557322874-Descriptive-Accounting-IFRS-Focus-21st-Edition-nodrm-1
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HOOFSTUK ?? Descriptive Accounting Twenty-first edition Descriptive Accounting Twenty-first edition ZR Koppeschaar DCom (Accounting) (UP), CA(SA) K Papageorgiou MCom (Accounting) (UP), CA(SA) Associate Professor, Department of Financial Governance, University of South Africa Senior lecturer, Department of Financial Accounting, University of South Africa J Rossouw C Smith M Acc (UFS), CA(SA) Associate Professor, Department of Accounting, University of the Free State HA van Wyk PhD (Public Sector Management) (UFS), CA(SA) MCom (Taxation) (UP), CA(SA) Senior lecturer, Department of Financial Governance, University of South Africa A Schmulian MCom (Taxation) (UP), CA(SA) University of the Free State Senior lecturer, Department of Accounting, University of Pretoria J Sturdy Assisted by: C Brittz MCom (Accounting) (UNISA), CA(SA) Senior lecturer, Department of Financial Governance, University of South Africa University of the Free State Members of the LexisNexis Group worldwide South Africa LexisNexis (Pty) Ltd DURBAN JOHANNESBURG 215 Peter Mokaba Road (North Ridge Road), Morningside, Durban, 4001 Building 8, Country Club Estate Office Park, 21 Woodlands Drive, Woodmead, 2080 CAPE TOWN 1st Floor, Great Westerford, 240 Main Road, Rondebosch, 7700 Australia www.lexisnexis.co.za LexisNexis, CHATSWOOD, New South Wales Austria LexisNexis Verlag ARD Orac, VIENNA Benelux Canada LexisNexis Benelux, AMSTERDAM LexisNexis Canada, MARKHAM, Ontario China LexisNexis, BEIJING France Germany LexisNexis, PARIS LexisNexis Germany, MÜNSTER Hong Kong LexisNexis, HONG KONG India Italy LexisNexis, NEW DELHI Giuffrè Editore, MILAN Japan Korea Malaysia LexisNexis, TOKYO LexisNexis, SEOUL LexisNexis, KUALA LUMPUR New Zealand LexisNexis, WELLINGTON Poland Singapore LexisNexis Poland, WARSAW LexisNexis, SINGAPORE United Kingdom LexisNexis, LONDON USA LexisNexis, DAYTON, Ohio © 2018 ISBN 978 0 409 12828 4 E-BOOK ISBN 978 0 409 12829 1 First edition Second edition Third edition Fourth edition Fifth edition Sixth edition 1997 1997 1998 1999 2000 2001 Seventh edition Eighth edition Ninth edition Tenth edition Eleventh edition Twelfth edition 2002 2003 2004 2005 2006 2007 Thirteenth edition 2008 Fourteenth edition 2009 Fifteenth edition 2010 Sixteenth edition 2011 Seventeenth edition 2012 Eighteenth edition 2013 Nineteenth edition Revised Reprinted Twentieth edition 2014 2015 2016 2016 Copyright subsists in this work. No part of this work may be reproduced in any form or by any means without the publisher’s written permission. Any unauthorised reproduction of this work will constitute a copyright infringement and render the doer liable under both civil and criminal law. Whilst every effort has been made to ensure that the information published in this work is accurate, the editors, publishers and printers take no responsibility for any loss or damage suffered by any person as a result of the reliance upon the information contained therein. Editor: Lisa Sandford Technical Editors: EDS team Preface The purpose of this book is to set out the basic principles and conceptual issues of the International Financial Reporting Standards (IFRS). The book attempts to: • provide an accounting basis against which professional accounting publications can be assessed; • review such publications critically, and identify possible shortcomings; and • focus on the nucleus of the publications and supply specific related examples. Descriptive Accounting is suitable for third-year and postgraduate students, as well as practising accountants. However, another book by the same authors, i.e. Introduction to IFRS, is designed for second-year students and provides a seamless introduction to Descriptive Accounting. Each chapter in Descriptive Accounting reflects the requirements of the International Financial Reporting Standards (IFRS) that serve as the main sources of the chapters. Principles are explained by means of practical examples, including journal entries where appropriate. As far as disclosure is concerned, the focus is on best practice, rather than minimum disclosure requirements. Although accounting standards in issue at 1 January 2018 were used as point of departure in this work, new standards, as well as improvements and amendments to existing standards issued subsequent to that date were also taken into account. This edition is also updated to include, among others, the requirements of the Conceptual Framework of Financial Reporting 2018. The South African Institute of Chartered Accountants (SAICA) finalised its syllabus overload review in 2017 and some aspects were excluded or moved to an awareness level – this edition also includes these changes. We trust that students, lecturers and practitioners will find the contents of this book useful when lecturing or studying, as well as in general practice. THE AUTHORS Pretoria v HOOFSTUK ?? Contents Page Preface ......................................................................................................................... v Table of acronyms ........................................................................................................ ix Index of Accounting Standards .................................................................................... xi Part A Chapter 1 The South African regulatory framework .................................................. 1 Chapter 2 The Conceptual Framework ..................................................................... 7 Chapter 3 IAS 1; IFRIC 17 Presentation of financial statements .............................. 27 Chapter 4 IAS 2 Inventories ...................................................................................... 57 Chapter 5 IAS 7 Statement of cash flows ................................................................. 83 Chapter 6 IAS 8 Accounting policies, changes in accounting estimates and errors ................................................................................................. 111 Chapter 7 IAS 10 Events after the reporting period .................................................. 141 Chapter 8 IAS 12; FRG 1, IFRIC 23 Income taxes ................................................... 149 Chapter 9 IAS 16; SIC 29; IFRIC 1 Property, plant and equipment.......................... 209 Chapter 10 IAS 19; IFRIC 14, FRG 3 Employee benefits .......................................... 249 Chapter 11 IAS 21 The effects of changes in foreign exchange rates ....................... 271 Chapter 12 IAS 23 Borrowing costs ........................................................................... 299 Chapter 13 IAS 24 Related party disclosures ............................................................ 313 Chapter 14 IAS 36 Impairment of assets ................................................................... 329 Chapter 15 IAS 37; IFRIC 1, 5, 6 and 21 Provisions, contingent liabilities and contigent assets ....................................................................................... 361 Chapter 16 IAS 38; SIC 32; IFRIC 12 Intangible assets ............................................ 385 Chapter 17 IAS 40 Investment property ..................................................................... 415 Chapter 18 IFRS 2; FRG 2 Share-based payment .................................................... 437 vii viii Descriptive Accounting Chapter 19 IFRS 5 Non-current assets held for sale, and discontinued operations .. Page 475 Chapter 20 IAS 32; IFRS 7 and 9; IFRIC 19 Financial instruments .......................... 519 Chapter 21 IFRS 13 Fair value measurement............................................................ 579 Chapter 22 IFRS 15 Revenue from contracts with customers ................................... 601 Chapter 23 IFRS 16 Leases ....................................................................................... 629 Part B Chapter 24 IAS 27; IFRS 10 and 12 Consolidated and separate financial statements ............................................................................................... 723 Chapter 25 IAS 28; IFRS 12 Investments in associates and joint ventures .............. 761 Chapter 26 IFRS 3 Business combinations................................................................ 795 Chapter 27 IFRS 11 and 12 Joint arrangements ....................................................... 839 Chapter 28 Financial reporting for small and medium-sized entities ......................... 847 HOOFSTUK ?? Table of acronyms Acronym Meaning / Brief explanation APB Accounting Practices Board, a body consisting of a wide spectrum of representative role-players in the South African economy that approves Standards of Generally Accepted Accounting Practice (GAAP) as well as recommended accounting practice. APC Accounting Practices Committee, a committee of the South African Institute of Chartered Accountants (SAICA) which is responsible for the distribution of documents (in limited instances also developing documents) containing what is considered to be Generally Accepted Accounting Practices in the form of Exposure Drafts (EDs), receiving comments from interested parties and submitting the final draft to the APB for approval. BEE Black economic empowerment. Usually “BEE transactions” – to empower black people to participate meaningfully in the South African economy. ED Exposure Draft, the first attempt by SAICA or the International Accounting Standards Board (IASB) to develop an accounting standard or a guideline on a particular topic. FASB Financial Accounting Standards Board, an accounting body in the USA. FRSC, FRSs Financial Reporting Standards Council (FRSC), a body corporate existing also in terms of the new Companies Act of 2008, with the objective of establishing Financial Reporting Standards (FRSs) in accordance with IFRSs for listed companies as well as profit and non-profit companies in consultation with representatives of such companies. GAAP Generally Accepted Accounting Practice, documents (called Statements or Standards; the current accepted term is “Standards”) published by SAICA, after approval by the APB. GAAP Standards are internationally also published by the IASB. Before the establishment of the IASB, its predecessor, the International Accounting Standards Committee (IASC) published International Accounting Statements (IASs), which also form part of GAAP. The IASB currently issues International Financial Reporting Standards (IFRSs). South African Standards of GAAP conform to relevant IASs and IFRSs. gaap Generally accepted accounting practice, not codified in standards, but nevertheless generally accepted. GMP GAAP Monitoring Panel, a joint initiative between SAICA and the Johannesburg Securities Exchange Limited (JSE Limited) to monitor compliance with Accounting Standards. IAS International Accounting Standard, an accounting standard, published by the IASC (see also “GAAP”) and later endorsed by the IASB. ix x Descriptive Accounting Acronym Meaning / Brief explanation IASB International Accounting Standards Board, a body which is committed to developing, in the public interest, a single set of high quality, global Accounting Standards that require transparent and comparable information in general purpose financial statements. In pursuit of this objective, the IASB co-operates with national accounting standard-setters to achieve convergence in accounting standards around the world (see also “GAAP”). IASC International Accounting Standards Committee, the IASB’s predecessor (see also “IASB”). IFRIC International Financial Reporting Interpretations Committee, a committee of the IASB that assists the IASB in establishing and improving standards of financial accounting and reporting. The IFRIC provides guidance on financial reporting issues not specifically addressed in International Financial Reporting Standards (IFRSs) or issues where unsatisfactory or conflicting interpretations have developed, or seem likely to develop. The IFRIC has superseded the Standards Interpretations Committee (SIC), a committee of the (former) IASC. IFRSs International Financial Reporting Standards, Standards issued by the IASB (see also “IASB” and “GAAP”). IRBA Independent Regulatory Board for Auditors, the statutory body that superseded the Public Accountants’ and Auditors’ Board in terms of Act 26 of 2005. JSE Johannesburg Securities Exchange (JSE Limited). SAICA South African Institute of Chartered Accountants. SIC Standing Interpretations Committee, the IFRIC’s predecessor (see “IFRIC”) which used to publish SIC Interpretations. Standard, Statement Used interchangeably to refer to publications on GAAP. Currently “Standard” is the accepted term. HOOFSTUK ?? 