CHAPTER
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Non-current Non-current Assets - Tangible
Study Notes
DipIFR Diploma in International Financial Financial Reporting
By: Hasaan Fazal
UPDATED FOR
2015 EXAMS
CHAPTER
1
Non-current Assets - Tangible
Di IFR Diploma in International Financial Financial Reporting
By: Hasaan Fazal
Study Notes
1
CHAPTER Non-current Assets - Tangible TABLE OF CONTENTS Chapter #
Title of Chapter
Page #
1
Non-current Assets – Assets – Tangible Tangible
05
2
Inventory
19
3
Revenue
27
4
Conceptual Conceptual framework
36
5
Borrowing Cost
51
6
Construction Contract
56
7
Leases
63
8
Non-current assets held for sale and Discontinued operations
71
9
Accounting for Government grants
83
10
Events after the reporting period
91
11
Impairment of Assets
96
12
Statement of Cash Flows
111
13
Financial Instruments
115
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Non-current Assets - Tangible
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Non-current Assets - Tangible
CHAPTER CHA PTER
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Non-current Assets - Tangible
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Non-current Assets - Tangible 1 Non-current Assets Till now we understand that non-current asset is a resource used by an asset for more than one accounting period. Further, non-current assets can be classified as tangible and intangible non-current assets.
1.1 Definition and recognition criteria of Asset And before before a resource resource is treated as an asset asset and recorded in in the financial financial statements statements of the company it must fulfill first of all the definition of asset and then the recognition criteria. According to IASB Framework Framework an asset is a resource: resource: 1. Controlled by an entity 2. From which economic future benefits are expected to flow to the entity From the above definition we understand two major things: 1. A resource does not not need to be owned by an entity to be treated as an asset. Even control is enough to constitute a resource as an asset. Where control means control on the economic benefits of the resource. 2. But just having a physical control is not enough the benefits must be enjoyed by the entity which is only possible when entity has a significant control over the resource. In short, control here refers to the control of the economic benefits of the asset and not the title of ownership or possessing the asset. However, even if a resource qualifies as an asset, an entity cannot write it in the financial statements (Statement of Financial Position) unless recognition criteria are fulfilled. IASB Framework provides the recognition criteria for recognition of assets in balance sheet which is as follows: An asset is recognised recognised in the balance sheet when when it is probable probable that: that: 1. the future economic benefits will flow to the entity entity 2. the asset has a cost or value that can be measured reliably. From the above criteria we can understand that one additional condition has been applied over the definition of asset i.e. cost or value of the asset can be ascertained reliably.
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Non-current Assets - Tangible
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Non-current Assets - Tangible 2 IAS 16 – Property, Property, Plant and Equipment 2.1 Definition and Recognition IASs recognize most of the tangible non-current assets with the name Property, Plant and Equipment and discuss them under IAS 16. Property Plant and Equipment are tangible items that: 1. are held for a. use in the production or supply of goods or services b. rental to others c. for administrative administrat ive purposes 2. are expected to be used during more than one period.
According to IAS 16 the cost of of an item of of Property, Property, Plant and Equipments Equipments shall be recognized as an asset if: 1. Future economic benefits associated with the item are probably probably to flow to the entity 2. Cost of the item can be measured reliably An entity uses this recognition recognition principle to evaluate all costs incurred related incurred related to Property, Plant and Equipment whether they should be recognized or not and how their accounting is done. Costs include: 1. Costs incurred initially (at the time of recognition) to acquire or construct an item of Property, Plant and Equipment 2. Costs incurred subsequently (after subsequently (after recognition and brought into usable condition) to add to, replace part of, or service it. We will discuss subsequent costs in more detail later. NOTE: Previously under IAS 16 there used to be two recognition principles one for initial costs and second for subsequent costs. But now the criteria has been unified for all the costs incurred
2.2 Measuring Initial Cost – Measurement at recognition An entity can either either purchase an asset or construct the item on its own. Even though the situations are different but rules regarding which costs to be included and excluded are almost similar. But we will deal with them one-by-one for better understanding.
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Non-current Assets - Tangible 2.2.1 Costs to be included and excluded – Purchased Costs to be included 1. Purchase price a. Including (added to purchase price): i. import duties ii. non-refundable purchase taxes b. excluding (deducted out of purchase price): i. trade discounts and ii. rebates 2. Directly attributable costs; costs ; which also include all such costs that were incurred to bring the asset for it to be capable of operating as intended. 3. Initial estimates of dismantling / restoration costs which became an obligation of the company at the time of acquisition of the asset. Where the amount is significant then present value of the provision will be calculated and added at the time of recognition which in subsequent period will be increased by the unwinding of the discount. Such costs are treated according to the provisions of IAS 37. Examples of directly attributable costs 1. Costs of employee benefits (as defined in IAS 19 Employee Benefits) Benefits ) arising directly from the construction or acquisition of the item of property, plant and equipment; 2. Costs of site preparation; 3. Initial delivery and handling costs; 4. Installation Installati on and assembly costs; 5. 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 (such as samples produced when testing equipment); and 6. Professional fees.
Costs to be excluded Simply, all such costs that are not directly not directly attributable or that can be avoided and avoided and the asset still would have been brought into useable condition than such costs cannot be capitalized and will be recognized in the profit and loss account. Examples include: 1. Costs of opening a new facility or business (known as pre-opening costs); 2. Costs of introducing a new product or service (including costs of advertising and promotional activities) (known as pre-operating costs); 3. Costs of conducting business in a new location or with a new class of customer (including costs of staff training); and 4. Administration Administr ation and other general overhead costs.
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Non-current Assets - Tangible When to stop capitalizing the initial costs? Recognition of costs in the carrying amount of an item of property, plant and equipment ceases when ceases when the item is in the location and condition necessary for it to be capable of operating in the manner intended by management. T h e r ef ef o r e , c o s t s i n c u r r e d i n u s i n g o r r e d e p l o y i n g a n i t e m a r e n o t i n c l u d e d i n the carrying amoun t of that item.
For example, the following costs are not included in the carrying amount of an item of property, plant and equipment: a) 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; b) initial operating losses, losses, such as those incurred while demand for the item’s output builds up; and c) costs of relocating or reorganising part or all of an entity’s operations.
2.2.2 Costs to be included and excluded – Self-constructed According to IAS 16, if an entity entity has constructed constructed an asset in-house in-house instead instead of buying buying it, even then same principles are applicable as are applicable for acquired assets i.e. costs that are to be included and excluded mentioned above will apply to selfconstructed assets as well. And if entity entity produces produces such assets assets in normal normal course of of business then cost of acquisition acquisition will be same as cost of sales (as determined under IAS 2). In simple words: 1. Any internal profits which profits which are charged in normal course of business to customers will be excluded to excluded to arrive at cost of production 2. Abnormal losses incurred losses incurred while production will be excluded 3. All such costs that are excluded under a case of an acquired asset ; as discussed in the above heading Excluded costs will stand excluded in selfconstructed asset as well. well .
2.2.3 Dealing with Interest costs and Incidental costs/revenues Interest charges Interest charged for delayed payments will not be added as cost of the asset as cost is measured at cash equivalents and interest will be charged as an expense unless that cost fulfills the capitalization criteria according to IAS 23
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Non-current Assets - Tangible Incidental costs and incomes Some costs might be incurred or incomes earned while asset is being made available to be used. Such incidental costs or incomes will not be adjusted in the cost of the asset as these incidental operations are (usually) not necessary to bring the asset into working condition and thus recognized in the profit and loss account in their respective classification of income and expense
3 Depreciation 3.1 What is depreciation and why it is needed? The assets acquired are used by the business to further its operations. This use and other factors result in the reduction of asset’s v alue. In order to give a true and fair view of business, asset’s value (depreciable value) is reduced systematically over its useful life. Depreciable amount of the asset is determined by deducting residual value out of its cost.
3.2 Depreciation – accounting treatment The depreciation charge for a period is usually recognized in profit and loss account as an expense but there are two exceptions to this: If the asset is used to produce an inventory then the depreciation charge will form part of the cost of the inventory i.e. cost of goods sold If the asset is used to produce or develop another asset (tangible or intangible) then it can be included in the cost of the relevant asset in accordance with relevant provisions.
3.3 Commencement and cessation of depreciation Depreciation of an asset commences when that asset is available for use and will cease ONLY at the earlier of: 1. The date asset is classified as held for sale 2. The date asset is derecognized Therefore, depreciation will not cease even if the asset is idle or is retired from active use. However, depreciation might be zero because of the methods used for depreciation by the entity. But certainly zero depreciation DOES NOT mean NOT mean that depreciation will not be calculated.
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Non-current Assets - Tangible Depreciation is recognized even if the fair value of an asset exceeds its carrying value. However, if residual value of an asset is found to be more than carrying value then certainly there is no point in depreciating it further and depreciation charge will stay at ZERO until the residual value falls below the carrying amount of an asset.
3.4 Depreciation of Land Land usually has an unlimited useful life. Therefore, it is not depreciated. Sometimes, land and building are acquired together but they are separable assets and are accounted separately. Also, increase in the value of land on which building is situated has no effect on the determination of depreciable value of building. However, in some cases cost of land is depreciated which are as follows: 1. If the cost of land includes the costs of site dismantlement, removal and restoration then that portion of cost of the land asset is depreciated over the period of these costs render benefits. 2. In some cases, the land itself may have a limited useful life, in which case it is depreciated in a manner that reflects the benefits to be derived from it e.g. coal mines
3.5 Methods of depreciation Entity shall select such depreciation method that best reflects the consumption pattern of the economic benefits in the asset. Standard has mentioned three depreciation methods, but entity can select any other method of depreciation as well. Methods mentioned in the standard are: 1. Straight line method 2. Reducing balance method 3. Units of production method Under straight-line method depreciation charge stays constant over the period of time and does not change from period to period provided that useful life or residual value of asset does not change. Straight-line method is best suited in situations where entity expects to derive equal amounts of benefits every period. Reducing balance method results in a decreasing charge over the useful life. This method is in line with most of the assets. As asset gets older its efficiency drops and thus the rate of derivation of benefits also decreases over the useful life of the asset. Therefore, recognition of depreciation expense and the benefits are both in line. Units of production or hours method is used where consumption pattern of the benefits cannot be predicted and the rate of consumption varies from period to period.
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Non-current Assets - Tangible 3.6 Change in residual value of the asset Change in residual value should be accounted for as change in accounting estimate i.e. the change will be accounted for prospectively and the depreciation charged already recognized in previous periods will not be adjusted and will be done accor ding to the provisions of IAS 8 – 8 – Accounting Policies, Changes in accounting estimates and Errors
3.7 Change in the useful life of the asset Change in useful life of the asset should be accounted for as change in accounting estimate i.e. the change will be accounted for prospectively and the depreciation charged already recognized in previous periods will not be adjusted and will be done according to the provisions of IAS 8 – 8 – Accounting Policies, Changes in accounting estimates and Errors
3.8 Change in the depreciation method of the asset Change in depreciation method should be accounted for as change in accounting estimate i.e. the change will be accounted for prospectively and the depreciation charged already recognized in previous periods will not be adjusted and will be done according to the provisions of IAS 8 – 8 – Accounting Policies, Changes in accounting estimates and Errors
4 Separate component assets Assets may consist of of more than one part. part. Usually different parts parts of assets assets are either either insignificant or have the same amount of useful life therefore whole asset is subjected to uniform depreciation charge each charge each period. However, each part of the asset can be depreciated separately under separately under any of the following conditions: 1. If part of an asset has a significant cost in relation to total cost of the asset asset and has a useful life different from rest of the parts 2. If entity intends to depreciate part of the asset separately
5 Subsequent Expenditures Subsequent expenditures are usually such costs that were incurred AFTER the asset is brought into useable condition. Previously, we used to have separate criteria for subsequent expenditures but now the recognition criteria have been unified. And the same recognition principle is applied to all the costs at the time they are incurred (as mentioned under heading 2.1). Costs include the costs incurred initially at the time of
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Non-current Assets - Tangible acquisition and the costs incurred subsequent to recognition of an asset to add to, replace part of, or service it. Standard has divided subsequent expenditures in three types:
Costs of day-to-day servicing Costs incurred to replace physical part Major inspection cost regardless of whether parts are replaced
Under the recognition principle, entity cannot include day-to-day servicing costs in the carrying amount of the asset on their incurrence and will be treated as an expense in the period they are incurred. Such costs include the costs incurred on: 1. Labour which is responsible for repair and maintenance of the asset 2. Consumables which are used in the operation of the asset and its maintenance 3. Small parts of the asset that need replacement after regular intervals are usually recognized as inventory and recognized in profit and loss as consumed. Sometimes parts of asset require replacement on recurring or non-recurring basis. If this is the case, then under recognition criteria mentioned, entity will recognize the cost of the newly installed part in place of an old one. And the carrying amount of the old part which has been replaced will be derecognized i.e. deducted from the carrying amount of the asset. If the cost of the replaced part was recognized in the cost of the asset then the carrying amount of replaced part will be derecognized regardless of whether the replaced part was depreciated separately. If it is not practicable for an entity to determine the carrying amount of such part then replacement cost can be used as an indication of what the cost was when such cost was acquired or constructed. However, such maintenance activities are carried out and costs are incurred even when no physical part is replaced. Even such costs that do not involve replacement of parts will be treated as replacement which in this case will be replacement of previous inspection costs. costs. Any remaining remaining carrying carrying amount of the previous previous inspection inspection cost cost will be derecognize derecognized. d. In case if the cost of previous inspection was not measured or identified then, if necessary, a future inspection cost of similar nature will be used as a guide to measure the cost of existing inspection “component”. Such inspection costs are later amortized over the period for which they are expected to stand useful and they can have different amortization rate than the depreciation rate of the original asset, usually for lesser period.
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Non-current Assets - Tangible 6 Measurement after recognition An entity has the option to adopt either cost model or revaluation model as its accounting policy and shall apply that policy to an entire class or property, plant and equipment.
Cost model Under this model entity carries its assets o n cost less any accumulated depreciation and any impairment losses. Word “any” has been included to count the fact that not all assets are subject to depreciation and the same goes for impairment.
Revaluation model Under this model entity carries its assets at fair value less any depreciation and any impairment losses.
What is fair value? In case of land and building fair value is usually determined by considering marketbased evidence of similar assets in similar state and in similar market in which they are situated now. For plant and equipment is the value market value of these assets which can be ascertained by studying the market for the same or reasonably similar assets in the market. If market-based evidence cannot be collected for the purpose of determination of fair value of asset then entity may need to estimate fair value using an income or a depreciated replacement cost approach. As the valuation valuation is sometime complex, complex, therefore, therefore, this task task is usually usually undertaken undertaken by professional professional valuers. If entity use revaluation model then following conditions are needed to be fulfilled: 1. Revaluations shall be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the end of the reporting period. 2. If an item of property, plant and equipment is revalued, the entire class of property, plant and equipment to which that asset belongs shall be revalued. The frequency of revaluations depends upon the changes in fair values of the items of property, plant and equipment being revalued. When the fair value of a revalued asset differs materially from its carrying amount, a further revaluation is required. Some items
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Non-current Assets - Tangible of property, plant and equipment experience significant and volatile changes in fair value, thus necessitating annual revaluation. Such frequent revaluations are unnecessary for items of property, plant and equipment with only insignificant changes in fair value. Instead, it may be necessary to revalue the item only every three or five years.
A class of property, property, plant plant and equipment equipment is a grouping grouping of assets assets of a similar nature and use in an entity’s operations. The following are examples of separate classes: 1. 2. 3. 4. 5. 6. 7. 8.
land; land and buildings; machinery; ships; aircraft; motor vehicles; furniture and fixtures; and office equipment.
The items within a class of property, plant and equipment are revalued simultaneously to avoid selective revaluation of assets and the reporting of amounts in the financial statements that are a mixture of costs and values as at different dates. However, a class of assets may be revalued on a rolling basis provided revaluation of the class of assets is completed within a short period and provided the revaluations are kept up to date. Accounting Accounting for revaluation revaluation The accounting of revaluation under simple situations is done in three steps: Step 1: Compare cost of the asset with with the fair market value of the asset to understand the increase or decrease required in the asset’s account If FMV > Cost Debit: Asset a/c [with the difference]
If FMV < Cost Credit: Asset a/c [with the difference]
Step 2: Any existing accumulated depreciation at the time of revaluation can be treated in two ways but the most followed option is to eliminate any accumulated depreciation. depreciation . This step remains the same under both situations i.e. revaluation increase or decrease Debit: Accumulated depreciation a/c [with accumulated depreciation so far] Step 3A:
Compare carrying value with the fair market value to determine the amount of revaluation increase or revaluation decrease
If FMV > Carrying value Credit: Revaluation surplus [with the difference]
If FMV < Carrying value Debit: Profit and Loss a/c [with the difference]
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Non-current Assets - Tangible Normally things are pretty straightforward and the accounting of revaluation concludes as mentioned above. However, if there was any previous revaluation loss before current revaluation increase OR if there was any revaluation gain before current revaluation decrease then step 3 will be amended as following: Step 3B(i): If there is any previously recognized revaluation decrease (as revaluation loss in P&L a/c) then current revaluation increase will first be applied to reverse previous decrease and the remaining amount will then be credited to the revaluation surplus account. Credit: Profit and loss a/c [to the extent reversible] Credit: Revaluation Surplus a/c [with amount left after completely reversing previous decrease] Step 3B(ii): If there is any previously recognized revaluation increase (as revaluation surplus under equity) then current revaluation decrease will first be applied to reverse any revaluation surplus and the remaining amount will then be debited to the profit and loss account Debit: Revaluation surplus a/c [to the extent reversible] Debit: Profit and Loss a/c [with amount left after completely reversing previous increase]
7 Derecognition of asset 7.1 When derecognition occurs? Carrying amount of an item of property, plant and equipment shall be derecognized: 1. disposal (such as sales) 2. When no future benefits are expected from its use or sale i.e. scrap
7.2 Gain/loss on derecognition – Accounting Treatment Gain or loss arising from derecognition shall be included in profit and loss account in the period such derecognition occurred. Gain cannot be classified as revenue. Gain or loss will be calculated as the difference between the net disposal proceeds and the carrying amount of an asset. However, if entity is in a rental business and also routinely sells such assets and this is its normal course of business then if entity stop using it for rental to others then it will be classified as an inventory and on derecognition (disposal or scrap) the proceeds from such sale shall be recognized as revenue.
