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Published by AccountingTools, Inc., Centennial, Colorado.

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ISBN-13: 978-1-64221-017-0
Printed in the United States of America
Table of Contents
Chapter 1 - Introduction
What is IFRS?
The IFRS Conceptual Framework
How this Book is Organized
How to Use this Book
Accounting Principles
Chapter 2 - Presentation of Financial Statements
Overview of the Financial Statements
The Statement of Financial Position
The Standard Balance Sheet Format
The Common Size Balance Sheet
How to Construct a Balance Sheet
Overview of the Statement of Profit or Loss
Presentation by Nature or Function
The Single-Step Income Statement
The Multi-Step Income Statement
The Contribution Margin Income Statement
The Multi-Period Income Statement
How to Construct the Income Statement
Overview of the Statement of Changes in Equity
Income Statement Disclosures
Chapter 3 - Statement of Cash Flows
Overview of the Statement of Cash Flows
The Direct Method
The Indirect Method
How to Prepare the Statement of Cash Flows
Disclosures for the Statement of Cash Flows
Chapter 4 - Consolidated and Separate Financial Statements
The Control Concept
Consolidation Accounting
Separate Financial Statements
Chapter 5 - Accounting Policies, Estimate Changes and Errors
Accounting Policies
Changes in Accounting Estimates
Errors
 Impracticability of Application
Disclosures for Policies, Estimate Changes, and Errors
Accounting Policies
Changes in Accounting Estimates
Errors
Chapter 6 - Financial Reporting in Hyperinflationary Economies
Overview of Hyperinflationary Reporting
Net Monetary Position
Comparative Information
Initial Restatement
Consolidation Issues
Termination of Hyperinflationary Period
Historical Presentation
Hyperinflationary Reporting Disclosures
Chapter 7 - Earnings per Share
Basic Earnings per Share
Diluted Earnings per Share
Disclosure of Earnings per Share
Chapter 8 - Interim Financial Reporting
Overview of Interim Financial Reporting
Content of an Interim Financial Report
Reduced Information Requirements
General Interim Reporting Rule
Goodwill Impairment Losses
Interim Period Restatements
The Integral View
Chapter 9 - Operating Segments
Overview of Segment Reporting
Segment Disclosure
Segment Disclosure
Revenue Disclosure
Geographic Area Disclosure
Chapter 10 - Joint Arrangements
Overview of Joint Arrangements
Financial Statement Presentation of Joint Arrangements
Chapter 11 - Investments in Associates and Joint Ventures
Investments in Associates and Joint Ventures
 Significant Influence
The Equity Method
Members’ Shares in Cooperative Entities
Disclosures
Chapter 12 - Disclosure of Interests in Other Entities
Overview of Interests in Other Entities
Interests in Subsidiaries
Interests in Joint Arrangements and Associates
Interests in Unconsolidated Structured Entities
Chapter 13 - Inventories
Overview of Inventory
The Periodic Inventory System
The Perpetual Inventory System
Inventory Costing
The First In, First Out Method
The Last In, First Out Method
The Weighted Average Method
Standard Costing
The Retail Inventory Method
The Gross Profit Method
Overhead Allocation
Net Realizable Value
Accounting for Obsolete Inventory
Work in Process Accounting
Inventory Measurement by Commodity Broker-Traders
Inventory Disclosures
Chapter 14 - Property, Plant, and Equipment
Recognition of Property, Plant and Equipment
Subsequent Fixed Asset Recognition
The Cost Model
The Revaluation Model
Depreciation
Straight-Line Method
Sum-of-the-Years’ Digits Method
Double-Declining Balance Method
Depletion Method
Units of Production Method
 Land Depreciation
Land Improvement Depreciation
Depreciation Accounting Entries
Derecognition of Property, Plant and Equipment
Compensation for Impaired Assets
Decommissioning Liabilities
Decommissioning Funds
Property, Plant and Equipment Disclosures
Chapter 15 - Intangible Assets
Overview of Intangible Assets
Accounting for Intangible Assets
Intangible Assets Acquired in a Business Combination
Internally Developed Intangible Assets
Other Forms of Intangible Asset Acquisition
Subsequent Intangible Asset Recognition
The Cost Model
The Revaluation Model
Intangible Asset Derecognition
Web Site Costs
Additional Intangible Asset Issues
Intangible Asset Disclosures
Chapter 16 - Investment Property
Overview of Investment Property
Accounting for Investment Property
Investment Property Transfers
Investment Property Disposals
Investment Property Disclosures – Fair Value Model
Investment Property Disclosures –Cost Model
Chapter 17 - Impairment of Assets
Overview of Asset Impairment
Indications of Impairment
Timing of the Impairment Test
Recoverable Amount
The Impairment Test
The Cash-Generating Unit
Asset Impairment Reversals
Other Impairment Topics
 Corporate Assets
Goodwill Allocation to Cash-Generating Units
Impairment Testing Efficiencies
Asset Impairment Disclosures
Chapter 18 - Assets Held for Sale and Discontinued Operations
Accounting for Non-Current Assets Held for Sale
Disclosure of Non-Current Assets Held for Sale
Disclosure of Discontinued Operations
Chapter 19 - Provisions, Contingent Liabilities and Contingent Assets
Overview of Provisions
Accounting for Provisions
The Provision for Restructuring
Accounting for Contingent Liabilities
Accounting for Contingent Assets
Accounting for Reimbursements
Accounting for Levies
Disclosure of Provisions and Contingent Items
Chapter 20 - Revenue from Contracts with Customers
The Nature of a Customer
Steps in Revenue Recognition
Step One: Link Contract to Customer
Step Two: Note Performance Obligations
Step Three: Determine Prices
Variable Consideration
Possibility of Reversal
Time Value of Money
Noncash Consideration
Payments to Customers
Refund Liabilities
Step Four: Allocate Prices to Obligations
Allocation of Price Discounts
Allocation of Variable Consideration
Subsequent Price Changes
Step Five: Recognize Revenue
Measurement of Progress Completion
Output Methods
Input Methods
 Change in Estimate
Progress Measurement
Right of Return
Consistency
Contract Modifications
Treatment as Separate Contract
Treatment as Continuing Contract
Entitlement to Payment
Bill-and-Hold Arrangements
Consideration Received from a Supplier
Customer Acceptance
Customer Options for Additional Purchases
Licensing
Nonrefundable Upfront Fees
Principal versus Agent
Repurchase Agreements
Unexercised Rights of Customers
Warranties
Contract-Related Costs
Costs to Obtain a Contract
Costs to Fulfill a Contract
Amortization of Costs
Impairment of Costs
Exclusions
Revenue Disclosures
Chapter 21 - Employee Benefits and Retirement Plans
Short-term Employee Benefits
Post-Employment Benefits
Defined Contribution Plans
Defined Benefit Plans
Projected Unit Credit Method
Attribution of Benefits to Periods of Service
Actuarial Assumptions
Past Service Cost
Gains and Losses on Settlement
Measurement of Plan Assets
Defined Benefit Costs
 Termination Benefits
Defined Contribution Plan Disclosures
Defined Benefit Plan Disclosures
Defined Benefit Plan Financial Statements
Chapter 22 - Share-based Payment
Overview of Share-based Payments
Share-based Payments Settled with Equity
Share-based Payments Settled with Cash
Share-based Payments with Cash Alternatives
Counterparty Has Choice of Settlement
Issuer Has Choice of Settlement
Share-based Payment Disclosures
Chapter 23 - Income Taxes
The Tax Base Concept
Current Tax Liabilities and Assets
Deferred Tax Liabilities and Assets
Taxable Temporary Differences
Deductible Temporary Differences
Unused Tax Losses and Tax Credits
Reassessment of Unrecognized Deferred Tax Assets
Investments in Other Entities
Tax Rates
Current and Deferred Tax Recognition
Uncertainty over Income Tax Treatment
Changes in Tax Status
Income Tax Presentation
Income Tax Disclosures
Chapter 24 - Business Combinations
The Acquisition Method
Identification of a Business Combination
Identify the Acquirer
Determine the Acquisition Date
Recognize Assets, Liabilities, and Non-controlling Interests
Recognize Goodwill or a Bargain Purchase Gain
Additional Acquisition Issues
Reverse Acquisitions
Subsequent Measurement
 Business Combination Disclosures
Chapter 25 - Financial Instruments
Measurement of Financial Assets and Liabilities
Initial Measurement
Subsequent Measurement
Expected Credit Losses
Impairment
Reclassification
Embedded Derivatives
Gains and Losses
Dividends and Interest
Hedging
Hedging Instruments
Hedged Items
Accounting for Hedges
Financial Asset and Liability Derecognition
Financial Asset Derecognition
Financial Liability Derecognition
Servicing Assets and Liabilities
Valuation of Replacement Financial Asset
Collateral
Financial Instrument Presentation
Financial Instrument Disclosures
Chapter 26 - Fair Value Measurement
Overview of Fair Value
General Concepts
Measurement Issues
Initial Recognition
Measurement of Non-Financial Assets
Measurement of Liabilities and Equity
Measurement of a Group of Financial Assets and Liabilities
Valuation Methods
Fair Value Disclosures
Chapter 27 - Effects of Changes in Foreign Exchange Rates
Foreign Exchange Transactions
Financial Statement Translation
Determination of Functional Currency
 Translation of Financial Statements
Hyperinflationary Effects
Derecognition of a Foreign Entity Investment
Foreign Currency Disclosures
Chapter 28 - Borrowing Costs
Overview of Borrowing Costs
Borrowing Cost Disclosures
Chapter 29 - Leases
The Nature of a Lease
Lease Components (Lessee)
Lease Components (Lessor)
The Lease Term
Lease Accounting by the Lessee
Lease Recognition
Initial Lease Measurement
Subsequent Lease Measurement - Assets
Subsequent Lease Measurement - Liabilities
Lease Modifications
Lease Accounting by the Lessor
Financing Leases
Operating Leases
Sale and Leaseback Transactions
Presentation of Lease Information
Lessee Presentations
Lessor Presentations
Lease Disclosures by the Lessee
Lease Disclosures by the Lessor
Chapter 30 - Related Party Disclosures
Overview of Related Parties
Related Party Disclosures
Chapter 31 - Events after the Reporting Period
Overview of Events after the Reporting Period
The Going Concern Issue
Disclosure of Events after the Reporting Period
Chapter 32 - Insurance Contracts
Insurance Contract Aggregation
Initial Recognition of Insurance Contracts
 Initial Measurement of Insurance Contracts
Estimated Future Cash Flows
Discount Rates Used
Risk Adjustment for Non-Financial Risk
Contractual Service Margin
Subsequent Measurement of Insurance Contracts
Modification of Insurance Contracts
Derecognition of Insurance Contracts
Accounting Policy Changes
Presentation of Insurance Contract Information
Disclosures
Chapter 33 - Agriculture
Accounting for Agriculture
Bearer Plants
Agriculture Disclosures
Chapter 34 - Government Grants
Accounting for Government Grants
Government Grant Presentation
Government Grant Disclosures
Chapter 35 - Regulatory Deferral Accounts
Accounting for Regulatory Deferral Accounts
Regulatory Deferral Account Presentation
Regulatory Deferral Account Disclosures
Chapter 36 - Mineral Resources
Accounting for Mineral Resources
Accounting for Stripping Costs
Mineral Resources Presentation
Mineral Resources Disclosures
Chapter 37 - Service Concessions
Overview of Service Concessions
Service Concession Disclosures
Chapter 38 - Other Topics
Liabilities from Waste Electrical and Electronic Equipment
Hedges of a Net Investment in a Foreign Operation
Distributions of Non-cash Assets to Owners
Extinguishing Financial Liabilities with Equity Instruments
Glossary
Index
Preface
The accounting by businesses throughout the world is largely governed by
International Financial Reporting Standards (IFRS). The source documents
for IFRS cover several thousand pages, so their heft alone makes them
difficult to research. The IFRS Guidebook lightens the research chore by
presenting the essential elements of IFRS in a single volume, with an
emphasis on key accounting requirements and disclosures. These essential
elements are closely supported by several hundred examples and tips.
Following an introduction to IFRS in Chapter 1, the Guidebook covers in
Chapters 2 through 9 all aspects of the presentation of financial statements,
including accounting changes and error corrections, earnings per share,
interim reporting, and operating segments. We then move on to the
accounting for assets, liabilities, and equity in Chapters 10 through 19, which
encompasses investments in other entities, inventories, fixed assets, asset
impairment, assets held for sale, provisions, and contingent liabilities.
Chapters 20 through 23 address a number of income statement topics –
revenue recognition, employee benefits, share-based payments, income taxes,
and more. Chapters 24 through 32 delve into a number of major transaction
types, including business combinations, fair value measurements, foreign
currency, leases, subsequent events, and insurance contracts. Finally,
Chapters 33 through 38 describe industry-specific accounting for agriculture,
construction, mineral resources, and more. The chapters include tips, podcast
references, and a variety of illustrations.
You can find the answers to many accounting questions in the Guidebook
that might otherwise require extensive research in the original IFRS source
documents, such as:
• What is the proper presentation of a balance sheet?
• What does an indirect method statement of cash flows look like?
• How do I calculate diluted earnings per share?
• What information must be included in interim financial statements?
• How do I use a cost layering system to account for inventory?
• What is the process for testing intangible assets for impairment?
• How do I account for fixed assets acquired in a business combination?
• When can I recognize revenue?
• How do I account for a defined benefit pension plan?
• How do I account for a business combination?
The IFRS Guidebook is designed for both professionals and students.
Professionals can use it as a handy reference tool that reduces research time,
while students will find that it clarifies many of the more arcane accounting
topics.
Centennial, Colorado
November 2018
About the Author
Steven Bragg, CPA, has been the chief financial officer or controller of four
companies, as well as a consulting manager at Ernst & Young. He received a
master’s degree in finance from Bentley College, an MBA from Babson
College, and a Bachelor’s degree in Economics from the University of
Maine. He has been a two-time president of the Colorado Mountain Club,
and is an avid alpine skier, mountain biker, and certified master diver. Mr.
Bragg resides in Centennial, Colorado. He has written the following books
and courses:
7 Habits of Effective CEOs
7 Habits of Effective CFOs
7 Habits of Effective Controllers
Accountant Ethics [for multiple states]
Accountants’ Guidebook
Accounting Changes and Error Corrections
Accounting Controls Guidebook
Accounting for Casinos and Gaming
Accounting for Derivatives and Hedges
Accounting for Earnings per Share
Accounting for Income Taxes
Accounting for Intangible Assets
Accounting for Inventory
Accounting for Investments
Accounting for Leases
Accounting for Managers
Accounting for Mining
Accounting for Retirement Benefits
Accounting for Stock-Based Compensation
Accounting for Vineyards and Wineries
Accounting Procedures Guidebook
Agricultural Accounting
Behavioral Ethics
Bookkeeping Guidebook
Budgeting
Business Combinations and Consolidations
Business Insurance Fundamentals
Business Ratios
Business Valuation
Capital Budgeting
CFO Guidebook
Change Management
Closing the Books
Coaching and Mentoring
Conflict Management
Constraint Management
Construction Accounting
Corporate Bankruptcy
Corporate Cash Management
Corporate Finance
Cost Accounting (college textbook)
Cost Accounting Fundamentals
Cost Management Guidebook
Credit & Collection Guidebook
Crowdfunding
Developing and Managing Teams
Effective Collections
Effective Employee Training
Employee Onboarding
Enterprise Risk Management
Entertainment Industry Accounting
Fair Value Accounting
Financial Analysis
Financial Forecasting and Modeling
Fixed Asset Accounting
Foreign Currency Accounting
Franchise Accounting
Fraud Examination
Fraud Schemes
GAAP Guidebook
Governmental Accounting
Health Care Accounting
Hospitality Accounting
How to Audit Cash
How to Audit Equity
How to Audit Fixed Assets
How to Audit for Fraud
How to Audit Inventory
How to Audit Liabilities
How to Audit Receivables
How to Audit Revenue
How to Conduct a Compilation
How to Conduct a Review
How to Run a Meeting
Human Resources Guidebook
IFRS Guidebook
Interpretation of Financial Statements
Inventory Management
Investor Relations Guidebook
Law Firm Accounting
Lean Accounting Guidebook
Mergers & Acquisitions
Money Laundering
Negotiation
New Controller Guidebook
New Manager Guidebook
Nonprofit Accounting
Oil & Gas Accounting
Optimal Accounting for Cash
Optimal Accounting for Payables
Partnership Accounting
Payables Management
Payroll Management
Performance Appraisals
Project Accounting
Project Management
Property Management Accounting
Public Company Accounting
Purchasing Guidebook
Real Estate Accounting
Records Management
Recruiting and Hiring
Revenue Management
Revenue Recognition
Sales and Use Tax Accounting
Succession Planning
The Balance Sheet
The Income Statement
The MBA Guidebook
The Soft Close
The Statement of Cash Flows
The Year-End Close
Treasurer’s Guidebook
Working Capital Management

On-Line Resources by Steven Bragg

Steven maintains the accountingtools.com web site, which contains
continuing professional education courses, the Accounting Best Practices
podcast, and thousands of articles on accounting subjects.
IFRS Guidebook is also available as a continuing professional education
(CPE) course. You can purchase the course (and many other courses) and
take an on-line exam at:
www.accountingtools.com/cpe
 Chapter 1
Introduction
Introduction
In this chapter, we provide an introduction to the nature of IFRS, the IFRS
conceptual framework, and how to use this book and other source materials
to research IFRS topics. We also provide brief descriptions of the accounting
principles upon which much of the IFRS elsewhere in this book is based.
What is IFRS?
IFRS is short for International Financial Reporting Standards. IFRS is
comprised of a group of accounting standards that have been developed over
a number of years. IFRS is used by businesses to properly organize their
financial information into accounting records and summarize it into financial
statements, as well as disclose certain supporting information.
One of the reasons for using IFRS is so that anyone reading the financial
statements of multiple companies has a reasonable basis for comparison,
since all companies using IFRS have created their financial statements using
the same set of rules.
IFRS covers a broad array of topics, which are aggregated into the following
major categories:
• Presentation. Covers the proper formatting and presentation of the
financial statements, and includes the following topic areas:
o Presentation of financial statements
o Statement of cash flows
o Consolidated and separate financial statements
o Accounting policies, estimate changes and errors
o Financial reporting in hyperinflationary economies
o Earnings per share
o Interim financial reporting
o Operating segments
• Assets, liabilities, and equity. Describes the accounting for assets,
liabilities, and equity, and includes the following topic areas:
o Joint arrangements
o Investments in associates and joint ventures
o Disclosure of interests in other entities
o Inventories
 o Property, plant, and equipment
o Intangible assets
o Investment property
o Impairment of assets
o Assets held for sale and discontinued operations
o Provisions, contingent liabilities and contingent assets
• Revenue and expenses. Covers the accounting issues related to revenue
and several key expense areas. The following topics are included:
o Revenue
o Employee benefits and retirement plans
o Share-based payment
o Income taxes
• Broad transactions. Describes several transaction types that cannot be
classified within one of the preceding areas, and which has broad
applicability to many industries. The following topic areas are
included:
o Business combinations
o Financial instruments
o Fair value measurement
o Effects of changes in foreign exchange rates
o Borrowing costs
o Leases
o Related party disclosures
o Events after the reporting period
o Insurance contracts
• Specific industries. Includes accounting that is specific to certain
industries, and includes the following topic areas:
o Agriculture
o Construction contracts
o Government grants
o Mineral resources
o Service concessions
o Other topics
IFRS is used by businesses reporting their financial results in those parts of
the world that accept this framework. The main competing accounting
framework is Generally Accepted Accounting Principles (GAAP), which is
used in the United States. GAAP is much more rules-based than IFRS. IFRS
focuses more on general principles than GAAP, which makes the IFRS body
of work much smaller, cleaner, and easier to understand than GAAP.
There are several working groups that are gradually reducing the
differences between the IFRS and GAAP accounting frameworks, so
eventually there should be only minor differences in the reported results of a
business if it switches between the two frameworks. The working groups are
proceeding diligently, but there are still many issues to reconcile, so it may
require a number of years before the two accounting frameworks are in
approximate alignment. There have been occasional statements that the two
frameworks (and presumably their supporting organizations) will eventually
be merged, but this has not yet occurred.
The IFRS Conceptual Framework
A generalized conceptual framework has been released by the International
Accounting Standards Board, which is responsible for the creation and
maintenance of IFRS. This framework lays out the concepts that underlie
how financial statements are to be prepared and presented. The main subject
areas addressed by the framework are as follows:
• Objective of financial reporting. The objective is to provide financial
information about the reporting organization that is useful to readers in
making decisions about providing resources to the organization. This
means that information must be provided concerning its assets,
liabilities, and efficiency of use of resources. Accrual accounting is
mandated when financial information is prepared.
• Qualitative characteristics of financial reporting. Certain types of
information are likely to be most useful to the readers of financial
information. This information should be relevant, so that it makes a
difference in decision making, either by having predictive value or by
confirming existing information. The information should also
faithfully represent the condition and results of an entity by being
complete, neutral in how information is presented, and free from error.
In addition, the following qualitative characteristics of financial
information should be enhanced to the extent possible, given the
constraint of the cost of financial reporting:
o Comparability. The information should be comparable to
similar information released by other entities.
o Verifiability. Multiple parties can reach a consensus that the
information presented is a faithful representation of the
 reporting entity.
o Timeliness. The information should be presented quickly
enough to assist in decision-making.
o Understandability. The information is clearly classified and
presented.
• Definition, recognition, and measurement of the financial statement
components. The key financial statements used to portray an entity are
the balance sheet and income statement. The balance sheet is
comprised of assets, liabilities, and equity, while the income statement
is comprised of income and expenses. These components of the
financial statements are defined as follows:
o Assets. These are resources controlled by an organization, and
from which it expects to derive future economic benefits.
These benefits may involve operational activities or
convertibility into cash.
o Liabilities. These are obligations arising from past events. A
liability may also arise from an irrevocable agreement to
acquire an asset on a future date. Some liabilities can only be
measured through estimation, since the exact amounts of these
liabilities have not yet been settled.
o Equity. This is the residual interest in an organization’s assets
after deducting all liabilities. This interest may include
invested funds and reserves against future expenditures.
o Income. This is increases in economic benefits that are derived
from either inflows of assets or decreases of liabilities, other
than investor contributions. The income concept can be split
further into revenue and gains, where revenue arises from
ordinary activities and gains are a catchall phrase arising from
other activities. An example of a gain is from the sale of a
long-term asset.
o Expenses. This is decreases in economic benefits that are
derived from outflows or the usage of assets, or the incurrence
of liabilities, other than distributions to investors. The
expenses concept can be split further into expenses and losses,
where expenses arise from ordinary activities and losses are a
catchall phrase arising from other activities. An example of a
loss is the destruction caused by flood damage.
 • Concepts of capital and capital maintenance. A financial concept of
capital means that the net assets of the business contribute to
performance. Under a physical concept of capital, the productive
capacity of the business is emphasized. The financial concept of
capital is most commonly used, as it emphasizes maintenance of
invested capital and/or the purchasing power of that capital. Under the
financial concept of capital, a profit is only earned when the net assets
at the end of a period exceed the amount at the beginning of the
period, excluding the effects of owner distributions and contributions.
Under the physical concept of capital, a profit is only earned when the
physical productive capacity at the end of a period exceeds the amount
at the beginning of the period, excluding the effects of owner
distributions and contributions. Changes in prices under the financial
concept of capital are recognized as a profit or loss (depending on the
circumstances), while such changes under the physical concept are
considered to be adjustments to equity.
In addition to these basic conceptual topics, the framework also addresses the
recognition concept. Recognition is the process of incorporating an item into
the financial statements if it meets the criteria for recognition, and can be
defined as an element of the financial statements. More specifically,
recognition occurs when the following conditions are met:
• Probable benefit. It is probable that the organization will derive a
benefit from the item.
• Measurable. The item has a cost or benefit that can be reliably
measured. The use of reasonable estimates is allowable.
For example, a favorable outcome of a lawsuit cannot be recognized until
such time as the settlement has been approved and the amount to be paid has
been determined. Prior to that date, there is no way to recognize the gain.
The framework also includes a discussion of the measurement bases that
are used to compile the financial statements. Measurement bases are needed
to derive the monetary amounts at which the various elements of the financial
statements are recognized. The following measurement bases may be used to
varying extents in financial statements:
• Historical cost. Assets are recorded at the amounts paid for them, and
liabilities are recorded at the amount of proceeds received in exchange
for incurring each obligation. This is the most commonly used basis of
measurement.
 • Current cost. Assets are recorded at the amount that would be paid if
these assets were to be acquired in the current period. Liabilities are
recorded at the undiscounted amount of cash that would be needed to
settle these obligations in the current period.
• Settlement value. Assets are recorded at the amount that could be
obtained from their sale in the current period in an orderly sale.
Liabilities are carried at the undiscounted amount of cash expected to
be paid in the current period to settle these obligations in the normal
course of business. This measurement basis is also known as realizable
value.
• Present value. Assets are recorded at the present discounted value of
their future net cash inflows. Liabilities are recorded at the present
discounted value of their future net cash outflows.
How this Book is Organized
This book is designed to provide a streamlined view of IFRS that can also be
used for training purposes.
The IFRS source document is several thousand pages long. Within those
pages, IFRS follows a rigid format that provides for each topic a set of
sections covering an introduction, objective, scope, definitions, recognition,
presentation, disclosure, and transition information. A companion volume
delves into the basis for conclusions reached, dissenting opinions, and
sometimes examples of how guidance can be used. Because of the highly
sub-divided nature of the presentation, it may be necessary to wade through a
substantial amount of information before finding the desired guidance. The
IFRS Guidebook condenses IFRS to provide only the information that is most
likely to be needed, and in far fewer sections. The book does so by focusing
on recognition, measurement, and disclosures, while eliminating much of the
implementation guidance that is less likely to be referenced by the
mainstream user.
The chapter layout of the IFRS Guidebook is structured to roughly adhere
to the names of the accounting standards used in IFRS. This means that the
chapters listed in the table of contents approximate the topics used in IFRS,
though the Guidebook consolidates some topics. We have chosen to use this
chapter format so that the reader can more easily cross-reference IFRS topics
in the Guidebook with the underlying IFRS pronouncements for more
detailed research.
How to Use this Book
There are multiple tools available in this book for researching IFRS topics.
The primary challenge is simply locating the correct topic, since there are
hundreds of them in the book. To make searching easier in the Guidebook,
we have added dozens of sub-topics, which appear in the table of contents
beneath the chapter titles. We have also endeavored to expand the index to
the greatest extent possible, using a number of alternative index terms.
Several other sources of information are:
• Podcast episodes. The author manages the Accounting Best Practices
podcast, which provides information about a variety of accounting
topics, and which has been downloaded over two million times. When
there is a podcast episode relevant to a chapter, it is noted in a text box
at the beginning of the chapter.
• Tips. A variety of accounting management tips are sprinkled
throughout the book, usually immediately after a related IFRS topic.
• Glossary. The book contains a lengthy glossary of accounting
terminology.
In addition, consider researching accounting topics on the
accountingtools.com website. The site contains articles, blog posts, podcasts,
and other information on over a thousand accounting topics. Use of the site is
completely free.
Accounting Principles
Almost all of this book contains descriptions of the accounting rules and
disclosures required by IFRS. However, the other chapters do not address the
general accounting principles that provide structure to the IFRS accounting
framework. These accounting principles have been described somewhat in
the conceptual framework that accompanies the IFRS pronouncements, and
are also based on common usage. The principles are:
• Accrual principle. The concept that accounting transactions should be
recorded in the accounting periods when they actually occur, rather
than in the periods when there are cash flows associated with them.
This is the foundation of the accrual basis of accounting. It is
important for the construction of financial statements that show what
actually happened in an accounting period, rather than being
artificially delayed or accelerated by the associated cash flows. For
example, if an entity were to ignore the accrual principle, it would
record an expense only after paying for it, which might incorporate a
lengthy delay caused by the payment terms for the associated supplier
 invoice.
• Conservatism principle. The concept that a business should record
expenses and liabilities as soon as possible, but record revenues and
assets only when it is certain that they will occur. This introduces a
conservative slant to the financial statements that may yield lower
reported profits, since revenue and asset recognition may be delayed
for some time. This principle tends to encourage the recordation of
losses earlier, rather than later. This concept can be taken too far,
where a business persistently misstates its results to be worse than is
realistically the case.
• Consistency principle. The concept that, once an accounting principle
or method is adopted, an organization should continue to use it until a
demonstrably better principle or method comes along. Not following
the consistency principle means that a business could continually jump
between different accounting treatments of its transactions that make
its long-term financial results extremely difficult to discern.
• Cost principle. The concept that a business should only record its
assets, liabilities, and equity investments at their original purchase
costs. This principle is becoming less valid, as a host of accounting
standards are heading in the direction of adjusting to fair value.
• Economic entity principle. The concept that the transactions of a
business should be kept separate from those of its owners and other
businesses. This prevents intermingling of assets and liabilities among
multiple entities.
• Full disclosure principle. The concept that one should include in or
alongside the financial statements of a business all of the information
that may impact a reader's understanding of those financial statements.
The accounting standards have greatly amplified upon this concept in
specifying an enormous number of informational disclosures.
• Going concern principle. The concept that a business will remain in
operation for the foreseeable future. This means that the accountant
would be justified in deferring the recognition of some expenses, such
as depreciation, until later periods. Otherwise, it would be necessary to
recognize all expenses at once and not defer any of them.
• Matching principle. The concept that, when revenue is recorded, all
related expenses should be recorded at the same time. Thus, inventory
is charged to the cost of goods sold at the same time that revenue is
 recorded from the sale of those inventory items. This is a cornerstone
of the accrual basis of accounting.
• Materiality principle. The concept that a transaction should be
recorded in the accounting records if not doing so might have altered
the decision making process of someone reading the company's
financial statements. This is quite a vague concept that is difficult to
quantify, which has led some of the more picayune controllers to
record even the smallest transactions.
• Monetary unit principle. The concept that a business should only
record transactions that can be stated in terms of a unit of currency.
Thus, it is easy enough to record the purchase of a fixed asset, since it
was bought for a specific price, whereas the value of the quality
control system of a business is not recorded. This concept keeps a
business from engaging in an excessive level of estimation in deriving
the value of its assets and liabilities.
• Reliability principle. The concept that only those transactions that can
be proven should be recorded. For example, a supplier invoice is solid
evidence that an expense has been recorded. This concept is of prime
interest to auditors, who are constantly in search of the evidence
supporting transactions.
• Revenue recognition principle. The concept that revenue should only
be recognized when a business has substantially completed the
earnings process. So many people have skirted around the fringes of
this concept to commit reporting fraud that a variety of standard-
setting bodies have developed a massive amount of information about
what constitutes proper revenue recognition. Being principles-based,
IFRS coverage of this topic remains at a relatively high level.
• Time period principle. The concept that a business should report the
results of its operations over a standard period of time. This may
qualify as the most glaringly obvious of all accounting principles, but
is intended to create a standard set of comparable periods, which is
useful for trend analysis.
When there is a question about IFRS that could result in several possible
treatments of an accounting transaction or disclosure, it is sometimes useful
to resolve the question by viewing the IFRS guidance in light of these
accounting principles. Doing so may indicate that one solution more closely
adheres to the general intent of the accounting framework, and so is a better
solution.
Summary
The IFRS Guidebook is intended to be what the name implies – a guide to
IFRS. We expect it to be used as a handy reference when there is a specific
question about IFRS, not as a book to be read from cover to cover. The
immense amount of material that was condensed into this book inevitably
means that there is little room for some of the explanatory comments
typically found in an introductory accounting textbook concerning why a
particular accounting rule was established. Instead, we assume that the reader
already has a working knowledge of the general structure of accounting, and
only need clarification on a particular accounting issue. If more information
is required about how accounting works, rather than the rules stated in the
Guidebook, consider buying the author’s other books on accounting
management, such as Closing the Books and The New Controller Guidebook.
All of the author’s books can be purchased at the accountingtools.com
website.
 Chapter 2
Presentation of Financial Statements
Introduction
IFRS sets forth standards of presentation that are designed to keep the
financial statements of a business as comparable as possible, both between its
own reports across multiple periods and between the financial reports of
multiple entities. These standards of presentation focus on the structure and
content of financial statements.
In this chapter, we address the requirements for the statements of
financial position, profit or loss, and changes in equity, along with relevant
examples. The requirements for the statement of cash flows are addressed in
the next chapter.
IFRS Source Document
• IAS 1, Presentation of Financial Statements
Overview of the Financial Statements
Financial statements are designed to show the financial results and financial
position of a business. This information can be evaluated by users to make
decisions about how to manage or interact with a business. Only a complete
set of financial statements can provide the full range of information needed.
A complete set of financial statements includes the following items:
• A statement of financial position (the balance sheet)
• A statement of profit or loss (the income statement) and other
comprehensive income
• A statement of changes in equity
• A statement of cash flows
• Notes that describe significant accounting policies and other
information
The following issues apply to the presentation of financial statements:
• Accrual basis. Financial statements shall be prepared using the accrual
basis of accounting, so that revenues are recognized when earned and
expenses recognized as incurred.
• Aggregation. Do not reduce the understandability of the financial
statements by aggregating material items that have different natures.
Also, do not obscure material information by aggregating it with
immaterial information.
• Comparative information. Disclose comparative information for the
previous period for all amounts included in the financial statements for
the most recent period. If relevant, also disclose comparative narrative
information in the accompanying notes. This means that a complete
set of financial statements should include two of each type of financial
statement. Further, if there has been a retrospective change in
accounting policy, a retrospective restatement, or a reclassification,
there should be three balance sheets, of which the additional one is
stated as of the beginning of the earliest comparative period.
• Compliance. If the financial statements comply with IFRS, disclose in
the accompanying notes that this is the case.
• Consistency. Continue to use the same presentation of information
within the financial statements from period to period, unless another
presentation would be more appropriate, or IFRS requires a change in
presentation.
• Departures. In the rare cases where management believes that
following IFRS will result in misleading information, disclose
management’s conclusion, the name of the IFRS from which the
company has departed, the circumstances of the departure, and the
effect of the departure on the financial statements. Also note that the
financial statements are a fair presentation of the company’s financial
position, performance, and cash flows. If IFRS does not allow a
departure from a reporting requirement, disclose the name of the
IFRS, the nature of the requirement, why management believes that
following the requirement yields misleading information, and the
adjustments that would be needed to correct the issue.
• Frequency. A complete set of financial statements should be issued at
least once a year.
• Going concern. A business should prepare financial statements on a
going concern basis, unless management intends to liquidate the
business or has no other realistic alternative. If there is uncertainty
about being able to continue as a going concern, disclose the relevant
uncertainties. If the financial statements are not prepared on a going
concern basis, disclose this fact, why the business is not considered a
going concern, and the basis on which the financial statements were
prepared.
• Identification. Clearly identify each financial statement and distinguish
 it from other information being presented within the same document.
In particular, state the following information prominently:
o The name of the entity
o Whether the financial statements apply to one entity or a group
of entities
o The period covered by the financial statements, or the date as
of the end of the reporting period
o The currency in which the financial statements are presented
o The level of rounding (if any) used to present amounts in the
financial statements
• Materiality. It may not be necessary to provide a disclosure required
by IFRS if the resulting information is not material. Conversely, it
may be necessary to provide disclosures beyond what is mandated by
IFRS, if the IFRS requirements are not sufficient to provide users with
a complete understanding of the impact of certain transactions.
• Offsetting. The netting of assets against liabilities, or of income against
expenses, is not allowed unless specifically permitted under IFRS. In
brief, netting is typically only allowed when the substance of the
underlying transaction also allows for the same netting. Netting
against an offsetting valuation allowance (such as netting the
allowance for doubtful accounts against accounts receivable) is
allowed.
• Other comprehensive income. Other comprehensive income may be
included in the statement of profit or loss, or it may be presented
separately. In either case, the statement of profit or loss should be
presented first.
• Prominence. All of the financial statements shall be presented with
equal prominence.
• Similarity. A business should aggregate similar items for presentation
purposes. A materially different class of items should be presented
separately. An item that is not individually material can be aggregated
with other items, though a possibility is to present such items
separately in the accompanying notes.
• Titles. It is allowable to apply a different title to a financial statement
than the ones used by IFRS. Thus, a statement of financial position
could be entitled a balance sheet.
The Statement of Financial Position
A statement of financial position (also known as a balance sheet) presents
information about an entity’s assets, liabilities, and shareholders’ equity,
where the compiled result must match this formula:
Total assets = Total liabilities + Equity
The balance sheet reports the aggregate effect of transactions as of a specific
date. The balance sheet is used to assess an entity’s liquidity and ability to
pay its debts. IFRS requires that the following line items be included in the
balance sheet:
Asset items:
• Assets classified as held for sale
• Biological assets
• Cash and cash equivalents
• Current tax assets
• Deferred tax assets
• Financial assets
• Intangible assets
• Inventories
• Investment property
• Investments accounted for under the equity method
• Property, plant, and equipment
• Trade and other receivables
Liability items:
• Current tax liabilities
• Deferred tax liabilities
• Financial liabilities
• Liabilities classified as held for sale
• Provisions
• Trade and other payables
Equity items:
• Issued capital
• Non-controlling interests
These IFRS requirements are the minimum amount of information that
should be imparted. Other line items can be added, as well as headings and
subtotals, if doing so will improve a user’s understanding of a balance sheet.
The decision to add other items can include an assessment of the nature,
liquidity, and function of assets, as well as the nature, timing, and amounts of
liabilities. Examples of additional line items are for:
 • Individual classes of property, plant, and equipment
• Individual types of receivables, such as trade receivables and
receivables from related parties
• Individual classes of inventory, such as for materials, work in process,
and finished goods
A current asset is one that will be sold or consumed within the normal
operating cycle of a business or the next 12 months, or which is a cash or
cash equivalent. This classification can also include assets held for the
purpose of trading. A current liability is one that will be settled within the
normal operating cycle of a business or the next 12 months. The presentation
of classifications within the balance sheet for current and non-current assets
and liabilities is required; the only alternative is to present assets and
liabilities in order of liquidity, which can be used when doing so provides
information that is more reliable and relevant. The following rules apply to
the current and non-current distinction:
• Deferred taxes. If there is an election to present line items as current or
non-current assets or liabilities within the balance sheet, IFRS
prohibits the classification of deferred tax assets as current assets. It
also prohibits the classification of deferred tax liabilities as current
liabilities.
• Lending breach. If a business breaches the terms of a lending
arrangement and the result is that the loaned funds are payable on
demand, classify the loan as a current liability, even if the lender
agrees not to demand payment. This rule does not apply if the lender
provides a grace period of at least one year after the reporting period.
• Obligation rollover. If a business has the discretion to roll over an
obligation for at least one year after the reporting period, classify the
obligation as non-current. However, if this action is not at the
discretion of the business, classify the obligation as a current liability.
• Settlement period. Separately disclose the amount of an asset or
liability line item expected to be recovered or settled within 12 months
from the amount that will be recovered or settled at a later date.
There is no requirement within IFRS for presenting line items in a certain
order or format.
The Standard Balance Sheet Format
Here is an example of a balance sheet which presents information as of the
end of two fiscal years:
 Lowry Locomotion
Balance Sheet
As of December 31, 20X2 and 20X1
The Common Size Balance Sheet
A common size balance sheet presents not only the standard information
contained in a balance sheet, but also a column that notes the same
information as a percentage of the total assets (for asset line items) or as a
percentage of total liabilities and shareholders’ equity (for liability or
shareholders’ equity line items).
It is extremely useful to construct a common size balance sheet that
itemizes the results as of the end of multiple time periods, so that trend lines
can be constructed to ascertain changes over longer time periods. The
common size balance sheet is also useful for comparing the proportions of
assets, liabilities, and equity between different companies, particularly as part
of an industry or acquisition analysis.
For example, if one were comparing the common size balance sheet of an
acquirer to that of a potential acquiree, and the acquiree had 40% of its assets
invested in accounts receivable versus 20% by the acquirer, this may indicate
that aggressive collection activities might reduce the acquiree’s receivables if
the acquirer were to buy it.
The common size balance sheet is not required under IFRS. However,
being a useful document for analysis purposes, it is commonly distributed
within a company for review by management.
There is no mandatory format for a common size balance sheet, though
percentages are nearly always placed to the right of the normal numerical
results. If balance sheet results are being reported as of the end of many
periods, it is even possible to dispense with numerical results entirely, in
favor of just presenting the common size percentages.
EXAMPLE
Lowy Locomotion creates a common size balance sheet that contains the
balance sheet as of the end of its fiscal year for each of the past two years,
with common size percentages to the right:
Lowry Locomotion
Common Size Balance Sheet
As of 12/31/20x02 and 12/31/20x1
How to Construct a Balance Sheet
If an accounting software package is being used, it is quite easy to construct a
balance sheet. Just access the report writing module, select the time period
needed for the balance sheet, and print it. If it is necessary to construct the
balance sheet manually, follow these steps:
1. Create the trial balance report.
2. List each account pertaining to the balance sheet in a separate
column of the trial balance.
3. Add the difference between the revenue and expense line items on
the trial balance to a separate line item in the equity section of the
balance sheet.
4. Aggregate these line items into those to be reported in the balance
sheet as a separate line item.
5. Shift the result into the company’s preferred balance sheet format.
The following example illustrates the construction of a balance sheet.
EXAMPLE
The accounting software for Lowry Locomotion breaks down at the end of
July, and the controller has to create the financial statements by hand. He
has a copy of Lowry’s trial balance, which is shown below. He transfers this
information to an electronic spreadsheet, creates separate columns for
accounts to include in the balance sheet, and copies the account balances
into these columns. This leaves a number of accounts related to the income
statement, which he can ignore for the purposes of creating the balance
sheet. However, he does include the net loss for the period in the “Current
year profit” row, which is included in the equity section of the balance sheet.
Lowry Locomotion Extended Trial Balance

In the “Aggregation” columns of the extended trial balance, the controller

has aggregated the liabilities for accounts payable and accrued liabilities in
the accounts payable line, and aggregated equity and current year profit into
the equity line. He then transfers this information into the following
condensed balance sheet:
Lowry Locomotion
Balance Sheet
For the month ended July 31, 20X1
Overview of the Statement of Profit or Loss
The statement of profit or loss is a financial report that summarizes an
entity’s revenue, expenses, and net income or loss. The intent of the
statement is to show the financial results of a business over a specific period
of time, such as a month, quarter, or year. The statement of profit or loss is
also known as the income statement.
A related concept that is sometimes reported alongside the income
statement is other comprehensive income. This classification contains all
changes that are not permitted to be recorded within the income statement,
because they have not yet been realized. Examples of other comprehensive
income items are unrealized gains and losses on securities that have not yet
been sold, as well as foreign currency translation adjustments.
When combined with other comprehensive income, the income statement
provides the following information:
• The derivation of profit or loss
• Total other comprehensive income
• Comprehensive income for the period (which is the sum of the last two
items)
Within this financial statement, also present an allocation of profit or loss and
other comprehensive income to each of the following items:
• Non-controlling interests
• Owners of the parent entity
The following items must be included in the income statement:
 • Revenue
• Interest revenue, calculated using the effective interest method
• Gains and losses due to the derecognition of financial assets that are
measured at their amortized cost
• Financing costs
• Impairment losses
• Any shares of the profits and losses of associates and joint ventures
that the entity accounts for using the equity method
• Gains and losses due to a reclassified financial asset that is now
measured at its fair value, based on the difference between its former
carrying amount and its fair value on the reclassification date
• Tax expense
• The total amount of discontinued operations
The following additional items apply to either the income statement or other
comprehensive income, or both:
• Income taxes. Disclose the amount of income tax associated with each
line item included in other comprehensive income, either within this
portion of the financial statements, or in the accompanying notes. It is
permissible to present other comprehensive income line items net of
any related taxes; an alternative presentation is to state these items
before tax effects, and then include the aggregate amount of income
taxes relating to all of these items in a separate line item. In the latter
case, allocate income taxes between those items that will eventually be
reclassified to the income statement, and those that will not be
reclassified.
• Offsetting. In nearly all cases, IFRS does not allow the offsetting of
revenue and expense items, which would thereby present only the
residual amount. The primary exception is when the underlying
agreement with a third party actually allows the company to offset
revenue and expense items.
• Other comprehensive income line items. Present line items in the other
comprehensive income section that are classified by nature. Also,
classify items separately that will not be reclassified to profit or loss at
a later date, and those which will be so classified.
• Reclassification adjustments. If there are any reclassification
adjustments (when items are shifted from other comprehensive income
to profit or loss) in the income statement, disclose both the
 reclassification adjustments and the amount of income tax related to
them. This disclosure can be made within the income statement or in
the accompanying notes.
• Additional items. Add other line items, headings, and subtotals to the
income statement when doing so improves users’ understanding of the
company’s financial performance. Consider the materiality and nature
of revenue and expense items when determining whether to include or
exclude a line item. Examples of circumstances that may trigger such
additional disclosures are inventory write-downs, the disposal of fixed
assets or investments, the settlement of litigation, and the restructuring
of a business.
Several variations on the layout of the income statement are shown later in
this section.
Presentation by Nature or Function
A key additional item is to present an analysis of the expenses in profit or
loss, using a classification based on their nature or functional area; the goal is
to maximize the relevance and reliability of the presented information. If
expenses are being presented by their nature, the format looks similar to the
following (not including other comprehensive income):
Sample Presentation by Nature of Items
Alternatively, if expenses are presented by their functional area, the format
looks similar to the following, where most expenses are aggregated at the
department level (not including other comprehensive income):
Sample Presentation by Function of Items

If expenses are classified by function, IFRS requires that additional

disclosures be made for depreciation and amortization expense, as well as for
employee benefits expense.
Of the two methods, presenting expenses by their nature is easier, since it
requires no allocation of expenses between functional areas. Conversely, the
functional area presentation may be more relevant to users of the information,
who can more easily see where resources are being consumed. IFRS simply
suggests that management select the format that is more reliable and relevant.
An example follows of an income statement that presents expenses by
their nature, rather than by their function.
EXAMPLE
Lowry Locomotion presents its results in two separate statements by their
nature, resulting in the following format, beginning with the income
statement:
Lowry Locomotion
Income Statement
For the years ended December 31
Lowry Locomotion then continues with the following statement of
comprehensive income:
Lowry Locomotion
Statement of Comprehensive Income
For the years ended December 31
The Single-Step Income Statement
The simplest format in which an income statement can be constructed is the
single-step income statement. In this format, present a single subtotal for all
revenue line items, and a single subtotal for all expense line items, with a net
gain or loss appearing at the bottom of the report. A sample single-step
income statement follows.
Sample Single-Step Income Statement

The single-step format is not heavily used, because it forces the reader of an
income statement to separately summarize subsets of information within the
income statement. For a more readable format, try the following multi-step
approach.
The Multi-Step Income Statement
The multi-step income statement involves the use of multiple sub-totals
within the income statement, which makes it easier for readers to aggregate
selected types of information within the report. The usual subtotals are for the
gross margin, operating expenses, and other income, which allow readers to
determine how much the company earns just from its manufacturing
activities (the gross margin), what it spends on supporting operations (the
operating expense total) and which components of its results do not relate to
its core activities (the other income total). A sample format for a multi-step
income statement follows.
Sample Multi-Step Income Statement

The Contribution Margin Income Statement

A contribution margin income statement is an income statement in which all
variable expenses are deducted from sales to arrive at a contribution margin,
from which all fixed expenses are then subtracted to arrive at the net profit or
loss for the period. This income statement format is a superior form of
presentation, because the contribution margin clearly shows the amount
available to cover fixed costs and generate a profit or loss.
In essence, if there are no sales, a contribution margin income statement
will have a zero contribution margin, with fixed costs clustered beneath the
contribution margin line item. As sales increase, the contribution margin will
increase in conjunction with sales, while fixed costs remain approximately
the same.
 A contribution margin income statement varies from a normal income
statement in the following three ways:
• Fixed production costs are aggregated lower in the income statement,
after the contribution margin;
• Variable selling and administrative expenses are grouped with variable
production costs, so that they are a part of the calculation of the
contribution margin; and
• The gross margin is replaced in the statement by the contribution
margin.
Thus, the format of a contribution margin income statement is:
Sample Contribution Margin Income Statement

In many cases, direct labor is categorized as a fixed expense in the

contribution margin income statement format, rather than a variable expense,
because this cost does not always change in direct proportion to the amount
of revenue generated. Instead, management needs to keep a certain minimum
staffing in the production area, which does not vary even if there are lower
production volumes.
The key difference between gross margin and contribution margin is that
fixed production costs are included in the cost of goods sold to calculate the
gross margin, whereas they are not included in the same calculation for the
contribution margin. This means that the contribution margin income
statement is sorted based on the variability of the underlying cost
information, rather than by the functional areas or expense categories found
in a normal income statement.
It is useful to create an income statement in the contribution margin
format when there is a need to determine that proportion of expenses that
truly varies directly with revenues. In many businesses, the contribution
margin will be substantially higher than the gross margin, because such a
large proportion of production costs are fixed and few of its selling and
administrative expenses are variable.
The Multi-Period Income Statement
A variation on any of the preceding income statement formats is to present
them over multiple periods, preferably over a trailing 12-month period. By
doing so, readers of the income statement can see trends in the information,
as well as spot changes in the trends that may require investigation. This is an
excellent way to present the income statement, and is highly recommended.
The following sample shows the layout of a multi-period income statement
over a four-quarter period, with key items noted in bold.
Sample Multi-Period Income Statement

The report shown in the sample reveals several issues that might not have
been visible if the report had only spanned a single period. These issues are:
• Cost of goods sold. This cost is consistently 35% of sales until Quarter
4, when it jumps to 40%.
• Advertising. There was no advertising cost in Quarter 2 and double the
amount of the normal £30,000 quarterly expense in Quarter 3. The
cause could be a missing supplier invoice in Quarter 2 that was
received and recorded in Quarter 3.
• Rent. The rent increased by £10,000 in Quarter 3, which may indicate
 a scheduled increase in the rent agreement.
• Interest expense. The interest expense jumps in Quarter 3 and does so
again in Quarter 4, while interest income declined over the same
periods. This indicates a large increase in debt.
In short, the multi-period income statement is an excellent tool for spotting
anomalies in the presented information from period to period.
How to Construct the Income Statement
If an accounting software package is being used, it is quite easy to construct
an income statement. Just access the report writing module, select the needed
time period for the income statement, and print it.
Tip: If a report writer is being used to create an income statement in the
accounting software, there is a good chance that the first draft of the report
will be wrong, due to some accounts being missed or duplicated. To ensure
that the income statement is correct, compare it to the default income
statement report that is usually provided with the accounting software, or
compare the net profit or loss on the report to the current year earnings
figure listed in the equity section of the balance sheet. If there is a
discrepancy, the income statement is incorrect.
The situation is more complex if the income statement is to be created by
hand. This involves the following steps:
1. Create the trial balance report.
2. List each account pertaining to the income statement in a separate
column of the trial balance.
3. Aggregate these line items into those to be reported in the income
statement as a separate line item.
4. Shift the result into the company’s preferred income statement
format.
The following example illustrates the construction of an income statement.
EXAMPLE
The accounting software for Lowry Locomotion breaks down at the end of
July, and the controller has to create the financial statements by hand. He
has a copy of Lowry’s trial balance, which is shown next. He transfers this
information to an electronic spreadsheet, creates separate columns for
accounts to include in the income statement, and copies those balances into
these columns. This leaves a number of accounts related to the balance
sheet, which he can ignore for the purposes of creating the income
statement.
Lowry Locomotion Extended Trial Balance

In the “Aggregation” columns of the extended trial balance, the controller

has aggregated the expenses for salaries and payroll taxes into the salaries
expense line, and aggregated the rent expense and other expenses into the
other expenses line. He then transfers this information into the following
condensed income statement:
Lowry Locomotion
Income Statement
For the month ended July 31, 20X1

Overview of the Statement of Changes in Equity

The statement of changes in equity reconciles changes in the equity
classification in the balance sheet within an accounting period. The statement
has a more specialized use than the income statement and balance sheet, and
so tends to be the least-read of the financial statements. The statement of
changes in equity should include the following line items:
• Total comprehensive income for the period attributable to owners of
the parent entity
• Total comprehensive income for the period attributable to non-
controlling interests (if any)
• The effects of retrospective application or restatement for each
component of equity with separate line items for changes in
accounting policies and from the correction of errors
• Changes due to profit or loss, other comprehensive income, and owner
transactions for each component of equity, in a reconciliation format
The following example shows a simplified format for the statement.
EXAMPLE
The controller of Lowry Locomotion assembles the following statement of
changes in equity to accompany his issuance of the financial statements of
the company:
Lowry Locomotion
Statement of Changes in Equity
For the year ended 12/31/20X3

Income Statement Disclosures

The financial statements should include a set of disclosures, commonly called
notes, that further clarify the contents of the information presented within the
statements. These notes can include a broad range of information, depending
upon the types of transactions in which a business engages. The minimum set
of information that should be included in the notes is as follows:
• Accounting policies. Describe those accounting policies of the entity
that are relevant to user understanding of the financial statements.
• Basis of preparation. Note the basis under which the financial
statements were prepared. Examples of measurement bases are
historical cost, current cost, and fair value. If multiple bases are used,
 indicate the categories of assets and liabilities to which each basis
applies.
• Capital management. Describe how the business manages its capital,
for which the following items are required:
o The company’s objectives, policies, and processes for
managing capital
o The nature of any externally-imposed capital requirements
o The consequences of non-compliance when the business has
not complied with externally-imposed capital requirements
o A quantitative summary of what the company considers to be
capital (some companies choose to include debt in their
definition of capital)
o Any changes in the capital base or management policies from
the previous period
• Change of period. If a business alters its fiscal year end, it must
disclose the reason for the change, and note that comparable-period
amounts presented in the financial statements are not entirely
comparable.
• Dividends. Note the amount of dividends recognized as distributions to
owners, as well as the related amount of dividends per share. Also
note the amount of any cumulative preference shares not recognized,
and the amount of any dividends proposed or declared that were not
recognized as a distribution during the period.
• Domicile. Note the domicile of the business and its legal form, and the
address of its registered office.
• Estimation uncertainty. Describe any estimates made about which
there is uncertainty that could lead to a material adjustment in the
carrying amount of the entity’s assets or liabilities within the next
year, including their nature and carrying amount. The disclosure could
include the range of possible outcomes and the expected resolution.
Examples of these estimates are the amount of inventory obsolescence
that may be triggered by technology changes, and provisions related to
the outcome of a lawsuit.
• Judgments. Describe the judgments management has made (other than
estimations) in order to apply accounting policies, and which have a
significant impact on the amounts recognized in the period. For
example, a judgment may be involved in the proper recognition of
 revenue when a company is providing lease financing to a buyer.
• Life span. If the entity has a limited life, state the expected duration of
its life.
• Other comprehensive income. Present an analysis of other
comprehensive income by item, for each component of equity.
• Nature of operations. Describe the nature of the operations and
principal activities of the business.
• Parent. Note the name of the corporate parent, and the ultimate parent
of the group owning the business.
• Puttable financial instruments. If there are any puttable financial
instruments that are classified as equity, disclose the amount classified
as equity, the company’s objectives for redeeming these instruments,
the related amount of cash flow caused by the redemption, and how
the cash outflow related to the redemption was determined.
• Reclassification. When there is a reclassification of items in the
financial statements and this includes reclassification of the
comparative periods, disclose the nature of and reason for the change,
as well as the amount of each line item reclassified. If it is
impracticable to reclassify comparative periods, disclose the reason
why, and the nature of the adjustments that would have been made if
reclassification had occurred.
• Reclassified financial instrument. If a financial instrument has been
reclassified between the liability and equity classifications, disclose
the amount reclassified, as well as the timing of and reason for the
change.
• Reserves. Describe the nature and purpose of each equity reserve (if
any).
• Share capital. For each class of share capital that has been issued,
disclose the following items:
o The number of authorized shares
o The number of shares issued and fully paid
o The number of shares issued and not fully paid
o The par value per share
o A reconciliation of the number of shares outstanding at the
beginning and end of the period
o Any rights or restrictions associated with the shares
o The number of shares held by the entity or its subsidiaries or
 associates
o The number of shares reserved for later issuance under the
terms of any agreements for the sale of shares, as well as the
details of those agreements
EXAMPLE
The Close Call Company discloses the following information about its
management of capital:
The company’s objective when managing capital is to expand the
business as rapidly as possible in additional cities, which involves
the aggressive use of all available funds, including maximization
of the amount of available debt. The management team realizes
that such an aggressive stance puts the business at increased risk
of a liquidity crisis, but it believes that the rapid expansion
enhances the long-term value of the company to its shareholders.
The strategy for capital management precludes the payment of
dividends in the short term. Also, if there is an immediate
opportunity to profitably employ additional funds, the company is
prepared to sell additional shares, though only if the opportunity is
likely to result in a net increase in value per share.
The company monitors its debt-to-equity ratio on an ongoing
basis. The objective of management is to maintain a debt-to-equity
ratio of between 3:1 and 4:1. The actual ratio at the end of 20X4
was 3.2:1, and 3.6:1 in 20X5.

In addition to the preceding disclosures, note any other items required under
IFRS that are not presented anywhere else in the financial statements, as well
as any items that are not required, but which are relevant to understanding the
financial statements.
Finally, IFRS mandates that notes be cross-referenced in a systematic
manner, so that users can easily refer from financial statement line items to
the relevant explanatory text in the notes. The following order of presentation
is recommended by IFRS for notes:
1. A statement that the business complies with IFRS
2. A summary of significant accounting policies used
3. Supporting discussions of information presented in the financial
statements, presented in the order in which each of the financial
statements were presented
 4. Other disclosures
Summary
IFRS is not overly rigoroUs in requiring a specific form of presentation for
the financial statements. However, this does not mean that a business should
routinely modify the layouts of its financial reports, since doing so may
confuse readers, and will certainly require significant restatements in all
comparable periods that are presented. Consequently, the best approach to
developing a financial statement presentation is to settle upon a reasonable
format early, and to only make subsequent changes following lengthy
deliberation regarding how those changes will improve the content of the
financial statements.
The presentation of the statement of cash flows is included in the
Statement of Cash Flows chapter. This separate treatment is used in order to
match the separate treatment given by IFRS to the statement of cash flows in
its IAS 7, Statement of Cash Flows.
 Chapter 3
Statement of Cash Flows
Introduction
The statement of cash flows is the least used of the financial statements, and
may not be issued at all for internal financial reporting purposes. The
recipients of financial statements seem to be mostly concerned with the profit
information on the income statement, and to a lesser degree with the financial
position information on the balance sheet. Nonetheless, the cash flows on the
statement of cash flows can provide valuable information, especially when
combined with the other elements of the financial statements.
This chapter addresses the two formats used for the statement of cash
flows, related disclosures, and how to assemble the information needed for
the statement.
IFRS Source Document
• IAS 7, Statement of Cash Flows
Overview of the Statement of Cash Flows
The statement of cash flows contains information about the flows of cash into
and out of a company during the same period covered by the income
statement; in particular, it shows the extent of those company activities that
generate and use cash and cash equivalents. It is particularly useful for
assessing the differences between net income and the related cash receipts
and payments. IFRS requires that a statement of cash flows be presented as
an integral part of the financial statements for all periods in which the
statements are presented. The following general requirements apply to the
statement of cash flows:
• Classifications. Report net cash provided or used in the categories of
operating, investing, and financing activities.
• Format. Entities are encouraged to use the direct method of report
presentation (see the next section).
The primary activities reported on the statement of cash flows are:
• Operating activities. These are an entity’s primary revenue-producing
activities. Examples of cash inflows from operating activities are cash
receipts from the sale of goods or services, royalties, and
commissions, as well as tax refunds. Examples of cash outflows for
operating activities are payments to employees and suppliers, taxes
 paid, and insurance premium payments. Loans made by financial
institutions are considered operating activities, since lending is the
primary revenue-generating activity of these entities.
• Investing activities. These generally involve the acquisition and
disposal of resources that will generate future income and cash flows
for a business. Only an expenditure that results in a recorded asset can
qualify as an investing activity. Examples of cash inflows from
investing activities are cash receipts from the sale of fixed assets, the
sale of the debt or equity instruments issued by other entities, the
repayment of loans by third parties, and payments under forward
contracts and futures contracts. Examples of cash outflows from
investing activities are cash payments to purchase fixed assets, acquire
debt or equity instruments, make loans to other parties, and payments
made under forward contracts and futures contracts.
• Financing activities. These are the activities resulting in alterations to
the amount of contributed equity and an entity’s borrowings.
Examples of cash inflows from financing activities are cash receipts
from the sale of an entity’s own equity instruments or from issuing
debt. Examples of cash outflows from financing activities are cash
outlays for share repurchases and the pay-down of outstanding debt.
EXAMPLE
Mole Industries has a rent-to-purchase feature on its line of trench digging
equipment, where customers can initially rent the equipment and then apply
the rental payments to an outright purchase. The rental of equipment could
be considered an investing activity. However, since the company earns the
bulk of its cash flow from the sale of equipment, the cash flows are placed
within the operating activities classification.

Tip: Create a policy regarding how certain items are to be classified within
the statement of cash flows. Otherwise, there may be some variation from
period to period in categorizing items as cash equivalents or investments.
When a futures contract, forward contract, or some similar arrangement is
accounted for as a hedge, the cash flows associated with the hedge are given
the same classification as the asset or liability being hedged.
When there are cash flows arising from certain activities, they can be
reported in the statement of cash flows on a net basis, rather than separately
showing cash inflows and outflows. The following items can be reported on a
net basis:
• Cash payments and receipts made on behalf of customers, where the
cash flows relate to the activities of the customer, rather than the
activities of the reporting entity. An example is rents collected on
behalf of a property owner, and which are then remitted to the
property owner.
• Cash payments and receipts related to items where there is a short
maturity, rapid turnover, and large amounts. An example is
borrowings having a maturity of three months or less.
• Cash payments and receipts related to the acceptance and repayment of
fixed-maturity deposits by a financial institution.
• Deposits placed by a financial institution with other financial
institutions, and the subsequent withdrawal of those deposits.
• Loans made to customers by a financial institution, and the repayment
of those loans.
The following situations are accorded special treatment under IFRS:
• Cash and cash equivalents. Present a reconciliation of the amount of
ending cash and cash equivalents shown in the statement of cash flows
to the same items appearing in the balance sheet.
• Control change. If there is a change in control of another entity,
classify the related cash flows, in aggregate, as investing activities. If
there are cash flows related to a change in ownership interest, but
which does not result in a loss of control, classify them as financing
activities.
• Foreign currency gains and losses. There may be unrealized gains and
losses on changes in foreign currency exchange rates. If so, report
these amounts in the statement of cash flows within a reconciliation of
the beginning and ending balances of cash and cash equivalents.
• Foreign currency reporting. Record transactions in a foreign currency
in the reporting entity’s functional currency, using the exchange rate
on the date of each cash flow. Similarly, the cash flows of a subsidiary
that are recorded in a foreign currency should be translated at the
exchange rate on the date of each cash flow. The weighted average
exchange rate for a reporting period may be used as a reasonable
substitute for the exchange rate on the date of each cash flow.
• Income taxes. Separately disclose income taxes. It is normally
 classified within the operating activities section, unless it can be
specifically associated with one of the other two sections of the
statement of cash flows.
• Interest and dividends. Separately disclose cash flows related to
interest and dividends, and consistently record them within either the
operating, investing, or financing activities sections. Also, the total
amount of interest paid in the period should be disclosed within the
statement of cash flows; the amount disclosed should include any
interest that may have been capitalized during the period.
• Non-cash transaction. The effects of a non-cash transaction are
excluded from the statement of cash flows. Examples of such
transactions are the conversion of debt to equity and paying for an
acquiree with stock.
Either the direct method or the indirect method can be used to present the
statement of cash flows. These methods are described in the following
sections.
The Direct Method
The direct method of presenting the statement of cash flows shows specific
cash flows in the operating activities section of the report. IFRS does not
rigidly enforce a specific set of line items within this type of report, but
consider using the presentation format shown in the following example.
EXAMPLE
Lowry Locomotion constructs the following statement of cash flows using
the direct method:
Lowry Locomotion
Statement of Cash Flows
For the year ended 12/31/20X1
A company should report the cash inflows and outflows for investing and
financing activities separately within the statement of cash flows. Thus, cash
payments for the purchase of fixed assets should be reported on a separate
line item from cash receipts from the sale of fixed assets.
IFRS encourages the use of the direct method, but it is rarely used, for the
excellent reason that the information in it is difficult to assemble; companies
simply do not collect and store information in the manner required for this
format. Instead, they use the indirect method, which is described in the
following section.
The Indirect Method
Under the indirect method of presenting the statement of cash flows, the
presentation begins with net income or loss, with subsequent additions to or
deductions from that amount for non-cash revenue and expense items,
resulting in cash generated from operating activities. This means that the
effects of the deferral or accrual of expenses in the income statement must be
removed, as well as such non-cash expenses as depreciation and
amortization, so that cash flows can be more readily observed.
The format of the indirect method appears in the following example.
EXAMPLE
Lowry Locomotion constructs the following statement of cash flows using
the indirect method:
Lowry Locomotion
Statement of Cash Flows
For the year ended 12/31/20X2

The indirect method is very popular, because the information required for it is
relatively easily assembled from the accounts that a business normally
maintains.
How to Prepare the Statement of Cash Flows
The most commonly-used format for the statement of cash flows is the
indirect method (as described in the preceding section). The general layout of
an indirect method statement of cash flows is shown below, along with an
explanation of the source of the information in the statement.
Company Name
Statement of Cash Flows
For the year ended 12/31/20XX

A less commonly-used format for the statement of cash flows is the direct
method. The general layout of this version is shown below, along with an
explanation of the source of the information in the statement.
Company Name
Statement of Cash Flows
For the year ended 12/31/20XX

As can be seen from the explanations for either the indirect or direct methods,
the statement of cash flows is more difficult to create than the income
statement and balance sheet. In fact, a complete statement may require a
substantial supporting spreadsheet that shows the details for each line item in
the statement.
If the company’s accounting software contains a template for the
statement of cash flows, use it. The information may not be aggregated quite
correctly, and it may not contain all of the line items required for the
statement, but it will produce most of the information needed, and is much
easier to modify than the alternative of creating the statement entirely by
hand.
Disclosures for the Statement of Cash Flows
The following disclosures are required by IFRS, and are associated with the
statement of cash flows:
• Cash not available for use. Disclose the amount of any cash and cash
equivalent balances that are not available for use. An example is when
cash is held by a subsidiary in a foreign country that does not allow
the repatriation of cash.
• Control changes. If there is a change in control of another entity,
disclose:
o The total consideration paid or received
o The amount paid or received in cash and cash equivalents
o The amount of cash and cash equivalents over which control
has been gained or lost
o The amount of other assets and liabilities over which control
has been gained or lost (summarized by category)
• Policy. Disclose the accounting policy used to determine the
composition of the cash and cash equivalent line items. If there is a
change in this policy, disclose the effects of the change.
IFRS also encourages, but does not require, the following disclosures:
• Investments in capacity. Separately state the amount of cash invested
in the expansion of operating capacity, and in the maintenance of
operating capacity. This disclosure reveals whether a business is re-
investing a sufficient amount in its operations.
• Segments. Expand upon the segment requirements for publicly-held
companies by stating cash flows from operating, investing, and
financing activities at the reportable segment level.
• Unused debt. If there are unused borrowing facilities, note the amount
and any restrictions on their use.
EXAMPLE
Lowry Locomotion discloses the following reconciliation of its cash and
cash equivalents, as well as other issues related to its cash balances and
available debt:
Cash and cash equivalents consist of cash on hand and in demand
deposits, and in investments in overnight repurchase agreements.
The cash and cash equivalents included in the statement of cash
flows is derived from the following amounts in Lowry’s balance
sheet:

At the end of 20X1 and 20X0, £220,000 of cash equivalents were

held by a subsidiary in a country that does not allow the
repatriation of cash.
At December 31, 20X1, the company had £3,000,000 of unused
borrowing facilities available under a line of credit arrangement
that expires on June 30, 20X3.
EXAMPLE
The Close Call Company reports the following cash flow information for its
two segments:

Summary
The statement of cash flows is a useful ancillary statement that sometimes
accompanies the income statement and balance sheet for internal reporting,
but which is nearly always included in financial statements issued to outside
parties. The report can be difficult to assemble, unless it is available as an
accounting software template, which is why it tends to be treated as an
occasional add-on to the other elements of the financial statements. If it will
be issued, we strongly recommend using the indirect method instead of the
direct method, since the information required for the direct method of
presentation is not easily gathered from the accounting records.
 Chapter 4
Consolidated and Separate Financial Statements
Introduction
When a company controls one or more entities, it should consolidate the
results of these entities into a set of financial statements. In this chapter, we
pay particular attention to deciding whether consolidation is necessary, and
then address the methodology for preparing and presenting consolidated
financial statements. There is also coverage of the circumstances under which
a company presents separate financial statements, and the related disclosures.
IFRS Source Documents
• IFRS 10, Consolidated Financial Statements
• IAS 27, Consolidated and Separate Financial Statements
The Control Concept
Consolidated financial statements are the financial statements of a group of
entities that are presented as being those of a single economic entity. The
related concepts are:
• A group is a parent entity and all of its subsidiaries
• A subsidiary is an entity that is controlled by a parent company
In short, consolidated financial statements are the combined financial
statements for a parent company and its subsidiaries.
Consolidated financial statements are useful for reviewing the financial
position and results of an entire group of commonly-owned businesses.
Otherwise, reviewing the results of individual businesses within a group does
not give an indication of the financial health of the group as a whole.
EXAMPLE
Pensive Corporation has £5,000,000 of revenues and £3,000,000 of assets
appearing in its own financial statements. However, Pensive also controls
five subsidiaries, which in turn have revenues of £50,000,000 and assets of
£82,000,000. Clearly, it would be extremely misleading to show the
financial statements of just the parent company, when the consolidated
results reveal that it is really a £55 million company that controls £85
million of assets.

To decide if consolidation is necessary, a business must first determine the

level of control that it exercises over another entity (the investee). Control
exists only when all of the following are present:
• Power over investee. The business has power over the investee, which
gives it the right to direct those investee activities that alter the
investee’s returns. Power typically comes from voting rights, but can
also be based on a historical record of having exercised power over the
investee. If there are several investors, the one who has power is the
one who can most significantly affect the returns of the investee.
• Returns from investee. The business is exposed to variable returns
from its investment in the investee. Multiple parties can qualify under
this criterion.
• Alter investee returns. The business can exercise its power over the
investee to alter the amount of its investment returns. An investor that
acts as an agent for the investee does not control the investee.
EXAMPLE
Three companies form an investee entity that will specialize in bridge
building for local governments. One of the investor companies will be
responsible for preparing bid proposals to the relevant governments, while
the second investor will oversee the work, and the third investor will oversee
ongoing maintenance. Thus, each of the entities exercises a certain amount
of control over the investee during different stages of the projects that will
be performed. For consolidation purposes, each of the investors must decide
whether it directs those activities of the investee that most significantly
affect its returns. Factors to consider include who controls the profit margins
of the investee, the difficulty of winning bids, and who controls bridge
construction and maintenance.

There may be situations where the preceding indicators of control are not
present, but there is evidence that the investor has a special relationship with
the investee that essentially gives it control. The following factors may
indicate the presence of a control relationship:
• Close linking. A large part of investee activities involve the investor,
or are conducted on its behalf.
• Dependency. The investee is dependent on the investor in such areas as
funding, guarantees, technology, raw materials, licenses, and technical
expertise.
• Return on investment. The returns of the investor are greater than its
ownership share of the investee.
 • Shared managers. The investee has key managers who used to be or
still are employees of the investor.
An investor may not have control over an investee if there are barriers to the
practical exercise of the rights of the investor. Any of the following examples
could keep control from being exercised:
• Legal or regulatory requirements
• No mechanism for exercising rights held
• Penalties or financial incentives
• The conversion price or terms associated with convertible instruments
• Tightly defined conditions under which control can be exercised
EXAMPLE
Ligature Corporation has entered into an agreement to buy the shares of an
investor in Malleable Manufacturing. When combined with Ligature’s
existing 25% ownership of Malleable, the company will have outright
majority ownership. However, for tax reasons, the sale will not take place
until the beginning of the next calendar year, which is four months away.
Since Ligature does not have the current ability to direct the activities of
Malleable, it does not exercise control.

An investor may effectively have control over an investee, even in the

absence of outright majority ownership, if the remaining ownership of the
investee is widely dispersed. This means that many other investors would
have to act in concert to override the wishes of the primary investor.
EXAMPLE
Ligature Corporation acquires 44% of the outstanding common shares of
Linden Limited. Linden is publicly held, which has contributed to the wide
dispersal of its remaining share holdings across several hundred additional
investors. The other investors have no mechanism for coordinating their
actions, and have no history of doing so. Under these conditions, the 44%
ownership stake of Ligature may very well give it effective control over
Linden.
EXAMPLE
Ligature Corporation owns 40% of the outstanding common shares of
Suture Corporation. Two other investors each own 30% of the remaining
shares of Suture. Since the two other investors can combine to block any
efforts by Ligature to control Suture, it does not appear that Ligature has
control over Suture.
An investor with a minority interest in an investee may exercise control over
an investee if it has the right to acquire additional shares. This situation may
arise through a contractual arrangement with another investor, or through the
investor’s holdings of debt instruments that can be converted into investee
shares. However, this determination depends on the circumstances, since the
right to acquire shares may also be unlikely, if the price at which they can be
purchased is substantially higher than their current market price.
EXAMPLE
Smithy Ironworks currently holds 25% of the shares of Alum Smelters, and
has the right to buy an additional 40% of the outstanding shares from the
current owner of Alum at any point during the next year. However, the price
at which Smithy can purchase these additional shares is double the current
market price. Consequently, Smithy does not have substantive control over
Alum.

An investor that has control over an investee may choose to delegate its
authority to another party. This other party is considered an agent of the
investor, and so should not consolidate its results with those of the investee.
When the right to make decisions is shifted to an agent, the investor is
considered to retain control over the investee via its agent.
An agent relationship is definitively proven to exist when the investor can
remove the agent without cause. An agent relationship is likely when the
party making decisions on behalf of investors must obtain their consent for
certain actions. Also, an agent relationship is not considered to exist unless
the party making decisions is being paid in accordance with the services
provided, and the compensation agreement contains those terms normally
found in an agent relationship. Conversely, if the party making decisions
holds a significant interest in the investee, it may not be acting in the role of
an agent.
A parent company does not have to present consolidated financial
statements under the following circumstances:
• If the parent is a subsidiary of another entity;
• All of the owners of the parent have been notified that consolidated
financial statements will not be produced; and
• The owners do not object to not receiving financial statements.
• In addition, the entity cannot be publicly held.
 • In addition, either the entity’s parent or the ultimate parent of the
group must produce consolidated financial statements that are
available to the public.
If the parent entity loses control over a subsidiary, the parent should take the
following steps to account for the change:
• Remove (derecognize) the former subsidiary’s assets and liabilities
from the consolidated financial statements. Assets and liabilities are
derecognized at their carrying amounts on the date when control is
lost.
• If a gain or loss had previously been recognized in other
comprehensive income, reclassify it to profit or loss when the related
assets and liabilities are disposed of.
• Recognize any remaining investment in the subsidiary that was
retained, at its fair value on the date when control was lost.
• If there is a gain or loss associated with the loss of control of the
former subsidiary, recognize it at this time.
Consolidation Accounting
Consolidation accounting is the process of combining the financial results of
several subsidiary companies into the combined financial results of the parent
company. The following steps document the consolidation accounting
process flow:
1. Adjust for dates. If the reporting period of a subsidiary varies from
that of the parent, the subsidiary prepares additional information to
effectively match the dates of its reported results to those of the
parent. If this is impracticable, the parent instead adjusts the
financial statements of the subsidiary for any significant transactions
occurring during the period in question. Under no circumstances can
the date differential be longer than three months.
2. Adjust for accounting policies. If a subsidiary records transactions
using a different accounting policy than that used by the parent
entity, adjust the recognition to match the accounting policy of the
parent.
3. Combine similar items. Combine similar assets, liabilities, equity,
revenue, expense, and cash flow items from the various subsidiaries
and the parent entity.
4. Record intercompany loans. If the parent company has been
consolidating the cash balances of its subsidiaries into an investment
 account, record intercompany loans from the subsidiaries to the
parent company. Also record an interest income allocation for the
interest earned on consolidated investments from the parent
company down to the subsidiaries.
5. Charge corporate overhead. If the parent company allocates its
overhead costs to subsidiaries, calculate the amount of the allocation
and charge it to the various subsidiaries.
6. Charge payables. If the parent company runs a consolidated
payables operation, verify that all accounts payable recorded during
the period have been appropriately charged to the various
subsidiaries.
7. Charge payroll expenses. If the parent company has been using a
common paymaster system to pay all employees throughout the
company, ensure that the proper allocation of payroll expenses has
been made to all subsidiaries.
8. Complete adjusting entries. At the subsidiary and corporate levels,
record any adjusting entries needed to properly record revenue and
expense transactions in the correct period.
9. Investigate asset, liability, and equity account balances. Verify that
the contents of all asset, liability, and equity accounts for both the
subsidiaries and the corporate parent are correct, and adjust as
necessary.
10. Review subsidiary financial statements. Print and review the
financial statements for each subsidiary, and investigate any items
that appear to be unusual or incorrect. Make adjustments as
necessary.
11. Eliminate intercompany transactions. If there have been any
intercompany transactions, reverse them at the parent company level
to eliminate their effects from the consolidated financial statements.
12. Eliminate investments. Reverse the parent’s recorded investment
amount in each of the subsidiaries, as well as the parent’s portion of
the equity recorded in the accounting records of each subsidiary.
13. Present non-controlling interests. Present the amount of non-
controlling interests in the equity section of the consolidated balance
sheet, in a line item separate from other items. If there were changes
in the amounts of these interests, adjust the carrying amounts of the
controlling and non-controlling interests to reflect the changes.
 14. Attribute profits and losses. When there are non-controlling
interests, separately attribute profit or loss and all line items within
other comprehensive income to non-controlling interests and the
owners of the parent.
15. Review parent financial statements. Print and review the financial
statements for the parent company, and investigate any items that
appear to be unusual or incorrect. Make adjustments as necessary.
16. Record income tax liability. If the company earned a profit, record
an income tax liability. It may be necessary to do so at the subsidiary
level, as well.
17. Close subsidiary books. Depending upon the accounting software in
use, it may be necessary to access the financial records of each
subsidiary and flag them as closed. This prevents any additional
transactions from being recorded in the accounting period being
closed.
18. Close parent company books. Flag the parent company accounting
period as closed, so that no additional transactions can be reported in
the accounting period being closed.
19. Issue financial statements. Print and distribute the financial
statements of the parent company.
Tip: If losses have been recorded on intercompany transactions, it is
possible that an asset impairment exists. If so, recognize the related loss on
impairment in the consolidated financial statements.
If a subsidiary uses a different currency as its operating currency, an
additional consolidation accounting step is to convert its financial statements
into the reporting currency of the parent company.
When creating consolidated financial statements, the following accounting
rules apply:
• Policies. Ensure that uniform accounting policies are being used across
the various subsidiaries in the treatment of similar transactions and
events.
• Relevant dates. Consolidation should only be performed from the date
when the investor gains control over the investee, and stops when
control over the investee ceases.
• Loss of control. If the parent loses control over the investee, the parent
completes the following tasks:
 o Removes the assets and liabilities of the former subsidiary
from its consolidated financial statements.
o Removes the carrying amounts of any non-controlling interests
and those elements of other comprehensive income
attributable to the non-controlling interests from its
consolidated financial statements.
o Recognizes any retained interest in the subsidiary at its fair
value.
o Recognizes any amounts in other comprehensive income that
relate to the subsidiary, as though the parent had directly
disposed of the underlying assets and liabilities. In some cases,
recognition means that a balance in other comprehensive
income is shifted directly into retained earnings.
o Depending on the circumstances of the preceding items, the
parent may recognize a gain or loss in profit or loss that relates
to the loss of control.
Separate Financial Statements
A parent entity may sometimes elect or be required to issue separate financial
statements. Separate financial statements are the financial statements of a
parent entity, in which investments in subsidiaries are recorded at their cost,
as financial instruments, or using the equity method. Thus, consolidated
financial statements are not presented. The following accounting applies
under these circumstances:
• The same investment accounting methodology must be applied
consistently to each category of investments.
• If an investment is held for sale, record it as per the guidance in the
Assets Held for Sale and Discontinued Operations chapter.
• If an investment is recorded at its fair value or cost, record it as per the
guidance in the Financial Instruments chapter.
• The parent recognizes a dividend from another entity when the
parent’s right to receive the dividend has been established. The
dividend is recognized in profit or loss, unless the parent has elected to
use the equity method; in the latter case, the dividend reduces the
carrying amount of the parent’s investment.
When a parent entity does not present consolidated financial statements, it
should disclose the following information in the notes accompanying its
financial statements:
 • Status. The fact that separate financial statements have been issued,
and the exemption under which they were issued.
• Identification. The name and principal place of business of the entity
whose consolidated financial statements are available for public use,
and where these statements can be obtained.
• Investments. An itemization of the significant investments of the
parent in subsidiaries, joint ventures, and associates, including their
names, principal places of business, and the parent’s ownership
percentages.
• Methodology. The methodology upon which the accounting for these
investments is based.
Summary
The bulk of this chapter has been concerned with the determination of
whether an investor has control over an investee, which then triggers
consolidation accounting. In reality, this is usually an easy matter to discern,
and is based on a simple majority of shares held. If such is not the case, and
management wishes to proceed with consolidation accounting, it is possible
that the consolidation will be challenged by the investor’s auditors. In
anticipation of such a challenge, be sure to fully document the reasons why
control is considered to have been established, and any changes in this
determination over successive reporting periods. If the issue of control
appears to be unusually difficult to discern, consult with the company’s
auditors in advance, to gain their perspective on the issue.
 Chapter 5
Accounting Policies, Estimate Changes and Errors
Introduction
From time to time, a company will find that it must alter its accounting
policies to reflect the impact of a new IFRS, or change a policy for internal
reasons. There may also be an ongoing series of changes to the accounting
estimates needed to formulate financial statements. Finally, there may be
occasional accounting errors from prior periods that must be corrected. In this
chapter, we describe how to account for and disclose these situations.
Consistent treatment of these issues is needed to ensure that a company’s
financial statements remain comparable over time.
IFRS Source Document
• IAS 8, Accounting Policies, Changes in Accounting Estimates and
Errors
Accounting Policies
Many accounting policies are derived internally from the nature of a business
and the types of accounting transactions that it routinely records. However,
an accounting policy may also be externally imposed. When an IFRS
specifically applies to a transaction, the accounting policies that are defined
for that transaction must incorporate IFRS. The incorporation of IFRS into
accounting policies is only required when the effect of doing so is material to
the resulting financial statements.
In a situation where there is no IFRS upon which an accounting policy
can be based, management should develop policies that result in relevant and
reliable financial information. In particular, the policies should yield unbiased
information that reflects the economic substance of transactions, and which
faithfully represent the financial performance, position, and cash flows of a
business.
In the development of accounting policies, when IFRS does not provide
guidance, management can consider the pronouncements of other standard-
setting bodies, accounting literature, and industry practices.
Once accounting policies have been developed, a business should apply
them consistently for similar transactions. Doing so also makes sense from an
efficiency perspective, since having a smaller set of broadly-applicable
accounting policies makes it easier to manage the accounting function.
 In general, accounting policies are not changed, since doing so alters the
comparability of accounting transactions over time. Only change a policy
when the update is required by IFRS, or when the change will result in more
reliable and relevant information.
If the initial application of an IFRS mandates that a business change an
accounting policy, account for the change under the transition requirements
stated in the IFRS. When there are no transition requirements that accompany
an IFRS, a business should apply the change retrospectively. Retrospective
application means that the accounting records be adjusted as though the new
accounting policy had always been in place, so that the opening equity
balance of all periods presented incorporates the effects of the change.
There are cases where it may be impracticable to determine the
retrospective effect of a change in accounting policy. If so, apply the new
policy to the carrying amounts of affected assets and liabilities as of the
beginning of the earliest period to which the policy can be applied, along
with the offsetting equity account. If the effect of a policy change cannot be
determined for any prior period, then do so from the earliest date on which it
is practicable to apply the new policy. When making policy changes, adjust
all other affected information in the notes that accompany the financial
statements.
Tip: Thoroughly document the reason for any change in an accounting
policy, since it will likely be reviewed by the company’s auditors.
EXAMPLE
Armadillo Industries changes from the last in, first out method of inventory
accounting to the first in, first out method. Doing so results in an increase in
the cost of ending inventory in the preceding period, which in turn increases
net profits for that period. Altering the inventory balance is a direct effect of
the change in policy. The calculation of the change in the prior period
income statement, net of income tax effects, is:

Changes in Accounting Estimates

When financial statements are produced, a common element of the
production process is to estimate a number of items, such as the amount of
the reserves for bad debt and inventory obsolescence, as well as fixed asset
useful lives and the fair value of various assets and liabilities. It is entirely
possible, if not expected, that these estimates will change over time as new
information is received and business conditions change. Consequently, there
will be an ongoing series of changes in accounting estimates.
Because changes to accounting estimates are a natural and ongoing
adjustment to the process of creating financial statements, they are not
considered to relate to prior periods. Consequently, changes in accounting
estimates are only dealt with on a prospective (go-forward) basis. This means
that these items are recorded in the period of the change in estimate and
future periods. There is no change to the financial statements for prior
periods.
EXAMPLE
The credit manager of Close Call Company reviews all open accounts
receivable, and concludes that the allowance for doubtful accounts is
overstated by £50,000. The allowance is therefore reduced by that amount,
which is a change in accounting estimate that only impacts the current
period.
The fixed asset accountant reviews the projected useful lives of the
company’s fixed assets, and concludes that several assets will have shorter
useful lives than had previously been estimated. Their useful lives are
therefore reduced in the depreciation calculations, which results in an
increase in the amount of depreciation expense recognized in the financial
statements for both the current period and future periods.
In both cases, there is no retrospective change to the financial statements for
prior periods.

Errors
There can be a number of errors in a set of financial statements. For example,
there can be incorrect transaction measurements, incorrect presentation, and
incorrect or missing disclosures in the accompanying notes. If financial
statements contain material errors, or immaterial errors made with the intent
of achieving a particular financial statement result, they are not considered to
be in compliance with IFRS.
EXAMPLE
The preliminary income statement of the Close Call Company shows profits
of £999,995. The controller makes an intentional immaterial error of £5 to
increase the amount of profits to £1,000,000, at which point the management
team qualifies for the company’s bonus plan. In this case, the financial
statements do not comply with IFRS, despite the minimal size of the error.