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: the defined terms used in the Standard; the principles and an application guidance; and 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: State-owned company (SOC Ltd): A company that falls within the meaning of ‘state-owned enterprise’ or is owned by a municipality. 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. Personal liability company (Inc.): A private company, whose MOI states that it is a personal liability company. 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: Chapter 1: The objective of general purpose financial reporting. Chapter 2: The reporting entity (to be added). Chapter 3: Qualitative characteristics of useful financial information. 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: Chapter 1: The objective of general purpose financial reporting; Chapter 2: Qualitative characteristics of useful financial information; Chapter 3: Financial statements and the reporting entity; Chapter 4: The elements of financial statements; Chapter 5: Recognition and derecognition; Chapter 6: Measurement; Chapter 7: Presentation and disclosure; and 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: contribute to transparency; strengthen accountability; and 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: completeness; neutrality; and free from error. 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. 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. 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: comparability; verifiability; timeliness; and 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: the same items over time; the same items in the same period; and 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: assets and liabilities and equity that existed at the end of the reporting period, or during the reporting period; and 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: the boundary of a reporting entity does not include arbitrary or incomplete information; the set of economic activities within the boundary of a reporting entity includes neutral information; and 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: assets, liabilities and equity, which relate to a reporting entity’s financial position; and 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: separate definition of an economic resource – to clarify that an asset is the economic resource, not the ultimate inflow of economic benefits. 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: 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 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. 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: 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 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: any assets and liabilities retained after the transaction or other event that led to the derecognition (this represents a control approach); and 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: it is uncertain whether an asset or liability exists (existence uncertainty); or 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 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). 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. 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. 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: The consumption of part or all of the economic resources that constitutes the asset (depreciation); Payments received that extinguish part or all of the asset; The effect of events that cause part or all of the historical cost of the asset to be no longer recoverable (impairment); and 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: Fulfilment of part or all of the liability; 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 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: 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 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: measurement inconsistency (accounting mismatch) (using different measurement bases for assets and liabilities that are related); and 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: 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 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: in the statement of profit or loss; or 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. According to the financial concept of capital, capital is equal to the net assets or equity of an entity. 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: 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. 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 fundamental 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 Assets Liabilities Equity Income 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) Certain line items should be presented on the face of the SFP (e.g. property, plant and equipment, inventories, provisions, etc.). 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). 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) 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). Expenditure items should be classified either by their function or their nature. 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.). The nature and amount of material items to be presented either on the face of the SPLOCI or separately in the notes. 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. 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. Reclassification adjustments relating to components of other comprehensive income need to be disclosed, either on the face, or in the notes. The notion of extraordinary items has been abandoned. continued Presentation of financial statements 29 Statement of changes in equity Reconciliation of equity at the beginning of the reporting period with equity at the end of the reporting period. 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). Dividends paid and the related dividends per share should be presented either on the face, or in the notes. Statement of cash flows Refer to chapter 5. Notes General features for the presentation of financial statements 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. Fair presentation and compliance with IFRSs. Financial statements are prepared on the going concern assumption. Items recognised on the accrual basis (i.e. when items satisfy the definitions and recognition criteria of the Conceptual Framework for Financial Reporting). Materiality and aggregation (present each material class of similar items separately). Offsetting (not allowed unless required/permitted by an IFRS). Frequency of reporting (at least annually). 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). Consistency of presentation (retain presentation and classification between periods). 3.2 Background The aim of IAS 1 is: to set out guidelines for the structure and content of financial statements; to set out the overall requirements for the presentation of financial statements; and 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: to provide information; about the financial position, financial performance and cash flows of an entity; that is useful to a wide range of users; in making economic decisions. A complete set of financial statements comprises (IAS 1.10): a statement of financial position as at the end of the period; a statement of profit or loss and other comprehensive income for the period; a statement of changes in equity for the period; a statement of cash flows for the period; notes to the financial statements, including a summary of significant accounting policies; comparative information in respect of the preceding period; and 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: the main factors that influenced the performance of the entity in the current period and will continue to do so in future periods; the entity’s policy regarding the maintenance and enhancement of performance; Presentation of financial statements 31 its policy in respect of dividends; the sources of funding and the policies on gearing and risk management; the strengths and resources of the entity that are not reflected in the statement of financial position; and 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: fair presentation and compliance with IFRSs; going concern; accrual basis of accounting; materiality and aggregation; offsetting; frequency of reporting; comparative information; and 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: faithful representation; definitions of elements (assets, liabilities, equity, income and expenses) of financial statements; and 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: why the objective of financial statements is not achieved in the particular circumstances; and 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): the fact that management has concluded that the financial statements fairly present the entity’s financial position, financial performance and cash flows; the fact that the financial statements comply in all material respects with the applicable Standards and Interpretations, except for the departure in question; the Standard or Interpretation from which the entity has departed; the nature of the departure, including the treatment that the Standard would require; 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; the treatment adopted; and 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): the title of the Standard or Interpretation requiring the entity to report information concluded to be misleading; Presentation of financial statements 33 the nature of the requirement; 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 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: assets and liabilities may not be offset against one another, except when such offsetting is required or permitted by a Standard or Interpretation; income and expenditure items should likewise not be offset against one another, except when a Standard or Interpretation requires or permits it; offsetting of profits, losses and related expenditure is allowed when amounts are not material and relate to similar items; and 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: the reason why the reporting period is not one year; and 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): two statements of financial position; two statements of profit or loss and other comprehensive income; two separate statements of profit of loss (if presented); Presentation of financial statements 35 two statements of cash flows; two statements of changes