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Non-current Assets - Tangible 7.3 Revaluation Surplus of the disposed asset Revaluation surplus (if any) in respect of Property, Plant and Equipment may be transferred to retained earnings at earnings at the time of derecognition. Transfers from revaluation reserve to retained earnings are NOT made through Income Statement.
7.4 Disposal Disposal can occur in the shape of: 1. 2. 3. 4.
Sale Lease Donation Any event requiring derecognition e.g. theft or natural loss
7.4.1 Deferred disposal consideration The disposal amount of the asset is initially recognized at fair value. If consideration is delayed then present value will be calculated and the sum of present value(s) against the total payable will be treated as interest revenue.
7.4.2 Treatment of revaluation surplus on disposal of asset Revaluation on disposal is transferred to equity and not to comprehensive income.
7.4.3 Third party compensation – Accounting Treatment If that is compensated by third party then carrying amount of asset and the compensation received should be transferred to income statement separately.
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Part A: Inventory
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Part A: Inventory Part B: Construction Contract
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Part A: Inventory 1 Inventory 1.1 Introduction One of the key assets that business holds is inventory which is also named as stock or goods. Inventories can simply be defined as such assets that business bought and hold with an intention to sell further in the or dinary course of business which simply means that it is the business of the entity to sell such assets on regular basis. Inventory is treated as current assets of the entity IAS 2 deals with the accounting treatments of inventories at different stages starting fr om recognition and after recognition and lastly when they are sold. Overall IAS 2 touches the following topics: 1. Cost of inventory to be recognized 2. Cost formula to be used for inventory valuation 3. Adjustments in the carrying value of inventory for write-downs 4. Subsequent recognition as an expense when the goods are sold
1.2 What is inventory? According to IAS 2 Inventories are assets:
(a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services.
2 Measurement of Inventory Inventories shall be measured at the lower of cost and net realisable value.
2.1 What is Cost of inventory? Costs to be included The cost of inventories shall comprise: (a) all costs of purchase; (b) costs of conversion; and
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Part A: Inventory (c) other costs incurred in bringing the inventories to their present location and condition.
Costs to be Excluded Examples of costs excluded from the cost of inventories and recognised as expenses in the period in which they are incurred are: (a) abnormal amounts of wasted materials, labour or other production costs; (b) storage costs, unless those costs are necessary in the production process before a further production stage; (c) administrative overheads that do not contribute to bringing inventories to t heir present location and condition; and (d) selling costs.
2.1.1 Cost of Purchase The costs of purchase of inventories comprise: (a) the purchase price, (b) import duties (c) irrecoverable taxes (d) transportation costs; e.g. carriage inwards, freight etc (e) handling costs e.g. insurance cost (f) any other cost that is directly dire ctly attributable to the acquisition of finished goods, materials and services. Following are deducted while determining cost of purchase: (a) Trade discounts, (b) Rebates, recoverable taxes (c) other similar items; e.g. grants
2.1.2 Cost of conversion Cost of conversion includes direct labour cost. It also includes fixed and variable overheads which are incurred in converting raw materials to finished goods. Fixed production overheads are fixed as they do not change with the change in the activity level i.e. these costs are independent of production level. Examples include factory rent, depreciation of asset if it is on straight line basis. Variable production overheads are variable costs because they change with the change in the activity level. For example; indirect material and indirect labour.
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Part A: Inventory Fixed production overheads are allocated using normal capacity. Normal capacity means the production capacity that is attainable under normal conditions and circumstances. Actual capacity may also be used for allocation purposes if it approximates normal c apacity. However, such fixed production overheads which cannot be allocated to a particular cost object then they will charged as an expense in profit and loss account. Variable production overheads are included in the production cost of eac h unit on basis of the basis of actual use. If a conversion process renders more than one product and conversion costs is not separately identifiable for each product then conversion cost can be divided on some rational basis. However, such allocation basis should be used consistently over the per iod of time. Methods of allocation include: (a) Sale price at split off point (b) Sale price after further processing (at completion) Usually if output contains main-products and by-products then the value of by-products is immaterial compared to the value of main-product. Therefore, by-product is valued at its NRV which is then deducted from the cost of the main-products.
2.1.3 Other Costs Other costs include all such costs that are incurred specifically for the inventory to bring them in present location or condition. For example, while preparing an order of a particular customer who demands special kind of packing then the additional cost of packing will be added in the cost of inventory.
2.2 Other Techniques for the measurement of cost of inventory IAS 2 allows the use of standard cost and retail method if the cost determined under such method is approximately the same as cost measured under t he provisions described above. Under standard costing management of the entity determ ines the different costs related to to production in advance on the basis of normal conditions and circumstances and such costs are then kept fairly constant. However, if circumstances and conditions change management should review its standards and must make amendments accordingly to reflect the changes. Retail method of costing the inventory is used in such industries where there is large number of inventories that change rapidly i.e. there is a rapid flow of inventories. In such situations if inventories have similar profit margin then cost of the inventory is determined by deducting profit margin from the selling price. This method makes costing much easier as with large amount of inventories it is impracticable to use other costing m ethods. However, care should be
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Part A: Inventory taken while determining the margin to be deducted as margin is usually determined in relation to price which can change.
2.3 Special Cases Borrowing Costs Borrowing costs can be included in the inventory if inventory fulfills the definition of qualifying asset which means an asset that takes substantial time to complete. However, inventories that are produced in a short period of time are not qualifying asset. For example, inventory held by usual producers other than building contractors. Also, the items that were ready to be used or sold at the time of acquisition are also not qualifying assets. For example, inventory held by retailers.
Deferred Payment Terms An entity may purchase inventories on deferred settlement terms. When the arrangement effectively contains a financing element, that element, for example a difference between the purchase price for normal credit ter ms and the amount paid, is recognised as interest ex pense over the period of the financing.
2.4 Cost of inventory for service providers To the extent that service providers have inventories, they measure them at the costs of their production. These costs consist primarily of the labour and other costs o f personnel directly engaged in providing the service, including supervisory personnel, and attributable overheads. Labour and other costs relating to sales and general administrative personnel are not included but are recognised as expenses in the period in which they are incurred. The cost of inventories of a service provider does not include profit margins or non-attributable overheads that are often factored into prices charged by service providers.
3 Cost formulas In order to simplify the cost measurement of of inventories or precisely said to simplify cost to inventories, entities can use cost formula. IAS 2 allows the use of First in First out assignment to (FIFO) and Weighted Average Cost me thod. LIFO is not permissible under IAS 2 . Entity can use cost formula like FI FO or Weighted Average to assign cost to the inventories if the goods are interchangeable. However, if entity holds such items in inventory in which each and
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Part A: Inventory every items is not interchangeable then for such inventory specific costs (actual costs or standard cost) are assigned and cost formula cannot be used on such inventory. The entity should divide inventories into groups on the basis of the nature and use of inventory and then apply the same cost formula to such goods which are similar in use and nature. However for such group of inventories which have different nature and use a different cost formula can be used. But difference in nature and use does not mean difference in the location of the asset or tax treatment.
4 Net realisable value 4.1 What is NRV? Net realisable value is the estimated selling price in the o rdinary course of business less :
the estimated estimated costs costs of completion; and
the estimated estimated costs costs necessary to make the sale.
4.2 Difference between NRV and Fair Value Net realisable value refers to the net amount that an entity expects ex pects to realise from the sale of inventory in the ordinary course of business. Fair value reflects the amount for which the same inventory could be exchanged between knowledgeable and willing buyers and sellers in the marketplace. NRV is an entity-specific value whereas fair value is not.
Net realisable value for inventories may not equal fair value less costs to sell.
4.3 Why is it important? Every entity wants to sell its inventory above cost i.e. at profit. But sometimes inventories are sold even below cost i.e. at loss for many reasons. Technically speaking loss means that entity was unable to recover all the costs c osts incurred. It might be because g oods are damaged or so outdated that no one wants to buy t hem anymore. In such situations if entity keeps the c arrying value of inventory unchanged i.e. at cost then it is not justifiable as the value of inventory is not t he same as its cost now. Therefore, in such situations entity will have to reduce the value of inventory to such value which is expec ted to be realized on the sale of such inventory. Bec ause if it is not reduced then financial statements m ay not give true and fair view of the business as far as the inventories are concerned.
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Part A: Inventory 4.4 How NRV policy is applied? Usually the inventories are written down on item by item basis but if there are large amount of inventories then it will be much convenient to have inventories classified in different groups on the basis of their use and nature. In such case each group on whole will be examined for NRV purposes. Items should be grouped on the basis of the ir nature and use. For example, entity might be holding three different types of finished goods. It might be inappropriate to write down inventories on the basis of inventory classification i.e. all the finished goods are written down. Entity should examine the three groups under finished goods separately.
4.5 How NRV can be measured? NRV comprises the best estimates of price and the selling costs. It even includes such fluctuations in price and cost due to subsequent events which are indicative of conditions which were present at the year end. The estimate of NRV can be derived from the contracts an entity has made with other firms or it can be derived from general market price prevailing at the time estimates are made.
4.6 NRV of Material and Supplies What is “material” and “supplies”? Materials are such items which are converted into finished goods and supplies are such items which are consumed in the conversion process. Entity sells finished items and not t he materials and supplies. Because of this the written down treatment of these two types of inventories is a bit different.
When material and suppliers are written down? Materials and Supplies are not written down below the cost if the finished good in which they have been used will be sold at o r above cost i.e. the cost incurred o n finished goods is expected to be recovered in full. However, if finished items NRV falls below the cost then material and supplies will also be written down to their respective NRV.
How NRV for material and supplies is measured? As material and supplies are not sold by the entity therefore to estimate NRV, replacement cost is used.
What if NRV increases again after inventory was written down?
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Part A: Inventory If entity still holds such inventory which was written down to NRV in the previous period and later the selling price increased then the amount written down will be reversed. Re versible can be made maximum up to the total amount originally written down previously and not beyond.
How written down value is treated? Any difference in cost and NRV, where NRV is lower than cost, will be w ritten-down and it will be recognized as an expense in the period it is written down or loss occurred.
How reversals are treated? In case of reversal of written-down value, such amount will be set-off against the amount of inventory which is treated as expense in the period in which the reversal occ urs.
How capitalized inventory is treated? If inventories have been capitalized in the cost o f another asset, for example, self-constructed asset, then in such case amount of inventories will form part of the depreciation expense of the asset.
5 Disclosure required in the financial statements The financial statements shall disclose: (a) the accounting policies adopted in measuring inventories, including the cost formula used; (b) the total carrying amount of inventories and the carrying amount in classifications appropriate to the entity; (c) the carrying amount of inventories carried at fair value less costs to sell; se ll; (d) the amount of inventories recognised as an expense during the period; (e) the amount of any write-down of inventories recognised as an expense in the period (f) the amount of any reversal of any write-down that is recognised as a reduction in the amount of inventories recognised as expense in the period (g) the circumstances or events that led to the reversal of a write-down of inventories; and (h) the carrying amount of inventories pledged as security for liabilities.
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Revenue
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Revenue
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Revenue
1 Introduction Many of us already have an impression what revenue is and if asked about it many will say that revenue is income of the business which is not wrong. But revenue is not the o nly kind of income that business earns so we must have c lear understanding about what revenue exactly is and what other kinds of incomes are. Also we must have set of criteria through t hrough which we can analyse when revenue and other incomes can be recognized in the financial statements. All such issues specifically related to Revenue are tackled under IAS 18 Revenue
1.1 IASB Framework about revenue In IASB framework one of FIVE elements of financial statements defined is Income. The definition of income encompasses both revenue and gain and interestingly framework has discussed each of them in good detail. Revenue is the income that arises in the course of the ordinary activities of an entity i.e. activities which are basically business of the entity and this is for what entity has been formed and exists. In simple words income earned from suc h activities which are the main business of the entity is Revenue. This can have different names in different types of business including sales, fees, interest, dividends, royalties and rent. Gains are such income that may, or may not , arise in the course of the ordinary activities of an entity. From the definition of gains we can understand two things: 1. gains are not earned on regular basis; and 2. gains are such income that may arise out of such activities which may be ordinary or not ordinary in nature. In simple words gains are such incomes which arises from such activities which are not the m ain business of the entity but they may or or may not be be ordinary in their nature.
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Revenue
2 Revenue as per IAS 18 IAS 18 has prescribed the accounting treatment of revenue after defining material in more detail and giving it more depth.
2.1 What is Revenue? – IAS 18 Revenue is the gross inflow of economic benefits (received and receivable) during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity , other than increases relating to contributions from equity participants .
Let’s analyse the definition part by part. Revenue is:
set -off against the cost Gross inflow of economic benefits i.e. revenue has not been set-off incurred to generate such revenue
Received and receivable i.e. revenue is recognized on accrual basis just like other elements of financial statements
During the period i.e. over a range of time
Arising in the course of ordinary activities i.e. such activities are undertaken on reg ular basis as the main business of the entity
When those inflows results in increases in equity i.e. such inflows generated from activities should increase the equity
Other than increases relating to contributions c ontributions from equity participants i.e. such increase is not an increase that is a result of additional capital invested by the owners in the company
3 Measuring Revenue Revenue shall be measured at the fair value of the consideration received or r eceivable. Where fair value means the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.
3.1 Trade discounts and volume rebates Revenue is measured at the fair value of the consideration received or rece ivable taking into account the amount of any trade discounts and volume rebates allowed by the entity
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Revenue
3.2 When the payment is deferred under a financing transaction When the inflow of cash or cash e quivalents is deferred and the arrangement constitutes a financing transaction then fair value of the consideration should be measured by discounting all future receipts using an imputed interest r ate. The difference between the fair value and nominal amount of consideration is recognized as interest revenue in accordance with this standard, IAS 39 and IFRS 9.
3.3. Exchange of goods or services When exchange is for goods or services with similar nature and value The exchange is not regarded as a transaction which generates revenue. This is often the case with commodities like oil or milk where suppliers exchange or swap inventories in various locations to fulfill demand on a timely basis in a particular location
When exchange is for goods or services with dissimilar nature and value The exchange is regarded as a transaction which generates revenue. The revenue is me asured at the fair value of the goods or services received, adjusted by the amount of any c ash or cash equivalents transferred. When the fair value of the t he goods or services received cannot be measured reliably, the revenue is measured at the fair value of the goods or services given up, adjusted by the amount of any cash or cash equivalents transferred.
4 Identification of transactions 4.1 General principle The recognition criteria in this Standard are usually applied separately to each transaction.
4.2 Special circumstances When single transaction has multiple components Apply recognition criteria separately to each component of a single transaction in order to reflect the substance of transaction. For example selling price contains subsequent service charges as well included in the product price . That portion should be deferred and recognized as services are rendered.
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Revenue
When multiple transactions are taken as one Apply recognition criteria together over a series of transaction to understand the commercial effect of transaction. For example sale and repurchase agreement
5 Recognition of revenue IAS 18 has prescribed the recognition criteria by dividing the transactions and events into three different categories which are as follows: 1. the sale of goods; 2. the rendering of services; and 3. the use by others of e ntity assets yielding interest, royalties and dividends.
5.1 Sale of goods Goods include goods produced by the entity for the purpose of sale and goods purchased for resale, such as merchandise purchased by a retailer or land and other property held for resale.
Criteria Revenue from the sale of goods shall be recognised when all the following conditions have been satisfied: (a) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods; (b) the entity retains neither continuing managerial involvement to the de gree usually associated with ownership nor effective control over the goods sold; (c) the amount of revenue can be measured reliably; (d) it is probable that the economic benefits associated with the transaction will flow to the entity; and (e) the costs incurred or to be incurred in respect of the transaction can be measured reliably.
How to know risks and rewards have been transferred? It depends on circumstances that nee d careful examination to assess whether transfer has occurred or not. In some cases transfer takes place with the transfer of the title of ownership or possession to the buyer but in some cases transfer occurs at a different time from the transfer of title or possession.
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What if risks and rewards have not been transferred? If the entity retains significant risks of ownership, the tr ansaction is not a sale and revenue is not recognised. An entity may retain a significant risk of ownership in a number of ways. Examples of situations in which the entity may retain the significant risks and rewards of ownership are: (a) when the entity retains an obligation for unsatisfactory performance not covered by normal warranty provisions; (b) when the receipt of the revenue from a particular sale is c ontingent on the derivation of revenue by the buyer from its sale of the goods; (c) when the goods are shipped subject to installation and the installation is a significant part of the contract which has not yet been completed by the entity; and (d) when the buyer has the right r ight to rescind the purchase for a reason specified in the sales contract and the entity is uncertain about the probability of return. However, if an entity retains only an insignificant risk of ownership, the transaction is a sale and revenue is recognised.
What if probability of inflow is weak? Revenue is recognised only when it is probable t hat the economic benefits associated with the transaction will flow to the entity. In some c ases, this may not be probable until the consideration is received or until an uncertainty is rem oved. However, when an uncertainty arises about the collectibility of an amount already included in revenue, the uncollectible amount or the amount in respect of which recovery has ceased to be probable is recognised as an expense, rather than as an adjustment of the amount of revenue or iginally recognised.
What if revenue or costs incurred cannot be measured reliably? Revenue and expenses that relate to the same transaction or other event are recognised simultaneously; this process is commonly referred to as the matching of revenues and expenses. However, revenue cannot be recognised when the expenses cannot be measured re liably; in such circumstances, any consideration already received for the sale of the goods is recognised as a liability.
5.2 Rendering of services The rendering of services typically involves the performance by the entity of a contractually agreed task over an agreed ag reed period of time. The services may be rendered within a single period or over more than one period. Services related to construction contracts are not dealt in this standard.
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Criteria When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be re cognised by reference to the stage of completion of the transaction at the end o f the reporting period. The outcome of a tr ansaction can be estimated reliably when all the following conditions are satisfied: (a) the amount of revenue can be measured reliably; (b) it is probable that the economic benefits associated with t he transaction will flow to the entity; (c) the stage of completion of the t ransaction at the end of the reporting re porting period can be measured reliably; and (d) the costs incurred for the t he transaction and the costs to complete the transaction can be measured reliably.
What is stage of completion method? The recognition of revenue by reference to the stage of completion of a transaction is often referred to as the percentage of completion method. Under this method, revenue is recognised in the accounting periods in which the se rvices are rendered. The recognition of re venue on this basis provides useful information on the extent of service activity and pe rformance during a period.
What if probability of inflow is weak? Revenue is recognised only when it is probable t hat the economic benefits associated with the transaction will flow to the entity. However, when an uncertainty arises about the collectibility of an amount already included in revenue, the uncollectible amount, or the amount in respect of which recovery has ceased to be probable, is recognised as an expense, r ather than as an adjustment of the amount of revenue o riginally recognised.