When material errors are made, they should be corrected under one of the
following scenarios:
• If the impacted financial statement is still being reported as a
comparative period, restate the financial statement in the period in
which it occurred.
• If the impacted financial statement is in a prior period that is no longer
being reported as a comparative period, restate the relevant opening
balances for the earliest period presented.
It may not be possible to make a retrospective correction of an error if it is
impracticable to determine the effect of the error. If this is the case for a prior
comparative period, make the adjustment to the relevant opening balances for
the current period. If it is not possible to even make the adjustment to the
relevant opening balances, correct the error in the current period.
EXAMPLE
During 20X3, Rapunzel Hair Products discovers that goods on consignment
with a large hair products distributor were accidentally not included in the
company’s ending inventory balance for 20X2, resulting in profits of
£100,000 not being reported. The tax rate for the company in 20X2 was
35%. Accordingly, Rapunzel discloses the following information:
Inventory items in the amount of £180,000 that were held at a
distributor under a consignment agreement were incorrectly
withheld from the ending inventory balance on December 31,
20X2. The 20X2 financial statements have been restated to correct
this error. The effect of the restatement is summarized below.
Impracticability of Application
There are a number of circumstances that make it impracticable to adjust the
financial statements for prior periods to account for policy changes or error
corrections. For example, the chart of accounts may not have been structured
in earlier periods to collect certain types of information. While it may be
possible to eventually reconstruct the necessary information from historical
records, doing so may not be cost-effective.
Another concern with restatements is that they should only be made based
on evidence that existed in the prior accounting period(s), and which would
have been available when those statements were authorized for issuance.
Conversely, it is not allowable to make prior period adjustments based on
information that was not available at that time.
Disclosures for Policies, Estimate Changes, and Errors
There are a number of variations on the disclosures required for the different
types of accounting policies, estimate changes, and errors, so we address each
one within the following sub-sections.
Accounting Policies
When a new IFRS is initially applied and its application impacts prior
periods, the current period, or future periods, disclose the following
information:
• The name of the IFRS
• Whether the change in accounting policy is in accordance with the
transitional guidance in the IFRS
• The transition guidance in the IFRS (if any), and any effect on future
periods
• The nature of the policy change
• The amount of the adjustment caused by the policy change for specific
financial statement line items, both for the current period and each
prior period
 • If practicable, the adjustment amount relating to periods prior to those
presented
• If retrospective application is impracticable, the reason for this
situation and a description of when and how the policy was applied
When a new IFRS is not yet effective, and has not been applied, disclose the
following:
• The fact that the IFRS is not yet effective and has not yet been applied
by the business
• The impact that the new IFRS will have on the financial statements
when it is initially applied
• Though not required, consider disclosing the name of the new IFRS,
the nature of the change, the date when application is required, and the
date when the company plans to apply it
For a voluntary change to an accounting policy, disclose the following:
• The nature of the change, and why the change provides more reliable
and relevant information
• The amount of the adjustment caused by the policy change for specific
financial statement line items, both for the current period and each
prior period
• If practicable, the adjustment amount relating to periods prior to those
presented
• If retrospective application is impracticable, the reason for this
situation and a description of when and how the policy was applied
Once these disclosures have been made for a change in accounting policy, it
is not necessary to repeat the disclosures in future periods, as long as the
policy is not changed again.
Changes in Accounting Estimates
If there is a change in accounting estimate, disclose the following
information:
• The nature and amount of the change, including the effect on future
periods
• If it is impracticable to estimate the impact of the change in future
periods, disclose this issue
Errors
If an accounting error is discovered, disclose the following information:
• The nature of the error
• The amount of the error correction applied to the periods presented, by
line item
 • The amount of the error correction included in the beginning balances
of the earliest period presented
• If it is impracticable to restate financial statements for a prior period,
note the circumstances and how the error was corrected
Once these disclosures have been made for an accounting error, it is not
necessary to repeat the disclosures in future periods.
For the preceding disclosures of changes caused by policies and errors, if the
reporting entity is publicly-held, also note the impact of the change on basic
and diluted earnings per share.
Summary
Retrospective changes can require a large amount of detective accounting
work, judgment, and thorough documentation of the changes made. Given the
amount of labor involved, it is cost-effective to find justifiable reasons for not
making retrospective changes. Two valid methods for doing so are to
question the materiality of the necessary changes, or to find reasons to instead
treat issues as changes in accounting estimate.
If retrospective application is completely unavoidable, it may make sense
to have the company’s auditors review proposed retrospective changes in
advance. Doing so minimizes the risk that an issue will be discovered by the
auditors during the annual audit, which will require additional retrospective
changes.
 Chapter 6
Financial Reporting in Hyperinflationary Economies
Introduction
When a business issues financial statements, the information contained
within those statements is likely to be based on a mix of historical and current
costs. When there is a rapid increase in prices, which is known as
hyperinflation, it is impossible to use the traditional approach to compiling
financial statements and still issue reports that are comparable across multiple
time periods. Instead, the rapid and ongoing changes in price make it appear
as though a business is experiencing an ongoing acceleration of its revenues,
expenses, assets, and liabilities. In this chapter, we address the methods
required under IFRS to adjust the financial statements of a business that is
located in a hyperinflationary economy.
IFRS Source Documents
• IAS 29, Financial Reporting in Hyperinflationary Economies
• IFRIC 7, Applying the Restatement Approach under IAS 29
Overview of Hyperinflationary Reporting
A business may operate within a country where the currency is losing its
purchasing power at a rapid rate. If so, reporting the financial results and
financial position of the business in that local currency is not useful, since it
is impossible to compare the resulting financial statements with those of prior
periods in any meaningful way. Even comparing transactions occurring at the
beginning and end of a single reporting period may be difficult.
There is no single trigger point above which hyperinflation is considered
to be present. Instead, a final determination is based on a mix of the
following conditions:
• The country’s population prefers to store its wealth outside of the
currency, such as in non-monetary assets or in a foreign currency.
• Prices tend to be quoted in a foreign currency.
• Credit sales are at elevated prices, to account for the expected loss of
currency value during the credit period.
• Prices, wages, and interest rates are linked to a price index.
• Over the past three years, the cumulative inflation rate has approached
or exceeded 100%.
Apply the following guidance from the beginning of the reporting period in
which the determination is made that hyperinflation exists:
• Primary rule. The financial statements must be stated in terms of the
measuring unit current at the end of the reporting period.
• Comparative information. Restate any comparative information
presented for a prior period in terms of the measuring unit current at
the end of the reporting period.
• Restatement gain or loss. Include any gain or loss on the net monetary
position in profit or loss. See the Net Monetary Position sub-section
later in this chapter for more information.
Tip: It is essential to rigidly follow the same restatement procedure when
preparing the financial statements for every reporting period. Otherwise, it
will be difficult to create reports that can be compared to those of prior
periods.
In addition to the preceding set of general rules, apply the following more
specific points to the restatement of financial statements:
Balance sheet:
• General price index. If a balance sheet item is not already stated in the
measuring unit current at the end of the reporting period, restate it
using a general price index.
• No general price index. If there is no general price index available for
the required periods, estimate the amount of the index. One way to
create such an estimate is to base it on changes in the exchange rate
between the functional currency and a more stable foreign currency.
• Current cost items. When a business is already updating certain line
items in its financial statements at their current cost, there is no need
to restate these line items, since they are already presented using the
measuring unit current at the end of the reporting period.
• Index-linked assets and liabilities. If an asset or liability is linked to a
change in prices under the terms of an agreement, adjust its amount as
per the contract terms to determine the amount at which it will be
recorded at the end of the reporting period.
• Monetary items. Do not restate monetary items, since they are already
expressed in the measuring unit current at the end of the reporting
period.
• Non-monetary items. If a non-monetary item is carried at its net
realizable value or fair value at the end of the period, do not adjust this
 amount. Restate all other non-monetary items; to do so, apply to the
historical cost and any accumulated depreciation the change in the
general price index from the date of acquisition to the end of the
reporting period. Non-monetary assets to which restatement should
probably be applied include:
o Property, plant, and equipment
o Inventories
o Goodwill, patents, and trademarks
• Constructed inventory. Restate work-in-process inventory and finished
goods based on the change in the price index from the dates on which
these items were purchased and converted to their present state.
• Missing acquisition dates. If there is no record of the acquisition date
of an asset, obtain an independent assessment of its value, which
becomes the starting value and date for any subsequent restatements.
• Revalued assets. Some assets may have been revalued at regular
intervals (such as property, plant, and equipment). If so, revalue their
recorded amounts from the date of the last revaluation.
• Recoverable amount limitation. If the restated amount of an asset is
greater than its recoverable amount, reduce the restated amount to its
recoverable amount.
• Investee results. A business may report its investment in an investee
using the equity method. If the investee is located in a
hyperinflationary economy, a business using the equity method should
calculate its share of the investee’s net assets and profit or loss only
after restating the financial statements of the investee.
• Equity (initial restatement). When hyperinflationary restatements are
initiated, apply a general price index to the components of owners’
equity (not including retained earnings and revaluation surplus) from
the dates when these items were originally contributed or arose in
some other manner to the beginning of the first period of application.
Eliminate any revaluation surplus that arose in a prior period.
• Equity (subsequent restatement). At the end of each subsequent period,
restate all elements of owners’ equity by applying a general price
index from the beginning of the reporting period. If equity items were
contributed during the period, the general price index is applied from
the date of contribution.
EXAMPLE
The Close Call Company opens a subsidiary in Byjerkistan, whose economy
subsequently experiences hyperinflation. Close Call converts the line items
in the year-end balance sheet of its Byjerkistan subsidiary as noted in the
following table, and based on a general price index that increased from 100
to 300 in the past year. The subsidiary’s inventory turns over twice a year.

Statement of comprehensive income:

• Basis of restatement. Express all items in the statement of
comprehensive income using the measuring unit current at the end of
the reporting period. The restatement should be applied using the
change in the general price index from those dates when revenue and
expense items were initially recorded.
• Current cost items. When transactions are recorded at their current
cost, it is as of the date when revenues are earned or costs consumed.
Since the effects of hyperinflation must be adjusted for as of the end of
a reporting period, these amounts must still be restated to the
measuring unit current at the end of the reporting period with a general
price index.
Statement of cash flows:
All line items in the statement of cash flows must be expressed using the
measuring unit current at the end of the reporting period.
Net Monetary Position
A result of the various restatements just noted is that there will probably be a
net gain or loss on the net monetary position of a business. This gain or loss
arises because a net balance of monetary assets over monetary liabilities will
lose purchasing power, while a net balance of monetary liabilities over
monetary assets will gain purchasing power. The amount of this net gain or
loss can be approximated by multiplying the change in the applicable general
price index by the difference between monetary assets and monetary
liabilities. Any gain or loss on the net monetary position is to be recorded
within profit or loss. Examples of monetary assets and liabilities are:
Examples of Monetary Assets

Examples of Monetary Liabilities

Comparative Information
IFRS mandates that comparative information from a prior period be included
in a set of financial statements. These comparative amounts are to be restated
using a general price index, so that the information is presented in terms of
the measuring unit current at the end of the current reporting period. Further,
all comparative information stated in the accompanying notes must also be
restated in the same manner.
Initial Restatement
When a business restates its financial statements for the first time because of
a hyperinflationary economy, the basic rule is to apply the restatement
requirements as though the economy had always been hyperinflationary. This
means that non-monetary items remeasured at their historical cost must be
restated at the beginning of the earliest period presented to reflect the effects
of inflation, through the end of the latest reporting period. Non-monetary
items carried on the books since that date must also be adjusted for
inflationary effects.
After the initial restatement has been completed, restate all figures in
subsequent periods only from the previous reporting period.
Consolidation Issues
When a parent company consolidates the financial statements of its
subsidiaries, and a subsidiary reports its financial statements in the currency
of a hyperinflationary economy, the parent must first restate the financial
statements of the subsidiary using a general price index for that currency.
After doing so, the parent may then consolidate the financial statements of its
subsidiaries.
When a subsidiary states its results in a foreign currency, its restated
financial statements are then translated to the reporting currency of the parent
company at the closing exchange rate at the end of the reporting period.
Termination of Hyperinflationary Period
When it is determined that an economy is no longer hyperinflationary, a
business shall terminate the restatement of its financial statements from that
point onward. At that point, the company should consider the amounts stated
in its financial statements at the end of the most recent reporting period to be
the basis for the carrying amounts stated in its subsequent financial
statements.
Historical Presentation
IFRS does not allow a business to present the information required within
this chapter as a supplement to financial statements that have not been
restated. It also discourages separate presentation of the financial statements
prior to their restatement.
Hyperinflationary Reporting Disclosures
IFRS requires that the following disclosures be made regarding financial
reporting in a hyperinflationary environment:
• Note that all periods presented in the financial statements have been
restated for changes in the purchasing power of the entity’s functional
currency as of the end of the reporting period.
• State whether the information in the financial statements is based on
historical or current costs.
• Identify the price index used for the restatement, as well as the level of
the index at the end of the reporting period. Also note the change in
the index in both the current and previous reporting periods.
Summary
The solution to financial reporting in hyperinflationary economies is to
restate the financial statements using a general price index. However, it can
be quite difficult to obtain a reliable price index, especially when the index is
needed for periods of less than one month. Accordingly, it may be necessary
to create an alternative measure of price changes, probably based on changes
in the country’s exchange rate in relation to one or more other currencies. If it
is necessary to use such an internally-derived price index, be sure to
thoroughly document how the information is collected and used. This may
call for a policy that describes which exchange rate shall be used, how often
the exchange information will be collected, the source of this information,
how the price index is to be derived from this information, and how the price
index is to be calculated for shorter periods within a reporting period. A
stringently-applied policy is needed to ensure that financial statements are
restated in a consistent manner.
 Chapter 7
Earnings per Share
Introduction
If the reporting entity is publicly-held, it must report two types of earnings
per share information within the financial statements. In this chapter, we
describe how to calculate both basic and diluted earnings per share, as well as
how to present this information within the financial statements. The
information presented in this chapter only applies to entities whose ordinary
shares are traded in a public market.
IFRS Source Document
• IAS 33, Earnings per Share
Basic Earnings per Share
Basic earnings per share is the amount of a company’s profit or loss for a
reporting period that is available to its ordinary shares that are outstanding
during a reporting period. If a business only has ordinary shares in its capital
structure, it presents only its basic earnings per share for income from
continuing operations and net income. This information is reported on its
income statement.
The formula for basic earnings per share is:
Profit or loss attributable to ordinary equity holders of the parent business
Weighted average number of ordinary shares outstanding during the period
In addition, subdivide this calculation into:
• The profit or loss from continuing operations attributable to the parent
company
• The total profit or loss attributable to the parent company
When calculating basic earnings per share, incorporate into the numerator
adjustments for the following items:
• The after-tax amounts of preference dividends. This is the after-tax
amount of preference dividends on noncumulative preference shares
declared in the period, and the after-tax amount of preference
dividends required in the period, even if not declared.
• Differences caused by the settlement of preference shares. In general,
any difference between the consideration paid by a business to acquire
preference shares and their carrying amount is included in the
calculation of profit or loss that is attributable to the holders of
 ordinary shares.
• Other similar effects of preference shares
Also, incorporate the following adjustments into the denominator of the basic
earnings per share calculation:
• Contingent shares. If there are contingently issuable shares, treat them
as though they were outstanding as of the date when there are no
circumstances under which the shares would not be issued. If shares
are contingently returnable, do not include them in this calculation.
• Weighted-average shares. Use the weighted-average number of shares
during the period in the denominator. This is done by adjusting the
number of shares outstanding at the beginning of the reporting period
for ordinary shares repurchased or issued in the period. This
adjustment is based on the proportion of the days in the reporting
period that the shares are outstanding.
EXAMPLE
Lowry Locomotion earns a profit of £1,000,000 net of taxes in Year 1. In
addition, Lowry owes £200,000 in dividends to the holders of its cumulative
preference shares. Lowry calculates the numerator of its basic earnings per
share as follows:
£1,000,000 Profit - £200,000 Dividends = £800,000
Lowry had 4,000,000 ordinary shares outstanding at the beginning of Year
1. In addition, it sold 200,000 shares on April 1 and 400,000 shares on
October 1. It also issued 500,000 shares on July 1 to the owners of a newly-
acquired subsidiary. Finally, it bought back 60,000 shares on December 1.
Lowry calculates the weighted-average number of ordinary shares
outstanding as follows:

Lowry’s basic earnings per share is:

£800,000 adjusted profits ÷ 4,495,000 weighted-average shares =
£0.18 per share
Diluted Earnings per Share
Diluted earnings per share is the profit for a reporting period per ordinary
share outstanding during that period; it includes the number of shares that
would have been outstanding during the period if the company had issued
ordinary shares for all potential dilutive ordinary shares outstanding during
the period.
If a company has more types of shares than ordinary shares in its capital
structure, it must present both basic earnings per share and diluted earnings
per share information; this presentation must be for both income from
continuing operations and net income. This information is reported within the
company’s income statement.
To calculate diluted earnings per share, include the effects of all dilutive
potential ordinary shares. This means that the number of shares outstanding is
increased by the weighted average number of additional ordinary shares that
would have been outstanding if the company had converted all dilutive
potential ordinary shares to ordinary shares. This dilution may affect the
profit or loss in the numerator of the dilutive earnings per share calculation.
The formula is:
(Profit or loss attributable to ordinary equity holders of parent company
+ After-tax interest on convertible debt + Convertible preferred dividends)
(Weighted average number of ordinary shares outstanding during the period
+ All dilutive potential ordinary shares)
It may be necessary to make two adjustments to the numerator of this
calculation. They are:
• Interest expense. Eliminate any interest expense associated with
dilutive potential ordinary shares, since the assumption is that these
shares are converted to ordinary shares. The conversion would
eliminate the company’s liability for the interest expense.
• Dividends. Adjust for the after-tax impact of dividends or other types
of dilutive potential ordinary shares.
Further adjustments may be required for the denominator of this calculation.
They are:
• Anti-dilutive shares. If there are any contingent share issuances that
would have an anti-dilutive impact on earnings per share, do not
include them in the calculation. This situation arises when a business
experiences a loss, because including the dilutive shares in the
calculation would reduce the loss per share.
 • Dilutive shares. If there are potential dilutive ordinary shares, add
them to the denominator of the diluted earnings per share calculation.
Unless there is more specific information available, assume that these
shares are issued at the beginning of the reporting period.
• Dilutive securities termination. If a conversion option lapses during
the reporting period for dilutive convertible securities, or if the related
debt is extinguished during the reporting period, the effect of these
securities should still be included in the denominator of the diluted
earnings per share calculation for the period during which they were
outstanding.
In addition to these adjustments to the denominator, also apply all of the
adjustments to the denominator already noted for basic earnings per share.
Tip: The rules related to diluted earnings per share appear complex, but
they are founded upon one principle – that the absolute worst-case scenario
is being established to arrive at the smallest possible amount of earnings per
share. If there is an unusual situation involving the calculation of diluted
earnings per share and are not sure what to do, that rule will likely apply.
In addition to the issues just noted, here are a number of additional situations
that could impact the calculation of diluted earnings per share:
• Most advantageous exercise price. When the number of potential
shares that could be issued is calculated, do so using the most
advantageous conversion rate from the perspective of the person or
entity holding the security to be converted.
• Settlement assumption. If there is an open contract that could be settled
in ordinary shares or cash, assume that it will be settled in ordinary
shares, but only if the effect is dilutive. The presumption of settlement
in stock can be overcome if there is a reasonable basis for expecting
that settlement will be partially or entirely in cash.
• Effects of convertible instruments. If there are convertible instruments
outstanding, include their dilutive effect if they dilute earnings per
share. Consider convertible preference shares to be anti-dilutive when
the dividend on any converted shares is greater than basic earnings per
share. Similarly, convertible debt is considered anti-dilutive when the
interest expense on any converted shares exceeds basic earnings per
share. The following example illustrates the concept.
EXAMPLE
Lowry Locomotion earns a net profit of £2 million, and it has 5 million
ordinary shares outstanding. In addition, there is a £1 million convertible
loan that has an eight percent interest rate. The loan may potentially convert
into 500,000 of Lowry’s ordinary shares. Lowry’s incremental tax rate is 35
percent.
Lowry’s basic earnings per share is £2,000,000 ÷ 5,000,000 shares, or
£0.40/share. The following calculation shows the compilation of Lowry’s
diluted earnings per share:

• Option exercise. If there are any dilutive options and warrants, assume
that they are exercised at their exercise price. Then, convert the
proceeds into the total number of shares that the holders would have
purchased, using the average market price during the reporting period.
Then use in the diluted earnings per share calculation the difference
between the number of shares assumed to have been issued and the
number of shares assumed to have been purchased. The following
example illustrates the concept.
Tip: The average market price is usually considered to be a simple average
of closing weekly or monthly prices. However, if prices fluctuate markedly,
it may be necessary to instead use an average of the high and low prices.
EXAMPLE
Lowry Locomotion earns a net profit of £200,000, and it has 5,000,000
ordinary shares outstanding that sell on the open market for an average of
£12 per share. In addition, there are 300,000 options outstanding that can be
converted to Lowry’s ordinary shares at £10 each.
Lowry’s basic earnings per share is £200,000 ÷ 5,000,000 ordinary shares,
or £0.04 per share.
Lowry’s controller wants to calculate the amount of diluted earnings per
share. To do so, he follows these steps:
1. Calculate the number of shares that would have been issued at the
market price. Thus, he multiplies the 300,000 options by the
average exercise price of £10 to arrive at a total of £3,000,000 paid
to exercise the options by their holders.
2. Divide the amount paid to exercise the options by the market price
to determine the number of shares that could be purchased. Thus,
he divides the £3,000,000 paid to exercise the options by the £12
average market price to arrive at 250,000 shares that could have
been purchased with the proceeds from the options.
3. Subtract the number of shares that could have been purchased from
the number of options exercised. Thus, he subtracts the 250,000
shares potentially purchased from the 300,000 options to arrive at a
difference of 50,000 shares.
4. Add the incremental number of shares to the shares already
outstanding. Thus, he adds the 50,000 incremental shares to the
existing 5,000,000 to arrive at 5,050,000 diluted shares.
Based on this information, the controller arrives at diluted earnings per share
of £0.0396, for which the calculation is:
£200,000 Net profit ÷ 5,050,000 Ordinary shares

• Put options. If there are purchased put options, only include them in
the diluted earnings per share calculation if the exercise price is higher
than the average market price during the reporting period.
• Written put options. If there is a written put option that requires a
business to repurchase its own stock, include it in the computation of
diluted earnings per share, but only if the effect is dilutive. If the
exercise price of such a put option is above the average market price
of the company’s stock during the reporting period, this is considered
to be “in the money,” and the dilutive effect is to be calculated using
the following method, which is called the reverse treasury stock
method:
1. Assume that enough shares were issued by the company at
the beginning of the period at the average market price to
raise sufficient funds to satisfy the put option contract.
2. Assume that these proceeds are used to buy back the required
number of shares.
 3. Include in the denominator of the diluted earnings per share
calculation the difference between the numbers of shares
issued and purchased in steps 1 and 2.
EXAMPLE
A third party exercises a written put option that requires Armadillo
Industries to repurchase 1,000 shares from the third party at an exercise
price of £30. The current market price is £20. Armadillo uses the following
steps to compute the impact of the written put option on its diluted earnings
per share calculation:
1. Armadillo assumes that it has issued 1,500 shares at £20.
2. The company assumes that the “issuance” of 1,500 shares is used to
meet the repurchase obligation of £30,000.
3. The difference between the 1,500 shares issued and the 1,000
shares repurchased is added to the denominator of Armadillo’s
diluted earnings per share calculation.

• Call options. If there are purchased call options, only include them in
the diluted earnings per share calculation if the exercise price is lower
than the market price.
Tip: There is only a dilutive effect on the diluted earnings per share
calculation when the average market price is greater than the exercise prices
of any options or warrants.
• Contingent shares in general. Treat ordinary shares that are
contingently issuable as though they were outstanding as of the
beginning of the reporting period, but only if the conditions have been
met that would require the company to issue the shares. If the
conditions were not met by the end of the period, then include in the
calculation, as of the beginning of the period, any shares that would be
issuable if the end of the reporting period were the end of the
contingency period, and the result would be dilutive.
• Contingent shares dependency. If there is a contingent share issuance
that is dependent upon the future market price of the company’s
ordinary shares, include the shares in the diluted earnings per share
calculation, based on the market price at the end of the reporting
period; however, only include the issuance if the effect is dilutive. If
the shares have a contingency feature, do not include them in the
 calculation until the contingency has been met.
• Issuances based on future earnings and stock price. There may be
contingent stock issuances that are based on future earnings and the
future price of a company’s stock. If so, the number of shares to
include in diluted earnings per share should be based on the earnings
to date and the current market price as of the end of each reporting
period. If both earnings and share price targets must be reached in
order to trigger a stock issuance and both targets are not met, do not
include any related contingently issuable shares in the diluted earnings
per share calculation.
Always calculate the number of potential dilutive ordinary shares
independently for each reporting period presented in the financial statements.
Disclosure of Earnings per Share
The basic and diluted earnings per share information is normally listed at the
bottom of the income statement, and is listed for every period included in the
income statement. Also, if diluted earnings per share is reported in any of the
periods included in a company’s income statement, it must be reported for all
of the periods included in the statement. The following sample illustrates the
concept.
Sample Presentation of Earnings per Share

Note that, if the company reports a discontinued operation, it must present the
basic and diluted earnings per share amounts for the discontinued operation.
The information can be included either as part of the income statement or in
the accompanying notes. The preceding sample presentation includes a
disclosure for earnings per share from discontinued operations.
Tip: If the amounts of basic and diluted earnings per share are the same, it
 is allowable to have a dual presentation of the information in a single line
item within the income statement.
In addition to the earnings per share reporting format just noted, a company is
also required to report the following information:
• Reconciliation. State the differences between the numerators and
denominators of the basic and diluted earnings per share calculations
for income from continuing operations. This should include the
individual effect of each class of instruments that impact earnings per
share.
• Potential effects. Describe the terms and conditions of any securities
not included in the computation of diluted earnings per share due to
their antidilutive effects, but which could potentially dilute basic
earnings per share in the future.
• Subsequent events. Describe any transactions occurring after the latest
reporting period but before the issuance of financial statements that
would have a material impact on the number of ordinary or potential
ordinary shares if they had occurred prior to the end of the reporting
period. Examples of such transactions are the issuance of shares for
cash, the issuance of warrants, and the redemption of ordinary shares
outstanding.
If the number of ordinary shares or potential ordinary shares changes because
of a share split or similar transaction, retrospectively adjust both basic and
diluted earnings per share for all of the periods presented. Also disclose the
fact that the revision has been made to the earnings per share information.
The same changes should be made if there are retrospective updates caused
by changes in accounting policies.
Summary
It will have been evident from the discussions of earnings per share that the
computation of diluted earnings per share can be quite complex if there is a
correspondingly complex equity structure. In such a situation, it is quite
likely that diluted earnings per share will be incorrectly calculated. To
improve the accuracy of the calculation, create an electronic spreadsheet that
incorporates all of the necessary factors impacting diluted earnings per share.
Further, save the calculation for each reporting period on a separate page of
the spreadsheet; by doing so, there will be an excellent record of how these
calculations were managed in the past.
 Chapter 8
Interim Financial Reporting
Introduction
When a company issues financial statements for reporting periods of less than
one year, the statements are said to cover an interim period. When preparing
financial information for these periods, consider whether to report
information assuming that quarterly results are stand-alone documents, or
part of the full-year results of the business. This chapter discusses the
disparities that these different viewpoints can cause in the financial
statements, as well as other requirements mandated under IFRS. The
guidance in this chapter is not specific to any particular type of reporting
entity, but is most commonly applicable to publicly-held businesses that are
required to report their quarterly results.
IFRS Source Documents
• IAS 34, Interim Financial Reporting
• IFRIC 10, Interim Financial Reporting and Impairment
Overview of Interim Financial Reporting
A business will periodically create financial statements for shorter periods
than the full fiscal year, which are known as interim periods. The most
common examples of interim periods are monthly or quarterly financial
statements, though any period of less than a full fiscal year can be considered
an interim period. The concepts related to interim periods are most commonly
applicable to the financial statements of publicly-held companies, since they
are required to issue quarterly financial statements that must be reviewed by
their outside auditors; these financials must account for certain activities in a
consistent manner, as well as prevent readers from being misled about the
results of the business on an ongoing basis. IFRS encourages publicly-traded
businesses to issue interim financial reports for at least the first half of their
fiscal years, and to make those reports available not more than 60 days after
the end of every reported interim period.
Content of an Interim Financial Report
An interim financial report should contain the following financial statements:
• Balance sheet. Presented as of the end of the current interim period
and as of the end of the preceding fiscal year.
• Statement of comprehensive income. Presented for the current interim
 period and the fiscal year-to-date, as well as for the same interim
period and fiscal year-to-date for the preceding year.
• Statement of changes in equity. Presented for the current fiscal year-to-
date, as well as for the same period in the preceding year.
• Statement of cash flows. Presented for the current fiscal year-to-date,
as well as for the same period in the preceding year.
• Disclosures of significant accounting policies and other explanatory
items.
In addition, if an accounting policy is applied retrospectively or there is a
reclassification of items, include an adjusted balance sheet for the earliest
comparative period.
Reduced Information Requirements
Interim financial reports are typically prepared and issued within time frames
that are more compressed than the time periods that apply to annual financial
reports. Because of this time compression, companies may elect to provide
less information in their interim reports than in their annual reports. If they do
so, the amount of information provided should at least give an update on the
information in the latest annual financial report. Thus, the focus of a reduced
set of information is to reveal significant new activities, events, and
circumstances. The following are examples of such items that may require
disclosure if they are significant:
• Asset impairment losses or the reversal of these losses
• Contingent liability or contingent asset changes
• Fair value changes in financial assets or liabilities
• Fair value hierarchy transfers
• Financial asset classification changes
• Fixed asset acquisitions or disposals
• Fixed asset purchase commitments
• Inventory write-down or the reversal of a write-down
• Litigation settlements
• Loan defaults that have not been remedied
• Prior period error corrections
• Related party transactions
• Restructuring provision reversals
For the purposes of interim reporting, consider the materiality of an item in
relation to its impact on the interim period financial information, rather than
its impact on the annual financial report. Doing so means that more items will
likely be considered material, and will therefore be included in interim
financial reports. This approach makes it less likely that the users of interim
financial reports will be misled by the absence of key information.
EXAMPLE
Close Call Company records revenues of £10,000,000 and profits of
£300,000 in its first quarter. The company’s budget, which management has
a reliable history of attaining, projects full-year revenues of £45,000,000 and
profits of £1,800,000. The company’s controller considers a material item to
represent at least five percent of net income. In the first quarter, the
company experiences an obsolete inventory loss of £18,000. Since this
amount exceeds the materiality limit for the first quarter results, it should be
separately reported within the interim financial report for that quarter.
However, the amount is too small to be material for the company’s full-year
results, and so should not be separately reported within the year-end
financial report.

The following additional disclosures must be included in each interim

financial report:
• Compliance. If the financial report complies with all IFRS
requirements, disclose that fact.
• Dividends. Separately note the amount of dividends paid for ordinary
shares and other shares.
• Estimates. Disclose and quantify the amount of any changes in
estimate reported from prior interim periods or prior fiscal years.
• Fair value. Include all related fair value disclosures for financial
instruments.
• Investment entities. When an entity is becoming or ceasing to be an
investment entity, disclose the change in status and reason for the
change. If the entity has become an investment entity, also note the
fair value of those entities no longer being consolidated, the total gain
or loss, and the line item in which the gain or loss is recognized.
• Policies. State that the existing accounting policies and computation
methods used in the interim financial report were the same ones used
in the preparation of the last annual financial report. If this was not the
case, describe the change and its effect on the financial statements.
• Revenue disaggregation. Note the disaggregation of revenue from
contracts with customers, as noted in the Revenue chapter.
 • Seasonality. Describe the seasonality or cyclicality of interim
operations.
• Securities. Note any issuances, repurchases, or repayments of debt and
equity securities.
• Segments. If segment reporting is required (usually just for publicly-
held entities), report by segment the revenues from external customers,
intersegment revenues, profit or loss, total assets where there has been
a material change since the last annual financial report, a
reconciliation of segment-level profit or loss to the consolidated profit
or loss (with separate identification of material reconciling items), and
a description of changes in the basis of segmentation or profit/loss
measurement since the last annual financial report.
• Structure. Note any changes in the composition of the business during
the period from changes in control, restructurings, discontinued
operations, and/or business combinations.
• Subsequent events. Note events that occurred after the interim
reporting period that are not included in the financial statements.
• Unusual items. Describe and quantify any unusual items affecting
assets, liabilities, equity, net income, or cash flows.
If a business elects to make a significant change to an estimate during the
final interim period of a fiscal year, but does not issue a separate interim
financial report for that period, it should describe and quantify the change in
the annual financial report for that year.
If a business elects to provide a condensed set of financial statements in
an interim financial report, those statements are subject to the following
presentation rules:
• Include the same headings and subtotals used in the most recent annual
financial statements.
• Include any line items or disclosures needed to keep the financial
statements from being misleading.
• Present basic and diluted earnings per share, if the company is
publicly-held.
• Prepare consolidated financial statements if the last annual financial
report contained consolidated statements.
IFRS merely sets forth the low-end boundaries for the minimum amount of
information that must be presented in interim financial reports. A business
may elect to provide a complete set of financial information that greatly
expands upon the minimum requirements set forth by IFRS.
General Interim Reporting Rule
The general rule for interim period reporting is that the same accounting
principles and practices be applied to interim reports that are used for the
preparation of annual financial reports. The following bullet points illustrate
revenues and expenses that follow the general rule, and which therefore do
not change for interim reporting:
• Revenue. Revenue is recognized in the same manner that is used for
annual reporting, with no exceptions. Do not anticipate or defer
revenues based on anticipated seasonal changes in sales in future
periods.
• Costs associated with revenue. If a cost is typically assigned to a
specific sale (such as cost of goods sold items), expense recognition is
the same as is used for annual reporting.
• Direct expenditures. If an expense is incurred in a period and relates to
that period, it is recorded as an expense in that period. An example is
salaries expense.
• Accruals for estimated expenditures. If there is an estimated
expenditure to be made at a later date but which relates to the current
period, it is recorded as an expense in the current period. An example
is accrued wages. Generally, accrue expenses in an interim period if
this would also be done at the end of the fiscal year.
• Inventory. If an inventory item is written down to its net realizable
value during an interim period, it is permissible to reverse the entry in
a later interim period if it would be appropriate to do so at the end of
the fiscal year. Also, do not defer the recognition of any cost variances
arising from a standard costing system; instead, charge them to
expense as incurred.
Tip: It is permissible to estimate inventory valuations as of the end of
interim reporting periods, usually based on historical sales margins.
In addition, there are cases where a company is accustomed to only making a
year-end adjustment, such as to its reserves for doubtful accounts, obsolete
inventory, and/or warranty claims, as well as for year-end bonuses. Where
possible, these adjustments should be made in the interim periods, thereby
reducing the amount of any residual adjustments still required in the year-end
financial statements.
EXAMPLE
Armadillo Industries incurs an annual property tax charge of £60,000. Also,
Armadillo has historically earned an annual volume discount of £30,000 per
year, based on its full-year purchases from a major supplier.
Since the property tax charge is applicable to all months in the year, the
controller accrues a £5,000 monthly charge for this expense. Similarly, the
volume discount relates back to volume purchases throughout the year, not
just the last month of the year, in which the discount is retroactively
awarded. Accordingly, the controller creates a monthly credit of £2,500 to
reflect the expected year-end volume discount of £30,000.
Goodwill Impairment Losses
A business may recognize a goodwill impairment loss in an interim period. In
some cases, the circumstances will have changed in a later interim period to
such an extent that the impairment charge would not have been made. In such
cases, IFRS does not allow for the reversal of a goodwill impairment loss that
had been recognized in a prior interim period.
Interim Period Restatements
If there is a change in accounting policy prior to the end of a fiscal year,
restate the financial statements for all presented current-year and comparative
interim periods to incorporate the change. This involves the following steps:
1. Include that portion of the item that relates to the current interim
period in the results of the current interim period.
2. Restate the results of prior interim periods of the current year to
include that portion of the item relating to each interim period.
3. Restate the results of any comparison interim periods in prior years.
If it is impracticable to do so for all presented periods, then do so from the
earliest date at which it is practicable to do so.
The Integral View
Under the integral view of producing interim reports, the assumption is that
the results reported in interim financial statements are an integral part of the
full-year financial results (hence the name of this concept). This viewpoint
produces the following accounting issues:
• Accrue expenses not arising in the period. If an expense will be paid
later in the year that is incurred at least partially in the current interim
reporting period, accrue some portion of the expense in the current
period. Here are several examples of the concept:
o Accumulating paid absences. If a company pays its employees
 for absences from work, and this right is carried forward in
time, the expense accrual should be updated in each interim
financial report.
o Advertising. If payment is made in advance for advertising that
is scheduled to occur over multiple time periods, recognize the
expense over the entire range of time periods.
o Bonuses. If there are bonus plans that contain a legal or
constructive obligation to pay, accrue the expense in all
accounting periods. Only accrue this expense if it is possible
to reasonably estimate the amount of the bonus obligation,
which may not always be possible during the earlier months
covered by a performance contract.
o Contingencies. If there are contingent liabilities that will be
resolved later in the year, and which are both probable and
reasonably estimated, then accrue the related expense. An
example is a contingent lease payment that is based on the
annual sales achieved by the lessee.
o Depreciation and amortization. If there is a fixed asset,
depreciation (for tangible assets) or amortization (for
intangible assets) is ratably charged to all periods in its useful
life. Do not depreciate or amortize an asset that will not be
acquired until a later interim period.
o Insurance contributions. If assessments are made into a
government-sponsored insurance fund once a year, accrue the
expense in all interim periods.
o Profit sharing. If employees are paid a percentage of company
profits at year-end, and the amount can be reasonably
estimated, then accrue the expense throughout the year as a
proportion of the profits recognized in each period.
o Property taxes. A local government entity issues an invoice to
the company at some point during the year for property taxes.
These taxes are intended to cover the entire year, so accrue a
portion of the expense in each reporting period.
o Purchase price changes. If there is a contractually-mandated
purchase price change that has been earned and will take
effect, accrue it in the relevant prior interim periods. This
recordation is not allowed if the price change is discretionary.
 • Tax rate. A company is usually subject to a graduated income tax rate
that incrementally escalates through the year as the business generates
more profit. Under the integral view, use the expected tax rate for the
entire year in every reporting period, rather than the incremental tax
rate that applies only to the profits earned for the year to date. If it is
practicable to do so, estimate and apply the expected full-year tax rate
at the level of each individual tax jurisdiction and category of income.
EXAMPLE
The board of directors of Lowry Locomotion approves a senior management
bonus plan for the upcoming year that could potentially pay the senior
management team a maximum of £240,000. It initially seems probable that
the full amount will be paid, but by the third quarter it appears more likely
that the maximum amount to be paid will be £180,000. In addition, the
company pays £60,000 in advance for a full year of advertising in
Locomotive Times magazine. Lowry recognizes these expenses as follows:

The accounting staff spreads the recognition of the full amount of the
projected bonus over the year, but then reduces its recognition of the
remaining expense starting in the third quarter, to adjust for the lowered
bonus payout expectation.
The accounting staff initially records the £60,000 advertising expense as a
prepaid expense, and recognizes it ratably over all four quarters of the year,
which matches the time period over which the related advertisements are run
by Locomotive Times.

One problem with the integral view is that it tends to result in a significant
number of expense accruals. Since these accruals are usually based on
estimates, it is entirely possible that adjustments should be made to the
accruals later in the year, as the company obtains more precise information
about the expenses that are being accrued. Some of these adjustments could
be substantial, and may materially affect the reported results in later periods.
Summary
When creating interim financial reports, judiciously apply the integral view to
the reports – that is, the integral method increases the comprehensiveness of
the information presented, but at the cost of maintaining a large number of
accruals and estimates. Since a key factor in closing the books for an interim
period is the reduced amount of time in which to complete closing activities,
it may be necessary to emphasize efficiency over comprehensiveness and
restrict the use of accruals to material items.
 Chapter 9
Operating Segments
Introduction
If a company is publicly-held, it needs to report segment information, which
is part of the disclosures attached to the financial statements. This
information is used to give the readers of the financial statements more
insights into the operations and prospects of a business, as well as to allow
them to make more informed judgments about the entity as a whole, and the
business environment within which it operates. In this chapter, we describe
how to determine which business segments to report separately, and how to
report that information.
IFRS Source Document
• IFRS 8, Operating Segments
Overview of Segment Reporting
An operating segment is a component of a public entity, and which possesses
the following characteristics:
• Business activities. It has business activities that can generate revenues
and cause expenses to be incurred. This can include revenues and
expenses generated by transactions with other operating segments of
the same public entity. In addition, a start-up operation that has yet to
earn revenues may have operating segments.
• Results reviewed. The chief operating decision maker (typically the
chief executive officer or chief operating officer) of the public entity
regularly reviews its operating results, with the intent of assessing its
performance and making decisions about allocating resources to it.
• Financial results. Financial results specific to it are available.
Generally, an operating segment has a manager who is accountable to the
chief operating decision maker, and who maintains regular contact with that
person, though it is also possible that the chief operating decision maker
directly manages one or more operating segments. A segment manager may
manage more than one operating segment.
Some parts of a business are not considered to be reportable business
segments under the following circumstances:
• Corporate overhead. The corporate group does not usually earn
outside revenues, and so is not considered a segment.
 • Post-retirement benefit plans. A benefit plan can earn income from
investments, but it has no operating activities, and so is not considered
a segment.
The primary issue with segment reporting is determining which business
segments to report. The rules for this selection process are quite specific.
Segment information should be reported if a business segment passes any one
of the following three tests:
1. Revenue. The revenue of the segment from both external and
intercompany sales is at least 10% of the combined internal and
external revenue of all operating segments; or
2. Profit or loss. The absolute amount of the profit or loss of the
segment is at least 10% of the greater of the combined profits of all
the operating segments that did not report a loss, or of the combined
losses of all operating segments reporting a loss (see the following
example for a demonstration of this concept); or
3. Assets. The assets of the segment are at least 10% of the combined
assets of all the operating segments of the business.
If the accountant runs the preceding tests and arrives at a group of reportable
segments whose combined revenues are not at least 75% of the consolidated
revenue of the entire business, then add more segments until the 75%
threshold is surpassed.
If there is a business segment that used to qualify as a reportable segment
and does not currently qualify, but which is expected to qualify in the future,
continue to treat it as a reportable segment.
It is acceptable to report the results and assets of additional segments, if
management believes that doing so will provide useful information to the
readers of the financial statements.
If there are operating segments that have similar economic characteristics,
their results can be aggregated into a single operating segment, but only if
they are similar in all of the following areas:
• The nature of their products and services
• The nature of their systems of production
• The nature of their regulatory environments (if applicable)
• Their types of customers
• Their distribution systems
The number of restrictions on this type of reporting makes it unlikely that one
would be able to aggregate reportable segments.
 After all of the segment testing has been completed, it is possible that
there will be a few residual segments that do not qualify for separate
reporting. If so, combine the information for these segments into an “other”
category and include it in the segment report for the entity. Be sure to
describe the sources of the revenues included in this “other” category.
Tip: The variety of methods available for segment testing makes it possible
that there will be quite a large number of reportable segments. If so, it can
be burdensome to create a report for so many segments, and it may be
confusing for the readers of the company’s financial statements.
Consequently, consider limiting the number of reportable segments to ten;
the information for additional segments can be aggregated for reporting
purposes.
EXAMPLE
Lowry Locomotion has six business segments whose results it reports
internally. Lowry’s controller needs to test the various segments to see
which ones qualify as being reportable. He collects the following
information:

In the table, the total profit exceeds the total loss, so the controller uses the
total profit for the 10% profit test. The controller then lists the same table
again, but now with the losses column removed and with test thresholds at
the top of the table that are used to determine which segments are reported.
An “X” mark below a test threshold indicates that a segment is reportable. In
addition, the controller adds a new column on the right side of the table,
which is used to calculate the total revenue for the reportable segments.
This analysis shows that the diesel locomotive, electric locomotive,
passenger car, and trolley car segments are reportable, and that the combined
revenue of these reportable segments easily exceeds the 75% reporting
threshold. Consequently, the company does not need to separately report
information for any additional segments.

Segment Disclosure
This section contains the disclosures for various aspects of segment reporting
that are required under IFRS. At the end of each set of requirements is a
sample disclosure containing the more common elements of the
requirements.
Segment Disclosure
The key requirement of segment reporting is that the revenue, profit or loss,
and assets of each segment be separately reported for any period for which an
income statement is presented. In addition, reconcile this segment
information back to the company’s consolidated results, which requires the
inclusion of any adjusting items. Also disclose the methods by which it was
determined which segments to report, and note the judgments made by
management in applying the aggregation criteria noted earlier in this chapter.
The essential information to include in a segment report includes:
• The types of products and services sold by each segment
• The basis of organization (such as by geographic region or product
line)
• Revenues from external customers
• Revenues from inter-company transactions
• Interest revenue
• Interest expense
• Depreciation and amortization expense
 • Material income and expense items
• Any interest in the profit or loss of associates or joint ventures
accounted for using the equity method
• Income tax expense or income
• Other material non-cash items
• Profit or loss
The following two items must also be reported if they are included in the
determination of segment assets, or are routinely provided to the chief
operating decision maker:
• Equity method interests in other entities.
• The total expenditure for additions to fixed assets. Expenditures for
most other long-term assets are excluded from this requirement.
The company should also disclose the following information about how it
measures segment information:
• How any transactions between reportable segments were accounted
for.
• The nature of any differences between reported segment profits or
losses and the consolidated profit or loss for the entity, before the
effects of income taxes and discontinued operations.
• The nature of any differences between the assets and/or liabilities
reported for segments and for the consolidated entity.
• The nature of any changes in the measurement of segment profits and
losses from prior periods, and their effect on profits and losses.
• A discussion of any asymmetrical allocations, such as the allocation of
depreciation expense to a segment without a corresponding allocation
of assets.
The preceding disclosures should be presented along with the following
reconciliations, which should be separately identified and described:

If an operating segment qualifies for the first time as being reportable, also
report the usual segment information for it in any prior period segment data
that may be presented for comparison purposes, even if the segment was not
reportable in the prior period. An exemption is allowed for this prior period
reporting if the required information is not available, or if it would be
excessively expensive to collect the information.
The operating segment information reported should be the same
information reported to the chief operating decision maker for purposes of
assessing segment performance and allocating resources. This may result in a
difference between the information reported at the segment level and in the
public entity’s consolidated financial results. If so, disclose the differences
between the two figures.
If a public entity alters its internal structure to such an extent that the
composition of its operating segments is altered, restate its reported results
for earlier periods, as well as interim periods, to match the results and
financial position of the new internal structure. This requirement is waived if
it is impracticable to obtain the required information. The result may be the
restatement of some information, but not all of the segment information. If an
entity does alter its internal structure, it should disclose whether there has
also been a restatement of its segment information for earlier periods. If the
entity does not change its prior period information, it must report segment
information in the current period under both the old basis and new basis of
segmentation, unless it is impracticable to do so.
EXAMPLE
The controller of Lowry Locomotion produces the following segment report
for the segments identified in the preceding example:

Tip: IFRS does not require that a business report information that it does
not prepare for internal use, if the information is not available and obtaining
it would be excessively expensive.
Revenue Disclosure
A publicly-held entity must report the sales garnered from external customers
for each product and service or group thereof, unless it is impracticable to
compile this information.
The entity must also describe the extent of its reliance on its major
customers. In particular, if revenues from a single customer exceed 10% of
the entity’s revenues, this fact must be disclosed, along with the total
revenues garnered from each of these customers and the names of the
segments in which these revenues were earned. It is not necessary to disclose
the name of a major customer.
If there is a group of customers under common control (such as different
departments of the federal government), the revenues from this group should
be reported in aggregate as though the revenues were generated from a single
customer.
EXAMPLE
Armadillo Industries reports the following information about its major
customers:
Revenues from one customer of Armadillo’s home security
segment represented approximately 12% of the company’s
consolidated revenues in 20X2, and 11% of consolidated revenues
in 20X1.
Geographic Area Disclosure
A publicly-held entity must disclose the following geographic information,
unless it is impracticable to compile:
• Revenues. All revenues generated from external customers, and
attributable to the entity’s home country, and all revenues attributable
to foreign countries. Foreign-country revenues by individual country
shall be disclosed if these country-level sales are material. There must
also be disclosure of the basis under which revenues are attributed to
individual countries.
• Assets. All long-lived assets (for which the definition essentially
restricts reporting to fixed assets) that are attributable to the entity’s
home country, and all such assets attributable to foreign countries.
Foreign-country assets by individual country shall be stated if these
assets are material.
It is also acceptable to include in this reporting the subtotals of geographic
information by groups of countries.
 Geographic area reporting is waived if providing it is impracticable. If so,
the entity must disclose the fact.
EXAMPLE
Armadillo Industries reports the following geographic information about its
operations:

Tip: A company may choose to disclose segment information that is not

compliant with IFRS. If so, do not describe the information as being
segment information.
Summary
The determination of whether a business has segments is, to some extent,
based upon whether information is tracked internally at the segment level.
Thus, if a company’s accounting systems are sufficiently primitive, or if
management is sufficiently disinterested to not review information about
business segments, it is possible that even a publicly-held company will have
no reportable business segments.
If there are a number of reportable segments, consider using the report
writing software in the accounting system to create a standard report that
automatically generates the entire segment report for the entity’s disclosures.
By using this approach, no time will be wasted manually compiling the
information, which avoids the risk of making a mistake while doing so.
However, if the reportable segments change over time, the report structure
must be modified to match the new group of segments.
 Chapter 10
Joint Arrangements
Introduction
When two entities decide to engage in mutually beneficial activities through a
joint arrangement, the accounting for the arrangement will vary, depending
upon its structure. In this chapter, we focus on the rules that trigger the
classification of a joint arrangement as either a joint operation or a joint
venture, as well as the accounting for each type of arrangement.
IFRS Source Document
• IFRS 11, Joint Arrangements
Overview of Joint Arrangements
A joint arrangement is one in which several parties exercise joint control
under a contractual arrangement. Such arrangements may be created to share
costs or risks, or to share access to certain types of technology, import
arrangements, and so forth. They may be established under any number of
legal structures, such as corporations or various types of limited liability
entities.
Joint control is considered to be when decisions about certain activities
require unanimous consent by those parties contractually entitled to share
control. Thus, a joint arrangement requires that the controlling parties must
act together to direct certain activities. Viewed from a negative perspective, a
party participating in a joint arrangement has the ability to prevent the other
parties from controlling the arrangement.
EXAMPLE
Kilo Corporation, Lima Limited, and Mike Manufacturing establish an
arrangement under which Kilo has 50% of the voting rights, Lima has 40%,
and Mike has 10%. The arrangement between these entities specifies that at
least 90% of the voting rights are required to make valid decisions
concerning the activities conducted by the joint arrangement. Given these
terms, Kilo does not control the arrangement, because it must obtain the
agreement of Lima for any decision. The implication of the arrangement is
that Kilo and Lima exercise joint control over the arrangement. Mike does
not have joint control, since its approval is not required in order to make
decisions concerning the arrangement, and it cannot block decisions.
An arrangement could still be considered a joint arrangement even in the
absence of unanimous consent among those parties having joint control, if the
contractual arrangement includes a provision for dealing with dispute
resolution, such as the use of an arbitrator.
The treatment of a joint venture depends upon its classification as either a
joint operation or a joint venture. The operators of a joint operation have
rights to the assets and obligations for the liabilities related to the
arrangement, while the operators of a joint venture have rights to the net
assets of the arrangement.
A joint operation exists when it is not structured as a separate legal entity,
with only a contractual arrangement stating the rights and responsibilities of
the parties. In this situation, the parties recognize in their own financial
statements their respective shares of the related revenues and expenses, as
well as any assets and liabilities.
A joint arrangement may also be structured through a separate entity,
which holds the assets and liabilities used to conduct the operations of the
arrangement. This type of arrangement can be considered either a joint
operation or a joint venture, depending upon the rights and obligations of the
parties. An arrangement that gives the operators rights to the assets and
liabilities of the separate entity is a joint operation, while an arrangement that
gives the operators rights to the net assets of the arrangement is a joint
venture. The following flowchart shows the decision points in deciding
whether an arrangement is a joint operation or a joint venture.
When an interest is acquired in a joint operation whose activities are
considered to be a business, the investing entity should apply the principles of
business combination accounting to the arrangement, based on its share in the
joint operation, but only to the extent that these principles do not conflict
with the accounting for joint arrangements. The applicable principles of
business combinations include:
• Measuring assets and liabilities at their fair values
• Recognizing acquisition-related expenses as the costs are incurred
• Recognizing deferred tax assets and liabilities caused by the initial
recognition of assets and liabilities
• Recognizing as goodwill any amount of consideration paid out that
exceeds the net amount of assets and liabilities acquired and assumed,
respectively
• Testing goodwill for impairment at least annually and when there is an
 indication of impairment
See the Business Combinations chapter for more information.
Joint Arrangement Decision Path

EXAMPLE
Oscar Corporation and Papa Manufacturing enter into a joint arrangement,
whereby they create Quebec Company, with each of the owners taking a
50% stake in the new business. By using the legal form of the corporation,
Oscar and Papa separate themselves from the assets and liabilities of
Quebec. This means that both parties have rights to the net assets of the
arrangement, which classifies the arrangement as a joint venture.
However, Oscar and Papa alter the corporate structure of the Quebec entity,
so that each one has an ongoing interest in the assets and liabilities of
Quebec. By making this change to the corporate structure, Oscar and Papa
have essentially altered the form of the transaction to be a joint operation.
EXAMPLE
Romeo Inc. and Sierra Corporation enter into a joint arrangement by
creating Tango Company, in which Romeo and Sierra each hold a 50%
interest. The legal form of the arrangement indicates that the owners have
rights to the net assets of the arrangement, which would logically lead to the
classification of the arrangement as a joint venture.
However, the arrangement was specifically created to supply both Romeo
and Sierra with equal proportions of a rare earth mineral, which Tango
extracts from a mine. Romeo and Sierra take virtually all of the output of the
mine, and also set the price at which they purchase it to match the costs
incurred by Tango. Because this arrangement means that Tango is
exclusively dependent upon Romeo and Sierra for its cash flows, the owners
essentially have an obligation to fund the settlement of Tango’s liabilities.
Also, since they take all of Tango’s output, they essentially have rights to all
of the economic benefits of Tango.
Thus, the facts and circumstances indicate that the arrangement is actually a
joint operation.

It is possible that the facts and circumstances under which an arrangement

was originally classified as a joint operation or joint venture will change over
time. If so, adjust the classification to meet the circumstances.
Financial Statement Presentation of Joint Arrangements
If an entity classifies its participation in a joint arrangement as a joint
operation, it should recognize the following information in its financial
statements:
• Assets. The entity’s assets in the joint operation, as well as its share of
any jointly-held assets.
• Liabilities. The entity’s liabilities incurred through the joint operation,
as well as its share of any jointly-incurred liabilities.
• Revenues from share of output. The amount of any revenues
recognized from the sale of the entity’s share of any output generated
 by the joint operation.
• Revenues from allocation. The amount of any revenues sold by the
joint venture and allocated to the entity.
• Expenses. The entity’s expenses incurred in relation to the joint
operation, and its share of any expenses that were jointly incurred.
When a party to a joint arrangement that is classified as a joint operation
enters into a transaction with the joint operation, it is essentially doing
business with the other parties to the arrangement. The following accounting
applies to such a transaction:
• Asset purchase. If the party purchases assets from the joint operation,
the party cannot recognize its share of the resulting gains or losses
until it has resold the assets to a third party.
• Gains and losses. The party should recognize any gains and losses
generated by the transaction only to the extent of the interests of the
other parties in the joint operation.
• Impairment. If the transaction reduces the net realizable value of the
assets of the joint operation, the party should recognize its full share of
the loss.
If an entity classifies its participation in a joint arrangement as a joint venture,
it should recognize in its financial statements the entity’s investment in the
joint venture, using the equity method of accounting. See the Investments in
Associates and Joint Ventures chapter for more information.
Summary
The flowchart in this chapter might make it appear as though most joint
arrangements will, by default, be classified as joint operations. However, the
overriding factor is the presence of a separate legal entity to house a jointly-
controlled entity. In most cases, barring the presence of a joint arrangement
that definitively states otherwise, most joint arrangements that make use of a
legal entity will probably be classified as joint ventures.
 Chapter 11
Investments in Associates and Joint Ventures
Introduction
Most of the guidance in this chapter is applicable to those situations where a
business is an investor with either significant or joint control over an
investee, and needs to record its initial and ongoing investment in the
investee. We also address a related topic, which is the proper classification of
member investments in a cooperative enterprise.
IFRS Source Documents
• IAS 28, Investments in Associates and Joint Ventures
• IFRIC 2, Members’ Shares in Cooperative Entities and Similar
Instruments
Investments in Associates and Joint Ventures
The proper type of accounting to use for an investment in an associate or
joint venture depends upon the level of control that an investor exercises over
the investee. The assumption in this section is that significant control is being
exercised, which leads to a requirement to use the equity method of
accounting for an investment. In this section, we address the concept of
significant influence, as well as how to account for an investment using the
equity method.
Significant Influence
The key element in determining whether to use the equity method is the
extent of the influence exercised by an investor over an investee. The
essential rules governing the existence of significant influence are:
• Voting power. Significant influence is presumed to be present if an
investor and its subsidiaries hold at least 20 percent of the voting
power of an investee. When reviewing this item, consider the impact
of potential voting rights that are currently exercisable, such as
warrants, stock options, and convertible debt. This is the overriding
rule governing the existence of significant influence.
• Board seat. The investor controls a seat on the investee’s board of
directors.
• Personnel. Managerial personnel are shared between the entities.
• Policy making. The investor participates in the policy making
processes of the investee. For example, the investor can affect
 decisions concerning distributions to shareholders.
• Technical information. Essential technical information is provided by
one party to the other.
• Transactions. There are material transactions between the entities.
These rules should be followed unless there is clear evidence that significant
influence is not present. Conversely, significant influence can be present
when voting power is lower than 20 percent, but only if it can be clearly
demonstrated.
An investor can lose significant control over an investee, despite the
presence of one or more of the preceding factors. For example, a government,
regulator, or bankruptcy court may gain effective control over an investee,
thereby eliminating what had previously been the significant influence of an
investor.
The Equity Method
If significant influence is present, an investor should account for its
investment in an investee using the equity method. In essence, the equity
method mandates that the initial investment be recorded at cost, after which
the investment is adjusted for the actual performance of the investee. The
following table illustrates how the equity method operates.
Equity Method Calculation

The investor’s share of the investee’s profits and losses are recorded within
profit or loss for the investor. Also, if the investee records changes in its other
comprehensive income, the investor should record its share of these items
within other comprehensive income, as well.
EXAMPLE
Armadillo Industries purchases 30% of the common stock of Titanium
Barriers, Inc. Armadillo controls two seats on the board of directors of
Titanium as a result of this investment, so it uses the equity method to
account for the investment. In the next year, Titanium earns £400,000.
Armadillo records its 30% share of the profit with the following entry:

A few months later, Titanium issues a £50,000 cash dividend to Armadillo,

which the company records with the following entry:

The percentage of investee profits and losses that an investor recognizes is

based on the investor’s actual ownership interest in the investee. The impact
of potential voting rights, as evidenced by warrants, stock options,
convertible debt, and so forth, is not included in the calculation of this
percentage.
When the equity method is in use, the investor should periodically
examine its investment to see if there has been any impairment of the
recorded amount. The impairment test is to compare the recoverable amount
of the investment with its carrying amount. If impairment has occurred, the
investor records an impairment loss in the amount by which the recoverable
amount is less than the carrying amount; this is used to reduce the recorded
investment in the investee. If the value of an investment subsequently
increases, the impairment loss can be reversed, to the extent that the
recoverable amount of the investment increases. Objective evidence of
impairment can result from one or more of the following loss events:
• Significant financial difficulties experienced by the joint venture or
associate
• A breach of contract by the joint venture or associate
• A concession is granted to the joint venture or associate due to
financial difficulties
• The joint venture or associate will probably require financial
reorganization
• There is no active market for the investment, due to the financial
difficulties of the joint venture or associate
If an investee reports a large loss, or a series of losses, it is possible that
recording the investor’s share of these losses will result in a substantial
decline of the investor’s recorded investment in the investee. If so, the
investor should stop using the equity method when its investment reaches
zero. If an investor’s investment in an investee has been written down to zero,
but it has other investments in the investee (such as loans), the investor
should continue to recognize its share of any additional investee losses, and
offset them against the other investments, in sequence of the seniority of
those investments (with offsets against the most junior items first). Any
further share of investee losses is only recorded if the investor has committed
to obligations on behalf of the investee. If the investee later begins to report
profits again, the investor does not resume use of the equity method until
such time as its share of investee profits have offset all investee losses that
were not recognized during the period when use of the equity method was
suspended.
EXAMPLE
Armadillo Industries has a 35% ownership interest in the common stock of
Arlington Research. The carrying amount of this investment has been
reduced to zero because of previous losses. To keep Arlington solvent,
Armadillo has purchased £250,000 of Arlington’s preferred stock, and
extended a long-term unsecured loan of £500,000.
During the next year, Arlington incurs a £1,200,000 loss, of which
Armadillo’s share is 35%, or £420,000. Since the next most senior level of
Arlington’s capital after common stock is its preferred stock, Armadillo first
offsets its share of the loss against its preferred stock investment. Doing so
reduces the carrying amount of the preferred stock to zero, leaving £170,000
to be applied against the carrying amount of the loan. This results in the
following entry by Armadillo:

In the following year, Arlington records £800,000 of profits, of which

Armadillo’s share is £280,000. Armadillo applies the £280,000 first against
the loan write-down, and then against the preferred stock write-down with
the following entry:

The result is that the carrying amount of the loan is fully restored, while the
carrying amount of the preferred stock investment is still reduced by
£140,000 from its original level.

There may be a reduction in the ownership interest of an investor in an

investee, where the equity method is already in use. If the reduction still
allows the investor to have significant influence over the investee, the
investor should continue to use the equity method. However, this change
means that the investor has effectively disposed of a portion of its share of
the assets and liabilities of the investee. Therefore, the investor should
reclassify to profit or loss a portion of those amounts related to the activities
of the investee that are currently reported in the other comprehensive income
of the investor.
If an investor classifies an equity method investee as held for sale, it
freezes use of the equity method while the investment is so classified. If, at a
later date, the held for sale classification is no longer valid, the investor must
retroactively apply the equity method from the date when the held for sale
classification was first applied to the investment.
Use of the equity method should be discontinued as of the date when the
investee can no longer be classified as an associate or a joint venture.
Specifically, the following circumstances cancel use of the equity method:
• The investee becomes a subsidiary, in which case its financial
statements are consolidated with those of the parent entity.
• The investment is classified as a financial asset, in which case the
investment is measured and recognized at its fair value.
When use of the equity method is discontinued, and if the investor had
previously recorded its share of investee transactions in other comprehensive
income, these items should be reclassified to profit or loss.
EXAMPLE
Armadillo Industries is a 25% investor in Titanium Housings Ltd., and so is
considered to have significant influence over Titanium. Titanium is
currently holding short-term investments in commercial paper for which it
has recorded an unrecognized gain of £100,000 in other comprehensive
income. Armadillo records its 25% share of this gain in other comprehensive
income. The next month, Armadillo loses significant influence over
Titanium when a federal regulator takes control of the entity. On the date of
the loss of control, Armadillo should reclassify the £25,000 gain to profit or
loss.

The following additional rules apply to the use of the equity method:
• Accounting policies. The accounting policies used by the investee
should be the same as those used by the investor. If not, adjust the
financial statements of the investee so that they present information in
 accordance with the policies used by the investor.
• Cumulative preference shares. The investee may have cumulative
preference shares outstanding that are held by other parties than the
investor. If so, the investor calculates its share of investee profits or
losses after adjusting for the dividends on these shares, even if the
dividends have not yet been declared.
• Financial statements used. To record the equity method, the investor
uses the most recent financial statements of the investee. If the
reporting period closing dates of the investor and investee are
different, the investee should prepare financial statements through the
date used by the investor, unless this is impracticable to do so. If there
is a difference in dates, adjust the financial statements of the investee
for significant transactions and events that occurred after the date of
the investee’s financial statements and through the ending date of the
investor’s financial statements. The upper limit on the difference in the
reporting periods of the entities is three months. For consistency, any
differences between the ending dates of the reporting periods of the
two entities should be the same from period to period.
• Impairments. When an investor sells assets to associates or joint
ventures, and there is an impairment loss or a reduction in net
realizable value on the assets sold, the investor recognizes these losses
in full.
• Inter-entity transactions. The investor only recognizes transactions
with an investee to the extent of the interests of any unrelated
investors in the investee. Thus, the investor’s share in the gains and
losses recorded by an investee for these transactions is eliminated.
• Non-monetary contribution. If the investor contributes a non-monetary
asset to an associate or joint venture in exchange for an equity interest,
and also receives assets in exchange, the investor can recognize the
full amount of any gain or loss on that portion of the contribution
relating to the assets received.
EXAMPLE
Armadillo Industries sells £200,000 of raw materials to its 25 percent owned
associate, Titanium Housings Ltd. The cost to Armadillo of these raw
materials is £125,000.
Armadillo initially records a profit of £75,000 on this transaction, but must
reduce the profit by its 25 percent stake in Titanium, which results in a
£56,250 profit.

Members’ Shares in Cooperative Entities

Groups of individuals or businesses sometimes work together to create
cooperatives that represent their interests. Members typically hold shares or
interests in these cooperatives. These shares or interests may contain a
redemption clause that requires a cooperative to buy back member shares or
interests.
A cooperative may not have to classify these shares or interests as
financial liabilities, despite the presence of a redemption clause. Proper
classification will depend upon the exact terms and conditions of the shares
or interests, as well as local laws and regulations, and the charter of the
cooperative. If there is no right of redemption or the cooperative can refuse
redemption, shares and interests are most likely classified as equity. If certain
conditions must be met before a redemption can take place, the related shares
or interests should not be treated as equity.
If there is a prohibition on redemptions above a certain number of shares
or interests, the shares and interests that can be redeemed are classified as
liabilities, while the other shares and interests are classified as equity. If the
proportion of shares or interests subject to this prohibition changes over time,
this can trigger a transfer between the equity and financial liability accounts
of the cooperative.
When measuring the amount of a financial liability related to a
redemption feature, a cooperative should initially do so at the fair value of the
redemption. Fair value is considered to be no less than the maximum
redemption amount payable from the first possible payment date.
If a member acts as a customer, the transactions related to that activity,
such as depositing funds in a deposit account, are considered operational
assets and liabilities of the cooperative.
EXAMPLE
The Ethanol Cooperative is run by a regional group of farmers, who have
pooled their assets to create an ethanol production facility that uses their
produce as input to the production process. Local regulations mandate that
cooperatives cannot redeem member shares if doing so reduces paid-in
capital below 60 percent of the highest amount of paid-in capital. The
highest amount of paid-in capital has been £10,000,000. At the end of the
current reporting period, the amount of paid-in capital is £8,400,000.
Based on these facts, £6,000,000 of the paid-in capital can be classified as
equity, and the remaining £2,400,000 as a financial liability.

Disclosures
An investment in an associate or joint venture should be classified as a non-
current asset. However, if the intent of the investor is to sell the investment,
the proper classification is to list the investment as held for sale.
When there is a transfer between the equity and financial liability
accounts of a cooperative that is caused by a change in the amount of
member shares or interests that may be redeemed, disclose the amount,
timing, and reason for the change.
Summary
The equity method is one of the more difficult methods for measuring an
investment, especially if a share of both profit and loss and other
comprehensive income transactions of the investee must be recognized, and
when losses place an investment on the cusp of terminating or restarting use
of the method. Accordingly, the best option is to closely examine the
presence of significant influence over an investee, and to make a persuasive
case that such influence is not present. If this argument is sufficiently
convincing, the investor can avoid use of the equity method, and instead treat
the situation as a simple investment.
 Chapter 12
Disclosure of Interests in Other Entities
Introduction
A business may own an interest in another entity. If so, the business should
disclose a sufficient amount of information about that interest to inform
readers of its financial statements about the nature of the relationship. This
chapter outlines a number of required disclosures, which are segregated by
type of interest.
IFRS Source Document
• IFRS 12, Disclosure of Interests in Other Entities
Overview of Interests in Other Entities
A company may have an interest in another entity, which means that the
company is exposed to a certain amount of variability in returns from the
other entity. The nature of a company’s interests in other entities could be
critical to its success, since these other entities may generate a substantial
amount of the profits or losses reported by the company. Consequently, the
readers of a company’s financial statements should be given sufficient
information to evaluate the nature of these interests and the risks associated
with them, as well as how these interests affect the financial performance,
position, and cash flows of the company. The following general types of
information are considered to represent sufficient disclosure:
• The judgments made to determine the nature of a relationship.
• Information about interests in specific types of entities, such as
subsidiaries, joint arrangements and associates, and structured entities
over which the company does not exercise control.
These disclosures may include a discussion of:
• Why a business does not control another entity, even though it owns
over half of the voting rights of the entity, or why it does control an
entity, despite having a lower ownership percentage.
• Why a business is considered an agent of another entity for certain
transactions, or why it considers itself to be acting as a principal.
• Why a business has significant influence over another entity, despite
holding less than 20% of its voting rights, or why the business does
not have significant influence despite holding more than 20% of its
voting rights.
The level and type of these disclosures will vary, depending upon the nature
of the relationships that a business has with other entities. In the following
sections, we will address the disclosures required for specific types of
interests in other entities.
Interests in Subsidiaries
When a business has subsidiaries, the general goals of disclosure are to
enable users of the information to understand the composition of the group of
companies, the involvement of non-controlling interests, any restrictions on
the use of subsidiary assets and liabilities, and risks. Users must also
comprehend the consequences of changes in ownership interests or the loss of
control over subsidiaries during a reporting period.
More specifically, the following information relating to subsidiaries must
be disclosed in the notes accompanying the financial statements:
• Reporting dates. When the financial statements of a subsidiary are
rolled into the parent company’s consolidated statements, and the
period encompassed by the financials of the subsidiary are different
from the reporting period of the parent, note the ending date of the
subsidiary’s reporting period and the reason for using the different
reporting period.
• Non-controlling interests. If there is a non-controlling interest in a
subsidiary, disclose the subsidiary’s name and principal place of
business, the proportions of the non-controlling interests’ ownership
interest and voting rights, any profit or loss allocated to the non-
controlling interests, and the accumulated amount of non-controlling
interests in the subsidiary as of the end of the period. Also disclose
dividends paid to the non-controlling interests, and summarized
financial information about the subsidiary in such areas as current
assets, non-current assets, current liabilities, non-current liabilities,
revenue, profit or loss, and total comprehensive income.
• Restrictions. Disclose any significant restrictions on the ability of the
parent entity to access or use the assets of the subsidiary, or settle its
liabilities, such as restrictions on cash transfers, or the presence of
guarantees that prevent dividends from being paid. Also note the
carrying amounts of the assets and liabilities to which these
restrictions apply.
• Risks. Note the terms of any contractual arrangements that may require
financial support to a consolidated structured entity, including the
 circumstances under which the reporting entity could be exposed to a
loss. If the parent or another entity in the reporting group has provided
support to a consolidated structured entity in the absence of a
contractual obligation to do so, describe the type and amount of
support provided, and the reasons for doing so. If the provision of
support resulted in the control of a structured entity, disclose the
reasons for extending support. Finally, if the reporting entity intends to
provide support to a consolidated structured entity, disclose this fact.
• Changes in ownership interest. Present a schedule showing the effects
of changes in the ownership interest in a subsidiary on the equity
attributable to owners of the parent, where the changes do not result in
a loss of control.
• Loss of control. If the parent entity loses control over a subsidiary,
disclose the gain or loss attributable to the fair value measurement of
the investment in the former subsidiary on the date when control was
lost, as well as the line item within which this information is classified
in the income statement.
Interests in Joint Arrangements and Associates
A joint arrangement is one in which several parties exercise joint control
under a contractual arrangement, while an associate is an entity over which
another party exercises significant control. When a business has interests in
joint arrangements or in associates, it should disclose enough information for
users of its financial statements to evaluate the nature and financial effects of
these interests, as well as any related risks. Consequently, the following
disclosures should be made in the notes that accompany the financial
statements.
For each material joint arrangement and associate, disclose:
• The name of the joint arrangement or associate, and its principal place
of business.
• The nature of the relationship with the joint arrangement or associate.
• The ownership interest percentage in the joint arrangement or
associate.
For each material joint venture and associate, disclose:
• Whether the investment is measured under the equity method or using
fair value.
• Dividends received from the joint venture or associate.
• Summarized financial information that includes current assets, non-
 current assets, current liabilities, non-current liabilities, revenue, profit
or loss from continuing operations, post-tax profits or losses from
discontinued operations, other comprehensive income, and total
comprehensive income.
• For each material joint venture, the cash and cash equivalents, current
financial liabilities, non-current financial liabilities, depreciation and
amortization, interest income, interest expense, and income taxes.
• The fair value of the investment, if a quoted market price is available
from which to derive the fair value, and if the investment is accounted
for under the equity method.
• For all individually immaterial joint ventures that are accounted for
using the equity method, the carrying amount of these investments, as
well as the aggregate share of profit or loss from continuing
operations, post-tax profit or loss from discontinued operations, other
comprehensive income, and total comprehensive income. The same
information should be provided separately for all individually
immaterial associates that are accounted for using the equity method.
Other disclosures that may apply to joint arrangements and associates are:
• The nature of any significant restrictions on the ability of the joint
venture or associate to transfer funds to the business, such as in the
form of dividends, loan repayments, or advances. Examples of
possible restrictions are loan covenants or contractual arrangements.
• The ending date of the reporting period of the joint venture or
associate, if it varies from that of the business, and the reason for using
this different date.
• Any unrecognized share of the losses of a joint venture or associate,
both for the period and in total, if the business has ceased recognizing
its share of losses under the equity method.
• Commitments relating to joint ventures, as well as total commitments
made but not recognized relating to joint ventures, and which may
cause a future outflow of cash. Examples of unrecognized
commitments are unconditional purchase obligations, commitments to
provide loans, and commitments to acquire the interest of another
party in a joint venture that is based on a future event.
Interests in Unconsolidated Structured Entities
A structured entity is one that has been structured in such a manner that
voting rights are not the key determinant of who controls it. A structured
entity tends to engage in a tightly restricted set of activities that support a
specific objective, such as conducting certain research and development
activities. It may also be insufficiently capitalized to fund its own activities,
and so depends on financial support from other parties. Examples of
structured entities are investment funds and asset-backed financings.
If a business consolidates the results of such a structured entity, it should
provide sufficient supporting information that users of the financial
statements can understand the nature of the interest, as well as evaluate the
nature of any risks associated with that interest. Accordingly, include the
following disclosures in the notes accompanying the financial statements:
• The nature of the relationship with unconsolidated structured entities,
including the purpose, size, activities, and financing of these entities.
• If the business does not have an interest in an unconsolidated
structured entity at the reporting date, disclose the carrying amount of
any assets transferred to the structured entity in the period, the income
amount and types of income from the entity, and the method for
determining which structured entities the business has sponsored. This
information should be presented in a tabular format.
• A tabular summary of the following information related to the nature
of risks related to structured entities:
o The carrying amounts of assets and liabilities recognized by
the company, relating to its interests in any unconsolidated
structured entities, as well as the line items in the balance
sheet where they are located.
o The maximum exposure to loss from the structured entities, as
well as how this amount is determined. If it is not possible to
quantify this information, state the reasons why.
o A comparison of the first two items, matching carrying
amounts to maximum exposure.
• If the business has provided support to a structured entity that it was
not obligated to provide, state the amount and type of support, and the
reason for doing so. Further, disclose situations in which the business
assisted the entity in procuring financial support.
• If the business intends to provide support to an unconsolidated
structured entity, disclose the nature of this support, as well as any
intended assistance in obtaining financial support.
The discussion of risk should include any remaining risk exposures related to
structured entities with which the business no longer has any contractual
involvement.
In order to provide complete disclosure of risk information pertaining to
structured entities, it may be necessary to disclose additional information,
such as the terms of an arrangement to provide financial support, the types of
profits or losses related to structured entities, whether there is a requirement
to absorb the losses of an unstructured entity, any difficulties experienced by
a structured entity in securing funding, the forms of funding obtained, and so
forth.
Summary
In order to fully understand the disclosure requirements in this chapter, it is
useful to peruse the Joint Arrangements chapter and the Investments in
Associates and Joint Ventures chapter, which precede this chapter. Some of
the disclosure requirements noted in those chapters duplicate the
requirements stated in this chapter; when this happens, a single disclosure of
the required information is sufficient to satisfy the disclosure requirements
stated in both chapters.
 Chapter 13
Inventories
Introduction
Inventory is one of the most important asset classifications, for it may
represent the largest asset investment by a manufacturer or seller of goods.
As a major asset, it is imperative that inventory be properly valued, as well as
those goods designated as having been sold. This chapter discusses the IFRS
requirements for inventory, and then expands upon them with discussions of
inventory tracking systems, costing methodologies, and a variety of related
topics. The guidance in this chapter does not apply to work in progress under
construction contracts, financial instruments, or agricultural assets.
Related Podcast Episodes: Episodes 56, 66, and 119 of the Accounting
Best Practices Podcast discuss inventory record accuracy, obsolete
inventory, and overhead allocation, respectively. They are available at:
accountingtools.com/podcasts
IFRS Source Document
• IAS 2, Inventories
Overview of Inventory
In general, inventory is to be accounted for at cost, which is considered to be
the sum of those expenditures required to bring an inventory item to its
present condition and location. There are three types of costs to apply to
inventory, which are:
• Direct costs. If a cost was directly incurred to produce or acquire a
specific unit of inventory, this is called a direct cost, and is recorded as
a cost of inventory. Typical direct costs are the purchase price, import
duties, sales taxes, transport charges, and site preparation, less any
trade discounts or rebates.
• Variable overhead costs. If there are any factory costs that are not
direct, but which vary with production volume, they are assigned to
inventory based on actual usage of a company’s production facilities.
There are usually not many variable overhead costs.
• Fixed overhead costs. If there are any factory costs that are not direct,
and which do not vary with production volume, they are assigned to
inventory based on the normal capacity of a company’s production
 facilities.
The accounting for overhead costs is particularly critical, given the large
amount of such costs that are allocated in many production facilities. The
basic IFRS rules for fixed overhead allocation are:
• Normal capacity allocation basis. Only allocate fixed overhead costs
to produced units based on the normal capacity of the company’s
production process. Normal capacity is the average production level
expected over multiple periods under normal operating circumstances.
• Low-production periods. During periods of abnormally low
production, the overhead allocation per produced unit is not increased.
This means that an excess amount of overhead cannot be charged to
produced units because production levels are unusually low; instead,
the excess amount of unallocated overhead is to be charged to expense
as incurred.
• High-production periods. During periods of abnormally high
production, the overhead allocation per produced unit should be
reduced in order to keep from recording an inventory amount that is
above its actual cost.
In addition, variable overhead is to be allocated to produced units based on
the actual level of usage of the manufacturing facility.
If some costs are incurred to produce more than one product, and where
the costs of production can be directly associated with specific products (such
as a primary product and a by-product), allocate the production cost between
the resulting products on a rational and consistent basis, which is typically
based on their relative sales values. An alternative approach is to measure by-
products whose sales values are immaterial at their net realizable values, and
to then deduct this amount from the cost of the primary product.
Tip: Though overhead must be allocated to inventory, this does not mean
that an inordinate amount of time should be spent compiling an exquisitely
designed allocation system. Instead, focus on a simple and efficient
allocation methodology that allows the books to be closed quickly.
Several other rules have been developed regarding inventory costs, most of
which are designed to keep certain costs from being allocated to inventory.
They are:
• Abnormal expenses. If unusually high costs are incurred, such as
abnormal freight, spoilage, or scrap charges, they are to be charged to
 expense in the period incurred.
• Administrative expenses. Administrative costs can only be allocated to
inventory when they are clearly related to production. In nearly all
cases, these costs are charged to expense as incurred.
• Deferred payment terms. When a business purchases inventories that
have delayed payment terms associated with them, the financing
element is recognized as interest expense over the financing period,
rather than a cost of inventory.
• Selling expenses. All costs related to selling are charged to expense as
incurred; they are never allocated to inventory.
• Storage costs. Charge storage costs to expense as incurred, unless
these costs are required as part of the production process.
Once costs have initially been apportioned to inventory, IFRS requires that
any decline in the utility of goods below their cost result in the recognition of
a loss in the current period. This decline in utility is most commonly caused
by the deterioration or obsolescence of inventory items. The Accounting for
Obsolete Inventory section describes how to account for this type of loss. A
decline in utility may also be caused by a decline in the price of inventory
items. The Net Realizable Value section describes how to calculate and
account for this type of loss.
The inventory cost flow assumption is the concept that the cost of an
inventory item changes between the time it is acquired or built and the time
when it is sold. Because of this cost differential, a company needs to adopt a
cost flow assumption regarding how it treats the cost of goods as they move
through the company.
For example, a company buys a widget on January 1 for £50. On July 1, it
buys an identical widget for £70, and on November 1 it buys yet another
identical widget for £90. The products are completely interchangeable. On
December 1, the company sells one of the widgets. It bought the widgets at
three different prices, so what cost should it report for its cost of goods sold?
There are several ways to interpret the cost flow assumption. For example:
• FIFO cost flow assumption. Under the first in, first out method,
assume that the first item purchased is also the first one sold. Thus, the
cost of goods sold would be £50. Since this is the lowest-cost item in
the example, profits would be highest under FIFO.
• Weighted average cost flow assumption. Under the weighted average
method, the cost of goods sold is the average cost of all three units, or
 £70. This cost flow assumption tends to yield a mid-range cost, and
therefore also a mid-range profit.
The cost flow assumption does not necessarily match the actual flow of
goods (if that were the case, most companies would use the FIFO method).
Instead, it is allowable to use a cost flow assumption that varies from actual
usage. For this reason, companies tend to select an assumption that either
minimizes profits (in order to minimize income taxes) or maximize profits (in
order to increase share value).
The cost flow assumption is a minor item when inventory costs are
relatively stable over the long term, since there will be no particular
difference in the cost of goods sold, no matter which assumption is used.
Conversely, dramatic changes in inventory costs over time will yield a
notable difference in reported profit levels, depending on the assumption
used. Therefore, be especially aware of the financial impact of the inventory
cost flow assumption in periods of fluctuating costs.
In the following sections, we describe the more commonly-used methods
for inventory costing, several of which are based on cost flow assumptions.
First, however, we address the two main record-keeping systems needed to
accurately track inventory, which are the periodic inventory system and the
perpetual inventory system.
The Periodic Inventory System
The periodic inventory system only updates the ending inventory balance
when a physical inventory count is conducted. Since physical inventory
counts are time-consuming, few companies complete them more than once a
quarter or year. In the meantime, the inventory account continues to show the
cost of the inventory that was recorded as of the last physical inventory
count.
Under the periodic inventory system, all purchases made between
physical inventory counts are recorded in a purchases account. When a
physical inventory count is done, shift the balance in the purchases account
into the inventory account, which in turn is adjusted to match the cost of the
ending inventory.
The calculation of the cost of goods sold under the periodic inventory
system is:
Beginning inventory + Purchases = Cost of goods available for sale
Cost of goods available for sale – Ending inventory = Cost of goods sold
EXAMPLE
Milagro Corporation has beginning inventory of £100,000, has paid
£170,000 for purchases, and its physical inventory count reveals an ending
inventory cost of £80,000. The calculation of its cost of goods sold is:
£100,000 Beginning inventory + £170,000 Purchases - £80,000
Ending inventory
= £190,000 Cost of goods sold

The periodic inventory system is most useful for smaller businesses that
maintain minimal amounts of inventory. For them, a physical inventory count
is easy to complete, and they can estimate cost of goods sold figures for
interim periods. However, there are several problems with the system:
• It does not yield any information about the cost of goods sold or
ending inventory balances during interim periods when there has been
no physical inventory count.
• The cost of goods sold must be estimated during interim periods,
which will likely result in a significant adjustment to the actual cost of
goods whenever a physical inventory count is eventually completed.
• There is no way to adjust for obsolete inventory or scrap losses during
interim periods, so there tends to be a significant (and expensive)
adjustment for these issues when a physical inventory count is
eventually completed.
A more up-to-date and accurate alternative to the periodic inventory system is
the perpetual inventory system, which is described in the next section.
The Perpetual Inventory System
Under the perpetual inventory system, an entity continually updates its
inventory records to account for additions to and subtractions from inventory
for such activities as received inventory items, goods sold from stock, and
items picked from inventory for use in the production process. Thus, a
perpetual inventory system has the advantages of both providing up-to-date
inventory balance information and requiring a reduced level of physical
inventory counts. However, the calculated inventory levels derived by a
perpetual inventory system may gradually diverge from actual inventory
levels due to unrecorded transactions or theft, so periodically compare book
balances to actual on-hand quantities.
EXAMPLE
This example contains several journal entries used to account for
transactions in a perpetual inventory system. Milagro Corporation records a
purchase of £1,000 of widgets that are stored in inventory:

Milagro records £250 of inbound freight cost associated with the delivery of
widgets:

Milagro records the sale of widgets on credit from inventory for £2,000, for
which the associated inventory cost is £1,200:

Milagro records a downward inventory adjustment of £500 caused by

inventory theft, and detected during an inventory count:

Inventory Costing
Several methods for calculating the cost of inventory are shown in this
section. Of the methods presented, only the first in, first out method and the
weighted average method have gained worldwide recognition. Standard
costing is an acceptable alternative to cost layering, as long as any associated
variances are properly accounted for. The retail inventory method and gross
profit method should be used only to derive an approximation of the ending
inventory cost, and so should be used only in interim reporting periods when
a company does not intend to issue any financial results to outside parties.
The First In, First Out Method
The first in, first out (FIFO) method of inventory valuation operates under the
assumption that the first goods purchased are also the first goods sold. In
most companies, this accounting assumption closely matches the actual flow
of goods, and so is considered the most theoretically correct inventory
valuation method.
Under the FIFO method, the earliest goods purchased are the first ones
removed from the inventory account. This results in the remaining items in
inventory being accounted for at the most recently incurred costs, so that the
inventory asset recorded on the balance sheet contains costs quite close to the
most recent costs that could be obtained in the marketplace. Conversely, this
method also results in older historical costs being matched against current
revenues and recorded in the cost of goods sold, so the gross margin does not
necessarily reflect a proper matching of revenues and costs.
EXAMPLE
Milagro Corporation decides to use the FIFO method for the month of
January. During that month, it records the following transactions:

The cost of goods sold in units is calculated as:

100 Beginning inventory + 200 Purchased – 125 Ending inventory
= 175 Units
Milagro’s controller uses the information in the preceding table to calculate
the cost of goods sold for January, as well as the cost of the inventory
balance as of the end of January.

Thus, the first FIFO layer, which was the beginning inventory layer, is
completely used up during the month, as well as half of Layer 2, leaving half
of Layer 2 and all of Layer 3 to be the sole components of the ending
inventory.
Note that the £42,000 cost of goods sold and £36,000 ending inventory
equals the £78,000 combined total of beginning inventory and purchases
during the month.
The Last In, First Out Method
The last in, first out (LIFO) method operates under the assumption that the
last item of inventory purchased is the first one sold. Picture a store shelf
where a clerk adds items from the front, and customers also take their
selections from the front; the remaining items of inventory that are located
further from the front of the shelf are rarely picked, and so remain on the
shelf – that is a LIFO scenario. IFRS does not permit the use of LIFO as a
method for measuring the cost of inventory.
The Weighted Average Method
When using the weighted average method, divide the cost of goods available
for sale by the number of units available for sale, which yields the weighted-
average cost per unit. In this calculation, the cost of goods available for sale
is the sum of beginning inventory and net purchases. Use this weighted-
average figure to assign a cost to both ending inventory and the cost of goods
sold.
The singular advantage of the weighted average method is the complete
absence of any inventory layers, which avoids the record keeping problems
that would be encountered with either the FIFO or LIFO methods that were
described earlier.
EXAMPLE
Milagro Corporation elects to use the weighted-average method for the
month of May. During that month, it records the following transactions:

The actual total cost of all purchased or beginning inventory units in the
preceding table is £116,000 (£33,000 + £54,000 + £29,000). The total of all
purchased or beginning inventory units is 450 (150 beginning inventory +
300 purchased). The weighted average cost per unit is therefore £257.78
(£116,000 ÷ 450 units).
The ending inventory valuation is £45,112 (175 units × £257.78 weighted
average cost), while the cost of goods sold valuation is £70,890 (275 units ×
£257.78 weighted average cost). The sum of these two amounts (less a
rounding error) equals the £116,000 total actual cost of all purchases and
beginning inventory.