in equity; and 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: the retrospective application of a change in accounting policy; the retrospective restatement of items in financial statements; or 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: the nature of the reclassification; the amount of each item or class of items that is reclassified; and the reason for the reclassification. However, where such reclassifications are impracticable, they need not be made, but the following should be disclosed: the reasons why they were not changed; and 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: a significant change in the nature of the operations has taken place; or 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 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): 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; whether the financial statements cover an individual entity or a group of entities; the date of the end of the reporting period or period covered by the report, whichever is applicable to the particular financial statements; the relevant component of the financial statements, for example statement of cash flows or statement of financial position; the currency used in the financial statements; and 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: 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 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): it is expected to be realised in, or is intended for sale or consumption in, the entity’s normal operating cycle; it is held primarily for the purpose of being traded; it is expected to be realised within 12 months after the end of the reporting period; or 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): it is expected to be settled in the entity’s normal operating cycle; it is held primarily for the purpose of being traded; it is due to be settled within 12 months after the end of the reporting period; or 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: the original repayment term was for a period longer than 12 months; and 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: refinancing on a long-term basis; rectification of a breach of a long-term loan agreement; and 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: property, plant and equipment; investment property; intangible assets; financial assets (excluding investments accounted for using the equity method, trade and other receivables, and cash and cash equivalents); investments accounted for using the equity method; biological assets; inventories; trade and other receivables; cash and cash equivalents; 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; trade and other payables; liabilities and assets for current tax; deferred tax liabilities and deferred tax assets; provisions; financial liabilities (excluding trade and other payables, and provisions); liabilities included in disposal groups classified as held for sale in accordance with IFRS 5; issued capital and reserves attributable to owners of the parent; and 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: 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; the function of the relevant items, leading to a distinction between, for example, operating assets and financial assets; and 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): the number of authorised shares; the number of shares issued and fully paid; the number of shares issued but not fully paid; the par value per share, or that the shares have no par value; a reconciliation of the number of shares outstanding at both the beginning and the end of the period; the rights, preferences and restrictions applicable to each category, including restrictions on the distribution of dividends and the repayment of capital; the shares in the entity held by the entity or its subsidiaries or associates; and 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: profit or loss for the year; and other comprehensive income for the year. In addition to the above, the statement of profit or loss and other comprehensive income should also present: profit or loss; Presentation of financial statements 45 total other comprehensive income; and 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: attributable to owners of the parent; and 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: attributable to owners of the parent; and 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: revaluation surpluses and deficits against existing revaluation surpluses; remeasurements of defined benefit plans; gains and losses arising from the translation of the financial statements of a foreign entity; gains or losses on remeasuring equity instruments classified as financial assets at fair value through other comprehensive income; gains and losses on cash flow hedges; changes in credit risk based on changes in fair value for liabilities held at fair value through profit or loss; and 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: depreciation; amortisation; and 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): revenue; gains and losses arising from the derecognition of financial assets measured at amortised cost; finance cost; the share of the profit or loss of associates and joint ventures accounted for using the equity method; 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); a single amount for the total of discontinued operations (refer to IFRS 5 Non-current Assets Held for Sale and Discontinued Operations); income tax expense (this line item includes only taxes that are income taxes within the scope of IAS 12 Income Taxes discussed); 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 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: items that will not subsequently be reclassified to profit or loss; and 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: net of the related tax effects; or 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): 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; the restructuring of the activities of an entity and the reversal of any provisions for the cost of restructuring; the disposal of property, plant and equipment; the disposal of investments; discontinued operations; the settlement of litigation; and 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: the total comprehensive income for the period, showing separately the total amounts attributable to owners of the parent and to non-controlling interests; 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 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: a statement that the financial statements comply with the International Financial Reporting Standards; a statement in which the basis of preparation and accounting policies are set out; 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; 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 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: 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. 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: revenue recognition; consolidation principles; application of the equity method of accounting for investments in associates or joint ventures; business combinations; joint arrangements; 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; government grants; and 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. 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: the absence of recent market prices in thinly-traded markets used to measure certain assets; the recoverable amount of property, plant and equipment; the rate of technological obsolescence of inventories; provisions subject to the effects of future litigation or legislation; and 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): 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 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; 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: 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. 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: a dividend payable must be recognised when the dividend is appropriately authorised and is no longer at the discretion of the entity; the dividend payable must be measured at the fair value of the net assets to be distributed; 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; the liability must be remeasured at each reporting date and at settlement, with changes recognised directly in equity; 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 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: the domicile of the entity; the legal form of the entity; the country of incorporation; the address of the registered office (or principal place of business, if it is different from the registered office); a description of the nature of the entity’s operations and its principal activities; the name of the parent and the ultimate parent entity of the group; and 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): be drawn up in accordance with the national law applicable to a listed company; 56 Descriptive Accounting – Chapter 3 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); 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; 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; fairly present the financial position, changes in equity, results of operations and cash flows of the group; comply with the Companies Act, 2008; and 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): 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 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: held for sale in the ordinary course of business; in the process of production for such sales; and to be consumed in the production of goods and services for sale. Excludes: work-in-progress arising from construction contracts; financial instruments; and biological assets to point of harvest. Partially excludes: mineral and mineral products; commodity brokers; and producers of agricultural and forest products after harvest. Cost Use either: FIFO; weighted average; identification, only where goods have been manufactured for specific purposes and are normally not interchangeable; standard costs; or 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.) Based on reliable evidence of expected realisation values available at the time of making the estimates. Write-down by item or by group of similar items, applied consistently. Where inventory is being kept in terms of a firm sales contract, still to be delivered, NRV based on contracted price. 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: import duties and other taxes; and any other directly attributable costs of acquisition less rebates, discounts and subsidies on purchases. Conversion costs Variable production overheads. Fixed production overheads allocated, based on normal capacity of production facilities. Excludes abnormal spillage. Other costs To bring the inventories to their present location and condition. Expenses incurred in respect of the design of a specific product for a particular customer. Include borrowing cost if IAS 23 requires capitalisation. 