Analysis of temporary differences:
Tax allowances on property, plant and equipment
Unrecognised deferred tax asset
Deferred tax asset recognised
The company has deductible temporary differences of R20 000 at the end of Year 2 (Year 1:
R55 000) in respect of tax allowances on property, plant and equipment, but no deferred tax asset
was recognised, as sufficient future taxable income to utilise the deductible temporary difference
was not deemed probable (IAS 12.81(e)).
Comment
¾ The deductible temporary difference of R55 000 in Year 1 would have resulted in a debit of
R15 400 to the deferred tax account. Because it is not probable that the asset will be realised,
the debit balance is not created in terms of IAS 12.24 and .29. The recoverability of the
unrecognised deferred tax asset is reassessed at the end of each reporting period in terms of
IAS 12.37.
¾ The balance of deferred tax for both years is R0. Therefore, the movement for Year 2 is also
R0. However, disclosure should be made of the components of the deferred tax expense
(IAS 12.80(c) and .81(g)). Disclosure of the benefit arising from a previously unrecognised
temporary difference of a prior year (Year 1) that is used to reduce the tax expense during the
current year (Year 2) should also be made (IAS 12.80(e) and (f)). The amounts presented
above* are evident from the calculation of the deferred tax above and represent the detailed
movements in the deferred tax balance.
¾ The benefit arising from utilising a previously unrecognised temporary difference of a prior year
can also be viewed as a change in accounting estimate, as it was estimated at the end of
Year 1 that there will probably not be sufficient taxable income in Year 2 to utilise the deductible
temporary difference of R55 000. No deferred tax asset was recognised then. However, during
Year 2, the taxable income was R120 000 and the full temporary difference could be utilised,
proving that the estimate at the end of Year 1 was incorrect and should be changed.
Consequently, an adjustment of R15 400 is made in Year 2 and this is disclosed separately in
the note for the income tax expense.
Income taxes 179
Example 8.20
Partially recognised deferred tax asset
Beta Ltd correctly recognised a provision during Year 1, which it is deductible for tax purposes
when paid in cash. Details of the provision are as follows:
Provision:
R
Expense recognised during Year 1 and balance at end of Year 1
120 000
Amount paid during Year 2
(20 000)
Balance end of Year 2
In Year 1, the results of Beta Ltd are as follows:
100 000
Operating profit (accounting profit)
Reversing deductible temporary difference (relating to the provision)
Accounting expense
Tax deduction
R
500 000
120 000
120 000
–
Tax loss
620 000
Current tax expense at 28%
173 600
Thus, Beta Ltd had a deductible temporary difference of R120 000 in Year 1 in respect of a
provision. Management is of the opinion that there will be sufficient future taxable income
available to utilise only R30 000 of the deductible temporary difference.
Assume that the deferred tax balance in Year 0 is R0, that there is no assessed tax loss carried
forward, and that the normal income tax rate is 28%.
The calculation of deferred tax is as follows:
Deferred
Tax
Temporary
Carrying
tax @28%
amount
base
difference
Dr/(Cr)
R
R
R
R
Provision: Year 1 balance
(120 000)
–
(120 000)
33 600
Deferred tax asset not recognised
(25 200)
8 400
Balance of deferred tax asset
recognised
Beta Ltd will pass the following journal entry relating to deferred tax in Year 1:
Dr
Cr
R
R
Deferred tax asset (SFP)
8 400
Income tax expense (R30 000 × 28%) (P/L)
8 400
Recognition of partial deferred tax asset for deductible temporary difference
The unrecognised asset is therefore R90 000 × 28% = R25 200
This unrecognised deferred tax asset is disclosed in the notes (see below).
In Year 2, the results of Beta Ltd are as follows:
Operating loss (accounting loss)
Reversing deductible temporary difference (relating to the provision)
Accounting expense
Tax deduction
R
(64 000)
(20 000)
–
(20 000)
Tax loss
(84 000)
Current tax expense
–
The balance of the provision at the end of Year 2 is R100 000. Of the initial deductible temporary
difference of R120 000 in Year 1, R20 000 has reversed, leaving a net balance of R100 000.
continued
180 Descriptive Accounting – Chapter 8
The first step is to establish the amount of the deferred tax asset that should be raised:
R
84 000
100 000
Assessed tax loss
Deductible temporary difference (relating to the provision)
184 000
Possible deferred tax asset (at a tax rate of 28%)
51 520
The second step before a deferred tax asset may be recognised in the statement of financial
position is to establish to what extent the asset will realise in the future, in that sufficient future
taxable income will be available when the deductible temporary difference reverses and the
assessed tax loss is utilised.
If management decides that it is probable that there will be taxable profits amounting to
R135 000 in the periods in which the deferred tax asset realises, a deferred tax asset is
recognised at an amount of R37 800 (R135 000 × 28%).
The calculation of deferred tax is as follows:
Deferred
Carrying
Tax
Temporary
tax @28%
amount
base
difference
Dr/(Cr)
R
R
R
R
Provision: Year 2 balance
(100 000)
–
(100 000)
Assessed tax loss
(84 000)
(84 000)
Possible deferred tax asset
Deferred tax asset not recognised
Balance of deferred tax asset
recognised
Beta Ltd will pass the following journal entry relating to deferred tax in Year 2:
Dr
R
Deferred tax (R37 800 – R8 400) (SFP)
29 400
Income tax expense (P/L)
Recognition of partial deferred tax asset and movement for the year
28 000
23 520
51 520
(13 720)
37 800
Cr
R
29 400
The unrecognised asset is therefore R13 720 ((184 000 – 135 000) × 28%) and it is disclosed in
the notes to the financial statements in terms of IAS 12.81(e), as follows:
The tax notes will be disclosed as follows:
2. Income tax expense
Major components of tax expense
Current tax (Year 1: given); (Year 2: assessed loss)
Deferred tax (see journals above)
(Originating)/reversing of deductible temporary difference on provision
(Year 1: 120 000 x 28%); (Year 2: 20 000 x 28%)
Assessed loss (Year 2: 84 000 x 28%)
Effect of unrecognised deferred tax asset (movement for the year)
(Year 1: 90 000 x 28%); (Year 2: movement of 25 200 – 13 720)
Tax expense
Year 1
R
Year 2
R
173 600
(8 400)
–
(29 400)
(33 600)
–
5 600
(23 520)
25 200
(11 480)
165 200
(29 400)
continued
Income taxes 181
Tax reconciliation
Year 1
R
500 000
Year 2
R
(64 000)
Tax at the standard tax rate of 28%
Effect of unrecognised portion of deferred tax asset
(Year 2: movement of 25 200 – 13 720)
140 000
(17 920)
25 200
(11 480)
Tax expense
165 200
(29 400)
Effective tax rate
(Year 1: R165 200/R500 000) = 33,04% effective tax rate)
(Year 2: R29 400/R64 000 = 45,94% effective tax rate)
33,04%
45,94%
33 600
–
(25 200)
28 000
23 520
(13 720)
8 400
37 800
Accounting profit (/loss)
3. Deferred tax
Analysis of temporary differences:
Provisions (120 000 × 28%); (100 000 × 28%)
Assessed loss (84 000 × 28%)
Unrecognised deferred tax asset (90 000 × 28%); (49 000 × 28%)
Deferred tax asset recognised
The company has deductible temporary differences of R49 000 (Year 1: R90 000) in respect of a
provision, and an assessed loss at the end of Year 2 for which no deferred tax asset was
recognised, as sufficient future taxable income to utilise the full deductible temporary differences
was not deemed probable (IAS 12.81(e)).
Comment
¾ The effect of unrecognised deferred tax assets on the statement of financial position should be
disclosed. Its effect on the tax expense in profit or loss and the tax reconciliation should also be
disclosed.
The discussion and illustrations above dealt with deductible temporary differences that
relate to normal income tax (taxed at 28%). There may also be deductible temporary
differences that relate to capital losses (for which the inclusion rate is 80%). Capital losses
(other than section 11(0) allowances) can be deducted from capital gains in the current year
of assessment. If the capital losses exceed the capital gains for the current year, that net
capital loss may be carried forward to the following year of assessment. Consequently, a
deferred tax asset for deductible capital losses can also only be recognised to the extent
that it is probable that capital gains will be available in future against which the capital losses
can be utilised (IAS 12.27A). Refer to Example 8.27 for more detail.
As the recognition of a deferred tax asset is dependent on the probability of future taxable
income, the recognised and unrecognised deferred tax assets are reassessed at each
reporting date (IAS 12.37). The entity should reduce or write off the deferred tax asset if it is
no longer probable that there will be sufficient taxable profit in future to utilise all or a portion
of the benefit of the asset (IAS 12.56). Should circumstances change and it becomes
probable that taxable profit will be available in future, the unrecognised portion of the
deferred tax asset is recognised accordingly. An example of such changed circumstances is
when the composition of the management of an entity changes, thereby changing its
expectations regarding future taxable profit.
This remeasurement and adjustment of the deferred tax asset is not an adjustment of the
previous year’s results, but rather a change in accounting estimate. The difference between
the extent to which the asset is recognised in the current and the preceding year is recognised
as a deferred tax adjustment in the current year’s statement of profit or loss and other
comprehensive income. The adjustment is disclosed to users in the tax reconciliation (see
IAS 12.81(c)).
182 Descriptive Accounting – Chapter 8
Example 8.21
8.21
Write-down of deferred tax asset and reversal
At the end of December 20.11, Berg Ltd correctly recognised a provision for environmental
restoration at an amount of R100 000. The appropriate discount rate is 10% per annum. Interest of
R10 000 (R100 000 × 10%) would be recognised on the provision during 20.12. Interest of R11 000
(R110 000 × 10%) would be recognised on the provision during 20.13.
Any amount in respect of this provision will be deductible for tax purposes when actually paid. At the
end of 20.11, management was of the opinion that there will be sufficient future taxable income
available to utilise all the deductible temporary differences. The deferred tax asset of R28 000
((R100 000 – Rnil) × 28%) was correctly recognised.
However, at the end of 20.12, Berg Ltd suffered significantly losses due to a recession. At the end
of 20.12, management was of the opinion that there will not be sufficient future taxable income
available to utilise the deductible temporary differences. The deferred tax asset could not be
recognised. The profit before tax amounted to only R1 500 for 20.12.
During 20.13, the local economy recovered and Berg Ltd made substantial profits again. At the
end of 20.13, management was of the opinion that there will be sufficient future taxable income
available to utilise all the deductible temporary differences. The deferred tax asset could be
recognised. The profit before tax amounted to R80 000 for 20.13.
The normal income tax rate is 28%. Details of the provision, the related temporary differences and
deferred tax are as follows:
Deferred tax
Provision – end 20.11
Expense recognised during 20.12
Provision – end 20.12
Write-down of deferred tax asset
previously recognised
Deferred tax asset not recognised
Balance of deferred tax asset
recognised – end 20.12
Carrying
amount
Tax
base
R
(100 000)
(10 000)
R
–
–
R
(100 000)
(10 000)
Deferred
tax @28%
Dr/(Cr)
R
28 000
2 800
(110 000)
–
(110 000)
30 800
(28 000)
(2 800)
–
Expense recognised during 20.13
Reversal of previous write-down
Previously unrecognised asset utilised
against tax expense of current year
Provision and balance of deferred tax
asset – end 20.13
Temporary
difference
(11 000)
–
(11 000)
3 080
28 000
2 800
(121 000)
–
(121 000)
33 880
20.12
R
1 500
10 000
–
11 500
20.13
R
80 000
11 000
–
91 000
3 220
25 480
Tax calculation
Accounting profit before tax
Add back expenses recognised for provision
Tax deductions (cash paid)
Taxable income for the year
Current tax payable (at a tax rate of 28%)
continued
Income taxes 183
The statement of profit or loss and other comprehensive income reflects the following:
20.12
20.13
R
R
Profit before tax
1 500
80 000
Income tax (expense)/income
(31 220)
8 400
(Loss)/Profit for the year
(29 720)
88 400
20.12
R
20.13
R
3 220
28 000
25 480
(33 880)
(2 800)
28 000
(3 080)
(28 000)
2 800
(2 800)
31 220
(8 400)
1 500
80 000
Tax at the standard tax rate of 28% (R1 500 × 28%); (R80 000 × 28%)
Write-down of deferred tax asset/(Reversal of previous write-down)
Effect of debit balance on deferred tax account not
recognised/(Previously unrecognised deferred tax asset utilised)
420
28 000
22 400
(28 000)
2 800
(2 800)
Tax expense
31 220
(8 400)
2 801%
– 10,50%
Notes
2. Income tax expense
Major components of tax expense
Current tax expense
Deferred tax expense/(income)
Originating deductible temporary differences
Write-down of deferred tax asset/(Reversal of previous write-down)
Deferred tax assets not recognised/(Previously unrecognised
deferred tax asset utilised in current year to reduce tax expense)
Tax expense/(income)
The tax reconciliation is as follows:
Accounting profit
Effective tax rate
(Year 1: R31 220/R1 500) = 2 801% effective tax rate)
(Year 2: (R8 400)/R80 000 = –10,50% effective tax rate)
3. Deferred tax
20.12
R
Analysis of temporary differences:
Provision for environment restoration
Deferred tax asset not recognised (28 000 + 2 800)
Deferred tax asset recognised
20.13
R
30 800
(30 800)
–
33 880
–
33 880
The company has deductible temporary differences of R110 000 at the end of 20.12 (20.13: R0) in
respect of a provision for environment restoration, but no deferred tax asset was recognised, as
sufficient future taxable income to utilise the deductible temporary difference was not deemed
probable (IAS 12.81(e)).
At the end of 20.13, the company has recognised a deferred tax asset in respect of deductible
temporary differences on its provision for environment restoration. Management believes that it is
probable that sufficient future taxable profits will be earned to utilise the deductible temporary
differences, as the company has signed various new contracts from which significant profits are
expected (IAS 12.82).
continued
184 Descriptive Accounting – Chapter 8
Comment
¾ The deferred tax asset that was recognised at the end of 20.11 was reviewed at the end of
20.12 in terms of IAS 12.56. The recognised deferred tax asset was written down as it was not
probable that sufficient taxable profit would be available to allow the benefit of the deferred tax
asset to be utilised.
¾ The unrecognised deferred tax asset was reassessed at the end of 20.13 in terms of IAS 12.37.
The deferred tax asset was again recognised at the end of 20.13 as it became probable that
future taxable profit would again be available to allow the deferred tax asset to be recovered.
¾ The write-down of the recognised deferred tax asset and the subsequent reversal therefore
should be disclosed separately in terms of IAS 12.80(g).
8.7 Enacted or substantively enacted tax rates and tax laws
IAS 12.46 and .47 require that current and deferred tax assets and liabilities must be
measured on the basis of tax rates and tax laws that have been enacted or substantively
enacted by the reporting date.
The South African Financial Reporting Guide, FRG 1, Substantively Enacted Tax Rates and
Tax Laws, addresses the issue of substantive enactment. It concludes that changes in tax
rates must be regarded as substantively enacted from when they are announced in the
Minister of Finance’s budget statement.
It should be borne in mind that changes in tax rates must be applied to the period to which
they relate. For example, a change in tax rate could be announced during a tax year as being
applicable to the following year, in which case the current tax balances in the statement of
financial position would be based on the previous tax rate, whereas the deferred tax balance
in the statement of financial position would be based on the new tax rate (i.e. at the tax rate
that is expected to apply in the period when the asset is realised or the liability settled – refer
to section 8.8 below).
If the tax rates are regarded as being substantively enacted after the reporting date, they are
regarded as non-adjusting events in terms of IAS 10 Events After the Reporting Period even
when the changes to tax rates are applied retrospectively. In this case, the required
disclosure in terms of IAS 10 is to be provided.
Changes in tax rates need to be distinguished from other changes in tax laws. In the case
of changes in tax laws, the detail of the changes is generally only decided upon at a later
date and substantive enactment therefore only occurs once the legislation is approved,
since prior to this date there is insufficient certainty about the details to be applied in practice
when the changes are actually enacted. As such, FRG 1 proposes that changes in tax laws,
other than changes to tax rates, should be regarded as being substantively enacted only
when they have been approved by Parliament and signed by the President.
FRG 1 recognises that it could be possible that changes in tax rates are inextricably linked
to other changes in the tax laws. If this is the case, then they should be regarded as being
substantively enacted only when they have been approved by Parliament and signed by the
President, and not on the date of the budget speech. An example of such changes was
when CGT was introduced in 2001 (i.e. the tax rate applicable to capital items changed from
0% to 15% (50% × 30%)).
These principles are also applied to interim financial statements prepared in accordance
with IAS 34. In other words, current and deferred tax balances in the interim financial
statements are to be measured using tax rates and tax laws that have been enacted or
substantively enacted by the interim reporting date.
Income taxes 185
8.8 Recognition and measurement of deferred tax
In the preceding examples, the deferred tax effect was recognised against profit or loss (i.e.
the movement in the deferred tax balance was recognised as a debit or credit entry to the
income tax expense). In those examples the items (e.g. property, plant and equipment and
provisions) that gave rise to the deferred tax also relates to items recognised within profit or
loss (e.g. depreciation, expenses for provision raised, etc.). The general guideline for the
recognition of deferred tax is that it should be treated in the same manner as the
accounting treatment of the underlying transaction or event. The deferred tax must be
recognised in other comprehensive income if the tax is related to an item which is
recognised in other comprehensive income either in the same or in another period
(IAS 12.61A). Examples include the revaluation of property, plant and equipment, (which is
addressed in chapter 9) and long-term investments at fair value through other
comprehensive income (refer to chapter 20).
Deferred tax must be recognised as income or an expense in the profit or loss for the year,
except if the tax arises from:
ƒ transactions recognised in other comprehensive income (e.g. a revaluation);
ƒ transactions recognised directly in equity (e.g. the correction of a prior period error in
retained earnings at the beginning of the year – see Example 6.4); or
ƒ a business combination (IAS 12.58).
If the tax status of a company should change through, for example, the restructuring of
equity or the relocation of the major shareholder, the tax consequences of the current and
deferred tax must be recognised in the profit or loss of the year. SIC 25 suggests that the
exception occurs where the tax consequences relate to transactions or events that were
treated as a direct charge to equity or other comprehensive income. In these instances, the
tax adjustment is also charged or credited directly to equity or other comprehensive income.
IAS 12.47 requires deferred tax assets and liabilities to be measured at the tax rates that
are expected to apply in the period when the asset is realised or the liability settled, based
on tax rates and tax laws that have been enacted or substantively enacted at the reporting
date (refer to section 8.7).
8.8.1 Reversal of deferred tax
Deferred tax balances are recognised in respect of temporary differences on assets and
liabilities. This implies that if the specific temporary difference no longer exists at the end of
the reporting period, any related deferred tax balance should be reversed. The deferred tax
balance is recalculated at the end of each reporting period. This recalculated balance is
compared to the balance at the end of the previous reporting period, and the
increase/decrease is recognised against the same component (e.g. profit or loss) of the
financial statements where the related item was recognised (as explained above).
When, for example, an item of plant that lead to the recognition of a deferred tax liability is
sold, the related deferred tax balance is reversed. The profit or loss on the disposal of the
plant would be recognised in profit or loss, and the movement in the deferred tax balance (to
Rnil) would also be recognised in profit or loss (as part of the income tax expense).
186 Descriptive Accounting – Chapter 8
Example 8.22
8.22
Reversal of the deferred tax balance, with capital gains tax
The accounting profit of Palm Ltd for the year ended 31 December 20.15 amounted to
R2 000 000. Palm Ltd’s only temporary difference relates to an item of plant. Palm Ltd acquired
the item of plant on 1 January 20.14 at a cost of R500 000. The plant is depreciated evenly over
8 years with no residual value. For tax purposes, a 40/20/20/20 tax allowance is applied. At the
end of 20.15, Palm Ltd sold the plant for R550 000.
The normal income tax rate is 28% and the capital gains tax inclusion rate is 80%.
Deferred tax on plant:
Carrying
amount
Tax
base
Temporary
difference
R
500 000
(200 000)
R
Cost
Depreciation/tax allowance 20.14
R
500 000
(62 500)
Deferred
tax @28%
Dr/(Cr)
R
Balance end of 20.14
Depreciation/tax allowance 20.15
437 500
(62 500)
300 000
(100 000)
137 500
37 500
(38 500)
(10 500)
375 000
(375 000)
200 000
(200 000)
175 000
(175 000)
(49 000)
49 000
Balance before disposal
Disposal
Balance end of 20.15
–
–
–
–
The accounting profit on the sale is as follows:
Proceeds
Carrying amount on the date of the sale (calculated above)
Accounting profit on the sale
The income tax consequences are as follows
(calculation done in the format of the Income Tax Act):
Recoupment:
Proceeds (limited to the cost price)
Income tax value on the date of the sale (calculated above)
Recoupment
Capital gain:
Proceeds:
Selling price
Recoupment
Less: Base cost (income tax value on the date of the sale as calculated above)
Cost price
Allowances
Capital gain
R
550 000
(375 000)
175 000
500 000
(200 000)
300 000
250 000
550 000
(300 000)
200 000
500 000
(300 000)
50 000
The capital gains tax inclusion rate is 80% and an amount of R40 000
(50 000 × 80%) will be included in the taxable income. Consequently, R10 000 of
the capital gain will not be taxed.
continued
Income taxes 187
Calculation of current tax for the year ended 31 December 20.15:
Accounting profit
Non-taxable items:
Portion of accounting profit on disposal of plant that relates to the
capital gain that is not taxable ((R550 000 – R500 000) × 20%)
Temporary differences:
Depreciation and tax allowance on plant
Depreciation on plant
Tax allowance on plant
Disposal of plant
Portion of accounting profit on disposal of plant that relates to the
capital gain that is taxable and the recoupment
((R550 000 – R375 000) – 10 000 above)
Recoupment of tax allowances (R500 000 – R200 000)
Taxable capital gains ((R550 000 – R500 000) × 80%)
Taxable income and current tax payable
Gross
amount
R
2 000 000
Tax at 28%
R
560 000
(10 000)
(2 800)
1 990 000
557 200
(37 500)
(10 500)
62 500
(100 000)
175 000
49 000
(165 000)
300 000
40 000
2 127 500
595 700
Notes
2. Income tax expense
R
Major components of tax expense
Current tax expense
Deferred tax income (10 500 – 49 000)
595 700
(38 500)
Tax expense
557 200
The tax reconciliation is as follows:
Accounting profit
2 000 000
Tax at the standard tax rate of 28% (R2 000 000 × 28%)
Portion of accounting profit on disposal of plant that relates to the capital
gain that is not taxable (R10 000 × 28%)
560 000
Tax expense
557 200
Effective tax rate (R557 200/R2 000 000)
27,86%
(2 800)
Comment
¾ The deferred tax liability amounted to R49 000 before the sale of the item of plant. There are no
temporary differences after the sale of the item of plant and the deferred tax liability should
amount to R0. The deferred tax balance of R49 000 is reversed with the recognition of the profit
on disposal of the asset, by debiting the deferred tax liability and crediting the income tax
expense with R49 000.
¾ The format used for the calculation of the current tax illustrates the amounts disclosed in the
note for the income tax expense.
¾ The accounting profit on the disposal of the plant amounted to R175 000 (proceeds of
R550 000 less the carrying amount of R375 000). This amount was deducted from the total
accounting profit (to calculate the taxable income) as two amounts (R10 000 under the
‘permanent’ differences and R165 000 under temporary differences) for illustrative purposes
only, in order to relate this to the capital gain that is not taxable and the recoupment and capital
gains that are taxable in terms of the Income Tax Act.
188 Descriptive Accounting – Chapter 8
8.8.2 Measuring of deferred tax in case of change in tax rate
An accounting estimate is made for the purpose of recognising the amount of deferred tax,
by referring to the information at the reporting date. It follows that when the tax rates
change, the deferred tax balance will be adjusted accordingly. The adjustment will be a
change in the accounting estimate that will form part of the income tax expense in the
statement of profit or loss and other comprehensive income of the current year, if the item
that lead to the temporary difference was also recognised in profit or loss.
When a new tax rate has already been announced by the tax authorities at the reporting
date, the announced rate should be used in measuring the deferred tax assets and liabilities
(refer to section 8.8 above).
Example 8.23
Change in the tax rate
Scenario A:
Gamma Ltd had the following temporary differences for the years ended 31 December 20.12 and
20.13.
20.13
20.12
R
R
Property, plant and equipment:
Carrying amount
150 000
200 000
Tax base
(80 000)
(120 000)
Taxable temporary difference
70 000
80 000
28%
29%
Normal income tax rate
The new normal income tax rate of 28% was announced at the beginning of 20.13.
Deferred tax liability
R
23 200
(19 600)
31 December 20.12 (R80 000 × 29%)
31 December 20.13 (R70 000 × 28%)
Net change in statement of profit or loss and other comprehensive income (P/L)
3 600
Disclosed as follows: Movement in temporary differences (R10 000 × 28%)
Tax rate change (R80 000 × 1%) OR (R23 200 × 1/29)
2 800
800
Journal entry
31 December 20.13
Deferred tax (SFP)
Income tax expense (P/L)
Recognition of movement in deferred tax for the current year
Dr
R
3 600
Cr
R
3 600
IAS 12.80(c) and (d) require the disclosure of the deferred tax expense or income attributable to
the origination or reversal of temporary differences, as well as disclosure of the amount applicable to
changes in the tax rate or changes in legislation (refer above). The note for the income tax expense
will be presented as follows (assume that the accounting profit for 20.13 amounted to R300 000):
continued
Income taxes 189
Notes
2. Income tax expense
20.13
R
Major components of tax expense
Current tax expense
[(R300 000 + R50 000 depreciation – R40 000 tax allowance) × 28%]
Deferred tax expense
Reversing temporary difference on property, plant and equipment
(R10 000 × 28%)
Effect of rate change (R80 000 × 1%) or (R23 200 × 1/29)
Tax expense
The tax reconciliation is as follows:
Accounting profit
86 800
(3 600)
(2 800)
(800)
83 200
300 000
Tax at the standard tax rate of 28% (R300 000 × 28%)
Effect of decrease in tax rate
84 000
(800)
Tax expense
83 200
Effective tax rate (R83 200/R300 000)
27,73%
The applicable normal income tax rate changed during the current year to 28% (20.12: 29%)
(IAS 12.81(d)).
Scenario B:
If the tax rate for 20.12 is 29% and on 30 December 20.12, a tax rate change to 28% is
announced for the 20.13 tax year, the deferred tax balance on 31 December 20.12 is measured
using the new tax rate at the reporting date (assume taxable temporary differences of R60 000 on
31 December 20.11):
Deferred tax liability
For the year ended 31 December 20.12
Opening balance: 1 January 20.12 (R60 000 × 29%)
Closing balance: 31 December 20.12 (R80 000 × 28%)
R
17 400
22 400
Net change in statement of profit or loss and other comprehensive income (P/L)
5 000
The movement for the year ended 31 December 20.12 is disclosed as follows:
Option 1: Adjust opening balance
Movement of deferred tax for 20.12 (R20 000* × 28%)
Tax rate change on opening balance (R60 000 × 1%)
5 600
(600)
Net change in statement of profit or loss and other comprehensive income (P/L)
5 000
* (R80 000 – R60 000)
OR
Option 2: Adjust closing balance
Movement of deferred tax for 20.12 (R20 000 × 29%)
Tax rate change on closing balance (R80 000 × 1%)
5 800
(800)
5 000
continued
190 Descriptive Accounting – Chapter 8
Comment
¾ IAS 12 refers to tax rates enacted or substantially enacted at the reporting date that must be
used in the measurement of deferred tax. If the new tax rate is announced prior to the reporting
date, the new rate may provide a more accurate estimate of the tax rates that will apply in the
periods when the assets realise or the liabilities are settled.
¾ The inclusion of rate changes in the tax expense or income in the statement of profit or loss
and other comprehensive income means that earnings per share for the current year will be
influenced by adjustments to the deferred tax balance due to tax rate increases or decreases.
¾ In this example, the effect of the change in the tax rate was recognised within profit or loss, as
the temporary difference relates to items that are recognised in profit or loss (annual
depreciation amount differs from tax allowance). However, should the relevant item or event
have been recognised in other comprehensive income (e.g. a revaluation as in Example 8.26
below), an appropriate amount of the effect of the rate change should be recognised in other
comprehensive income.
8.8.3 Measuring of deferred tax allowing for the expected manner of recovery
It was indicated in section 8.4 that is inherent in the recognition of an asset or liability that an
entity expects to recover or settle the carrying amount of that asset or liability. Furthermore,
it was indicated that deferred tax is then recognised if it is probable that the 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.
When deferred tax liabilities and assets are measured, the tax consequences of the manner
in which the entity expects to recover or settle the carrying amount of its assets and
liabilities must be considered (IAS 12.51). The manner in which assets are recovered and
liabilities settled may influence the tax rate, as well as the tax base of items (IAS 12.51A). In
such cases, an entity measures deferred tax liabilities and deferred tax assets using the tax
rate and the tax base that are consistent with the expected manner of recovery or
settlement.
An example of the potential influence of tax rates is a situation in which a tax authority taxes
an entity’s capital gains at an effective tax rate of 22,4% (80% of the capital gain at 28% –
refer to section 8.3.2 for more information on Capital Gains Tax on companies) when an
asset is sold, and at a rate of 28% if revenue is generated through the use of that asset. In
South Africa, different tax rates apply to items of a revenue nature (28%) and items of a
capital nature (0% or 22,4%).
The future economic benefits associated with an asset generally arise from three manners
of recovery (how the carrying amount of an asset will be recovered) namely:
ƒ through sale (the tax consequences may be a recoupment (at 28%) and/or a capital gain
(at 80% × 28%));
ƒ through use (e.g. as the plant is used, the inventory sold will be taxed at 28%); or
ƒ through use and then subsequent sale (e.g. a revalued depreciable asset where the
residual value is lower than the carrying amount but higher than the original cost).
Depreciating an asset implies that the carrying amount of the asset is expected to be
recovered through use. If this premise is applied to an asset that is not depreciated, for
example land (unlimited life), then land will be recovered only through sale. Therefore
deferred tax recognised for a non-depreciable asset will reflect the tax consequences of
selling the asset.
The carrying amount of a depreciable asset in terms of IAS 16 can be recovered through the
use of the asset, which will generate taxable profits, or by selling the asset. It is considered
that the carrying amount of an asset will be recovered through sale once it has been
classified as a non-current asset held for sale in terms of IFRS 5.
Income taxes 191
If a non-depreciable asset is revalued under IAS 16 Property, Plant and Equipment, then
IAS 12.51B requires that the deferred tax liability or asset that arises from such a revaluation
is measured based on the tax consequences that will follow from recovering the carrying
amount of that asset through sale.
Example 8.24
Deferred tax on revalued land
Sigma Ltd acquired land at a cost of R800 000 on 1 July 20.10. The entity’s year end is
31 December. The land was revalued to R950 000 on 31 December 20.12. Assume a normal
income tax rate of 28% and the capital gains tax inclusion rate is 80%.
Deferred
Carrying
Temporary
Tax base
tax
amount
difference
(liability)
R
R
R
R
Land at cost (non-depreciable asset)
800 000
800 000
–
–
Revaluation surplus
150 000
150 000
(33 600)
–
Land at revaluation
950 000
800 000
150 000
(33 600)
Journal entries relating to the land:
Dr
R
1 July 20.10
Land
Bank
Initial recognition of purchase of land
800 000
31 December 20.12
Land
Revaluation surplus (OCI)
Revaluation of land
150 000
31 December 20.12
Revaluation surplus: Tax effect (OCI)
Deferred tax liability (SFP) (150 000 × 80% × 28%)
Recognition of deferred tax on revaluation of land
Cr
R
800 000
150 000
33 600
33 600
Comment
¾ Land is a non-depreciable asset revalued under IAS 16 and the deferred tax liability is measured
on the basis that the carrying amount of land will be recovered through sale.
¾ The tax base of the land is the amount deductible in future. When the land is recovered through
sale (deemed), the cost would be deductible. Therefore, the tax base is equal to the cost of
R800 000.
¾ The deferred tax on the revaluation of land is recognised against other comprehensive income
as the item to which it relates (the revaluation led to the temporary difference) was recognised in
other comprehensive income.
¾ Non-depreciable assets, for example, land, will not lead to the recognition of deferred tax under
the cost model. The temporary difference that arises on initial recognition is exempt in terms of
IAS 12.15, as the difference arises from the initial recognition of an asset in a transaction which
at the time of the transaction does not affect either the accounting profit or the taxable profit.
¾ If the non-depreciable asset is revalued in terms of IAS 16, the revaluation no longer relates to
the initial recognition of the asset as it is a subsequent remeasurement and is therefore no
longer an exempt temporary difference.
192 Descriptive Accounting – Chapter 8
Example 8.25
Deferred tax on revalued plant
Plant with a carrying amount of R400 000 and a tax base of R375 000 was revalued to R650 000.
The original cost of the plant was R500 000. Assume a normal income tax rate of 28% and the
capital gains tax inclusion rate is 80%.
If the carrying amount is recovered through use, the deferred tax will be calculated as follows:
Deferred
Carrying
Tax
Temporary
tax
amount
base
difference
(liability)
R
R
R
R
Plant
400 000
375 000
25 000
(7 000)
Revaluation
250 000
–
250 000
(70 000)
650 000
375 000
275 000
(77 000)
Deferred tax is measured on both temporary differences at 28%.
If the carrying amount is recovered through sale, the deferred tax will be calculated as follows:
Deferred
Carrying
Tax
Temporary
tax
amount
base
difference
(liability)
R
R
R
R
Plant
400 000
375 000
25 000
(7 000)
Revaluation
250 000
–
250 000
(61 600)
Up to cost*
Above cost**
650 000
375 000
100 000
150 000
(28 000)
(33 600)
275 000
(68 600)
* R500 000 – R400 000 = R100 000
** R650 000 – R500 000 = R150 000; R150 000 × 80% × 28% = R33 600
Comment
¾ A sale of the plant will result in a recoupment of R125 000 that will be taxed at 28%, leading to
a tax consequence of R35 000 (R125 000 × 28%; or 7 000 + 28 000 in calculation above). Only
80% of the capital gain of R150 000 will be taxed at 28%, leading to a tax consequence of
R33 600 (R150 000 × 80%× 28%). The total tax consequence flowing from the recovery of the
carrying amount of the asset through a sale is then R68 600 (R35 000 + R33 600), which
represents the measurement of the deferred tax balance on the plant.
¾ Deferred tax on the temporary difference of R25 000 (as a result of the difference between the
depreciation and the tax allowance) is measured at 28%.
¾ Deferred tax on the revaluation surplus is measured as follows:
on the amount up to the original cost (R100 000) at 28%; and
on the amount above the original cost (R150 000) at 80% × 28%.
¾ It is clear that the expected manner of recovery of the carrying amount of the plant has an
effect on the calculation of deferred tax. If the carrying amount is recovered through use, the
total deferred tax is R77 000. However, if the carrying amount is recovered through sale, the
total deferred tax amounts to R68 600.
¾ Entities do not have a free choice in selecting which tax rates should be applied to the various
temporary differences, nor can they merely specify their selected rates in an accounting policy.
These rates should be determined by applying IAS 12.47 and IAS 12.51. Preparers of financial
statements should consider whether sufficient details have been provided in the financial
statements on how the deferred tax balance was determined. In some cases, the required
disclosures might have to be supplemented by additional information to achieve fair
presentation.
continued
Income taxes 193
The notes relating to the deferred tax balance in the statement of financial position may be
disclosed as follows:
Notes
3. Deferred tax
Recovery
Recovery
through
through
use
sale
R
R
Analysis of temporary differences:
Tax allowances on property, plant and equipment
7 000
7 000
Revaluation
70 000
61 600
Deferred tax liability
77 000
68 600
The following information should also be disclosed in respect of the expected recovery through
sale:
The company has revalued its plant (refer to note xx) and expects to recover the carrying amount
through sale. Included in the deferred tax balance is a temporary difference of R150 000 on which
capital gains tax is expected.
During 2016, the inclusion rate of capital profits changed from 66,6% to 80% for companies.
This change will influence the measurement of deferred tax where the carrying amount of
an asset is expected to be recovered through sale. The effect of a change in the tax rate
was also discussed in section 8.8.2.
Example 8.26
Change in tax rate for capital gains
Sigma Ltd acquired land at a cost of R800 000 on 1 July 20.14. The entity’s year end is
31 December. The land was revalued to R950 000 on 31 December 20.15. At that time, 66,6% of
capital gains were taxable. During 20.16, the inclusion rate for capital gains changed to 80%. The
land was revalued to R970 000 on 31 December 20.16. Assume a normal income tax rate of 28%.
Deferred
Carrying
Temporary
Tax base
tax
amount
difference
(liability)
R
R
R
R
–
–
Land at cost (non-depreciable asset)
800 000
800 000
Revaluation surplus during 20.15
150 000
150 000
(27 972)
–
Balance at 31 December 20.15
(150 000 × 66,6% × 28%)
Change in tax rate
[150 000 × (80% – 66,6%) × 28%]
Deferred tax at 80% × 28%
Revaluation surplus during 20.16
Balance at 31 December 20.16
950 000
800 000
150 000
(27 972)
(5 628)
(33 600)
(4 480)
20 000
970 000
800 000
170 000
(38 080)
Journal entries
Dr
R
31 December 20.16
Revaluation surplus: Tax effect (OCI)
Deferred tax liability (SFP)
Recognition of change in tax rate for capital gains
Cr
R
5 628
5 628
continued
194 Descriptive Accounting – Chapter 8
Dr
R
20 000
Land
Revaluation surplus (OCI)
Revaluation of land
Cr
R
20 000
Revaluation surplus: Tax effect (OCI)
Deferred tax liability (SFP) (20 000 × 80% × 28%)
Recognition of deferred tax on revaluation of land
4 480
4 480
Comment
¾ The revaluation itself and the related deferred tax are recognised in other comprehensive
income (IAS 12.61A). Therefore, the remeasurement of the deferred tax as a result of the new
inclusion rate for the capital gain is also recognised in other comprehensive income.
For the purpose of measuring the deferred tax on a revalued non-depreciable asset, the
assumption is made that the carrying amount of the asset will be recovered through sale.
Consequently, all or a part of the deferred tax is measured at the effective capital gains tax
rate. Similarly, the effective capital gains tax rate should be used for measuring a deferred
tax asset if capital losses are expected. Capital losses (other than section 11(0) allowances)
can be deducted from capital gains in the current year of assessment. However, if the
capital losses exceed the capital gains for the current year, that net capital loss may be
carried forward to the following year of assessment. Consequently, a deferred tax asset for
deductible capital losses can also only be recognised to the extent that it is probable that
capital gains will be available in future against which the capital losses can be utilised
(IAS 12.27A). Refer to section 8.6 above for more detail on the recognition of deferred tax
assets.
Example 8.27
Deferred tax assets on expected capital losses
Dumela Ltd acquired land at a cost of R800 000 on 1 January 20.14 and it was classified as
property, plant and equipment. Ignore the building component for this example. The entity’s year
end is 31 December. On 31 December 20.15, the land was classified as held for sale in terms of
IFRS 5. The land was impaired to the fair value of R700 000. Costs to sell are regarded as
immaterial.
The normal income tax rate is 28% and the capital gains tax inclusion rate is 80%. Dumela Ltd had
no capital gains during 20.15.
Case 1 – Sufficient taxable capital gains are expected in future against which the capital
loss can be utilised:
Deferred tax calculations:
Deferred
Carrying
Temporary
Tax base
tax
amount
difference
asset
R
R
R
R
Land at cost (non-depreciable asset)
800 000
800 000
–
–
–
Impairment loss
(100 000)
(100 000)
22 400
Balance at 31 December 20.15
700 000
800 000
(100 000)
22 400
continued
Income taxes 195
Journal entries
Dr
R
31 December 20.15
Impairment loss (P/L)
Land
Impairment loss on land held for sale
Cr
R
100 000
100 000
Deferred tax asset (SFP)
Income tax expense (P/L)
Recognition of deferred tax on impairment of land
22 400
22 400
Comment
¾ The impairment loss is recognised within profit or loss as the asset is classified as held for sale,
and the related deferred movement is then recognised against the income tax expense in profit
or loss.
¾ There were no tax allowances granted on the land and, consequently, the section 11(o)
allowance cannot be claimed for the expected loss. The expected loss on the deemed disposal
is then regarded as a capital loss.
¾ Sufficient taxable capital gains are expected in future, against which the expected capital loss
on the disposal of the land in the near future, can be utilised. Consequently, a deferred tax
asset may be recognised.
¾ Capital losses may only be deducted against capital gains to reduce any capital gains tax.
Capital losses may not be deducted from the taxable income of a revenue nature.
Consequently, a deferred tax asset on capital losses may not be offset against a deferred tax
liability on temporary differences on items of a revenue nature for tax purposes. Refer to section
8.11 below related to offsetting of deferred tax.
Case 2 – Sufficient taxable capital gains are not expected in future against which the capital
loss can be utilised:
Deferred tax calculations:
Deferred
Carrying
Temporary
Tax base
tax
amount
difference
asset
R
R
R
R
–
–
Land at cost (non-depreciable asset)
800 000
800 000
Impairment loss
(100 000)
–
(100 000)
22 400
Possible deferred tax asset at
31 December 20.15
Deferred tax asset not recognised
Balance at 31 December 20.15
700 000
800 000
(100 000)
22 400
(22 400)
–
Comment
¾ The journal entry for the impairment loss is the same as in Case 1 above. However, there is no
journal entry for the deferred tax asset, as it is not recognised.
¾ Sufficient taxable capital gains are not expected in future, against which the expected capital
loss on the disposal of the land in the near future, can be utilised. Consequently, a deferred tax
asset may not be recognised.
If a deferred tax liability or asset arises from investment property that is measured using
the fair value model in IAS 40, there is a rebuttable presumption that the carrying amount of
the investment property will be recovered through sale (i.e., the deferred tax liability or asset
will reflect the tax consequences of recovering the carrying amount through sale)
(IAS 12.51C). If this presumption is rebutted, then the requirements of IAS 12.51 and .51A
will be followed. Refer to section 17.7.2 for more detail. The following indicate that the
presumption could be rebutted:
ƒ the investment property is depreciable; and
196 Descriptive Accounting – Chapter 8
ƒ it is held within a business model whose objective is to consume substantially all of the
economic benefits embodied in the investment property over time, rather than through
sale.
Example 8.28
Deferred tax on investment property, with capital gains tax
The accounting profit of Leseli Ltd for the year ended 31 December 20.15 amounted to
R2 000 000. Leseli Ltd’s only temporary difference relates to an investment property that was
acquired on 1 February 20.15 at a cost of R1 000 000. The investment property is measured at fair
value and the fair value was R1 100 000 at 31 December 20.15. The presumption of IAS 12 was
not rebutted. The investment property did not qualify for any tax allowances.
During the current year, Leseli Ltd also sold an item of land (cost of R300 000) for R420 000. This
gain represents a capital gain for tax purposes.
The normal income tax rate is 28% and the capital gains tax inclusion rate is 80%.
Deferred tax on investment property:
Carrying
amount
Tax
base
Temporary
difference
R
Deferred
tax @
CGT %
Dr/(Cr)
R
Cost
Fair value gain 20.15
R
1 000 000
100 000
R
1 000 000
–
100 000
(22 400)
Balance end of 20.15
1 100 000
1 000 000
100 000
(22 400)
Calculation of current tax for the year ended 31 December 20.15:
Accounting profit
Non-taxable items:
Portion of accounting fair value gain on investment property for which
deferred tax is not measured ((R1 100 000 – R1 000 000) × 20%)
Portion of accounting profit on disposal of land that relates to the
capital gain that is not taxable ((R420 000 – R300 000) × 20%)
Accounting profit reversed (R420 000 – R300 000)
Capital gain included in taxable income (R120 000 × 80%)
Temporary differences:
Fair value gain on investment property
Portion of accounting fair value gain on investment property for which
deferred tax is not measured ((R1 100 000 – R1 000 000) × 80%)
Fair value gains/tax allowance on investment property
Taxable income and current tax payable
Gross
amount
R
2 000 000
Tax at 28%
R
560 000
(20 000)
(5 600)
(24 000)
(120 000)
96 000
(6 720)
1 956 000
547 680
(80 000)
(22 400)
(80 000)
–
1 876 000
525 280
Comment
¾ The format used for the calculation of the current tax illustrates the amounts disclosed in the
note for the income tax expense. The calculation of the current tax could also be done as
follows:
continued
Income taxes 197
Alternative calculation of current tax for the year ended 31 December 20.15:
Gross
amount
R
Accounting profit
2 000 000
Accounting profit on disposal of land (R420 000 – R300 000)
(120 000)
Capital gain included in taxable income (R120 000 × 80%)
96 000
Fair value gain on investment property reversed
(R1 100 000 – R1 000 000)
Fair value gains/tax allowance on investment property
Taxable income and current tax payable
Tax at 28%
R
(100 000)
–
1 876 000
525 280
Notes
2. Income tax expense
R
Major components of tax expense
Current tax expense
Deferred tax expense
525 280
22 400
Tax expense
547 680
The tax reconciliation is as follows:
Accounting profit
2 000 000
Tax at the standard tax rate of 28% (R2 000 000 × 28%)
Portion of accounting profit on disposal of land that relates to the capital
gain that is not taxable ((R420 000 – R300 000) × 20% × 28%)
Portion of accounting fair value gain on investment property for which
deferred tax is not measured ((R1 100 000 – R1 000 000) × 20% × 28%)
560 000
Tax expense
547 680
Effective tax rate (R547 680/R2 000 000)
27,38%
(6 720)
(5 600)
Comment
¾ A deferred tax liability on the temporary difference relating to the investment property is indeed
recognised. However, the deferred tax is not measured at 28% of the temporary difference as
the presumption is made that the carrying amount of the investment property will be recovered
through sale. The tax consequences of the manner in which the carrying amount will be
recovered would be a capital gain, for which the inclusion rate is only 80%. The deferred tax is
then measured at 80% × 28% of the temporary difference.
¾ However, 100% of the fair value gain on the investment property is included in the accounting
profit, but the related deferred tax expense only reflects 80% × 28% thereof. Consequently, the
income tax expense will be out of proportion (28%) to the accounting profit. The effect of this
difference is explained to the users of financial statements in the tax reconciliation.
¾ Similarly, 100% of the realised accounting profit on the disposal of the land is also included in
the accounting profit, but the related current tax expense (capital gains tax) only reflects 80% ×
28% thereof. Consequently, the income tax expense will be out of proportion (28%) to the
accounting profit. The effect of this difference is explained to the users of financial statements
in the tax reconciliation.
IAS 12 prohibits the discounting of deferred tax assets and liabilities (IAS 12.53). It is
argued that discounting requires accurate and detailed scheduling of the timing of the
reversal of each temporary difference. In many cases, this scheduling is impractical and
complex. In addition, discounting results in deferred tax assets and liabilities that would not
be comparable between entities.
198 Descriptive Accounting – Chapter 8
8.9 Dividend tax
Dividend tax is a tax imposed on shareholders at a rate of 20% on receipt of dividends. The
dividend tax is categorised as a withholding tax, as the tax is withheld and paid (on behalf of
the shareholder) to the SARS by the company paying the dividend and not the person liable
for the tax (who is the benefitting owner of the dividend).
Example 8.29
Accounting treatment of dividend tax
Delta Ltd declared a cash dividend of R100 000 on 30 November 20.18. The dividend
dividend tax was paid in cash on 12 December 20.18.
Journal entries
Dr
R
30 November 20.18
Dividend declared (Equity)
100 000
Current liability: Shareholders for dividends (SFP)
Current liability: the SARS – Dividend tax payable (SFP)
Recognition of dividend declared
12 December 20.18
Current liability: Shareholders for dividends (SFP)
Current liability: the SARS – Dividend tax payable (SFP)
Bank
Payment of dividends to shareholders and dividend tax paid to the SARS
and the
Cr
R
80 000
20 000
80 000
20 000
100 000
A dividend will be exempt from dividend tax (section 64F(1)) if the recipient is a resident
company. As such, South African companies receiving a dividend from an investment in
another South African company will not be liable for the dividend tax on the dividend
received. The full dividend will merely be recognised in profit or loss, without any tax
consequences as the dividend received is also exempt (section 10(1)(k)) for the purpose of
income taxes. The effect of the exempt dividend received was explained in the tax
reconciliation as was indicated in Example 8.1. However, other entities (e.g. a trust that
applies IFRSs) that receive a dividend will still be subject to the dividend tax. That entity will
then recognise the gross amount (100%) as income, with the dividend tax (20%) as part of
the income tax expense (income taxes include withholding taxes in terms of IAS 12.2).
8.10 Foreign tax
IAS 12 Income Taxes is applicable to South African taxes that are levied on taxable profits,
as well as foreign taxes levied on taxable profits obtained from foreign sources (IAS 12.2).
Foreign taxes may be very complex and the purpose of this text is merely to illustrate the
effect of foreign taxes on the disclosure of the tax expense in the financial statements. A
South African company, as a ‘resident’, will be subject to South African normal tax on its
worldwide income, depending on the provisions of any double tax agreements. This implies
that the foreign income of a South African company may also be taxed in South Africa. The
amount of any foreign tax paid may qualify as foreign tax credits (rebates) (see section 6
quat and quin) and be deducted from the amount of taxation payable to the SARS. Foreign
income and the amount of foreign taxes paid will first be translated to rand.
Income taxes 199
Example 8.30
8.30
Accounting treatment of foreign tax credits
Local Ltd has a branch outside South Africa. The company’s local accounting profit (and taxable
income from SA sources) amounted to R2 000 000. The branch’s accounting profit (and taxable
income from foreign sources) amounted to the equivalent of R500 000. The branch paid foreign
taxes equivalent to R100 000.
The company’s total current tax expense amounts to:
R
Income from South Africa
2 000 000
Income from foreign sources
500 000
Total taxable income
2 500 000
SA normal current tax expense (R2 500 000 × 28%)
700 000
Tax payable to South African tax authority (the SARS):
Total tax expense
Less: Foreign tax credits (section 6quat)
700 000
(100 000)
Tax payable to the SARS (current liability)
600 000
Comment
¾ The total tax expense of R700 000 is equal to the expected tax expense of 28% of the
accounting profit. Therefore, a tax reconciliation in the note for the income tax expense is not
needed.
A foreign subsidiary (under the control of a South African parent company) would be
included in the consolidated financial statements of the parent. The foreign subsidiary, as a
foreign business establishment, may be taxed in the foreign country and not in South Africa.
The effect of a different foreign tax rate (compared to the South African normal income tax
rate of 28%) should be disclosed in the consolidated financial statements (refer to
IAS 12.85).
Example 8.31
8.31
Disclosure of differences due to foreign tax
Local Ltd has control over Foreign Ltd, a foreign subsidiary that is classified as a foreign business
establishment. Local Ltd’s local accounting profit (and taxable income from SA sources) amounted
to R2 000 000. Foreign Ltd’s accounting profit (and taxable income from foreign sources)
amounted to the equivalent of R500 000. Foreign Ltd paid foreign taxes equivalent to R100 000
(20% of taxable income).
Each company will pay current tax on its own taxable income, as follows:
Calculation of current tax for the separate entities:
Local Ltd (R2 000 000 × 28%)
Foreign Ltd (R500 000 × 20%)
Gross
amount
R
2 000 000
500 000
Current
tax
R
560 000
100 000
Consolidated accounting profit and current tax expense
2 500 000
660 000
continued
200 Descriptive Accounting – Chapter 8
The group will present the following note for its income tax expense in the consolidated financial
statements:
Notes
7. Income tax expense
R
Major components of tax expense
Current tax expense
660 000
Deferred tax expense
–
Tax expense
The tax reconciliation is as follows:
Accounting profit (R2 000 000 + R500 000)
660 000
2 500 000
Tax at the standard tax rate of 28% (R2 500 000 × 28%)
Effect of the different tax rate on foreign income taxed in another
jurisdiction (R500 000 × (28% – 20%))
700 000
Tax expense
660 000
Effective tax rate (R660 000/R2 500 000 × 100)
(40 000)
26,4%
Comment
¾ The difference in the consolidated tax expense as a result of the foreign income that are not
taxed at the same rate as South African income, is disclosed in the note for the tax expense
(also refer to IAS 12.85).
8.11 Consolidation and equity method
Consolidations of group entities and the equity method for accounting of associate and joint
venture may also have an effect on the deferred tax balances and the income tax expense.
This section only deals with some basic tax effects of groups (refer to chapters 24 and 26)
and associates and joint ventures (refer to chapter 25).
The consolidation process commences with adding together (combining) like items of assets,
liabilities, equity, income and expenses as they appear in the financial statements of the
parent and its subsidiaries on a line-by-line basis. A subsidiary’s line items for the deferred
tax balance, income tax expense and the tax expense of other comprehensive income are
combined with those of the parent. The following tax related matters may be relevant with
consolidation of a group:
ƒ The net identifiable assets of the subsidiary are generally measured at their fair values
with a business combination. The tax bases of these net assets are unaffected and the
resulting temporary differences are not exempt from the recognition of deferred tax. It is
only temporary differences that arose with the initial recognition of an asset or liability in
a transaction, which is not a business combination, that are exempt from the recognition
of deferred tax (refer to section 8.5.2 and 8.5.3 for more detail). Consequently, deferred
tax is to be recognised on all temporary differences arising with a business combination
(refer to section 26.5 for more detail).
ƒ Temporary differences may also arise from the elimination of unrealised intragroup
transactions. The unrealised gain or loss is eliminated from the consolidated carrying
amount, while the tax base is unaffected. Consequently, deferred tax is recognised on
the resulting temporary difference (refer to section 25.4.2 for more detail).
ƒ Differences in foreign taxes of a foreign subsidiary will be explained in the tax
reconciliation in the note to the consolidated income tax expense (refer to section 8.10).
ƒ Deferred tax assets and liability of different group entities may not be offset (refer to
section 8.13 for more detail).
Income taxes 201
The equity method is used to account for an investor’s interest in an associate or joint
venture. The investment in the associate or joint venture is subsequently adjusted with the
investor’s proportionate share of the after tax profit or loss and other comprehensive income
of the associate or joint venture. This implies that the various line items (including the tax
line items) of the associate or joint venture are not combined with those of the investor, as
the case would be with consolidation. The investor’s proportionate share of the after tax
profit or loss of the associate or joint venture is presented as a separate line item (before
the income tax expense) in the statement of profit or loss, while the income tax expense line
item does not include any amount in respect of the associate or joint venture. Consequently,
the amount for the income tax expense will not be in line with (28%) of the profit before tax,
and this will be explained in the tax reconciliation.
Example 8.32
8.32
Consolidation and equity method
Parent Ltd had an 80% interest in Subsidiary Ltd and a 25% in Associate Ltd since their incorporation
in 20.16. The normal income tax rate is 28% and no company had any temporary differences. The
following is an extract from the companies’ statements of profit or loss for the current year ended
31 December 20.19:
Profit or loss
Parent
Subsidiary Associate
Ltd
Ltd
Ltd
R
R
R
Gross profit
800 000
600 000
400 000
Dividends received from Subsidiary Ltd
48 000
–
–
Dividends received from Associate Ltd
10 000
–
–
Profit before tax
Income tax expense (current tax)
Profit for the year
858 000
(224 000)
600 000
(168 000)
400 000
(112 000)
634 000
432 000
288 000
The consolidated statement of profit or loss and other comprehensive income reflects the
following:
P = Parent; S = Subsidiary; A = Associate
20.19
R
Gross profit (800 000 (P) + 600 000 (S))
1 400 000
Dividend income (intragroup dividends are eliminated)
–
Share of profit of associate (288 000 (A) × 25%)
72 000
Profit before tax
1 472 000
Income tax expense (224 000 (P) + 168 000 (S))
(392 000)
Profit for the year
1 080 000
Notes
2. Income tax expense
20.19
R
Major components of tax expense
Current tax expense
Deferred tax expense
392 000
–
Income tax expense
392 000
The tax reconciliation is as follows:
Accounting profit
1 472 000
Tax at the standard tax rate of 28% (R1 472 000 × 28%)
Equity accounted share of profit of associate (R72 000 × 28%)
412 160
(20 160)
Tax expense
392 000
Effective tax rate (R392 000/R1 472 000)
26,63%
continued
202 Descriptive Accounting – Chapter 8
Comment
¾ The parent and subsidiary is consolidated on a line-by-line basis and the parent’s dividends
received from the subsidiary are eliminated.
¾ Parent Ltd’s share of profit of associate is included in the consolidated profit before tax in
accordance with the equity method. Parent Ltd’s dividends received from the associated are
also eliminated from profit or loss and are deducted from the investment in associate. The
investor’s shares of the associate’s after-tax profit in thus included in the line item for profit
before tax. Consequently, the consolidated income tax expense will not be 28% of the
consolidated profit before tax. The investor’s share of the profit of the associate is then included
in the tax reconciliation.
¾ The dividends received by the parent will be in the tax reconciliation of the parent’s separate
financial statements as the dividend are not taxable (refer to Example 8.1). However, these
dividends are eliminated from the consolidated profit before tax and are no longer part of the
consolidated profit before tax, which is the starting point of the tax reconciliation. Consequently,
these dividends are not part of the tax reconciliation of the consolidated income tax expense.
8.12 Uncertainty over Income Tax treatments
In this chapter, it was explained that the current and deferred tax should be based on the
applicable tax laws. The Income Tax legislation in South African is very comprehensive and
arguably addresses most of the transactions an entity would enter into. However, it may
occur that an entity is uncertain about the tax treatment of a unique transaction. Such
cases are addressed in IFRIC 23 Uncertainty over Income Tax treatments.
The acceptability of a particular tax treatment by an entity may not be known until the South
African Revenue Services (SARS) or a court takes a decision in the future. Consequently, a
dispute or examination of a particular tax treatment by SARS may affect an entity’s
accounting for a current or deferred tax asset or liability. IFRIC 23 should be considered
when there is such uncertainty over income tax treatments. IFRIC 23 requires an entity to:
ƒ determine whether it considers each uncertain tax treatment separately or together with
one or more uncertainties based on which approach better predicts the resolution of the
uncertainty;
ƒ assume that SARS will examine the aspect and have full knowledge of all related
information;
ƒ consider whether it is probable that SARS will accept its planned tax treatment:
– if an entity concludes that it is probable, the entity calculates the taxable income, tax
bases, etc. consistently with its planned tax treatment;
– if an entity concludes that it is not probable, the entity shall reflect the effect of the
uncertainty tax treatment by using the most likely amount or the expected value,
depending on which it expects to better predict the resolution of the uncertainty; and
ƒ reassess its judgement or estimate, if the facts and circumstances change or when new
information become available. Any change should be treated as a change in accounting
estimate by applying IAS 8 Accounting Policies, Changes in Accounting Estimates and
Errors.
When there is uncertainty over the income tax treatment, an entity shall determine whether
to disclose:
ƒ its judgements in determining the taxable income, tax bases, etc. (refer to IAS 1.122);
ƒ information about the assumptions and estimates made in determining the taxable
income, tax bases, etc. (refer to IAS 1.125-129); and
ƒ the potential effect of the uncertainty as a tax-related contingency (refer to IAS 12.88)
when the entity concluded that SARS will accept its uncertain tax treatment.
Income taxes 203
8.13 Presentation and disclosure
An entity may only offset current tax assets and current tax liabilities if:
ƒ it has a legally enforceable right to offset the recognised amounts; and
ƒ the entity intends to either settle on a net basis or to realise the asset and settle the
liability simultaneously (IAS 12.71).
The entity will, as a taxpayer, usually have the right of offset if the taxes are levied by the
same tax authority and the tax authority permits the entity to make or receive a single net
payment (IAS 12.72). This implies, inter alia, that an entity may not offset the current tax
liability for local tax against the current tax asset from foreign tax in the statement of
financial position. In the consolidated financial statements, the current tax asset of one entity
shall only be offset against the current tax liability of another entity in the group if both the
above conditions are met (which may typically not be the case).
Deferred tax assets and deferred tax liabilities shall only be offset if the entity:
ƒ has a legally enforceable right to offset current tax assets against current tax liabilities;
and
ƒ the deferred tax assets and deferred tax liabilities relate to income taxes levied by the
same tax authority on either:
– the same taxable entity; or
– different taxable entities which intend to either settle current tax liabilities and assets
on a net basis or to realise the assets and settle the liabilities simultaneously, in each
future period in which significant amounts of deferred tax liabilities or assets are
expected to be settled or recovered (IAS 12.74).