In the preceding example, if Milagro used a perpetual inventory system to

record its inventory transactions, it would have to recompute the weighted
average after every purchase. The following table uses the same information
in the preceding example to show the recomputations:

Note that the cost of goods sold of £67,166 and the ending inventory balance
of £48,834 equal £116,000, which matches the total of the costs in the
original example. Thus, the totals are the same, but the moving weighted
average calculation results in slight differences in the apportionment of costs
between the cost of goods sold and ending inventory.
Standard Costing
The preceding methods (FIFO and weighted average) operate under the
assumption that some sort of cost layering is used, even if that layering
results in nothing more than a single weighted-average layer. The standard
costing methodology arrives at inventory valuation from an entirely different
direction, which is to set a standard cost for each item and to then value those
items at the standard cost – not the actual cost at which the items were
purchased.
Standard costing is clearly more efficient than any cost layering system,
simply because there are no layers to keep track of. However, its primary
failing is that the resulting inventory valuation may not equate to the actual
cost. The difference is handled through several types of variance calculations,
which may be charged to the cost of goods sold (if minor) or allocated
between inventory and the cost of goods sold (if material).
 At the most basic level, a standard cost is created simply by calculating
the average of the most recent actual cost for the past few months. An
additional factor to consider when deriving a standard cost is whether to set it
at a historical actual cost level that has been proven to be attainable, or at a
rate that should be attainable, or one that can only be reached if all operations
work perfectly. Here are some considerations:
• Historical basis. This is an average of the costs that a company has
already experienced in the recent past, possibly weighted towards just
the past few months. Though clearly an attainable cost, a standard
based on historical results contains all of the operational inefficiencies
of the existing production operation.
• Attainable basis. This is a cost that is more difficult to reach than a
historical cost. This basis assumes some improvement in operating and
purchasing efficiencies, which employees have a good chance of
achieving in the short term.
• Theoretical basis. This is the ultimate, lowest cost that the facility can
attain if it functions perfectly, with no scrap, highly efficient
employees, and machines that never break down. This can be a
frustrating basis to use for a standard cost, because the production
facility can never attain it, and so always produces unfavorable
variances.
Of the three types of standards noted here, use the attainable basis, because it
gives employees a reasonable cost target to pursue. If standards are
continually updated on this basis, a production facility will have an incentive
to continually drive down its costs over the long term.
Standard costs are stored separately from all other accounting records,
usually in a bill of materials for finished goods, and in the item master file for
raw materials.
At the end of a reporting period, the following steps show how to
integrate standard costs into the accounting system (assuming the use of a
periodic inventory system):
1. Cost verification. Review the standard cost database for errors and
correct as necessary. Also, if it is time to do so, update the standard
costs to more accurately reflect actual costs.
2. Inventory valuation. Multiply the number of units in ending
inventory by their standard costs to derive the ending inventory
valuation.
 3. Calculate the cost of goods sold. Add purchases during the month to
the beginning inventory and subtract the ending inventory to
determine the cost of goods sold.
4. Enter updated balances. Create a journal entry that reduces the
purchases account to zero and which also adjusts the inventory asset
account balance to the ending total standard cost, with the offset to
the cost of goods sold account.
EXAMPLE
A division of the Milagro Corporation is using a standard costing system to
calculate its inventory balances and cost of goods sold. The company
conducts a month-end physical inventory count that results in a reasonably
accurate set of unit quantities for all inventory items. The controller
multiplies each of these unit quantities by their standard costs to derive the
ending inventory valuation. This ending balance is £2,500,000.
The beginning balance in the inventory account is £2,750,000 and purchases
during the month were £1,000,000, so the calculation of the cost of goods
sold is:

To record the correct ending inventory balance and cost of goods sold, the
controller records the following entry, which clears out the purchases asset
account and adjusts the ending inventory balance to £2,500,000:

IFRS mandates that standard costs be regularly reviewed and adjusted to

bring them into alignment with the company’s normal levels of capacity
utilization and efficiency, as well as the current costs of materials and labor.
The Retail Inventory Method
The retail inventory method is sometimes used by retailers that resell
merchandise to estimate their ending inventory balances. This method is
based on the relationship between the cost of merchandise and its retail price.
To calculate the cost of ending inventory using the retail inventory method,
follow these steps:
 1. Calculate the cost-to-retail percentage, for which the formula is
(Cost ÷ Retail price).
2. Calculate the cost of goods available for sale, for which the formula
is (Cost of beginning inventory + Cost of purchases).
3. Calculate the cost of sales during the period, for which the formula is
(Sales × Cost-to-retail percentage).
4. Calculate ending inventory, for which the formula is (Cost of goods
available for sale - Cost of sales during the period).
EXAMPLE
Milagro Corporation sells home coffee roasters for an average of £200, and
which cost it £140. This is a cost-to-retail percentage of 70%. Milagro’s
beginning inventory has a cost of £1,000,000, it paid £1,800,000 for
purchases during the month, and it had sales of £2,400,000. The calculation
of its ending inventory is:

The retail inventory method is a quick and easy way to determine an

approximate ending inventory balance. However, there are also several issues
with it:
• The retail inventory method is only an estimate. Do not rely upon it
too heavily to yield results that will compare with those of a physical
inventory count.
• The retail inventory method only works if there is a consistent mark-
up across all products sold. If not, the actual ending inventory cost
may vary wildly from what was derived using this method.
• The method assumes that the historical basis for the mark-up
percentage continues into the current period. If the mark-up was
different (as may be caused by an after-holidays sale), the results of
the calculation will be incorrect.
IFRS points out that the retail method is often calculated separately for each
retail department of a business; this can lead to a more accurate estimation of
inventory cost.
The Gross Profit Method
The gross profit method can be used to estimate the amount of ending
inventory. This is useful for interim periods between physical inventory
counts, or when inventory was destroyed and it is necessary to back into the
ending inventory balance for the purpose of filing a claim for insurance
reimbursement. Follow these steps to estimate ending inventory using the
gross profit method:
1. Add together the cost of beginning inventory and the cost of
purchases during the period to arrive at the cost of goods available
for sale.
2. Multiply (1 - expected gross profit %) by sales during the period to
arrive at the estimated cost of goods sold.
3. Subtract the estimated cost of goods sold (step #2) from the cost of
goods available for sale (step #1) to arrive at the ending inventory.
The gross profit method is not an acceptable method for determining the
year-end inventory balance, since it only estimates what the ending inventory
balance may be. It is not sufficiently precise to be reliable for audited
financial statements.
EXAMPLE
Mulligan Imports is calculating its month-end golf club inventory for March.
Its beginning inventory was £175,000 and its purchases during the month
were £225,000. Thus, its cost of goods available for sale is:
£175,000 beginning inventory + £225,000 purchases
= £400,000 cost of goods available for sale
Mulligan's gross margin percentage for all of the past 12 months was 35%,
which is considered a reliable long-term margin. Its sales during March were
£500,000. Thus, its estimated cost of goods sold is:
(1 - 35%) × £500,000 = £325,000 cost of goods sold
By subtracting the estimated cost of goods sold from the cost of goods
available for sale, Mulligan arrives at an estimated ending inventory balance
of £75,000.

There are several issues with the gross profit method that make it unreliable
as the sole method for determining the value of inventory, which are:
• Applicability. The calculation is most useful in retail situations where a
company is simply buying and reselling merchandise. If a company is
instead manufacturing goods, the components of inventory must also
include labor and overhead, which make the gross profit method too
simplistic to yield reliable results.
 • Historical basis. The gross profit percentage is a key component of the
calculation, but the percentage is based on a company's historical
experience. If the current situation yields a different percentage (as
may be caused by a special sale at reduced prices), the gross profit
percentage used in the calculation will be incorrect.
• Inventory losses. The calculation assumes that the long-term rate of
losses due to theft, obsolescence, and other causes is included in the
historical gross profit percentage. If not, or if these losses have not
previously been recognized, the calculation will likely result in an
inaccurate estimated ending inventory (and probably one that is too
high).
Overhead Allocation
The preceding section was concerned with charging the direct costs of
production to inventory, but what about overhead expenses? In many
businesses, the cost of overhead is substantially greater than direct costs, so
considerable attention must be expended on the proper method of allocating
overhead to inventory.
There are two types of overhead, which are administrative overhead and
manufacturing overhead. Administrative overhead includes those costs not
involved in the development or production of goods or services, such as the
costs of front office administration and sales; this is essentially all overhead
that is not included in manufacturing overhead. Manufacturing overhead is
all of the costs that a factory incurs, other than direct costs.
The costs of manufacturing overhead should be allocated to any inventory
items that are classified as work-in-process or finished goods. Overhead is
not allocated to raw materials inventory, since the operations giving rise to
overhead costs only impact work-in-process and finished goods inventory.
The following items are usually included in manufacturing overhead:

The typical procedure for allocating overhead is to accumulate all

manufacturing overhead costs into one or more cost pools, and to then use an
activity measure to apportion the overhead costs in the cost pools to produced
units. Thus, the overhead allocation formula is:
Cost pool ÷ Total activity measure = Overhead allocation per unit
EXAMPLE
Mulligan Imports has a small production operation for an in-house line of
golf clubs. During April, it incurs costs for the following items:

All of these items are classified as manufacturing overhead, so Mulligan

creates the following journal entry to shift the costs into an overhead cost
pool:

Overhead costs can be allocated by any reasonable measure, as long as it is

consistently applied across reporting periods. Common bases of allocation
are direct labor hours charged against a product, or the amount of machine
hours used during the production of a product. The amount of allocation
charged per unit is known as the overhead rate.
The overhead rate can be expressed as a proportion, if both the numerator
and denominator are stated in a currency. For example, Armadillo Industries
has total indirect costs of £100,000 and it decides to use the cost of its direct
labor as the allocation measure. Armadillo incurs £50,000 of direct labor
costs, so the overhead rate is calculated as:
£100,000 Indirect costs
£50,000 Direct labor
The result is an overhead rate of 2.0.
Alternatively, if the denominator is not stated in a currency, the overhead
rate is expressed as a cost per allocation unit. For example, Armadillo decides
to change its allocation measure to hours of machine time used. The company
has 10,000 hours of machine time usage, so the overhead rate is now
calculated as:
£100,000 Indirect costs
10,000 Machine hours
The result is an overhead rate of £10.00 per machine hour.
EXAMPLE
Mulligan Imports has a small golf shaft production line, which manufactures
a titanium shaft and an aluminum shaft. Considerable machining is required
for both shafts, so Mulligan concludes that it should allocate overhead to
these products based on the total hours of machine time used. In May,
production of the titanium shaft requires 5,400 hours of machine time, while
the aluminum shaft needs 2,600 hours. Thus, 67.5% of the overhead cost
pool is allocated to the titanium shafts and 32.5% to the aluminum shafts.
In May, Mulligan accumulates £100,000 of costs in its overhead cost pool,
and allocates it between the two product lines with the following journal
entry:

This entry clears out the balance in the overhead cost pool, readying it to
accumulate overhead costs in the next reporting period.

If the basis of allocation does not appear correct for certain types of overhead
costs, it may make more sense to split the overhead into two or more
overhead cost pools, and allocate each cost pool using a different basis of
allocation. For example, if warehouse costs are more appropriately allocated
based on the square footage consumed by various products, then store
warehouse costs in a warehouse overhead cost pool, and allocate these costs
based on square footage used.
Thus far, we have assumed that only actual overhead costs incurred are
allocated. However, it is also possible to set up a standard overhead rate that
is used for multiple reporting periods, based on long-term expectations
regarding how much overhead will be incurred and how many units will be
produced. If the difference between actual overhead costs incurred and
overhead allocated is small, charge the difference to the cost of goods sold. If
the amount is material, allocate the difference to both the cost of goods sold
and inventory.
EXAMPLE
Mulligan Imports incurs overhead of £93,000, which it stores in an overhead
cost pool. Mulligan uses a standard overhead rate of £20 per unit, which
approximates its long-term experience with the relationship between
overhead costs and production volumes. In September, it produces 4,500
golf club shafts, to which it allocates £90,000 (allocation rate of £20 × 4,500
units). This leaves a difference between overhead incurred and overhead
absorbed of £3,000. Given the small size of the variance, Mulligan charges
the £3,000 difference to the cost of goods sold, thereby clearing out the
overhead cost pool.

A key issue is that overhead allocation is not a precisely-defined science –

there is plenty of latitude in how to allocate overhead. The amount of
allowable diversity in practice can result in slipshod accounting, so be sure to
use a standardized and well-documented method to allocate overhead using
the same calculation in every reporting period. This allows for great
consistency, which auditors appreciate when they validate the supporting
calculations.
Net Realizable Value
IFRS requires that inventories be measured at the lower of cost or net
realizable value. This becomes an issue when the original cost of inventory is
no longer recoverable, which can occur when inventory is damaged or
becomes obsolete, or its selling price declines.
The cost of inventory is normally written down to its net realizable value
on an individual-item basis, though it is permissible to do so for groups of
similar items. A group write-down should not be used for an entire class of
inventory, such as finished goods.
When there are materials or supplies that are being stored in expectation
of being used to manufacture finished goods, it is not necessary to write
down their cost if the finished goods into which they will be incorporated will
be sold at cost or above.
The net realizable value of inventory should be reassessed in every
reporting period. If there is clear evidence that there has been an increase in
net realizable value in one of these subsequent periods, the original amount of
the write-down should be reversed to the extent of the increase in net
realizable value.
Accounting for Obsolete Inventory
Related Podcast Episodes: Episode 225 of the Accounting Best Practices
Podcast discusses the reserve for obsolete inventory. It is available at:
www.accountingtools.com/podcasts or iTunes
A materials review board is used to locate obsolete inventory items. This
group reviews inventory usage reports or physically examines the inventory
to determine which items should be disposed of. Then review the findings of
this group to determine the most likely disposition price of the obsolete items,
subtract this projected amount from the book value of the obsolete items, and
set aside the difference as a reserve. As the company later disposes of the
items, or the estimated amounts to be received from disposition change,
adjust the reserve account to reflect these events.
EXAMPLE
Milagro Corporation has £100,000 of excess home coffee roasters it cannot
sell. However, it believes there is a market for the roasters through a reseller
in China, but only at a sale price of £20,000. Accordingly, the controller
recognizes a reserve of £80,000 with the following journal entry:

After finalizing the arrangement with the Chinese reseller, the actual sale
price is only £19,000, so the controller completes the transaction with the
following entry, recognizing an additional £1,000 of expense:

The example makes inventory obsolescence accounting look simple enough,

but it is not. The issues are:
• Timing. A company’s reported financial results can be improperly
altered by changing the timing of the actual dispositions. As an
example, if a supervisor knows that he can receive a higher-than-
estimated price on the disposition of obsolete inventory, he can either
accelerate or delay the sale in order to shift gains into whichever
reporting period needs the extra profit.
• Timely reviews. Inventory obsolescence is a minor issue as long as
 management reviews inventory on a regular basis, so that the
incremental amount of obsolescence detected is small in any given
period. However, if management does not conduct a review for a long
time, this allows obsolete inventory to build up to quite impressive
proportions, along with an equally impressive amount of expense
recognition. To avoid this issue, conduct frequent obsolescence
reviews, and maintain a reserve based on historical or expected
obsolescence, even if specific inventory items have not yet been
identified.
EXAMPLE
Milagro Corporation sets aside an obsolescence reserve of £25,000 for
obsolete roasters. However, in January the purchasing manager knows that
the resale price for obsolete roasters has plummeted, so the real reserve
should be closer to £35,000, which would call for the immediate recognition
of an additional £10,000 of expense. However, since this would result in an
overall reported loss in Milagro’s financial results in January, he waits until
April, when Milagro has a very profitable month, and completes the sale at
that time, thereby incorrectly delaying the additional obsolescence loss until
the point of sale.

Work in Process Accounting

Work in process (WIP) is goods in production that have not yet been
completed. It typically involves the full amount of raw materials needed for a
product, since that is usually included in the product at the beginning of the
manufacturing process. During production, the cost of direct labor and
overhead is added in proportion to the amount of work done.
In prolonged production operations, there may be a large amount of
investment in work in process. Conversely, the production of some products
occupies such a brief period of time that the accounting staff does not bother
to track it at all; instead, the items in production are considered to still be in
the raw materials inventory. In this latter case, inventory essentially shifts
directly from the raw materials inventory to the finished goods inventory,
with no separate work in process tracking.
Work in process accounting involves tracking the amount of WIP in
inventory at the end of an accounting period and assigning a cost to it for
inventory valuation purposes, based on the percentage of completion of the
WIP items.
 In situations where there are many similar products in process, it is more
common to follow these steps to account for work in process inventory:
1. Assign raw materials. We assume that all raw materials have been
assigned to work in process as soon as the work begins. This is
reasonable, since many types of production involve kitting all of the
materials needed to construct a product and delivering them to the
manufacturing area at one time.
2. Compile labor costs. The production staff can track the time it works
on each product, which is then assigned to the work in process.
However, this is painfully time-consuming, so a better approach is to
determine the stage of completion of each item in production, and
assign a standard labor cost to it based on the stage of completion.
This information comes from labor routings that detail the standard
amount of labor needed at each stage of the production process.
3. Assign overhead. If overhead is assigned based on labor hours, it is
assigned based on the labor information compiled in the preceding
step. If overhead is assigned based on some other allocation
methodology, the basis of allocation (such as machine hours used)
must first be compiled.
4. Record the entry. This journal entry involves shifting raw materials
from the raw materials inventory account to the work in process
inventory account, shifting direct labor expense into the work in
process inventory account, and shifting factory overhead from the
overhead cost pool to the WIP inventory account.
It is much easier to use standard costs for work in process accounting. Actual
costs are difficult to trace to individual units of production.
The general theme of WIP accounting is to always use the simplest
method that the company can convince its auditors to accept, on the grounds
that a complex costing methodology will require an inordinate amount of
time by the accounting staff, which in turn interferes with the time required to
close the books at the end of each month.
Inventory Measurement by Commodity Broker-Traders
A broker-trader that deals in commodities can measure its inventory at fair
value, less any remaining costs to sell. If this approach is used, the broker-
trader should record any change in the fair value less costs to sell in profit or
loss in the period in which the fair value change occurs.
Inventory Disclosures
The following information should be disclosed about a company’s inventory
practices in its financial statements:
• Basis. The basis on which inventories are stated, including the cost
formula used.
• Carrying amount. The total carrying amount of inventory, and for any
relevant inventory classifications, such as merchandise, materials,
work-in-process, and finished goods. Also note the amount of any
inventories being carried at their fair value, less any costs to sell.
• Charge to expense. The amount of inventory charged to expense
during the period.
• Pledges. The carrying amount of any inventories that have been
pledged as security for liabilities.
• Reversals. The amount of any reversal of an inventory write-down
during the period, and the circumstances leading to the reversal.
• Write-downs. The amount of any write-downs of inventory to net
realizable value.
Summary
When designing systems that will properly account for inventory, the key
consideration is the sheer volume of transactions that must be tracked. It can
be extremely difficult to consistently record these transactions with a minimal
error rate, so tailor the accounting system to reduce the record keeping work
load while still producing results that are in accordance with IFRS. In
particular, be watchful for any additional accounting procedures that only
refine the inventory information to a small degree, and eliminate or
streamline them whenever possible. In essence, this is the accounting area in
which having a cost-effective recordkeeping system is of some importance.
 Chapter 14
Property, Plant, and Equipment
Introduction
One of the central functions of accounting is the proper classification and
measurement of fixed assets, which can comprise a substantial part of the
balance sheets of many companies. In this chapter, we discuss which costs
can be capitalized into fixed assets, how these costs may be altered or
revalued over time, which depreciation methods to use, how to derecognize
an asset, and other topics related to the costs of decommissioning certain
assets.
In the following sections, we use the term fixed assets interchangeably
with property, plant and equipment.
Related Podcast Episode: Episode 109 of the Accounting Best Practices
Podcast discusses fixed asset accounting differences between GAAP and
IFRS. They are available at: accountingtools.com/podcasts
IFRS Source Documents
• IAS 16, Property, Plant and Equipment
• IFRIC 1, Changes in Existing Decommissioning, Restoration and
Similar Liabilities
• IFRIC 5, Rights to Interests Arising from Decommissioning,
Restoration and Environmental Rehabilitation Funds
Recognition of Property, Plant and Equipment
A fixed asset is a tangible item that is to be used in multiple reporting
periods, and which is used for production, administration, or rentals. When a
business expends funds, it can recognize a fixed asset in the amount of the
expenditure if it is probable that there will be future economic benefits
flowing to the business, or for safety or environmental reasons, and if the cost
can be measured reliably. From a practical perspective, it may be easier to
charge such expenditures directly to expense if their benefits will be
consumed within just a few months. Also, given the increase in accounting
documentation required for a fixed asset (which will become evident later in
this chapter), it is more efficient to set a capitalization limit, below which
expenditures that would normally qualify for treatment as fixed assets are
charged directly to expense as incurred. These best practices should result in
a vastly smaller number of expenditures being accounted for as fixed assets.
The following additional rules and suggestions apply to the recognition of
expenditures as fixed assets:
• Abnormal costs. If unusually large amounts of wasted costs are
incurred in the construction of a fixed asset, these wasted costs should
not be capitalized into the cost of the fixed asset. Instead, charge them
to expense as incurred.
• Aggregation. Depending on the circumstances, it may be acceptable to
aggregate a number of low-value items for the purposes of recognizing
a single fixed asset, such as a group of desks.
• Assets constructed for sale. If a company capitalizes an asset that it
normally constructs for sale, the capitalized cost of the asset should be
the same as the cost of the units constructed for sale.
• Bearer plants. These are living plants that are used in the production
of agricultural produce. They are accounted for in the same manner as
self-constructed assets, where the cost to cultivate the plants is
considered part of the asset.
• Cash price equivalent. The capitalized cost of a purchased asset is its
cash price equivalent. Thus, if lengthy credit terms are associated with
a purchase, do not capitalize the interest cost implied by the difference
between the cash price and credit price of the asset.
• Inspections. If a major inspection is required as a condition of
continuing to operate a fixed asset (such as a passenger plane),
recognize the cost of the inspection as a fixed asset, and derecognize
the carrying amount of any remaining asset from the preceding
inspection. This derecognition is required, even if the cost of the
preceding inspection was never separately identified; thus, it may be
necessary to estimate the amount of the preceding inspection and
derecognize it.
• Interest. Interest expense may be included in the capitalized cost of a
fixed asset. See the Borrowing Costs chapter for more information.
• Minor spare parts. Low-value spare parts are usually treated as part of
inventory, rather than as fixed assets, and so are carried as assets
without any associated depreciation. They are charged to expense
when consumed.
• Non-monetary exchange. When an asset is acquired through a non-
monetary exchange, the asset acquired is measured at the fair value of
 the asset given up. If it is not possible to derive that fair value, the fair
value of the asset obtained can be used instead. If this fair value also
cannot be derived, use the carrying amount of the asset given up. Such
an exchange is only considered to have taken place if it has
commercial substance, which means that the future cash flows of the
entity are expected to change as a result of the transaction.
• Replacement parts. If a major part is replaced in a fixed asset,
recognize the cost of the part as a fixed asset, and derecognize the
carrying amount of the part that was replaced. This derecognition is
required, even if the cost of the replaced part was never separately
identified. If it is not possible to determine the carrying amount of the
replaced part, use the cost of the replacement as an indicator of the
original cost of the item being replaced.
• Servicing costs. The ongoing servicing costs of a fixed asset are
charged to expense as incurred, rather than being included in the
capitalized cost of the asset.
• Spare parts. Spare parts and servicing equipment can only be
classified as fixed assets if they meet all of the requirements for fixed
assets. If not, they are instead classified as inventory.
• Targeted parts and equipment. If servicing equipment and spare parts
are only used in connection with a specific fixed asset, they are
accounted for as fixed assets (subject to the capitalization limit noted
above).
EXAMPLE
Universal Airlines acquires a twin engine commuter plane from a failed
carrier and initially accounts for it as a single asset, with a purchase price of
£750,000. Two years later, both engines reach the end of their allowed
service lives of 6,000 hours. Each new engine costs £100,000.
The original invoice for the commuter plane did not itemize the cost of the
engines, so Universal instead uses the cost of the replacement engines as the
basis for estimating the cost of the original engines. To do so, Universal uses
its 10% cost of capital to discount the £200,000 cost of the engines for two
years, resulting in a discounted cost of £165,290 (calculated as £200,000 ×
0.82645).
Universal then subtracts the £165,290 cost of the existing engines from the
asset record for the commuter plane and adds the cost of the new engines.
The resulting change in the gross carrying amount of the plane is:
 £750,000 Purchase price + £200,000 New engines - £165,290 Old
engines
= £784,710 Gross carrying amount

A fixed asset is initially recognized at its cost. These costs can include any of
the following items, which include those costs needed to bring the asset to the
location and condition intended for it by management:

Also, trade discounts and rebates should be deducted from the capitalized
cost of a fixed asset, as well as the proceeds from the sale of any items
produced during asset testing.
Conversely, the following costs should be charged to expense as incurred,
and not be capitalized into a fixed asset:
• Administration
• Conducting business in a new location
• General overhead costs
• Introducing a new product
• Opening a new facility
The costs associated with a fixed asset should continue to be capitalized until
the asset is in the location and condition intended for it by management. At
that point, no further costs are capitalized. This means that shifting a fixed
asset to a new location cannot be capitalized, nor can any subsequent
operating losses.
Subsequent Fixed Asset Recognition
Once a fixed asset has initially been measured, the accountant has a choice of
continuing to measure it at cost (the cost model), or of revaluing it on a
regular basis (the revaluation model). Both models are addressed in this
section.
The Cost Model
Under the cost model, continue to carry the cost of a fixed asset, minus any
accumulated depreciation and accumulated impairment losses. This is the
simplest approach, since the least amount of accounting is required.
When the cost model is selected, it should be applied to an entire class of
fixed assets; thus, one cannot shift between the cost and revaluation models
for individual items within a class of assets.
The Revaluation Model
If it is possible to measure the fair value of an asset reliably, there is an
option to carry the asset at its revalued amount. Subsequent to the
revaluation, the amount carried on the books is the fair value, less subsequent
accumulated depreciation and accumulated impairment losses. Under this
approach, fixed assets must be revalued at sufficiently regular intervals to
ensure that the carrying amount does not differ materially from the fair value
in any period.
The fair values of some fixed assets may be quite volatile, necessitating
revaluations as frequently as once a year. In most other cases, IFRS considers
revaluations once every three to five years to be acceptable.
When a fixed asset is revalued, there are two ways to deal with any
depreciation that has accumulated since the last revaluation. The choices are:
• Force the carrying amount of the asset to equal its newly-revalued
amount by proportionally restating the amount of the accumulated
depreciation; or
• Eliminate the accumulated depreciation against the gross carrying
amount of the newly-revalued asset. This method is the simpler of the
two alternatives, and is used in the example later in this section.
Tip: Though all of the assets in an asset class must be revalued at the same
time, it is possible to stretch the requirement and revalue them on a rolling
basis, as long as the revaluation is completed within a short period of time
and the revaluation analysis is subsequently kept up to date.
Use a market-based appraisal by a qualified valuation specialist to determine
the fair value of a fixed asset. If a fixed asset is of such a specialized nature
that a market-based fair value cannot be obtained, use an alternative method
to arrive at an estimated fair value. Examples of such methods are using
discounted future cash flows or an estimate of the replacement cost of an
asset.
If the election is made to use the revaluation model and a revaluation
results in an increase in the carrying amount of a fixed asset, recognize the
increase in other comprehensive income, as well as accumulate it in equity in
an account entitled “revaluation surplus.” However, if the increase reverses a
revaluation decrease for the same asset that had been previously recognized
in profit or loss, recognize the revaluation gain in profit or loss to the extent
of the previous loss (thereby erasing the loss).
If a revaluation results in a decrease in the carrying amount of a fixed
asset, recognize the decrease in profit or loss. However, if there is a credit
balance in the revaluation surplus for that asset, recognize the decrease in
other comprehensive income to offset the credit balance. The decrease
recognized in other comprehensive income decreases the amount of any
revaluation surplus already recorded in equity.
The following table summarizes the proper recognition of revaluation
changes just described.
Revaluation Change Recognition

In essence, IFRS requires the prominent display of any revaluation losses,

and gives less reporting stature to revaluation gains.
If a fixed asset is derecognized, transfer any associated revaluation
surplus to retained earnings. The amount of this surplus transferred to
retained earnings is the difference between the depreciation based on the
original cost of the asset and the depreciation based on the revalued carrying
amount of the asset.
EXAMPLE
Nautilus Tours elects to revalue one of its tourism submarines, which
originally cost £12,000,000 and has since accumulated £3,000,000 of
depreciation. It is unlikely that the fair value of the submarine will vary
substantially over time, so Nautilus adopts a policy to conduct revaluations
for all of its submarines once every three years. An appraiser assigns a value
of £9,200,000 to the submarine. Nautilus creates the following entry to
eliminate all accumulated depreciation associated with the submarine:

At this point, the net cost of the submarine in Nautilus’ accounting records is
£9,000,000. Nautilus also creates the following entry to increase the carrying
amount of the submarine to its fair value of £9,200,000:

Three years later, on the next scheduled revaluation date, the appraiser
reviews the fair value of the submarine, and determines that its fair value has
declined by £350,000. Nautilus uses the following journal entry to record the
change:

This final entry eliminates all of the revaluation gain that had been recorded
in other comprehensive income, and also recognizes a loss on the residual
portion of the revaluation loss.

When the revaluation model is selected, it should be applied to an entire class

of fixed assets; thus, it is not possible to shift between the revaluation and
cost models for individual items within a class of assets. Examples of asset
classes are land, machinery, motor vehicles, furniture and fixtures, and office
equipment.
Depreciation
The purpose of depreciation is to charge to expense a portion of an asset that
relates to the revenue generated by that asset. This is called the matching
principle, where revenues and expenses both appear in the income statement
in the same reporting period, which gives the best view of how well a
company has performed in a given accounting period. There are three factors
to consider in the calculation of depreciation, which are:
• Useful life. This is the time period over which an asset is expected to
be productive, or the number of units of production expected to be
generated from it. Useful life can also be defined by the expected
amount of wear and tear, the level of expected technical obsolescence
of an asset, as well as by any legal limitation on the usage period of an
asset. Past its useful life, it is no longer cost-effective to continue
operating the asset, so one can dispose of it or stop using it.
Depreciation is recognized over the useful life of an asset.
Tip: Rather than recording a different useful life for every asset, it is easier
to assign each asset to an asset class, where every asset in that asset class
has the same useful life. This approach may not work for very high-cost
assets, where a greater degree of precision may be needed.
• Salvage value. When a company eventually disposes of an asset, it
may be able to sell the asset for a reduced amount, which is the
salvage value. Depreciation is calculated based on the asset cost, less
any estimated salvage value. If salvage value is expected to be quite
small, it is generally ignored for the purpose of calculating
depreciation. Salvage value is not discounted to its present value. In
those rare cases where the estimated salvage value equals or exceeds
the carrying amount of an asset, perhaps due to an increase in the
estimated amount of salvage value, do not depreciate the asset further,
unless the estimated salvage value subsequently declines.
Tip: If the amount of salvage value associated with an asset is estimated to
be minor, it is easier from a calculation perspective to not reduce the
depreciable amount of the asset by the salvage value. Instead, assume that
the salvage value is zero.
EXAMPLE
Pensive Corporation buys an asset for £100,000, and estimates that its
salvage value will be £10,000 in five years, when the company plans to
dispose of the asset. This means that Pensive will depreciate £90,000 of the
asset cost over five years, leaving £10,000 of the cost remaining at the end
of that time. Pensive expects to then sell the asset for £10,000 and eliminate
the asset from its accounting records.

• Depreciation method. Depreciation expense can be calculated using an

accelerated depreciation method, or evenly over the useful life of the
asset. The advantage of using an accelerated method is that more
depreciation can be recognized early in the life of a fixed asset, which
defers some income tax expense recognition into a later period. The
advantage of using a steady depreciation rate is the ease of calculation.
Examples of accelerated depreciation methods are the double
declining balance and sum-of-the-years’ digits methods. The primary
method for steady depreciation is the straight-line method. No matter
which method is used, the depreciation of an asset should begin when
it is ready for use. Depreciation does not stop when an asset is idle,
 except under the units of production method (as described later in this
section).
IFRS mandates that the useful life and salvage value of an asset be evaluated
at least once a year, to see if these estimates have changed. If so, alter the
remaining depreciation to account for the changes.
EXAMPLE
Pensive Corporation acquires production equipment for £240,000, and
initially concludes that the equipment should be depreciated over 10 years
and have a salvage value of £40,000. This results in annual depreciation of
£20,000.
At the end of the fifth year, the production manager reviews the situation
and decides that the declining serviceability of the equipment will result in
its sale at the end of the eighth year, rather than the tenth year. Also, its
salvage value will only be £20,000. At this point, the remaining carrying
amount of the asset has declined to £140,000. The remaining depreciable
amount is now £120,000, which should be depreciated over just three more
years, which is £40,000 per year.

The mid-month convention states that, no matter when a fixed asset was
purchased in a month, it was assumed to have been purchased in the middle
of the month for depreciation purposes. Thus, if a fixed asset was bought on
January 5th, assume that it was bought on January 15th; or, if it was bought
on January 28, still assume that it was bought on January 15th. By doing so,
it is easier to calculate a standard half-month of depreciation for that first
month of ownership.
If the mid-month convention is used, this also means that a half-month of
depreciation must be recorded for the last month of the asset's useful life. By
doing so, the two half-month depreciation calculations equal one full month
of depreciation.
Many companies prefer to use full-month depreciation in the first month
of ownership, irrespective of the actual date of purchase within the month, so
that they can slightly accelerate their recognition of depreciation, which in
turn reduces their taxable income in the near term.
IFRS mandates that each part of a fixed item with a cost that is significant
in relation to the total cost be tracked and depreciated separately. This
requirement should be followed with caution, since the accounting
department may find itself tracking a plethora of additional items. The best
interpretation of this rule is to separately depreciate those portions of a fixed
asset that have different useful lives than the rest of an asset. For example, the
jet engines in a passenger jet should be depreciated separately from the
airframe, since the useful life of the airframe should substantially exceed that
of the engines. Similarly, the roof of a building could be depreciated
separately, since it may be replaced several times over the life of the building.
IFRS mandates that fixed assets be depreciated using whichever
depreciation method most closely reflects the expected pattern of
consumption of their future economic benefits, and to apply that method
consistently across reporting periods. Fixed assets are to be reviewed at least
annually to see if the depreciation method in use continues to reflect this
pattern of consumption. If not, the most relevant depreciation method is to be
applied for the remaining useful life of the assets. Realistically, it is difficult
to ascertain the pattern of consumption of future economic benefits, so the
accounting department tends to instead rely upon the simplest possible
depreciation method, which is the straight-line method. In the following sub-
sections, we describe the most commonly-used depreciation methods, and
where their use is most applicable.
Straight-Line Method
Under the straight-line method of depreciation, recognize depreciation
expense evenly over the estimated useful life of an asset. The straight-line
calculation steps are:
1. Subtract the estimated salvage value of the asset from the amount at
which it is recorded on the books.
2. Determine the estimated useful life of the asset. It is easiest to use a
standard useful life for each class of assets.
3. Divide the estimated useful life (in years) into 1 to arrive at the
straight-line depreciation rate.
4. Multiply the depreciation rate by the asset cost (less salvage value).
EXAMPLE
Pensive Corporation purchases the Procrastinator Deluxe machine for
£60,000. It has an estimated salvage value of £10,000 and a useful life of
five years. Pensive calculates the annual straight-line depreciation for the
machine as:
1. Purchase cost of £60,000 – estimated salvage value of £10,000 =
Depreciable asset cost of £50,000
2. 1 ÷ 5-year useful life = 20% depreciation rate per year
 3. 20% depreciation rate × £50,000 depreciable asset cost = £10,000
annual depreciation
Sum-of-the-Years’ Digits Method
The sum of the years’ digits (SYD) method is more appropriate than straight-
line depreciation if the asset depreciates more quickly or has greater
production capacity in earlier years than it does as it ages. Use the following
formula to calculate it:

The following table contains examples of the sum of the years’ digits noted in
the denominator of the preceding formula:

The concept is most easily illustrated with the following example.

EXAMPLE
Pensive Corporation buys a Procrastinator Elite machine for £100,000. The
machine has no estimated salvage value, and a useful life of five years.
Pensive calculates the annual sum of the years’digits depreciation for this
machine as:

The sum of the years’ digits method is clearly more complex than the
straight-line method, which tends to limit its use unless software is employed
to automatically track the calculations for each asset.
Double-Declining Balance Method
The double declining balance (DDB) method is a form of accelerated
depreciation. It may be more appropriate than the straight-line method if an
asset experiences an inordinately high level of usage during the first few
years of its useful life.
To calculate the double-declining balance depreciation rate, divide the
number of years of useful life of an asset into 100 percent, and multiply the
result by two. The formula is:
(100% ÷ Years of useful life) × 2
The DDB calculation proceeds until the asset’s salvage value is reached, after
which depreciation ends.
EXAMPLE
Pensive Corporation purchases a machine for £50,000. It has an estimated
salvage value of £5,000 and a useful life of five years. The calculation of the
double declining balance depreciation rate is:
(100% ÷ Years of useful life) × 2 = 40%
By applying the 40%rate, Pensive arrives at the following table of
depreciation charges per year:

Note that the depreciation in the fifth and final year is only for £1,480, rather
than the £3,240 that would be indicated by the 40% depreciation rate. The
reason for the smaller charge is that Pensive stops any further depreciation
once the remaining book value declines to the amount of the estimated
salvage value.

An alternative form of double declining balance depreciation is 150%

declining balance depreciation. It is a less aggressive form of depreciation,
since it is calculated as 1.5 times the straight-line rate, rather than the 2x
multiple that is used for the double declining balance method. The formula is:
(100% ÷ Years of useful life) × 1.5
EXAMPLE
[Note: We are repeating the preceding example, but using 150% declining
balance depreciation instead of double declining balance depreciation]
Pensive Corporation purchases a machine for £50,000. It has an estimated
salvage value of £5,000 and a useful life of five years. The calculation of the
150% declining balance depreciation rate is:
(100% ÷ Years of useful life) × 1.5 = 30%
By applying the 30%rate, Pensive arrives at the following table of
depreciation charges per year:

In this case, the depreciation expense in the fifth and final year of £3,602
(£12,005 × 30%) results in a net book value that is somewhat higher than the
estimated salvage value of £5,000, so Pensive instead records £7,005 of
depreciation in order to arrive at a net book value that equals the estimated
salvage value.
Depletion Method
Depletion is a periodic charge to expense for the use of natural resources.
Thus, it is used in situations where a company has recorded an asset for such
items as oil reserves, coal deposits, or gravel pits. The calculation of
depletion involves these steps:
1. Compute a depletion base.
2. Compute a unit depletion rate.
3. Charge depletion based on units of usage.
The depletion base is the asset that is to be depleted. It is comprised of the
following four types of costs:
• Acquisition costs. The cost to either buy or lease property.
• Exploration costs. The cost to locate assets that may then be depleted.
In most cases, these costs are charged to expense as incurred.
• Development costs. The cost to prepare the property for asset
extraction, which includes the cost of such items as tunnels and wells.
• Restoration costs. The cost to restore property to its original condition
after depletion activities have been concluded.
To compute a unit depletion rate, subtract the salvage value of the asset from
the depletion base and divide it by the total number of measurement units that
are expected to be recovered. The formula for the unit depletion rate is:

Then create the depletion charge based on actual units of usage. Thus, if 500
barrels of oil are extracted and the unit depletion rate is £5.00 per barrel,
£2,500 can be charged to depletion expense.
The estimated amount of a natural resource that can be recovered will
change constantly as assets are gradually extracted from a property. As the
estimated remaining amount of extractable natural resource is revised,
incorporate these estimates into the unit depletion rate for the remaining
amount to be extracted. This is not a retrospective calculation.
EXAMPLE
Pensive Corporation’s subsidiary Pensive Oil drills a well with the intention
of extracting oil from a known reservoir. It incurs the following costs related
to the acquisition of property and development of the site:

In addition, Pensive Oil estimates that it will incur a site restoration cost of
£57,000 once extraction is complete, so the total depletion base of the
property is £600,000.
Pensive’s geologists estimate that the proven oil reserves that are accessed
by the well are 400,000 barrels, so the unit depletion charge will be £1.50
per barrel of oil extracted (£600,000 depletion base ÷ 400,000 barrels).
In the first year, Pensive Oil extracts 100,000 barrels of oil from the well,
which results in a depletion charge of £150,000 (100,000 barrels × £1.50
unit depletion charge).
At the beginning of the second year of operations, Pensive’s geologists issue
a revised estimate of the remaining amount of proven reserves, with the new
estimate of 280,000 barrels being 20,000 barrels lower than the original
estimate (less extractions already completed). This means that the unit
depletion charge will increase to £1.61 (£450,000 remaining depletion base
÷ 280,000 barrels).
During the second year, Pensive Oil extracts 80,000 barrels of oil from the
well, which results in a depletion charge of £128,800 (80,000 barrels ×
£1.61 unit depletion charge).
At the end of the second year, there is still a depletion base of £321,200 that
must be charged to expense in proportion to the amount of any remaining
extractions.
Units of Production Method
Under the units of production method, the amount of depreciation that is
charged to expense varies in direct proportion to the amount of asset usage.
Thus, more depreciation is charged in periods when there is more asset usage,
and less depreciation in periods when there is less asset usage. It is the most
accurate method for charging depreciation, since it links closely to the wear
and tear on assets. However, it also requires that asset usage is tracked, which
means that its use is generally limited to more expensive assets. Also, it is
necessary to estimate total usage over the life of the asset.
Tip: Do not use the units of production method if there is not a significant
difference in asset usage from period to period. Otherwise, a great deal of
time will be spent tracking asset usage, resulting in a depreciation expense
that varies little from the results that would have been derived with the
straight-line method (which is far easier to calculate).
Follow these steps to calculate depreciation under the units of production
method:
1. Estimate the total number of hours of usage of the asset, or the total
number of units to be produced by it over its useful life.
2. Subtract any estimated salvage value from the capitalized cost of the
asset, and divide the total estimated usage or production from this
net depreciable cost. This yields the depreciation cost per hour of
usage or unit of production.
3. Multiply the number of hours of usage or units of actual production
by the depreciation cost per hour or unit, which results in the total
depreciation expense for the accounting period.
If the estimated number of hours of usage or units of production changes over
time, incorporate these changes into the calculation of the depreciation cost
per hour or unit of production. This will alter the depreciation expense on a
go-forward basis.
EXAMPLE
Pensive Corporation’s gravel pit operation, Pensive Dirt, builds a conveyor
system to extract gravel from a gravel pit at a cost of £400,000. Pensive
expects to use the conveyor to extract 1,000,000 tons of gravel, which
results in a depreciation rate of £0.40 per ton (1,000,000 tons ÷ £400,000
cost). During the first quarter of activity, Pensive Dirt extracts 10,000 tons
of gravel, which results in the following depreciation expense:
£0.40 Depreciation cost per ton × 10,000 Tons of gravel = £4,000
Depreciation expense
Land Depreciation
Nearly all fixed assets have a useful life, after which they no longer
contribute to the operations of a company or they stop generating revenue.
During this useful life, they are depreciated, which reduces their cost to what
they are supposed to be worth at the end of their useful lives. Land, however,
has no definitive useful life, so there is no way to depreciate it.
The one exception is when some aspect of the land is actually used up,
such as when a mine is emptied of its ore reserves. In this case, depreciate the
natural resources in the land using the depletion method, as described earlier
in this section.
Land Improvement Depreciation
Land improvements are enhancements to a plot of land to make it more
usable. If these improvements have a useful life, depreciate them. If
functionality is being added to the land and the expenditures have a useful
life, record them in a separate land improvements account. Examples of land
improvements are:
• Drainage and irrigation systems
• Fencing
• Landscaping
• Parking lots and walkways
A special item is the ongoing cost of landscaping. This is a period cost, not a
fixed asset, and so should be charged to expense as incurred.
EXAMPLE
Pensive Corporation buys a parcel of land for £1,000,000. Since it is a
purchase of land, Pensive cannot depreciate the cost. Pensive intends to use
the land as a parking lot, so it spends £400,000 to pave the land, and add
walkways and fences. It estimates that the parking lot has a useful life of 20
years. It should record this cost in the land improvements account and
depreciate it over 20 years.
Depreciation Accounting Entries
The basic depreciation entry is to debit the depreciation expense account
(which appears in the income statement) and credit the accumulated
depreciation account (which appears in the balance sheet as a contra account
that reduces the amount of fixed assets). Over time, the accumulated
depreciation balance will continue to increase as more depreciation is added
to it, until such time as it equals the original cost of the asset. At that time,
stop recording any depreciation expense, since the cost of the asset has now
been reduced to zero.
The journal entry for depreciation can be a simple two-line entry designed
to accommodate all types of fixed assets, or it may be subdivided into
separate entries for each type of fixed asset.
EXAMPLE
Pensive Corporation calculates that it should have £25,000 of depreciation
expense in the current month. The entry is:

In the following month, Pensive’s controller decides to show a higher level

of precision at the expense account level, and instead elects to apportion the
£25,000 of depreciation among different expense accounts, so that each
class of asset has a separate depreciation charge. The entry is:

EXAMPLE
Pensive Corporate has £1,000,000 of fixed assets, for which it has charged
£380,000 of accumulated depreciation. This results in the following
presentation on Pensive’balance sheet:

Pensive then sells a machine for £80,000 that had an original cost of
£140,000, and for which it had already recorded accumulated depreciation
of £50,000. It records the sale with this journal entry:
As a result of this entry, Pensive’s balance sheet presentation of fixed assets
has changed, so that fixed assets before accumulated depreciation have
declined to £860,000, and accumulated depreciation has declined to
£330,000. The new presentation is:

The amount of net fixed assets declined by £90,000 as a result of the asset
sale, which is the sum of the £80,000 cash proceeds and the £10,000 loss
resulting from the asset sale.

Depreciation is usually charged directly to expense. However, the

depreciation associated with the production process can instead be included
in factory overhead, which is then allocated to units produced. The net effect
is a delay in the recognition of the depreciation, until the units are sold and
the related cost of goods sold is recognized.
Derecognition of Property, Plant and Equipment
When management no longer intends to use a fixed asset, the asset should be
derecognized. Derecognition refers to the removal of a fixed asset from the
accounting records of a business. The lack of intent to use does not
necessarily mean that a fixed asset is only derecognized when it is sold or
scrapped. An asset may also be derecognized even if it remains on the
premises. The key deciding factor when derecognizing a fixed asset is
whether the company expects to receive any future economic benefits from
its use or disposal. If not, the asset can be derecognized at once.
The date on which disposal occurs is when the recipient obtains control of
the asset.
If there is a gain or loss on the derecognition of a fixed asset, the amount
is to be recorded in profit or loss. The gain or loss is calculated as the
difference between any proceeds from disposal of an asset and its remaining
carrying amount. The proceeds received from an asset disposal are to be
recorded at fair value. If the buyer defers payment, a portion of the proceeds
should be considered interest income.
 When a business only infrequently derecognizes fixed assets, any
resulting gains are not considered part of the revenue line item in the
company’s income statement. However, if a company is in the business of
routinely buying and selling fixed assets or renting them, the proceeds from
sale of these assets are included in revenue.
EXAMPLE
Ambivalence Corporation buys a machine for £100,000 and recognizes
£10,000 of depreciation per year over the following ten years. At that time,
the machine is not only fully depreciated, but also ready for the scrap heap.
Ambivalence gives away the machine for free, and records the following
entry.

EXAMPLE
To use the same example, Ambivalence Corporation gives away the
machine after eight years, when it has not yet depreciated £20,000 of the
asset's original £100,000 cost. In this case, Ambivalence records the
following entry:

EXAMPLE
Ambivalence Corporation still disposes of its £100,000 machine, but does so
after seven years, and sells it for £35,000 in cash. In this case, it has already
recorded £70,000 of depreciation expense. The entry is:

What if Ambivalence had sold the machine for £25,000 instead of £35,000?
Then there would be a loss of £5,000 on the sale. The entry would be:
Compensation for Impaired Assets
When a fixed asset is impaired, lost, or given up, and the owner receives
compensation from a third party for the asset, the owner recognizes this
payment in profit or loss as soon as it is recorded as a receivable.
Decommissioning Liabilities
A business may incur an obligation to dismantle equipment or restore a
property to its original condition, once the end of an asset’s useful life has
been reached. The costs associated with these activities are known as
decommissioning liabilities. This obligation may be incurred when an asset is
initially constructed or installed, or at some later date during its use. The
following rules apply to possible changes in the amount of this
decommissioning liability:
• Cost model in use. If an asset is measured using the cost model, any
change in the decommissioning liability also offsets the cost of the
related asset. If a decrease in the decommissioning liability exceeds
the carrying amount of the related asset, recognize the remainder in
profit or loss. If an increase in the decommissioning liability increases
the cost of the related asset, it may be necessary to test the asset for
impairment, to see if an impairment loss should be recognized.
• Revaluation model in use. If an asset is measured using the revaluation
model, any change in the decommissioning liability alters the
revaluation surplus or deficit associated with that asset. A decrease in
the decommissioning liability is recognized in other comprehensive
income and within the revaluation surplus, though the reversal of a
revaluation deficit should be recognized in profit or loss. If the amount
of the decrease would exceed the carrying amount of an asset under
the cost model, recognize the excess amount in profit or loss. An
increase in the decommissioning liability is recognized in profit or
loss, though the elimination of any existing revaluation surplus should
first be recognized in other comprehensive income.
Under both models, if there are changes in the decommissioning liability
after the useful life of an asset has been completed, the changes are to be
reflected immediately in profit or loss.
Decommissioning Funds
A business may contribute cash to a fund that is intended to pay for the costs
of decommissioning a facility, such as a nuclear plant, or for remediating
groundwater pollution, and so forth. A company may set up its own fund for
this purpose, or contribute cash to a general fund into which other companies
are also required to contribute assets. In the latter case, the funding
requirements of contributors may increase if one of the other contributors
goes bankrupt. The funds are usually administered by an independent trustee,
and the contributors have restricted access to contributed funds.
When a company has an obligation to pay decommissioning costs for a
fixed asset, it should separately recognize the amount of the
decommissioning liability and the amount of its payments into the fund,
which means that these amounts appear in separate liability and asset line
items, respectively, in the balance sheet.
If the company has the right to be reimbursed by the fund for any
amounts not used for decommissioning, the company should recognize the
reimbursement at the lesser of the company’s share of the fair value of the net
assets in the fund that are attributable to the contributors, or the recognized
amount of the decommissioning obligation. If there is a subsequent change in
the right to receive reimbursement, other than what is caused by payments to
or from the fund, recognize it in profit or loss.
If the company incurs an additional obligation to contribute funds, as may
arise from the bankruptcy of a fellow contributor, recognize an additional
liability if it is probable that the additional amount must be paid.
Property, Plant and Equipment Disclosures
For each class of fixed assets, disclose the following information in the notes
accompanying the financial statements:
• A reconciliation for the period of the carrying amount, showing
changes caused by additions, assets held for sale, business
combinations, revaluations, impairment losses recognized or reversed,
depreciation, exchange rate differences, and other changes
• Depreciation methods and useful lives used
• The basis for measuring the gross carrying amount
• The beginning and ending gross carrying amounts and accumulated
depreciation, in aggregate
In addition, disclose the following information:
• Any assets pledged as security for liabilities
• Any changes in accounting estimates related to salvage values, useful
lives, depreciation methods, and removal or restoration costs
• Any commitments to acquire fixed assets
• Any title restrictions
• Compensation paid by third parties for fixed assets that were impaired,
lost, or given up
• The amount of expenditures capitalized into the carrying amount of
assets under construction
• If assets were revalued, note the following:
o The revaluation date, and whether an independent appraiser
was involved
o By class, the carrying amount that would have been
recognized under the cost model
o The revaluation surplus, any change in the amount for the
period, and any restrictions on its distribution to shareholders
If a company is paying cash into a decommissioning fund, disclose the
following information:
• The nature of the company’s interest in the fund
• Any restrictions on access to assets in the fund
• If potential additional payments must be made, disclose the nature of
the liability, estimate the financial effect, indicate any remaining
uncertainties, and note the possibility of any later reimbursement
If a company experiences a change in its decommissioning liability and uses
the revaluation model, disclose any resulting change in the revaluation
surplus that is triggered by the liability change.
In addition, IFRS recommends disclosure of the following items, but does
not require it:
• The carrying amount of idle fixed assets
• The carrying amount of retired fixed assets that are not classified as
held for sale
• The gross carrying amount of any fixed assets that are fully
depreciated and still in use
• If the cost model is used, any material differences between the fair
value and carrying amount of fixed assets
Summary
Even a brief perusal of this chapter will make it clear that the accounting for
fixed assets is one of the more time-consuming accounting activities, simply
because the related accounting records must be monitored (and possibly
adjusted) for years. Accordingly, the efficient accountant will do anything
possible to charge expenditures to expense at once, rather than recording
them as fixed assets. The best options for reducing the number of fixed assets
are to maintain a high capitalization limit, and to adopt a skeptical attitude
when anyone wants to add subsequent expenditures to a fixed asset. Also,
avoid using the revaluation model whenever possible, since it adds
unnecessary complexity to the accounting process. The result should be a
considerably reduced number of fixed assets.
 Chapter 15
Intangible Assets
Introduction
Most fixed assets are tangible assets, such as equipment, furniture, and
buildings. However, they can also include intangible assets, such as computer
software, licenses, and franchise agreements. Depending on the
circumstances, intangible assets can comprise a large part of the asset base of
a business, and so deserve detailed attention from the accounting department
to ensure that they are properly recognized. In this chapter, we discuss the
nature of intangible assets and how to account for them, as well as the related
topic of web site costs.
IFRS Source Documents
• IAS 38, Intangible Assets
• SIC 32, Intangible Assets – Web Site Costs
Overview of Intangible Assets
An intangible asset is one that lacks physical substance, and from which an
entity expects to generate economic returns for more than one accounting
period. Examples of intangible assets are:
Marketing-related intangible assets:
• Internet domain names
• Newspaper mastheads
• Noncompetition agreements
• Trademarks
Customer-related intangible assets:
• Customer lists
• Customer relationships
• Order backlogs
Artistic-related intangible assets:
• Literary works
• Motion pictures and television programs
• Musical works
• Performance events
• Pictures
• Video recordings
Contract-based intangible assets:
 • Broadcast rights
• Employment contracts
• Fishing licenses
• Franchise agreements
• Lease agreements
• Licensing agreements
• Mortgage servicing rights
• Service contracts
• Use rights (such as drilling rights or water rights)
Technology-based intangible assets:
• Computer software
• Patented technology
• Trade secrets (such as secret formulas and recipes)
Intangible assets may be aggregated into classes for accounting treatment.
Examples of intangible asset classes are brand names, publishing titles,
computer software, licenses and franchises, copyrights and patents, designs
and prototypes, and assets under development.
Intangible assets can sometimes be treated as an integral part of a tangible
asset. For example, the operating system with which a computer is pre-loaded
is rarely accounted for as a separate intangible asset. Instead, its cost is
included in the cost of the computer asset.
Accounting for Intangible Assets
An intangible asset can only be accounted for separately when it is clearly
identifiable. An asset is considered identifiable when it can be separately
sold, licensed, transferred, or exchanged, or it arises from certain contractual
rights. In order to recognize an intangible asset, it must be possible to reliably
measure the cost of the asset and its probable future economic benefits. These
assertions are assumed to be satisfied if a business directly acquires an
intangible asset, but must be proven if the assets are to be segregated from a
business acquisition.
EXAMPLE
Suture Corporation pays an outside attorney £40,000 to file a patent
application for an electronic method for destroying cancer cells, and incurs
£35,000 of internal labor costs to provide the documentation needed for the
patent application. Suture expects to earn millions in licensing fees from its
ownership of the patent. Later, Suture spends £250,000 to defend the patent
from a competing claim.
Suture should capitalize the £75,000 associated with the patent application,
but must charge the defense cost to expense as incurred.

The initial accounting for an intangible asset is to record the asset at its cost,
which should include the following items to the extent that they areincurred
to acquire the asset and bring the asset to its working condition:

The cost of an intangible asset should be compiled minus the amounts of any
related trade discounts and rebates. Also, the costs of new product
introductions, conducting business in a new location, overhead, and
administration should not be included in the cost of an intangible asset.
Further, if the payment terms to acquire an intangible asset are deferred
beyond normal credit terms, the cost to capitalize is the cash price equivalent;
any amount above the cash price equivalent should be charged to interest
expense.
Costs are accumulated into an intangible asset until the date when the
asset has reached the condition required for it to operate in the manner
intended by management. Thus, any costs incurred after that date to redeploy
an asset should be charged to expense as incurred, rather than being added to
its cost.
Once an intangible asset has been recorded, it is amortized over its useful
life. If there is no discernible usage pattern, amortization should be on a
straight-line basis. If an intangible asset is used in the construction of
products or services, it can instead be allocated to inventory.
EXAMPLE
Thimble Clean buys the rights to a patented technology that allows it to
manufacture potent detergents in pill form, which are dropped into washing
machines. Thimble pays £200,000 for the technology, and decides to
amortize this cost through the units of production method, where it will
amortize £0.25 for every pill manufactured. Thimble includes this £0.25 cost
in the standard cost of the product, which increases the recorded cost of
inventory. Thimble then charges this inventory cost to the cost of goods sold
whenever it sells a detergent pill.

Intangible Assets Acquired in a Business Combination

Many intangible assets are acquired as part of a business combination, where
the acquirer pays a certain amount for an acquiree, and then assigns a portion
of the purchase price to specific tangible and intangible assets of the acquiree,
with any unassigned residual amount designated as goodwill. Many of these
intangible assets are being recognized for the first time; that is, the acquiree
may never have recognized them during its years of operation as an
independent entity.
An intangible asset acquired through a business combination is recorded
at its fair value as of the acquisition date. If there is some uncertainty about
the range of possible fair values, it may be necessary to use an average of the
various possible valuations, weighted based on their probabilities.
EXAMPLE
Pulsed Laser Drilling Corporation acquires a competitor that has made a
significant investment in the development of a high-powered laser for
drilling oil wells. At the time of the acquisition, the competitor had signed a
contract with a large oil and gas exploration company to use the laser drill
for a total fee of £18,000,000. The discounted cash flows associated with
this contract are £7,200,000, which is used as a substitute for fair value by
Pulsed Laser in estimating the valuation of the project that it should record
as an intangible asset.

Here are several additional rules that may apply to the recognition of
intangible assets acquired in a business combination:
• Linked asset. If an intangible asset is linked to a contract or other
specifically identifiable asset or liability, recognize the intangible asset
as part of the related item.
• Research and development projects. It is allowable to recognize an in-
process research and development project of an acquiree as an
intangible asset, as long as the project meets the criteria for an
intangible asset.
• Similar assets. Similar intangible assets can be combined into a single
asset, though they must have useful lives of roughly the same
duration.
Once a research and development project has been recognized as an
intangible asset by the acquirer, the following rules apply to any additional
expenditures made in association with that project:
• Research expenditures. Expenditures made on research activities are
 charged to expense as incurred.
• Development expenditures. Expenditures made on development
activities are charged to expense as incurred, unless they satisfy all of
the following capitalization requirements:
o Future economic benefits are probable
o Management intends to complete and use the asset, and has the
ability to do so
o Technical feasibility of the product has been demonstrated
o The amount of the development expenditure can be reliably
measured
o There are adequate resources to complete the project
Internally Developed Intangible Assets
It is possible under IFRS to recognize internally-generated intangible assets.
To do so, split expenditures related to a prospective intangible asset into
those incurred during the research and development phases of constructing
the asset. All research-related expenditures are to be charged to expense as
incurred. Examples of research-related expenditures are:
• Activities designed to acquire new knowledge
• The search for and application of research findings
• The search for and/or formulation of product or process alternatives
Expenditures related to development activities can be capitalized as
intangible assets, but only if they meet all of the criteria already noted for
acquired development activities, which are reproduced here:
• Future economic benefits are probable
• Management intends to complete and use the asset, and has the ability
to do so
• Technical feasibility of the product has been demonstrated
• The amount of the development expenditure can be reliably measured
• There are adequate resources to complete the project
Examples of development-related expenditures are:
• The design and testing for prototypes, or of alternative materials,
processes, and so forth
• The design of tools, molds, and related items that involve new
technology applications
• The design, construction, and operation of a pilot plant that is not
intended for commercial production levels
IFRS does not allow the following internally-generated items or similar items
to be recognized as intangible assets:
• Brands
• Customer lists
• Goodwill
• Mastheads
• Publishing titles
EXAMPLE
The Electronic Inference Corporation is developing a new manufacturing
process for its electronic calculator line. The company expends £150,000 on
the development of this process through the first half of 20X2, and is then
able to demonstrate as of July 1 that the process meets the criteria for an
intangible asset. The £150,000 expended prior to that date must be charged
to expense.
The company estimates that the recoverable amount of knowledge embodied
in the new process is £300,000. In the following four months, the company
incurs an additional £330,000 of costs, which it capitalizes into an intangible
asset. Since the capitalized amount is £30,000 higher than the recoverable
amount, the controller writes off the difference as an asset impairment.

A number of items cannot be capitalized into intangible assets, and must

instead be charged to expense as incurred. This situation arises because the
expenditures do not meet the criteria listed earlier for development activities.
Examples of expenditures that are rarely capitalized as intangible assets are
those related to training activities, advertising and promotions, relocations,
reorganizations, and start-up activities.
Other Forms of Intangible Asset Acquisition
In this section, we describe several additional scenarios under which a
business may acquire an intangible asset:
• Asset exchanges. A business may acquire an intangible asset through a
non-monetary exchange. The cost of the acquired asset is measured at
fair value, unless the exchange has no commercial substance. If fair
value cannot be derived, the carrying amount of the asset given up is
used instead. A transaction is considered to have commercial value
when the expected future cash flows (in terms of risk, timing, and/or
amount) of a business will change because of the transaction.
• Government grants. A government entity may grant an intangible
asset, such as airport landing rights, to a business. If so, the recipient
 has the choice of either recognizing the asset at its fair value, or at
some nominal amount plus those expenditures needed to prepare the
asset for its intended use.
Subsequent Intangible Asset Recognition
Once an intangible asset has initially been measured, the accountant has a
choice of continuing to measure it at cost (the cost model), or of revaluing it
on a regular basis (the revaluation model). Both models are addressed in this
section.
The Cost Model
Under the cost model, continue to carry the cost of an intangible asset, minus
any accumulated amortization and accumulated impairment losses. This is the
simplest approach, since the least amount of accounting is required.
When the cost model is selected, it should be applied to an entire class of
intangible assets; thus, it is not possible to shift between the cost and
revaluation models for individual items within a class of assets.
The Revaluation Model
If it is possible to measure the fair value of an asset reliably on an active
market, there is an option to carry the asset at its revalued amount. There are
few active markets for intangible assets, which renders this option
unavailable in many situations. Subsequent to revaluation, the amount carried
on the books is the fair value, less subsequent accumulated amortization and
accumulated impairment losses. Under this approach, continue to revalue
intangible assets at sufficiently regular intervals to ensure that the carrying
amount does not differ materially from the fair value in any period.
If the revaluation model is initially used and it is later found that there is
no longer an active market from which to derive a revaluation, subsequently
use the last revalued amount as the carrying amount, less any accumulated
amortization or accumulated impairment losses for the periods since the last
revaluation. It is possible that the termination of an active market indicates
that the value of the asset has been impaired, which may call for impairment
testing.
The fair values of some intangible assets may be quite volatile,
necessitating frequent revaluations. This is not necessary when there is a
history of insignificant movements in the fair value of assets.
When an intangible asset is revalued, there are two ways to deal with any
amortization that has accumulated since the last revaluation. The choices are:
• Force the carrying amount of the asset to equal its newly-revalued
 amount by proportionally restating the amount of the accumulated
amortization; or
• Eliminate the accumulated amortization against the gross carrying
amount of the newly-revalued asset. This method is the simpler of the
two alternatives, and is used in the following example.
EXAMPLE
The Red Herring Fish Company owns a fishing license for herring, which it
purchased for £100,000. The term of the license is ten years, after which the
fisheries department of the federal government will auction it again to the
highest bidder. There is an active resale market for fishing licenses, since
boat operators are constantly entering and departing the market for herring
fishing.
After two years, Red Herring has amortized £20,000 of the carrying amount
of the fishing license. At that time, the fisheries department announces that it
will begin to reduce the number of licenses sold at auction, with the intent of
eventually having 30% fewer fishing licenses outstanding. This prospective
restriction in supply triggers an immediate jump in the resale market for the
price of fishing licenses, to £130,000. Red Herring revalues its fishing
license asset based on this jump in price by eliminating all accumulated
amortization associated with the asset and then increasing the carrying
amount of the asset. The entries are:

To eliminate accumulated depreciation

To match carrying amount to revalued amount

Red Herring must now amortize the new £130,000 carrying amount of the
fishing license over its remaining eight-year term. If the company uses the
straight-line method to do so, the annual amortization will be £16,250.

If the election is made to use the revaluation model and a revaluation results
in an increase in the carrying amount of an intangible asset, recognize the
increase in other comprehensive income, as well as accumulate it in equity in
an account entitled “revaluation surplus.” However, if the increase reverses a
revaluation decrease for the same asset that had been previously recognized
in profit or loss, recognize the revaluation gain in profit or loss to the extent
of the previous loss (thereby erasing the loss).
If a revaluation results in a decrease in the carrying amount of an
intangible asset, recognize the decrease in profit or loss. However, if there is
a credit balance in the revaluation surplus for that asset, recognize the
decrease in other comprehensive income to offset the credit balance. The
decrease recognized in other comprehensive income decreases the amount of
any revaluation surplus already recorded in equity.
The following table summarizes the proper recognition of revaluation
changes just described.
Revaluation Change Recognition

In essence, IFRS requires the prominent display of any revaluation losses,

and gives less reporting stature to revaluation gains.
If a fixed asset is derecognized, transfer any associated revaluation
surplus to retained earnings. The amount of this surplus transferred to
retained earnings is the difference between the amortization based on the
original cost of the asset and the amortization based on the revalued carrying
amount of the asset.
When the revaluation model is selected, it should be applied to an entire
class of intangible assets; do not shift between the revaluation and cost
models for individual items within a class of assets. This rule does not apply
when there is no active market for the assets, since it is then impossible to use
the revaluation method.
Intangible Asset Derecognition
An intangible asset should be removed from the accounting records
(derecognized) when it is disposed of, or when the company no longer
expects to derive any additional economic benefits from it. The disposal date
is when the recipient obtains control of the asset.
When an intangible asset is derecognized, recognize in profit or loss any
gain or loss on the disposal, which is calculated as the difference between the
net sale proceeds and the remaining carrying amount of the asset. Any
consideration paid to the business in exchange for a sold intangible asset
should be recognized at its fair value. If payment is deferred, the difference
between the amount eventually paid and the cash price equivalent should be
recognized as interest income.
Web Site Costs
A business may incur costs, both internally and from third parties, to develop
and maintain a web site on which it promotes and sells its products and
services. IFRS considers such a web site to be an internally generated
intangible asset. Its development cost can only be capitalized if it complies
with all of the following requirements:
• Future economic benefits are probable
• Management intends to complete and use the asset, and has the ability
to do so
• Technical feasibility of the product has been demonstrated
• The amount of the development expenditure can be reliably measured
• There are adequate resources to complete the project
If these requirements cannot be met, all expenditures related to the web site
should be charged to expense as incurred.
Subject to the preceding requirements, development costs that can be
capitalized include obtaining a domain name, acquiring hardware and
software, installing applications, designing web pages, preparing and
uploading information, and stress testing.
All other costs related to a website must be charged to expense as
incurred. These costs include feasibility studies, defining specifications,
evaluating alternatives, site hosting, advertising products and services on the
site, and site maintenance.
When determining the useful life of a web site for the purpose of
amortizing related costs that have been capitalized, IFRS recommends that
the useful life be “short.”
EXAMPLE
The Close Call Company compiles the cost of its new web site, which is
used by customers to place orders for cross-town delivery services. The
following table shows which items will be capitalized into an intangible
asset and which will be charged to expense, on the assumption that the web
site meets the criteria for capitalization as an internally developed intangible
asset:
Additional Intangible Asset Issues
The following additional topics apply to the accounting for intangible assets:
• Useful life, indefinite. An intangible asset may be determined to have
an indefinite useful life when there is no foreseeable limit to the span
of time over which the asset will continue to generate cash for the
business. Such an asset is not amortized. The useful life of each
indefinite-life asset should be reviewed in each reporting period; if the
circumstances no longer support indefinite life status, assign it a useful
life and begin amortizing it. The switch from an indefinite life to a
finite life can be an indicator that the carrying amount of an intangible
asset is impaired.
• Useful life, definite. If there is a limit to the cash-generating abilities of
an intangible asset, amortize it. The useful life of an asset should not
exceed the duration of any contract from which it arises, unless the
contract can be renewed, and without significant cost. A renewal
period should be factored into the determination of useful life when
 there is evidence that a contract will be renewed, that any renewal
requirements will be satisfied, and that the cost of renewal is less than
the benefits to be derived from the renewal. When determining the
useful life of an intangible asset, consider the following factors:
o Anticipated competitor actions impacting the asset
o Any limits on use of the asset, such as the useful lives of other
assets
o Any types of obsolescence that may apply to the asset
o Changes in market demand for the output of the asset
o Expected asset usage
o The maintenance cost required to achieve economic benefits
from the asset
o Typical useful life durations for similar assets used in a similar
way
EXAMPLE
AMM Corporation (a contraction of Annoying Marketing Materials) buys a
customer list from a competitor, and plans to use it for a variety of bulk
mailings. The benefit to be obtained from the list will be relatively short-
lived, since the useful life only applies to the customers on the list when it
was acquired. Accordingly, AMM plans to amortize the carrying amount of
the list over a single year.
EXAMPLE
Radiosonde Communications operates a country music radio station. A
government agency awards Radiosonde a broadcast license renewal once
every five years, based on minimal requirements related to public service
announcements and the filing of relevant license renewal documents.
Radiosonde plans to pay the minimal renewal fee required for each
subsequent renewal, as it has done for the past two license renewals. Though
there are alternatives to radio technology, such as Internet radio stations,
these options do not yet appear to threaten the radio business model. Based
on this information, the broadcast license asset should be considered to have
an indefinite life, and so should not be amortized.
Two years later, the incursions of both satellite radio and Internet radio have
substantially reduced the market demand for the country music station.
Accordingly, Radiosonde not only conducts an impairment analysis of the
broadcast license asset, but also decides not to renew the license, and begins
amortizing the post-impairment carrying amount of the asset over the
remaining years until the license expires.

• Amortization period. When an intangible asset has a finite useful life,

begin amortizing it when the asset is in the location and condition
needed to be capable of operating as intended by management.
Amortization should be halted when an asset is classified as held for
sale, or when it is derecognized. The amortization method should
reflect the usage pattern of the asset; if there is no discernible usage
pattern, use the straight-line method of amortization. In some cases,
there may be a predominant limiting factor associated with an
intangible asset, such as the loss of a radio license after three years, or
the loss of a toll road contract after £150 million in toll revenues have
been reached. If so, the amortization should be based on the
predominant limiting factor.
• Amortization adjustments. Both the amortization period and
amortization method should be reviewed at least once a year, and
adjusted as necessary.
• Residual value. Residual value is deducted from the gross carrying
amount of an asset to arrive at the amount of the asset that can be
amortized. When an intangible asset has a finite useful life, its residual
value is assumed to be zero, unless a third party has committed to buy
the asset at the end of its useful life, or a residual value can be derived
from an active market for the asset. The amount of the residual value
should be reviewed at least annually, and adjusted as necessary.
EXAMPLE
Failsafe Containment is awarded a patent on a magnetic fusion power
containment system, from which Failsafe expects to obtain licensing fees for
at least 10 years. Failsafe initially recognizes the patent using the cost
model, at a carrying amount of £200,000. The company has signed a
contract with a utility company to acquire the patent for £80,000 after six
years have passed.
Failsafe should apply the residual value of £80,000 to the initial carrying
amount of £200,000 to arrive at a depreciable amount of £120,000, and
depreciate it over six years. If the straight-line method of amortization is
used, this will result in annual amortization of £20,000.

• Impairment testing. When an intangible asset has an indefinite useful

 life, test it for impairment at least once a year, as well as when there is
an indication of possible impairment. There is impairment if the
recoverable amount of an asset is less than its carrying amount.
Intangible Asset Disclosures
Disclose the following information about intangible assets in the notes
accompanying the financial statements for each class of assets, and further
subdivided by internally-generated intangible assets and other intangible
assets:
• Amortization expense. Where the amortization expense appears in the
statement of comprehensive income.
• Amortization methods. The amortization methods used, if the assets
have finite useful lives.
• Gross amounts. The beginning and ending balances of gross carrying
amounts and the combined amount of accumulated amortization and
accumulated impairments.
• Reconciliation. A reconciliation of the beginning and ending carrying
amounts, including additions from internal development, additions
from business combinations, additions acquired separately, assets
classified as held for sale, revaluation changes, impairment changes,
amortization, foreign currency exchange differences, and other items.
• Useful life determination. Whether the useful lives are considered
finite or indefinite. If the former, disclose the duration of the useful
lives.
If any intangible assets are accounted for under the revaluation model,
disclose by asset class the effective date of revaluation, the aggregate
carrying amount of revalued items, the carrying amount that would have been
recognized if the cost model had been used, and a reconciliation of the
revaluation surplus (if any), as well as any restrictions on the distribution of
the revaluation surplus to shareholders.
In addition, disclose the following more general information as necessary:
• Committed purchases. Any amounts contractually committed for the
acquisition of intangible assets.
• Government grants. If assets were acquired through a government
grant and recognized at fair value, disclose their initial fair values,
carrying amounts, and whether they are now measured under the cost
model or the revaluation model.
• Indefinite useful lives. The carrying amounts of assets with indefinite
 useful lives, and the reasons for assigning them indefinite status.
• Material changes. If there have been material changes in accounting
estimate, such as useful lives, amortization methods, and/or residual
amounts, disclose the nature and amount of these changes.
• Material items. The carrying amount, remaining amortization period,
and description of any specific intangible assets that are material to the
financial statements.
• Pledged as security. The carrying amounts of any intangible assets
pledged as security for liabilities.
• Research and development. The aggregate amount of research and
development expense recognized during the period.
• Restricted title. The amount and name of any intangible assets with
restricted titles.
IFRS also encourages, but does not require, the disclosure of any fully
amortized intangible assets that are still in use, as well as a description of any
intangible assets that do not meet the criteria for asset recognition, but which
the company controls.
Summary
Most intangible assets are acquired. Since there is rarely an active market for
intangible assets, this means that most of these items are recorded using the
cost model, which requires little ongoing maintenance once the initial cost
has been recognized. Consequently, and with the exception of occasional
impairment testing, the accounting for intangible assets tends to be relatively
easy.
It may be tempting to go through the additional documentation required
to recognize an internally generated intangible asset. However, consider that
capitalizing a large amount of expenditures may yield financial results that
are unusually profitable, and in exchange for the incurrence of a large amount
of amortization in later years that will weigh down reported results in those
periods. If these assets must be capitalized, at least disclose in the financial
statements what the company’s results would have been if the capitalization
of internal intangible assets had not taken place.
 Chapter 16
Investment Property
Introduction
Investment property is a non-monetary asset that is held with the intent of
earning a return, either from its rental or appreciation. The accounting for
investment property is somewhat different from the accounting for fixed
assets. In this chapter, we describe the nature of investment property, the
costing methods available for measuring it, and what types of information to
disclose about it.
IFRS Source Document
• IAS 40, Investment Property
Overview of Investment Property
An owner holds investment property with the intent of either earning rental
income, gaining from capital appreciation, or both. Because of this
investment focus, an investment property is expected to create cash flows that
are separate from the other assets that a business may own. This investment
approach is different from owner-occupied property, where the property is
used to house production or administrative activities, but there is no
expectation of rental income or appreciation. Examples of investment
property are:
• A building held with the intent of being leased as a right-of-use asset,
even if that is not currently the case
• Land for which a future use has not yet been determined
• Land held in order to benefit from the appreciation of its price over
time
• Property under development that is intended to be an investment
property
Conversely, the following are not considered to be investment properties:
• Property being developed on behalf of another party
• Property being developed for immediate sale, or ready for immediate
sale
• Owner-occupied property that is used by the owner or its employees
• Property being leased under a finance lease (see the Leases chapter)
The following additional concepts may apply to the classification of property
as investment property:
 • Extra services. The owner of an investment property may provide
additional services to the occupants of the property, such as janitorial
services. If so, the property can still be accounted for as an investment
property if the services provided are an insignificant part of the entire
arrangement. If the services provided are significant, the property is to
be accounted for as an owner-occupied property.
• Leased to related party. If a business leases space to its corporate
parent or a subsidiary, the property cannot be classified in the
consolidated financial statements of the group as investment property,
since the entity as a whole is leasing from itself. However, the
property could be classified as investment property in the financial
statements of just the business leasing the property, since it is an
investment property from the perspective of that entity.
• Multiple uses. In those cases where different portions of a property
could be separately classified as investment property and other types
of property, they can be accounted for separately if they can be sold
separately. If not, the property can only be accounted for as an
investment property if an insignificant proportion of it is used for non-
investment purposes.
EXAMPLE
The Sojourn Hotel provides a number of services to its guests, including
linen changes, room clean up, meals, and an on-site health club. Since the
services provided are significant, Sojourn must account for the property as
owner-occupied, rather than investment property.
EXAMPLE
The Acme Conglomerate owns the headquarters building in which its
corporate staff works. Since it is owner-occupied, it is classified as a fixed
asset.
Acme also owns a building which it obtained through a business
combination, and which it is currently upgrading with the intent of leasing
the facility. This is classified as an investment property.

Accounting for Investment Property

An investment property can only be recognized as an asset when its cost can
be reliably measured and its economic benefits will probably flow to the
owning entity. This definition has the following implications:
• Deferred payment. If the acquirer of an investment property buys it
 with a deferred payment, capitalize only that portion of the cost that is
the cash price equivalent. Recognize any excess amount paid over the
cash price equivalent as interest expense.
• Ongoing expenditures. Those expenditures required for the day-to-day
servicing of a property are charged to expense as incurred. These
items generally fall into the category of repairs and maintenance.
• Replacement. If portions of an investment property are replaced (such
as a roof), that portion of the property being replaced is derecognized
and replaced with the expenditure for the replacement item.
• Start-up costs. Those start-up expenditures needed to bring an
investment property up to the standard envisaged by management can
be capitalized. All other start-up costs are to be charged to expense as
incurred.
• Transaction costs. If there are transaction costs associated with the
initial acquisition of an investment property, include them in the initial
measurement of the asset. Examples of such fees are legal services and
property transfer taxes.
• Waste. If abnormal amounts of material, labor, or other items are
wasted during the development of an investment property, charge
them to expense as incurred.
The following additional scenarios may apply to the accounting for an
investment property:
• Leased asset. If an investment property is held under a finance lease
(see the Leases chapter), recognize the property at the lower of the
present value of its minimum lease payments or its fair value.
• Non-monetary purchase. If an investment property is acquired through
an exchange of non-monetary assets, measure the cost of the
investment property at fair value unless the exchange has no
commercial substance or the fair values of assets exchanged cannot be
determined. There is no commercial substance when the risk, timing,
or amount of an entity’s cash flows does not change significantly as
the result of a transaction. When the fair values of both the asset given
up and received are available as the basis for measuring an investment
property, the fair value of the asset received is preferred over the fair
value of the asset given up. If no fair value is available, measure the
property at the carrying amount of the asset given up.
Once an investment property has been initially recognized, the owner can
elect to account for it under either the cost model or the fair value model.
Also, the owner must consistently apply the same model to all of its
investment properties.
Under the fair value model, an investment property is recognized at its
fair value on an ongoing basis, with any change in fair value recognized in
profit or loss in the period in which the fair value change occurs. If a business
elects to use the fair value model, it must continue to use the model until the
property being measured has either been disposed of or reclassified as owner-
occupied, even if the number of comparable market transactions used as the
basis for fair value measurements subsequently declines.
IFRS encourages use of the fair value model where valuations are
compiled by a qualified and certified independent valuation expert.
EXAMPLE
The Acme Conglomerate buys an office tower in London for £75,000,000,
with the intention of leasing it. Acme uses the fair value model to measure
its value, and hires a reputable local valuation firm to provide a valuation
analysis once a year. Over the next five years, these valuations result in the
recognition of the following gains and losses by Acme:

Under the cost model, an investment property is recognized at its cost, which
is depreciated on an ongoing basis and periodically evaluated for impairment.
This is the simpler of the two models and is less expensive to maintain, and
so tends to be used more frequently.
EXAMPLE
The Acme Conglomerate buys a warehouse in Eastbourne for £8,000,000
and intends to lease it to a third party. The property manager estimates that
the warehouse will have a useful life of 25 years and will then be torn down,
so the asset is depreciated at a rate of £320,000 per year. By the end of the
25-year period, the carrying amount of the property on Acme’s books will
have been reduced to zero. Since the company has not elected to employ the
fair value method, changes in fair value are not measured, and so have no
impact on the carrying amount of the asset.

The following additional issues may apply to the investment property

accounting topic:
• Asset pools. An entity may operate a property fund, for which it sells
shares to investors. The entity can choose either the fair value or cost
models for this fund, and may still elect to use the other valuation
method for its remaining investment properties. However, it cannot
use a mix of the methods for the properties within such a fund. If an
asset is shifted from a pool recorded at fair value to a pool recorded at
cost, the fair value of the asset on its transfer date becomes its cost.
• Basis for fair value. The measurement of fair value under the fair
value method should reflect changes in rental income from an
investment property being leased to third parties.
• Included assets. When deriving the fair value of an investment
property where certain assets are integral to the fair value, do not
double count these integral assets as fixed assets. Thus, if the fair
value of an investment property is based in part on its being furnished,
do not also recognize the furnishings as separate assets.
• Inability to measure fair value. If the market for comparable properties
is inactive, there may not be sufficient comparative information to
derive fair value information. If this is the case during the construction
of an investment property, but it is expected that fair value information
will be available by the time the property has been completed,
measure it at cost until the fair value information is available. If it is
not possible to obtain fair value information on a continuing basis,
then measure the property using the cost model. If the cost model is
used because no fair value information is available, it is permissible to
use the fair value model for the entity’s other investment properties.
Owner-occupied property is accounted for as a normal fixed asset. See the
Property, Plant, and Equipment chapter for more information.
Investment Property Transfers
It is possible to transfer assets into or out of an investment property. This is
only allowed when there is a change in use. Evidence of a change in use is
considered to be only one of the following four alternatives:
• Shift from owner use. The owner elects to stop its own use of a
property as owner-occupied and starts treating it as investment
 property.
• Shift to owner use. The owner elects to stop using a property as an
investment and starts using it on an owner-occupied basis.
• Shift to sale. The owner intends to sell a property, and so commences
work to ready it for sale.
• Shift from sale. The owner elects to stop attempting to sell a property,
and instead enters into an operating lease with a tenant, which means
that the property is now treated as an investment property.
When an entity uses the cost model to account for its investment properties,
shifting assets between different classifications of assets (as just noted)
results in no change in the cost basis of an asset.
When an entity uses the fair value model to account for its investment
properties, the cost for subsequent accounting is considered to be the fair
value of an asset on the date when its designated use changes.
If an owner-occupied property is transferred into an investment property
classification where it is now carried at fair value, the asset is revalued as of
the transfer date. See the Property, Plant, and Equipment chapter for a
discussion of asset revaluations. In essence, the revaluation concept means:
• In general, if there is a decrease in the carrying amount of an asset,
recognize it in profit or loss.
• If there is a decrease in the carrying amount of an asset, but there is a
revaluation surplus, the loss is first offset against the surplus, which
means that it is recognized in other comprehensive income.
• In general, if there is an increase in the carrying amount of an asset, it
is recognized in other comprehensive income and is considered a
revaluation surplus.
• If there is an increase in the carrying amount of an asset, but there was
a previous impairment loss, the gain is first offset against the loss,
which means that it is recognized in profit or loss.
If an owner has property classified as inventory for sale, and which has been
measured using the fair value model, and the property is then transferred to
the investment property classification, any change in value on the transfer
date is to be recognized in profit or loss.
If a business has been constructing an asset and has been measuring it at
cost during the construction period, and intends to measure the asset at fair
value, it can do so upon the completion of the asset. When completed, any
difference between the carrying amount of the asset and its fair value is
recognized in profit or loss.
Investment Property Disposals
When an investment property is disposed of or permanently withdrawn from
use, it should be removed from the balance sheet, which is known as
derecognition. Derecognition can occur when a property is sold, or is leased
under a finance lease.
When a portion of a property is disposed of and replaced (as is common
when constructed assets wear out and must be replaced), the accounting
treatment varies depending on the valuation model used. The differences are:
• Fair value model. If an asset is already being measured at its fair
value, include the cost of the replacement item in the carrying amount
of the asset, and then reassess its fair value.
• Cost model. If an asset is already being measured at its cost,
derecognize the item being replaced and add the cost of the item being
added. If it is not possible to determine the cost of the item being
replaced, the cost of the replacement can be used to indicate what the
cost of the replaced item was when it was new.
When an investment property is sold or otherwise disposed of, recognize the
difference between its carrying amount and the net disposal proceeds as a
gain or loss. When making this calculation, measure any consideration
received for the property at its fair value. If the amount of consideration
received is deferred, the difference between the cash price equivalent and the
amount actually paid is to be recognized as interest income by the seller.
Investment Property Disclosures – Fair Value Model
If a business uses the fair value model to measure its investment property, it
should disclose the following information:
• Classification criteria. The criteria used to distinguish between owner-
occupied, held for sale, and investment property.
• Model used. The type of valuation model used.
• Obligations. Any contractual obligations to buy, construct, or repair
investment property.
• Profit or loss recognition. The amount of rental income, direct
operating expenses related to rental properties, direct operating
expenses related to non-rental properties, and the cumulative change
in fair value recognized in profit or loss from the transfer of an asset
from a cost method pool to a fair value method pool.
• Reconciliation. A reconciliation of the beginning and ending carrying
 amounts of investment property, including additions from
acquisitions, additions from subsequent expenditures, additions from
business combinations, assets held for sale, fair value adjustments,
foreign exchange differences, transfers into or out of the inventory
classification, transfers into or out of the owner-occupied
classification, and other changes.
• Restrictions. Any restrictions on the realizability of investment
property, or on related receipt remittances.
• Valuation experts. The extent to which valuation experts are used to
measure the fair value of investment property. If there has been no
valuation by such a person, disclose this fact.
In those investment property cases where the fair value model cannot be used
due to a lack of comparable market transactions, the reconciliation should
separate the amounts related to these cases. Further, a business should
disclose the affected properties, and why the fair value model cannot be used.
If possible, also note a range of estimates within which it is highly likely that
the fair value lies for these properties. Finally, when these items are disposed
of, note that they have been disposed of, the carrying amount on the sale date,
and the gain or loss recognized.
Investment Property Disclosures – Cost Model
If a business uses the cost model to measure its investment property, it should
disclose the following information:
• Model used. The type of valuation model used.
• Classification criteria. The criteria used to distinguish between owner-
occupied, held for sale, and investment property.
• Profit or loss recognition. The amount of rental income, direct
operating expenses related to rental properties, and direct operating
expenses related to non-rental properties.
• Restrictions. Any restrictions on the realizability of investment
property, or on related receipt remittances.
• Obligations. Any contractual obligations to buy, construct, or repair
investment property.
• Depreciation. The depreciation methods applied to the investment
property, as well as the related useful lives or depreciation rates.
• Gross amounts. The gross carrying amount, as well as the combined
accumulated depreciation and accumulated impairment losses for the
investment property at the beginning and end of the reporting period.
 • Reconciliation. A reconciliation of the beginning and ending carrying
amounts of investment property, including additions from
acquisitions, additions from subsequent expenditures, additions from
business combinations, held for sale items, depreciation, impairment
losses, reversed impairment losses, foreign exchange differences,
transfers to and from the inventory classification, transfers to and from
the owner-occupied classification, and other changes.
• Fair value. When it is not possible to reliably estimate the fair value of
investment property, describe the property, and explain why its fair
value cannot be reliably measured. If possible, also note the range of
estimates within which it is highly likely that the fair value lies.
Summary
A company may initiate a variety of operational decisions that make it
difficult to discern whether a property should be accounted for as owner-
occupied or investment property (which has a significant impact on the
related accounting). To clarify the situation, create a policy that states the
operational characteristics that will result in accounting treatment as one type
of property or the other, and consistently adhere to that policy over time. This
can be a major issue for a larger company with numerous investment
properties, if it were to account for them on an inconsistent basis.
 Chapter 17
Impairment of Assets
Introduction
An asset should not be carried in an entity’s accounting records at more than
its recoverable amount, which is the amount that can be recovered by a
business through the ongoing use or sale of the asset. Otherwise, there is a
risk of overstating the assets listed in a company’s balance sheet, possibly by
a large amount. In this chapter, we address how to identify an impairment
situation, how to calculate the amount of an impairment, and the
circumstances under which an impairment can be reversed.
IFRS Source Document
• IAS 36, Impairment of Assets
Overview of Asset Impairment
In essence, asset impairment has occurred when the carrying amount of an
asset is greater than its recoverable amount. If this happens, write off the
difference in profit or loss as an impairment loss. The following steps show
the general process flow for impairment accounting:
1. Assess whether an asset may be impaired.
2. Measure the recoverable amount of the asset.
3. Measure and recognize the impairment loss.
The steps just indicated are described in greater detail in the following sub-
sections.
Indications of Impairment
There should be an assessment of impairment indicators at the end of each
reporting period. If it appears that asset impairment may have taken place,
estimate the recoverable amount of the impairment. The following are
examples of impairment indicators:
• Adverse effects. There have been, or are about to be, significant
changes that adversely affect the operating environment of the
business.
• Damage or obsolescence. There is evidence of damage to the asset, or
of obsolescence.
• Discount rate change. Interest rates have increased, and this will
materially impact the value in use of an asset, based on a reduction in
the discounted present value of its cash flows. This is only the case if
 changes in market interest rates will actually alter the discount rate
used to calculate the value in use.
EXAMPLE
Rio Shipping acquired a freighter three years ago for £20 million, and
routinely conducts an impairment analysis that is based on the discounted
cash flows to be expected from the ship over the next ten years. The
discount rate that Rio uses for the analysis is 6%, which is based on the
current long-term interest rates that a similar company could obtain in the
market place.
Short-term interest rates have recently spiked to 9%. If Rio were to use this
rate as the discount rate, it would greatly reduce the present value of future
cash flows, and likely create an impairment issue. However, since short-term
rates fluctuate considerably, and the freighter still has a long useful life,
management judges that this is the wrong interest rate to use as a basis for
the discount rate, and elects to ignore it. Their decision is bolstered by the
fact that long-term interest rates are holding steady at 6%.