How to determine stage of completion? The stage of completion of a transaction may be determined by a variety of methods. An entity uses the method that measures reliably the services performed. Depending on the nature of the transaction, the methods may include: (a) surveys of work performed; (b) services performed to date as a percentage of total services to be performed; or (c) the proportion that costs incurred to date bear to the estimated total costs of the transaction. Only costs that reflect services performed to date are included in costs incurred to date. Only costs that reflect services performed or to be performed are included in the estimated total costs of t he transaction.
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Progress payments and advances received from customers often do not reflect the services performed
What if outcome of the transaction cannot be measured reliably? An entity is generally able to make reliable estimates after it has agreed agree d to the following with the other parties to the transaction: (a) each party’s enforceable rights reg arding the service to be provided and rece ived by the parties; (b) the consideration to be exchanged; and (c) the manner and terms of settlement. However, if there is uncertainty about any of the factor and thus unable to judge the outcome of the transaction then revenue shall be recognised only to the extent of the expenses recognised that are recoverable. When the outcome of a transaction cannot be estimated reliably and it is not probable that the costs incurred will be recovered, revenue is not recognised and the costs incurred are recognised as an expense. When the uncertainties that prevented the outcome of the contract being estimated reliably no longer exist, revenue is recognised as normal
5.3 Interest, Royalties and Dividends The use by others of entity assets gives rise to revenue in the form of: (a) interest— interest—charges for the use of cash or cash equivalents or amounts due to the entity; (b) royalties— royalties—charges for the use of long-term assets of the entity, for example, patents, trademarks, copyrights and computer software; and (c) dividends— dividends—distributions of profits to holders of equity investments in proportion to their holdings of a particular class of capital.
Criteria General provisions: Revenue arising from interest, royalties and dividends shall be recognised when: (a) it is probable that the economic benefits associated with the transaction will flow to the entity; and (b) the amount of the revenue can be measured reliably.
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Revenue
Specific provisions: (a) interest shall be recognised using the effective interest method as set out in IAS 39 (b) royalties shall be recognised on an accrual basis in accordance with the substance of the relevant agreement; and (c) dividends shall be recognised when the shareholder’s right to receive payment in respect of dividend is established. When unpaid interest has accrued before t he acquisition of an interest-bearing investment, the subsequent receipt of interest is allocated between pre-acquisition and post-acquisition periods; only the post-acquisition portion is recognised as revenue. Royalties accrue in accordance with the terms of the relevant agreement and are usually recognised on that basis unless, having regard to the substance of the agreement, it is more appropriate to recognise revenue on some ot her systematic and rational basis. Revenue is recognised only when it is probable t hat the economic benefits associated with the transaction will flow to the entity. However, when an uncertainty arises about the collectibility of an amount already included in revenue, the uncollectible amount, or the amount in respect of which recovery has ceased to be probable, is recognised as an expense, rather than as an adjustment of the amount of revenue originally recognised.
6 Disclosures: An entity shall disclose: (a) the accounting policies adopted for the recognition of re venue, including the methods adopted to determine the stage of completion of transactions involving the rendering of services; (b) the amount of each significant category o f revenue recognised during the period, including revenue arising from: (i)
the sale of goods;
(ii)
the rendering of services;
(iii) interest; (iv) royalties; (v)
dividends; and
(c) the amount of revenue arising from e xchanges of goods or services included in each significant category of revenue. An entity discloses any contingent liabilities and contingent assets. Contingent liabilities and contingent assets may arise from items such as w arranty costs, claims, penalties or possible losses.
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Conceptual Framework
CHA HAPTER PTER
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Conceptual Framework
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Conceptual Framework
1 Qualitative characteristics of financial statements As we understand that different users re quire financial information for assistance in their economic decisions. Entities publish financial statements so that users can get their information needs fulfilled. The dependence of users’ economic decision on financial statements is c rucial and if the financial information is not accurate or is not true and fair then users may end up making wrong decisions. Therefore, financial statements need to have certain attributes in order to be useful to its users. We call these attributes Qualitative characteristics of financial information/statements
IASB Framework for Presentation and Preparation of Financial Statements states FOUR principal characteristics as follows: 1. Understandability 2. Relevance 3. Reliability 4. Comparability
1.1 Understandability Users cannot use such financial information that they cannot understand. Problems in understanding may arise due to user’s inabilities or because o f the information itself. Definitely entity cannot do anything about users and its upon the user to have at basic level of understanding about financial statements. Also, users are not required to be professional accountants and that is why where we expect to have complex information then it’s neither fault on part of user nor from the side of the entity preparing financial statements. However, entity can present information in such a manner that it helps in understanding. Also with proper explanation financial statements can be made more understandable. Therefore, entity is required to take reasonable measures in order to make financial statements easy to understand. But it does not mean that c omplex information which is also of material nature should be excluded from the financial statements on the basis that it is not easily understandable.
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Conceptual Framework
1.2 Relevance Information is considered relevant which adds value to the dec ision making process by providing the required bits and pieces of past, present and future times. Through relevant information users can evaluate whether they ar e moving along the right path i.e. making correct decisions. Information is also said to be relevant when it is capable of confirming or corre cting the existing thought process and information. Many students might think that financial statements always relates to past (financial period that have already passed) then how come past information can help us in making decisions? Well to give you a simple example, we all use our experience to decide dec ide about something and certainly experience is always what we always achieve from the past. Same way, past information given in financial statements helps us in predicting the financial position and financial performance of the company in upcoming financial periods. So, even past information can be relevant. Relevance is enhanced by the following factors:
Nature
Materiality
Nature refers to what information is about. Information is material if its omission or misstatement could influence the eco nomic decisions of users taken on the basis of the financial statements. Materiality helps us in judging in a particular situation whether a misstatement in information or omission of information can influence user’s decisions in such a way t hat if that information was not misstated or omitted then they would have reached different co nclusion. In some cases, nature of the information alone is enough to be relevant irrespective of its materiality.
1.3 Reliability Information is reliable when it is dependable. Information may be relevant but this alone does not suffice as an alternative for re liability as well. Information must be reliable as well as relevant in order to be useful for decision making. There are many other factors that contribute towards the enhancement of reliability of the financial information which are as follows:
All the events are faithfully reported (Faithful representation) including events are reported on the basis of economic reality (Substance over form)
Information is neutral and free from bias (Neutrality)
Judgments are involved, reasonable caution should is taken in preparation of information (Prudence)
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Conceptual Framework
Information is complete (Completeness)
Faithful representation Faithful representation implies that only such events should be reported in t he financial statements which can be identified, measured and presente d in a way that can correctly corre ctly portray their effects. To cater this recognition criteria have been established for different elements of the financial statements. Therefore, only those events should be r eported which fulfill the recognition criteria. In case there is any uncertainty or risk is surrounding the identification, recognition, measurement and presentation the reporting such events is contrary to faithful representation as it will not convey the message related to such events appropriately. For example, although most entities generate goodwill internally over time, it is usually difficult to identify or measure that goodwill reliably.
Substance over form According to this concept events should be re ported on the basis of economic substance of t he transaction rather than legal form of t he transactions i.e. economic substance of the truncation will be preferred over legal form o f the transactions and events. However, it must be noted that this concept is applied only the in the situations where e conomic reality is different from legal reality of the event. Most of the time the person who is the owner ow ner of the asset is also responsible for risks and rewards associated with such asset and in t his case substance over form is not applicable. However, in cases where the two aspects are in conflict then the n economic substance will be considered for reporting purposes. For example in legal t erms asset might have been sold but if the seller is still responsible for the r isks and rewards associated with the asset then in this case reporting on the basis of legal re ality will not be faithful as the seller’s financial position and performance is still getting affected by the asset “sold”.
Neutrality To be reliable, the information contained in financial statements must be neutral, that is, free from bias. Financial statements are not neutral if, by the selection or presentation of information, they influence the making of a decision or judgeme nt in order to achieve a predetermined result or outcome.
Prudence Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. Prudence plays crucial role in
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Conceptual Framework
measuring different items that require estimation and involve judgment. Framework requires that such care should be taken while e xercising judgment which is expected from re asonably prudence person in a given situation. However, prudence does not mean:
Creation of hidden reserves
Excessive provisions
Deliberate understatement of assets or income
Deliberate overstatement of liabilities or expenses
All the above four cases are contrary to the neutrality principle/quality.
Completeness To be reliable, the information in financial statements must be com plete and no such information should be omitted that is relevant to the users and can influence their decision
1.4 Comparability Comparability of information refers to its ability to stand useful overtime and against the financial information from other sources. Users cannot evaluate different aspects of entity’s financial position and financial performance if they are unable to compare the financial information of one period with another or financial information of one e ntity with another entity’s financial information. So information. So they require financial statements to be prepared in such way that they are comparable so that t hat they compare the financial position, performance and changes in financial position of the same entity through time or with other entities. Comparability is achieved by compliance and consistency. Compliance requires complying with the requirements of the International Accounting Standards as these standards are made with a view to narrow down the differences in accounting treatments. On the other hand consistency suggests that entity should be consistent with its accounting policies and their application over time and should not change them most often unless necessary. However, comparability does not require that one st ays uniform even if there are other ways to make financial statements even more reliable and relevant. Consistency does not amount to uniformity as it is inappropriate to leave accounting policy unchanged if alternatives exist which can make information more relevant and reliable.
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Conceptual Framework Why is it difficult to achieve absolute relevant and reliable financial information?
Absolute relevant and reliable information is impossible to be achieved due to different constraints. The main reason for this is qualitative characteristics itself as t hey are interrelated and thus one is enhanced most often at the expense of the other. Other reasons are:
Time: In order to make information complete and reliable it requires time, but if information not communicated on time then it will lose its relevance and in that case high level of re liability and completeness will not suffice. Information needs to be both relevant and r eliable in order to be useful and sometimes sacrifices have to be made to achieve a perfect mix of relevance and reliability due to time constraints. der ived from the information must exceed the cost Cost-benefit analysis: Benefits that can be derived incurred to gather the same information. But as benefits are valued differently by every person under different situations therefore, cost-benefit analysis is more of a judgmental process. Higher the degree of reliability and relevance required more costs will be incurred.
2 True and fair presentation OR Fair presentation Financial statements are required to be giving true and fair view of the business i.e. financial position and performance as portrayed in the financial statements should be in line with the real situation at ground. This framework does not attempt to describe how to achieve fair presentation. However, fair presentation is expected to be achieved by the application of International Accounting standards and keeping the qualitative characteristics of financial information discussed in this framework under consideration.
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Conceptual Framework
3 Elements of financial statements The main purpose of financial statements is to provide financial information to the users to assist them in their economic decisions. The financial statements basically present the financial information in such form that it is not only understandable but also useable. That is w hy financial statements present the financial effects of different business events including business transactions. In order to enhance the quality of information in financial statements, business transactions are grouped in different classes or categories o n the basis of their economic characteristics. These broad classes or categories are called elements of financial statements . In IASB Framework for the Preparation and Presentation of Financial Statements (Framework) there are in total FIVE elements of financial statements mentioned which are as follows: (a) Assets (b) Liabilities (c) Equity (d) Income (e) Expense Framework went on further to explain which combination of elements are used to measure
financial position, financial performance and changes in financial position of the entity. The elements directly related to the measurement of financial position of the entity are assets,
liabilities and equity. These elements are presented in t he Statement of Financial Position which was previously known as Balance Sheet. The elements directly related to the measurement of financial performance of the entity are
income and expense. These elements are presented in the Income Statement . The elements directly related to the measurement of changes in financial position involve the
elements of both balance sheet and income statement and depends on the circumstances. So, elements that are used to measure me asure the change in financial position cannot be strictly specified.
Statement of changes in equity and and Statement of cash flows collectively provide an insight into the changes in financial position of the company. And as we know both of these statements involve mostly all of the above five items and sometimes less therefore, elements are not mentioned in the framework for such measurement.
Another important point to remember is that e ach element in itself is a group of many transactions and each group can further be broken down to different groups i.e. sub-
classification can be done within each element depending on the nature, characteristics, function, time and other factors.
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Conceptual Framework
For example, Assets can be further furt her divided into Non-current assets and Current assets. These
sub-classes will NOT be treated as separate elements rather sub-classes of a particular element. How elements are to be combined to measure specific financial aspect is not mentioned in the framework rather it is mentioned in the International Accounting Accounting Standards (IASs). IASs IASs provide the instructions regarding regarding formant formant of presentation, calculations, calculations, measurement and and other accounting aspects.
3.1 Assets Definition An asset is a resource controlled by the entity as a re sult of past events and from which future economic benefits are expected to flow to the entity.
What is future economic benefit? The future economic benefit embodied in an asset is the potential to generate cash and c ash equivalents either directly or indirectly. The potential may be a productive one that is part of the operating activities of the entity. It may also take the form of convertibility into cash or cash equivalents or a capability to reduce cash outflows, such as when an alternative manufacturing process lowers the costs of production. Cash itself renders a service to the entity because of its command over other resources. Benefits can be rendered or consumed either by using, converting it to other assets or by disposing the asset.
Nature and Forms of assets Many assets possess physical form but it is not an essential feature and benefits can still be rendered out of assets known as intangible assets like patents, copyrights etc. Also some assets can be used for more than t han one accounting period whereas some assets are beneficial only for one accounting period.
Ownership versus Control – Substance over form Mostly assets are associated with their owners but ownership is not an essential evidence of existence of asset. It is the control of risks and rewards that associates the asset with a particular entity which may or may not own an asset.
Generating assets and Incurring expenditures The assets are obtained by the entity e ntity mostly through the outflow of other assets either in past or in future as a result of past events. But there are certain cases where assets are acquired by
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Conceptual Framework
the entity which may not involve an o utflow of resources such as grants. On the other hand not every outflow of resources amounts to asset. Ther e is a difference between capital c apital and revenue expenditures.
Future assets??? Future events do not amount to asset for example intention to buy asset in future does not quality for an asset just now.
3.2 Liability Definition A liability is a present obligation of the e ntity arising from past events, the settlement of w hich might require an outflow of resources from the entity embodying economic benefits.
What is obligation? An obligation is a duty or responsibility to act or perform in a certain way. Obligations may be legal i.e. enforceable under law or statute or constructive i.e. arising out of norm, business practice and customs.
Present obligation out of past An essential characteristic of a liability is that the entity has a present obligation but this present obligation has arisen out of past events. For e xample, the acquisition of goods and the use of services give rise to trade payables (unless paid for in advance or on delivery).
Outflow of resources The settlement of a present obligation usually involves involves the entity giving up resources embodying economic benefits in order to satisfy the claim of the other party. Settlement of a present obligation may occur in a number of ways, for e xample, by: (a) payment of cash; (b) transfer of other assets; (c) provision of services; (d) replacement of that obligation with another obligation; or (e) conversion of the obligation to equity. An obligation may also be extinguished by other means, such as a creditor waiving or forfeiting its rights.
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Conceptual Framework
3.3 Equity Equity is the residual interest in the assets of the entity after deducting all its liabilities. It may be sub-classified based on appropriations of retained earnings and reserves. Such classifications may be relevant to users as it indicates legal or other restric tions on entity to apply its equity. Classifications may also indicate the differing rights towards dividends and voting or repayment of contributed equity. Transfers to reserves from ret ained earnings are an appropriation and not an expense. Such transfers or appropriations from equity to the owners or others may be different for different types of entities. The amount at which equity is shown in the balance sheet is dependent on the measurement of assets and liabilities. Normally, the aggregate amount of equity only by coincidence corresponds with the aggregate market value of the shares of the entity or the sum that could be raised by disposing of either the net assets on a piecemeal basis or the entity as a whole on a going concern basis.
3.4 Income Income is an increase in economic benefits during the accounting period in the form of inflows or enhancements of assets examples include cash, receivables and goods and services received in exchange for goods and services supplied or decreases of liabilities that result in increases in equity For example, an entity may provide goods and services to a lender in settlement of an obligation to repay an outstanding loan. However income is an increase in equity other than those relating to contributions from equity participants. The definition of income encompasses both revenue and gains. Revenue arises in the course of t he ordinary activities of an entity and is referr ed to by a variety of different names including sales, fees, interest, dividends, royalties and rent. Gains represent other items that meet m eet the definition of income and may, or may not, arise in the course of the ordinary activities act ivities of an entity. For example gain on disposal of fixed asset. Gains represent increases in economic benefits and as such ar e no different in nature from revenue. Hence, they are not regarded as constituting a separate element in this Framework . Gains also include unrealised gains for example revaluation gain on non-current asset. It is unrealised as it is not included in the profit and loss.
Reporting gains When gains are recognised in the income statement, they are usually displayed separately because knowledge of them is useful for the purpose of making economic decisions. Gains are often reported net of related expenses.
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Conceptual Framework
3.5 Expenses Expenses are decreases in economic eco nomic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that re sult in decreases in equity, other than those relating to distributions to equity participants. The definition of expenses encompasses losses as well as those e xpenses that arise in the course of the ordinary activities of the entity. Expenses that arise in the course of the ordinary activities of the entity include, for example, cost of sales, wages and depreciation. They usually take the form of an outflow or depletion of assets such as cash and cash equivalents, inventory, property, plant and equipment. Losses represent other items that t hat meet the definition of expenses and may, or may not, arise in the course of the ordinary activities act ivities of the entity. Losses represent decreases in economic e conomic benefits and as such they are no different in nature from other expenses. Hence, they are not regarded as a separate element in this Framework . The definition of expenses also includes unrealised losses, for example, those ar ising from the effects of increases in the rate of exchange for a foreign currency in respect of the borrowings of an entity in that currency.
Reporting losses When losses are recognised in the income statement, they are usually displayed separately because knowledge of them is useful for the purpose of making economic decisions. Losses are often reported net of related income.
4 Recognition of elements of financial statements Recognition is the process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the criteria for recognition. It involves the depiction of the item in words and by a monetary amount and the inclusion of that amount in the balance sheet or income statement totals. The failure to recognise such items is not rectified by disclosure of the accounting policies used nor by notes or explanatory material.
When an item should be recognized? An item that meets t he definition of an element should be recognised if:
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Conceptual Framework (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with re liability.
Interrelationship between elements The interrelationship between the elements means that an item that meets the definition and recognition criteria for a particular element, for example, an asset, automatically requires the recognition of another element, for ex ample, income or a liability.