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: how the cost of inventories is determined; and 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: work-in-progress under construction contracts (IFRS 15), including directly related service contracts; agricultural produce at the point of harvest, and biological assets related to agricultural activity (IAS 41); and 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: 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 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: held for sale in the ordinary course of business, for example fuel at a petrol station and sweets sold by a café; in the process of production for such sale, for example a partly completed piece of furniture (work-in-progress) of a furniture manufacturer; 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 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: determining the cost; applying a cost allocation technique to measure the cost of inventories; determining the net realisable value; recognising the inventories at the lower of cost and net realisable value in the annual financial statements; and 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: purchasing costs; conversion costs; and other costs incurred in bringing inventories to their present location and condition. The cost of inventories excludes: 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; 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 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; administrative expenses not related to bringing the inventories to their present location and condition; and 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: the purchase price of finished goods or raw materials; 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; transport costs; handling costs; and other costs directly attributable to the acquisition of the inventories. From these costs, the following are deducted if included: trade discounts (and cash and settlement discounts in terms of CC 09/06); and 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: The purchase price of the goods before any rebates or discount is R703 703,70 (including VAT levied at 15%). Alpha Ltd will receive a 10% volume rebate on the purchase price of the goods. 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: direct labour; variable production overhead costs; and 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: costs of designing products for a particular customer; borrowing costs relating to inventories where substantially necessary long ageing periods are required, as in the case of wine; and 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: 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’. 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: 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. 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). 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. 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). 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: other overhead costs that clearly relate to bringing inventories to their present location and condition, for example design costs, some research and development, etc.; 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 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: Fixed overheads amount to R7 500 000 per annum. Variable production overheads amount to R200 per unit. 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: the standard cost method; and 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: first-in, first-out (FIFO); or weighted average costs; or 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: costs to complete the inventories (if cost elements are not fully completed, e.g. work in progress); trade and other discounts allowed; advertising; sales commission; packaging; and 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: damaged inventories; wholly or partially obsolete inventories; declines in selling prices; increases in estimated costs to completion; and 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: 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. 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). 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 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: the accounting policy pertaining to the measurement and the cost formula used; 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; the carrying amount of inventories carried at fair value less costs to sell of commodity brokers/traders; the amount of inventories recognised as an expense during the period; the amount of any write-down of inventories recognised as an expense; if such a write-down is reversed in a subsequent period, the amount reversed and the circumstances which resulted in the reversal; and 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 to provide users with useful information in respect of historical changes in cash and cash equivalents of an entity; and to enable the users to formulate an opinion and make a better estimate of the cash performance of an entity. Cash and cash equivalents Cash consists of cash on hand and demand deposits. 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 Chief revenue-producing activities. Cash effect of transactions that are used in determining profit or loss. Present in one of two ways: Indirect method or Direct method. +/– Cash flows from investing activities Activities which relate to the acquisition and disposal of long-term assets and other investments. Distinguish between maintenance of operating capacity and increase in operating capacity. Present gross receipts and gross payments. +/– Cash flows from financing activities Activities that result in changes in size and composition of the borrowings and contributed equity. Present gross receipts and gross payments. = Net movement in cash and cash equivalents. Specific aspects Group statements: control gained or lost in a subsidiary = single line item in consolidated statement of cash flows as part of investing activities. Interest and dividends paid and received are disclosed separately. 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. 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. Repayments of a lease for the lessee are divided between capital and interest portions: – Interest = classified as operating activities. – Capital = classified as financing activities. Cash flows from discontinued operations should be disclosed under each category of cash flows. 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): operating activities (activities that are revenue-producing); investing activities (activities that are needed to support the income-generating process, e.g. investing in fixed and other long-term assets); and 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: to provide useful information on how an entity generates cash and how an entity utilises cash; in respect of the historical changes; 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: 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; to forecast the cash that will probably be available in the future to finance expansions; to determine which sources of cash have been used to finance operating and investing activities; 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; to evaluate the timing and certainty of generated cash in order to assess the ability of the entity to adapt to changing circumstances; to enhance the comparability of the operating results of different entities by eliminating the effects of different accounting policies; and 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: cash flows from operating activities; cash flows from investing activities; and 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: cash receipts from royalties, fees, commissions and other revenue; cash payments to and on behalf of employees (such as contributions to pension funds); cash payments or refunds of income taxes (unless they can be specifically linked to financing and investing activities); and 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.: the indirect method; or 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. 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 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: gross cash receipts from customers; and 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: 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; cash receipts from the disposal of property, plant and equipment, intangible assets and other long-term assets; cash payments to acquire or cash receipts to dispose of equity or debt instruments of other entities and interests in joint ventures; cash advances and loans to other parties (other than financial institutions), or cash receipts from their repayment; and 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: the maintenance of operating capacity; and 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): proceeds from the issuing of shares or other equity instruments; payments to acquire or redeem shares of the entity; proceeds from the issuing of debentures, loans, notes, bonds, mortgages and other short- and long-term borrowings; repayments in respect of amounts borrowed; and 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: financing changes; changes from obtaining or losing control of subsidiaries; foreign exchange changes; fair value changes; and 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: the total consideration paid or received; the cash and cash equivalents portion of the total consideration paid or received; the amount of cash and cash equivalents in the subsidiary over which control is obtained or lost; and 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: classified as cash from financing activities (IAS 7.42A); and 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: 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 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: 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. 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). Cash flows from the acquisition and disposal of subsidiaries and other entities are shown separately under investing activities (refer to section 5.5.1). 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: the policy followed in determining the composition of cash and cash equivalents; the components of cash and cash equivalents; 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; 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; information on non-cash financing and investing transactions; 104 Descriptive Accounting – Chapter 5 a reconciliation of liabilities arising from financing activities, presenting cash flow and non-cash flow movements (IAS 7.44D); 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 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: 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: required by an Accounting Standard or Interpretation; or 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: relevant to the decision-making needs of users; and 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): the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and 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: 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 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: it is required by a Standard or an Interpretation; or 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: retrospectively applies an accounting policy; makes a retrospective restatement of items in its financial statements; or 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: the end of the current period; the end of the preceding period; and 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: Other Standards or Interpretations (on similar and related issues) Conceptual Framework Pronouncements by other standard-setting bodies (with a similar conceptual framework) Other accounting literature 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: the title of the Standard or Interpretation; when applicable, that the change in accounting