• Economic performance. The economic performance of an asset has

declined, or is expected to decline. This can include higher than
expected maintenance costs, actual net cash flows that are worse than
the budgeted amount, or a significant decline in net cash flows or
operating profits.
• Market capitalization change. The carrying amount of all the assets in
the company is more than the entity’s market capitalization.
• Market value decline. An asset’s market value declines significantly
more than would be indicated by the passage of time or normal use.
• Usage change. There have been or are about to be significant changes
in the usage of an asset, such as being rendered idle, plans for
discontinuance or restructuring, plans for an early asset sale, or
assessing an intangible asset from having an indefinite life to having a
finite one.
Any of the preceding indicators or other factors may reveal that there is a
possibility of asset impairment; if subsequent investigation reveals that there
will be no impairment charge, the mere existence of one or more of these
indicators may be grounds for adjusting the useful life, depreciation method,
or salvage value associated with an asset.
EXAMPLE
Rio Shipping finds that a worldwide glut in the market for supertankers has
reduced the usage level of its Rio Sunrise supertanker by 10 percent. This
does not translate into a sufficient drop in the cash flows or market value of
the ship to warrant an impairment charge. Nonetheless, Rio’s management is
concerned that the glut could continue for many years to come, and so it
alters the depreciation method for the supertanker from the straight-line
method to the 150% declining balance method, in order to accelerate
depreciation and reduce the carrying amount of the asset more quickly.
Timing of the Impairment Test
IFRS states that one should assess whether there is any indication of
impairment at the end of each reporting period, so this is an extremely
frequent test.
Even if there is no indication of impairment, test an intangible asset for
impairment if the asset has an indefinite useful life or if it is not yet available
for use (e.g., intangible assets that are not yet being amortized). Perform this
test at least once a year, and do so at the same time each year. If there are
multiple intangible assets, test each one at a different time of the year. If an
intangible asset was initially recognized during the current fiscal year, test it
for impairment by the end of the current fiscal year.
The reason why the standard requires this annual analysis of intangible
assets that are not yet available for sale is that there is more uncertainty
surrounding the ability of these assets to generate sufficient future economic
benefits. Given the higher level of uncertainty, there is more ongoing risk that
they will be impaired.
In addition, conduct an impairment test on any goodwill acquired in a
business combination at least once a year.
Recoverable Amount
If there is an indication of impairment, determine the recoverable amount of
the asset in question. The recoverable amount is defined as the higher of its
fair value less costs of disposal and its value in use.
The fair value less costs of disposal is one of the two components of the
calculation of an asset’s recoverable amount. There are several ways to
determine the fair value less costs of disposal, as outlined here.
The best source of information for fair value less costs of disposal is a
price in a binding sales agreement in an arm’s length transaction, which is
adjusted for any incremental costs to sell. It can be difficult to find such a
situation that dovetails so perfectly with an in-house asset, so expect to use
one of the following approaches that do not yield such perfect information
(listed in declining order of preference):
1. Pricing in an active market. If an asset trades in an active market,
assume that its market price is a reasonable representation of its fair
value, from which one can then subtract any costs of disposal to
arrive at the fair value less costs of disposal. In such a market,
assume that the bid price is the market price. If there are no bid
prices, use the price of the most recent transaction instead (as long as
there has been no significant change in the economic circumstances
since the date of the transaction). An active market is considered to
be one in which the items being traded are homogenous, there are
willing buyers and sellers, and prices are available to the public.
2. Best information available. In the absence of an active market or a
binding sale agreement, use the best information available to
estimate the amount that can be obtained by disposing of the asset in
an arm’s length transaction between knowledgeable and willing
parties. Consider the result of the recent sales of similar assets
elsewhere in the industry as “best information.”
Tip: The best information used to derive fair value less costs to sell should
not include a forced sale, except if management believes that it will be
compelled to sell an asset in this manner.
When deriving fair value less costs of disposal, what is involved in “costs of
disposal”? Examples are:
• Asset removal costs
• Costs to bring the asset into condition for sale
• Legal costs
• Taxes on the sale transaction
These are only examples of disposal costs; if there are similar types of costs
that relate to a sale transaction, consider them to be disposal costs.
Value in use is the other key component of the calculation of an asset’s
recoverable value (which must be higher than an asset’s carrying amount in
order to avoid an asset impairment). Value in use is essentially the discounted
cash flows associated with an asset or cash-generating unit. Consider the
following issues when deriving an asset’s value in use:
• Possible variations in the amount or timing of cash flows related to an
asset
 • The current market risk-free rate of interest
• Such other factors as illiquidity and risk related to holding the asset
If these considerations warrant a change in the value in use of an asset, build
adjustments into either the cash flows or discount rate used to derive the
value in use. Adjustments to the cash flows can include a weighted average
of all possible cash flow outcomes.
The cash flow estimates used to derive the value in use should be based on
the following:
• Management’s best estimate of the economic conditions likely to exist
over the remaining useful life of the asset. These estimates should be
based on reasonable and supportable assumptions, with a greater
weighting given to external evidence.
• The most recent budget or forecast that has been approved by
management, covering a maximum of five years (unless a longer
period can be justified by having already shown the ability to forecast
accurately over a longer period). Do not include any changes in cash
flows expected to arise from future restructurings or from the
presumed future enhancement of an asset’s performance.
Tip: Include in a cash flow analysis those changes arising from a future
restructuring, once management has committed to the plan. Thus, if it is
clear that cash flows will improve as a result of such a plan, gaining
management approval of the plan may be crucial to avoiding an impairment
charge.
• Projections beyond the period covered by the most recent budget or
forecast that are extrapolations using a steady or declining growth rate
for subsequent years (unless an increasing rate can be justified). Do
not use a growth rate that exceeds the long-term average growth rate
for the product, market, industry, or country where the company
operates (unless a higher rate can be justified).
Tip: One of the reasons for using a steady or declining growth rate in
projections is that more favorable conditions will attract more competitors,
who will keep the cash flow growth rate from increasing. Thus, if an
increasing cash flow growth rate is to be included in a forecast, justify what
will keep competitors from driving the rate down, such as the existence of
significant barriers to entry, or such legal protection as a patent.
Also, ensure that the assumptions on which the cash flow projections are
based are consistent with the results the company has experienced in the past,
which thereby establishes another evidence trail which supports the veracity
of the cash flow projections.
Tip: Inordinately high cash flow projections are frowned upon, so expect to
run afoul of the auditors if unjustifiable cash flow increases are inserted in
the value in use calculations. Do not try to avoid an impending impairment
charge with alterations to cash flows, since this merely pushes off the
inevitable until somewhat later in the useful life of the asset, when it is
impossible to hide the issue over the few remaining years of the life of the
asset.
When constructing the cash flow projections for the value in use analysis, be
sure to include these three categories of cash flow:
• Cash inflows. This arises from continuing use of the asset.
• Cash outflows. This is from the expenditures needed to operate the
asset at a level sufficient to generate the projected cash inflows, and
should include all expenditures that can be reasonably allocated to the
asset. If this figure is derived for a cash-generating unit where some of
the assets have shorter useful lives, the replacement of these assets
over time should be considered part of the cash outflows.
• Cash from disposal. This is the net cash proceeds expected from the
eventual sale of the asset following the end of its useful life.
Do not include in the cash flow projections any cash flows related to
financing activities or income taxes.
Tip: As just noted, include in the cash flow projections the cash outflows
connected to overhead that is applied to an asset. Since a larger amount of
overhead application will reduce the value in use of the asset and make an
impairment charge more likely, establish an overhead application procedure
that justifiably allocates the smallest amount of overhead possible to any
assets that are subject to impairment tests. Only include those overhead
costs for which there is a direct linkage to the asset.
Once the cash flows related to an asset have been compiled, establish a
discount rate for use in deriving the net present value of the cash flows. This
discount rate should reflect the current assessment of:
• The time value of money by the market for an investment similar to
the asset under analysis. This means that the risk profile, cash flow
timing, and cash flow amounts of the asset should be reflected in the
 investment for which a market-derived interest rate is used.
• The risks specific to the asset for which adjustments have not already
been incorporated into the cash flow projections.
The Impairment Test
An asset is impaired when its carrying amount is greater than its recoverable
amount. In some cases, there is no way to determine the fair value of an asset
less costs to sell, since there is no active market for the asset. If so, use the
value in use as the recoverable amount of an asset.
Tip: If either an asset’s fair value less costs of disposal or its value in use is
higher than its carrying amount, there is no impairment. Thus, it is not
necessary to calculate both figures as part of an impairment test.
When a fixed asset approaches the end of its useful life, it may be sufficient
to use the fair value less costs of disposal as the foundation for an impairment
test, and ignore its value in use. The reason is that the value of an asset at this
point in its life is mostly comprised of any proceeds from its disposal, rather
than from future cash flows (which are likely to be minor).
Tip: The instructions in IAS 36 imply that an investigation of fair values
and discount rate calculations for cash flows is needed to conduct an
impairment test. However, the standard also states that “estimates,
averages, and computational short cuts may provide reasonable
approximations” of these requirements. Consequently, use short cuts
whenever there is a reasonable basis for doing so.
Recognize an impairment loss when the recoverable amount of an asset is
less than its carrying amount. The amount of the loss is the difference
between the recoverable amount and the carrying amount. This loss should be
recognized immediately in profit or loss.
If an asset has already been revalued, recognize the impairment loss in
other comprehensive income to the extent of the prior revaluation, with any
additional impairment being recognized as a normal expense.
After an impairment loss is recognized, adjust the depreciation on the
asset in future periods to account for the reduced carrying amount of the
asset.
EXAMPLE
Rio Shipping owns a small coastal freighter with an original cost of £14
million and estimated salvage value of £4 million, and which it has been
depreciating on the straight-line basis for five years. The freighter now has a
carrying amount of £9 million.
Rio conducts an impairment test of the freighter asset, and concludes that the
fair value less cost to sell of the asset is much lower than original estimates,
resulting in a recoverable amount of £7 million. Rio takes a £2 million
impairment charge to reduce the carrying amount of the freighter from £9
million to £7 million.
The freighter still has five years remaining on its useful life, so Rio revises
the straight-line depreciation for the asset to be £600,000 per year. This is
calculated as the revised £7 million carrying amount minus the £4 million
salvage value, divided by the five remaining years of the freighter’s useful
life.
The Cash-Generating Unit
An impairment test should be conducted for an individual asset, unless the
asset does not generate cash inflows that are mostly independent of those
from other assets. If an asset does not generate such cash inflows, conduct the
test at the level of the cash-generating unit of which the asset is a part. All
subsequent testing of and accounting for an impairment at the level of a cash-
generating unit is identical to its treatment as if it had been an individual
asset.
A cash-generating unit is the smallest identifiable group of assets that
generates cash inflows independently from the cash inflows of other assets.
Examples of cash-generating units are product lines, businesses, individual
store locations, and operating regions. It is allowable for a cash-generating
unit to have all of its cash inflows derive from internal transfer pricing, as
long as the unit could sell its output on an active market. Once a group of
assets are clustered into a cash-generating unit, continue to define the same
assets as being part of the unit for future impairment testing (unless there is a
justifiable reason for a change).
An impairment test should remain at the level of the individual asset
rather than for a cash-generating unit in either of the following cases:
• The fair value less costs of disposal of the asset is higher than its
carrying amount.
• The value in use (i.e., discounted cash flows) of the asset is estimated
to be close to its fair value less costs of disposal.
EXAMPLE
Rio Shipping owns a rail line that extends from its private shipping terminal
on Baffin Island to a warehousing area two miles inland, where it stores ore
shipped to it from several mines further inland. The rail line exists only to
support deliveries of ore, and it has no way of creating cash flows
independent of Rio’s other operations on Baffin Island. Since it is
impossible to determine the recoverable amount of the rail line, Rio
aggregates it into a cash-generating unit, which is its entire shipping
operation on Baffin Island.
EXAMPLE
Rio Shipping enters into a contract with the Port of New York to provide
point-to-point ferry service on several routes across the Hudson River. The
Port requires service for 18 hours a day on four routes. One of the four
routes has minimal passenger traffic, and so is operating at a significant loss.
Rio can identify the ferry asset associated with this specific ferry route.
Rio cannot test for impairment at the individual asset level for the ferry
operating the loss-generating route, because it does not have the ability to
eliminate that route under its contract with the Port. Instead, it must test for
impairment at the cash-generating unit level, which is all of the ferry routes
together.

Recognize an impairment loss when the recoverable amount of a cash-

generating unit is less than its carrying amount. The carrying amount of the
cash-generating unit as a whole cannot be reduced, since it is not recorded in
the company’s records as such – it is recorded as a group of individual assets.
To record the loss, allocate it in the following order:
1. Reduce the amount of any goodwill assigned to the cash-generated
unit. If there is any loss still remaining, proceed to the next step.
2. Assign the remaining loss to the assets within the cash-generating
unit on the basis of the carrying amount of each asset. When doing
so, the carrying amount of an asset cannot be reduced below the
highest of its:
• Value in use (i.e., discounted cash flows)
• Fair value less costs of disposal
• Zero
If it is not possible to assign all of the pro rata portion of a loss to an
asset based on the preceding rule, allocate it to the other assets in the
cash-generated unit based on the carrying amounts of the other
assets.
EXAMPLE
Rio Shipping owns Rio Bay, which is a container ship that it acquired as part
of an acquisition. Rio Shipping has allocated £2 million of goodwill from
the acquisition to the Rio Bay for the purposes of its annual impairment test.
The ship is designated as a cash-generating unit that is comprised of three
assets, which are:
• Hull – Carrying amount of £20 million
• Engines – Carrying amount of £7 million
• Crane hoists – Carrying amount of £3 million
Thus, the total carrying amount of the Rio Bay is £32,000,000, including the
allocated goodwill.
Rio determines that the recoverable amount of the Rio Bay is £28,000,000,
which represents an impairment loss of £4 million. To allocate the loss to
the assets comprising the cash-generating unit, the company first allocates
the loss to the outstanding amount of goodwill. This eliminates the goodwill,
leaving £2 million to be allocated to the three assets comprising the unit.
The allocation is conducted using the following table:

Asset Impairment Reversals

At the end of each reporting period, assess whether any prior impairment loss
has declined. The following are all indicators of such an impairment decline:
• Economic performance. The economic performance of the asset is
better than expected.
• Entity performance. There have been significant favorable changes in
the company to enhance the asset’s performance or restructure the
operations of which it is a part.
• Environment. The business environment in which the company
operates has significantly improved.
• Interest rates. Interest rates have declined, which may reduce the
discount rate used to calculate discounted cash flows, thereby
increasing the recoverable amount of the asset.
 • Market value. The asset’s market value has increased.
If this analysis concludes that the amount of impairment has declined or been
eliminated, estimate the new recoverable amount of the asset and increase the
carrying amount of the asset to match its recoverable amount. This
adjustment is treated as a reversal of the original impairment loss. Also,
document what change in estimates caused the impairment recovery.
If an impairment charge is being reversed, only increase the carrying
amount of an asset back to where that carrying amount would have been
without the prior impairment charge, and net of any amortization or
depreciation that would have been recognized in the absence of an
impairment charge. Also, once the reversal is recorded, revise the periodic
depreciation charge so that it properly reduces the new carrying amount over
the remaining life of the asset.
EXAMPLE
Rio Shipping has almost fully automated the operations of its Rio Giorgio
container ship, so that it can cruise the oceans with a crew of just three
people (one per shift). Rio Shipping has also installed an advanced impeller
propulsion system that cuts the ship’s fuel requirements in half. These
changes vastly reduce the cash outflows normally needed to operate the
ship.
Rio had previously recognized a £4 million impairment loss on Rio Giorgio.
The new cash flow situation results in a recoverable amount that matches the
carrying amount of the ship prior to its original impairment charge.
However, there would have been an additional £200,000 of depreciation
during the period between the original impairment loss and the reversal of
the impairment charge, so Rio Shipping can only reverse £3.8 million of the
original impairment amount.

If an impairment charge is reversed for a cash-generating unit, allocate the

reversal to all of the assets comprising that unit on a pro rata basis, using the
carrying amounts of those assets as the basis for the allocation. This is the
same concept already described for the allocation of an impairment loss –
only now it is in reverse. When this allocation is calculated back to individual
assets, the resulting asset carrying amount cannot go above the lower of:
• The recoverable amount of the asset, or
• The carrying amount of the asset, net of depreciation or amortization,
as if the initial impairment had never been recognized.
If there is an allocation limitation caused by either of these items, allocate the
remaining impairment reversal among the other assets in the unit.
EXAMPLE
Rio Shipping conducts a re-examination of the recoverable amount of its Rio
Bay container ship, which was described in an earlier example for the initial
recognition of impairment losses. Various changes to the propulsion system
of the ship have reduced its operating costs to the point where Rio Shipping
can justifiably increase its estimate of the ship’s recoverable amount by £1
million. The revised carrying amounts of the assets comprising the cash-
generating unit are carried forward from the prior example, and are noted
below:

The following table shows the adjusted carrying amounts of the three assets
following the allocation of the impairment reversal back to them.

However, to properly allocate the impairment reversal back to these assets,

Rio Shipping must determine the carrying amount of each asset, net of
depreciation, as if the initial impairment had never occurred. This causes a
problem, because the hull and crane hoist both have a longer estimated
useful life than the engines, which are expected to be replaced midway
through the life of the other assets. Consequently, the engines have been
depreciated at a quicker rate than the other assets, and so cannot accept the
full amount of the impairment allocation.
This results in the following additional allocation of the impairment reversal,
where only a portion of the allocation can go to the engines, while the
remaining impairment reversal is allocated among the other two assets.
 * Calculation not shown here
** Calculated as the adjusted carrying amount of £6,770,000 minus the
carrying amount as if the initial impairment had never occurred, of
£6,600,000.

Recognize any impairment reversal in profit and loss as soon as it occurs.

Even if the analysis to reverse an impairment loss does not actually result
in an impairment reversal, it may provide sufficient cause to adjust the
remaining useful life of the asset, as well as the depreciation method used or
its estimated salvage value.
The preceding discussion of how to reverse an impairment loss applies
equally to individual assets and cash-generating units.
Tip: IFRS does not allow the reversal of an impairment loss recognized for
goodwill, on the grounds that such a reversal would be caused by an
increase in internally generated goodwill. IFRS does not allow the
recognition of internally generated goodwill.
Other Impairment Topics
Questions may arise about how to deal with corporate assets in the analysis of
impairment, as well as whether to allocate goodwill to cash-generating units.
These topics are addressed below.
Corporate Assets
Assets that are recognized at the corporate level are ones that do not generate
cash inflows independently of other assets, so their carrying amounts cannot
be fully attributed to other cash-generating units. An example of a corporate
asset is a research facility. It is not usually possible to allocate the cost of
these assets to any cash-generating units, unless there is a direct relationship
between them.
Goodwill Allocation to Cash-Generating Units
If a company has acquired assets as part of a business combination, allocate
the goodwill associated with that combination to any cash-generating units,
but only if those units are expected to benefit from the synergies of the
combination.
Tip: This rule can be safely ignored in many cases, because the standard
also states that the goodwill allocation only extends down to the point at
which management monitors goodwill for its own internal purposes. In
most cases, goodwill monitoring only extends down to the business unit
level; thus, as long as a cash-generating unit is smaller than a business unit,
the requirements of this standard do not apply.
If goodwill is allocated to a cash-generating unit and the company then sells
that unit, include the allocated goodwill in the carrying amount of the unit;
this will impact the amount of any gain or loss recognized on disposal of the
unit.
If a company sells assets from a cash-generating unit to which goodwill
has been allocated, assign a portion of the goodwill to the assets being sold,
based on the relative values of the assets being sold and that portion of the
unit being retained.
EXAMPLE
Rio Shipping had previously acquired a container ship unloading dock in the
Port of Los Angeles for £50 million, of which £10 million was accounted for
as goodwill. Rio accounts for the overhead cranes in the dock as a cash-
generating unit, to which it allocates £6 million of the goodwill associated
with the acquisition.
Two years later, Rio sells one of the cranes for £5 million. Management
estimates that the value of the remainder of the cash-generating unit is £15
million. Based on this information, Rio’s accounting staff allocates £1.5
million of the goodwill to the crane, based on the following calculation:
£6 million goodwill × (£5 million crane value ÷ (£5 million crane
value + £15 million cash-generating unit value))
= £6 million goodwill × 25% of the combined value of the crane
asset and cash-generating unit
= £1.5 million goodwill allocation

Impairment Testing Efficiencies

Any intangible asset that has an indefinite useful life is supposed to be tested
for impairment on an annual basis. To save time in performing this annual
test, use the most recent detailed calculation of such an asset’s recoverable
amount that was made in a preceding period, but only if the situation meets
all of the following criteria:
• Related assets and liabilities are unchanged. The assets and liabilities
of the cash-generating unit of which the intangible asset is a part have
not changed significantly (if the intangible asset is part of a cash-
generating unit at all);
• Remote likelihood of change. The events and circumstances since the
last calculation indicate only a remote likelihood that the current
recoverable amount would be less than the asset’s carrying amount;
and
• Substantial difference. The most recent calculation of the recoverable
amount yielded an amount substantially greater than the asset’s
carrying amount.
Asset Impairment Disclosures
For each class of assets, disclose the following information about asset
impairments in the notes accompanying the financial statements:
• Impairment recognition. The amounts of impairment losses and
impairment loss reversals recognized in profit or loss, and where this
information is located in the statement of comprehensive income.
• Revalued asset impairment recognition. The amount of impairment
losses and impairment loss reversals on revalued assets recognized in
profit or loss, and where this information is located in the statement of
comprehensive income.
Whenever there is a material impairment loss or impairment loss reversal,
disclose the following at the individual asset or cash-generating unit level:
• Amount. The amount of the loss or loss reversal recognized or
reversed.
• Asset information. The nature of the asset, and the reportable segment
(if any) in which it is included.
• Basis of change. Whether the recoverable amount of the asset or cash-
generating unit is based on the value in use or the fair value less costs
of disposal. If the former, disclose the discount rate used to make the
current estimate, as well as the discount rate used for the previous
estimate. If the latter, disclose the basis used to arrive at fair value less
costs of disposal.
• Cash-generating unit information. The nature of the cash-generating
unit, the amount of the impairment loss or impairment loss reversal,
 the reportable segment (if any) in which it is included, and any
changes in the way the assets in the unit have been aggregated (as well
as the reason for the change).
• Circumstances. The circumstances leading to the loss or loss reversal.
If there are no material impairment losses or reversals to disclose at the
individual asset or cash-generating unit level, disclose the following
impairment information instead, in aggregate:
• Circumstances. The circumstances leading to the loss or loss reversal.
• Class information. The primary classes of assets impacted by any
impairment losses, and the classes of assets impacted by the reversal
of impairment losses.
A business may have recognized a significant amount of goodwill or
intangible assets with indefinite useful lives. If so, disclose the following
information for each cash-generating unit for which the carrying amount of
these items forms a significant proportion of the entity’s total carrying
amount of the items:
• Goodwill allocation. The amount of goodwill allocated to the cash-
generated unit.
• Intangibles allocation. The amount of intangible assets with indefinite
useful lives allocated to the cash-generating unit.
• Recoverable amount. The recoverable amount of the cash-generating
unit, and how that amount was determined. In addition:
o If the recoverable amount is based on value in use, disclose the
key assumptions for the cash flow projections used and how
each assumption was determined, as well as how these
assumptions have changed over time. Also note the discount
rate applied to the projections, as well as the duration of the
projections, and explain the reason for using cash flows for a
period of greater than five years (if applicable). Finally, note
the growth rate used to extrapolate cash flow projections
beyond the budget period, and justify the rate if it is greater
than the long-term growth rate in the company’s market or
country of operation.
o If the recoverable amount is based on fair value less costs of
disposal, disclose the valuation technique used. If the
technique is not based on a quoted price for an identical unit,
disclose key assumptions used and how each assumption was
 determined, the level of the fair value hierarchy in which the
measurement method is placed, and any changes in the
valuation technique (and the reason for the change). If the
measurement is based on discounted cash flow projections,
disclose the projection period, the growth rate used to
extrapolate cash flows into the future, and the discount rate
applied to those projections.
• Assumption change. If there is a reasonably possible change in a key
assumption that would cause a carrying amount to exceed its
recoverable amount, disclose the amount of the possible change and
the value assigned to the targeted assumption. Also note the amount
by which the value must change in order to match the recoverable
amount to the carrying amount.
If the allocation of goodwill and intangible assets with indefinite lives is
allocated across a number of cash-generating units, with minor allocations to
each unit, disclose this fact, along with the aggregate allocated carrying
amount of these items.
If the recoverable amounts of a group of cash-generated units are based
on the same key assumptions, and the carrying amount of the goodwill and
intangible assets with indefinite lives allocated to this group form a
significant proportion of the company’s total carrying amount of goodwill
and intangible assets with indefinite lives, disclose the following additional
information:
• Assumptions. All key assumptions used, and how management
determines the values assigned to those assumptions.
• Goodwill. The aggregate carrying amount of all goodwill assigned to
this group of units.
• Intangible assets. The aggregate carrying amount of all intangible
assets with indefinite lives assigned to this group of units.
• Assumption change. If there is a reasonably possible change in a key
assumption that would cause the carrying amount of a group to exceed
its recoverable amount, disclose the amount by which the recoverable
amount of the group currently exceeds its carrying amount. Also note
the amount assigned to that key assumption, and the amount by which
it must change in order to match the recoverable amount to the
carrying amount.
If a business is required to report segment information (see the Operating
Segments chapter), disclose for each segment the amount of impairment
losses recognized in the period, as well as the amount of impairment loss
reversals in the period.
If any goodwill acquired in a business combination has not been allocated
to a cash-generating unit, state why the allocation has not taken place, and the
amount of unallocated goodwill.
Summary
The review, measurement, and recognition of asset impairments can be quite
time-consuming, and requires a certain amount of disclosure in the notes
accompanying the financial statements. The situation is aggravated when the
basis for an impairment loss changes in a subsequent period, resulting in
further labor to measure, recognize, and disclose an impairment reversal.
Given these issues, it makes sense to create a company policy for what
constitutes a material amount of impairment to recognize. Below the
threshold level defined in the policy, no impairment losses or reversals
should be recognized. This policy should be discussed with the company’s
auditors, who can give input regarding the threshold recognition level to
incorporate into the policy.
For the reasons just noted, impairment losses and reversals should require
several levels of approval before being recognized. It is entirely possible that
a lower-level accountant may calculate a need for a large number of small
impairment charges and reversals, which a more senior person with a better
grasp of the efficiencies involved would be less inclined to approve.
 Chapter 18
Assets Held for Sale and Discontinued Operations
Introduction
From time to time, a business may find that it no longer needs certain assets,
and so will put them up for sale or discontinue their use. IFRS mandates that
such assets and the results of their operations be segregated in the financial
statements, so that readers can discern their impact on the financial results
and financial position of a business. In this chapter, we describe the
accounting for assets designated as being held for sale, as well as the
disclosure of discontinued operations.
IFRS Source Document
• IFRS 5, Non-Current Assets Held for Sale and Discontinued
Operations
Accounting for Non-Current Assets Held for Sale
An asset or a disposal group (which is a group of assets and liabilities to be
disposed of together) is to be classified as held for sale if it is expected that
the carrying amount of the asset will be recovered primarily through a sale,
rather than through the ongoing use of the asset. The held for sale designation
only applies if:
• The asset or disposal group is available for immediate sale in its
current condition; and
• It is highly probable that the asset or disposal group will be sold.
The sale of an asset or disposal group is only considered highly probable
when all of the following conditions are present:
• Management has committed to a sale plan;
• The search for a buyer is currently being pursued;
• The asset or disposal group is being actively marketed for sale;
• The price being offered is reasonable in relation to its fair value;
• The sale is expected to be completed within one year; and
• Significant changes to the plan or its withdrawal are unlikely.
EXAMPLE
The management of Thurston Enterprises wants to shift its warehouse to a
new and more automated facility. To do so, it commits to the sale of the
present warehouse and actively markets it at the market price. The real estate
agent handling the transaction believes that a buyer can be found within one
year.
To make the best use of company resources, the management team intends
to continue operating from the existing warehouse until a buyer is found,
and while the new facility is being constructed. The company does not plan
to close on a sale transaction at least until the new facility has been
completed and all automated systems have been properly tested.
Since the seller refuses to complete a sale until the new facility is ready, the
existing facility cannot be considered available for immediate sale in its
current condition, and so should not be classified as held for sale.
EXAMPLE
Flipped Enterprises specializes in buying business properties, upgrading
them, and selling them off within a short period of time at a higher price.
Because Flipped does not intend to resell its properties until they have been
properly renovated, these assets cannot initially be classified as held for sale,
since they are not available for immediate sale.

The following additional scenarios and rules may apply to the held for sale
classification:
• Assets to be abandoned. If an asset or disposal group is to be
abandoned, rather than sold, it cannot be classified as held for sale. A
temporarily idled asset is not considered to be abandoned.
• Assets to be distributed. If the intent is for an asset or disposal group to
be distributed to the owners of the business, they are classified as held
for distribution to owners, rather than held for sale.
• Duration extension. It is allowable to extend the period over which a
sale will occur to more than one year, if the delay is caused by
circumstances beyond the control of the entity, and management is
still committed to sell the asset or disposal group. An extension of the
one-year period is allowed in all of the following circumstances:
o When the held for sale designation was first applied, it was
expected that a third party would impose conditions that
would delay the transaction, a firm purchase commitment
would probably be obtained within one year, and a response to
the imposed conditions could not begin until the purchase
commitment was obtained.
o When a firm purchase commitment is obtained, after which
conditions are unexpectedly imposed that will delay the sale,
 the seller has taken action to respond to the conditions, and a
favorable resolution is expected.
o Conditions formerly considered unlikely arise during the sale
period that will extend the sale period, the seller has taken
steps to respond to the situation, and the asset is being actively
marketed at a reasonable price.
EXAMPLE
The management of the Tesla Power Company has committed to the sale of
a coal-fired power generation facility, and believes that a firm purchase
commitment can be obtained within one year. Since power generation is a
regulated industry, the sale is subject to regulatory approval. Such approval
may take time to obtain, since there has been a public outcry over the use of
coal for power generation. Thus, Tesla is aware that conditions will be
imposed on a sale, but can take no action until it finds a buyer and applies to
the regulatory agency to complete the sale. Under these circumstances, Tesla
can classify the facility as held for sale.
EXAMPLE
The management of Creekside Industrial commits to a plan to sell its battery
production facility, and accordingly classifies the property as held for sale.
A buyer is found, who makes a firm commitment to purchase the property.
During the due diligence phase of the purchase, the buyer discovers that
battery acid has leaked into the ground and is now flowing into the local
creek. Creekside is required by the buyer to remediate this problem, which
will require more than a year to rectify. Creekside takes immediate steps to
remediate the problem, and expects that the situation will be resolved. Under
these circumstances, Creekside can continue to classify the facility as held
for sale.
EXAMPLE
The management of Excalibur Shaving Company commits to a plan to sell
its old razor blade production line, and accordingly classifies it as held for
sale. However, the market subsequently declines for premium razor blades,
so Excalibur is unable to sell the production line during the next year. The
company continues to actively market the equipment, but believes that the
market will become more heated, and so does not reduce the offered price to
the existing market rate. Since the asset is not being marketed at a
reasonable price, it can no longer be classified as held for sale.
 • Intent to resell. In those instances when a business acquires an asset or
disposal group with the intent of reselling it, it can immediately
classify the asset as held for sale, but only if it expects to complete a
sale within one year, and any other criteria for this classification can
be met within a few months of the acquisition date.
• Late classification. If an asset or a disposal group meets the criteria for
the held for sale classification after the end of a reporting period, but
before the financial statements are authorized for issuance, this fact
should be disclosed in the notes accompanying the financial
statements.
• Shareholder approval. In those cases where a sale is contingent upon
shareholder approval, only consider the sale of an asset or disposal
group to be highly likely if shareholder approval is also highly likely.
An asset that qualifies as being held for sale should be measured at the lower
of its carrying amount or its fair value less costs to sell. When this results in
recognition at an amount lower than the carrying amount, recognize an
impairment loss at once for the difference. If there is a subsequent increase in
fair value less costs to sell, it is allowable to recognize the associated gain,
capped at the amount of any cumulative impairment loss.
EXAMPLE
Finchley Fireworks designates its Radlett production facility as held for sale.
Because of the designation, Finchley must measure the Radlett facility at the
lower of its carrying amount or its fair value less costs to sell. The carrying
amount of the facility is £650,000, while its fair value less costs to sell is
only £425,000. Accordingly, Finchley should recognize an impairment loss
of £225,000 in profit or loss, which reduces the carrying amount of the
facility to its fair value less costs to sell.

When an asset is classified as held for sale, it should not be depreciated. The
same accounting applies to any asset being held for distribution to owners.
The following special accounting considerations may apply to the preceding
guidance:
• Intent to resell. In those cases where a business acquires an asset or
disposal group with the intent of reselling it, the effect of the
preceding accounting guidance is that it will be initially measured at
the lower of its carrying amount or fair value less costs to sell.
• Costs to sell. When a sale is expected to be completed in more than
 one year, measure the costs to sell (as used in the lesser of the carrying
amount or fair value less costs to sell calculation) at their present cost.
Any subsequent increase in this cost is to be recognized as a financing
cost when the sale is eventually completed.
• Criteria no longer met. If an asset or disposal group no longer meets
the held for sale criteria, immediately remove it from this
classification, and measure it at the lower of either:
o Its carrying amount prior to being classified as held for sale,
less any depreciation that would have been recognized if the
asset had never been classified as held for sale; or
o Its recoverable amount as of the date when the held for sale
classification no longer applies. The recoverable amount is the
greater of an asset’s value in use and its fair value less costs to
sell. Value in use is the present value of the cash flows
expected from an asset or cash-generating unit.
Any measurement adjustments made to the carrying amount of an
asset or asset group after the held for sale designation is removed are
to be recognized at once in profit or loss. If only a portion of the
assets in a disposal group are no longer classified as held for sale, any
other assets and liabilities remaining in the group can still be
classified as held for sale, if they continue to meet the criteria for this
classification.
Disclosure of Non-Current Assets Held for Sale
When there are non-current assets or disposal groups held for sale, disclose
the following information in the financial statements or the accompanying
notes:
• Asset classes. If there are several classes of assets and liabilities that
are being held for sale, disclose them by class, either within the
balance sheet or in the accompanying notes. This requirement is
waived if a subsidiary that is held for sale was acquired with the intent
of selling it.
• Classification change. If an asset or disposal group is no longer
classified as held for sale, note the circumstances of the decision and
its effect on the results of operations for all periods presented.
• Cumulative income or expense. If there is any cumulative income or
expense associated with an asset or disposal group that is classified as
held for sale and which is recognized in other comprehensive income,
 it must be classified separately in other comprehensive income.
• Description. Describe the asset or disposal group, as well as the
circumstances of the sale, and the expected timing of the disposal.
• Gain or loss. If an impairment gain or loss was recognized on the
adjustment of an asset or disposal group to its fair value less costs to
sell, state the amount of the gain or loss.
• Presentation. An asset or disposal group that qualifies as being held
for sale should be presented separately in the balance sheet. Similarly,
if there are liabilities in a disposal group, present them separately from
other liabilities in the balance sheet. If there are assets and liabilities in
a disposal group, they are not to be presented as a net amount in the
balance sheet.
• Segment. For publicly-held companies, note the segment in which the
asset or disposal group is presented.
If assets or disposal groups were classified in the comparative balance sheets
for prior periods as being held for sale, do not re-classify them if the
classification has changed in the most recent balance sheet.
Disclosure of Discontinued Operations
A discontinued operation is a component of an entity that is either held for
sale or which has been disposed of, and which is either:
• A subsidiary acquired with the intent of reselling it;
• Part of a plan to dispose of a major business line or area of activities;
or
• A major business line or area of operations.
A component of an entity contains operations and cash flows that can be
clearly distinguished from the remainder of a business. Thus, a component is
considered to be a cash-generating unit of a business.
A company should disclose a sufficient amount of information for users
to understand the effects of discontinued operations. This means that a single
line item in the income statement be presented that comprises the following:
• The post-tax profit or loss earned by discontinued operations; and
• The post-tax gain or loss from the measurement to fair value less costs
to sell or the disposal of the discontinued operations.
In addition, disclose the following information in the financial statements or
the notes accompanying them:
• Adjustments. If there are adjustments in the current period to the
disposal of a discontinued operation in a prior period, classify it
 separately in the discontinued operations section of the income
statement, and disclose its nature. Such changes typically arise from
purchase price adjustments, indemnification issues, and the resolution
of other uncertainties related to a disposal.
• Analysis. A breakdown of the discontinued operations line item into its
component parts, including revenue, expenses, pre-tax profit or loss,
income tax expense, any gain or loss on measurement or disposal and
the associated income tax. This is not required for a subsidiary that
was acquired with the intent to resell it.
• Cash flows. The net cash flows from the operating, investing, and
financing activities of the operation. This is not required for a
subsidiary that was acquired with the intent to resell it.
• Income attributable to owners. The income from continuing operations
and from discontinued operations that is attributable to the owners of
the parent entity.
For comparability purposes, the disclosures noted here should be included in
the financial statements for all reporting periods presented.
If a component of an entity is no longer classified as held for sale, shift its
results of operations from the discontinued operations section to the income
from continuing operations section of the income statement. This restatement
applies to all comparison periods reported. When this restatement is included
in the comparison periods, label the restated amounts as being re-presented
from discontinued operations.
EXAMPLE
A sample format for a company’s income statement that includes the results
of discontinued operations is:
Summary
Assets to be classified as held for sale must first meet a number of
requirements. Consider taking full advantage of this broad set of
requirements by allowing very few assets or disposal groups to be classified
as held for sale. The held for sale classification requires special reformatting
of the financial statements, as well as the exemption of certain assets from
depreciation, and further accounting effort if anything is ever reclassified out
of the held for sale classification. In short, insist on full compliance with
IFRS to avoid the held for sale designation as much as possible.
 Chapter 19
Provisions, Contingent Liabilities and Contingent
Assets
Introduction
Most organizations have liabilities of various kinds, about which they do not
possess perfect information regarding the timing or amount of payments.
Depending on the circumstances, it may be necessary to recognize or at least
disclose information about these liabilities. In this chapter, we delve into the
definitions of provisions and contingent liabilities, and how to account for
them. We also address the accounting for contingent assets.
IFRS Source Document
• IAS 37, Provisions, Contingent Liabilities and Contingent Assets
• IFRIC 21, Levies
Overview of Provisions
A provision is a liability whose timing or amount is uncertain. Examples of
provisions are:
• Decommissioning costs for a facility
• Obligations to clean up environmental damage
• Obligations to pay lawsuit damages
• Warranty obligations for products sold
A provision can be distinguished from other types of liabilities, such as
accounts payable, whose amounts are defined on a supplier invoice, and
which are due for settlement on a specific date. An accrued liability is not a
provision, since this type of liability relates to specific goods or services that
have already been received. While it may be necessary to estimate the
amount of an accrued liability, a liability is clearly present, and the level of
uncertainty tends to be minor.
A provision is recognized when the circumstances meet the following
criteria:
• There is a present obligation that arises from a past event;
• Settlement with company resources will probably be required; and
• The amount of the liability can be reliably estimated.
EXAMPLE
Subterranean Access sells well digging equipment. Subterranean has a
generous warranty policy, under which it repairs or replaces all damaged or
nonfunctioning products within one year of the sale date. Given the uses to
which its products are put, Subterranean tends to experience relatively high
warranty claims. The company controller reviews the warranty situation to
see if a provision should be recognized, and notes the following points:
• The company offers a warranty as part of each product sale, so there
is a present obligation that arises from a past event.
• Given the company’s historical experience with warranty claims, it is
much more likely than not that claims will be presented to the
company.
• The company has a long history of settling warranty claims, and so
can readily derive an expected settlement amount.
Based on the facts of the situation, Subterranean should recognize a
provision for warranty claims.

If it is not possible to meet all three of the preceding conditions, do not record
a provision. Instead, continue to review the situation in each succeeding
reporting period to see if the conditions have been met, and recognize the
provision in whichever period the conditions are met.
The following clarifications apply to the conditions for recognizing a
provision:
• A past event is considered to have created an obligation if it is more
likely than not that an obligation exists at the end of a reporting
period. This decision should be based on all available evidence.
• A past event is considered to have created a current obligation when
the obligation can be legally enforced, or when there is a constructive
obligation, where other parties have a valid expectation that the
business will settle the obligation.
• A provision is not recognized for a future event, since a business could
take action now to avoid that future event. For example, if there is
pending legislation to require enhanced water filtration systems at a
chemical plant, a company could avoid the liability by selling off or
shutting down the plant.
• There is no obligation that could result in the recognition of a
provision, unless a company action that potentially creates the
obligation has been communicated to the parties to whom the
obligation would be owed.
 • A past event may not give rise to a provision until a later date, when
the business makes a statement that creates a constructive obligation,
or a law is passed that retroactively creates an obligation. It is not
sufficient for a law to be proposed; it must be virtually certain of being
enacted as drafted before it gives rise to an obligation from which a
provision should be recognized.
• If there are a number of similar obligations, consider the entire group
of obligations when determining the probability of whether the
company will have to make a payment, rather than at the level of each
individual obligation. For example, the probability of a single
warranty claim on a specific product sale is quite low, but when
warranty claims for all product sales are considered, a certain amount
of warranty claims will probably be paid.
EXAMPLE
Elkins Engineering is being sued by a client over a supposedly faulty
building design that may be causing air conditioning problems. After
consulting with a number of air conditioning experts about the issues raised
by the client, the management of Elkins concludes that it is more likely than
not that an obligation exists, and so recognizes a provision of £200,000 to
cover its expected liability related to the lawsuit.
EXAMPLE
The Hilltop Hog Company has operated a slaughterhouse for many years
near the town of Hilltop. During that time, the company has buried the
unusable parts of hog carcasses in a nearby field. While completely legal,
the buried offal is causing a stench that annoys the local residents. After
several years of inaction, Hilltop’s management issues a press release, in
which it commits to more properly dispose of the remains. This
communication creates a constructive obligation, so the company should
recognize a provision for the proposed cleanup operation.
EXAMPLE
Omni Consulting is housed in a facility that it owns. The roof of the building
is designed to last for 20 years, and the roof has been in existence for 19
years. Omni cannot recognize a provision for replacement of the roof in the
following year, because a provision is based on a past obligating event, and
replacement of the roof is a future obligation. Omni could even avoid the
obligation by moving to a new building.
Accounting for Provisions
The amount of a provision to recognize is a company’s best estimate of the
amount that would be required for it to rationally settle a liability at the end
of the current reporting period. The estimate of this amount could be based
on what it would cost to transfer the obligation to a third party. The amount
of this estimate can be difficult to discern, and so may require the judgment
of management, possibly with input drawn from similar prior situations or the
advice of experts. If there are a number of estimated payout amounts that are
not closely clustered together, it may be necessary to recognize an expected
value, which is based on the probabilities of various payouts being made. If
one payout estimate in a range of estimates is no more likely to occur than
another, recognize the midpoint of the range as the provision.
EXAMPLE
Green Lawn Care manufactures electric lawn mowers. Based on its past
experience with warranty claims, no warranty claims will be received for
90% of its products. A battery replacement will be required for 8% of the
products, which will cost £50, and a motor replacement will be required for
2% of the products, which will cost £175. Green sells 100,000 lawn mowers.
Based on these probabilities and costs, the warranty provision that the
company should recognize is calculated as follows:
(75% × £0 × 100,000 Units) + (8% × £50 × 100,000 Units) + (2% ×
£175 × 100,000 Units)
= £750,000 Provision

The following additional factors may apply to the accounting for a provision:
• Future operating losses. It is not acceptable to recognize a provision
for a future operating loss, since a future loss is not considered a
current liability. However, if a future loss is anticipated, this may be
grounds for reviewing company assets for impairment.
• Impact of future event. It is possible that a future event will impact the
amount of an obligation that will be paid out. If so, adjust the
recognized amount of a provision to reflect the future event. For
example, the operator of a nuclear power generating facility is aware
of new technology that will be helpful in reducing the cleanup cost
associated with the environmental damage caused by the facility. An
assessment of the cost reductions that may be generated by this
technology can be included in the calculation of a provision. However,
 the reduction of a provision based on the anticipated development of
technology that does not yet exist is not allowed.
• Impact of new legislation. It may be necessary to recognize a provision
when it is virtually certain that new legislation will be enacted, the
terms of the legislation are known, and it is certain to be implemented.
In most cases, not all of these variables will be known, so it is
generally advisable to wait until legislation has been enacted.
• Onerous contracts. A company may be party to an onerous contract,
where the obligations outweigh the expected benefits. If so, the net
obligation under the contract should be recognized as a provision. The
amount to recognize is the least net cost of exiting from the contract.
“Least net cost” is the lower of the cost of fulfilling a contract and the
penalties associated with not fulfilling it. A provision is not needed if
such a contract can be cancelled with no penalty to the company.
• Ongoing provision adjustments. IFRS requires that provisions be
reviewed at the end of each reporting period, and adjusted to match the
best estimate of the obligation amount. If management believes it is no
longer probable that a payout will be required under a provision, it is
permissible to reverse the provision.
• Present value. When a payout under a provision is not expected for
some time, and the effect of the time value of money on the provision
is therefore material, recognize the present value of the provision.
When present value is used, the carrying amount of a provision
increases in each subsequent reporting period, to incorporate the
passage of time. This periodic increase is accounted for as a borrowing
cost. If settlement is expected to be in the near future, the effect of the
time value of money will be immaterial, and so can be ignored. Use
the market interest rate as the discount rate used to calculate the
present value of a provision.
EXAMPLE
Argo Drilling leases property from a government entity for oil exploration
and development purposes. Part of the agreement mandates that Argo pay
for remediation of the property once all drilling has been completed and any
oil extracted. Based on its experience with similar arrangements, the
management of Argo realizes that 75% of the eventual restoration cost will
be based on the construction of the drilling pad, and 25% on the later
extraction of oil.
At the end of the current reporting period, Argo has completed the drilling
pad, but has not commenced drilling. At this point, Argo can take action to
avoid 25% of the remediation costs by not drilling. Consequently, it should
only recognize a provision for that 75% of the remediation costs that are
linked to the construction of the drilling pad. If Argo later elects to begin
drilling, it must then recognize a provision for the remaining 25% of the
remediation cost.
EXAMPLE
Green Lawn Care leases its current headquarters location under a five-year
lease. At the end of the fourth year, Green moves to a new location. The
terms of the old facility lease do not allow Green to cancel the lease or
sublease the facility. Green should recognize a provision in the amount of
the remaining unavoidable lease payments.
If the terms of the lease had allowed Green to sublease, the appropriate
amount of the provision would be the difference between expected payments
received from the sublease agreement and the lease payments to the landlord
under the original lease.

The Provision for Restructuring

A restructuring is a plan to materially change either the manner in which a
business is conducted or the scope of its business. Examples of restructurings
are the termination of a line of business or geographic location, relocating
business activities, eliminating a layer of management, and a reorganization
that alters the nature and focus of company operations.
It is possible to recognize a provision for a corporate restructuring, as
long as all of the preceding requirements for a provision have been met. In
addition, management must have a formal plan for the restructuring that
identifies that portion of the business and principal locations that will be
affected, as well as the function, location, and approximate number of
employees who will be terminated, the amount of expenditures related to the
restructuring, and when the plan will be implemented. Also, the actions or
announcements of management must have raised an expectation among those
affected that it will proceed with the restructuring. The following additional
factors may apply:
• Board notification. In some countries, the decision to restructure
ultimately lies with a separate board whose members may not include
management. If so, an announcement of management’s intentions may
 be considered to have taken place once it notifies this board of its
intention to restructure, since the members of the board may represent
those individuals who will be impacted by the plan.
• Decision as basis for provision. If management or the board of
directors reaches a decision to proceed with a restructuring, this is not
by itself sufficient grounds for recognizing a related provision. In
order to justify the use of a provision, management would also have to
begin implementation of the plan or announce the main features of the
plan to those affected by it, and do so by the end of the reporting
period.
• Detail provided. A simple announcement of a restructuring is not a
sufficient method for raising expectations among those affected;
instead, the announcement must be in sufficient detail regarding the
features of the plan that a valid expectation is raised that the
restructuring will take place.
• Timing. If a restructuring is announced for a period well in the future,
this does not raise a valid expectation that the plan will be
implemented. Instead, the start date and implementation time frame
should be short enough that management would not have a significant
opportunity to modify the plan.
EXAMPLE
At its December 31 board meeting, the board of directors of Argo Drilling
decides to adopt a plan to shut down its South American drilling operations.
However, the company does not communicate this plan to those affected by
the end of the reporting period, so no restructuring provision can be
recognized in the current period.
If the board had chosen to announce a layoff associated with the shutdown
of drilling operations to the affected employees on the same date as its
decision to do so, the company could have recognized a restructuring
provision in the current period.

If management begins to implement a restructuring plan or announces its

main features to those affected by it after the last day of a reporting period, it
should disclose the restructuring if the activity is considered material, and
knowledge of it could influence the decisions of those who use the
company’s financial statements.
It is not permissible under IFRS to include in a restructuring provision
any identifiable future operating losses. Instead, these losses are to be
recognized only as they are incurred.
Management may be tempted to dump as many expenses as possible into
a restructuring provision, thereby clearing the way for the recognition of
outsized profits in future reporting periods. IFRS restricts this behavior by
only allowing the direct expenditures related to a restructuring to be included
in the related provision. Expenditures included in the provision should not be
associated with the ongoing activities of the business. Thus, the provision
should not include costs related to marketing, new investments, or the
relocation or retraining of those employees whose employment will continue
with the company after the restructuring.
Accounting for Contingent Liabilities
A contingent liability is not recognized, because it has not yet been confirmed
that a business has an obligation, or it is not yet possible to make a reliable
estimate of the amount due, or it is not probable that the business has to pay
out resources to settle the obligation. Under these circumstances, a contingent
liability is disclosed, but not recognized. The only situation in which a
contingent liability is not even disclosed is when the possibility of the
business having to pay is remote.
There are situations where a business may be jointly and severally liable
for an obligation, along with one or more other entities. In this case, that
portion of the liability the business assumes will be met by the other parties
should be classified as a contingent liability. The remaining portion for which
the business expects to be liable, and for which it can estimate a probable
payment, is recognized as a provision.
Tip: There may be a number of contingent liabilities hovering in the
background of a company’s operations, none of which yet have a sufficient
probability of payment that recognition as a provision is justified. However,
this situation can change, so review contingent liabilities on a regular basis
to see if the probability of payout has increased to the point where they
should be recognized as provisions.
Accounting for Contingent Assets
There may be a possibility that a business will receive an asset at some point
in the future. For example, a company may be pursuing a lawsuit against a
business partner, the outcome of which could be a large settlement in the
company’s favor. Under IFRS, such a contingent asset is not recognized, on
the grounds that doing so may result in the recognition of income that will
never actually be realized.
Only when the receipt of an asset is virtually certain can a company
recognize it. To use the preceding lawsuit example, a jury award to the
company would still not result in the virtual certainty of receipt, since the
other party may not have the funds available with which to pay the award.
Receipt of the asset could be considered virtually certain only when the
payment arrived in the company’s bank account.
When it appears probable that the receipt of economic benefits will occur,
a contingent asset should be disclosed.
Accounting for Reimbursements
There may be cases where a business is reimbursed by a third party for some
portion or all of a provision, such as through the use of an insurance policy.
The amount of this reimbursement can only be recognized if it is virtually
certain that the business will be reimbursed in the event of a settlement of the
obligation embodied by a provision. Also, the amount of the reimbursement
asset recognized cannot be larger than the amount of the provision with
which it is paired.
If recognized, treat the reimbursement as a separate asset, so it is not
netted against the amount of the provision. However, it is permissible to net
the provision expense and reimbursement amount in the income statement.
EXAMPLE
A cargo ship operated by Silesian Shipping is attacked by pirates in the
Indian Ocean and sunk. The value of the ship and its cargo is £20,000,000.
The ship and cargo were insured, less a 30% deductible, and the insurer has
already stated in writing that it will reimburse the company. Silesian can
recognize a reimbursement asset of £14,000,000, which represents the
anticipated amount of the reimbursement claim to be paid by the insurer.

Accounting for Levies

A government may impose a levy on an organization. The first indication that
a levy may exist is the enactment of legislation allowing a government to
impose the levy. The levy should be recognized by the organization as soon
as a triggering event occurs. An example of a triggering event for a levy that
is based on revenue is the generation of that revenue. For example, if a levy
will be imposed at a rate of 0.5% of gross sales, then the entity should
recognize the levy at that percentage rate as the revenue is generated. The
following additional circumstances may apply:
• Future periods obligation. A business is required by the government to
continue operating in future periods. This does not mean that the
levies associated with those future periods should be recognized now.
• Levy asset. If the amount of a levy has been paid in advance, the entity
should recognize it as a prepaid asset, which will be charged to
expense in later periods.
• Progressive obligation. If there is an obligating event that triggers a
levy, and that event is spread over a period of time, then the levy
should also be recognized over a period of time, rather than all at once.
Thus, a levy based on revenues should be recognized in proportion to
the amount of revenue generated over time.
• Threshold attainment. If a levy is only applied after a certain threshold
level has been reached, an organization should not recognize the levy
if the entity is currently operating below the designated threshold
level.
Disclosure of Provisions and Contingent Items
When a business recognizes a provision, it should disclose the following
information in the notes accompanying its financial statements for each class
of provision:
• Carrying amount. The carrying amount of the provision at the
beginning and end of the reporting period.
• Changes. The nature and amount of any new provisions made, as well
as increases in existing provisions.
• Present value related. Any increase in the discounted amount of
provisions that were caused by the passage of time or a change in the
discount rate used to derive present value.
• Reversals. Any unused provision amounts that were reversed in the
period.
• Usage. The amounts used in the provisions in the period.
It is not necessary to provide comparative information for the preceding
disclosures that relate to any earlier reporting periods shown alongside the
financial statements for the current reporting period.
In addition, disclose the following information about each class of
provision that is reported in the financial statements:
• Description. The nature and expected payment timing for the
 obligations.
• Reimbursement. The amounts of any reimbursements related to
provisions, including the amount of any reimbursement assets that
have been recognized.
• Uncertainties. Any uncertainties regarding the timing or amount of the
payments to be made.
A provision is reported separately from trade payables and other forms of
accounts payable.
If there are any contingent liabilities for which the probability of
occurrence is less than remote, disclose by class of contingent liability a
description of the liability, an estimate of its financial effect, any payment or
timing uncertainties, and whether any reimbursements can be expected. If it
is not practicable to disclose this information, state this point.
If there appear to be contingent assets, describe the nature of these assets
and (if possible) provide an estimate of their financial effect. If it is not
practicable to disclose this information, state this fact. When making these
disclosures, avoid misleading the users of this information about the
likelihood of income actually being recognized from the contingent assets.
There may be cases where a company is embroiled in a dispute with a
third party, and disclosing some of the information required in this section
may harm its position in regard to settling the dispute. If so, it is not
necessary to disclose any information that would harm the company. Instead,
disclose the nature of the dispute, state that certain information is not being
disclosed, and why it is not being disclosed.
When aggregating information for the reporting of provisions, be careful
to separate clearly disparate types of provisions. For example, all of the
various warranties related to company products or services could probably be
grouped into a single class, while provisions related to the settlement of
lawsuits are clearly different, and so should be aggregated into a separate
class.
EXAMPLE
The following are sample disclosures related to provisions:
The company has recognized a provision for expected warranty
claims on its drilling products sold during the past 12 months. It is
expected that the majority of this expenditure will be incurred in
the next three months, and all of the expenditure will be incurred
within one year.
 The company has recognized a provision of £500,000 related to
the decommissioning costs of several drilling pads. These costs
are expected to be incurred in no less than five years, and in not
more than 15 years. The provision has been estimated at current
prices, and using existing technology. The provision is based on
the present value of future expenditures, using a 4% discount rate.
The company is engaged in litigation with a competitor who
alleged copyright infringement of a drilling process used by the
company, and is seeking damages of £25,000,000. The
information usually required by IAS 37, Provisions, Contingent
Liabilities and Contingent Assets is not disclosed on the grounds
that it could prejudice the outcome of the litigation. Management
is of the opinion that the claim has no merit, and will require no
payout of funds.

Summary
The key element to consider when dealing with provisions and contingencies
is the concept of materiality. It is not necessary to recognize or disclose an
item that is immaterial. In the interests of efficiency, it makes sense to avoid
the recognition or disclosure of excessively small matters. By avoiding this
burden, the accounting staff can reduce the effort required to monitor and
update minor liability issues. In addition, the readers of a company’s financial
statements are not inundated with a large amount of picayune liability issues
that might otherwise give the impression of an organization weighted down
by an excessive number of liabilities.
 Chapter 20
Revenue from Contracts with Customers
Introduction
Historically, the accounting standards related to the recognition of revenue
have built up in a piecemeal manner, with guidance being established
separately for certain industries and types of transactions. The result has been
an inconsistent set of standards that, while workable, have not resulted in
revenue recognition principles that could be applied consistently across many
industries.
The accounting for revenue has been streamlined to a considerable extent
with the release of IFRS 15. Now, the overall intent of revenue recognition is
to do so in a manner that reasonably depicts the transfer of goods or services
to customers, for which consideration is paid that reflects the amount to
which the seller expects to be entitled. The following sections describe the
five-step process of revenue recognition, as well as a number of ancillary
topics.
IFRS Source Document
• IFRS 15, Revenue from Contracts with Customers
The Nature of a Customer
Revenue recognition only occurs if the third party involved is a customer. A
customer is an entity that has contracted to obtain goods or services from the
seller’s ordinary activities in exchange for payment.
In some situations, it may require a complete examination of the facts and
circumstances to determine whether the other party can be classified as a
customer. For example, it can be difficult to discern whether there is a
customer in collaborative research and development activities between
pharmaceutical entities. Another difficult area is payments between oil and
gas partners to settle differences between their entitlements to the output from
a producing field.
EXAMPLE
The Red Herring Fish Company contracts with Lethal Sushi to co-develop a
fish farm off the coast of Iceland, where the two entities share equally in any
future profits. Lethal Sushi is primarily in the restaurant business, so
developing a fish farm is not one of its ordinary activities. Also, there is no
clear consideration being paid to Lethal. Based on the circumstances, Red
Herring is not a customer of Lethal Sushi.

Steps in Revenue Recognition

IFRS 15 establishes a series of actions that an entity takes to determine the
amount and timing of revenue to be recognized. The main steps are:
1. Link the contract with a specific customer.
2. Note the performance obligations required by the contract.
3. Determine the price of the underlying transaction.
4. Match this price to the performance obligations through an
allocation process.
5. Recognize revenue as the various obligations are fulfilled.
We will expand upon each of these steps in the following sections.
Step One: Link Contract to Customer
The contract is used as a central aspect of revenue recognition, because
revenue recognition is closely associated with it. In many instances, revenue
is recognized at multiple points in time over the duration of a contract, so
linking contracts with revenue recognition provides a reasonable framework
for establishing the timing and amounts of revenue recognition.
A contract only exists if there is an agreement between the parties that
establishes enforceable rights and obligations. It is not necessary for an
agreement to be in writing for it to be considered a contract. More
specifically, a contract only exists if the following conditions are present:
• Approval. All parties to the contract have approved the document and
substantially committed to its contents (based on all relevant facts and
circumstances). The parties can be considered to be committed to a
contract despite occasional lapses, such as not enforcing prompt
payment or sometimes shipping late. Approval can be in writing or
orally.
• Rights. The document clearly identifies the rights of the parties.
• Payment. The payment terms are clearly stated. It is acceptable to
recognize revenue related to unpriced change orders if the seller
expects that the price will be approved and the scope of work has been
approved.
• Substance. The agreement has commercial substance; that is, the cash
flows of the seller will change as a result of the contract, either in
terms of their amount, timing, or risk of receipt. Otherwise,
organizations could swap goods or services to artificially boost their
 revenue.
• Probability. It is probable that the organization will collect the amount
stated in the contract in exchange for the goods or services that it
commits to provide to the other party. In this context, “probable”
means “likely to occur.” This evaluation is based on the customer’s
ability and intention to pay when due. The evaluation can incorporate
a consideration of the past practice of the customer in question, or of
the class of customers to which that customer belongs.
If these criteria are not initially met, the seller can continue to evaluate the
situation to see if the criteria are met at a later date.
Note: These criteria do not have to be re-evaluated at a later date, unless the
seller notes a significant change in the relevant facts and circumstances.
EXAMPLE
Prickly Corporation has entered into an arrangement to sell a large quantity
of rose thorns to Ambivalence Corporation, which manufactures a number
of potions for the amateur witch brewing market. The contract specifies
monthly deliveries over the course of the next year.
Prior to the first shipment, Prickly’s collections manager learns through her
contacts that Ambivalence has just lost its line of credit and has conducted a
large layoff. It appears that the customer’s ability to pay has deteriorated
significantly, which calls into question the probability of collecting the
amount stated in the contract. In this case, there may no longer be a contract
for the purposes of revenue recognition.
EXAMPLE
Domicilio Corporation, which develops commercial real estate, enters into a
contract with Cupertino Beanery to sell a building to Cupertino to be used as
a coffee shop. This is Cupertino’s first foray into the coffee shop business,
having previously only been a distributor of coffee beans to shops within the
region. Also, there are a massive number of coffee shops already established
in the area.
Domicilio receives a £100,000 deposit from Cupertino when the contract is
signed. The contract also states that Cupertino will pay Domicilio an
additional £900,000 for the rest of the property over the next three years,
with interest. This financing arrangement is nonrecourse, meaning that
Domicilio can repossess the building in the event of default, but cannot
obtain further cash from Cupertino. Cupertino expects to pay Domicilio
from the cash flows to be generated by the coffee shop operation.
Domicilio’s management concludes that it is not probable that Cupertino
will pay the remaining contractual amount, since its source of funds is a
high-risk venture in which Cupertino has no experience. In addition, the loan
is nonrecourse, so Cupertino can easily walk away from the arrangement.
Accordingly, Domicilio accounts for the initial deposit and future payments
as a deposit liability, and continues to recognize the building asset. If it later
becomes probable that Cupertino will pay the full contractual amount,
Domicilio can then recognize revenue and an offsetting receivable.

Whether a contract exists can depend upon standard industry practice, or vary
by legal jurisdiction, or even vary by business segment.
There may be instances in which the preceding criteria are not met, and
yet the customer is paying consideration to the seller. If so, revenue can be
recognized only when one of the following events has occurred:
• The contract has been terminated and the consideration received by the
seller is not refundable; or
• The seller has no remaining obligations to the customer, substantially
all of the consideration has been received, and the payment is not
refundable.
These alternatives focus on whether the contract has been concluded in all
respects. If so, there is little risk that any revenue recognized will be reversed
in a later period, and so is a highly conservative approach to recognizing
revenue.
If the seller receives consideration from a customer and the preceding
conditions do not exist, then the payment is to be recorded as a liability until
such time as the sale criteria have been met.
A contract is not considered to exist when each party to the contract has a
unilateral right to terminate a contract that has not been performed, and
without compensating the other party. An unperformed contract is one in
which no goods or services have been transferred to the customer, nor has the
seller received any consideration from the customer in exchange for any
promised goods or services.
In certain situations, it can make sense to combine several contracts into
one for the purposes of revenue recognition. For example, if there is a
portfolio of contracts that have similar characteristics, and the entity expects
that treating the portfolio as a single unit will have no appreciable impact on
the financial statements, it is acceptable to combine the contracts for
accounting purposes. This approach may be particularly valuable in
industries where there are a large number of similar contracts, and where
applying the model to each individual contract could be impractical.
Tip: When accounting for a portfolio of contracts, adjust the accompanying
estimates and assumptions to reflect the greater size of the portfolio.
If the seller enters into two or more contracts with a customer at
approximately the same time, these contracts can be accounted for as a single
contract if any of the following criteria are met:
• Basis of negotiation. The contracts were negotiated as a package, with
the goal of attaining a single commercial objective.
• Interlinking consideration. The consideration that will be paid under
the terms of one contract is dependent upon the price or performance
noted in the other contract.
• Performance obligation. There is essentially one performance
obligation inherent in the two contracts.
EXAMPLE
Domicilio Corporation enters into three contracts with Milford Sound to
construct a concert arena. These contracts involve construction of the
concrete building shell, installation of seating, and the construction of a
staging system. The three contracts are all needed in order to arrive at a
functioning concert arena. Final payment on all three contracts shall be
made once the final customer (a local municipality) approves the entire
project.
Domicilio should account for these contracts as a single contract, since they
are all directed toward the same commercial goal, payment is dependent on
all three contracts being completed, and the performance obligation is
essentially the same for all of the contracts.

Step Two: Note Performance Obligations

A performance obligation is essentially the unit of account for the goods or
services contractually promised to a customer. The performance obligations
in the contract must be clearly identified. This is of considerable importance
in recognizing revenue, since revenue is considered to be recognizable when
goods or services are transferred to the customer. Examples of goods or
services are noted in the following table.
Examples of Goods and Services, and Related Sellers

There may also be an implicit promise to deliver goods or services that is not
stated in a contract, as implied by the customary business practices of the
seller. If there is a valid expectation by the customer to receive these
implicitly-promised goods or services, they should be considered a
performance obligation. Otherwise, the seller might recognize the entire
transaction price as revenue when in fact there are still goods or services yet
to be provided.
If there is no performance obligation, then there is no revenue to be
recognized. For example, a company could continually build up its inventory
through ongoing production activities, but just because it has more sellable
assets does not mean that it can report an incremental increase in the revenue
in its income statement. If such an activity-based revenue recognition model
were allowed, organizations could increase their revenues simply by
increasing their rate of activity.
If there is more than one good or service to be transferred under the
contract terms, only break it out as a separate performance obligation if it is a
distinct obligation or there are a series of transfers to the customer of a
distinct good or service. In the latter case, a separate performance obligation
is assumed if there is a consistent pattern of transfer to the customer.
The “distinct” label can be applied to a good or service only if it meets both
of the following criteria:
• Capable of being distinct. The customer can benefit from the good or
service as delivered, or in combination with other resources that the
customer can readily find; and
 • Distinct within the context of the contract. The promised delivery of
the good or service is separately identified within the contract.
Goods or services are more likely to be considered distinct when:
• The seller does not use the goods or services as a component of an
integrated bundle of goods or services.
• The items do not significantly modify any other goods or services
listed in the contract.
• The items are not highly interrelated with other goods or services
listed in the contract.
The intent of these evaluative factors is to place a focus on how to determine
whether goods or services are truly distinct within a contract. There is no
need to assess the customer’s intended use of any goods or services when
making this determination.
EXAMPLE
Aphelion Corporation sells a package of goods and services to Nova
Corporation. The goods include a deep field telescope, an observatory to
house the telescope, and calibration services for the telescope.
The observatory building can be considered distinct from the telescope and
calibration services, because Nova could have the telescope installed in an
existing facility instead. However, the telescope and calibration services are
linked, since the telescope will not function properly unless it has been
properly calibrated. Thus, one performance obligation can be considered the
observatory, while the telescope and associated calibration can be stated as a
separate obligation.
EXAMPLE
Norrona Software enters into a contract with a Scandinavian clothing
manufacturer to transfer a software license for its clothing design software.
The contract also states that Norrona will install the software and provide
technical support for a two-year period. The installation process involves
adjusting the data entry screens to match the needs of the clothing designers
who will use the software. The software can be used without these
installation changes. The technical support assistance is intended to provide
advice to users regarding advanced features, and is not considered a key
requirement for software users.
Since the software is functional without the installation process or the
technical support, Norrona concludes that the items are not highly
interrelated. Since these goods and services are distinct, the company should
identify separate performance obligations for the software license,
installation work, and technical support.

In the event that a good or service is not classified as distinct, aggregate it

with other goods or services promised in the contract, until such time as a
cluster of goods or services have been accumulated that can be considered
distinct.
The administrative tasks needed to fulfill a contract are not considered to
be performance obligations, since they do not involve the transfer of goods or
services to customers. For example, setting up information about a new
contract in the seller’s contract management software is not considered a
performance obligation.
Step Three: Determine Prices
This step involves the determination of the transaction price built into the
contract. The transaction price is the amount of consideration to be paid by
the customer in exchange for its receipt of goods or services. The transaction
price does not include any amounts collected on behalf of third parties.
EXAMPLE
The Twister Vacuum Company sells its vacuum cleaners to individuals
through its chain of retail stores. In the most recent period, Twister
generated £3,800,000 of receipts, of which £200,000 was sales taxes
collected on behalf of local governments. Since the £200,000 was collected
on behalf of third parties, it cannot be recognized as revenue.

The transaction price may be difficult to determine, since it involves

consideration of the effects noted in the following subsections.
Variable Consideration
The terms of some contracts may result in a price that can vary, depending on
the circumstances. For example, there may be discounts, rebates, penalties, or
performance bonuses in the contract. Or, the customer may have a reasonable
expectation that the seller will offer a price concession, based on the seller’s
customary business practices, policies, or statements. Another example is
when the seller intends to accept lower prices from a new customer in order
to develop a strong customer relationship. If so, set the transaction price
based on either the most likely amount or the probability-weighted expected
value, using whichever method yields that amount of consideration most
likely to be paid. In more detail, these methods are:
 • Most likely. The seller develops a range of possible payment amounts,
and selects the amount most likely to be paid. This approach works
best when there are only two possible amounts that will be paid.
• Expected value. The seller develops a range of possible payment
amounts, and assigns a probability to each one. The sum of these
probability-weighted amounts is the expected value of the variable
consideration. This approach works best when there are a large
number of possible payment amounts. However, the outcome may be
an expected value that does not exactly align with any amount that
could actually be paid.
EXAMPLE
Grissom Granaries operates grain storage facilities along the Danube River.
Its accounting staff is reviewing a contract that has just been signed with a
major farming co-operative, and concludes that the contract could have four
possible outcomes, which are noted in the following expected value table:

The expected value derived from the four possible pricing outcomes is
£1,815,000, even though this amount does not match any one of the four
pricing outcomes.

Whichever method is chosen, be sure to use it consistently throughout the

contract, as well as for similar contracts. However, it is not necessary to use
the same measurement method to measure each uncertainty contained within
a contract; different methods can be applied to different uncertainties.
Also, review the circumstances of each contract at the end of each
reporting period, and update the estimated transaction price to reflect any
changes in the circumstances.
EXAMPLE
Cantilever Construction has entered into a contract to tear down and replace
five bridges along a major highway. The local government (which owns and
maintains this section of the highway) is extremely concerned about how the
work will interfere with traffic on the highway. Accordingly, the
government includes in the contract a clause that penalizes Cantilever
£10,000 for every hour over the budgeted amount that each bridge
demolition and construction project shuts down the interstate, and a £15,000
bonus for every hour saved from the budgeted amount.
Cantilever has extensive experience with this type of work, having torn
down and replaced 42 other bridges along the highway in the past five years.
Based on the company’s experience with these other projects and an
examination of the budgeted hours allowed for shutting down the interstate,
the company concludes that the most likely outcome is £120,000 of variable
consideration associated with the project. Cantilever accordingly adds this
amount to the transaction price.
Possibility of Reversal
Do not include in the transaction price an estimate of variable consideration
if, when the uncertainty associated with the variable amount is settled, it is
probable that there will be a significant reversal of cumulative revenue
recognized. The assessment of a possible reversal of revenue could include
the following factors, all of which might increase the probability of a revenue
reversal:
• Beyond seller’s influence. The amount of consideration paid is
strongly influenced by factors outside of the control of the seller. For
example, goods sold may be subject to obsolescence (as is common in
the technology industry), or weather conditions could impede the
availability of goods (as is common in the production of farm
products).
• Historical practice. The seller has a history of accepting a broad range
of price concessions, or of changing the terms of similar contracts.
• Inherent range of outcomes. The terms of the contract contain a broad
range of possible consideration amounts that might be paid.
• Limited experience. The seller does not have much experience with the
type of contract in question. Alternatively, the seller’s prior experience
cannot be translated into a prediction of the amount of consideration
paid.
• Long duration. A considerable period of time may have to pass before
the uncertainty can be resolved.
Note: The probability of a significant reversal of cumulative revenue
recognized places a conservative bias on the recognition of revenue, rather
 than a neutral bias, so there will be a tendency for recognized revenue
levels to initially be too low. However, this approach is reasonable when
considering that revenue information is more relevant when it is not subject
to future reversals.
If management expects that a retroactive discount will be applied to sales
transactions, the seller should recognize a refund liability as part of the
revenue recognition when each performance obligation is satisfied. For
example, if the seller is currently selling goods for £100 but expects that a
20% volume discount will be retroactively applied at the end of the year, the
resulting entry should be:

EXAMPLE
Medusa Medical sells a well-known snake oil therapy through a number of
retail store customers. In the most recent month, Medusa sells £100,000 of
its potent Copperhead Plus combination healing balm and sunscreen lotion.
The therapy is most effective within one month of manufacture and then
degrades rapidly, so that Medusa must accept increasingly large price
concessions in order to ensure that the goods are sold. Historically, this
means that the range of price concessions varies from zero (in the first
month) to 80% (after four months). Of this range of outcomes, Medusa
estimates that the expected value of the transactions is likely to be revenue
of £65,000. However, since the risk of obsolescence is so high, Medusa
cannot conclude that it is probable that there will not be a significant
reversal in the amount of cumulative revenue recognized. Accordingly,
management concludes that the price point at which it is probable that there
will not be a significant reversal in the cumulative amount of revenue
recognized is actually closer to £45,000 (representing a 55% price
concession). Based on this conclusion, the controller initially recognizes
£45,000 of revenue when the goods are shipped to retailers, and continues to
monitor the situation at the end of each reporting period, to see if the
recognized amount should be adjusted.
EXAMPLE
Iceland Cod enters into a contract with Lethal Sushi to provide Lethal with
10,000 pounds of cod per year, at €15 per pound. If Lethal purchases more
than 10,000 pounds within one calendar year, then a 12% retroactive price
reduction will be applied to all of Lethal’s purchases for the year.
Iceland has dealt with Lethal for a number of years, and knows that Lethal
has never attained the 10,000 pound level of purchases. Accordingly,
through the first half of the year, Iceland records its sales to Lethal at their
full price, which is €30,000 for 2,000 pounds of cod.
In July, Lethal acquires Wimpy Fish Company, along with its large chain of
seafood restaurants. With a much larger need for fish to supply the
additional restaurants, Lethal now places several large orders that make it
quite clear that passing the 10,000 pound threshold will be no problem at all.
Accordingly, Iceland’s controller records a cumulative revenue reversal of
€3,600 to account for Lethal’s probable attainment of the volume purchase
discount.
EXAMPLE
Armadillo Industries is a new company that has developed a unique type of
ceramic-based body armor that is extremely light. To encourage sales, the
company is offering a 90-day money back guarantee. Since the company is
new to the industry and cannot predict the level of returns, there is no way of
knowing if a sudden influx of returns might trigger a significant reversal in
the amount of cumulative revenue recognized. Accordingly, the company
must wait for the money back guarantee to expire before it can recognize
any revenue.
Time Value of Money
If the transaction price is to be paid over a period of time, this implies that the
seller is including a financing component in the contract. If this financing
component is a significant financing benefit for the customer and provides
financing for more than one year, adjust the transaction price for the time
value of money. In cases where there is a financing component to a contract,
the seller will earn interest income over the term of the contract.
A contract may contain a financing component, even if there is no explicit
reference to it in the contract. When adjusting the transaction price for the
time value of money, consider the following factors:
• Standalone price. The amount of revenue recognized should reflect the
price that a customer would have paid if it had paid in cash.
• Significance. In order to be recognized, the financing component
should be significant. This means evaluating the amount of the
 difference between the consideration to be paid and the cash selling
price. Also note the combined effect of prevailing interest rates and
the time difference between when delivery is made and when the
customer pays.
If it is necessary to adjust the compensation paid for the time value of money,
use as a discount rate the rate that would be employed in a separate financing
transaction between the parties as of the beginning date of the contract. The
rate used should reflect the credit characteristics of the customer, including
the presence of any collateral provided. This discount rate is not to be
updated after the commencement of the contract, irrespective of any changes
in the credit markets or in the credit standing of the customer.
EXAMPLE
Hammer Industries sells a large piece of construction equipment to Eskimo
Construction, under generous terms that allow Eskimo to pay Hammer the
full amount of the £119,990 receivable in 24 months. The cash selling price
of the equipment is £105,000. The contract contains an implicit interest rate
of 6.9%, which is the interest rate that discounts the purchase price of
£119,990 down to the cash selling price over the two year period. The
controller examines this rate and concludes that it approximates the rate that
Hammer and Eskimo would use if there had been a separate financing
transaction between them as of the contract inception date. Consequently,
Hammer recognizes interest income during the two-year period prior to the
payment due date, using the following calculation:

As of the shipment date, Hammer records the following entry:

At the end of the first year, Hammer recognizes the interest associated with
the transaction for the first year, using the following entry:

At the end of the second year, Hammer recognizes the interest associated
with the transaction for the second year, using the following entry:
These entries increase the size of the loan receivable until it reaches the
original sale price of £119,990. Eskimo then pays the full amount of the
receivable, at which point Hammer records the following final entry:

Also, note that the financing concept can be employed in reverse; that is, if a
customer makes a deposit that the seller expects to retain for more than one
year, the financing component of this arrangement should be recognized by
the seller. Doing so properly reflects the economics of the arrangement,
where the seller is using the cash of the customer to fund its purchase of
materials and equipment for a project; if the seller had not provided the
deposit, the seller would instead have needed to obtain financing.
There is assumed not to be a significant financing component to a
contract in the presence of any of the following factors:
• Advance payment. The customer paid in advance, and the customer
can specify when goods and services are to be delivered.
• Variable component. A large part of the consideration to be paid is
variable, and payment timing will vary based on a future event that is
not under the control of either party.
• Non-financing reason. The reason for the difference between the
contractual consideration and the cash selling price exists for a reason
other than financing, and the amount of the difference is proportional
to the alternative reason.
EXAMPLE
Spinner Maintenance offers global technical support to the owners of
rooftop solar power systems in exchange for a €400 fee. The fee pays for
service that spans the first five years of the life of the power systems, and is
purchased as part of the package of solar panels and initial installation work.
This maintenance is intended to provide phone support to homeowners who
are researching why their power systems are malfunctioning. The support
does not include any replacement of solar panels for hail damage.
The support period is quite extensive, but Spinner concludes that there is no
financing component to these sales, for the following reasons:
• The administrative cost of a monthly billing would be prohibitive,
since the amount billed on a monthly basis would be paltry.
• Those more technologically proficient customers would be less likely
to renew if they could pay on a more frequent basis, leaving Spinner
with the highest-maintenance customers who require the most
support.
• Customers are more likely to make use of the service if they are
reminded of it by the arrival of monthly invoices.
In short, Spinner has several excellent reasons for structuring the payment
plan to require an advance payment, all of which are centered on
maintaining a reasonable level of profitability. The intent is not to provide
financing to customers.
EXAMPLE
Glow Atomic sells a nuclear power plant to a French provincial government.
The certification process for the plant is extensive, spanning a six-month test
period. Accordingly, the local government builds into the contract a
provision to withhold 20% of the contract price until completion of the test
period. The rest of the payments are made on a milestone schedule, as the
construction work progresses. Based on the circumstances and the amount of
the withholding, the arrangement is considered to be non-financing, so Glow
Atomic does not break out a financing component from the total
consideration paid.
Noncash Consideration
If the customer will be paying with some form of noncash consideration,
measure the consideration at its fair value. If it is not possible to measure the
payment at its fair value, instead use the standalone selling price of the goods
or services to be delivered to the customer. This approach also applies to
payments made with equity instruments. In rare cases, the customer may
supply the seller with goods or services that are intended to assist the seller in
its fulfillment of the related contract. If the seller gains control of these assets
or services, it should consider them to be noncash consideration paid by the
customer.
EXAMPLE
Industrial Landscaping is hired by Pensive Corporation to mow the lawns
and trim shrubbery at Pensive’s corporate headquarters on a weekly basis
throughout the year. Essentially the same service is provided each week.
Pensive is a startup company with little excess cash, so it promises to pay
Industrial with 25 shares of Pensive stock at the end of each week.
Industrial considers itself to have satisfied its performance obligation at the
end of each week. Industrial should determine the transaction price as being
the fair value of the shares at the end of each week, and recognizes this
amount as revenue. There is no subsequent change in the amount of revenue
recognized, irrespective of any changes in the fair value of the shares.
Payments to Customers
The contract may require the seller to pay consideration to the customer,
perhaps in the form of credits or coupons that the customer can apply against
the amounts it owes to the seller. This may also involve payments to third
parties that have purchased the seller’s goods or services from the original
customer. If so, treat this consideration as a reduction of the transaction price.
The following special situations may apply:
• Customer supplies a good or service. The customer may provide the
seller with a distinct good or service; if so, the seller treats the
payment as it would a payment to any supplier.
• Supplier payment exceeds customer delivery. If the customer provides
a good or service to the seller, but the amount paid by the seller to the
customer exceeds the fair value of the goods or services it receives in
exchange, the excess of the payment is considered a reduction of the
transaction price. If the fair value of the goods or services cannot be
determined, then consider the entire amount paid by the seller to the
customer to be a reduction of the transaction price.
If it is necessary to account for consideration paid to the customer as a
reduction of the transaction price, do so when the later of the following two
events have occurred:
• When the seller recognizes revenue related to its provision of goods or
services to the customer; or
• When the seller either pays or promises to pay the consideration to the
customer. The timing of this event could be derived from the
customary business practices of the seller.
EXAMPLE
Dillinger Designs manufactures many types of hunting rifles. Dillinger
enters into a one-year contract with Backwoods Survival, which has not
previously engaged in rifle sales. Backwoods commits to purchase at least
£240,000 of rifles from Dillinger during the contract period. Also, due to the
considerable government-mandated safety requirements associated with the
sale of rifles, Dillinger commits to pay £60,000 to Backwoods at the
inception of the contract; these funds are intended to pay for a locking gun
safe to be kept at each Backwoods store, as per firearms laws pertaining to
retailers.
Dillinger determines that the £60,000 payment is to be treated as a reduction
of the £240,000 sale price. Consequently, whenever Dillinger fulfills a
performance obligation by shipping goods under the contract, it reduces the
amount of revenue it would otherwise recognize by 25%, which reflects the
proportion of the £60,000 payment related to locking gun safes of the
£240,000 that Dillinger will be paid by Backwoods.
Refund Liabilities
In some situations, a seller may receive consideration from a customer, with
the likelihood that the payment will be refunded. If so, the seller records a
refund liability in the amount that the seller expects to refund back to the
customer. The seller should review the amount of this liability at the end of
each reporting period, to see if the amount should be altered.
Step Four: Allocate Prices to Obligations
Once the performance obligations and transaction prices associated with a
contract have been identified, the next step is to allocate the transaction prices
to the obligations. The basic rule is to allocate that price to a performance
obligation that best reflects that amount of consideration to which the seller
expects to be entitled when it satisfies each performance obligation. To
determine this allocation, it is first necessary to estimate the standalone
selling price of those distinct goods or services as of the inception date of the
contract. If it is not possible to derive a standalone selling price, the seller
must estimate it. This estimation should involve all relevant information that
is reasonably available, such as:
• Competitive pressure on prices
• Costs incurred to manufacture or provide the item
• Item profit margins
• Pricing of other items in the same contract
• Standalone selling price of the item
• Supply and demand for the items in the market
 • The seller’s pricing strategy and practices
• The type of customer, distribution channel, or geographic region
• Third-party pricing
The following three approaches are acceptable ways in which to estimate a
standalone selling price:
• Adjusted market assessment. This involves reviewing the market to
estimate the price at which a customer in that market would be willing
to pay for the goods and services in question. This can involve an
examination of the prices of competitors for similar items and
adjusting them to incorporate the seller’s costs and margins.
• Expected cost plus a margin. This requires the seller to estimate the
costs required to fulfill a performance obligation, and then add a
margin to it to derive the estimated price.
• Residual approach. This involves subtracting all of the observable
standalone selling prices from the total transaction price to arrive at
the residual price remaining for allocation to any non-observable
selling prices. This method can only be used if one of the following
situations applies:
o The seller sells the good or service to other customers for a
wide range of prices; or
o No price has yet been established for that item, and it has not
yet been sold on a standalone basis.
The residual approach can be difficult to use when there are several goods or
services with uncertain standalone selling prices. If so, it may be necessary to
use a combination of methods to derive standalone selling prices, which
should be used in the following order:
1. Estimate the aggregate amount of the standalone selling prices for all
items having uncertain standalone selling prices, using the residual
method.
2. Use another method to develop standalone selling prices for each
item in this group, to allocate the aggregate amount of the standalone
selling prices.
Once all standalone selling prices have been determined, allocate the
transaction price amongst these distinct goods or services based on their
relative standalone selling prices.
Tip: Appropriate evidence of a standalone selling price is the observable
price of a good or service when the seller sells it to a similar customer
 under similar circumstances.
Once the seller derives an approach for estimating a standalone selling price,
it should consistently apply that method to the derivation of the standalone
selling prices for other goods or services with similar characteristics.
EXAMPLE
Luminescence Corporation manufactures a wide range of light bulbs, and
mostly sells into the wholesaler market. The company receives an order
from the federal government for two million fluorescent bulbs, as well as for
100,000 units of a new bulb that operates outdoors at very low temperatures.
Luminescence has not yet sold these new bulbs to anyone. The total price of
the order is €7,000,000. Luminescence assigns €6,000,000 of the total price
to the fluorescent bulbs, based on its own sales of comparable orders. This
leaves €1,000,000 of the total price that is allocable to the low temperature
bulbs. Since Luminescence has not yet established a price for these bulbs
and has not sold them on a standalone basis, it is acceptable to allocate
€1,000,000 to the low temperature bulbs under the residual approach.

If there is a subsequent change in the transaction price, allocate that change

amongst the distinct goods or services based on the original allocation that
was used at the inception of the contract. If this subsequent allocation is to a
performance obligation that has already been completed and for which
revenue has already been recognized, the result can be an increase or
reduction in the amount of revenue recognized. This change in recognition
should occur as soon as the subsequent change in the transaction price occurs.
Allocation of Price Discounts
It is assumed that a customer has received a discount on a bundled purchase
of goods or services when the sum of the standalone prices for these items is
greater than the consideration to be paid under the terms of a contract. The
discount can be allocated to a specific item within the bundled purchase, if
there is observable evidence that the discount was intended for that item. In
order to do so, all of the following criteria must apply:
1. Each distinct item in the bundle is regularly sold on a standalone
basis;
2. A bundle of some of these distinct items is regularly sold at a
discount to their standalone selling prices; and
3. The discount noted in the second point is essentially the same as the
discount in the contract, and there is observable evidence linking the
 entire contract discount to that bundle of distinct items.
If this allocation system is used, the seller must employ it before using the
residual approach noted earlier in this section. Doing so ensures that the
discount is not applied to the other performance obligations in the contract to
which prices have not yet been allocated.
In all other cases, the discount is to be allocated amongst all of the items
in the bundle. In this latter situation, the allocation is to be made based on the
standalone selling prices of all of the performance obligations in the contract.
EXAMPLE
The Hegemony Toy Company sells board games that re-enact famous
battles. Hegemony regularly sells the following three board games:

Hegemony routinely sells the Stalingrad and Waterloo products as a bundle

for €120.
Hegemony enters into a contract with the War Games International website
to sell War Games the set of three games for €240, which is a 20% discount
from the standard price. Deliveries of these games to War Games will be at
different times, so the related performance obligations will be settled on
different dates.
The €60 discount would normally be apportioned among all three products
based on their standalone selling prices. However, because Hegemony
routinely sells the Stalingrad/Waterloo bundle for a €60 discount, it is
evident that the entire discount should be allocated to these two products.
If Hegemony later delivers the Stalingrad and Waterloo games to War
Games on different dates, it should allocate the €60 discount between the
two products based on their standalone selling prices. Thus, €33.33 should
be allocated to the Stalingrad game and €26.67 to the Waterloo game. The
allocation calculation is:

If the two games are instead delivered at the same time, there is no need to
conduct the preceding allocation. Instead, the discount can be assigned to
them both as part of a single performance obligation.
Allocation of Variable Consideration
There may be a variable amount of consideration associated with a contract.
This consideration may apply to the contract as a whole, or to just a portion
of it. For example, a bonus payment may be tied to the completion of a
specific performance obligation. It is allowable to allocate variable
consideration to a specific performance obligation or a distinct good or
service within a contract when the variable payment terms are specifically
tied to the seller’s efforts to satisfy the performance obligation.
EXAMPLE
Nova Corporation contracts with the Deep Field Scanning Authority to
construct two three-meter telescopes that will operate in tandem in the low-
humidity Atacama Desert in Chile. The terms of the contract include a
provision that can increase the allowable price charged, if the commodity
cost of the titanium required to build the telescope frames increases. Based
on the prices stated in forward contracts at the contract inception date, it is
likely that this variable cost element will increase the transaction price by
£250,000. The variable component of the price is allocated to each of the
telescopes equally.
Subsequent Price Changes
There are a number of reasons why the transaction price could change after a
contract has begun, such as the resolution of uncertain events that were in
need of clarification at the contract inception date. When there is a price
change, the amount of the change is to be allocated to the performance
obligations on the same basis used for the original price allocation at the
inception of the contract. This has the following ramifications:
• Do not re-allocate prices based on subsequent changes in the
standalone selling prices of goods or services.
• When there is a price change and that price is allocated, the result may
be the recognition of additional or reduced revenue that is to be
recognized in the period when the transaction price changes.
• When there has been a contract modification prior to a price change,
the price allocation is conducted in two steps. First, allocate the price
change to those performance obligations identified prior to the
modification if the price change is associated with variable
consideration promised before modification. In all other cases, allocate
 the price change to those performance obligations still remaining to be
settled as of the modification date.
The result should be a reported level of cumulative revenue that matches the
amount of revenue an organization would have recognized if it had the most
recent information at the inception date of the contract.
Step Five: Recognize Revenue
Revenue is to be recognized as goods or services are transferred to the
customer. This transference is considered to occur when the customer gains
control over the good or service. Indicators of this date include the following:
• When the seller has the right to receive payment.
• When the customer has legal title to the transferred asset. This can still
be the case even when the seller retains title to protect it against the
customer’s failure to pay.
• When physical possession of the asset has been transferred by the
seller. Possession can be inferred even when goods are held elsewhere
on consignment, or by the seller under a bill-and-hold arrangement.
Under a bill-and-hold arrangement, the seller retains goods on behalf
of the customer, but still recognizes revenue.
• When the customer has taken on the significant risks and rewards of
ownership related to the asset transferred by the seller. For example,
the customer can now sell, pledge, or exchange the asset.
• When the customer accepts the asset.
• When the customer can prevent other entities from using or obtaining
benefits from the asset.
It is possible that a performance obligation will be transferred over time,
rather than as of a specific point in time. If so, revenue recognition occurs
when any one of the following criteria are met:
• Immediate use. The customer both receives and consumes the benefit
provided by the seller as performance occurs. This situation arises if
another entity would not need to re-perform work completed to date if
the other entity were to take over the remaining performance
obligation. Routine and recurring services typically fall into this
classification.
EXAMPLE
Long-Haul Freight contracts to deliver a load of goods from Paris to Berlin.
This service should be considered a performance obligation that is
transferred over time, despite the fact that the customer only benefits from
the goods once they are delivered. The reason for the designation as a
transference over time is that, if a different trucking firm were to take over
partway through the journey, the replacement firm would not have to re-
perform the freight hauling that has already been completed to date.
EXAMPLE
Maid Marian is a nationwide home cleaning service run by friars within the
Franciscan Order. Its customers both receive and simultaneously consume
the cleaning services provided by its staff. Consequently, the services
provided by Maid Marian are considered to be performance obligations
satisfied over time.