Future economic benefits The concept of probability is used in the recognition criteria to refer to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the entity. Assessments of the degree of uncertainty attaching to the flow of future economic benefits ar e made on the basis of the evidence available when the financial statements are prepared. For example if entity is confident of re ceiving the debts by due date then asset should be recognized. However, if entity is ce rtain otherwise that debts will not be re coverable (flow of benefits to the entity is improbable) then that part of debts will be written off as an expense.
Reliability of measurement The second criterion for the re cognition of an item is that it possesses a cost or value that can be measured with reliability. Reliable measurement does not require to have absolute reliability and it is accepted by the framework that some item requires estimation and involve judgment. However, such estimates should be reasonable.
Recognition at a later date An item that, at a particular point in time, fails to meet the recognition criteria may qualify for recognition at a later date as a result of subsequent circumstances or events.
Essential for users but not meeting criteria An item that possesses the essential characteristics o f an element but fails to meet the criteria for recognition may nonetheless warrant disclosure in the notes, e xplanatory material or in supplementary schedules. This is appropriate when knowledge of the item is considered to be relevant to the evaluation of the financial position, performance and changes in financial position of an entity by the users of financial statements.
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Conceptual Framework
4.1 Asset An asset is recognised in the balance sheet when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably. When the expenditure is incurred and t here is uncertainty regarding flow of future e conomic benefits to the entity then such expenditure will be treated as an expense.
4.2 Liabilities A liability is recognised in the balance sheet w hen it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably. r eliably. In practice, obligations under contracts that are equally proportionately unperformed are not recognized as liabilities.
4.3 Income Income is recognised in the income stateme nt when increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. This means, in effect, that recognition of income o ccurs simultaneously with the recognition of increases in assets or decre ases in liabilities. The procedures normally adopted in practice for re cognising income, for example, the requirement that revenue should be earned, are applications of the recognition criteria in this
Framework so that only those incomes are recognized which can be measured reliably with a significant degree of certainty.
4.4 Expenses Expenses are recognised in the income statement when decrease in future eco nomic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. This means, in effect, that recognition of e xpenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets (for example, the accr ual of employee entitlements or the depreciation of equipment).
Expenses and matching principle Expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning o f specific items of income. This process, commonly referred to as the matching of costs with revenues, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other
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Conceptual Framework
events; for example, the various components of expense making up the cost of goods sold are recognised at the same time as the income derived from the sale of the goods. However, the application of the matching concept under this Framework does not allow the recognition of items in the balance sheet which do not meet the definition of assets or liabilities.
Expenses associated with long term assets When economic benefits are expected to arise over several accounting periods and the association with income can only be broadly or indirectly determined, expenses are recognised in the income statement on the basis of systematic and rational allocation procedures. This is often necessary in recognising the expenses associated with the using up of assets such as property, plant, equipment, goodwill, patents and trademarks; in such cases the expense is referred to as depreciation or amortisation. These allocation procedures are intended to recognise expenses in the accounting per iods in which the economic benefits associated with these items are consumed or expire.
When expenditure becomes expense? An expense is recognised immediately in the income statem ent when expenditure produces no future economic benefits or when, and to the extent that, future economic benefits do not qualify, or cease to qualify, for recognition in the balance sheet as an asset. An expense is also recognised in the income statement in t hose cases when a liability is incurred without the recognition of an asset, as when a liability under a product warranty arises. An expense is also recognised in the income statement in those cases when a liability is incurred without the recognition of an asset (eve n when there is no expenditure incurre d in past or cost converted into expense), as when a liability under a product warranty arises.
5 Measurement of elements What is measurement? Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statement.
Basis of measurement A number of different measurement bases ar e employed to different degrees and in varying combinations in financial statements. They include the following: (a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to ac quire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange fo r the obligation,
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Conceptual Framework or in some circumstances (for example, income taxes), at the amounts of cash or c ash equivalents expected to be paid to satisfy the liability in the normal course of business.
(b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently. (c) Realisable (settlement) value. Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their set tlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business. (d) Present value. Assets are carried at the present discounted value of the future net cash inflows that the item is expected expect ed to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business. The measurement basis most commonly adopted by entities in preparing their financial statements is historical cost. This is usually combined with other measurement bases. For example, inventories are usually carried at the lower of cost and net realisable value, marketable securities may be carried at market value and pension liabilities are carried at their present value. Furthermore, some entities use the current cost basis as a response to the inability of the historical cost accounting model to deal with t he effects of changing prices of non-monetary assets.
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5
Borrowing Costs
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5
Borrowing Costs
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5
Borrowing Costs
1 Introduction – Borrowing Borrowing Costs A common question is that if asset is ac quired by taking a loan then what is the acco unting treatment of interest paid on the t he loan applied for acquisition or construction of asset? This matter is dealt in IAS 23 Borrowing cost.
1.1 Core principle for recognition Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset form part of the cost of that asset. a sset. Other borrowing costs are recognised as an expense in the period in which they are incurred However, this standard does not deal with the recognition of following costs: a.
actual or imputed cost of equity, including preferred capital not classified as a liability.
b. borrowing costs directly attributable to the acquisition, construction or production of: i.
a qualifying asset measured at fair value, for ex ample a biological asset; or
ii.
inventories that are manufactured, or otherwise produced, in large quantities on a repetitive basis.
What are borrowing costs? Borrowing costs are interest and other costs that an entity incurs in connection with the borrowing of funds.
What is qualifying asset? A qualifying asset is an asset that nece ssarily takes a substantial period of time to get ready for its intended use or sale. Depending on the c ircumstances, any of the following may be qualifying assets: (a) inventories (b) manufacturing plants (c) power generation facilities (d) intangible assets (e) investment properties.
What is NOT a qualifying asset? (a) Financial assets, (b) Inventories that are manufactured, or otherwise produced, over a short period of time. (c) Assets that are ready for their intended use or sale when acquired are not qualifying assets (assets acquired by retailer)
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Borrowing Costs
2 Borrowing costs eligible for capitalisation 2.1 Eligibility criteria 1. Borrowing costs must be directly attr ibutable to the asset and can be measured reliably 2. Borrowing costs were incurred t owards on borrowings that were applied on acquisition, construction or production of asset and it is probable that future economic benefits will flow to the entity 3. Directly attributable borrowing costs are those costs that would have been avoided if the expenditure on assets had not been made. expenditures that have resulted in payments of cash, transfers of other assets or the assumption of interest-bearing liabilities for the acquisition, construction or production of asset. 4. Asset must be a qualifying asset If all of the conditions stated above ar e met only then borrowing costs can be capitalized otherwise it will be expensed i.e. accounted for in profit and loss account.
2.2 Specific and General borrowings If entity has made borrowings specifically for a qualifying asset the n borrowing costs incurred that are directly attributable are readily identifiable and the all of the actual borrowing costs incurred towards such borrowings are eligible for capitalization. However, if the entity has temporarily invested part of such specific borrowings and has earned an income then such income shall be offset ag ainst the actual costs incurred towards borrowing and the net amount will be capitalised. In some cases, applies funds on qualifying asset out of the loans w hich were not acquired specifically for a qualifying asset rather to meet different obligations. Such borrowings are general borrowings and are often with different interest rates. To overcome the difficulty, entity uses a single capitalization rate which is weighted average of the borrowing costs incurred on outstanding borrowings during the period. Any income earned on temporary investment out of general borrowings shall not be cancelled out against borrowing cost on general borrowings The borrowing costs capitalized shall not exceed the borrowing cost incurred during the period. In other words the maximum borrowing cost eligible for capitalization is the actual amount incurred.
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Borrowing Costs
2.3 Use of judgement IAS 23 recognises the fact that borrowing arrangements or the way borrowings are applied to the qualifying assets may get so complex that it is difficult to determine the amount of borrowing costs attributable to qualifying asset. In such case entity is allowed to exercise judgement to determine amount of borrowing to be capitalized. Examples are: Loans taken in foreign currency or linked to foreign currency where exchange rate fluctuates significantly. Parent has borrowed money on different rates and then lends the same to subsidiaries on varying conditions.
3 Commencement of capitalisation An entity shall begin capitalising borrowing costs as part of the c ost of a qualifying asset on the commencement date. The commencement date for capitalisation is the date when the entity first meets all of the following conditions: (a) it incurs expenditures for the asset; (b) it incurs borrowing costs; and (c) it undertakes activities that are nece ssary to prepare the asset for its intended use or sale. The activities necessary to bring the asset in useful or saleable conditions include technical and administrative work prior to the commencement of physical construction of the asset. However, it does not include such period of t ime when there is no such production or development is taking place that changes asset’s condition. Any borrowing cost incurred for incurred for such period is not eligible for capitalization.
3.1 Government grants and progress payments If entity receives any progress payment or government grant against the ex penditures on the qualifying asset then the total expenditures will be reduced w ith the same. Borrowing cost for capitalization purposes on expenditures incurred shall be determined after such progress payments and government grants are dealt with according to entity’s accounting policies.
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Borrowing Costs
4 Suspension of capitalisation An entity shall suspend capitalisation of borrowing costs during extended periods in which it suspends active development of a qualifying asset. An entity may incur borrowing costs during an e xtended period in which it suspends the activities necessary to prepare an asset for its intended use or sale. Such costs are costs of holding partially completed assets and do not qualify for capitalisation.
4.1 When capitalization is NOT suspended? 1. When entity is carrying out significant technical and administrative work 2. When delay is part of the construction or production of asset to bring the asset into useful or saleable condition. Or such delay is normal for the process.
5 Cessation of capitalization An entity shall cease capitalising borrowing costs when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete. Routine administrative work may still continue even after asset is com plete for use or sale then capitalisation should stop. Also, minor adjustments or final touches might still be left to be done and asset is already ready for use or sale then capitalization must stop.
5.1 Assets consisting of different independent parts or levels When an entity completes the construction co nstruction of a qualifying asset in parts and each part is capable of being used while construction continues on other parts, t he entity shall cease capitalising borrowing costs when it completes substantially all the activities necessary to prepare that part for its intended use or sale.
6 Disclosures An entity shall disclose: (a) the amount of borrowing costs capitalised during the period; and (b) the capitalisation rate used to determine the amount of borrowing costs eligible for capitalisation.
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Construction Contracts
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Construction Contracts
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Construction Contracts
1 Introduction: A battle of PRUDENCE and ACCRUAL/MATCHING ACCRUAL/MATCHING concepts Prudence concept dictates very basic principle about recognition/realization of income and expenses in the financial statements. According to prudence one must record the expenses when expenses when he anticipates that there can be an outflow of resources. However, income should be recognized only when it is certain. So in other words it suggests that one must always be on side of safety, if uncertainty prevails over incomes, it will be better to report understated profits instead of overstated profits. profits. Things were simple and we were able to apply the prudence concept to virtually every business transaction to compute revenue and expenses to be recognized till we came across such transactions which take longer than than 1 year to complete. Let’s rephrase it, such transactions which are initiated and will terminate with in one financial year, it is really easy to determine whether there will be profit or loss b e f o r e w e prepare financial statements as everything remains within the time frame to be as reported in financial statement. However, when transactions takes more than 1 financial period to complete, we face a dilemma a s t r a n s ac ac t i o n n o t y e t c o m p l e t e (r (r e n d e r i n g n o c l u e a b o u t p r o f i t o r l o s s ) a n d t i m e t o p r e p a r e f i n a n c i a l s t a t em em e n t a r r i v e d . So accountants faced a problem that how the revenues, costs, profits and losses for such transaction should be reported as by the time of making of financial statement we are not sure about there final result or precisely, we had no means to measure the profit or loss to be recognized midway of the transaction. This call was answered by an amendment in few standards and now we have heading in IAS – IAS – 18 18 Rendering of Services and introduction of IAS – 11 – 11 Construction Contracts etc. The underlying concept of recognizing the profits or losses related to transactions spanned over more than one financial period (for example construction of a building) is that we must recognized associated revenues and costs according to matching or accrual principle. principle . If we follow the prudence concept than we must recognize the revenues and profits, only after the contract is completed. This has two undesired consequences: 1. Profits of the company in the year contract is completed will seems to be unnaturally high suddenly which can cause false alarms among users of financial statements that why it went so high in just one year.
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Construction Contracts 2. As the contract has been carried out NOT in NOT in one financial period than its revenue and costs should also not be recognized in one financial period i.e. year of completion.
The solution is that we must follow the accrual concept and must recognize the revenues and costs in the relevant period but this could have created a room for creative accounting as as with no policy regarding the recognition and measurement of revenue and costs it would be really subjective and managements of the companies can measure the figures at their free will and still claiming that it is a reliable measure. To control this, a systematic approach of measurement was required this is where the concept of stage of completion came completion came into existence.
2 Construction Contracts – defined defined A construction contract is a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use. A construction construction contract contract is a contract: contract: 1. Specifically negotiated for for 2. The construction of an asset (one) (one) or a combination of assets (more) assets (more) 3. that are closely interrelated or interdependent in interdependent in terms of their: i. Design ii. Technology and function iii. Ultimate purpose or use S p e c i f i c a llll y n e g o t i a t e d means contract is a resultant of a particular proposal and
particular set of negotiation meetings and in the end particular acceptance for the same. Construction of an asset or a c a c o m b i n a t i o n o f as as s e t s means contract may be negotiated for a single asset such as building, dam, tunnel etc. And it can also be related to construction of different pieces e.g. cement mixing plant is one big contract in which so many machineries need to be erected and many buildings, it is still one contract though the assets to be constructed are more than one. C l o s e l y i n t e r r e l a t ed ed o r i n t e r d e p e n d e n t means the whole contract is either of same
design e.g. design e.g. housing colony, technology and function or their ultimate purpose or use e.g. same cement mixing plant we discussed above.
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Construction Contracts
3 Construction Contracts – Types Types According to IAS 11, Construction Construction contract contract can be one of the following following types; 1. Fixed price contract 2. Cost plus contract A f i x e d p r i c e c o n t r a c t is a construction contract in which the contractor agrees to a fixed contract price, price , or a fixed rate per unit of output , output , which in some cases is subject to cost escalation clauses. A c o s t p l u s c o n t r a c t is a construction contract in which the contractor is reimbursed for allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee.
4 ‘Combining’ and ‘Segmenting’ a construction contract Usually the conditions of IAS 11 applies to every contract individually i.e. every contract is assumed to be separate from other contracts. However, sometimes it is necessary to: T r e at at o n e c o n t r a c t a s s e p a r a t e c o n t r a c t s when a contract covers a number of assets,
the construction of each asset shall be treated as a separate construction contract when: 1. separate proposals have been submitted for each asset; 2. each asset has been subject to separate negotiation and the contractor and customer have been able to accept or reject that part of the contract relating to each asset; and 3. the costs and revenues of each asset can be identified. T r e at at a g r o u p o f c o n t r a c t s a s o n e c o n t r a c t , WHETHER WITH A SINGLE
CUSTOMER OR WITH SEVERAL CUSTOMERS, shall be treated as a single construction contract when: 1. the group of contracts is negotiated as a single package; 2. the contracts are so closely interrelated that they are, in effect, part of a single project with an overall profit margin; and 3. the contracts are performed concurrently or in a continuous sequence. A contract may provide provide for the c o n s t r u c t i o n o f a n a d d i t i o n a l a s s e t at at the option of the customer or may be amended to include the construction of an additional asset. The construction of the additional asset shall be treated as a separate construction contract when: 1. the asset differs significantly in design, technology or function from the asset or assets covered by the original contract; or 2. the price of the asset is negotiated without regard to the original contract price.
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Construction Contracts
5 Contract Revenue and Contract Cost 5.1 Contract revenue According to IAS 11 C o n t r a c t R e v e n u e comprises of the following: 1. The initial amount of revenue agreed in the contract 2. Changes in revenue arising from arising from (provided that amounts can be measured reliably): i. Claims Claims (e.g. (e.g. an amount customer seeks to collect from client or another party as reimbursement reimburseme nt for costs not included in contract, for example any disputed change in contract, loss borne by the contractor due to delayed payment from client etc) However, it can be included in contract revenue only when there is a great probability that customer will accept the claim and amount of claim can be measured reliably ii. Incentive payments (e.g. client agreed on a bonus of 20% of total contract price for early completion of contract) However, it can be included in contract revenue only when there is a great probability that performance standard will be met and amount of incentive can be measured reliably iii. Variations in contract work (e.g. contractor is building a stadium and now client wants him to build 2 additional spectator stands, thus changing the scope of contract as additional work will be carried out against additional fee) However , revenues arising from variation can only be recognized only there is a probability that customer will approve the variation and will also agree on additional price to be charged , secondly that amount of revenue can be measured reliably. reliably.
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Construction Contracts
5.2 Contract cost ////////////// ///////////// / EXTRA Costs that relate directly to the specific contract can be reduced reduced by by any incidental income e.g. by selling surplus material or gain on disposal of plant and equipment used at construction site
According to IAS 11 C o n t r a c t C o s t comprises of the following: 1. Costs that r e l a t e d i r e c t l y t o t h e s p e c i f i c c o n t r a c t (e.g. (e.g. site labour cost, material used in construction, cost of hiring plant and equipment including its deprecation etc) 2. Costs that are a t t r i b u t a b l e t o c o n t r a c t a c t i v i t y i n g e n e r a l and can be allocated to the contract ; (e.g. insurance costs, cost of design expert assistance not specifically for a particular contract, borrowing cost); and 3. Such other costs as are s p e c i f i c a l l y c h a r g e a b l e t o t h e c u s t o m e r under the terms of the contract. (e.g. such costs which have been agreed to be reimbursed by the customer as agreed in contract. It can include general administration costs)
6 Recognition of Contract Revenue and Cost Accounting Accounting treatment treatment for recognizing recognizing revenue revenue and cost depends depends on whether whether outcome outcome of the contract can be estimated reliably or not.
YES! Outcome can be estimated reliably Outcome of the contract is Profit The revenue and cost to be recognized will will be computed according to stage . o f c o m p l e ti ti o n
Outcome of the contract is Loss W h o l e am am o u n t o f anticipated loss should be recognized as an expense in in the immediately
period in which such expectation is formed irrespective of the fact: Whether the work on contract has commenced Stage of completion of contract
NO! Outcome cannot be estimated reliably Cost incurred is
Cost incurred is
Recoverable
NOT Recoverable
Revenue to be recognized will be equal to cost incurred
Revenue to be recognized will be equal to amount recoverable
Cost to be recognized will be equal to cost incurred
Cost to be recognized will be equal to cost incurred
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Construction Contracts How to Know Outcome of the contract can be measured reliably?