These conditions for offsetting allow an entity to offset deferred tax assets and deferred tax
liabilities without requiring a detailed scheduling of the timing of the reversal of each
temporary difference. However, where the entity has a net deferred tax asset after offsetting,
the requirements for the recognition of a deferred tax asset must be met, meaning that there
must be sufficient taxable profit in future periods against which the asset will be utilised.
Example 8.33
Offset of tax assets and liabilities
Echo Ltd has a 60% interest in Kilo Ltd. On reporting date, Echo Ltd has a deferred tax liability of
R100 000 in its statement of financial position. Kilo Ltd has had an assessed tax loss for a number
of years, resulting in a deferred tax asset of R300 000 in Kilo Ltd’s statement of financial position.
When Echo Ltd consolidates the statement of financial position of Kilo Ltd on reporting date, the
question is whether Kilo Ltd’s deferred tax asset can be offset against the deferred tax liability of
Echo Ltd.
In terms of IAS 12.74, deferred tax assets and deferred tax liabilities may only be offset if the entity
(in this case, the group) has a legally enforceable right to offset current tax assets against current tax
liabilities and the deferred tax assets and deferred tax liabilities relate to the same taxable entity or
will be settled on a net basis.
Separate legal persons are liable for income taxes in South Africa, not groups of companies.
Echo Ltd and Kilo Ltd may not settle their current tax liabilities on a net basis. On consolidation,
Echo Ltd may not offset the deferred tax liability of R100 000 against the deferred tax asset of
R300 000.
Capital losses may only be deducted against capital gains to reduce any capital gains tax
payable. Capital losses may not be deducted from the taxable income of a revenue nature.
Consequently, in applying the criteria for offsetting deferred balances, a deferred tax asset
on capital losses may not be offset against a deferred tax liability on temporary differences
on items of a revenue nature for tax purposes. This is because the entity has no legal right
to offset the payment of the two types of taxes levied.
204 Descriptive Accounting – Chapter 8
8.13.1 Statement of profit or loss and other comprehensive income and notes
IAS 12 requires the tax expense and tax income related to profit or loss from ordinary
activities to be presented in the profit or loss section in the statement of profit or loss and
other comprehensive income (IAS 12.77), and the following major components to be
disclosed separately in the notes to the statement of profit or loss and other comprehensive
income (IAS 12.79 and .80):
ƒ the current tax expense (income);
ƒ any adjustment recognised in the reporting period for the current tax of prior periods;
ƒ the amount of the deferred tax expense (income) relating to the origination and reversal
of temporary differences;
ƒ the amount of the deferred tax expense (income) relating to changes in the tax rate or
the imposition of new taxes;
ƒ the amount of the benefit arising from a previously unrecognised tax loss, tax credit or
temporary difference of a prior period that is applied to reduce a current and/or deferred
tax expense;
ƒ the deferred tax expense arising from the write-down and reversal of a previous writedown of a deferred tax asset where the asset is adjusted as a result of a change in the
probability that sufficient taxable profits will realise in future periods; and
ƒ the amount of tax expense (income) relating to those changes in accounting policies and
errors that are included in profit or loss in accordance with IAS 8, because they cannot
be accounted for retrospectively.
The following information is also required (IAS 12.81):
ƒ a reconciliation of the relationship between tax expense (income) and accounting profit
in either a numerical reconciliation between tax expense (income) and the product of the
accounting profit multiplied by the applicable tax rate, or a numerical reconciliation
between the applicable tax rate and the average effective tax rate;
ƒ an explanation of changes in the applicable tax rate(s) compared to the rate for the
previous accounting periods;
ƒ for each type of temporary difference, unused tax loss and unused tax credit, the
amount of deferred tax income or expense recognised in the statement of profit or loss
and other comprehensive income, if it is not apparent from the changes in the amounts
recognised in statement of financial position; and
ƒ for discontinued operations, the tax expense related to:
– the gain or loss on discontinuance; and
– the profit or loss from the ordinary activities of the discontinued operation, together
with the comparative amounts (refer to IFRS 5).
The tax effect of all items presented in other comprehensive income (IAS 12.81(ab) must,
in terms of IAS 1, be presented either in a note or on the face of the other comprehensive
income section of the statement of profit or loss and other comprehensive income.
8.13.2 Statement of financial position and notes
The following must be disclosed (IAS 12.81):
ƒ the aggregate current and deferred tax relating to items that are charged or credited to
equity in terms of IAS 12.62A;
ƒ the amount and, where applicable, the expiry date 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;
ƒ the aggregate amount of temporary differences associated with investments in
subsidiaries, branches, associates and interests in joint arrangements for which deferred
tax liabilities have not been recognised;
Income taxes 205
ƒ for each type of temporary difference, unused tax loss and unused tax credit, the
amount of the deferred tax assets and liabilities recognised in the statement of financial
position for each period presented;
ƒ the amount of income tax consequences of dividends declared or paid before the
financial statements were authorised for issue, but not recognised as a liability;
ƒ for deferred tax assets, the amount and the nature of the evidence supporting their
recognition, where utilisation of the deferred tax asset is dependent on future taxable
profits in excess of profits arising from the reversal of existing taxable temporary
differences and where the entity has suffered a loss in either the current or preceding
period (IAS 12.82);
ƒ the amount of the change in an acquirer’s pre-acquisition deferred tax asset (see
IAS 12.67) as a result of a business combination;
ƒ if the deferred tax benefits acquired in a business combination are not recognised at the
acquisition date but are recognised after it (see IAS 12.68), a description of the event or
change in circumstances that caused the deferred tax benefits to be recognised (refer to
section 26.5 for more information on deferred taxes relating to business combinations);
and
ƒ any tax-related contingent liabilities/assets in accordance with IAS 37 (see IAS 12.88
and section 8.12 above).
8.14 Comprehensive example
The trial balance of Delta Ltd for the year ended 31 December 20.13 is as follows:
Credits
Ordinary share capital
Retained earnings (1 January 20.13)
Long-term loan
Bank overdraft
Trade payables
Revenue
Dividends received
Deferred tax (1 January 20.13)
Debits
Donations
Interest paid
Cost of sales
Operating expenses (including depreciation)
Land at cost
Buildings at carrying amount
Plant and machinery at carrying amount
Prepaid insurance premium
Trade receivables
Dividends paid (30 June 20.13)
SARS (provisional payments)
Notes
R
1
2
3
4
5
6
7
8
R
200 000
1 736 910
500 000
40 000
246 000
10 500 000
15 000
62 090
15 000
110 000
6 000 000
2 040 000
1 790 000
1 600 000
630 000
25 000
380 000
30 000
680 000
13 300 000
13 300 000
Additional information
1 Dividends received are exempt from income tax and are thus not taxable.
2 The deferred tax balance on 1 January 20.13 arose as a result of a taxable temporary difference on
plant and machinery of R248 000 and a deductible temporary difference on the allowance for credit
losses of R26 250.
3 The donations are not deductible for income taxes purposes.
4 The SARS permits no allowance on the building, while Delta Ltd depreciates the building at
R125 000 per annum.
206 Descriptive Accounting – Chapter 8
5
6
7
The tax base of the plant and machinery on 31 December 20.13 is R364 000. Depreciation on plant
and machinery for the current year is R170 000, and the tax allowance is R188 000.
Assume that the prepaid premium is deductible for tax purposes during the current year, in which it
was actually paid.
Trade receivables in the trial balance comprise the following:
R
Trade receivables
430 000
Allowance for credit losses
(50 000)
380 000
The SARS permits an allowance of 25% on the doubtful debts (allowance for credit losses). The
allowance for credit losses for 20.12 was R35 000.
8 The current tax and deferred tax for the current year should still be recognised. The normal income
tax rate is 28%. Delta Ltd’s tax payable, based on the tax return for 20.12, was R5 000 less than
the amount recognised as a liability. Delta Ltd paid R680 000 as provisional tax during the current
year.
The income tax notes to the financial statements of Delta Ltd for the year ended 31 December 20.13
may be compiled as follows from the information provided (ignore comparative amounts):
Calculations
R
1. Profit before tax
Revenue
Cost of sales
Other income: Dividends received
10 500 000
(6 000 000)
4 500 000
15 000
4 515 000
Expenses:
Operating expenses
Donations
Interest paid
(2 040 000)
(15 000)
(110 000)
2 350 000
2. Current tax
Profit before tax
Non-deductible/non-taxable items
Dividends received
Donations
Depreciation – building
Temporary differences (31 750 × 28% = 8 890*)
Depreciation – plant and machinery
Tax allowances – plant and machinery
Allowance for credit losses (50 000 – 35 000)
Doubtful debts (allowance for credit losses): 20.12 (35 000 × 25%)
Doubtful debts (allowance for credit losses): 20.13 (50 000 × 25%)
Prepaid insurance premium
Taxable income
Current tax at 28%
* Agrees to movement as per deferred tax calculation
2 350 000
125 000
(15 000)
15 000
125 000
(31 750)
170 000
(188 000)
15 000
8 750
(12 500)
(25 000)
2 443 250
684 110
Income taxes 207
3. Deferred tax
Carrying
amount
Tax
base
Temporary
difference
R
R
R
01/01/20.13
Plant and machinery
Allowance for credit losses
248 000
(26 250)
Deferred
tax
balance
@ 28%
Dr/(Cr)
R
Deferred
tax
movement
in P/L
@ 28%
R
(69 440)
7 350
(62 090)
31/12/20.13
Land
Buildings
Plant and machinery
Prepaid insurance premium
Trade receivables
1 790 000
1 600 000
630 000
25 000
380 000
–
–
364 000
–
417 500
1 790 000
1 600 000
266 000
25 000
(37 500)
Exempt#İ
Exempt#
(74 480)
(7 000)
10 500
Gross
Allowance for credit losses
430 000
(50 000)
430 000
(12 500)
–
(37 500)
–
10 500
8 890*
(70 980)
#
İ
IAS 12.15
Alternative view: The carrying amount of the land is assumed to be recovered through sale under
the assumption relevant to revalued land (IAS 12.51B) (refer to Example 8.24). Therefore, the tax
base would then be equal to the base cost for CGT purposes, namely, R1 790 000, as this amount
will be allowed as a deduction against the proceeds from the sale when calculating the capital gain
on disposal. No deferred tax is recognised under either approach.
Journal entries
Income tax expense (P/L)
Taxation payable to the SARS (Current liability) (SFP)
Recognition of current tax payable for current year
Income tax expense (P/L)
Deferred tax (non-current liability) (SFP)
Recognition of movement in deferred tax balance for current year
Dr
R
684 110
Cr
R
684 110
8 890
8 890
Notes
4. Income tax expense
R
Major components of tax expense
Current tax expense
679 110
ƒ Current year
ƒ Overprovision 20.12
684 110
(5 000)
Deferred tax – current
Allowances on plant and machinery (74 480 – 69 440)
Prepaid insurance premium (7 000 – 0)
Allowance for credit losses (7 350 – 10 500)
8 890
5 040
7 000
(3 150)
688 000
continued
208 Descriptive Accounting – Chapter 8
Tax (rate) reconciliation
Accounting profit
R
R
2 350 000
2 350 000
Tax rate
Tax at the standard tax rate
Tax effect of:
Donations (R15 000 × 28%); (R4 200/R2 350 000 × 100)
Buildings – depreciation
(R125 000 × 28%); (R35 000/R2 350 000 × 100)
Overprovision of current tax ((R5 000/R2 350 000) × 100)
Non-taxable income: dividends received
(R15 000 × 28%); (R4 200/R2 350 000 × 100)
28%
658 000
28,00
4 200
0,18
35 000
(5 000)
1,49
(0,21)
(4 200)
(0,18)
Income tax expense/Effective tax rate (688 000/2 350 000)
688 000
29,28
%
5. Deferred tax
R
Analysis of temporary differences:
Accelerated tax allowances for tax purposes (R266 000 × 28%)
Prepaid expense (R25 000 × 28%)
Allowance for credit losses (R37 500 × 28%)
74 480
7 000
(10 500)
Deferred tax liability
70 980
CHAPTER
9
Property, plant and equipment
(IAS 16; SIC 29 and IFRIC 1)
Contents
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
9.9
9.10
9.11
9.12
Overview of IAS 16 Property, Plant and Equipment..........................................
Background .......................................................................................................
Nature of property, plant and equipment ...........................................................
Recognition .......................................................................................................
9.4.1
Components ......................................................................................
9.4.2
Replacement of components at regular intervals ..............................
9.4.3
Major inspections ..............................................................................
9.4.4
Spare parts and servicing equipment ................................................
9.4.5
Safety and environmental costs ........................................................
Measurement ....................................................................................................
9.5.1
Initial measurement ...........................................................................
9.5.2
Asset dismantling, removal and restoration costs .............................
9.5.3
Deferred beyond normal credit terms ................................................
9.5.4
Exchange of property, plant and equipment items .............................
9.5.5
Subsequent measurement ................................................................
Depreciation ......................................................................................................
9.6.1
Depreciable amount ..........................................................................
9.6.2
Useful life...........................................................................................
9.6.3
Useful life of land and buildings ........................................................
9.6.4
Residual value ...................................................................................
9.6.5
Depreciation methods .......................................................................
9.6.6
Accounting treatment ........................................................................
Revaluation .......................................................................................................
9.7.1
Fair value...........................................................................................
9.7.2
Non-depreciable assets: subsequent revaluations
and devaluations ...............................................................................
9.7.3
Non-depreciable assets: realisation of revaluation surplus ...............
Impairment losses and compensation for loss ..................................................
Derecognition ....................................................................................................
Deferred tax implications ...................................................................................
9.10.1
Manner of recovery ...........................................................................
9.10.2
Deferred tax implications of cost model ............................................
9.10.3
Non-depreciable assets: deferred tax implications
of revaluation model ..........................................................................
9.10.4
Capital Gains Tax ..............................................................................
Disclosure ..........................................................................................................
Comprehensive example of cost model ............................................................
209
210
211
211
212
212
213
215
216
216
218
218
220
223
224
226
226
226
226
227
228
229
231
231
231
232
233
233
235
236
236
236
238
239
241
245
210 Descriptive Accounting – Chapter 9
9.1 Overview of IAS 16 Property, Plant and Equipment
Definition
ƒ
ƒ
ƒ
ƒ
ƒ
Held for use in the production of goods; or
the supply of services;
for rental to others; or
for administrative purposes.
Used during more than one period.
Recognition
ƒ
ƒ
ƒ
ƒ
ƒ
Components;
replacement of components at regular intervals;
major inspections;
spare parts and servicing equipment; and
safety and environmental costs.
Measurement
ƒ
ƒ
ƒ
ƒ
ƒ
Initial cost;
asset dismantling, removal and restoration cost;
deferred settlement;
exchange of PPE items; and
subsequent measurement.
Cost model
Cost less accumulated
depreciation and accumulated
impairment losses
Revaluation model
Fair value less accumulated depreciation and
accumulated impairment losses since last
revaluation
Impairment losses/compensation loss
An item of PPE is measured at cost or revalued amount less accumulated
depreciation and impairment losses irrespective of whether the cost model or the
revaluation model is used.
Derecognition
An item of PPE is derecognised in the statement of financial position:
ƒ on disposal; or
ƒ when no future economic benefits are expected from its use or disposal.
Tax implications
ƒ The measurement of deferred tax liabilities and assets must reflect the tax
consequences that would follow from the manner in which the entity expects, at
the end of the reporting period, to recover the carrying amounts of its assets.
ƒ The deferred tax asset or liability that arises when non-depreciable assets are
measured using the revaluation model should reflect the tax consequences of
recovering the carrying amount of the asset through sale.
Disclosure
ƒ Depreciation recognised as an expense or shown as a part of the cost of other
assets during a period should be disclosed; and
ƒ for each class of asset, the gross carrying amount and accumulated depreciation
(including impairment losses) at the beginning and the end of the period; and
ƒ for each class of asset, a detailed reconciliation of movements in the carrying
amount at the beginning and end of the period.
Property, plant and equipment 211
9.2 Background
Property, plant and equipment (PPE) normally constitutes a large proportion of the assets of
an entity. IAS 16 deals with tangible assets that are expected to be used during more than
one period.
IAS 16 excludes from its application:
ƒ biological assets related to agricultural activity, other than bearer plants, in accordance
with IAS 41, Agriculture;
ƒ mineral rights and mineral reserves such as oil, natural gas and similar non-regenerative
resources;
ƒ PPE classified as held for sale in accordance with IFRS 5 Non-current Assets Held for
Sale and Discontinued Operations; and
ƒ assets such as investment property (IAS 40 Investment Property).
IAS 16 does apply to:
ƒ bearer plants, and are defined as living plants that are used in the production or supply
of agricultural produce and are expected to produce for more than one period and has a
remote likelihood to be sold as agricultural produce. The produce of the bearer plants are
accounted for in terms of IAS 41; and
ƒ PPE used in maintaining biological assets and mineral resources; and
ƒ PPE acquired through a lease agreements in terms of IFRS 16.
IAS 16 allows two alternative accounting treatments for PPE, without indicating any
preference. After initial recognition of an item of PPE at cost, the asset may either be
shown:
ƒ at cost less accumulated depreciation and accumulated impairment losses (the cost
model); or
ƒ at a revalued amount, being the fair value of the asset on the date of revaluation, less
accumulated depreciation and accumulated impairment losses since the last revaluation
(the revaluation model).
An entity adopts one of the models as its accounting policy and applies the policy to a
specific class of PPE.
9.3 Nature of property, plant and equipment
Property, plant and equipment (PPE) consists of tangible assets, sometimes also called
fixed assets, which:
ƒ are held for use in the production of goods; or
ƒ for the supply of services; or
ƒ for rental to others; or
ƒ for administrative purposes; and
ƒ are expected to be used during more than one financial period. The intention is
clearly to use these assets to generate revenue rather than to sell them.
The 2018 Conceptual Framework for Financial Reporting (Conceptual Framework) defines
an asset as a present economic resource controlled by the entity as a result of past events
(refer to chapter 2). However, in terms of IAS 16, the IASB preserved the reference to the
definition of an asset in the 2001 Conceptual Framework. Therefore, in order to be
recognised as an asset, PPE should, in terms of the 2001 Conceptual Framework, be a
resource controlled by the entity as a result of past events from which future economic
benefits are expected to flow to the entity. When an entity controls an asset, it has the power
to obtain the future economic benefits of the underlying resource and can restrict the access
212 Descriptive Accounting – Chapter 9
of others to the asset. The past event normally refers to the date of acquisition or the date of
completion when the asset is ready for its intended use. The future economic benefits that
are expected to flow to the entity include the revenue from the goods sold or services
rendered, as well as cost savings and other benefits resulting from the use of the asset.
A class of property, plant and equipment is a grouping of assets of a similar nature and use
in an entity’s operations. IAS 16.37 lists the following examples of separate classes:
ƒ land;
ƒ land and buildings;
ƒ machinery;
ƒ ships;
ƒ aircraft;
ƒ motor vehicles;
ƒ furniture and fixtures; and
ƒ office equipment.
Land and buildings are normally purchased as a unit, but are recorded separately because of
the differences in their nature:
ƒ land normally does not have a limited life and is therefore not depreciated while;
ƒ buildings, by contrast, have a limited life and are therefore depreciated.
Plant typically refers to the machinery and production line of a manufacturing concern. This
asset has a limited life and is depreciated, often using depreciation methods such as the unit
of production method.
9.4 Recognition
An item of PPE is recognised as an asset if it is probable that economic benefits associated
with the item will flow to the entity and the cost can be measured reliably.
9.4.1 Components
Upon aquisition of PPE the cost should be allocated to its significant parts. The reason for
the allocation is that each part may have a different useful life. An entity must, where
appropriate, identify the significant parts of an item of PPE on initial recognition.
IAS 16 does not prescribe what a unit or a part of PPE is that should be recognised and
measured. Judgement is therefore always required in identifying such parts or components.
Example 9.1
9.1
Identification of components
A company with a 31 December year end has one asset, namely a helicopter. The helicopter was
acquired on 1 January 20.12 at a cost of R1 000 000. The following components and respective
useful lives were identified on initial recognition:
Engine of the helicopter:
R300 000 (the engine can only be used for 30 000 flight hours before replacement).
Remainder of the helicopter:
R700 000 (the helicopter, excluding the engine, is estimated to be available for use for 10 years).
During 20.12, 7 800 flight hours were undertaken.
Depreciation for the year ended 31 December 20.12, per significant component, is calculated as
follows:
Depreciation on the engine: R300 000 × (7 800/30 000) = R78 000
Depreciation on the remainder of the helicopter: R700 000 × 1/10 = R70 000
continued
Property, plant and equipment 213
The total depreciation on the helicopter for the year ended 31 December 20.12 is R148 000
(78 000 + 70 000).
Assume that the remainder of the helicopter (excluding the engine) consisted inter alia, on initial
recognition, of 5 electronic components of R1 000 each. The entity estimates that the components
will be replaced every 3 years.
In such circumstances, it should be established on initial recognition whether the components are
significant enough to be depreciated separately. In practice, cost efficiency will be a determining
factor when the decision is made.
If the components are significant, they will be depreciated over their separate useful lives as
illustrated earlier.
If the components are not significant, they will be treated as part of the remainder of the helicopter
and be depreciated over a useful life of 10 years. When they are replaced, the recognition criteria
will determine whether the amount incurred should be capitalised or expensed. If the amount is
capitalised, the carrying amount of the components that are replaced is derecognised.
After the initial recognition, an item of PPE is reflected at cost less accumulated depreciation
and accumulated impairment losses. The same recognition rule is applied in determining the
costs that will initially be capitalised as part of the cost of the PPE item and costs that are
capitalised subsequently. As far as subsequent costs are concerned, the costs may result
from additions to assets, replacement of a part thereof or the maintenance or service
thereof. In terms of the general recognition principle as described in IAS 16.7, the normal
day-to-day maintenance cost of an item is, however, recognised as an expense and is not
capitalised to the asset. This expense is described as repairs and maintenance and consists
mainly of the cost of labour, consumables and small spares.
9.4.2 Replacement of components at regular intervals
Certain parts of PPE items are replaced frequently. Examples of these types of assets are:
ƒ the relining of a furnace;
ƒ the seats and galleys in an aircraft; and
ƒ the interior walls of a building, for example an office block.
The main asset, such as the furnace, aircraft or building, has a much longer useful life than
the lining, seats, galleys and interior walls.
IAS 16.43 and .44 require that the initial cost of an item of PPE recognised be allocated to
its significant components, and that each component then be depreciated separately. The
remaining part of the item of PPE, consisting of all the components that are not individually
significant, represents a separate component. The depreciation rates and useful lives used
to depreciate the respective components of the asset may differ from those of the asset as a
whole.
When such a component is replaced, the cost of the replaced component is capitalised as
part of the carrying amount of the item of PPE, provided that the recognition criteria are met.
The remaining carrying amount of the replaced component shall be derecognised at that
stage. If it is not possible to determine the carrying amount of the replaced
component, (e.g. where the part has not been depreciated separately), the cost of the
new component may be used as an indication of what the original cost of the part
would have been (IAS 16.70). It is technically possible for a component of an asset to only
be recognised once the replacement expenditure has been incurred.
214 Descriptive Accounting – Chapter 9
Example 9.2
9.2
Replacement of components
Beta Ltd operates a furnace which cost R20 000 000, inclusive of R4 000 000 relating to the cost
of lining the furnace. The useful life of the furnace is 20 years. The furnace linings need to be
replaced every five years and as six years of the useful life of the furnace have already expired,
the linings were replaced a year ago at a cost of R5 000 000. At the end of their useful lives, the
linings will have no residual value.
The original purchase of the furnace took place on 2 January 20.7, and it was also available for
use on that date. The year end is 31 December.
The following are applicable at 31 December 20.12:
Carrying amount of furnace (excluding lining) on 31 December 20.12
Original cost including lining
Lining
R
20 000 000
(4 000 000)
Furnace excluding lining
Accumulated depreciation on the furnace (excluding lining) to 31 December 20.11
(16 000 000/20 × 5)
Depreciation for 20.12 (16 000 000/20)
16 000 000
Carrying amount on 31 December 20.12
11 200 000
Carrying amount of the lining on 31 December 20.12
Cost of original lining
Written-off from 2 January 20.7 to 31 December 20.11 (4 000 000/5 × 5)
4 000 000
(4 000 000)
(4 000 000)
(800 000)
–
New lining capitalised on 2 January 20.12
Accumulated depreciation (5 000 000/5)
5 000 000
(1 000 000)
Carrying amount on 31 December 20.12
4 000 000
Depreciation for 20.12
Furnace
Lining
800 000
1 000 000
Total
1 800 000
Comment
¾ If, at initial recognition of the furnace, the lining was not identified as a separate
component, but the R5 000 000 incurred to replace the lining now qualifies for recognition as
an asset (component), then it would be necessary to derecognise the remaining carrying
amount of the lining that was replaced. Assume the carrying amount of the lining cannot be
determined. The carrying amount will then be based on the cost of the new lining, which amounts
to R5 000 000. Since the total cost of the furnace would be depreciated over 20 years and the
lining component was not identified separately at initial recognition, it follows that the carrying
amount of the replaced ‘lining component’ at replacement date should be the following deemed
amount:
R
Deemed cost
5 000 000
Deemed accumulated depreciation (5 000 000/20 × 5)
(1 250 000)
Deemed carrying amount of old lining at date of derecognition
3 750 000
continued
Property, plant and equipment 215
The carrying amount of the furnace on 31 December 20.11, directly after replacement of the lining,
would therefore be as follows:
R
Cost of furnace
20 000 000
Accumulated depreciation of furnace (20 000 000/20 × 5)
(5 000 000)
Derecognition of old lining (see above)
(3 750 000)
Capitalisation of new lining
5 000 000
16 250 000
9.4.3 Major inspections
Certain assets need regular major inspections for faults, regardless of whether the parts of
the item are replaced – this is done to ensure that operation can continue efficiently. An
example of such an asset is an aircraft which, after (say) every 5 000 hours’ flying time,
needs a major inspection to ensure continued optimum operation. When the inspection
occurs, the inspection cost is capitalised to the asset (provided that the recognition
criteria are met). The cost of the inspection is then depreciated. Any remaining carrying
amount of the previous inspection that was not fully depreciated is derecognised
once the new inspection occurs.
On initial recognition, a part of the cost of the asset is allocated to inspection costs (as if the
inspection had been performed on the day of initial recognition). This component is then
depreciated over the expected period to the next inspection.
The cost of an inspection need not necessarily be identified when the asset is acquired or
erected. The estimated cost of a future similar inspection may be used as an indication
of the cost of what the current inspection component of the asset at acquisition was, if
required. In this way, the amount that needs to be depreciated separately over the useful life
of the remainder of the asset can be estimated.
Example 9.3
9.3
Inspection costs
Charlie Ltd acquired a machine on 2 January 20.11 that needs a major inspection every two years.
The cost price of the machine is R2 000 000, and it is estimated that the cost of a major inspection
will be R200 000. The useful life of the machine is estimated to be eight years and the company
has a 31 December year end.
The depreciation and carrying amounts of the machine on 31 December 20.11 and 20.12:
Inspection
Machine
*Total
component
R
R
R
Cost (2 000 000 – 200 000)
1 800 000
200 000
2 000 000
Depreciation 20.11:
Machine (1 800 000/8)
(225 000)
–
(225 000)
Inspection (200 000/2)
(100 000)
(100 000)
–
Carrying amount on 31 December 20.11
Depreciation 20.12
1 575 000
(225 000)
Carrying amount on 31 December 20.12
1 350 000
100 000
(100 000)
–
1 675 000
(325 000)
1 350 000
* The inspection component is not a separate asset, but forms part of the machine. In this
example, the cost of inspection was identified on initial recognition as a separate component.
continued
216 Descriptive Accounting – Chapter 9
If the inspection was done after 18 months instead of the originally estimated two years, and the
actual cost of the first physical inspection amounted to R300 000, the disclosure of this matter in
the PPE note for the year ended 31 December 20.12 will be as follows:
Charlie Ltd
Notes for the year ended 31 December 20.12
13. Property, plant and equipment
Carrying amount on 1 January 20.11
Acquisitions
Depreciation 20.11(see above)
Machinery
20.12
R
–
2 000 000
(325 000)
Carrying amount on 31 December 20.11
1 675 000
Carrying amount on 31 December 20.11
R
1 675 000
Cost
Accumulated depreciation
Depreciation 20.12 [(225 000 + (200 000/2 × 6/12) + (300 000/2 × 6/12)]
Derecognition of initial inspection cost [(200 000 – (100 000 + 50 000)]
Capitalisation of inspection cost incurred
Carrying amount on 31 December 20.12
Cost (2 000 000 – 200 000 + 300 000)
Accumulated depreciation (325 000 + 350 000 – 100 000 – 50 000)
2 000 000
(325 000)
(350 000)
(50 000)
300 000
1 575 000
2 100 000
(525 000)
Comment
¾ If the cost of inspection was not identified as a separate component on initial recognition, the
cost of inspection would have been depreciated as part of the total machine over its useful life
of eight years. The deemed carrying amount of the cost of inspection (based on the cost of
R300 000 of the inspection) is derecognised when the inspection is performed after 18 months.
The carrying amount to be derecognised amounts to R243 750 [300 000 – (300 000 × 1,5/8)].
The cost of the inspection (i.e., R300 000) will be capitalised as a separate component of the
machine and will be depreciated over the expected period to the next inspection.
9.4.4 Spare parts and servicing equipment
The accounting treatments of spare parts and servicing equipment are clearly described in
IAS 16.8 as follows:
ƒ (Small) spare parts and servicing equipment are usually carried as inventory and
recognised in profit or loss as consumed.
ƒ Major spare parts, stand-by equipment and servicing equipment qualify as items of PPE
if the entity expects to use these assets during more than one period.
Depreciation on these items should commence when they are available for use as intended
by management.
9.4.5 Safety and environmental costs
Sometimes entities are obliged to acquire certain PPE items for safety or environmental
purposes. Although such assets will not directly give rise to increased future economic
benefits embodied in a specific asset itself, the entity is obliged to acquire such assets for
increased future economic benefits from related assets. Consequently, these assets are
therefore recognised as assets.
Property, plant and equipment 217
The combined carrying amount of the related asset and environmental assets must, in terms
of IAS 36, Impairment of Assets, be evaluated for impairment. The recoverable amount will
be determined by viewing the related asset and environmental assets as a single cashgenerating unit.
Example 9.4
9.4
Environmental asset and impairment loss
A Ltd manufactures items which unfortunately cause air pollution. New and stricter environmental
legislation requires that new air filters be attached to the exhaust pipes of all the manufacturing
machines. Relevant monetary values on 31 December 20.13 (year end) were as follows:
Existing manufacturing machines:
R
Cost
2 000 000
Accumulated depreciation
(500 000)
Carrying amount on 31 December 20.13
1 500 000
Cost of air filters (available for use on 31 December 20.13)
400 000
The manufacturing machines will reach the end of their useful lives after five years, as from
31 December 20.13, and will until then generate pre-tax cash flows of R475 000 per annum. A
suitable discount rate is 7,2% per annum after tax. The normal income tax rate is 28%. The
manufacturing machines have no residual values at the end of their production lives. Currently, the
machines can be sold at a fair value less costs of disposal (net selling price) of R1 780 000.
The carrying amount of the cash-generating unit comprising the manufacturing machines as well
as the air filters, will be R1 900 000 (R1 500 000 (machines) + R400 000 (filters)) at
31 December 20.13.
The above carrying amount of the cash-generating unit, amounting to R1 900 000, must
accordingly be tested for impairment. The value in use is calculated using a financial calculator:
(n = 5; i = 10 (7,2%/72%); PMT = R475 000; Compute PV = ?)
Value in use is R1 800 624, being the present value, whilst the fair value less costs of disposal is
R1 780 000 (given). The recoverable amount in respect of the cash-generating unit is therefore
R1 800 624 (the higher of the two), which represents the value in use.
An impairment loss of R99 376 (1 900 000 – 1 800 624) is recognised and allocated to the
individual assets of the cash-generating unit in proportion to their carrying amounts:
Existing manufacturing machines:
R
78 455
20 921
Manufacturing machines (1 500 000/1 900 000 × 99 376)
Air filters (400 000/1 900 000 × 99 376)
99 376
The journal entry will be as follows:
31 December 20.13
Impairment loss (P/L)
Accumulated depreciation and impairment losses – machines (SFP)
Recognition of impairment loss on cash-generating unit
Dr
R
99 376
Cr
R
99 376
218 Descriptive Accounting – Chapter 9
9.5 Measurement
PPE items that qualify for recognition as assets are initially measured at cost.
9.5.1 Initial measurement
Elements of cost
The cost of PPE is derived as the amount of cash or cash equivalent paid, or the fair value
of the other consideration given, to acquire an asset at the time of its acquisition or
completion of construction or, if applicable, the amount attributed to that asset when initially
recognised in accordance with the requirements of other IFRSs. It can also be the fair value
of other forms of payments to acquire the asset. Capitalisation of costs ceases as soon
as the asset is in the condition and location necessary for it to be capable of
operating in the manner intended by management.
IFRS 13 Fair Value Measurement provides guidance on how fair value should be measured.
Please refer to the chapter 21 dealing with IFRS 13 for more information.
The following items are to be included in cost:
ƒ the purchase price, including import duties and non-refundable purchase taxes, after the
deduction of trade discounts and rebates. Value-Added Tax (VAT) paid on qualifying
assets by a registered vendor is refundable and is therefore excluded. VAT forms part of
the cost if the buyer is not registered for VAT or no input VAT can be claimed on the
asset;
ƒ any directly attributable costs of bringing the asset to the location and condition
necessary for it to operate in the way management intended. Examples of such directly
attributable costs are:
– the cost of employee benefits arising directly from the construction or acquisition of
the item of PPE;
– the cost of site preparation;
– initial delivery and handling costs;
– installation and assembly costs;
– the costs of testing whether the asset is functioning properly, after deducting the net
proceeds from selling any items produced while bringing the asset to that location and
condition (e.g. samples produced when testing equipment). A clear distinction should
however be made between testing costs and initial operating losses (the latter may
not be capitalised); and
– professional fees; and
ƒ the initial estimate of the cost of dismantling, removing and restoring the site on which
the asset is located (refer to section 9.5.2). A related obligation would arise in this
context when the item is acquired or as a result of the use of the item for purposes other
than the manufacturing of inventory during that period.
The following items are to be excluded from cost:
ƒ costs of opening a new facility;
ƒ costs of introducing a new product or service (including costs of advertising and
promotional activities);
ƒ costs of conducting business in a new location or with a new class of customer (including
costs of staff training);
ƒ administration and other general overhead costs;
ƒ costs incurred while an item capable of operating in the manner intended by
management has yet to be brought into use or is operated at less than full capacity;
Property, plant and equipment 219
ƒ initial operating losses, for example those incurred while demand for the item’s output
grows; and
ƒ costs of relocating or reorganising part or all of an entity’s operations.
Incidental operations
Operations that relate to the construction or development of a PPE item, but are not
necessary to bring the item to the condition and location to be capable of operation in the
manner intended by management, are dealt with in IAS 16.21. Income and expenditure
that result from such incidental operations are not capitalised to the asset, but are
included in profit or loss under appropriate classifications of income and expenses. If a
building site is, for example, rented out as a parking area before commencement of
construction on the site, the rental income (and related costs) will not be taken into account
in determining the cost of the property, but will be included in relevant line items in the profit
or loss section of the statement of profit or loss and other comprehensive income.
Self-constructed assets
IAS 16.22 deals with self-constructed assets and states inter alia that internal profits are
eliminated in arriving at costs. Furthermore, abnormal wastage of materials, labour and
other resources do not form part of the cost price of an asset. The principles of IAS 2
Inventory, regarding the capitalisation of manufacturing costs, should be followed.
Bearer plants are accounted for in the same way as the self-constructed items of PPE.
Therefore, all covering activities that are necessary to cultivate the bearer plants before they
are in the location and condition necessary to be capable of operating in the manner
intended by management form part of the cost of the asset.
Example 9.5
9.5
Determining the cost of PPE
A mine acquires a machine that is used to sink mine shafts. The asset is the first of its kind to be
used in South Africa. The asset is imported and installed at the mine.
The details of the costs incurred to prepare the asset for use are as follows:
R’000
Cost paid to supplier to deliver the asset to the harbour of destination
5 000
Import tax levied on import of machine at the harbour
450
Cost paid to transport company to transport the asset from harbour to mine
250
Twenty of the mine’s current employees were used for 2 months to build a
foundation and install the machine. The annual cost of one of the employees
90
General operating costs of the mine for the 2 months
1 500
A technician supported the employees during the installation of the machine.
The cost of the consultations
100
After the completion of the installation the mine invited its most important customers
to a function to commission the asset. The cost of the function
50
During the function, the machine was switched on for the first time to sink the first
mineshaft. Management will use the first shaft as an opportunity to establish whether
the machine operates as intended. It will require approximately 2 years to complete
the shaft before it can be utilised. The shaft will be used for 20 years for mining
operations. The cost to the mine of the first shaft
2 000
The shaft will cost the mine approximately R600 000 more than the normal costs for
other shafts, due to technical reasons.
continued
220 Descriptive Accounting – Chapter 9
The cost of the machine will be determined as follows in terms of IAS 16:
Cost paid to supplier to deliver machine to harbour of destination
Import taxes on the import of machine at the harbour
Cost paid to the transport company to transport the asset from harbour to mine
Cost of the employees during installation
Cost per employee for 2 months: R90 000 × 2/12 = R15 000
Cost included in cost of machine: 15 000 × 20 = R300 000
General operating costs are excluded from the cost of the asset (IAS 16.19(d))
Professional fees of technician
The cost of the commissioning does not form part of the cost of the asset (IAS 16.19(b)).
The initial operating loss of R600 000 is excluded from the cost of the machine
in terms of IAS 16.20(b).
Total cost of the machine
R’000
5 000
450
250
300
–
100
–
–
6 100
Comment
¾ The question to be raised concerning the cost incurred on the first-time use is whether these
costs are really expenses for testing, or rather expenses to operate the machine. In this
example, the first shaft served as a test to establish whether the machine functions as intended
but is also used to sink a shaft to be used on completion. This indicates that the R2 000 000 to
sink the shaft is an operating expense, rather than a testing expense. The costs are therefore
not included in the cost of the machine. If the test costs could be identified separately from
operating costs, they would be capitalised. If it is assumed that they amount to 10% of the
operating costs, namely R200 000, the total cost of the machine would then have been
R6 300 000 (R200 000 will thus be included in the cost of the asset).
9.5.2 Asset dismantling, removal and restoration costs
IAS 16.16(c) states that the initial estimate of the costs of dismantling and removing the PPE
item and restoring the site on which it is located will form part of the cost of the asset. The
obligations for costs accounted for are recognised and measured in accordance with IAS 37
Provisions, Contingent Liabilities and Contingent Assets. The annual interest/finance cost on
the provision is accounted for by crediting the provision and debiting finance cost in the
profit or loss. This interest is not cost relating to borrowing of funds and may not be
capitalised to the asset in terms of IAS 23 Borrowing costs.
An entity applies IAS 2 to costs resulting from obligations for the dismantling and removing
of an item of PPE (as well as for the restoring of the site on which the asset is situated), if
the costs were incurred during a specific period in which the item of PPE was used to
produce inventory. This implies that these costs will be capitalised to inventory and not to
the item of PPE.
Example 9.6
9.6
Dismantling and removing costs
A Ltd acquired an office building.
R
Cost of construction at 1 July 20.12
1 090 000
Expected dismantling and removal costs at end of useful life of asset
120 000
Applicable discount rate after tax (28%)
6,48%
Useful life of office building
24 years
If it is assumed that the building is erected on rented premises and that the rental agreement
requires dismantling of the building at the end of its useful life, the cost of the asset on
1 July 20.12 will be the following:
R
Cost of construction
1 090 000
Expected dismantling and removal costs discounted to present value
FV = R120 000; n = 24; i = 6,48/0,72 = 9; PV = ?* (See IAS 37)
15 169
Cost price of building
1 105 169
continued
Property, plant and equipment 221
Journal entries for dismantling and removal costs
Year 1
Office building (SFP)
Provision for dismantling and removal costs (SFP)
Recognition of dismantling provision
Dr
R
15 169
Finance cost (P/L) (15 169 × 9%)
Provision for dismantling and removal costs (SFP)
Recognition of finance cost for year 1
Year 2
Finance cost (P/L) [(15 169 + 1 365) × 9%]
Provision for dismantling and removal costs (SFP)
Recognition of finance cost for year 2
1 365
Cr
R
15 169
1 365
1 488
1 488
Year 3 to 23
Entries similar to Year 2 for Years 3 to 23
Year 24
Finance cost (P/L) (110 092 × 9%)
Provision for dismantling and removal costs (SFP)
Recognition of finance cost for year 24
Provision for dismantling and removal costs (SFP)
Bank (SFP) (110 092 + 9 908)
Payment of dismantling of building
9 908
9 908
120 000
120 000
Amortisation table
Year 1
Year 2
Year 24
Interest
R
1 365
1 488
9 908
Balance
R
16 534
18 022
120 000
If the dismantling costs are revised at a later stage, IFRIC 1 Changes in Existing
Decommissioning, Restoration and Similar Liabilities (refer to chaper 15) deals with the
accounting treatment of these changes in estimates.
Under the cost model:,
ƒ If the related liability reduces (i.e. the liability is debited), this amount (the reduction)
will be offset against the asset but cannot create a net credit balance on the item of PPE.
Any excess beyond the carrying amount of the affected asset shall be recognised
immediately in the profit or loss section of the statement of profit or loss and other
comprehensive income.
ƒ If the related liability increases (i.e. the liability is credited), the carrying amount of
the item of PPE will increase. However, under these circumstances, an entity must
consider whether the increased carrying amount will be recoverable in full and
consequently, the asset must be subjected to impairment testing. The increase in the
carrying amount of the asset does not go hand-in-hand with an increase in expected
economic benefits from the asset and consequently, recovery of the carrying amount of
the asset could be problematic.
These adjustments are accounted for and disclosed as changes in estimate from the date
that the estimate is revised.
Under the revaluation model
ƒ A decrease in the related liability (i.e. liability is debited) will be credited to other
comprehensive income (that will not be reclassified to profit or loss) in the statement of
profit or loss and other comprehensive income and accumulated in the revaluation
surplus unless it reverses a debit taken to the profit or loss section of the statement of
222 Descriptive Accounting – Chapter 9
profit or loss and other comprehensive income previously, in which case the profit or loss
section of the statement of profit or loss and other comprehensive income is credited.
ƒ An increase in the related liability (i.e. the liability is credited) will be debited as
other comprehensive income in the statement of profit or loss and other comprehensive
income and will therefore reduce the revaluation surplus related to the specific asset,
and any excess will be debited to the profit or loss section of the statement of profit or
loss and other comprehensive income.
ƒ If a decrease in the related liability exceeds the carrying amount of the asset that would
have been recognised had the asset been recognised at the cost model, the excess
must be recognised in the profit or loss section of the statement of profit or loss and
other comprehensive income. This would imply that the gain would be the same as the
gain that would have arisen under the cost model.
Increases in the revaluation surplus (and decreases in the provision) are limited to the
carrying amount of the relevant assets as determined according to the cost model.
When the revaluation model is used, a change in the provision might indicate that the asset
should be revalued. When revaluing an asset that has to be dismantled, the net replacement
cost should include a pro rata amount (depreciated value of the dismantling cost) related to
the dismantling cost.
Example 9.7
9.7
Changes in dismantling costs
H Ltd erected an asset during 20.12 and completed it on 31 December 20.12 The asset must be
dismantled after 20 years.
On 31 December 20.12, the company estimated the dismantling costs at an amount of R150 000.
Assume a fair discount rate of 5% before tax.
The following amounts related to dismantling costs are therefore included in the cost of the asset
on initial recognition:
FV = 150 000; PMT = nil; i = 5% (note 1); n = 20 years
Therefore PV = 56 533
The dismantling costs are reassessed on 1 January 20.15 and are estimated at
R250 000
The provision for dismantling costs will change as follows:
Balance of the provision for dismantling costs (before change in estimate)
R62 328
Balance after reassessment of dismantling costs in the future:
FV = 250 000; PMT = nil; i = 5%; n = 18 years (remaining)
Therefore PV = 103 880
An upward adjustment of R41 552 (R103 880 – R62 328) must be made to the provision.
If the company accounts for the asset in terms of the cost model, the adjustment will be treated
as follows:
Dr
Cr
R
R
Asset (cost) (SFP)
41 552
Provision for dismantling costs (SFP)
41 552
Reassessment of dismantling provision
IFRIC 1.5(c) determines that where the carrying amount increases, as above, the entity should
assess whether there is an indication of impairment of the asset.
continued
Property, plant and equipment 223
If the company accounts for the asset in terms of the revaluation model, the adjustment will be
treated as follows:
Assume a revaluation surplus of R30 000 before the adjustment. Ignore taxation.
The revaluation surplus is reduced to Rnil. Thereafter any excess is recognised in profit or loss if
the adjustment exceeds the balance of the revaluation surplus.
Dr
Cr
R
R
Revaluation surplus (OCI)
30 000
Increase in dismantling costs (P/L) (41 552 – 30 000)
11 552
Provision for dismantling costs (SFP)
41 552
Reassessment of dismantling provision
Note: A pre-tax discount rate is used because the carrying amount of the provision for dismantling
costs is a pre-tax amount.
9.5.3 Deferred beyond normal credit terms
When payment for an item of PPE is deferred beyond normal credit terms, its cost is the
cash price equivalent of the amount actually paid. This treatment is required because the
consideration is receivable in cash in the future, resulting in a lower present value than the
actual face value of the consideration. The difference between this amount and the total
amount paid is recognised as a finance cost over the period of credit, unless it is capitalised
in accordance with IAS 23 Borrowing Costs as borrowing costs. The whole deferred
settlement period will represent the abnormal credit term. This treatment is in line with
IFRS 9 as it suggests that the granting of abnormal credit terms will result in the effect of
discounting being material. For instance, if the normal credit term is 30 days and the entity
will only have to pay after six months, the cash price equivalent of the asset will be
calculated as the total amount payable, reduced by the interest for the whole six-month
period. This is necessary since the creditor must be initially accounted for at its fair value.
Fair value is calculated by discounting all future cash flows, at a market-related interest rate,
back to transaction date.
Example 9.8
Abnormal credit terms
On 1 February 20.12, a company purchases an industrial stand at a cost of R15 000 000, of which
R3 000 000 is attributable to the land and R12 000 000 to the factory building. The latter has a useful
life of 20 years. The transfer of ownership takes place on 30 June 20.12. The seller is willing to defer
payment of the purchase price until 31 December 20.12, whilst the normal credit terms would be two
months from date of transfer. On 31 December 20.12, the company obtains a long-term loan of
R15 000 000 at an interest rate of 18% per annum and settles the purchase price. Interest is
compounded annually in arrears. On 1 July 20.12, the property is available for use and
commissioned. The property is not considered to be an investment property.
In this case, it is normal practice for the purchase to take place when ownership is transferred, but
payment is only made six months later. To determine the cost of the asset, the cash price
equivalent therefore has to be determined on 30 June 20.12.
Note that IAS 23 specifies that interest cannot be capitalised once a property has already been
brought into use and thus the property is not a qualifying asset in terms of IAS 23.
Calculation of cost of the fixed property:
Cash price
Interest (18% × 6/12 = 9%; 9/109 × 15 000 000)
R
15 000 000
(1 238 532)
Cash price equivalent or (FV = 15 000 000; n = 1; i = 18/2 = 9; PV = ?)
13 761 468
continued
224 Descriptive Accounting – Chapter 9
The journal entries will be as follows:
30 June 20.12
Land (SFP) (3/15 × 13 761 468)
Buildings (SFP) (12/15 × 13 761 468)
Creditors/Payables (SFP)
Acquisition of land and buildings on credit
31 December 20.12
Bank (SFP)
Long-term liability (SFP)
Recognition of long-term loan
Creditors (SFP)
Finance cost (P/L)
Bank (SFP)
Recognition of payment of creditor
Depreciation (P/L) (11 009 174/20 years × 6/12)
Accumulated depreciation – buildings (SFP)
Current year depreciation charge
Dr
R
2 752 294
11 009 174
Cr
R
13 761 468
15 000 000
15 000 000
13 761 468
1 238 532
275 229
15 000 000
275 229
9.5.4 Exchange of property, plant and equipment items
When PPE items are acquired in exchange for other assets, whether monetary, non-monetary
or a combination of the two, the cost price of the item acquired is measured at fair value.
When the fair values of both assets (acquired and given up) can be determined
reliably, the fair value of the asset given up will be used (this is therefore the rule),
unless the fair value of the asset acquired is more evident, in which case that value may be
used. A gain or loss is recognised as the difference between the fair value and the carrying
amount of the asset given up, where applicable.
There are, however, two exceptions to the general rule that assets that were acquired in
exchange transactions should be measured at fair value:
ƒ The first exception is where the exchange transaction lacks commercial substance.
ƒ The second occurs where the fair values of both the asset that is acquired and the asset
that is given up cannot be estimated reliably.
In both these cases, the asset that is acquired is measured at the carrying amount of the
asset given up, and no gain or loss is recognised.
The reference to commercial substance is explained in IAS 16.25. In this regard, it is
necessary to consider the definition of the entity-specific value of an asset. The entityspecific value is the present value of the cash flows that an entity expects from the
continued use of the asset, plus the present value of its disposal at the end of its useful life.
Note that the entity-specific value of an asset refers to after-tax cash flows, and any tax
allowances on these assets should be included in the calculation.
An entity determines whether an exchange transaction has commercial substance by
considering the extent to which its future cash flows are expected to change as a result of
the transaction. An exchange transaction has commercial substance if:
ƒ the configuration (risk, timing and amount) of the cash flows of the asset received differs
from the configuration of the cash flows of the asset transferred; or
ƒ the entity-specific value of the portion of the entity’s operations affected by the
transaction changes as a result of the exchange; and
ƒ the difference in the above is significant relative to the fair value of the assets
exchanged.
Property, plant and equipment 225
Example 9.9
9.9
Exchange of assets
Echo Ltd entered into the following exchange of assets transactions during the year ended
31 December 20.13:
Transaction 1
A motor vehicle, with a carrying amount of R120 000 in the records of Echo Ltd and a fair value of
R140 000, was exchanged for a delivery vehicle of Delta Ltd, with a fair value of R142 000. The
fair value of both vehicles can be readily determined, since an active market for similar used
vehicles exists.
Transaction 2
A machine with a carrying amount of R150 000 owned by Echo Ltd is exchanged for another
machine, which is carried at R145 000 in the records of Beta Ltd. The fair values of the two
machines cannot readily be ascertained.
Transaction 3
A computer system with a carrying amount of R220 000 in the books of Echo Ltd is exchanged for
a manufacturing plant with a carrying amount of R225 000 in the records of Charlie Ltd. The fair
value of the computer system is virtually impossible to determine, as these items are seldom sold,
but the following can be estimated reliably:
Probability
Fair value
R
Possibility 1
30%
200 000
2
10%
250 000
3
20%
230 000
4
40%
210 000
The fair value of the manufacturing plant is R222 000 and is readily determinable since an active
market for these used assets exists.
Transaction 4
Echo Ltd exchanges a machine with a carrying amount of R1 700 000 for a similar machine of the
same age and condition. The existing machine that is painted red is exchanged for the other
machine that is painted blue, as the managing director likes blue machines. The fair values of the
two machines are R1 720 000 (red) and R1 750 000 (blue) respectively. Since the blue machines
are more popular, they have a higher fair value. Both machines’ residual values are immaterial.
In each of the abovementioned transactions, determine the amount at which the new asset
acquired in the exchange should be measured in the financial statements of Echo Ltd.
Transaction 1
The delivery vehicle will be measured at R140 000. Refer to IAS 16.26.
Transaction 2
The machine acquired in the exchange transaction will be measured at R150 000 which is the
carrying amount of the machine given up. Refer to IAS 16.24.
Transaction 3
The estimated fair value of the computer system given up is the following:
([200 000 × 30%] + [250 000 × 10%] + [230 000 × 20%] + [210 000 × 40%]) = R215 000.
Refer to the first part of IAS 16.26.
The fair value of the item that is acquired is R222 000.
The manufacturing plant should be measured at R222 000 (its fair value) since it is more readily
determinable than the fair value of the asset given up. Refer to the last part of IAS 16.26.
Transaction 4
This is an example of a transaction without commercial substance as described in IAS 16.24. The
transaction does not comply with any of the requirements of commercial substance, as specified in
IAS 16.25. Consequently, the acquired blue machine will be reflected at R1 700 000 in the records of
Echo Ltd – that is, at the carrying amount of the red machine given up.
226 Descriptive Accounting – Chapter 9
9.5.5 Subsequent measurement
An entity will, after initial recognition, make a choice between the cost model (IAS 16.30) and
the revaluation model (IAS 16.31). In terms of the cost model, an item of PPE will, after
initial recognition as an asset, be carried at its cost less any accumulated depreciation and
accumulated impairment losses.
In terms of the revaluation model, an item of PPE will, after initial recognition, be carried at
the revalued amount, provided its fair value can be measured reliably. The revalued amount
referred to is the fair value on the date of revaluation less any accumulated depreciation and
accumulated impairment losses since the revaluation date. Revaluations must be done on a
regular basis to ensure that the carrying amount of the asset at end of the reporting period
does not differ substantially from the fair value at end of the reporting period.
PPE is therefore disclosed at cost/revalued amount less accumulated depreciation and
impairment losses. The same model must however, be used for all items of PPE in a
specific class.
9.6 Depreciation
IAS 16.6 and .50 state that depreciation is the systematic allocation of the depreciable
amount of an asset over its useful life.
9.6.1 Depreciable amount
Depreciable amount refers to the cost of an asset or another amount that replaces cost,
less residual value. The residual value of an asset is the estimated amount that the entity
would currently obtain from the disposal of the asset, after deducting the estimated costs of
disposal, if the asset were already of the age and in the condition expected at the end of its
useful life.
The aim is therefore to allocate the depreciable amount (original cost less the residual
value) of an asset over its useful life (the period during which the depreciable asset will be
used) to income generated by the asset. Consequently, the depreciable amount is
recovered through use, and the residual value is recovered through sale.
In order to decide on the amount of depreciation that should be allocated, three aspects
should be considered, namely:
ƒ the useful life;
ƒ the expected residual value; and
ƒ the method of depreciation.
9.6.2 Useful life
The following factors are considered in determining the useful life of an asset:
ƒ the expected use of the asset by the entity, determined by referring to the asset’s
expected capacity or physical production;
ƒ the expected physical wear-and-tear, dependent on operating factors such as the
number of shifts and the repairs and maintenance programme, as well as repairs and
maintenance while not in use;
ƒ the technical or commercial obsolescence resulting from changes and improvements in
production or a change in the demand for the product or service output of the asset; and
ƒ legal and similar limitations on the use of the asset, such as maturity dates of related
leases (normally finance leases).
The useful life of an asset is defined in terms of the asset’s expected utility to the entity,
while the economic life of an asset refers to the total life of an asset while in the possession
Property, plant and equipment 227
of one or more owners. The asset management policy of an entity may involve the disposal
of assets:
ƒ after a specified period; or
ƒ after the consumption of a certain portion of the economic benefits embodied in the asset
prior to the asset reaching the end of its economic life.
The useful life of the asset may therefore be shorter than its economic life.
The estimate of the useful life of PPE is a matter of judgement based on the entity’s
experience with similar assets. IAS 16.51 requires that the useful life should be reviewed
annually. If, prior to the expiry of the useful life of an asset, it becomes apparent that the
original estimate was incorrect, in that the useful life is longer or shorter than originally
estimated, an adjustment to the incorrect estimate must be made. This adjustment is not a
correction of an error, as estimates are an integral part of accrual accounting and may, by
their very nature, be inaccurate. Adjustments to such estimates form part of the normal
operating expense items, and may, at most, be disclosed separately in terms of IAS 8
Accounting Policies, Changes in Accounting Estimates and Errors, if size or nature warrants
such treatment. Changes in accounting estimates are not adjusted retrospectively, but
only in the current year and future periods. This rule also applies to subsequent expenditure
on an asset; or a change in the maintenance policy that results in a lengthening of the useful
life; or if changes in technology or market affect the demand for the products and the useful
life.
Example 9.10
9.10
Change in estimate of useful life
Assume the following details for equipment of A Ltd on 31 December 20.12:
Cost (5-year useful life)
Accumulated depreciation (450 000/5 × 2)
Carrying amount
R
450 000
(180 000)
270 000
At the end of 20.13, the remaining useful life of the equipment was estimated at 3 years. It is
anticipated that neither the useful life nor the residual value of the asset of Rnil will change.
Taking the above into account, the depreciation for 20.12 to 20.14 will be as follows:
20.12: R450 000/5 = R90 000 (no restatement of comparatives).
20.13: R270 000/(3 + 1) = R67 500 (change applied from the beginning of the year)
Change in estimate for 20.13 (R67 500 (new) – R90 000 (old) = R22 500 decrease in
depreciation for the current year).
The cumulative future effect of the change in estimate is an increase in depreciation of
R25 000, as the total future depreciation is now R202 500 (R67 500 × 3), whereas it would
have been R180 000 (R90 000 × 2) before the change.
20.14: Depreciation of R67 500 per annum will now be recognised.
9.6.3 Useful life of land and buildings
Land and buildings are divisible assets that should be treated separately for accounting
purposes, even if they were acquired as a unit. These items are separated as land usually
has an infinite useful life and is therefore not depreciated, while buildings have a finite useful
life and are therefore depreciable assets. An increase in the value of the land on which a
building was erected does not affect the useful life of the building.
Depreciation may be provided on land if it is subject to the exploration of minerals or a
decrease in value due to other circumstances. For example, a dumping site that can only be
utilised for a limited number of years will be subject to depreciation. If the cost of land
includes restoration costs, a portion of the cost will have to be depreciated over the
228 Descriptive Accounting – Chapter 9
period of expected benefits. The value of land may also be affected adversely by
considerations such as its location. In the latter circumstances, it may be necessary to write
the value of the land down to recognise the decline in value – this would represent an
impairment loss.
9.6.4 Residual value
In terms of IAS 16.6, the residual value of an asset is the estimated amount that the entity
would currently obtain from the disposal of the asset, after deducting the estimated costs of
disposal, if the asset were already of the age and in the condition expected at the end of its
useful life. Therefore, the residual value of an asset is the current value which ignores the
effect of future inflation.
Depreciation must be provided on any asset with a limited useful life, even if the fair value
of such an asset exceeds its carrying amount, provided the residual value does not exceed
the carrying amount. However, if the residual value of an asset is equal to or exceeds its
carrying amount at any time, no depreciation will be provided for on that asset, unless and
until the residual value declines below the carrying amount of the asset.
In practice, the residual value is normally not significant and will therefore not be material in
the calculation of the depreciable amount.
In terms of IAS 16, the residual value of any asset must be reviewed at least at the end of
each financial year. The change in the residual value will be accounted for as a normal
change in accounting estimate. Consequently, the depreciation for the current and
future years will be recalculated. In view of this, depreciation amounts may vary on an
annual basis. This rule applies to both the cost model and the revaluation model.
Example 9.11
9.11
Reviewing of residual value
Foxtrot Ltd acquired an asset with a useful life of 5 years on 1 January 20.10 for an amount of
R1 200 000. The estimated residual value of the asset was R100 000 on the date of acquisition.
The annual review of the residual value of the asset under discussion during the past 3 years
produced the following residual values:
R
31 December 20.10
100 000
31 December 20.11
50 000
31 December 20.12
120 000
The depreciable amount of the asset (taking into account the annual review of the residual value)
for 20.10 to 20.12, and the depreciation amount for 20.10 (current year) and future years, will be the
following:
Year
Calculation
20.10 Depreciable amount (1 200 000 – 100 000)
Depreciation (1 100 000/5)
20.11 Depreciable amount
(1 200 000 – 220 000 – 50 000)
Depreciation (930 000/4)
20.12 Depreciable amount
(1 200 000 – 220 000 – 232 500 – 120 000)
Depreciation (627 500/3)
Depreciation
Depreciable
Current
Future
amount
R
R
R
1 100 000
–
–
220 000
220 000
930 000
–
–
627 500
–
232 500
–
232 500
–
209 167
209 167
continued
Property, plant and equipment 229
Comment
¾ Although the residual value was revised at the end of each year, the revised residual value is
taken into account from the beginning of the respective year for the purposes of calculating
depreciation.