• Immediate enhancement. The seller creates or enhances an asset

controlled by the customer as performance occurs. This asset can be
tangible or intangible.
• No alternative use. The seller’s performance does not create an asset
for which there is an alternative use to the seller (such as selling it to a
different customer). In addition, the contract gives the seller an
enforceable right to payment for the performance that has been
completed to date. A lack of alternative use happens when a contract
restricts the seller from directing the asset to another use, or when
there are practical limitations on doing so, such as the incurrence of
significant economic losses to direct the asset elsewhere. The
determination of whether an asset has an alternative use is made at the
inception of the contract, and cannot be subsequently altered unless
both parties to the contract approve a modification that results in a
substantive change in the performance obligation.
Construction contracts are likely to be designated as being performance
obligations that are transferred over time. Under this approach, they can use
the percentage-of-completion method to recognize revenue, rather than the
completed contract method. This means that they can recognize revenue as a
construction project progresses, rather than waiting until the end of the
project to recognize any revenue.
EXAMPLE
Oberlin Acoustics is contractually obligated to deliver a highly-customized
version of its Rhino brand electric guitar to a diva-grade European rock star.
The contract clearly states that this customized version can only be delivered
to the designated customer, and it is likely that this individual would pursue
legal action if Oberlin were to attempt to sell it elsewhere (such as to the
lead guitarist of a rival band). Also, Oberlin might have to incur significant
costs to reconfigure the guitar for sale to a different customer. In this
situation, there is no alternative use.
However, if Oberlin had instead contracted to deliver one of its standard
Rhino brand guitars, the company could easily transfer the asset to a
different customer, since the products are essentially interchangeable. In this
case, there would be a clear alternative use.
EXAMPLE
Tesla Power Company is hired by a local government to construct one of its
new, compact fusion power plants in the remote hinterlands of Malawi.
There is clearly no alternative use for the power plant, since Tesla would
have to incur major costs to dismantle the facility and truck it out of the
remote area before it could be sold to a different customer. However, the
contract states that 50% of the price will be paid at the end of the contract
period, and there is no enforceable right to any payment; this means that
Tesla must consider its performance obligation to be satisfied as of a point in
time, rather than over time.
EXAMPLE
Hassle Corporation is in talks with a potential acquirer. The acquirer insists
that Hassle have soil tests conducted in the area around its main production
facility, to see if there has been any leakage of pollutants. Hassle engages
Wilson Environmental to conduct these tests, which is a three-month
process. The contract includes a clause that Wilson will be paid for its costs
plus a 20% profit if Hassle cancels the contract. The acquisition talks break
off after two months, so Hassle notifies Wilson that it no longer needs the
environmental report. Since Wilson cannot possibly sell the information it
has collected to a different customer, there is no alternative use. Also, since
Wilson has an enforceable right to payment for all work completed to date,
the company can recognize revenue over time by measuring its progress
toward satisfying the performance obligation.
Measurement of Progress Completion
When a performance obligation is being completed over a period of time, the
seller recognizes revenue through the application of a progress completion
method. The goal of this method is to determine the progress of the seller in
achieving complete satisfaction of its performance obligation. This method is
to be consistently applied over time, and shall be re-measured at the end of
each reporting period.
Note: The method used to measure progress should be applied consistently
for a particular performance obligation, as well as across multiple contracts
that have obligations with similar characteristics. Otherwise, reported
revenue will not be comparable across different reporting periods.
Both output methods and input methods are considered acceptable for
determining progress completion. The method chosen should incorporate due
consideration of the nature of the goods or services being provided to the
customer. The following sub-sections address the use of output and input
methods.
Output Methods
An output method recognizes revenue based on a comparison of the value to
the customer of goods and services transferred to date to the remaining goods
and services not yet transferred. There are numerous ways to measure output,
including:
• Surveys of performance to date
• Milestones reached
• The passage of time
• The number of units delivered
• The number of units produced
Another output method that may be acceptable is the amount of consideration
that the seller has the right to invoice, such as billable hours. This approach
works when the seller has a right to invoice an amount that matches the
amount of performance completed to date.
The number of units delivered or produced may not be an appropriate
output method in situations where there is a large amount of work-in-process,
since the value associated with unfinished goods may be so substantial that
revenue could be materially under-reported.
The method picked should closely adhere to the concept of matching the
seller’s progress toward satisfying the performance obligation. It is not
always possible to use an output method, since the cost of collecting the
necessary information can be prohibitive, or progress may not be directly
observable.
EXAMPLE
Viking Fitness operates a regional chain of fitness clubs that are oriented
toward younger, very athletic people. Members pay a €1,200 annual fee,
which gives them access to all of the clubs in the chain during all operating
hours. In effect, Viking’s performance obligation is to keep its facilities
open for use by members, irrespective of whether they actually use the
facilities. Clearly, this situation calls for measurement of progress
completion based on the passage of time. Accordingly, Viking recognizes
revenue from its annual customer payments at the rate of €100 per member
per month.
Input Methods
An input method derives the amount of revenue to be recognized based on
the to-date effort required by the seller to satisfy a performance obligation
relative to the total estimated amount of effort required. Examples of possible
inputs are costs incurred, labor hours expended, and machine hours used. If
there are situations where the effort expended does not directly relate to the
transfer of goods or services to a customer, do not use that input. The
following are situations where the input used could lead to incorrect revenue
recognition:
• The costs incurred are higher than expected, due to seller
inefficiencies. For example, the seller may have wasted a higher-than-
expected amount of raw materials in the performance of its obligations
under a contract.
• The costs incurred are not in proportion to the progress of the seller
toward satisfying the performance obligation. For example, the seller
might purchase a large amount of materials at the inception of a
contract, which comprise a significant part of the total price.
Tip: If the effort expended to satisfy performance obligations occur evenly
through the performance period, consider recognizing revenue on the
straight-line basis through the performance period.
EXAMPLE
Eskimo Construction is hired to build a weather observatory in Svalbard,
which is estimated to be a six-month project. Utilities are a major concern,
especially since the facility is too far away from the local town of
Longyearbyen for a power line to be run out to it. Accordingly, a large part
of the construction cost is a diesel-powered turbine generator. The total cost
that Eskimo intends to incur for the project is:
The turbine is to be delivered and paid for at the beginning of the
construction project, but will not be incorporated into the facility until late
summer, when the building is scheduled to be nearly complete.
Eskimo intends to use an input method to derive the amount of revenue,
using costs incurred. However, this approach runs afoul of the turbine cost,
since the immediate expenditure for the turbine gives the appearance of the
project being 31.25% complete before work has even begun. Accordingly,
Eskimo excludes the cost of the turbine from its input method calculations,
only using the other costs as the basis for deriving revenue.

The situation described in the preceding example is quite common, since

materials are typically procured at the inception of a contract, rather than
being purchased in equal quantities over the duration of the contract.
Consequently, the accountant should be particularly mindful of this issue and
incorporate it into any revenue recognition calculations based on an input
method.
A method based on output is preferred, since it most faithfully depicts the
performance of the seller under the terms of a contract. However, an input-
based method is certainly allowable if using it would be less costly for the
seller, while still providing a reasonable proxy for the ongoing measurement
of progress.
Change in Estimate
Whichever method is used, be sure to update it over time to reflect changes in
the seller’s performance to date. If there is a change in the measurement of
progress, treat the change as a change in accounting estimate.
A change in accounting estimate occurs when there is an adjustment to
the carrying amount of an asset or liability, or the subsequent accounting for
it. Changes in accounting estimate occur relatively frequently, and so would
require a considerable amount of effort to make an ongoing series of
retroactive changes to prior financial statements. Instead, IFRS only requires
that changes in accounting estimate be accounted for in the period of change
and thereafter. Thus, no retrospective change is required or allowed.
Progress Measurement
It is only possible to recognize the revenue associated with progress
completion if it is possible for the seller to measure the seller’s progress. If
the seller lacks reliable progress information, it will not be possible to
recognize the revenue associated with a contract over time. There may be
cases where the measurement of progress completion is more difficult during
the early stages of a contract. If so, it is allowable for the seller to instead
recognize just enough revenue to recover its costs in satisfying its
performance obligations, thereby deferring the recognition of other revenue
until such time as the measurement system yields more accurate results.
Right of Return
A common right granted to customers is to allow them to return goods to the
seller within a certain period of time following the customer’s receipt of the
goods. This return may take the form of a refund of any amounts paid, a
general credit that can be applied against other billings from the seller, or an
exchange for a different unit. The proper accounting for this right of return
involves three components, which are:
1. Recognize the net amount of revenue to which the seller expects to
be entitled after all product returns have been factored into the sale.
2. A refund liability that encompasses the number of units that the
seller expects to have returned to it.
3. An asset based on the right to recover products from customers who
have demanded refunds. This asset represents a reduction in the cost
of goods sold. The amount is initially based on the former carrying
amount of the inventory, less recovery costs and expected reductions
in the value of the returned products.
This accounting requires the seller to update its assessment of future product
returns at the end of each reporting period, both for the refund liability and
the recovery asset. This update may result in a change in the amount of
revenue recognized.
Note: When a customer exchanges one product for another product with the
same characteristics (such as an exchange of one size shirt for another), this
is not considered a return.
EXAMPLE
Ninja Cutlery sells high-end ceramic knife sets through its on-line store and
through select retailers. All customers pay up-front in cash. In the most
recent month, Ninja sold 5,000 knife sets, which sold for an average price of
€250 each (€1,250,000 in total). The unit cost is €150. Based on the history
of actual returns over the preceding 12-month period, Ninja can expect that
200 of the sets (4% of the total) will be returned under the company’s
returns policy. Recovery costs are immaterial, and Ninja expects to be able
to repackage and sell all returned products for a profit. Based on this
information, Ninja records the following transactions when the knife sets are
originally delivered:

In these entries, the refund liability is calculated as the 200 units expected to
be returned, multiplied by the average price of €250 each. The recovery
asset is calculated as the 200 units expected to be returned, multiplied by the
unit cost of €150.

Consistency
The preceding five steps must be applied consistently to all customer
contracts that have similar characteristics, and under similar circumstances.
The intent is to create a system of revenue recognition that can be relied upon
to yield consistent results.
Contract Modifications
A contract modification occurs when there is a scope or price change to the
contract, and the change is approved by both signatories to the contract.
Other terms may be used for a contract modification, such as a change order.
It is possible that a contract modification exists, despite the presence of a
dispute between the parties concerning scope or price. All of the relevant
facts and circumstances must be considered when determining whether there
is an enforceable contract modification that can impact revenue recognition.
If a change in contract scope has already been approved, but the
corresponding change in price to reflect the scope change is still under
discussion, the seller must estimate the change in price. This estimate is
based on the criteria used to determine variable consideration.
Treatment as Separate Contract
There are circumstances under which a contract modification might be
accounted for as a separate contract. For this to be the case, the following two
conditions must both be present:
• Distinct change. The scope has increased, to encompass new goods or
services that are distinct from those offered in the original contract.
• Price change. The price has increased enough to encompass the
standalone prices of the additional goods and services, adjusted for the
circumstances related to that specific contract.
When these circumstances are met, there is an economic difference between a
modified contract for the additional goods or services and a situation where
an entirely new contract has been created.
EXAMPLE
Blitz Communications is buying one million cell phone batteries from
Creekside Industrial. The parties decide to alter the contract to add the
purchase of 200,000 battery chargers for a price increase of £2.8 million.
The associated price increase includes a 30% discount, which Creekside was
already offering to Blitz under the terms of the original contract. This
contract change reflects a distinct change that adds new goods to the
contract, and includes an associated price change that has been adjusted for
the discount terms of the contract. This contract modification can be
accounted for as a separate contract.
Treatment as Continuing Contract
It may not be possible to treat a contract modification as a separate contract.
If so, there are likely to be goods or services not yet transferred to the
customer as of the modification date. The seller can account for these residual
deliveries using one of the following methods:
• Remainder is distinct. If the remaining goods or services to be
delivered are distinct from those already delivered under the contract,
account for the modification as a cancellation of the old contract and
creation of a new one. In this case, the consideration that should be
allocated to the remaining performance obligations is the sum total of:
o The original consideration promised by the customer but not
yet received; and
o The new consideration associated with the modification.
EXAMPLE
Grizzly Golf Carts, maker of sturdy golf carts for overweight golfers,
contracts with a local suburban golf course to deliver two golf carts for a
total price of €12,000. The carts are different models, but have the same
standalone price, so Grizzly allocates €6,000 of the transaction price to each
cart. One cart is delivered immediately, so Grizzly recognizes €6,000 of
revenue. Before the second cart can be delivered, the golf course customer
requests that a third cart be added to the contract; this is a heftier cart that
has a built-in barbecue grill. The contract price is increased by €8,000,
which is less than the €10,000 standalone price of this model.
Since the second and third carts are distinct from the first cart model, there is
a distinct change in the contract, which necessitates treating the change as a
new contract. Accordingly, the second and third carts are treated as though
they are part of a new contract, with the remaining €14,000 of the
transaction price totally allocated to the new contract.
EXAMPLE
As noted in an earlier example, Nova Corporation contracted with the Deep
Field Scanning Authority to construct two three-meter telescopes. The terms
of the contract included a provision that could increase the allowable price
charged by £250,000, with this price being apportioned equally between the
two telescopes. One month into the contract period, Deep Field completely
alters the configuration of the second telescope, from a reflector to a
catadioptric model. The change is so significant that this telescope can now
be considered a separate contract. However, since the variable price was
already apportioned at the inception of the original contract, the £125,000
allocated to each telescope will continue. This is because the variable
consideration was promised prior to the contract modification.

• Remainder is not distinct. If the remaining goods or services to be

delivered are not distinct from those already delivered under the
contract, account for the modification as part of the existing contract.
This results in an adjustment to the recognized amount of revenue (up
or down) as of the modification date. Thus, the adjustment involves
calculating a change in the amount of revenue recognized on a
cumulative catch-up basis.
EXAMPLE
Domicilio Corporation enters into a contract to construct the world
headquarters building of the International Mushroom Farmers’ Cooperative.
Mushroom requires its architects to be true to the name of the organization,
with the result being a design for a squat, dark building with no windows,
high humidity, and a unique waste recycling system. Domicilio has not
encountered such a design before, and so incorporates a cautious stance into
its assumptions regarding the contract terms.
The contract terms state that Domicilio will be paid a total of €12,000,000,
broken into a number of milestone payments. There is also a €100,000 on-
powered turbine generator. The total cost that Eskimo intends to incur for
the project is:

The project manager anticipates trouble with several parts of the

construction project, and advises strongly against including any part of the
completion bonus in the transaction price.
At the end of seven months, the project manager is surprised to find that
Domicilio is on target to complete the work on time. Also, the company has
completed 65% of its performance obligation, based on the €5,850,000 of
costs incurred to date relative to the total amount of expected costs. Through
this point, the company has recognized the following revenues and costs:

The project manager is still uncomfortable with recognizing any part of the
completion bonus.
With one month to go on the project, the project manager finally allows that
Domicilio will likely complete the project one week early, though he has
completely lost all interest in eating mushrooms. At this point, the company
has completed 92.5% of its performance obligation (based on costs
incurred), so the controller recognizes an additional €92,500 for that portion
of the €100,000 on-time completion bonus that has already been earned.

• Mix of elements. If the remaining goods or services to be delivered are

comprised of a mix of distinct and not-distinct elements, separately
identify the different elements and account for them as per the dictates
of the preceding two methods.
Entitlement to Payment
At all points over the duration of a contract, the seller should have the right to
payment for the performance completed to date, if the customer were to
cancel the contract for reasons other than the seller’s failure to perform. The
amount of this payment should approximate the selling price of the goods or
services transferred to the customer to date; this means that costs are
recovered, plus a reasonable profit margin. This reasonable profit margin
should be one of the following:
• A reasonable proportion of the expected profit margin, based on the
extent of the total performance completed prior to contract
termination; or
• A reasonable return on the cost of capital that the seller has
experienced on its cost of capital for similar contracts, if the margin on
this particular contract is higher than the return the seller typically
generates from this type of contract.
An entitlement to payment depends on contractual factors, such as only being
paid when certain milestones are reached or when the customer is completely
satisfied with a deliverable. There may not be an entitlement to payment if
one of these contractual factors is present. Further, there may be legal
precedents or legislation that may interfere with or bolster an entitlement to
payment. For example:
• There may be a legal precedent that gives the seller the right to
payment for all performance to date, even though this right is not
clarified within the contract terms.
• Legal precedent may reveal that other sellers having similar rights to
payment in their contracts have not succeeded in obtaining payment.
• The seller may not have attempted to enforce its right to payment in
the past, which may have rendered its rights legally unenforceable.
Conversely, the terms of a contract may not legally allow a customer to
terminate a contract. If so, and the customer still attempts to terminate the
contract, the seller may be entitled to continue to provide goods or services to
the customer, and require the customer to pay the amounts stated in the
contract. In this type of situation, the seller has an enforceable right to
payment.
An enforceable right to payment may not match the payment schedule
stated in a contract. The payment schedule does not necessarily sync with the
seller’s right to payment for performance. For example, the customer could
have insisted upon delayed payment dates in the payment schedule in order to
more closely match its ability to make payments to the seller.
EXAMPLE
A customer of Hodgson Industrial Design pays a £50,000 nonrefundable
upfront payment to Hodgson at the inception of a contract to overhaul the
design of the customer’s main product. The customer does not like
Hodgson’s initial set of design prototypes, and cancels the contract. On the
cancellation date, Hodgson’s billable hours on the project sum to £65,000.
Hodgson has an enforceable right to retain the £50,000 it has already been
paid. The right to be paid for the remaining £15,000 depends on the contract
terms and legal precedents.

Bill-and-Hold Arrangements
There is a bill-and-hold arrangement between a seller and customer when the
seller bills the customer, but initially retains physical possession of the goods
that were sold; the goods are transferred to the customer at a later date. This
situation may arise if a customer does not initially have the storage space
available for the goods it has ordered.
In a bill-and-hold arrangement, the seller must determine when the
customer gains control of the goods, since this point in time indicates when
the seller can recognize revenue. Customer control can be difficult to discern
when the goods are still located on the premises of the seller. The following
are indicators of customer control:
• The customer can direct the use of the goods, no matter where they are
located
• The customer can obtain substantially all of the remaining benefits of
the goods
Further, the following conditions must all be present for the seller to
recognize revenue under a bill-and-hold arrangement:
• Adequate reason. There must be a substantive reason why the seller is
continuing to store the goods, such as at the direct request of the
customer.
• Alternate use. The seller must not be able to redirect the goods, either
to other customers or for internal use.
• Complete. The product must be complete in all respects and ready for
transfer to the customer.
• Identification. The goods must have been identified specifically as
belonging to the customer.
Under a bill-and-hold arrangement, the seller may have a performance
obligation to act as the custodian for the goods being held at its facility. If so,
the seller may need to allocate a portion of the transaction price to the
custodial function, and recognize this revenue over the course of the custodial
period.
EXAMPLE
Micron Metallic operates stamping machines that produce parts for washing
machines. Micron’s general manager has recently decided to implement the
just-in-time philosophy throughout the company, which includes sourcing
goods with suppliers who are located as close to Micron as possible. One of
these suppliers is Horton Corporation, which designs and builds stamping
machines for Micron. In a recent contract, Micron buys a customized
stamping machine and a set of spare parts intended for that machine. Since
Micron is implementing just-in-time concepts, it does not want to store the
spare parts on its premises, and instead asks Horton to store the parts in its
facility, which is just down the street from the Micron factory.
Micron’s receiving staff travels to the Horton facility to inspect the parts and
formally accepts them. Horton also sets them aside in a separate storage
area, and flags them as belonging to Micron. Since the parts are customized,
they cannot be used to fulfill any other customer orders. Under the just-in-
time system, Horton commits to having the parts ready for delivery to
Micron within ten minutes of receiving a shipping order.
The arrangement can clearly be defined as a bill-and-hold situation.
Consequently, Horton should apportion the transaction price between the
stamping machine, the spare parts, and the custodial service involved in
storing the parts on behalf of Micron. The revenue associated with the
machine and parts can be recognized at once, while the revenue associated
with the custodial service can be recognized with the passage of time.

Consideration Received from a Supplier

A supplier may pay consideration to its customer, which may be in the form
of cash, credits, coupons, and so forth. The customer can then apply this
consideration to payments that it owes to the supplier, thereby reducing its
net accounts payable.
The proper accounting for this type of consideration is to reduce the
purchase price of the goods or services that the customer is acquiring from
the supplier in the amount of the consideration received. If the consideration
received relates to the customer attaining a certain amount of purchasing
volume with the supplier (i.e., a volume discount), recognize the
consideration as a reduction of the purchase price of the underlying
transactions. This recognition can be made if attainment of the consideration
is both probable and can be reasonably estimated. If these criteria cannot be
met, then wait for the triggering milestones, and recognize them as the
milestones are reached. Factors that can make it more difficult to determine
whether this type of consideration is probable or reasonably estimated
include:
• Duration. The relationship between the consideration to be received
and purchase amounts spans a long period of time.
• Experience. The customer has no historical experience with similar
products, or cannot apply its experience to changing circumstances.
• External factors. External factors can influence the underlying activity,
such as changes in demand.
• Prior adjustments. It has been necessary to make significant
adjustments to similar types of expected consideration in the past.
EXAMPLE
Puller Corporation manufactures plastic door knobs. Its primary raw
material is polymer resin, which it purchases in pellet form from a regional
chemical facility. Puller will receive a 2% volume discount if it purchases at
least €500,000 of pellets from the supplier by the end of the calendar year.
Puller has a long-term relationship with this supplier, has routinely earned
the discount for the last five years, and plans to place orders in this year that
will comfortably exceed the €500,000 mark. Accordingly, Puller accrues the
2% discount as a reduction of the purchase price of its pellet purchases
throughout the year.
EXAMPLE
Puller has just entered into a new relationship with another supplier that will
deliver black dye to the factory for inclusion in all of the company’s black
door knob products. This supplier offers a 5% discount if purchases exceed
€50,000 for the calendar year. Puller has not sold this color of door knob
before and so has no idea of what customer demand may be. Given the high
level of uncertainty regarding the probability of being awarded the discount,
Puller elects to record all purchases at their full price, and will re-evaluate
the probability of attaining the discount as the year progresses.

The only exceptions to this accounting are:

• When the customer specifically transfers an asset to the supplier in
exchange. If so, the customer treats the transaction as it would any sale
 to one of its customers in the normal course of business. If the amount
paid by the supplier is higher than the standalone selling price of the
item transferred to the supplier, the customer should account for the
excess amount as a reduction of the purchase price of any goods or
services received from the supplier.
• The supplier is reimbursing the customer for selling costs that the
customer incurred to sell the supplier’s products to third parties. If so,
the amount of cash received is used to reduce the indicated selling
costs. If the amount paid by the supplier is greater than the amount for
which the customer applied for reimbursement, record the excess as a
reduction of the cost of sales.
• The consideration is related to sales incentives offered by
manufacturers who are selling through a reseller. When the reseller is
receiving compensation in exchange for honoring incentives related to
the manufacturer’s products, the reseller records the amount received
as a reduction of its cost of sales. This situation only arises when all of
the following conditions apply:
o The customer can tender the incentive to any reseller as part of
its payment for the product;
o The reseller receives reimbursement from the manufacturer
based on the face amount of the incentive;
o The reimbursement terms to the reseller are only determined
from the incentive terms offered to consumers; they are not
negotiated between the manufacturer and reseller; and
o The reseller is an agent of the manufacturer in regard to the
sales incentive transaction.
If only a few or none of these criteria are met for a sales incentive offered by
a manufacturer, account for the transaction as a reduction of the purchase
price of the goods or services that the reseller acquired from the
manufacturer. If all of the criteria are met, consider the transaction to be a
revenue-generating activity for the reseller.
Customer Acceptance
A customer may include an acceptance clause in a contract with a seller. An
acceptance clause states that the customer has the right to inspect goods and
reject them or demand proper remedial efforts before formal acceptance.
Normally, customer control over goods occurs as soon as this acceptance step
has been completed.
 There are situations in which the seller can determine that control has
passed to a customer, even if a formal acceptance review has not yet taken
place. This typically occurs when customer acceptance is based upon a
delivery meeting very specific qualifications, such as certain dimension or
weight requirements. If the seller can determine in advance that these criteria
have been met, it can recognize revenue prior to formal customer acceptance.
If the seller cannot determine in advance that a customer will accept the
delivered goods, it must wait for formal acceptance before it can confirm that
the customer had taken control of the delivery, which then triggers revenue
recognition.
EXAMPLE
Stout Tanks, Inc. manufactures scuba tanks, which it sells in bulk to a large
customer in Bonaire, Drive-Thru Scuba. Drive-Thru insists upon a complete
hydrostatic test of each tank before accepting delivery, since an exploding
air tank is a decidedly terminal experience for a diver wearing the tank.
Stout decides to conducts its own hydrostatic test of every tank leaving its
factory. Since Stout is conducting the same test as Drive-Thru, Stout can
reasonably establish that customer acceptance has occurred as soon as the
scuba tanks leave its factory. As such, Stout can recognize revenue on the
delivery date, and not wait for Drive-Thru to conduct its test.

Even if a customer recognizes revenue in advance of formal customer

acceptance, it may still be necessary to determine whether there are any
remaining performance obligations to which a portion of the transaction price
should be allocated. For example, a seller may have an obligation to not only
manufacture production equipment, but also to install it at the customer site.
This later step could be considered a separate performance obligation.
A variation on the customer acceptance concept is when a seller delivers
goods to a customer for evaluation purposes. In this case, the customer has no
obligation to accept or pay for the goods until the end of a trial period, so
control cannot be said to have passed to the customer until such time as the
customer accepts the goods or the trial period ends.
Customer Options for Additional Purchases
A seller may offer customers a number of ways in which to obtain additional
goods or services at reduced rates or even for free. For example, the seller
may offer a discount on a contract renewal, award points to frequent buyers,
host periodic sales events, and so on.
 When a contract grants a customer the right to acquire additional goods or
services at a discount, this can be considered a performance obligation if the
amount is material and the customer is essentially paying in advance for
future goods or services. In this case, the seller recognizes revenue associated
with the customer option when:
• The option expires; or
• The future goods or services are transferred to the customer.
If revenue is to be recognized for such an option, allocate the transaction
price to the option based on the relative standalone price of the option. In the
likely event that the standalone selling price of the option is not directly
observable, use an estimate of its price. The derivation of this estimate should
include the discount that the customer would obtain by exercising the option,
adjusted for the following two items:
• Reduced by the amount of any discount that the customer could have
received without the option, such as a standard ongoing discount
offered to all customers; and
• The probability that the customer will not exercise the option.
A material right to additional purchases of goods or services is not considered
to have been passed to a customer if the option is at a price that reflects the
standalone selling price of a good or service. In this case, there is no
particular advantage being granted to the customer, since it could just as
easily purchase the goods or services at the same price, even in the absence of
the option.
EXAMPLE
Twister Vacuum Company sells its top-of-the-line F5 vacuum cleaner to 50
customers for €800 each. As part of each sale, Twister gives each customer a
discount code that, if used, gives the customer a 50% discount on the
purchase of Twister’s F1 hand-held vacuum cleaner, which normally sells
for €100. The discount expires in 60 days.
In order to determine the standalone selling price of the discount code,
Twister estimates (based on past experience) that 30% of all customers will
use the code to purchase the F1 model. This means that the standalone
selling price of the discount code is €15, which is calculated as follows:
€100 F1 standalone price × 50% discount × 30% probability of
code usage = €15
The combined standalone selling prices of the F5 vacuum and the discount
code sum to €815. Twister uses this information to allocate the €800
transaction price between the product and the discount code, using the
following calculation:

This allocation means that Twister can recognize €785.28 of revenue

whenever it completes a performance obligation related to the sale of the F5
units to the 50 customers. Twister also allocates €14.72 to the discount code
and recognizes the revenue associated with this item either when it is
redeemed by a customer in the purchase of an F1 vacuum cleaner, or when
the code expires.
EXAMPLE
Sojourn Hotel has a customer loyalty program that grants customers one
loyalty point for each night that they stay in a Sojourn-affiliated hotel. Each
loyalty point can be redeemed to reduce another stay at a Sojourn hotel by
€5. If not used, the points expire after 24 months. During the most recent
reporting period, customers earn 60,000 loyalty points on €2,000,000 of
customer purchases. Based on past experience, Sojourn expects 60% of the
points to be redeemed. Based on the likelihood of redemption, each point is
worth €3 (calculated as €5 redemption value × 60% probability of
redemption), so all of the points awarded are worth €180,000 (calculated as
€3/ point × 60,000 points issued).
The loyalty points program gives a material right to customers that they
would not otherwise have had if they had not stayed at a Sojourn hotel (i.e.,
entered into a contract with Sojourn). Thus, Sojourn concludes that the
issued points constitute a performance obligation. Sojourn then allocates the
€2,000,000 of customer purchases for hotel rooms to the hotel room product
and the points awarded based on their standalone selling prices, based on the
following calculations:

The €165,138 allocated to loyalty points is initially recorded as a contract

liability. The €1,834,862 allocated to hotel rooms is recognized as revenue,
since Sojourn has completed its performance obligation related to these
overnight stays.
As of the end of the next quarterly period, Sojourn finds that 8,000 of the
loyalty points have been redeemed, so it recognizes revenue related to the
loyalty points of €22,018 (calculated as 8,000 points ÷ 60,000 points ×
€165,138).

Licensing
A seller may offer a license to use intellectual property owned by the seller.
Examples of licensing arrangements are:
• Licensing to use software
• Licensing to listen to music
• Licensing to view a movie
• Franchising the name and processes of a restaurant
• Licensing of a book copyright to republish the book
• Licensing to use a patent within a product
If a contract contains both a licensing agreement and a provision to provide
goods or services to the customer, the seller must identify each performance
obligation within the contract and allocate the transaction price to each one.
If the licensing agreement can be separated from the other elements of a
contract, the seller must decide whether the license is being transferred to the
customer over a period of time, or as of a point in time. A key point in
making this determination is whether the license is intended to give the
customer access to the intellectual property of the seller only as of the point
in time when the license is granted, or over the duration of the license period.
The first case would indicate that the revenue associated with the license is
recognized as of a point in time, while the second case would indicate that the
revenue is recognized over a period of time.
A license is more likely to have been granted as of a point in time when a
customer can direct the use of a license and obtain substantially all of the
remaining benefits from the license on the date when the license is granted to
it. This will not be the case if the intellectual property to which the customer
has rights continues to change throughout the license period, which occurs
when the seller continues to engage in activities that significantly affect its
intellectual property.
The intent of the seller of a license is to provide the customer with the
right to access its intellectual property when the seller commits to update the
property, the customer will be exposed to the effects of those updates, and the
updates do not result in the transfer of a good or service to the customer.
These conditions may not be stated in a contract, but could be inferred from
the seller’s customary business practices. For example, if the customer pays
the seller a royalty based on its sales of products derived from intellectual
property provided by the seller, this implies that the seller will be updating
the underlying intellectual property. If these conditions are present, the
associated revenue should be recognized over time, rather than as of a point
in time.
If the facts and circumstances of a contract indicate that the revenue
associated with a contract should be recognized as of a point in time, this
does not mean that the revenue can be recognized prior to the point in time
when the customer can use and benefit from the license. This date may be
later than the commencement date of the underlying contract. For example,
the license to use intellectual property may be granted, but the actual property
may not yet have been delivered to the customer or activated.
If it is not possible to separate the licensing agreement from the other
components of a contract, account for them as a single performance
obligation. An example of when this situation arises is when a license is
integrated into a tangible product to such an extent that the product cannot be
used without the license.
Note: A guarantee by the seller that it will defend a patent from
unauthorized use is not considered a performance obligation.
A contract under which there is a right to use a license may include the
payment of a royalty to the seller. This arrangement may occur, for example,
when the customer is acting as a distributor to re-sell the licensed intellectual
property to other parties. In this situation, the seller may only recognize the
royalty as revenue as of the later of these two events:
• The subsequent sale to or usage by the third party has occurred; or
• The underlying performance obligation associated with the royalty has
been satisfied.
EXAMPLE
Territorial Lease Corporation (TLC) has spent years accumulating a massive
database of oil and gas leases throughout Scandinavia. It sells this
information to oil and gas exploration companies, which use it to derive the
prices at which they are willing to bid for oil and gas leases. TLC sells the
information in three ways, which are:
• It sells a CD that contains lease information that is current as of the
 ship date. TLC does not issue any further updates to customers.
Since TLC does not update the intellectual property, the associated
revenue recognition can be considered to occur as of a point in time,
which is the delivery date of the CD.
• The company also sells subscriptions to an on-line database of lease
information, which it updates every day. Since TLC is continually
upgrading the database, the recognition of revenue is considered to
take place over time. Accordingly, TLC recognizes revenue over the
term of the subscriptions it sells.
• TLC sells its lease information to another company, Enviro
Consultants, which repurposes the information for the environmental
remediation industry. The information is billed to the customers of
Enviro, and Enviro pays TLC a 50% royalty once Enviro receives
payment from its customers. Since the subsequent sale of the
information has occurred by the time TLC receives royalty
payments, it can recognize the payments as revenue upon receipt.

Nonrefundable Upfront Fees

In some types of contracts, it is customary for the seller to charge a customer
a nonrefundable upfront fee. Examples of these fees are:
• Health club member ship fee
• Phone service activation fee
• Long-term contract setup fee
There may be a performance obligation associated with these fees. In some
cases, it could actually relate to an activity that the seller completes at the
beginning of a contract. However, this activity rarely relates to the fulfillment
of a performance obligation by the seller, and simply represents an
expenditure. Consequently, the most appropriate treatment of this fee is to
recognize it as revenue when the goods or services stated in the contract are
provided to the customer. Several additional issues to consider are:
• Recognition period. If the seller grants the customer a material option
to renew the contract, the revenue recognition period associated with
the upfront fee is extended over the additional contract term.
• Setup costs. It is possible that the costs incurred to set up a contract are
an asset, which should be charged to expense over the course of the
contract.
EXAMPLE
Providence Alarm Systems offers its customers a home monitoring system
that includes a £200 setup fee and a monthly £35 charge to monitor their
homes through an alarm system, for a minimum one-year period. Providence
does not charge the setup fee again if a customer chooses to renew.
The setup activities that Providence engages in do not transfer a good or
service to customers, and so do not create a performance obligation. Thus,
the upfront fee can be considered an advance payment relating to the
company’s monthly monitoring activities. Providence should recognize the
£200 fee over the initial one-year monitoring period, as services are
provided.

Principal versus Agent

There are situations where the party providing goods or services to a
customer is actually arranging to have another party provide the goods and
services. In this case, the party is an agent, not the principal party acting as
seller. Use the following rules to differentiate between the two concepts of
principal and agent:

The differentiation between principal and agent is of some importance, for a

principal recognizes the gross amount of a sale, while an agent only
recognizes the fee or commission it earns in exchange for its participation in
the transaction. This fee or commission may be the net amount remaining
after the agent has paid the principal the amount billed for its goods or
services provided to the customer.
In a situation where the seller is initially the principal in a transaction but
then hands off the performance obligation to a third party, the seller should
not recognize the revenue associated with the performance obligation.
Instead, the seller may have assumed the role of an agent.
EXAMPLE
High Country Vacations operates a website that puts prospective vacationers
in touch with resorts located in ski towns around the world. When a
vacationer purchases a hotel room on the website, High Country takes a 15%
commission from the resort where the hotel room is located. The resort sets
the prices for hotel rooms. High Country is not responsible for the actual
provision of hotel rooms to vacationers.
Since High Country does not control the hotel rooms being provided, is
arranging for the provision of services by a third party, does not maintain an
inventory of rooms, cannot establish prices, and is paid a commission, the
company is clearly an agent in these transactions. Consequently, High
Country should only recognize revenue in the amount of the commissions
paid to it, not the amount paid by vacationers for their hotel rooms.
EXAMPLE
Dirt Cheap Tickets sells discounted tickets for cruises with several
prominent cruise lines. The company purchases tickets in bulk from cruise
lines and must pay for them, irrespective of its ability to re-sell the tickets to
the public. Dirt Cheap can alter the prices of the tickets that it purchases,
which typically means that the company gradually lowers prices as cruise
dates approach, in order to ensure that its excess inventory of tickets is sold.
There is no credit risk, since tickets are paid for at the point of purchase. If
customers have issues with the cruise lines, Dirt Cheap will intercede on
their behalf, but generally encourages them to go directly to the cruise lines
with their complaints.
Based on its business model, Dirt Cheap is acting as the principal. It controls
the goods being sold, has inventory risk, and actively alters prices.
Consequently, Dirt Cheap can recognize revenue in the gross amount of the
tickets sold.

Repurchase Agreements
A repurchase agreement is a contract in which the seller agrees to sell an
asset and either promises or has the option to repurchase the asset. The asset
that the seller repurchases can be the original asset sold, a substantially
similar asset, or an asset of which the original unit is a part. There are three
variations on the repurchase agreement:
• Forward. The seller has an obligation to repurchase the asset.
• Call option. The seller has the right to repurchase the asset.
• Put option. The seller has an obligation to repurchase the asset if
 required to by the customer.
If the contract is essentially a forward or call option, the customer never gains
control of the asset, since the seller can or will take it back. Given the
circumstances, revenue recognition can vary as follows:
• Reduced repurchase price. If the seller either can or must repurchase
the asset for an amount less than the original selling price (considering
the time value of money), the seller accounts for the transaction as a
lease.
• Same or higher repurchase price. If the seller either can or must
repurchase the asset for an amount equal to or greater than the original
selling price (considering the time value of money), the seller accounts
for the transaction as a financing arrangement.
• Sale-leaseback. If the transaction is a sale-leaseback arrangement, the
seller accounts for the transaction as a financing arrangement.
When a customer has a put option, the proper accounting depends upon the
market price of the asset and the existence of a sale-leaseback arrangement.
The alternatives are:
• Incentive to exercise option. If the customer has a significant economic
incentive to exercise the option, the seller accounts for the transaction
as a lease. Such an incentive would exist, for example, when the
repurchase price exceeds the expected market value of an asset
through the period when the put option can be exercised (considering
the time value of money).
• No incentive to exercise option. If the customer does not have an
economic incentive to exercise a put option, the seller accounts for the
agreement as a sale of a product with a right of return.
• Sale-leaseback. Even if the seller has a significant economic incentive,
as noted in the last bullet point, if the arrangement is a sale-leaseback
arrangement, the seller accounts for it as a financing arrangement.
• Higher repurchase price. If the repurchase price is equal to or higher
than the selling price and is more than the asset’s expected market
value (considering the time value of money), the seller accounts for it
as a financing arrangement.
• Higher repurchase price with no incentive. In the rare case where the
repurchase price is equal to or higher than the original purchase price,
but is less than or equal to the expected market value of the asset
(considering the time value of money), this indicates that the customer
 has no economic incentive to exercise the option. In this case, the
seller accounts for the transaction as a sale of a product with a right of
return.
When the seller accounts for a transaction as a financing arrangement, the
seller continues to recognize the asset, as well as a liability for any
consideration it has received from the customer. The difference between the
amount of consideration paid by and due to the customer is to be recognized
as interest and processing (or related) costs.
If a call option or put option expires without being exercised, the seller
can derecognize the repurchase liability and recognize revenue instead.
EXAMPLE
Domicilio Corporation sells a commercial property to Mole Industries for
€3,000,000 on March 1, but retains the right to repurchase the property for
€3,050,000 on or before December 31 of the same year. This transaction is a
call option.
Control over the property does not pass to Mole Industries until after the
December 31 termination date of the call option, since Domicilio can
repurchase the asset. In the meantime, Domicilio accounts for the
arrangement as a financing transaction, since the exercise price exceeds the
amount of Mole’s purchase price. This means that Domicilio retains the
asset in its accounting records, records the €3,000,000 of cash received as a
liability, and recognizes interest expense of €50,000 over the intervening
months, which gradually increases the amount of the liability to €3,050,000.
On December 31, Domicilio lets the call option lapse; it can now
derecognize the liability and recognize €3,050,000 of revenue.
EXAMPLE
Assume the same transaction, except that the option is a requirement for
Domicilio to repurchase the property for €2,900,000 at the behest of the
customer, Mole Industries. This is a put option. The market value by the end
of the year is expected to be lower than €2,900,000.
At the inception of the contract, it is apparent that Mole will have an
economic incentive to exercise the put option, since it can earn more from
exercising the option than from retaining the property. This means that
control over the property does not really pass to Mole. In essence, then, the
transaction is to be considered a lease.

Unexercised Rights of Customers

A customer may prepay for goods or services to be delivered at a later date,
which the seller initially records as a liability, and later as revenue when the
goods or services are delivered. However, what if the customer does not
exercise all of its rights to have goods or services delivered? The unexercised
amount of this prepayment may be referred to as breakage.
The amount of breakage associated with a customer prepayment should
be recognized as revenue. The question is, when should the recognition
occur? There are two possible scenarios:
• Existing pattern. If there is a historical pattern of how a customer
exercises the rights associated with its prepayments, the seller can
estimate the amount of breakage likely to occur, and recognize it in
proportion to the pattern of rights exercised by the customer.
• No expectation. If there is no expectation that the seller will be entitled
to any breakage, the seller recognizes revenue associated with
breakage only when there is a remote likelihood that the customer will
exercise any remaining rights.
No revenue related to breakage should be recognized if it is probable that
such recognition will result in a significant revenue reversal at a later date.
In a situation where there are unclaimed property laws, the seller is
legally required to remit breakage to the applicable government entity. In this
case, the breakage is recorded as a liability (rather than revenue), which is
cleared from the seller’s books when the funds are remitted to the
government.
EXAMPLE
Clyde Shotguns receives a €10,000 deposit from a customer, to be used for
the construction of a custom-made shotgun. Clyde completes the weapon
and delivers it to the customer, recognizing €9,800 of revenue based on the
number of billable hours expended. Clyde notifies the customer of the
residual deposit amount, but the customer does not respond, despite repeated
attempts at communication. Under the escheatment laws of the local state
government, Clyde is required to remit these residual funds to the state if
they have not been claimed within three years. Accordingly, Clyde initially
records the €200 as an escheatment liability, and pays over the funds to the
government once three years have passed.

Warranties
A warranty is a guarantee related to the performance of delivered goods or
services. If related to a product, the seller typically guarantees the
replacement or repair of the delivered goods. If related to a service, the
warranty may involve replacement services, or a full or partial refund.
If a customer has the option to separately purchase a warranty, this is to
be considered a distinct service to be provided by the seller. As such, the
warranty is to be considered a separate performance obligation, with a portion
of the transaction price allocated to it. If there is no option for the customer to
separately purchase a warranty, the warranty is instead considered an
obligation of the seller, in which case the following accounting applies:
• Accrue a reserve for product warranty claims based on the prior
experience of the business. In the absence of such experience, the
company can instead rely upon the experience of other entities in the
same industry. If there is considerable uncertainty in regard to the
amount of projected product warranties, it may not be possible to
record a product sale until the warranty period has expired or more
experience has been gained with customer claims.
• Adjust the reserve over time to reflect changes in prior and expected
experience with warranty claims. This can involve a credit to earnings
if the amount of the reserve is too large, and should be reduced.
• If there is a history of minimal warranty expenditures, there is no need
to accrue a reserve for product warranty claims.
A warranty may provide a customer with a service, as well as a guarantee that
provided goods or services will function as claimed. Consider the following
items when determining whether a service exists:
• Duration. The time period needed to discover whether goods or
services are faulty is relatively short, so a long warranty period is
indicative of an additional service being offered.
• Legal requirement. There is a legal requirement to provide a warranty,
in which case the seller is more likely to just be offering the mandated
warranty without an additional service.
• Tasks. If the warranty requires the seller to perform specific tasks that
are identifiable with the remediation of faulty goods or services, there
is unlikely to be any additional identifiable service being offered.
If an additional service is being offered through a warranty, consider this
service to be a performance obligation, and allocate a portion of the
transaction price to that service. If the seller cannot reasonably account for
this service separately, instead account for both the assurance and service
aspects of the warranty as a bundled performance obligation.
There may be a legal obligation for the seller to compensate its customers
if its goods or services cause harm. If so, this is not considered a performance
obligation. Instead, this legal obligation is considered a loss contingency. A
loss contingency arises when there is a situation for which the outcome is
uncertain, and which should be resolved in the future, possibly creating a
loss. For example, there may be injuries caused by a company’s products
when it is discovered that lead-based paint has been used on toys sold by the
business.
When deciding whether to account for a loss contingency, the basic
concept is to only record a loss that is probable and for which the amount of
the loss can be reasonably estimated. If the best estimate of the amount of the
loss is within a range, accrue whichever amount appears to be a better
estimate than the other estimates in the range. If there is no “better estimate”
in the range, accrue a loss for the minimum amount in the range.
If it is not possible to arrive at a reasonable estimate of the loss associated
with an event, only disclose the existence of the contingency in the notes
accompanying the financial statements. Or, if it is not probable that a loss
will be incurred, even if it is possible to estimate the amount of a loss, only
disclose the circumstances of the contingency without accruing a loss.
If the conditions for recording a loss contingency are initially not met, but
then are met during a later accounting period, the loss should be accrued in
the later period. Do not make a retroactive adjustment to an earlier period to
record a loss contingency.
Contract-Related Costs
Thus far, the discussion has centered on the recognition of revenue – but
what about the costs that an organization incurs to fulfill a contract? In this
section, we separately address the accounting for the costs incurred to
initially obtain a contract, costs incurred during a contract, and how these
costs are to be charged to expense.
Costs to Obtain a Contract
An organization may incur certain costs to obtain a contract. If so, it is
allowable to record these costs as an asset, and amortize them over the life of
the contract. The following conditions apply:
• The costs must be incremental; that is, they would not have been
incurred if the organization had not obtained the contract.
• If the amortization period will be one year or some lesser period, it is
 allowable to simply charge these costs to expense as incurred.
• There is an expectation that the costs will be recovered.
An example of a contract-related cost that could be recorded as an asset and
amortized is the sales commission associated with a sale, though as a
practical expedient it is usually charged to expense as incurred.
EXAMPLE
A water engineering firm bids on a contract to investigate the level of silt
accumulation in the Charlottenburg Canal in Germany, and wins the bid.
The firm incurs the following costs as part of its bidding process.

The firm must charge the staff time, printing fees, and travel costs to
expense as incurred, since it would have incurred these expenses even if the
bid had failed. Only the commissions paid to the sales staff can be
considered a contract asset, since that cost should be recovered through its
future billings for consulting services.
Costs to Fulfill a Contract
In general, any costs required to fulfill a contract should be recognized as
assets, as long as they meet all of these criteria:
• The costs are tied to a specific contract;
• The costs will be used to satisfy future performance obligations; and
• There is an expectation that the costs will be recovered.
Costs that are considered to relate directly to a contract include the following:
• Direct labor. Includes the wages of those employees directly engaged
in providing services to the customer.
• Direct materials. Includes the supplies consumed in the provision of
services to the customer.
• Cost allocations. Includes those costs that relate directly to the
contract, such as the cost of managing the contract, project
supervision, and depreciation of the equipment used to fulfill the
contract.
• Chargeable costs. Includes those costs that the contract explicitly
states can be charged to the customer.
• Other costs. Includes costs that would only be incurred because the
 seller entered into the contract, such as payments to subcontractors
providing services to the customer.
Other costs are to be charged to expense as incurred, rather than being
classified as contract assets. These costs include:
• Administration. General and administrative costs, unless the contract
terms explicitly state that they can be charged to the contract.
• Indistinguishable. Costs for which it is not possible to determine
whether they relate to unsatisfied or satisfied performance obligations.
In this case, the default assumption is that they relate to satisfied
performance obligations.
• Past performance costs. Any costs incurred that relate to performance
obligations that have already been fulfilled.
• Waste. The costs of resources wasted in the contract fulfillment
process, which were not included in the contract price.
EXAMPLE
Tele-Service International enters into a contract to take over the phone
customer service function of Artisan’s Delight, a manufacturer of hand-
woven wool shopping bags. Tele-Service incurs a cost of €50,000 to
construct an interface between the inventory and customer service systems
of Artisan’s Delight and its own call database. This cost relates to activities
needed to fulfill the requirements of the contract, but does not result in the
provision of any services to Artisan’s Delight. This cost should be amortized
over the term of the contract.
Tele-Service assigns four of its employees on a full-time basis to handle
incoming customer calls from Artisan’s customers. Though this group is
providing services to the customer, it is not generating or enhancing the
resources of Tele-Service, and so its cost cannot be recognized as an asset.
Instead, the cost of these employees is charged to expense as incurred.
Amortization of Costs
When contract-related costs have been recognized as assets, they should be
amortized on a systematic basis that reflects the timing of the transfer of
related goods and services to the customer. If there is a change in the
anticipated timing of the transfer of goods and services to the customer,
update the amortization to reflect this change. This is considered a change in
accounting estimate.
Impairment of Costs
The seller should recognize an impairment loss in the current period when the
carrying amount of an asset associated with a contract is greater than the
remaining payments to be received from the customer. The calculation is:
Remaining consideration to be received – Costs not yet recognized as
expenses
= Impairment amount (if result is a negative figure)
Note: When calculating possible impairment, adjust the amount of the
remaining consideration to be received for the effects of the customer’s
credit risk.
At a later date, if the conditions causing the original impairment have
improved or no longer exist, it is allowable to reverse some or all of the
impairment loss. The amount of this impairment loss reversal cannot exceed
the amount of the original impairment, net of any subsequent amortization.
Exclusions
The revenue recognition rules contained within IFRS 15 do not apply to the
following areas, for which more specific recognition standards apply:
• Lease contracts
• Insurance contracts
• Financial instruments involving receivables, investments, liabilities,
debt, derivatives, hedging, or transfers and servicing
• Guarantees, not including product or service warranties
• Nonmonetary exchanges between entities in the same line of business,
where the intent is to facilitate sales transactions to existing or
potential customers
EXAMPLE
Two distributors of heating oil swap stocks of different grades of heating oil,
so that they can better meet the forecasted demand of their customers. No
revenue recognition occurs in this situation, since the two parties are in the
same line of business and the intent of the transaction is to facilitate sales to
potential customers.

Since IFRS 15 only applies to contracts with customers, there are a number
of transactions that do not incorporate these elements, and so are not covered
by the provisions of this Topic. Consequently, the following transactions and
events are not covered:
• Dividends received
 • Non-exchange transactions, such as donations received
• Changes in regulatory assets and liabilities caused by alternative
revenue programs for rate-regulated entities
Revenue Disclosures
There are a number of disclosures related to revenue. As a general overview,
the intent of the disclosures is to reveal enough information so that readers
will understand the nature of the revenue, the amount being recognized, the
timing associated with its recognition, and the uncertainty of the related cash
flows. More specifically, disclosures are required in the following three areas
for both annual and interim financial statements:
• Contracts. Disclose the amount of revenue recognized, any revenue
impairments, the disaggregation of revenue, performance obligations,
contract balances, and the amount of the transaction price allocated to
the remaining performance obligations. Contract balances should
include beginning and ending balances of receivables, contract assets,
and contract liabilities. In particular:
o Revenue. Separately disclose the revenue recognized from
contracts with customers.
o Impairment losses. Separately disclose any impairment losses
on receivables or contract assets that arose from contracts with
customers. These disclosures must be separated from the
disclosure of losses from other types of contracts.
o Disaggregation. Disaggregate the reported amount of revenue
recognized into categories that reflect the nature, amount,
timing, and uncertainty of cash flows and revenue. Examples
are:
■ By contract type (such as by cost-plus versus fixed-
price contract)
■ By country or region
■ By customer type (such as by retail versus government
customer)
■ By duration of contract
■ By major product line
■ By market
■ By sales channels (such as by Internet store, retail chain,
or wholesaler)
■ By transfer timing (such as sales as of a point in time
 versus over time)
The nature of this disaggregation may be derived from how
the organization discloses information about revenue in other
venues, such as within annual reports, in presentations to
investors, or when being evaluated for financial performance
or resource allocation judgments. If the entity is publicly-held
and therefore reports segment information, consider how the
reporting of disaggregated revenue information might relate to
the revenue information reported for segments of the business.
It is also allowable for certain non-public entities to not
disaggregate revenue information, but only if this disclosure is
replaced by the disclosure of revenue by the timing of
transfers to customers, and with a discussion of how economic
factors (such as contract types or customer types) impact the
nature, amount, timing, and uncertainty of cash flows and
revenue.
EXAMPLE
Lowry Locomotion operates a number of business segments generally
related to different types of trains. It compiles the following information for
its disaggregation disclosure:

o Contract-related. The disclosure of contract balances for all

entities shall include the opening and closing balances of
receivables, contract assets, and contract liabilities. Publicly-
held and certain other entities must provide considerably more
 information. This includes:
■ Revenue recognized in the period that was included in
the contract liability at the beginning of the period, and
revenue recognized in the period from performance
obligations at least partially satisfied in previous
periods (such as from changes in transaction prices).
■ How the timing of the completion of performance
obligations relates to the timing of payments from
customers and the impact this has on the balances of
contract assets and contract liabilities.
■ Explain significant changes in the balances of contract
assets and contract liabilities in the period. Possible
causes to discuss might include changes caused by
business combinations, impairments, or cumulative
catch-up adjustments.
o Performance obligations. Describe the performance
obligations related to contracts with customers, which should
include the timing of when these obligations are typically
satisfied (such as upon delivery), significant payment terms,
the presence of any significant financing components, whether
consideration is variable, and whether the consideration may
be constrained. Also note the nature of the goods or services
being transferred, and describe any obligations to have a third
party transfer goods or services to customers (as is the case in
an agent relationship). Finally, describe any obligations related
to returns, refunds, and warranties.
o Price allocations. If there are remaining performance
obligations to which transaction prices are to be allocated,
disclose the aggregate transaction price allocated to those
unsatisfied obligations. Also note when this remaining
revenue is likely to be recognized, either in a qualitative
discussion or by breaking down the amounts to be recognized
by time band. None of these disclosures are needed if the
original expected duration of a contract’s performance
obligation is for less than one year. Also, certain non-public
entities can elect to not disclose any of this information.
EXAMPLE
Franklin Oilfield Support provides gas field maintenance to gas exploration
companies in Africa. Franklin discloses the following information related to
the allocation of transaction prices to remaining performance obligations:
Franklin provides gas field maintenance services to several of the
larger gas exploration firms in the Jubilee field in Ghana. The
company typically enters into two-year maintenance service
agreements. Currently, the remaining performance obligations are
for €77,485,000, which are expected to be satisfied within the next
24 months. These obligations are noted in the following table,
which also states the year in which revenue recognition is
expected:

• Judgments. Note the timing associated with when performance

obligations are satisfied, as well as how the transaction price was
determined and how it was allocated to the various performance
obligations. In particular:
o Recognition methods. When performance obligations are to be
satisfied over time, describe the methods used to recognize
revenue, and explain why these methods constitute a faithful
depiction of the transfer of goods or services to customers.
o Transfer of control. When performance obligations are
satisfied as of a point in time, disclose the judgments made to
determine when a customer gains control of the goods or
services promised under contracts.
o Methods, inputs and assumptions. Disclose sufficient
information about the methods, inputs, and assumptions used
to determine transaction prices, the constraints on any variable
consideration, allocation of transaction prices, and
measurement of obligations for returns, refunds, and so forth.
The discussion of transaction prices should include how
variable consideration is estimated, how noncash
consideration is measured, and how the time value of money is
 used to adjust prices.
o Disclosure avoidance. Certain non-public entities can elect not
to disclose information about the following items pertaining to
judgments:
■ Why revenue recognition methods constitute a faithful
depiction of the transfer of goods or services to
customers.
■ The judgments made to determine when a customer
gains control of the goods or services promised under
contracts.
■ All methods, inputs, and assumptions used, though this
information must still be supplied in regard to the
determination of whether variable consideration is
constrained.
• Asset recognition. Note the recognized assets associated with
obtaining or completing the terms of the contract. This shall include
the closing balances of contract-related assets by main category of
asset, such as for setup costs and the costs to obtain contracts. The
disclosure should also include the amount of amortization expenses
and impairment losses recognized in the period. Also describe:
o Judgments. The judgments involved in determining the
amount of costs incurred to obtain or fulfill a customer
contract.
o Amortization. The amortization method used to charge
contract-related costs to expense in each reporting period.
A non-public entity can elect not to make the disclosures just noted
for asset recognition.
It may be necessary to aggregate or disaggregate these disclosures to clarify
the information presented. In particular, do not obscure information by
adding large amounts of insignificant detail, or by combining items whose
characteristics are substantially different.
There may be a change in estimate related to the measurement of progress
toward completion of a performance obligation. If the change in estimate will
affect several future periods, disclose the effect on income from continuing
operations, net income, and any related per-share amounts (if the entity is
publicly held). This disclosure is only required if the change is material. If
there is not an immediate material effect, but a material effect is expected in
later periods, provide a description of the change in estimate.
Summary
A key benefit of IFRS 15 is that the recognition of revenue from contracts
with customers will now be quite consistent across a number of contract
types and industries. Previously, industry-specific standards did not always
treat essentially the same types of transactions in a similar manner. This may
mean that some industries may experience significant recognition changes,
since they were previously governed by highly specific recognition rules.
Some entities, irrespective of their industry, may find that their recognition
accounting will also change to a considerable extent if they had previously
been using an interpretation of the existing standards that is no longer valid.
For many industries, however, especially those involving retail transactions,
the net effect of this standard is minimal.
 Chapter 21
Employee Benefits and Retirement Plans
Introduction
There are a number of benefit plan arrangements that can be extended to
employees, such as short-term benefits that are consumed in the current
period, specific types of benefits issued after employee retirement, and the
returns and principal on funds invested on behalf of employees. In this
chapter, we address how to account for and disclose each of these variations
on employee benefits and retirement plans.
IFRS Source Documents
• IAS 19, Employee Benefits
• IAS 26, Accounting and Reporting by Retirement Benefit Plans
• IFRIC 14, The Limit on a Defined Benefit Asset, Minimum Funding
Requirements and their Interaction
Short-term Employee Benefits
Short-term employee benefits are those for which there is an expectation of
settlement within the next 12 months. Examples of these benefits are:

If there is a subsequent change in the expectation for when short-term

benefits will be disbursed, it may be necessary to reclassify the benefits as
long-term benefits.
When an employee renders services for which there are associated short-
term benefits, the employer should recognize an accrued liability, and does
not have to incorporate discounted present value calculations into this
liability. If the employer has already paid for benefits that will not be earned
by employees for multiple periods, the unearned portion of these payments
should be recorded in the prepaid expenses account, and charged to expense
as earned. The basic accounting for a prepaid expense follows these steps:
1. Upon the initial recordation of a supplier invoice in the accounting
system, verify that the item meets the employer’s criteria for a
prepaid expense.
2. If the item meets the employer’s criteria, charge it to the prepaid
expenses account. If not, charge the invoice to expense in the current
 period.
3. Record the amount of the expenditure in the prepaid expenses
reconciliation spreadsheet.
4. At the end of the accounting period, establish the number of periods
over which the item will be amortized, and enter this information in
the reconciliation spreadsheet.
5. At the end of the accounting period, create an adjusting entry to
amortize a portion of the cost to the most relevant expense account.
6. Once all amortizations have been completed, verify that the total in
the spreadsheet for the current accounting period matches the total
balance in the prepaid expenses account. If not, reconcile the two
and adjust as necessary.
Tip: When there is a small expenditure for a short-term benefit, charge it to
expense as incurred, even if it relates to a future period. This approach
reduces the number of reconciling items to track.
EXAMPLE
Hammer Industries pays the £120,000 disability insurance for its entire
workforce at the beginning of the year, and intends to ratably charge it to
expense over the year. Its initial entry is:

At the end of each subsequent accounting period throughout the year,

Hammer amortizes the prepaid expenses account with the following journal
entry, which will result in the charging of the entire amount of prepaid
insurance to expense by the end of the year:

The following additional accounting issues may apply to the accounting by

an employer for short-term employee benefits:
• Overhead allocation. In some cases, it may be permissible to include
short-term employee benefits in the cost pools that are then assigned to
manufactured goods. See the Inventories chapter for more
information.
• Paid absences. When an employer allows its employees to accumulate
 paid absence time (such as accrued vacation pay), it recognizes
expense when employees provide the services that earn them the paid
absence time. In those cases where the right to paid absences does not
accumulate, the cost of paid time off is charged to expense as incurred.
Common examples of paid absences for which the right does not
accumulate are jury duty, bereavement pay, maternity leave, and
military service.
EXAMPLE
There is already an existing accrued balance of 40 hours of unused vacation
time for Fred Smith on the books of Kelvin Corporation. In the most recent
month that has just ended, Fred accrued an additional five hours of vacation
time (since he is entitled to 60 hours of accrued vacation time per year, and
60 ÷ 12 = five hours per month). He also used three hours of vacation time
during the month. This means that, as of the end of the month, Kelvin should
have accrued a total of 42 hours of vacation time for him (40 hours existing
balance + 5 hours additional accrual - 3 hours used).
Fred is paid £30 per hour, so his total vacation accrual should be £1,260 (42
hours × £30/hour). The beginning balance for him is £1,200 (40 hours ×
£30/hour), so Kelvin accrues an additional £60 of vacation liability.
EXAMPLE
Martha Smith gives birth, so Kelvin Corporation grants her maternity leave
for one month, at the amount of her normal full pay. Since this is not an
accumulating benefit, Kelvin did not accrue the expected amount of
maternity leave in advance. Instead, it charges this cost to expense as
incurred.

• Profit sharing and bonus plans. Do not recognize the expected payout
cost of a profit sharing or bonus plan, unless a past event causes an
obligation and this amount can be reliably measured. There is only an
obligation when there is no realistic alternative for a business, other
than to pay the indicated amounts. Grounds for reliable estimation are
only considered to be present when there is a formula for calculating
the amount of payment, or past practice clearly shows the amount of
the obligation, or management determines the amount to be paid
before the financial statements are authorized for issuance.
EXAMPLE
Kelvin Corporation operates a profit sharing plan, under which it pays a
10% share of annual profits to those of its employees who have been with
the company for the entire year. Though there is employee turnover, the
terms of the plan state that the full 10% will be paid to qualifying
employees. Thus, the company accrues an expense for the full 10% of
profits.
Alternatively, if the profit sharing plan had stated that 10% of profits were to
be paid out to those working for the company at the beginning of the year,
but only if they were still working for the company at the end of the year,
this effectively means that some lesser amount than 10% will actually be
paid out, assuming a certain amount of employee turnover. In this case,
historical experience could be used to arrive at a profit sharing accrual that is
less than the 10% figure.

Post-Employment Benefits
Post-employment benefits, as the name implies, relate to those benefits
received by employees after they have retired from their employer. Examples
of post-employment benefits are lump sum payments, pensions, life
insurance, medical care, and long-term disability benefits. It also includes
termination benefits, since they are issued after an employee has left the
employer. Depending on the terms of the underlying plans, post-employment
benefits may be issued to the beneficiaries of employees, such as their
surviving family members. Post-employment benefit plans fall into two
classifications, which are:
• Defined benefit plans. This is a benefit plan under which the employer
is responsible for the amount of benefits paid out from the plan; the
amount of funds it pays into the plan is predicated on the estimated
future cost of benefit payouts. In these plans, the risk that benefits will
be less than expected falls on the employer.
• Defined contribution plans. This is a benefit plan under which the
employer is only responsible for the amount of funds it pays into the
plan, not the amount of benefits that are eventually paid out from the
plan. The amount eventually received by former employees is based
on a combination of the funds paid into the plan and any subsequent
investment returns. In these plans, the risk that benefits will be less
than expected falls on former employees.
Employers may sometimes band together to offer a defined benefit plan or
defined contribution plan to their employees. In such a plan (known as a
multi-employer plan), an individual employer accounts for its share of
payments into the plan in exactly the same manner as if the plan were
designed solely for the use of that employer. If a multi-employer plan is a
defined benefit plan and there is not sufficient information available for an
employer to account for the plan as a defined benefit plan, it can instead
account for the plan as a defined contribution plan.
There may be a method in place among the employers in a multi-
employer plan to distribute any plan surplus among the members, or to fund a
deficit. When an employer uses the accounting for a defined contribution
plan and such surpluses or deficits are allocated out, the employer should
recognize the asset or liability in profit or loss.
When the members of a multi-employer plan are under common control,
such as a parent and its subsidiaries, this is not considered a multi-employer
plan. Participation in such a plan is considered a related party transaction.
A local government may mandate that all employers in its region enroll in
a government-managed benefit plan. If so, account for payments into such a
plan in the same manner as for a multi-employer plan. This type of plan may
be considered a defined benefit or defined contribution plan, but if the
method of payment into it is on a pay-as-you-go basis with no obligation to
pay future benefits, it is typically treated as a defined contribution plan.
An employer may purchase an insurance contract that requires an insurer
to provide post-employment benefits. This type of contract is considered a
defined contribution plan for accounting purposes. The contract is instead
considered a defined benefit plan if the employer has an obligation to pay
benefits directly when due, or to pay additional benefits that the insurer does
not pay.
Defined Contribution Plans
The accounting for a defined contribution plan is far simpler than for a
defined benefit plan. Under a defined contribution arrangement, the employer
charges to expense the contributions made into the plan. If there is an
overpayment, this is classified as a prepaid expense. In those rare cases where
the employer does not plan to make payments into a defined contribution
plan for at least 12 months, it should record the associated liability on a
discounted basis.
EXAMPLE
Kelvin Corporation has a defined contribution plan, under which it matches
the first 5% of employee gross pay that employees choose to have deducted
from their wages and placed in a retirement account. In the most recent
period, the matching amount was £28,000. Kelvin accrues this amount as an
expense, though it does not plan to settle the liability until the beginning of
the following reporting period.

Defined Benefit Plans

A defined benefit plan is one in which the employer guarantees the benefits
that will be paid. The accounting for defined benefit plans is immensely more
complex than for a defined contribution plan, because the employer is
responsible for the cost of benefits that may not be paid out for a number of
years. The basic accounting steps are:
1. Calculate the funding deficit or surplus. Use the projected unit credit
method (discussed later) to determine the cost of a benefit earned by
employees in exchange for current and prior period service. This
involves a number of estimates, such as employee turnover,
employee mortality, future changes in medical costs, and future
changes in salaries. The amount of this benefit is then discounted to
its present value, after which the fair value of all existing plan assets
are deducted from it.
2. Calculate net defined benefit. Adjust the balance from the first step
for the effect of limiting any net defined benefit asset at the asset
ceiling. The asset ceiling is the present value of any economic
benefits available as plan refunds or reductions in future
contributions to a benefit plan. This economic benefit is available if
it can be realized at some point during the life of the plan, and is
measured as the surplus at the end of the reporting period, less any
associated costs, such as taxes. A plan refund is only available when
the employer has an absolute right to the refund. The economic
benefit from a reduction in future contributions is calculated as the
future service cost for each period over the lesser of the expected life
of the plan and the expected life of the entity.
3. Recognize items in profit or loss. Determine the amounts of current
service costs, past service cost, gain or loss on settlement, or net
interest in the net defined benefit that can be recognized in profit or
loss.
4. Remeasure the net defined benefit. Determine the remeasurement of
the net defined benefit to be recognized in other comprehensive
 income. This remeasurement includes the following items:
• Actuarial gains and losses
• The return on plan assets, less the amounts included in the net
interest on the net defined benefit
• The change in the effect of the asset ceiling, not including
those amounts incorporated into the net interest on the net
defined benefit
Tip: IFRS suggests that a qualified actuary be used to measure defined
benefit obligations. Given the obvious complexity of the associated
accounting, it is nearly mandatory to do so, especially if the actuary can
provide the related accounting entries and supporting detail.
If a business only chooses to employ an actuary at long intervals to measure
its benefit liability, it should adjust the current liability balance for any
material transactions or circumstances in the interim, such as variations in
interest rates.
Tip: IFRS allows for the use of computational shortcuts in some cases, if
they provide a reliable approximation of what the normal computation
process would yield.
The following additional accounting issues can apply to a defined benefit
plan:
• Constructive obligation. There may be a constructive obligation to pay
benefits, even in the absence of a legal obligation. This situation arises
when altering an informal practice would cause unacceptable damage
to employee relations.
• Presentation. If an employer has a net defined benefit liability or asset,
it should present the amount in the balance sheet.
• Surplus. If there is a surplus in a defined benefit plan, the employer
measures the net amount of this asset as the lower of the surplus or the
asset ceiling. The asset ceiling is the present value of any economic
benefits available as plan refunds or reductions in future contributions
to a benefit plan. An asset surplus typically arises when a benefit plan
is overfunded, or when there are actuarial gains.
EXAMPLE
Kelvin Corporation has a long-standing practice of funding a defined benefit
pension plan. There is no legal obligation for Kelvin to do so, but it has been
engaged in this practice for many years. Not receiving this benefit would
likely increase employee turnover significantly, since they rely upon it to
supplement their other retirement income. Given the circumstances, Kelvin
has a constructive obligation to account for the benefits issued.
Projected Unit Credit Method
The projected unit credit method is used to calculate the present value of a
defined benefit obligation, as well as any related current service cost and past
service cost. In essence, the method adds a unit of benefits to which
employees are entitled. It then measures each of these units separately in
order to arrive at the final benefit obligation.
EXAMPLE
Hodgson Industrial Design has a defined benefit plan. The plan states that a
lump sum will be paid to each employee upon retirement, which equates to
2% of their final compensation for each year of service to Hodgson. The
aggregate amount of compensation paid to employees in the current year is
£10,000,000. Management expects this rate of pay to increase by 4%,
compounded, in each future year. The discount rate that Hodgson employs is
10%. The following table shows how the company’s benefit obligation
increases over time, with no changes in actuarial assumptions. Realistically,
the calculated results in the table would likely be lower if any employees
were to terminate their employment prior to retirement.
(000,000s)

Note: The Year 1 obligation is the present value of the benefit

attributed to prior years. The current service cost is the present
value of the benefit that is attributed to the current year.
Attribution of Benefits to Periods of Service
The present value of defined benefit obligations and current service costs
should be attributed to periods of service as defined under the corporate
benefit formula. However, use the following straight-line attribution when
employee service in later years will result in a materially higher benefit level
than in earlier years:

EXAMPLE
Micron Metallic provides its employees with a monthly pension of ¼% of
their final compensation for each year of service with the company. The
pension is payable once employees are 68 years old.
The benefit provided equals the present value of each monthly pension as of
the applicable person’s retirement date, through the expected date of death.
The present value of the defined benefit obligation is calculated as:

The benefits under a defined benefit plan are conditional, since they are based
on ongoing future employment. If an employee leaves an employer prior to
the vesting date, then that person will not receive any benefits. Thus,
measuring the defined benefit obligation requires the accountant to estimate
what proportion of employees will not become vested.
A defined benefit obligation will continue to increase until such time as
any additional employee service time does not lead to a material amount of
additional benefits. If there is such a date, attribute benefits to the reporting
periods prior to that date, as per the plan formula. Otherwise, benefits would
be mistakenly attributed to later periods, when they have actually already
been earned. Conversely, if employee service in later years will trigger a
materially higher benefit level, amortize the benefit on a straight-line basis
until the date when no material additional benefits accrue.
EXAMPLE
Micron Metallic has a post-retirement benefit plan, the terms of which
mandate that Micron will pay out a £10,000 retirement payment to all
employees who have worked for the company at least 25 years, but before
they reach age 60. Since service beyond the age of 60 does not lead to a
material increase in the amount of the payout, the company should attribute
the £10,000 benefit to each year from age 35 to 60, with an adjustment to
incorporate the probability that employees may not complete the service
period.
Micron also maintains a post-employment medical plan, under which retired
employees are reimbursed for 25% of their medical costs if they work for
the company for at least 10 years, and which increases the reimbursement to
60% if their service period is at least 25 years. The 25-year vesting period
results in a substantially higher benefit level. To account for these variations
in its medical plan, Micron uses the following calculations:
• None of the expected medical costs are attributed to employees not
expected to reach 10 years of service.
• 2.5% of the present value of expected medical costs (25%
reimbursement ÷ 10-year service period) is attributed to each year of
service for those employees expected to reach 10 years of service but
not 25 years of service.
• 2.4% of the present value of expected medical costs (60%
reimbursement ÷ 25-year service period) is attributed to each year of
service for those employees expected to reach 25 years of service.
Actuarial Assumptions
Actuarial assumptions are a company’s best estimates regarding the variables
that go into the calculation of post-employment benefit costs. There are a
number of these assumptions that can impact benefit costs, including:
• Demographic assumptions. Includes estimates for employee mortality,
turnover rates, disability, early retirement, and dependents who will be
benefit-eligible.
• Financial assumptions. Includes the discount rate used, benefit levels,
future salary levels, and the proportion of benefit costs to be paid by
employees. Additional comments are:
o General. Financial assumptions should be based on market
expectations for the period over which obligation settlement is
expected.
o Benefit limits. Should incorporate any limitations or caps
placed on the employer’s share of benefit costs.
o Discount rate. Should be based on market yields on high
 quality corporate bonds. If the market for such bonds is thin in
a country, use the yield on government bonds instead. This
rate is used to discount post-employment benefit obligations.
o Salaries. Should include the estimated future amount of
compensation increases that impact benefits, which requires
consideration of inflation, seniority levels, promotions, and
supply and demand in the labor market.
o State benefits. Incorporates any future changes in the amount
of state benefits that impact benefit plan payments. This is
necessary when the changes were enacted in the current
reporting period, or evidence suggests that state benefits will
change in a predictable manner.
The number of assumptions multiplies when the effects of a medical benefits
plan are thrown into the mix. In this case, assumptions can address the
frequency and cost of future claims, which in turn are comprised of
assumptions about changes in the health of employees, technology changes,
changes in the method of delivering health care, and so forth.
In general, the actuarial assumptions used to develop benefit liabilities
should be both unbiased and mutually compatible. Assumptions are
considered to not be biased when they are not imprudently optimistic, nor too
conservative. A key issue is the compatibility of assumptions, so that (for
example) the estimated rate of inflation is in accord with the rate at which
compensation will be increased over time. If assumptions are not compatible,
the results of a benefit formula will be difficult to justify.
Past Service Cost
Past service cost is any change in the present value of a defined benefit
obligation that is caused by a plan amendment or curtailment. In other words,
a retroactive change impacts the cost of benefits that employees already
earned from their service in prior periods.
Before calculating a past service cost, remeasure the net defined benefit
using the current fair value of plan assets before applying the plan
amendment or curtailment. Then determine the existence of any past service
cost on this new baseline. If there is a cost, recognize it on the earlier of the
plan amendment or curtailment date, or when the business recognizes any
related restructuring costs or termination benefits.
EXAMPLE
Hassle Corporation offers a pension plan that provides a pension of 0.5% of
the final salary of every qualifying employee for each year of service,
following a 15-year vesting period. The board of directors of Hassle decides
to increase the amount of the plan to 0.8%On the date when this change is
approved, the present value of the increased benefit is:

Hassle should recognize the £257,000 portion of the pension increase at

once, since it relates to employees who are already vested.
The average remaining vesting period for the remaining employees is seven
years, so Hassle should amortize the remaining £162,000 portion of the
pension increase over the next seven years.
Gains and Losses on Settlement
Settlement occurs when there is a termination of any further obligations by
the employer under a defined benefit plan. The gain or loss on settlement is
calculated as the difference between the present value of the obligation being
settled and the actual settlement price. The full amount of the gain or loss is
recognized when the settlement occurs.
If an employer buys an insurance policy to take over its obligations under
a defined benefit plan, this only constitutes a settlement when the employer
no longer has any legal or constructive obligation to pay additional amounts
if the insurance policy does not pay out all of the benefits mandated by the
defined benefit plan.
Measurement of Plan Assets
An employer has a plan deficit when the fair value of plan assets is less than
the present value of its defined benefit obligations, or a plan surplus when the
fair value of plan assets exceeds the present value of its defined benefit
obligations. The key element in this calculation is the fair value of plan
assets, which is not always readily determinable. If not, use the discounted
expected future cash flows associated with the assets as a substitute for fair
value.
An employer may occasionally be reimbursed for its expenditures under a
defined benefit plan. It should recognize these reimbursements only when
their receipt is virtually certain, and should classify such an incoming
reimbursement as a separate asset.
Defined Benefit Costs
IFRS requires that a business recognize the following three components of
defined benefit cost:
• Service cost. This is a combination of current service cost, past service
cost, and gains or losses on settlement, and is recognized in profit or
loss.
• Net interest on the net defined benefit liability. This is calculated by
multiplying the net defined benefit liability or asset by the discount
rate, and is recognized in profit or loss.
• Remeasurements of the net defined benefit. Remeasurement of the
benefit includes actuarial gains and losses, the return on plan assets,
and changes in the effect of the asset ceiling. It is recognized in other
comprehensive income. It is never subsequently reclassified to profit
or loss, but can be transferred within equity.
Termination Benefits
A termination benefit arises from the decision to terminate the employment
of an employee. These benefits most commonly are paid out in a lump sum,
but can also be a step-up in the amount of post-employment benefits paid.
The accounting for a termination benefit depends upon the existence of a
clause to provide additional services in exchange for the benefit. For
example, if no additional services are required of an employee, the act of
termination triggers the immediate recognition of the associated termination
benefits. However, if a benefit is only paid if an employee provides
additional future services, it should be recognized over the future service
period. More specifically, IFRS mandates that termination benefits be
recognized on the earlier of the date when the employer can no longer
withdraw the benefit offer, or when it recognizes costs for a restructuring.
When the employer can no longer withdraw its offer of benefits is considered
to be the earlier of when an employee accepts the termination benefits or
when any kind of restriction on the employer’s ability to withdraw the offer
takes effect.
EXAMPLE
The management of Giro Cabinetry decides to shut down its Durham facility
in three months and to terminate the employment of all 100 employees who
work at the facility at that time. The company announces a retention bonus
of £24,000 that will be paid to any of the employees who continue to work
for the company until the shutdown date. This bonus is in exchange for
services to be provided over the next three months, so Giro should charge
£800,000 to expense in each of the next three months to account for the
retention bonus (adjusted for subsequent employee turnover).

Defined Contribution Plan Disclosures

In each period, an employer operating a defined contribution plan should
disclose the contribution amount recognized as an expense.
When financial statements are prepared for a defined contribution plan, it
should include a statement of net assets available for benefits, which should
contain the following information:
• The asset balance at the end of the period
• The basis of asset valuation
• Details about any investment greater than 5% of net assets or 5% of
any class of security
• Details of any investment in the employer
• Any liabilities other than the actuarial present value of promised
retirement benefits
The following disclosures should accompany the statement of net assets for a
defined contribution plan:
• Policies. The funding policy and investment policies.
• Activities. Significant activities during the period, the effects of any
plan changes, membership changes, and changes in its terms and
conditions.
• Statements. Separate statements on which are disclosed the
transactions and investment performance during the period, and its
financial position at the end of the period.
• Fair value. If plan assets are not carried at fair value, disclose why fair
value is not used.
The report of a retirement benefit plan could contain such information as the
name of the employer, the employee groups covered, the number of
participants receiving benefits, the type of plan, whether participants
contribute to the plan, a description of promised benefits, any plan
termination terms, and any changes in this information during the reporting
period.
Defined Benefit Plan Disclosures
There are a number of disclosures related to defined benefit plans that focus
on their characteristics, risks, amounts, and impact on cash flows. The
following information should be included in the notes that accompany the
financial statements:
Plan characteristics:
• Overall. The nature of the benefits provided.
• Changes. A description of any amendments, curtailments and
settlements.
• Governance. A description of the governance responsibilities for the
plan.
• Regulatory framework. A description of the regulatory framework for
which the plan is designed.
• Risks. The risks to which the plan exposes the employer.
Plan amounts:
• Reconciliation. A reconciliation of changes during the period in plan
assets, the present value of the defined benefit obligation, the effect of
the asset ceiling, and reimbursement rights. The reconciliation should
include (if applicable) the current service cost, interest income or
expense, return on plan assets, actuarial gains and losses from
demographic assumptions, actuarial gains and losses from financial
assumptions, changes from limiting a benefit asset to the asset ceiling,
past service cost gains and losses from settlements, effects of
exchange rates, employer contributions, participant contributions,
payments from the plan, and the effects of disposals and business
combinations.
• Asset classes. Separate the fair value of plan assets into classes, where
classes are based on the nature and risk of the assets. There should be
a further subdivision between those asset classes for which there is a
quoted market price in an active market, and those for which this
information is not available. Possible asset classes include cash and
cash equivalents, equity instruments, debt instruments, real estate,
derivatives, and asset-backed securities.
• Own instruments. The amounts of the company’s own financial
instruments that are held as plan assets, at their fair value.
• Own property. The amounts of company-occupied property that are
held as plan assets, at their fair value.
• Assumptions. The significant actuarial assumptions employed in the
determination of the present value of the defined benefit obligation.
Also, it may be useful to disclose the basis used to determine the amount of
economic benefit available, which is used in the determination of the asset
ceiling, which in turn factors into the calculation of the net defined benefit
asset.
Cash flows:
• Contributions. The expected amount of contributions to the plan in the
next fiscal year.
• Funding. The employer’s funding arrangements and policies that may
affect future contributions to the plan.
• Matching strategies. The use of any strategies to match assets to
liabilities, in order to manage risk.
• Maturity profile. A description of the maturity profile of the defined
benefit obligation, including the weighted average duration of the
obligation. Consider a discussion of the timing of benefit payments.
• Sensitivity analysis. For each significant actuarial assumption, a
sensitivity analysis that shows how the defined benefit obligation
would have been altered by changes in the assumption, as well as the
methods used to prepare these analyses and any changes in these
methods from the previous period.
Multi-employer plans:
• Allocations. How deficits or surpluses are to be allocated to the
participating employers in the event of a withdrawal from the plan or
the plan’s termination.
• Funding. The plan’s minimum and normal funding arrangements, as
well as how contributions are calculated.
• Liabilities. The extent to which the employer can be liable for the
obligations of other employers in the plan.
• Alternative treatment. If the employer accounts for the plan as a
defined contribution plan, disclose the fact that the plan is actually a
defined benefit plan, why there is not enough information to account
for it as such, expected contributions to the plan in the next fiscal year,
information about any plan surplus or deficit that may impact future
contributions, and the level of the employer’s participation in the plan
when compared to the other plan participants.
Risk sharing between plans (where plans are under common control):
• Charging policy. The contractual agreement or policy for charging the
net defined benefit cost. If there is no agreement or policy, state this
fact.
• Contribution policy. The policy for calculating the contribution to be
made by the employer.
Additionally, it may be necessary to provide some of the preceding
information on a disaggregated basis. For example, disclosures could be
made for different geographic locations, regulatory environments, or
reporting segments of a business.
Finally, do not offset the assets of one plan against the liabilities of
another plan, unless there is a legal right to use the assets of one plan to
reduce the liabilities of the other plan, or the company intends to realize the
surplus in one plan and use it to settle obligations under the other plan.
Defined Benefit Plan Financial Statements
When financial statements are prepared for a defined benefit plan, it should
use either of the following statements:
• The net assets available for benefits, the actuarial present value of
promised retirement benefits, and the resulting excess or deficit
amount; or
• A statement of net assets available for benefits, and a statement of
changes in net assets available for benefits, plus footnote disclosure of
the actuarial present value of promised retirement benefits.
Alternatively, the actuarial information can be provided in an
accompanying actuarial report.
A statement of net assets available for benefits should include the following
information:
• The asset balance at the end of the period
• The basis of asset valuation
• Details about any investment greater than 5% of net assets or 5% of
any class of security
• Details of any investment in the employer
• Any liabilities other than the actuarial present value of promised
retirement benefits
A statement of changes in net assets available for benefits should include the
following information:
• Employer contributions
• Employee contributions
• Investment income
• Other income
• Benefits paid or payable
• Administrative expenses
• Other expenses
 • Income taxes
• Profits and losses on the disposal of investments or changes in their
value
• Transfers to and from other plans
Also disclose for the separate financial statements of a defined benefit plan
the following items:
• Activities. Any significant activities in the period, the effect of any
changes relating to the plan, changes in its membership, or changes in
its terms and conditions.
• Actuarial changes. The effect of actuarial changes in actuarial
assumptions that impacted the actuarial present value of promised
retirement benefits.
• Actuarial information. Actuarial information, provided either with the
financial statements or via a separate report. Note whether the present
value of expected payments are based on current or projected salaries.
• Assumptions. Significant actuarial assumptions made, and the method
used to derive the actuarial present value of promised retirement
benefits.
• Fair value. If plan assets are not carried at fair value, disclose why fair
value is not used.
• Funding adequacy. Describe the adequacy of planned future funding.
• Policies. The policy for funding promised benefits, and any investment
policies.
• Relationships. State the relationship between the actuarial present
value of promised retirement benefits and the net assets available for
benefits.
• Statements. Separate statements on which are disclosed the
transactions and investment performance during the period, and its
financial position at the end of the period.
• Valuation date. The date of the last actuarial valuation.
The report of a retirement benefit plan could contain such information as the
name of the employer, the employee groups covered, the number of
participants receiving benefits, the type of plan, whether participants
contribute to the plan, a description of promised benefits, any plan
termination terms, and any changes in this information during the reporting
period.
Summary
A defined benefit plan is startlingly more complex to account for than a
defined contribution plan. The level of complexity nearly demands the use of
an outside actuarial expert to routinely provide an employer with the
information needed to properly account for its benefit plan. Conversely, the
defined contribution plan is simple to measure and recognize. In addition, the
defined benefit plan places all of the risk of changes in the cost of benefits on
the employer, which can severely impact profits in many future periods. For
these reasons, we strongly advocate the sole use of defined contribution
plans. While the accounting staff is rarely at the center of the decision to use
a defined benefit plan, it should at least present its views regarding the
complexity and added cost of such plans to the management team.
 Chapter 22
Share-based Payment
Introduction
Many organizations issue payments to their employees that are derived in
some manner from the price of company stock. These payments may
ultimately be paid in cash or shares. Similarly, though less commonly, share-
based payments may be made to people or entities outside of the business,
such as when legal services are paid for with company shares. The
accounting for these payments varies, depending upon how they are
calculated and paid. In this chapter, we address the various scenarios under
which different types of accounting for share-based payments are applied.
IFRS Source Document
• IFRS 2, Share-based Payment
Overview of Share-based Payments
There are a number of possible ways in which a company could issue shares
as a form of payment, perhaps through the outright issuance of shares, or
share options, or warrants. No matter which method of payment is employed,
the overriding goal of the accounting for these payments is to charge their
effects to expense or an asset. More specifically, the accounting can fall into
one of the following areas:
• Equity-settled, share-based payment. If the company only pays with its
shares, it records an increase in equity, with an offsetting debit to the
relevant asset or expense account to which the payment relates.
• Cash-settled, share-based payment. If the company pays an amount in
cash that is calculated from a certain number of shares, it records a
liability, with an offsetting debit to the relevant asset or expense
account to which the payment relates.
There may also be situations in which the firm receives goods or services,
and the terms of the arrangement give the supplier a choice of settling in cash
or through the issuance of equity instruments.
We will explore these issues further in the following sections.
Share-based Payments Settled with Equity
As noted in the last section, equity-settled, share-based transactions are
recorded as an increase in equity, with an offsetting debit to the relevant asset
or expense account to which the payment relates. This measurement should
be based on the fair value of the goods or services received. If it is not
possible to measure their fair value, measure the transaction at the fair value
of the equity instruments that are used to settle the liability. The following
additional issues may apply:
• Payments to employees. When services are rendered by employees or
others providing similar services, it is usually not possible to measure
the transaction at the fair value of the services received. Accordingly,
measure these transactions at the fair value of the equity instruments
granted, as of the grant date. This is a significant issue, since it applies
to share options granted to employees.
• Payments to parties other than employees. When share-based
payments are made to parties other than employees, it is assumed that
the fair value of the goods or services received can be estimated in a
reliable manner. The fair value of these items should be measured at
the date when the company receives the goods or the services are
rendered. If it is not possible to measure the fair values of the goods or
services received, use the fair value of the equity instruments paid as
of the date when the company receives the goods or the services are
rendered.
EXAMPLE
Snyder Corporation orders specially-designed GPS chips from a supplier,
for inclusion in its next GPS satellite. As an inducement to deliver the chips
by August 31, Snyder offers 5,000 shares to the supplier. The GPS chips are
custom-designed for Snyder, so it is not possible to directly determine their
fair value. As an alternative, Snyder values the inducement transaction using
the market price of its shares on the August 31 delivery date, which is £10
per share. This results in the recognition of a £50,000 expense on the
delivery date.