Fixed Price Contract 1. 2.
3.
4.
Total contract revenue can be measured reliably; It is probable that the economic benefits associated with the contract will flow to the entity; Both the contract costs to complete the contract and the stage of contract completion at the end of the reporting period can be measured reliably; and The contract costs attributable to the contract can be clearly identified and measured reliably so that actual contract costs incurred can be c ompared with prior estimates.
Cost Plus Contract 1.
2.
It is probable that the economic benefits associated with the contract will flow to the entity; and The contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably.
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7
Leases
CHAPTER CHA PTER
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Leases
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7
Leases
1 What is Lease? A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time. The definition of a lease includes contracts for the hire of an asset that contain a provision giving the hirer an option to acquire title to the asset upon the fulfilment of agreed conditions. These contracts are sometimes known as hire purchase contracts.
1.1 Types of leases There are two types of lease agreements mentioned under IAS 17: 1. Finance lease 2. Operating lease A finance lease lease is a lease that transfers substantially all the risks and r ewards incidental to ownership of an asset. Title may or may not eve ntually be transferred. An operating lease is a lease other than a finance lease.
2 Classification of leases The type of leasing agreement a n entity has entered into is identified on the basis of the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee.
Risks include the possibilities of losses from: 1. idle capacity 2. technological obsolescence 3. variations in return because of changing economic conditions
Rewards may be represented by: 1. the expectation of profitable operation over the asset’s economic life 2. gain from appreciation in value 3. realisation of a residual value.
A lease is classified as a finance lease if it transfers substantially all all the risks and rewards rewards incidental to ownership.
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Leases
A lease is classified classified as an operating lease if it does not transfer substantially all the risks and and rewards incidental to ownership.
2.1 Additional guidance on classification IAS 17 recognises the fact that certain lease agreement can be so complex that it is not easily determinable whether a lease is a finance or an operating lease. Therefore it provides additional guidance. IAS 17 has mentioned several conditions and any of such conditions and indications either individually or in combination is present in the lease agreement then it is considered as a finance lease which are as follows: (a) the lease transfers ownership of the asset to the lessee by the end of the lease term; (b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at t he time the option will be exerc ised and at the inception of the lease it is reasonably certain that option to purchase the asset will be exercised by the lessee; (c) the lease term is for the major part of the economic life of the asset even if title is not transferred; (d) at the inception of the lease the present value of the minimum lease payments amounts is equal to fair value or significantly close to fair value in amount (e) the leased assets are of such a specialised nature that only the lessee can use them without major modifications. (f) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation cancellation are borne by the lessee; (g) gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example, in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); (h) the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent. However, these indications, conditions and examples must not be considered as a conclusive evidence to determine the type of lease agreement rather the circumstances should be taken as a whole to correctly understand the type of the lease agreement.
When the classification of lease is done? The determination whether risks and rewards has been t ransferred or not should be done at the
inception of lease .
2.2 Changes in provision of lease agreement AFTER classification If at any time the lessee and the lessor agree to t o change the provisions of the lease, other t han by renewing the lease, in a manner that would have resulted in a different classification of the
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Leases
lease under the criteria in paragraphs 7 –12 –12 if the changed terms had been in effect at the inception of the lease, the revised agreement is regarded as a new agreement over its term (which may require a different accounting treatment as opposed to accounting treatment before such changes in provisions) However, changes in estimates (for example, changes in estimates of the economic life or of the residual value of the leased property), or changes in circumstances (for example, default by the lessee), do not give rise to a new classification of a lease for accounting purposes.
3 Lease including both land and building 3.1 Implications for classification of lease When a lease includes both land and buildings elements, an entity assesses the classification of each element as a finance or an operating lease separately in accordance with the relevant provision of IAS 17 (para 7-13). In determining whether the land el ement is an operating or a finance lease, an important consideration is that land normally has an indefinite economic life. For a lease of land and buildings in which the amount that would initially be recognised for the land element is immaterial, the land and buildings may be tr eated as a single unit for the purpose of lease classification and classified as a finance or operating lease. In such a case, the economic life of the buildings is regarded as the economic life of the entire leased asset .
3.2 Implications for minimum lease payments Whenever necessary in order to classify and account for a lease of land and buildings, the minimum lease payments (including any lump-sum upfront payments) are allocated between the land and the buildings elements in proportion to the relative fair values of the leasehold interests in the land element and buildings element of the lease at the inception of the lease. If the lease payments cannot be allocated reliably between these two elements, the entire lease is classified as a finance lease, unless it is clear that both elements are operating o perating leases, in which case the entire lease is classified as an operating lease.
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Leases
4 Finance leases accounting ACCA F7 syllabus requires accounting for leases in the books of lessee. As no c lear reference has been made about the accounting for leases in the books of lessor, therefore, we will concentrate only on the accounting for leases from the perspective of lessee
4.1 Finance lease – initial recognition Lessees shall recognise finance leases as assets and liabilities in their statements of financial position at amounts which is lower of:
Fair value the leased property; and
Present value of minimum lease payments
Present value of minimum lease payments is calculated using interest rate implicit in the lease. If it is impracticable then lessee’s incremental borrowing rate shall be used for discounting. Important point to note is that re cognition is done at the commencement of the lease term whereas, the values to be used for recognition are determined at the inception of lease.
4.1.1 Initial direct costs Any initial direct costs of the lessee are added to the amount recognised as an asset. Initial direct costs are often incurred in connection with specific leasing activities, such as negotiating and securing leasing arrangements. The costs identified as directly attributable to activities performed by the lessee for a finance lease are added to the amount reco gnised as an asset.
4.1.2 Presentation of liabilities for leased assets It is not appropriate for the liabilities for leased assets to be presented in the financial statements as a deduction from the leased assets. If for the presentation of liabilities in the statement of financial position a distinction is made between current and no n-current liabilities, the same distinction is made for lease liabilities.
4.2 Finance lease – subsequent measurement
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Leases
4.2.1 Finance charge Minimum lease payments shall be apportioned between the finance charge and the reduction of the outstanding liability. The finance charge shall be allocated to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability. In practice, in allocating the finance charge to periods during the lease term, a lessee may use some form of approximation to simplify the calculation. There are several methods to split finance charge and principal components in the lease r entals.
4.2.2 Depreciation A finance lease gives rise to de preciation expense for depreciable asset w hich should be accounted for according to IAS 16 and and IAS 38. The depreciable policy for the leased asset shall be consistent with the policy applicable to assets owned by the lessee. If there is reasonable certainty cer tainty that the lessee will obtain ownership by the e nd of the lease term, the period of ex pected use is the useful life of the asset; otherwise the asset is depreciated over the shorter of the lease term and its useful life.
4.2.3 Why not simply record rentals payable as expense? The sum of the depreciation expense for the asset and the finance expe nse for the period is rarely the same as the lease payments payable for the period, and it is, therefore, inappropriate simply to recognise the lease payments payable as an ex pense. Accordingly, the asset and the related liability are unlikely to be equal in amount after t he commencement of the lease term. ter m.
4.2.4 Impairment of leased asset To determine whether a leased asset has become impaired, an entity applies IAS 36 Impairment
of Assets .
4.2.5 Contingent rent Contingent rents shall be charged as e xpenses in the periods in which they are incurred
CHAPTER
7
Leases
5 Effect of misclassification misclassification Under finance lease the lessee is r equired to record the acquired asset in his books and the corresponding liability at the commencement of lease. If such lease transactions are not r eflected in the lessee’s statement stateme nt of financial position, the economic resources and the level of o bligations of an entity are understated, thereby distorting financial ratios. Therefore, it is appropriate for a finance lease to be recognised in the lessee’s statement of financial position both as an asset and as an obligation to pay future lease payments. At the commencement of the lease term, the asset and the liability for the future lease payments are recognised in the st atement of financial position at the same amounts except for any initial direct costs o f the lessee that are added to the amount recognised as an asset.
6 Operating leases accounting Lease payments under an operating lease shall be recognised as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit. For operating leases, lease payments (excluding costs for services such as insurance and maintenance) are recognised as an expense o n a straight-line basis unless another systematic basis is representative of the time pattern of the user’s benefit, even if the payments are not on that basis.
7 Disclosures – Finance Finance lease Lessees shall make the following disclosures for finance leases: (a) for each class of asset, the net carrying amount at the end of the reporting period. (b) a reconciliation between the total of future minimum lease payments at the end of the reporting period, and their present value. In addition, an entity shall disclose the total of future minimum lease payments at the end of the reporting period, and their present value, for each of the following periods: i.
not later than one year;
ii.
later than one year and not late r than five years;
iii.
later than five years.
(c) contingent rents recognised as an e xpense in the period. (d) the total of future minimum sublease payments expected to be received under noncancellable subleases at the end of the reporting period.
CHAPTER
7
Leases (e) a general description of the lessee’s material leasing arrangements including, but not limited to, the following: i.
the basis on which contingent rent payable is determined;
ii.
the existence and terms of renewal re newal or purchase options and escalation clauses; and
iii.
restrictions imposed by lease arrangements, such as those concerning dividends, additional debt, and further leasing.
In addition, the requirements for disclosure in accordance with IAS 16, IAS 36, IAS 38, IAS 40 and IAS 41 apply to lessees for assets leased under finance leases.
8 Disclosures – Operating Operating lease Lessees shall make the following disclosures for operating leases: (a) the total of future minimum lease payments under non-cance llable operating leases for each of the following periods: i.
not later than one year;
ii.
later than one year and not late r than five years;
iii.
later than five years.
(b) the total of future minimum sublease payments expected to be received under noncancellable subleases at the end of the reporting period. (c) lease and sublease payments recognised as an expense in the period, with separate amounts for minimum lease payments, contingent rents, and sublease payments. (d) a general description of the lessee’s significant leasing arrangements including, but not limited to, the following: i.
the basis on which contingent rent payable is determined;
ii.
the existence and terms of renewal r enewal or purchase options and escalation clauses; and
iii.
restrictions imposed by lease arrangements, such as those concerning dividends, additional debt and further leasing.
CHAPTER
8
Non-current Non-current Assets held for sale & Discontinued operations
CHA HAPTER PTER
8
Non-current Non-current Assets held for sale & Discontinued operations
CHAPTER
Non-current Non-current Assets held for sale & Discontinued operations
8
1 Introduction to IFRS 5 The objective of this IFRS is to specify the accounting for assets held for sale , and the presentation and disclosure of discontinued operations. This IFRS requires that: a.
assets that meet the criteria to be classified as held for sale to be presented separately in the statement of financial position; and
b. the results of discontinued operations to be presented separately in in the statement of comprehensive income.
Asset held for sale An asset (or disposal group) whose carrying amount will be re covered principally through sale rather than through usage of the asset.
Disposal group A group of assets to be disposed of, by sale or otherwise, toge ther as a group in a single transaction, and liabilities directly associated with those assets that will be transferred in the transaction.
2 Classification as non-current asset held for sale An entity shall classify a non-current asset (or disposal group) as held for sale if its carrying amount will be recovered principally through a sale transaction rather t han through continuing use.
2.1 Criteria - important To classify as held for sale the asset (or disposal group) (a) must be available for immediate sale in its present condition; and (b) its sale must be highly probable .
2.1.1 When the sale is considered highly probably? For the sale to be highly probable, (a)
the appropriate level of management must be
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8
Non-current Non-current Assets held for sale & Discontinued operations (b)
committed to a plan to sell the asset (or disposal group), and
(c)
an active programme to locate a buyer and complete the plan must have been initiated. Further,
(d)
the asset (or disposal group) must be actively marketed for sale at a price that is reasonable in relation to its current fair value.
(e)
the sale should be expected to qualify for recognition as a completed sale within one year from the date of classification,
(f)
actions required to complete the plan should indicate that it is unlikely that significant changes to the plan will be made o r that the plan will be withdrawn
(g)
The probability of shareholders’ approval (if required in the jurisdiction) should be considered as part of the assessment of whether the sale is highly probable.
Exception: Extension Exception: Extension in period of sale beyond one year Events and circumstances may cause the sale of asset to be delayed beyond one year. However, this will not prevent the entity to classify asset as held for sale if the events were beyond entity’s control and entity is still committed to se ll the asset. However this exception is only available if the events and c ircumstances causing delay are arisen in the following situations: Expected conditions on transfer of asset The date when sale of non-current asset was committed it was expected that parties other than buyer will impose condition on transfer of asset. To respond such conditions a firm purchase commitment is required which is highly probable within in one year Unexpected conditions on transfer A firm purchase commitment was obtained but still buyer or others imposed conditions on transfer of non-current asset. However, actions have bee n taken in response to conditions on timely basis and a favourable resolution to factors causing delay is expected Unlikely situations During initial one-year period unlikely situations have arisen due to which asset held for sale is not sold by the end of the period. However, necessary actions have been taken in response to changing circumstances and asset. The asset is still available for imme diate sale is being actively marketed at a price reasonable in the changed circumstances and the sale is highly probable.
Sale transaction Sale transactions include exchanges of non-current assets for other non-current assets when the exchange has commercial substance in accordance with IAS 16 Property, Plant and Equipment.
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8
Non-current Non-current Assets held for sale & Discontinued operations
2.2 Timing of classification A non-current asset meant for subsequent disposal can be classified as held for sale at the date of acquisition ONLY IF: (a) sale transaction is expected to complete within one year of such classification; c lassification; and (b) it is highly probable that if any other conditions of the criteria are not met at that date will be met within a short period following acquisition (usually (usually within in three months) That means relaxation can be given for other conditions for a short period of time if one -year requirement is fulfilled at the date of acquisition.
Criteria met after the reporting period If the criteria are met after the reporting period, an entity shall NOT classify a non-current asset (or disposal group) as held for sale in those financial statements when issued. However, when those criteria are met after the reporting re porting period but before the authorisation of the financial statements for issue, the entity shall disclose (not classify) the following information: (a) a description of the non-current asset (or disposal group); (b) a description of the facts and circumstances of the sale, or leading to the t he expected disposal, and the expected manner and timing of t hat disposal; (c) if applicable, the reportable segment in which the non-current asset (or disposal group) is presented in accordance with IFRS 8 Operating Segments .
2.3 Non-current assets that are to be abandoned An entity shall NOT classify as held for sale such non-current asset (or disposal group) that is to be abandoned. Non-current assets (or disposal groups) to be abandoned include: (a) non-current assets (or disposal groups) that are to be used to the end of t heir economic life; and (b) non-current assets (or disposal groups) that are to be closed rather than sold. However, if the disposal group to be abandoned meets the definition of discontinued operation, the entity shall present the results re sults and cash flows of the disposal group as discontinued operations at the date on which it ceases to be used. In simple words non-current assets to be abandoned shall not be classified as held for sale but can be classified as discontinued operation.
A non-current asset that has been bee n temporarily taken out of use cannot account for as abandoned.
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8
Non-current Non-current Assets held for sale & Discontinued operations
3 Measurement of non-current assets held for sale An entity shall measure a non-current asset (or disposal group) classified as held for sale at the lower of its carrying amount and fair value less costs to sell. If the asset (or disposal group) is acquired as part of a business combination, it shall be measured at fair value less costs to sell. When the sale is expected to occur beyond one year, the entity shall measure the costs to sell at their present value. Any increase in the present value of the costs to sell se ll that arises from the passage of time (unwinding of discount) shall be treated as finance cost and reported in profit and loss. Immediately before the initial classification of asset as held for sale, its carrying amount should be measured in accordance with applicable IFRSs. For example asset will be first measured under IAS 16 and then this t his carrying amount i.e. cost will be used for measurement purposes in classification as held for sale
3.1 Accounting for Impairment An entity shall recognise an impairment loss for any initial or subsequent write -down of the asset (or disposal group) to fair value less costs to sell An entity shall recognise gain for any subsequent increase in fair value less costs to sell se ll of an asset, but not in excess of o f the cumulative impairment loss that has been recognised either in accordance with this IFRS or previously in accordance with IAS 36 The adjustments of impairment loss or reversals in carrying amount o f a disposal group shall be recognized in the order specified in IAS 36. A gain or loss not previously recognised by the date of the sale of a non-current asset (or disposal group) shall be recognised at the date of derecognition. An entity shall not depreciate (or amortise) a non-current asset while it is classified as held for sale or while it is part of a disposal group classified as held for sale. Interest and other expenses attributable at tributable to the liabilities of a disposal group classified as held for sale shall continue to be r ecognised.
CHAPTER
8
Non-current Non-current Assets held for sale & Discontinued operations
4 Changes to sale plan If an entity has classified an asset (or disposal group) as held for sale, but the cr iteria are no longer met, the entity shall cease to classify the asset (or disposal group) as held for sale. The entity shall measure a non-current asset t hat ceases to be classified as held for sale (or ceases to be included in a disposal group classified as held for sale) at the lower of: (a) its carrying amount adjusted for depreciation, amortization or revaluation had i t not been classified as held for sale. and (b) its recoverable amount at the date of the subsequent decision not to sell. The adjustments to the carrying amount of the asset that ceases to be classified as held for sale shall be included in profit and loss from continuing operations.
5 Presentation and disclosure – Assets held for for sale (a) An entity shall present a non-current asset classified as held for sale and the assets of a disposal group classified as held for sale separately from other assets in the statement of financial position. (b) The liabilities of a disposal group classified as held for sale shall be pre sented separately from other liabilities in the statement of financial position. (c) Those assets and liabilities shall not be offset and presented as a single amount. (d) The major classes of assets and liabilities classified as held for sale shall be separately disclosed either in the statement of financial position or in the notes (e) An entity shall present separately any cumulative income or expense recognised in other comprehensive income relating to a non-c urrent asset (or disposal group) classified as held for sale. (f) Any gain or loss on the remeasurement reme asurement of a non-current asset (or disposal group) classified as held for sale that does not mee t the definition of a discontinued operation shall be included in profit or loss from continuing operations.
Additional disclosures An entity shall disclose the following information in the notes in the period in which a noncurrent asset (or disposal group) has been e ither classified as held for sale or sold: (a) a description of the non-current asset (or disposal group); (b) a description of the facts and circumstances of the sale, or leading to the t he expected disposal, and the expected manner and timing of that disposal;
CHAPTER
8
Non-current Non-current Assets held for sale & Discontinued operations (c) the gain or loss related to impairment losses or reversals, if not separately presented in the statement of comprehensive income then reference to the caption in the statement of comprehensive income that includes that gain or loss; (d) if applicable, the reportable segment in which the non-current asset (or disposal group) is presented in accordance with IFRS 8 Operating Segments .