¾ In terms of IAS 8, the nature of the change, the amount, and the effect on future periods should
be disclosed, if significant. The effect of the changes in estimate is as follows:
20.11: Current year: increase in depreciation of R12 500 (232 500 – 220 000)
Cumulative future effect: increase in depreciation of
R37 500 [(232 500 × 3) – (220 000 × 3)]
20.12: Current year: decrease in depreciation of R23 333 (209 167 – 232 500)
Cumulative future effect: decrease in depreciation of
R46 666 [(209 167 × 2) – (232 500 × 2)]
9.6.5 Depreciation methods
Depreciation is allocated from the date on which the asset is available for use (in the
location and condition necessary for it to be capable of operating in the manner intended by
management), rather than when it is commissioned or brought into use. It is therefore
possible that depreciation on an asset could commence before it is physically brought into
use, because it was available for use before the date on which it was commissioned.
Depreciation on an asset should cease only when the asset is derecognised in terms of
IAS 16 or when it is classified as held for sale in terms of the strict criteria of IFRS 5 (see
chapter 19). An asset is only derecognised when it is disposed of or when no further
economic benefits are expected from the asset, either from its use or disposal. Depreciation
does not cease when an asset becomes temporarily idle or even if it is retired from active
use, unless the depreciable amount has been written-off in total or will not deliver future
economic benefits. However, if the unit-of-production method (a usage method) is used to
determine depreciation, depreciation may sometimes be zero. In addition, an interruption in
the use of an asset will lead to a lower depreciation charge, as no units will be produced
during the period it was idle.
Because of the view that depreciation is the allocation of the depreciable amount of an asset
to income over its useful life, it follows that the allocation should reflect the pattern in which
the asset’s future economic benefits are expected to be consumed by the entity. For
example, if the asset will generate more units at the beginning of its useful life than at the
end thereof, a depreciation method should be selected that will result in larger write-downs
in the beginning and smaller write-downs at the end of its useful life.
Revenue-based methods to calculate depreciation are not allowed. This is because a
revenue-based method reflects a pattern of economic benefits being generated from the
asset, rather than the expected pattern of consumption of the future economic benefits
embodied in the asset.
Depreciation may be calculated using a variety of methods, for example:
ƒ the straight-line method; or
ƒ the diminishing balance method (also known as reducing balance method); or
ƒ the sum-of-digits method; or
ƒ the units of production method.
9.6.5.1 Straight-line method
The allocation of depreciation in fixed instalments is usually adopted where the income
produced by the asset or part of the asset is a function of time rather than of usage, and
where the repair and maintenance charges and benefits are fairly constant.
230 Descriptive Accounting – Chapter 9
9.6.5.2 Diminishing balance method
This method of depreciation, where the amount allocated declines on an annual basis, is
used where there is uncertainty about the amount of income that will be derived from the
asset. It is also appropriate where the effectiveness of the asset is expected to decline
gradually. It is often argued that the cost related to repairs and maintenance increases as an
asset ages, and that depreciation in declining instalments results in the total debit for the
cost of using the asset remaining fairly constant. When applying the diminishing balance
method, information about the technical or commerical obsolescence of the product is
relevant for estimating both the pattern of consumption of future economic benefits and the
useful life of the asset. The sum-of-digits method is also a reducing balance method.
9.6.5.3 Units of production method
The units of production method results in a charge based on the expected use or output of
the assets, called production units. The units of production method probably provide the
best approximation of the consumption of economic benefits contained in an asset. It has
the added advantage that it will prevent the depreciation of assets before they have been
brought into use, as the depreciation charge will only arise when the asset is used to
produce units.
Example 9.12
9.12
Depreciation methods
Alpha Ltd has the following equipment:
Cost of equipment (1 January 20.10)
Residual value (unchanged over useful life)
Useful life
Year end
The asset was available for use as intended by management on 1 January 20.10.
R310 000
R10 000
5 years
31 December
Using the allowed depreciation methods, the depreciation charge for Years 1 to 3 will be
calculated as follows:
Straight-line method: (310 000 – 10 000)/5 = R60 000 annually
Diminishing balance method: Assume a depreciation rate of 25%.
R
Year 1: (310 000 – 10 000) × 25%
=
75 000
Year 2: (310 000 – 10 000) × 75% × 25%
=
56 250
Year 3: (310 000 – 10 000) × 75% × 75% × 25%
=
42 188
Sum-of-digits: (1 + 2 + 3 + 4 + 5 = 15)
Year 1: (310 000 – 10 000) × 5/15
=
100 000
Year 2: (310 000 – 10 000) × 4/15
=
80 000
Year 3: (310 000 – 10 000) × 3/15
=
60 000
Units of production method: Assume the number of units per year = 8 000 (Year 1) + 6 000
(Year 2) + 3 000 (Year 3) + 2 000 (Year 4) + 1 000 (Year 5) = 20 000 units over the useful life of
the asset.
R
Year 1: 8/20 × (310 000 – 10 000)
=
120 000
Year 2: 6/20 × (310 000 – 10 000)
=
90 000
Year 3: 3/20 × (310 000 – 10 000)
=
45 000
Comment
¾ If the estimated residual value of the above equipment changes to R15 000, the original
residual value of R10 000 will change to R15 000 in the calculation of depreciation, resulting in
a change in depreciation in the current and future periods.
¾ The depreciation method used must be reviewed annually and, where the expectation varies
significantly from the previous estimates, it must be recognised as a change in accounting
estimate.
Property, plant and equipment 231
9.6.6 Accounting treatment
Although depreciation is normally recognised as an expense in the profit or loss section of
the statement of profit or loss and other comprehensive income, it may be capitalised as
part of the cost of another asset. Examples of this treatment can be found in IAS 2
Inventory, (where inventory is manufactured); IAS 16 Property, Plant and Equipment (where
assets are self-constructed), and IAS 38 Intangible Assets (where intangible assets may be
developed).
In all the above cases, the useful life, residual value and depreciation method are reviewed
at least at each financial year end. If expectations differ from previous estimates, the
changes shall be accounted for as a change in an accounting estimate. A change in the
useful life, depreciation method or residual value will thus result in a change in the
depreciation charge for the current year and future periods. Disclosure of the nature and
amount of the change in estimate (if material), as well as the effect on the current and
future periods, is required in terms of IAS 8.39 and .40.
Example 9.13
9.13
Change in depreciation methods
A company that operates a bus service determined on 1 January 20.12 that the appropriate
depreciation method for a specific bus is the production unit method.
The bus was acquired for R750 000. The originally estimated useful life was 150 000 kilometres.
During the first year of use, depreciation of R200 000 was recognised. The bus therefore had a
carrying amount of R550 000 at the end of the first year of use.
In the second year of use, management decided that, due to safety requirements, the bus can
only be used for a total term of 3 years, irrespective of the number of kilometres travelled. The
appropriate depreciation method therefore changes to the straight-line method.
Carrying amount at the end of Year 1
R550 000
Remaining useful life
2 years
Depreciation per annum on the straight-line method (550 000/2)
R275 000
Comment
¾ The change in the depreciation method is treated and disclosed as a change in estimate (if
material). The effect of the change in estimate is as follows:
Current year: Increase in depreciation of R75 000 (275 000 – 200 000)
Cumulative future effect: Decrease in depreciation of R75 000
[(750 000 – (200 000 × 2 years)) – 275 000].
9.7 Revaluation
All PPE is initially measured at cost. On subsequent measurement, the entity may, however,
choose to use either the cost model or the revaluation model. The revaluation model may,
however, only be chosen for subsequent measurement of an item of PPE if the fair value of
the asset can be measured reliably. If the fair value of the item under review cannot be
measured reliably, the asset will be measured using the cost model.
The frequency of revaluations depends upon the change in fair value of the items of PPE.
Revaluations should be made with sufficient regularity to ensure that the carrying amount
does not differ materially from the fair value at the end of the reporting period.
9.7.1 Fair value
The fair value of items of PPE subsequently measured under the revaluation model should
be determined according to the requirements of IFRS 13 (refer to chapter 21). According to
IFRS 13.27, a fair value measurement of a non-financial asset takes into account the market
participant’s ability to generate economic benefits by using the asset in its highest and best
232 Descriptive Accounting – Chapter 9
use. According to IFRS 13.62, there are three widely used valuation techniques to
determine fair value. The three valuation techniques are as follows:
ƒ the market approach;
ƒ the cost approach; and
ƒ the income approach.
The fair value of property is quite often determined using the market value, if it is assumed
that the same type of business will be continued on the premises. Usually these values are
obtained from independent professional valuators.
9.7.2 Non-depreciable assets: subsequent revaluations and devaluations
If a specific asset’s carrying amount decreases as a result of a revaluation, this decrease
must first be debited against a credit in the revaluation surplus related to that specific asset,
via other comprehensive income, in the statement of profit or loss and other comprehensive
income. Any excess of the write-down over the existing revaluation credit must be written-off
immediately to the profit or loss section of the statement of profit or loss and other
comprehensive income. With a subsequent increase in the value of the specific asset, the
profit or loss section of the statement of profit or loss and other comprehensive income
should first be credited, but the amount credited to the profit or loss section should be limited
to the amount of the previous write-down debited to this section. Thereafter, the remaining
amount is credited to the revaluation surplus via other comprehensive income in the
statement of profit or loss and other comprehensive income. Deficits of one item cannot be
set-off against surpluses of another, even if such items are from the same class. The
revaluation surplus may subsequently be used to absorb subsequent revaluation deficits or
impairment losses.
Example 9.14
9.14
NonNon-depreciable asset: revaluation movements
Brit Ltd is the owner of a plot. The plot is not depreciated and does not meet the requirements of
investment property. The plot is valued according to the revaluation model.
R
1 January 20.9 Carrying amount
150 000
1 January 20.10 Revalued amount
125 000
1 January 20.11 Revalued amount
135 000
1 January 20.12 Revalued amount
160 000
1 January 20.13 Revalued amount
145 000
Journal entries
Dr
R
1 January 20.10
Revaluation deficit (P/L)
Land (SFP)
25 000
1 January 20.11
Land (SFP)
Revaluation surplus (P/L)
10 000
1 January 20.12
Land (SFP)
Revaluation surplus (P/L)
Revaluation surplus (OCI)
1 January 20.13
Revaluation surplus (OCI)
Revaluation deficit (P/L)
Land (SFP)
Cr
R
25 000
10 000
25 000
15 000
10 000
10 000
5 000
15 000
continued
Property, plant and equipment 233
The statement of profit or loss and other comprehensive income will contain the following:
20.13
20.12
20.11
20.10
R
R
R
R
(Profit or loss section)
Other (expenses)/income
(5 000)
15 000
10 000
(25 000)
(Other comprehensive income section)
(Loss)/Gain on revaluation
(10 000)
10 000
–
–
The statement of changes in equity will contain
the following:
Revaluation surplus
Balance at beginning of year
10 000
–
–
–
Other comprehensive income
(10 000)
10 000
–
–
–
10 000
–
–
Balance at end of year
9.7.3 Non-depreciable assets: realisation of revaluation surplus
On revaluation, the difference between the revalued amount and the carrying amount is
recognised in the revaluation surplus via other comprehensive income if an upwards
revaluation occurred. The revaluation surplus is never subsequently reclassified to profit or
loss, but an entity may realise the revaluation surplus by making a direct transfer to retained
earnings through the statement of changes in equity. The revaluation surplus of nondepreciable assets are realised when the asset is retired or disposed of. The amount
transferred from the revaluation surplus should be net of tax.
Example 9.1
9.15
NonNon-depreciable asset: realisation of revaluation surplus
P Ltd adopted a policy to revalue land. The company owns a piece of land acquired at a cost of
R1 500 000 on 1 January 20.11. The year end of the company is 31 December. Ignore taxation.
The company revalued the building to a market value of R2 000 000 on 31 December 20.13.
The revaluation surplus that will be created is calculated as follows:
R
Carrying amount of the building on 31 December 20.13
1 500 000
Market value
2 000 000
Revaluation surplus
500 000
When the land is finally derecognised, the revaluation surplus will be transferred to retained
earnings. The journal entry will be as follows:
Dr
Cr
R
R
Revaluation surplus (Equity)
500 000
Retained earnings (Equity)
500 000
Realisation of revaluation surplus
9.8 Impairment losses and compensation for loss
The carrying amount of an item of PPE is usually recovered on a systematic basis over the
useful life of the asset through usage. If the use of an item or a group of similar items is
impaired by (e.g.) damage or technological obsolescence or other economic factors, the
recoverable amount of the asset may be less than its carrying amount. Should this be the
case, the carrying amount of the asset is written down to its recoverable amount.
234 Descriptive Accounting – Chapter 9
To determine whether there has been a decline in the value of an item of PPE, an entity
applies IAS 36. This Standard explains how an entity should review the carrying amount of
its assets; how the recoverable amount is determined, and when and how an impairment
loss is recognised or reversed (refer to chapter 14).
IAS 16.65 and .66 provide guidance on how to account for the monetary or non-monetary
compensation that an entity may receive from third parties for the impairment or loss of
items of PPE. Often the monetary compensation received has to be used for economic
reasons to restore impaired assets or to purchase or construct new assets in order to
replace the assets lost or given up. Examples of these may include:
ƒ reimbursement by insurance companies after an impairment or loss of items of PPE, for
example due to natural disasters, theft or mishandling;
ƒ compensation by the government for items of PPE that are expropriated;
ƒ compensation related to the involuntary conversion of items of PPE, for example
relocation of facilities from a designated urban area to a non-urban area in accordance
with a national land policy; or
ƒ physical replacement in whole or in part of an impaired or lost asset.
The specific guidance on how to account for the abovementioned situations, deals with the
following:
ƒ impairments or losses of items of PPE;
ƒ related compensation from third parties; and
ƒ subsequent purchase or construction of assets.
The above-mentioned instances are separate economic events and are accounted for as
follows:
ƒ impairments of items of PPE must be recognised and measured in terms of the Standard
on impairment of assets, (IAS 36);
ƒ the retirement or disposal of items of PPE must be recognised in terms of IAS 16;
ƒ monetary or non-monetary compensation received from third parties for items of PPE
that were impaired, lost or given up must be included in profit or loss when receivable;
and
ƒ the cost of assets restored, purchased, or constructed as a replacement must be
accounted for in terms of IAS 16.
Example 9.1
9.16
Compensation for the loss of PPE
On 1 January 20.12, a motor vehicle with a carrying amount of R150 000 was stolen. The
company, Alpha Ltd, was fully insured. The insurance company paid out R160 000 (in cash) on
31 January 20.12. On 1 February 20.12, a new vehicle was purchased for R160 000 to replace
the stolen one. The financial year ends on 31 December. Assume all amounts are material.
The above information will be disclosed as follows in the notes of Alpha Ltd for the year ended
31 December 20.12.
Profit before tax
R
Income
Compensation received from insurance claim
160 000
Expenses
Loss of motor vehicle due to theft
150 000
Comment
¾ In terms of IAS 16.65 and .66, the insurance proceeds received when an asset is impaired, the
loss of the asset, and the purchase of a replacement asset, are all separate transactions and
must be disclosed as such.
Property, plant and equipment 235
9.9 Derecognition
An item of PPE is derecognised in the statement of financial position:
ƒ on disposal; or
ƒ when no future economic benefits are expected from its use or disposal.
The above two criteria preclude the derecognition of an asset by mere withdrawal from use,
unless the withdrawn asset can no longer be used or sold to produce any further economic
benefits.
The gain or loss arising from the derecognition of an item of PPE shall be determined as the
difference between the net disposal proceeds (if any) and the carrying amount of the item on
the date of disposal. This gain or loss shall be recognised in the profit or loss section
of the statement of profit or loss and other comprehensive income (unless IFRS 16
Leases, requires otherwise on a sale and leaseback transaction where it is deferred). A gain
is not classified as revenue. However the date of disposal will be date the buyer obtains
control of the asset in terms of IFRS 15 (refer chapter 22).
Depreciation on an item of PPE ceases at the earlier of the date on which the asset is
classified as held for sale (or included in a disposal group that is classified as held for sale),
or the date the asset is derecognised.
Example 9.17
9.17
Disposal and withdrawal of assets
Lima Ltd entered into the following two transactions relating to items of PPE during the year ended
31 December 20.12:
ƒ Asset A, with a carrying amount of R210 000 on 1 January 20.12 and an original cost of
R400 000, was sold for R220 000 on 30 June 20.12. The payment will only be received on
30 June 20.13.
ƒ Asset B, with a carrying amount of R400 000 on 1 January 20.12 and original cost of R800 000,
was withdrawn from use on 30 September 20.12 after environmental inspectors certified that the
asset could no longer be used. The asset cannot be altered to secure further use, which makes
sale thereof unlikely. The scrap value of the asset is negligible.
Both these assets are depreciated at 20% per annum on a straight-line basis and the current
interest rate on asset financing is 10% per annum. Assume that the revenue recognition criteria
have been adhered to in the case of Asset A and that the disposal was therefore recognised on
30 June 20.12.
The profit or loss arising on derecognition of the two assets, as well as any other relevant profit or
loss items, is as follows:
Asset A
R
Proceeds on disposal (See IAS 16.72)
200 000
(n = 1; FV = 220 000; i = 10%; Compute PV = 200 000)
Carrying amount at disposal (210 000 – (400 000 × 20% × 6/12))
(170 000)
Profit on sale of Asset A in profit or loss section of the statement of profit or loss
and other comprehensive income
30 000
Interest received (200 000 × 10% × 6/12)
Asset B
Proceeds on withdrawal from use
Carrying amount at withdrawal (400 000 – (800 000 × 20% × 9/12))
Loss on withdrawal to profit or loss section of the statement of profit or loss
and other comprehensive income
10 000
R
–
(280 000)
(280 000)
Comment
¾ IFRS 5 requires specific disclosure of non-current assets (including PPE) that have been
earmarked for disposal within 12 months after taking the decision to dispose of the asset.
236 Descriptive Accounting – Chapter 9
9.10 Deferred tax implications
From an accounting perspective, depreciation methods, depreciation rates and residual values
are based on criteria such as the useful life of the asset to the entity, rather than its
economic life.
Deferred tax implications may therefore arise because of differences in:
ƒ the dates from which depreciation and wear-and-tear are calculated (date ready for
intended use versus date brought into use);
ƒ the use of different methods and rates to calculate depreciation, wear-and-tear and building
allowances, and the effect of subsequent changes due to the annual reassessment of
accounting allocations;
ƒ the use of residual values and subsequent changes (e.g. revaluations) to the values
which are not recognised for taxation purposes;
ƒ depreciation allowances that are calculated proportionately while wear-and-tear allowances
(e.g. in section 12C) are claimed for the full year; and
ƒ idle and damaged PPE, where depreciation and impairment adjustments are made for
accounting purposes that are not recognised for income tax purposes.
Revaluations may have an impact on the deferred tax balance. When an asset is revalued,
the carrying amount of the asset increases/decreases but the tax base of the asset remains
the same.
9.10.1 Manner of recovery
In terms of IAS 12.51 Income Taxes, the measurement of deferred tax liabilities and assets
must 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 amounts of its
assets or liabilities.
IAS 12.51B furthermore states that the deferred tax asset or liability that arises when using
the revaluation model in IAS 16 on non-depreciable assets should reflect the tax
consequences of recovering the carrying amount of the asset through sale.
The carrying amount of depreciable PPE can be separated into a residual value and a
depreciable amount. In determining the residual value, an entity is effectively affirming that it
expects to recover the depreciable amount of an asset through use, and its residual value
through sale.
An item of depreciable PPE will only be recovered through sale when it is classified as held
for sale in terms of IFRS 5.
9.10.2 Deferred tax implications of cost model
Deferred tax on PPE is calculated on the difference between the historical cost carrying
amount and the tax base of an asset. This is regarded as a temporary difference that will
result in either a deferred tax liability (based on a taxable temporary difference) or a deferred
tax asset (based on a deductible temporary difference).
The carrying amount of a non-depreciable asset, such as land that has an unlimted life, will
be recovered only through sale. Because the asset is not depreciated, no part of its carrying
amount is expected to be recoverd through use.
Property, plant and equipment 237
Example 9.18
9.18
Non-depreciable asset
Mpho Ltd acquired land at a cost of R1 000 000 on 1 January 20.13. The year end of the company
is 31 December. Normal income tax is provided for at 28%.
Temporary difference on land on 31 December 20.13:
Carrying
Temporary
Deferred tax
Tax base
amount
difference
asset/(liability)
R
R
R
R
Land
1 000 000
1 000 000
–
–
Comment
¾ Please refer to IAS 12 BC6 regarding the manner of recovery of a non-depreciable asset.
When an item of PPE is depreciated but no tax deduction is allowed, no deferred tax is
recognised, because the temporary differences are part of the temporary differences that
arose on initial recognition (IAS 12.22(c)).
Example 9.19
9.19
Depreciation of non-tax-deductible PPE
Ndlovu Ltd acquired a building, which they intend to use for 20 years, with no residual value, on
1 April 20.12 for R1 000 000. The year end of the company is 31 March. No tax deductions are
available for the building. Normal income tax is provided for at 28%.
Temporary difference on the building on 31 March 20.13:
Carrying
Tax base
amount
R
R
Building
950 000
–
Temporary
difference
R
950 000
Deferred tax
asset/(liability)
R
Exempt
(IAS 12.22(c))
Comment
¾ No deferred tax is recognised on the current temporary difference of R950 000, because it is
part of the temporary differences arising on initial recognition (IAS 12.22(c)). The depreciation
of R50 000 is a non-deductible item in the taxable income calculation.
The example below illustrates the treatment of temporary differences when the item of PPE
is depreciated and tax deductions are allowed.
Example 9.2
9.20
Temporary differences on PPE
Zet Ltd acquired a machine at a cost of R100 000 on 1 July 20.12. The year end of the company is
31 December.
The company estimates the useful life of the machine as 5 years at initial recognition.
The machine is used in a process of manufacture; consequently, the South African Revenue
Service (SARS) allows a wear-and-tear allowance, not apportioned for part of a year, of 40% in
the first year in which the machine is brought into use and 20% in the three following years in
terms of section 12C of the Income Tax Act.
On 31 December 20.12, the relevant amounts for the machine are as follows:
Accounting depreciation: R100 000/5 × 6/12 = R10 000
Therefore, the carrying amount of the machine is R90 000 on 31 December 20.12.
Wear-and-tear allowances for tax purposes: R100 000 × 40% = R40 000
Therefore, the tax base of the machine is R60 000 on 31 December 20.12.
Normal income tax is provided for at a rate of 28%.
continued
238 Descriptive Accounting – Chapter 9
Temporary difference on the machine on 31 December 20.12:
Temporary
Deferred tax
Carrying
Tax base
amount
difference asset/(liability)
R
R
R
R
Machine
90 000
60 000
30 000
(8 400)
Comment
¾ The carrying amount of the machine represents the future economic benefits arising from the
use of the asset that will be included in taxable income in future. The tax base represents the
future tax deductions. Therefore, R90 000 will be included in future taxable income and
R60 000 will be allowed as a deduction. A future tax liability of R8 400 (30 000 × 28%) will
arise.
When a depreciable PPE item has a residual value and the residual value exceeds the
carrying amount, the PPE item is recovered through sale only. For example, if the carrying
amount of the asset is R50 000 and the residual value is R55 000 the total carrying amount
of R50 000 will be recovered through sale.
9.10.3 Non-depreciable assets: deferred tax implications of revaluation model
SARS does not recognise revaluations when determining the tax base of an asset. SARS
normally uses only historical cost as the point of departure. As a result, the tax base of an
asset will remain unchanged at revaluation, but the carrying amount of the asset will change.
The deferred tax on the revaluation of an item of PPE must be recognised against the
revaluation surplus via other comprehensive income, as the underlying reason for the
temporary difference (the increase in the carrying amount of the asset) is recognised in
other comprehensive income. IAS 12.61A and .62(a) require deferred tax to be recognised
in other comprehensive income if the tax relates to an item that was recognised in other
comprehensive income.
If a non-depreciable asset (e.g. land) is revalued in terms of IAS 16, the manner of recovery
of a revalued non-depreciable asset is through sale. When the assumption is that the
asset will be recovered through sale, the tax base of the asset will be equal to its base
cost (as the base cost will be allowed as a deduction against the proceeds to determine the
capital gain when the asset is sold).
Example 9.2
9.21
Revaluation of a non-depreciable asset
Metsi Ltd acquired land at a cost of R1 000 000 on 1 January 20.12. The land is revalued to
R1 500 000 on 31 December 20.12. Assume a normal income tax rate of 28% and an 80% capital
gains tax inclusion rate. Metsi Ltd presents other comprehensive income before related tax effects
and the tax effects are shown in aggregate.
Temporary difference on the machine on 31 December 20.12:
Deferred tax
Temporary
Carrying
@ CGT rate*
Tax base
amount
difference
asset/(liability)
R
R
R
R
Land
1 500 000
1 000 000
500 000
(112 000)
* Assume the asset was acquired after 1 October 2001.
Comment
¾ The carrying amount of the revalued asset has increased, but the tax base remains at
R1 000 000. As a result, the temporary difference increased by R500 000, which is equal to the
amount of the revaluation surplus on the asset. Since the asset is non-depreciable, deferred tax
should be raised on the revaluation surplus at the tax rate that would apply when the asset is
sold – in South Africa, Capital Gains Tax (CGT) will arise at 80% × normal income tax rate.
The deferred tax on the revaluation of an item of PPE is recognised against the revaluation
surplus via other comprehensive income.
continued
Property, plant and equipment 239
The journal entries will be as follows:
1 January 20.12
Land (SFP)
Bank (SFP)
Acquisition of land
Dr
R
1 000 000
31 December 20.12
Land (SFP)
Revaluation surplus (OCI)
Revaluation of land to its fair value
Revaluation surplus (OCI)
Deferred tax (SFP)
Deferred tax on revaluation surplus
Cr
R
1 000 000
500 000
500 000
112 000
112 000
Extract from statement of profit or loss and other comprehensive income
for the year ended 31 December 20.12
R
Profit for the year
Other comprehensive income:
Items that will not be reclassified to profit or loss:
Gain on revaluation
Income tax relating to items that will not be reclassified to profit or loss
xxx
500 000
(112 000)
Other comprehensive income for the year, net of tax
388 000
Total comprehensive income for the year
xxx
Extract from statement of changes in equity for the year ended 31 December 20.12
Revaluation
Retained
surplus
earnings
R
R
–
Balance at 1 January 20.12
xxx
Total comprehensive income for the year
388 000
Profit for the year
Other comprehensive income for the year
Balance at 31 December 20.12
–
388 000
388 000
xxx
–
xxx
9.10.4 Capital Gains Tax
In terms of the latest tax legislation, capital gains on the sale of capital assets will be subject
to Capital Gains Tax (CGT) from 1 October 2001 unless ‘roll-over’ relief is applicable.
The capital gain is calculated as the difference between the proceeds on disposal of an
asset and the ‘base cost’ of the asset as defined in the Income Tax Act.
CGT is only applicable to assets sold after 1 October 2001. For assets acquired before
1 October 2001, only the part of the gain that arises after 1 October 2001 will be subject to
CGT. The base cost of the asset at 1 October 2001 must thus be determined and will serve as
the tax base of the asset under these specific circumstances. Currently the capital gains tax
inclusion rate for companies is 80%. Example 9.22 illustrates the current tax calculation of
capital gains on the sale of capital assets.
240 Descriptive Accounting – Chapter 9
Example 9.2
9.22
Capital Gains Tax
The following items were included in the profit before tax of R550 000 of Alpha Ltd. Assume that
there were no other non-taxable/non-deductible items or temporary differences for the year. The
normal income tax rate is 28%.
R
Land sold for capital gain:
The accounting profit on the sale of land
200 000
The following information relates to land:
Proceeds
Revalued carrying amount on date of sale
Base cost (CGT purposes)
The current tax will be calculated as follows:
Profit before tax
Non-taxable and non-deductible items:
Accounting profit not taxable (200 000 × 20%)
1 100 000
900 000
800 000
550 000
(40 000)
Taxable profit before temporary differences
Movement in temporary differences#
510 000
80 000
Taxable profit
590 000
Current tax at 28%
165 200
#
(900 000 – 800 000 = 100 000 × 80% = 80 000) – (Rnil) = 80 000
(reversal of taxable temporary differences)
Major components of tax expense:
South African normal tax
Current tax (Current year)
165 200
Deferred tax
Movement in temporary differences (80 000 × 28%)
(22 400)
142 800
Tax rate reconciliation
Profit before tax
550 000
Tax at 28%
154 000
Non-taxable/non-deductible items
ƒ Profit on sale of land not taxable (40 000 × 28%)
(11 200)
Income tax expense
142 800
Land sold for capital loss:
The accounting loss on the sale of land
The following information relates to land:
Proceeds
Revalued carrying amount on date of sale
Base cost (CGT purposes)
Assume future capital gains are probable in the future.
200 000
700 000
900 000
800 000
continued
Property, plant and equipment 241
The current tax will be calculated as follows:
Profit before tax
Non-taxable and non-deductible items:
Accounting loss not deductible (200 000 × 20%)
R
550 000
40 000
Taxable profit before temporary differences
Movement in temporary differences#
Movement in temporary differences (unused capital loss) (100 000 × 80%)
590 000
80 000
80 000
Taxable profit
750 000
Current tax at 28%
210 000
#
(900 000 – 800 000 = 100 000 × 80% = 80 000) – (Rnil) = 80 000
(reversal of taxable temporary differences)
Major components of tax expense:
SA Normal tax
Current tax (Current year)
Deferred tax
Movement in temporary differences (80 000 × 28%)
Unused capital loss created (80 000 × 28%)
210 000
(22 400)
(22 400)
165 200
Tax rate reconciliation
Profit before tax
550 000
Tax at 28%
Non-taxable/non-deductible items
ƒ Accounting loss on sale of land not deductible (40 000 × 28%)
154 000
Tax expense
165 200
11 200
9.11 Disclosure
In terms of IAS 16, the following information on PPE must be disclosed:
ƒ Accounting policy:
– For each class of PPE, the measurement basis used in establishing the gross carrying
amount;
– the depreciation methods for each class of asset; and
– the useful lives or depreciation rates for each class of PPE.
ƒ Statement of profit or loss and other comprehensive income and notes for each
class of asset:
– The depreciation recognised as an expense or shown as a part of the cost of other
assets during a period should be disclosed in terms of IAS 1 Presentation of Financial
Statements. A breakdown between the different classes of assets is not required. The
depreciation charge need not be split between amounts related to historical cost and
revaluation amounts;
– the effect of significant changes on the estimate of:
* useful lives;
* residual values;
* dismantling, removal or restoration costs; and
* depreciation method; and
242 Descriptive Accounting – Chapter 9
– the amount of compensation received from third parties for the impairment, giving up
or loss of items of PPE, must be disclosed in a note if not presented on the face of the
statement of profit or loss and other comprehensive income.
ƒ Statement of financial position and notes:
– For each class of asset, the gross carrying amount and accumulated depreciation
(including impairment losses) at the beginning and the end of the period; and
– for each class of asset, a detailed reconciliation (refer to # below) of movements in the
carrying amount (refer to $ immediately below) at the beginning and end of the period
(lay out illustrated below).
$
The carrying amount is the amount at which an asset is recognised in the statement of
financial position after deducting the accumulated depreciation and impairment losses. This
implies that accumulated depreciation and impairment losses must be combined when
disclosing the opening and closing carrying amounts.
#
The abovementioned reconciliation must contain the following:
• the carrying amount at the beginning and the end of the period;
• additions;
• assets classified as held for sale or included in a disposal group classified as held for sale
in terms of IFRS 5 and other disposals;
• acquisitions through business combinations;
• increases or decreases in value arising from revaluations;
• impairments, as well as reversals of impairment losses;
• depreciation;
• net exchange differences due to the translation of the financial statements of a foreign
operation from functional to presentation currency (if different), including translation of a
foreign operation into presentation currency of the reporting entity; and
• other changes.
Comparative amounts in respect of the reconciliation are required.
ƒ The amount incurred on PPE still under construction (in other words, on which no
depreciation has been provided).
ƒ A statement that PPE serves as security for liabilities, showing:
– the details and amount of restrictions on title; and
– the existence and amount of PPE pledged as security.
ƒ The following carrying amounts of PPE can also be disclosed voluntarily:
– temporarily idle items;
– items retired from active use and not classified as held for sale in terms of IFRS 5; and
– where the cost model is used, the fair value of each class of PPE if it differs materially
from the carrying amount.
ƒ The following additional information regarding assets that have been revalued must be
disclosed in terms of IAS 16:
– the disclosure required by IFRS 13 relating to assets measured at fair value;
– the effective date of the most recent revaluations;
– whether the revaluation was done independently;
– the carrying amount of each class of revalued PPE, if the cost model was used; and
– the revaluation surplus, including the change for the period and limitations on
distributions to shareholders (in other words, whether it is viewed as non-distributable).
Property, plant and equipment 243
Example 9.2
9.23
Disclosure of accounting policy and notes
Notes to the consolidated financial statements
1. Accounting policies
Property, plant and equipment
Plant and equipment are stated at cost, excluding the costs of day-to-day servicing, less
accumulated depreciation and accumulated impairment in value. Such costs include the cost of
replacing part of such plant and equipment when that cost is incurred when the recognition criteria
are met. Land is measured at fair value less impairment charged subsequent to the date of the
revaluation. Depreciation is calculated on a straight-line basis over the useful life of the assets.
The useful life of the assets is estimated as follows:
20.13
20.12
Plant and equipment
5 to 15 years
5 to 15 years
The carrying amounts of plant and equipment are reviewed for impairment when events or
changes in circumstances indicate that the carrying amount may not be recoverable.
Following initial recognition at cost, the land is carried at a revalued amount, which is the fair value
at the date of the revaluation less any accumulated impairment losses.
Valuations are performed frequently enough to ensure that the fair value of a revalued asset does
not differ materially from its carrying amount.
Any revaluation surplus is credited to the asset revaluation surplus included in the equity section of
the statement of financial position via other comprehensive income, except to the extent that it
reverses a revaluation decrease of the same asset previously recognised in profit or loss, in which
case the increase is recognised in profit or loss. A revaluation deficit is recognised in profit or loss,
except that a deficit directly offsetting a previous surplus on the same asset is offset against the
surplus in the asset revaluation reserve via other comprehensive income.
Upon disposal, any revaluation reserve relating to the particular asset being sold is transferred to
retained earnings.
An item of PPE is derecognised upon disposal or when no future economic benefits are expected
from its use or disposal. Any gain or loss arising on derecognition of the asset (calculated as the
difference between the net disposal proceeds and the carrying amount of the asset) is included in
the profit or loss section of the statement of profit or loss and other comprehensive income in the
year the asset is derecognised.
The asset’s residual value, useful life and depreciation method are reviewed, and adjusted if
appropriate, at each financial year end.
When each major inspection is performed, its cost is recognised in the carrying amount of the
plant and equipment as a replacement, if the recognition criteria are satisfied.
continued
244 Descriptive Accounting – Chapter 9
2. Property, plant and equipment
Land
R’000
Plant and
equipment
R’000
Total
R’000
31 December 20.13
Carrying amount at beginning of year
9 933
15 878
25 811
Cost
Accumulated depreciation and impairment losses
9 933
–
30 814
(14 936)
42 197
(16 386)
Additions
Assets included in discontinued operation
and other disposals
Revaluation surplus
Acquisition of a subsidiary
Impairment lossesŸ
Depreciation for the year
Exchange adjustment
1 612
6 043
7 655
(2 674)
846
2 897
(187)
–
10
(3 193)
–
4 145
(161)
(3 357)
119
(5 867)
846
7 042
(348)
(3 857)
129
Carrying amount at end of year
12 437
19 474
31 411
Cost or revalued amount
Accumulated depreciation and impairment losses
12 624
(187)
32 193
(12 719)
44 817
(13 406)
Ÿ
This impairment loss relates to the assets attributable to a discontinued operation and has been
recognised in the profit or loss section of the statement of profit or loss and other
comprehensive income in the line item ‘Loss for the year from a discontinued operation’.
Impairment of property, plant and equipment
Immediately before its classification as a discontinued operation of Hose Ltd on 31 December 20.13,
a recoverable amount was estimated for certain items of PPE. An impairment loss totalling
R348 000 was recognised to reduce the carrying amount of certain of those assets to the
recoverable amount. The recoverable amount estimation was based on fair value less costs of
disposal and was determined at the cash-generating unit level consisting of the Euro land-based
assets of Hose Ltd relating to the reportable rubber equipment segment. An independent valuation
was obtained to determine fair value, which was based on recent transactions for similar assets
within the same industry.
Plant and
Land
Total
equipment
R’000
R’000
R’000
31 December 20.12
Carrying amount at beginning of year
10 783
12 747
23 530
Cost
Accumulated depreciation and impairment losses
Movements for the year:
Additions
Disposals
Impairmentʌ
Depreciation for the year
Exchange adjustment
24 654
(11 907)
39 541
(16 011)
1 587
(2 032)
–
–
(405)
6 235
–
(301)
(2 728)
(75)
7 822
(2 032)
(301)
(3 082)
(126)
Carrying amount at end of year
9 933
15 878
25 811
Cost
Accumulated depreciation and impairment losses
9 933
–
30 814
(14 936)
42 197
(16 386)
ʌ
10 783
–
The R301 000 impairment loss represents the write-down of certain PPE in the fire prevention
segment to the recoverable amount. This has been recognised in the profit or loss section of the
statement of profit or loss and other comprehensive income in the line item “Cost of sales”.
The recoverable amount was based on value in use and was determined at the cash generating
unit level. The cash generating unit consists of the Euro land-based assets of Sprinklers Ltd
and Showers Ltd, a subsidiary and a jointly-controlled entity of the Group respectively. In
determining value in use for the cash generating unit, the cash flows were discounted at a rate
of 12,8% on a pre-tax basis.
continued
Property, plant and equipment 245
Revaluation of land
The group engaged Chartered Surveyors & Co, an accredited independent valuer, to determine
the fair value of its land. The date of the revaluation was 30 November 20.13.
If the land and buildings were measured using the cost model, the carrying amounts would be as
follows:
20.13
20.12
R’000
R’000
Cost
11 778
9 933
Accumulated impairment losses
(187)
–
Net carrying amount
11 591
9 933
Land with a carrying amount of R4 805 000 (20.12: R305 000) is subject to a first charge to secure
two of the Group’s bank loans.
9.12 Comprehensive example of cost model
The following is an extract from the fixed asset register of Impala Ltd on 31 December 20.12:
Asset type
Land
Buildings
Vehicles
Date of purchase
Cost
1 January 20.12
1 January 20.12
1 January 20.12
R
1 800 000
2 500 000
1 600 000
Accumulated
depreciation
R
–
125 000
200 000
Useful life
Wear-and-tear
allowance
–
20 years
8 years
–
2% straight-line
20% straight-line
Impala Ltd concluded the following asset transactions during the year:
ƒ Land with a cost of R400 000 was sold unexpectedly on 1 March 20.13 for R325 000.
ƒ A stand was purchased for R350 000. The stand is used as an owner-occupied property.
ƒ Improvements amounting to R135 000 were effected to buildings on 1 January 20.13.
ƒ A vehicle (original cost R160 000) was sold unexpectedly on 30 June 20.13 for R115 000.
ƒ The assets under consideration have no residual value and this situation will remain unchanged
until the end of the useful lives of the assets.
ƒ The manner in which assets are recovered is not expected to change.
ƒ On 1 January 20.13, Impala Ltd determined that the remaining useful life of the buildings was
25 years.
ƒ Assume a normal income tax rate of 28%.
Impala Ltd
Extract of Statement of financial position as at 31 December 20.13
Note
Assets
Non-current assets
Property, plant and equipment
Equity and liabilities
Non-current liabilities
Deferred tax
R
3
5 239 600
4
94 836
246 Descriptive Accounting – Chapter 9
Impala Ltd
Extract from the notes for the year ended 31 December 20.13
1. Accounting policy
Property, plant and equipment
Property, plant and equipment are shown at historical cost.
No depreciation is provided for on land.
Buildings and vehicles are depreciated according to the straight-line basis over their expected
remaining useful lives:
ƒ Buildings – 24 years
ƒ Vehicles – 6 years
Rates are considered appropriate to reduce carrying amounts of the assets to estimated residual
values (Rnil) over their expected useful lives.
2. Profit before tax
Profit before tax is stated after taking the following items into account:
Expenses:
R
Loss on disposal of land (400 000 – 325 000)
75 000
Loss on disposal of vehicles
15 000
Depreciation
290 400
During the year, the remaining useful life of the buildings was revised. This resulted in a decrease
in depreciation in the current year of R31 705 and an increase in depreciation in the future of
R31 705.
3. Property, plant and equipment
Land
Buildings
Vehicles
Total
R
R
R
R
Carrying amount beginning of year
1 800 000
2 375 000
1 400 000
5 575 000
Cost
Accumulated depreciation
Movements for the year:
Disposals
Additions
Depreciation for the year
1 800 000
–
Carrying amount end of year
1 750 000
2 409 600
1 080 000
5 239 600
Cost
Accumulated depreciation
1 750 000
–
2 635 000
(225 400)
1 440 000
(360 000)
5 825 000
(585 400)
(400 000)
350 000
–
2 500 000
(125 000)
1 600 000
(200 000)
5 900 000
(325 000)
–
135 000
(100 400)
(130 000)
–
(190 000)
(530 000)
485 000
(290 400)
4. Deferred tax
Analysis of temporary differences:
Accelerated wear-and-tear for tax purposes [(122 700 × 28%) + (216 000 × 28%)]
R
94 836
Property, plant and equipment 247
Calculations
Buildings
Cost
Accumulated depreciation/wear-and-tear
Carrying amount 31 December 20.12
Additions
Depreciation/wear-and-tear 31 December 20.13
(2 510/25)/[(2 500 + 135) × 2%]
Historical
cost
R
Tax
base
R
Temporary
difference
R
2 500 000
(125 000)
2 500 000
(50 000)
–
(75 000)
2 375 000
135 000
2 450 000
135 000
(75 000)
–
2 510 000
2 585 000
(75 000)
(100 400)
(52 700)
(47 700)
Carrying amount 31 December 20.13
2 409 600
2 532 300
(122 700)
Vehicles
Cost
Accumulated depreciation/wear-and-tear
1 600 000
(200 000)
1 600 000
(320 000)
–
120 000
Carrying amount 31 December 20.12
Depreciation/wear-and-tear 30 June 20.13
1 400 000
(100 000)
1 280 000
(160 000)
120 000
60 000
Carrying amount 30 June 20.13
Disposals (160/8 × 6,5); [160 – (160 × 20% × 1,5)]
Depreciation/wear-and-tear 31 December 20.13
1 300 000
(130 000)
(90 000)
1 120 000
(112 000)
(144 000)
180 000
(18 000)
54 000
Carrying amount 31 December 20.13
1 080 000
864 000
216 000
Depreciation – change in accounting estimate
Old method [(2 375 000 + 135 000)/19] = 132 105
New method = 100 400
Difference (132 105 – 100 400) = 31 705
CHAPTER
10
Employee benefits
(IAS 19; IFRIC 14 and FRG 3)
Contents
10.1
10.2
10.3
10.4
10.5
10.6
10.7
Overview of IAS 19 Employee Benefits .............................................................
Background .......................................................................................................
Short-term employee benefits ...........................................................................
10.3.1 Recognition and measurement ...........................................................
10.3.2 Disclosure ............................................................................................
Post-employment benefits .................................................................................
10.4.1 Types of post-employment benefit plans .............................................
10.4.2 Defined contribution plans ...................................................................
10.4.3 Defined benefit plans ...........................................................................
10.4.4 Classification of post-employment benefit plans .................................
10.4.5 Accounting for post-employment benefit plans ...................................
Other long-term employee benefits (IAS 19.153 to .158) ..................................
10.5.1 Recognition, measurement and disclosure .........................................
Termination benefits (IAS 19.159 to .171).........................................................
10.6.1 Recognition .........................................................................................
10.6.2 Measurement ......................................................................................
10.6.3 Disclosure ............................................................................................
10.6.4 Tax implications ...................................................................................
Equity compensation benefits ...........................................................................
249
250
250
251
251
261
261
261
261
262
262
263
265
266
266
266
267
267
267
269
250 Descriptive Accounting – Chapter 10
10.1 Overview of IAS 19 Employee Benefits
The following is a broad summary of IAS 19:
Employee benefits
Short-term
employee
benefits
Postemployment
benefits
Other long-term
employee
benefits
Termination
benefits before
retirement
Payable
within
12 months
Benefits
after
retirement
Payable after
12 months
Benefits at
termination
Salaries and
wages,
compensated
absences,
bonuses,
other non-cash
benefits
A: Defined
contribution
plans
(provident funds)
P/L: In respect
of employer’s
contribution.
SFP: Liability if
contributions
not paid
Long-term
jubilee benefits,
ƒ absences,
ƒ bonuses,
ƒ disability
benefits, etc
Redundancy
payments
B: Defined benefit
plans
(pension funds)
Not covered, refer
to IAS 19)
P/L and SFP
(liability if unpaid):
Payable within
12 months –
apply
requirements
of short-term
employee
benefits.
Payable after
12 months –
apply
requirements of
other long-term
employee
benefits
10.2 Background
Benefits provided in exchange for services rendered by employees whilst employed, as well
as benefits provided subsequent to employment, can take on many forms. Some
employment benefits even include benefits paid to either employees or their dependants. In
terms of IAS 19, these employee benefits can be classified into the following main categories:
ƒ short-term employee benefits;
ƒ post-employment benefits;
ƒ other long-term employee benefits; and
ƒ termination benefits.
Note that equity compensation benefits are dealt with in IFRS 2.
Because each category of employee benefit identified in terms of IAS 19 has different
characteristics, the Standard establishes separate requirements and accounting treatments
for each category. Consequently, the different categories are dealt with on an individual
basis in this chapter.
Employee benefits 251
10.3 Short-term employee benefits
Short-term employee benefits are employee benefits (other than termination benefits) that are
expected to be settled wholly within twelve months after the end of the annual reporting
period in which the employees rendered the related service, and include items, for example:
ƒ wages, salaries and social security contributions;
ƒ paid annual leave and paid sick leave;
ƒ profit-sharing and bonuses; and
ƒ non-monetary benefits (e.g. medical care, housing, cars and free or subsidised goods or
services) for employees currently employed by the entity.
The definition of short-term employee benefits requires that only benefits expected to be
settled wholly within twelve months after the end of the annual reporting period be classified
as such. The Standard does not specify what is meant by the term ‘wholly’, i.e whether it
applies to an individual employee or to the the total benefit for all employees. The authors
are of the opinion that it should reflect the characteristics of the benefits, therefore
classifying the benefit as a whole.
An entity does not need to reclassify short-term employee benefits if the timing of the
settlement of the benefits changes temporarily. However, if the characteristics of the
benefits change or the change in the expected timing of the settlement of the benefits is not
temporary, the entity must consider whether the benefits still meet the definition of shortterm benefits. They will most probably be classified as ‘other long-term benefits’. Refer to
section 10.6 for a discussion of other long-term employee benefits.
Accounting for short-term employee benefits is generally straightforward because no actuarial
assumptions are required to measure the obligation or the cost and there is no possibility of
any actuarial gain or loss. In addition, short-term employee benefits are measured on an
undiscounted basis.
10.3.1 Recognition and measurement
10.3.1.1 All short-term employee benefits
When an employee has rendered services to an entity during an accounting period (e.g. in
exchange for a salary), the entity must recognise the undiscounted amount of short-term
employee benefits expected to be paid in exchange for those services by raising an expense
together with a corresponding decrease in an asset or increase in a liability (accrued
expense). Therefore normal accrual accounting applies. An expense should be raised
unless another Standard requires or permits the inclusion of the benefits in the cost of the
asset – see, for example, IAS 2 Inventories, paragraphs 10 to 22 and IAS 16 Property, Plant
and Equipment, paragraphs 15 to 28.
Example 10.
10.1
Salary and the employee’s cost to company
Mr Salary is an employee in the employ of Entity X. The following is the salary slip of Mr Salary for
July 20.13:
R
Gross salary
10 000
Provident fund contribution
(750)
Medical aid fund contribution
(900)
Unemployment insurance fund contribution
(100)
Employee tax
(2 000)
Net salary paid over to Mr Salary
6 250
continued
252 Descriptive Accounting – Chapter 10
Entity X contributes the same amount as the employee to the provident fund, medical aid fund and
unemployment insurance fund.
R
Contributions by Entity X
Provident fund contribution
750
Medical aid fund contribution
900
Unemployment insurance fund contribution
100
The journal entry to account for the salary of Mr Salary and the payment thereof is the following:
Dr
Cr
R
R
Short-term employee benefit cost (P/L)
10 000
Provident fund – payable (SFP)
750
Medical aid fund – payable (SFP)
900
SARS – payable (SFP)
2 000
Unemployment insurance fund – payable (SFP)
100
Salary due to employee (SFP)
6 250
Create obligations for amounts deducted from gross salary by Entity X,
before the net salary is paid to Mr Salary
Short-term employee benefit cost (P/L)
Provident fund – payable (SFP)
Medical aid fund – payable (SFP)
Unemployment insurance fund – payable (SFP)
Recognise employer’s contributions in respect of sundry items
of Mr Salary for the month
1 750
Provident fund – payable (SFP)
Medical aid fund – payable (SFP)
SARS – payable (SFP)
Unemployment insurance fund – payable (SFP)
Salary due to employee (SFP)
Bank (SFP)
Pay salary and deductions and contributions by employer over to relevant
creditors
1 500
1 800
2 000
200
6 250
750
900
100
11 750
For Entity X, the total cost to have Mr Salary in its employment for the above month would be
calculated as follows:
R
Gross salary (includes net salary and all deductions)
10 000
Contributions by Entity X
Medical aid fund contribution
900
Provident fund contribution
750
Unemployment insurance fund contribution
100
Employee benefit cost for company
11 750
Comment
¾ Several methods exist to account for the above, but only one is illustrated here.
¾ The fact that Mr Salary’s salary is utilised to pay contributions to funds and tax will not change
the fact that Entity X still pays him a gross salary of R10 000. The deductions funded by the
employee therefore do not influence Mr Salary’s gross salary.
¾ The employer’s contributions to the respective funds increase the total cost related to the
services of the employee to above his gross salary – the R11 750 is often referred to as ‘cost to
company’.
Employee benefits 253
Example 10.
10.2
Short-term employee benefits
Wimble Ltd pays over salaries to employees on the first working day of each calendar month. The
company’s reporting period ends on 31 December. The total salary bill for December 20.13
amounted to R100 000, and this amount will be paid over on 2 January 20.14. The journal entry as
at 31 December 20.13, to account for the above, will be as follows:
Dr
Cr
R
R
31 December 20.13
Short-term employee benefit costs (P/L)#
100 000
100 000
Accrued expenses (SFP)
Accrual of salary cost at year end
If, for some reason, say R20 000 of the R100 000 was paid over on 30 December 20.13 (i.e.
before 31 December 20.13), the journal entries up to 31 December 20.13 would be as follows:
Dr
Cr
R
R
31 December 20.13
Short-term employee benefit costs (P/L)#
20 000
Bank (SFP)
20 000
Payment of salary cost
Dr
Cr
R
R
80 000
Short-term employee benefit costs (P/L)
*80 000
Accrued expenses (SFP)
Accrual of salary cost at year end
In the case of accrued salary expenses, the expense will be allowed for tax purposes in terms of
section 11(a) of the Income Tax Act 58 of 1962, because the expenditure is actually incurred and
the entity has an obligation to pay the salaries. The deferred tax on the accrued expense will thus
be Rnil. This is calculated by comparing the carrying amount of the accrued expense, amounting
to R100 000, with the tax base of the liability, being R100 000. The tax base is calculated as
follows: Carrying amount R100 000 – Rnil (nothing will be deductible in future).
* (100 000 – 20 000 already paid).
#
Note that this amount need not necessarily be expensed, but can also be capitalised to the cost
of an asset, provided that this is required or permitted in terms of International Financial
Reporting Standards (e.g. IAS 2 and IAS 16).
The issue of recognising non-monetary benefits such as the use of a motor vehicle is
problematic. The question is whether the related costs if the underlying asset should be
treated as employee benefits or as expenses by nature such as depreciation, maintenance,
insurance and fuel. There is a strong argument that when sush a vehicle is used for private
use of an employee that portion of the expenses should rather be recognised as employee
benefits.
In the event of short-term compensated absences, profit-sharing and bonus plans, the basic
rules on short-term employee benefits may require slight modifications to ensure proper
application.
10.3.1.2 Short-term compensated absences
Short-term compensated absences refer to annual or other leave and can be classified as
either:
ƒ accumulating compensated absences (leave); or
ƒ non-accumulating compensated absences (leave).
254 Descriptive Accounting – Chapter 10
Accumulating compensated absences are compensated absences that can be carried forward to future periods if the entitlement of the current period is not used in full. For example,
ten days’ paid annual leave (accumulating) not utilised in full in the current year can be carried
forward to the next year and utilised then.
Non-accumulating compensated absences do not carry forward, and on the basis of the
information in the above example, it means that the 10 days accumulated annual leave from
the current year will lapse at the end of the current year and cannot be utilised in the following year.
Accumulating compensated absences may be classified as vesting and non-vesting. Vesting
benefits are benefits where employees are entitled to a cash payment upon leaving the entity.
Non-vesting benefits are benefits where employees are not entitled to a cash payment upon
leaving the entity.
When accounting for accumulating compensated absences (leave), the expected cost of the
benefit should be recognised when the employees render service that increases their entitlement to future compensated absences. The amount is measured as the additional amount
an entity expects to pay as a result of the unused entitlement that has accumulated at the
reporting date. The basic formula to calculate this would be:
Amount = Expected number of days’ leave that might be taken/paid
out in future years × tariff per day
Note that the basic formula presented above distinguishes between days’ leave to be taken
and days’ leave to be paid out. Depending on which of the two options the employer believes
would arise, the tariff used to measure the leave pay accrual would differ. A combination of
the two options would also be possible.
If the employer expects employees to have all accumulated leave paid out in cash, the
employer will use a tariff based on the gross basic salary of these employees to measure
the leave pay accrual (unless in rare circumstances the leave conditions specify something
else). However, if the employees are expected to be absent during the leave days (i.e.
take leave/take time off), the tariff used to measure the leave pay accrual will be based on
the cost to company amount for employees – this would be the basic gross salary plus the
additional contributions paid by the employer. This is the case because the employer will still
be required to make contributions to the pension fund, medical aid fund, etc during the
absence of the employees.
Example 10.
10.3
Recognition and utilisation of leave
Bat Ltd, with a year end of 31 December 20.14, has an employee that earns R240 000 per annum
(R20 000 per month). The employee is entitled to one calendar month’s leave. Assume that the
employee will take leave for the the whole of December 20.14.
The journal entry for each month from January to November 20.14 will be as follows:
Dr
Cr
R
R
January to November 20.14
Short term employee benefits expense (P/L) (240 000/11)
21 818
Leave pay accrual (SFP)
1 818
Bank/Liabilty (SFP)
20 000
Recognition of employee benefits with leave accrual for each month.
December 20.14
Leave pay accrual (SFP)
Bank/Liability (SFP)
Recognition of salary while on leave
20 000
20 000
continued
Employee benefits 255
The leave pay accrual is recognised while the employee delivers services to the entity. Therefore
R1 818 is recognised as an expense on a monthly basis. When leave is taken in December 20.14
the salary will be debited to leave pay accrual and not expenses, as the employee did not deliver
any services in December 20.14.
It should be noted that in most instances in practice, the leave pay accrual is only adjusted at year
end and not on a monthly basis.
Example 10.
10.4
Vesting short-term accumulated compensated absences
At the beginning of 20.13, Entity X permanently employed one employee, namely Mr Y. Mr Y
received a gross salary of R295 000 per year (cost to company is R350 000), and is entitled to
20 working days’ leave a year. This leave benefit can be carried forward to the next year if not
utilised in the current year, but any untaken leave must be paid out in cash if Mr Y leaves the
employment of the entity. Assume that there are 261 working days in a year and that the company
expects Mr Y to take all leave days due in the following year. All leave payments are therefore
correctly classified as short-term employee benefits.
Since Mr Y’s leave can be carried forward to the next year, it is accumulating in nature. The fact that
it must be paid out when he leaves the employ of Entity X illustrates the fact that the leave vests.
Case 1: Mr Y takes no holiday leave for the year ended 31 December 20.13
Mr Y will receive his full gross salary and the employer contributions will continue during his
absence. The aggregated journal entry to account for this would be the following:
Dr
Cr
R
R
Short-term employee benefit costs (P/L)
Bank (SFP)
Recognise the total salary cost of Mr Y as an expense for the year
350 000
350 000
ƒ Should the company expect Mr Y to utilise his accumulated leave in 20.14.
The fact that Mr Y did not utilise his leave during 20.13, but plans to take it in 20.14, means that an
accrual for leave pay should be created for the leave to be carried forward to the next year
(20.14). Since it is expected that Mr Y will take all his leave, his cost to company amount
(R380 550 – assume a salary increase of 8,7286% for 20.14) should be used to determine the
tariff to accrue leave pay. The journal entry to create the accrual is the following:
Dr
Cr
R
R
Short-term employee benefit costs (P/L)
29 161
Accrual for leave pay (SFP) (380 550/261 × 20)
29 161
Recognise the accrued leave pay of Mr Y for the year
The effect of the second journal entry is that the employee benefit cost of 20.14 would increase, as
Mr Y did not use his annual leave but earned it through service. It is therefore carried forward to
the next year.
Comment
Comment
¾ From an accounting perspective, the additional expense relates to the additional revenue
generated by the fact that Mr Y did not take his leave in 20.13, and therefore worked during the
time when he should have taken leave.
¾ Mr Y’s gross annual salary is based on the assumption that he should only be present at work
for 241 of the 261 working days in a year. The accrued expense increases the employee benefit
cost, as Mr Y was present at work for 261 working days.
¾ When the leave of both the previous year and the current year (or part of it) is taken in a
following year (say 20.14), Mr Y will be present at work for less than 241 working days. The
accrued expense will reverse, as leave is taken, and the employee benefit cost for the year will
be reduced accordingly. The accrued leave pay that would arise during 20.14 will increase the
employee benefit cost in respect of the period of leave not taken by the employee.
continued
256 Descriptive Accounting – Chapter 10
ƒ Should the company expect Mr Y to have all accumulated leave days paid out in cash:
A tariff based on the gross basic salary of Mr Y should be used to measure the leave pay
accrual (unless in rare circumstances the leave conditions specify something else). The journals
should be as follows.
Dr
Cr
R
R
Short-term employee benefit costs (P/L)
350 000
Bank (SFP)
350 000
Recognise the total salary cost of Mr Y as expense for the year
– similar to Case 1.
Short-term employee benefit costs (P/L)
Accrual for leave pay (SFP) (295 000/261 × 20)
Recognise the accrued leave pay of Mr Y for the year – Gross salary
should be used as discussed to calculate the leave pay provision.
22 605
22 605
Case 2: Continue to assume that the salary increase for 20.14 is 8,7286%. 50% of the
accumulated leave for 20.14, as well as the full amount of annual leave accumulated during
20.13, is taken in 20.14.
Assume, in this case, that Mr Y takes his full accumulated leave of 20.13 as well as 50% of his
leave for the current year in the 20.14 financial year. It is company policy to first use the accrued
leave pay from the previous year before utilising the accrued leave pay for the current year (FIFO).
The aggregated journal entry to account for the above is as follows:
Dr
Cr
R
R
Short-term employee benefit costs (P/L)
380 550
Bank (SFP)
380 550
Recognise the gross salary cost of Mr Y as an expense for the year
Assuming the company expects a salary increase of 10% in 20.15 (R418 605 = 380 550 × 1,1),
the closing balance of the accrued leave pay that arose in 20.14 will therefore amount to R16 039
[418 605/261 × 10] at the end of 20.14, and the whole accrued leave pay expense of 20.13 will
reverse.
Dr
Cr
R
R
Accrual for leave pay (SFP)
29 161
Short-term employee benefit costs (P/L)
29 161
Write back leave pay accrual for 20.13 in 20.14
Short-term employee benefit costs (P/L)
[418 605/261 × 20] × 50%
Accrual for leave pay (SFP)
Recognise the remaining accrued leave pay of Mr Y for 20.14
not utilised in the current year (20.14)
16 039
16 039
Comment
¾ The total employee benefit cost for 20.14 would be R367 428 , namely R380 550 – R29 161 +
R16 039
In the case of vesting benefits, the total amount of the benefits should generally be raised as
a liability. The fact that accumulating compensated absences may be non-vesting does not
affect the recognition of the related obligation, but measurement of the obligation should
also take into account the possibility that employees could leave before using an
accumulated non-vesting entitlement.