policy is made in accordance with its transitional provisions; the nature of the change in accounting policy; when applicable, a description of the transitional provisions; when applicable, the transitional provisions that may have an effect on future periods; 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; 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 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: the nature of the change in accounting policy; the reasons why applying the new accounting policy provides reliable and more relevant information; 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; 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 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: this fact; and 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: the carrying amount of an asset or a liability; or 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: the nature of the change; the amount of the change; and 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): restating the comparative amounts for the prior period(s) presented in which the error occurred; or 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: the nature of the prior period error; 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; 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 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: the effects of retrospective application (change of policy) or retrospective restatement (errors) are not determinable; the retrospective application or retrospective restatement requires assumptions about what management's intent would have been in a prior period; 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 Fair value less costs of disposal (R1 230 000 – R18 000) 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 Provide evidence of conditions that existed at the end of the reporting period; Irrespective of whether the fact was actually known at the end of the reporting period; Update the relevant amounts in financial statements to reflect adjusting events. NON-ADJUSTING EVENTS Indicative of conditions that arose after the reporting period; Unrelated to conditions that existed at the end of the reporting period; 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: not a present obligation at reporting period; therefore do not recognise at reporting period; disclose in note to financial statements (IAS 1). Going concern Financial statements must not be prepared on the basis of a going concern if: entity plans to go into liquidation; or ceases its commercial activities; or 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: those that provide additional evidence of the conditions that existed at the end of the reporting period (adjusting events); and those that are indicative of conditions that arose after the reporting period (nonadjusting events). These two categories require different accounting treatments. The alternatives are: inclusion in the financial statements as adjustments to assets and liabilities and accompanying income and expense items; or 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): 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. 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. Inventory: the sale of inventories after the reporting period may give evidence about their net realisable value at the end of the reporting period. 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. 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. 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): A large business combination or, conversely, the sale of a subsidiary after the reporting period. 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. Substantial purchase or sale of assets, or expropriation of major assets by the government. 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. Conclusion of material commitments, for instance issuing of material warranties. Litigation as a result of events that occurred after the reporting period. 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: 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 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: 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. Adjusting events – update the relevant amounts and other disclosures to reflect the new information. 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: nature of the non-cash asset to be distributed; carrying amount of the non-cash asset at the end of the reporting period; 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; 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: Tax rate expected to apply when temporary differences reverse; 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: South African taxes that are levied on taxable profits; foreign taxes levied on taxable profits obtained from foreign sources (refer to section 8.10) (IAS 12.2); and 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: 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; the carrying amount of assets and accounting expenses are not deductible for income tax purposes; the carrying amount of liabilities in the accounting records differs from the tax base thereof; the carrying amount of liabilities in the accounting records is not deductible for income tax purposes; 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; 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 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: deductible temporary differences; the carryforward of unused tax losses; and 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: the carrying amount of the asset or liability; the tax base thereof; 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); the applicable measurement of the deferred tax balance; and Income taxes 157 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: 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: 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: the initial recognition of goodwill (refer to the comment below); or 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: 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 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: 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 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: 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: deductible temporary differences (section above); the carryforward of unused tax losses (assessed tax losses); and 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: 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; it is probable that the entity will have taxable profits before the unused tax losses or unused tax credits expire; the unused tax losses result from identifiable causes which are unlikely to recur; and 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: 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 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: the entity defers the claim for certain tax deductions from taxable income; the entity sells, and possibly leases back, assets that have appreciated in value, but for which the tax base has remained constant; and 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: transactions recognised in other comprehensive income (e.g. a revaluation); 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 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: through sale (the tax consequences may be a recoupment (at 28%) and/or a capital gain (at 80% × 28%)); through use (e.g. as the plant is used, the inventory sold will be taxed at 28%); or 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: the investment property is depreciable; and 196 Descriptive Accounting – Chapter 8 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: 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). 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). 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). 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: 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; assume that SARS will examine the aspect and have full knowledge of all related information; 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 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: its judgements in determining the taxable income, tax bases, etc. (refer to IAS 1.122); information about the assumptions and estimates made in determining the taxable income, tax bases, etc. (refer to IAS 1.125-129); and 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: it has a legally enforceable right to offset the recognised amounts; and 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: 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 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): the current tax expense (income); any adjustment recognised in the reporting period for the current tax of prior periods; the amount of the deferred tax expense (income) relating to the origination and reversal of temporary differences; the amount of the deferred tax expense (income) relating to changes in the tax rate or the imposition of new taxes; 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; 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 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): 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; an explanation of changes in the applicable tax rate(s) compared to the rate for the previous accounting periods; 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 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): the aggregate current and deferred tax relating to items that are charged or credited to equity in terms of IAS 12.62A; 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; 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 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; 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; 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); 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; 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 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 Current year 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 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 Components; replacement of components at regular intervals; major inspections; spare parts and servicing equipment; and safety and environmental costs. Measurement 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: on disposal; or when no future economic benefits are expected from its use or disposal. Tax implications 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. 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 Depreciation recognised as an expense or shown as a part of the cost of other assets during a period should be disclosed; and 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 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: biological assets related to agricultural activity, other than bearer plants, in accordance with IAS 41, Agriculture; mineral rights and mineral reserves such as oil, natural gas and similar non-regenerative resources; PPE classified as held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations; and assets such as investment property (IAS 40 Investment Property). IAS 16 does apply to: 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 PPE used in maintaining biological assets and mineral resources; and 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: at cost less accumulated depreciation and accumulated impairment losses (the cost model); or 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: are held for use in the production of goods; or for the supply of services; or for rental to others; or for administrative purposes; and 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: land; land and buildings; machinery; ships; aircraft; motor vehicles; furniture and fixtures; and office equipment. Land and buildings are normally purchased as a unit, but are recorded separately because of the differences in their nature: land normally does not have a limited life and is therefore not depreciated while; 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: the relining of a furnace; the seats and galleys in an aircraft; and 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: (Small) spare parts and servicing equipment are usually carried as inventory and recognised in profit or loss as consumed. 