An entity shall disclose, in the period of the decision to change the plan to sell the non-current asset (or disposal group), a description of the facts and circ umstances leading to the decision and the effect of the decision on the results of operations for the per iod and any prior periods presented.
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8
Non-current Non-current Assets held for sale & Discontinued operations
5.1 Statement of financial position with assets held for sale ABC Company Statement of financial position as at _____________ Assets Non-current assets Goodwill
X
Property, Plant and equipment
X X
Current assets Inventory
X
Trade receivables
X
Cash
X X
Non-current asset held for sale
X X
Total assets
X
Equity Share capital
X
Share premium
X
Revaluation surplus
X
Amount recognized in other comprehensive income directly associated with non-current asset held for sale
X
Total equity
X
Liabilities Non-current liabilities Loans
X
Deferred tax liabilities
X X
Current liabilities Trade payables
X
Tax payable
X X
Liabilities directly associated with non-current asset held for sale
X X
Total liabilities
X
Total equity and liabilities
X
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8
Non-current Non-current Assets held for sale & Discontinued operations
6 Classification of discontinued operation A discontinued operation is a component of an entity that either has been disposed of, or is classified as held for sale, and (a) represents a separate major line of business or geographical area of operations, (b) is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of operations or (c) is a subsidiary acquired exclusively with a view to resale. A component of an entity comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. In other words, a component of an entity will have been a cash-generating unit or a group of cash-generating units while being held for use
7 Presentation and Disclosure – discontinued operation An entity shall disclose: (a) a single amount in the statement of comprehensive income comprising the total of: a.
the post-tax profit or loss of discontinued operations and
b. 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. (b) an analysis of the single amount in (a) into: a.
the revenue, expenses and pre-tax profit or loss of discontinued operations and the related income tax expense
b. the gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of the assets or disposal group(s) constituting the discontinued operation; and the related income tax expense The analysis may be presented in the notes or in the statement of comprehensive income or in a separate income statements in a section identified as r elating to discontinued operations i.e. separate from continuing operations. (c) the net cash flows attributable to t he operating, investing and financing activities of discontinued operations either in the notes or cash flow statement
CHAPTER
8
Non-current Non-current Assets held for sale & Discontinued operations
Adjustments in the current period to amounts previously presented in discontinued operations that are directly related to the t he disposal of a discontinued operation in a prior period shall be classified separately in discontinued operations. The nature and amount of such adjustments shall be disclosed. Examples of circumstances in which these adjustments may arise include the following: (a) the resolution of uncertainties that arise from t he terms of the disposal transaction, such as the resolution of purchase price adjustments and indemnification issues with the purchaser. (b) the resolution of uncertainties that arise from and are directly related to the operations of the component before its disposal, such as e nvironmental and product warranty obligations retained by the seller. (c) the settlement of employee benefit plan o bligations, provided that the settlement is directly related to the disposal transaction. If an entity ceases to classify a component of an entity as held for sale, the results of operations of the component previously presented in discontinued operations shall be reclassified and included in income from continuing operations for all periods presented. The amounts for prior periods shall be described as having been re-presented.
CHAPTER
8
Non-current Non-current Assets held for sale & Discontinued operations
7.1 Income Statement with Discontinued operations ABC Company Income Statement for the year ended _____________ _____________ Results from continuing operations Revenue
X
Cost of sales
(X)
Gross profit
X
Other income
X
Distribution costs
(X)
Administrative expenses
(X)
Other expenses
(X)
Profit before tax
X
Income tax
(X)
Profit from continuing operations
(X)
Results from discontinued operations Profit/loss from discontinued operations Profit for the year
X/(X) X
CHAPTER
8
Non-current Non-current Assets held for sale & Discontinued operations
7.2 Statement of Comprehensive income with Discontinued operations ABC Company Statement of comprehensive income for the year ended _____________ _____________ Results from continuing operations Revenue
X
Cost of sales
(X)
Gross profit
X
Other income
X
Distribution costs
(X)
Administrative expenses
(X)
Other expenses
(X)
Profit before tax
X
Income tax
(X)
Profit from continuing operations
(X)
Results from discontinued operations Profit/loss from discontinued operations Profit for the year
X/(X) X
Other comprehensive income Gain/loss on disposal on fixed asset revaluation Changes in revaluation surplus Total comprehensive income for the year
X X/(X) X
CHAPTER
9
Accounting for Government Government Grants
CHAPTER CHA PTER
9
Accounting for for Government Government Grants
CHAPTER
9
Accounting for Government Government Grants
1 Government Grants The terms like grants and subsidies are common and almost everyone is aware of them as t hese terms are often told and discussed in news. Government can support business entities in many different ways and if the information pertaining to such financial support is not reasonably reported in the financial statements, then users might confuse the financial effects of grants w ith the financial effects normal business operations. Therefore, guidance was required on this matter so that financial statements are more understandable and useful for comparison purposes. Government grants and other types of g overnment assistance are dealt in IAS 20 - Accounting
for government grants and disclosure of government assistance.
1.1 Scope of IAS 20 This Standard shall be applied:
in accounting for, and in the disclosure of, government gr ants and
in the disclosure of other forms of government assistance.
However IAS 20 does not deal with: (a) the special problems arising in accounting for government grants in financial statements reflecting the effects of changing c hanging prices or in supplementary information of a similar nature. (b) tax related government assistance income tax holidays reduced income tax rates etc (c) government participation in the ownership of the entity. (d) government grants covered by IAS 41 Agriculture Agriculture.
2 Government grants - defined Government grants (a.k.a. subsidies, subversions or premiums) are assistance by government in the form of transfers of resources re sources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity. However, they exclude the following:
government assistance which cannot reasonably be monetized
transactions with government which cannot be distinguished from the normal trading transactions of the entity (e.g. selling goods to government)
CHAPTER
9
Accounting for Government Government Grants
Government assistance is action by government designed to provide an economic benefit specific to an entity or range of entities. However, it does not include benefits provided by government which indirectly favours the trading operations or conditions of the entity for example imposition of trading constraints on competitors
Government refers to:
government,
government agencies; and
similar bodies whether local, national or international
Government assistance takes many forms varying both in the nature of the assistance given and in the conditions which are usually attached to it. By nature, government assistance can either be grants (monetary or non-monetary) or any assistance in monetary or non-monetary form such as tax reduction, forgivable loans, interest free loans etc. The purpose of the assistance may be to encourage an entity to embark em bark on a course of action which it would not normally have taken if the assistance was not provided. For example, government wishes to increase urea production in the country and for t his government offers subsidies, tax exemptions on imports of raw material and spare parts etc. This facility can either be provided to specific company or range of companies producing urea.
3 Types of grants Grants related to assets are government grants whose primary condition is that an e ntity qualifying for them should purchase, construct or otherwise acquire long-term assets. Subsidiary conditions may also be attached restricting the type or location of the assets or the periods per iods during which they are to be acquired or held.
Grants related to income are government grants other than those related to assets.
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9
Accounting for Government Government Grants
4 Accounting for government grants 4.1 Recognition criteria Government grants, including non-monetary grants at fair value, shall not be recognised until there is reasonable assurance that: (a) the entity will comply with the conditions attaching to t hem; and (b) the grants will be received. Receipt of a grant does not of itself provide conclusive evidence that the conditions attaching to the grant have been or will w ill be fulfilled. The manner in which a grant is received does not affect the accounting method to be adopted in r egard to the grant. Thus a grant is accounted for in the same manner whether it is received re ceived in cash or as a reduction re duction of a liability to the government.
4.2 Approaches to the accounting for government grant There are two broad approaches to the accounting for government grants:
the capital approach, under which a grant is recognised outside profit or loss i.e. credited to stakeholder’s equity and
the income approach, under which a grant is recognised in profit or loss over one or more periods i.e. credited to the income statement or statement of comprehensive income (whichever is applicable)
Those in support of the capital approach argue as follows: (a) government grants are a “financing device” (i.e. a mode to help financially) and should be dealt with as such in the statement of financial position rather than be recognised in profit or loss to offset the items of expense that they finance. Bec ause no repayment is expected, such grants should be recognised outside profit or loss. (b) They are simply incentives without related costs and not e arned Arguments in support of the income approach are as follows: (a) because government grants are receipts from a source other than shareholders, they should not be recognised directly in equity (b) The entity earns them through compliance with t heir conditions.They should therefore be recognised in profit or loss using systematic basis (c) Just like taxes which are treated as expense, grants should be treated as income.
CHAPTER
9
Accounting for Government Government Grants
Which approach to be followed? According to para 12, IAS 20 requires entities to use income approach which is as follows:
Government grants shall be recognised in profit or loss on a systematic basis over the periods in which the the entity recognises as expenses expenses the related costs for for which the grants are intended to compensate. As per income approach grants should be recognized in profit or loss on systematic basis in which grants are matched with the portion of related costs recognized as expense in the profit or loss. Recognition of government grants in profit or loss on a receipts basis is NOT in accordance with the accrual accounting assumption and would be acceptable only if no basis existed for allocating a grant to periods other t han the one in which it was rec eived.
Heading 5 through 7 might be confusing for some students. Important thing to recognize in the financial remember is that heading 5 and 6 will discuss what to recognize present in the financial statements statements whereas heading 7 will discuss how to present in
5 Grants under different situations 5.1 Grants related to specific expenses Grants in recognition of specific expenses are recognised in profit or loss in the same per iod as the relevant expenses i.e. by matching grants with related costs recognized in the period as
expense
5.2 Grants related to depreciable assets Grants related to depreciable assets are usually recognised in profit or loss over the per iods and in the proportions in which depreciation expense on those assets is recognised. In simple words the allocation basis used for computing depreciation are used for determining the grant to be recognized.
5.3 Grants related to non-depreciable assets Grants for non-depreciable asset are recognized in profit and loss by matching grants with costs incurred in the period to meet the conditions and requirements of the grant package As an example, a grant of land may be conditional upon the erection of a building on the site and it may be appropriate to rec ognise the grant in profit or loss ov er the life of the building.
CHAPTER
9
Accounting for Government Government Grants
5.4 Grants received as financial aid Grants are sometimes received as part of a package of financial or fiscal aids to which a number of conditions are attached i.e. one grant package has different components or conditions and therefore appropriate amount of grant is allocated to each requirement and (as per the situation) separate systematic basis are used to determine the grant to be recognized in respect re spect of each component or conditions.
5.5 Government grant received as compensation A government grant that becomes receivable as compensation for expenses or losses already incurred or for the purpose of giving immediate financial support to the entity with no future related costs shall be recognised in profit or loss of the period in which it becomes receivable.
6 Non-monetary government grants A government grant may take the t he form of a transfer of a non-monetary asset, such as land or other resources i.e. non-cash, for the use of the entity. In such cases both grant and asset can be valued using any of the two methods:
Usually fair value of non-monetary asset is assessed and used to account for both grant and asset
Alternatively nominal value of non-monetary asset can be used to re cord both asset and grant
7 Presentation of grants 7.1 Presentation of grants related to assets Government grants related to assets can c an be presented in statement of financial position in either of the following two ways: (a) setting up the grant as deferred income i.e. grant will be recognized over the useful life of the asset on systematic basis (b) deducting the grant in arriving at the carrying amount of the asset i.e. grant will be recognized in the profit and loss over the useful life of depreciable asset as a reduced depreciation expense According to the standard both methods are acceptable alternatives.
CHAPTER
9
Accounting for Government Government Grants
Presentation in statement of cash flows The purchase of assets and the rece ipt of related grants can cause major movements in the cash flow of an entity. For this reason such movements are often disclosed as separate items irrespective of the treatment in the t he statement of financial position.
7.2 Presentation of grants related to income Grants related to income are sometimes presented in the statement of comprehensive income or income statement in in one of the following ways and both m ethods are appropriate: (a) as a credit: o
separately (separate line item) or
o
under a general heading such as ‘ Other income’ (in accumulated form);
(b) deducted in reporting the related expense i.e. related expense will be reduced by the grant recognized Supporters of the first method claim that netting the effect is inappropriate as it hampers the comparability of financial information For the second method it is argued that entity would have not incurred an expe nse in the absence of grant therefore net results should be reported otherwise it may be misleading
8 Repayment of government grants 8.1 Principle A government grant that becomes repayable shall be accounted for as a change in accounting estimate according to IAS 8. Usually grant becomes repayable if conditions of grant package ar e not fulfilled. For example, entity was required to continue the business operations for five years after the receipt of grant but it stopped its operations after two years.
8.2 Repayment of a grant related to income Repayment of a grant related to t o income shall be applied in the following manner:
Firstly against any unamortised deferred credit recognised in r espect of the grant; then
To the extent that the repayment exceeds any such deferred credit, or when no deferred credit exists, the repayment shall be recognised immediately in profit or loss.
CHAPTER
9
Accounting for Government Government Grants
8.3 Repayment of a grant related to an asset Repayment of a grant related to t o an asset shall be recognised in the following manner:
Increase the carrying amount of the asset or reduce the deferred income balance by the amount repayable.
The cumulative additional depreciation that would have been recognised in profit or loss to date in the absence of the grant shall be r ecognised immediately in profit or loss.
Circumstances giving rise to repayment of a grant related to an asset may require consideration to be given to the possible impairment of the new carrying amount of the asset.
9 Government assistance As stated earlier that government grant is a type of government assistance but the assistance of any the following nature is excluded from the definition of government grants:
government assistance which cannot be monetized e.g. provision of guarantees; and
transactions with government which cannot be distinguished from the normal trading transactions of the entity (e.g. selling goods to government)
However if benefit derived from such assistance is significant then the nature and extent should be disclosed
10 Disclosures The following matters shall be disclosed: (a) the accounting policy adopted for government grants, including the methods of presentation adopted in the financial statements; (b) the nature and extent of o f government grants recognised in the financial statements (c) unfulfilled conditions and other contingencies attaching to grants recognize
CHAPTER
10
Events after the reporting period
10
CHA HAPTER PTER
Events after the Reporting period
CHAPTER
10
Events after the reporting period
1 Events after the reporting period Events after the reporting period are those events, favourable and unfavourable, that occur between:
the end of the r eporting period and
the date when the financial statements are authorised for issue.
Two types of events can be identified: (a) those that provide evidence of conditions that existed at the end of the reporting period (adjusting events after the reporting period); and (b) those that are indicative of conditions that arose after the reporting period (nonadjusting events after the reporting period).
1.1 Authorizing financial statements to be issued The process involved in authorising the financial statements for issue will vary depending upon: (a) the management structure, (b) statutory requirements; and (c) procedures followed in preparing and finalising the financial statements.
Approval from Shareholders In some cases, an entity is required to submit its financial statements to its shareholders for approval after the financial statements have been issued. In such cases, the financial statements are authorised for issue on the date of issue, not the date when shareholders approve the financial statements.
Issued to supervisory body In some cases, the management of an entity is required to issue its financial statements to a supervisory board (made up solely of non-executives) for approval. In such cases, the financial statements are authorised for issue when the management authorises them for issue to the supervisory board.
Events after the reporting period include all events up to the date when the financial o ccur after the public announcement statements are authorised for issue, even if those events occur of profit or of other selected financial information.
CHAPTER
10
Events after the reporting period
2 Adjusting events 2.1 Principle An entity shall adjust the amounts recognised in its financial statements to reflect adjusting events after the reporting period.
2.2 Examples The following are examples of adjusting events after the reporting period that require an entity to adjust the amounts recognised in its financial statements, or to recognise items t hat were not previously recognised: (a) court order confirmed the present obligation at the end of reporting period and might require recognition or adjustment of provision (b) The asset needs to be impaired or impairment recognized needs to be revised on receipt of latest information. For example: i.
Bankruptcy confirmed the loss of receivables
ii.
Lower Net realisable value as a r esult of lower selling price of inventory sold
(c) Any adjustment necessary in the cost o f the asset bought before reporting date but cost determined after reporting date. Similarly, adjust needed in the sales proceeds from the asset sold before reporting date but sale finalized after the reporting date (d) Determination of profit sharing or bonus payments after reporting pe riod because of present or constructive obligation that arise due to the events took place before the end of reporting period (e) the discovery of fraud or errors that show that the financial statements are incorrect.
3 Non-adjusting events 3.1 Principle An entity shall not adjust the amounts recognised in its financial statements to reflect nonadjusting events after the reporting pe riod.
3.2 Examples The following are examples of non-adjusting events after the reporting period that would generally result in disclosure (i.e. no adjustments but only disclosures if material): (a) a major business combination or disposing of a major subsidiary
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Events after the reporting period (b) announcing a plan to discontinue an operation; (c) major purchases of assets, classification of assets as held for sale other disposals of assets, or expropriation of major assets by government; (d) the destruction of a major production plant by a fire; (e) announcing, or commencing the implementation of, a major restructuring (f) major ordinary share transactions and potential ordinary share transactions (g) abnormally large changes in asset prices or foreign exchange rates; (h) changes in tax rates or tax laws enacted or announced that have a significant effect on current and deferred tax assets and liabilities (i) entering into significant commitments or contingent liabilities, for example, by issuing significant guarantees; (j) commencing major litigation arising solely out of events that occurr ed after the reporting period.
4 Dividend If an entity declares dividends to holders of equity instruments after the reporting period, the entity shall not recognise those dividends as a liability at the end of the reporting period. If dividends are declared after the reporting period but before the financial statements are authorised for issue, the dividends are not recognised as a liability at the end of the r eporting period because no obligation exists at that time. Such dividends are disclosed in the notes in accordance with IAS 1
5 Going concern An entity shall not prepare its financial statements on a going concern basis if management determines after the reporting period either that it intends to liquidate the entity or to cease trading, or that it has no realistic alternative but to do so. This requires change in the basis of accounting rather than adjustments to previously recognized figures. In addition to that IAS 1 disclosure requirements also needed to be fulfilled i.e.:
financial statements are not prepared on going-concern basis
management is aware of such events that cast significant doubts on entity’s ability to be remain going concern (which may arise after the reporting period)
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Events after the reporting period
6 Disclosures (a) An entity shall disclose the date when t he financial statements were authorized for issue including: i.
who gave that authorisation.
ii.
If the entity’s owners or others have the power to amend amend the financial statements after issue
(b) The entity shall update disclosures relating to conditions that existed at reporting date in the light of new information received after the reporting date. (c) Non-adjusting events of material nature could influence the use of financial statements. Therefore, entity should disclose the following for each material category of nonadjusting event after the reporting period: i.