Employee benefits 257
The above is presented as follows:
Short-term compensated absences
Accumulating short-term
compensated absences
Non-accumulating short-term
compensated absences
Vesting
Non-vesting
Employee not entitled
to cash payment on
leaving the entity
Employee
entitled to cash
payment upon
leaving the entity
Employee not
entitled to cash
payment upon
leaving the entity
Recognise only if
leave will be taken
in current leave
cycle
Raise entire
liability
Raise amount
that will probably
be ‘paid’ if leave
is taken
Since, per definition, the liability amount for accumulating short-term compensated absences
is due for settlement within 12 months after the end of the annual reporting period in which
the services were rendered, it is always classified as a current liability.
Example10
Example10.
10.5
Non-vesting paid annual leave and related liabilities
Strike Ltd has 50 employees, who are each entitled to 10 working days’ non-vesting paid annual
leave for each completed year of service. Unused paid annual leave may be carried forward for
one calendar year. Paid annual leave is first taken out of the previous year’s entitlement, and then
out of the current year’s entitlement (first-in, first-out-basis). At 31 December 20.13, the average
unused entitlement is four days per employee. Based on past experience, the entity expects that
41 employees will take 10 days’ paid annual leave in 20.14, and that the remaining nine
employees will each take an average of 14 days’ paid leave each. Assume the average daily pay
rate per employee to be used in the calculation is R60, and that 10% (i.e. 4) of the 41 employees
will resign during 20.14 before taking their leave.
Depending on the circumstances, the above case will lead to the following liabilities being raised
(see journals) at 31 December 20.13 if FIFO or LIFO principles are applied:
ƒ FIFO: As 90% of the 41 and 100% of the nine employees are expected to utilise (using FIFO)
the four days’ entitlement per employee as at 31 December 20.13, the following leave pay
liability should be raised:
4 days × R60/day × (41 – 4 (10%) + 9) employees = R11 040
Dr
Cr
R
R
Short-term employee benefit costs (P/L)
11 040
Accrued leave pay (SFP)
11 040
Accrual for leave pay using FIFO principles
continued
258 Descriptive Accounting – Chapter 10
ƒ LIFO: If paid annual leave was taken first from the current year’s (20.14) entitlement (LIFO
utilisation), the liability to be raised will be much less, as only employees taking more leave
than the current year’s allocation will give rise to a liability in respect of paid annual leave. The
following leave pay liability would then be raised:
4 days × R60/day × 9 employees = R2 160.
Dr
Cr
R
R
Short-term employee benefit costs (P/L)
2 160
Accrued leave pay (SFP)
2 160
Accrual for leave pay using LIFO principles
ƒ If the unused leave pay can be carried forward indefinitely with a cash payment on resignation
for any unused days (a vesting benefit),the liability raised would be the following:
(41 + 9) × R60/day × 4 days = R12 000.
Dr
Cr
R
R
Short-term employee benefit costs (P/L)
12 000
Accrued leave pay (SFP)
12 000
Accrual for leave pay – vesting benefit
Non-accumulating compensated absences do not carry forward, but lapse if not utilised in
the current year. These benefits do not entitle employees to a cash payment upon leaving the
entity. Common examples of these compensated absences include maternity leave, paternity
leave and compensated absences for military service. An entity recognises no liability or
expense until the time of such absence, as employee service does not increase the amount
of the benefit.
10.3.1.3 Profit-sharing and bonus plans
Although the recognition of the expected cost of profit-sharing and bonus payments is
similar to that associated with other short-term employee benefits, IAS 19.19 introduces two
additional criteria that should be met before recognition may take place, namely:
ƒ the entity should have a present legal or constructive obligation to make such payments
as a result of past events; and
ƒ a reliable estimate of the obligations should be possible.
The difference between a legal and a constructive obligation may be illustrated by using a
bonus payment to illustrate both instances. Should an employee be entitled to a thirteenth
cheque in terms of his contract of employment, this would constitute a legal obligation.
However, should the contract of employment not mention a thirteenth cheque, but the entity has
an established practice of paying thirteenth cheques over several years in the past, the latter
would constitute a constructive obligation. The entity has no realistic alternative but to make
the payment.
A reliable estimate of the expense associated with the legal or constructive obligation under a
profit-sharing or bonus plan can be made, when and only when:
ƒ the formal terms of the plan contain a formula for determining the amount of the benefit;
and
ƒ the entity determines the amounts to be paid before the financial statements are authorised
for issue; or
ƒ past practice gives clear evidence of the amount of the entity’s constructive obligation.
Some profit-sharing plans require employees to remain in the entity’s service for a specified
period in order to receive a share of the profit. Such plans result in a constructive obligation,
as employees render service that increases the amount payable if they remain in service
until the end of the specified period.
Employee benefits 259
If profit-sharing and bonus plans are not wholly payable within twelve months after the
end of the annual reporting period during which the employees render the related service,
the amounts are classified as other long-term employee benefits.
Should profit-sharing and bonus payments meet the definition of ‘share-based payments’ (i.e.
be paid by issuing shares or amounts determined by reference to share prices), they should
be accounted for in terms of IFRS 2 (refer to chapter 18).
Both other long-term employee benefits and equity compensation benefits are discussed in
detail later in this chapter.
Example 10.
10.6
Short-term employee benefits and bonus plans
Shoppers Ltd is a supermarket in Pretoria with a 31 December 20.13 reporting date. The company
currently has 30 staff members of whom 18 are packers/cleaners, 10 are administrative and sales
personnel, and two are managers.
The basic salaries (excluding the bonuses) of the employees are as follows:
Basic salary per employee
Type of work
per year
R
Packers/cleaners
70 000
Administrative and sales personnel
120 000
Managers
220 000
Assume there are no increases expected in 20.14
The packers/cleaners and administrative personnel are each entitled to 20 working days’ paid
holiday leave per year, of which five days may be transferred to the next year. The leave carried
forward is not paid out if the employee leaves or retires. The managers are entitled to 25 working
days’ paid holiday leave per year, with no limit on transferring leave to subsequent years, which is
payable on resignation or retirement. All employees are entitled to 10 working days’ paid sick
leave per year that expires if not taken.
Experience (also i.r.o. 20.13) has indicated that packers/cleaners take, on average, 18 days of
ordinary leave per year; the administrative personnel take 14 days each, while the managers take
17 days each. On average, employees take four days of sick leave per year. Because of work
pressure, employees are expected to use only 60% of leave carried forward. Leave is taken on a
FIFO basis and it is assumed that leave will be taken within twelve months after the end of the
annual reporting period during which the employees rendered the related service.
Bonuses (cash) are paid at the end of December, and are calculated on the number of service
years per employee as follows:
Service years
Benefit
1 to 5 years
100% of monthly basic salary
6 to 10 years
120% of monthly basic salary
More than 10 years
150% of monthly basic salary
The service years of the employees are as follows:
Packers/
Administrative and
Service years
Managers
cleaners
sales personnel
#
1 to 5 years
*5
3
none
6 to 10 years
8
3
none
More than 10 years
5
4
2
18
10
2
* Including two workers who started working on 1 July 20.13, who are entitled to 50% of a year’s
allocation.
#
Including one worker who started working on 1 December 20.13, and is entitled to one twelfth of
a year’s allocation.
continued
260 Descriptive Accounting – Chapter 10
Bonuses are thus paid pro rata if an employee has worked for less than a year. The three
employees who were employed during the current year took their full pro rata leave benefits.
Assume that a calendar year consists of 266 working days.
The short-term employee benefits of Shoppers Ltd for the year ended 31 December 20.13 are
calculated as follows:
Basic salaries
R
Packers/cleaners: (16 × 70 000) + (2 × 70 000 × 6/12)
1 190 000
Administrative staff: (9 × 120 000) + (1 × 120 000 × 1/12)
1 090 000
Managers: (2 × 220 000)
440 000
2 720 000
Cumulative journal for 20.13
Short-term employee benefit costs (P/L)
Bank (SFP)
Payment of salaries and deductios
Bonuses
Packers/cleaners:
Administrative staff:
Managers:
Dr
R
2 720 000
(70 000/12 × 3) + (70 000/12 × 2 × 6/12) +
(70 000/12 × 1,2 × 8) + (70 000/12 × 1,5 × 5)
(120 000/12 × 2) + (120 000/12 × 1/12 × 1) +
(120 000/12 × 1,2 × 3) + (120 000/12 × 1,5 × 4)
(220 000/12 × 1,5 × 2)
Cr
R
2 720 000
123 083
116 833
55 000
294 916
Journal raised at 31 December 20.13
Short-term employee benefit costs (P/L)
Bank (SFP) (paid at the end of Dec)
Payment of bonuses
Dr
R
294 916
Cr
R
294 916
R
Leave (compensated absences)
Packers/cleaners:
(70 000/266 × 2* × 16) × 60%
Administrative staff: (120 000/266 × 5# × 9) × 60%
Managers:
(220 000/266 × 8$ × 2)
5 053
12 180
13 233
30 466
Journal raised at 31 December 20.13
Short-term employee benefit costs (P/L)
Leave pay accrual (SFP)
Accrual for leave pay
Dr
R
30 466
Cr
R
30 466
* (20 – 18)
#
(20 – 14), but limited to 5
$
(25 – 17), but not limited
Comment
¾ Note that the managers’ leave pay accrual is based on their basic salary – this supports the
assumption that it will be paid out in total. However, if it is anticipated that only 50% will be paid
out and the rest will be taken as days absent, the calculation will be based partly on basic
salary and partly on basic salary plus employer’s contribution (refer to section 10.3.1.2).
Employee benefits 261
10.3.2 Disclosure
IAS 19.25 does not require specific disclosures in respect of short-term employee benefits.
However, other Standards, for example IAS 1, do require the following specific disclosures:
ƒ IAS 1.104 requires the total amount of employee benefit expense to be disclosed either
on the face of the profit or loss section of the statement of profit or loss and other
comprehensive income, or in the notes to the financial statements. Presumably all shortterm employee benefits will form part of the aggregate amount for employee benefit
expense.
ƒ IAS 24 Related Party Disclosures requires the disclosure of employee benefits for key
management personnel.
10.4 Post-employment benefits
Post-employment benefits are employee benefits that are payable after the completion of
employment. These benefits can take many forms, but can broadly be classified into two
main categories, namely:
ƒ retirement benefits, for example pensions and payments from provident funds; and
ƒ other post-employment benefits, for example post-employment life insurance and
medical care.
10.4.1 Types of post-employment benefit plans
There are two categories of post-employment benefit plan alternatives that employers may
use, namely:
ƒ defined contribution plans (e.g. provident plans); and
ƒ defined benefit plans (e.g. pension plans).
The Pension Funds Act 24 of 1956 (as amended) (the Pension Funds Act), which regulates
most of these plans, provides for minimum funding requirements for these plans, and
prescribes the valuation methods and the frequency of valuation. Defined contribution plans
are discussed below, while defined benefit plans are discussed in section 10.4.3.
10.4.2 Defined contribution plans
10.4.2.1 Background
Defined contribution plans are post-employment benefit plans under which amounts to be
paid to employees as retirement benefits are determined by reference to cumulative total
contributions to a fund (by both employer and employee) together with investment earnings
thereon. The liability (legal or constructive obligation) of the employer is limited to the agreed
amount (contributions) to be paid to the separate fund (funded plan) to provide for the
payment of post-employment benefits to employees. Most provident funds fall into this category.
A record is maintained by the fund of the contributions (by employee and employer) each
member makes to the fund, as well as the investment earnings thereon. The ultimate
benefits payable to the members will not exceed the contributions made by and on behalf of
the members and the investment earnings generated by these contributions.
10.4.2.2 Risk
In view of the above, the risk that benefits will be less than expected (actuarial risk) and the
risk that the assets invested in will be insufficient to meet expected benefits (investment risk)
fall on the employee.
10.4.2.3 Premiums on an insurance policy
Note that where premiums on an insurance policy are paid to fund a post-employment
benefit obligation, such a plan will generally represent a defined contribution plan (refer to
IAS 19.46).
262 Descriptive Accounting – Chapter 10
Contributions to an insurance policy in the name of a specific employee or group of
employees, in accordance with which the insurer has to pay certain benefits to employees,
also represent defined contributions. If, in rare circumstances, the employer retains an
additional legal or constructive obligation, such a plan shall be treated as a defined benefit
plan (see section 10.4.3. below).
10.4.3 Defined benefit plans
10.4.3.1 Background
Defined benefit plans are post-employment benefit plans under which amounts to be paid as
retirement benefits to current and retired employees are determined using a formula usually
based on employees’ remuneration and/or years of service. This implies that a benefit that is
to be paid to an employee is determined before the employee retires – the employer promises
a benefit based on a formula. For instance, a pension (defined benefit plan) is promised to
an employee based on the employee’s future salary at retirement date, as well as the
number of years in the employment of the employer. Another example is the promise to pay
medical aid contributions on behalf of the employee after retirement.
An entity should account for both its legal obligation under the formal terms of a defined
benefit plan, and its constructive obligation resulting from its past practices.
The obligation of the entity is to provide agreed benefits to its current and former
employees once they retire. Given the number of variables impacting on the final or average
remuneration of an employee – inflation, salary increases, working life, promotions, timing of
promotions, etc. – it is obvious that it will prove quite difficult to determine such an
obligation.
To finance and fund the benefits agreed upon, the entity uses assets set aside for this
purpose from contributions by the employer and employees, plus the investment returns on
those accumulated contributions (in aggregate called plan assets). These plan assets do
not stand to the ‘credit’ of any specific member of the plan (unlike defined contribution
plans), and the benefits that a member receives are also not related to these contributions.
Pension funds generally fall into this category.
10.4.3.2 Components of a defined benefit plan
As can be seen from the above discussion, a defined benefit plan comprises:
ƒ a defined benefit obligation (promised benefit owing); and
ƒ plan assets (assets used to service or fund the above obligation).
Note that the fair value of the plan assets theoretically represents the present value of the
expected future benefits from these assets. By contrast, the obligation to pay benefits in the
future represents a future obligation. To ensure that these two amounts are comparable, the
future obligation is discounted to present value.
This present value of the obligation arising from the future expected retirement benefits is
determined actuarially on a periodic basis. Actuarial valuations are also used to determine
future contribution levels. Any actuarial variances are accounted for in other comprehensive
income.
10.4.3.3 Risk
Both the risk that benefits will cost more than expected (actuarial risk) and the risk that assets
invested will be insufficient to meet expected benefits (investment risk) fall on the employer.
This is the opposite of a defined contribution plan (refer to section 10.4.2.2 above).
10.4.4 Classification of post-employment benefit plans
In practice, the classification of post-employment benefit plans can be difficult. For example,
the plan may prescribe the extent of contributions on which retirement benefits are based,
while the entity may still be liable for a minimum level of retirement benefits. Such a
Employee benefits 263
retirement benefit plan has characteristics of both a defined contribution plan and a defined
benefit plan. The deciding factor for classification as a defined contribution plan is that the
employer only has an obligation to make a contribution to the plan, while, in the case of a
defined benefit plan, the employer has an obligation to provide a certain benefit to the
pensioner.
In IAS 19.32 to .45, the distinction between defined contribution plans and defined benefit
plans (in the context of multi-employer plans, state plans and insured benefits) is discussed
at some length.
Classification should be effected using the principle of substance over form. The
substance of the retirement plan is established by reference to the main terms and
contingents. In the main, it is necessary to determine whether the entity has an obligation in
terms of formal or informal arrangements to provide retirement benefits. Should an
obligation exist, the plan is classified as a defined benefit plan. If the obligation of the entity
is limited to specified contributions to the plan, it is a defined contribution plan.
10.4.5 Accounting for post-employment benefit plans
10.4.5.1 Defined contribution plans
Accounting for defined contribution plans is straight forward, as the obligation of
reporting entity for each period is determined by the amounts to be contributed for
period. No actuarial valuation of the obligation or the associated expense is necessary,
the obligations are accounted for on an undiscounted basis, unless they do not fall
within twelve months after the end of the annual reporting period during which
employees render the service involved.
the
that
and
due
the
Recognition and measurement
Should an employee have rendered a service to an entity during a specific period, the entity
should recognise the contribution payable to the defined contribution fund in exchange for
the service as follows:
A liability (accrued expense) should be raised after deducting any contribution already paid,
and at the same time a corresponding expense should be raised. Note that the expense will
only represent the employer’s contribution to the defined contribution plan. Under certain
circumstances, the expense could be capitalised to the cost of an asset, provided this is
permitted or required in terms of another accounting standard. Note that, should the
contribution paid exceed the contribution due for services rendered at the reporting date,
the excess should be recognised as a pre-paid expense. Normal accrual accounting is
therefore applied.
Should contributions to a defined contribution plan not fall due wholly within twelve months
after the end of the annual reporting period during which the service was rendered, the
contributions should be discounted to present value using the discount rate discussed later
on in this chapter (refer to IAS 19.83).
Disclosure
ƒ An entity shall disclose the amount recognised as an expense for defined contribution
plans in the note on profit before tax.
ƒ Where required in terms of IAS 24 Related Party Disclosures an entity discloses
information on contributions to defined contribution plans made for key management
personnel.
264 Descriptive Accounting – Chapter 10
Example 10.
10.7
Defined contribution plans
Bledo Ltd paid the following in respect of staff costs during the year ended 31 December 20.13:
R
Salaries (gross)
11 000 000
Wages (gross)
9 000 000
Contributions to defined contribution plan paid over
2 500 000
The rules of the defined contribution plan determine the following in respect of contributions:
Contribution by employer
= 10% of total remuneration paid to employees.
Contribution by employee* = 9% of total remuneration paid to employees.
* The employer and employee usually make the same contribution, but this may not necessarily
be the case in practice.
The disclosure resulting from the above will be as follows:
2
Profit before tax
R
22 000 000
Employee benefit expense:
Short-term employee benefit costs: Salaries and wages#
Defined contribution plan expense
20 000 000
*2 000 000
#
The employee’s contribution forms part of the gross salary expense, as it is paid over by the
employer on behalf of the employee.
* R(11 000 000 + 9 000 000) × 10% = R2 000 000.
Journal entries
1 January to 31 December 20.13
Short-term employee benefit costs (P/L)
Bank (SFP) (net of deduction for employee contributions at 9%)
Accrued expenses – contributions to plan (SFP)
Accrued contribution of the employees
Dr
R
20 000 000
18 200 000
1 800 000
Defined contribution plan expense (P/L) (employer)
Accrued expenses – contributions to plan (SFP)
Accrued contribution of the employer
2 000 000
Accrued expenses (SFP)
Bank (SFP)
Contributions paid over to the plan during the year
2 500 000
10 January 20.14
Accrued expenses (SFP)#
Bank (SFP)
Balance of the accrued contributions paid over to the plan
Cr
R
2 000 000
2 500 000
1 300 000
1 300 000
# Note that of the total amount of R1 300 000 paid over to the fund on 10 January 20.14, is
calculated as follows: 1 800 000 + 2 000 000 – 2 500 000 = R1 300 000. This amount would be
reflected as a liability in the statement of financial position at 31 December 20.13.
10.4.5.2 Defined benefit plans
Recognition, measurement and disclosure
The recognition, measurement and disclosure of defined benefit plans are not covered in
this text book. Refer to IAS 19 for further detail.
Employee benefits 265
10.4.5.3 Tax implications of post-employment benefit plans
An employer may, in terms of section 11(l) of the Income Tax Act (as amended), deduct
contributions made for the benefit of employees to pension, provident and benefit funds,
subject to the following provisos:
ƒ If the contribution is a lump-sum payment, the South African Revenue Services (SARS)
may allow the deduction in annual instalments in the proportion he deems acceptable.
ƒ If the contributions (including any lump sum) per employee exceed 10% of the approved
remuneration (for remuneration SARS considers to be fair and reasonable in relation to
the value of the employee’s services), SARS may disallow the excess above the 10%
mentioned earlier. Any disallowed excess will fall away, but the SARS must allow at least
10% of the approved remuneration and has the discretion to allow more than 10%.
In practice, SARS allows the employer a deduction of up to 20% of the approved
remuneration of the employee.
Section 11(l) of the Income Tax Act does not cover an employer’s contributions to a
retirement annuity fund on behalf of his employees, but will enable an employer to
determine the amounts deductible in future (tax base) for a defined benefit plan, provided
certain significant assumptions are made.
In terms of section 11(m) of the Income Tax Act, annuities paid to former employees,
dependants of former employees and former partners on retirement may be deducted for tax
purposes, subject to certain provisos and limits.
Generally speaking, an employer who pays a termination lump sum (a lump sum at
retirement) to a retiring employee will be allowed a tax deduction if all requirements of
section 11(a) of the Income Tax Act are met.
Great care should be exercised when making such termination lump-sum payments, as the
reason for the payment may affect the deductibility thereof. In short, three possible
situations exist in respect of termination lump sums:
ƒ If the lump sum is paid in terms of a service contract, it will be allowed as a deduction.
ƒ If the lump sum paid acts as an incentive for current staff, it will probably be allowed as a
deduction, following the principles laid down in Provider v COT 1950 (4) SA 289 (SR).
ƒ If the lump sum is paid in respect of past services (where the two situations mentioned
above are not applicable), the amount will not be allowed as a deduction, following the
principles expounded in WF Johnstone & Co Ltd v CIR 1951 (2) SA 283 (AD).
Defined contribution plans will generally not have deferred tax implications for the employer.
However, if certain amounts are not allowed as a tax deduction, but are allowed for
accounting purposes, non-deductible expenses may arise.
10.5 Other long-term employee benefits (IAS 19.153 to .158)
Other long-term employee benefits (other than post-employment benefits and termination
benefits) are employee benefits that are expected not to be settled wholly within twelve
months after the end of the annual reporting period during which the employees render the
related service. Post-employment benefits, termination benefits and equity compensation
benefits are excluded.
Examples of other long-term employee benefits are the following:
ƒ long-term compensated absences, for example long-service or sabbatical leave;
ƒ jubilee or other long-service benefits;
ƒ long-term disability benefits;
ƒ profit-sharing and bonuses; and
ƒ deferred compensation.
266 Descriptive Accounting – Chapter 10
Due to the nature of other long-term employee benefits, measurement of these benefits is not
usually subject to the same degree of uncertainty as the measurement of post-employment
benefits. For these reasons, IAS 19 requires a simplified method of accounting for other
long-term employee benefits.
10.5.1 Recognition, measurement and disclosure
The recognition, measurement and disclosure of other long-term employee benefits are not
covered in this text book. Refer to IAS 19 for further detail.
10.6 Termination benefits (IAS 19.159 to .171)
Termination benefits are employee benefits payable as a result of either:
ƒ an entity’s decision to terminate an employee’s or group of employees’ employment
before normal retirement age; or
ƒ an employee’s decision to accept voluntary redundancy in exchange for those benefits.
Payments (or other benefits) made to employees when their employment is terminated may
result from legislation, contractual or other agreements with employees or their representatives,
or a constructive obligation based on past business practice, custom or a desire to act
equitably. Such termination benefits are typically lump-sum payments, but sometimes also
include:
ƒ enhancements of retirement benefits or other post-employment benefits, either directly or
indirectly through an employee benefit plan; and
ƒ salaries until the end of a specified notice period, if the employees render no further
service that provides economic benefits to the entity.
Benefits paid (or other benefits provided) to employees, regardless of the reason for the
employee’s departure, are not termination benefits. These benefits are post-employment
benefits, and, although payment of such benefits is certain, the timing of their payment is
uncertain.
IAS 19 deals with termination benefits separately from other employee benefits, as the event
which gives rise to an obligation here is the termination, rather than employee service.
10.6.1 Recognition
An entity shall, in terms of IAS 19.165, recognise termination benefits as a liability and a
corresponding expense at the earlier of the following dates:
ƒ when the entity can no longer withdraw the offer of those benefits; or
ƒ when the entity recognises costs for a restructuring that is within the scope of IAS 37
Provisions, Contingent Liabilities and Contingent Assets and involves the payment of
termination benefits.
An entity can no longer withdraw an offer for termination benefits at the earlier of the date on
which the employees accept the offer, or when a restriction (legal, regulatory or contractual)
on the entity’s ability to withdraw the offer takes effect. If an entity decides to terminate
employees’ employment, the entity can no longer withdraw its offer for termination benefits
when the entity has communicated its termination plan to all affected employees. This
termination plan must meet the following criteria:
ƒ the actions required to complete the plan must indicate that it is unlikely that significant
changes to the plan will be made;
ƒ the plan must indicate the following:
– the number of employees whose services are to be terminated;
– their job classifications or functions; and
– their locations (each individual affected does not need to be identified in the plan);
Employee benefits 267
ƒ the time at which the plan will be implemented; and
ƒ the termination benefits that employees will receive in sufficient detail that employees are
able to determine the type and amount of benefits they will receive when the
employment is terminated.
Due to the nature and origin of termination benefits, an entity may have to account for a plan
amendment or curtailment of other employee benefits at the same time.
10.6.2 Measurement
Termination benefits are measured on initial recognition and if they are expected to be
wholly settled within twelve months after the end of the annual reporting period in which they
are recognised, the requirements for short-term employee benefits must be applied. If the
benefit is expected not to be settled wholly within twelve months after the end of the annual
reporting period in which it is recognised, the requirements for other long-term employee
benefits must be applied.
In the case of an offer made to encourage voluntary redundancy, the measurement of
termination benefits shall be based on the number of employees expected to accept the
offer. Where there is uncertainty about the number of employees who will accept an offer of
termination benefits, a contingent liability exists.
10.6.3 Disclosure
ƒ No specific disclosure is required by IAS 19 itself, although the requirements of certain
other Standards may be applicable.
ƒ A contingency exists where there is uncertainty about the number of employees who will
accept an offer of termination benefits. As required by IAS 37 Provisions, Contingent
Liabilities and Contingent Assets, an entity discloses information about the contingency
unless the possibility of a loss is remote.
ƒ Termination benefits may result in an expense requiring disclosure as a separately
disclosable item in terms of IAS 1.86. This will be the case where the size, nature or
incidence of an expense is such that its disclosure is relevant to an explanation of the
performance of the entity for the period.
ƒ Where required by IAS 24 Related Party Disclosures, an entity discloses information
about termination benefits for key management personnel.
10.6.4 Tax implications
Termination benefits are deductible as expenses for accounting purposes, and it is probable
that SARS will be prepared to allow such payments for tax purposes, provided that the
retrenchment package complies with labour law/legislation. The fact that these expenses
may sometimes not be deductible for tax purposes arises, as it may be doubtful whether
such payments are incurred in the production of income.
It is useful to clarify the retrenchment packages with SARS beforehand. SARS will also
allow a deduction if benefits are paid in terms of a service contract, as such payments will
fall under section 11(a) of the Income Tax Act.
268 Descriptive Accounting – Chapter 10
Example 10.
10.8
Tax implications of termination benefits
Termo Ltd decided in December 20.13 to restructure its workforce (which was immediately
communicated) in such a way that all employees of the age of 55, but below the age of 60 at the
reporting date, could retire immediately should they choose to do so. Employees of 60 years and
older, up to the age of 65 at the statement of financial position date, will be forced to retire
immediately, but will receive the post-employment benefits they would have been entitled to had
they retired at the age of 65. A directive on the matter was obtained from SARS beforehand, and
amounts will therefore be allowed for tax purposes. Assume a tax rate of 28%. Payment of any
benefits associated with early or voluntary retirement will take place one week after the statement
of financial position date (end of the reporting period). The following information relates:
Employees between 55 years and 59 years and 364 days:
Total number of employees in age bracket
Average payment per employee to encourage retirement
Percentage of employees expected to take advantage of the offer
40
R20 000
60%
Employees with ages between 60 and 64 years and 364 days:
Total number of employees
Additional contribution to defined contribution fund made on 7 January 20.14 to ensure
promised post-employment benefits as at 65 years of age
20
R600 000
Journal entries
Dr
R
31 December 20.13
Termination benefits (P/L) (60% × 40 × R20 000)
Accrued termination benefits (SFP)
Accrual for expected number of employees taking voluntary packages
480 000
480 000
Termination benefits (P/L)
Defined contribution plan obligation(SFP)
Additional obligation in respect of defined contribution plan to account
for promised benefits
600 000
Deferred tax (SFP)
Income tax expense (P/L)
Provision for deferred tax at 28% of R1 080 000
302 400
600 000
302 400
Payment takes place on 7 January 20.14, and only 50% of the targeted employees
(between 55 years and 59 years and 364 days) decided to take voluntary retirement.
Dr
R
7 January 20.14
Accrued termination benefits (SFP)
480 000
Bank (40 × 50% × R20 000)
Termination benefits overprovided (P/L)
Payment of voluntary redundancy packages
Defined contribution plan obligation (SFP)
Bank (SFP)
Payment of additional contributions to defined contribution fund
Cr
R
Cr
R
400 000
80 000
600 000
600 000
continued
Employee benefits 269
Disclosure at 31 December 20.13
The Standard does not require any specific disclosures, but if it is assumed that the total amount
paid/accrued in respect of termination benefits is material, classification and disclosure as a
separately disclosable item is necessary (provide nature and amount).
Profit before tax
Employee benefit cost
ƒ Termination benefits
10.7 Equity compensation benefits
This matter is dealt with under IFRS 2, in chapter 18.
R
1 080 000
CHAPTER
11
The effects of changes in foreign
exchange rates
(IAS 21)
Content
11.1
11.2
11.3
11.4
11.5
11.6
11.7
11.8
Overview of IAS 21 The Effects of Changes in Foreign Exchange Rates.........
Background .......................................................................................................
Exchange rate ...................................................................................................
Accounting implications .....................................................................................
11.4.1
Presentation currency .......................................................................
11.4.2
Functional currency ...........................................................................
Reporting foreign currency transactions in functional currency.........................
11.5.1
Monetary and non-monetary items ...................................................
11.5.2
Uncovered transactions ....................................................................
11.5.3
Tax implications of foreign currency transactions .............................
Translation of financial statements into presentation currency .........................
Foreign operations ............................................................................................
11.7.1
Translation of a foreign operation for inclusion in the financial
statements of the reporting entity ......................................................
11.7.2
Intragroup monetary items ................................................................
11.7.3
Non-coterminous financial periods ....................................................
11.7.4
Revaluation of assets ........................................................................
11.7.5
Goodwill.............................................................................................
11.7.6
Foreign exchange differences on a net investment in a foreign
operation ...........................................................................................
11.7.7
Disposal or partial disposal of a foreign operation ............................
Disclosure ..........................................................................................................
271
272
272
272
273
274
274
275
275
276
282
283
283
283
285
286
286
287
290
293
296
272 Descriptive Accounting – Chapter 11
11.1 Overview of IAS 21 The Effects of Changes in Foreign Exchange
Rates
Foreign exchange activities
Foreign currency transactions
(IAS 21.20 to .34)
Translation of financial statements and
foreign operations
(IAS 21.38 to .49)
Hedging of foreign
currency transactions
(IFRS 9.6.1 to .6.6)
Hedge of a net investment in a
foreign operation
(IFRS 9.6.5.13 to .6.5.14 and IFRIC 16)
11.2 Background
The volatility in foreign currency exchange movements is a fairly general phenomenon in the
world economy. Changes in the value of currencies have specific accounting implications,
which are addressed in IAS 21 The Effects of Changes in Foreign Exchange Rates, and
other accounting standards. IAS 21 provides guidance on the translation of transactions in
foreign currencies and the presenting of financial statements in a foreign currency.
In South Africa, the South African Reserve Bank controls all foreign transactions. The
movement of foreign exchange to and from the country is subject to the regulations issued
periodically by the Reserve Bank.
11.3 Exchange rate
In terms of IAS 21.8, the functional currency is the currency of the primary economic
environment in which the entity operates. A foreign currency is a currency other than the
functional currency of the entity. The exchange rate is the ratio at which the currencies of
two countries are exchanged. This rate is quoted by commercial banks and can be one of
several rates, depending on the nature of the foreign currency transaction. For example, if
foreign currency is required to pay for an import, the foreign currency must be bought from a
bank. In these circumstances, the bank acts as the seller of foreign currency and therefore
the selling rate will be quoted. By contrast, if goods are exported and foreign currency is
received for the export, the bank acts as the buyer of foreign currency and the appropriate
rate of exchange quoted by the bank will be the buying rate.
The spot exchange rate is the exchange rate for immediate delivery of currencies to be
exchanged at a particular time. The closing rate is the spot exchange rate at the end of the
reporting period. (IAS 21.8) The forward rate is the exchange rate for the exchange of two
currencies at a future agreed date.
A hedge against unfavourable exchange rate fluctuations can be obtained by, inter alia,
concluding an agreement, called a forward exchange contract, with a bank, in which the
bank undertakes to supply the foreign exchange at a predetermined rate when the currency
is required. This rate is the forward rate, which is calculated by reference to the spot
exchange rate ruling at the time the forward exchange contract is entered into and the
interest rate differential existing between the two countries whose currencies are being
exchanged. The currency of the country having a lower interest rate will trade at a premium
while the currency of the country having a higher interest rate will trade at a discount. The
forward rate is therefore quoted as a premium or a discount to the spot exchange rate. For
example, if the USA dollar is quoted at a premium to the rand, it implies that the dollar is
more highly regarded by investors than the rand.
The effects of changes in foreign exchange rates 273
Example 11.1
Calculating the forward rate
Importer Ltd has an obligation to pay a USA debt after two months. The spot exchange rate is
US$1 = R7,00. The forward rate for two months is quoted at a premium of 60 points per month.
The forward rate is calculated as follows:
R
Spot exchange rate:
7,000
Add: Premium (two months) (60 points per month) (2 × 0,0060)
0,012
Forward rate
7,012
It is therefore determined that the exchange in two months’ time will take place at a rate of
US$1 = R7,012, regardless of the actual spot exchange rate at the end of two months. As a result,
both the risk of unfavourable exchange fluctuations and the possible benefit of favourable
exchange fluctuations have been eliminated for the entity.
Example 11.2
Calculating the forward rate
Assume that a local manufacturer needs US$500 000 in six months’ time to pay a USA debt. The
manufacturer wishes to protect itself against unfavourable exchange rate fluctuations, and
therefore requests a foreign exchange dealer to quote a forward rate for six months. The spot
exchange rate on the date of the request is US$1 = R7,00.
The foreign exchange dealer, who trades daily on foreign exchange markets, assesses (in terms
of the interest parity theory) the interest rate in the USA, with a view to finding the amount that
should be invested immediately in order to render, together with interest, US$500 000 in six
months’ time.
If the interest rate in the USA is 7,5% per annum, it can be calculated that US$481 928 at 7,5%
per annum will render US$500 000 after six months. When converted at the spot exchange rate of
US$1 = R7,00, US$481 928 × 7 = R3 373 496 is therefore required. If the South African interest
rate is 13% per annum, it means that (R3 373 496 × 13/100 × ½) + R3 373 496 = R3 592 773 will
be payable by the manufacturer after six months. The forward rate that will be quoted by the
foreign exchange dealer will be US$1 = R7,1855 (3 592 773/500 000).
Exchange rates can be quoted directly or indirectly. With the direct method the exchange
rate shows how much of the local currency has to be exchanged for one unit of the foreign
currency. For example, if one has to pay R12,50 to obtain one US dollar, the direct quotation
is $1 = R12,50. With the indirect method the exchange rate is expressed as the amount of
foreign currency that is required to purchase one unit of the domestic currency. In this
example the indirect quotation is thus R1 = $0,080.
11.4 Accounting implications
An entity can enter into foreign denominated activities in one of two ways:
ƒ By entering into foreign currency transactions directly. (In such a case, the foreign
currency transactions need to be converted to the functional currency of the entity); or
ƒ by conducting its foreign activities through a foreign operation, for example a subsidiary,
associate, joint arrangement or branch of the reporting entity. (In such a case, the foreign
operation will keep accounting records in its own functional currency, which, if different
from the presentation currency of the reporting entity, must be translated to the
presentation currency of the reporting entity.)
IAS 21 addresses the abovementioned situations, namely conversion of foreign currency
transactions to an entity’s functional currency and translation of the financial statements of a
foreign operation of an entity to the presentation currency of the reporting entity.
274 Descriptive Accounting – Chapter 11
IAS 21 does not address the hedging of foreign currency transactions or the hedge of a net
investment in a foreign operation. These situations are addressed in IFRS 9, Financial
Instruments, and are dealt with in chapter 20.
SIC 7, Introduction of the Euro, addresses the introduction of the euro (̀ሻ and the change
from the use of national currencies by participating member states of the European Union,
and therefore does not apply to most South African companies.
11.4.1 Presentation currency
An entity’s presentation currency is the currency in which the financial statements are
presented (IAS 21.8). An entity may present its financial statements in any currency or
currencies (presentation currency) (IAS 21.19). For example, a South African company with
a primary listing on the JSE Limited and a secondary listing on the New York Stock
Exchange may present its financial statements in South African rand and USA dollar.
11.4.2 Functional currency
Functional currency is defined as the currency of the primary economic environment in
which an entity operates (IAS 21.8). An entity does not have a free choice of functional
currency, meaning that an entity has to determine its functional currency by applying the
principles in IAS 21.9 to .13.
IAS 21.9 lists primary indicators, while IAS 21.10 and .11 list secondary indicators that must
be considered in determining an entity’s functional currency. The primary indicators are
linked to the primary economic environment of the entity, while the secondary indicators
provide additional supporting evidence to determine an entity’s functional currency
(IAS 21.BC9). If it is evident from the primary indicators what an entity’s functional currency
is, there is no need to consider the secondary factors.
The primary economic environment in which an entity operates is normally the one in which
it primarily generates and expends cash. The following primary factors are considered when
determining the functional currency of an entity (IAS 21.9):
ƒ the currency that mainly influences sales prices for goods or services (normally the
currency in which the sales price for goods or services is denominated and settled);
ƒ the currency of the country whose competitive forces and regulations mainly determine
the sales price of its goods and services; and
ƒ the currency that mainly influences labour, material and other costs of providing goods or
services (normally the currency in which such costs are denominated and settled).
The following secondary factors may also provide evidence of an entity’s functional currency
(IAS 21.10):
ƒ the currency in which funds from financing activities, such as issuing debt and equity
instruments, are generated; and
ƒ the currency in which receipts from operating activities are usually retained.
In certain instances, determining the functional currency of an entity may be straightforward,
while in other instances judgement may be required to determine the functional currency
that most faithfully represents the economic effects of the underlying transactions, events
and conditions (IAS 21.12).
For example, a gold mining company will recognise all its sales in USA dollar, as gold is
denominated in international trade in USA dollar. The competitive forces of a single country
will also not necessarily influence the sales price of gold. If this company is in South Africa,
a significant part of its labour cost will be rand-based. Therefore, based on the primary
indicators alone it might be difficult to determine the functional currency. One will then also
need to consider the secondary indicators, for example whether the gold mining company
uses foreign financing and in which country its bank accounts are.
The effects of changes in foreign exchange rates 275
In a group context, IAS 21.17 determines that each entity in the group will determine its own
functional currency, based on the indicators in IAS 21.9 to .14 and considering the facts and
circumstances that are relevant to that individual entity. This process may result in an entity
in the group having a different functional currency to the reporting entity, or a functional
currency that is the same as that of the reporting entity. As a result, IAS 21 defines a foreign
operation as an entity that is a subsidiary, associate, joint arrangement or branch of a
reporting entity, the activities of which are based or conducted in a country or currency other
than those of the reporting entity.
In addition to the primary and secondary indicators discussed above, IAS 21.11 lists further
secondary indicators that must be considered in determining the functional currency of a
foreign operation, namely:
ƒ whether the activities of the foreign operation are carried out as an extension of the
reporting entity, rather than being carried out with a significant degree of autonomy;
ƒ whether transactions with the reporting entity are a high or low proportion of the foreign
operation’s activities;
ƒ whether cash flows from activities of the foreign operation directly affect the cash flows of
the reporting entity and are readily available for remittance to it; and
ƒ whether cash flows from the activities of the foreign operation are sufficient to service
existing and normally expected debt obligations without funds being made available by
the reporting entity.
Where a foreign operation carries on business as if it were an extension of the reporting
entity’s operations, the functional currency of the foreign operation will always be the same
as that of the reporting entity, as it will be contradictory in such a case if the two entities
were to operate in different primary economic environments (IAS 21.BC6).
It follows that it is not necessary to translate the results and financial position of a foreign
operation that has the same functional currency as the parent, as the transactions will
already be measured in the parent’s functional currency.
Once an entity has determined its functional currency, it is not changed unless there is a
change in the primary economic environment in which the entity operates its business
(IAS 21.13).
11.5 Reporting foreign currency transactions in functional currency
11.5.1 Monetary and non-monetary items
Monetary and non-monetary items must be clearly distinguished. A monetary item is defined
as units of currency held and assets and liabilities to be received or paid in a fixed or
determinable number of units of currency. The essential feature being a right to receive (or
an obligation to deliver) a fixed or determinable number of units of currency, All other assets
and liabilities are non-monetary items. The essential feauture in this case is the absence of
a right to receive (or an obligation to deliver) a fixed or determinable number of units of
currency.
The following are examples of monetary and non-monetary items (IAS 21.16):
Monetary items
ƒ Pensions and other employee benefits to be
paid in cash
ƒ Provisions that are to be settled in cash
ƒ Lease liabilities
ƒ Cash dividends that are recognised as a liability
ƒ A contract to receive (or deliver) a variable
number of the entity’s own equity instruments in
which the fair value to be received (or delivered)
equals a fixed number of units of currency
Non-monetary items
ƒ Amounts prepaid for goods or services
ƒ Goodwill
ƒ Intangible assets
ƒ Inventories
ƒ Property, plant and equipment
ƒ Right-of-use assets
ƒ Provisions that are to be settled by the
delivery of a non-monetary asset
276 Descriptive Accounting – Chapter 11
11.5.2 Uncovered transactions
A foreign currency transaction is a transaction that has been concluded or has to be settled
in a foreign currency. Examples of unhedged foreign currency transactions include the
following (IAS 21.20):
ƒ buying and selling of goods and services in a foreign currency;
ƒ borrowing and lending of funds in a foreign currency; and
ƒ the acquisition and disposal of assets and the incurring and settling of liabilities in a
foreign currency.
Uncovered foreign currency transactions are recorded on initial recognition in the functional
currency using the spot exchange rate ruling at the transaction date.
Two questions arise from the above:
ƒ which exchange rate must be used; and
ƒ what is the transaction date?
11.5.2.1 The exchange rate
Where foreign debt must be paid, currency must be purchased to repay such debt and the
selling rate of the bank applies. By contrast, where foreign currency will be collected, it must
be sold for South African currency and the buyer’s rate of the bank applies. The appropriate
exchange rate for accounting for such transactions must thus be determined from the
perspective of the bank. For practical reasons an average rate is usually applied. The spot
exchange rate is the rate specified at close of business on the transaction date and is
normally used. The closing rate is the spot exchange rate at close of business on the last
day of the financial year.
11.5.2.2 Transaction date
The date of the transaction is the date on which the transaction first qualifies for recognition
in terms of the accounting standards (IAS 21.22).
Where goods are delivered free on board (FOB) from the port of departure, the significant
risks and rewards associated with ownership are transferred to the buyer on delivery to the
port of departure. The purchaser pays for the shipping costs and insurance as well as the
price of the purchased items calculated according to the FOB price. If goods are dispatched
on a cost, insurance, freight (CIF) basis, the risks and rewards associated with ownership
still pass at the port of departure, but the seller arranges for the shipping of the items
involved. Although the terminology used differs, the risks and rewards associated with
ownership are transferred at point of shipment for both FOB and CIF sales. Should other
shipping terms be used, the transaction date may differ from the date of shipment. However,
the transaction date will still be the date on which the risks and rewards of ownership are
transferred to the purchaser.
From a practical viewpoint, an approximate rate for a specific date or an average rate for a
week, month or even a longer period may be used as a substitute for the actual rate, as long
as the exchange rate does not fluctuate significantly (IAS 21.22).
Once a non-monetary item has been recorded at a particular amount, the amount will not
subsequently change due to currency fluctuations, unless the non-monetary item is one that
is measured at fair value in terms of IFRS 13, Fair Value Measurement, after the date of
acquisition (IAS 21.23(c)). Then the date of valuation becomes the new transaction date.
If a foreign non-monetary item must be written down to net realisable value in terms of IAS 2
Inventories, or recoverable amount in terms of IAS 36 Impairment of Assets, the carrying
amount is determined by comparing:
ƒ the cost or carrying amount translated at the spot exchange rate on the transaction or
valuation date; and
ƒ the net realisable or recoverable amount translated at the spot exchange rate on the
reporting date when the value was determined (IAS 21.25).
The effects of changes in foreign exchange rates 277
The difference between the amounts is written-off in the functional currency. The effect of
this comparison may be that an impairment loss is recognised in the functional currency but
would not be recognised in the foreign currency, or vice versa.
Example
Example 11.3
Impairment of non-monetary foreign currency asset
On 15 June 20.13, a company acquired inventory for US$1 000. On that date, the exchange rate
was US$1 = R12,48. On 31 December 20.13, none of the inventory was sold but the net realisable
value was US$960.
On 31 December 20.13, the exchange rate was US$1 = R13,00.
The write-down to net realisable value is calculated as follows:
R
Net realisable value (US$960 × 13,00)
12 480
Carrying amount (US$1 000 × 12,48)
(12 480)
Write-down to realisable value
–
Therefore, even though a write-down to net realisable value of US$40 (US$1 000 – US$960)
exists in the foreign currency, such a write-down is not recognised in the functional currency as a
result of the impact of the foreign exchange rate.
11.5.2.3 Exchange rate differences
Where a foreign monetary item has not been paid at the reporting date, it will be converted
at the closing rate ruling on that date, and any differences are taken to the profit or loss
section of the statement of profit or loss and other comprehensive income (IAS 21.28).
Currency fluctuations after the reporting date are accounted for in accordance with IAS 10
Events after the Reporting Period.
If a foreign monetary item is settled prior to the reporting date, any difference that may arise
is taken to the profit or loss section of the statement of profit or loss and other
comprehensive income (IAS 21.28).
IAS 23.6 Borrowing Costs allows, under certain conditions, the capitalisation of foreign
exchange differences to the extent that it is regarded as an adjustment to interest costs
(refer to chapter 12).
Example 11
11.4
Foreign currency transaction – creditor
RSA Ltd, a company conducting business in South Africa, purchased inventory from an overseas
supplier for FC200 000 on 30 September 20.11, when R1 = FC1. The supplier will only be paid on
31 December 20.13. No forward cover was taken out for the transaction. The exchange rates were
as follows:
31 December 20.11
R1 = FC0,80
31 December 20.12
R1 = FC1,00
31 December 20.13
R1 = FC1,25
RSA Ltd uses a perpetual inventory system to account for its inventories and has a 31 December
year end.
The inventory was sold as follows:
20.11: 75%
20.12: 25%
The selling price is cost plus 100%.
continued
278 Descriptive Accounting – Chapter 11
Journal entries
Dr
R
30 September 20.11
Inventory (SFP)
Creditors (SFP) (FC200 000 × R1)
200 000
31 December 20.11
Receivables (SFP)
Sales (P/L) (R200 000 × 75% × 200/100)
300 000
Cost of sales (P/L)
Inventory (SFP) (R200 000 × 75%)
Foreign exchange difference (P/L)
Creditors (SFP) (FC200 000/0,8 – R200 000)
31 December 20.12
Receivables (SFP)
Sales (P/L) (R200 000 × 200% × 25%)
200 000
300 000
150 000
150 000
50 000
50 000
100 000
100 000
Cost of sales (P/L)
Inventory (SFP) (R200 000 × 25%)
50 000
Creditors (SFP)
Foreign exchange difference (P/L)
((FC200 000/1,00) – (FC200 000/0,8))
50 000
31 December 20.13
Creditors (SFP)
Foreign exchange difference (P/L)
((FC200 000/1,25) – (FC200 000/1,00))
Creditors (SFP)
Bank (SFP) (FC200 000/1,25)
Cr
R
50 000
50 000
40 000
40 000
160 000
160 000
Comment
¾ It is clear that when the rand deteriorates, it is to the disadvantage of the South African
creditor. The opposite is obviously also true.
Example 11.5
Foreign exchange transaction – sales and a debtor
Kappa Ltd, operating in South Africa, entered into a sales transaction with a foreign company on
30 September 20.11. Since Kappa Ltd anticipated that the rand would deteriorate in the
foreseeable future, the transaction was denominated in FC. In terms of this transaction, Kappa Ltd
delivered inventory valued at FC200 000 to the foreign company on 30 September 20.11 when the
exchange rate was R1 = FC1. The foreign company will settle the amount outstanding in respect
of the inventory sold to them on 31 December 20.13. No forward cover was taken out. Kappa Ltd
has a 31 December year end. The relevant exchange rates are as follows:
31 December 20.11
31 December 20.12
31 December 20.13
R1 = FC0,80 or FC1 = R1,25
R1 = FC1,00 or FC1 = R1,00
R1 = FC1,25 or FC1 = R0,80
continued
The effects of changes in foreign exchange rates 279
The journal entries in the records of Kappa Ltd will be as follows:
30 September 20.11
Debtor (SFP) (FC200 000/FC1 or × R1)
Sales (P/L)
Recognise sales on transaction date
Dr
R
200 000
200 000
31 December 20.11
Debtor (SFP) ((FC200 000/FC0,8 or × R1,25) – R200 000)
Foreign exchange difference (P/L)
Adjust balance of debtor to closing rate at year end
50 000
31 December 20.12
Foreign exchange difference (P/L)
Debtor (SFP) (R250 000 – (FC200 000/FC1,00 or × R1,00))
Adjust balance of debtor to closing rate at year end
50 000
31 December 20.13
Bank (SFP) (FC200 000/FC1,25 or × R0,80)
Foreign exchange difference (P/L) (FC200 000 × (1,00 – 0,80))
Debtor (SFP)
Adjust balance of debtor to closing rate at year end and account for
settlement by debtor
OR
Foreign exchange difference (P/L) (FC200 000 × (1,00 – 0,80))
Debtor (SFP)
Restate debtor to rand amount before settlement
Bank (SFP)
Debtor (SFP)
Settlement of outstanding debt by debtor
Cr
R
50 000
50 000
160 000
40 000
200 000
40 000
40 000
160 000
160 000
Comment
¾ It is clear that it is to the advantage of the seller (Kappa Ltd) if the rand deteriorates – it will
receive more rand per FC.
¾ By contrast, it is to the disadvantage of Kappa Ltd should the rand appreciate, as it would then
receive fewer rand per FC.
¾ Also note the difference in notation of the rand versus the foreign currency as provided in this
question, namely R1 = FC or FC1 = R. The notation has an impact on the technique of
translation: when using R1 = FC, division is used and for FC1 = R, multiplication is used.
Example 11.6
Loan denominated in foreign currency
A South African company with a financial year end of 31 December borrows FC3 000 on
30 June 20.11 and receives R3 300. Interest on the loan is repayable in arrears at 10% per
annum. The capital is repayable on 30 June 20.13. The exchange rates are as follows:
30 June 31 December
FC1 = R
FC1 = R
20.11
1,100
1,087
20.12
1,053
1,010
20.13
1,136
1,099
continued
280 Descriptive Accounting – Chapter 11
The foreign exchange differences arising on the capital will be calculated as follows:
Date
FC
Rate
30.06.20.11 Receive
3 000
1,100
31.12.20.11 Foreign exchange difference (balancing amount)
R
3 300
(39)
31.12.20.11 Balance
31.12.20.12 Foreign exchange difference (balancing amount)
3 000
1,087
3 261
(231)
31.12.20.12 Balance
30.06.20.13 Payment
30.06.20.13 Foreign exchange difference (balancing amount)
3 000
(3 000)
1,010
1,136
3 030
(3 408)
378
30.06.20.13 Balance
–
1,136
–
The loan represents a financial liability in terms of IFRS 9 Financial Instruments, which will initially
be measured at fair value and subsequently be measured at amortised cost. Assuming the 10%
interest rate is market-related, the amortised cost balance would be equal to the capital
outstanding as indicated in the table above. The amortised cost method requires that interest must
be recognised on a time-apportioned basis. Consequently, interest will be accrued on a day-to-day
basis and as IAS 21 requires transactions to be measured at the spot exchange rate applicable
on the transaction date, an average exchange rate must be used to translate the finance
charges. The accrued interest represents a monetary liability that must be remeasured to the spot
exchange rate at the reporting date.
The following finance charges and foreign exchange differences will arise:
Date
FC
Rate
R
31.12.20.11 Interest expense
1501
1,09352
164
31.12.20.11 Foreign exchange difference (balancing amount)
(1)
31.12.20.11
30.06.20.12
30.06.20.12
30.06.20.12
31.12.20.12
31.12.20.12
Balance
Interest expense
Interest paid
Foreign exchange difference (163 + 161 – 316)
Interest expense
Foreign exchange difference (balancing amount)
150
150
(300)
150
1,03154
31.12.20.12
30.06.20.13
30.06.20.13
30.06.20.13
30.06.20.13
Balance
Interest expense
Interest paid
Foreign exchange difference (152 + 161 – 341)
Balance
150
150
(300)
1,010
1,0735
1,136
1.
2.
3.
4.
5.
–
1,087
1,073
1,053
1,136
163
161
(316)
(8)
155
(3)
152
161
(341)
28
–
3 000 × 10% × 6/12 = 150
(1,100 + 1,087)/2 = 1,0935 (average rate for 30 June 20.11 to 31 December 20.11)
(1,087 + 1,053)/2 = 1,07 (average rate for 1 January 20.12 to 30 June 20.12)
(1,053 + 1,010)/2 = 1,0315 (average rate for 1 July 20.12 to 31 December 20.12)
(1,010 + 1,136)/2 = 1,073 (average rate for 1 January 20.13 to 30 June 20.13)
The entries for the loan will be as follows:
Dr
R
30 June 20.11
Bank (SFP)
Loan (SFP)
31 December 20.11
Loan (SFP)
Foreign exchange difference (P/L)
Finance charges (P/L)
Interest accrued (SFP)
Cr
R
3 300
3 300
39
39
164
164
continued
The effects of changes in foreign exchange rates 281
Dr
R
Interest accrued (SFP)
Foreign exchange difference (P/L)
30 June 20.12
Finance charges (P/L)
Interest accrued (SFP)
Interest accrued (SFP) (164 – 1 + 161)
Foreign exchange difference (P/L)
Bank (SFP)
31 December 20.12
Loan (SFP)
Foreign exchange difference (P/L)
Finance charges (P/L)
Interest accrued (SFP)
Interest accrued (SFP)
Foreign exchange difference (P/L)
30 June 20.13
Foreign exchange difference (P/L)
Loan (SFP)
Loan (SFP)
Bank (SFP)
Cr
R
1
1
161
161
324
8
316
231
231
155
155
3
3
378
378
3 408
3 408
Finance charges (P/L)
Interest accrued (SFP)
161
Interest accrued (SFP) (155 – 3 + 161)
Foreign exchange difference (P/L)
Bank (SFP)
313
28
161
341
If a gain or loss on a non-monetary item is recognised in other comprehensive income, then
IAS 21 requires the foreign exchange difference also to be recognised in other
comprehensive income (IAS 21.30). It follows that the treatment of foreign exchange
differences corresponds with the treatment of the gain or loss of the underlying nonmonetary item. This principle also applies to deferred tax (IAS 12).
Example 11
11.7
Profit or loss on foreign shares presented in other comprehensive income
in terms of IFRS 9
Euro Ltd purchases 100 000 ordinary shares in a USA company on 1 December 20.12 at US$14
per share. The entity has elected to present gains and losses on the investment in other
comprehensive income in terms of IFRS 9, since these shares are an equity investment that it
intends to keep as a long-term investment. The year end of the entity is 31 December.
The market price of the shares on 31 December 20.12 and 31 December 20.13 amounted to
US$17 and US$20 respectively. The following represents the appropriate rand/dollar spot
exchange rates.
US$1 = R
1 December 20.12
5,50
31 December 20.12
6,20
31 December 20.13
5,80
continued
282 Descriptive Accounting – Chapter 11
The fair values of the investment on the above dates, in rand, are calculated as follows:
US$
R
1 December 20.12 (100 000 × US$14); (US$1 400 000 × R5,50)
1 400 000
7 700 000
31 December 20.12 (100 000 × US$17); (US$1 700 000 × R6,20)
1 700 000
10 540 000
31 December 20.13 (100 000 × US$20); (US$2 000 000 × R5,80)
2 000 000
11 600 000
From the above, it is clear that the change in the fair value of the shares would represent a
combination of the change in the rand/dollar exchange rate component and a change in the dollar
market price component.
The journal entries to account for the changes in fair value on 31 December 20.12 and 31 December
20.13 are as follows:
Dr
Cr
31 December 20.12
R
R
Foreign share investment (asset) (SFP) (10 540 000 – 7 700 000)
2 840 000
Mark-to-market reserve (OCI)
2 840 000
Recognise the fair value adjustment of the financial asset
at year end
31 December 20.13
Foreign share investment (asset) (SFP) (11 600 000 – 10 540 000)
Mark-to-market reserve (OCI)
Recognise the fair value adjustment of the financial asset
at year end
1 060 000
1 060 000
Comment
¾ A financial assets measured at fair value through other comprehensive income (elected
classification) is not a monetary item (IFRS 9.B5.7.3). When accounting for fair value
adjustments for a non-monetary asset, no distinction is made between the pure fair value
adjustment in the foreign currency and the foreign exchange differences that arise from the
translation to the functional currency (IAS 21.52(a)).
¾ A financial assets measured at fair value through other comprehensive income (mandatory
classification) is treated as a monetary item (IFRS 9.B5.7.2A). Accordingly, such a financial
asset is treated as an asset measured at amortised cost in the foreign currency and exchange
differences on the amortised cost are recognised in profit or loss.
11.5.3 Tax implications of foreign currency transactions
The tax position of foreign currency transactions is too complex to discuss in detail here.
Accordingly, only the most important rules applicable in most circumstances are addressed.
The deferred tax consequences of each case will need to be assessed on the facts and
circumstances applicable to the specific scenario.
Unhedged transactions
Section 25D of the Income Tax Act 58 of 1962 (the Income Tax Act) states that a company
must convert foreign amounts by applying the spot exchange rate on the date of receipt or
accrual, or when an expenditure or loss was incurred, subject to certain exceptions in
section 25D(2)–(7). Thus, the accounting treatment and the tax treatment will be the same
under normal circumstances. Foreign exchange gains and losses are dealt with in section
24I of the Income Tax Act. The treatment of foreign exchange gains and losses is similar for
accounting and tax.
Temporary differences may, however, arise in certain circumstances. For example, where
the transaction is related to a loan, an advance or a debt used to acquire an asset on which
a wear-and-tear allowance is claimed (a so-called section 24I(7)(a) asset) and the asset is
not brought into use in the period in which it was acquired. Any foreign exchange differences
arising from the conversion of such a loan, advance or debt will be transferred to the period
in which the asset is brought into use for tax purposes. For accounting purposes, the foreign
exchange differences are recognised in the period of acquisition.
The effects of changes in foreign exchange rates 283
11.6 Translation of financial statements into presentation currency
The purpose with the translation of financial statements of an entity is to preserve as far as
possible the results of the interrelationships of amounts appearing in the financial
statements in the functional currency to the presentation currency. If an entity’s functional
currency differs from its presentation currency, the results and financial position of an entity
is translated using the closing rate method (IAS 21.39 to .41):
ƒ assets and liabilities for each statement of financial position presented (including
comparatives) are translated at the closing rate at the date of that statement of financial
position;
ƒ income and expenses for each statement of profit or loss and other comprehensive
income (including comparatives) are translated at exchange rates at the dates of the
transactions (for practical reasons, a rate that approximates the exchange rates at
transaction dates may be used, if exchange rates do not fluctuate significantly); and
ƒ all resulting foreign exchange differences are recognised in other comprehensive income
as a separate component of equity, normally called the foreign currency translation
reserve (FCTR) (the exchange differences result from translating income and expenses
at the exchange rates at the dates of the transactions, and assets and liabilities at the
closing rate, as well as translating the opening net assets at a closing rate that differs
from the previous closing rate).