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: 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; 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 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: costs of opening a new facility; costs of introducing a new product or service (including costs of advertising and promotional activities); costs of conducting business in a new location or with a new class of customer (including costs of staff training); administration and other general overhead costs; 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 initial operating losses, for example those incurred while demand for the item’s output grows; and 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:, 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. 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 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. 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. 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: The first exception is where the exchange transaction lacks commercial substance. 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: 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 the entity-specific value of the portion of the entity’s operations affected by the transaction changes as a result of the exchange; and 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: the useful life; the expected residual value; and the method of depreciation. 9.6.2 Useful life The following factors are considered in determining the useful life of an asset: the expected use of the asset by the entity, determined by referring to the asset’s expected capacity or physical production; 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; 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 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: after a specified period; or 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: the straight-line method; or the diminishing balance method (also known as reducing balance method); or the sum-of-digits method; or 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: the market approach; the cost approach; and 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: reimbursement by insurance companies after an impairment or loss of items of PPE, for example due to natural disasters, theft or mishandling; compensation by the government for items of PPE that are expropriated; 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 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: impairments or losses of items of PPE; related compensation from third parties; and subsequent purchase or construction of assets. The above-mentioned instances are separate economic events and are accounted for as follows: impairments of items of PPE must be recognised and measured in terms of the Standard on impairment of assets, (IAS 36); the retirement or disposal of items of PPE must be recognised in terms of IAS 16; 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 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: on disposal; or 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: 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. 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: the dates from which depreciation and wear-and-tear are calculated (date ready for intended use versus date brought into use); 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; the use of residual values and subsequent changes (e.g. revaluations) to the values which are not recognised for taxation purposes; depreciation allowances that are calculated proportionately while wear-and-tear allowances (e.g. in section 12C) are claimed for the full year; and 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 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 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: 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. 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. 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. The amount incurred on PPE still under construction (in other words, on which no depreciation has been provided). 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. 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. 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 losses 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) 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: Land with a cost of R400 000 was sold unexpectedly on 1 March 20.13 for R325 000. A stand was purchased for R350 000. The stand is used as an owner-occupied property. Improvements amounting to R135 000 were effected to buildings on 1 January 20.13. A vehicle (original cost R160 000) was sold unexpectedly on 30 June 20.13 for R115 000. The assets under consideration have no residual value and this situation will remain unchanged until the end of the useful lives of the assets. The manner in which assets are recovered is not expected to change. On 1 January 20.13, Impala Ltd determined that the remaining useful life of the buildings was 25 years. 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: Buildings – 24 years 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, absences, bonuses, 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: short-term employee benefits; post-employment benefits; other long-term employee benefits; and 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: wages, salaries and social security contributions; paid annual leave and paid sick leave; profit-sharing and bonuses; and 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: accumulating compensated absences (leave); or 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 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 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: 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 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 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: the entity should have a present legal or constructive obligation to make such payments as a result of past events; and 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: the formal terms of the plan contain a formula for determining the amount of the benefit; and the entity determines the amounts to be paid before the financial statements are authorised for issue; or 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: 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. 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: retirement benefits, for example pensions and payments from provident funds; and 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: defined contribution plans (e.g. provident plans); and 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: a defined benefit obligation (promised benefit owing); and 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 An entity shall disclose the amount recognised as an expense for defined contribution plans in the note on profit before tax. 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: 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. 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: If the lump sum is paid in terms of a service contract, it will be allowed as a deduction. 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). 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: long-term compensated absences, for example long-service or sabbatical leave; jubilee or other long-service benefits; long-term disability benefits; profit-sharing and bonuses; and 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: an entity’s decision to terminate an employee’s or group of employees’ employment before normal retirement age; or 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: enhancements of retirement benefits or other post-employment benefits, either directly or indirectly through an employee benefit plan; and 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: when the entity can no longer withdraw the offer of those benefits; or 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: the actions required to complete the plan must indicate that it is unlikely that significant changes to the plan will be made; 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 the time at which the plan will be implemented; and 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 No specific disclosure is required by IAS 19 itself, although the requirements of certain other Standards may be applicable. 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. 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. 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 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: 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 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): 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); the currency of the country whose competitive forces and regulations mainly determine the sales price of its goods and services; and 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): the currency in which funds from financing activities, such as issuing debt and equity instruments, are generated; and 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: 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; whether transactions with the reporting entity are a high or low proportion of the foreign operation’s activities; 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 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 Pensions and other employee benefits to be paid in cash Provisions that are to be settled in cash Lease liabilities Cash dividends that are recognised as a liability 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 Amounts prepaid for goods or services Goodwill Intangible assets Inventories Property, plant and equipment Right-of-use assets 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): buying and selling of goods and services in a foreign currency; borrowing and lending of funds in a foreign currency; and 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: which exchange rate must be used; and 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: the cost or carrying amount translated at the spot exchange rate on the transaction or valuation date; and 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): 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; 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 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: 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. 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. 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. 