The nature of the event
ii.
Estimated financial effect or disclaimer of such an estimate
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Impairment of Assets
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Impairment of Assets
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Impairment of Assets
1 Introduction One of the problems in using historical cost basis to value assets is that with the passage of t ime the carrying amount of asset may become significantly different from the recoverable amount. Recoverable amount in simple words mean the monetary value of benefits that can be rendered from the asset. Therefore, if the carrying amount of asset in the statement of financial position is not a reasonable expression of benefits it can render than financial information may become unreliable. This issue has been taken in IAS 36 Impairment of assets prescribes the procedures that an entity applies to ensure that its assets are carried at no more than their recoverable amount.
1.1 Bottom line principle Carrying amount of the asset should not excee d its recoverable amount An asset is carried at more than its recoverable amount if its carrying amount exce eds the amount to be recovered through use or sale of the asset. If this is the case, the asset is described as impaired and the Standard requires the e ntity to recognise an impairment loss.
1.2 IAS 36 - Scope Apart from setting out principles regarding asset’s impairment, this t his standard also discusses when the impairment loss already recognized is to be reversed. This Standard shall be applied in accounting for the impairment of all assets including the following financial assets classified as subsidiaries, associates and joint ventures. However, this standard does not apply to such assets for which existing IFRSs prescribes valuation procedures i.e.: 1. Inventories 2. assets arising from construction contracts 3. deferred tax assets 4. assets arising from employee benefits 5. financial assets that are within the scope of IFRS 9 6. financial assets other than subsidiaries, associates and joint ventures for which IAS 39 is applicable 7. investment property that is measured at fair value 8. biological assets measured at fair value less costs to sell 9. deferred acquisition costs, and and intangible assets, arising from an insurer’s contractual rights under insurance contracts
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Impairment of Assets 10. non-current assets classified as held-for-sale
2 Impairment 2.1 Principle An asset is impaired when its carrying amount excee ds its recoverable amount.
2.2. Identifying impairment An entity shall assess at the end of each reporting period whether there is any indication that an asset may be impaired. If any such indication exists, the e ntity shall estimate the recoverable amount of the asset. With few exce ptions, entity is not required to formally make an e stimate of recoverable amount in the absence of indications.
2.2.1 Exceptions to assessment For certain assets entity is required to make formal estimates of recove rable amount irrespective of indications i.e. even if there are no indications still the estimate will be made which are as follows: 1. Intangible assets with indefinite useful life 2. Intangible asset not yet available for use 3. Goodwill acquired in business combination
2.3 Indicators of impairment Indications of impairment may come from a source outside the entity or within the entity. According to the standard entity is r equired to consider, as a minimum, following indications:
2.3.1 Indications from external sources 1. Decline in market value which is significantly larger than the expected decline due to normal usage and passage of time 2. Significant changes in technological, market, economic or legal environment adversely affecting the entity 3. Increase in market interest rate thus increasing the discount factor that decreases the value in use which ultimately cause decrease in asset’s recoverable amount. 4. Carrying amount of net assets exceeds m arket capitalization i.e. aggregate market value of entity’s shares is lesser than the book value of its net assets. assets.
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Impairment of Assets
2.3.2 Indications from internal sources 1. Obsolescence or physical damage 2. Significant changes to the extent t o which or the manner in which asset is used or expected to be used thus adversely affecting the entity i.e. idle, restructuring, disposal, reassessed as finite asset. 3. Worse than expected economic performance of an asset. The above list of indicators is not exhaustive and entity may identify other indications of impairment requiring assessment of recoverable amount. For example, significant imbalance in cash (inflows and outflows) flowing from the asset contrary to the expectations.
Additional considerations of indications If there is an indication of possible impairment then it may also indicate that adjustments are required in the following: 1. Remaining useful life, 2. Depreciation (amortization) rate or method, or 3. Residual value of asset
3 Measuring recoverable amount Recoverable amount of an asset is HIGHER of: a) Fair value less cost to sell b) Value in use If either of these values exceeds asset’s carrying carrying amount then asset is not impaired and estimating the other amount is not necessary. Fair value less cost to sell may be determinable even if it is not traded in active market. However if reliable estimates cannot be made then e ntity may take value in use use as asset’s recoverable amount. In cases (e.g. asset held for disposal) when the re is no reason to believe that value in use materially exceeds fair value less cost to sell (as future cash flows from continuing use are negligible and mainly consists of disposal di sposal proceeds) then asset’s fair value less cost to sell may be used as recoverable amount.
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Impairment of Assets
3.1 Recoverable amount of indefinite intangible asset Intangible assets with indefinite useful life are required to be tested annually irrespective of indications of impairment. However, preceding period’s recoverable amount calculations can be used for current period’s impairment testing purposes if: a) Intangible asset is impairment tested as part of a cash generating unit (CGU) and asset s and liabilities constituting CGU have not changed significantly since the most recent recoverable amount calculation b) Recoverable amount exceeded the asset’s carrying amount substantially in most recent calculations. c)
Analysis of events and circumstances since last calculation show that probability of asset’s carrying amount exceeding its curre nt recoverable amount is remote
3.2 Fair value less cost to sell IAS 36 stated the following instructions to determine fair value less cost to sell: a) The best evidence is the price in a binding sale agreement less directly attributable disposal costs. b) In the absence of sale agreement, asset’s current market price (or price from most recent transaction if appropriate) less cost to sell. c)
In the absence of sale agreement and active market for an asset, fair value less cost to sell is based on the best information available to entity considering the industry estimates.
d) Fair value less cost to sell does not reflect forced sale unless management is compelled to sell immediately Costs of disposal, other than those that have been recognised as liabilities, are deducted in determining fair value less costs to sell. Examples are: a) legal costs, b) stamp duty and similar transaction taxes, c)
costs of removing the asset,
d) direct incremental costs to bring an asset into saleable condition. However disposal costs exclude: a) termination benefits b) reorganising costs of business following the disposal of an asset
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Impairment of Assets
3.3 Value in use The following points must be considered while calculating value in use: (a) estimate of the future cash flows the entity expects to generate from the asset; (b) possibility of variations in the amount or timing of those future cash flows; (c) the time value of money, represented by the current market risk-free rate of interest; (d) the cost of uncertainty inherent in the asset; and (e) other appropriate factors that needs to be considered Estimating the value in use of an asset involves the following steps: (a) estimating the future cash flows generated from continuing use of the asset AND through disposal; and (b) discounting future cash flows.
3.3.1 Future cash flows – Basis In estimating future cash flows: (a) The calculations should be based: a.
on reasonable and supportable assumptions based on management’s best estimate of economic conditions that will exist over the remaining useful life of the asset
b. on most recent budgets/forecasts approved by the manageme nt excluding cash flows from restructuring or improving/enhancing asset (b) For projections, budgets and forecasts should cover period of five years at max unless a longer period is justified. (c) Extrapolate the projections based on periods beyond five year s using a steady or declining growth rate. Increasing rate c an be used if justified but not excee ding longterm average growth rate of the product, industry, country or countries in which the entity operations unless higher rate is justified. Its upon management to assess the reasonableness r easonableness of the assumptions on which its current cash flow projections are based by ex amining the causes of differences between past cash flow projections and actual cash flows.
3.3.2 Composition of estimates of cash flows Estimates of future cash flows shall include: (a) projections of cash inflows from the continuing use of the asset;
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Impairment of Assets (b) projections of cash outflows that are necessarily incurred to generate the cash inflows from continuing use of the asset e.g. servicing cost (including cash outflows to prepare the asset for use) and can c an be directly attributed, or allocated on a reasonable and consistent basis, to the asset; and (c) net cash flows, if any, to be received (or paid) for the disposal of the asset at the end of its useful life.
Future cash flows shall be estimated for t he asset in its current condition. Estimates of future cash flows shall exclude estimated future cash flows from: (a) cash flows from assets that are not dependant on assets under review to g enerate such cash flows. (b) Cash flows relating to obligations already recognized as liabilities (c) a future restructuring to which an entity is not yet committed; or (d) improving or enhancing the asset’s asset’s performance. (e) Financing activities (f) Income tax The estimate of net cash flows from the disposal of asset shall be the amount obtained from the disposal of the asset less disposal cost.
3.3.3 Foreign currency future cash flows For future cash flows generated in foreign currency, the present value is calculated in the same currency and then converted using spot rate at the date of value in use calculation.
3.3.4 Discount rate The discount rate (rates) shall be a pre-tax rate (rates) that reflect(s) current market assessments of: (a) the time value of money; and (b) the risks specific to the asset for which the future cash flow estimates have not bee n adjusted.
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Impairment of Assets
4 Impairment loss – Individual Individual assets other than goodwill The carrying amount of an asset shall be reduced to its recoverable amount if and only if carrying amount exceeds recoverable amount. The amount deducted from t he carrying amount is an impairment loss.
Non-revalued asset An impairment loss shall be recognized in profit or loss
Revalued asset If asset is revalued then impairment loss is r ecognized in other comprehensive income (simply, equity) i.e. impairment loss is set against revaluation surplus. If impairment loss exceeds the revaluation surplus then the excess amount shall be recognized in profit or loss. In case impairment loss exceeds carrying c arrying amount then entity shall recognize a liability if it is required by another Standard. If impairment is recognized: (a) Depreciation (amortization) shall be adjusted to allocate revised carrying amount (less scrap value) over its remaining useful life. (b) Deferred tax assets/liabilities shall be determined using asset’s revised c arrying amount and tax base.
5 Cash-generating unit 5.1 Problem and solution A basic principle is that if asset is impaired t hen recoverable amount is estimated for each asset individually. However, if the estimate is not possible for individual assets then recoverable amount is determined for a group o f asset taken as one unit i.e. cash-generat ing unit. The recoverable amount of an individual asset cannot be determined if: (a) asset’s value in use cannot be estimated to be close to its fair value less co sts to sell; and (b) asset does not generate cash inflows that are largely independent of those from other
assets.
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Impairment of Assets
In simple words as asset alone is not g enerating any cash and cash is flowed from the asset only when used together with other assets then the value in use for t he asset alone will not be easily determinable. For example, passenger railway can gene rate cash flows alone however, railway used for mining activities cannot generate cash flows on its own and thus value in use for the mine as a whole, to which mining railway belongs, will be determined.
5.2 Determining Cash-generating Unit A cash-generating unit is the smallest identifiable group of assets t hat generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. There are two things to understand in this definition:
Identification of an asset’s cash-generating cash-generating unit
Whether cash inflows of such asset (group assets) is independent
Identification of an asset’s cash-generating cash-generating unit involves judgement. If recoverable amount cannot be determined for an individual asset, an entity identifies the lowest aggregation of assets that generate largely independent cash inflows. In identifying whether cash inflows from an asset (or group o f assets) are largely independent of the cash inflows from other assets (or g roups of assets), an entity considers various factors including:
how management monitors the entity’s operations (such as by product lines, businesses, individual locations, districts or regional areas)
how management makes decisions about continuing or disposing dis posing of the entity’s assets and operations.
Whether active market exists for the output of asset or group of assets
Consistency Once the individual asset or group of asset is identified as a cash-generating unit then management should remain consistent from period to period and changes should be made only when there is a change in the assets or type of assets making up cash generating unit.
5.3 Carrying amount and recoverable amount of CGU To determine the recoverable amount of a CGU, same procedure is followed as applied for individual asset.
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Impairment of Assets
The recoverable amount of a CGU is higher of the following: (a) Fair value less cost to sell of CGU (b) Value in use of CGU The carrying amount of a cash-generating unit shall be determined on a basis consistent with the way the recoverable amount of t he cash-generating unit is determined. Generally, the carrying amount of CGU: 1. includes the carrying amount of only those assets t hat are directly attributable or can be allocated on reasonable basis as the inflows from only such assets will be used to determine CGU’s value in use 2. excludes the liabilities already recognized unless CGU’s recoverable amount can only be determined by including such liabilities. Recognized liability will form part of recoverable amount in situations like the buyer is required to assume the liability in which case the fair value less cost to sell of CG U will be:
Selling price of CGU + Liability taken up by the buyer – Disposal costs Sometimes CGU’s recoverable amount is determined by adding the asset’s other then CGU e.g. receivables. In this case, carrying amount of CGU will be: 1. Increased by the carrying amount of such assets 2. Decreased b the carr ying amount of such liabilities IAS 36 permits the use of most recent detailed calculation of recoverable amount of CGU in preceding period in current period for impairment test provided: (a) Composition of CGU have not changed significantly since last calculation (b) Recoverable amount exceeded carrying amount substantially in the most r ecent calculation (c) Likelihood of carrying amount exceeding recoverable amount due to c hanges in circumstances is remote.
5.4 Goodwill Goodwill is an asset representing the future eco nomic benefits arising from other assets
acquired in a business combination that are not:
individually identified and
separately recognised.
In simple words, here we are talking about purchased goodwill.
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Impairment of Assets
Goodwill: 1. does not generate cash flows independently of other assets or groups of assets, 2. often contributes to the cash flows of multiple cash-generating units. 3. sometimes cannot be allocated on a non-arbitrary basis to individual cash-generating units, but only to groups of cash-generating units
5.4.1 Allocating goodwill to CGU For impairment purposes, from the acquisition date the acquired goodwill shall be allocated to each of the acquirer’s CGU(s) CGU (s) that is expected to benefit fr om the synergies of the combination irrespective of whether other assets o r liabilities acquired are assigned to those CGU(s). Each CGU(s) to which goodwill is allocated shall: 1. represent lowest level at which g oodwill is monitored for internal management purposes 2. not be larger than an operating segment as defined under IFRS 8 If the initial accounting for a business combination can be determ ined only provisionally by the end of the period in which the combination is affected, the acquirer: (a) accounts for the combination using those provisional values; and (b) recognises any adjustments to those provisional values as a result of completing the initial accounting within 12 months period after acquisition date. If it is not possible to complete initial accounting within the specified period then this should be disclosed. If entity disposes an operation within CGU to which g oodwill has been allocated then the goodwill related to operation shall be: (a) measured on the basis of the relative re lative values of: a.
the operation disposed of and
b. the portion of the cash-generating unit r etained (b) included in the carrying amount of the operation to determine gain/loss on disposal If entity reorganizes its reporting re porting structure in a way that composition of CGU(s) to which goodwill is allocated changes then goodwill shall also be reallocated using relative value approach as used in disposal of an operating within CGU(s)
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Impairment of Assets
5.4.2 Testing CGU(s) with goodwill for impairment Related goodwill not allocated When goodwill relates to a cash-generating unit but has not been allocated to that unit, the unit shall be tested for impairment: (a) whenever there is an indication that the unit may be impaired, (b) by comparing the the unit’s carrying amount, excluding any goodwill, with its recoverable amount. However, if a CGU includes the intangible asset of the following kind then it should be impairment tested annually: (a) With indefinite asset, or not yet available for use (b) Which can only be tested for impairment as part of CGU
Related goodwill allocated A cash-generating unit to which goodwill has been allocated shall be tested for impairment (a) annually, and whenever there is an indication that the unit may be impaired, (b) by comparing the unit’s carrying amount, including the goodwill, with its recoverable amount.
5.4.3 Timing of impairment tests CGU(s) to which goodwill has been can be tested for impairment at any time during the year provided the tests are performed at the same time every year. Different CGU(s) may be tested at different times i.e. there is no compulsion that all of the CGU(s) should be tested at the same time. However, the goodwill allocated was acquired in the curre nt period then CGU shall be teste d within 12 months. If an asset within the CGU (a CGU to which goodwill is allocated) is tested for impairment at the same time the CGU is tested then asset is tested for impairment and impairment loss (if any) is recognized before CGU is tested for impairment
5.5 Corporate assets Corporate assets include group or divisional assets such as the building of a headquarters or a division of the entity, EDP equipment or a re search centre.
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Impairment of Assets
The structure of an entity determines whether an asset meets this Standard’s definition of corporate assets for a particular cash-gener ating unit. The distinctive characteristics of corporate assets are that: (a) they do not generate cash c ash inflows independently of other assets or groups of assets and (b) their carrying amount cannot be fully attributed to the cash-generating unit under review. Because corporate assets do not generate separate cash inflows, the recoverable amount of an individual corporate asset cannot be determined unless management has decided to dispose of the asset. As a consequence, if there is an indication that a corporate asset may be impaired then the CGU to which this asset belongs is tested for impairment In testing a CGU for impairment, an entity shall identify all the corporate assets that relate to CGU under review. If a portion of the c arrying amount of a corporate asset:
Can be allocated to the related r elated CGU then it is tested te sted for impairment including the portion of carrying amount of the corporate asset.
Cannot be allocated to the related CGU then: Step 1: CGU is tested for impairment excluding exc luding the corporate asset. Step 2: (a) identify the smallest group of CGU that includes: a.
The CGU under review (i.e. a CGU generating cash flows independently ); and
b. CGU to which a portion of corporate c orporate asset can be allocated (i.e. a bigger CGU that encompass both corporate asset and the CGU under review e.g. entity as a whole) (b) Test the group of units for impairment including the carrying amount of corporate asset allocated to that group g roup of units.
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Impairment of Assets
6 Impairment loss for cashgenerating unit An impairment loss is recognized if the recoverable amount of the CGU(s) is less than the carrying amount of the CGU(s) In allocating an impairment loss to the assets in the CGU(s), an entity shall not reduce the carrying amount of an asset below the highest of: (a) its fair value less costs to sell (if determinable); (b) its value in use (if determinable); and (c) zero. An impairment loss shall be allocated to reduce the carrying amounts of the assets constituting CGU(s) in the following order: (a) first, to reduce the carrying amount of any goodwill allocated to the C GU(s); and (b) then, to the other assets of the CGU(s) pro rata on the basis of the carrying amount of each asset in the CGU(s) (c) However, if an asset within the CGU (a CGU to which goodwill is allocated) is t ested for impairment at the same time the CGU is tested then asset is tested for impairment and impairment loss (if any) is recognized before CGU is tested for impairment i.e. even before reducing the carrying amount of goodwill. These reductions in carrying amounts shall be treated as impairment losses on individual assets After allocation, any remaining amount of impairment loss related to CGU(s) shall be recognized as a liability if it is required by another Standard.
6.1 Exceptions If recoverable of an individual asset in a CGU is not determinable then impairment loss is allocated on the arbitrary basis among the assets o f the CGU except goodwill. The following also applies: (a) An impairment loss is recognized if carrying amount exceeds the higher of : a.