IAS 21.55 is clear that when an entity presents its financial statements in a currency that is
different from its functional currency, it may not claim compliance with IFRS, unless those
financial statements have been translated in terms of the abovementioned principles. If any
other translation method is used, the financial statements must be clearly identified as
supplementary information to distinguish this information from information that complies with
IFRS (IAS 21.57(a)).
11.7 Foreign operations
11.7.1 Translation of a foreign operation for inclusion in the financial statements
of the reporting entity
IAS 21 requires each individual entity within a group of companies to determine its functional
currency and measure its results and financial position in that currency. The determination
of each entity’s functional currency must be performed on a stand-alone basis, as the group
does not have a functional currency. An entity may present its financial statements in any
currency. For example, when a group consists of individual entities with different functional
currencies, the results and financial position of each entity are expressed in a common
currency (the presentation currency of the parent) so that consolidated financial statements
may be presented.
The translation of the financial statements of a foreign operation with a functional currency
that differs from that of the reporting entity takes place directly into the currency in which the
financial statements (consolidated or separate, in the case of a branch) of the reporting entity
are presented. In other words, the financial statements of the foreign operation are not first
translated into the functional currency of the reporting entity and then into the presentation
currency, but are translated directly into the presentation currency (IAS 21.BC18).
The translation of the financial statements of a foreign operation into the presentation
currency of the reporting entity for inclusion in the separate financial statements of the
reporting entity (in the case of a branch), or consolidated financial statements of the
reporting entity (in the case of an associate, joint venture or subsidiary) is exactly the same
as discussed in section 11.6 above.
IAS 21.41 further requires that when the foreign operation is consolidated, a portion of the
foreign currency translation reserve (FCTR) is allocated to the non-controlling interests.
284 Descriptive Accounting – Chapter 11
Example 11.8
Foreign currency – translation of a branch
The head office of Epsilon Co, with a functional and presentation currency of rand, made a loan of
FC20 800 to its newly formed foreign branch, Zeta, on 1 January 20.12 The foreign branch earned
profit of FC25 800 for the year ended 31 December 20.12.
On 1 January 20.12, the exchange rate was FC1 = R2,00, and on 31 December 20.12, it was
FC1 = R2,40. The weighted average exchange rate for 20.12 was FC1 = R1,95.
If the functional currency of the branch is FC and there were no other transactions between the
branch and head office, the trial balance of the branch on 31 December 20.12 will be as follows:
Dr
Cr
FC
FC
Loan from head office
–
20 800
Profit for the year
–
25 800
Property, plant and equipment
40 000
–
Receivables
3 000
–
Cash
3 600
–
46 600
The translation of the trial balance using the closing rate will be as follows:
FC
Credits
Loan from head office
20 800
Profit for the year
25 800
FCTR (balancing amount)
Rate
2,40
1,95
46 600
R
49 920
50 310
11 610
111 840
Debits
Property, plant and equipment
Receivables
Cash
40 000
3 000
3 600
2,40
2,40
2,40
96 000
7 200
8 640
111 840
If the branch earns a profit of FC30 000 in 20.13, the average exchange rate for 20.13 is
FC1 = R2,20 and the rate on 31 December 20.13 is FC1 = R2,40 once again, the trial balance of
the branch on 31 December 20.13 will be as follows:
Dr
Cr
FC
FC
Loan from head office
46 600
Opening balance
Retained earnings 20.12
Profit for the year
Property, plant and equipment
Receivables
Cash
20 800
25 800
50 000
10 000
16 600
30 000
–
–
–
76 600
76 600
continued
The effects of changes in foreign exchange rates 285
Using the closing rate the translated trial balance will be as follows:
FC
Credits
Loan from head office
46 600
Profit for the year
30 000
FCTR (balancing amount)
Rate
R
2,40
2,20
111 840
66 000
6 000
183 840
Debits
Property, plant and equipment
Receivables
Cash
50 000
10 000
16 600
2,40
2,40
2,40
120 000
24 000
39 840
183 840
The decrease in the FCTR for 20.13 is R11 610 – R6 000 = R5 610 and is recognised in equity via
other comprehensive income.
The FCTR will be disclosed as follows in the financial statements:
Epsilon Co
Extract from the statement of profit or loss and other comprehensive income
for the year ended 31 December 20.13
20.13
20.12
R
R
Profit for the year
xxx
xxx
Other comprehensive income:
Items that may subsequently be reclassified to profit or loss:
Gain/(loss) on translation of foreign operation
(5 610)
11 610
Total comprehensive income for the year (xxx – 5 610); (xxx + 11 610)
xxx
xxx
Epsilon Co
Extract from the statement of changes in equity for the year ended 31 December 20.13
Foreign
currency
translation
reserve
R
Balance at 1 January 20.12
–
Changes in equity for 20.12
Total comprehensive income
Profit for the year
–
Other comprehensive income
11 610
Balance at 31 December 20.12
Changes in equity for 20.13
Total comprehensive income
Profit for the year
Other comprehensive income
11 610
Balance at 31 December 20.13
6 000
–
(5 610)
11.7.2 Intragroup monetary items
Once the financial statements of the foreign operation have been translated to the
presentation currency of the reporting entity, the incorporation of the results and financial
position of the foreign operation into those of the reporting entity follows normal
consolidation procedures, such as the elimination of intragroup balances and intragroup
transactions of a subsidiary (IAS 21.45).
286 Descriptive Accounting – Chapter 11
An intragroup monetary asset or liability cannot be eliminated against the corresponding
intragroup liability or asset without showing the results of currency fluctuations in the
consolidated financial statements (IAS 21.45).
Example 11.9
Intragroup monetary balances
A parent, with the South African rand as its functional and presentation currency, made a loan of
FC1 000 to its foreign subsidiary, with the FC as its functional currency, when the exchange rate
was FC1 = R4,00.
On the reporting date, the full loan is still outstanding. The exchange rate is FC1 = R4,20.
In its separate financial statements, the parent will remeasure the monetary item to R4 200 and
recognise a foreign exchange gain in the ‘profit or loss’ section of the statement of profit or loss
and other comprehensive income of R200.
The subsidiary will carry the loan in its separate financial statements at FC1 000. In order to
prepare consolidated financial statements, the liabilities of the subsidiary will be translated at
closing rate, meaning that the liability will be translated to R4 200.
The intragroup balance of R4 200 will be eliminated on consolidation, but the exchange gain of R200
will not be eliminated and will be shown in the consolidated profit or loss section of the statement of
profit or loss and other comprehensive income.
11.7.3 Non-coterminous financial periods
When the financial statements of a foreign operation are as of a date different from those of
the reporting entity, the foreign operation prepares additional statements as of the same
date as the reporting entity’s financial statements. When additional statements cannot be
prepared, IFRS 10 allows the use of a different reporting date, provided that the difference is
no greater than three months and adjustments are made for the effects of any significant
transactions or other events that occur between different dates. In such a case, the assets
and liabilities of the foreign operation are translated at the exchange rate on the reporting
date of the foreign operation. Adjustments are made for significant changes in exchange
rates up to the reporting date of the reporting entity. The same approach is applied to
associates and joint ventures (IAS 21.46).
11.7.4 Revaluation of assets
IAS 21.47 determines that any fair value adjustments to the carrying amount of assets and
liabilities arising on the acquisition of that foreign operation shall be treated as assets and
liabilities of the foreign operation. The fair value adjustments clearly relate to the identifiable
assets and liabilities of the acquired entity and must therefore be translated at closing rate
(IAS 21.BC28).
When assets are revalued in a foreign subsidiary after the date of acquisition, the method of
translation will impact on the rand amount of the revaluation surplus. This is explained in the
following example.
Example 11.10
Subsequent revaluation of assets
Echo Ltd acquired a 65% interest in Kilo Ltd on 1 January 20.10. On 1 January 20.12, Kilo Ltd
acquired a property for FC500 000. The property was revalued to FC1 000 000 on
1 January 20.13. The year end of the group is 31 December.
The following exchange rates apply:
FC1 = R
1 January 20.10
R0,80
31 December 20.11
R0,90
31 December 20.12
R1,00
31 December 20.13
R1,30
continued
The effects of changes in foreign exchange rates 287
The historical cost and the revalued amount of the property are translated at the exchange rate
ruling at the date of revaluation. The revaluation surplus is R500 000 ((FC1 000 000 × R1,00) –
(FC500 000 × R1,00)). On 31 December 20.13, the property is stated at R1 300 000 (FC1 000 000
× R1,30 (closing rate)). The revaluation surplus remains unchanged at R500 000, but the FCTR
increases by R150 000 (FC500 000 × (R1,30 – R1,00)).
11.7.5 Goodwill
Goodwill arising on the acquisition of a foreign operation must be treated as an asset of the
foreign operation, as opposed to an asset of the acquirer. The goodwill will therefore be
expressed in the functional currency of the foreign operation and be translated at the closing
rate (IAS 21.47). When the non-controlling interests are measured at the proportionate
share of the foreign operation’s net identifiable assets, the non-controlling interests will not
share in the foreign currency translation reserve (FCTR) on goodwill, because the noncontrolling interests do not contribute to goodwill. However, when the non-controlling
interests are measured at fair value, both the acquirer and the non-controlling interests will
contribute to goodwill. Therefore, the non-controlling interests will have a share in the
foreign currency translation reserve (FCTR) on goodwill. The share is based on the profitsharing ratio.
Example 11.11
Foreign currency translation of a subsidiary (including goodwill)
The following is an extract of the abridged trial balances of Lima Ltd and its foreign subsidiary,
Oscar Ltd, for the year ended 31 December 20.13:
Lima Ltd
Functional currency (non-hyperinflationary)
R
Share capital
80 000
Retained earnings – beginning of year
20 000
Profit before tax
15 000
115 000
Investment in Oscar Ltd
Current assets
Income tax expense
45 600
64 400
5 000
115 000
Oscar Ltd
Functional currency (non-hyperinflationary)
Share capital
Retained earnings – beginning of year
Profit before tax
FC
80 000
–
20 000
100 000
Current assets
Income tax expense
94 000
6 000
100 000
continued
288 Descriptive Accounting – Chapter 11
Additional information
Lima Ltd acquired a 65% controlling interest in Oscar Ltd on 1 January 20.13 (incorporation date).
Non-controlling interests in the foreign operation are measured as the non-controlling interests’
proportionate share of the foreign operation’s net identifiable assets.
Applicable exchange rates are as follows:
BV = R
1 January 20.13
R0,80
31 December 20.13
R0,90
20.13 Average
R0,85
The presentation currency of Lima Ltd is rand (ZAR).
The functional currency of Oscar Ltd differs from the presentation currency of Lima Ltd. The
assets and liabilities of Oscar Ltd should be translated using the closing rate.
Using the closing rate, the translated trial balance and eventual consolidation will be as follows:
20.13
FC
Rate
R
Share capital
80 000
0,80
64 000
Profit after tax
14 000
0,85
11 900
Profit before tax
20 000
0,85
17 000
Income tax expense
(6 000)
0,85
(5 100)
FCTR
balancing
8 700
Current assets
94 000
94 000
0,90
84 600
84 600
94 000
0,90
84 600
Analysis of owners’ interest of Oscar Ltd
31 December 20.13
Total
Rate
FC
At acquisition
Share capital
Goodwill
80 000
5 000
Investment in Oscar Ltd
85 000
Since acquisition
Profit after tax
FCTR (excluding
goodwill)
FCTR (goodwill only)
Lima Ltd
At
acquisition
65%
R
Lima Ltd
NonSince
controlling
acquisition interests
65%
35%
R
R
64 000
4 000
41 600
4 000
22 400
–
68 000
45 600
22 400
Total
100%
R
0,80
0,80
14 000
0,85
11 900
8 700
7 735
5 655
4 165
3 045
500
500
–
99 000
0,90
89 100
13 890
29 610
continued
The effects of changes in foreign exchange rates 289
Comment
¾ As the non-controlling interests in the foreign operation are measured as the non-controlling
interests’ proportionate share of the foreign operation’s net identifiable assets, the goodwill will
only relate to the acquirer. The goodwill is calculated in rand (R) and then translated into
foreign currency (FC):
R
Consideration
45 600
Non-controlling interests
22 400
Net identifiable assets
Goodwill
68 000
64 000
4 000
Goodwill in FC = 4 000/0,80 = 5 000
¾ The FCTR on goodwill will only relate to the acquirer and will be calculated as follows:
(5 000 × 0,90) (closing) – 4 000 (at acquisition) = 500
¾ The FCTR (excluding goodwill) equals the amount calculated in the translated trial balance
above. As goodwill is not included in the translated trial balance, an additional consolidation
journal entry is required to account for the FCTR on goodwill:
Dr
Cr
R
R
Goodwill (SFP)
500
Foreign currency translation reserve (OCI)
500
¾ The foreign currency translation difference that is attributable to the non-controlling interests is
included as part of the non-controlling interests in the statement of financial position.
¾ If the non-controlling interests were measured at fair value, both the acquirer and the
non-controlling interests would contribute to goodwill. The non-controlling interests would share
in the FCTR on goodwill calculated by using the profit-sharing ratio.
Lima Ltd Group
Extract from the consolidated statement of profit or loss and other comprehensive income
for the year ended 31 December 20.13
R
Profit before tax (15 000 + 17 000)
32 000
Income tax expense (5 000 + 5 100)
(10 100)
Profit for the year
Other comprehensive income:
Items that may subsequently be reclassified to profit or loss:
Exchange rate differences on translation of foreign operations (8 700 + 500)
21 900
Total comprehensive income for the year
Profit attributable to:
Owners of the parent (15 000 – 5 000 + 7 735) or (21 900 – 4 165)
Non-controlling interests (as per analysis)
31 100
Total comprehensive income attributable to:
Owners of the parent (17 735 + 5 655 + 500) or (31 100 – 7 210)
Non-controlling interests (4 165 + 3 045)
9 200
17 735
4 165
21 900
23 890
7 210
31 100
continued
290 Descriptive Accounting – Chapter 11
Lima Ltd Group
Consolidated statement of financial position as at 31 December 20.13
R
Assets
Non-current assets
Goodwill (4 000 + 500) or (5 000 x 0,90)
Current assets (64 400 + 84 600)
4 500
149 000
Total assets
153 500
Equity and liabilities
Equity attributable to owners of the parent
Share capital
Retained earnings (20 000 + 17 735)
Other components of equity
Foreign currency translation reserve (5 655 + 500)
80 000
37 735
6 155
Non-controlling interests (as per analysis)
123 890
29 610
Total equity and liabilities
153 500
11.7.6 Foreign exchange differences on a net investment in a foreign operation
A net investment in a foreign operation is the amount of the reporting entity’s interest in the
net assets of that operation (IAS 21.08). In other words, if a foreign operation has equity of
FC1 000 at the reporting date and an investor holds an 80% interest in that foreign
operation, the investor’s net investment in the foreign operation will be FC800. This will also
be the amount of the foreign operation that is effectively included in the consolidated
financial statements of the investor.
An entity may, however, have a monetary item that is receivable from or payable to a
foreign operation. An item for which settlement is neither planned nor likely to occur in
the foreseeable future is, in substance, part of the entity’s net investment in that foreign
operation. Such monetary items may include long-term receivables or loans. They do not
include trade receivables and trade payables (IAS 21.15).
IAS 21 requires that foreign exchange differences arising on such monetary items that in
essence form part of a reporting entity’s net investment in a foreign operation, be recognised
in the profit or loss section of the statement of profit or loss and other comprehensive
income in the separate financial statements of the reporting entity or the individual financial
statements of the foreign operation, as the case may be (IAS 21.32).
If an item that is considered to be part of the net investment is denominated in the functional
currency of the reporting entity, a foreign exchange difference arises in the individual
financial statements of the foreign operation. The opposite happens where the relevant item
is denominated in the functional currency of the foreign operation – in this instance, the
exchange rate difference will arise in the separate financial statements of the parent.
In the consolidated financial statements (statements including both the reporting entity as
well as the foreign operation), such exchange rate differences are reclassified to a separate
category of equity (normally the foreign currency translation reserve (FCTR)) through other
comprehensive income in the statement of profit or loss and other comprehensive income
(IAS 21.32). This is done by transferring the exchange rate difference under discussion to
the foreign currency translation reserve (FCTR) by way of a pro forma consolidation journal
entry. The effect of this transfer is that this type of monetary item is now treated in exactly
the same way for accounting purposes in the consolidated financial statements as an equity
interest would be. For purposes of this principle, consolidated financial statements include
consolidation and equity accounting.
The effects of changes in foreign exchange rates 291
If the net investment is sold at a later date, the accumulated foreign exchange differences in
the foreign currency translation reserve (FCTR) that ended up in equity via other
comprehensive income are reclassified to the statement of profit or loss and other
comprehensive income (IAS 21.32) as a reclassification adjustment.
Example 11
11.12
Net investment in foreign operation – monetary item
Bravo Ltd is the parent of Europe Inc, a wholly-owned subsidiary (100% interest). Both entities
have 31 December year ends. Bravo Ltd purchased all the shares of Europe Inc on
1 January 20.13. On this date, Bravo Ltd granted a loan to Europe Inc.
No repayment terms have been agreed on, and Bravo Ltd will not require settlement of the loan in
the foreseeable future.
The loan is thus a monetary item forming part of the net investment of Bravo Ltd in Europe Inc.
The respective functional currencies of Bravo Ltd and Europe Inc are the SA rand (R) and the
euro (̀). The presentation currency of the Group is the SA rand (R).
The following are the relevant ̀:R exchange rates:
̀1:R
1 January 20.13
8,20
Average rate (rate changes evenly over time): 1 January 20.13 – 31 December 20.13
8,50
31 December 20.13
8,80
Case 1: Loan in the functional currency of the subsidiary
Assume that the loan granted on 1 January 20.13 amounted to ̀200 000.
The journal entry required to initially account for the loan in the separate financial statements of
Bravo Ltd, is the following:
Dr
Cr
R
R
1 January 20.13
Loan to subsidiary (̀200 000 × R8,20)
1 640 000
Bank
1 640 000
Recognise loan granted to subsidiary denominated in euro
The journal entry that would appear in the separate financial statements of Bravo Ltd at year end
is the following:
Dr
Cr
R
R
31 December 20.13
Loan to subsidiary (̀200 000 × (R8,80 – R8,20))
120 000
Foreign exchange difference (P/L)
120 000
Recognise foreign exchange difference on the loan to subsidiary
denominated in euro (̀)
Comment
¾ Since a monetary item denominated in a foreign currency appears in the separate financial
statements of Bravo Ltd, a foreign exchange difference will arise in the separate financial
statements of Bravo Ltd, provided fluctuations in exchange rates took place during the year.
¾ In terms of IAS 21.28, these foreign exchange differences are recognised in the profit or loss
section of the statement of profit or loss and other comprehensive income.
¾ Consequently, no foreign exchange difference will be recognised in the separate financial
statements of Europe Inc, since the loan is denominated in the functional currency of
Europe Inc, namely euro (̀ሻ.
continued
292 Descriptive Accounting – Chapter 11
On consolidation, the trial balance of Europe Inc will be translated using the closing rate method.
The effect of this is that the loan (creditor) translated to rand in the records of Europe Inc, will be
shown as follows:
Exchange
̀
R
rate
Loan (creditor)
200 000
8,80
1 760 000
The credit loan included in the consolidated financial statements amounts to R1 760 000. The debit
loan included in the consolidated financial statements, also amounts to R1 760 000 (1 640 000 +
120 000). These items are intra group items and must be eliminated on consolidation.
IAS 21.32 requires that a foreign exchange difference on a monetary item forming part of the net
investment in a subsidiary and recognised in the separate financial statements in the profit or loss
section of the statement of profit or loss and other comprehensive income must be transferred to
the FCTR (part of equity) on consolidation, via other comprehensive income.
The pro forma consolidation journal entry to give effect to IAS 21.32 is as follows:
Dr
R
31 December 20.13
Foreign exchange difference (P/L)
120 000
Foreign currency translation reserve (OCI)
Transfer foreign exchange difference on monetary item that forms
part of the net investment in a subsidiary, to equity
Cr
R
120 000
Case 2: Loan in the functional currency of the parent
Assume that the amount of the loan granted on 1 January 20.13, amounts to R1 640 000.
The journal entry in the separate financial statements of Europe Inc, at initial recognition, is as follows:
Dr
Cr
̀
̀
1 January 20.13
Bank
200 000
Loan from parent (R1 640 000/8,20)
200 000
Recognise loan denominated in rand received from parent
The journal entry in the separate financial statements of Europe Inc at year end is as follows:
Dr
Cr
̀
̀
31 December 20.13
Loan from parent ((R1 640 000/8,80) – ̀200 000)
13 636
Foreign exchange difference (P/L)
13 636
Recognise foreign exchange difference on loan received from
parent denominated in rand
Comment
¾ Since a monetary item denominated in a foreign currency appears in the separate financial
statements of Europe Inc, a foreign exchange difference will arise in the separate financial
statements of Europe Inc, provided fluctuations in exchange rates took place during the year.
¾ In terms of IAS 21.28, these foreign exchange differences are recognised in the profit or loss
section of the statement of profit or loss and other comprehensive income.
¾ Consequently, no foreign exchange differences will be recognised in the separate financial
statements of Bravo Ltd, since the loan is denominated in the functional currency of Bravo Ltd,
namely rand.
continued
The effects of changes in foreign exchange rates 293
On consolidation, the trial balance of Europe Inc will be translated using the closing rate method.
When the loan (creditor) and the foreign exchange difference in the records of Europe Inc are
translated to rand, they would appear as follows:
Exchange
̀
R
rate
Loan (creditor) (R1 640 000/8,80)
186 364
8,80
1 640 000
Foreign exchange difference (P/L)
13 636
8,50
115 906
The credit loan included in the consolidated financial statements amounts to R1 640 000. The
debit loan included in the consolidated financial statements, also amounts to R1 640 000. These
items are intragroup items that can now be eliminated.
As in Case 1 above, IAS 21.32 requires that a foreign exchange difference on a monetary item
forming part of the net investment in a subsidiary and recognised in the separate financial
statements in the profit or loss section of the statement of profit or loss and other comprehensive
income, must be transferred to the FCTR (part of equity) on consolidation, via other
comprehensive income in the statement of profit or loss and other comprehensive income.
The pro forma consolidation journal entry to give effect to IAS 21.32, is as follows:
Dr
Cr
R
R
31 December 20.13
Foreign exchange difference (P/L)
115 906
Foreign currency translation reserve (OCI)
115 906
Transfer foreign exchange difference on monetary item forming part
of the net investment in subsidiary to equity
Comment
¾ At the translation of the assets, liabilities, income and expenses of a foreign subsidiary with a
functional currency that differs from that of the parent, a foreign exchange difference will arise
that will be recognised in the FCTR.
¾ Part of the income items mentioned above, is the foreign exchange difference of ̀13 636 that
will be translated to rand at an average exchange rate of ̀1 = R8,50 and that will eventually,
due to the translation technique as prescribed in IAS 21, be adjusted to a closing rate of
̀1 = R8,80.
¾ The difference between the translation of the ̀13 636 at ̀1 = R8,50 and ̀1 = R8,80, is R4 094
(rounded up) and together with the original R115 906 transferred to the FCTR via the
consolidation journal, this would equal the R120 000 that appears in the FCTR in Case 1.
The above discussion deals with the case where the specific monetary item is denominated
in the functional currency of either the reporting entity or the foreign operation. It is also
possible for the relevant item to be denominated in a foreign currency other than the
functional currency of the reporting entity or the foreign operation. For instance, the
monetary item is denominated in euro, but the functional and presentation currency of the
reporting entity is rand and that of the foreign operation is USA dollar. Under such
circumstances, exchange rate differences will arise in both the separate financial statements
of the reporting entity as well as in the individual financial statements of the foreign
operation. In the consolidated financial statements, these exchange rate differences are also
transferred to the foreign currency translation reserve (FCTR) (IAS 21.33).
11.7.7 Disposal or partial disposal of a foreign operation
On the disposal of a foreign operation, the cumulative amount of the exchange differences
relating to that foreign operation, recognised in other comprehensive income and
accumulated in the separate component of equity (FCTR), shall be reclassified from equity
to profit or loss as a reclassification adjustment when the gain or loss on disposal is
recognised.
The following are considered to be disposals:
• disposal of an entity’s entire interest;
294 Descriptive Accounting – Chapter 11
• partial disposal which results in the loss of control of a foreign subsidiary; and
• partial disposal of a joint arrangement or an associate where the remaining interest is a
financial asset (loss of significant influence or joint control).
The cumulative amount of the exchange differences relating to the foreign operation that
has been attributed to the non-controlling interests will be derecognised, but will not be
reclassified to profit or loss.
On the partial disposal of a subsidiary that includes a foreign operation, the entity will
reattribute the proportionate share of the cumulative amount of the exchange differences
recognised in other comprehensive income to the non-controlling interests. In any other
partial disposals disposal of a foreign operation the entity shall reclassify to profit or loss
only the proportionate share of the cumulative amount of the exchange differences
recognised in other comprehensive income. Partial disposals are any reductions in
ownership interests except those seen as disposals above. Therefore a partial disposal will
occur when an entity disposes of an interest in its foreign operation without losing control,
significant influence or joint control.
Example 11.13
Disposal of a foreign operation
Able Ltd owns a foreign subsidiary, Barter Ltd. Barter Ltd has a functional currency that differs
from that of Able Ltd. Able Ltd acquired an 80% controlling interest in Barter Ltd on
1 January 20.11 for R80 000 and no goodwill arose at acquisition date. The non-controlling
interests are measured at their proportionate share of the net identifiable assets of the subsidiary.
Able Ltd sells its entire interest in Barter Ltd for R800 000 on 31 December 20.13.
The equity of Barter Ltd (translated to rand for consolidation purposes) at 31 December 20.13 is as
follows:
R
Equity at acquisition:
100 000
Share capital
Retained earnings
10 000
90 000
Equity since acquisition:
850 000
Retained earnings 1 January 20.13
Profit for the year 20.13
FCTR balance 1 January 20.13
FCTR movement for the year 20.13
500 000
100 000
200 000
50 000
Total equity
950 000
The retained earnings of Able Ltd on 31 December 20.13 is made up as follows:
Retained earnings 1 January 20.13
Profit for the year 20.13
2 000 000
800 000
Analysis of owner’s interest of Barter Ltd – 31 December 20.13
Able Ltd (80% – 0%)
At acquisition
Share capital
Retained earnings
Investment in Barter Ltd
Total
At
acquisition
Since
acquisition
R
R
R
Noncontrolling
interests
R
10 000
90 000
8 000
72 000
2 000
18 000
100 000
80 000
20 000
continued
The effects of changes in foreign exchange rates 295
Able Ltd (80% – 0%)
Since acquisition
To beginning of current year
Retained earnings
FCTR
Current year
Profit for the year
FCTR
Dispose of entire interest
Total
At
acquisition
Since
acquisition
R
R
R
Noncontrolling
interests
R
500 000
200 000
400 000
160 000
100 000
40 000
100 000
50 000
80 000
40 000
20 000
10 000
680 000
(680 000)
190 000
(190 000)
950 000
(950 000)
(80 000)
–
–
–
The consolidated profit at disposal of the investment in Barter Ltd is calculated as follows:
Derecognise assets and liabilities
Derecognise non-controlling interests
Proceeds on disposal
R
(950 000)
190 000
800 000
Profit on disposal (excluding reclassification of FCTR)
40 000
Comment
¾ IAS 21.48 determines that the FCTR accumulated in the separate component of equity is
reclassified to the statement of profit or loss and other comprehensive income (profit or loss
section) on disposal of an interest in a foreign operation. The FCTR (reserve in equity) of
R200 000 (160 000 + 40 000) must thus be reclassified to the statement of profit or loss and
other comprehensive income (profit and loss section). This is done by reducing the relevant line
item in the other comprehensive income section of the statement of profit or loss and other
comprehensive income (refer to 1 below) and increasing an appropriate line item in the profit or
loss section (refer to 2 below).
Extract from the statement of profit or loss and other comprehensive income
for the year ended 31 December 20.13
Profit for the year (800 000 + 100 000 + 40 000 + 200 0002)
Other comprehensive income for the year:
Items that may subsequently be reclassified to profit or loss:
Exchange difference on translating foreign operation
Reclassification adjustment of FCTR due to the disposal of a foreign operation
Other comprehensive income for the year
Total comprehensive income for the year
Profit attributable to:
Owners of the parent (800 000 + 80 000 + 40 000 + 200 000)
Non-controlling interests
R
1 140 000
50 000
(200 000)1
(150 000)
990 000
1 120 000
20 000
1 140 000
Total comprehensive income attributable to:
Owners of the parent (1 120 000 + 40 000 – 200 000)
Non-controlling interests (20 000 + 10 000)
960 000
30 000
990 000
continued
296 Descriptive Accounting – Chapter 11
Extract from the statement of changes in equity
for the year ended 31 December 20.13
Foreign
Retained
currency
earnings
translation
reserve
R
R
Balance at 1 January 20.13
(2 000 000 + 400 000)
2 400 000
160 000
Changes in equity for 20.13
Total comprehensive income
1 120 000
(160 000)
Profit for the year
Other comprehensive income
1 120 000
(160 000)
Disposal of interest in foreign operation
Balance at 31 December 20.13
Noncontrolling
interests
R
160 000
30 000
20 000
10 000
(190 000)
3 520 000
–
–
Comment
¾ The above R200 000 included in the profit for the year represents the FCTR realised on
disposal and transferred to the profit and loss section of the statement of profit or loss and other
comprehensive income. The FCTR attributed to the non-controlling interests will be
derecognised, but will not be reclassified to profit or loss.
¾ The R40 000 included in profit for the year represents the consolidated gain on the disposal of
the entire interest in the subsidiary (excluding the FCTR reclassification).
¾ The closing retained earnings balance of R3 520 000 is made up of the closing retained
earnings of Able Ltd of R2 800 000 (R2 000 000 + R800 000) and the since acquisition
reserves of Barter Ltd of R680 000 and the group profit on disposal of Barter Ltd of R40 000
(R2 800 000 + R680 000 + R40 000 = R3 520 000).
11.8 Disclosure
IAS 21.51 to .57 requires the following disclosure:
ƒ The amount of foreign exchange differences recognised in the profit or loss section of
the statement of profit or loss and other comprehensive income. Foreign exchange
differences recognised in the profit or loss section of the statement of profit or loss and
other comprehensive income as part of fair value adjustments on financial instruments at
fair value through profit or loss in terms of IFRS 9, Financial Instruments, need not be
identified separately.
ƒ The net foreign exchange differences recognised in other comprehensive income and
accumulated as a separate component of equity and reconciliation between the opening
and closing balances.
ƒ When the presentation currency is different from the functional currency, the following
must be disclosed:
– that fact;
– the functional currency; and
– the reason for using a different presentation currency.
ƒ When the entity translates its financial statements using a method which is not in line
with IAS 21:
– the information must be identified as supplementary information;
– the presentation currency of the supplementary information must be disclosed;
– the functional currency of the entity must be disclosed; and
– the method of translation used to determine the supplementary information must be
disclosed.
The effects of changes in foreign exchange rates 297
Example 11.14
Disclosure of accounting policies and notes
Notes to the consolidated financial statements
1. Accounting policies
Foreign currency transactions
(i) Functional and presentation currency
Items included in the financial statements of each of the group’s entities are measured using the
currency of the primary economic environment in which the entity operates (‘the functional
currency’). The consolidated financial statements are presented in rand, which is Plantkor Ltd’s
functional and presentation currency.
(ii) Transactions and balances
Foreign currency transactions are translated into the functional currency using the exchange rates
at the dates of the transactions. Foreign exchange differences resulting from the settlement of
such transactions and from the translation of monetary assets and liabilities denominated in foreign
currencies at year end exchange rates are generally recognised in profit or loss. The portion of the
gain or loss on qualifying cash flow hedges and net investment hedges that is determined to be an
effective hedge is recognised in other comprehensive income. Foreign exchange differences that
relate to borrowings are presented in the statement of profit or loss, within finance costs. All other
foreign exchange differences are presented in the statement of profit or loss within other income or
other expenses.
Non-monetary items that are measured at fair value in a foreign currency are translated using the
exchange rates at the date when the fair value was determined. Translation differences on assets
and liabilities carried at fair value are reported as part of the fair value gain or loss. For example,
translation differences on non-monetary assets such as financial assets measured at fair value
through other comprehensive income (elected classification) are recognised in other
comprehensive income.
(iii) Group companies
The results and financial position of foreign operations that have a functional currency different
from the presentation currency are translated into the presentation currency as follows:
ƒ assets and liabilities for each balance sheet presented are translated at the closing rate at the
date of that balance sheet;
ƒ income and expenses for each statement of profit or loss and statement of comprehensive
income are translated at average exchange rates; and
ƒ all resulting exchange differences are recognised in other comprehensive income.
On consolidation, exchange differences arising from the translation of any net investment in foreign
entities are recognised in other comprehensive income. When a foreign operation is sold the
associated exchange differences are reclassified to profit or loss, as part of the gain or loss on
sale.
Goodwill and fair value adjustments arising on the acquisition of a foreign operation are treated as
assets and liabilities of the foreign operation and translated at the closing rate.
CHAPTER
12
Borrowing costs
(IAS 23)
Contents
12.1
12.2
12.3
12.4
12.5
12.6
12.7
Overview of IAS 23 Borrowing Costs ................................................................
Background .......................................................................................................
Accounting treatment ........................................................................................
Rules of capitalisation .......................................................................................
12.4.1 Qualifying assets .................................................................................
12.4.2 Borrowing costs ...................................................................................
12.4.3 Commencement of capitalisation ........................................................
12.4.4 Suspension of capitalisation ................................................................
12.4.5 Cessation of capitalisation ...................................................................
12.4.6 Limit on capitalisation ..........................................................................
12.4.7 Total cost of the qualifying asset exceeds the recoverable amount ....
Capitalisation procedures ..................................................................................
12.5.1 Weighted average expenditure ...........................................................
12.5.2 Specific financing ................................................................................
12.5.3 General pool of funds ..........................................................................
12.5.4 Combination – specific and general loans ...........................................
12.5.5 Group statements ................................................................................
12.5.6 Foreign exchange differences ............................................................
Tax implications .................................................................................................
Disclosure ..........................................................................................................
299
300
300
300
301
301
301
301
303
303
303
304
304
305
305
306
306
306
307
308
310
300 Descriptive Accounting – Chapter 12
12.1 Overview of IAS 23 Borrowing Costs
Definitions
ƒ Borrowing costs.
ƒ Qualifying asset.
Recognition
ƒ Capitalise borrowing costs directly attributable to the
production, construction or acquisition of qualifying
asset.
ƒ Commence when expenditure for the asset and
borrowing costs are being incurred and activities
necessary to prepare asset are undertaken.
ƒ Suspend when active development of qualifying asset is
interrupted for extended periods.
ƒ Cease when substantially all the activities necessary to
prepare qualifying asset for intended use or sale are
complete.
Borrowing costs
eligible for
capitalisation
ƒ Specific funds: actual borrowing costs incurred, less any
investment income from surplus funds invested.
ƒ General funds: weighted average rate of borrowing
costs. Limited to actual borrowing costs incurred.
12.2 Background
Previously, the accounting standard on borrowing costs, IAS 23, allowed two accounting
treatments for borrowing costs on the acquisition, erection or production of qualifying assets.
Borrowing costs could be capitalised against the cost of the asset or recognised as an
expense. However, the revised edition of IAS 23 that appeared in March 2007 forces entities
to capitalise borrowing costs against such qualifying assets. Consequently, the policy choice
to expense borrowing costs on qualifying assets is removed. The elimination of a choice of
accounting policy has improved comparability between the financial statements of entities
and aligned the accounting standards issued by the IASB and FASB (issuing US GAAP).
12.3 Accounting treatment
IAS 23 regulates the circumstances under which borrowing costs shall be capitalised.
According to IAS 23, if borrowing costs are directly related to the acquisition, construction or
production of a qualifying asset, they must be capitalised in terms of IAS 23.1. Other
borrowing costs are recognised as an expense. Entities are not required to apply IAS 23 to a
qualifying asset carried at fair value (e.g. biological assets) or inventory manufactured
or produced in large quantities on a repetitive basis.
Where borrowing costs are capitalised, the recognition criteria for assets must be met. In
other words, it must be relevant and faithfully represented. The cost of calculating the
borrowing costs to be capitalised should not exceed the benefits of the information.
Capitalisation must be applied consistently to the borrowing costs of all qualifying assets,
and the accounting policy must be disclosed in the financial statements.
IAS 23 does not deal with the actual or deemed cost of equity or preferred share capital
classified as equity.
Borrowing costs 301
12.4 Rules of capitalisation
There are certain requirements, for example when capitalisation shall commence, when it
shall be suspended temporarily, and when it shall cease. In addition, a limit is placed on the
extent of the borrowing costs to be capitalised, and on the treatment where the total cost,
including the capitalised borrowing costs exceeds the recoverable or realisable value of the
asset.
Borrowing costs that are directly related to the acquisition, construction or production of
qualifying assets are capitalised. Capitalisation shall proceed even if the carrying amount of
the asset exceeds the recoverable or net realisable amount. An appropriate impairment to
recoverable amount or net realisable value write-down would then be recognised.
12.4.1 Qualifying assets
Capitalisation of borrowing costs can only take place for qualifying assets. A qualifying
asset is an asset that necessarily takes a substantial time to get ready for its intended
use or sale. Assets that are ready for intended use or sale at acquisition are therefore not
qualifying assets.
Qualifying assets include assets manufactured for own use to produce future revenue, as
well as manufacturing plants, intangible assets, power-generation facilities, properties that
will become self-constructed investment properties once completed, and investment
properties measured at cost that are being developed. Routinely-produced inventories are
excluded, but inventory with long production processes, for example ships and good wines,
may qualify for capitalisation. Financial assets are also excluded.
A qualifying asset must take a substantial period of time to complete. However, IAS 23
provides no guidance on the length of the period, and therefore judgement is required.
12.4.2 Borrowing costs
The general rule is that borrowing costs must be directly attributable to a qualifying
asset and that they would have been avoided if the expenditure on the qualifying asset had
not been incurred.
Borrowing costs are interest and other costs incurred by an entity in connection with the
borrowing of funds. They include:
ƒ interest on borrowed funds, for example bank overdrafts and short- and long-term
borrowings using the effective interest method in terms of IFRS 9;
ƒ foreign exchange gains and losses arising from foreign currency borrowings to the extent
that they are regarded as an adjustment to interest costs; and
ƒ interest in respect of lease liabilities recognised in accordance with IFRS 16.
12.4.3 Commencement of capitalisation
The capitalisation of borrowing costs as part of the cost of a qualifying asset should
commence when:
ƒ borrowing costs are incurred;
ƒ expenditure on the asset are incurred; and
ƒ activities that are necessary to prepare the asset for its intended use or sale are in
progress.
12.4.3.1 Borrowing costs are being incurred
Borrowing costs are usually incurred when the entity obtains interest-bearing external
finance, for example overdrafts, and short- or long-term borrowings to finance the
completion of the qualifying assets.
The borrowing costs may arise from loans made specifically for the purpose of completing
the qualifying asset (hence specific loans), or the entity may have a general pool of loans,
302 Descriptive Accounting – Chapter 12
or a centralised policy for raising and co-ordinating finance where it is not possible to link
loans directly to qualifying assets and an exercise of judgement is required (hence general
loans). The nature of the funding will determine when the borrowing costs will be incurred:
ƒ specific loan: borrowing costs will be incurred from the date that the loan funds are
advanced to the entity;
ƒ bank overdraft: borrowing costs will be incurred from the date that the overdraft facility
is used by the entity; and
ƒ mortgage loan: borrowing costs will be incurred from the date that the entity actually
draws down on the loan facility (note that the borrowing costs are only incurred on the
loan draw-downs and not on the total bond amount registered).
IAS 23 does not address the issue of interest-free loans or instances of deferred terms of
payment beyond normal market credit terms. It may be appropriate to calculate marketrelated deemed interest in such cases. Such interest will qualify as borrowing costs in terms
of this Standard, as borrowing costs include the interest expense calculated using the
effective interest method as described in the relevant Standard dealing with financial
instruments.
For compound financial instruments, for example convertible or redeemable instruments, the
requirements of the Standard dealing with financial instruments are followed and the interest
element (in terms of substance over form) may also qualify for capitalisation.
12.4.3.2 Expenditure is being incurred
Expenditure is being incurred on a qualifying asset if the payment of cash, or the transfer of
ownership of assets, or the receipt of interest-bearing liabilities has taken place. Expenditure
is reduced by any progress payments and grants (including government grants) received on
qualifying assets. The conclusion of a loan agreement in anticipation of the construction of
an asset does not necessarily give rise to ‘expenditure’.
The average carrying amount of an asset during a period, including borrowing costs
capitalised earlier, shall be used when the capitalisation rate for a period is applied to the
carrying amount of an asset. This will be the case where borrowing costs and expenditure
are funded out of a pool of funds (general loans) and interest is not funded out of other
surplus cash resources (i.e., interest is funded out of the pool of funds).
12.4.3.3 Activities necessary to prepare the asset for its intended use or sale
are in progress
‘Activities’ is used in a broad context, and includes more than just the physical
construction of the asset. It also includes technical and administrative work prior to the
commencement of the physical construction, for example obtaining permits or council
approval prior to construction. If the asset is merely ‘owned’ and no construction or
development is taking place, the requirement is deemed not to have been met. For example,
borrowing costs incurred while land is under development are capitalised during the
period in which activities related to the development are undertaken. However, borrowing
costs incurred while land acquired for development is held without any associated
development activity, do not qualify for capitalisation.
Example 12.1
Date of commencement of capitalisation of borrowing cost
Loaner Limited decides on 1 January 20.12 to erect a building. The current cash position of the
entity is not sufficient to erect the building without securing additional borrowed funds.
On 1 February 20.12, a loan is approved by NBF Bank and an amount of R10 000 000 is paid over
to Loaner Ltd on 30 April 20.12 in terms of the loan agreement. The loan bears interest at a
market-related interest rate of 12% per annum.
continued
Borrowing costs 303
On 1 March 20.12, the entity obtains approval from the metro council to erect a building on the
relevant plot, and on 2 March 20.12, the architects commence planning the building. On
1 April 2012, planning has advanced to such an extent that site preparation takes effect. The entity
and the architects, as well as the site preparation personnel, agreed that the first payment would
be made on 30 April 20.12 – the date on which the additional funding is received.
In terms of IAS 23.17, capitalisation must commence as soon as the entity has incurred borrowing
costs as well as expenditures for the asset, and the activities necessary to prepare the asset for its
intended use (or sale) have commenced.
On 1 March 20.12, as soon as the entity had obtained permission to erect the building, the
activities necessary to prepare the asset for its intended use had commenced. Expenditures are
incurred from 2 March 20.12, when the architects and site preparation personnel commence with
their activities. From 30 April 20.12, interest (borrowing costs) will be incurred. On 30 April 20.12, all
the conditions of IAS 23.17 are met, and therefore borrowing costs will be capitalised from that date.
12.4.4 Suspension of capitalisation
Where the active development of qualifying assets is interrupted for extended periods,
the capitalisation of borrowing costs is suspended until the active development resumes.
Capitalisation of borrowing costs is not normally suspended during a period when
substantial technical and administrative work is carried out. The capitalisation is also not
suspended for short interruptions in activities due to external factors, for example ongoing
bad weather and delays inherent in the acquisition process of an asset. If it is necessary to
age inventory, capitalisation will continue.
A measure of judgement is often required, as IAS 23 does not explain terms such as
‘extended period’ and ‘active development’. A general rule of thumb is to consider whether
the events causing the interruption are under the control of management. Events beyond the
control of management do not normally lead to the suspension of capitalisation, whereas
events caused by incorrect planning and other management inefficiencies may indicate that
capitalisation should be suspended.
12.4.5 Cessation of capitalisation
The capitalisation of borrowing costs ceases when substantially all activities necessary to
prepare the qualifying asset for its intended use or sale are complete. Even though
routine administrative work may still continue, capitalisation will cease once substantially all
activities are completed, usually when physical construction is complete. Note that the
cessation of capitalisation is linked to completeness and readiness, rather than the actual
dates when the asset is brought into use or is sold.
When the construction of an asset is completed on a piecemeal basis, it is possible that one
part may be completed for its intended use while construction continues on the other parts.
In this instance, capitalisation is ceased on the part that is completed. Where all parts need
to be completed before any part can be used or sold, capitalisation continues until the
construction as a whole is substantially complete. An example of the above is a production
plant in which production takes place in a specific sequence in different sections of the plant
and where the product is only complete once it has passed through all the sections.
12.4.6 Limit on capitalisation
A limit is placed on the capitalisation of borrowing costs for general loans, in that the amount
of borrowing costs capitalised during a period must not exceed the total amount of
borrowing costs incurred during that period. This limit may arise because of the
weighted average capitalisation rates and averaged expenditure used in the calculation. In
consolidated financial statements, the limit is established with reference to the consolidated
amount of borrowing costs.
304 Descriptive Accounting – Chapter 12
This does not imply, however, that all borrowing costs may be capitalised. Only the
borrowing costs that are directly attributable to the acquisition, construction or production of
a qualifying asset or that would have been avoided if the expenditure on the qualifying asset
had not been incurred but rather utilised to redeem existing loans, qualify for capitalisation.
On some projects, the financing arrangements for specific loans are such that the entity has
to pay borrowing costs on the full amount of the loan from the date specified in the
agreement. Surplus funds that are not utilised immediately are then invested temporarily
until required. Such investment income must be offset against the actual borrowing costs
incurred, in order to determine the amount of borrowing costs to be capitalised. If the
borrowed funds are paid into a bank overdraft on a temporary basis, the interest saved shall
theoretically also qualify as ‘investment income’ for these purposes.
12.4.7 Total cost of the qualifying asset exceeds the recoverable amount
Capitalisation may result in the carrying amount or the expected ultimate cost of a qualifying
asset exceeding its recoverable amount or net realisable value. In this case, capitalisation
continues. If the carrying amount exceeds the recoverable amount or net realisable amount,
the impairment or write-down is treated in accordance with IAS 36 or IAS 2. Such
impairment or write-down may subsequently be reversed in accordance with these Standards.
Where assets are revalued, the historical cost and capitalised borrowing costs are replaced
by the revalued amount.
12.5 Capitalisation procedures
The principle applied in IAS 23 is that the part of borrowing costs that must be capitalised is
that part which would have been avoided if the company had not incurred the expenditure
on that particular qualifying asset. Any technique that complies with this principle is
acceptable. Where specific loans were incurred in order to construct the asset, it is fairly
easy to identify the borrowing costs. By contrast, where a company or group with a complex
financing structure is involved in the construction of a qualifying asset, it becomes
progressively more difficult to determine the amount of borrowing costs that must be
capitalised. In these circumstances, it is important that the technique used to determine the
borrowing costs is the one that best meets the abovementioned principle.
The procedures for the calculation of the borrowing costs to be capitalised can usually be
carried out as follows:
Specific financing related to the project
ƒ Specific loan:
– calculate the interest on the total loan amount from the date that the loan was
advanced;
– determine the utilisation of the loan funds for the expenses incurred on the project;
– calculate the surplus funds and the interest income;
– deduct the interest income from the interest cost; and
– capitalise this net interest cost to the qualifying asset.
ƒ Bank overdraft and mortgage loan:
– determine the utilisation of the overdraft facility/mortgage for the expenses incurred on
the project (this represents the borrowing amount);
– calculate the interest on this borrowing amount (note that no interest income can be
earned on a bank overdraft/mortgage loan, since no surplus funds are invested); and
– capitalise this interest cost to the qualifying asset.
General pool of funds
ƒ determine the borrowing costs on loans/bank overdrafts/mortgage loans included in the
pool of funds;
Borrowing costs 305
ƒ determine the weighted average capitalisation rate of general loans;
ƒ determine the expenditure incurred on the qualifying asset not funded out of specific
funding or surplus cash funds that may be available since interest will not be incurred;
ƒ apply the capitalisation rate to the (weighted) expenditure of the qualifying asset to
calculate the borrowing costs that can be capitalised; and
ƒ check that this borrowing cost amount does not exceed the amount of actual borrowing
costs incurred.
Because the borrowing costs that may be capitalised are those that could have been
avoided had the company not incurred expenditure on the particular asset, notional
borrowing costs (income lost due to funds that could have been invested productively being
used for construction purposes) are not capitalised. It is also inappropriate to merely use the
market-related interest rate, which may not approximate the actual rate paid. It is however,
acceptable that the ratio of total borrowing costs to the total outstanding loans be used to
calculate a weighted average rate. Actual rates or a weighted rate, or a combination thereof,
may therefore be used. The terms of the loan agreement determine whether compound or
simple interest is calculated, and over what periods interest is payable.
12.5.1 Weighted average expenditure
It is important to consider when the expenditure on the qualifying assets was incurred. It
may be incurred at the beginning, or evenly throughout the period, or at the end of the
period. When expenses were incurred evenly through a period, a weighted average of
expenditure for the period under discussion is calculated.
12.5.2 Specific financing
Example 12.2
Specific loan: elementary application
The following information is presented:
R
Budgeted cost of the project to construct plant
4 000 000
Expenses incurred evenly during the year ended 30 June 20.12
2 400 000
A loan of R4 000 000 was obtained to finance the project on 1 July 20.11 at an interest rate of
20% per annum. This loan was negotiated specifically for this project. Interest on any surplus
funds invested is earned at 16% per annum. Interest of R800 000 and R448 000 respectively were
paid and received on 30 June 20.12. The year end of the company is 30 June. The loan capital is
repayable after 10 years. The amount that must be capitalised for a specific loan is the actual
borrowing cost incurred, less investment income earned from the temporary investment of the
surplus cash funds of the specific loan
The borrowing costs that must be capitalised to the plant for the year ended 30 June 20.12 are as
follows:
R
Borrowing costs incurred for the year
800 000
Interest received on surplus funds invested
(448 000)
Borrowing costs capitalised
352 000
Journal entry:
Property, plant and equipment (SFP)
Interest paid (P/L)
Borrowing costs capitalised
Dr
R
352 000
Cr
R
352 000
306 Descriptive Accounting – Chapter 12
12.5.3 General pool of funds
Where general loans are raised that are used for a variety of purposes (including the
construction of a qualifying asset), the capitalisation rate is the weighted average of the
borrowing rates applicable to the outstanding loans of the entity during the period. The
borrowing costs on specific loans used to construct a qualifying asset are excluded from this
calculation, as these are capitalised fully in any event.
During October 2015, the International Accounting Standards Board (IASB) agreed to clarify
the wording in IAS 23 to include funds specifically borrowed to finance the construction of a
qualifying asset, the construction of which has been completed, to be included as part of the
general borrowings for the purposes of determining the capitalisation rate of the entity’s
general borrowings.
Example 12.3
Pool of funds: elementary application
Assume the same information as in example 12.2 above
Apart from the loan of R4 000 000 the entity also has another loan of R2 000 000 at an interest
rate of 16% per annum. Neither of the loans were specifically obtained for the project to construct
the plant.
First a weighted average interest rate is calculated;
Interest
R
R
First loan
4 000 000
800 000
(4 000 000 × 20%)
Second loan
2 000 000
320 000
(2 000 000 × 16%)
Total
6 000 000
1 120 000
R
Weighted average interest rae 18,67% (1 120 000/6 000 000 × 100/1)
Borrowing costs capitalised:
Borrowing costs based on expenses incurred (2 400 000/2 × 18.67%)
224 040
Journal entry:
Property, plant and equipment (SFP)
Interest paid (P/L)
Borrowing costs capitalised
Dr
R
224 040
Cr
R
224 040
12.5.4 Combination – specific and general loans
Where a specific loan is raised for a particular project, but the loan is insufficient to finance
the full project, general loans on which borrowing costs are payable may also be used. The
specific loans are utilised first to cover the expenditure of the asset, and the balance of
expenditure is attributed to general loans.
12.5.5 Group statements
In group financial statements, several problems may exist regarding the identification of the
loans on which the capitalisation rate will be determined. These problems arise in complex
circumstances, where different companies in the group borrow money in different markets
and lend these monies to companies within the group on different bases. Usually, each
subsidiary uses the rates applicable to its loans. In consolidated financial statements, the
borrowing rates of the loans made to the group by third parties are used. The difference
between the borrowing cost reognised by individual companies and what it should be for
consolidated financial statments should be reversed upon consolidation.
Borrowing costs 307
Example 12.4
Capitalising borrowing costs in groups
Assume that the interest capitalised in the subsidiary’s separate financial statements is R831 000
and in the consolidated financial statements it should have been R763 000 due to the lower
weighted average interest rates of the group.
Consolidation journal entry
Interest paid (P/L)
Capital expenditure (SFP)
Adjustment of borrowing costs capitalised
Recorded by subsidiary
Required in consolidated financial statements
Reversal of entry
Dr
R
68 000
Dr
R
68 000
831 000
763 000
68 000
12.5.6 Foreign exchange differences
In IAS 23.6(e), borrowing costs may include exchange differences arising from foreign
currency borrowings, to the extent that they are regarded as adjustments to interest costs.
Consequently, not all exchange differences qualify for capitalisation. In general, the interest
on a foreign currency loan that is directly attributable to a qualifying asset must be converted
to the functional currency, and qualifies for capitalisation as borrowing costs. The treatment
of exchange differences arising on the principal amount of the loan is less clear. If it is
assumed that exchange rates are usually a function of the differential interest rate between
different countries, it may be argued that the full amount of exchange differences qualify for
capitalisation, yet market volatility indicates that market sentiment and other factors also
influence exchange rates, and these elements of exchange differences do not qualify for
capitalisation in terms of IAS 23. Consequently, how an entity applies IAS 23 to foreign
currency borrowings is a matter of accounting policy, requiring the exercise of judgement.
It is therefore prudent to limit the exchange differences on the capital amount of borrowings
that qualifies for capitalisation to the amount of borrowing costs that would have been
incurred on the functional currency equivalent borrowings in the functional currency. The
next example explains this interpretation.
308 Descriptive Accounting – Chapter 12
Example 12.5
Treatment of foreign exchange differences
Alpha Ltd, a company with a financial year ending on 31 December, conducts business in South
Africa. On 1 January 20.12, the company borrows FC1 000 000 to finance the development of a
qualifying asset of R2 000 000 in South Africa. Interest on the foreign loan is payable at 8% per
annum in arrears, while the equivalent interest rate on such a loan in South Africa is 12% per
annum in arrears. It is the policy of Alpha Ltd to include the foreign exchange gains or losses on
the principal amount of the loan and interest expense accrual (if any) in borrowing cost. It is also
the policy of Alpha Ltd to limit the borrowing costs capitalised to the amount of borrowing costs
that would have been incurred on equivalent borrowings in the functional currency. The exchange
rates are as follows:
FC1 = R
1 January 20.12
2,00
31 December 20.12
3,00
Average for the year
2,50
The actual interest payable (8% × FC1 000 000)
FC80 000
Translated at 2,50
R200 000
If the loan had been incurred in South Africa:
Equivalent of FC1 000 000 on 1 January 20.12 @ 2,00
R2 000 000
Interest (12% × R2 000 000)
R240 000
Restatement of principal amount:
1 January 20.12 (FC1 000 000 × 2,00)
R2 000 000
31 December 20.12 (FC1 000 000 × 3,00)
R3 000 000
Exchange difference on principal amount
R1 000 000
Total amount of borrowing costs capitalised are limited to
R240 000
Where a foreign loan is hedged by a forward exchange contract (FEC), the exchange
differences are not treated as borrowing costs for capitalisation, as this will disturb the
matching of the income and expenses of the hedged relationship. The FEC is accounted for
in accordance with IFRS 9.
12.6 Tax implications
As a result of differences between the income tax and accountancy treatment of pre-production interest, temporary differences may arise. The Income Tax Act 58 of 1962 allows a
deduction for pre-trade expenses in terms of section 11A. Section 11A allows for a
deduction of qualifying expenditure and losses incurred before the commencement of that
trade once a trade is carried on.
If a taxpayer already carries on a trade, the pre-production expenses may be deducted in
terms of the general deduction formula (section 11(a)) or may be regarded to be of a capital
nature and form part of the base cost of the asset.
Example 12.6
Deferred tax on borrowing costs and pre-trade expenditure
Alpha Ltd has a qualifying asset of which the borrowing costs are capitalised. The following
expenses were incurred at the beginning of each year on the qualifying asset:
R
Year 1
80 000
Year 2
150 000
Year 3
200 000
Year 4
120 000
550 000
continued
Borrowing costs 309
Alpha Ltd started trading at the beginning of Year 5 and the asset is depreciated at 15% per
annum on a straight-line basis. South African Revenue Service (SARS) allows a wear-and-tear
allowance at 20% on cost, and the normal income tax rate is 28%. The borrowing cost is allowed
as a pre-trade expenditure in terms of section 11A. The following borrowing costs on the asset were
capitalised:
R
Year 1
12 000
Year 2
24 000
Year 3
30 000
Year 4
16 800
82 800
Deferred tax
Year 5
Carrying
amount
R
*537 880
Temporary
difference
R
R
**440 000
97 880
Tax base
Deferred tax liability (97 880 × 28%)
* Carrying amount
Cost
Capitalised (interest)
27 406
550 000
82 800
Depreciation (632 800 × 15%)
632 800
(94 920)
537 880
** Tax base
Cost (excluding borrowing costs capitalised)
Wear-and-tear (550 000 × 20%)
550 000
(110 000)
440 000
Comment
¾ The taxable temporary difference arose as follows:
Depreciation
Wear-and-tear
Pre-trade interest (borrowing costs capitalised)
R
94 920
(110 000)
(82 800)
(97 880)
¾ If the asset is depreciated for accounting purposes, but no wear-and-tear allowance is allowed
for tax purposes, the temporary difference that arises between the carrying amount and the tax
base, excluding the element of borrowing cost, will be exempt from deferred tax. However, the
temporary difference arising from the capitalised borrowing cost and the pre-trade interest will
result in a deferred tax liability. The current tax calculation will be as follows:
R
Profit before tax
xxx
Non-deductible expenses
82 500
Depreciation (550 000 × 15%)
82 500
Movement in temporary differences
(70 380)
The movement in temporary differences may be broken down as follows:
Depreciation on borrowing cost component (82 800 × 15%)
Pre-trade interest
Taxable income
12 420
(82 800)
xxx
310 Descriptive Accounting – Chapter 12
Example 12.7
Deferred tax on borrowing costs
The following are the details of a plant that is used in the production of income on which SARS
grants a section 12C (40:20:20:20) deduction on 31 December 20.12.
R
Cost
1 495 400
Capitalised borrowing cost
275 000
Depreciation at 10% per annum on cost (1 770 400 × 10% × 6/12)
1 770 400
(88 520)
Carrying amount
1 681 880
The plant was available for use and was brought into use on 30 June 20.12. The plant is used to
expand an existing business. The normal income tax rate is 28% and the borrowing costs were
deducted for tax purposes in terms of the general deduction formula.
Deferred tax is calculated as follows:
Borrowing
Cost
Total
cost
element
element
R
R
R
Cost
1 770 400
1 495 400
275 000
Depreciation
(88 250)
(74 770)
(13 750)
Carrying amount
Tax base (1 495 400 – 598 160 (1 495 400 ×40%)
Temporary difference
Deferred tax at 28%
1 681 880
897 240
784 640
1 420 630
897 240
523 390
261 250
–
261 250
219 699
146 549
73 150
12.7 Disclosure
The following aspects must be disclosed separately:
ƒ the policy regarding the capitalisation of borrowing costs;
ƒ the capitalisation rate used to determine the amount of borrowing costs of general loans
to be capitalised (IAS 23.26(b)); and
ƒ the amount of borrowing costs capitalised during the period (IAS 23.26(a)).
Example 12.8
Disclosure of borrowing costs capitalised
Entity A erected a plant on which borrowing costs are capitalised at 12,5% per annum during the
year ended 30 June 20.12. The carrying amount of the asset, including borrowing costs of
R125 000 (interest expense of R150 000 minus investment income earned of R25 000), amounts
to R1 125 000. The total finance costs incurred for the year amount to R200 000.
The above facts will be disclosed as follows in the notes to the financial statements for the year
ending 30 June 20.12:
1 Accounting policy
1.1 Borrowing costs
Borrowing costs incurred on qualifying assets in terms of the requirements of IAS 23 are
capitalised from the date on which the borrowing costs, as well as expenditures for the asset, are
incurred. In addition, the activities necessary to prepare the asset for its intended use or sale must
have commenced. Capitalisation ceases as soon as the activities necessary to prepare the asset
for its intended use are completed.
continued
Borrowing costs 311
10 Finance costs
Borrowing costs incurred (Disclosure not required by standard)
Borrowing costs capitalised
(Disclosure not required by standard)
R
200 000
(125 000)
75 000
During the year, the entity capitalised borrowing costs at a rate of 12,5% per annum.