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: assets and liabilities for each balance sheet presented are translated at the closing rate at the date of that balance sheet; income and expenses for each statement of profit or loss and statement of comprehensive income are translated at average exchange rates; and 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 Borrowing costs. Qualifying asset. Recognition Capitalise borrowing costs directly attributable to the production, construction or acquisition of qualifying asset. Commence when expenditure for the asset and borrowing costs are being incurred and activities necessary to prepare asset are undertaken. Suspend when active development of qualifying asset is interrupted for extended periods. Cease when substantially all the activities necessary to prepare qualifying asset for intended use or sale are complete. Borrowing costs eligible for capitalisation Specific funds: actual borrowing costs incurred, less any investment income from surplus funds invested. 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: interest on borrowed funds, for example bank overdrafts and short- and long-term borrowings using the effective interest method in terms of IFRS 9; foreign exchange gains and losses arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs; and 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: borrowing costs are incurred; expenditure on the asset are incurred; and 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: specific loan: borrowing costs will be incurred from the date that the loan funds are advanced to the entity; bank overdraft: borrowing costs will be incurred from the date that the overdraft facility is used by the entity; and 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 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. 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 determine the borrowing costs on loans/bank overdrafts/mortgage loans included in the pool of funds; Borrowing costs 305 determine the weighted average capitalisation rate of general loans; 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; apply the capitalisation rate to the (weighted) expenditure of the qualifying asset to calculate the borrowing costs that can be capitalised; and 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: the policy regarding the capitalisation of borrowing costs; the capitalisation rate used to determine the amount of borrowing costs of general loans to be capitalised (IAS 23.26(b)); and 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 Parent, Subsidiaries, Fellow subsidiaries, Joint ventures, Associates, Benefit plans, Ventures; and Entities which influence significantly. Entities controlled or jointly controlled by persons who are related. 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: Parent Subsidiaries Fellow subsidiaries KMP compensation Transactions Show total compensation under following categories: In respect of various categories, disclose the following: Short-term, other longterm, postemployment, termination benefits Relationship Share-based payments Nature Amount Amounts outstanding Allowance for credit losses 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): identifying related party relationships and transactions; identifying outstanding balances (including commitments) between an entity and its related parties; identifying the circumstances in which disclosure of related party relationships, transactions and outstanding balances between an entity and its related parties is required; and 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)): has control or joint control over the reporting entity; or has significant influence over the reporting entity; or 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)): the entity and the reporting entity are members of the same group; or one entity is an associate or joint venture of the other entity; or both entities are joint ventures of the same third entity; or 316 Descriptive Accounting – Chapter 13 one entity is a joint venture of a third entity and the other entity is an associate of the third entity; or 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 the entity is controlled or jointly controlled by a person identified in paragraph 9(a) of IAS 24 as discussed above; or 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). 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: that person’s children and spouse or domestic partner; children of that person’s spouse or domestic partner; and 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: controlled or jointly controlled by persons identified in IAS 24.9(a); or significantly influenced by persons controlling or jointly controlling the reporting entity; or 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: An investor has power over the investee; and an investor is exposed, or has rights, to variable returns from its involvement with the investee; and 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: Parent A will be disclosed as a related party, as the parent A controls subsidiary B. 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: an associate includes subsidiaries of the associate; and 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: 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 two joint venturers, simply because they share joint control over a joint venture; or 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 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): purchases or sales of goods (finished or unfinished); Related party disclosures 323 purchases or sales of property and other assets; rendering or receiving of services; leases; transfers of research and development; transfers under license agreements; transfers under finance agreements, including loans and equity contributions in cash or in kind; provision of guarantees or collaterals; 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 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: disclosure of related party relationships; disclosure of key management personnel compensation; and disclosure of other related party transactions. 13.5.1 Disclosure of related party relationships All entities: Relationships between a parent and its subsidiaries must be disclosed irrespective of whether there were transactions between them (IAS 24.13). An entity must disclose the name of its parent and, if different, the name of the ultimate controlling party (IAS 24.13). 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). 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: 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; post-employment benefits, for example pensions, other retirement benefits, postemployment life insurance and post-employment medical care; 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; termination benefits; and 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): the nature of the related party relationships; the amount of the transactions; 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; provisions for doubtful debts related to the amount of outstanding balances, and 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): the parent; entities with joint control or significant influence over the entity; subsidiaries; associates; Related party disclosures 325 joint ventures in which the entity is a venturer; key management personnel of the entity or its parent; and 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: related party transactions and outstanding balances, including commitments, with a government that has control, joint control or significant influence over the reporting entity; and 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: the name of the government and the nature of its relationship with the reporting entity (i.e. control, joint control or significant influence); 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: significant in terms of size; carried out on non-market terms; outside normal day-to-day business operations, for example the purchase and sale of a business; disclosed to regulatory or supervisory authorities; reported to senior management; and 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): omissions or misstatements of items; if they could, individually or collectively; 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: that related parties will enter into transactions that unrelated parties would not; 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 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: Kingfisher Ltd has a wholly-owned subsidiary, A Ltd, which in turn owns a 60% subsidiary, B Ltd. Kingfisher Ltd has a 30% interest in C Ltd (significant influence) which in turn has a 40% interest in D Ltd. 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 Recoverable amount – higher of an asset’s fair value less costs of disposal and its value in use. 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. Fair value – IFRS 13 Fair value measurement. 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. Impairment loss – amount by which the carrying amount of an asset or CGU exceeds its recoverable amount. 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 Significant decline in asset’s value. Significant changes in technological, market, economic or legal environment. Market interest rates/other market rates of return on investments increased and decrease the asset’s recoverable amount materially. Carrying amount of net assets is more than its market capitalisation. Internal sources of information Evidence of obsolescence or physical damage to an asset. 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). Evidence that economic performance of an asset is/will be worse than expected. Test for impairment End of each reporting period, if indication of impairment. Intangible asset with indefinite useful life/ intangible asset not yet available for use – test annually. Goodwill – annually. RECOGNISING AND MEASURING AN IMPAIRMENT LOSS Individual asset Cost model – recognise in profit/loss (P/L). Revaluation model – account for as revaluation decrease. Cash-generating unit Allocate first to goodwill. Pro rata to other assets of CGU. Limit – carrying amount of asset not reduced below higher of: – fair value less disposal costs; – value in use; – Rnil. Reversing Cost model – recognise in profit/loss (P/L). Revaluation model – account for as revaluation increase. Limit – increased carrying amount may not exceed what carrying amount would have been if no impairment. Reversing Loss on goodwill may not be reversed. Allocate reversal pro rata to other assets of CGU. 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: tangible and intangible assets; investments in subsidiaries; joint arrangements; and associates, although the last three items are financial assets. IAS 36 is not applicable to assets such as: inventories; construction contracts; deferred tax assets; employee benefits; investment property measured at fair value; biological assets from agricultural activity carried at fair value less estimated point-of-sale costs; deferred acquisition costs; intangible assets arising from IFRS 4, non-current assets classified as held for sale under IFRS 5; and 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: Recoverable amount is the higher of an asset’s or CGU’s fair value less costs of disposal and its value in use. 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. 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). 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. Impairment loss is the amount by which the carrying amount of an asset or CGU exceeds its recoverable amount. 