Asset’s Fair value less cost to sell
b. The resultant carrying amount after the allocation of CGU’s impairment (b) No impairment will be recognized if related C GU is not impaired even if individual asset’s carrying amount exceeds its fair v alue less cost to sell. sell.
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Impairment of Assets
7 Reversing an Impairment loss 7.1 General principles – applicable to both asset and CGU alike At the end of eac h reporting period, an entity should assess whether there is an indication that impairment loss already recognized for an asset other t han good: (a) May no longer exist; or (b) Have decreased If any such indications exist then entity shall estimate the recoverable amount of the asset. For estimating purposes, an entity shall use the information from external and internal sources (as were discussed for impairment testing). If there is an indication that impairment loss may no longer exist or have changed then the depreciation (amortization) method or residual value may need to be adjusted even if impairment loss is not reversed. Impairment is reversed when there is a change in the estimate used to determine asset’s recoverable amount since the date last impairment loss is recognized. In this case, the carrying amount of the asset is increased to recoverable amount but not exceeding the carrying amount that asset would had if no impairment loss for the asset was recognized. However, asset’s cash flows do not increase due to unwinding of discount even if asset’s recoverable amount appears to be more t han its carrying amount.
7.2 Specific principles – Individual assets Any impairment reversal for an asset other than goodwill shall be recognized immediately in profit or loss. In case of revalued asset, impairment reversal shall be treated as revaluation increase and recognized in other comprehensive income. However, if any impairment loss related to revalued asset was recognized in profit or loss then reversal shall be made in the profit or loss to the extent loss is recognized in profit or loss.
7.3 Special principles – CGU Excluding goodwill, A reversal of an impairment loss for a c ash-generating unit shall be allocated to the assets of the unit pro rata with the carrying amounts of those assets.
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Impairment of Assets
These increases in carrying amounts shall be treated as reversals of impairment losses for individual assets and recognised accordingly. In allocating the impairment reversal, the car rying amount shall not exceed the lower o f: (a) its recoverable amount (if determinable); and (b) the carrying amount asset would had if no impairment loss been r ecognized.
7.4 Reversing an impairment – Goodwill Impairment loss related to goodwill cannot be reversed.
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Statement of Cash flows
12
CHA HAPTER PTER
Statement of Cash Flows
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Statement of Cash flows
Why Income statement is not enough? No doubt profit figures of the entity over the year provide valuable information to ascertain entity’s performance. Information regarding financial performance let the users understand how effectively and efficiently management has used the r esources at its disposal. Financial performance is also a measure of economic r esources available to the entity. Improvement in financial performance means entity’s resources has increased and is now in even better position to control more resources. On the other hand resources generate cash and cash equivalents. If we sum up, we can safely say that any change in financial performance is the result of change in resources of the entity which also means that entity’s potential to ge nerate cash flows is affected. So we understand that information regarding financial performance and cash flows of t he entity is important for the users of financial information and they cannot rely j ust on the Income statement for the following reasons: 1. Income statements are prepared on o n accrual basis instead of cash basis i.e. income is recognized when it is earned instead of when the amount is received and e xpense is recognized when it is incurred instead of when amount is paid. Due to the same re ason as the amounts of expenses and incomes are not shown on cash basis i.e. actual receipt and payments thus income statement figures are not a true representation of actual cash flows. 2. And as said earlier, increase in profit means increase in net assets. Net assets include non-current assets and current assets. Therefore, if the profit is increasing then it does not necessarily means that cash has increased it can be any asset. For example, ex ample, when sales are made on credit basis then our profits increase as we have e arned an income and on the other hand our debtors increase. This way net assets will increase but cash remains still the same. Therefore, profits calculated in the income statement do not mean equivalent increase in cash. From the above discussion we can understand that only profitable business is not enough for the stakeholders, especially shareholders as they want these profits to be converted into cash as we profits earned but distributed through cash got no worth and to pay out such profits in the form of dividend entity needs cash. Therefore, capability of entity to generate cash and cash equivalent becomes even more important profitability.
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Statement of Cash flows
Remember, companies become insolvent because they are no more capable to generate enough cash flows to pay out their liabilities on time and not the profitability. That is why you might have seen companies which are in losses for years but still operating whereas the o nes with profits most often go bankrupt. Understanding this IASB has issued an International Accounting Standard (IAS) 7 – 7 – Statement Statement of Cash flows
1 IAS 7 – Statement Statement of Cash flows As discussed earlier, for the users o f financial statements, beside profit it is important to know the capability of an entity to generate cash and cash equivalents and how such cash and cash equivalents are applied by the entity. Assessing this need of the users, IAS 7 is issued with an objective that a statement (Statement of Cash Flows) shall be prepared as part of a complete set of financial statements that summarizes the changes occurred in cash and c ash equivalents in a financial period. As this statement pertains to events already occurred in past therefore information provided by it is historical in nature.
1.1 Scope of IAS 7 IAS 7 requires every entity, no matter what business it is in, shall prepare Statement of Cash Flows as part of a complete set se t of financial statements. It is important to understand that omitting Statement of Cash Flows will render Financial Statements incomplete as per IAS 1 and IAS 7 and other applicable International Accounting Standards. In case of financial institutions for where Cash and Cash e quivalents is an inventory and as it might appear that underlying subject of both Income Stat ement and Statement of Cash Flows F lows is same therefore preparing statement of cash flows might not be necessary. IAS 7 has clearly stated that whatever activities entity might undertake to generate revenues and however the cash is considered in terms of business operations, every entity requires cash to pay its liabilities, to carry out day t o day business operations and to pay out their shareholders. Therefore, presentation how the cash has flown during the period is essential. Thus preparation of Statement of Cash Flows is mandatory and it cannot be substituted with other financial statements (like income statement as in case of banks).
1.2 Benefits of cash flow information As pointed out in the start that statement of cash flows combined with other financial statements of an entity can help provide insight about:
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Statement of Cash flows a.
the changes in net assets of the entity over a period of time
b. financial structure c.
its ability to generate cash flows, t imings of such cash flows and capacity to coup up with varying business environment
With this much information users can predict where present day value of cash flows that are expected to flow in future. One of the biggest advantages of preparing st atement of cash flows is cash receipts and payments do not get affected by the changes in accounting policies due to differences in national accounting framework or nature of the business. And such policies have deep effects on other financial statements like income statement and stateme nt of financial position. Therefore, comparing statement of cash flows of different entities over a period of time becomes fairly easy and simple. Although statement of cash flows is based on past data but even historical information can be useful for example in assessing weather last year’s expectations were met. Also how changes c hanges in cash flows and changes in overall profitability are related to each other.
2 Statement of cash flows 2.1 What is Statement of cash flows? Statement of cash flows simply summarizes the changes in c ash and cash equivalents over a period of time as a result of different business activities resulting in cash flows. For this purpose business activities are divided into three categories: a.
Operating
b. Investing c.
Financing
Cash comprises cash on hand and demand deposits. Cash equivalents are short-term, highly liquid investments that are r eadily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.
Cash flows are inflows and outflows of cash and cash equivalents. Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities.
Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
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Statement of Cash flows
Financing activities are activities that result in changes in the size and composition of the contributed equity and borrowings of the entity.
2.2 Not just Cash but Cash equivalents as well! Statement of cash flows does not only provide information on hard cash but also about cash equivalents. Cash equivalents are simply those short term investments which are held more as cash rather than as investments. Cash equivalents are:
Short term (three months or less)
High liquid investments i.e. readily convertible to known amounts of cash
Subject to insignificant risk of variations in value of investment
Any instrument or investment that fulfils the criteria will be considered as cash equivalent. for example equity shares are not cash e quivalents as they are mostly not redeemable or short term in nature or experience fluctuating redeemable value. However, if shares are acquired close to maturity then they will be t reated as cash equivalents.
2.3 Short term borrowings from bank Sometime banks allow their customers to withdraw excee ding the actual amount available or when there is no cash available in the account. This facility to withdraw surplus cash from the bank helps customers to meet urgent nee ds. This is a short term borrowing which is paid back in really short period of time. However to consider bank overdraft as cash equivalents, entity should be using this facility as part of its c ash management activity and uses it frequently causing the bank balance to fluctuate from normal (positive or cr edit balance) to overdrawn (negative or debit balance).
Effect of treating overdraft as a borrowing and cash equivalent
If overdraft is not treated treate d as cash equivalent then it will form part of short term borrowings and will presented as a financing activity in the stateme nt of cash flows.
If overdraft is treated as cash equivalent then it will be cancelled out against other cash and cash equivalents, as it is a contra balance, to arrive at the figure of net cash and cash equivalents.
2.4 Movements in cash equivalents Movements in cash and cash equivalents shall not be treated as cash flows or in other words such if a term deposit with the bank is matured and the same amount is reinvested in debentures maturing in a month time then this shall not be reported as a movement in operating, investing or financing activity on the face of statement of cash flows. This is a usual practice of entities which is known as cash management.
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Financial Instruments
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CHA HAPTER PTER
Financial Instruments
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Financial Instruments
1 Financial instruments - Introduction Financial instrument in essence is simply a contract that will ultimately result in financial asset in the hands of one party and corresponding financial liability in the hands of another party to the same contract. For example, invoice, bill receivable, promissory note, cheques are well known examples of financial instruments. However, the distinguishing factor between financial instrument and other contracts is that financial instrument needs to give rise to financial asset/liabilities instead of receiving tangible asset or set tling obligation in kind. For many students it appears to be a new contract but it really is not new as quite in the early topics of accounting we have seen examples of financial instruments but without mentioning this name. For example: (a) When goods are sold on credit then buyer and seller enter in to a contract to make the payment at a future date. Under this contract seller gains the right to receive
cash (financial asset) and buyer is under an obligation to pay cash (financial liability). Thus credit transaction of sale/purchase give rise to financial instrument. In other words trade receivables and trade payables are a result of financial instrument. Document of contract in this case will be invoice. (b) In loan agreements lender and borrower enters in to a contract under which lender has the right to rece ive specific sum of money and borrower is under an obligation to pay specific sum of money. Thus lending/borrowing gives to financial instrument. Document of contract in this case will w ill be loan agreement. (c) In case of lease, lessor has the right to receive rentals whereas lessee agrees to pay rentals at a specific date in agreed upon intervals. Thus lease agreement is an e xample of financial instrument. (d) One entity issued debentures (loan notes) to ra ise finance. The person subscribing to the bonds will be called holder of the bond. Whereas the entity issuing such bond will be called issuer of the bond. Bonds in the hands of holder are his investment and thus holds the right receive interest (if any) and the principal amount at maturity date. Whereas the entity issuing the debentures is under an obligation to pay interest (if any) and the principal amount at maturity date.
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Financial Instruments
In examples above we observe that parties settle the contract through receipt/payment of
cash. However, it is not necessary that financial instruments are settled in terms of cash alone. Cash is not the only type of financial asset. For example:
(a) An entity borrowed a long term loan from bank. On maturity date instead of paying cash, entity issued ordinary shares to the bank that is ac cepted by the bank as settlement. In this case although cash is not paid but still liability is settled as bank has accepted to take shares as consideration. Shares are also a type financial asset. (b) Entity issued convertible bonds under which the holder has the r ight to either receive the cash at the date of maturity or to have the bonds converted in ordinary shares before maturity date. In this case if the holder exercise his right of conversion then liability will stand settled on conversion of bonds to shares without any cash flow happening.
2 Financial Instruments Standards – IAS 32/IAS 39/IFRS 7/IFRS 9 Financial instruments are evolving specie in the world of business and thus standardizing such thing that is still evolving is a quite a c hallenge. For the same reason accounting world is also adapting to it. With IAS 32 and 3 9 as the first attempt we now have four different standards at the moment covering different aspects of financial instruments in bits and pieces. As of now we have four different standards as follows: IAS 32: guiding on presentation of financial instruments IAS 39: This standard is to be replaced completely by IFRS 9 in near future and thus cover those areas that are yet to be covered by IFRS 9. This relates to much important area which is recognition and measurement but only for those cases where IFRS 9 is still catching up or for which IFRS 9 is not ye t applicable. IFRS 7: details guidance on disclosures of financial instruments IFRS 9: As mentioned earlier contains c ontains guidance on measurement and recognition on financial instruments that will ultimately replace IAS 39. 2. What is financial instrument? As described in the introduction financial instrument is any contract that gives rise to a
financial asset of one one entity and a financial financial liability or equity instrument instrument of another entity
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Financial Instruments
2.1 What is financial asset? A financial asset is any asset that is: (a) cash; (b) an equity instrument of another entity; (c) a contractual right: a. to receive cash or another financial asset from another entity; or b. to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or (d) a contract that will or may be settled in the entity’s own equity equity instruments and is: a.
a non-derivative for which the entity is or may be obliged to receive a variable var iable number of the entity’s own equity instruments; instruments; or
b. a derivative that will or may be settled other than by the exchange o f a fixed amount of cash or another ano ther financial asset for a fixed fixed number of the entity’s own equity instruments.
2.2 What is financial liability? A financial liability is any liability that is: (a) a contractual obligation: a.
to deliver cash or another financial asset to another entity; or
b. to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or (b) a contract that will or may be settled in the entity’s e ntity’s own equity instruments and is: a.
a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or
b. a derivative that will or may be settled other than by the exchange o f a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.
3 Recognition and measurement As financial instruments results in assets and liabilities therefore, guidance was needed on recognition of assets/liabilities and their measurement. However, the case with financial instruments is a little different from usual assets and liabilities. We will be discussing the recognition, classification and measurement of assets and liabilities separately by dividing the discussion for each as follows: 1. Initial recognition, and initial measurement
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Financial Instruments 2. Subsequent classification and subsequent measurement 3. Derecognition
4 Financial asset 4.1 Initial recognition Financial asset is recognized in the statement of financial position when entity becomes party to the contract i.e. financial instrument.
4.2 Initial measurement All financial assets are initially measured at fair value plus any transaction cost except those that are classified as fair value through profit or loss.
4.3 Initial classification Financial assets are initially classified in accordance with their subsequent classification Financial asset at fair value through profit or loss At the initial recognition entity may specify financial asset to be m easured at fair value with gains and losses processed through profit or loss. This is usually done if entity anticipates that measuring on this basis will significantly reduce the recognition and measurement inconsistency that would have arisen if it was measured on different basis.
4.4 Subsequent classification Entity should classify financial assets as subsequently measured at either: 1. Amortized cost; or 2. Fair value Decision regarding the basis of measurement to be used is made considering two factors: 1. Entity’s business model for managing financial assets 2. Contractual cash flow characteristics of financial asset To learn more about business model and contractual cash flow c haracteristic please read end of chapter appendix.
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Financial Instruments
4.4.1 Classified as measured at amortized cost A financial asset shall be classified at amortized cost if both o f the following conditions are satisfied: 1. The asset is held by the entity e ntity that has a business model to hold until maturity to co llect contractual cash flow 2. Contractual cash flow consists of repayment of principal amount and interest on principal amount only. Measuring asset at amortized cost implies the use of effective interest rate that helps reconcile and account for the future value and present value of financial asset.
4.4.2 Classified as measured at fair value Financial asset shall be measured at fair value if any of the above two conditions are not me t i.e. financial assets that are not measured at amortized cost are measured at fair value. This implies that any gain or loss arising on financial asset that are measured at fair value will be processed through profit or loss account (i.e. income statement)
5 Financial Liabilities 5.1 Initial recognition Financial liability is recognized in the statement of financial position when entity becomes party to the contract i.e. financial instrument.
5.2 Initial measurement All financial assets are initially measured at fair value minus any transaction cost except those that are classified as fair value through profit or loss.
5.3 Subsequent classification and measurement Financial liabilities are classified at amortized cost using an effective interest method except for: 1. Financial liabilities at fair value through profit and loss (FVPL) 2. Transfer of financial asset not qualifying for derecognition or continuing involvement approach applies 3. Financial guarantee contracts 4. Commitments to provide a loan at below market rate
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Financial Instruments
5.3.1 Financial liabilities at fair value through profit or loss Financial liabilities are measured at fair value through profit or loss if: 1. Instrument is held essentially for trading instead of collecting cash flow at maturity. 2. It is a derivative liability 3. At initial recognition entity has specified instrument to be m easured at fair value through profit or loss
5.3.2 Transfers not qualifying derecognition If entity has not transferred substantially all the risks and rewards associated with the financial asset then entity will continue to re cognize it as asset and recognize liability for consideration received. The entity shall recognize asset to the extent it has continuing involvement and also recognize associated liability where measurement is done as follows: 1. If transferred asset is measured at amortized cost then retained asset and associated liability is measured at amortized cost 2. If transferred asset is measured at fair value then retained asset and liability measured at value equal to fair value of r ight and liability.
5.3.3 Financial guarantee contracts Such financial instruments shall be measured at a higher of: 1. The amount determined as per the r ule laid down in IAS 37 2. The amount initially recognized less cumulative amortization recognized as per I AS 18 where appropriate.
5.3.4 Commitment to provide loan at below market rate After the initial recognition issuer of such commitment shall subsequently measure it at higher of: 1. The amount determined as per the r ules laid down in IAS 37 2. The amount initially recognized less cumulative amortization recognized as per IAS 18 where appropriate
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Financial Instruments
Appendix Entity’s business model For the purpose of financial assets’ measurement IFR S 9 requires analysis of entity’s business model to determine whether entity’s object ive is to hold to hold financial assets to collect contractual cash flows. Every entity needs not to be running business with an objective to receive contractual cash flows. Business model is not about the intentions of management regarding particular instrument. It is about how entity is being operated i.e. objectives and decisions of key management personnel. In simple words business model is not determined by assessing intentions of management regarding each financial asset rather how t hey are managed overall. Entity needs not to have a single business model and for the same reason no single classification entity wide. One entity may have diverse investment portfolio with one portfolio of asset held for collection at maturity and the other for trading. Similarly if entity’s business model is to hold asset until maturity does not imply that it has to hold all of the asset until they are mature. Entity may sell an asset if: 1. Financial asset is no longer in accordance with e ntity’s policies e.g. credit rating of asset fell fell below entity’s minimum requirement 2. Entity needs to finance non-current assets However, if sales prior to maturity rose beyond a frequent number of assets then entity needs to assess if such sales are in line with its objective to hold asset till maturity .
Cash flow characteristics of asset Just like in business model, in assessment regarding cash flow characteristics of asset entity is required to determine if cash flows are only for: 1. The repayments of principal amount 2. The interest on the principal amount outstanding For the purpose of assessment, interest is consideration only for: 1. Time value of money 2. Risk associated with the principal amount outstanding