16 Property, plant and equipment
(Extract from this note if it is assumed that the entity owns only this plant and that the plant was
available for use as intended by management only on the last day of the financial year – therefore
no depreciation is written-off).
Plant
R
Carrying amount on 1 July 20.11
–
Cost
Accumulated depreciation
Movements during the year
Additions (1 125 000 – 125 000 (borrowing costs))
Borrowing cost capitalised
Carrying amount on 30 June 20.12
Cost
Accumulated depreciation
–
–
1 125 000
1 000 000
125 000
1 125 000
1 125 000
–
CHAPTER
13
Related party disclosures
(IAS 24)
Contents
13.1
13.2
13.3
13.4
13.5
13.6
13.7
Overview of IAS 24 Related Party Disclosure ...................................................
Background .....................................................................................................
Identifying related parties ................................................................................
13.3.1
A person or close family member ....................................................
13.3.2
Entities controlled, jointly controlled or significantly influenced
by certain related individuals ...........................................................
13.3.3
Key management personnel ............................................................
13.3.4
The entity and the reporting entity are members of the same
group................................................................................................
13.3.5
Parties with significant influence ......................................................
13.3.6
Parties with joint arrangements .......................................................
13.3.7
Related parties (subsidiaries, associates and joint ventures) ..........
13.3.8
Post-employment benefit plan .........................................................
13.3.9
Entities deemed not to be related parties ........................................
Related party transactions ..............................................................................
Disclosure........................................................................................................
13.5.1
Disclosure of related party relationships ..........................................
13.5.2
Disclosure of key management personnel compensation ...............
13.5.3
Disclosure of related party transactions ..........................................
13.5.4
Government-related entities ............................................................
13.5.5
Suggested format for disclosure of related party transactions ........
Materiality ........................................................................................................
Comprehensive example ................................................................................
313
314
314
315
316
316
316
317
317
318
319
320
321
322
323
323
324
324
325
326
326
327
314 Descriptive Accounting – Chapter 13
13.1 Overview of IAS 24 Related Party Disclosure
IAS 24
Related party
Persons
Entities
Persons who
control, jointly
control and
influence
significantly
ƒ Parent,
ƒ Subsidiaries,
ƒ Fellow
subsidiaries,
ƒ Joint ventures,
ƒ Associates,
ƒ Benefit plans,
ƒ Ventures; and
ƒ Entities which
influence
significantly.
ƒ Entities
controlled or
jointly
controlled by
persons who
are related.
ƒ Entities
that are
significantly
influenced by
persons who
control or
jointly control
the entity or
identified KMP
Persons who
are key
management
personnel
(KMP) of the
entity or its
parent
Disclosure
Relationships
Show
relationship
with:
ƒ Parent
ƒ Subsidiaries
ƒ Fellow
subsidiaries
KMP
compensation
Transactions
Show total
compensation
under
following
categories:
In respect of
various
categories,
disclose the
following:
ƒ Short-term,
other longterm,
postemployment,
termination
benefits
ƒ Relationship
ƒ Share-based
payments
ƒ Nature
ƒ Amount
ƒ Amounts
outstanding
ƒ Allowance for
credit losses
ƒ Credit losses
written off
13.2 Background
The qualitative characteristic of financial reports known as faithful representation, implies,
inter alia, that the information contained in the reports faithfully represents that which it
purports to represent. It means that the financial reports represent the result of transactions
between independent parties on a normal arm’s length basis, unless the opposite is
stated. If transactions take place other than on a normal arm’s length basis, this should be
disclosed in the financial statements. Related party transactions are sometimes not at arm’s
length and are transactions that involve the transfer of resources, services or obligations
between related parties, regardless of whether a price is charged (IAS 24.9).
The closing of transactions on terms different to those normally applicable in the market
often occurs between parties that are ‘related’. As reporting for accounting purposes is
usually based on the values agreed upon by the parties to the transaction, which are not
necessarily the values determined in the free market, the financial statements of entities with
Related party disclosures 315
material related party transactions may not be comparable with the statements of entities
without these types of transactions. A related party relationship could also have a significant
influence on the financial position and operating results of the reporting entity, as these
parties are often involved in transactions that unrelated parties would not enter into. Even
the mere existence of such a relationship without any transactions may be sufficient to affect
the transactions of the reporting entity with other parties.
For these reasons, knowledge of related party transactions, outstanding balances and
relationships may affect assessments of an entity’s operations by users of financial
statements, including assessments of the risks and opportunities facing the entity.
The objective of IAS 24 is therefore to ensure that an entity’s financial statements contain
the disclosures necessary to draw attention to the possibility that its financial position and
profit or loss may have been affected by the existence of related parties and by transactions
with, and outstanding balances of, such parties (IAS 24.1).
Unusual transactions, for example mass sales, the exchange of assets, transactions of a
non-recurring nature and transactions where the risks of ownership do not pass to the
buyer, are often indicative of the existence of related party relationships. Sometimes,
transactions between related parties, for example free management services or an
advertising campaign that benefits several companies in a group, where the costs are borne
by one company, are not recorded.
The Standard is applied in (IAS 24.2):
ƒ identifying related party relationships and transactions;
ƒ identifying outstanding balances (including commitments) between an entity and its
related parties;
ƒ identifying the circumstances in which disclosure of related party relationships,
transactions and outstanding balances between an entity and its related parties is
required; and
ƒ determining the disclosure requirements of these items as above.
The Standard also requires that related party transactions and outstanding balances between
related parties should be disclosed in the consolidated and separate financial statements
of a parent or investors with joint control of, or significant influence over an investee
(IAS 24.3) presented in terms of IFRS 10 Consolidated Financial Statements and IAS 27
Separate Financial Statements. This Standard also applies to individual financial statements.
Since intragroup-related party transactions and outstanding balances are eliminated in the
consolidated financial statements of a group, such transactions and balances are only
disclosed in the entity’s own financial statements (IAS 24.4).
13.3 Identifying related parties
A related party is a person or entity that is related to the entity that is preparing its
financial statements (referred to as the ‘reporting entity’).
A person or close member of that person’s family is related to a reporting entity if that
person (IAS 24.9(a)):
ƒ has control or joint control over the reporting entity; or
ƒ has significant influence over the reporting entity; or
ƒ is a member of the key management personnel of the reporting entity or its parent.
An entity is related to a reporting entity if any of the following conditions apply (IAS 24.9(b)):
ƒ the entity and the reporting entity are members of the same group; or
ƒ one entity is an associate or joint venture of the other entity; or
ƒ both entities are joint ventures of the same third entity; or
316 Descriptive Accounting – Chapter 13
ƒ one entity is a joint venture of a third entity and the other entity is an associate of the
third entity; or
ƒ the entity is a post-employment benefit plan for the benefit of employees of either the
reporting entity or an entity related to the reporting entity. If the reporting entity is itself
such a benefit plan, the sponsoring employers are also related to the reporting entity; or
ƒ the entity is controlled or jointly controlled by a person identified in paragraph 9(a) of
IAS 24 as discussed above; or
ƒ a person who has control or joint control over the reporting entity has significant
influence over the entity or is a member of the key management personnel of the entity
(or of a parent of the entity).
ƒ the entity, or any member of a group of which it is a part, provides key management
personnel services to the reporting entity or to the parent of the reporting entity.
In considering each possible related party relationship, attention is directed to the
substance of the relationship and not merely its legal form (IAS 24.10). Elements of the
definition of a related party are discussed in more detail below.
13.3.1 A person or close family member
Close members of the family of a person are those family members who may be expected to
influence or to be influenced by that person in their dealings with the entity. These close
members of the family of a person include:
ƒ that person’s children and spouse or domestic partner;
ƒ children of that person’s spouse or domestic partner; and
ƒ dependants of that person or that person’s spouse or domestic partner (IAS 24.9).
In other words, they are close members of a family of individuals who have control,
significant influence or joint control over the entity or key management personnel.
The intention of this component of the definition of a related party is to prevent entities from
transacting with close members of family rather than with individuals in order to avoid the
disclosure required by the Standard.
13.3.2 Entities controlled, jointly
by certain related individuals
controlled
or
significantly
influenced
Entities are related if they are:
ƒ controlled or jointly controlled by persons identified in IAS 24.9(a); or
ƒ significantly influenced by persons controlling or jointly controlling the reporting entity; or
ƒ by key management personnel of the reporting entity or its parent.
This part of the definition is intended to prevent entities from avoiding the disclosure
requirements of the Standard by transacting with entities that are controlled, jointly
controlled or significantly influenced by the individuals, instead of transacting with the
individuals themselves.
13.3.3 Key management personnel
‘Key management personnel’ is defined as those persons having authority and responsibility
for planning, directing and controlling the activities of the entity, directly or indirectly,
including any director (whether executive or otherwise) of that entity (IAS 24.9).
Any executive or non-executive director of an entity will be a related party of that entity.
Other individuals that are not directors could also be a related party of the entity if they have
the authority and responsibility for planning, directing and controlling the activities of the
entity.
Related party disclosures 317
Example 13.1
Related individuals
Mr A is a non-executive director of Entity B. He owns 100% of the issued share capital of Entity C.
The related parties of Entity B are:
Mr A is a related party of Entity B as he is a member of key management personnel (nonexecutive director).
Entity C is a related party of Entity B, as Entity C is controlled by a member of the key
management personnel of Entity B (Mr A owns 100% of Entity C).
Entity B will have to disclose transactions with Mr A and Entity C.
Both Mr A and Entity B are also related parties of Entity C. Mr A controls Entity C (IAS 24.9(a)(i)).
Since he controls Entity C and is also a member of the key management personnel of Entity B
(IAS 24.9(b)(vii), Entity B is also a related party of Entity C.
Entity C will have to disclose transactions with Mr A and Entity B.
13.3.4 The entity and the reporting entity are members of the same group
The entity and the reporting entity are members of the same group which means that each
parent, subsidiary and fellow subsidiary within a group is related to the other entities within
the group.
A party is thus related to a reporting entity if it is controlled by the reporting entity. The
definition of control of an investee as per IFRS 10 Consolidated Financial Statements is as
follows:
ƒ An investor has power over the investee; and
ƒ an investor is exposed, or has rights, to variable returns from its involvement with the
investee; and
ƒ the investor has the ability to affect those returns through its power over the investee.
Example 13.2
Members of the same group
Parent A has control over subsidiary B and subsidiary C.
In the separate financial statements of parent A, both subsidiary companies B and C will be
disclosed as related parties to the parent as they are controlled by the parent.
In the separate financial statements of subsidiary B:
ƒ Parent A will be disclosed as a related party, as the parent A controls subsidiary B.
ƒ Subsidiary C will be disclosed as a related party as it is under common control, that is, both
subsidiary B and subsidiary C are controlled by the same entity.
On similar grounds, parent A and subsidiary B will be disclosed as related parties in the separate
financial statements of subsidiary C.
It should however be noted that the reference to ‘a party’ in this context is not limited to corporate
entities only, as individuals are also able to control an entity.
13.3.5 Parties with significant influence
‘Significant influence’ means the power to participate in the financial and operating policy
decisions of the other party, but not to control or have joint control of those policies. This
significant influence may be gained by share ownership, statute or agreement.
The discussion of significant influence contained in IAS 28 Investments in Associates and
Joint Ventures states that if an entity holds, either directly or indirectly (e.g. through
subsidiaries), 20% or more of the voting power of the investee, it is normally presumed to
have significant influence (IAS 28.5).
318 Descriptive Accounting – Chapter 13
It should be noted that investments held by venture capital organisations or mutual funds,
unit trusts and similar entities that are not equity-accounted under IAS 28, are also included
in this definition of significant influence.
13.3.5.1 Reporting entity is an associate
A party is related to an entity if the party holds an interest in the reporting entity and
exercises significant influence over that entity (an associate).
An associate is defined by IAS 28 Investments in Associates and Joint Ventures as an entity
over which the investor has significant influence.
Example 13.3
Significant influence over associate
Entity A has a 30% interest, constituting significant influence, in Entity B.
Entity B must disclose in its financial statements that Entity A is a related party.
13.3.5.2 Reporting entity is an investor
A party is related to an entity if the party is an associate of the reporting entity (IAS 24.9(b)(ii)).
Example 13.4
Investor with significant influence
Entity A has a 30% interest, constituting significant influence, in Entity B.
In Entity A’s financial statements, Entity B will be disclosed as a related party.
13.3.6 Parties with joint arrangements
A joint arrangement is an arrangement in which two or more parties have joint control
(IFRS 11.4 Joint Arrangements).
Joint control is defined as the contractually agreed sharing of control of an arrangement,
which exists only when decisions about the relevant activities require the unanimous
consent of the parties sharing control (IFRS 11.7).
13.3.6.1 Reporting entity is the joint venture
A party is related to a reporting entity if it has joint control over the reporting entity.
Example 13.5
Entity is jointly controlled
Entity A has a 45% interest in Entity B and exercises joint control over Entity B in terms of a
contractual arrangement with another party.
In Entity B’s financial statements, Entity A will be disclosed as a related party.
13.3.6.2 Reporting entity has joint control
An entity is related to a reporting entity if one entity is a joint venture of the other entity
(IAS 24.9(b)(ii)).
Example 13.6
Entity has joint control
Entity A has a 45% interest in Entity B and exercises joint control over Entity B in terms of a
contractual arrangement with another party.
In Entity A’s financial statements, Entity B will be a related party.
Related party disclosures 319
13.3.7 Related parties (subsidiaries, associates and joint ventures)
In the definition of a related party:
ƒ an associate includes subsidiaries of the associate; and
ƒ a joint venture includes subsidiaries of the joint venture.
Therefore, an associate’s subsidiary and the investor that has significant influence over the
associate, are related to each other.
Two or more venturers are not related parties simply because they share joint control over a
joint venture (IAS 24.11(b).
Relationships between a parent and its subsidiaries must be disclosed irrespective of
whether there have been transactions between them.
Example 13.7
Associates and joint ventures of the same third party
The following entities are part of the Entity A Group:
Entity A
45%
35%
Entity C
(associate)
Entity B
(joint venture)
The following related parties are identified and disclosed in the separate financial statements of
each entity within the group:
Entity A’s (separate) financial statements
Entity B (joint venture) and Entity C (associate) are related parties of Entity A.
Entity B’s financial statements
Entity A and Entity C are related parties of Entity B.
Entity C’s financial statements
Entity A and Entity B are related parties of Entity C.
Comment
¾ An entity is a related party of the reporting entity if one of the entities is a joint venture of a third
party and the other entity is an associate of the third party.
¾ The parties Entity B (joint venture) and Entity C (associate) are related according to
paragraph 9(b)(iv) of the related party definition. If both Entity B and Entity C had been
associates, then these two entities would not have been related parties.
Example 13.8
Subsidiaries, associates and joint ventures
The following entities are part of the Entity A Group:
Entity A
(parent)
80%
65%
Entity B
(subsidiary)
25%
Entity C
(subsidiary)
35%
Entity D
(associate)
45%
Entity E
(joint venture)
Entity F
(associate)
continued
320 Descriptive Accounting – Chapter 13
The following related parties are identified and disclosed in the separate financial statements of
each entity within the group:
Entity A’s (parent) separate financial statements
Entity B (subsidiary), Entity C (subsidiary), Entity D (associate), Entity E (joint venture) and
Entity F (associate of Entity B) are related parties. (Refer to IAS 24, paragraph 9(b)(i) and (ii)).
Entity A’s consolidated financial statements
In the consolidated financial statements of A, only Entity D, E and F are related parties to the
group, as they are regarded as one reporting entity (and all the intragroup transactions between
Entity A (parent) and Entity B and C (subsidiaries) are eliminated).
Entity D is a related party of Entity A, as it is an associate of Entity A.
Entity E is also a related party of Entity A, as it is a joint venture of Entity A.
Entity F is a related party of Entity A, as it is an associate of Entity B which is a subsidiary of
Entity A.
Entity B’s financial statements
The parent, Entity A, Entity C (subsidiary of Entity A), Entity D (associate of Entity A) and Entity E
(joint venture of Entity A) and Entity F (associate of Entity B) are related parties (refer to IAS 24,
paragraph 9(b)(i) and (ii)).
Entity C’s financial statements
The parent, Entity A, Entity B (subsidiary of Entity A), Entity D (associate of Entity A) and Entity E
(joint venture of Entity A) and Entity F (associate of Entity B) are related parties (refer to IAS 24,
paragraph 9(b)(i) and (ii)).
Entity D’s financial statements
Entity A is a related party of Entity D as it exercises significant influence over Entity D.
Entity E is a related party of Entity D as it is a joint venture of Entity A (IAS 24(b)(iv).
Entity A is a related party of Entity D (IAS 24(b)(ii) and as a result Entity B and Entity C are related
parties of Entity D as they are all members of the Entity A group.
Entities F is not a related party of Entity D as none of the components of the definition of a related
party are applicable (also refer IAS 24.IE7).
Entity E’s financial statements
Entity A is a related party of Entity E as it exercises joint control over Entity E.
Entity D is a related party of Entity E as it is an associate of Entity A (IAS 24(b)(iv).
Entity A is a related party of Entity E and as a result Entity B and Entity C are related parties of Entity
E as they are all members of the Entity A group (IAS 24(b)(ii).
Entities F is not a related party of Entity E as none of the components of the definition of a related
party are applicable.
Entity F’s financial statements
Entity B is a related party of Entity F as it exercises significant influence over Entity F.
Entity A is a related party of Entity F as it controls Entity B.
Entity C is a related party of Entity F as Entity F is an associate of Entity B which is in the same group
of Entities as Entity C.
Entities D and E are not related parties as none of the components of the definition of a related party
are applicable.
13.3.8 Post-employment benefit plan
A party is related to an entity if the party is a post-employment benefit plan for the benefit of
the employees of either the reporting entity, or of an entity that is a related party to the
reporting entity. If the reporting entity is itself a plan, the sponsoring employers are also
related to the reporting entity (refer to IAS 24.9(b)(v)).
Related party disclosures 321
Example 13.9
Post-employment plan
Fund A has been created for the benefit of the employees of Entity A and Fund B has been
created for the benefit of the employees of Entity B, which is a subsidiary of Entity A.
Fund A and Fund B are related parties of Entity A.
13.3.9 Entities deemed not to be related parties
IAS 24.11 determines that the following are not necessarily related parties:
ƒ two entities, simply because they have a director or other member of key management
personnel in common, or because a member of key management personnel of one entity
has significant influence over the other entity; or
ƒ two joint venturers, simply because they share joint control over a joint venture; or
ƒ providers of finance, trade unions, public utilities and government departments and
agencies, simply by virtue of their normal dealings with an entity (even though they may
affect the freedom of action of an entity or participate in its decision-making process); or
ƒ a customer, supplier, franchisor, distributor or general agent with whom an entity
transacts a significant volume of business, merely by virtue of the resulting economic
dependence.
The use of the words ‘simply’ and ‘merely’ in the above context are extremely important, as
it indicates that other factors could result in the parties being related.
Example 13.10
Identifying related parties
The following figure shows the related parties of the# reporting entity, A Ltd. Related parties are
identified by*, while unrelated parties are identified by .
Example 1
Z Ltd*
Parent
Y Ltd*
Fellow subsidiary
A Ltd
Control
W Ltd*
Subsidiary
X Ltd*
Associate
Joint control
B Ltd*
Subsidiary
C Ltd* Jointlycontrolled entity
Significant
influence
D Ltd*
Associate
Significant
influence
E Ltd*
Subsidiary
K Ltd*
Subsidiary
F Ltd*
Associate
M Ltd#
Associate
L Ltd*
Associate
continued
322 Descriptive Accounting – Chapter 13
Comment
¾ It can be argued that M Ltd (Example 1 above) does not qualify as a related party as A Ltd
exercises only significant influence over D Ltd and does not, as a result, exercise significant
influence over M Ltd. In each instance, one should consider the underlying circumstances and
the economic reality. If A Ltd should have significant influence over M Ltd, it is recognised as a
related party. If no such influence exists, M Ltd does not qualify as a related party.
Example 2
Q Ltd*
Parent
Mr Y*
CEO of Q Ltd
Significant
influence
S Ltd* Private company
Mr Y holds 100% of the shares
Control
R Ltd*
Associate
P Ltd#
Joint venturer
A Ltd
Joint control
Joint control
Significant influence
H Ltd*
Associate
G Ltd*
Joint venture
Control
J Ltd*
Subsidiary
Comment
¾ When determining whether parties are related or not, the economic substance rather than the
legal form of the relationship should be considered. The aim of the disclosure of transactions with
related parties is to provide users of the financial statements with information on the risk profile of
the reporting entity.
¾ Where transactions are eliminated on consolidation, these transactions need not be disclosed.
The relationship between parents and subsidiaries should, however, still be disclosed.
¾ Where equity accounting results in the partial elimination of transactions, only the transactions
that are not eliminated should be disclosed. Examples include transactions with associates and
with jointly controlled entities.
13.4 Related party transactions
A related party transaction is a transfer of resources, services or obligations between a
reporting entity and a related party, regardless of whether a price is charged (IAS 24.9).
This definition therefore includes all transactions with related parties, irrespective of whether
they took place on an arm’s length basis or not. Relations with related parties may result in
substantial changes to the financial statements without any transactions being entered into.
A subsidiary may be prevented by its parent from conducting any research. IAS 24 does not
require that the effect of such influences, which do not lead to transactions, be determined,
and deals only with the disclosure of actual transactions.
IAS 24 provides the following examples of situations where transactions between related
parties should be disclosed by the reporting entity (IAS 24.21):
ƒ purchases or sales of goods (finished or unfinished);
Related party disclosures 323
ƒ purchases or sales of property and other assets;
ƒ rendering or receiving of services;
ƒ leases;
ƒ transfers of research and development;
ƒ transfers under license agreements;
ƒ transfers under finance agreements, including loans and equity contributions in cash or
in kind;
ƒ provision of guarantees or collaterals;
ƒ commitments to do something if a particular event occurs or does not occur in the future,
including recognised and unrecognised executory contracts (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 Provisions, Contingent Liabilities and Contingent
Assets); and
ƒ settlement of liabilities on behalf of the entity or by the entity on behalf of that related party.
Related parties have a degree of flexibility in the price-setting process that is not present in
transactions between unrelated parties. IAS 24 does not require that the methods used for
transfer pricing between related parties should be disclosed.
The Standard states that disclosures that related party transactions were made on terms
equivalent to those that prevail in arm’s length transactions are made only if such terms can
be substantiated (IAS 24.23).
13.5 Disclosure
The disclosure requirements of IAS 24 address the following:
ƒ disclosure of related party relationships;
ƒ disclosure of key management personnel compensation; and
ƒ disclosure of other related party transactions.
13.5.1 Disclosure of related party relationships
All entities:
ƒ Relationships between a parent and its subsidiaries must be disclosed irrespective of
whether there were transactions between them (IAS 24.13).
ƒ An entity must disclose the name of its parent and, if different, the name of the ultimate
controlling party (IAS 24.13).
ƒ If neither the entity’s parent nor the ultimate controlling party produces consolidated
financial statements available for public use, the name of the next most senior parent
(the first parent in the group above the immediate parent that produces consolidated
financial statements available for public use (IAS 24.16)) that does so shall be disclosed
(IAS 24.13).
ƒ To enable users of financial statements to establish a view about the effects that related
party relationships have on an entity, it is appropriate to disclose the related party
relationship when control exists, irrespective of whether there have been transactions
between the related parties.
The requirement to disclose related party relationships between a parent and its subsidiaries
is in addition to the disclosure requirements in IAS 27 Separate Financial Statements and
IFRS 12 Disclosure of Interests in Other Entities.
324 Descriptive Accounting – Chapter 13
13.5.2 Disclosure of key management personnel compensation
For this purpose, compensation includes all employee benefits as defined in IAS 19,
Employee Benefits, including share-based payments within the scope of IFRS 2,
Share-based Payment. Employee benefits are all forms of consideration paid in exchange
for services rendered to the entity. It also includes considerations paid on behalf of a parent
in respect of the entity.
IAS 24.17 requires disclosure of key management personnel compensation in total and for
each of the following categories:
ƒ short-term employee benefits, for example wages, salaries and social security
contributions, paid annual leave and paid sick leave, profit-sharing and bonuses (if
payable within twelve months of the end of the period) and non-monetary benefits for
example medical care, housing, cars and free or subsidised goods or services;
ƒ post-employment benefits, for example pensions, other retirement benefits, postemployment life insurance and post-employment medical care;
ƒ other long-term benefits, for example long service leave or sabbatical leave, jubilee or
other long-service benefits, long-term disability benefits and, if they are not payable wholly
within twelve months after the end of the period, profit-sharing, bonuses and deferred
compensation;
ƒ termination benefits; and
ƒ share-based payments.
Amounts incurred by the entity for the provision of key management personnel services that
are provided by a separate management entity shall be disclosed, however the entity is not
required to apply the requirements in IAS 24.17 to the compensation paid or payable by the
management entity to the management entity’s employees or directors.
13.5.3 Disclosure of related party transactions
In terms of IAS 24, information about related party transactions and outstanding balances
necessary for an understanding of the potential effect of the relationship on the financial
statements should be disclosed.
At a minimum, disclosure must include (IAS 24.18):
ƒ the nature of the related party relationships;
ƒ the amount of the transactions;
ƒ the amount of outstanding balances, including commitments (distinguished between
payable to and receivable from) and
– their terms and conditions, including whether they are secured, and the nature of the
consideration to be provided in settlement; and
– details of any guarantees given or received;
ƒ provisions for doubtful debts related to the amount of outstanding balances, and
ƒ the expense recognised during the period in respect of bad or doubtful debts due from
related parties.
The abovementioned required disclosure must be presented for each of the following
categories (IAS 24.19):
ƒ the parent;
ƒ entities with joint control or significant influence over the entity;
ƒ subsidiaries;
ƒ associates;
Related party disclosures 325
ƒ joint ventures in which the entity is a venturer;
ƒ key management personnel of the entity or its parent; and
ƒ other related parties.
IAS 24 provides guidelines for the disclosure of transactions with related parties, but does
not require a specific format of presentation. Items of a similar nature may be disclosed in
aggregate, except when separate disclosure is necessary for an understanding of the
effects of related party transactions on the financial statements of the entity (IAS 24.24).
Professional judgement is required when deciding on the presentation of the disclosure of
transactions with related parties.
As the transactions between related parties that are equity-accounted are not normally
eliminated on consolidation, these related party transactions should be disclosed. The same
rule applies to joint ventures that are also accounted for under the equity method in terms of
IFRS 11 Joint Arrangements.
13.5.4 Government-related entities
A government-related entity is exempt from the disclosure requirements in relation to:
ƒ related party transactions and outstanding balances, including commitments, with a
government that has control, joint control or significant influence over the reporting entity;
and
ƒ transactions with another entity that is a related party because the same government has
control, joint control or significant influence over both the reporting entity and the other
entity (IAS 24.25).
If the exemption in IAS 24.25 is applied, the entity must disclose the following about the
transactions and related outstanding balances referred to above:
ƒ the name of the government and the nature of its relationship with the reporting entity
(i.e. control, joint control or significant influence);
ƒ the following information in sufficient detail to enable users of the entity’s financial
statements to understand the effect of related party transactions on its financial
statements:
– the nature and amount of each individually significant transaction; and
– for other transactions that are collectively, but not individually, significant, a qualitative
or quantitative indication of their extent (IAS 24.26).
In determining the level of detail to be disclosed, judgement should be applied. The
reporting entity will consider the closeness of the related party relationship and other factors
relevant in establishing the level of significance of the transaction. Factors to consider are
whether the transaction is:
ƒ significant in terms of size;
ƒ carried out on non-market terms;
ƒ outside normal day-to-day business operations, for example the purchase and sale of a
business;
ƒ disclosed to regulatory or supervisory authorities;
ƒ reported to senior management; and
ƒ subject to shareholder approval.
326 Descriptive Accounting – Chapter 13
13.5.5 Suggested format for disclosure of related party transactions
The following diagram could serve as a useful aid in the disclosure of related party transactions:
Parent
Subsidiary
Associate
Joint
venture
Other
Key
management
personnel
Joint control,
significant
influence over
reporting entity
Transaction
amount
Outstanding
balance
Terms
Guarantees
Allowance
account for
credit losses
Bad debts
(SAICA)
13.6 Materiality
IAS 1.31 Presentation of Financial Statements determines that applying the concept of
materiality means that a specific disclosure requirement in a Standard need not be satisfied
if the information is not material. This by implication means that, if related party information
is not material, an entity need not comply with IAS 24 for that information.
IAS 1 Presentation of Financial Statements defines ‘material’ as (IAS 1.7):
ƒ omissions or misstatements of items;
ƒ if they could, individually or collectively;
ƒ influence the economic decisions of users taken on the basis of the financial statements.
Materiality depends on the size and nature of the omission or misstatement judged in the
surrounding circumstances. The size or nature of the item, or a combination of both, could
be the determining factor.
In the context of related party disclosures, size is not of primary importance, as IAS 24.9
defines a related party transaction as a transfer of resources, services or obligations
between related parties, regardless of whether a price is charged. If judged on size
alone, a transaction for which no price is charged may be considered to be immaterial as it
has no value. The Standard gives ample examples of the qualitative importance of related
party disclosures, including:
ƒ that related parties will enter into transactions that unrelated parties would not;
ƒ the profit or loss and financial position of an entity may be affected by a related party
relationship even if related party transactions do not occur; and
ƒ knowledge of related party transactions may affect assessments of an entity’s operations
(IAS 24.6 to .8).
Based on this, companies will have to prove that related party disclosures are qualitatively
not material in order to make use of IAS 1.31. Given the qualitative importance placed on
related party disclosures by IAS 24, this may be difficult to do.
Related party disclosures 327
13.7 Comprehensive example
Kingfisher Ltd is a diversified retail group that operates speciality stores. The group structure is as
follows:
ƒ Kingfisher Ltd has a wholly-owned subsidiary, A Ltd, which in turn owns a 60% subsidiary, B Ltd.
ƒ Kingfisher Ltd has a 30% interest in C Ltd (significant influence) which in turn has a 40% interest in
D Ltd.
ƒ Mrs Weaver has significant influence over Kingfisher Ltd.
The group structure can schematically be presented schematically as follows:
(30% interest)
Kingfisher Ltd
(20% interest)
Mrs Weaver
(100%)
(Subsidiary)
C Ltd
A Ltd
(40% interest)
D Ltd
(60% interest)
B Ltd
Kingfisher Ltd is considering whether or not the following transactions constitute related party
transactions for the year ended 31 December 20.13:
1. Bateleur Ltd is responsible for certain administration and investment services of Kingfisher
Ltd. Mr Bird, a non-executive director of Kingfisher Ltd, is also a director of Bateleur Ltd.
In terms of IAS 24, a non-executive director is included in the definition of key management
personnel; therefore Mr Bird is a related party.
IAS 24.11 determines that two entities are not related parties simply because they have a
director or other member of key management personnel in common. Bateleur Ltd is therefore not
a related party of Kingfisher Ltd based solely on the fact that Mr Bird is a director of both
companies. Other facts may, however, indicate that the two parties are related.
2. Kingfisher Ltd provides a range of administrative, technical-advisory and other services to
its associate (C Ltd) in accordance with its needs, and subject to various agreements drawn
up under normal commercial terms and conditions. In return, the associate pays a fee and
reimburses Kingfisher Ltd for costs it incurs. During the year, fees amounted to R560 000
and an amount of R49 000 was reimbursed.
Associates are related parties; therefore disclosure should be as follows:
The company provides a range of administrative, technical-advisory and other services to its
associate, in accordance with its needs and subject to various agreements drawn up under normal
commercial terms and conditions. In return, the associate pays a fee and reimburses the company
for costs it incurs.
Information relating to the associate is as follows:
Fees
Amounts reimbursed
No balances were outstanding on 31 December 20.13
Other information relating to the associate can be found in note x.
R
560 000
49 000
328 Descriptive Accounting – Chapter 13
3. Mr Quail, the managing director of Kingfisher Ltd, engaged the services of his daughter (a
design student) to select and hang new curtains in the company’s new office. An amount of
R12 000 was paid to Miss Quail and R170 000 to Deco Ltd. There is no connection between
Deco Ltd and Kingfisher Ltd.
Miss Quail is a close family member of a director of the company.
This is therefore a related party relationship and disclosure should be made of the transaction as
follows:
Miss Quail, a daughter of Mr Quail, provided certain once-off consulting services to the company
during the year. A market-related amount of R12 000 was paid to her. No amounts are outstanding
on 31 December 20.13.
4. Kingfisher Ltd made sales in the ordinary course of business of R56 000 to B Ltd, of which
R23 000 was outstanding at the year end.
Kingfisher Ltd and B Ltd are related parties, as Kingfisher Ltd exercises control over B Ltd.
However, no disclosure of this transaction is required in the consolidated financial statements, as
these intra-group transactions are eliminated.
The related party relationship will have to be disclosed as follows:
A related party relationship exists between Kingfisher Ltd and B Ltd by virtue of a 100% holding in
A Ltd, and A Ltd's 60% holding in B Ltd.
This information will normally be disclosed in the notes dealing with investments and the note on
related parties will refer to the investment note in this regard.
5. Mrs Weaver, who has a 20% shareholding in Kingfisher Ltd, made a loan of R250 000 on
1 January 20.13 to Kingfisher Ltd. Interest is payable at 20% per annum.
Mrs Weaver has significant influence over the reporting entity. There is thus a related party
relationship between Mrs Weaver and Kingfisher Ltd, requiring disclosure as follows:
A non-controlling shareholder, Mrs Weaver, has made a loan of R250 000 to the company. Interest
of R50 000 for the year, representing a rate of 20%, was charged on this loan. The terms and
conditions of the settlement and the nature of the settlement should also be disclosed.
6. Kingfisher Ltd purchases all its health products from Health Ltd. During the current year,
purchases from Health Ltd amounted to R110 million.
No related party relationship exists, as a relationship resulting from economic dependence in itself
is not deemed to be a related party relationship.
7. During the year, D Ltd sold a building to Kingfisher Ltd at its market value of R2,5 million.
No related party relationship exists as C Ltd does not have control over D Ltd. IAS 24.12 states that
an investor will also be related to subsidiaries of an associate. In this case D Ltd is not a subsidiary
of C Ltd.
8. Mrs Nest, a junior employee of Kingfisher Ltd, received a loan of R85 000 from
Kingfisher Ltd at a commercial rate of interest for the purchase of a new car during the year.
Interest amounted to R6 500.
There is no related party relationship between Mrs Nest and Kingfisher Ltd as she does not have
any significant influence over the reporting entity and is not part of key management personnel.
CHAPTER
14
Impairment of assets
(IAS 36)
Contents
14.1
14.2
14.3
14.4
14.5
14.6
14.7
14.8
Overview of IAS 36 Impairment of Assets .........................................................
Identifying impairment .......................................................................................
Measurement of recoverable amount and recognition of impairment loss ........
14.3.1 Fair value less costs of disposal.........................................................
14.3.2 Value in use........................................................................................
14.3.3 Recognition of impairment loss ..........................................................
14.3.4 Measuring recoverable amount for an intangible asset
with an indefinite useful life ................................................................
Reversal of impairment loss ..............................................................................
Cash-generating units .......................................................................................
14.5.1 Identification of cash-generating units ................................................
14.5.2 Recoverable amount and carrying amount of a
cash-generating unit ...........................................................................
14.5.3 Allocating goodwill to cash-generating units ......................................
14.5.4 Corporate assets ................................................................................
14.5.5 Recognition of an impairment loss for a cash-generating unit
and the allocation thereof ...................................................................
14.5.6 Timing of impairment test for a cash-generating unit .........................
14.5.7 Non-controlling interests.....................................................................
14.5.8 Reversal of impairment losses for cash-generating units ..................
Disclosure ..........................................................................................................
14.6.1 Statement of profit or loss and other comprehensive income:
Profit or loss section ...........................................................................
14.6.2 Statement of profit or loss and other comprehensive income:
Other comprehensive income section ................................................
14.6.3 Notes to the financial statements .......................................................
Tax implications .................................................................................................
Comprehensive example ...................................................................................
329
330
331
332
333
333
336
336
337
339
339
341
342
345
345
347
349
352
354
354
354
355
357
357
330 Descriptive Accounting – Chapter 14
14.1 Overview of IAS 36 Impairment of Assets
DEFINITIONS
ƒ Recoverable amount – higher of an
asset’s fair value less costs of disposal
and its value in use.
ƒ Value in use – present value of future
cash flows expected to be derived from
an asset or CGU. These cash flows will
include both those from the continuing
use of the asset and from its disposal at
the end of its useful life.
ƒ Fair value – IFRS 13 Fair value
measurement.
ƒ Costs of disposal – incremental costs
directly attributable to disposal of the
asset (excluding finance costs and
income tax expenses).
Including: legal costs, stamp duty,
transaction taxes, the cost of removing
the assets.
Excluding: termination benefits,
reorganisation costs.
ƒ Impairment loss – amount by which the
carrying amount of an asset or CGU
exceeds its recoverable amount.
ƒ Cash-generating unit (CGU) – smallest
identifiable group of assets that generates
cash inflows that are largely independent
of the cash flows from other assets or
groups of assets.
Including: assets that can be attributed
directly or allocated on a reasonable and
consistent basis (such as goodwill and
corporate assets in some cases).
Excluding: carrying amount of recognised
liabilities, unless the recoverable amount
of the CGU cannot be determined without
the liability.
IDENTIFYING AN ASSET THAT MAY
BE IMPAIRED
External sources of information
ƒ Significant decline in asset’s value.
ƒ Significant changes in technological,
market, economic or legal environment.
ƒ Market interest rates/other market rates of
return on investments increased and
decrease the asset’s recoverable amount
materially.
ƒ Carrying amount of net assets is more than
its market capitalisation.
Internal sources of information
ƒ Evidence of obsolescence or physical
damage to an asset.
ƒ Significant changes to extent to which
asset is used (e.g. asset becoming idle,
plans to discontinue/restructure operations,
plans to dispose of asset and reassessing
the useful life of an asset as finite rather
than indefinite).
ƒ Evidence that economic performance of an
asset is/will be worse than expected.
Test for impairment
ƒ End of each reporting period, if indication
of impairment.
ƒ Intangible asset with indefinite useful life/
intangible asset not yet available for use –
test annually.
ƒ Goodwill – annually.
RECOGNISING AND MEASURING AN IMPAIRMENT LOSS
Individual asset
ƒ Cost model – recognise in profit/loss
(P/L).
ƒ Revaluation model – account for as
revaluation decrease.
Cash-generating unit
ƒ Allocate first to goodwill.
ƒ Pro rata to other assets of CGU.
ƒ Limit – carrying amount of asset not
reduced below higher of:
– fair value less disposal costs;
– value in use;
– Rnil.
Reversing
ƒ Cost model – recognise in profit/loss
(P/L).
ƒ Revaluation model – account for as
revaluation increase.
ƒ Limit – increased carrying amount may
not exceed what carrying amount would
have been if no impairment.
Reversing
ƒ Loss on goodwill may not be reversed.
ƒ Allocate reversal pro rata to other assets of
CGU.
ƒ Limit carrying amount of individual asset to
lower of:
– recoverable amount; or
– what carrying amount would have
been if no impairment.
Impairment of assets 331
14.2 Identifying impairment
IAS 36 applies mainly to:
ƒ tangible and intangible assets;
ƒ investments in subsidiaries;
ƒ joint arrangements; and
ƒ associates,
although the last three items are financial assets.
IAS 36 is not applicable to assets such as:
ƒ inventories;
ƒ construction contracts;
ƒ deferred tax assets;
ƒ employee benefits;
ƒ investment property measured at fair value;
ƒ biological assets from agricultural activity carried at fair value less estimated point-of-sale
costs;
ƒ deferred acquisition costs;
ƒ intangible assets arising from IFRS 4, non-current assets classified as held for sale
under IFRS 5; and
ƒ financial assets within the scope of IAS 39, which are excluded as the recoverability of
these items is dealt with in the relevant Standards.
IAS 36 contains a number of definitions, which are essential in explaining the
impairment approach:
ƒ Recoverable amount is the higher of an asset’s or CGU’s fair value less costs of
disposal and its value in use.
ƒ Value in use is the present value of future cash flows expected to be derived from an
asset or CGU. These cash flows will include both those from the continuing use of the
asset and from its disposal at the end of its useful life.
ƒ Fair value is the price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants at the measurement date (refer to
IFRS 13, Fair value measurement).
ƒ Carrying amount is the amount at which an asset is recognised (in the statement of
financial position) after deducting any accumulated depreciation or amortisation and
accumulated impairment losses thereon.
ƒ Impairment loss is the amount by which the carrying amount of an asset or CGU
exceeds its recoverable amount.
ƒ A cash-generating unit (CGU) is the smallest identifiable group of assets that
generates cash inflows that are largely independent of the cash flows from other assets
or groups of assets.
An entity shall at each reporting date (presumably year end and interim dates) assess
whether there are indications that assets may be impaired. If such indications exist, the
entity must calculate the recoverable amounts of the particular assets, provided the impact
thereof is material.
Irrespective of whether there is any indication of impairment and whether it is
material, an entity shall also annually test the following assets for impairment:
ƒ an intangible asset with an indefinite useful life;
332 Descriptive Accounting – Chapter 14
ƒ an intangible asset not yet available for use;
ƒ goodwill acquired in a business combination (IAS 36.80 to .99).
The impairment test may be conducted at any time during the year, provided it is performed
at the same time every year. However, if such an intangible asset is recognised initially
during the current annual period, it must be tested for impairment before the end of the
current annual period.
Note that the materiality of an item will not play a role when conducting the compulsory
impairment tests, but it will play a role when examining normal indications of impairment.
A entity must, as a minimum, consider the following indicators in assessing whether
assets are likely to be impaired (IAS 36.12):
External sources of information
ƒ There are observable indications that the asset’s value has declined significantly, that is,
more than would be expected as a result of the passage of time or normal use during the
period.
ƒ Significant changes with an adverse effect on the entity have taken place during the
period, or will take place in the near future, in the technological, market, economic or
legal environment in which the entity operates or in the market to which the products of
an asset are dedicated.
ƒ Market interest rates or other market rates of return on investments have increased
during the period, and those increases are likely to affect the discount rate used in
calculating an asset’s value in use, and decrease the asset’s recoverable amount
materially.
ƒ The carrying amount of the net assets of the reporting entity is more than its market
capitalisation (i.e. number of shares × quoted market price).
Internal sources of information
ƒ Evidence is available of obsolescence of, or physical damage to, an asset.
ƒ Significant changes with an adverse effect on the entity have taken place during the
period, or are expected to take place in the near future, to the extent to which, or manner
in which, an asset is used or is expected to be used. These changes include the asset
becoming idle, plans to discontinue or restructure the operation to which an asset
belongs, plans to dispose of an asset before the previously expected date, and
reassessing the useful life of an asset as finite rather than indefinite.
ƒ Evidence is available from internal reporting that indicates that the economic
performance of an asset is, or will be, worse than expected.
If previous analyses have shown that the carrying amount of the asset is not sensitive to the
above indicators, it is not necessary to calculate the recoverable amount of the asset. Once
there is an indication that an asset may be impaired, the remaining useful life estimate,
depreciation method or residual value of the asset may also be affected. These must
therefore be reviewed and adjusted, even if no impairment loss is recognised.
14.3 Measurement of recoverable amount and recognition of impairment
loss
An asset is impaired when its carrying amount is larger than its recoverable amount. The
recoverable amount is the higher of an asset’s fair value less costs of disposal and its value
in use.
If the carrying amount of the asset is written-down to its recoverable amount, an impairment
loss should be recognised:
ƒ in the profit or loss section in the statement of profit or loss and other comprehensive
income; or
Impairment of assets 333
ƒ in the revaluation surplus via the other comprehensive income section in the statement
of profit or loss and other comprehensive income for any revalued assets if there is a
revaluation surplus for that specific asset.
14.3.1 Fair value less costs of disposal
Fair value is the price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the measurement date (refer to
IFRS 13 Fair Value Measurement).
The costs of disposal are the incremental costs that are directly attributable to the disposal
of the asset (excluding, finance costs and income tax expenses):
ƒ include costs such as legal costs, stamp duty, transaction taxes, the cost of removing the
assets, and any direct incremental costs incurred to bring the asset into a condition for
sale. It excludes expenses for which provision has already been made;
ƒ exclude termination benefits and costs associated with reducing or re-organising the
entity as a result of the sale of the asset.
Example 14.1
14.1
Fair value less costs of disposal
At 31 December 20.14, Quantum Ltd owns a machine with a carrying amount of R106 666 for
which there is an active market. The machine can at this stage be disposed of to a knowledgeable,
willing buyer for R108 500.
This machine initially cost R200 000 and is depreciated on a straight-line basis over 7,5 years. A
total of 3,5 years of the useful life of the machine have already expired as at 31 December 20.14.
Any broker involved in such transaction will charge a fee of R2 000 and the cost to dismantle and
remove the asset will be R3 000. No provision for this cost of R3 000 has been recognised in terms
of IAS 37. Before considering the recoverable amount of the asset, the asset was serviced to ensure
that it is in good working order. The technician charged R1 500 for the service.
To determine the fair value less costs of disposal of this asset the following calculation is made:
R
Selling price in an active market
108 500
Less: Brokerage
(2 000)
Cost of service – bringing asset into condition for its sale
(1 500)
Cost of dismantling/removing the asset
(3 000)
Fair value less costs of disposal
102 000
14.3.2 Value in use
The steps required to establish value in use are the following:
ƒ estimate the future cash inflows and outflows to be derived from the continued use and
eventual disposal of the asset; and
ƒ apply an appropriate discount rate to the future cash flows.
The value in use calculation should reflect the following elements:
ƒ an estimate of the future cash flows the entity expects to derive from the asset;
ƒ expectations about possible variations in the amount or timing of those future cash flows;
ƒ the time value of money, represented by the current market risk-free rate of interest;
ƒ the price for bearing the uncertainty inherent in the asset;
ƒ other factors, such as illiquidity, that market participants would reflect in pricing the future
cash flows the entity expects to derive from the asset.
334 Descriptive Accounting – Chapter 14
14.3.2.1 Cash flow projections
IAS 36.33 requires that cash flow projections:
ƒ be based on reasonable and supportable assumptions, based on management’s best
estimate of the economic conditions that will exist over the remaining useful life of the
asset;
ƒ be based on the most recent financial budgets or forecasts that have been approved by
management. These projections must cover a maximum of five years unless a longer
period is justified, and must exclude estimated future cash inflows or outflows expected
to arise from future restructurings or from improving or enhancing the performance of the
asset; and
ƒ beyond the period in budgets or forecasts are estimated by extrapolating the projections
based on the budgets/forecasts with a steady or declining growth rate, unless an
increasing rate can be justified. The growth rate must not exceed the long-term growth
rate of the products/industry/country.
Cash flows projections should include:
ƒ cash inflows from the continuing use of the asset;
ƒ cash outflows incurred to generate the cash inflows (including outflows that can be
directly attributed or allocated on a reasonable basis, such as the day-to-day servicing of
the asset); and
ƒ net cash inflows on the disposal of the asset at the end of its useful life.
The cash flows from the disposal of the asset at the end of its useful life is the amount that
the entity expects to obtain from the disposal of the asset in an arm’s length transaction
between knowledgeable and willing parties, after deducting the estimated costs of disposal.
The cash flows from disposal are based on prices prevailing at the estimate date for similar
assets at the end of their useful life which are adjusted for the effect of future price increases
(due to general inflation or specific price increases).
Future cash flows must be estimated for the asset in its current condition, excluding:
ƒ future cash inflows or outflows from the future restructuring of the entity to which the
entity is not yet committed; or
ƒ future capital expenditure that will enhance or improve the performance of the asset.
Future cash flows shall include future cash outflows necessary to maintain the level of
economic benefits expected to arise from the asset in its current condition – that is, day-today servicing. When a CGU comprises assets with different useful lives, and all these
assets are essential to the ongoing operation of the unit, the replacement of assets in the
unit is deemed to be part of the day-to-day servicing of the unit when estimating cash flows
associated with the unit. The same principle would apply when an asset comprises
components with different useful lives.
Fair value differs from value in use. Fair value reflects the assumptions market
participants would use when pricing the asset. In contrast, value in use reflects the effects of
factors that may be specific to the entity and not applicable to entities in general.
Fair value does not reflect any of the following factors to the extent that they would not be
generally available to market participants (IAS 36.53A):
ƒ additional value derived from the grouping of assets;
ƒ synergies between the asset being measured and other assets;
ƒ legal rights or legal restrictions that are specific only to the current owner of the asset; or
ƒ tax benefits or tax burdens that are specific to the current owner of the asset.
Impairment of assets 335
14.3.2.2 Discount rate
The required discount rate, which is a pre-tax current market rate, is independent of the
entity’s capital structure. The rate includes the time value of money and a provision for the
particular type of risk to which the asset in question is exposed. To avoid double counting,
the discount rate must not reflect risks for which the future cash flow estimates have already
been adjusted, and vice versa. Therefore, if the discount rate accommodates the effect of
price increases due to inflation, cash flows will be measured in nominal terms (i.e. be
increased for inflation). However, if the discount rate excludes the effect of inflation, the cash
flows to be discounted must be measured in real terms (i.e. not increased for inflation). In all
material respects, this asset-specific rate corresponds to the one used in the investment
decision, except that a pre-tax rate is required to determine impairment.
When an asset-specific rate is not available from the market, the entity uses the entity’s
weighted average cost of capital, its incremental borrowing rate and other market borrowing
rates as a starting point to develop an appropriate rate. These rates are adjusted to reflect
the specific risks of the projected cash flows and to exclude risks not relevant to the
projected cash flows, or risks for which cash flows have been adjusted. These risks include
country risk, currency risk, price risk and cash flow risk. This pre-tax rate is then applied to
discount the expected cash flows from using the asset to establish its value in use.
Example 14.2
14.2
Recoverable amount
The asset mentioned in Example 14.1 has a remaining useful life of four years from
31 December 20.12. Quantum Ltd is of the opinion that this asset will generate cash inflows of
R60 000 per year and directly associated necessary cash outflows of R20 000 per year over the
next four years. This was confirmed in management’s most recent cash flow budget. The asset will
be disposed of at a net amount of R4 000 at the end of its useful life.
An appropriate after-tax discount for this type of asset is 15,84% per annum. The tax rate is 28%.
Assume all amounts are material.
The value in use of this asset will be determined as follows:
Net cash inflows per annum (60 000 – 20 000)
R40 000
Period over which inflows will occur
4 years
Expected net cash inflow at disposal
R4 000
Pre-tax discount rate (15,84%/72%)
22%
Present value of cash generated via usage and disposal:
PMT = R40 000; n = 4 years; i = 22%; FV = R4 000; PV = R101 552
If the asset is impaired, the impairment loss that is recognised in the profit or loss section of the
statement of profit or loss and other comprehensive income will be calculated as follows:
(The recoverable amount is the higher of the fair value less costs of disposal and the value in use
of the asset under consideration).
R
Fair value less costs of disposal (from the previous example)
102 000
Value in use
101 552
Therefore, the recoverable amount will be the higher amount
102 000
The impairment loss will be determined as the difference between the recoverable amount and the
carrying amount.
Therefore, the impairment loss is:
R
Carrying amount
106 666
Recoverable amount
(102 000)
Impairment loss to be recognised
4 666
The depreciation charge for the year ended 31 December 20.14 is: R200 000/7,5 = R26 667
The depreciation charge for subsequent years is: R102 000*/4 = R25 500
* New carrying amount
336 Descriptive Accounting – Chapter 14
14.3.2.3 Value in use where the entity is committed to restructuring
Although it was stated in section 2.2 that a future restructuring to which an entity is not yet
committed must not impact on cash flows when calculating value in use, the situation
changes when an entity becomes committed to a restructuring.
Once an entity is committed to the restructuring, its estimates of future cash inflows and
cash outflows for the purpose of determining value in use shall reflect the cost savings and
other benefits from restructuring resulting from the most recent budgets/forecasts approved
by management. Furthermore, estimates of future cash outflows for restructuring are
included in a restructuring provision in terms of IAS 37.
Example
Example 14.3
14.3
Value in use - entity committed to a restructuring
A Ltd uses a manufacturing machine to manufacture product X that generates net cash flows of
R1 000 000 per annum. This machine is currently operated by two full-time employees. However,
product X’ performance is not as good as initially expected and management is considering a
restructuring plan in terms of which the machine will be used to manufacture product Y instead.
This will increase the annual cash flows of the machine by R800 000 per annum.
However, one of the employees will be retrenched. In terms of the service termination agreement
entered into with the employee, the entity will make a termination payment of R100 000 to the
employee.
The expected costs to adjust the machine to manufacture product Y, is R120 000.
Before management is committed to the restructuring, the value in use will be calculated with
reference to annual net cash flows of R1 000 000.
Once management is committed to the restructuring, the annual cash flows for the value in use
calculation will be R1 680 000 (1 000 000 + 800 000 – 120 000).
The termination costs of R100 000 will be raised as a provision, since there is a legal present
obligation to make the payment and should be ignored when calculating the value in use.
Comment
¾ In terms of IAS 36.44(b), any cash flows resulting from future improvements to the asset
must be ignored when calculating the value in use.
14.3.3 Recognition of impairment loss
If the impaired asset (other than goodwill) is accounted for on the cost basis, the
impairment loss is recognised in the profit or loss section in the statement of profit or loss
and other comprehensive income.
The impairment losses for assets (other than goodwill) that are revalued are treated as
decreases of the revaluation surplus in the other comprehensive income section of the
statement of profit or loss and other comprehensive income. Should the impairment loss
exceed the revaluation surplus, the excess is recognised as an expense in the profit or loss
section of the statement of profit or loss and other comprehensive income. However, note
that the impairment loss of one revalued asset may not be adjusted against the revaluation
surplus of another revalued asset, as surpluses and deficits are offset on an item-for-item
basis.
The depreciation charge in respect of an asset subject to impairment shall be adjusted for
future periods to allocate the asset’s revised carrying amount (net of the impairment loss)
less its residual value, on a systematic basis over its useful life.
14.3.4 Measuring recoverable amount for an intangible asset with an indefinite
useful life
It was noted earlier that some assets must be tested for impairment annually, irrespective of
whether there are indications of impairment. An intangible asset with an indefinite useful life
Impairment of assets 337
is an example of such an asset. Due to the practical implications of testing for impairment on
an annual basis, IAS 36 allows an entity to use the most recent detailed calculation of such
an asset’s recoverable amount made in a preceding period to test for impairment in the
current period, provided all the following criteria are met (IAS 36.24):
ƒ If this intangible asset forms part of a CGU, the assets and liabilities of the unit must
have remained mostly unchanged since the previous calculation of recoverable amount.
ƒ The most recent recoverable amount calculation must have resulted in a recoverable
amount that exceeded the carrying amount of the asset now tested for impairment, by a
wide margin.
ƒ Based on an analysis of the circumstances surrounding the most recent recoverable
amount calculation, the likelihood that the current recoverable amount determination
would be less than the asset’s carrying amount must be remote.
14.4 Reversal of impairment loss
An entity must at each reporting date assess whether there are indications that earlier
impairment losses recognised for assets other than goodwill, may have decreased or no
longer exist. This does not imply that the recoverable amounts must automatically be
calculated on all previously impaired assets. The objective of IAS 36 is rather to look for
indications that these impairments may have reversed wholly or partially. The recoverable
amounts are calculated only on those assets where there are indications that the impairment
losses may have reversed.
The following are indications (similar to those indicating original impairment, but the
inverse thereof) that must be considered as a minimum:
External sources of information
ƒ There are observable indications that the asset’s value has increased significantly during
the period.
ƒ Significant changes with a favourable effect on the entity have taken place during the
period, or will take place in the near future, in the technological, market, economic or
legal environment in which the entity operates, or in the market to which the asset is
dedicated.
ƒ Market interest rates or other market rates of return on investments have decreased
during the period, and those decreases are likely to affect the discount rate used in
calculating the asset’s value in use, and increase the asset’s recoverable amount
materially.
Internal sources of information
ƒ Significant changes with a favourable effect on the entity have taken place during the
period, or are expected to take place in the near future, to the extent to which, or manner
in which, the asset is used or is expected to be used. These changes include capital
expenditure that has been incurred during the period to improve or enhance an asset’s
performance or restructure the operation to which the asset belongs.
ƒ Evidence is available from internal reporting that indicates that the economic
performance of the asset is, or will be, better than expected.
If the recoverable amount of an identified impaired asset (other than goodwill) is
recalculated and it now exceeds the carrying amount of the asset, the carrying amount of
the asset is increased to the new recoverable amount (subject to a calculated maximum –
see next paragraph). This is a reversal of impairment losses which reflects, in essence, that
due to a change in circumstances the estimated service potential through sale or use of the
asset has increased since the date (mostly in prior periods) on which the asset became
impaired. The reversal of an impairment loss may also indicate that the remaining useful life,
depreciation method and residual value of the particular asset must also be reviewed.
338 Descriptive Accounting – Chapter 14
Examples of changes in estimates that cause an increase in service potential include:
ƒ a change in the basis for determining the recoverable amount (say from fair value less
costs of disposal to value in use);
ƒ where the recoverable amount was based on value in use, a change in the amount or
timing of estimated future cash flows or the discount rate; or
ƒ if the recoverable amount was based on fair value less costs of disposal, a change in
estimate of the components of fair value less costs of disposal.
The impairment loss is reversed only to the extent that it does not exceed the carrying
amount (net of depreciation or amortisation) that would have been determined for the asset
(other than goodwill) in prior years, if there had been no impairment loss. An impairment
loss is not reversed because of unwinding of the discount rate used in the calculation of
value in use, as the service potential of the asset has not increased.
A reversal of an impairment loss is recognised as follows:
ƒ if the asset (other than goodwill) is accounted for on the cost basis: the reversal of an
impairment loss is recognised in the profit or loss section of the statement of profit or loss
and other comprehensive income;
ƒ if the asset is revalued: the reversal of the impairment loss is treated as an increase in
the revaluation surplus directly in other comprehensive income in the statement of profit
or loss and other comprehensive income. In instances where the whole or part of the
impairment loss of an asset was recognised as an expense in the profit or loss in the
statement of profit or loss and other comprehensive income in prior periods, a reversal
for that impairment loss (or part thereof) is first recognised as income in profit or loss in
the statement of profit or loss and other comprehensive income, until all prior recognised
impairment losses have been reversed, whereafter this remainder is shown as an increase
of the revaluation surplus through other comprehensive income in the statement of profit
or loss and other comprehensive income. Such revaluations would only be recognised if
this is within the revaluation cycle of the asset and all assets in the same class of asset
are also revalued.
Example 14.4
14.4
Reversal of impairment loss – individual asset
The carrying amount of a machine of Cheers Ltd on the date of the statement of financial position,
30 June 20.15, is as follows:
R
Cost
50 000
Accumulated depreciation
(calculated at 10% per annum, straight-line, assuming no residual value)
(25 000)
Carrying amount at the end of Year 5
25 000
The fair value less costs of disposal the asset under consideration is R20 000. The present value
of the expected return from the use of the asset over its useful life amounts to R15 000. The value
in use for this item is therefore R15 000. Ignore taxation.
The recoverable amount, being the higher of fair value less costs of disposal (R20 000) and
value in use (R15 000), is therefore R20 000. The carrying amount (R25 000) must therefore be
written-down to the recoverable amount (R20 000) by R5 000. This amount will be recognised as
an impairment loss of R5 000, with a depreciation charge of R5 000 in the profit or loss section in
the statement of profit or loss and other comprehensive income of the current year.
Assume that the recoverable amount for the machine is re-estimated on 30 June 20.17 as follows:
R
Fair value less costs of disposal
14 000
Value in use
18 000
The revised recoverable amount is therefore R18 000 (the higher).
continued
Impairment of assets 339
The recoverable amount has increased, thereby reversing a part of the impairment loss
recognised in prior years. The maximum increase in the recoverable amount allowed is calculated
as follows:
Depreciation for Year 20.16 and 20.17:
ƒ Recoverable amount end of Year 20.15
R20 000
ƒ Remaining useful life
5 years
ƒ Depreciation
R4 000 per annum
Depreciation for Year 20.16 and 20.17:
The carrying amount at the end of 20.17:
(50 000 – 25 000 – 5 000 (impairment loss) – 4 000 (depreciation) – 4 000 (depreciation))
Increase in recoverable amount/reversal of impairment loss (15 000 – 12 000)
R
12 000
3 000
New carrying amount
15 000 *
* The new carrying amount is limited to what the carrying amount would have been, had no
impairment loss been recognised for the asset in prior years (20.15). The recoverable amount of
R18 000 is thus ignored if the historical cost-carrying amount is lower.