• Unidentifiable goods or services. If the fair value of the goods or

services to be received is less than the fair value of the equity
consideration paid, this may mean that additional unidentifiable goods
or services are yet to be received. If so, measure the unidentifiable
items as the difference between the fair values of the identifiable items
and the equity consideration as of the grant date.
• Vesting. There is not usually a vesting period associated with equity
paid in exchange for goods or services. If there is no vesting,
 recognize the asset or expense associated with an equity payment at
once. If there is a vesting period, it is assumed that the related services
will be rendered during the vesting period, which means that the
related expense is recognized over the vesting period. Also, if equity
instruments do not vest because a vesting condition was not satisfied,
do not recognize any asset or expense related to the transaction.
• Market conditions. A market condition may be included in a vesting
arrangement, such as requiring that a company’s share price reach a
certain point before an option can be exercised. When estimating fair
value, take the existence of market conditions into account. However,
once fair value has been established, the related amounts of goods or
services are to be recognized, even if it is found by the end of the
vesting period that the market condition has not been met.
• Reload feature. A share option may contain a reload feature, where an
employee is automatically granted additional options if he or she
exercises existing options and uses shares to satisfy the exercise price.
When there is a reload feature, do not include it in the estimation of
the fair value of options granted. If a reload feature is triggered,
account for it as an entirely new option grant.
• Subsequent measurement. Once a share-based payment has been
measured and equity has been increased by the amount measured,
there is no subsequent adjustment to equity. For example:
o An expense is recognized for options granted in exchange for
services, but the option recipient later forfeits the options. The
issuing company cannot reverse its expense recognition.
o An employee never exercises vested options, so they lapse.
The issuing company cannot reverse the amount of
compensation expense related to the options.
EXAMPLE
Luminescence Corporation issues 10,000 share options to a key employee,
with a four-year vesting period. The shares have a fair value of £80,000 as
of the grant date, so the company recognizes compensation expense related
to the options of £20,000 in each of the next four years.
Luminescence issues 5,000 share options to another employee, which will
vest when the development of a product has been completed and it is
launched. The estimated amount of time required to develop the project is an
additional 12 months. On the grant date, the options are valued at £36,000.
Accordingly, the company recognizes compensation expense related to the
options of £3,000 per month. If the estimated duration of the development
process changes, the company should adjust its recognition period to match
the revised estimate.
Luminescence issues 12,000 share options (valued at £80,000) to the
supplier of the company’s computer support services, which shall vest over
the next year in proportion to the number of service requests resolved within
one hour. Based on historical results, the company controller ratably accrues
an expense of £60,000 to reflect the estimated issuance of 75% of the
options. Once the year is complete, it is apparent that the supplier has been
worse than usual at responding to service calls, and so is only entitled to
62% of the original option grant, which is £49,600. Accordingly, the
controller adjusts the expense to £49,600 for the year.
Luminescence issues 4,000 share options to an attorney who handles the
company’s trademark litigation. The options are contingent upon the price of
the company’s stock exceeding £15 within the next 12 months. The attorney
is expected to meet all other service conditions associated with the grant.
Accordingly, the company recognizes the fair value of the grant over the 12-
month period, irrespective of whether the market condition feature is met.
Luminescence grants 200,000 restricted stock units to its chief engineer,
which vest on the grant date. The fair value of the grant is £500,000, which
is triple his compensation for the past year. Under the terms of the
arrangement, the RSUs will only be transferred to the engineer ratably over
the next five years if he complies with the terms of the non-compete
agreement. Since the RSUs are essentially linked to the non-compete
agreement, and the amount of the future payouts are quite large, it is evident
that the arrangement is really intended to be compensation for future
services yet to be rendered to the company. Consequently, the appropriate
accounting treatment is not to recognize the expense at once, but rather to
recognize it ratably over the remaining term of the non-compete agreement.

When it is not possible to measure the fair value of goods or services

received, the alternate valuation technique is to use the fair value of the
equity instruments granted. This fair value should be based on available
market prices, adjusted for any special terms and conditions associated with
the equity instruments granted. If it is not possible to derive a market price
for the equity instruments, the alternative is to use an accepted valuation
methodology for pricing financial instruments. Models that are commonly
used to derive fair value are the Black-Scholes-Merton formula and the lattice
model. Key characteristics of these models are:
• Black-Scholes-Merton formula. Assumes that options are exercised at
the end of the arrangement period, and that price volatility, dividends,
and interest rates are constant through the term of the option being
measured.
• Lattice model. Can incorporate ongoing changes in price volatility and
dividends over successive time periods in the term of an option. The
model assumes that at least two price movements are possible in each
measured time period.
A key component of the value of a company’s stock is its volatility, which is
the range over which the price varies over time, or is expected to vary. Since
an employee holding a stock option can wait for the highest possible stock
price before exercising the option, that person will presumably wait for the
stock price to peak before exercising the option. Therefore, a stock that has a
history or expectation of high volatility is worth more from the perspective of
an option holder than one that has little volatility. The result is that a
company with high stock price volatility will likely charge more employee
compensation to expense for a given number of shares than a company whose
stock experiences low volatility.
Stock price volatility is partially driven by the amount of leverage that a
company employs in its financing. Thus, if a business uses a large amount of
debt to fund its operations, its profit will fluctuate in a wider range than a
business that uses less debt, since the extra debt can be used to generate more
sales, but the associated interest expense will reduce net profits if revenues
decline.
EXAMPLE
Armadillo Industries grants an option on £25 stock that will expire in 12
months. The exercise price of the option matches the £25 stock price.
Management believes there is a 40% chance that the stock price will
increase by 25% during the upcoming year, a 40% chance that the price will
decline by 10%, and a 20% chance that the price will decline by 50%. The
risk-free interest rate is 5%. The steps required to develop a fair value for the
stock option using the lattice model are:
1. Chart the estimated stock price variations.
2. Convert the price variations into the future value of options.
 3. Discount the options to their present values.
The following lattice model shows the range and probability of stock prices
for the upcoming year:

In short, the option will expire unexercised unless the stock price increases.
Since there is only a 40% chance of the stock price increasing, the present
value of the stock option associated with that scenario can be assigned the
following expected present value for purposes of assigning a fair value to
the option at the grant date:
£5.95 Option present value × 40% Probability = £2.38 Option value
at grant date
EXAMPLE
Armadillo Industries issues stock options with 10-year terms to its
employees. All of these options vest at the end of four years (known as cliff
vesting). The company uses a lattice-based valuation model to arrive at an
option fair value of £15. The company grants 100,000 stock options. On the
grant date, it assumes that 10% of the options will be forfeited. The exercise
price of the options is £25.
Given this information, Armadillo charges £28,125 to expense in each
month. The calculation of this compensation expense accrual is:
(£15 Option fair value × 100,000 Options × 90% Exercise
probability) ÷ 48 Months
= £28,125

It is possible that the fair value of the equity instruments granted cannot be
determined. If so, measure these items based on their intrinsic value, which is
the difference between their fair value and the amount the recipient must pay
to acquire the shares. This amount is to be measured at the end of each
reporting period, through the final settlement, exercise, or forfeiture date,
with all changes being recognized in profit or loss. The final amount
recognized is only based on the final number of shares that vest or are
exercised. Only in this case is it permissible to reverse an expense accrual for
an expense that was previously recognized in relation to shares that do not
vest or options that are not exercised. The following two additional scenarios
may apply to the intrinsic value measurement methodology:
• If settlement of a share-based payment occurs during a vesting period,
treat the early settlement as accelerated vesting, which means that all
remaining expenses that would have been recognized in a later period
are recognized in the settlement period.
• When an option holder pays the issuer on the settlement date, treat this
payment as repurchase of equity instruments, which is a deduction
from equity. However, in the unlikely case that the payment from the
option holder is greater than the intrinsic value of the equity
instruments being bought, recognize the difference as an expense.
EXAMPLE
Underwater Anomalies, which conducts shipwreck searches, has not
uncovered a profitable wreck for some time, and so is reduced to paying for
services with share options. Each option has an exercise price of £2 and a
fair value of £10. The intrinsic value of each option is therefore £8, which is
the difference between the fair value and exercise price.

It is not uncommon for a business to alter the terms under which equity
instruments were issued. For example, it may have originally issued share
options at an exercise price that is now well above the market price of the
company’s shares, and so institutes a modification to reduce the exercise
price. The following accounting applies to these modifications for equity
instruments issued to both employees and outside parties:
• Minimum recognition. The minimum amount to recognize is the fair
value of the equity instruments granted, unless the instruments do not
vest. This minimum level of recognition applies, even if there are
subsequent modifications to the terms under which an instrument was
granted, and even if the instrument is subsequently cancelled.
• Additional recognition. If terms modifications are favorable to the
recipient of an equity instrument (that is, the fair value is increased),
 recognize the incremental increase in value.
• Cancellation or settlement. If an equity issuance is cancelled or settled
(but not forfeited), account for the event as though the vesting period
has been accelerated. This means that the remaining expense that
would have been recognized over subsequent periods is recognized
entirely in the current period. If any payment is made to the recipient
of a grant when the grant is cancelled or settled, account for it as
though the equity instrument had been repurchased, which is a
reduction of equity. If this payment exceeds the fair value of the grant,
recognize the difference as an expense.
• Replacement. If an equity instrument is essentially cancelled and
replaced by a new equity instrument, the minimum accounting is to
recognize the fair value of the equity instruments originally granted,
plus any increase in the compensation paid to the recipient through the
new issuance. This incremental change in fair value is the fair value of
the replacement instruments, less the net fair value of the cancelled
instruments. Net fair value is the fair value of the cancelled
instruments just prior to their cancellation, minus the amount of any
payment made to the recipient that is considered a deduction from
equity.
EXAMPLE
The board of directors of Armadillo Industries initially grants 5,000 stock
options to the engineering manager, with a vesting period of four years. The
shares are worth £100,000 at the grant date, so the controller plans to
recognize £25,000 of compensation expense in each of the next four years.
After two years, the board is so pleased with the performance of the
engineering manager that they accelerate the vesting schedule to the current
date. The controller must therefore accelerate the remaining £50,000 of
compensation expense that had not yet been recognized to the current date.
EXAMPLE
Armadillo Industries issues 10,000 stock options to various employees in
20X1. The designated exercise price of the options is £25, and the vesting
period is four years. The total fair value of these options is £20,000, which
the company charges to expense ratably over four years, which is £5,000 per
year.
One year later, the market price of the stock has declined to £15, so the
board of directors decides to modify the options to have an exercise price of
£15.
Armadillo incurs additional compensation expense of £30,000 for the
amount by which the fair value of the modified options exceeds the fair
value of the original options as of the date of the modification. The
accounting department adds this additional expense to the remaining
£15,000 of compensation expense associated with the original stock options,
which is a total unrecognized compensation expense of £45,000. The
company recognizes this amount ratably over the remaining three years of
vesting, which is £15,000 per year.

Share-based Payments Settled with Cash

As noted earlier, cash-settled, share-based payments are recorded as a
liability, with an offsetting debit to the relevant asset or expense account to
which the payment relates. The amount of this liability is measured at the fair
value of the goods or services acquired, and is continually remeasured in each
reporting period until the liability is settled. If the fair value changes during
this measurement period, the change is recognized at once in profit or loss.
A common application of the cash settlement concept is when employees
are granted share appreciation rights, under which they are paid cash if the
underlying company shares increase in value. Assuming that there is indeed a
run-up in the price of the company’s stock, the value of the stock
appreciation rights increase over time, which results in an increase in the
associated recognition of compensation expense.
When share appreciation rights are granted, it is assumed that the
corresponding service period has already been completed (unless there is
evidence to the contrary), which means that the full amount of associated cost
for the goods or services provided are recognized as expense on the grant
date. Conversely, if the rights apply to a service period that has not yet
occurred, the expense is recognized over that period.
EXAMPLE
Uncanny Corporation grants 20,000 share appreciation rights (SARs) to its
chief executive officer (CEO). Each SAR entitles the CEO to receive a cash
payment that equates to the increase in value of one share of company stock
above a baseline value of £25. The award cliff vests after two years. The fair
value of each SAR is calculated to be £11.50 as of the grant date. The entry
to record the associated amount of compensation expense for the first year
is:
At the end of the first year of vesting, the fair value of each SAR has
increased to £12.75, so an additional entry is needed to adjust the vested
amount of compensation expense for the £12,500 incremental increase in the
value of the award over the first year (calculated as £1.25 increase in SAR
fair value × 20,000 SARs × 0.5 service period).
At the end of the vesting period, the fair value of each SAR has increased
again, to £13.00, which increases the total two-year vested compensation
expense for the CEO to £260,000. Since £127,500 of compensation expense
has already been recognized at the end of the first year, the company must
recognize an additional £132,500 of compensation expense.

Share-based Payments with Cash Alternatives

Some share-based payment instruments allow either the issuer or the recipient
of an equity payment to select settlement in cash or equity. In these cases, the
issuer should account for the transaction as though it were a cash-settled
share-based transaction, if there is a liability to settle in cash. Otherwise, the
transaction is treated as a payment that is settled with equity. These
transactions are handled differently, depending upon whether the
counterparty or the issuing entity can select the form of payment. The
following subsections address the alternative treatments.
Counterparty Has Choice of Settlement
When the issuer of an equity instrument has granted the recipient the right to
choose cash or equity as payment, this is essentially a compound financial
instrument that contains debt (i.e., the right to receive cash) and equity
components. The accounting for this situation is:
• Parties other than employees. When such a compound financial
instrument is issued to an entity other than an employee, and when the
fair value of the goods or services provided can be measured directly,
the proper measurement is to subtract the fair value of the debt
component from the fair value of the goods or services received, to
arrive at the value of the equity component.
• Transactions with employees. When such a compound financial
instrument is issued to an employee, separately measure the fair values
of the debt component and the equity component. The fair value of the
 instrument is the combined fair values of these two elements.
When the instrument is eventually settled, the liability portion of the
compound financial instrument is to be remeasured to its fair value. The
accounting then varies, depending on the manner of payment:
• Paid with equity. If the transaction results in only equity instruments
being issued to the recipient, the liability is then shifted into equity,
and is considered to be the consideration paid for the equity
instruments issued.
• Paid with cash. If the transaction results in only cash being paid in
settlement, the cash payment settles the full amount of the liability. If
there was an equity component to the transaction that had already been
recognized in equity, there is no change to its previous recognition.
EXAMPLE
Subterranean Access buys drilling equipment for £300,000 on March 31.
The supplier has the option of being paid with either 50,000 Subterranean
shares on December 31 or a cash payment in one month that will equal the
market price on that date of 40,000 shares. The company’s controller
estimates that the end-of-year option has a fair value of £375,000 and the
one-month option has a fair value of £275,000.
When Subterranean receives the drilling equipment, the controller should
debit the fixed asset account for £300,000, credit a liability account for
£275,000 (which represents the cash option) and credit equity for £25,000.
The £25,000 portion of the entry represents the difference between the price
of the drilling equipment and the fair value of the associated liability.
Issuer Has Choice of Settlement
If the issuing entity can choose whether to pay in stock or cash, it must
decide whether there is a current obligation to pay in cash. This is the case
when the use of equity instruments is impossible (such as when there is no
authorization to issue additional shares), there is a corporate policy to pay in
cash, past practice has been to always settle in cash, or to settle in cash when
requested to by the counterparty. If there is a current obligation to pay in
cash, account for the transaction as a cash-settled share-based payment. When
a cash payment is made, treat it as a deduction from equity.
If there is no obligation to pay in cash, account for the transaction as an
equity-settled share-based payment. When an equity payment is made, no
further accounting is required, beyond the initial recognition of the payment
on the date of grant.
When the issuing entity can choose between modes of payment, the usual
alternative is to pick the choice having the lower fair value. If the entity
instead elects to pay using the choice that has the higher fair value, charge the
difference in the fair values of the choices to expense as of the settlement
date.
Share-based Payment Disclosures
When a business is involved in share-based payment arrangements, it should
disclose the following information in the notes accompanying its financial
statements:
• Descriptions. Describe each type of share-based payment arrangement
in use during the period, including their terms, vesting requirements,
maximum option term, and whether settlement is in cash or equity.
This information can be aggregated for similar types of arrangements.
• Option information. Describe the number and weighted average
exercise prices for options outstanding at the beginning of the
reporting period, as well as separately for those options granted,
forfeited, exercised, and expired during the period, and separately for
those options outstanding at the end of the period, and exercisable at
the end of the period.
• Exercised options. If options were exercised during the period,
disclose the weighted average share price on the exercise date. This
information can instead be a weighted average share price during the
period, if options were exercised several times during the period.
• Options outstanding. For those options remaining outstanding at the
end of the period, note the range of exercise prices and the weighted
average contractual life remaining.
In those cases where the entity derived the fair value of goods or services
received, or of equity instruments issued, provide the following information
about fair values:
• Share options. If share options were granted, disclose the weighted
average fair value of these options as of the measurement date, plus
the option pricing model used and the inputs to that model, how
expected volatility was determined and the extent to which it was
based on historical volatility information, and how other option
features were incorporated into the fair value measurement.
• Other equity instruments. If equity instruments other than share
 options were granted during the period, disclose the number and
weighted average fair value of these items as of the measurement date,
how fair value was determined, how expected dividends were
incorporated into the fair value calculation, and how other instrument
features were incorporated into the fair value measurement.
• Modified arrangements. If a share-based payment was modified during
the period, explain the modifications, note the incremental change in
fair value resulting from the modifications, and disclose how the
incremental change in fair value was determined.
It may also be necessary to disclose the following information:
• Fair value measurement. If the fair values of goods or services
received were used to value share-based payments, disclose how the
fair values were determined. If it was not possible to derive the fair
values of goods or services, state this point and why it was not
possible to do so.
• Expenses. Disclose the total expense derived from share-based
payment transactions in which the goods or services received were
immediately charged to expense. Separately disclose that part of the
expense arising from equity-settled share-based payments.
• Liabilities. Note the total carrying amount of liabilities derived from
share-based payment transactions at the end of the period, as well as
the total end-of-period intrinsic value of those liabilities for which the
counterparty’s rights have vested.
Summary
The accounting for share-based payments does not have to be especially
difficult, as long as each one is properly documented and follows a standard
payment approach, such as always paying with shares and never allowing the
option for a cash payment. However, if the terms of each share-based
payment differ, it can represent an accounting nightmare, where the
accounting staff has to research the proper accounting for each individual
transaction and then track them all separately. Consequently, it is best to
adopt just one or two standard forms of share-based payment, and apply them
consistently to all such arrangements. Ideally, there should be no more than
one share-based arrangement for payments made to employees, and one for
payments made to outsiders.
 Chapter 23
Income Taxes
Introduction
The accounting for income taxes can be among the more complex accounting
topics, since it deals with both the current and future tax consequences of
converting existing assets into cash, and the eventual settlement of existing
liabilities. Depending on these expected outcomes, a business may need to
recognize either a deferred tax liability or asset. Since the expectations for the
values at which assets and liabilities will eventually be converted to cash or
settled are always changing, this means that the estimated amounts of future
taxes will also likely change on an ongoing basis.
Most of the discussion in this chapter focuses on the proper accounting
treatment of current and deferred tax liabilities and assets, though we also
address income tax presentation and disclosure topics.
IFRS Source Documents
• IAS 12, Income Taxes
• IFRIC 23, Uncertainty over Income Tax Treatments
• SIC 25, Income Taxes – Changes in the Tax Status of an Entity or its
Shareholders
The Tax Base Concept
A central concept of income tax accounting is the tax base. This is the
amount attributed to an asset or liability for tax purposes, and which will be
deductible for tax purposes against any revenues generated from use of the
asset or liability.
EXAMPLE
Nova Corporation acquired a grinding machine several years ago for
£80,000. For tax purposes, Nova has already charged £20,000 of this cost to
depreciation. The tax base of the machine is therefore £60,000. The
telescope mirrors that will be produced with the grinding machine will
generate taxable revenue. This tax base will continue to decline over time as
Nova continues to depreciate the machine, and charge the depreciation
expense against future revenue.
EXAMPLE
Finchley Fireworks recognizes accrued expenses of £12,000. Since Finchley
reports its taxable results using the cash basis of accounting, the accrued
expenses have no tax base. If Finchley were to instead report its taxable
results using the accrual basis of accounting, the accrued expenses would
have a tax base of £12,000.

Here are several variations on the tax base concept:

• Customer prepayments. If revenue is received in advance, it is initially
recorded as a liability. The tax base of this liability is its carrying
amount, minus any revenue that will not be taxable in later periods.
• Not recognized. Depending on the tax jurisdiction, some assets and
liabilities have a tax base, but are not recognized under IFRS as being
assets or liabilities. For example, a jurisdiction may require that
research and development costs be recognized as an asset for tax
purposes, but are charged to expense as incurred under IFRS. This
delay in the recognition of expense for tax purposes is considered a
deferred tax asset.
Differences between the tax base and carrying amount of assets and liabilities
are set by tax law, and usually only apply to a relatively small number of
balance sheet line items. In all other cases, the tax base and carrying amount
of an asset or liability should be identical.
Current Tax Liabilities and Assets
When there is a tax liability due in the current period, a business must charge
it to expense and either record an offsetting liability or pay the amount of the
liability. If the business pays an amount that exceeds its current tax liability,
it recognizes the overage as an asset.
When there is a benefit related to a tax loss in the current period, and that
amount can be carried back to recover a tax already recognized in a previous
period, a business should recognize the benefit as an asset.
Deferred Tax Liabilities and Assets
There are many cases in which a business may incur a tax obligation that will
not be paid until a later period, or a potential reduction of a tax obligation that
also cannot be utilized until a later period. These situations result in deferred
tax liabilities and deferred tax assets, respectively. The following general
principles apply to deferred tax liabilities and assets:
• Tax rates. A deferred tax asset or liability is measured at the tax rates
expected to apply to the business in the period when they are
eventually used, based on tax rates that have already been enacted or
announced.
 • Discounting. Despite the fact that deferred tax liabilities and assets
may persist over many years, they are not to be discounted to their
present values. The reason for not doing so is that it would be very
difficult to determine when these items will actually be used or settled,
which increases the risk of deriving an incorrect present value.
• Review. The carrying amounts of all deferred tax assets must be
reviewed at the end of each reporting period, and reduced to the extent
that it is no longer probable that sufficient taxable profit will be
available to offset them. These reductions can be reversed at a later
date if the expected amount of taxable income increases again.
Taxable Temporary Differences
A taxable temporary difference is a difference between the tax base and
carrying amount of an asset or liability that will result in taxable amounts in
future periods. Eventually, the difference between the tax base and carrying
amount will disappear as the related asset or liability is consumed; hence the
concept that these taxable differences are “temporary.” In short, the passage
of time eventually eliminates all taxable temporary differences. Examples of
situations in which taxable temporary differences arise are:
• A tax jurisdiction allows interest income to be recognized when the
related cash amount is received. Since the cash amount is always
received after month-end, and the affected business always accrues the
income in advance of receipt, there is a deferred tax liability
associated with the late recognition of interest income.
• Many tax jurisdictions allow companies to use accelerated
depreciation methods for tax reporting purposes. If these companies
use a less aggressive depreciation approach for their internal record
keeping, such as the straight-line method, this delays the recognition
of taxable income, which is a deferred tax liability.
• Certain aspects of IFRS allow a business to revalue its assets to their
fair values. Tax jurisdictions may not allow this revaluation to carry
over for tax reporting purposes, which results in a temporary
difference that may be a deferred tax asset or deferred tax liability,
depending upon whether an asset is revalued upward or downward.
• Under the equity method of accounting, the carrying amount of a
parent company’s investment in another entity will vary over time,
while the tax base for that investment may not change. The result is a
temporary difference that may be a deferred tax asset or deferred tax
 liability, depending upon changes in the recorded value of the
investment.
• When an acquirer takes over another business, the acquirer can
generally record the acquired assets and liabilities at their fair values.
However, the applicable tax jurisdiction may require that the tax base
of the previous owner be carried forward for these assets, resulting in a
tax difference.
• An acquirer may record a goodwill asset in relation to a business
combination, in an amount matching the difference between the
compensation paid and the fair value of all assets and liabilities
acquired. Many tax jurisdictions do not allow the recognition of any
reduction in goodwill as a tax-deductible expense, even though such
reductions will reduce accounting profits. In these jurisdictions, then,
goodwill has a mandatory tax base of zero, which will yield a
temporary difference for as long as the acquirer maintains the
goodwill asset in its accounting records.
The general rule for taxable temporary differences is to recognize a deferred
tax liability for the tax that must be paid in future periods, except when the
liability comes from the initial recognition of:
• Goodwill; or
• A transaction that is not a business combination and does not affect
accounting or taxable profit.
EXAMPLE
Nova Corporation’s tax advisor points out that it is permissible to use
accelerated depreciation for tax purposes on a new vacuum deposition
machine for its mirror operations. The company elects to use straight-line
depreciation in order to calculate its accounting profit in each period. The
difference in depreciation methods results in a taxable temporary difference,
which will disappear when the asset has been fully depreciated.
EXAMPLE
Finchley Fireworks reports its taxable results using the cash basis of
accounting. For tax purposes, the company deducts the monthly rent on its
headquarters building from revenues as soon as it pays the rent. Since the
rent is paid in advance, the company records this payment as a prepaid
expense for its own internal record keeping. Given these two differences in
treating the transaction, a taxable temporary difference arises, which will
disappear once Finchley charges the rent to expense on its own books.
EXAMPLE
Hammer Industries acquires a small regional competitor, and recognizes
£2,000,000 of goodwill as a result of the transaction. The tax jurisdiction in
which Hammer is located permits the amortization of goodwill over a 20-
year period on a straight-line basis. This means that the tax basis of the
goodwill asset declines by 5% per year, which is £100,000. After one year,
and assuming no goodwill impairment, this means there is a taxable
temporary difference of £100,000, for which Hammer can recognize a
deferred tax liability.
EXAMPLE
The Subterranean Access drilling company has a drilling rig that originally
cost £200,000, and which now has a carrying amount of £120,000, due to
£80,000 of straight-line depreciation that has been recorded since the asset
was acquired.
Thus far, the company has used accelerated depreciation to record taxable
depreciation on the drilling rig of £160,000, leaving a tax base of £40,000.
The company’s income tax rate is 35%. The difference between the
£120,000 carrying amount and the £40,000 tax base is a taxable temporary
difference of £80,000. Based on this difference and the tax rate,
Subterranean Access recognizes a deferred tax liability of £28,000
(calculated as £80,000 taxable temporary difference × 35% tax rate). The
deferred tax liability is the delayed amount of income taxes that the
company must eventually recognize over the remaining depreciable life of
the drilling rig.
EXAMPLE
Nova Corporation revalues a class of its fixed assets, resulting in an increase
in their values of £500,000, from a carrying amount of £20,000,000 to a new
amount of £20,500,000. The tax base of these assets is £18,500,000. Nova’s
tax rate is 35%. There had been a deferred tax liability of £525,000 prior to
the revaluation (calculated as the £1,500,000 difference between the tax base
and the old carrying amount, multiplied by the 35% tax rate). This amount
now increases by £175,000 to reflect the £500,000 increase in carrying
amount, multiplied by the 35% tax rate.
Deductible Temporary Differences
A deductible temporary difference is a difference between the tax base and
carrying amount of an asset or liability that will result in deductible amounts
in future periods. For example, a deductible temporary difference arises when
the tax base of an asset is greater than its carrying amount, which means that
a larger tax benefit exists than would otherwise be indicated by the carrying
amount. Eventually, the difference between the tax base and carrying amount
will disappear as the related asset or liability is consumed. Thus, the passage
of time will result in the elimination of all deductible temporary differences.
Examples of situations in which deductible temporary differences arise are:
• A company may charge pension costs to expense as employees
complete the service periods mandated by vesting requirements.
However, tax jurisdictions may not allow these expenses until the
pension benefits are actually paid out to employees, which may not be
until many years have passed. During the intervening period, the
company has a deferred tax asset.
• A company may charge research costs to expense as incurred, but a tax
jurisdiction may require that these costs be capitalized and then
amortized over time. If so, the company has a deferred tax asset until
the amortization period is complete.
• An acquirer may buy another business and record the assets and
liabilities of that business at their fair values. If the fair value of an
asset is lower than its existing tax base, the difference is a deferred tax
asset.
• Certain aspects of IFRS allow a business to revalue its assets to their
fair values. Tax jurisdictions may not allow this revaluation to carry
over for tax reporting purposes, which results in a temporary
difference that may be a deferred tax asset or deferred tax liability,
depending upon whether an asset is revalued upward or downward.
The general rule for deductible temporary differences is to recognize a
deferred tax asset to the extent that it is probable that the difference can be
utilized against taxable profits. Thus, if there is no probability of having
taxable profits, deductible temporary differences should not be recognized.
However, it is possible to recognize a deferred tax asset to the extent there
will be sufficient offsetting taxable profit relating to the same tax jurisdiction
and the same taxable entity.
A deferred tax asset can also be recognized to the extent that the
company can use tax planning opportunities to create taxable profits in the
future. A tax planning opportunity is an action that a business can take to
increase its taxable income in order to take advantage of a tax loss or tax
credit carryforward that would otherwise expire. For example, a company
could sell an investment in a municipal bond (for which there is no taxable
income) and use the proceeds to buy a corporate bond (for which the interest
income is taxable).
EXAMPLE
The standard accounting policy for Nova Corporation is to recognize a
warranty expense with each of the telescopes that it ships, which is primarily
related to the possible failure of the mechanical components of its motor
drives. However, the tax jurisdiction in which Nova resides does not allow
the warranty cost to be charged to expense until actual warranty claims are
paid out. In the most recent reporting period, Nova recognizes a warranty
expense of £20,000, for which there is a tax base of zero. The difference is a
deductible temporary difference. Assuming a 35% tax rate, Nova should
recognize a deductible temporary tax of £7,000, though only if it is probable
that the company will earn a sufficient amount of taxable profits in later
periods to offset this tax asset.
EXAMPLE
In the current period, Nova Corporation reports an accounting profit of
£150,000. In addition, it has £20,000 of taxable temporary differences and
£12,000 of deductible temporary differences. Its taxable income is
calculated as:

EXAMPLE
At the end of its most recent reporting period, Hammer Industries has the
following asset and liability balances in its accounting and tax records:

The differences in the table for accounts receivable and inventory are caused
by the recognition by Hammer of a £300,000 bad debt reserve against
accounts receivable and an inventory obsolescence reserve of £200,000,
neither of which are allowed for tax purposes. The £7,000,000 difference
between the carrying amount and the tax base of the fixed assets is caused
by the company’s use of accelerated depreciation for tax purposes and
straight-line depreciation for the calculation of its accounting profit.
Given the company’s 35% tax rate, Hammer records a deferred tax
provision of £2,275,000 (calculated as the total temporary difference of
£6,500,000 × 35% tax rate).
Unused Tax Losses and Tax Credits
A deferred tax asset related to unused tax losses and unused tax credits is
only recognized to the extent that sufficient future taxable income will be
generated to offset the tax asset. Since the existence of unused tax losses
strongly implies recent company losses, it is quite possible that there is not a
near-term expectation for future taxable income, so it may not be possible to
recognize this type of deferred tax asset at all. The existence of convincing
evidence of future taxable income is sufficient evidence to recognize a
deferred tax asset, though the nature of the evidence must be disclosed in a
company’s financial statements.
When determining whether there will be sufficient future taxable income
available to warrant the recognition of a deferred tax asset, consider the
following points:
• The probability of generating taxable profits prior to the expiration of
the tax asset
• The sufficiency of taxable temporary differences related to the same
tax jurisdiction
• Whether tax planning opportunities are available
• Whether the prior tax losses were caused by issues that are unlikely to
arise again
Reassessment of Unrecognized Deferred Tax Assets
In each reporting period, reassess all deferred tax assets that have not yet
been recognized. It is allowable to recognize these deferred tax assets to the
extent that it now appears probable that future taxable profits will offset
them. However, once an unrecognized tax asset expires, it is withdrawn from
consideration for recognition in a future period.
Investments in Other Entities
When a business initially records an investment in subsidiaries, branches,
associates, or joint arrangements, the entry is usually at cost, which will also
be the initial tax base. Over time, the carrying amount of this investment may
change, due to the business’ share of any undistributed profits, or a write-
down in the carrying amount of an investment to its recoverable amount.
Also, when there is a foreign subsidiary, exchange rate changes can result in
a difference between the carrying amount and tax base of an investment.
When there is a difference between the carrying amount and tax base of
these types of investments, an entity should recognize a deferred tax liability,
unless the entity can control the timing of when the temporary difference is
reversed, and it is not probable that the difference will reverse in the
foreseeable future.
A deferred tax asset should only be recognized on the difference between
the carrying amount and tax base of these types of investments when it is
probable that the underlying temporary differences will reverse in the
foreseeable future, and there will be a sufficient amount of taxable profit
against which the temporary difference can be offset.
Tax Rates
A business may be subject to a graduated income tax rate, and generates a
sufficient amount of income to be subject to several levels of this tax
structure. For example, a tax jurisdiction may charge a 10% income tax on
the first £1,000,000 of profits, and a 30% tax on all additional profits. In this
situation, a business should derive an expected average tax rate, and use it to
derive the amount of deferred tax assets and liabilities.
In some tax jurisdictions, the income tax rate may change if some portion
of earnings is paid out to shareholders in the form of dividends. In this
situation, the amount at which deferred tax assets and liabilities are
recognized is based on the tax rate that applies to undistributed profits.
EXAMPLE
The government of Azorbistan encourages companies located within its
boundaries to distribute their profits to shareholders by taxing undistributed
earnings at a 60% tax rate. The tax rate on distributed profits is only 20%. In
its year-end financial statements, Azor Mining Corporation makes no
mention of dividends declared, and recognizes 100,000 Azorbian pounds in
profits. Accordingly, the company recognizes a current tax liability and tax
expense of 60,000 pounds.
At the next board meeting in the following year, the board of directors of
Azor declares an 80,000 pound dividend, which allows the company to
declare a 32,000 pound reduction of its income tax expense, along with a
current tax asset in the same amount. The 32,000 pound income tax reversal
is calculated as:
(60% Tax on undistributed earnings – 20% Tax on distributed
earnings) × 80,000 Pound dividend
= 32,000 Pounds

When an asset is sold or a liability is settled, the local tax jurisdiction may
apply a different income tax rate to the transaction, depending upon the type
of transaction. For example, selling an asset may trigger an asset sale tax that
varies from the standard income tax rate. When this is the case, measure
deferred tax assets and liabilities at the tax rates that are currently expected to
apply when the underlying assets are recovered or the liabilities are settled.
EXAMPLE
Sharper Designs owns a ceramic extruder that it uses to create high-end
ceramic knives for professional chefs. The extruder currently has a carrying
amount of £150,000 and a tax base of £90,000. Sharper Designs will incur a
tax rate of 15% if it sells the extruder. The company is currently charged an
incremental tax rate of 35% on its operating income.
Given the differing tax rates, the company has two choices. It can:
• Sell the extruder now and recognize a deferred tax liability of £9,000
(calculated as £60,000 differential ×15% tax rate)
• Continue to use the extruder and recognize a deferred tax liability of
£21,000 (calculated as £60,000 differential × 35% tax rate)

Current and Deferred Tax Recognition

The general rule for the recognition of income taxes is that both current and
deferred taxes are recognized in profit or loss for the current period, except to
the extent that the tax is caused by a business combination, or the underlying
event appears in other comprehensive income or directly in equity. To be
more specific about the exceptions:
• Other comprehensive income items. Income taxes appear in other
comprehensive income if the underlying transaction also appears in
other comprehensive income. For example, a fixed asset revaluation or
foreign exchange differences due to the translation of financial
statements both appear in other comprehensive income, along with
their tax effects.
• Equity items. IFRS allows the effects of a small number of items to be
 charged directly to equity, such as retrospective changes to accounting
policies. When this happens, the related tax effect is also recorded in
equity.
• Business combination. When there is a business combination, some
elements of the transaction may include tax issues such as those just
noted for other comprehensive income or equity items, and which
therefore call for recognition outside of profit or loss.
Additional tax recognition issues are:
• Acquired deferred tax assets. An acquirer may obtain tax loss
carryforwards or other types of deferred tax assets from an acquiree.
The circumstances may not dictate that these assets be recognized
separately as part of the business combination. However, if new
information about the facts and circumstances that existed at the
acquisition date causes these assets to be recognized, use them to
reduce the amount of goodwill generated by the acquisition. If there is
no goodwill, recognize these tax assets in profit or loss.
• Dividend withholding. Depending on the tax jurisdiction, a business
may be required to pay a portion of the dividends issued to
shareholders to the tax authorities, which is considered a withholding
on behalf of the shareholders. The business acts as the agent of the tax
authorities when it remits the withheld amount. The company should
charge the amount of the withholding to equity, as a part of the
dividends paid.
• Share-based payments. A business may issue share-based payments to
its employees. The business may recognize the expense associated
with the employee services received in exchange for these payments,
though some tax jurisdictions only allow a tax deduction when the
related share options are exercised. This timing difference in
recognition of the expense for tax purposes creates a deferred tax
asset. If the tax jurisdiction only permits a deduction based on a future
share price at which an option will be exercised, estimate the
deduction based on the company’s share price at the end of the
reporting period.
• Tax asset recoverability. If there is a subsequent judgment that a tax
asset is not as recoverable as previously expected (since there may be
no offsetting future profits), it will be necessary to derecognize the
asset. When these types of changes occur, they are recognized in profit
 or loss. This situation can arise as part of a business combination,
when the combined results of the merged entities may alter expected
future profits to a sufficient extent to trigger the recognition or
derecognition of a tax asset.
• Tax rate changes. A deferred tax asset or liability may have initially
been established based on the existence of a certain tax rate. If that
rate changes, so too must the related tax asset or liability.
Uncertainty over Income Tax Treatment
There will be cases in which it is not clear how tax law applies to a particular
situation, and where the state of affairs will not be resolved until a taxation
authority or court issues a decision. In this situation, the accountant should
determine whether to consider each uncertain tax treatment individually or
grouped with other uncertain tax treatments, using whichever approach better
predicts how the uncertainty will be resolved. For example, it could cluster
several related issues together based on how it expects the relevant taxation
authority to make its examination of the issue and reach a determination.
The accountant should consider the probability that a taxing authority will
accept an uncertain tax position. If acceptance is considered probable, the
accountant should determine the taxable profit or loss, tax bases, unused tax
losses, and so forth in a manner consistent with the tax treatment used in the
related income tax filings. Conversely, if acceptance is not considered
probable, the accountant should reflect the effect of this uncertainty when
determining the same tax issues, using either the most likely or the expected
value of the outcome amount; the alternative selected should best predict how
the uncertainty will be resolved.
The facts and circumstances related to a judgment or estimate regarding
the acceptability of a tax treatment may change. If so, the accountant should
incorporate the effect of the change into a change in accounting estimate.
Changes in Tax Status
There may be an alteration in the tax status of a business, perhaps because its
legal form of incorporation has changed, or it is now publicly held, or
because the parent entity has moved to a different country. When these types
of changes occur, it may result in a change in the taxes applied to the
business; tax rates may change, or perhaps the business will no longer qualify
for tax incentives, or maybe it will qualify for new tax incentives.
When there is a change in tax status, both the current and deferred tax
consequences of the change should be recognized in profit or loss in the
period when the change occurs. If the tax status change relates to items that
are recognized in equity, recognize the associated tax effects in equity. If the
tax status change relates to items that are recognized in other comprehensive
income, recognize the associated tax effects in other comprehensive income.
Income Tax Presentation
Consider the following points when presenting information about income
taxes in the financial statements:
• Current tax offsets. It is only allowable to offset current tax assets and
liabilities when a business has a legal right to actually set off the
recognized amounts, and intends to either settle the amounts on a net
basis or realize the asset and settle the liability simultaneously. A legal
right to set off tax assets and liabilities usually only arises when both
relate to taxes levied by the same tax jurisdiction.
• Deferred tax offsets. It is only allowable to offset deferred tax assets
and liabilities when a business has a legal right to actually set off the
recognized amounts, and the deferred items relate to taxes levied by
the same tax jurisdiction on either the same entity, or on different
entities that plan to settle the amounts on a net basis or realize the
asset and settle the liability simultaneously in those periods when they
come due.
In addition, the tax expense related to the profit or loss from ordinary
activities is to be presented as part of profit or loss.
Income Tax Disclosures
There are a number of disclosures required for income taxes, which are as
follows:
• General. The major elements of tax expense must be disclosed
separately. The elements requiring separate disclosure include:
o The current tax expense
o Tax adjustments recognized in the period for the current tax of
prior periods
o The amount of deferred tax expense related to the creation or
reversal of temporary differences
o The amount of deferred tax expense related to changes in tax
rates or new taxes
o The benefit from a previously unrecognized tax loss, credit, or
temporary difference in a prior period that offsets a current tax
expense, or separately to reduce a deferred tax expense
 o A deferred tax expense caused by the write-down of a deferred
tax asset or the reversal of its write-down
o The amount of tax expense associated with changes in
accounting policies or accounting errors that are not accounted
for retrospectively
• Equity-related. The aggregate amount of all current and deferred taxes
relating to items that were charged directly to equity.
• OCI-related. The amount of income tax related to each component of
other comprehensive income.
• Reconciliation. A discussion of the relationship between income taxes
and accounting profit. This can be in the form of a reconciliation of
the tax expense to the accounting profit multiplied by the applicable
tax rate, or a reconciliation of the average effective tax rate and the
applicable tax rate. In either case, describe the basis on which the
applicable tax rate is computed. The average effective tax rate is the
tax expense divided by the accounting profit.
• Rate change. The reasons for any changes in the applicable tax rate
from the previous reporting period.
• Deductible temporary differences. The amount of any deductible
temporary differences, unused tax losses, and unused tax credits for
which there is no recognition of a deferred tax asset, as well as any
expiration dates.
• Temporary differences. The aggregate amount of any temporary
differences related to investments in subsidiaries, associates, and joint
arrangements, where deferred tax liabilities have not been recognized.
• Balance sheet presentation. The amount of deferred tax assets and
liabilities for each type of temporary difference, unused tax loss, and
unused tax credit that appears in the balance sheet.
• Income statement presentation. The amount of deferred income taxes
recognized in profit or loss for each type of temporary difference,
unused tax loss, and unused tax credit that is recognized in the income
statement.
• Discontinued operations. The tax expense related to the gain or loss on
discontinued operations, and the tax expense related to the ordinary
activities of these operations.
• Dividend consequences. The amount of income tax consequences
related to any dividends that were declared prior to financial statement
 issuance, but for which there is no liability in the financial statements.
• Pre-acquisition asset change. The amount of any change in a pre-
acquisition deferred tax asset that is caused by a business combination.
• Post-acquisition asset change. If deferred tax benefits are not
recognized as part of a business combination, but are recognized at a
later date, describe what caused the benefits to be recognized.
• Unusual tax asset recognition. The amount of any deferred tax asset
and the reason for its recognition when using it is dependent on
unusually large future taxable profits, and the entity has recognized a
loss in the current or preceding period.
• Dividend consequences. The income tax consequences resulting from
the payment of dividends to shareholders, where doing so alters the
income tax rate paid. Note the tax consequences that are practicably
determinable, and whether there are any tax consequences that are not
practicably determinable.
EXAMPLE
Selected sample disclosures are:
Major components of tax expense (000s)

Income tax relating to other comprehensive income (000s)

Explanation of relationship between tax expense and accounting

profit (000s)

Summary
From the perspective of efficient accounting, it is generally best to avoid
recognizing deferred tax assets if there is even a reasonable chance that the
offsetting amount of taxable profits will not be generated in the near future.
This choice will be particularly easy to make when there is a history of
minimal profits, or profits that swing in such a random manner that they are
essentially impossible to predict.
The typical accountant usually remembers to recognize income taxes at
the end of each reporting period. What is not so readily remembered is that
there may also be tax effects associated with transactions that are recognized
in other comprehensive income or directly in equity, and for which tax effects
must also be recognized. It is useful to include this point in the closing
procedures for each reporting period.
 Chapter 24
Business Combinations
Introduction
When one entity purchases another entity, it is referred to as a business
combination. In a business combination, the acquirer must integrate the
financial statements of the acquiree into its own financial statements, which
can be a complex process. IFRS contains specific rules for doing so, with the
intent of bringing some standardization to the process. In this chapter, we
address the accounting for and disclosure of a business combination.
IFRS Source Document
• IFRS 3, Business Combinations
The Acquisition Method
When a business combination is completed, the acquirer must ensure that it
properly identifies, measures, and recognizes all of the assets and liabilities of
the acquiree, as well as any non-controlling interest in the acquiree, and any
goodwill arising from the acquisition. This process, which is called the
acquisition method, can be a complex process. Accordingly, we break it
down in the following sub-sections to address each aspect of the method
separately. The sub-sections are stated in the approximate order of the work
flow that one would follow to account for a business combination.
Identification of a Business Combination
Before accounting for a business combination, it is first necessary to
determine if a business combination has occurred. A business combination
has only occurred if a business has been acquired. If not, a transaction is
instead accounted for as a purchase of assets.
In essence, a business is defined as an entity that uses its own processes to
transform inputs into outputs. Thus, the acquisition of a group of machines
from another company is probably not a business combination, since none of
these elements are present. The acquisition of a startup company can be more
difficult to classify as a business combination, for it may not yet contain
many processes, and not yet have any outputs. In marginal situations where it
is not clear that a business is being acquired, look for the following signs that
indicate business operations:
• The entity has at least begun planning its primary activities
• The entity has employees and/or intellectual property that could be
 used to transform inputs
• The entity is implementing a plan to generate outputs
• The entity can access customers capable of purchasing its outputs
Usually, the presence of a business is clear; the most difficult recognition
situations arise when a business is so new at the point of acquisition that it
has not yet begun those activities normally found in a business operation.
Identify the Acquirer
The entity that gains control of the other entity is considered the acquirer.
This is not always clear, especially in reverse acquisition situations where a
privately-held business is rolling itself into a publicly-held shell company.
Indicators of the acquirer are:
• The acquirer is transferring away cash or accepting liabilities as part of
the transaction
• The acquirer issues its equity to the owners of the other party
• The acquirer may be significantly larger than the other entity
• The acquirer pays a premium for the equity interests of the other entity
• The management team of the acquirer dominates the management of
the combined entity
• The owners of the acquirer can appoint or remove a majority of the
board of directors
• The owners of the acquirer retain the largest share of voting rights
If a new entity is formed as part of a business combination, as arises in a
triangular merger, the new entity may not be the acquirer; the acquirer may
instead be one of the original entities.
Determine the Acquisition Date
A business combination should be accounted for as of the acquisition date,
which is the date on which the acquirer obtains control of the acquiree. This
is normally the closing date, which is when the acquirer formally transfers
payment to the owners of the acquiree, and takes on the assets and liabilities
of the acquiree. However, a separate agreement could initiate control on a
different date, so consider all facts to ensure that the correct date is chosen.
Recognize Assets, Liabilities, and Non-controlling Interests
In essence, the key principle underlying the accounting for a business
combination is for the acquirer to recognize all assets, liabilities, and non-
controlling interests in the acquiree, as of the acquisition date. All assets and
liabilities recognized should be at their fair values on the acquisition date.
The valuation assigned to non-controlling interests should be at either their
values or their proportionate share of the acquiree’s recognized net assets.
 When a business is acquired, the acquirer essentially starts with a large
asset known as goodwill, which represents the net purchase price, and which
it wants to whittle down by shifting as much of the asset to individually
recognized assets and liabilities as possible. These assets and liabilities are
eventually depreciated, amortized, or settled in some other manner, and so are
eliminated from the acquirer’s balance sheet. Eventually, only goodwill
remains on the balance sheet; the acquirer must monitor the goodwill balance
over time and possibly write it off as a loss if the underlying acquired
business has lost value.
The following points outline the key elements of how the recognition of
assets and liabilities is to be achieved:
• Recognition criteria. Only assets and liabilities that would normally be
recognized under IFRS can be recognized in a business combination.
• New assets and liabilities. It is permissible for the acquirer to
recognize assets and liabilities that the acquiree had not recognized in
the past. For example, the acquirer may recognize a number of
intangible assets, such as customer lists and brand names. These
situations arise because the acquiree was not allowed under IFRS rules
to recognize internally-developed assets. Intangible items are
recognized if they can be separated from the acquiree and sold,
licensed, or exchanged. Even if an intangible item cannot be
transferred away in this manner, it may still qualify as a recognizable
intangible item if it exists under a contractual relationship. Examples
of intangible assets are:

EXAMPLE
Hubble Corporation acquires Aphelion Enterprises. Aphelion sells large
telescopes to high-end amateurs throughout the world. Normally, Hubble
would classify Aphelion’s customer list as a valuable intangible asset, since
it could theoretically be sold to a third party. However, Aphelion has signed
confidentiality agreements with its clients that prevent it from selling or
leasing their contact information. Since there is a restriction on use of the
list, Hubble cannot recognize the customer list as an intangible asset.
The Aphelion brand name has been heavily promoted for years, and could
potentially be sold to a competing telescope firm. Since the brand is
transferable, Hubble could recognize the brand as an intangible asset.

• Assembled workforce. Many business combinations involve the

acquisition of an assembled workforce, which may appear to be an
obvious intangible asset. However, recognition of an assembled
workforce is specifically prohibited under IFRS, since it is presumed
to be part of the goodwill asset.
• Contingent liabilities. If an acquiree has a contingent liability, the
acquirer recognizes the liability even if it is not probable that an
outflow of resources will be required to settle the liability.
• Contracts being negotiated. If contracts with customers are still in the
process of being negotiated on the acquisition date, these contracts
cannot yet be considered assets, and so cannot be recognized as such
by the acquirer. Do not subsequently record these contracts as assets if
they are finalized after the acquisition date.
• Indemnification asset. The seller may take on the obligation to
indemnify the acquirer, based on the outcome of a contingency that
was not resolved as of the acquisition date, thereby guaranteeing that
the acquirer will not suffer a loss, or that its loss will be capped. The
acquirer should recognize an indemnification asset at the same time
that it recognizes a loss on an item that is to be indemnified.
• Leases. Determine whether each lease is favorable or unfavorable in
relation to current market terms. If the terms of the lease are favorable,
recognize an intangible asset. If the terms are unfavorable, recognize a
liability.
EXAMPLE
New Centurion Corporation, translator of Latin texts, is acquired by Gaelic
Textbooks. New Centurion has been leasing a facility for the past 20 years
in a rent-controlled district. The rent agreement cannot be transferred. The
rent paid is now seriously below the market rate. Despite the non-transferal
clause, Gaelic can recognize the difference between the rent paid and the
market rate as an intangible asset, since the asset exists under a contractual
relationship.
 • Reacquired rights. As part of a business combination, an acquirer may
reacquire a right that it had previously granted to an acquiree, such as
a distribution license or a technology licensing arrangement. A
reacquired right is considered a separately-identifiable intangible item.
If there is a difference between the terms of the reacquired right and
current market transactions, recognize it as a settlement gain or loss.
EXAMPLE
Amblin’ Ale acquires Belgium Bottlers, to which Amblin’ had formerly
granted an exclusive distribution arrangement within Belgium. Amblin’
therefore reacquires the distribution rights, which it can recognize as an
intangible asset. Amblin’ plans to amortize the asset over the remaining term
of the original arrangement.
Recognize Goodwill or a Bargain Purchase Gain
After all assets and liabilities have been measured, as just described, the
acquirer either recognizes a goodwill asset or a bargain purchase gain.
Goodwill is measured as follows:

EXAMPLE
Jefferson Industrial acquires Pathmark Manufacturing for £6,500,000.
Jefferson’s accounting staff identifies tangible Pathmark assets with a fair
value of £5,800,000, intangible assets that it values at £4,000,000, and
liabilities of £3,700,000. The goodwill associated with the transaction is
therefore derived as follows:

The amount of consideration paid to the sellers of the acquiree is measured at

its fair value on the acquisition date. This fair value measurement applies to
all assets paid, liabilities assumed, and equity interests issued by the acquirer.
This guidance can potentially apply to many types of consideration paid, such
as:
• A business owned by the acquirer
• Cash
• Debt or convertible debt
• The transfer of intellectual property
• Warrants
The fair value of the consideration paid may vary from its carrying amount
on the books of the acquirer. If there is a difference, and the consideration is
being paid to the owners of the acquiree, the acquirer recognizes a gain or
loss in the amount of the difference. However, if the consideration is instead
paid to the acquiree entity, and the acquirer then gains control over the
acquiree, the acquirer must continue to recognize the consideration paid at its
carrying amount; otherwise, the acquirer would be adjusting the basis of its
assets by shifting assets internally.
The acquirer may offer contingent consideration to the owners of the
acquiree, such as a payment that is based on the subsequent profitability of
the acquiree. If so, the acquirer should recognize its best estimate of the fair
value of this additional consideration as of the acquisition date. The amount
of this consideration may change over time, based on changes arising after
the acquisition date. If so, the accounting treatment depends upon the nature
of the consideration, as follows:
• Equity consideration. If the contingent consideration is paid in equity,
the amount of this consideration is not to be remeasured.
• Other consideration. If the contingent consideration is paid with some
form of asset, remeasure the consideration at each reporting date, and
recognize any changes in the fair value of the contingent consideration
in profit or loss.
EXAMPLE
EuroDesigns buys Danforth Engineering. Part of the purchase agreement
contains a clause under which EuroDesigns will pay Danforth’s former
owners 50% of the profits of Danforth that are in excess of £200,000 in each
of the next three years. Management’s best estimate of the total amount of
these payments is £800,000, which it recognizes as contingent consideration
as of the acquisition date.
The recognition of goodwill is the most common state of affairs. However, it
is also possible that an acquirer will pay an amount that is less than the fair
values of the assets acquired and liabilities assumed, perhaps due to the
seller’s need to rush the sale transaction. This is known as a bargain
purchase. If there is a bargain purchase, the acquirer recognizes a gain in
profit or loss as of the acquisition date that is based on the net difference
between the consideration paid and the assets and liabilities acquired.
EXAMPLE
The owners of Failsafe Containment have to rush the sale of the business in
order to obtain funds for estate taxes, and so agree to a below-market sale to
Armadillo Industries for £5,000,000 in cash of a 75% interest in Failsafe.
Armadillo hires a valuation firm to analyze the assets and liabilities of
Failsafe, and concludes that the fair value of its net assets is £7,000,000 (of
which £8,000,000 is assets and £1,000,000 is liabilities), and the fair value
of the 25% of Failsafe still retained by its original owners has a fair value of
£1,500,000.
Since the fair value of the net assets of Failsafe exceeds the consideration
paid and the fair value of the noncontrolling interest in the company,
Armadillo must recognize a gain in earnings, which is calculated as follows:
£7,000,000 Net assets - £5,000,000 Consideration - £1,500,000
Noncontrolling interest
= £500,000 Gain on bargain purchase
Armadillo records the transaction with the following entry:

Additional Acquisition Issues

An acquirer may elect to gain control over an acquiree in stages, by acquiring
an initial non-controlling stake and then increasing the percentage over time.
This is called a step acquisition. The accounting for a step acquisition is to re-
measure at fair value the equity interest already held on the date when the
acquirer finally gains control over the acquiree. If this measurement results in
a change from the existing carrying amount of the investment, the acquirer
should recognize the resulting gain or loss. If the acquirer had previously
been recognizing changes in the value of its (at that time) non-controlling
interest in other comprehensive income, the amount of these changes should
be recognized when control is achieved, as though the acquirer had disposed
of its prior non-controlling interest.
It is entirely possible that the measurement of an acquisition will not be
complete on the acquisition date, since some issues will not be resolved,
possibly for a number of months. If so, the acquirer should record provisional
amounts as of the acquisition date, and then retrospectively adjust those
provisional amounts for any new information obtained about the facts and
circumstances in existence on the acquisition date. This may result in the
recognition of entirely new assets and liabilities. The offset to changes in
provisional amounts is an increase or reduction in the goodwill balance. The
period over which these retrospective changes can be made is limited to one
year from the acquisition date. Realistically, most applicable information
should be available within a few months of the acquisition date.
EXAMPLE
Armadillo Industries acquires Cleveland Container on December 31, 20X3.
Armadillo hires an independent appraiser to value Cleveland, but does not
expect a valuation report for three months. In the meantime, Armadillo
issues its December 31 financial statements with a provisional fair value of
£4,500,000 for the acquisition. Three months later, the appraiser reports a
valuation of £4,750,000 as of the acquisition date, based on an unexpectedly
high valuation for a number of fixed assets.
In Armadillo’s March 31 financial statements, it retrospectively adjusts the
prior-year information to increase the carrying amount of fixed assets by
£250,000, as well as to reduce the amount of goodwill by the same amount.

The participants in a business combination may have been business partners

prior to the acquisition. If so, there may be a number of pre-existing
arrangements between the parties as of the acquisition date. These
arrangements should be kept separate from the acquisition transaction. Doing
so can reduce the number of assets and liabilities incorporated into the
acquisition transaction.
The acquirer may incur a number of costs as part of an acquisition, such
as advisory fees, accounting services, legal advice, valuation services,
finder’s fees, and the costs of running an acquisitions department. These costs
are to be charged to expense as incurred. However, if there are costs
associated with issuing debt or equity instruments as part of a business
combination, these costs are to be dealt with as described in the Financial
Instruments chapter.
Reverse Acquisitions
A reverse acquisition occurs when the legal acquirer is actually the acquiree
for accounting purposes. The reverse acquisition concept is most commonly
used when a privately-held business buys a public shell company for the
purposes of rolling itself into the shell and thereby becoming a publicly-held
company. This approach is used to avoid the expense of engaging in an initial
public offering.
To conduct a reverse acquisition, the legal acquirer issues its shares to the
owners of the legal acquiree (which is the accounting acquirer). The fair
value of this consideration is derived from the fair value amount of equity the
legal acquiree would have had to issue to the legal acquirer to give the
owners of the legal acquirer an equivalent percentage ownership in the
combined entity.
When a reverse acquisition occurs, the legal acquiree may have owners
who do not choose to exchange their shares in the legal acquiree for shares in
the legal acquirer. These owners are considered a noncontrolling interest in
the consolidated financial statements of the legal acquirer. The carrying
amount of this noncontrolling interest is based on the proportionate interest of
the noncontrolling shareholders in the net asset carrying amounts of the legal
acquiree prior to the business combination.
EXAMPLE
The management of High Noon Armaments wants to take their company
public through a reverse acquisition transaction with a public shell company,
Peaceful Pottery. The transaction is completed on January 1, 20X4. The
balance sheets of the two entities on the acquisition date are as follows:
On January 1, Peaceful issues 0.5 shares in exchange for each share of High
Noon. All of High Noon’s shareholders exchange their holdings in High
Noon for the new Peaceful shares. Thus, Peaceful issues 500 shares in
exchange for all of the outstanding shares in High Noon.
The quoted market price of Peaceful shares on January 1 is £10, while the
fair value of each common share of High Noon shares is £20. The fair values
of Peaceful’s few assets and liabilities on January 1 are the same as their
carrying amounts.
As a result of the stock issuance to High Noon investors, those investors
now own 5/6ths of Peaceful shares, or 83.3% of the total number of shares.
To arrive at the same ratio, High Noon would have had to issue 200 shares
to the shareholders of Peaceful. Thus, the fair value of the consideration
transferred is £4,000 (calculated as 200 shares × £20 fair value per share).
Goodwill for the acquisition is the excess of the consideration transferred
over the amount of Peaceful’s assets and liabilities, which is £3,900
(calculated as £4,000 consideration - £100 of Peaceful net assets).
Based on the preceding information, the consolidated balance sheet of the
two companies immediately following the acquisition transaction is:
Subsequent Measurement
Once a business combination has been initially recorded, the assets and
liabilities are to be accounted for in the normal manner, as required by IFRS
for the relevant classifications of items. However, the following exceptions
apply:
• Contingent consideration. The amount of contingent consideration to
be paid may change after the acquisition date, based on events
occurring after that date. The obvious example is when an acquiree
achieves an earnings target that entitles its former owners to an
additional payment. In this situation, the accounting depends upon the
type of consideration paid, which is:
o Equity payment. If the consideration is paid in some form of
equity, no further accounting is necessary.
o Other payment. If the consideration is not in equity (a cash
payment or a change in the amount of debt payable is typical),
record the change at its fair value, which triggers the
recognition of a gain or loss.
• Indemnification assets. If an indemnification asset is recorded,
management should evaluate it in each reporting period to see if it is
still collectible, and adjust its recorded amount accordingly.
• Reacquired rights. When an acquirer reacquires a legal right that it had
previously granted to the acquiree when it was an independent entity,
the amount of this asset is to be amortized over the remaining term of
the original contract with the acquiree. If the acquirer then sells the
reacquired right to a third party, the remaining carrying amount of the
asset is used as the basis for determining any gain or loss on the sale.
Business Combination Disclosures
When an acquirer completes a business combination, it should disclose
sufficient information for users to evaluate the nature and financial effect of a
transaction. This applies if the combination occurred either within the
reporting period or before the financial statements were authorized for
issuance. The following is considered sufficient disclosure:
• Acquisition costs. The amount of acquisition costs, the amount charged
to expense, and where these items are located in the financial
statements. Also note any of these costs not charged to expense, and
how they were recognized.
• Assets and liabilities. The amounts of each major class of asset
acquired and liability assumed.
• Bargain purchase. If there was a bargain purchase, note the amount of
any gain recognized, and where the gain is located in the financial
statements. Also note the reasons why the combination resulted in a
gain.
• Combination in stages. If a combination was completed in stages, note
the fair value on the acquisition date of the interest held in the acquiree
immediately prior to the combination, as well as any gain or loss
resulting from the remeasurement to fair value, and where this
information is located in the financial statements.
EXAMPLE
On June 30, 20X1, Armadillo acquired 20% of the outstanding
common stock of High Pressure Designs (“High Pressure”). On
March 31, 20X3, Armadillo acquired 45% of the outstanding
common stock of High Pressure. The fair value of Armadillo’s
equity holdings in High Pressure was £3,500,000 at the acquisition
date, which represented a £200,000 gain. The gain is recorded in
other income in the company’s income statement for the quarter
ended March 31, 20X3.

• Consideration. The total fair value of the consideration paid, as well as

by class of consideration, such as cash, liabilities incurred, and equity
interests paid. If there is contingent consideration, state the amount
recognized, describe the arrangement, and estimate the range of
possible payments; if the range cannot be estimated or is unlimited,
disclose these points.
EXAMPLE
The contingent consideration arrangement contained within the
purchase agreement for Darnley Enterprises is to pay Darnley’s
former owners 25% of the profits of Darnley that are in excess of
£500,000 for the next three years. There is no upper limit on the
amount that can be paid. Management estimates that the range of
payments will be from £0 to £2,000,000 in each of the three years.

• Contingent liabilities. Describe the nature of each obligation and when

it may be paid, as well as related uncertainties, and any expected
reimbursement. If it is not possible to measure the fair value of a
contingent liability, disclose why the measurement cannot be made,
and (if possible) an estimate of its financial effect, related
uncertainties, and any possible reimbursement.
EXAMPLE
The company has recognized a contingent liability of £150,000 for
expected warranty claims on products sold by Darnley in the past
12 months. The bulk of this expenditure is expected to occur in the
next three months, and all of it by the end of the fiscal year. No
reimbursement of these funds by a third party is expected.

• Date. The date of the acquisition.

• Description. The name of the acquiree, a description of it, the reasons
for the combination, and how the acquirer gained control of it.
EXAMPLE
On February 15, 20X4, Peacock acquired 100% of the outstanding
ordinary shares of Green Plumage (“Green”) with an all-cash
purchase, and obtained control of Green at that time. Green is a
provider of exotic animals to zoos throughout the world. As a
result of the acquisition, Peacock expects to be the leading
provider of leased exotic animals in all markets outside of Asia,
and expects to enact a small increase in its leasing rates.

• Equity interest. The percent of the acquiree’s voting equity acquired.

• Financial results. The revenue and profit or loss of the acquiree
following the acquisition date that have been included in the statement
of comprehensive income, as well as the revenue and profit or loss of
 the combined entity as though the acquisition had taken place at the
beginning of the fiscal year.
EXAMPLE
The revenue included in the consolidated statement of
comprehensive income since February 15, 20X4 contributed by
Green Plumage (“Green”) was £16,300,000. Green also
contributed £1,900,000 of profits during the same period. If Green
had been consolidated from January 1, 20X4, the consolidated
statement of comprehensive income would have included revenue
of £17,800,000 and profit of £2,200,000.

• Goodwill tax deduction. The amount of goodwill expected to be tax

deductible.
• Goodwill. The factors that comprise the recognized amount of
goodwill, such as planned synergies and assets that do not qualify for
separate recognition.
EXAMPLE
The goodwill of £5,000,000 arising from the acquisition of
Arbuthnot Distillery consists primarily of the synergies and
economies of scale expected from combining the purchasing
contracts and distribution operations of the two companies.

• Non-controlling interest. If there is a non-controlling interest in the

acquiree, disclose the amount of this interest and how it was measured.
Also note the valuation method and inputs used to measure each of
these interests.
EXAMPLE
The fair value of the non-controlling interest in Darnley
Enterprises was estimated by applying a market approach. The fair
value measurements are based on significant inputs for similar
items, and so represent a fair value measurement categorized
within Level 2 of the fair value hierarchy. Key assumptions used
in determining the valuation were an adjustment for lack of
control of Darnley by the non-controlling interest, and financial
multiples of entities considered similar to Darnley.

• Receivables. If receivables are being acquired, state their fair value,

 the gross contractual amount, and the estimated amount of these cash
flows that will not be collected. This information should be separated
by class of receivable.
EXAMPLE
The fair value of the financial assets acquired includes credit card
receivables with a fair value of £3,200,000. The gross amount of
these receivables due is £3,650,000, of which £450,000 is
expected to be uncollectible.

• Separate transactions. A description of any transactions with the

acquiree that are reported separately from the business combination, as
well as how they were accounted for, the amounts recognized, and
where the information is located in the financial statements. If these
transactions essentially settle a pre-existing relationship, state how the
settlement amount was determined.
If the effect of a business combination is immaterial, but the cumulative
effect of several combinations in the same period is material, disclose all of
the preceding information in aggregate for the group of business
combinations.
If a material business combination is completed after the reporting period
but before the financial statements have been authorized for issuance, provide
the complete set of disclosures just noted. However, this is not necessary if
(as is frequently the case) the accounting for the business combination is not
yet complete; if so, note which disclosures could not be made, and why.
If adjustments were recognized in the current period that relate to
business combinations that were initially recognized in prior periods, provide
sufficient disclosures to evaluate the financial effects of the adjustments.
These disclosures shall include:
• Contingent consideration. Continue to report changes in the
recognized amounts of contingent assets and liabilities, until they are
settled. Also note changes in the range of possible outcomes and the
reasons for these changes, as well as the valuation methods and inputs
used to measure these contingent items.
EXAMPLE
As of year-end, the amount originally recognized for the
contingent consideration arrangement with the former owners of
Darnley Enterprises had not changed. Management now estimates
 that the expected upper end of the range of possible contingent
payments has declined from £2,000,000 in each of the next three
years to no more than £1,200,000 in each of the next three years.

• Contingent liabilities. Continue to report changes in the provisions for

contingent liabilities until they are settled, including changes in their
carrying amounts, provisions added or reversed, expected
reimbursements, and a description of the nature of these items, the
expected timing of payouts, and the level of uncertainty regarding
their timing or amounts.
EXAMPLE
As of year-end, the amount of expected warranty claims has
increased by £30,000, for which an additional reserve has been
recognized. With four months remaining in the warranty period to
which these claims apply, the range of future warranty-related
payments is estimated to be between £140,000 and £200,000.

• Gains and losses. The amount and nature of any gains or losses
recognized that relate to assets or liabilities acquired in a prior
business combination, if they are material enough to impact a reader’s
understanding of the financial statements.
• Goodwill reconciliation. Reconcile the beginning and ending carrying
amounts of goodwill and accumulated impairment losses, including
additional goodwill recognized, adjustments related to the recognition
of deferred tax assets, goodwill included in assets designated as held
for sale, impairment losses, foreign exchange rate differences, and
other changes.
• Incomplete accounting. For business combinations where the
accounting is incomplete, state the reasons why, the items for which
accounting is incomplete, and the nature and amount of any
adjustments made in the reporting period.
If the effect of the adjustments for a single business combination is
immaterial, but the cumulative effect of the adjustments for several
combinations in the same period is material, disclose all of the preceding
information for adjustments in aggregate.
Summary
One of the more burdensome aspects of acquisition accounting is the
requirement to retrospectively adjust the provisional amounts that were
initially recorded as part of a business combination. Retrospective adjustment
is to be avoided, since it involves modifying the financial statements of prior
periods. To avoid this issue, set a high threshold for materiality when
deciding if a retrospective change should be made. Also, delay the reporting
of the accounting period in which an acquisition takes place for as long as
possible, so that adjustments can be made before the financial statements
have been issued.
The accounting for a reverse acquisition is particularly difficult, since it is
encountered rarely and involves adjustments that are not usually found in a
business combination. It is best to engage the services of a reverse acquisition
accounting specialist, to ensure that this transaction is recorded correctly.
Otherwise, the consolidated information reported by the public company that
arises from such a transaction may require subsequent adjustment, which will
be plainly visible to the investment community through the company’s public
filings of financial information.
 Chapter 25
Financial Instruments
Introduction
The discussion of financial instruments occupies more space within IFRS
than any other topic, including how financial instruments are to be measured,
recognized, presented, and disclosed within the financial statements. Though
IFRS professes to limit itself to providing general principles upon which to
construct accounting transactions, the treatment of financial instruments
verges most closely upon the rules-based guidance used in Generally
Accepted Accounting Principles. Accordingly, the discussion of financial
instruments in the following sections will appear unusually dense when
compared to other IFRS topics.
IFRS Source Documents
• IFRS 7, Financial Instruments: Disclosures
• IFRS 9, Financial Instruments
• IAS 32, Financial Instruments: Presentation
• IAS 39, Financial Instruments: Recognition and Measurement
Measurement of Financial Assets and Liabilities
This section covers how to initially measure financial assets and liabilities, as
well as how to treat later reclassifications of these items. There is an
additional discussion of the measurement of derivatives that are incorporated
into other financial instruments.
Initial Measurement
A financial asset or liability is to initially be measured at its fair value, plus or
minus any transaction costs associated with the related asset acquisition or
liability issuance. The basis of measurement may subsequently change, but
the initial measurement is at fair value.
It is also possible to designate an asset as being measured at fair value
through profit or loss, which means that all subsequent changes in the fair
value of an item are immediately recognized in profit or loss. This option is
available if doing so reduces an inconsistency in how an asset is measured,
and in certain other circumstances. Once the option is taken, future
measurements must also be made at fair value.
Alternatively, a financial asset may be measured at fair value through
other comprehensive income, which means that changes in the value of the
asset are stated in other comprehensive income, rather than profit or loss.
Once the asset is sold, the gain or loss in other comprehensive income is
shifted to profit or loss. Such treatment is possible only when the following
two conditions are present:
• The related business objective is to hold the asset in order to collect
contractual cash flows and to sell the asset; and
• The asset’s terms trigger cash flows on certain dates that are
comprised of principal and interest.
EXAMPLE
The Close Call Company acquires 1,000 shares of Global Industrial for
£50,000 and classifies the shares as at fair value through profit or loss. After
one year, the quoted price of the shares declines, reducing their value to
£40,000. After an additional year, Close Call sells the shares for £62,000.
The related entries are:

To record initial stock purchase

To record decline in value after one year

To record sale of stock

A financial instrument may also be classified as an equity instrument. This is

only the case if the instrument contains no obligation to deliver a financial
asset to another entity, or to exchange financial assets or liabilities under
potentially unfavorable conditions. Also, if the instrument will be settled in
the entity’s own equity instruments, it either does not require the issuance of
a variable amount of the entity’s equity instruments, or involves the exchange
of a fixed payment for a fixed amount of the entity’s equity instruments.
If an investment is in an equity instrument, an entity can make an
irrevocable election to present changes in the fair value of that instrument in
other comprehensive income. This election is not available if the equity
instrument is classified as held for trading. Dividends received on such
investments are to be recognized in profit or loss.
The following bullet points denote the rules under which certain financial
instruments should be classified:
• Preference shares. A preference share would normally be considered
an equity instrument. However, if its terms require the issuer to
redeem it for a fixed amount, classify it instead as a financial liability.
• Puttable instruments. A puttable instrument gives the holder the option
to demand payment from the issuer. In most cases, the issuer should
classify a puttable instrument as a liability.
• Derivative with settlement choices. If the holder of a derivative
instrument can choose the form of settlement, the derivative is
classified as either a financial asset or liability, unless all settlement
choices result in classification as an equity instrument.
• Compound financial instruments. If a financial instrument contains
elements of both a liability and equity instrument, classify and
measure each part separately. This situation is most likely to arise
when an instrument creates a financial liability and grants the holder
the option to convert the liability into an equity instrument of the
issuer (as is the case with a convertible bond). In this case, determine
the fair value of the liability component first, and then assign any
remaining residual value to the equity instrument.
EXAMPLE
The Close Call Company issues 1,000 convertible bonds that mature in four
years, and which have a face value of £1,000 each. The total proceeds
garnered by Close Call are therefore £1,000,000. The prevailing market
interest rate on the issuance date is 8%.
Close Call measures the liability and equity components of this compound
instrument by measuring the liability component first, and assigning the
residual amount to the equity component. The present value of the
£1,000,000 of bond principal due in four years is £735,030, using the 8%
discount rate. Therefore, the equity component of the instrument is assigned
the residual value of £264,970.
Subsequent Measurement
Once a financial asset has initially been measured, it must subsequently be
measured either at its fair value or amortized cost. This decision is based on a
combination of the cash flow characteristics of the asset and the related
business model for managing this type of asset. Measurement should be at
amortized cost when the company’s business model is to hold the asset in
order to obtain principal and interest payments. In all other circumstances, a
financial asset is measured at its fair value.
EXAMPLE
Capitalist Lending is in the business of acquiring portfolios of loans from
banks, and collecting the principal and interest payments on those loans until
they have been paid off. Capitalist should measure these loan portfolios at
their amortized cost, since it intends to hold the loans until their maturity.
Capitalist Lending also has a division that acquires bundles of home
mortgages from lenders and repackages them into securities, which it sells.
In this case, Capitalist intends to sell off the mortgages through the
securitization vehicle, and so should measure the mortgages at their fair
values.

All financial liabilities should be subsequently measured at their amortized

cost, with the following exceptions:
• Financial liabilities that are being measured at fair value through profit
or loss, such as derivatives.
• Financial liabilities arising from a financial asset transfer that does not
qualify for derecognition, because the entity continues to retain the
risks and rewards of ownership.
• Financial guarantee contracts, which are measured at the greater of the
loss allowance and the amount initially recognized less the cumulative
amount of income recognized. The same measurement applies to
commitments to provide a loan at a below-market rate.
• Contingent consideration payable by the acquirer in a business
combination. Subsequent changes in the fair value of this
consideration are recognized in profit or loss.
When measuring financial assets at their amortized cost, the standard
measurement technique is the effective interest method (which is described in
the following example).
EXAMPLE
Currency Bank purchases a loan that had been issued by another bank, at a
stated principal amount of £100,000, which the debtor will repay in three
years, with three annual interest payments of £5,000 and a balloon payment
of £100,000 upon the maturity date of the loan.
Currency acquired the loan for £90,000, which is a discount of £10,000 from
the principal amount of the loan. Based on this information, Currency
calculates an effective interest rate of 8.95%, which is shown in the
following amortization table:

When the cash flows associated with a financial asset have been modified
(perhaps through renegotiation), recalculate the gross carrying amount of the
asset, which is considered the present value of the revised cash flows, using
the asset’s original effective interest rate. This revision will result in the
recognition of either a modification gain or loss in profit or loss.
Expected Credit Losses
An organization may anticipate that credit losses related to its financial assets
will occur in the future. If so, it should recognize a loss allowance for these
expected losses. The amount of this allowance is recognized in other
comprehensive income. On each subsequent reporting date, if the credit risk
on a financial instrument has not changed significantly, the loss allowance for
that item should equal the 12-month expected credit loss. However, if the
credit risk has increased significantly, the loss allowance shall instead equate
to the lifetime expected credit loss. When there is an adjustment to the
amount of expected credit losses, the change is recognized in profit or loss;
this is classified as an impairment gain or loss.
The treatment of expected credit losses is somewhat different for trade
receivables. As long as the receivables do not contain a significant financing
component, the loss allowance should always equate to the lifetime expected
credit loss. This approach may still be used when there is a financing
component, if mandated by the entity’s accounting policy. This approach
may also be applied to lease receivables, if mandated by the entity’s
accounting policy.
The measurement of expected credit losses should involve a probability-
weighted analysis of a range of possible outcomes, as well as the time value
of money.
Impairment
If there is no reasonable expectation for recovering a financial asset, write off
all or a portion of the carrying amount of the asset.
If financial assets are recorded at their amortized costs, periodically
assess whether there is objective evidence that these amortized costs are
impaired. Objective evidence is considered to be an event or several events in
combination that will have a negative impact on the future cash flows
associated with a financial asset, and which can be reliably estimated.
Objective evidence can arise from any of the following items:
• A borrower will probably have to reorganize or enter bankruptcy.
However, a credit rating downgrade is not considered direct evidence
of impairment, though it may be when combined with additional
information.
• A breach of contract.
• A lender grants a concession to a borrower, due to the financial
difficulties of the borrower.
• Financial difficulties are experienced by the parties to a contract.
• There is a measurable decrease in cash flows from a group of financial
assets which cannot yet be ascribed to a specific asset within a group,
with the change caused by a decline in the payment status of
borrowers or a regional economic decline that correlates with defaults
on assets.
• There is no longer an active market for a financial asset, due to
financial difficulties. Impairment has not necessarily occurred just
because the financial instruments issued by a company are no longer
publicly traded.
EXAMPLE
There has been an increase in the unemployment rate in the region served by
Capitalist Lending, which in turn has driven down property prices on the
homes for which Capitalist has issued mortgages. This has resulted in a
measurable decrease in the estimated future cash flows from those
mortgages. These conditions are objective evidence that the mortgages
issued by Capitalist Lending are impaired.

If there is objective evidence of impairment, measure the amount of the

impairment as the difference between the carrying amount of an asset and the
present value of its future estimated cash flows, using as the discount rate the
effective interest rate that was used at the initial recognition of the asset. The
impairment can be recorded as either a direct deduction from the account in
which the financial asset is recorded, or as an addition to an offsetting
allowance account, with the loss recognized in profit or loss.
EXAMPLE
Armadillo Industries invests £100,000 in the bonds of Reliable Corporation.
In the next month, Reliable issues its financial results, which indicate that it
is experiencing exceptional financial difficulties. These financial statements
constitute evidence that Reliable will not be able to pay off the full amount
of the debt. Accordingly, Armadillo records an impairment loss in the
amount of its best estimate of what Reliable will not be able to pay back,
which is £30,000. The entry to directly reduce the investments account is:

If there is no objective evidence of impairment for an individual financial

asset, include it in a group of assets having similar credit risk characteristics,
and review the entire group to see if there is evidence of impairment. If so,
apply the preceding process to calculate the amount of the impairment, and
apply it to the group of assets.
If there is a subsequent decline in the amount of an impairment loss, it is
allowable to reverse the loss that was recognized in a prior period. The
amount of this reversal is limited to what the amortized cost of the asset
would have been if the original impairment had not taken place. The entire
amount of such reversals should be recognized in profit or loss.
It is also possible to subsequently measure a financial asset at its fair
value, with all changes in fair value being recognized at once in profit or loss.
Reclassification
If a financial asset is reclassified, doing so is only as of the reclassification
date. There is no prior period restatement of gains, losses, or interest that may
have been recognized in a prior period. Reclassifications can be treated in
multiple ways, as noted in the following points:
• From cost basis to fair value through other comprehensive income. If
a reclassification involves beginning to measure a financial asset at its
fair value through other comprehensive income that had been
measured at its amortized cost, the gain or loss caused by the
 difference between the amortized cost and the fair value is recognized
in other comprehensive income.
• From cost basis to fair value through profit or loss. If a
reclassification involves beginning to measure a financial asset at its
fair value through profit or loss, any gain or loss on the difference
between the existing carrying amount of the asset and its fair value is
recognized in profit or loss at the reclassification date.
• From fair value through comprehensive income to cost basis. If a
reclassification involves beginning to measure a financial asset at its
amortized cost that had been measured at its fair value through
comprehensive income, the existing fair value on the reclassification
date becomes the carrying amount of the asset. Any cumulative gain
or loss already recognized in other comprehensive income is removed
from equity and is netted against the fair value of the asset at the
reclassification date.
• From fair value through comprehensive income to fair value through
profit or loss. When the reclassification is from fair value through
comprehensive income to the fair value through profit or loss,
continue to measure the asset at its fair value. In addition, reclassify
any cumulative gain or loss in other comprehensive income to profit or
loss.
• From fair value through profit or loss to cost basis. If a
reclassification involves beginning to measure a financial asset at its
amortized cost that had been measured at its fair value through profit
or loss, the existing fair value on the reclassification date becomes the
carrying amount of the asset.
• From value through profit or loss to fair value through comprehensive
income. When the reclassification is from the valuation through profit
or loss to the fair value through comprehensive income, continue to
measure the asset at its fair value.
Financial liabilities are not to be reclassified.
Embedded Derivatives
An embedded derivative is a combination of a derivative and a non-derivative
instrument. The derivative element triggers cash flow changes that may be
based on such factors as changes in interest rates, commodity prices, foreign
exchange rates, and so forth. A derivative that can be transferred away from a
financial instrument is considered to be a separate financial instrument, rather
than an embedded derivative. When a derivative is embedded in a financial
instrument, apply the usual initial measurement criteria to the combined
instrument.
If a derivative is embedded within a contract and the contract is not an
asset, it is acceptable to separately account for the derivative if the
characteristics of the derivative differ from those of the contract, and the
entire contract is not measured at fair value through profit or loss.
EXAMPLE
Capitalist Lending issues a debt instrument to a farming enterprise, in which
the interest rate is indexed to changes in the price of a corn index. This
arrangement is made because the farm’s income is closely tied to the price
of corn, and it is better able to pay interest when the price of corn is high.
Capitalist should account for the debt and derivative elements of the
instrument separately, since the risk inherent in the loan and the embedded
derivative are dissimilar.

Gains and Losses

The treatment of gains and losses on financial assets and liabilities depends
upon whether they are being recorded at their fair value or carrying amounts.
The differences are:
• Measured at fair value through profit or loss. A gain or loss on a
financial asset or liability that is measured at its fair value through
profit or loss is recognized in profit or loss, unless it is part of a
hedging transaction.
• Measured at fair value through other comprehensive income. When a
financial asset is measured at fair value through other comprehensive
income, gains and losses are recognized in other comprehensive
income. Once the asset is derecognized, this cumulative gain or loss is
moved from equity to profit or loss. If the asset is instead reclassified,
see the preceding Reclassification sub-section for a description of how
to handle any associated gains or losses.
• Measured at carrying amount. A gain or loss on a financial asset or
liability that is measured at its carrying amount is only recognized in
profit or loss when the item is derecognized, or reclassified to be
measured at its fair value. Gains or losses are also recognized through
the ongoing amortization of these items. A loss on a financial asset
may also be recognized if it is impaired.
In addition, if a financial liability is being measured at fair value through
profit or loss, any portion of a change in fair value that is associated with a
change in credit risk is to be recorded within other comprehensive income,
while the remaining portion is presented in profit or loss. If this splitting of
recognition would expand an accounting mismatch in profit or loss, ignore
the separate treatment of credit risk and instead record the entire amount of
the gain or loss in profit or loss.
All gains and losses on loan commitments and financial guarantee
contracts that are designated as being at fair value through profit or loss are
always presented in profit or loss.
Dividends and Interest
Any interest income and expense associated with financial instruments is to
be recorded within profit or loss in the period earned.
Dividends received are to be recorded within profit or loss, but only if
there is a right to receive payment, the amount of the payment can be reliably
measured, and it is probable that the economic benefits linked to the
dividends will flow to the receiving entity.
A dividend distribution is to be offset directly against equity, net of any
applicable income tax effect. However, if an equity instrument is classified as
a liability, any associated dividend payments are instead classified as interest
expense.
If there is a transaction cost associated with an equity transaction (such as
registration or legal fees), record it as a deduction from equity, net of any
applicable income tax effect. If an equity issuance transaction is abandoned,
these transaction costs are instead recognized as expenses. If these costs are
associated with a compound instrument that is comprised of equity and other
elements, the costs are allocated to the various components of the instrument
in a rational and consistent manner, and then accounted for in accordance
with the type of instrument to which they are allocated.
Hedging
When an adverse change in the fair value or cash flows of an asset or liability
is anticipated, a business may pair a hedging instrument with the underlying
asset or liability. The hedging instrument is expected to experience changes
in its fair value or cash flows that offset the changes in the underlying asset or
liability. Such a pairing establishes a hedging relationship, for which the
accounting differs from what would be the case if the two instruments were
not linked together as a designated hedge.
EXAMPLE
The Close Call Company has acquired a financial asset for £45,000. Close
Call anticipates some variability in the value of the asset, and decides to
hedge it to mitigate possible future losses. Accordingly, the CFO enters into
a derivative contract and designates it as a hedge of the financial asset.
Three months later, Close Call experiences a gain of £6,000 on the financial
asset and a loss of £5,000 on the derivative. When combined, these gains
and losses sum to a £1,000 gain, which Close Call recognizes in profit or
loss.
Hedging Instruments
The following rules apply to the use of hedging instruments in a hedging
relationship:
• External parties. A hedging instrument must involve an external party.
If a hedge were to be set up with an instrument that involves a fellow
subsidiary entity, the hedge would be eliminated upon consolidation,
and therefore would not qualify for hedge accounting within the
consolidated financial statements of the entire group. If a subsidiary is
only reporting its own results, such a hedge might still be reportable,
as long as the counterparty is not consolidated into the subsidiary.
• Multiple instruments. Several derivatives can be combined and treated
as a hedging instrument.
• Derivatives. A derivative that is measured at fair value through profit
or loss can be designated as a hedging instrument, with a few
exceptions.
• Non-derivatives. A non-derivative financial asset or liability can be
designated as a hedging instrument, with a few exceptions.
• Proportion of hedge. If only a portion of a hedging instrument is
designated as a hedge of a financial asset or liability, hedge accounting
applies only to the designated portion.
Hedged Items
Quite an array of items can be hedged. The most common items to be hedged
are recognized financial assets and liabilities, though other possibilities are
the net amount of an investment in a foreign operation, a highly probable
forecast transaction, and an unrecognized firm commitment.
Items can be hedged individually or in groups. Grouped hedging only
applies when the items included in a group are managed together on a group
basis for risk management purposes.
 It is acceptable to hedge only a portion of a financial asset or liability. For
example, there may be risks associated with only a portion of the cash flows
of a financial asset. However, hedge accounting can only be applied to a
portion of a hedged item when the effectiveness of the hedge can be
measured.
When there is a grouping of financial assets and financial liabilities,
hedge accounting does not apply when the net amount of the group is to be
hedged. Hedge accounting can only be applied to a group of financial assets
or a group of financial liabilities.
Accounting for Hedges
The underlying principle of hedge accounting is to recognize the offsetting
effects of changes in the value of a hedging instrument and the hedged item
with which it is paired by recognizing the changes at the same time, thereby
presenting a reduced net impact in any given reporting period.
A hedging relationship only exists for hedge accounting purposes when
all of the following conditions are present:
• Documentation. There is a formal, documented designation of a
hedging relationship at the inception of the hedge, which includes the
risk management objective and the strategy for attaining it, as well as
how hedge effectiveness will be measured.
• Cash flow probability. For a cash flow hedge (as discussed later) that
is a forecast transaction, the transaction must be highly probable and
have an exposure to cash flow variations that could impact profit or
loss.
• Measurement reliability. It is possible to reliably measure the
effectiveness of both the hedging instrument and the hedged item.
• Effectiveness. The hedge is expected to be highly effective in
offsetting the changes in fair value or cash flows associated with the
hedged item for all periods for which the hedge is designated. The
actual results of the hedge should be within the range of 80% to 125%
effectiveness.
EXAMPLE
Capitalist Lending designates a hedging relationship, which results in an
actual gain on the hedging instrument of £78,000 and a loss on the related
financial asset of £100,000. The offset is 78% (measured as £78,000 gain ÷
£100,000 loss). Since the 78% figure is below the minimum threshold for a
highly effective lease, the hedging relationship is considered to not be highly
effective.