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: an intangible asset with an indefinite useful life; 332 Descriptive Accounting – Chapter 14 an intangible asset not yet available for use; 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 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. 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. 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. 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 Evidence is available of obsolescence of, or physical damage to, an asset. 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. 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: in the profit or loss section in the statement of profit or loss and other comprehensive income; or Impairment of assets 333 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): 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; 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: estimate the future cash inflows and outflows to be derived from the continued use and eventual disposal of the asset; and apply an appropriate discount rate to the future cash flows. The value in use calculation should reflect the following elements: an estimate of the future cash flows the entity expects to derive from the asset; expectations about possible variations in the amount or timing of those future cash flows; the time value of money, represented by the current market risk-free rate of interest; the price for bearing the uncertainty inherent in the asset; 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: 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; 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 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: cash inflows from the continuing use of the asset; 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 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: future cash inflows or outflows from the future restructuring of the entity to which the entity is not yet committed; or 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): additional value derived from the grouping of assets; synergies between the asset being measured and other assets; legal rights or legal restrictions that are specific only to the current owner of the asset; or 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): 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. 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. 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 There are observable indications that the asset’s value has increased significantly during the period. 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. 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 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. 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: a change in the basis for determining the recoverable amount (say from fair value less costs of disposal to value in use); 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 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: 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; 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: Recoverable amount end of Year 20.15 R20 000 Remaining useful life 5 years 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: how management monitors and controls operations (i.e. by product line, businesses, locations); or 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: the future cash inflows used to determine the CGUs value in use; and 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: 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 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: 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; 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); excludes assets that cannot be allocated on a reasonable basis such as goodwill and corporate assets in some cases; and 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: represent the lowest level within the entity at which goodwill is monitored for internal management purposes; and 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: included in the carrying amount of the operation disposed of when determining the gain or loss on disposal; and 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: firstly against the goodwill allocated to the CGU; and 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: firstly, to reduce the amount of goodwill allocated to the CGU (or group of units); and 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: its fair value less costs of disposal; its value in use (if applicable); and 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: 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. 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. 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: the assets and liabilities making up the unit have not changes significantly since the most recent recoverable amount calculation; the most recent recoverable amount calculation resulted in an amount that exceeded the carrying amount of the unit by a substantial margin; 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: the consideration transferred in the business combination measured at fair value at acquisition date; 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); 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 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: 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. 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): 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: assets other than goodwill are increased on a pro rata basis, based on their carrying amounts in the unit; and 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: its recoverable amount; and 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: 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: Goodwill Machine (500 000 × 9/10) Building (1 000 000 × 49/50) 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: 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. 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: The amount of impairment losses recognised in other comprehensive income during the period. 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: A description of the events and circumstances that led to the recognition or reversal of the impairment loss. The amount of the impairment loss recognised or reversed. For an individual asset: – the nature of the asset; and – the reportable segment to which the asset belongs. 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. Whether the recoverable amount of the asset or CGU is its fair value less costs of disposal or its value in use. If the recoverable amount is fair value less costs of disposal, the basis used to determine fair value less costs of disposal. 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: The main classes of assets affected by impairment losses (reversals of impairment losses) for which no information is disclosed in terms of the above. 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. An entity is encouraged to disclose the assumptions used to determine the recoverable amount of assets/CGUs in the period. 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: the carrying amount of goodwill allocated to the CGU (group of CGUs); the carrying amount of intangible assets with indefinite useful lives allocated to the CGU (group of CGUs); 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 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; 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 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: the aggregate carrying amount of goodwill allocated to those CGUs (groups of CGUs); the aggregate carrying amount of intangible assets with indefinite useful lives allocated to those CGUs (groups of CGUs); a description of the key assumption(s); 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 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: executory contracts, except where the contract is onerous; and 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: Identification refers to the assessment of a particular item with a view to determining whether it fulfils the definition of the element concerned. Recognition comprises two facets: timing and measurement. This means at what point in time and at what value the element must be recognised. 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: the entity has a present legal or constructive obligation to forfeit economic benefits as a result of events in the past (‘whether it complies’); it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation (‘when’); and 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: a legal obligation; or 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: 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. 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. 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: 15% that the claim will fail; 20% that an amount of R1 million will be granted; 25% that an amount of R1,5 million will be granted; 20% that an amount of R1,8 million will be granted; or 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: a brief description of the nature of the obligation and the expected timing of any outflow of economic benefits associated there with; 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.; 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; the carrying amount at the beginning and the end of the period; 370 Descriptive Accounting – Chapter 15 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 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: the loss that would be incurred by specific fulfilment of the contract; and 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 Lease payments per year (no escalation) 100 000 Fine payable on early cancellation of the contract 150 000 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 Remaining lease payments from 1 January 20.13 100 000 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: the extent of the entity’s operations; or the way in which business is done. The provision that is established in this way must be: necessitated by the restructuring; and 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): 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. 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: started to implement the restructuring plan; or 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. 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. 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: 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; 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 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: a brief description of the nature of the contingent asset; 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; 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 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: a change in the estimated cash flows required to settle the obligation; a change in the current market-based discount rate used to calculate the present value of the obligation; and 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: 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. 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. 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. 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. 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. 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. 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