Calculation of limitation on increased carrying amount:
Carrying amount had impairment not been recognised
R
15 000
Cost price (before recognition of impairment)
Accumulated depreciation at 30 June 20.17 (5 000 × 7)
50 000
(35 000)
Comment
Comment
¾ The reversal of the impairment loss to the amount of R3 000 is credited to profit or loss in the
statement of profit or loss and other comprehensive income, as the machine is measured on
the cost method in this example.
¾ The carrying amount after reversal of impairment loss (12 000 + 3 000) is R15 000. The
increased carrying amount is equal to what the carrying amount would have been, had
depreciation on historical cost been allocated normally over the years without taking impairment
into account, namely R50 000 – (7 × 5 000) = R15 000.
14.5 Cash-generating units
14.5.1 Identification of cash-generating units
IAS 36 requires the recoverable amount of an asset to be estimated when an asset is
impaired. Where the future cash flows cannot be attributed to a single asset to establish the
recoverable amount on a reasonable basis, it is necessary to identify the smallest
cash-generating unit (CGU) to which such cash flows can be attributed. A CGU is therefore
the smallest identifiable group of assets that generates cash inflows that are largely
independent of the cash inflows from other assets or groups of assets.
Assume that a small-scale diamond mining operation runs a shaft, a railway line and a
locomotive with two coaches to transport the diamond-bearing gravel to a diamond washing
plant. Under these circumstances, it would be highly unlikely that any of the individual
assets could generate independent cash flows without the co-operation of the other three
assets. Consequently, the four assets would be combined to form a CGU.
In recognising CGUs, the lowest aggregation of assets that generate independent cash
flows is recognised. Normally the cash inflows from the continuing use of the asset or group
of assets refer to the cash and cash equivalents received from parties outside the reporting
entity. These cash flows must be independent of the cash flows of other assets or CGUs.
340 Descriptive Accounting – Chapter 14
To establish the independence of these cash flows, consideration is given to factors such
as:
ƒ how management monitors and controls operations (i.e. by product line, businesses,
locations); or
ƒ how management makes decisions to continue to sell parts of the entity’s assets or
operations.
In certain instances, CGUs may be identified where all or a portion of the cash flows are
from internal sources. Internal cash flows refer to cash flows within the entity’s operation
itself, for example the transfer of products between departments, branches and businesses.
These cash flows qualify for the recognition of CGUs only if active markets exist for the
output. When calculating the recoverable amount for these CGUs, management must use
its best estimate of future arm’s length prices for the output, as the actual transfer prices
used for internal transfers may not be market-related. These arm’s-length transaction prices
must be used in estimating:
ƒ the future cash inflows used to determine the CGUs value in use; and
ƒ the future cash outflows used to determine the value in use of any other assets or
CGUs that are affected by internal transfer pricing.
Example 14.5
14.5
Cash-generating unit
Delta Ltd produces a single product and owns plants A, B and C. Each plant is located on a
different continent. A produces a component that is assembled in either B or C. The combined
capacity of B and C is not fully utilised. Delta’s products are sold worldwide from either B or C. For
example, B’s production can be sold on C’s continent if the products can be delivered faster from
B than from C. Utilisation levels of B and C depend on the allocation of sales between the two
sites.
Identify the CGUs for A, B and C in each of the following cases:
Case 1: There is an active market for A’s products.
Case 2: There is no active market for A’s products.
Case 1
It is likely that A is a separate CGU because there is an active market for its products, although all
of its cash flows are generated internally.
Although there is an active market for the products assembled by B and C, cash inflows for B and
C depend on the allocation of production across the two sites. It is unlikely that the future cash
inflows for B and C can be determined individually. Therefore, it is likely that B and C together
constitute the smallest identifiable group of assets that generates cash inflows that are largely
independent.
In determining the value in use of A and B plus C, Delta adjusts financial budgets/forecasts to
reflect its best estimate of future prices for A’s products achieved in arm’s length transactions.
Case 2
It is likely that the recoverable amount of each plant cannot be assessed independently because:
ƒ there is no active market for A’s products. Therefore, A’s cash inflows depend on sales of the
final product by B and C; and
ƒ although there is an active market for the products assembled by B and C, cash inflows for B
and C depend on the allocation of production across the two sites. It is unlikely that the future
cash inflows for B and C can be determined individually.
As a consequence, it is likely that A, B and C together (i.e. Delta as a whole) is the smallest
identifiable group of assets that generates cash inflows that are largely independent.
Impairment of assets 341
Example 14.6
14.6
Internal cash flows when identifying CGUs
H Ltd manufactures a chemical product XHO. Raw material X is converted into XH during the
manufacturing process. XH is then further processed into XHO.
The entity is divided into two sections for management purposes. Section A converts raw material
X to XH and Section B processed XH to XHO.
Section A purchases raw material X at a cost of R 9 000 per kilogram and incurs conversion costs
of R1 500 per kilogram. Section A charges a transfer price of R15 000 per kilogram of XH
transferred to Section B. If XH is not transferred to Section B it can be sold in the market at
R20 000 per kilogram.
Since there is an active market for the output of Section A, Section A can be regarded as a CGU,
even though all the output is internally transferred to Section B.
The following is an estimate of the kilograms of XH that will be produced by Section A (assume
that the section will use the current assets for a further 4 years):
20.11 – 200 kg; 20.12 – 180 kg; 20.13 – 160 kg; 20.14 – 150 kg
The expected cash flow per kilogram is R9 500 (R20 000 – (9 000 + 1 500)).
The value in use is as follows, assuming a fair rate of return of 10% per annum:
R
20.11 (CF1)
200 × 9 500
1 900 000
20.12 (CF2)
180 × 9 500
1 710 000
20.13 (CF3)
160 × 9 500
1 520 000
20.14 (CF4)
150 × 9 500
1 425 000
Present value (NPV) (discounted at 10%)
5 255 789
The value in use of Section A for impairment purposes is thus R5 255 789.
14.5.2 Recoverable amount and carrying amount of a cash-generating unit
As with individual assets, the recoverable amount of a CGU is the higher of its fair value less
costs of disposal and value in use. The same rules apply to the calculation of the
recoverable amounts of individual assets and CGUs. There are however a number of
problems which arise specifically in calculating recoverable amounts for CGUs that are
addressed in IAS 36.
When establishing whether a CGU is impaired, the first step is to calculate its carrying
amount. The general rule is that the manner in which the carrying amount of the CGU is
determined shall be consistent with that of the recoverable amount of the CGU – meaning
that the same items must be included. If the recoverable amount is lower than the carrying
amount of the CGU, an impairment loss is recognised in respect of that CGU.
The carrying amount of a cash-generating unit:
ƒ includes those assets that can be attributed directly or allocated on a reasonable and
consistent basis (such as goodwill and corporate assets in some cases) and that will
generate future cash inflows used in determining the value in use of the CGU;
ƒ excludes the carrying amount of recognised liabilities, unless the recoverable amount of
the CGU cannot be determined without the liability (where the purchaser of a unit is
required to take over the liability);
ƒ excludes assets that cannot be allocated on a reasonable basis such as goodwill and
corporate assets in some cases; and
ƒ excludes assets that will not produce the estimated future cash inflows.
Where assets are grouped together to determine their recoverability, all assets that generate
or are used to generate the relevant stream of cash inflows should be included in the
342 Descriptive Accounting – Chapter 14
specific CGU. If this is not done, it may appear that the CGU is fully recoverable, when in
fact an impairment loss has occurred.
In some cases, certain assets such as goodwill or corporate assets (e.g. a head office
building) may contribute to the estimated future cash flows of a CGU, but these assets
cannot be allocated to the CGU on a reasonable and consistent basis.
Sometimes the recoverable amount of a CGU may include some recognised liabilities where
such liabilities are directly associated with the CGU. To perform a meaningful comparison
between the carrying and recoverable amounts of a CGU, the carrying amount of the liability
must be deducted when calculating both the value in use and fair value less costs of
disposal of the CGU. An example of such a liability would be an obligation to restore a site
to its original pristine condition once manufacturing activities on it have ceased. If this site is
sold, the liability in respect of the restoration will attach to the site and if its recoverable
amount is to be determined, this liability will be included in the calculation.
14.5.3 Allocating goodwill to cash-generating units
For the purpose of performing impairment tests, goodwill acquired in a business
combination shall, from the acquisition date, be allocated to each of the acquirer’s CGUs
(or groups of CGUs) that are expected to benefit from the synergies of the business
combination. This is done irrespective of whether the acquirer allocates other assets of the
acquiree to those CGUs or groups of CGUs. Each such CGU to which the goodwill is
allocated shall:
ƒ represent the lowest level within the entity at which goodwill is monitored for internal
management purposes; and
ƒ not be larger than a primary or secondary segment in accordance with IAS 14.
Goodwill will not usually generate cash flows independently of other assets or groups of
assets, and often contributes to the cash flows of several CGUs. Consequently, it may
sometimes not be possible to reasonably and on a consistent basis allocate goodwill to
individual CGUs, but it may be possible to allocate the goodwill to groups of CGUs.
If the initial allocation of goodwill acquired in a business combination cannot be completed
before the end of the annual period in which the business combination is effected, that initial
allocation shall be completed before the end of the first annual period beginning after the
acquisition date. For example, goodwill was acquired in a business combination on
30 June 20.13, while the year end of the entity is 31 December 20.13. Due to several
uncertainties, the initial accounting of the business combination cannot be completed by
31 December 20.13. Consequently, the allocation of goodwill to the CGUs also cannot be
completed. Under these circumstances, the allocation of goodwill must thus be completed
by 31 December 20.14.
If goodwill has been allocated to a CGU and the entity disposes of a portion of that
CGU, the goodwill associated with the portion of the CGU disposed of, shall be:
ƒ included in the carrying amount of the operation disposed of when determining the gain
or loss on disposal; and
ƒ measured on the basis of the split between the relative values of the operation disposed
of and the portion of the CGU retained. This basis is used, unless another method better
reflects the goodwill associated with the operation disposed of.
Impairment of assets 343
Example 14.7
14.
Cash-generating unit and goodwill
B Ltd sells an operation forming part of a CGU to which goodwill was allocated, for R200 000. The
total goodwill (R160 000) allocated to the CGU cannot be allocated to this smaller part of the CGU
on a reasonable and consistent basis. The portion of the CGU not disposed of has a recoverable
amount of R600 000.
Because the goodwill allocated to the complete CGU cannot be allocated to the portion disposed
of on a non-arbitrary basis, the goodwill disposed of, with the portion of the CGU for R200 000, will
amount to 25% (R40 000) (200/(200 + 600) × 160 000) of the total goodwill allocated to the CGU.
The portion of goodwill retained in the CGU will amount to 75% (R120 000) of the total goodwill.
The relative value approach will be used unless some other method better reflects the goodwill
associated with the part of the CGU disposed of.
The principle applied when disposing of a portion of a CGU will also be applied when an
entity re-organises its reporting structure to change the composition of one or more CGUs to
which goodwill has been allocated. The goodwill shall thus be reallocated to the CGUs
affected. The reallocation will take place on the same basis as that used when disposing of
part of a CGU.
14.5.3.1 Cash-generating units with no goodwill allocated to them
As already stated, goodwill can sometimes not be allocated to a CGU on a reasonable and
consistent basis, even though goodwill relates to such a CGU. Goodwill will under these
circumstances be allocated to a group of CGUs which contains, amongst others, the CGU
to which the goodwill could not be allocated.
For these smaller CGUs (not including allocated goodwill), testing for impairment will only
take place whenever there is an indication that the CGU may be impaired, by comparing
its carrying amount (excluding goodwill) with its recoverable amount. Any impairment loss
will be allocated to the assets of this smaller CGU pro rata, based on the carrying amounts
of the assets in the CGU. Note that since there is no goodwill in the CGU, the impairment
loss need not first be allocated to the goodwill contained in the CGU.
Example 14.8
14.
Cash-generating unit - no goodwill allocated
X Ltd acquired a 100% interest in Z Ltd on 1 January 20.11 for R58 000. Z Ltd consists of three
CGUs, namely A, B and C. The fair values of the net assets of CGUs A, B and C were R25 000,
R15 000 and R10 000 respectively at date of acquisition. The following now relates to CGUs A, B
and C:
A
B
C
Total
R
R
R
R
31 December 20.11
Net carrying amount (excluding goodwill)
31 000
12 000
9 000
52 000
Recoverable amount (including effect of goodwill)
33 000
15 000
8 100
56 100
The impairment loss(es) for the CGUs at 31 December, assuming indications of impairment, if
goodwill cannot be allocated to any of the CGUs on a reasonable and consistent basis, will be as
follows:
A
B
C
Total
R
R
R
R
Net carrying amounts of assets
31 000
12 000
9 000
52 000
Recoverable amounts
33 000
15 000
8 100
–
Impairment loss on individual CGU
Net carrying amount for total CGUs with no goodwill
allocated to any individual CGU
–
–
900 *
(900)
51 100
* Impairment loss will be allocated to the individual assets of CGU C, based on their carrying
amounts.
344 Descriptive Accounting – Chapter 14
14.5.3.2 Cash-generating units to which goodwill has been allocated
A CGU to which goodwill has been allocated (it may comprise several smaller CGUs to
which goodwill could not be allocated on a reasonable and consistent bases) shall be
tested for impairment annually and also whenever there is an indication that the CGU
may be impaired. The impairment testing is done by comparing the carrying amount of the
CGU, including goodwill, with the recoverable amount of the unit. This matter is discussed in
detail in section 3.5; however, the basic principles are explained briefly below:
If the recoverable amount of the CGU exceeds the carrying amount, the CGU and the
goodwill allocated to it shall be regarded as not being impaired.
If the carrying amount of the CGU exceeds the recoverable amount, the CGU and the
goodwill allocated to it shall be regarded as impaired. Consequently, the entity shall
recognise the resulting impairment loss in the following manner:
ƒ firstly against the goodwill allocated to the CGU; and
ƒ secondly to the other assets in the CGU pro rata on the basis of the carrying amount of
each asset.
The following example will illustrate the situation if the goodwill can be allocated to individual
CGUs based on a reasonable and consistent basis:
Example 14.9
14.9
Cash-generating unit – goodwill allocated
Use the same information as in the previous example, but assume that goodwill can be allocated
to the individual CGUs based on the fair values of the assets in the individual CGUs. The following
will relate to CGUs A, B and C:
A
B
C
Total
31 December 20.11
R
R
R
R
Net carrying amount excluding goodwill
31 000
12 000
9 000
52 000
Goodwill allocated based on fair values at date of
acquisition: (25 000 + 15 000 + 10 000 = 50 000)
A (25/50 × (58 000 – 50 000)
4 000
4 000
B (15/50 × (58 000 – 50 000)
2 400
2 400
C (10/50 × (58 000 – 50 000))
1 600
1 600
Recoverable amounts
Impairment losses
35 000
(33 000)
14 400
(15 000)
*2 000
–
10 600
(8 100)
#
2 500
60 000
(56 100)
$
3 900
* The R2 000 impairment loss will be off-set against the R4 000 goodwill allocated to CGU A,
leaving R2 000 of goodwill in the CGU.
#
The R2 500 impairment loss will wipe out the allocated goodwill of R1 600 in CGU C. The
remainder of the impairment loss (R900) will be allocated to the individual assets in the CGU,
based on their carrying amounts.
$
The impairment loss of R3 900 determined by using the total figures of R60 000 and R56 100 is
not relevant, as goodwill has been allocated to the individual CGUs.
When both tests are required, the CGU without the allocation of goodwill (the smaller CGU)
will be tested for impairment first, provided there is an indication of impairment. The carrying
amounts of the assets in the smaller CGU are adjusted for impairment and included in the
bigger CGU (including allocated goodwill). This CGU is then tested for impairment.
Impairment of assets 345
Example 14.10
14.10
Cash-generating unit included in bigger cash-generating unit
Use the same information as in Example 14.11 in respect of X Ltd and Z Ltd (and ignore
Example 14.12). Take into account that an impairment loss of R900 occurred in CGU C, but not in
A or B, and that goodwill is only allocated to the larger CGU ABC (comprising CGUs A, B and C).
The following is applicable:
CGU
ABC
R
31 December 20.11
Newly-calculated carrying amount after impairment loss in CGU C (52 000 – 900)
51 100
Goodwill allocated to CGU ABC (58 000 – 50 000)
8 000
Carrying amount of CGU ABC including allocated goodwill
Recoverable amount CGU ABC (given)
Impairment loss for CGU ABC
59 100
(56 100)
3 000
The impairment loss of R3 000 will be set off against the goodwill of R8 000, leaving a remainder of
R5 000, and other net assets with a combined carrying amount of R56 100 (51 100 + 8 000 – 3 000).
14.5.4 Corporate assets
The principles governing the calculation of impairment losses for corporate assets are very
similar to those used for the calculation of impairment losses for goodwill. IAS 36.102
clarifies the matter and provides a summary of the calculation of impairment losses on
goodwill that is also applied to corporate assets. IAS 36 provides a detailed example of the
treatment of corporate assets in its Illustrative Example 8.
14.5.5 Recognition of an impairment loss for a cash-generating unit and the
allocation thereof
As for an individual asset, an impairment loss for a CGU to which goodwill (or a corporate
asset, if applicable) has been allocated will arise when the carrying amount of the CGU
exceeds its recoverable amount or, put differently, if the recoverable amount is less than the
carrying amount of the CGU (or group of CGUs).
The impairment loss identified will be allocated to reduce the carrying amounts of the assets
in the CGU in the following order:
ƒ firstly, to reduce the amount of goodwill allocated to the CGU (or group of units); and
ƒ secondly to other assets of the unit (or group of units) pro rata on the basis of the
carrying amount of each asset in the unit (or group of units).
The above reductions in carrying amounts will be treated as impairment losses on individual
assets and recognised in the profit or loss section or the other comprehensive income
section of the statement of profit or loss and other comprehensive income for revalued
assets that have a balance on the revaluation surplus attributable to that specific asset.
Example 14.11
14.
Allocation of impairment loss
A Ltd acquired B Ltd on 1 January 20.10 for R30 million. B Ltd has two operations, one in Namibia
and one in Botswana, and each operation is a CGU. At the acquisition date, the purchase price of
the operation in Namibia comprised the following:
R’000
Fair value of identifiable assets
8 000
Goodwill
2 400
Purchase price – total
10 400
continued
346 Descriptive Accounting – Chapter 14
Depreciation is provided for on a straight-line basis over 10 years, while goodwill is not amortised,
but is tested for impairment on an annual basis. There are no residual values at any time during
the useful life of these assets.
On 31 December 20.11, the government of Namibia announced export restrictions on local
production, resulting in a reduction of production of 50% in B Ltd’s operations in Namibia. The fair
value less costs of disposal for the operation cannot be determined and its value in use is
R4,8 million.
The impairment loss for the Namibian operation is calculated and allocated as follows:
IdentiGoodfiable
Total
will
assets
R’000
R’000
R’000
Cost
2 400
8 000
10 400
Accumulated depreciation
–
(1 600)
(1 600)
Carrying amounts
Impairment loss
2 400
(2 400)
Recoverable amount (value in use)
–
6 400
(1 600)
8 800
(4 000)
4 800
4 800
Comment
¾ The impairment loss of the CGU is allocated first to goodwill (until goodwill is nil) and then to
other assets.
Once an impairment loss has been allocated, it is necessary to test that the carrying amount
of any individual asset in the CGU is not reduced to below the highest of:
ƒ its fair value less costs of disposal;
ƒ its value in use (if applicable); and
ƒ nil.
If the allocation of an impairment loss results in the carrying amount of an individual asset in
the CGU being reduced below any of the above limits, the excess must be reallocated to the
other assets in the CGU or group of CGUs on a pro rata basis. This is best explained in an
example.
Example 14.12
14.12
Limitation on allocation of impairment loss
Bravo Africa Ltd has a business that manufactures and sells compact discs (CDs) of the
performances of famous artists in South Africa. The assets used in the business qualify as a CGU.
The carrying amounts of the assets in the CGU as at 31 December 20.14 are as follows:
R
Equipment
30 000
Machinery
28 000
Furniture
42 000
Goodwill
25 000
125 000
The following information regarding the recoverable amount of the CGU is available:
Fair value less costs of disposal
R70 000
Value in use
R82 000
The effect of the impairment of the unit must still be recorded. The only fair value less costs of
disposal available for individual assets is for furniture, for which there is an active market. This fair
value less costs of disposal amounts to R38 000.
continued
Impairment of assets 347
The recoverable amount of the CGU is the higher of the fair value less costs of disposal and value
in use, thus R82 000. The carrying amount of the unit of R125 000 exceeds the recoverable amount;
therefore the CGU is impaired, and an impairment loss of R43 000 (R125 000 – 82 000) is recognised.
The impairment loss is allocated first to goodwill (utilising goodwill of R25 000) and the remaining
R18 000 on a pro rata basis to the remaining assets in the unit.
The allocation to the individual assets in the above journal entry is calculated as follows:
R
(5 400)
(5 040)
(7 560)
Old
carrying
amount
R
30 000
28 000
42 000
New
carrying
amount
R
24 600
22 960
34 440
(18 000)
100 000
82 000
Impairment
loss
Equipment (30/100 × 18 000)
Machinery (28/100 × 18 000)
Furniture (42/100 × 18 000)
(43 000 – 25 000)
Fair value less
costs of
disposal
R
Not available
Not available
38 000
As the impairment loss on furniture results in a carrying amount (R34 440) which is less than the
higher of R38 000 and nil, the amount of R3 560 (R38 000 – 34 440) must be allocated to the
other two assets on a pro rata basis.
R
1 841
1 719
Equipment ((30/(28 + 30)) × 3 560)
Machinery ((28/(28 + 30)) × 3 560)
3 560
The journal entry for Bravo Africa Ltd is as follows:
Impairment loss in CGU (P/L)
Goodwill (allocated first) (SFP)
Equipment (5 400 + 1 841) (SFP)*
Machinery (5 040 + 1 719) (SFP)*
Furniture (7 560 – 3 560) (SFP)*
*Accumulated depreciation
Dr
R
43 000
Cr
R
25 000
7 241
6 759
4 000
14.5.6 Timing of impairment test for a cash-generating unit
The timing of impairment tests for cash-generating units are the following:
ƒ The annual impairment test for a CGU to which goodwill has been allocated may be
performed at any time during the annual period, provided the test is performed at the
same time every year. This means that if the yearend of a CGU falls on 31 December,
the impairment test related to this CGU need not be performed on 31 December, but
may be performed at any other time during the year (say 31 May). However, if it is
decided to perform the impairment test for this CGU on 31 May, the test must be
performed consistently on 31 May every year.
ƒ Different CGUs may be tested at different times in the year, for instance some CGUs
may be tested on 31 March, some on 31 May and some on 31 August, although all these
CGUs may be part of the same group of companies.
ƒ If some or all of the goodwill allocated to a CGU was acquired in a business combination
during the current financial year, that CGU shall be tested for impairment before the end
of the current financial year. For instance, if the CGU was acquired on 31 October 20.14
and the company has a year end of 31 December 20.14, the CGU must be tested for
impairment for the first time on 31 December 20.14.
348 Descriptive Accounting – Chapter 14
If the individual assets constituting a CGU to which goodwill has been allocated are tested
for impairment because there are indications of impairment for those individual assets, and
at the same time the unit containing the goodwill is tested for impairment, the individual
assets shall be tested for impairment before the CGU containing the goodwill is tested. This
obviously implies that the carrying amounts of the individual assets are reduced by their
related impairment losses before calculating the impairment loss of the CGU.
Example 14.13
14.13
Individual assets and cash-generating units
X Ltd acquired a 100% interest in Z Ltd on 1 January 20.14. Z Ltd owns only three assets, namely
D, E and F. Goodwill of R10 000 is applicable to the subsidiary (CGU) as a whole. The following
relates to assets D, E and F:
31 December 20.14
D
E
F
R
R
R
Net carrying amounts (not goodwill)
31 000
12 000
9 000
Recoverable amounts
33 000
15 000
8 100
The impairment loss(es) on the individual assets (these are tested first) at 31 December 20.14, if
indications of impairment are assumed, will be:
31 December 20.14
D
E
F
R
R
R
Carrying amount of asset
31 000
12 000
9 000
Recoverable amount
33 000
15 000
8 100
Impairment loss on Asset F
–
–
*
900
If the whole CGU (Z Ltd) is subject to impairment, the CGU as a whole (including Assets D, E and
F, and goodwill) is tested for impairment. This is done after the individual assets have been tested
for impairment – Asset F was impaired. The recoverable amount of the total CGU (including
goodwill) is R60 100; consequently the impairment loss for the CGU (including goodwill) is
calculated as follows:
Carrying amount
R
Asset D
31000
Asset E
12 000
Asset F (net of impairment loss) (9 000 – 900*)
8 100
Goodwill
10 000
Total carrying amount of CGU
Recoverable amount
Impairment loss on CGU
61 100
60 100
1 000
Comment
¾ The impairment loss on Asset F was set off against this asset first, before the CGU was tested
for impairment, while the impairment loss of R1 000 in respect of the CGU (Z Ltd) as a whole is
then set-off against the goodwill in the CGU.
¾ Similarly, if the CGUs (not containing goodwill) constituting a group of CGUs to which goodwill
has been allocated, are tested for impairment at the same time as the group of CGUs
(containing the goodwill), the individual CGUs shall be tested for impairment first, that is, before
testing the group of CGUs containing the goodwill.
Impairment of assets 349
In the annual impairment test of a cash-generating unit to which goodwill has been
allocated, the most recent detailed calculation made in a preceding period of the
recoverable amount could be used, provided all of the following criteria are met:
ƒ the assets and liabilities making up the unit have not changes significantly since the most
recent recoverable amount calculation;
ƒ the most recent recoverable amount calculation resulted in an amount that exceeded the
carrying amount of the unit by a substantial margin;
ƒ based on an analysis of events that have occurred and circumstances that have changed
since the most recent recoverable amount calculation; the likelihood that a current
recoverable amount determination would be less that the current carrying amount of the
unit is remote.
14.5.7 Non-controlling interests
In terms of IFRS 3.32, goodwill on acquisition date is calculated as the difference between
the sum of the following:
ƒ the consideration transferred in the business combination measured at fair value at
acquisition date;
ƒ the amount of the non-controlling interests in the acquiree measured either at fair value
or the non-controlling interests’ proportionate share of the acquiree’s net assets (an
entity can select either of these per business combination and it would normally not form
part of the general accounting policy of a group);
ƒ where a business combination is achieved in stages, the acquisition-date fair value of the
acquirer’s previously held equity interest in the acquiree; and
ƒ the identifiable assets acquired and liabilities assumed at acquisition date.
The above confirms that there are two measurement options in the case of non-controlling
interests and that these form part of the goodwill calculation; consequently, the amount
of goodwill attributable to a business combination would vary, depending on how
non-controlling interests are measured.
14.5.7.1 Non-controlling interests measured at fair value
Assume that an 80% interest in a subsidiary is acquired by a parent for R1 000 000, when
the total identifiable net assets of the subsidiary amounts to R900 000. The non-controlling
interests have a fair value at date of acquisition of R240 000.
Where non-controlling interests are measured at fair value, total goodwill attributed to a
subsidiary in the consolidated financial statements will be calculated as follows: R340 000
goodwill = (R1 000 000 + 240 000 + 0) – 900 000). This total goodwill figure comprises two
components:
ƒ The first component of goodwill is generated by measuring the non-controlling interests
(20%) at fair value (R240 000) and comparing this fair value to the non-controlling
interests’ portion of the identifiable net assets of the subsidiary of R180 000 (900 000
× 20%). Goodwill included as part of the fair value of the non-controlling interests would
therefore be R60 000.
ƒ The second component of goodwill would be the goodwill generated by the controlling
interest (parent) (80%) when purchasing the interest in the subsidiary. This amount is
determined by reducing the total goodwill of R340 000 (calculated above) by the goodwill
generated by the fair value of the non-controlling interests of R60 000 (see first
component). This would be R280 000 (340 000 – 60 000).
Since both the non-controlling interests and the controlling interest contributed to the total
goodwill figure, the amount of goodwill included in the carrying amount of a subsidiary on
consolidation would be represent 100% of the goodwill attributed to the subsidiary (parent
and non-controlling interests).
350 Descriptive Accounting – Chapter 14
Testing for the impairment of goodwill annually in terms of IAS 36 involves comparing the
entire carrying amount of a CGU with its entire recoverable amount.
Impairment testing will not create a problem where the non-controlling interests are
measured at fair value, since the goodwill attributable to both controlling (parent) (80%) and
non-controlling interests (20%) would form part of the carrying amount of the subsidiary and
also its recoverable amount.
Example 14.14
14.14
Non-controlling interests and impairment – measurement at fair value
The fair value of the total identifiable net assets of a subsidiary is R1 500 and a parent acquires an
80% interest in those items for R1 600. The NCI’s proportionate share of the identifiable net assets
of the subsidiary amounted to R300 (1 500 × 20%). The NCI is measured at its fair value of R350.
Applying the normal principles contained in IFRS 3. 32 to calculate goodwill, the sum of
R1 600 + R350, namely R1 950, will be compared to the total identifiable net assets of the
subsidiary, namely R1 500, to determine goodwill of R450. The goodwill contributed by the NCI
amounts to R50 (350 – 1 500 × 20%), while the goodwill contributed by the parent amounts to
R400 (450 – 50) and relates to the parent’s 80% interest in the subsidiary (total being parent’s and
NCI’s). The portion of goodwill attributed to the NCI is recognised in the consolidated financial
statements under this measurement basis and total goodwill of R450 will appear in the
consolidated financial statements.
Using the above information, if there is an NCI component in a CGU (the CGU is a subsidiary not
wholly-owned by the parent to which goodwill has been allocated), the carrying amount of the
CGU (subsidiary) in the consolidated financial statements will include allocated goodwill of R450
as well as both the parent’s and the NCI’s interest in the identifiable net assets of the subsidiary
(R1 500). This results in a total carrying amount of R1 950.
This amount of R1 950 includes the goodwill of the NCI of R50.
Note that in terms of IAS 36.C4, the recoverable amount of the CGU (subsidiary) will be
determined for the CGU as a whole.
Following the basic principle that the carrying amount of the CGU and its recoverable amount
should be symmetrical (compare apples with apples) when testing for impairment, the carrying
amount of the CGU to be compared to the recoverable amount of the CGU, should be R1 950.
If the recoverable amount of the entire subsidiary amounts to R1 450, an impairment loss of R500
(1 950 – 1 450) will be identified.
Applying the basic principle of IAS 36.104 in respect of the allocation of the impairment loss of a
CGU, the impairment loss of R500 should first be allocated to goodwill recognised (R450) in the
consolidated financial statements and the remaining R50 should then be allocated to the other
assets in the CGU.
Comment
¾ In profit or loss, the impairment loss is allocated between the parent and the NCI in the
profit-sharing ratio.
¾ R450 goodwill (parent and NCI) currently forms part of the carrying amount of the CGU.
¾ The possible impairment loss of R500 would be allocated to goodwill of the CGU until it wipes
out the total goodwill recognised (R450). The remainder of R50 (500 – 450) of the impairment
loss will be allocated to other assets in the CGU pro rata using their carrying amounts as basis.
¾ Detailed examples in this regard are presented in Illustrative Examples 7A to 7C of IAS 36.
14.5.7.2 Non-controlling interests is measured at the proportionate share
of the acquiree’s identifiable net assets
Where non-controlling interests are measured at the proportionate share of the acquiree’s
identifiable net assets, the total goodwill attributed to a subsidiary will comprise only one
component (nothing contributed by non-controlling interests not measured at fair value):
ƒ Compare the sum of the consideration transferred# (R1 000 000), the non-controlling
interests measured at their proportionate share of the identifiable net assets$ (R180 000)
Impairment of assets 351
(900 000 × 20%) and, if applicable, the fair value of the previously-held equity interest in
the subsidiary& (nil) to the net assets of the subsidiary (R900 000). Goodwill would thus
be R280 000 (1 000 000 + 900 000 × 20%) – 900 000 (net assets)). Clearly no
component of the goodwill amount of the subsidiary is contributed by the non-controlling
interests as they are measured at their proportionate share of identifiable net assets of
the subsidiary, not fair value. This implies that the total amount of goodwill included in
the carrying amount of the subsidiary (R280 000), would represent the goodwill of the
subsidiary contributed by the parent who holds 80% of the shares. The non-controlling
interests would contribute nothing.
Testing for the impairment of goodwill on an annual basis in terms of IAS 36 involves
comparing the entire carrying amount of a CGU with its entire recoverable amount.
Where non-controlling interests are measured at their proportionate share of the identifiable
net assets of the subsidiary, the carrying amount of the subsidiary will only include goodwill
related to the controlling interest of 80% (parent) and nothing in respect of the noncontrolling interests. By contrast, the recoverable amount of the subsidiary would include
goodwill related to both the parent and the non-controlling interests. Clearly this would lead
to a situation where like is not compared with like; therefore the carrying amount of the
subsidiary should be grossed up to include the unrecognised portion of goodwill.
Example 14.15
14.15
Non-controlling interests and impairment – measurement at proportionate
share of identifiable net assets
The fair value of the total identifiable net assets of a subsidiary is R1 500. A parent acquires an
80% interest in those items for R1 600. The non-controlling interests (NCI) are measured at their
proportionate share of the net assets of the subsidiary and amount to R300 (1 500 × 20%).
Applying the normal principles contained in IFRS 3.32 to calculate goodwill, the sum of
R1 600 + (20% × R1 500), namely R1 900, will be compared to the total identifiable net assets of
the subsidiary, namely R1 500, to determine goodwill of R400. The goodwill of R400 relates to the
parent’s 80% interest in the subsidiary and therefore represents only 80% of the total goodwill
(total being parent’s and non-controlling interests’ goodwill) that can be associated with the
subsidiary as a whole. The portion of goodwill attributed to the NCI is not recognised in the
consolidated financial statements under this measurement basis.
To determine the grossed-up goodwill for the subsidiary as a whole of R500 (400/80%), notional
goodwill of R100 (500 – 400) (which has not been recognised in the consolidated financial
statements) should be added to the original R400.
Using the above information, if there is an NCI component in a CGU (the CGU is a subsidiary not
wholly-owned by the parent to which goodwill has been allocated), the carrying amount of the
CGU (subsidiary) in the consolidated financial statements will include allocated goodwill of R400,
as well as both the parent’s and the NCI’s interest in the identifiable net assets of the subsidiary
(R1 500). This will give a total carrying amount of R1 900.
This amount of R1 900 does not include the notional goodwill of the NCI of R100. If that were
included, the carrying amount of the CGU would have been R2 000 (1 900 + 100).
Note that in terms of IAS 36.C4, the recoverable amount of the CGU (subsidiary) will be
determined for the CGU as a whole.
Following the basic principle that the carrying amount of the CGU and its recoverable amount
should be symmetrical (compare apples with apples) when testing for impairment, the carrying
amount of the CGU to be compared to the recoverable amount of the CGU should be R2 000. This
will be achieved if the actual recognised carrying amount of the CGU is adjusted notionally by
R100 (500 × 20%) for the calculation of the impairment loss on the CGU.
If the recoverable amount of the entire subsidiary amounts to R1 450, an impairment loss of R550
(2 000 – 1 450) will be identified. Note that this amount assumes that the R100 goodwill
attributable to the NCI is also available for the impairment loss to be offset, but this is not the case.
Consequently, the impairment loss should be reduced by the R100 in respect of notional goodwill
that does not form part of the carrying amount of the subsidiary that was tested for impairment.
continued
352 Descriptive Accounting – Chapter 14
Applying the basic principle of IAS 36.104 in respect of the allocation of the impairment loss of a
CGU, the (net) impairment loss of R450 (550 – 100) should first be allocated to goodwill
recognised (R400) in the consolidated financial statements. The remainder of R50 should then be
allocated to the other assets in the CGU.
Comment
¾ In profit or loss, the impairment loss is allocated between the parent and the NCI in the
profit-sharing ratio.
¾ R400 goodwill currently forms part of the carrying amount of the CGU.
¾ The possible impairment loss of R550 that could have been allocated to goodwill if the parent
owned a 100% of the CGU needs to be reduced by R100 to R450, to align it with the goodwill
recognised of R400. The remainder of R50 (450 – 400) of the impairment loss will be allocated
to other assets in the CGU pro rata using their carrying amounts as basis.
¾ If the impairment loss amounted to only R360 instead of R450, the total impairment loss would
be allocated to goodwill and the goodwill balance will be reduced to R40 (400 – 360).
¾ Detailed examples in this regard are presented in Illustrative Examples 7A to 7C of IAS 36.
14.5.8 Reversal of impairment losses for cash-generating units
The reversal of impairment losses for CGUs is similar to that of individual assets
(IAS 36.122 to .124).
When the impairment loss of a CGU is reversed, the reversal must be allocated to the
carrying amounts of the assets in the unit, except for goodwill, as follows:
ƒ assets other than goodwill are increased on a pro rata basis, based on their carrying
amounts in the unit; and
ƒ goodwill that is allocated to the unit, is never reinstated. This is to avoid recognising
internally-generated goodwill, which is prohibited by IAS 38.
When the reversal of an impairment loss for a CGU is allocated to the assets in the unit, the
carrying amounts of the assets must not increase above the lower of:
ƒ its recoverable amount; and
ƒ the carrying amount that would have been determined had no impairment loss been
recognised in prior periods.
If the carrying amount of individual assets increases above the amount stated above, the
residual is allocated to the remaining assets (except for goodwill) in the unit on a pro rata
basis.
Note that where goodwill has been written-down to the recoverable amount in the interim
financial statements, the amount may not be reversed in the second part of the financial
year.
Example 14.16
14.16
Reversal of impairment in the case of a cash-generating unit
On 1 January 20.14, a CGU consists of the following assets:
ƒ
ƒ
ƒ
ƒ
Goodwill
Machine (useful life 10 years)
Building (useful life 50 years)
Land (indefinite useful life)
R
100 000
500 000
1 000 000
570 000
continued
Impairment of assets 353
On 31 December 20.14, the CGU was impaired. The following is applicable:
R
Carrying amount of CGU:
ƒ Goodwill
ƒ Machine (500 000 × 9/10)
ƒ Building (1 000 000 × 49/50)
ƒ Land
100 000
450 000
980 000
570 000
2 100 000
Value in use
1 000 000
Fair value less costs of disposal of CGU
900 000
Recoverable amount of CGU = R1 000 000
Impairment loss: R2 100 000 – R1 000 000 = R1 100 000
It is impossible to determine the value in use less costs to sell of the assets separately.
The impairment loss allocated as follows:
Goodwill
Machine
Building
Land
Total
R
R
R
R
R
Carrying amount
100 000
450 000
980 000
570 000
2 100 000
Impairment loss
allocated to goodwill
(100 000)
(100 000)
Carrying amount
The remaining
impairment loss of
R1 000 000
(1 100 000 – 100 000)
must be allocated to
the other assets on a
pro rata basis
Carrying amount after
impairment loss
Depreciation for the
year ended
31 December 20.15
Carrying amount
31 December 20.15
–
450 000
980 000
570 000
2 000 000
–
*(225 000)
*(490 000)
*(285 000)
(1 000 000)
–
225 000
490 000
285 000
1 100 000
–
(25 000)
(10 000)
–
(35 000)
–
200 000
480 000
285 000
965 000
* (450 000/2 000 000 × 1 000 000); (980 000/2 000 000 × 1 000 000); (570 000/2 000 000 × 1 000 000)
On 31 December 20.15, there was an improvement in the circumstances resulting in the
impairment. The recoverable amount of the CGU is calculated as R2 200 000.
In terms of IAS 36.123, the reversal must be allocated pro rata to all the assets, except goodwill.
The reversal is as follows:
R
Carrying amount of CGU on 31 December 20.15
965 000
Recoverable amount
2 200 000
Maximum reversal
1 235 000
On 31 December 20.15, the recoverable amount of the land is R500 000.
continued
354 Descriptive Accounting – Chapter 14
In terms of IAS 36.123, the reversal must not be more than the lowest of the carrying amount, if no
impairment loss was recognised, or the recoverable amount of the asset. The carrying amount of
the assets would be as follows if no impairment loss was recognised previously:
Machine Building
Land
Total
R
R
R
R
Carrying amount 31 December 20.15
(no impairment loss
570 000
*400 000 *960 000
Recoverable amount
–
–
500 000
Limit on carrying amount after reversal
Carrying amount before reversal
400 000
200 000
960 000
480 000
500 000
285 000
Maximum reversal on asset
200 000
480 000
215 000
895 000
* (500 000/10 × 8); (1 000 000/50 × 48)
The reversal of impairment loss must be allocated as follows:
Goodwill Machine
Building
R
R
R
Carrying amount
31 December 20.15
–
200 000
480 000
Reversal
Maximum reversal
–
200 000
480 000
Land
R
Total
R
285 000
965 000
215 000
895 000
364 740
1 235
000
(340 000)
Pro rata allocation of
R1 235 000 – no limit
–
Unused reversal
–
(55 959)
(134 301)
(149 740)
Carrying amount after
reversal
–
400 000
960 000
500 000
*
255 959
*
614 301
*
1 860
000
* (200 000/965 000 × 1 235 000); (480 000/965 000 × 1 235 000); (285 000/965 000 × 1 235 000)
14.6 Disclosure
In the financial statements of an entity, the following must be disclosed for each class of
assets (a class is a grouping of assets of similar nature and use):
14.6.1 Statement of profit
Profit or loss section
or
loss
and
other
comprehensive
income:
ƒ The amount of impairment losses recognised in the profit or loss section in the statement
of profit or loss and other comprehensive income during the period, and the line item(s)
of the statement of profit or loss and other comprehensive income in which those
impairment losses are included.
ƒ The amount of reversals of impairment losses recognised in the profit or loss section in
the statement of profit or loss and other comprehensive income during the period, and
the line item(s) of the statement of profit or loss and other comprehensive income in
which those impairment losses are reversed.
14.6.2 Statement of profit or loss and
Other comprehensive income section
other
comprehensive
income:
ƒ The amount of impairment losses recognised in other comprehensive income during the
period.
ƒ The amount of reversals of impairment losses recognised in other comprehensive
income during the period.
Impairment of assets 355
14.6.3 Notes to the financial statements
If the impairment loss recognised or reversed on an individual asset or CGU is material, the
following additional information is provided for an individual asset or a CGU, including
goodwill:
ƒ A description of the events and circumstances that led to the recognition or reversal of
the impairment loss.
ƒ The amount of the impairment loss recognised or reversed.
ƒ For an individual asset:
– the nature of the asset; and
– the reportable segment to which the asset belongs.
ƒ For a CGU:
– a description of the CGU (whether it is a product line, a plant, a business operation, a
geographical area, or a reportable segment);
– the amount of the impairment loss recognised or reversed by class of assets and by
reportable primary segment; and
– if the aggregation of assets for identifying the CGU has changed since the previous
estimate of the CGU’s recoverable amount (if any), a description of the current and
former way of aggregating assets and the reasons for changing the way the CGU is
identified.
ƒ Whether the recoverable amount of the asset or CGU is its fair value less costs of
disposal or its value in use.
ƒ If the recoverable amount is fair value less costs of disposal, the basis used to determine
fair value less costs of disposal.
ƒ If the recoverable amount is value in use, the discount rate(s) used in the current
estimate and previous estimate (if any) of value in use.
If impairment losses recognised (reversed) during the period are not individually material
to the financial statements of the reporting entity as a whole, an entity must disclose for the
aggregate impairment losses and reversals thereof, a brief description of the following:
ƒ The main classes of assets affected by impairment losses (reversals of impairment
losses) for which no information is disclosed in terms of the above.
ƒ The main events and circumstances that led to the recognition (reversal) of these
impairment losses for which no information is disclosed in terms of the above.
ƒ An entity is encouraged to disclose the assumptions used to determine the recoverable
amount of assets/CGUs in the period.
ƒ If, at the initial allocation of goodwill as discussed in IAS 36.84, any portion of goodwill
has not been allocated to a CGU or group of CGUs at the reporting date, the amount of
unallocated goodwill shall be disclosed, with reasons why the amount remains
unallocated.
An entity shall disclose the information required below for each CGU (group of CGUs) for
which the carrying amount of goodwill or intangible assets with indefinite useful lives
allocated to that CGU (group of CGUs) is significant in comparison with the entity’s total
carrying amount of goodwill or intangible assets with indefinite useful lives:
ƒ the carrying amount of goodwill allocated to the CGU (group of CGUs);
ƒ the carrying amount of intangible assets with indefinite useful lives allocated to the CGU
(group of CGUs);
ƒ the basis on which the CGU’s (group of CGUs’) recoverable amount has been
determined (i.e. value in use or fair value less costs of disposal);
356 Descriptive Accounting – Chapter 14
ƒ if the CGU’s (group of CGUs’) recoverable amount is based on value in use:
– each key assumption on which management has based its cash flow projections for
the period covered by the most recent budgets/forecasts. Key assumptions are those
to which the CGU’s (group of CGUs’) recoverable amount is most sensitive;
– a description of management’s approach to determining the value(s) assigned to each
key assumption, whether those values reflect past experience or, if appropriate, are
consistent with external sources of information, and, if not, how and why they differ
from past experience or external sources of information;
– the period over which management has projected cash flows based on financial
budgets/forecasts approved by management and, when a period greater than five
years is used for a CGU (group of CGUs), an explanation of why that longer period is
justified;
– the growth rate used to extrapolate cash flow projections beyond the period covered
by the most recent budgets/forecasts, and the justification for using any growth rate
that exceeds the long-term average growth rate for the products, industries, or country
or countries in which the entity operates, or for the market to which the CGU (group of
CGUs) is dedicated; and
– the discount rate(s) applied to the cash flow projections;
ƒ if the CGU’s (group of CGUs’) recoverable amount is based on fair value less costs of
disposal, the valuation techniques used to measure fair value less costs of disposal. An
entity is not required to provide the disclosure required by IFRS 13. If fair value less
costs to sell is not measured using a quoted price for an identical CGU (group of CGUs),
the following information shall also be disclosed:
– each key assumption on which management has based its determination of fair value
less costs of disposal;
– a description of management’s approach to determining the value(s) assigned to each
key assumption, whether those values reflect past experience or, if appropriate, are
consistent with external sources of information, and, if not, how and why they differ
from past experience or external sources of information;
– the level of the fair value hierarchy (refer to IFRS 13) within which the fair value
measurement is categorised in its entirety (without giving regard to the observability of
costs of disposal); and
– if there has been a change in valuation technique, the change and the reasons for
making it; and
ƒ if a reasonably possible change in a key assumption on which management has based
its determination of the CGU’s (group of CGUs’) recoverable amount would cause the
unit’s (group of units’) carrying amount to exceeds its recoverable amount:
– the amount by which the CGU’s (group of CGUs’) recoverable amount exceeds its
carrying amount;
– the value assigned to the key assumption; and
– the amount by which the value assigned to the key assumption must change, after
incorporating any consequential effects of that change on the other variables used to
measure the recoverable amount, in order for the CGU’s (group of CGUs’)
recoverable amount to be equal to its carrying amount.
If some or all of the carrying amount of goodwill or intangible assets with indefinite useful
lives is allocated across multiple CGUs (groups of CGUs), and the amount so allocated to
each CGU (group of CGUs) is not significant in comparison with the entity’s total carrying
amount of goodwill or intangible assets with indefinite useful lives, that fact shall be
disclosed, as well as the aggregate carrying amount of goodwill or intangible assets with
indefinite useful lives allocated to those CGUs (groups of CGUs).
Impairment of assets 357
In addition, if the recoverable amounts of any of those CGUs (groups of CGUs) are based
on the same key assumption(s) and the aggregate carrying amount of goodwill or intangible
assets with indefinite useful lives allocated to them is significant in comparison to the
entity’s total carrying amount of goodwill or intangible assets with indefinite useful lives, an
entity shall disclose that fact, together with:
ƒ the aggregate carrying amount of goodwill allocated to those CGUs (groups of CGUs);
ƒ the aggregate carrying amount of intangible assets with indefinite useful lives allocated
to those CGUs (groups of CGUs);
ƒ a description of the key assumption(s);
ƒ a description of management’s approach to determining the value(s) assigned to the key
assumption, whether those values reflect past experience or, if appropriate, are
consistent with external sources of information, and, if not, how and why they differ from
past experience or external sources of information; and
ƒ if a reasonably possible change in the key assumption(s) would cause the aggregate of
the CGU’s (group of CGUs’) carrying amounts to exceed the aggregate of their
recoverable amounts:
– the amount by which the aggregate of the CGU’s (group of CGUs’) recoverable
amount exceeds the aggregate of their carrying amounts;
– the value(s) assigned to the key assumption(s); and
– the amount by which the value(s) assigned to the key assumption(s) must change,
after incorporating any consequential effects of the change on the other variables
used to measure the recoverable amount, in order for the aggregate of the CGU’s
(group of CGUs’) recoverable amounts to equal the aggregate of their carrying
amounts.
14.7 Tax implications
The impairment losses recognised on individual assets or CGUs are not recognised as tax
deductions in terms of the Income Tax Act 58 of 1962. Consequently, temporary differences,
and therefore deferred tax, arise when an impairment loss is recognised or reversed. (Refer
to the comprehensive example).
14.8 Comprehensive example
On 1 January 20.12 Bird Ltd had the following balances with regard to property, plant and equipment:
Accumulated
Cost
depreciation
R’000
R’000
Land
300
–
Buildings
4 000
400
Plant
4 000
1 600
All the above assets were acquired 1 January 20.10. Buildings and plant are depreciated on the
straight-line basis over 20 years and 5 years respectively and are carried at cost less accumulated
depreciation. Residual values are Rnil. Land, buildings and the plant are accounted for in accordance
with the cost model. Land is a non-depreciable asset.
On 30 June 20.12 a machine (with an original cost of R700 000 and a useful life of 5 years), which is
an integral part of the above plant, was destroyed by a fire and replaced with a similar one for
R800 000. Bird Ltd received an insurance claim of R210 000.
During the 20.12 financial year the market values of properties to drop sharply. On 31 December 20.12
the value in use and the fair value less cost of disposal of land and buildings was R2 000 000 and
R2 400 000 respectively. It was estimated that the market value of the land is 10% of the market value
of the total property. The fair values of the land and buildings at 31 December 20.12 were R130 000
and R1 900 000 respectively.
358 Descriptive Accounting – Chapter 14
The following notes to the financial statements of Bird Ltd for the year ended 31 December 20.12
would be disclosed:
Notes for the year ended 31 December 20.12
1. Property, plant and equipment
Land
R’000
300
Buildings
R’000
3 600
Plant
R’000
2 400
Total
R’000
6 300
Gross carrying amount or cost
Accumulated depreciation
300
–
4 000
(400)
4 000
(1 600)
8 300
(2 000)
Impairment losses through profit or loss
(included in other expenses) (C1)
Additions
Depreciation for the year (C2)
(60)
–
–
(1 240)
–
(200)
(350)
800
(810)
(1 650)
800
(1 010)
Carrying amount at beginning of year
Carrying amount at end of year
240
2 160
2 040
4 440
Gross carrying amount or cost
Accumulated depreciation and impairment losses
300
(60)
4 000
(1 840)
4 100
(2 060)
8 400
(3 960)
2. Profit before tax
The following items are included:
Income
Compensation from insurer for impairment loss on property, plant and equipment
(IAS 16.65)
Expenses
Impairment losses individually regarded as material (IAS 36.130):
R’000
210
(1 650)
Machine destroyed by fire
Land and buildings: Adverse economic climate (1 240 + 60)
(350)
(1 300)
Depreciation on property, plant and equipment
(1 035)
Calculations
C1. Machine destroyed
R
700
Cost
Depreciation
20.10 – 20.11 (700/5 × 2)
20.12 (700/5 × 6/12)
Carrying amount 30 June 20.12
(280)
(70)
350
Impairment loss (350 – 0 = 350)
Property B – Impairment loss
Carrying amount (4 000 – (4 000/20 × 2) – (4 000/20) = 3 400)
Recoverable amount (2 400 × 10%=240; 2 400 × 90% = 2 160)
Impairment loss
Land
R’000
300
240
Buildings
R’000
3 400
2 160
60
1 240
Impairment of assets 359
C2. Depreciation
R
200
Buildings (4 000/20)
Plant
Machine destroyed [C1]
New machine (800/5 × 6/12)
70
80
660
Rest ((4 000 – 700)/5)
810
C3. Reversal of impairment loss
Carrying amount (2 160 – (2 160/17))
Recoverable amount (400 and 5 000) limited to (IAS 36.117)
(4 000 – (4 000/20 × 4) = 3 200)
Land
R’000
240
300
Buildings
R’000
2 033
3 200
60
1 167
CHAPTER
15
Provisions, contingent liabilities
and contingent assets
(IAS 37; IFRIC 1, 5, 6 and 21)
Contents
15.1
15.2
15.3
15.4
15.5
15.6
15.7
15.8
15.9
15.10
15.11
Overview of IAS 37 Provisions, Contingent Liabilities and
Contingent Assets ...........................................................................................
Background .....................................................................................................
Relationship between provisions and contingent liabilities .............................
Provisions ........................................................................................................
15.4.1
Recognition ......................................................................................
15.4.2
Measurement ...................................................................................
15.4.3
Disclosure ........................................................................................
15.4.4
Onerous contract .............................................................................
15.4.5
Restructuring ...................................................................................
15.4.6
Additional matters surrounding provisions .......................................
Contingent liabilities ........................................................................................
15.5.1
Measurement ...................................................................................
15.5.2
Disclosure ........................................................................................
15.5.3
Contingent liabilities recognised at business combinations .............
Contingent assets............................................................................................
15.6.1
Disclosure ........................................................................................
Tax implications...............................................................................................
Changes in existing decommissioning, restoration and similar liabilities
(IFRIC 1)..........................................................................................................
15.8.1
Deferred tax consequences of decommissioning, restoration
and similar liabilities .........................................................................
Rights to interests arising from decommissioning, restoration
sand environmental rehabilitation funds (IFRIC 5) ..........................................
15.9.1
Background......................................................................................
15.9.2
Accounting for the interest in a fund ................................................
15.9.3
Obligations to make additional contributions to the fund .................
15.9.4
Disclosure ........................................................................................
Liabilities arising from participating in a specific market –
waste electrical and electronic equipment (IFRIC 6) .......................................
Levies (IFRIC 21) ............................................................................................
361
362
363
363
365
365
367
369
370
371
373
374
375
375
376
376
377
378
379
380
381
381
381
382
382
382
383
362 Descriptive Accounting – Chapter 15
15.1 Overview of IAS 37 Provisions, Contingent Liabilities
and Contingent Assets
Provisions
and
contingent
liabilities
Start
Present
obligation
as a result of
obligating event?
No
Yes
Is there a
probable
outflow?
No
Is there a
possible
obligation?
Yes
No
Is the outflow
of resources
remote?
Yes
Yes
Is there a
reliable
estimate?
No
(rare)
No
Yes
IAS 37
Can obligation
exist
independently
from entity’s
future actions?
No
Yes
Disclose a
contingent liability
in a note
Create
a provision
Contingent
assets
Possible asset,
existence
confirmed
by uncertain
future event
No
Yes
Is there a
probable inflow?
Yes
Disclose a
contingent asset
in a note
No
Do nothing
Provisions, contingent liabilities and contingent assets 363
15.2 Background
IAS 37 deals with the accounting recognition and disclosure of provisions, contingent
liabilities and contingent assets in financial statements. This means that it is often required
that factual knowledge that only became available after the end of the reporting period be
considered.
IAS 37 is not applicable to provisions, contingent liabilities and contingent assets of:
ƒ executory contracts, except where the contract is onerous; and
ƒ items covered by other IFRSs such as:
– financial instruments that are within the scope of IFRS 9 Financial Instruments;
– the rights and obligations arising from contracts with customers within the scope of
IFRS 15 Revenue from Contracts with Customers. However, as IFRS 15 contains no
specific requirements to address contracts that are or have become onerous, IAS 37
will apply to such cases; and
– leases addressed in IFRS 16 Leases. However, IAS 37 applies to any lease that
becomes onerous before commencement date, short-term leases and leases which
the underlying asset is accounted for as low value.
The 2018 Conceptual Framework for Financial Reporting defines a liability as a present
obligation of the entity to transfer an economic resource as a result of past events. However,
no changes have been made to the definition of a liability in IAS 37, the IASB preserved the
reference to the definition of a liability in the 2001 Conceptual Framework. The reference to
a liability in IAS 37, refer to the definition of a liability as a present obligation of the entity
arising from past events, the settlement of which is expected to result in an outflow from the
entity of resources embodying economic benefits.
15.3 Relationship between provisions and contingent liabilities
The accounting process is, inter alia, concerned with the identification, recognition and
disclosure of elements of financial statements:
ƒ Identification refers to the assessment of a particular item with a view to determining
whether it fulfils the definition of the element concerned.
ƒ Recognition comprises two facets: timing and measurement. This means at what point in
time and at what value the element must be recognised.
ƒ As soon as the element is recognised, it is disclosed appropriately. The disclosure may
be qualitative (description) or quantitative (figures) or both.
The above may be represented schematically as follows:
Identification
Recognition may possibly take place after
identification. Two aspects are considered:
Whether
Timing
Measurement
The characteristics of
elements in terms of the
2001 Conceptual
Framework are
displayed.
When there is sufficient
probability that there will
be an outflow of
resources.
How much is the
amount that must
be disclosed?
Disclosure
How
It is disclosed:
qualitatively,
quantitatively,
or both?
The fundamental difference between contingent liabilities and provisions is in the degree of
fulfilment of the requirements of identification. In the case of a provision, no doubt exists
regarding identification: a provision is a liability, because it has the characteristics of a
liability, as stated in the 2001 Conceptual Framework.
364 Descriptive Accounting – Chapter 15
In the case of a contingent liability, there is a greater measure of uncertainty about the
fulfilment of the requirements of identification than for a provision: the uncertainty may
already exist at identification, because the contingent liability is described as 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. A contingent liability may also take the form of a real present
obligation (not only a possible obligation) – but one that may however not be recognised,
because either the ‘when’ (timing) or the ‘how much’ (measurement) is not known.
Example 15.1
Contrasting a provision and contingent liability
Guests were catered for by a restaurant and after the reception, twelve people died as a result of
food poisoning contracted at the function. On 31 October 20.14, the relatives of the deceased
instituted a claim of R6 million against the entity. The year end of the company is 31 December.
The following two possibilities exist as at 31 December 20.14 in respect of the accounting
treatment of the claim:
Option 1: Provision
Should the legal advisors of the restaurant be of the opinion that the claim will probably be
successful and that the amount of R6 million represents a reasonable estimate of the amount to be
paid, the entity will recognise a liability, that is, a provision. A provision, as defined, is a liability of
uncertain timing or amount. In this case, uncertainty as to when the amount will be paid exists, but
sufficient certainty exists about the fact that there is a liability as well as the approximate amount
that should be paid.
Option 2: Contingent liability
If the legal advisors are of the opinion that it is merely possible that the claim may be successful, but
not probable, the matter will be disclosed as a contingent liability. It will thus not be recognised in the
financial statements, but will only be disclosed in the notes to the financial statements. In terms of the
definition of a contingent liability, the possible obligation arises from past events (the reception with
the contaminated food) and the existence of the obligation will only be confirmed at the occurrence
(judgment against the entity) or non-occurrence (judgment in favour of the entity) of uncertain future
events.
Example 15.2
Progression from a contingent liability to a provision
Suppose that Alfa Ltd provides and installs a factory plant for a customer and guarantees that
80% capacity will be achieved within three months of the commencement of production. If this
target is not achieved, Alfa is liable for damages to the extent of the lost production. Initially,
there is a small possibility that Alfa will have to perform, and therefore no accounting recognition
is required. After two weeks, it would appear that a liability may indeed materialise, but as it is
uncertain whether an outflow of resources will occur, as well as what the amount of such an
outflow will be, no liability is recognised, but the situation is explained by way of a note. This
treatment stays unchanged as long as the outflow of resources, or the amount of such an
outflow, remains uncertain. As soon as there is reasonable certainty of the fact that there will
indeed be an outflow of resources, as well as about the amount of such an outflow, a provision
is created and a liability is recognised in the financial statements.