In addition, a hedge must be reviewed on a regular basis, and judged to have

been highly effective throughout the hedging period. Hedge accounting
should stop when the hedging relationship no longer meets the qualifying
criteria.
There are three types of hedging scenarios, each of which requires
different accounting. The preceding list of hedging conditions applies to all
of them. They are listed as follows.
Fair Value Hedge
This is a hedge against changes in the fair value of a hedged item that can be
attributed to a specific risk. The accounting for a fair value hedge is:
• If the hedged item is measured at fair value through profit or loss,
recognize the gain or loss on the hedging instrument in profit or loss.
• If the hedged item is measured at fair value through other
comprehensive income, recognize the gain or loss on the hedging
instrument in profit or loss. However, if the hedged item is an equity
instrument, then recognize the gain or loss on the hedging instrument
in other comprehensive income.
• If the hedged item is measured at cost, adjust its carrying amount with
the gain or loss on the hedging instrument, and recognize the change
in profit or loss. If the effective interest method is used to measure the
hedged item, the adjustment to the carrying amount of the hedged item
shall be amortized based on a recalculated effective interest rate. The
amortization must be completed by the maturity date of the financial
instrument being hedged.
Fair value hedge accounting shall be terminated if the hedge accounting
criteria are no longer met, the company revokes the hedging designation, or
the hedging instrument expires or is otherwise terminated or exercised.
EXAMPLE
Armadillo Industries buys bonds having a cumulative face value of £80,000,
and which pays interest of 6%. The interest rate paid matches the current
market interest rate. Armadillo’s CFO anticipates that interest rates will
increase, which will reduce the market value of the bonds. Accordingly, the
CFO engages in an interest rate swap with Currency Bank, under which
Armadillo swaps its fixed bond payments for floating interest payments
from Currency.
A few months later, interest rates have indeed increased, which reduces the
market value of the bonds by £7,000. The swap has increased in value by
£6,500, since Armadillo will now receive an increased amount of interest
payments from Currency. The related journal entries are:

To record decline in value of bonds

To record increase in value of interest rate swap

Cash Flow Hedge

This is a hedge against changes in the cash flows associated with a hedged
item, which can be attributed to a specific risk. The accounting for a cash
flow hedge is:
• Recognize that portion of any gain or loss on an effective hedge in
other comprehensive income. The following additional factors may
apply:
o If the hedge is for a forecasted transaction, this amount is
shifted to profit or loss when the transaction later results in the
recognition of a financial asset or liability that impacts profit
or loss. If there is an expectation that any portion of a loss
recorded in other comprehensive income will not be recovered
in later periods, reclassify it into profit or loss at once.
o If the hedge is for a forecasted transaction that will result in
the recognition of a non-financial asset or liability, the
accounting treatment is to move the gains and losses recorded
in other comprehensive income into the carrying amount of
the asset or liability.
• Recognize in profit or loss that portion of any gain or loss on a hedge
that is not considered effective.
In all other cases that do not fall under the preceding guidance for a cash flow
hedge, the rule is to shift any gains and losses initially recorded in other
comprehensive income into profit and loss when the hedged cash flows affect
profit or loss.
Cash flow hedge accounting should be discontinued under any of the
following circumstances:
• The hedging instrument expires or is otherwise terminated or sold, in
which case the gain or loss recorded in other comprehensive income
should be shifted to profit or loss only when the forecast transaction
occurs.
• The hedging instrument no longer meets the hedge accounting criteria,
in which case the gain or loss recorded in other comprehensive income
should be shifted to profit or loss only when the forecast transaction
occurs.
• The forecast transaction will not occur, in which case the gain or loss
recorded in other comprehensive income shall be shifted to profit or
loss at once.
• The business revokes the hedging designation. If the hedged
transaction is still expected to occur, shift the gain or loss recorded in
other comprehensive income to profit or loss only when the forecast
transaction occurs. If the hedged transaction is not expected to occur,
shift the gain or loss recorded in other comprehensive income to profit
or loss at once.
EXAMPLE
Entwhistle Electric orders an automated battery production line from a
supplier in the United States for $450,000, for delivery to its London facility
in 180 days. Entwhistle’s functional currency is the pound. On the date
when the contract is signed, Entwhistle expects to pay £375,000, based on
the current exchange rate between the U.S. dollar and the pound. The CFO
of Entwhistle wants to guard against any weakening of the pound against the
dollar over the next 180 days, which would require a larger payment by
Entwhistle.
To avoid this risk, the CFO enters into a forward contract to purchase
$450,000 in 180 days for £375,000, and designates the forward contract as a
hedge against future increases in the price of the dollar as it applies to the
production line contract.
90 days later, the pound has indeed declined in value in comparison to the
dollar, so that the $450,000 payment will now require a payment of
£400,000, which equates to a £25,000 increase in the value of the forward
contract. There are no further changes in the exchange rate, so Entwhistle is
paid £25,000 when the forward contract is settled. On the contracted
delivery date, Entwhistle pays £400,000 for the production line, and reduces
the carrying amount of the fixed asset by netting it against the gain on the
forward contract. The related entries are:

To record gain on forward contract to purchase $450,000

To settle forward contract

To purchase production line equipment

To net hedging gain against fixed asset

Net Investment Hedge in a Foreign Operation

This is a hedge against changes in the amount of an entity’s interest in the net
assets of a foreign operation. The accounting for a net investment hedge is
similar to what was just described for a cash flow hedge. The following rules
apply:
• Recognize that portion of any gain or loss on an effective hedge in
other comprehensive income. This amount shall be shifted to profit or
loss when the net investment in the foreign operation is disposed of.
• Recognize that portion of any gain or loss on a hedge that is not
considered effective in profit or loss.
EXAMPLE
Franklin Drilling invests in an oil refinery in Brazil, which it plans to sell in
four years. To hedge the investment for the next four years, Franklin
borrows 150 million Brazilian reals and designates the loan as a hedge of the
net investment in the oil refinery.
Over the next four years, there is a 20 million Brazilian real foreign currency
gain on the loan. Franklin defers the gain in equity, and uses it at the end of
four years, when it sells the refinery and incurs an offsetting foreign
exchange loss.
Other Topics
There are several variations on the preceding hedging topics, which are noted
in the following bullet points:
• Firm commitment foreign currency risk. When there is a hedge of the
foreign currency risk associated with a firm commitment, it can be
accounted for as either a fair value hedge or a cash flow hedge.
• Unrecognized firm commitment. When there is a hedge of an
unrecognized firm commitment, recognize subsequent changes in its
fair value as a gain or loss. The fair value changes in the hedging
instrument are also recognized in profit or loss.
Financial Asset and Liability Derecognition
This section deals with the measurement of and accounting for various
aspects of the derecognition of financial assets and liabilities, as well as
several related matters.
Financial Asset Derecognition
A business should derecognize a financial asset under the following
circumstances:
• When its contractual right to any cash flows associated with the
financial asset expires, or
• When it transfers the financial asset to a third party, where it also
transfers the right to receive cash flows or retains this right but
assumes an obligation to pay the cash flows to other parties. If there is
an obligation to pay third parties, the transaction is only considered a
transfer when:
o There is no payment obligation unless an equivalent amount is
received from the financial instrument; and
o The business cannot sell or pledge the financial asset; and
o The business is not allowed a material delay in its payment of
the cash flows to the recipients.
In the event of a financial asset transfer, review any retention of risks and
rewards, and apply the following rules as applicable:
• If essentially all risks and rewards of ownership have been transferred,
derecognize the financial asset, and recognize new assets and
liabilities for any rights or obligations created under the transfer
agreement.
• If essentially all risks and rewards are retained, continue to recognize
 the financial asset.
• If the business has not retained control over the financial asset but still
retains some risks and rewards, derecognize the financial asset and
recognize new assets and liabilities for any rights or obligations
created under the transfer agreement.
• If the business has retained control over the financial asset, continue to
recognize the financial instrument in the amount of the company’s
continuing involvement in the asset.
EXAMPLE
Close Call Company sells a financial asset under an agreement where Close
Call agrees to repurchase the instrument at a fixed price. Close Call should
not derecognize the asset, because the company has retained the risks and
rewards of ownership.
Close Call sells another financial asset. This time, it retains a right of first
refusal, so that it can repurchase the asset at fair value if the transferee later
elects to sell it. In this case, the risks and rewards of ownership have shifted
to the transferee, so Close Call should derecognize the asset.
Close Call sells yet another financial asset, this time with a put option
attached that allows the transferee the option to sell the asset back to Close
Call. The option is currently in the money. In this case, the presence of a put
option that will likely be exercised means that Close Call has retained the
risks and rewards of ownership, and so should not derecognize the asset.

The transfer of risks and rewards is evaluated based on the change in a

business’ exposure to the cash flows associated with a financial asset before
and after a transfer has been completed. This change can be computed as the
before-and-after present value of the cash flows to which a business is
exposed.
If a business retains the risks and rewards of ownership, despite having
accepted consideration for a financial asset, it should continue to recognize
the transferred asset, as well as an offsetting liability in the amount of the
consideration received for the asset. If an asset and offsetting liability must be
recognized for a transferred asset, the net carrying amount recorded should
either match the fair value or the amortized cost of the retained rights and
obligations, depending upon whether the entity measures these items at their
fair value or amortized cost, respectively. In any following periods, the entity
should continue to recognize any income related to the transferred asset, as
well as any expenses related to the liability for the consideration received.
Further, these income and expense amounts should not be offset against each
other.
If there are both rights and obligations associated with a transferred asset
that are being recorded, do not net these items together for reporting
purposes; they should be reported separately.
The presence or absence of control over a financial asset is the key
element in determining how to account for a transferred financial instrument.
A business is not considered to have retained control if the transferee has the
ability to unilaterally sell the financial asset to an unrelated third party.
When a financial asset is entirely derecognized, there are two possible
approaches to accounting for it, which are:
• Asset not part of larger asset. Recognize in profit or loss the difference
between the consideration received for the asset and its carrying
amount.
• Asset is part of larger asset. Allocate the carrying amount of the larger
financial asset between the portion being derecognized and the portion
being retained, based on their relative fair values. Then recognize in
profit or loss the difference between the consideration received for the
asset and its carrying amount. For this purpose, the recent prices of
actual transactions are the best indicator of fair value. When such
information does not exist, estimate fair value based on the difference
between the fair value of the larger financial asset (in total) and the
consideration received from the transferee for the derecognized
component.
The following additional situations may apply to a financial asset that has
been transferred, where a business should continue to recognize a transferred
asset to the extent of its continuing involvement:
• Guarantee. If a business has guaranteed a transferred asset, the level of
involvement is the lesser of the maximum amount of consideration
that it could be required to repay, or the amount of the asset.
• Option. If there is an option on the asset, the level of involvement is
the amount of the asset that the business may have to repurchase under
the terms of the option. If the option is measured at fair value, the
level of involvement is the lesser of the option exercise price or the
fair value of the asset.
Financial Liability Derecognition
It is only acceptable to derecognize a financial liability when all obligations
associated with the liability have been cancelled or discharged, or the liability
expires. Several variations on this concept are:
• Exchange of instruments. When there is an exchange of debt
instruments with substantially different terms, derecognize the old
liability and recognize the new liability.
• Terms change. If there is a substantial change in the terms of a
financial liability, derecognize the old liability and recognize the new
liability.
When a financial liability is extinguished or transferred and there is a
difference between the consideration paid and the carrying amount of the
liability, recognize the difference in profit or loss.
Servicing Assets and Liabilities
When a business transfers a financial instrument, but retains the right to
service that instrument for a fee, it should recognize a servicing asset or
liability, based on these criteria:
• Servicing asset. If the payments under the servicing contract are
expected to exceed adequate compensation for the servicing activity,
recognize as a servicing asset an allocation of the carrying amount of
the original financial instrument.
• Servicing liability. If the payments under the servicing contract are not
expected to be adequate, the business should recognize a servicing
liability at its fair value.
Valuation of Replacement Financial Asset
If the outbound transfer of a financial asset results in a business also
recognizing a new financial asset, or assuming a new servicing or other
liability, recognize the replacement asset or liability at its fair value.
Collateral
There may be situations where the transferring entity provides non-cash
collateral to the recipient of a financial asset. If so, the accounting for the
collateral depends upon the terms associated with the underlying contract.
The following bullets note the possible variations:
Transferring entity:
• Right to sell. If the transferee has the right to sell or repledge the
collateral, the transferring entity must classify the collateral separately
from its other assets in its balance sheet.
• Default. If the transferring entity defaults, it should derecognize the
collateral.
Transferee:
• Sale of collateral. If the transferee sells the collateral, it must
recognize both the proceeds from sale of the collateral and a liability
in the amount of the collateral that represents its obligation to return
the collateral.
• Default. If the transferring entity defaults, the transferee should
recognize the collateral at its fair value. If the transferee has already
sold the collateral, it should derecognize its obligation to return the
collateral.
Financial Instrument Presentation
When a company buys back its shares (known as treasury stock), present the
amount of these buybacks as a deduction from equity. No gain or loss is to be
recognized on treasury stock transactions. Any amounts paid for treasury
stock only appear within the equity section of the balance sheet; they do not
appear in the income statement.
It is only allowable to offset financial assets and liabilities and present
just the net amount in the balance sheet when there is a legal right to actually
offset the assets and liabilities, and when the entity intends to settle with the
counterparty on a net basis, or to settle the assets and liabilities
simultaneously. Since this situation is exceedingly rare, most businesses will
not offset their financial assets and liabilities.
When there are dividends, interest, gains or losses associated with a
financial instrument, recognize them in profit or loss. If there is a distribution
to the holders of a company’s equity instruments, recognize the distributions
in equity, not the income statement.
Any transaction cost of an equity transaction is to be deducted directly
from equity. These transactions typically include registration fees, printing
and legal costs, and advisory fees. However, if these fees are associated with
an equity transaction that is abandoned, the fees are to be charged to expense,
instead of equity.
Financial Instrument Disclosures
In general, disclosures for financial instruments should enable the users of a
company’s financial statements to evaluate the impact of financial
instruments on the results and financial position of the business.
The following disclosures are required for all financial instruments,
except interests in subsidiaries and similar arrangements, employee benefit
plans, insurance contracts, share-based payments, and instruments that must
be classified as equity instruments.
Balance sheet disclosures:
• Carrying amounts. Disclose the aggregate carrying amount of each of
the following classes of financial instrument:
o Assets measured at fair value through profit or loss that were
designated as such when initially recognized
o Assets measured at fair value through profit or loss that must
be measured in this manner under IFRS
o Assets measured at amortized cost
o Assets measured at fair value through other comprehensive
income
o Liabilities measured at fair value through profit or loss that
were designated as such when initially recognized
o Liabilities measured at fair value through profit or loss that
must be measured in this manner under IFRS
o Liabilities measured at amortized cost
• Asset measurements at fair value through profit or loss. If an asset that
would normally be measured at its amortized cost is instead measured
at fair value through profit or loss, disclose the following:
o The maximum amount of credit risk exposure
o The amount of credit risk reduction caused by credit
derivatives
o The cumulative and period-specific change in fair value
caused by changes in credit risk (that is not caused by market
risk)
o The cumulative and period-specific change in fair value of any
related credit derivatives
• Liability measurements at fair value through profit or loss. If a
liability is measured at fair value through profit or loss and presents
changes in the related credit risk in other comprehensive income,
disclose the following:
o The cumulative change in fair value caused by related changes
in credit risk
o The difference between the amount due at maturity and the
current carrying amount of the liability
o Any transfers in the period within equity of the cumulative
gain or loss, as well as the reason for these changes
 o The amount in other comprehensive income that was
recognized as the result of a liability derecognition
• Measurement method. The method used to derive the fair value of
financial assets and liabilities, and why the method is appropriate. If
there is a belief that the preceding fair value disclosures do not
faithfully represent fair value changes related to credit risk, note the
reasons for this position. If reporting changes in credit risk for a
liability in other comprehensive income would cause or expand an
accounting mismatch in profit or loss, describe how this determination
was made.
• Asset measurements at fair value through other comprehensive
income. If changes in the fair value of investments in equity
instruments are to be reported in other comprehensive income,
describe which investments have been so designated, the reasons for
using this form of presentation, the ending fair values of these
investments, any transfers of cumulative gain or loss within equity and
the reasons for these transfers, dividends recognized that relate to
derecognized investments, and dividends recognized that relate to
investments held. If such an investment is derecognized, note the
reason for disposal, its fair value on the derecognition date, and the
associated cumulative gain or loss.
• Reclassifications. The business may have reclassified a financial asset
during the reporting period. If so, disclose the date of reclassification,
the amount reclassified, the related change in the business model that
triggered the reclassification, and describe the effects on the financial
statements. If a reclassified asset is now measured at amortized cost,
report the effective interest rate on the date of reclassification and the
recognized amount of interest income or expense, and continue to do
so until derecognition. Also note for these assets now measured at
amortized cost their fair value at the end of the reporting period, as
well as the gain or loss on changes in fair value that would have been
recognized if reclassification had not occurred.
• Offsets. Disclose the effect of netting arrangements on the company’s
financial position. To do so, note in tabular format the gross amount of
those assets and liabilities that can be offset, the amounts that are
offset, the net amounts presented in the balance sheet, the amounts
subject to a master netting arrangement, and the net amount after
 deducting the master netting arrangement line item just noted. Also
describe the offsetting rights associated with any master netting
arrangements.
• Collateral. The carrying amount of any financial assets that have been
pledged as collateral, and the terms related to the pledge. Conversely,
if the entity holds collateral that is the property of another party, and
can sell or repledge the collateral even if there is no default by the
other party, disclose the fair value of the collateral, the fair value of
any collateral that has been sold or repledged and whether there is an
obligation to return the collateral, and the terms under which the entity
can use the collateral.
• Credit losses allowance. When financial assets are carried at fair value
through other comprehensive income, no loss allowance is used to
reduce the reported amount of these assets, nor is such an allowance to
be reported in the balance sheet as a reduction of the carrying amounts
of these assets. A loss allowance may be described in the notes to the
financial statements.
• Compound instruments. Describe the existence of any financial
instruments that contain liability and equity components, and which
have multiple embedded derivatives whose values are interdependent.
An example is callable convertible debt.
• Defaults and other breaches. If there are loans payable at the end of a
reporting period, disclose any loan defaults and the carrying amount of
the defaulted loans. Also state whether a default was remedied or loan
terms renegotiated. Also note any other breaches that allow the lender
to accelerate loan payment.
• Transaction costs. If there are transaction costs associated with the
procurement of equity investments in the company, disclose the
amount of these costs.
Income statement disclosures:
• Net gains or losses. Note all net gains or losses on financial assets or
liabilities measured at fair value through profit or loss, and at
amortized cost, and financial assets measured at fair value through
other comprehensive income.
• Interest. Using the effective interest method, disclose the total interest
income and total interest expense related to financial assets measured
at amortized cost. Do the same for any financial liabilities not
 measured at fair value through profit or loss.
• Fees. Disclose the income and expense for fees generated by financial
assets and liabilities not measured at fair value through profit or loss,
as well as for fiduciary activities.
• Derecognition analysis. Provide an analysis of any gains or losses
related to the derecognition of financial assets measured at amortized
cost, including the reasons for derecognition.
Other disclosures:
• Hedging, general. State the risk management strategy of the entity and
how it is used to manage risk. Note how the hedging activities could
impact the amount, timing, and uncertainty of the entity’s future cash
flows. Further, note the effects that hedge accounting have had on the
financial statements.
• Hedging, strategy. For each category of risk exposure, describe the
risk management strategy. The description should be sufficient for
users to evaluate how risks occur, how each risk is managed, and the
extent of risk exposures. Topics of discussion may include the hedging
instruments used, how hedge effectiveness is determined, how the
hedge ratio is established, and the sources of hedge ineffectiveness.
Finally, for each hedged item, describe how the risk component was
determined, and how this component relates to the hedged item in its
entirety.
• Hedging, future cash flows. For each risk category, note how the terms
and conditions of hedging instruments affect the timing, amount, and
uncertainty of future cash flows. This should include the timing of the
nominal amount of each hedging instrument, and (where applicable)
the average price of the hedging instrument. When there are frequent
hedging resets, describe the strategy for these hedging relationships
and the frequency of the resets. Also disclose the sources of hedge
ineffectiveness that will affect hedging relationships.
• Hedging, effects on financial position and performance. In a tabular
format, note by risk category for each type of hedge the following
information:
o General. The carrying amount of the hedging instruments, the
balance sheet line item that includes the instruments, the
hedge fair value change used to determine hedge
ineffectiveness, and the nominal amounts of the instruments.
 o Fair value hedges. The carrying amount of the hedged item,
the accumulated amount of fair value hedge adjustments on
the hedged item, where the hedged item is located in the
statement of financial position, the change in hedge value used
to recognize hedge ineffectiveness, and the accumulated
amount of fair value hedge adjustments remaining for any
hedged items that are no longer being adjusted for hedging
gains or losses. Also note the amount of hedge ineffectiveness
recognized in profit or loss, and the line item in the statement
of comprehensive income where this amount is located.
o Cash flow hedges and hedges of net investments in a foreign
operations. The change in value of the hedged item that
triggered the recognition of hedge ineffectiveness, the
balances in the cash flow hedge reserve and foreign currency
translation reserve for continuing hedges, and the balances
remaining in these reserves for any hedging relationships that
no longer have hedge accounting applied to them. Also note
by separate risk category the hedging gains or losses
recognized in other comprehensive income, any hedge
ineffectiveness recognized in profit or loss (and where this is
stated in the statement of comprehensive income), and any
reclassification adjustments from the cash flow hedge reserve
or foreign currency translation reserve (and where this
reclassification is located in the statement of comprehensive
income).
• Fair value. Disclose the fair value of each class of financial assets and
liabilities in comparison to its carrying amount. If a fair value is not
available for a financial asset or liability, disclose for each class of
items the accounting policy for recognizing the difference between
initial fair value and the transaction price, the reason why transaction
price is not the best evidence of fair value, and a reconciliation of the
difference yet to be recognized as of the beginning and end of the
reporting period. These disclosures are not needed when the carrying
amount approximates fair value (such as for trade payables).
EXAMPLE
The Close Call Company presents the following table in its financial
statement disclosures to clarify those differences between fair value and
transaction price that have not yet been recognized in profit or loss:

Financial instrument risks:

• Risk, general. A sufficient disclosure should be made to inform
financial statement users about the types and amounts of risks to
which a business is exposed from financial instruments. For each type
of risk disclosed, note the exposure to risk, how it arises, the policies
and processes for managing and measuring the risk, and any changes
in these items from the preceding period.
• Credit risk, strategy. Note the entity’s credit risk management
practices and how they relate to the recognition of expected credit
losses, as well as significant credit risk concentrations.
• Credit risk, practices. Disclose how significant changes in the credit
risk of financial instruments are determined, how default is defined,
how financial instruments were grouped for collective measurement,
how credit impairment is determined, the write-off policy, and similar
matters.
• Credit risk, expected credit losses. Provide an explanation of changes
in the credit loss allowance, provide in a tabular format a
reconciliation for the period that shows the changes in the loss
allowance for 12-month expected credit losses, the loss allowance at
lifetime expected credit losses, and financial assets that were credit-
impaired when purchased or originated. Also note the total amount of
undiscounted expected credit losses initially recognized in the period.
Finally, explain how significant changes in the gross carrying amount
of the instruments in the period altered the loss allowance.
• Credit risk, collateral. By class of financial instrument, note the
maximum exposure to credit risk without reference to any associated
collateral, as well as the nature and quality of collateral held. Note any
changes in the quality of the collateral resulting from changes in the
collateral policy in the period. When a loss allowance has not been
 recognized due to collateral, provide information about the associated
financial instruments. Quantify the extent of the collateral held for
credit-impaired financial assets.
• Credit risk, subject to enforcement. Note the contractual amount
remaining on any assets that were written off in the period, and for
which there is ongoing enforcement activity.
• Credit risk, exposure. Disclose the gross carrying amount of financial
assets, by credit risk rating grades, as well as the exposure to credit
risk on loan commitments and financial guarantee contracts.
• Collateral. When the entity takes possession of collateral during the
period, describe the collateral and its carrying amount. If the collateral
is not readily convertible into cash, note the policy for disposing of or
using collateral assets.
• Liquidity risk. Present an analysis of non-derivative financial liabilities
that reveals remaining contractual maturities, and separately for
derivative financial liabilities. Also describe how the company
manages these liquidity risks.
• Market risk. Present a sensitivity analysis for each type of market risk
to which the business is exposed, showing the impact on profits of
reasonably possible changes in risk variables, as well as the methods
used to prepare the analysis, and any changes in these methods from
the preceding period. If this analysis does not fully represent the risk
associated with a financial instrument, disclose the issue.
EXAMPLE
The Close Call Company discloses the following sensitivity analysis related
to the impact of changes in interest rates on its profitability:
At year end, if interest rates had been 25 basis points lower, with
no changes to other variables, the after-tax profit for the year
would have been £700,000 higher, due to lower interest expense
on the company’s variable-rate debt. If interest rates had been 25
basis points higher, with no changes in other variables, the after-
tax profit for the year would have been £420,000 lower, due to
higher interest expense on the company’s variable-rate debt. The
company’s profit is more sensitive to interest rate decreases than
increases, because the amount of interest rate increases is capped
in its debt agreements.
Financial asset transfers:
• Transfers, general. A sufficient amount of information should be
disclosed to enable the users of a company’s financial statements to
comprehend the relationship between transferred financial assets that
are not fully derecognized and related liabilities, as well as to
understand the ongoing involvement in these assets and any associated
risks.
• Transfers where assets not fully derecognized. When transferred
financial assets have not been completely transferred to a third party,
disclose by class the nature of the partially transferred items, the
remaining risks and rewards of ownership to which the company is
exposed, and any relationship between the transferred assets and
associated liabilities. If there are associated liabilities where the
counterparty only has recourse to transferred assets, state the fair
values of the transferred assets and related liabilities, and the net
position. If the company continues to recognize the full amount of
transferred assets, disclose the carrying amounts of these assets and
any related liabilities. If the company only recognizes the assets to the
extent of its continuing involvement in them, disclose the total original
carrying amount, the amount still recognized, and the carrying amount
of any related liabilities.
EXAMPLE
Capitalist Lending discloses the following information in tabular form
regarding the disposition of its financial assets that have been transferred,
but not entirely derecognized:

• Transfers where assets are fully derecognized. When a business

 completely derecognizes financial assets but continues to be involved
in them, it should disclose the carrying amount of the related assets
and liabilities and where these items are recognized in the balance
sheet, as well as their fair values, the maximum exposure caused by its
continuing involvement and how this amount was determined, the
undiscounted cash payments that may be needed to repurchase
derecognized assets and any remaining contractual maturities for these
payments, and any discussions needed to support these disclosures. If
there is continuing involvement in financial assets, disclose the gain or
loss recognized when the assets were transferred, and any income or
expense from the company’s continuing involvement. Also, if the
proceeds from transfer activity are concentrated within the last few
days of a reporting period, disclose when the bulk of the transfer
activity took place, the gains or losses recognized within that period,
and the total proceeds from transfers within that period.
EXAMPLE
Capitalist Lending discloses the following information in tabular form
regarding its financial assets that have been completely derecognized:

* OCI – Other Comprehensive Income

Summary
Despite the comparatively large amount of discussion given to financial
instruments within IFRS, it is entirely possible that a business will have few
of these items to measure or report; this topic tends to be of more interest to
the financial institutions that deal with financial instruments on a daily basis,
and those larger organizations that use derivatives to hedge certain activities
and financial positions.
The paperwork related to hedge accounting is particularly onerous. By
complying with it, a business does a better job of matching reported short-
term gains and losses between hedged items and hedging instruments.
However, many of these short-term gains and losses have no impact on cash
flows until the underlying instruments have been settled, in which case the
accounting department is essentially engaging in a large amount of
compliance paperwork to smooth out its reported profit or loss. If such
smoothing is of little importance to management, it is more efficient to
simply engage in those hedging transactions that make sense, without
attempting to comply with the hedging documentation required by IFRS.
 Chapter 26
Fair Value Measurement
Introduction
Historically, much of the information in the financial statements has been
derived from the original costs at which assets were purchased and liabilities
incurred. Over time, this information tends to become more inaccurate as the
fair values of the underlying assets and liabilities vary from the values at
which they were recorded. Consequently, many aspects of IFRS are designed
to force companies to periodically revise certain aspects of their accounting
records to reflect fair values, rather than historical costs. In other cases, IFRS
presents users with the option of revaluing items to their fair values. When
these requirements are stated elsewhere in IFRS, users should consult this
chapter to determine how fair value is to be measured and disclosed.
IFRS Source Document
• IFRS 13, Fair Value Measurement
Overview of Fair Value
This section describes the fair value concept, how fair value is measured, and
the valuation methods used to develop fair value estimates.
General Concepts
The general intent of the fair value concept is to derive the price at which an
asset is sold or a liability transferred on the open market. Obtaining this price
involves the following concepts:
• An orderly transaction, where transactions are of a usual and
customary nature. In other words, a sales transaction is not forced, as
would be the case in a bankruptcy sale.
• There are market participants, who are independent of each other, are
knowledgeable about the items being bought and sold, have the ability
to enter into transactions, and are not being forced to enter into
transactions.
• The transaction takes place in the principal market for the item, which
is the market having the highest level of activity and volume for that
item. If the principal market is not available, then the next most
advantageous market is assumed, where the price paid is maximized,
net of transaction and transport costs. The market in which a business
normally enters into a transaction is considered the principal market.
When deriving fair value from the market price in the principal market, do
not adjust the market price for transaction costs. However, if it is necessary to
transport goods to or from a principal market, it is acceptable to include
transport costs in the derivation of fair value.
If it is not possible to arrive at a fair value, it is possible to estimate fair
value using a different valuation technique. When selecting an alternative
technique, the overriding issue is to maximize the use of observable inputs,
which are types of information that are developed from market data that
reflect the assumptions used by market participants when setting prices. The
selection should also minimize the use of unobservable inputs, which are
types of information for which market data are not available. This is of some
importance, since the fair value concept is based on the presence of market
data that market participants would use in deriving prices.
Measurement Issues
When measuring an asset or liability at its fair value, the intent is to conduct
the measurement at the level of the individual asset or liability. Doing so
means that those characteristics of an item that may influence its price should
be incorporated into the valuation. Examples of such characteristics are:
• The condition of an asset, such as an unusual amount of damage or
wear
• The location of an asset, such as a distant location that will require
unusually high transport costs to retrieve
• Restrictions on the sale of an asset, such as a lien that must be cleared
before the sale can proceed
• Restrictions on the use of an asset, such as zoning restrictions on a
building
At times, it may be necessary to measure groups of assets or liabilities, rather
than single items. This concept is most commonly applied when aggregating
items into a cash-generating unit, which is a group of assets and liabilities
whose cash inflows are mostly independent of the cash inflows of other
assets. This means that a fair value could be assigned to an entire business
unit.
Initial Recognition
When an asset is acquired or a liability assumed, the price at that point is
either the amount paid to acquire the asset or assume the liability. This is not
the same as fair value, which is actually the reverse – the price at which the
company could sell an asset, or which it would pay to transfer a liability to a
third party. This can be a crucial difference, for a business may not buy an
asset or incur a liability at their fair values. If IFRS permits the initial
recognition of an asset or liability at its fair value for a specific asset or
liability, rather than the initial price, recognize a gain or loss on the difference
between the transaction price and fair value.
There are a number of situations in which the transaction price could
differ from the fair value. For example, a transaction may be between related
parties, or one party to a transaction may be forced to sell under duress, or
there are unstated rights included in a transaction, or a transaction takes
places in a different market from the one in which the fair value was
determined.
Measurement of Non-Financial Assets
The fair value concept may be applied to the valuation of non-financial
assets. If so, fair value is assumed to be based on the highest and best use of
an asset. This means that fair value is based on the maximized value of an
asset, even if the item is not actually used in that manner. The highest and
best use concept is limited by the condition of an asset and any applicable
legal restrictions (such as zoning). The use to which an asset is already being
put is assumed to be its highest and best use, unless other factors indicate that
a different use would achieve a higher valuation.
EXAMPLE
Snyder Corporation acquires a key patent from a defunct rival, and plans to
use it in a defensive manner, denying licensing rights to competitors. This
defensive approach is not the highest and best use of the patent, since it
could be used to earn licensing revenue from rivals. Despite its current use,
Snyder should assign a fair value to the patent under the highest and best use
concept, as though the company were licensing the patent.
EXAMPLE
Pianoforte International acquires a plot of land as part of its purchase of the
assets of a bankrupt rival. The zoning for the land currently designates it as
being for industrial use only. An adjacent site was recently re-zoned to
accommodate high-density residential apartments. Based on this
information, Pianoforte needs to determine the value of the land under the
current zoning and under high-density residential zoning, taking into
account all necessary conversion costs to the alternative zoning
arrangement. Doing so may indicate that the alternative arrangement is the
highest and best use of the property, which may alter its fair value.
It is possible that the highest and best use of an asset may require its
presumed inclusion in a group of assets and liabilities. If so, value the other
assets and liabilities in that group under the same assumption.
Measurement of Liabilities and Equity
The fair value concept assumes that both financial and non-financial
liabilities, as well as equity instruments, are sold to a third party on the
measurement date, and would not be settled on that date. The formulation of
fair value uses the following decision tree, in declining order of preference:
1. Use the quoted price in an active market for an identical item.
2. If the preceding option is not available, use the quoted price in a less
active market for an identical item, or other observable inputs.
3. If the preceding two options are not available, use an alternative
valuation technique. One option is the income approach, which is
based on the present value of future cash flows associated with the
item being valued. Another option is the market approach, which
derives a valuation from similar liabilities or equity instruments.
It is permissible to adjust the quoted price of a liability or equity item only if
there are factors specific to the liability or equity item being measured that
are not found in the comparable items from which fair value is being derived.
For example:
• A liability is compared to a debt instrument issued by another entity
whose credit rating differs from that of the company.
• An equity instrument is compared to an equity instrument issued by
another company, which contains a super voting privilege not found in
the company’s equity instrument.
EXAMPLE
The Close Call Company issues 1,000,000 shares to an individual, as
payment for the purchase of her company. The shares carry a restriction
from resale feature that will automatically terminate in six months. The fair
value of these shares is measured based on the quoted price for the
company’s unrestricted shares, less an adjustment to reflect the increased
risk to investors of not being able to trade the shares for the next six months.

The following additional factors may apply to the derivation of fair value for
liability or equity items:
• Credit risk. When deriving the fair value of a liability, factor in the
effect of the company’s own credit risk – that is, the risk that the
 company will not settle the liability. The importance of this factor can
vary, depending upon whether a liability is to be settled in cash or
goods; if the latter, it may not be physically possible to obtain or
produce the goods required by the designated settlement date.
• Guarantees. If a third party is providing a guarantee that the company
will settle a liability, and the company accounts for this guarantee
separately, determine the fair value of the liability without including
the effect of the guarantee.
It can be difficult to discern a fair value for liabilities and equity items,
especially if they contain transfer restrictions or other unusual features.
Nonetheless, there may be an observable market for similar items, from
which a fair value can be estimated. As is the case with all fair value
measurements, the goal is to derive a value that maximizes observable inputs
and minimizes unobservable inputs.
Measurement of a Group of Financial Assets and Liabilities
When a group of financial assets and liabilities are being managed based on
their net exposure to market or credit risks, it is permissible to measure the
fair value of the group based on the price received to sell an asset for a certain
risk exposure, or paid to transfer a liability for a certain risk exposure. Thus,
the fair value of the group is measured based on its risk exposure as priced by
the market. This type of fair value measurement only applies if a company:
• Manages the group of financial assets and liabilities based on risk
exposure, based on a documented strategy;
• Informs key management personnel about the risk information related
to the group of financial assets and liabilities; and
• Measures these items at their fair values at the end of each reporting
period.
The following additional guidance applies to this topic:
• Consistent risk durations. The durations of the risks to which a group
of assets and liabilities are exposed should be substantially the same.
• Consistent risk types. The market risks to which a group of assets and
liabilities are exposed should be the same, rather than having a mix of
exposures to such factors as interest rate risk and commodity price
risk.
• Counterparty exposure. If the financial assets and liabilities in a group
relate to a particular counterparty, include in the fair value assessment
the effect of the company’s net exposure to the credit risk of the
 counterparty, including the effect of a master netting agreement
between the parties (where the obligations of the two parties can be
offset against each other).
• Most applicable price. Apply that price within the bid-ask spread that
best represents fair value under the circumstances.
Valuation Methods
There are a number of methods available for deriving fair value. Among the
more popular are:
• Cost method. The cost method develops a fair value based on what it
would cost to acquire a substitute asset, adjusted for the obsolescence
of the existing asset.
• Income method. The income method arrives at a fair value through the
use of discounted cash flows analysis. A probability-weighted average
of several different cash flow scenarios may be required. If options are
involved, this can require the use of an option pricing model, such as a
lattice model or the Black–Scholes-Merton formula.
EXAMPLE
Vertical Drop Corporation has assumed the decommissioning liability for a
ski lift, which will have to be removed from its installation points on the side
of a mountain in five years, using Vertical Drop’s heavy-lift helicopters. The
cost associated with this liability may vary considerably, based on the level
of government oversight of the process. Accordingly, Vertical Drop
develops a set of possible cash flows, resulting in a £975,000 weighted
average cash flow scenario that is calculated as follows:

• Market method. The market method develops a fair value based on

sale transactions for similar assets and liabilities. For example, the sale
price of several businesses could be compared to their revenues, and
this multiple could then be used to derive the possible value of a
business, based on its own sales.
The method selected to derive a valuation should be based on maximum use
of observable inputs, while minimizing the use of unobservable inputs.
 If there is an active market for identical assets and liabilities, it is
probably acceptable to derive a fair value from a single valuation method,
since the basis for the valuation is entirely from observable inputs. If the
amount of observable information is less apparent, it may be necessary to use
multiple valuation methods. If so, evaluate the reasonableness of the results,
and select as the designated fair value that amount within the range of
valuations that is most representative of fair value.
EXAMPLE
Oberlin Acoustics acquires production equipment through a business
combination. The equipment was originally purchased as a standard model,
after which it underwent a modest amount of customization. Oberlin
considers its current usage to be its highest and best use. The company
decides that the cost and market methods can be used to derive the fair value
of the equipment, but not the income method, since separately-identifiable
cash flows cannot be derived for it.
Oberlin finds quoted prices for similar machines in similar condition and
adjusts them to account for the customized nature of the equipment, yielding
a fair value range of £80,000 to £88,000 from the market method. The
industrial engineering staff estimates the cost required to build substitute
equipment that has comparable utility, which indicates a fair value range of
£82,000 to £95,000 from the cost method.
The company decides that the lower end of the indicated fair value ranges is
most indicative of the fair value of the equipment, because fewer subjective
adjustments needed to be made to the information used for the market
method.
If the level of equipment customization had been greater, it may not have
been possible to use the market approach, in which case Oberlin may have
had to rely exclusively upon the results of a cost method analysis.

The valuation methods used should be applied consistently across multiple

reporting periods. However, a change is allowed if doing so results in a more
representative fair value. Such a situation may arise when new information
becomes available, market conditions change, information previously used is
no longer available, and so forth. If there is a change in valuation method,
treat it as a change in accounting estimate (see the Accounting Policies,
Estimate Changes and Errors chapter).
When measuring an asset or liability, and there is a bid price and an ask
price, the preferred price to use for valuation purposes is that price within the
bid-ask spread that best represents fair value under the circumstances. It is
also permissible to use the bid price for asset valuations and the ask price for
liability valuations.
IFRS uses a fair value hierarchy to designate three levels of information
that can be used as inputs to a valuation method. These levels are:
• Level 1. These are quoted prices from active markets in which
identical assets or liabilities are sold, which are available on the
measurement date. These prices should be used without adjustment
whenever possible. This type of information is available for many
financial instruments that are traded on stock exchanges.
• Level 2. These are inputs other than quoted prices that can be observed
for an asset or liability, such as quoted prices for similar items in
active markets, and quoted prices for identical items in non-active
markets. These prices may be adjusted based on asset location or
condition, the comparability of comparison items, market activity, and
similar factors.
• Level 3. These are inputs that cannot be observed for an asset or
liability, such as the entity’s own information. These inputs can and
should be adjusted for any other available information that
incorporates the assumptions of market participants.
Information derived from Level 1 of the hierarchy is always preferred for use
in a valuation method, while information derived from Level 3 is the least
preferred. If information from a lower level of the hierarchy is used to adjust
information in a higher level (such as adjusting a market price with an
unobservable input from Level 3), the resulting information is considered to
have originated in the lower level.
Any valuation method can be applied to the information originating from
any of the levels of the fair value hierarchy.
Fair Value Disclosures
A business should disclose the following information about fair value in the
notes accompanying its financial statements, preferably in a tabular format:
• Valuation techniques. By asset and liability class, the valuation
techniques and inputs used for those assets and liabilities measured at
fair value after initial recognition. The following additional
information should be provided:
o The fair value measurement at the end of the reporting period.
o The reason for measurement, for any non-recurring fair value
measurements.
o The level of the fair value hierarchy from which the fair value
measurement information is derived.
o The amounts of any transfers between levels of the fair value
hierarchy, the reasons for the transfers, and how the entity
decides when a transfer has occurred
o For measurements derived from Levels 2 or 3 of the fair value
hierarchy, the techniques and inputs used, as well as any
changes in valuation method and the reason for the change.
o A reconciliation of beginning and ending Level 3
measurements for recurring fair value measurements, noting
total gains or losses recognized in profit or loss (and where
they are included in the income statement), total gains or
losses recognized in other comprehensive income (and where
they are included in the income statement), purchases, sales,
issues, settlements, and any transfers into or out of Level 3,
along with the reasons for the transfers and the company
policy for deciding when a transfer has occurred.
o The total amount of Level 3 gains and losses included in profit
or loss that are attributable to unrealized gains and losses for
related assets and liabilities, and where this information
appears in the income statement.
o The valuation processes used for fair value measurements
within Level 3.
o A narrative description of the sensitivity of recurring Level 3
fair value measurements to changes in unobservable inputs,
where such changes can trigger significantly different fair
value measurements. Also note any interrelationships between
the various inputs and how these interrelationships can alter
the effects of fair value changes.
o A disclosure of how changes in unobservable inputs to
recurring Level 3 measurements can cause significant fair
value changes in financial assets and liabilities, as well as how
the changes were calculated.
o Why the highest and best use of an asset is not being followed,
and why this is the case.
 • Effects. The effect on profit or loss or other comprehensive income of
recurring fair value measurements using Level 3 inputs.
• Fair value not measured. In those cases where the fair value of assets
and liabilities are not measured at fair value, but fair value information
is disclosed, note the level of fair value hierarchy information used,
the valuation techniques used if Levels 2 or 3 were employed, and any
variances from the highest and best use of assets, as well as why this is
the case.
• Group valuation. If a group of financial assets and liabilities are being
managed based on their net exposure and its fair value is based on risk
exposure, disclose this fact.
• Credit enhancements. If a liability has an attached third-party credit
enhancement (such as a guarantee), disclose this fact and whether the
enhancement is included in the fair value of the liability.
The classes of assets and liabilities within which these disclosures are made
should be based on the nature and risks of the underlying items, as well as the
level of the fair value hierarchy from which the related fair value
measurements are derived. It may be necessary to aggregate information into
several classes for Level 3 information, since Level 3 information tends to be
more uncertain.
EXAMPLE
Medusa Medical discloses its recurring fair value measurements in the
following tabular format:

Summary
The use of fair values is worthwhile when a business has so little turnover in
its balance sheet that the values in some line items vary significantly from
their current market values. From this perspective, the imposition of fair
value principles is certainly a laudable goal. However, the accountant may
have a different perspective on the situation, since he or she must derive fair
values on a regular basis, document the reasons for fair value changes, and
defend these findings against the inquiries of auditors. Thus, from an
efficiency perspective, fair value is an unmitigated pain. From the viewpoint
of the accountant, then, the use of fair value is to be avoided, especially when
the differences between historical cost and fair value are minor.
 Chapter 27
Effects of Changes in Foreign Exchange Rates
Introduction
A large number of businesses routinely engage in foreign currency
transactions with their business partners, in which case they probably deal
with foreign currencies. Others have subsidiaries located in foreign countries,
and need to convert the financial statements of these entities into the currency
used by the parent for consolidation purposes. We deal with the accounting
for and disclosure of these two situations in the following sections.
IFRS Source Document
• IAS 21, The Effects of Changes in Foreign Exchange Rates
Foreign Exchange Transactions
A business may enter into a transaction where it is scheduled to receive a
payment from a customer that is denominated in a foreign currency, or to
make a payment to a supplier in a foreign currency.
EXAMPLE
Blitz Communications creates enterprise-level telephone systems. Its
purchases of circuit boards from South Korea are denominated in the South
Korean won, while its purchases of cables from Australia are denominated
in the Australian dollar. Since both transactions are settled in currencies
other than Blitz’s functional currency, they are classified as foreign
exchange transactions.

On the date of recognition of each such transaction, record it in the functional

currency of the reporting entity, based on the spot exchange rate in effect on
that date. It may not be possible to determine the spot exchange rate on the
date of recognition of a transaction. If so, it is acceptable to use an average
rate for all transactions occurring within a period. An average rate is not an
acceptable substitute when the rate fluctuates significantly. If two currencies
cannot currently be exchanged, use the exchange rate on the first subsequent
date on which an exchange can be made.
If there is a change in the expected exchange rate between the functional
currency of the entity and the currency in which a transaction is denominated,
record a gain or loss in earnings in the period when the exchange rate
changes. This can result in the recognition of a series of gains or losses over a
number of accounting periods, if the settlement date of a transaction is
sufficiently far in the future. This also means that the stated balances of the
related receivables and payables will reflect the current exchange rate as of
each subsequent balance sheet date.
EXAMPLE
Armadillo Industries sells goods to a company in the United Kingdom, to be
paid in pounds having a value at the booking date of $100,000. Armadillo
records this transaction with the following entry:

Later, when the customer pays Armadillo, the exchange rate has changed,
resulting in a payment in pounds that translates to a $95,000 sale. Thus, the
foreign exchange rate change related to the transaction has created a $5,000
loss for Armadillo, which it records with the following entry:

The following table shows the impact of transaction exposure on different

scenarios.
Risk When Transactions Denominated in Foreign Currency

Financial Statement Translation

A company may have subsidiaries located in other countries, and creates
financial statements for those subsidiaries that are denominated in the local
currency, which is known as the functional currency. If so, the parent
company will need to translate the financial statements of these subsidiaries
into the currency used by the parent company when it creates consolidated
financial statements for the entire entity (called the presentation currency).
The steps in this process are as follows:
1. Determine the functional currency of the foreign entity.
2. Remeasure the financial statements of the foreign entity into the
presentation currency of the parent company.
 3. Record gains and losses on the translation of currencies.
Determination of Functional Currency
The financial results and financial position of a company should be measured
using its functional currency, which is the currency that the company uses in
the majority of its business transactions.
If a foreign business entity operates primarily within one country and is
not dependent upon the parent company, its functional currency is the
currency of the country in which its operations are located. However, there
are other foreign operations that are more closely tied to the operations of the
parent company, and whose financing is mostly supplied by the parent. In
this latter case, the functional currency of the foreign operation is probably
the currency used by the parent entity. These two examples anchor the ends
of a continuum on which the currency status of most foreign operations will
be found. Unless an operation is clearly associated with one of the two
examples provided, it is likely that a determination of functional currency
must be made based on the unique circumstances pertaining to each entity.
For example, the functional currency may be difficult to determine if a
business conducts an equal amount of business in two different countries.
An examination of the following factors can assist in determining a
functional currency:
The functional currency in which a business reports its financial results
should rarely change. A shift to a different functional currency should be
used only when there is a significant change in the economic facts and
circumstances. If there is a change in functional currency, do not restate
previously-issued financial statements into the new currency. The effects of
the change should only be reported on a prospective basis, using the
exchange rate between the old and new functional currencies on the date of
the change.
EXAMPLE
Armadillo Industries has a subsidiary in Australia, to which it ships its body
armor products for sale to local police forces. The Australian subsidiary sells
these products and then remits payments back to corporate headquarters.
Armadillo should consider U.S. dollars to be the functional currency of this
subsidiary.
Armadillo also owns a subsidiary in Russia, which manufactures its own
body armor for local consumption, accumulates cash reserves, and borrows
funds locally. This subsidiary rarely remits funds back to the parent
company. In this case, the functional currency should be the Russian ruble.
Translation of Financial Statements
When translating the financial statements of an entity for consolidation
purposes into the reporting currency of a business, translate the financial
statements using the following rules:
• Foreign currency monetary items. Translate using the closing
exchange rate for the reporting period. If there is a difference in the
exchange rate from the rate at which a monetary item was translated in
the preceding reporting period, record the difference in profit or loss.
• Non-monetary items measured at historical cost in a foreign currency.
Translate using the exchange rate on the transaction date. If there is a
difference in the exchange rate from the rate at which a non-monetary
item was translated in the preceding reporting period, record the
difference in other comprehensive income. If a gain or loss on a non-
monetary item was recognized in profit or loss during the period, any
associated exchange component of that transaction should be
recognized in profit or loss at the same time.
• Non-monetary items measured at fair value in a foreign currency.
Translate using the exchange rate on the fair value measurement date.
If there is a difference in the exchange rate from the rate at which a
non-monetary item was translated in the preceding reporting period,
record the difference in other comprehensive income.
• Net investment. If a parent entity has a net investment in a foreign
entity that is a monetary item, and there is a difference in the exchange
rate from the rate at which the investment was translated in the
preceding reporting period, record the difference in the consolidated
financial statements within other comprehensive income. This amount
is shifted to profit or loss once the parent has disposed of its net
investment in the foreign entity.
• Different balance sheet date. If the foreign entity being consolidated
has a different balance sheet date than that of the reporting entity, use
the exchange rate in effect as of the foreign entity’s balance sheet date.
If there are significant changes in the exchange rate up to the end of
the reporting period, adjust for these changes.
If there are translation adjustments resulting from the implementation of these
rules, record the adjustments in the equity section of the parent company’s
consolidated balance sheet.
EXAMPLE
The backhoe operation of Grubstake Brothers has accounts receivable of
£1,000,000, a cash dividend payable of £150,000, and a required value
added tax remittance of £80,000. Since these items are all settled in cash,
they are considered monetary items.
Grubstake also has £170,000 of backhoe parts in stock, £2,000,000 of
goodwill, and £8,500,000 of production equipment. Since these items are
not settled in cash, they are considered non-monetary items.
EXAMPLE
Grubstake Brothers buys a $500,000 stamping machine from an American
supplier in November, when the exchange rate is £1:$1.6, and records the
machine as a £312,500 fixed asset. The payable has not yet been settled at
the end of the year, when the exchange rate is £1:$1.5. Since Grubstake’s
functional currency is the British pound, the payable must be translated at
year-end using the exchange rate on that date, which results in a payable of
£333,333, which is £20,833 higher than the amount at which the fixed asset
was recorded. Grubstake records the £20,833 difference in profit or loss as a
foreign exchange loss.
EXAMPLE
Armadillo Industries has a subsidiary located in England, which has its net
assets denominated in pounds. The functional currency of Armadillo is U.S.
dollars. At year-end, when the parent company consolidates the financial
statements of its subsidiaries, the U.S. dollar has depreciated in comparison
to the pound, resulting in a decline in the value of the subsidiary’s net assets.

The following table shows the impact of translation exposure on different

scenarios.
Risk When Net Assets Denominated in Foreign Currency

If the process of converting the financial statements of a foreign entity into

the reporting currency of the parent company results in a translation
adjustment, report the related profit or loss in other comprehensive income.
EXAMPLE
A subsidiary of Armadillo Industries is located in Argentina, and its
functional currency is the Argentine peso. The relevant peso exchange rates
are:
 • 0.20 to the dollar at the beginning of the year
• 0.24 to the dollar at the end of the year (closing rate)
• 0.22 to the dollar for the full-year weighted average rate
The subsidiary had no retained earnings at the beginning of the year. Based
on this information, the financial statement conversion is as follows:

* Reference from the following income statement

A business can opt to present its financial statements in any currency. If it

does so, and the functional currency is different from the presentation
currency, the following rules apply:
• Assets and liabilities. Translate using the closing exchange rate at the
balance sheet date for assets and liabilities.
• Income statement items. Translate revenues, expenses, gains, and
losses using the exchange rate as of the dates when those items were
originally recognized. An average rate for the period can be applied to
this requirement, unless there is significant fluctuation in the exchange
rate.
 • Exchange differences. Record all resulting exchange differences in
other comprehensive income. If the differences relate to a subsidiary
that is not wholly-owned, allocate a portion of the differences to the
non-controlling interests in the consolidated balance sheet.
If a business is located in a hyperinflationary economy and is translating its
financial statements into a different presentation currency, translate all
amounts using the closing exchange rate on the balance sheet date.
Hyperinflationary Effects
An entity may find itself operating in a hyperinflationary environment. If so,
it must restate its financial statements in accordance with the mandates of
IFRS, which are described in the Financial Reporting in Hyperinflationary
Economies chapter.
Derecognition of a Foreign Entity Investment
When a company sells or liquidates its investment in a foreign entity,
complete the following steps to account for the situation:
1. Remove the translation adjustment recorded in equity and other
comprehensive income for the investment
2. Report a gain or loss in the period in which the sale or liquidation
occurs
If a company only sells a portion of its investment in a foreign entity,
recognize in profit or loss only a proportionate share of the accumulated
translation adjustment recognized in other comprehensive income.
Foreign Currency Disclosures
Disclose the following information related to changes in foreign exchange
rates:
• Exchange differences. The aggregate amount of exchange differences
in profit or loss, other than those arising from financial instruments
measured at fair value through profit or loss.
• Exchange differences reconciliation. A reconciliation of the net
exchange differences recognized in other comprehensive income, from
the beginning to the end of the period.
• Different presentation currency. The fact that a different presentation
currency than the functional currency is used, if this is the case, and
the reason for the difference.
• Change in functional currency. The fact that there has been a change
in functional currency, if this is the case, and the reason for the
change.
 • Different currency used for presentation. If the financial statements are
presented in a currency that is not the presentation or functional
currency and the mandated translation adjustments have not been
made, state that the information is supplemental, note the currency
being used, the entity’s functional currency, and the translation
method used to create the supplemental information.
Summary
The key factor to consider when translating financial statements into the
reporting currency is the use of average exchange rates. Consider creating a
standard procedure for calculating the weighted average exchange rate for
each relevant currency for each reporting period and then retain the
calculation to justify the exchange rate(s) for audit purposes. Using a
weighted average is much more efficient from an accounting perspective than
translating specific transactions at the associated exchange rate on a daily
basis.
 Chapter 28
Borrowing Costs
Introduction
The borrowing costs topic essentially addresses a single issue, which is the
capitalization of borrowing costs when those costs are associated with the
construction or acquisition of a fixed asset. The capitalization of borrowing
costs is not a common issue to be concerned about, unless a business is
spending multiple months constructing a fixed asset, and has incurred debt to
build the asset. In most other cases, borrowing cost capitalization can be
ignored.
In this chapter, we describe the mechanics of borrowing cost
capitalization, as well as the relevant accounting and disclosures associated
with this topic.
IFRS Source Document
• IAS 23, Borrowing Costs
Overview of Borrowing Costs
Borrowing is a cost of doing business, and if a company incurs a borrowing
cost that is directly related to a fixed asset, it is reasonable to capitalize this
cost, since it provides a truer picture of the total investment in the asset. Since
a business would not otherwise have incurred the borrowing cost if it had not
acquired the asset, this cost is essentially a direct cost of owning the asset.
Conversely, if a business did not capitalize this borrowing cost and
instead charged it to expense, it would be unreasonably reducing the amount
of reported earnings during the period when the company incurred the
expense, and increasing earnings during later periods, when it would
otherwise have been charging the capitalized borrowing cost to expense
through depreciation.
According to IFRS, when a business incurs borrowing costs that are
directly attributable to the acquisition, production, or construction of
qualifying assets, it should capitalize those costs and include them in the cost
of the qualifying assets. All other borrowing costs should be charged to
expense as incurred. A business is not required to capitalize borrowing costs
when the borrowing is associated with an asset that is measured at fair value,
or with inventories that are being manufactured on a repetitive basis.
EXAMPLE
Milford Sound builds a new corporate headquarters. The company hires a
contractor to perform the work, and makes regular progress payments to the
contractor. Milford should capitalize the interest expense related to this
project.
Milford Sound creates a subsidiary, Milford Public Sound, which builds
custom-designed outdoor sound staging for concerts and theatre activities.
These projects require many months to complete, and are accounted for as
discrete projects. Milford should capitalize the interest cost related to each
of these projects.

Tip: If the amount of borrowing cost that may be applied to a fixed asset is
minor, try to avoid capitalizing it. Otherwise, extra time will be spent
documenting the capitalization, and the auditors will spend time
investigating it – which may translate into higher audit fees.
A borrowing cost is considered to be eligible for capitalization if it would
have been avoided if expenditures for a qualifying asset had not been made.
For example, a borrowing cost that should be capitalized arises when a
business takes on debt specifically to fund the construction of a building.
Considerable judgment can be required to ascertain the correct amount of
borrowing costs to capitalize under any of the following circumstances:
• When funds are acquired through a central location, such as the
corporate headquarters of the parent company
• When funds are obtained from multiple debt instruments, having
varying interest rates
• When funds are denominated in foreign currencies and there are
exchange rate fluctuations
• When the entity operates in a highly inflationary environment
When an entity borrows funds for the entire business and allocates the
required amount of these funds to qualifying assets, calculate the amount of
borrowing costs that can be capitalized using the following formula:
Capitalization rate × Expenditures on qualifying asset = Borrowing costs to
capitalize
Further points regarding the contents of this formula are:
• The capitalization rate is the weighted average amount of those
borrowing costs of the entity during the period, not including those
borrowing costs incurred specifically to acquire a qualifying asset.
Depending on the circumstances, it may be more appropriate to use
 the weighted average of all borrowings for just a single subsidiary, or
for a consolidated business.
• The expenditures on a qualifying asset can be considered the average
carrying amount of the asset during the measurement period, including
those borrowing costs that were capitalized in prior periods.
EXAMPLE
Milford Public Sound incurs an average expenditure over the construction
period of an outdoor arena complex of £15,000,000. It has taken out a short-
term loan of £12,000,000 at 9% interest specifically to cover the cost of this
project. Milford can capitalize the borrowing cost of the entire amount of the
£12,000,000 loan at 9% interest, but it still has £3,000,000 of average
expenditures that exceed the amount of this project-specific loan.
Milford has two bonds outstanding at the time of the project, in the
following amounts:

The weighted-average interest rate on these two bond issuances is 8.8%

(£2,640,000 interest ÷ £30,000,000 principal), which is the interest rate that
Milford should use when capitalizing the remaining £3,000,000 of average
expenditures.

Follow these steps to calculate the amount of interest to be capitalized for a

specific project:
1. Construct a table itemizing the amounts of expenditures made and
the dates on which the expenditures were made.
2. Determine the date on which borrowing cost capitalization ends.
3. Calculate the capitalization period for each expenditure, which is the
number of days between the specific expenditure and the end of the
interest capitalization period.
4. Divide each capitalization period by the total number of days
elapsed between the date of the first expenditure and the end of the
borrowing cost capitalization period to arrive at the capitalization
multiplier for each line item.
5. Multiply each expenditure amount by its capitalization multiplier to
arrive at the average expenditure for each line item over the
 capitalization measurement period.
6. Add up the average expenditures at the line item level to arrive at a
grand total average expenditure.
7. If there is project-specific debt, multiply the grand total of the
average expenditures by the interest rate on that debt to arrive at the
capitalized borrowing cost related to that debt.
8. If the grand total of the average expenditures exceeds the amount of
the project-specific debt, multiply the excess expenditure amount by
the weighted average of the company’s other outstanding debt to
arrive at the remaining amount of borrowing cost to be capitalized.
9. Add together both capitalized borrowing cost calculations. If the
combined total is more than the total borrowing cost incurred by the
company during the calculation period, reduce the amount of
borrowing cost to be capitalized to the total borrowing cost incurred
by the company during the calculation period.
10. Record the borrowing cost capitalization with a debit to the project’s
fixed asset account and a credit to the interest expense account.
EXAMPLE
Milford Public Sound is building a concert arena. Milford makes payments
related to the project of £10,000,000 and £14,000,000 to a contractor on
January 1 and July 1, respectively. The arena is completed on December 31.
For the 12-month period of construction, Milford can capitalize all of the
borrowing cost on the £10,000,000 payment, since it was outstanding during
the full period of construction. Milford can capitalize the borrowing cost on
the £14,000,000 payment for half of the construction period, since it was
outstanding during only the second half of the construction period. The
average expenditure for which the borrowing cost can be capitalized is
calculated in the following table:

* In the table, the capitalization period is defined as the number of

months that elapse between the expenditure payment date and the end
of the interest capitalization period.
The only debt that Milford has outstanding during this period is a line of
credit, on which the interest rate is 8%. The maximum amount of interest
that Milford can capitalize into the cost of this arena project is £1,360,000,
which is calculated as:
8% Interest rate × £17,000,000 Average expenditure = £1,360,000
Milford records the following journal entry:

Tip: There may be an inordinate number of expenditures related to a larger

project, which could result in a large and unwieldy calculation of average
expenditures. To reduce the workload, consider aggregating these expenses
by month, and then assume that each expenditure was made in the middle
of the month, thereby reducing all of the expenditures for each month to a
single line item.
The following additional rules may apply to the amount of borrowing costs
capitalized in association with a qualifying asset:
• Start of capitalization. Begin capitalizing borrowing costs on the
commencement date of the qualifying asset. This date is when
expenditures are first incurred, borrowing costs are incurred, and
activities are undertaken to prepare the asset for its intended use.
• Suspension of capitalization. Stop capitalizing borrowing costs during
extended time periods when the development of a qualifying asset has
been suspended. This does not include periods when there is other
ongoing technical or administrative work, or when a temporary delay
is a necessary part of the asset completion process.
• Termination of capitalization. All further capitalization of borrowing
costs should cease when substantially all of the tasks needed to
prepare a qualifying asset for its intended use have been completed.
Minor modifications or routine administrative work should not
interfere with the termination of borrowing cost capitalization. If a
portion of a qualifying asset is complete and can be used, stop
capitalizing the borrowing costs attributable to that portion, even if the
remainder of the asset has not yet been completed. Conversely, if a
portion of a qualifying asset is complete but cannot be used without
the completion of the remainder of the asset, do not stop capitalizing
the borrowing costs attributable to that portion of the asset.
EXAMPLE
Milford Public Sound is building three arenas, all under different
circumstances. They are:
1. Arena A. This is an entertainment complex, including a stage area,
movie theatre, and restaurants. Milford should stop capitalizing
borrowing costs on each component of the project as soon as it is
substantially complete and ready for use, since each part of the
complex can operate without the other parts being complete.
2. Arena B. This is a single outdoor stage with integrated multi-level
parking garage. Even though the garage is completed first, Milford
should continue to capitalize borrowing costs for it, since the garage
is only intended to service patrons of the arena, and so will not be
operational until the arena is complete.
3. Arena C. This is an entertainment complex for which Milford is
also constructing a highway off-ramp and road that leads to the
complex. Since the complex is unusable until patrons can reach the
complex, Milford should continue to capitalize borrowing costs
until the off-ramp and road are complete.

• Invested funds. The amount of borrowing costs incurred that can be

capitalized must be reduced by the amount of any interest income
earned from the temporary investment of borrowed funds before they
are spent on a qualifying asset.
• Maximum amount permitted. An entity is not permitted to capitalize
borrowing costs that exceed the amount of the actual borrowing costs
incurred by the business during a reporting period. Instead, the amount
capitalized is capped at the amount of the actual borrowings incurred.
• Recoverable amount. When the carrying amount of a qualifying asset
(including capitalized borrowing costs) exceeds its recoverable
amount, write the carrying amount down to the recoverable amount.
EXAMPLE
Milford Public Sound issues a one-year note for £20,000,000 at 6% interest
to pay for the construction of a new arena. At the end of the one-year period,
Milford has incurred £1,200,000 in interest costs, but has also earned
£250,000 on interest income from the temporary investment of funds
received from the note. Thus, the maximum amount of interest expense that
Milford can capitalize is £950,000 (£1,200,000 interest cost - £250,000
interest income).
Borrowing Cost Disclosures
If a company has capitalized any of its borrowing costs, disclose the amount
of borrowing cost capitalized in the period, as well as the capitalization rate
used to derive the amount of capitalized borrowing costs.
EXAMPLE
Suture Corporation discloses the following information about the borrowing
costs it has capitalized as part of the construction of a laboratory facility:
The company incurred borrowing costs of £800,000 during the
year. Of that amount, it charged £650,000 to expense and included
the remaining £150,000 in the capitalized cost of its Dumont
laboratory facility. The capitalized borrowing costs were derived
from a capitalization rate of 7.8%.

Summary
The key issue with borrowing cost capitalization is whether to use it at all. It
requires a certain amount of administrative effort to compile, and so is not
recommended for lower-value fixed assets. Instead, reserve its use for larger
projects where including borrowing costs in an asset will improve the quality
of the financial information reported by a business. If the choice is made to
capitalize borrowing costs, adopt a procedure for determining the amount to
be capitalized and closely adhere to it, with appropriate documentation of the
results. This will result in a standardized calculation methodology that
auditors can more easily review.
 Chapter 29
Leases
Introduction
This chapter addresses the core concepts surrounding the accounting for
leases by all parties entering into these arrangements. There are several
fundamental leasing issues that we will cover in the following pages,
including the following:
• Types of leases. There are several possible designations that can be
applied to a lease, depending upon the facts and circumstances
associated with it. Each of these designations triggers a different set of
accounting rules.
• Balance sheet recognition. One of the key aspects of the accounting
for leases is that most lease assets and lease liabilities are now
recognized on the balance sheet. Under previous guidance, it was
possible for lessees to keep certain leases off their balance sheets,
which masked their true financial condition.
• Elections. There are several lease-related elections that an entity can
take, which are generally designed to simplify the accounting for
leases.
• Disclosures. The presentation and disclosure rules for leases are quite
extensive, in order to provide the maximum amount of information to
the readers of an organization’s financial statements.
IFRS Source Documents
• IFRS 16, Leases
The Nature of a Lease
A lease is an arrangement under which a lessor agrees to allow a lessee to
control the use of identified property, plant, and equipment for a stated period
of time or an amount of usage in exchange for one or more payments. A lease
arrangement is quite a useful opportunity for the following reasons:
• The lessee reduces its exposure to asset ownership
• The lessee obtains financing from the lessor in order to pay for the
asset
• The lessee now has access to the leased asset
An arrangement is considered to give control over the use of an asset when
both of these conditions are present:
 • The lessee obtains the right to substantially all of the economic
benefits from using an asset; and
• The lessee obtains the right to direct the uses to which an asset is put.
EXAMPLE
Blitz Communications obtains the rights to the entire output of an undersea
cable for the next ten years, in order to benefit from an expected increase in
traffic from new data centers in Greenland to users in the United Kingdom.
Since Blitz has the right to substantially all of the economic benefits from
using the cable, the underlying contract is considered a lease. If the
arrangement had instead been for only a certain proportion of the total
capacity of the cable, where the cable operator could choose which fibers
within the cable would carry Blitz’s data, the arrangement would not be
considered a lease.
EXAMPLE
The Cupertino Beanery enters into a contract to operate a store from retail
space. Part of the contract states that Cupertino must pay 10% of its
revenues to the landlord. Cupertino still obtains the right to substantially all
of the economic benefits from using the retail space – subsequent to
obtaining the revenues, the company then pays 10% to the landlord. This
contract clause does not prevent the contract from being designated as a
lease.
EXAMPLE
Austrian Helicopter Rescue leases a helicopter for use in its personnel rescue
operations. As part of the lease agreement, Austrian is only allowed to
operate the helicopter during daylight hours. This restriction is designed to
reduce the risk of damage to the craft. This protective right limits the scope
of Austrian’s usage of the helicopter, but does not actually prevent it from
having the right to use the asset. Thus, the restriction does not prevent the
contract from being designated as a lease.

The following additional points all apply to whether a lease exists:

• Partial period. If a leasing arrangement only lasts for a portion of the
period spanned by a contract, a lease is still presumed to exist for the
partial period specified within the contract.
• Right of substitution. If a contract allows the supplier to substitute an
identified asset with another asset throughout the usage period, there is
no lease. This situation only applies when the supplier has the
 practical ability to substitute alternative assets, and the supplier
obtains a positive economic benefit from doing so. The evaluation of
the ability to substitute assets does not include assets that are unlikely
to occur.
EXAMPLE
Nautilus Tours leases several submarines from Underwater Assets, for use in
shallow-water tourist visits to nearby reefs. The lease agreement states that
Underwater Assets can substitute a submarine for repairs or maintenance in
the event that a submarine is not operating properly. This contract language
still allows Nautilus Tours to have the right to an identified asset, so the
existence of the lease is not called into question.
EXAMPLE
Nova Corporation operates a deep field scanning telescope for sky survey
work, which it leases from Alpha Centauri Leasing. If the contract language
is interpreted in a certain way, it appears possible that Alpha could substitute
the telescope at a later date. However, the telescope is located at Nova’s
observatory and would be difficult to dismount and replace. The cost of
substitution is therefore likely to be higher than any benefits that Alpha
might gain from the substitution. In this case, it appears likely that there is a
lease.
EXAMPLE
Grissom Granaries stores corn and wheat along the Danube River. It enters
into an agreement with a local transport firm to transport crops up and down
the river. The volume of transport services indicated in the contract
translates into the ongoing use of 10 barges. The transport firm has several
hundred barges that it can use to fulfill the contract. When not in use, the
barges are stored at one of the transport firm’s riverside facilities. No
specific barges are described in the contract. Given these conditions, it is
apparent that Grissom does not direct the use of the barges, nor does it have
the right to obtain substantially all of the economic benefits from use of the
barges. Consequently, this arrangement is not a lease.
EXAMPLE
The Hegemony Toy Company enters into a contract with an international
shipping company to deliver a shipload of goods from Singapore to Rome.
The specific freighter to be used is named in the contract, and only
Hegemony’s board games will be shipped. However, the shipping company
will operate the freighter during the voyage. This arrangement is not a lease,
since Hegemony cannot direct the uses to which the freighter is put.

Since the accounting for a lease only applies to property, plant, and
equipment, it does not apply to the following types of assets that may also be
leased:
• Biological assets (such as orchards)
• Exploration assets (such as oil and gas exploration rights)
• Licensed intellectual property
• Service concession arrangements
The assessment of whether a contract contains a lease is only conducted at
the initiation of the lease or when the terms and conditions of the related
contract have been altered.
Lease Components (Lessee)
Once it has been established that a contract contains a lease, it is necessary to
separate the lease into its components (if any). This can result in a business
tracking several different leases within one contract. A separate lease
component exists when both of the following conditions are present:
• The lessee can benefit from the right of use of a single asset, or
together with other readily available resources; and
• The right of use is separate from the rights to use other assets in the
contract. This is not the case when the rights of use of the different
assets significantly affect each other.
The right to use land is always considered a separate lease component, unless
doing so would have an insignificant effect.
As a practical expedient, the lessee can choose not to separate lease
components from non-lease components, so that they are accounted for as a
single lease.
EXAMPLE
Treetops Telecommunications leases a cell phone tower, along with the land
on which it is positioned and the building within which it is located. The
building was designed specifically to house the cell phone tower and related
equipment. In this case, the rights of use of the different assets significantly
affect each other, so one lease arrangement encompasses all of the assets.
The inclusion of the land component in the same lease is considered to have
an insignificant effect.

There may also be non-lease components to a contract. These components

will not meet the criteria just stated for a lease component, but will transfer a
good or service to the lessee. There may also be other activities that do not
qualify as non-lease components, since there is no transfer of goods or
services; for example, the reimbursement of lessor costs falls into this
category.
A common charge associated with a lease is common area maintenance.
The lessor typically performs maintenance and cleaning services for all
common areas in a building, and then charges a portion of these costs through
to the building tenants. The lessee would otherwise have to perform these
services itself or pay a third party to do so. Common area maintenance costs
are considered a non-lease component.
The classifications of lease components are not reassessed after the
commencement date of the lease, unless the contract is subsequently
modified and the change is not treated as a separate contract. Lease
classifications can also be revisited if the lease term changes or there is a
change in the probability that an option will be exercised to purchase an
underlying asset.
Once all lease and non-lease components have been identified, allocate
the consideration in the contract to them. This allocation is derived as
follows:
1. Determine the standalone price of each separate lease and non-lease
component. This should be based on the observable standalone price.
If this price is not available, it can be estimated.
2. Allocate the consideration in proportion to the standalone prices of
the various components.
3. If there are any initial direct costs associated with the contract,
allocate these costs on the same basis as the lease payments.
EXAMPLE
Micron Metallic leases a stamping machine and a CNC (computer numerical
control) machine for its washing machine production facility, along with
periodic maintenance and repair services. The total consideration that
Micron will pay over the five-year term of the lease is £800,000.
Micron’s controller concludes that there are two separate leases, since the
stamping and CNC machines are to be used separately, in different parts of
the factory. The controller also decides to account for the maintenance and
repair services as non-lease components of the contract. Further, these
services are considered to be distinct for each machine, and so are separate
non-lease performance obligations.
The controller needs to allocate the £800,000 of consideration to the various
lease and non-lease components. She notes that there are a number of local
suppliers that provide similar maintenance and repair services for each of the
machines, and that standalone prices can be found to separately lease the
two machines. These standalone prices are noted in the following table:

The controller allocates the £800,000 consideration in the contract to the

lease and non-lease components on a relative basis, employing their
standalone prices. This results in the following allocation:

The consideration in a lease should be remeasured and reallocated when

either of the following events occurs:
• The lease liability is remeasured. This could be triggered by a change
in the term of the lease or a revision to the assessment of whether a
lease option will be exercised.
• There is a contract modification that is not being accounted for as a
separate contract.
Lease Components (Lessor)
In general, a lessor allocates consideration to lease components in the same
manner as the lessee. In addition, the lessor allocates any capitalized costs to
the lease and non-lease components to which those costs relate. An example
of a capitalized cost is the initial direct costs incurred to create a contract.
Initial direct costs are discussed in the Lease Accounting by the Lessor
section.
If a lessor receives a variable payment amount that relates to a lease
component, it should recognize the payment as income in the same period as
the one on which the variable payment was based.
EXAMPLE
Prickly Corporation leases space from Capital Inc., which it uses as a retail
store to sell cacti and other thorny plants. Following the end of each month,
Prickly is required to pay 2% of its revenue to Capital; this is the variable
portion of the lease payment for the retail space. In early March, Prickly
sends a payment of £540 to Capital, which is the variable portion of the
payment, and which relates to its February sales. Capital should recognize
this payment as income in its February income statement.
Prickly discloses in its financial statements the fixed amount of its lease
cost, while separately disclosing the £540 as a variable lease cost.

The Lease Term

One of the key components of a lease is the lease term. This is considered to
be the noncancelable period of a lease, as well as the following additional
periods that may apply:
• Lease extension options if it is reasonably certain that the lessee will
exercise these options
• Lease termination options if it is reasonably certain that the lessee will
not exercise these options
An entity makes a judgment call as of the lease commencement date
regarding which of the preceding factors will apply to the derivation of an
estimated lease term. This judgment is based on those factors that create an
economic incentive for the lessee. Examples of economic incentives are
reduced lease payments in the optional period, the significance of any
leasehold improvements, and the importance of the underlying asset to the
lessee’s operations.
EXAMPLE
Subatomic Research operates a laboratory in leased facilities. The laboratory
has been designated as an airborne infection isolation room by the federal
government, which is quite a difficult certification to obtain. The lease has
an option for Subatomic to extend the lease term by five years. It is highly
likely that Subatomic will renew the lease, given the high cost of moving
elsewhere and then applying for recertification.
EXAMPLE
Newton Enterprises offers free science classes to high school students.
These endeavors require Newton to lease training facilities. Its most recent
lease is for 10 years, with a termination option after seven years. Annual
lease payments are £100,000. If Newton terminates the lease, it must pay a
£30,000 termination penalty. The managers of Newton conclude that it is not
reasonably certain that Newton will need the facilities after seven years of
use, especially considering the relatively small size of the termination
penalty when compared to the amount of the annual lease payments.
Consequently, Newton elects to measure the lease term as being seven years.

The lessee should reconsider whether it is reasonably certain to exercise a

lease extension option when there is a significant event that:
• Is within the lessee’s control and;
• The event affects whether the lessee is still reasonably certain to
exercise an option that had not previously been included in its
estimation of the lease term.
The lessee should revise the lease term when there is a change in the non-
cancellable duration of a lease. Here are two examples of such a situation:
• The lessee elects to exercise an option that had not previously been
included in its assessment of the lease term.
• An event occurs that prohibits the lessee from exercising an option that
had previously been included in its assessment of the lease term.
If the lessor provides a period of free rent, the lease term is considered to
begin at the commencement date and to include all rent-free periods.
A lease term should not extend past the period when it is enforceable. A
lease is no longer enforceable when both the lessee and the lessor can
terminate the lease without permission from the other party and by paying no
more than an insignificant penalty.
Lease Accounting by the Lessee
The accounting for a lease by the lessee is noted in the following sub-
sections.
Lease Recognition
The lessee must recognize an asset and liability for all leases having a term of
more than 12 months, unless the asset associated with the lease has a low
value. The asset to be recognized is a right-of-use asset that represents the
right of the lessee to use the asset during the lease term. The liability to be
recognized is the obligation of the lessee to pay the lessor.
A lessee may elect not to record a right-of-use asset for a short-term lease
(which has a term of 12 months or less) or a lease for which the associated
asset is of low value. In this situation, the lessee recognizes the lease
payments for those leases as an expense. This may be done on a straight-line
basis over the term of the lease or on some other systematic basis. An
alternative systematic basis is used if the alternative is more representative of
the pattern of benefits enjoyed by the lessee.
The election to classify a leased asset as short-term is made for the class
of assets to which the right of use relates. A class of assets is similar in nature
and has a common use within the operations of the lessee. Conversely, the
election to classify a leased asset as being of low value can be made by
individual lease.
Examples of low-value underlying assets are personal computers,
telephones, lesser items of office furniture, and tablet computers.
Initial Lease Measurement
As of the commencement date of a lease, the lessee measures the liability and
the right-of-use asset associated with the lease. These measurements are
derived as follows:
• Lease liability. The present value of the lease payments, discounted at
the discount rate for the lease. This rate is the rate implicit in the lease
when that rate is readily determinable. If not, the lessee instead uses its
incremental borrowing rate. The lease payments encompassed by the
lease liability measurement include the following items:
o Payments made at the commencement date
o Fixed payments, minus any lease incentives payable to the
lessee
o Variable lease payments that depend on an index or a rate
(such as a consumer price index)
o The exercise price of an option to purchase the underlying
asset, if it is reasonably certain that the lessee will exercise the
option
o Penalty payments associated with an assumed exercise of an
option to terminate the lease
o Residual value guarantees, if it is probable that these amounts
will be owed. Note that a lease provision requiring the lessee
to pay for any deficiency in residual value that is caused by
damage or excessive usage is not considered a guarantee of
the residual value.
• Right-of-use asset. The initial amount of the lease liability, plus any
lease payments made to the lessor before the lease commencement
date, plus any initial direct costs incurred, minus any lease incentives
received.
EXAMPLE
Inscrutable Corporation enters into a five-year lease, where the lease
payments are £35,000 per year, payable at the end of each year. Inscrutable
incurs initial direct costs of £8,000. The rate implicit in the lease is 8%.
At the commencement of the lease, the lease liability is £139,745, which is
calculated as £35,000 multiplied by the 3.9927 rate for the five-period
present value of an ordinary annuity. The right-of-use asset is calculated as
the lease liability plus the amount of the initial direct costs, for a total of
£147,745.
Subsequent Lease Measurement - Assets
Following the commencement of a lease, the lessee uses a cost model to
measure the right-of-use asset. The cost model requires the lessee to measure
the right-of-use asset at cost, with the following adjustments:
• Minus any accumulated depreciation
• Minus any accumulated impairment losses
• Adjusted for any remeasurement of the lease liability for lease
modifications or to reflect in-substance fixed lease payments
The right-of-use asset is depreciated from the lease commencement date to
the earlier of the end of the asset’s useful life or the lease term. However, if
the lease transfers ownership of the underlying asset to the lessee, the lessee
can only depreciate the asset through the end of the asset’s useful life.
Note: If an organization revalues its fixed assets, it can instead apply the
revaluation model to the subsequent measurement of its right-of-use assets.
If the firm applies the fair value model to its investment property, it can
apply the fair value model to those of its right-of-use assets that can be
classified as investment property.
Subsequent Lease Measurement - Liabilities
The lessee must measure the lease liability after the commencement date
through the following actions:
• Increase the carrying amount of the liability to reflect the interest on
the lease liability
• Reduce the carrying amount by the lease payments made
• Remeasure the carrying amount for any reassessment of or
modifications made to the lease
The interest associated with the lease liability is the amount that results in a
constant periodic rate of interest on the remaining liability balance. The
interest rate used is the interest rate implicit in the lease; if that rate cannot be
determined, the rate to use is the lessee’s incremental borrowing rate.
Following the commencement date, the lessee recognizes the following
amounts in profit or loss:
• The interest on the lease liability
• Any variable lease payments not included in the lease liability
measurement. These payments are recognized in the same period
when the condition triggering the payments occurs.
Following the commencement date, the lessee may need to remeasure the
lease liability in association with any changes in the lease payments. The
amount of this liability remeasurement is recognized as a right-of-use asset
adjustment. Several notes regarding this remeasurement are as follows:
• Reduction to zero. If the carrying amount of the right-of-use asset
declines to zero and an additional reduction is needed in the lease
liability measurement, the residual amount is recognized in profit or
loss.
• Revised discount rate. It may be necessary to remeasure the lease
liability with a discounting calculation that employs a different
discount rate. This happens when there is a change in the lease term or
there is an altered assessment of an option to purchase the underlying
asset. The new discount rate is the interest rate implicit in the lease for
the remainder of the lease term or the incremental borrowing rate at
the date of reassessment.
• Revised lease liability. The lease liability should be remeasured by
discounting the revised lease payments when there is a change in the
amounts expected to be paid under a residual value guarantee or there
is a change in the future lease payments that result from a variation in
the index used to determine the lease payments.
Lease Modifications
A lease may be modified partway through its term. If so, the lessee accounts
for the modification as a separate lease when both of the following conditions
are present:
• The scope of the lease is expanded by adding the right to one or
several underlying assets
• The consideration by the lessee increases due to an increase in the
scope of the contract
There are other circumstances in which a lease modification is not accounted
for as a separate lease. Instead, as of the effective date of the lease
modification, the lessee allocates the altered consideration based on the
criteria noted previously for the Lease Components (Lessee) section. Also,
the lessee remeasures the lease liability by discounting the new lease
payments with a revised discount rate. The revised discount rate is the
interest rate implicit in the lease for the remaining lease period; if this rate
cannot be determined, then the lessee’s incremental borrowing rate is used
instead. The following changes will likely occur as a result of the liability
remeasurement:
• When a lease modification reduces the scope of a lease or terminates
it, decrease the carrying amount of the related right-of-use asset. If
there is a gain or loss relating to this partial or full lease termination,
recognize it in profit or loss.
• When any other type of lease modification occurs, adjust the right-of-
use asset accordingly.
Lease Accounting by the Lessor
A lessor is the entity that leases its assets to another entity, the lessee, in
exchange for payments. In this section, we discuss the accounting by the
lessor for finance leases and operating leases.
Financing Leases
A finance lease is one in which the lessor transfers substantially all of the
risks and rewards associated with asset ownership to the lessee. Examples of
situations that would usually lead to a lease being classified in this manner
are as follows:
• Ownership of the leased asset is transferred to the lessee by the end of
the lease term.
• The lessee has an option to buy the leased asset at a price expected to
be far enough below the asset’s fair value at the option exercise date to
make it reasonably certain that the lessee will exercise the option.
• The term of the lease covers the majority of the economic life of the
leased asset.
• The present value of the lease payments at the lease inception date is
substantially all of the fair value of the leased asset.
• The asset is so specialized that only the lessee can use it without
requiring major modifications.
Situations that could lead to a lease being classified as a finance lease are as
follows:
 • If the lessee cancels the lease, the lessee bears the cost of any losses
incurred by the lessor.
• If there are gains or losses associated with changes in the fair value of
the residual asset, they accrue to the lessee.
• The lessee can continue the lease for an additional period at a rate that
is well below the market rate.
A lease is classified as a finance lease or an operating lease (see the next sub-
section) at the inception of the lease. This classification is only reassessed if
there is a modification to the lease.
When a lessor has entered into a lease agreement that is classified as a
financing lease, the asset is presumed to be owned by the lessee. Therefore,
the lessor reports a receivable in its balance sheet in the amount of its net
investment in the lease. Each lease payment made by the lessee is considered
a repayment of principal, plus interest income.
At the commencement date of a lease, the measurement of the lessor’s net
investment in the lease is comprised of the following payments from the
lessee:
• Fixed payments minus any lease incentives payable
• Variable lease payments that depend on an index or some similar basis
• Residual value guarantees provided to the lessor
• The exercise price of a purchase option, if it is reasonably certain that
the lessee will exercise the option
• Lease termination penalties, if the expected lease term assumes that
the lessee will exercise a termination option
When measuring the net investment in a lease, the lessor uses the interest rate
that is implicit in the lease.
Initial direct costs, such as legal fees or commissions, are included in the
initial measurement of the net investment in a lease. These costs then reduce
the amount of income recognized over the lease term.
The selling profit for a financing lease is usually recognized by a
manufacturer or dealer lessor when the lease term begins, to match the policy
of such an entity for outright sales transactions. The revenue recognized
when the lease term begins is the lesser of the fair value of the asset leased or
the present value of minimum lease payments, discounted at the market
interest rate. The offsetting cost of goods sold to be recognized is the carrying
amount of the leased property, minus the present value of any unguaranteed
residual value.
 If a manufacturer or dealer lessor quotes a lessee an artificially low
interest rate on a financing lease, the amount of selling profit recognized shall
be limited to the profit that would have been recognized if the market interest
rate had been charged. Though a selling profit may be recognized when the
lease term begins, any interest income associated with the lease is recognized
over the term of the lease.
When a manufacturer or dealer lessor incurs up-front costs in connection
with a finance lease, it should charge them to expense when the related
selling profit is recognized, rather than including them in the net investment
in the lease.
On an ongoing basis, lease payments made by the lessee to the lessor are
apportioned by the lessor between interest income and a reduction of the
receivable balance. The calculation of interest income should result in a
constant periodic rate of interest on the lessor’s remaining net investment in
the lease.
In any reporting period, if there has been a reduction in the estimated
amount of the unguaranteed residual value of a lease, revise the income
allocation over the remaining lease term.
EXAMPLE
Nova Corporation leases a deep field telescope to the British Science
Institute (BSI) under a five-year lease. The telescope cost Nova £500,000 to
build. The BSI is expected to pay £200,000 at the end of the lease as part of
a buyout clause. The payments due under the lease are one payment of
£99,139, payable at the end of each year. Nova’s implicit interest rate is
10%. The present value multiplier for an ordinary annuity of 1 for five
periods at 10% interest is 3.79079. The present value multiplier for £1 due in
five years at 10% interest is 0.62092.
Nova recognizes the transaction with the following entries:
• Revenue. This is the £375,815 present value of the lease payments
(calculated as £99,139 × 3.79079 present value factor).
• Cost of goods sold. This is the asset cost of £500,000, less the
£124,184 present value of the buyout price on the telescope
(calculated as £200,000 × 0.62092 present value factor), resulting in
a cost of goods sold of £375,816.
• Lease receivable. This is the £495,695 sum of the lease payments,
plus the buyout price of £200,000, for a total receivable of £695,695.
• Unearned interest. This is the lease receivable of £695,695, minus
 the £375,815 present value of the lease payments, minus the
£124,184 present value of the buyout price of the telescope, or
£195,696.
Based on this information, Nova documents the initial leasing transaction
with the following entry:

Nova then calculates the annual amount of interest income that it should
recognize, based on the following table:

When there is a modification to a finance lease, the lessor should account for
it as a separate lease when both of the following conditions are present:
• The scope of the lease is expanded by adding the right to one or
several underlying assets
• The consideration paid by the lessee increases due to an increase in the
scope of the contract
A finance lease may be altered and the modification is not accounted for as a
separate lease. When the lease would otherwise have been classified as an
operating lease if the modification had been present at the initiation of the
lease, the lessor should account for the modification as a new lease from the
effective date of the change. Also, the lessor should measure the carrying
amount of the asset at the net investment in the lease just prior to the effective
date of the modification.
Operating Leases
An operating lease is one in which the lessor retains substantially all of the
risks and rewards associated with asset ownership.
When a lessor enters into a leasing arrangement that is classified as an
operating lease, it should recognize the income from this arrangement on a
straight-line basis over the term of the lease, unless some other method of
recognition more closely adheres to the time pattern over which the benefit
derived from the asset declines. The straight-line basis is the default form of
income recognition, even if the receipts from lease payments do not follow
the same pattern.
Any costs incurred to earn leasing income are charged to expense. The
primary cost so recognized is likely to be depreciation expense. The manner
of calculating depreciation expense should be the same as the lessor uses for
similar assets. Any costs incurred by the lessor to negotiate and arrange a
lease are to be added to the capitalized cost of a leased asset and depreciated
over the term of the lease.
If a manufacturer or dealer lessor enters into an operating lease, it cannot
recognize a selling profit at the inception of the lease, since it has not sold the
underlying asset (as was the case for a financing lease).
When there is a modification to an existing operating lease, the lessor
accounts for it as a new lease from the effective date of the modification.
Sale and Leaseback Transactions
As the name implies, a sale and leaseback transaction involves the lease of an
asset to a lessor, after which the selling party leases the asset back from the
lessor. This transaction usually arises in order to shift a large amount of cash
to the seller of the property. A lessor is willing to engage in such a
transaction in order to earn interest income on the financing aspect of the
transaction. The accounting for a sale and leaseback arrangement, assuming
that an actual sale has taken place, is as follows:
• The seller (lessee) measures the right-of-use asset at the proportion of
the previous carrying amount of the asset that the seller can still use.
This means that the seller can only recognize a gain or loss for that
amount of the usage rights that were shifted to the buyer (lessor).
• The buyer (lessor) accounts for the acquired asset in the normal
manner for a fixed asset, as described in the Property, Plant and
Equipment chapter. The buyer accounts for the lease in the normal
manner for a lessor, as described earlier in this chapter.
If the fair value of the consideration for the asset does not match the fair
value of the asset, or if the lease payments are not at market rates, the
following adjustments must be made to measure the proceeds from the sale at
fair value:
 • Account for any below-market terms as lease prepayments.
• Account for any above-market terms as additional financing provided
to the seller (lessee).
• The preceding adjustments for below- or above-market terms are
based on the more easily determinable of the following:
o The difference between the fair value of the consideration and
the fair value of the asset; or
o The difference between the present value of the contractual
lease payments and the present value of the market-price lease
payments.
If a sale and leaseback transaction is not considered to be a sale, then the
accounting for it is as follows:
• The seller (lessee) continues to recognize the transferred asset. The
seller recognizes a financial liability equal to the amount of its
proceeds from the transfer transaction.
• The buyer (lessor) does not recognize the transferred asset. The buyer
recognizes a financial asset equal to the amount of its payment under
the transfer transaction.
Presentation of Lease Information
The parties to a lease must present in the balance sheet or in the
accompanying disclosures the information noted in the following sub-
sections.
Lessee Presentations
The lessee is responsible for presenting the following information related to
leases:
• Present right-of-use assets (except for investment property) separately
from other assets. If this is not done in the balance sheet, the lessee
can instead include these assets in the same line item where the assets
would have been recorded if they had been owned, while also
disclosing the line items within which these assets are included.
• Present lease liabilities separately from other liabilities. If this is not
done in the balance sheet, the lessee should disclose the line items
within which these liabilities are included.
• Present interest expense on the lease liability separately from the
depreciation charge related to the right-of-use asset.
• Classify cash payments on the principal portion of a lease liability
within the financing activities section of the statement of cash flows.
 • Classify those payments related to short-term leases, leases of low-
value assets, and variable lease payments not considered in the
calculation of lease liability within the operating activities section of
the statement of cash flows.
Lessor Presentations
When a lessor has assets that are being leased out under operating leases,
these assets are to be presented in the balance sheet in accordance with the
nature of the asset.
Lease Disclosures by the Lessee
A lessee needs to disclose information about its leases that is sufficient to
give users a basis for assessing the effect that leases have on the financial
performance, financial position and cash flows of the organization.
Specifically, the lessee needs to disclose the following information within a
single note or separate section in its financial statements and preferably in a
tabular format:
• The depreciation on right-of-use assets, separately by class of
underlying asset
• The interest expense associated with lease liabilities
• The expense related to short-term leases for which a right-of-use asset
is not recognized
• The expense related to leases of low-value assets for which a right-of-
use asset is not recognized
• The expense related to any variable lease payments that were not used
to calculate lease liabilities
• Any income from the sublease of right-of-use assets
• The total cash outflow associated with leases
• Any additions to the right-of-use assets
• Any gains or losses arising from sale and leaseback transactions
• The carrying amount of all right-of-use assets as of the end of the
reporting period, separately by class of underlying asset
It may be necessary to disclose additional information in order to give a
complete presentation to users. This additional disclosure may include
information that helps users to assess the following:
• The nature of the entity’s leasing activities
• Any potential future cash outflows that are not reflected in the lease
liability. These outflows may include variable lease payments,
extension options, termination options, residual value guarantees and
 commitments for leases that have not yet occurred.
• Any covenants or restrictions associated with the leases
• Any sale and leaseback transactions
An organization that is not recognizing a right-of-use asset for short-term
leases or leases of low-value assets must disclose that fact.
Lease Disclosures by the Lessor
A lessor needs to disclose information about its leases that is sufficient to
give users a basis for assessing the effect that leases have on the financial
performance, financial position and cash flows of the entity. Specifically, the
lessor needs to disclose the following information within a single note or
separate section in its financial statements and preferably in a tabular format:
• For a finance lease: The selling profit or loss, the finance income on
the net investment in the lease, and income associated with variable
lease payments that were not included in the calculation of the net
investment in the lease.
• For an operating lease: The income from the lease, with separate
disclosure of any income derived from variable lease payments that
were not derived from an index or some similar basis.
In addition to the preceding tabular format, the lessor will need to disclose
the following additional information:
Finance Leases
• Provide a qualitative and quantitative explanation of any significant
changes in the carrying amount of the lessor’s net investment in
finance leases.
• Provide a maturity analysis of the receivable for lease payments. This
analysis should reveal the undiscounted lease payments to be received
annually in each of the next five years, plus the total to be received for
the remaining years. The undiscounted lease payments should also be
reconciled to the net investment in the lease. The line items to include
in this reconciliation include the unearned finance income associated
with the lease payments receivable, as well as any undiscounted
unguaranteed residual value.
Operating Leases
• Provide the standard disclosures required for all fixed assets (see the
Property, Plant and Equipment chapter). For this reporting,
disaggregate each class of fixed assets into those assets subject to
operating leases and those not subject to these leases.
 • Provide a maturity analysis of lease payments, stating the
undiscounted lease payments to be received annually in each of the
next five years, plus the total to be received for the remaining years.
It may be necessary to disclose additional information in order to give a
complete presentation to users. This additional disclosure may include
information that helps users to assess the following:
• The nature of the entity’s leasing activities.
• The manner in which the lessor manages the risk associated with any
rights it may retain in leased assets. This information should include
risk reduction activities for these leased assets, such as residual value
guarantees and buy-back agreements.
Summary
Companies that are in the leasing business are well aware of the lease
accounting rules set forth in this chapter, and so will usually structure the
terms of a leasing arrangement to make it quite clear that a lease should be
classified as either an operating or financing lease. Thus, it is rather unusual
to be faced with an uncertain lease classification situation.
The accounting for right of use assets and lease liabilities can be difficult,
so it makes sense to adopt a detailed procedure that states exactly how these
leases are supposed to be measured and recognized, along with templates for
the journal entries to be used. Also, consider having a senior accountant
review the initial accounting for every lease, to ensure that it is correct.
 Chapter 30
Related Party Disclosures
Introduction
IFRS devotes an entire accounting standard to related party disclosures,
which is somewhat unusual, because it does not mandate any accounting
recordation – only the disclosure of information involving related party
transactions. This chapter describes the nature of a related party transaction,
and then itemizes the required disclosures for these types of transactions. The
intent of these requirements is to draw particular attention to how the balance
sheet and income statement may have been impacted by transactions with
related parties, who might not otherwise have been willing to engage in the
same transactions if they had not been related parties. This guidance applies
to individual financial statements, as well as to the consolidated financial
statements of a business.
IFRS Source Document
• IAS 24, Related Party Disclosures
Overview of Related Parties
A company may do business with a variety of parties with which it has a
close association. These parties are known as related parties. Examples of
related parties are:
• Other subsidiaries under common control
• Owners of a business, its key managers, and their families
• The parent entity
• Post-employment benefit plans for the benefit of employees
• An entity that provides key management personnel services to the
reporting entity
Entities not considered to be related parties are lenders, trade unions, public
utilities, government entities that do not control the business, entities that
have a director or key manager in common, and fellow joint venturers who
jointly control a venture.
There are many types of transactions that can be conducted between
related parties, such as sales, asset transfers, leases, lending arrangements,
guarantees, allocations of common costs, and the filing of consolidated tax
returns.
The disclosure of related party information is considered useful to the
readers of a company’s financial statements, particularly in regard to the
examination of changes in the financial results and financial position over
time, and in comparison to the same information for other businesses.
Related Party Disclosures
In general, any related party transaction should be disclosed that would
impact the decision making of the users of a company’s financial statements.
This involves the following disclosures:
• General. The nature of all related party relationships, even in the
absence of any transactions between the parties, and the name of the
ultimate controlling party (usually the parent entity).
• Compensation. The total amount of compensation for key management
personnel, as well as for their short-term benefits, post-employment
benefits, other long-term benefits, termination benefits, and any share-
based payments. This is not necessary for management personnel
services acquired from another entity.
• Transaction level. For specific related party transactions, the nature of
the relationship, transaction terms and conditions, outstanding
balances, commitments or guarantees, related collateral arrangements,
provisions for related doubtful debts, and any related bad debt expense
recognized during the period. These disclosures should be reported
separately for the parent entity, any entities with joint control or
influence over the business, subsidiaries, associates, joint ventures,
key management personnel, and other related parties.
• Key management personnel services. The amounts incurred for key
management personnel services from a separate management entity.
• Government control. Transaction-level disclosures are not required
when the related party is a government entity that has control or
influence over the business, or another entity over which the same
government entity also exercises control or influence. Instead, disclose
the name of the government entity and the nature of the relationship
with it, as well as the nature and amount of those transactions
considered significant. If a number of transactions are considered
significant only if they are aggregated into a group, indicate the
significance of these aggregated transactions (either numerically or
descriptively). A transaction is considered to be more significant if it
is of unusual size, contains non-market terms, is not a common
transaction, is disclosed to either senior management or regulatory
 authorities, or requires the approval of shareholders.
Examples of transactions that may require related party disclosure are the
purchase or sale of goods or property, rendering of services, provision of
guarantees, and settlement of liabilities on behalf of another entity.
Depending on the transactions, it may be acceptable to aggregate some
related party information by type of transaction.
When disclosing related party information, do not state or imply that the
transactions were on an arm’s-length basis, unless the claim can be
substantiated.
EXAMPLE
During the year ended December 31, 20X2, the federal government
provided Failsafe Containment Corporation with a £10,000,000 startup loan
for the company’s research into the development of a portable fusion
reactor. The loan requires a single balloon payment in ten years, plus the
payment of all accumulated interest on the maturity date. The government
charges a fixed rate of 2% interest on the loan, as compared to the 9% rate
that the company would otherwise have obtained from its lenders.