Provisions, contingent liabilities and contingent assets 365
The following summary is provided in the Implementation Guidance to IAS 37 to illustrate
the relationship between provisions and contingent liabilities:
Where, as a result of past events, there may be an outflow of resources embodying future
economic benefits in settlement of: (a) a present obligation, or (b) a possible obligation
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.
There is a present
obligation that probably
requires an outflow
of resources.
There is a possible obligation
or a present obligation that
may, but probably will not,
require an outflow
of resources.
There is a possible
obligation or a present
obligation where the
likelihood of an outflow of
resources is remote.
A provision is recognised.
No provision is recognised.
No provision is recognised.
Disclosure is required
for the provision.
Disclosure is required for the
contingent liability.
No disclosure is required.
Example 15.3
Application of above table
Alfa Ltd is sued for R1 million for damages caused by a defective product that has been
manufactured and sold. The following two situations represent possible outcomes to the claim:
(a) Alfa Ltd’s legal advisors are of the opinion that the claim will probably succeed.
A present obligation exists as a result of a past obligating event (sale of a defective product). An
outflow of resources embodying future economic benefits is probable. A provision must be
recognised for the best estimate of the amount (R1 million) to settle the obligation.
(b) Alfa Ltd’s legal advisors are of the opinion that it is unlikely that Alfa Ltd will be found
liable.
Based on the opinion of Alfa Ltd’s legal advisors, a present obligation does not exist, but it is
possible that the entity may still have to pay. No provision is recognised. A contingent liability
must be disclosed, unless the possibility of an outflow of resources embodying economic benefits
is remote.
15.4 Provisions
A provision is defined in IAS 37.10 as a liability of which the amount or timing is uncertain.
15.4.1 Recognition
Provisions are not a separate element of financial statements, but form part of liabilities.
They are, however, distinguished from other liabilities, for example trade payables and
accrued amounts, by the element of uncertainty associated with them. This uncertainty
takes the form of uncertainty about either the timing or the amount at which it is recognised.
As indicated above, ‘timing’ refers to the moment when there will be reasonable certainty
about the resources that the entity must transfer to another party. Provisions are not
recognised as an element of financial statements until reasonable certainty exists.
In terms of IAS 37.14, a provision is only recognised when when all three of the below
criteria are met:
ƒ the entity has a present legal or constructive obligation to forfeit economic benefits as a
result of events in the past (‘whether it complies’);
ƒ it is probable that an outflow of resources embodying economic benefits will be required
to settle the obligation (‘when’); and
ƒ a reliable estimate of the obligation can be made (‘how much’).
366 Descriptive Accounting – Chapter 15
Two types of obligations can thus exist in terms of a provision, namely:
ƒ a legal obligation; or
ƒ a constructive obligation.
A legal obligation is an obligation that derives from a contract (explicit or implicit terms);
legislation or other operation of law.
A constructive obligation is an obligation that is not legally enforceable, but arises as a
result of management policy and decisions that create a valid expectation with third parties
that the entity will act in a certain manner.
A past event that gives rise to a present obligation is called an obligating event. It is
necessary for an event to leave the entity with no realistic alternative to settle the obligation
for that event to be an obligating event. This is the case only where the settlement of the
obligating event is enforced by law or in the case of a constructive obligation.
In rare cases, it is not clear that there is a present obligation. In these cases, 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.
Example 15.4
15.4
Meeting the requirements for recognising a provision
All three of the abovementioned recognition requirements must be met before a provision can be
recognised.
When an entity delivers assurance-type warranties to its clients, the following requirements
must be met before a provision is created:
ƒ An entity is normally liable for complying with the terms of the warranty contract. The warranty
contract creates a legal obligation for the entity to perform in terms of the contract if the client
claims in terms of the warranty. These contracts are concluded at a date in the past, i.e. the date
of the delivery of goods or services.
ƒ When the probability of the client claiming in terms of the warranty contract is assessed, one
must have reasonable certainty that the client will exercise his/her rights, if required.
ƒ The estimate of the number of clients likely to claim against warranty contracts will influence the
reliability of the estimate of the provision. It should be possible, based on historical information
and the costs related to performing on a warranty, to arrive at a reliable estimate of the
expected future outflows related to the warranty.
An assurance-type warranty contract should, because of the above reasons, thus result in a
provision in terms of IAS 37.
Example 15.
15.5
Legal versus constructive obligations
Gamma Ltd has retail outlets for electrical appliances in three different countries:
Finland:
In Finland, legislation requires retailers of electrical appliances to provide a one-year
standard warranty that specifies the appliances will comply with agreed-upon
specifications.
South
South Africa has no legislation in this regard, but most retailers selling electrical
Africa:
appliances usually provide a one-year standard warranty that specifies the appliances
will comply with agreed-upon specifications. However, Gamma Ltd did not follow this
custom. In view of the company’s attitude, customers boycotted the company for two
months. Subsequently, management issued a press release to the effect that it would
also in future provide a one-year standard warranty.
Cambodia: Cambodia has no legislation in this regard, although the management of Gamma Ltd
is considering the introduction of a standard warranty. However, no announcement to
this effect has been made.
continued
Provisions, contingent liabilities and contingent assets 367
The question is when a provision for the warranties should be raised in each of the above cases.
In general, a provision is recognised when there is a present obligation as a result of past events.
The past events in this case are the sales of electrical appliances, and to incur a present
obligation, the company must have either a legal or a constructive obligation to accept returned
goods.
Finland:
A legal obligation arises immediately after a sale, as a law governs the matter.
Consequently, a provision for returns must be recognised.
South
Africa:
A constructive obligation exists as a valid expectation arose with customers after
the company’s public announcement to this effect. A provision must thus be
recognised.
Cambodia:
As Cambodia has no legislation in this regard and customers are not aware of the
company’s intentions, no legal or constructive obligation exists. No provision must
be recognised in this case.
It is also important to take note that only those obligations that can exist independently of
an entity’s future actions (in other words, the future conduct of its business) are
recognised as provisions (IAS 37.19). If an obligation can be avoided by way of future
action, the entity still has a realistic alternative to settling the obligation. An example of this
principle would be the obligation to replace the lining of a grain silo in future due to an Act
requiring grain silo linings to be replaced on a regular basis. Should the entity decide to
rather utilise the silo for other purposes, for example storing sugar rather than storing grain,
the replacement of the lining becomes unnecessary. This obligation is thus dependent on
the fact that the entity who owns the grain silo will still utilise the silo in exactly the same
manner as currently. Therefore the obligation does not exist independently from the entity’s
future actions, and may not be recognised as provision.
15.4.2 Measurement
In accordance with IAS 37.36, a provision is measured in terms of the amount that
represents the best estimate of the amount required to settle the obligation at the end of
the reporting period.
When a single obligation is being measured, the individual most likely estimate is used as
the best estimate of the liability. The entity will however also consider other possible
outcomes. Where the other possible outcomes are either mostly higher or mostly lower than
the most likely outcome, the best estimate will be a higher or lower amount.
Where there is a continuous range of possible outcomes, and each point in that range is as
likely as any other point, the mid-point of the range is used.
IAS 37.45 states that if the effect of discounting is material, the provision must be
measured at the present value of the expected future outflow of resources. This applies to
the liabilities that have an effect over the long term, as often occurs in the case of
environmental costs, for example rehabilitation of disturbed land in the mining industry.
Because the expenses in these cases may occur over a very long period or may only be
incurred after a long period has lapsed, it can present an unrealistic impression if the
expected expenses over these long periods are not discounted to present values for the
purposes of the provision. The discount rate and the cash flows must both be expressed in
either nominal terms (including the effect of inflation) or in real terms (excluding the effect of
inflation) and on a before-tax basis. The discount rate must recognise current market
evaluations of the time value of money as well as the risks that are associated with the
particular obligation. Although the Standard is not clear, an entity’s own credit risk is
currently not regarded in practice as a risk that is associated with the liability and is therefore
not included in the discount rate. The discount rate must not reflect risks for which future
cash flow estimates have been adjusted, and may be revised if changed circumstances
warrant it.
368 Descriptive Accounting – Chapter 15
When discounting is used in the measurement of a provision, the carrying amount will
increase on an annual basis over time. The debit leg of the increase in the provision is
recognised as finance costs in the profit or loss section of the statement of profit or loss
and other comprehensive income.
Example 15.
15.6
Provisions and the time value of money
Charlie Ltd is a manufacturing company with a 31 December year end. The company’s
manufacturing plant releases toxic substances that will contaminate the land surrounding the plant
unless they are collected and stored safely. The local authorities approved the erection of the
plant, provided the entity undertakes to build safe storage tanks for the toxic substances and to
remove these after a period of 20 years and restore the environment to its original condition.
On 1 January 20.13 (the day on which the plant was commisioned), it was determined that it would
cost approximately R20 million at future prices to remove the tanks and restore the environment
after 20 years have expired. It is expected that the cost involved would be tax deductable (at
normal income tax rate of 28%) and a nominal before-tax discount rate amounts to 15%. The
actual cost of decontamination in 20.32 amounted to R21 million.
The journal entries for 20.13, 20.14 and settlement in 20.32 are as follows:
Dr
R
1 January 20.13
Asset (refer to IAS 16.16(c)) (SFP)
Provision for environmental costs (SFP)
[20 000 000 × 1/(1,15)20]
Initial recognition of discounted environmental costs
31 December 20.13
Finance costs [(1 222 006 × 1,15) – 1 222 006] (P/L)
Provision for environmental costs (SFP)
Accounting for the increase in the provision as a result
of the time value of money
31 December 20.14
Finance costs [(1 222 006 + 183 301) × 15%] (P/L)
Provision for environmental costs (SFP)
Accounting for increase in provision due to time value of money
31 December 20.32
Provision for environmental costs (SFP)
Environmental costs (P/L)
Bank (SFP)
Accounting for the actual environmental costs at the end
of 20 years
Cr
R
1 222 006
1 222 006
183 301
183 301
210 796
210 796
20 000 000
1 000 000
21 000 000
The following amounts will appear in the statements of financial position at the end of 20.13 and
20.14:
R
20.13
Provision [20 000 000 × 1/(1,15)19] or [1 222 006 + 183 301]
1 405 307
20.14
Provision [20 000 000 × 1/(1,15)18] or [1 405 307 + 210 796]
1 616 103
Future events that are expected to have an effect on the amount that the entity will
eventually need to settle the provision may be taken into account in the measurement
process. In IAS 37.49, the example is used of new technology that may become available
later and may influence the rehabilitation of contaminated land. It would be acceptable to
Provisions, contingent liabilities and contingent assets 369
include the appropriate cost reductions that are expected as a result of the application of the
new technology in the calculation of the provision, and therefore to measure the provision at
an appropriately lower value.
The technique of calculating an expected value may also be applied to determine an
appropriate amount at which to measure a provision.
Example 15.
15.7
Measurement of a provision using expected values
The Truth, a newspaper with a daily circulation of 500 000 copies, publishes an article in which it is
alleged that a prominent politician is having an improper extramarital affair with the wife of an
opposition politician. The owner of the company, Truth Media Ltd, is summonsed for alleged
defamation amounting to R5 million. The company’s legal advisors assessed the possible
outcomes of the case as follows:
Probabilities:
ƒ 15% that the claim will fail;
ƒ 20% that an amount of R1 million will be granted;
ƒ 25% that an amount of R1,5 million will be granted;
ƒ 20% that an amount of R1,8 million will be granted; or
ƒ 20% that an amount of R2 million will be granted.
The amount at which the provision will be measured is calculated as follows:
R
15% × 0
–
20% × R1 million
200 000
25% × R1,5 million
375 000
20% × R1,8 million
360 000
20% × R2 million
400 000
Expected value
1 335 000
15.4.3 Disclosure
Provisions are disclosed as a separate line item on the face of the statement of financial
position.
No detailed disclosure is required in the extremely rare cases where the disclosure of
information, as stated below, may prejudice the position of the entity in negotiations (in
respect of a dispute) with other parties in respect of the matter for which the provision is
required. Such instances are, in general, extremely rare. This does not, however, imply that
the provision cannot be created: it is still done, but only its general nature and the reason
why it is not disclosed more comprehensively are stated. An example of required disclosure
in this regard appears in Example 3 of disclosure examples of IAS 37.
The following must be disclosed for each category of provision:
ƒ a brief description of the nature of the obligation and the expected timing of any outflow
of economic benefits associated there with;
ƒ any significant uncertainty about the amount or timing of the expense must be stated.
Where it is necessary for a better understanding of the financial statements, the main
assumptions about future events must be disclosed. Such future events may, for
example, be related to proposed legislation, technological development, etc.;
ƒ where there is an anticipated reimbursement of a provision, the amount of the expected
recovery must be stated, as well as the amount of any asset that has been recognised in
respect of it;
ƒ the carrying amount at the beginning and the end of the period;
370 Descriptive Accounting – Chapter 15
ƒ movements in each category of provisions must be reflected separately, with an
indication of:
– additional provisions made in the period and increases in existing provisions;
– amounts incurred (utilised) and offset against the provision during the period;
– amounts reversed during the period for being superfluous; and
– the increase in the amount of the provision during the period due to the passage of
time, or a change in the discount rate; and
ƒ should an entity commence the implementation of a restructuring plan after the end of
the reporting period or disclose the main features of such a plan to affected parties after
the end of the reporting period, disclosure in terms of IAS 10 (refer to chapter 7) is
required. This is the case provided the restructuring is material and that non-disclosure
would impact on economic decisions of users.
Comparative information is not required.
15.4.4 Onerous contracts
An onerous contract is a contract in which the unavoidable costs of meeting the obligations
under the contract exceed the economic benefits expected to be received under it. The
present obligation as a result of a past obligating event is the signing of the onerous
contract, which gives rise to a legal obligation. When the contract becomes onerous, an
outflow of resources embodying economic benefits becomes probable. As a result the
present obligation in terms of onerous contracts is recognised in the financial statements as
a provision. This provision is the smaller of:
ƒ the loss that would be incurred by specific fulfilment of the contract; and
ƒ the loss incurred if the contract were to be cancelled and the payment of fines associated
with the cancellation enforced.
Probable impairment losses relating to assets under such a contract must be recognised
separately in terms of IAS 36 (refer to chapter 14), and do not normally lead to any
obligations.
Example 15.8
Onerous lease contract
On 1 January 20.11, Zanzi Ltd entered into a lease contract for computers. The computers were
determined as low value assets in accordance with paragraph 6 of IFRS 16. The lease is to run for
a period of three years (contract expires on 31 December 20.13). As a result of several factors, the
board of directors decided on 31 October 20.12 to enter a new lease agreement with a different
supplier for computers, with commencement date 1 January 20.13. However, the lease contract
determines the following:
R
ƒ Lease payments per year (no escalation)
100 000
ƒ Fine payable on early cancellation of the contract
150 000
ƒ The computers cannot be sub-let
The company’s year end is 31 December.
The decision of the board of directors on 31 October 20.12 resulted in an onerous contract.
Assume that the time value of money does not play a material role here. Since the contract
represents a present legal obligation, a provision needs to be raised for the smaller of:
R
ƒ Remaining lease payments from 1 January 20.13
100 000
ƒ Fine payable on cancellation
150 000
continued
Provisions, contingent liabilities and contingent assets 371
Consequently, a provision of R100 000 (the smaller figure) is accounted for on 31 December 20.12
as follows:
Dr
Cr
R
R
Fine at cancellation of lease contract (P/L)
100 000
Provision for onerous contract (SFP)
100 000
Recognise provision for an onerous contract
Onerous contracts may therefore, in some cases, be regarded as an exception to the
principle that future losses may not be provided for. Losses from future activities are
normally not provided for before such activities have indeed occurred. However, in the case
of a contractual obligation which is in the form of an onerous contract, such an obligation is
accounted for immediately.
Executory contracts are contracts in terms of which not one of the parties involved has
performed, or both have performed to an equal extent. An example would be a normal order
placed for generally available inventories – an order that can be cancelled at any time.
IAS 37 does not deal with executory contracts, unless they are onerous (IAS 37.3).
15.4.5 Restructuring
A specific form of provision, discussed in IAS 37, is where a plan for restructuring is put into
operation. Restructuring is defined in IAS 37.10 as a programme that is planned and
controlled by management and that brings about material change to either:
ƒ the extent of the entity’s operations; or
ƒ the way in which business is done.
The provision that is established in this way must be:
ƒ necessitated by the restructuring; and
ƒ must not form part of the normal ongoing operations of the entity.
An example of restructuring is when a large supermarket chain closes certain branches and
converts some of them into smaller specialty shops. Other examples include the closing
down of branches in a particular area and the opening of branches in other areas, changes
in the management structure and a reorganisation that has a major influence on the nature
and focus of the activities of the entity.
A restructuring may or may not take the form of a discontinued operation as described in
IFRS 5, depending on whether a component of an entity is closed down or not (refer to
chapter 19).
An obligation for restructuring only arises when all the following conditions are met
(IAS 37.72):
ƒ A detailed plan, identifying at least the following, must exist:
– the part of the business that is to be restructured;
– the principal areas that are affected;
– the location, function and approximate number of employees that will be compensated
for terminating their services;
– the expenditure that will be undertaken; and
– when the plan will be implemented.
ƒ A valid expectation must have been raised in those affected that the entity will carry out
the restructuring by starting to implement the plan or announcing its main features to
those affected by it. In the latter case, restructuring must indeed commence shortly, as a
long delay could give rise to the expectation that it will no longer be implemented and a
constructive obligation would thus not exist.
372 Descriptive Accounting – Chapter 15
Whether a constructive obligation indeed exists at the end of the reporting period when
management or the directors have taken a decision before the end of the reporting
period, and whether a provision must thus be raised, will depend on whether the entity,
before the end of the reporting period:
ƒ started to implement the restructuring plan; or
ƒ announced the main features of the restructuring plan in such a way that the affected
parties have a valid expectation that the restructuring will take place.
The circumstances of each case will be decisive. Negotiations with labour unions and
prospective buyers will be indicative of the existence, or otherwise, of the constructive
obligation.
An obligation for the sale of an operation does not arise before a binding sales agreement
is concluded (IAS 37.78). In this case, professional judgement is not applicable – even if
announcements have already been made, the obligation only arises when the relevant
contract is concluded, because the management of the entity may still change its mind. This
is therefore not a constructive obligation, but a legal one. Should a sale form part of a
restructuring, the related assets must be reviewed for impairment in terms of IAS 36 (refer to
chapter 14). If a sale forms part of a restructuring, a constructive obligation for other parts
of the restructuring may arise before a binding sales agreement is entered into.
If financial reporting should occur before the restructuring process has been completed, and
there is therefore still uncertainty about the extent of the amounts involved, such expenses
will be estimated and provided for. The expenses that are therefore directly involved in
the restructuring will appear as a provision on the statement of financial position – this
provision includes expenses that are both essential to the restructuring and that do not
relate to the continuing operations of the entity. Examples of such direct expenses include
severance packages of members of staff, fines for the cancellation of contracts, costs of
dissolution, costs of discontinuation of renting, and retention payments made to key staff.
Costs for the retraining or relocation of continuing staff, marketing or investment in new
systems and distribution networks are not included in the provision, as these relate to the
future operations of the entity and do not constitute an obligation for the restructuring of the
business at the end of the reporting period. Also, future operating losses are not provided
for, unless they originate from an onerous contract. Profits on the expected sale of assets
are never taken into account in measuring a provision, as it would be tantamount to the
premature recognition of income (IAS 37.51).
Example 15.9
Timing of raising restructuring provisions
No implementation of closure of division before end of the reporting period
On 15 June 20.14, the board of an entity decided to close down a division. The decision was not
communicated to any of those affected before the end of the reporting period (30 June 20.14), and
no other steps were taken to implement the decision.
As there has been no obligating event, there is no obligation. No provision is thus recognised on
30 June 20.14.
Communication/implementation of closure before end of the reporting period
On 15 June 20.14, the board of an entity decided to close down a division manufacturing a
particular product. On 22 June 20.14, a detailed plan for closing down the division was approved
by the board; letters were sent to customers advising them to seek an alternative source of supply,
and redundancy notices were sent to the staff of the division.
The obligating event is the existence of a detailed plan and the communication of the decision to
the customers and employees, which gives rise to a constructive obligation from that date as a
valid expectation that the division will be closed, has been raised.
An outflow of resources embodying economic benefits in settlement is probable.
A provision will be recognised on 30 June 20.14 for the best estimate of the costs of closing the
division.
Provisions must not be recognised for future operating losses. The possible incurrence of future
operating losses is an indication that certain assets may be impaired.
Provisions, contingent liabilities and contingent assets 373
15.4.6 Additional matters surrounding provisions
IAS 37.53 states that where an entity has a right of recovery against a third party in
respect of a provision or a part of a provision, the part that can be recovered from the third
party must be recognised as a separate asset if it is virtually certain that the amount will be
received. The related provision and asset in the statement of financial position will thus
each be shown separately and will not be offset against each other. In the statement of profit
or loss and other comprehensive income, however, the expense leg of the provision and
the income leg of the related reimbursement may be offset against each other. The amount to
be recognised for the reimbursement of the provision is limited to the amount of the provision
to which it is related, and an asset in respect of the recovery may only be raised when it is
virtually certain that the amount will be received. The following summary is provided in the
Implementation Guide to IAS 37 to explain these matters:
Some or all of the expenditure required to settle a provision is expected to be reimbursed
by another party.
The entity has no
obligation for the part of
the expenditure to be
reimbursed by the other
party.
The obligation for the amount expected
to be reimbursed remains with the
entity and it is virtually certain that
reimbursement will be received if the
entity settles the provision.
The obligation for the amount
expected to be reimbursed
remains with the entity and the
reimbursement is not virtually
certain if the entity settles the
provision.
The entity has no
liability for the amount
to be reimbursed by the
other party.
The reimbursement is recognised as a
separate asset in the statement of
financial position and may be offset
against the expense in the statement of
profit or loss and other comprehensive
income. The amount recognised for the
expected reimbursement does not
exceed the liability.
The expected reimbursement
is not recognised as an asset.
No disclosure is
required.
The reimbursement is disclosed
together with the amount recognised
for the reimbursement.
The expected reimbursement
is disclosed as a contingent
asset.
Example 15.10
Right of recovery in respect of provisions
A retailer sells electrical appliances subject to a two-year warranty (assurance-type). Given the
above information, the following situations, inter alia, are possible:
Case 1
The manufacturer of the electrical appliances does not provide a warranty on the items sold.
In this case, the retailer will have to provide for the total warranty provision and the amount (say
R100 000) involved will be raised as a liability and a corresponding expense. The journal entry in
the retailer’s records will be as follows:
Dr
Cr
R
R
Warranty expense (P/L)
100 000
Warranty provision (SFP)
100 000
Accounting for warranty provision
Case 2
The retailer provides the warranty which is backed up fully by the manufacturer on a rand-for-rand
basis.
continued
374 Descriptive Accounting – Chapter 15
In this case, the retailer will raise a warranty provision with a corresponding warranty expense.
Since the manufacturer is prepared to accept responsibility for the warranty offered by the retailer,
the retailer may raise a corresponding asset in respect of the anticipated reimbursement, provided
the retailer is virtually certain the manufacturer will and can fulfil its undertaking to back the
retailer’s guarantee. The journal entries in the retailer’s records will be as follows (assuming an
amount of R100 000):
Dr
Cr
R
R
#
Warranty expense (P/L)
100 000
Warranty provision (SFP)*
100 000
Accounting for the warranty provision
Reimbursement on warranty (SFP)*
#
Warranty reimbursement (income) (P/L)
Accounting for reimbursement asset on warranty
100 000
100 000
#
These two amounts may be offset in the statement of profit or loss and other comprehensive
income.
* The asset and liability may not be offset in the statement of financial position.
Comment
¾ If the reimbursement is not virtually certain, the reimbursement will be disclosed as a contingent
asset in a note.
Gains that may arise on the future sale of assets are not provided for, as doing this would
amount to the premature recognition of income. Losses on the sale of assets, for example
as a result of restructuring, could however be recognised in terms of IAS 36 (the recoverable
amount may change to fair value less cost to sell due to the restructuring, and thus an
impairment may be required). Future operating losses are not provided for, as this would
amount to the premature recognition of losses.
As in the case of all elements of financial statements, provisions, like liabilities, must be
assessed continually to ensure that the amount against which they are measured is still
acceptable in the light of the normal measurement principles. If an adjustment is required, it
is made through the profit or loss section of the statement of profit or loss and other
comprehensive income.
Naturally, provisions may only be used for the purposes for which they were originally
created.
If an entity is jointly and severally liable for an obligation, the obligation is disclosed as a
contingent liability to the extent that it is expected that other parties will settle the liability.
The total obligation will thus be carried partly as a liability and partly as a contingent liability.
15.5 Contingent liabilities
A contingent liability is a condition or circumstance at the end of the reporting period of
which the eventual result (beneficial or prejudicial) will only be confirmed upon the
occurrence or non-occurrence of one or more uncertain future events that are beyond the
control of the entity.
A contingent liability may take the form of either a possible obligation or an actual present
obligation.
ƒ In the form of a possible obligation, there is uncertainty about whether the obligation
indeed exists – such uncertainty will later be removed by the occurrence or nonoccurrence of future events that are not completely under the control of the entity.
ƒ In the form of an actual present obligation, the uncertainty manifests itself either in the
fact that it may be improbable that resources will be utilised to settle the obligation, or
because the amount cannot be measured reliably.
Provisions, contingent liabilities and contingent assets 375
To distinguish between a possible oligation and a present obligation of which the outflow of
benefits is not probable may prove to be difficult in many cases.
Contingent liabilities are never recognised as an element of financial statements, although
they are usually disclosed by way of a note. The reason for this is that the recognition
criteria for elements (the ‘when’ and/or the ‘how much’) are not sufficiently met.
15.5.1 Measurement
Contingent liabilities are measured at the best estimate of the amount that will be required to
settle the liability at the end of the reporting period, should it indeed materialise. The risks
and uncertainties that are associated with the contingent liability are taken into consideration
during the estimation process. For example, should the effect of the time value of money be
material, for example because the contingent liability would only be settled after a long
period has lapsed, the expected expense is discounted to its present value. The discount
rate is a pre-tax rate that would reflect the risks associated with the particular contingent
liability.
The same rules that apply to the measurement of provisions also apply to contingent
liabilities, but obviously the associated finance cost is not recognised in the profit or loss
section of the statement of profit or loss and other comprehensive income.
15.5.2 Disclosure
The following disclosure requirements apply in the case of contingent liabilities:
ƒ for each class of contingent liability, a brief description of its nature is given, as well as,
where practicable:
– an estimate of its financial effect;
– an indication of the uncertainties relating to the amount or timing of any outflow; and
– the possibility of any reimbursement;
ƒ where a provison and a contingent liability relate to the same set of circumstances, the
disclosure for the contingent liability is cross-referenced to the disclosure for the
provision to clearly illustrate the relationship; and
ƒ where the disclosure of the above information does not take place as it would be
impracticable and is not disclosed for this reason, that fact must be stated.
The above disclosure requirements do not apply when the possibility of any outflow of
resources is remote – then no disclosure is required.
No specific disclosure is required in cases in which the disclosure of information, as set out
above, may prejudice the position of the entity in negotiations (in respect of a dispute) with
other parties with regard to the matter to which the contingency relates. IAS 37.92 does,
however, indicate that these circumstances are extremely rare. The general nature of the
circumstances and the fact that the information is not disclosed, as well as the reason why it
is not disclosed, must be stated. Refer to Example 3 of Appendix D to IAS 37 for an
example on this matter.
376 Descriptive Accounting – Chapter 15
Example 15.11
Contingent liability – measurement and disclosure
Delta Limited has established that it has a contingent liability in respect of a summons and related
court case for breach of contract amounting to R2 million at 31 December 20.14 (the year end).
The court case will, due to the backlog in court cases currently evident in the justice system, only
be finalised in three years’ time. An appropriate pre-tax discount rate associated with this company
would be 12%. Disclosure will be as follows:
Delta Ltd
Notes for the year ended 31 December 20.14
11. Contingent liability
A court case in respect of a claim for breach of contract to the amount of R2 million has been
instituted against the company. Since the trial will only be finalised in three years’ time due to a
backlog in the allocation of cases, the estimated present value of the anticipated payment that may
be required is calculated as R1 423 561 (2 000 000 × 1/(1,12)³). There is no possibility of claiming
this amount from a third party resulting in reimbursement.
15.5.3 Contingent liabilities recognised at business combinations
In terms of IAS 37, contingent liabilities must be disclosed by way of a note, and must not be
recognised as a liability. However, in terms of IFRS 3 (refer to chapter 26), some contingent
liabilities of the acquiree are raised as liabilities when accounting for a business combination
under the acquisition method. Contingent liabilities assumed in a business combination must
only be recognised if it is a present obligation that arises from past events and its fair value
can be measured reliably. A contingent liability that is only a possible obligation may,
however, not be recognised in such a business combination as it does not meet the
definition of a liability.
The reason for recognising contingent liabilities when accounting for the business
combination is that the acquirer in a business combination would factor the existence of a
contingent liability into his price when making an offer for the purchase of another company –
this fact would reduce the purchase price offered. If the net assets of the acquiree therefore do
not take into account the contingent liability (reducing net assets), goodwill arising on the
business combination may be understated, or the gain from the bargain purchase that arose will
be overstated.
15.6 Contingent assets
A contingent asset is a possible asset that arises from past events, the existence of which
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 37.10).
A contingent asset may, for example, be associated with a claim instituted by the entity that
may lead to the realisation of income for the entity. However, contingent assets are not
recognised in financial statements, since this may result in the recognition of income
that may never be realised. Hence, the recognition of income is usually postponed until
its realisation is virtually certain. When its realisation is virtually certain, such income is
no longer merely a contingency and it is appropriate to recognise the income and related
asset.
Provisions, contingent liabilities and contingent assets 377
The following summary is provided in the Implementation Guidance to IAS 37 to explain the
accounting treatment of contingent assets:
Where, as a result of past events, there is a possible asset 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, the following apply:
The inflow of economic
benefits is virtually certain.
The asset is not contingent
and is recognised.
Example 15.12
The inflow of economic
benefits is probable, but not
virtually certain.
The inflow is not
probable.
No asset is recognised.
No asset is recognised.
Disclosure is required in a note.
No disclosure is required.
Accounting treatment – contingent and other assets
Delta Ltd summonsed Echo Ltd on 30 April 20.14 for breach of copyright. The court case is in
progress at the moment, and the lawyers of Delta Ltd expect that the court will award an amount of
R900 000 to the company. Echo Ltd is a financially sound company and will be able to pay the
R900 000. Delta Ltd’s year end is 30 June.
In view of the above information, there are two possibilities with regard to the accounting treatment
on 30 June 20.14 of the income that would accrue to Delta Ltd should the case be decided in the
company’s favour:
On 30 June 20.14, the outcome of the court case is uncertain, but it is probable that
Delta Ltd will win the case:
Delta Ltd does not recognise the expected income of R900 000, but discloses a contingent asset by
way of a note.
On 30 June 20.14, it is virtually certain that Delta Ltd will receive R900 000 in damages for
breach of copyright:
Delta Ltd recognises an asset and the related income of R900 000 in the statement of financial
position and statement of profit or loss and other comprehensive income respectively. The
statement of profit or loss and other comprehensive income item will, in all probability, be disclosed
in the notes to the financial statements.
15.6.1 Disclosure
Should an inflow of economic benefits be probable, the following disclosure requirements
apply to contingent assets:
ƒ a brief description of the nature of the contingent asset;
ƒ an estimate of the financial effect of the contingent asset, measured in accordance with
the same principles that apply to provisions and contingent liabilities, provided it is
practicable to obtain this information;
ƒ where the disclosure of the above information does not take place as it would be
impracticable and is not disclosed for this reason, that fact must be disclosed; and
ƒ no specific disclosure is required in cases in which the disclosure of information, as set
out above, may prejudice the position of the entity in negotiations with other parties in
respect of the matter to which the contingency relates. IAS 37.92 does, however,
indicate that these circumstances are extremely rare. The general nature of the
circumstances and the fact that the information is not disclosed, as well as the reason
why it is not disclosed, must be stated.
378 Descriptive Accounting – Chapter 15
15.7 Tax implications
This part of the chapter is not meant to provide detailed guidance on the tax implications of
provisions, and merely gives an overview of some aspects of tax related to provisions.
In terms of the general prohibition contained in section 23(e) of the Income Tax Act 58 of
1962, a taxpayer may not claim a deduction when determining taxable income, should this
deduction originate from a reserve transfer or any other capitalisation of income (raising of a
provision). This section supports the principle contained in the general deduction formula in
section 11(a). Section 11(a) determines that expenses may only be deducted when
incurred, unless the Income Tax Act provides specifically for the deduction of expenses not yet
incurred when taxable income is determined. The expense resulting from provisions may
either be deductible for tax purposes when the provision is raised, deductible in the
future when the provision is settled or not deductible at any stage.
Example 15.13
Deferred tax on provisions – deductible in current year
Assume Echo Ltd raised a provision to the amount of R100 000 during 20.14 (the current year).
Assume the SARS allows the R100 000 as a tax deduction in the current year. Normal income tax
rate of 28%.
Deferred tax for 20.14 resulting from the above, is the following:
Carrying
Tax
Temporary Deferred tax
base
difference
amount
@ 28%
R
R
R
R
Provision for warranty claims
(100 000) (100 000)*
–
–
* The tax base of the provision is the carrying amount (R100 000) less the amount that will be
deductable for tax purposes in the future (zero).
The following example illustrates the difference in treatment of a provision depending on
whether the related expense is deductiblein the future or not deductible.
Example 15.14
Deferred tax on provisions – deductible in the future or non-deductible
for tax purposes
Foxtrot Ltd became the defendant in two court cases during the year ended 31 December 20.14. It
appears probable that the company will have to pay damages to both claimants. An amount of
R800 000 is claimed for infringement on a patent (capital of nature), while R1 000 000 is claimed
for damages caused by products sold by Foxtrot Ltd. The claim will be deductible for tax purposes
when it is actually settled. Both these amounts were raised as provisions at year end. The
deferred tax resulting from the above information is the following:
Infringement on a patent
Carrying
Tax
Temporary Deferred tax
20.14
amount
base
difference
@ 28%
R
R
R
R
Provision for damages in respect
of infringement on patent
(800 000)
(800 000)
–
–
Comment
Comment
¾ Since nothing will be deductible for tax purposes in future due to the capital nature of the claim,
the carrying amount of the provision will be equal to its tax base and the resultant deferred tax
will be Rnil.
continued
Provisions, contingent liabilities and contingent assets 379
Damages caused by Foxtrot Ltd’s products
Carrying
Tax
Temporary Deferred tax
20.14
amount
base
difference
@ 28%
R
R
R
R
Provision for damages from use
of products
(1 000 000)
–
(1 000 000)
280 000
Comment
¾ The claim will be deductible for tax purposes when settled. As the carrying amount of the provision
less the amount that will be deductible in future is equal to Rnil, the deductible temporary difference
is R1 000 000 and a debit of R280 000 is raised in the deferred tax account.
15.8 Changes in existing decommissioning, restoration and similar
liabilities (IFRIC 1)
The elements of cost of property, plant and equipment as listed in IAS 16.16 include an
initial estimate of the cost of dismantling and removing the item and restoring the site on
which it is located, provided these costs were raised via an associated provision. The
obligation related to the provision could arise either when the item is acquired or as a
consequence of having used the item during a particular period for purposes other than
producing inventories during that period. If the item is used to manufacture inventories, the
cost leg of the provision entry will be capitalised as part of the cost of inventories.
Although IAS 16 was clear on what to do at initial recognition with such costs and the related
provision, there was a lack of guidance as to what would happen if the amount of the initial
estimate included in the cost of the PPE item were to change at a later stage when the
estimate is revised.
IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities deals only
with the accounting treatment relating to changes in the measurement of any
decommissioning, restoration or similar liabilities that form part of both PPE and provisions.
Since the provisions associated with the abovementioned costs generally relate to amounts
to be paid at some date in the future, these items are mostly discounted to present value at
date of recognition. The subsequent unwinding of the discount factor would result in an
increase in the related provision and a debit against finance cost in the statement of profit or
loss and other comprehensive income as is the case with any provision where the time value
of money plays a role (refer to section 15.4.2). IFRIC 1.8 prohibits the capitalisation of finance
costs arising from this source and the unwinding of the discount rate does not constitute a
change in accounting estimate.
Changes in the measurement of an existing decommissioning, restoration or similar liability
arise from:
ƒ a change in the estimated cash flows required to settle the obligation;
ƒ a change in the current market-based discount rate used to calculate the present value
of the obligation; and
ƒ an increase that reflects the passage of time (unwinding of discount rate).
Since the unwinding of the discount rate does not represent a change in accounting
estimate, IFRIC 1 only covers the impact of the first two items listed above.
The accounting treatment differs, depending on whether the cost or revaluation model is
used to account for PPE. Changing the carrying amount of a property, plant and equipment
item (for both the cost and revaluation models) will also change the depreciable amount of
the asset involved. This adjusted depreciable amount will be depreciated over the asset’s
remaining useful life. Once the related asset has reached the end of its useful life, all
subsequent changes in the value of the liability will be recognised in the profit or loss section
of the statement of profit or loss and other comprehensive income as they occur. Refer to
chapter 9 example 9.7 for an example on changes in dismantling costs.
380 Descriptive Accounting – Chapter 15
15.8.1 Deferred tax consequences of decommissioning, restoration and similar
liabilities
A temporary difference that arises from the amount of the asset and liability recognised at
initial recognition of a decommissioning, restoration and similar liability or on subsequent
revisions of estimates, is generally viewed as being within the scope of the ‘initial recognition
exemption’ in IAS 12, paragraph 15 or 24. This is because the temporary difference that
arises at the initial recognition of the asset and liability does not affect accounting profit or
taxable profit. The amount of accretion in the provision from unwinding of the discount does,
however, give rise to a temporary difference subsequent to initial recognition. A similar issue
arises at the initial recognition of a right-of-use asset and lease liability. In practice diversity,
does exist in the application of the initial recognition exemption for leases. Accordingly,
some entities might take an alternative view that the initial recognition exemption should not
be applied for leases and therefore not to decommissioning, restoration or similar liabilities.
However, a consistent policy should be adopted for deferred tax accounting for leases and
decommission, restoration and similar liabilities (IAS 8.13).
Example 15.15
.15
Deferred tax on decommissioning liability
Excom has an item of plant and a related decommissioning provision. The item of plant was
available for use on 1 January 20.14, and has a useful life of 40 years. Its initial cost was
R60 million, which included R5 million for decommissioning costs in terms of IAS 16.16(c). The
R5 million was calculated by discounting cash outflows in respect of decommissioning costs of
R108,623 million over 40 years using an appropriate discount rate of 8%. The entity’s year end is
31 December. The South African Receiver of Revenue (SARS) grants a section 12C allowance of
25% per annum on the cost of the plant, excluding the decommissioning cost. On
31 December 20.14, the decommissioning liability was increased by R8 million due to a change in
estimate. The decommissioning costs will only be allowed as a deduction for tax purposes when
the costs are incurred. Excom deems the initial recognition exemption to apply
to
decommissioning liabilities. The deferred tax resulting from the above information is the following:
1 January 20.14
Plant
– Purchase price
– Decomissioning cost
Decommissioning provision
– Cost
Carrying
amount
R
55 000 000
5 000 000
Tax
base
R
55 000 000
–
Temporary
difference
R
Deferred
tax @ 28%
R
–
5 000 000
–
Exempt
(5 000 000)
Exempt
(5 000 000)
–
55 000 000
13 000 000
(1 700 000)
55 000 000
–
– 13 000 000
(13 750 000) 12 050 000
31 December 20. 14
Plant
– Purchase price
– Decomissioning cost
– Accumulated depreciation
Decommissioning provision
– Cost
– Unwinding of discount
(5 000 000 × 8%)
(13 000 000)
(400 000)
– (13 000 000)
–
(400 000)
–
Exempt
(3 374 000)
Exempt
112 000
Comment
¾ In the event that Excom did not deem the initial recognition exemption to apply to the
decommissioning liability, deferred tax will be recognised on all the temporary differences
marked as ‘Exempt’ in the solution above. The net impact on the deferred tax calculation will
however be Rnil.
Provisions, contingent liabilities and contingent assets 381
15.9
15.9.1
Rights to interests arising from decommissioning, restoration
and environmental rehabilitation funds (IFRIC 5)
Background
IFRIC 5 Rights to Interests Arising from Decommissioning, Restoration and Environmental
Rehabilitation Funds is an interpretation of how to account for decommissioning, restoration
and environmental rehabilitation funds, sometimes called ‘decommissioning funds’ or just
‘funds’.
An entity may, on its own or in collaboration with other entities, decide to set aside funds for
the ultimate decommissioning of plant (e.g. a nuclear plant) or certain equipment (e.g. cars),
or for the purposes of environmental rehabilitation (e.g. the restoration of mined land). Such
funds are often administered separately by independent trustees and the contributions of the
entities (contributors) are invested in a range of assets that may include debt and/or equity
investments, which are utilised to help defray the contributors’ decommissioning costs.
When contributors eventually become liable for decommissioning costs, they are able to
institute a claim on the fund for an amount up to the lower of the decommissioning costs
incurred and the entity’s share of assets of the fund. The contributors may be required to
structure their contributions based on its current activity, while any benefits could be based
on its past activity. This may lead to a mismatch in contributions made and the value of the
claim from the fund.
The fund operates separately from any of the contributors and is governed, in accordance
with its founding documents, by a board of trustees. Any access by contributors to any
surplus assets over those used to meet decommissioning costs is either restricted or
prohibited. Contributors may be entitled to reimbursement for decommissioning expenses to
the extent of their fund contributions plus any actual earnings on those contributions less
their share of the costs of administering the fund. Contributors may also be obliged to make
additional contributions, for example if one of the contributors went bankrupt.
The accounting issues that arise from these arrangements include how a contributor must
account for its interest in a fund, as well as how an obligation arising from a requirement to
make additional contributions (e.g., in the event of the bankruptcy of another contributor),
must be accounted for.
IFRIC 5 applies to the accounting in the financial statements of a contributor to a
decommissioning fund where the assets of the fund are administered separately (i.e. either
in a separate legal entity or as segregated assets within another entity) where the
contributor’s right to access the assets is restricted. Where residual funds remain after the
completion of decommissioning and such funds may be distributed to contributors, IFRS 9
applies.
15.9.2
Accounting for the interest in a fund
The obligation to pay decommissioning costs and its interest in a fund as described above
are recognised separately in the financial statements of the contributor, unless the
contributor is not liable to pay decommissioning costs, even if the fund fails to pay.
The contributor has to determine whether it has control, joint control or significant influence
over the fund and account for its interest in accordance with IFRS 10, IFRS 11 or IAS 28.
Where interest in funds is not within the scope of the above Standards, the possibilities that
such interest gives rise to either both an asset (the right to receive assets from the fund) and
a liability (the decommissioning obligation), or only a net asset or liability (the net
decommissioning obligation relative to attributable fund assets), were considered by the
IFRIC. Since the contributor remains liable for the decommissioning costs when a fund does
not relieve the contributor of its obligation to pay such costs, it was concluded that both an
asset and a liability exist in such circumstances. Therefore, in circumstances where
IFRS 10, IFRS 11 or IAS 28 do not apply, and the fund does not relieve the contributor of its
382 Descriptive Accounting – Chapter 15
obligation to pay decommissioning costs, the principles set out in IAS 37 must be applied.
IAS 37 provides that when an entity remains liable for expenditure, a provision must be
recognised even where reimbursement is available, and if the reimbursement is virtually
certain to be received when the obligation is settled, then it must be treated as a separate
asset. It therefore follows that an asset, that is, the right to receive reimbursement from the
fund, must be raised, measured at the lower of the amount of the decommissioning
obligation and the entity’s share of the fair value of the net assets of the fund adjusted for
actual or expected factors that affect the entity’s ability to access these assets. The carrying
amount of this asset must be reviewed regularly and any changes recognised in the profit or
loss section of the statement of profit or loss and other comprehensive income. A liability
must also be raised for the amount of the decommissioning obligation.
15.9.3
Obligations to make additional contributions to the fund
The mere fact of participating in a fund, may result in a contributor finding itself in the
position of a guarantor of the contributions of the other contributors, and therefore becoming
jointly and severally liable for the obligations of other contributors. Also, the value of the
investment assets of the fund may decrease in such a manner that they are rendered
insufficient to fulfil the fund’s obligations. The principles described in IAS 37 are appropriate
for such circumstances, since IAS 37.29 states that ‘where an entity is jointly and severally
liable for an obligation, the part of the obligation that is expected to be met by other parties
is treated as a contingent liability.’ However, when it is probable that additional contributions
will indeed be made, a liability is recognised (IFRIC 5.10).
15.9.4
Disclosure
The following disclosure requirements are applicable:
ƒ When control, joint control or significant influence exists and the interest in the fund is
accounted for in accordance with the relevant Standard, the disclosure requirements of
the particular Standard (refer to IFRS 12) are followed.
ƒ Where the accounting treatment of IAS 37 on provisions, contingent liabilities and
contingent assets is applied, the contributor discloses its interest in the fund in
accordance with this Standard.
ƒ When a contributor has an obligation to make potential additional contributions, for
example in the event of the bankruptcy of another contributor, and such an obligation is
not recognised as a liability in terms of IAS 37, a brief description of the nature of the
contingent liability must be provided, unless the possibility of any outflow in settlement is
remote. Where practicable, the following must also be disclosed:
– an estimate of its financial effect;
– an indication of the uncertainties relating to the amount or timing of any outflow; and
– the possibility of any reimbursement.
ƒ The nature of the entity’s interest and any restrictions on access to the assets in the fund
must also be disclosed.
15.10 Liabilities arising from participating in a specific market
– waste electrical and electronic equipment (IFRIC 6)
IFRIC 6 Liabilities arising from Participating in a Specific Market – Waste Electrical and
Electronic Equipment deals with the liabilities that arise under the EU Directive on Waste
Electrical and Electronic Equipment (WE&EE). More specifically, it deals with when the
liability arising from the decommissioning of WE&EE must be recognised by producers of
that type of equipment. Since this is an EU matter, it is unlikely that many companies in
South Africa will have to apply this IFRIC, unless parent companies have subsidiaries that
were incorporated in the EU.
Provisions, contingent liabilities and contingent assets 383
Example 15.16
Provision for waste management costs
Electro Ltd, an entity which sold electronic equipment to private households during 20.12, has a
market share of 5% in 20.12. It subsequently discontinues its operations and by 20.16, that is the
year serving as the ‘measurement period’ for the specific EU state in which it used to operate, the
company has no market share. The total waste management costs of €30 000 000 associated with
selling electrical and electronic equipment for private households in the member states are
allocated to those entities with a market share in the 20.16 calendar year – the latter year being
the measurement period.
Since Electro Ltd is no longer operational in 20.16 and consequently has a market share of €nil,
the company has no obligation to provide for any of the waste management costs of ̀30 000 000.
However, if another entity, Equiplec Ltd, enters the market for electronic equipment in 20.16 and
achieves a market share of 4%, that company will be held responsible for the costs of waste
management for periods before 20.16, and will incur a liability and raise a provision for €1 200 000
(€30 000 000 × 4%). This is so, even though Equiplec Ltd was not operational during the years
when the waste management costs arose and had not produced any products for which waste
management costs are allocated in 20.16.
15.11 Levies (IFRIC 21)
An IFRS Interpretations Committee project examined whether IFRIC 6 should also be
applied to other levies charged for participation in a market on a specified date, in order to
identify the event giving rise to a liability. The project’s scope was subsequently widened to
consider a broader range of levies, rather than focusing on levies charged to participate in a
specific market. A government may impose a levy on an entity (e.g. the United Kingdom
bank levy, railway tax in France and fees paid to the Federal Government by pharmaceutical
manufacturers in the US). IFRIC 21 provides guidance regarding when a liability to pay a
levy, accounted for in terms of IAS 37, should be recognised by the entity paying the levy.
Example 15.17
.17
Recognition of a liability for a levy
FB Ltd is company that needs to pay a number of levies in accordance with legislation. FB Ltd’s
current reporting period ends on 31 December 20.14. The following levies are applicable to
FB Ltd:
Levy 1: 1,5% of current year revenue is payable as it is generated.
ƒ Levy 1 is triggered progressively as FB Ltd earns revenue; therefore, the liability will be
recognised progressively over the period that revenue is generated (i.e. progressively over
20.14). The obligating event is the generation of revenue during 20.14.
Levy 2: 1,5% of the previous year’s (20.13) revenue is payable as soon as FB Ltd generates
revenue in 20.11. FB Ltd started to generate revenue in the current year on 4 January 20.11.
ƒ Levy 2 is triggered as soon as FB Ltd earns revenue in 20.11. Therefore, the liability will be
recognised in full on 4 January 20.14 since the obligating event is the first generation of revenue
in 20.14. The amount of the levy will be determined by the amount of revenue generated in
20.13. It is important to note that the generation of revenue in 20.13 does not give rise to an
obligation to pay the levy.
Levy 3: A levy is payable if FB Ltd earns revenue above R20 million in the current year (20.14).
The levy is structured as follows: 0% is payable for the first R20 million, and 2% is payable for
revenue earned above R20 million. FB Ltd reached the R20 million revenue threshold on
5 June 20.14.
ƒ Levy 3 is triggered on 5 June 20.14, when FB Ltd reaches the R20 million revenue threshold.
The obligating event is the revenue earned after the threshold is reached. The liability will be
recognised between 5 June 20.14 and 31 December 20.14, and the amount of the liability will be
based on the amount of revenue earned above R20 million.
CHAPTER
16
Intangible assets
(IAS 38, SIC 32 and IFRIC 12)
Contents
16.1
16.2
16.3
16.4
16.5
16.6
16.7
16.8
16.9
16.10
Overview of IAS 38 Intangible Assets.............................................................
Nature of intangible assets ..............................................................................
Recognition and initial measurement ..............................................................
16.3.1
Recognition ......................................................................................
16.3.2
Separate acquisitions ......................................................................
16.3.3
Acquisition as part of a business combination .................................
16.3.4
Exchanges of intangible assets .......................................................
16.3.5
Acquisition by way of government grant ..........................................
16.3.6
Service concession arrangements ..................................................
Internally generated intangible assets .............................................................
16.4.1
Internally generated goodwill ...........................................................
16.4.2
Other internally generated intangible assets ...................................
16.4.3
Website costs ..................................................................................
Subsequent measurement ..............................................................................
16.5.1
Cost model.......................................................................................
16.5.2
Revaluation model ...........................................................................
16.5.3
Intangible assets with a finite useful life ..........................................
16.5.4
Intangible assets with indefinite useful lives ....................................
Impairment ......................................................................................................
Derecognition ..................................................................................................
Disclosure........................................................................................................
Tax implications...............................................................................................
Comprehensive example ................................................................................
385
386
387
388
388
389
390
391
392
392
393
393
393
397
401
401
402
403
405
406
406
407
411
411
386 Descriptive Accounting – Chapter 16
16.1 Overview of IAS 38 Intangible Assets
DEFINITIONS
Intangible assets are assets:
ƒ without physical substance;
ƒ that are identifiable; and
ƒ that are non-monetary.
An asset is a resource:
ƒ controlled by an entity as a result of past
events; and
ƒ from which future economic benefits are
expected to flow to the entity.
An asset meets the identifiability criterion
when it:
ƒ is separable, capable of being separated
or divided from the entity and sold,
transferred,
licensed,
rented
or
exchanged; or
ƒ arises from contractual or other legal
rights, regardless of whether those rights
are transferable or separable from the
entity or from other rights and obligations.
RECOGNITION
ƒ probable that future economic benefits
will flow to the entity; and
ƒ costs of the intangible asset can be
measured reliably.
INITIAL MEASUREMENT
ƒ Separate acquisitions.
ƒ Acquisition part of business combination.
ƒ Exchanges of intangible assets.
ƒ Acquisition by way of government grant.
INTERNALLY GENERATED INTANGIBLE
ASSETS
Internally generated goodwill
Written off in period incurred.
Research costs
Written off in period incurred.
Development costs
Capitalised if criteria are met (IAS 38.57).
Website costs
Website that arises from development is
recognised as an intangible asset (SIC 32).
If solely or primarily for promoting and
advertising – expenses written off.
SUBSEQUENT MEASUREMENT
Cost model
Cost less any accumulated amortisation and
impairment losses.
Revaluation model
Fair value on the date of revaluation less any
subsequent accumulated amortisation and
impairment losses.
Intangible assets with finite useful life
ƒ Amortised over useful life, from date the
asset is available for use.
ƒ Amortisation ceases at the earlier of: the
date the asset is classified as held for
sale in terms of IFRS 5; or the date on
which the asset is derecognised; or the
date on which the asset is fully amortised.
ƒ Residual value deemed to be nil, unless
there is a commitment by a third party to
purchase the asset at the end of its useful
life, or there is an active market (which
will still exist at end of the useful life).
ƒ Change in residual value, amortisation
method or period is a change in
accounting estimate.
Intangible assets with indefinite useful
lives
ƒ Not amortised, but tested for impairment
annually (more often than annually where
indication of impairment).
ƒ Review useful life annually.
Intangible assets 387
16.2 Nature of intangible assets
IAS 38 Intangible Assets provides criteria for the identification of intangible assets and
provides guidance on the recognition, measurement and disclosure of these assets.
IAS 38 does not apply to:
ƒ intangible assets that are within the scope of another Standard, namely:
– intangible assets held by an entity for sale in the ordinary course of business (IAS 2,
Inventories);
– deferred tax assets (IAS 12 Income Taxes);
– leases of intangible assets accounted for in accordance with IFRS 16 Leases;
– assets arising from employee benefits (IAS 19 Employee Benefits);
– goodwill acquired in a business combination (IFRS 3 Business Combinations);
– deferred acquisition costs and intangible assets arising from an insurer’s contractual
rights under insurance contracts (IFRS 4 Insurance Contracts);
– non-current intangible assets classified as held for sale (IFRS 5 Non-current Assets
Held for Sale and Discontinued Operations);
– assets arising from contracts with customers that are recognised in accordance with
IFRS 15 Revenue from Contracts with Customers;
– financial assets as defined in IAS 32 Financial Instruments: Presentation; and
ƒ mineral rights and expenditure on the exploration for, or development and extraction of,
minerals, oil, natural gas and similar non-regenerative resources.
Rights held by a lessee under licensing agreements for items such as motion picture films,
video recordings, plays, manuscripts, patents and copyrights are within the scope of IAS 38
and are excluded from the scope of IFRS 16.
The definition of an asset in this Standard was not revised following the revision of the
definition of an asset in the Conceptual Framework for Financial Reporting issued in 2018
(refer to chapter 2).
IAS 38 defines intangible assets as:
ƒ being without physical substance;
ƒ being identifiable;
ƒ being non-monetary.
An asset is a resource:
ƒ controlled by an entity as a result of past events; and
ƒ something from which future economic benefits are expected to flow to the entity.
When an entity controls an asset, it has the power to obtain the future economic benefits
flowing from the underlying resource, and can also restrict the access of others to those
benefits. The capacity to exercise control over intangible assets usually arises from a legal
right. To illustrate: an entity may only control the technical knowledge used to ensure future
economic benefits for the company if it is protected through copyright, a restraint of trade
agreement or a legal duty of employees to maintain confidentiality. However, an entity does
not usually have sufficient control over a team of skilled staff to recognise them as intangible
assets.
The future economic benefits expected to flow to the entity from the intangible asset
include revenue from the sale of goods and services, as well as cost savings and other
benefits resulting from the use of the asset. Knowledge about the efficient structuring of
production facilities may, for example, result in cost savings rather than in an increase in
revenue.
388 Descriptive Accounting – Chapter 16
An intangible asset may sometimes be contained in a physical substance, for example a
compact disc for software, a legal document for patents, or film. This definition may
therefore result in confusion about what asset or part of an asset is tangible and must be
treated in accordance with IAS 16 Property, Plant and Equipment and what asset or part of
an asset is intangible, and must thus be treated in accordance with IAS 38. In such
instances, professional judgement is required, and the relationships between assets and the
outcome of processes must be considered in order to determine which element is the most
significant (IAS 38.4).
The operating system of a computer, for example Windows, forms an integral part of the
hardware and must, for accounting purposes, be treated as property, plant and equipment.
Other software applications and packages, for example MS Office, however, qualify as
intangible assets. In the case of research and development activities, the development of a
prototype is the result of a process through which knowledge is created and therefore both
the process and prototype must be treated as intangible assets.
The identifiability requirement of the definition is used to distinguish goodwill from
intangible assets. Goodwill is a payment made by an acquirer in a business combination, in
anticipation of future economic benefits from assets that cannot be individually identified. It
represents future economic benefits arising from the synergy between identifiable assets or
from intangible assets that do not meet the criteria for recognition as an intangible asset.
An asset meets the identifiability criterion when it:
ƒ is separable (it is capable of being separated or divided from the entity and sold,
transferred, licensed, rented or exchanged, either individually or together with a related
contract, asset or liability); or
ƒ arises from contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations.
Examples of intangible assets include:
ƒ Computer software
ƒ Patents
ƒ Copyrights
ƒ Motion picture films
ƒ Customer lists
ƒ Mortgage servicing
rights
ƒ Fishing licenses
ƒ Import quotas
ƒ Franchises
ƒ Customer or supplier
relationships
ƒ Customer loyalty
ƒ Market share
ƒ Marketing rights
ƒ Trademarks
ƒ Other licenses
ƒ Publishers’ titles
ƒ Production quotas
ƒ Models
ƒ Prototypes
ƒ Recipes and
formulae
Each group of intangible assets with a similar nature and use in the entity is identified as a
class of intangible assets that is disclosed separately in the financial statements.
16.3 Recognition and initial measurement
16.3.1 Recognition
An intangible asset shall be measured initially at cost (IAS 38.24). An item should be
recognised as an intangible asset, if:
ƒ the item meets the definition of an intangible asset; as well as
ƒ the recognition criteria for an intangible asset, namely:
– it must be probable that future economic benefits specifically attributable to the asset,
will flow to the entity. The determination of the probability of future economic benefits
is based on professional judgement, using reasonable and supportable assumptions.
These represent management’s best estimate of the probable economic conditions
Intangible assets 389
that will exist over the useful life of the asset. Evidence supporting the probability of
receiving future economic benefits includes market research, feasibility studies,
comprehensive business plans and the like; and
– the costs of the intangible asset can be measured reliably.
This requirement applies to costs incurred initially to acquire or internally generate, and
those incurred subsequently to add to, replace part of, or service it.
Costs incurred to acquire or generate an intangible item that were initially recognised as an
expense by the reporting entity must not be reinstated once recognition criteria are met as
part of the cost of an intangible asset at a later date.
Generally speaking, subsequent expenditure in the case of intangible assets will be incurred
to maintain expected future economic benefits embodied in such an asset. Consequently,
such expenditure will be expensed. Furthermore, consistent with IAS 38.63, subsequent
expenditure on brands, mastheads and similar items, whether externally acquired or
internally generated, will also be expensed in the profit or loss section of the statement of
profit or loss and other comprehensive income.
16.3.2 Separate acquisitions
When an intangible asset is acquired, the cost of the asset can usually be measured
reliably, and consists of the following:
ƒ the purchase price, including import duties and non-refundable purchase taxes, after
deducting trade discounts and rebates; and
ƒ any costs directly attributable to preparing the asset for its intended use.
Examples of directly attributable costs:
ƒ the cost of employee benefits arising directly from bringing the asset to its working
condition;
ƒ professional fees arising directly from bringing the asset to its working condition; and
ƒ the costs of testing whether the asset is functioning properly.
Examples of costs that are excluded:
ƒ the costs of introducing a new product or service (including the cost of advertising and
promotional activities);
ƒ the costs of conducting business in a new location or with a new class of customer
(including costs of staff training); and
ƒ administration and other general overhead costs.
The recognition of costs in the carrying amount of an intangible asset ceases when the
asset is in a condition necessary for it to be capable of operating in the manner intended by
management. Therefore, costs associated with redeploying an intangible asset are not
included in the carrying amount of the asset, for example:
ƒ costs incurred while an asset capable of being operated as management intended has
not been brought into use; and
ƒ initial operating losses, for example those incurred while demand for the asset’s output builds
up.
Incidental operations are not necessary to bring an asset to the condition necessary for it to
be capable of operating in the manner intended by management; therefore the income and
related ex