Summary
Related party transactions are surprisingly common, especially when the
owners of a company are continually propping up a business with additional
funding or granting favorable financing terms. Accordingly, this is a topic
worthy of regular review, since there can be an ongoing series of related party
transactions that must be disclosed.
 Chapter 31
Events after the Reporting Period
Introduction
There will always be a continuing series of events that can impact the
information incorporated into a company’s financial statements, and some of
them will occur after the reporting period. This chapter sets forth the general
principles needed to determine whether the recognition of these subsequent
events can be safely delayed until the next set of financial statements, or if
the statements relating to the last accounting period must be revised to
incorporate them.
IFRS Source Document
• IAS 10, Events after the Reporting Period
Overview of Events after the Reporting Period
An event after the reporting period is considered to be one that arises between
the end of the reporting period and when the financial statements for that
period are authorized for issuance. There are two types of these events:
• Additional information. An event provides additional information
about conditions in existence at the end of a reporting period,
including estimates used to prepare the financial statements for that
period.
• New events. An event provides new information about conditions that
did not exist at the end of a reporting period.
There are rare cases where a company may be required to submit its financial
statements to its shareholders for approval. If so, the financial statements are
considered to have been authorized for issuance on the date of issuance,
rather than the shareholder approval date.
EXAMPLE
The Close Call Company completes its financial statements for the past
year, to which the following dates apply:
• Draft statements completed on January 25
• Statements authorized for issuance by the board of directors on
February 15
• Investment community notified of financial results on February 28
• Financial statements issued to shareholders on March 5
• Shareholders approve financial statements at annual meeting on
 March 15
The financial statements of Close Call were authorized for issuance on
February 15, which is when they were approved by the board of directors.

IFRS states that the financial statements should include the effects of all
events after the reporting period that provide additional information about
conditions in existence during the reporting period. This rule requires that all
entities evaluate subsequent events through the date when financial
statements are available to be issued. Examples of situations calling for the
adjustment of financial statements are:
• Lawsuit. If events take place before the date of the financial statements
that trigger a lawsuit, and lawsuit settlement occurs after the reporting
period, consider adjusting the amount of any contingent loss already
recognized to match the amount of the actual settlement.
• Bad debt. If a company issued invoices to a customer before the date
of the financial statements, and the customer goes bankrupt as a
subsequent event, consider adjusting the allowance for doubtful
accounts to match the amount of receivables that will likely not be
collected.
• Net realizable value. If the business sells inventory after the reporting
period at a low price, this indicates that the net realizable value of the
inventory may have been low during the reporting period, which may
call for a reduction in the carrying amount of those inventory items.
If there are subsequent events that provide new information about conditions
that did not exist as of the date of the financial statements, these events
should not be recognized in the financial statements. Examples of situations
that do not trigger an adjustment to the financial statements if they occur after
the date of the financial statements are:
• A business combination
• Changes in the value of investments after the end of the reporting
period
• Changes in the value of assets due to changes in exchange rates
• Destruction of company assets
• Dividends declared after the reporting period
• Entering into a significant guarantee or commitment
• Sale of equity
• Settlement of a lawsuit where the events causing the lawsuit arose
 after the reporting period
The Going Concern Issue
IFRS mandates that a company should not prepare its financial statements
under the assumption that it is a going concern, if events arise after the
reporting period that indicate the business may no longer be a going concern.
This scenario arises when management determines that it has no realistic
alternative other than to liquidate the business or cease trading.
Disclosure of Events after the Reporting Period
A company should disclose the following information regarding events after
the reporting period:
• The date when the financial statements were authorized for issuance
• Who gave the authorization for financial statement issuance
Also, if any party can amend the financial statements after issuance, disclose
this point. Further, if information was received concerning conditions in
existence at the end of the reporting period, update all disclosures
accompanying the financial statements to include the effects of this
information.
There may be situations where the non-reporting of a subsequent event
would result in misleading financial statements. If so, disclose the nature of
the event and an estimate of its financial effect (or a statement that no
estimate can be made). Examples of such events are a major business
combination, the destruction of a major facility, significant commitments, and
the commencement of a major restructuring.
Summary
The recognition of subsequent events in financial statements can be quite
subjective in many instances. Given the amount of time required to revise
financial statements at the last minute, it is worthwhile to strongly consider
whether the circumstances of a subsequent event can be construed as not
requiring the revision of financial statements.
There is a danger in inconsistently applying the subsequent event rules, so
that similar events do not always result in the same treatment of the financial
statements. Consequently, it is best to adopt internal rules regarding which
events will always lead to the revision of financial statements; these rules will
likely require continual updating, as the business encounters new subsequent
events that had not previously been incorporated into its rules.
 Chapter 32
Insurance Contracts
Introduction
An insurance contract deals with uncertainty, such as whether an event will
occur, exactly when it will occur, or the amount of a payment due when a
triggering event occurs. The contract may even deal with an event that has
already occurred, but for which the related financial effect remains unclear.
The key element of the contract is that the contract issuer accepts significant
insurance risk from the insured party. Examples of insurance contracts are
noted in the following table.
Types of Insurance Contracts

Conversely, a contract that does not expose an insurer to any significant risk,
or which shifts risk back to the policyholder, is not considered an insurance
contract. Self-insurance is also not considered an insurance contract, since
there is no agreement with a third party.
An insurer may sell a variety of insurance contracts to its policyholders.
This chapter describes the accounting and disclosure requirements of insurers
in regard to these insurance contracts, with a particular emphasis on the
relevance and reliability of the information presented in an insurer’s financial
statements.
IFRS Source Document
• IFRS 17, Insurance Contracts
Insurance Contract Aggregation
An insurer should identify clusters of insurance contracts that have similar
risks, and which are managed as a group; these clusters are known as
portfolios of insurance contracts. Insurance contracts within the same product
line will probably be included in the same portfolio, since they typically have
similar risks and are managed as a group. At a minimum, the insurer should
divide each portfolio of contracts into the following groups:
• Those contracts that are onerous as of the point of initial recognition;
 • Those contracts that are have no significant possibility of becoming
onerous as of the point of initial recognition; and
• All remaining contracts.
It is allowable to further subdivide these groups, such as by differing levels of
profitability, or by differing probabilities that the contracts will become
onerous at a later date. However, the firm should not include contracts in the
same group that have been issued more than one year apart.
Once contract groups have been established, their composition should not
be revised thereafter.
If the company applies the premium allocation approach to its contracts
(as discussed later in the Subsequent Measurement of Insurance Contracts
section), it may assume that none of the contracts will be classified as
onerous as of the point of initial recognition, barring the presence of facts and
circumstances indicating otherwise.
If the company does not apply the premium allocation approach, the firm
should evaluate whether contracts not considered onerous at their initial
recognition have no significant possibility of becoming so, based on the
following:
• The likelihood of changes in assumptions that would result in the
reclassification of contracts as being onerous.
• The use of information provided by the firm’s internal reporting
system.
The measurement of contracts, as discussed in the following sections, is to be
applied to each of the contract portfolios described in this section.
Initial Recognition of Insurance Contracts
Once a group of insurance contracts has been identified, the insurer should
recognize the group as of the earliest of the following:
• The beginning of the coverage period;
• The first payment due date from a policyholder; and
• If the group is comprised of onerous contracts, the point at which the
group becomes onerous.
If there is no payment due date stated in a contract, then the first payment is
considered to be due as soon as it has been received.
The insurer must recognize an asset or liability for the insurance
acquisition cash flows relating to any group of issued contracts that the firm
pays or receives prior to recognition of the group, unless it elects to recognize
them at once as income or expenses. This asset or liability is subsequently
derecognized when the group of contracts is recognized.
Initial Measurement of Insurance Contracts
When a group of insurance contracts is initially recognized, the insurer
should measure it as the total of:
• Fulfillment cash flows, which are comprised of:
o Estimated future cash flows
o An adjustment for the time value of money as well as the
financial risks associated with those cash flows
o A risk adjustment for any non-financial risk
• The contractual service margin
Fulfillment cash flows include all of the following:
• Premium payments
• Payments made to the policyholder that are fixed
• Payments made to the policyholder that vary, depending on the returns
generated by underlying assets
• Allocated cash flows attributable to the portfolio with which a contract
is associated
• Claims handling costs
• Costs incurred to provide benefits paid in kind
• Policy administration costs
• Taxes, such as value-added taxes
• Payments made as a fiduciary to meet the tax obligations of the
policyholder
• Cash inflows from asset recoveries
• Allocated overhead costs
• Other costs that can be specifically charged to the policyholder
Several elements of these measurement items are described further in the
following sub-sections.
Estimated Future Cash Flows
The estimated future cash flows included in the measurement of a group of
insurance contracts are comprised of all future cash flows related to each
contract in the group. These cash flows are derived using the probability-
weighted mean of the full range of possible outcomes, reflecting conditions
existing at the measurement date. One should estimate the probabilities and
amounts of future payments related to existing contracts based on claims
already made by policyholders, as well as any other information about the
characteristics of the insurance contracts, and any relevant historical data
about the insurer’s prior experience. The range of estimates should address
the probabilities that renewal options, surrender options, conversion options
and so forth are exercised. The cash flows arise from the substantive rights
and obligations of the parties to each contract that exist during the reporting
period. Under these rights, the policyholder is required to pay premiums to
the insurer, while the insurer has an obligation to provide payouts to the
policyholder under certain circumstances.
Discount Rates Used
An insurer must adjust its contract-related cash flows for the time value of
money. The discount rate used to derive this present value should be based on
the characteristics of the cash flows and the liquidity characteristics of the
underlying contracts, and be consistent with the observable market prices of
any financial instruments having cash flows with timing and liquidity similar
to those of the insurance contracts.
Risk Adjustment for Non-Financial Risk
When the insurer bears some uncertainty for cash flows relating to non-
financial risk, it should adjust the estimated present value of future cash flows
for the compensation being paid to the insurer for this risk. This risk
adjustment should have the following characteristics:
• A higher risk adjustment is needed for risks with low frequency and
high severity than for risks with high frequency and low severity.
• A higher risk adjustment is needed for contracts with a longer duration
than contracts with a shorter duration.
• A higher risk adjustment is needed when there is a wider probability
distribution than for a risk with a narrower distribution.
• A higher risk adjustment is needed when less is known about the
current estimate.
Contractual Service Margin
The unearned profit that an insurer will eventually earn as it provides services
is called the contractual service margin. The insurer should measure this
service margin when it initially recognizes a group of insurance contracts.
EXAMPLE
Angus Insurance provides various types of insurance to farmers, including
crop insurance, dairy insurance, equine insurance, and poultry insurance.
Angus issues 100 crop insurance contracts that have a coverage period of
three years. None of these contracts are expected to lapse prior to the end of
the coverage period. Angus expects to receive premiums of £1,800,000 right
after the initial recognition of the group of contracts, which results in a
present value of these premiums of £1,800,000.
An initial review of the cash flows associated with these contracts suggests
that there will be annual cash outflows of £400,000. Using a discount rate of
6%, the present value of these cash outflows is £1,069,200. Angus estimates
that the risk adjustment for non-financial risk is £150,000.
This information results in the following measurement:

Subsequent Measurement of Insurance Contracts

At the end of each reporting period, an insurer should measure the carrying
amount of each group of insurance contracts. This carrying amount is
comprised of:
• The remaining coverage liability, which is comprised of the fulfillment
cash flows related to future service, plus the contractual service
margin.
• The liability for incurred claims, which is comprised of the fulfillment
cash flows related to past service.
In addition, the insurer can recognize income and expenses for the following
changes in the carrying amount of the liability for a contract’s remaining
coverage:
• Insurance revenue, which is derived from any reduction in the liability
for remaining coverage (which occurs when services are provided).
• Insurance service expenses, for any losses incurred on groups of
onerous contracts, as well as for the reversal of any of these losses.
• Insurance finance income or expenses, which is derived from the time
value of money and effects of any financial risk.
Further, the insurer can recognize income and expenses for the following
changes in the carrying amount of the liability for a contract’s incurred
claims:
• Insurance service expenses, which are derived from any increase in the
liability due to claims and expenses incurred in the reporting period.
• Insurance service expenses, which are derived from any subsequent
 changes in fulfillment cash flows associated with incurred claims and
expenses.
• Insurance finance income or expenses, which is derived from the time
value of money and the effects of any financial risk.
Finally, the insurer must measure the contractual service margin as of the end
of the reporting period. This amount represents the profit in a contract group
that had not previously been recognized because it related to future services
yet to be provided. When a contract does not have a direct participation
feature, the contractual service margin’s carrying amount at the end of a
reporting period equals the amount at the beginning of the period, adjusted
for the impact of new contracts on the group, interest accreted on the carrying
amount of the contractual service margin in the period, changes in fulfillment
cash flows, the effect of currency exchange differences on the service margin,
and the amount recognized as insurance revenue in the period.
A portion of the contractual service margin is recognized in each period
for a group of insurance contracts. The amount recognized should reflect the
services provided in the period. The amount to be recognized is calculated in
the following manner:
1. Identify the coverage units (quantity of coverage) in a group of
contracts.
2. Allocate the contractual service margin to each coverage unit that
was provided in the current period and expected to be provided at a
later date.
3. Recognize the profit or loss associated with the amount allocated to
those coverage units provided in the current period.
When an insurance contract has been classified as onerous, the insurer should
recognize a loss in the amount of the net outflow from the contract, so that
the resulting carrying amount of the liability equals its fulfillment cash flows,
and the contractual service margin is zero. Once a loss has been recognized
on a group of onerous contracts, the insurer should allocate any subsequent
changes in fulfillment cash flows of the liability for remaining coverage
systematically, between the liability for remaining coverage and the loss
component of the liability for remaining coverage. If there is a subsequent
decrease in fulfillment cash flows that is caused by changes in the estimates
of future cash flows, allocate it to the loss component until its balance is
reduced to zero.
An insurer can use the simpler premium allocation approach to measure
insurance contracts, but only if there is an expectation that doing so will yield
an outcome that does not differ materially from the preceding approach, and
the contract coverage period is one year or less. To use the premium
allocation approach:
• At the initial point of recognition, the carrying amount of the liability
is any premiums received at that point, minus any insurance
acquisition cash flows (unless they are recognized as an expense), plus
or minus any amount caused by the derecognition of the asset or
liability recognized for insurance acquisition cash flows.
• For each subsequent reporting period, the carrying amount of the
liability is the liability at the beginning of the period, plus all
premiums received in the period, minus any insurance acquisition cash
flows (unless they are recognized as expense), plus the amortization of
insurance acquisition cash flows recognized in the period (unless they
were recognized as expense), plus any financing component
adjustments, minus the recognized insurance revenue for coverage
provided in the period, minus any investment component paid for
incurred claims.
There is no requirement to adjust future cash flows for the time value of
money and any effects of financial risk if they are expected to be received
within one year of the date when the claims are incurred.
EXAMPLE
Assume the same facts presented earlier for the example involving Angus
Insurance. All of the expectations outlined at the initial recognition of the
contracts turn out to be exactly correct in Year 1. However, the outcome is
different in Year 2, when a reduction in incurred expenses increases the
expected profitability of the group of contracts. The results appear in the
following table.

Modification of Insurance Contracts

The terms of an insurance contract may be modified, either by a change in the
applicable regulations or by the mutual agreement of the parties to the
contract. When this happens, the insurer should derecognize the original
contract and then recognize the modified contract as an entirely new contract.
Derecognition of Insurance Contracts
An insurer can derecognize an insurance contract when it has been
extinguished or modified; in the latter case, see the preceding discussion of
modifications of insurance contracts. When a contract is extinguished, the
insurer is no longer at risk, and so is not required to transfer any resources to
satisfy the terms of the contract. When a contract within a group of contracts
is derecognized, the insurer should take these steps:
• Adjust the fulfillment cash flows of the group to remove the present
value of future cash flows and any risk adjustment for non-financial
risk that has been derecognized from the group.
• Alter the contractual service margin to adjust for the change in
fulfillment cash flows.
• Revise the number of coverage units to reflect the number of these
units derecognized from the group.
Accounting Policy Changes
Quite a large number of accounting policies may relate to the accounting for
insurance, and each of them can have an impact on the amounts recognized
or the classification of balance sheet items. The following table contains a
sampling of the transactions to which accounting policies could be applied.
Transactions to Which Accounting Policies Could be Applied

Presentation of Insurance Contract Information

An insurer should separately present in the balance sheet the following
carrying amounts for groups of contracts that are:
• Insurance contracts that are assets
• Insurance contracts that are liabilities
• Reinsurance contracts that are assets
• Reinsurance contracts that are liabilities
In the statement of financial performance, the insurer should separately
present an insurance service result that includes insurance revenue and
insurance service expenses. The insurer should also separately present any
insurance finance income or expenses; these items are related to changes in
the effect of the time value of money and financial risk. Any income or
expenses related to reinsurance contracts should be presented separately.
Disclosures
The financial disclosures made by an insurer should allow users to assess the
effects of insurance contracts on the firm’s finances. With this goal in mind,
the following disclosures are required:
• Premium allocation approach. If the firm uses the premium allocation
approach, it should disclose how it qualified for the use of this
approach, whether it makes an adjustment for the time value of money
and the effect of financial risk, and the method chosen to recognize
insurance acquisition cash flows. Several of the following disclosures
have reduced requirements if the insurer has used the premium
allocation approach.
• Reconciliations. Present a reconciliation that demonstrates how the net
carrying amount of contracts changed during the period due to cash
flows, as well as income and expenses recognized in the financials.
There should be separate reconciliations for insurance contracts issued
and reinsurance contracts held, as well as separate reconciliations for:
o Net liabilities or assets for the remaining coverage component
o Any loss component
o Any liabilities for incurred claims
o Estimates of the present value of future cash flows
o Risk adjustments for non-financial risk
o Contractual service margin
• Insurance revenue. Disclose an analysis of insurance revenue,
including any amounts relating to changes in the liability for
remaining coverage, as well as the allocation of that portion of
insurance premiums relating to the recovery of insurance acquisition
cash flows.
• Balance sheet effect. State the effect on the balance sheet for insurance
contracts issued and reinsurance contracts held that have just been
recognized in the period, showing their impact at the point of initial
recognition on the estimated present value of future cash outflows, the
estimated present value of future cash inflows, the risk adjustment for
 non-financial risk, and the contractual service margin. When making
this disclosure, separately state the information for acquired contracts
and onerous contracts.
• Recognition of contractual service margin. Explain when the firm
expects to recognize the contractual service margin that remains at the
end of the reporting period, stating this information separately for
contracts issued and reinsurance contracts held.
• Insurance finance income or expense. Explain the total amount of
insurance finance or expense, noting the relationship between these
items and the investment return on the firm’s assets.
• Direct participation features. When contracts contain direct
participation features, describe the structure of the underlying items
and their fair value, along with several additional disclosures for less
likely situations.
• Judgments. Note the significant judgments made in applying this
accounting standard. In particular, disclose the inputs, assumptions,
and estimation techniques used. Also, if insurance finance or income
was reported separately, explain the methods used to determine this
amount that was recognized in profit or loss.
• Confidence level. State the confidence level used to arrive at the risk
adjustment for non-financial risk.
• Yield curve. Disclose the yield curve used to calculate discounted cash
flows that do not vary based on the returns generated by underlying
items.
• Nature and extent of risks. Disclose a sufficient amount of information
to enable users of the firm’s financial statements to evaluate the
nature, timing, amount, and uncertainty of future cash flows associated
with insurance contracts. For each type of risk, state the risk exposure
and how it arises, the firm’s objectives and processes for managing the
risk, how the risks are measured, and how these items have changed
from the preceding period. Also summarize quantitative information
about the firm’s exposure to risk as of the end of the reporting period.
• Regulatory frameworks. Discuss the effect of the regulatory
frameworks within which the firm operates, such as its minimum
required capital.
• Risk concentrations. Disclose all significant concentrations of risk
related to insurance contracts, noting how these concentrations are
 determined and how each risk concentration is defined (in terms of a
shared characteristic).
• Sensitivity analysis. Note the firm’s sensitivities to changes in risk
exposures related to its insurance contracts, providing an analysis of
how profits and equity would be impacted by those changes in risk
exposures that are reasonably possible. Also state the methods and
assumptions used to prepare this analysis, and disclose any changes in
these methods and assumptions from the previous period.
• Actual claims. Disclose how actual policyholder claims compared to
prior estimates of the undiscounted amount of the claims. Reconcile
this disclosure to the aggregate carrying amount of the groups of
insurance contracts.
• Credit risk. Disclose the amount of credit risk that best represents the
maximum exposure to credit risk. Also provide information about the
credit quality of any reinsurance contracts held that are assets.
• Liquidity risk. Describe how the firm manages liquidity risk, providing
a maturity analysis for groups of insurance contracts, showing net cash
flows for each of the next five years and in aggregate beyond that
period.
Summary
The reporting outcomes for insurance contracts can vary significantly
depending upon how contracts are clustered into groups. Therefore, it makes
sense to use a highly systematized approach to aggregating contracts, so that
reporting results will be more consistent from period to period. This means
having a well-defined procedure for how to sort through contracts and assign
them to specific groups.
 Chapter 33
Agriculture
Introduction
IFRS provides guidance concerning agricultural activities, which span
livestock, forestry, crops, orchards, fish farming, and related activities. The
guidance in this chapter applies to biological assets on an ongoing basis, as
well as to agricultural produce when it is harvested.
IFRS Source Document
• IAS 41, Agriculture
Accounting for Agriculture
Agriculture covers many activities involving the enhancement of living
animals and plants, in order to increase their quantity or quality. A business
should recognize a biological asset only if all of the following conditions are
true:
• The business controls the asset;
• Future economic benefits related to the asset will flow to the business;
and
• Either the fair value or cost of the asset can be measured in a reliable
manner.
A biological asset should be measured when it is initially recognized, as well
as at the end of each reporting period. The measurement should use the fair
value of the asset, less any costs to sell. Fair value may not differ appreciably
from cost when little biological transformation has yet taken place, or if the
biological transformation has little impact on price. For example, the initial
growth of a hardwood tree may be minimal, resulting in no real change in
value for a number of years.
When agricultural produce is harvested, the measurement should also be
at the fair value of the asset, less any costs to sell. This measurement only
takes place when the produce is harvested. Subsequent to harvesting, produce
is treated as inventory.
For these measurements, fair value is considered to be based on the
current market conditions in which market participants are willing to enter
into transactions. Thus, the fair value of a biological asset or agricultural
produce is not necessarily the price at which an entity may have contracted to
sell its assets at some point in the future.
 When a biological asset is initially recognized at its fair value less costs to
sell, any related gain or loss is recognized in profit or loss. The same
accounting applies when there is a change in fair value from period to period.
EXAMPLE
A calf is born at Cud Farms, so Cud recognizes a gain of £500 that reflects
the market value of a newborn calf. One year later, the price of the cow has
risen to £2,200, so Cud recognizes a gain of £1,700 to account for the
increase in fair value. One year after that, a glut of cows on the market drops
the fair market value to £1,900, so Cud recognizes a loss of £300.
EXAMPLE
Spud Potato Farms harvests its Fall crop of potatoes, and recognizes a gain
of £150,000 in profit or loss as soon as the harvest is complete.

It may not be possible to measure the fair value of a biological asset upon its
initial recognition. If so, measure the asset at its cost, less any accumulated
depreciation and accumulated impairment losses. If a fair value later becomes
available on a reliable basis, the asset should be revalued at the fair value.
If a biological asset was initially measured at its fair value less costs to
sell, it must continue to be measured in that manner until the asset is disposed
of.
In all cases, agricultural produce must be measured at its fair value less
costs to sell; this requirement is based on the assumption that fair values are
always available for agricultural produce.
A government grant related to a biological asset should be recognized in
profit or loss only when the following conditions are met:
• The grant is unconditional;
• All conditions associated with the grant have been met;
• The grant is measured at fair value less costs to sell; and
• The grant becomes receivable.
EXAMPLE
The local government issues a £100,000 grant to any farmer willing to
operate a farm in an area formerly zoned for heavy industrial use. The grant
stipulates that a farmer will be paid in full after having documented at least
three consecutive years of farming on the same land. Given this condition, a
farmer cannot recognize the grant until the required three-year period has
elapsed.
Bearer Plants
A bearer plant is a plant that generates produce, such as an apple tree. The
plant itself is not an agricultural product. A bearer plant has the following
characteristics:
• Is used in the production of agricultural produce;
• Is expected to bear agricultural products for more than one season; and
• Is not likely to be sold as agricultural produce.
Thus, wheat is not a bearer plant, since it is routinely harvested. Trees can be
treated as agricultural produce, if the intent is to cut them down to produce
lumber. An apple tree is considered a bearer plant, even though it may
eventually be cut down and sent to a lumber mill; since its use as lumber is a
secondary application.
Agriculture Disclosures
A business engaged in agriculture should disclose the following information
in the notes accompanying its financial statements:
• Commitments. Any commitments to develop or acquire biological
assets.
• Gain or loss. The aggregate gain or loss recognized in the reporting
period from the initial recognition of biological assets and agricultural
produce, and from changes in the fair value less costs to sell of
biological assets.
• Groupings. Describe each group of biological assets, such as groups of
mature and immature assets. Mature assets have reached a state in
which they can be harvested or can sustain ongoing harvests. IFRS
encourages a quantified description that can help in assessing the
timing of future cash flows. A suggested grouping is for consumable
biological assets, which are those assets to be harvested or sold.
Another possible grouping is bearer biological assets, which are self-
regenerating assets, such as fruit trees and grape vines.
• Nature of activities. The nature of the activities required for each
group of biological assets.
• Quantities. The physical quantities of each group of biological assets
at the end of the reporting period, as well as the amount produced
during the period.
• Reconciliation. A reconciliation of the carrying amounts of biological
assets between the beginning and end of the period, including gains
and losses on changes in fair value less costs to sell, increases caused
 by purchases, decreases caused by sales and items held for sale,
decreases caused by harvests, increases caused by business
combinations, foreign exchange differences, and other issues.
• Restricted title. The carrying amounts of those biological assets whose
titles are restricted, and those amounts pledged as security.
• Risk management. Any financial risk management strategies applied to
agricultural activity.
EXAMPLE
Cud Farms discloses the following information in the notes accompanying
its financial statements:
Cud Farms produces goat milk for a number of local school
districts. At year-end, Cud held 320 goats able to produce milk
and 150 kids being raised to produce milk in the future. During the
year ended 20X2, the company produced 88,000 gallons of goat
milk, with a fair value less costs to sell of £230,000. The fair value
of milk is based on quoted prices in the local area.
The company is exposed to changes in the price of goat milk.
There is no expectation of reduced milk prices in the near future,
so the company does not engage in derivative transactions to
offset this risk. The management team reviews the milk price
forecast on a weekly basis to determine the ongoing need for more
active financial risk management.

If the fair values of biological assets cannot be measured reliably, disclose the
following information:
• Conversion to fair value. If it becomes possible to measure assets at
fair value during the period, describe these assets, explain why fair
value can now be measured, and the impact of the change.
• Depreciation. The depreciation method used to ratably reduce the cost
of the assets.
• Description. A description of the assets.
• Estimates. The range of estimates within which the fair value is likely
to be (if possible).
• Explanation. An explanation of why fair value cannot be measured in
a reliable manner.
• Gains or losses. The gains or losses recognized on the disposal of
biological assets measured at cost, as well as a reconciliation for the
 period that includes impairment losses, reversals of impairment losses,
and depreciation.
• Gross amounts. The gross carrying amount and accumulated
depreciation as of the beginning and end of the reporting period.
• Useful lives. The useful lives incorporated into depreciation
calculations.
If the entity has received government grants, disclose the nature of these
grants recognized in the period, any unfulfilled conditions related to
outstanding grants, and any significant decreases that are expected in the
amount of future government grants.
Summary
Agriculture is one of the few areas in which IFRS allows a business to
recognize gains and losses from self-generated assets. In agriculture, a gain
can be recognized as soon as produce is harvested, while the initial
recognition of a gain on a biological asset is a similar situation. In most
businesses, no gain or loss can be recognized in profit or loss until a sale
transaction has been completed with a third party.
 Chapter 34
Government Grants
Introduction
A government may provide a variety of assistance to entities operating within
its borders, perhaps to alter their activities to meet the goals of the
government, or perhaps simply to provide economic assistance during
difficult financial circumstances. In this chapter, we discuss how to account
for, present, and disclose the various forms of government assistance that a
business may receive.
IFRS Source Documents
• IAS 20, Accounting for Government Grants and Disclosure of
Government Assistance
• SIC 10, Government Assistance – No Specific Relation to Operating
Activities
Accounting for Government Grants
When a business receives a government grant, it must account for the receipt
of an asset or the reduction of a liability. Also, the business needs to report in
its financial statements the extent to which the grant or other assistance has
altered its financial results; otherwise the intrusion of government assistance
makes it difficult to compare the results and condition of the company from
period to period.
The essential accounting for a government grant is that it should not be
recognized unless there is reasonable assurance that the business will receive
the grant and will comply with any associated conditions. Simply receiving a
grant is not sufficient grounds for recognizing it, since the government may
demand the return of the funds if the company does not comply with the
associated conditions. The recognition of a government grant in profit or loss
should be spread over the periods during which the business expects to
recognize the expenses that the grant is designed to offset. These expenses
may relate to the conditions associated with the grant. For example, a
government may issue funds to a business in exchange for the training of
certain employees; if so, the amount of the grant is recognized in proportion
to the amount of expense recognized that relates to employee training.
EXAMPLE
Nascent Corporation receives a grant of land from the local city government
that has a fair value of £1,000,000, on the condition that the company builds
a factory on the premises. Accordingly, Nascent recognizes the fair value of
the land over the 30-year useful life of the factory.
EXAMPLE
A federal disaster relief agency pays £10,000,000 to a major teaching
hospital whose primary facility was destroyed in a flash flood, to assist it in
rebuilding. Two years of construction work will be required to rebuild the
facility at a cost of £25,000,000 in the first year and £18,000,000 in the
second year. Based on this expenditure pattern, the hospital should
recognize the £10,000,000 as noted in the following table:

If a government issues a grant that is intended to compensate a business for

expenses already incurred, or to give immediate financial support with no
future expenditures required by the recipient, the business can recognize the
grant in profit or loss as soon as it becomes a valid receivable. In such a case,
the recipient should fully disclose the amount and reason for the receipt, to
keep from misleading investors regarding a sudden improvement in its
reported results.
The following additional rules may apply to government grants:
• Below-market interest rate. If a government issues a loan that has a
below-market interest rate, treat the rate difference from the market
rate as a government grant.
• Depreciable assets. If a grant is related to a depreciable asset,
recognize the grant in profit or loss over the periods when depreciation
will be recognized, and in the same proportions that depreciation will
be recognized. Thus, if depreciation is recognized using the straight-
line method, use the same approach for the recognition of the grant.
• Forgivable loan. If a government issues a forgivable loan and there is
reasonable assurance that the business will meet the associated
conditions required to forgive the loan, treat it as a government grant.
Otherwise, treat it as a loan.
• Government assistance. A government may give assistance, such as
technical advice, on which it is difficult to assign a value. If so, it is
 best to avoid recognizing the assistance, but consider disclosing the
nature of the assistance if not doing so would result in financial
statements that are misleading.
• Multiple conditions. If there are multiple conditions associated with a
government grant, it may be necessary to apportion parts of the grant
to each condition, and recognize each apportioned element of the grant
based on the company’s compliance with each underlying condition.
EXAMPLE
A local government issues a grant of £500,000 to Luminescence
Corporation, of which £400,000 is allocated to assistance with the
construction of a new facility, and £100,000 to building a trail that skirts the
premises of the property. Once the trail has been built, Luminescence will
incur no ongoing trail maintenance obligation.
To account for the grant, the company recognizes the £400,000 portion of
the grant as income over the 20-year useful life of the facility. The company
can recognize the £100,000 portion of the grant as soon as it completes
construction of the trail.

• No conditions. A government may elect to provide assistance to an

entire industry sector or geographic region in which a company does
business. If so, there may be no conditions associated with the
extension of assistance. Under these circumstances, assistance given is
considered a government grant for accounting purposes.
• Non-monetary grant. IFRS encourages the recognition of non-
monetary grants by the recipient at their fair value, though it is also
acceptable to record such a grant at some nominal amount.
• Repayment. Circumstances may dictate that a business must repay a
grant to a government. If so, this is considered a change in accounting
estimate, which is accounted for on a prospective basis. When
accounting for a repayment, first offset the payment against any of the
deferred credit that is still unamortized. If doing so does not
completely offset the payment, recognize the remaining amount in
profit or loss. If a repayment relates to a specific company asset
against which the grant was originally offset, increase the carrying
amount of the asset by the amount of the repayment. In the latter case,
the increase in asset carrying amount will increase the amount of
depreciation; the cumulative amount of depreciation related to the
 increase in carrying amount that would have been recognized to date if
the grant had not been issued should be recognized at once in profit or
loss.
EXAMPLE
Hegemony Toy Company receives a £150,000 grant from a local
government, to be used in the construction of a new factory within the
boundaries of the granting government entity. Hegemony offsets the grant
against the £5,000,000 construction cost of the new factory, resulting in a
net carrying amount of £4,850,000 that will be depreciated over the
projected 20-year life of the factory. One year later, the granting government
finds that Hegemony did not comply with all of the requirements of the
grant, and demands immediate repayment. Hegemony does so, which
increases the gross carrying amount of the factory to £5,000,000. In
addition, Hegemony must also recognize the additional £7,500 of
depreciation expense that it would have recognized if the grant had not
occurred.

Government Grant Presentation

When a government entity issues a grant to a business, either in cash or as a
non-monetary asset, the recipient should report the grant in its balance sheet
using one of the following methods:
• Deferred income approach. Recognize the grant as deferred income,
and recognize it in profit or loss over the useful life of the asset. Under
this approach, the grant is recognized in an “other income” line item in
the income statement.
• Asset deduction. Deduct the amount of the grant from the carrying
amount of the related asset, which results in a reduced amount of
depreciation recognition over the life of the asset.
EXAMPLE
Domicilio Corporation receives a grant of £100,000 from a local
government that is to be applied toward the development of an on-site solar
power generation facility at its corporate headquarters. Domicilio accounts
for the grant by deducting it from the £600,000 carrying amount of the solar
facility, which will reduce the amount of depreciation recognized by the
company over the projected 20-year useful life of the facility.

Government Grant Disclosures

It may be necessary to disclose the amount and nature of a grant in order to
give the reader of a company’s financial statements a better understanding of
the financial results and financial position being presented. If a grant has an
unusual impact on a particular line item in the financial statements, it may be
useful to disclose this effect. In particular, the following disclosures should
be made in the notes accompanying the financial statements:
• Accounting policy. The nature of the policy under which the company
accounts for government grants, as well as how the information is
presented in the financial statements.
• Conditions. Any unfulfilled conditions associated with government
assistance that has been recognized in the financial statements.
• Grant descriptions. The nature of the grants recognized by the
business. Also note other types of government assistance benefiting
the business.
Summary
An organization may take the easy approach to recording the value of a non-
monetary grant at a nominal amount. Doing so is certainly efficient, but does
a disservice to the users of its financial statements, who have no idea that the
business may have just received a substantial asset that could be of benefit for
years to come. Accordingly, if it is possible to obtain a fair value without too
much effort, consider assigning a fair value to non-monetary assets received
as grants.
 Chapter 35
Regulatory Deferral Accounts
Introduction
Rate regulation occurs when an independent regulator oversees and approves
the prices charged by a business entity to its customers. This circumstance
most commonly occurs when there is a monopoly, or utility services are
being provided.
Regulatory deferral accounts contain balances that might not normally be
recognized as assets or liabilities, but which are expected to be included in
the basis for prices that a rate regulator will allow an entity to charge to its
customers. Examples of these costs are purchase price variances, project
cancellation costs, and the cost of natural disasters. In some countries, the
standard-setting bodies either require or permit rate-regulated entities to
capitalize certain expenditures that would normally be charged to expense,
with the same deferral treatment for certain types of income. These costs are
later charged to expense to match the associated rate increases.
In this chapter, we address the accounting for, presentation of, and
disclosures related to regulatory deferral accounts.
IFRS Source Documents
• IFRS 14, Regulatory Deferral Accounts
Accounting for Regulatory Deferral Accounts
If an entity has already included in regulatory deferral accounts expenditures
that would normally have been charged to expense under other IFRS
standards, it is permissible to continue using its existing accounting policies
for the treatment of these expenditures. This means that existing policies for
the recognition, measurement, impairment, and derecognition of these
accounts can continue to be used. These policies can only be changed if
doing so makes the financial statements more relevant or reliable for users.
This accounting is limited to first-time adopters that have already
recognized regulatory deferral account balances in their financial statements.
If they follow the requirements noted here during their initial adoption of
IFRS, they can continue to follow the requirements in later periods.
Regulatory Deferral Account Presentation
In general, regulatory deferral accounts must be presented in separate line
items in the statement of financial position. Further, if there are changes in
these accounts, the resulting expense changes must be noted in separate line
items in the statement of profit or loss or other comprehensive income. More
specifically, the presentation requirements for regulatory deferral accounts in
the financial statements are as follows:
Statement of Changes in Financial Position
• Present a separate line item in the statement of financial position for
the aggregate amount of all regulatory deferral account debit balances.
• Present a separate line item in the statement of financial position for
the aggregate amount of all regulatory deferral account credit
balances.
• The preceding two lines items are not to broken down into current or
long-term classifications. Instead, they are to be separated by
interposing subtotals for all other line items prior to the presentation of
the deferral accounts.
• When there is a deferred tax asset or liability resulting from the
recognition of regulatory deferral account balances, pair these items
for presentation purposes with the related regulatory deferral accounts.
Do not present them within the total deferred tax asset or liability for
the entity.
Profit or Loss
• Present in the other comprehensive income section the net movement
in these account balances during the reporting period. Use separate
line items to present this information for changes in items that will not
be later reclassified to profit or loss, and which will later be
reclassified to profit or loss.
• Present in profit or loss in a separate line item any remaining net
movement in the regulatory deferral account balances for the reporting
period, with the exception of items that are not included in profit or
loss. This line item should be separated from other income and
expense line items by interposing subtotals for all of these other line
items prior to the presentation of this line item.
Other
• When there is a discontinued operation or a disposal group that must
be presented separately, do not move the related regulatory deferral
account balances and their changes to the separate presentations.
Instead, continue to present this information in the standard locations.
• When calculating earnings per share, present an additional set of
 earnings per share information that excludes any changes in the
regulatory deferral account balances.
Regulatory Deferral Account Disclosures
Generally, the disclosure of regulatory deferral accounts includes an
explanation of those amounts in the financial statements that are caused by
rate regulation, which will assist users in understanding the amounts, timing,
and uncertainty of future cash flows related to these accounts. More
specifically:
• Nature of information. The nature of the rate regulation that
establishes allowable prices, and the risks associated with this
regulation. Identify the rate regulators, and whether the regulator is a
related party. Further, note how the future recovery of each type of
deferred account by risks and uncertainties, such as changes in
customer demand or future regulatory actions.
• Effects of regulation. The effects of rate regulation on the financial
results, position, and cash flows of the entity. This includes the
following items:
o The basis under which deferred account balances are
recognized and derecognized, how they are initially and
subsequently measured, and how they are assessed for
impairment.
o For each class of account balance, reconcile the beginning and
ending carrying amounts in a table. This may include the
amount recognized in the period, any amounts recognized in
the period, impairments, items acquired through a business
combination, and so forth.
o The rate of return or discount rate used to indicate the time
value of money, which applies to each deferral account.
o The remaining periods over which it is expected that the
remaining account balances will be recovered or amortized.
• Income taxes. The impact of rate regulation on the amount and timing
of income tax recognition as they apply to current and deferred taxes.
Also note any regulatory deferral account balance that relates to
taxation, and the movement in that account balance.
• Subsidiaries. If there is a subsidiary or joint venture that has rate-
regulated activities and which uses regulatory deferral accounts,
disclose the amounts in these accounts and net changes in the
 balances.
• Non-recoverability. When a deferral account balance is no longer fully
recoverable or reversible, disclose the issue, the reason for non-
recoverability or non-reversibility, and the associated amount of the
account balance reduction.
Summary
A more expansive accounting standard is eventually expected to be issued
that more fully addresses the concerns of regulated entities. In the meantime,
this standard is designed to provide a short-term solution to the problem of
how to deal with deferral accounts that would otherwise likely have to be
charged to expense when an entity adopts IFRS.
 Chapter 36
Mineral Resources
Introduction
This chapter addresses several accounting aspects of mining operations that
are completely unique to this activity – specifically, the possible
capitalization of exploration and evaluation costs, as well as the designation
of stripping costs as either fixed assets, inventory, or expenses.
IFRS Source Documents
• IFRS 6, Exploration for and Evaluation of Mineral Resources
• IFRIC 20, Stripping Costs in the Production Phase of a Surface Mine
Accounting for Mineral Resources
A mining company essentially engages in the exploration for and extraction
of mineral resources. The focus of this section is on the exploration phase,
which is considered to include not only the initial exploration for minerals,
but also the evaluation of whether the resulting mineral deposits can be
extracted.
Certain expenditures in the exploration and evaluation phase should be
recorded as assets, rather than being charged to expense as incurred.
Examples of expenditures that could be recorded as assets are:
• Evaluation of the commercial viability and technical feasibility of
mineral extraction
• Exploration rights
• Exploratory drilling and trenching
• Sampling
• Studies in the geological, topographical, geochemical, and related
areas
The primary IFRS guidance regarding these activities is that exploration and
evaluation assets initially be recorded at their cost. The subsequent
accounting for exploration and evaluation assets is to apply either the cost
model or the revaluation model to them. See the Property, Plant, and
Equipment chapter for more information. Once the evaluation of a mineral
property has been completed, it is possible that a capitalized exploration asset
will then be considered impaired, because it is not economically feasible or
technologically viable to extract the minerals. Impairment should be
recognized when the carrying amount of such an asset exceeds its estimated
recoverable amount. The following circumstances are indicators that
impairment testing should be employed:
• Exploration in the area has not yielded commercially viable mineral
quantities, so further exploration is to be discontinued.
• Substantive additional exploration expenditures are not planned.
• The right to explore has or is about to expire, and will not be renewed.
• Though development will proceed, the carrying amount of the asset
will probably not be recovered.
It is possible that a business may also have to recognize a liability for the
eventual restoration of a property because of its mining activities.
To properly account for the exploration and extraction of mineral
resources, a mining business should create an accounting policy that specifies
which expenditures are to be applied to the exploration and evaluation area,
and then apply the policy consistently. There should be an additional policy
for allocating assets to cash-generating units in order to assess them for
impairment (see the Impairment of Assets chapter). It is allowable to
subsequently change these policies, if doing so makes the financial
statements of the business more reliable and relevant to users of the
information.
The guidance in this section does not apply to expenditures incurred prior
to exploration activities, as occurs before a business has secured the rights to
explore a designated area. Also, this section does not apply to the extraction
phase, which is after extraction feasibility has been demonstrated.
Accounting for Stripping Costs
In a surface mining operation, a mining company usually needs to remove a
layer of waste materials (called overburden) before reaching the targeted
mineral deposit. The removal of overburden is called stripping.
There are several options for the accounting for stripping costs incurred
during the development phase of a mine, which are:
• Treat as inventory. If there is usable ore in the overburden, record the
stripping cost as inventory.
• Treat as fixed asset. If there is no usable ore in the overburden,
capitalize the stripping cost into the cost of the mine, along with an
allocation of directly attributable overhead costs, and then depreciate
it. The usual form of depreciation is the units of production method,
though another method can be used if it is more appropriate. This
option is only available if the stripping cost will probably result in
 improved access to the underlying ore, the business can identify the
ore to which access will be improved, and costs associated with
accessing that particular ore body can be measured reliably.
• Charge to expense. If the preceding two options are not applicable,
charge the stripping cost to expense as incurred.
EXAMPLE
Pensive Corporation’s gravel pit operation, Pensive Dirt, removes
overburden from a gravel pit at a cost of £400,000. Pensive expects to
extract 1,000,000 tons of gravel, which results in a depreciation rate of £0.40
per ton (1,000,000 tons ÷ £400,000 cost). During the first quarter of activity,
Pensive Dirt extracts 10,000 tons of gravel, which results in the following
depreciation expense:
£0.40 depreciation cost per ton × 10,000 tons of gravel = £4,000
depreciation expense

There may be cases where a modest amount of inventory can be extracted

from overburden, while the remainder of the overburden contains no usable
minerals. In this case, it is acceptable to allocate the cost of stripping between
inventory and the asset derived from stripping costs. The allocation should be
based on a relevant production measure, such as:
• The proportion of waste extracted in comparison to the expected
proportion
• The proportion of ore extracted in comparison to the expected
proportion
• The cost of inventory produced in comparison to the expected cost
Once any stripping costs have been capitalized, they are depreciated,
revalued, and/or evaluated for impairment, just like any other fixed asset.
Mineral Resources Presentation
Any exploration and evaluation assets should be consistently classified as
either tangible or intangible fixed assets. For example, drilling rights can be
considered an intangible asset, while a drilling rig is considered a tangible
asset.
When exploration and evaluation expenditures are recorded as assets,
classify these assets in a separate line item in the balance sheet.
Mineral Resources Disclosures
A mining entity should separately disclose the following information in the
notes that accompany its financial statements, or within the financial
statements:
• Policies. The accounting policies related to the recognition of
exploration and evaluation assets.
• Mineral resources line items. The amounts of revenues, expenses,
operating cash flows, investing cash flows, assets, and liabilities
arising from mineral resources exploration and evaluation.
Summary
This chapter has focused on the treatment of expenditures incurred during the
exploration for mineral resources and the removal of overburden. For more
general information about the ongoing accounting for fixed assets and
impairment testing, please refer to the Property, Plant, and Equipment chapter
and the Impairment of Assets chapter.
 Chapter 37
Service Concessions
Introduction
A company may be brought in by a government to either service existing
infrastructure or to develop and operate entirely new infrastructure, with the
intent of providing a service to the public. For example, a company may build
and operate a toll road, or it may operate an existing airport facility. These
arrangements typically incorporate performance standards, systems for
adjusting prices charged, and requirements for resolving disputes. The
underlying infrastructure is handed back to the government after the period
covered by the arrangement has been completed. This chapter describes the
accounting by a business that is operating under a service concession
arrangement, where the granting government controls the services to be
provided and the prices that may be charged, and owns a significant residual
interest in the infrastructure at the end of the arrangement.
IFRS Source Documents
• IFRIC 12, Service Concession Arrangements
• SIC 29, Service Concession Arrangements - Disclosures
Overview of Service Concessions
A service concession arrangement is one in which a business essentially gives
the public access to major infrastructure facilities, such as the examples noted
in the following table.
Sample Infrastructure Assets

Under a service concession arrangement, a business typically receives a right

to be paid within a fee structure in exchange for the incurrence of an
obligation to provide services to the public.
Arrangements that are not considered service concessions typically
involve outsourcing the internal services of a government entity, such as meal
service, janitorial service, building maintenance, and computer systems
support.
When a business enters into a service concession arrangement, it should
follow these rules when accounting for transactions:
 • Borrowing costs. Borrowing costs incurred by the business as part of
its service concession arrangement are charged to expense as incurred.
However, if the borrowing costs relate to a contractual right to receive
an intangible asset (such as a license), capitalize these costs during the
construction phase of the asset, and amortize them over the term of the
arrangement.
• Consideration paid. A business may be cast in the role of either
constructing, upgrading, or maintaining infrastructure, or of providing
a public service. If it is providing more than one of these services, it
should allocate the consideration paid to each service, based on their
fair values. See the Revenue chapter regarding how these payments
are to be recognized.
• Construction services. If a business is constructing or upgrading
infrastructure assets for a government entity, it treats the arrangement
as a construction contract. The accounting for construction contracts is
described in the Construction Contracts chapter.
• Fixed assets. A business does not own the infrastructure that it
operates, and so does not recognize it as a fixed asset.
• Intangible asset. If a business receives a right to charge users for the
service it is providing, the business should recognize an intangible
asset. See the following example.
• Obligation to restore infrastructure. If the business undertakes to
restore infrastructure to a certain condition or level of serviceability, it
should recognize a liability in the amount of the estimated expenditure
required to do so.
• Retainable assets. A government entity may provide a business with
assets as part of a service concession that the business is allowed to
dispose of as it wishes. These assets are not to be accounted for as a
government grant, but rather as assets measured at their fair values,
with an offsetting liability for unfulfilled obligations assumed. These
obligations are then charged to expense as the obligations are fulfilled.
• Services revenue. If services are provided to users, account for them as
service revenue. This accounting is described in the Revenue chapter.
EXAMPLE
Rio Shipping enters into an agreement with the port authority of Southport
to construct a ferry terminal and be the exclusive provider of ferry service to
all surrounding cities and towns for the next 10 years. Rio constructs the
terminal at a direct cost of £10,000,000, which is reimbursed by the port
authority. Rio should recognize an intangible asset, which is the right to
collect fees from customers using the ferry service. The amount of this
intangible asset to recognize is the fair value of the consideration receivable
in exchange for the construction oversight services provided.
Rio estimates the fair value of the consideration received to be the £400,000
cost of construction supervision plus an 8% profit margin. This results in a
recognized intangible asset of £432,000. Rio then amortizes the intangible
asset over the ten years of the service concession on a straight-line basis,
which is £43,200 of amortization per year.
Rio collects payments from ferry users as they make use of the ferry
services, so the company can recognize revenue from these payments as
they are received.

Service Concession Disclosures

Both the operator and the grantor of a service concession should disclose the
following information in the notes accompanying their financial statements,
either for each individual concession or in aggregate for each class of
concession arrangement:
• Classification. How the arrangement has been classified for reporting
purposes.
• Concession changes. Any changes in the arrangement during the
reporting period.
• Description. A description of the service concession arrangement.
• Options. The terms of any options to renew or terminate the
arrangement.
• Rights and obligations. Any rights involving the use of assets, as well
as any obligations to provide services, acquire or build property, or
return assets at the end of the arrangement.
• Terms. Significant terms of the arrangement that may affect the future
cash flows of the parties, such as the duration of the concession and
the conditions under which prices are adjusted.
In addition, the business should disclose the amount of revenues and
expenses recognized in the period that relate to the concession.
Summary
Service concession arrangements can be quite complex, especially when a
business is required to provide ongoing maintenance and infrastructure
upgrades, is subject to a variety of price alteration rules, and intangible assets
are recognized as part of an arrangement. Under these circumstances, it is
best to develop formal procedures for how to account for each arrangement,
have them approved in advance by the company’s auditors, and monitor
transactions on an ongoing basis. Without this level of oversight, there is a
substantial risk that the accounting for service concession arrangements will
go awry.
 Chapter 38
Other Topics
Introduction
The topics covered in this chapter are of some importance to those entities
impacted by them, but are not broad enough to require coverage in separate
chapters. The topics relate to the liability for waste electrical and electronic
equipment, hedging a net investment in a foreign operation, distributing non-
cash assets to the owners of a business, and swapping financial liabilities for
equity instruments.
IFRS Source Documents
• IFRIC 6, Liabilities arising from Participating in a Specific Market –
Waste Electrical and Electronic Equipment
• IFRIC 16, Hedges of a Net Investment in a Foreign Operation
• IFRIC 17, Distributions of Non-cash Assets to Owners
• IFRIC 19, Extinguishing Financial Liabilities with Equity Instruments
Liabilities from Waste Electrical and Electronic Equipment
The European Union issued the Directive on Waste Electrical and Electronic
Equipment, which contains regulations that deal with the collection,
treatment, recovery, and disposal of waste equipment. In the directive,
decommissioning activities for private households are split into “new” waste
occurring after August 13, 2005 and historical waste before that date. The
directive requires the producers of household equipment to pay
decommissioning costs for historical waste if they were operating in this
market during a period to be specified by each member state of the European
Union. Payments are based on the proportionate share of each producer in the
relevant markets, by type of equipment.
If a producer participated in a market to which the directive applies, and
did so during the measurement period approved by a member state of the
European Union, it should recognize a decommissioning liability once the
measurement period has been clarified.
EXAMPLE
Broadcast Radio sells emergency short-wave radios for personal use. During
2004, it achieved a market share of 8%. Its market share suffers thereafter,
reaching 1% in 2006. The company exits the market at the beginning of
2007. A member state passes legislation in 2007, mandating that
decommissioning liability will be assigned based on 2007 market shares.
Since Broadcast is no longer in the market during the measurement period, it
is assigned no liability.

Hedges of a Net Investment in a Foreign Operation

A business may have invested in a foreign operation, which could be
classified as a subsidiary, associate, joint venture, or branch. Depending on
its relationship with the foreign operation, a business may be required to
translate the results of that operation into its own currency for reporting
purposes. In these situations, it is entirely possible that ongoing differences in
the exchange rates applicable to the business and its foreign operation will
require the recognition of a gain or loss in other comprehensive income.
These gains or losses are recognized in profit or loss whenever the business
disposes of its net investment in the foreign operation.
The managers of a business may want to negate these foreign exchange
gains and losses by establishing hedges. A hedge is officially established
when a link is recognized between the net investment in a foreign operation
and a hedging instrument. The following accounting issues relate to these
hedging situations:
• Hedge holdings. A hedging instrument for a net investment in a
foreign operation can be held by any entity within a group.
• Hedging cap. The amount of the hedge is capped at the carrying
amount of the net assets of the foreign operation reported in the
consolidated financial statements of the parent entity.
• Hedging relationship qualification. If hedging of a net investment in a
foreign operation is contemplated at several levels of a consolidated
business, be aware that only one hedging relationship qualifies for
hedge accounting in the consolidated financial statements of the entity.
In order to recognize hedge accounting by a higher level parent, any
hedge accounting applied at a lower level must be reversed.
• Hedge dependency. The amount of net assets that can be hedged is
dependent upon the existence of any hedge accounting by a lower-
level parent within the organization.
• Effectiveness assessment. When assessing the effectiveness of a hedge
of a net investment in a foreign operation, compare the functional
currency of the hedged risk and the functional currency of the parent
entity (which may not be the currency of the entity in the group where
 the hedge is held).
• Intermediate-level parent. If there is an intermediate-level parent of a
foreign operation, this has no effect on the risk of the parent, since the
parent still experiences foreign exchange risk in its consolidated
financial statements.
• Disposal recognition method. When a foreign operation is disposed of,
any hedging gains or losses in other comprehensive income should be
recognized in profit or loss. The method for doing so can affect the
amount included in the foreign exchange reserve for a specific foreign
operation. Consequently, the corporate parent should have a policy for
consistently using either the step-by-step method or the direct method
of consolidation. The step-by-step method requires that the financial
statements of a foreign operation first be translated into the functional
currency of any intermediate parent and then into the functional
currency of the ultimate parent, while the direct method translates the
financial statements directly into the functional currency of the
ultimate parent.
EXAMPLE
Pianoforte International is the ultimate parent company; it presents its
consolidated financial statements in pounds. Pianoforte has a wholly-owned
subsidiary, Keyboard Deluxe, which reports its consolidated results in
Euros. Keyboard, in turn, owns Ivory Keys, which reports its results in U.S.
dollars. The £25,000,000 investment by Pianoforte in Keyboard includes an
equivalent £5,000,000 investment in Ivory Keys.
The ultimate parent, Pianoforte, wants to hedge the foreign exchange risk
associated with its £5,000,000 investment in Ivory Keys. The amount of the
hedge can be equal to or less than the £5,000,000 net investment. To do so,
Keyboard borrows $6,200,000, which is the dollar equivalent of the
£5,000,000 investment. Pianoforte can designate the borrowing as a hedge
of the pound/dollar spot exchange rate associated with the net investment in
Ivory Keys. This transaction is allowable for hedge accounting purposes.
Keyboard could also use the hedge in its own consolidated financial
statements, since it owns the hedging instrument.

For more information about hedging, see the Financial Instruments chapter.
Distributions of Non-cash Assets to Owners
A business may sometimes issue non-cash assets to its owners, perhaps
through a dividend. The terms of the dividend may allow recipients to choose
between a cash and non-cash payout. The relevant accounting is as follows:
• Recognition date. Recognize the related liability to pay the distribution
on the dividend declaration date, which is usually when the board of
directors authorizes the distribution.
• Measurement. Measure the liability at the fair value of the assets to be
distributed. If the owners have a choice of accepting a cash or non-
cash distribution, base the amount of the liability on the probability of
the percentage of each option that will be chosen. The carrying
amount of this payable is to be adjusted over time as the fair values of
the underlying assets change, with the offset to the adjustment being
recorded in equity.
• Dividend settlement. When a dividend is paid out, the business
recognizes any difference between the carrying amount of the assets
distributed and the amount of the dividend payable in profit or loss.
This difference is presented in a separate line item in the income
statement.
A business issuing non-cash assets should disclose the following information
in the notes accompanying its financial statements:
• Balances. The beginning and ending balances of the dividend payable.
• Carrying amount. Any changes in the carrying amount of the dividend
payable.
• Late declaration. If a non-cash dividend is declared after the reporting
period but before the financial statements have been authorized for
issuance, state the nature of the non-cash item, its carrying amount and
fair value, and the method used to measure fair value.
Extinguishing Financial Liabilities with Equity Instruments
A borrower and a lender may sometimes elect to renegotiate a financial
liability and replace it with the equity of the borrower, so that the lender now
becomes a shareholder of the borrower. The accounting by the borrower in
this situation is as follows:
• Form of payment. The issuance of equity in exchange for a financial
liability is considered to be consideration paid, and results in the
removal of the liability from the records of the borrower, if it has been
paid in full. If there is a difference between the amount of the
consideration paid and the carrying amount of the related liability,
recognize it in profit or loss.
• Equity measurement. The equity issued in exchange for a liability
should be measured at its fair value. If fair value cannot be measured,
measure the equity at the fair value of the liability being extinguished.
Recognize the equity instruments on the date when the liability is
extinguished.
• Terms modifications. If some of the liability still remains and its terms
have been modified, allocate the consideration paid between the
extinguished and surviving portions of the liability. If the terms have
been substantially modified, extinguish the old liability and create a
new liability to reflect the new terms. If a gain or loss is recognized on
the terms modification, present it in a separate line item in the income
statement.
 Glossary
A
Accounting policy. A principle, convention, rule, or practice used in
preparing financial statements.
Accounting profit. The profit recorded for a reporting period, prior to the
deduction of income taxes.
Acquiree. The entity that an acquirer gains control of in a business
combination.
Acquirer. The entity that gains control of an acquiree in a business
combination.
Active market. A market with sufficiently high frequency and volume to
provide ongoing pricing information.
Actuarial gains and losses. A change in the present value of the obligations
associated with a defined benefit plan, caused by changes in actuarial
assumptions and actual experience.
Agricultural produce. Products harvested from biological assets, examples of
which are wool, cotton, milk, grapes, and picked fruit.
Amortization. The systematic charge to expense of the cost of an intangible
asset over its useful life.
Antidilution. Either an increase in earnings per share or a decline in loss per
share when the assumption is made that ordinary shares are issued.
Asset ceiling. The present value of any economic benefits available as plan
refunds or reductions in future contributions to a benefit plan.
Associate. An entity over which another party exercises significant influence.
B
Basic earnings per share. The earnings for an accounting period divided by
the ordinary shares outstanding during that period.
Bearer plant. A living plant that is used in the production of agricultural
produce.
Biological assets. A living plant or animal, examples of which are sheep,
dairy cattle, fruit trees, and vines.
Borrowing costs. Interest and related costs associated with the borrowing of
cash.
Business combination. An event in which an acquirer gains control of another
business.
C
Carrying amount. The recognized amount of an asset, less accumulated
depreciation and accumulated impairment losses.
Cash. The sum total of all cash on hand and demand deposits.
Cash equivalent. A short-term, very liquid investment that is easily
convertible into a known amount of cash, and which is so near its maturity
that it presents an insignificant risk of a change in value because of changes
in interest rates.
Cash flows. The inflow or outflow of cash and cash equivalents.
Cash-generating unit. An asset group whose cash inflows are mostly
independent of the cash inflows of other assets.
Change in accounting estimate. A change that adjusts the carrying amount of
an asset or liability, or the subsequent accounting for it. It results from new
information.
Chief operating decision maker. A person who is responsible for making
decisions about resource allocations to the segments of a business, and for
evaluating those segments.
Close family members. The children, spouse, domestic partner, step-children,
or dependents of a person who has control or significant influence over a
business.
Consolidated financial statements. The combined financial statements of a
group of entities, presented as the financial results, financial position, and
cash flows of a single entity.
Construction contract. A contract under which an asset or group of
interrelated assets will be constructed.
Constructive obligation. An obligation derived from the past practices,
policies, or statements of a business that create an expectation that an
obligation will be settled.
Contingent asset. A possible asset that may arise from past events, which will
be confirmed by a future event not entirely under the control of an entity.
Contingent liability. A possible liability that may arise from past events,
which will be confirmed by a future event not entirely under the control of an
entity.
Contingent rent. A variable lease payment that is based on a future amount,
such as a percentage of future sales or a future price index.
Contract. An agreement between parties that results in rights and obligations
by the parties.
Contractual service margin. The unearned profit component within the
carrying amount of a group of insurance contracts.
Cost approach. A valuation derived from the amount required to replace the
service capacity of an asset.
Cost plus contract. A construction contract under which the contractor is
reimbursed for allowable costs, plus either a percentage of costs incurred or a
fixed fee.
Costs to sell. Those costs directly attributable to the disposal of an asset.
Credit risk. The risk that the counterparty to a financial instrument will not
discharge an obligation, triggering the recognition of a loss by the other
party.
Current cost. The current replacement cost or market price of an item.
Current service cost. The increase in the present value of a defined benefit
obligation that is caused by employee service in the current period.
D
Deductible temporary difference. A temporary difference that will result in
deductible amounts in future periods.
Deferred tax asset. The amount of income taxes recoverable in future periods
that relate to deductible temporary differences, tax loss carryforwards, and
tax credit carryforwards.
Deferred tax liability. The amount of income taxes payable in future periods
that relate to taxable temporary differences.
Defined benefit plan. A post-employment benefit plan in which the amount of
benefits to be provided is stated, but not the amount of funding required to
achieve the designated benefits.
Defined contribution plan. A post-employment benefit plan in which the
amount of contributions to the plan is stated, but not the amount of benefits
that will eventually be paid out as a result of these contributions.
Depreciation. The systematic charge to expense of the cost of an asset over
its useful life.
Derecognition. The elimination of an asset or liability from an entity’s
balance sheet.
Derivative. A contract whose value changes in relation to an outside value,
requiring a small initial investment (if any), and which is settled on a future
date.
Development. The application of research results to new products or
processes before production begins.
Diluted earnings per share. The earnings for an accounting period divided by
the ordinary shares outstanding during that period and all potential ordinary
shares.
Dilution. When earnings per share is reduced by the assumption that all
potential ordinary shares are converted to ordinary shares.
Direct method. A format of the statement of cash flows that presents specific
cash flows in the operating activities section of the report.
Discontinued operation. A component of an entity that is either held for sale
or which has been disposed of.
Discretionary participation feature. A contractual right to receive additional
benefits that are based in some manner on the investment returns or profits of
the insurer.
Disposal costs. Those costs incurred to dispose of an asset or cash-generating
unit.
Disposal group. A group of assets and liabilities to be disposed of in a single
transaction.
E
Economic life. The period over which an asset is expected to be economically
usable, or the number of production units expected to be generated by it.
Effective interest rate. The interest rate that a borrower actually pays, based
on the frequency of debt compounding, fees, points paid or received,
transaction costs, and premiums or discounts.
Equity instrument. A contract that yields a residual interest in an entity.
Equity method. Accounting for an investment by adjusting the initial
investment amount for changes in the investor’s share of the investee’s net
assets.
Events after the reporting period. Events arising between the end of the
reporting period and when the financial statements for that period are
authorized for issuance.
Exchange rate. The ratio at which a unit of one currency can be exchanged
for another currency.
Exploration and evaluation expenditures. Expenditures arising from the
exploration for and evaluation of mineral resources prior to the point when it
is demonstrated that mineral extraction is feasible and viable.
F
Fair value. The price paid in an orderly market transaction to sell an asset or
transfer a liability.
Finance lease. A lease under which the risks and rewards of ownership of an
asset are shifted to the lessee.
Financial asset. An asset that is either cash, equity in another entity, a
contractual right to receive cash or other financial assets, or to exchange such
assets and liabilities under potentially favorable conditions.
Financial guarantee contract. A contract under which the issuer must
reimburse the holder for any losses caused by non-payments by a third party
under a lending arrangement.
Financial instrument. Any contract that creates a financial asset for one party
and a financial liability or equity instrument for the counterparty.
Financial liability. A liability that is an obligation to deliver cash or another
financial asset, or to exchange financial assets or liabilities under potentially
unfavorable terms.
Financial risk. The possibility of a future change in a specified interest rate,
exchange rate, price index, or some similar variable.
Financing activities. Any actions that alter the size and composition of
contributed equity or borrowings.
Fixed price contract. A construction contract under which the contractor
accepts a fixed contract price.
Foreign currency. A currency other than the functional currency being used
by an entity.
Forgivable loan. A loan for which the lender is prepared to waive repayment
under certain circumstances.
Fulfillment cash flows. The expected present value of the net change in future
cash flows that will occur as a business fulfills insurance contracts.
Functional currency. The currency used in the primary economic
environment in which a business operates. This is the environment in which
an entity primarily generates and expends cash.
G
Goodwill. The residual asset arising from the future economic benefits of a
business combination, which is not identified as a separate asset.
Government assistance. Government action to provide benefits to qualifying
entities.
Government grant. Resources transferred by a government to an entity in
return for compliance with certain conditions.
Grant date. The date on which an entity and the recipient of a share-based
payment arrangement mutually arrive at the terms and conditions of the
arrangement.
Gross investment in a lease. The sum of the lease payments to be received by
a lessor under a finance lease and the unguaranteed residual value belonging
to the lessor.
Guaranteed benefits. An obligation by an insurer to pay benefits to which a
policyholder has an unconditional right.
Guaranteed residual value. That portion of the residual value of a leased
asset that is guaranteed by the lessee.
H
Harvest. The separation of produce from a biological asset, or the termination
of the life of a biological asset.
Hedge effectiveness. The extent to which variations in the cash flows or fair
value of a hedged item are offset by variations in the cash flows or fair value
of a hedging instrument.
Hedging instrument. A derivative, financial asset, or financial liability whose
cash flows or fair value are expected to offset changes in the cash flows or
fair value of a hedged item.
Held for trading. A financial asset or liability that is acquired for the purpose
of generating a short-term profit, or which is a derivative.
Historical cost. Costing based on measures of historical prices, without
subsequent restatement.
I
Impracticable. When it is not possible to apply a requirement, despite having
made a reasonable effort to do so.
Income approach. A valuation derived from the discounted present value of
future cash flows.
Indirect method. A format of the statement of cash flows that uses accrual-
basis accounting as part of the presentation of cash flow information.
Initial direct costs. The incremental costs incurred to obtain a lease that
would not be incurred if the lease were not obtained.
Insurance contract. A contract in which the insurer accepts insurance risk
from the policyholder, paying the policyholder if an insured event occurs.
Insurance risk. Any risk other than financial risk that is transferred from a
policyholder to an insurer.
Intangible asset. A non-monetary asset that lacks physical substance, and
from which economic returns are expected for more than one period.
Interim financial report. A financial report containing a complete or
condensed set of financial statements.
Interim period. A financial reporting period that is shorter than a full fiscal
year.
Intrinsic value. The difference between the fair value of those shares that a
party has a right to receive and the amount it must pay for the shares.
Investing activities. The acquisition and disposal of long-term assets, as well
as other assets not considered to be cash equivalents.
Investment property. Property held with the intent of earning rental income or
capital appreciation.
J
Joint arrangement. An arrangement in which several parties exercise joint
control under a contractual arrangement.
Joint operation. A joint arrangement in which the participating parties have
rights to the assets and obligations for the liabilities of the arrangement.
Joint venture. A joint arrangement in which the participating parties have
rights to the net assets of the arrangement.
K
Key management personnel. Those managers having the authority and
responsibility for planning, controlling, and directing the activities of a
business.
L
Lease. An agreement under which the lessor conveys the right to use an asset
to the lessee in exchange for one or more payments.
Lease incentives. Those payments made by a lessor to a lessee in association
with a lease agreement.
Lease modification. An alteration of the scope of a lease or the consideration
for a lease.
Lease term. The period over which a lessee has a right to use a leased asset,
without the threat of cancellation, adjusted for any options that can extend or
shorten the lease duration and which are likely to be exercised.
Levy. A tax or fee imposed by a government entity.
Liquidity risk. The risk that a business will not have sufficient cash to meet its
obligations under a financial instrument.
M
Market approach. A valuation derived from similar market transactions.
Market condition. A condition upon which the terms of an equity instrument
are based.
Market risk. The risk that changes in market prices will cause the future cash
flows related to a financial instrument to fluctuate.
Master netting arrangement. A contractual arrangement to settle multiple
financial transactions with a single counterparty on a net basis.
Material. An individual or collective omission from or misstatement of
financial statements that could influence the decisions of users.
Monetary items. Money and items to be received or paid in money.
N
Net investment in a lease. The gross investment in a lease, which has been
discounted using the interest rate implicit in the lease.
Non-controlling interest. That portion of the equity in a business that is not
held by its parent.
Notes. Information that accompanies the financial statements, and which
provide narrative descriptions, as well as information that is in disaggregated
form or in addition to what is presented in the financial statements.
O
Obligating event. An event that essentially gives an entity no choice other
than to settle an obligation.
Onerous contract. A contract that requires the incurrence of costs that will
exceed the benefits derived from it.
Operating activities. The primary revenue-generating activities of a business.
Operating cycle. The time span from the acquisition of an asset to its
realization in cash or cash equivalents.
Operating lease. A lease that does not transfer substantially all of the risks
and rewards related to the ownership of the asset being leased.
Operating segment. A component of a business that earns revenue and incurs
expenses, for which separate financial information is available, and which is
regularly evaluated by the chief operating decision maker in regard to
resource allocations and performance assessment.
Ordinary share. An equity instrument that is subordinate to all other types of
equity instruments.
Other comprehensive income. Items that are excluded from net income, such
as gains and losses from financial statement translation, the effective portion
of gains and losses on hedging instruments, and the remeasurement of
defined benefit plans.
Owner-occupied property. Property held and to be used for production or
administrative purposes.
P
Parent. An entity that controls other entities.
Past service cost. The change in present value of a defined benefit obligation
for services performed by employees in prior periods. This amount can
change when the underlying plan is altered or there is a significant reduction
in the number of employees who will receive coverage under the plan.
Performance obligation. A contractual promise to transfer goods or services
to a customer.
Potential ordinary share. Securities that can be converted to ordinary shares,
such as options, warrants, and convertible securities.
Presentation currency. The currency in which a business prepares its
financial statements.
Prior period error. A misstatement or omission in the financial statements
for a prior period caused by the misuse or nonuse of information that was
available when the statements were issued.
Profit or loss. The total amount of income minus expenses, not including any
elements of other comprehensive income.
Progress billing. Billings for work performed on a contract.
Property, plant and equipment. Tangible items to be used in multiple periods,
and which are used for production, rental, or administration.
Provision. A liability whose timing or amount is uncertain.
Puttable instrument. A financial instrument that allows its holder the option
to put the instrument back to the issuer for cash or some other financial
instrument.
Q
Qualifying asset. An asset requiring a significant time period to prepare for
its intended use.
R
Rate regulation. A controlled process for establishing the prices that can be
charged to customers, which is overseen by a rate regulator.
Reclassification adjustment. Items formerly recognized in other
comprehensive income that are reclassified to profit or loss.
Recoverable amount. The greater of an asset’s value in use and its fair value
less costs to sell.
Reinsurance contract. Insurance issued by one insurer to another to
compensate for possible losses that may be incurred on the insurance
contracts issued by the latter insurer.
Related parties. Those joint ventures, associates, principal owners, key
management personnel, post-employment benefit plans for the benefit of
employees, close family members of principal owners and managers, and
other parties having control or significant influence over a business.
Related party transaction. A transaction in which there is a transfer of assets
or liabilities between the reporting entity and a related party, even in the
absence of a price related to the transaction.
Reload feature. The automatic granting of additional share options that
occurs whenever an option holder exercises previously-granted options and
uses shares to satisfy the exercise price.
Research. Investigations designed to gain new knowledge.
Residual value. The estimated amount currently obtainable from an asset
disposal, less disposal costs, if it were in the condition expected at the end of
its useful life.
Retention. That portion of a progress billing not paid until all contractually-
specified conditions and defects have been rectified.
Retrospective application. The application of a new accounting policy to
prior financial statements.
Revenue. Income generated by the ordinary activities of an entity.
Right-of-use asset. An asset that indicates a lessee’s right to the asset
associated with a lease for the term of the lease.
S
Separate financial statements. The financial statements of a parent entity, in
which investments are recorded at their cost or as financial instruments.
Service cost. A combination of current service cost, past service cost, and
gains or losses on settlement.
Settlement. A transaction that terminates any further obligations by an
employer under a defined benefit plan.
Share option. A contract that gives its holder the right, but not the obligation,
to acquire the shares of an entity at a certain price, and within a certain period
of time.
Short-term lease. A lease that has a term of 12 months or less as of its
commencement date.
Significant influence. Having the power to participate in the financial and
operating policy decisions of an investee.
Spot exchange rate. The exchange rate between two currencies that is
available for immediate delivery.
Structured entity. An entity that has been structured in such a manner that
voting rights are not the key determinant of who controls it.
Sublease. A situation in which a lessee re-leases a leased asset to a third
party.
Subsidiary. An entity over which control is exercised by another entity.
T
Tax base. The amount attributed to an asset or liability for tax purposes.
Taxable profit. The profit for a reporting period that is determined using the
rules of the relevant taxation authority, upon which income taxes are
calculated.
Taxable temporary difference. A temporary difference that will result in
taxable amounts in future periods.
Temporary difference. A difference between the tax base and carrying
amount of an asset or liability.
Total comprehensive income. The net change in equity during a period, not
including transactions with owners. This is essentially the total amount of
profit or loss and other comprehensive income.
Transaction costs. The fees and commissions, levies, taxes, and duties related
to a transaction.
U
Useful life. Either the expected period over which an asset will be used, or the
number of production units expected to be obtained from the asset.
V
Value in use. The present value of the cash flows expected from an asset or
cash-generating unit.
Vest. The accrual of non-forfeitable rights.
 Index

Abnormal costs 130

Accounting policies 53
Accrual principle 6
Acquired deferred tax assets 300
Acquisition method 305
Acquisition, reverse 312
Actuarial assumptions 271
Administrative overhead 121
Administrative tasks 215
Agent versus principal 248
Agriculture, accounting for 409
Amortization of costs 255
Anti-dilutive shares 68
Assembled workforce 308
Asset impairment
Indicators 175
Overview of 175
Associate, interests in 105
Associate, investment in 96

Balance sheet 11
Balance sheet, construction of 16
Bargain purchase gain 309
Basic earnings per share 66
Basis of preparation 30
Bill-and-hold arrangements 239
Black-Scholes-Merton formula 282
Bonus plans 264
Borrowing costs, overview of 367
Business combination, identification of 305

Capitalization limit 129

Cash flow hedge 332
Cash-generating unit 349
Change in accounting estimate 54, 233, 261
Change in estimate 233
Collateral 338
Common area maintenance 377
Common size balance sheet 14
Component of an entity 196
Conceptual framework 3
Conservatism principle 7
Consideration from supplier 240
Consistency principle 7
Consolidation accounting 49
Contingencies, accounting for 253
Contingent assets 205
Contingent consideration 314
Contingent liabilities 205
Contingent shares 67
Contracts
Continuing 235
Cost of 253
Existence of 211
Linkage to customers 210
Modification of 234
Multiple 212
Separation of 235
Contractual service margin 401
Contribution margin income statement 25
Control concept 45
Cost amortization 255
Cost impairment 255
Cost method 352
Cost model 132
Cost principle 7
Counterparty exposure 352
Current asset 12
Current cost 5
Current liability 12
Current tax assets 292
Current tax liabilities 292
Current tax recognition 300
Customer acceptance 242
Customer, nature of 209

Decommissioning funds 149

Decommissioning liabilities 148
Deductible temporary difference 295
Deferred tax recognition 300
Defined benefit financial statements 277
Defined benefit plan 265, 266
Defined contribution plan 265, 266
Depletion method 141
Depreciation 135
Depreciation accounting 145
Derecognition 146
Diluted earnings per share 68
Dilutive shares 68
Direct cost 108
Direct method 37
Disclosures 257
Discontinued operations 196
Discount rate 219
Distinct criterion 214
Distributions to owners, non-cash 431
Double declining balance method 139

Economic entity principle 7

Embedded derivative 327
Employee benefits, short term 262
Equity method 97
Error correction 55
Estimation uncertainty 31
Events after the reporting period 395

Fair value
Hedge 331
 Model 169
Overview of 348
Finance lease 384
Financial instruments
Compound 322
Derecognition 335
Dividends 328
Gains and losses 328
Hedging 329
Interest 328
Measurement of 320
Presentation 339
Reclassification 326
Financial liability extinguishment 432
Financial statement translation 360, 362
Financing activities 35
First in, first out method 113
Fixed assets
Cost inclusions 131
Depreciation of 135
Derecognition of 146
Recognition of 129
Revaluation of 132
Fixed overhead cost 108
Foreign entity derecognition 365
Foreign exchange transactions 358
Foreign operation hedging 430
Full disclosure principle 7
Functional currency 360

GAAP, what is 2
Going concern issue 397
Going concern principle 7
Goodwill, recognition of 309
Government grants
Accounting for 414
Presentation 417
Graduated income tax rate 298
Gross profit method 119

Hedge, cash flow 332

Hedge, fair value 331
Hedge, net investment 334
Hedging
Accounting for 330
Instruments 329
Overview 329
Held for sale assets 191
Highest and best use 350
Historical cost 5
Hyperinflationary effects 365
Hyperinflationary reporting 59

IFRS, what is 1
Impaired asset compensation 148
Impairment
Of corporate assets 186
Recovery of 177
Reversal of 183
Test 180
Timing of 177
Impairment of costs 255
Impracticability of application 56
Income approach 351
Income method 352
Income statement 18
Income statement, construction of 28
Income tax presentation 302
Indemnification asset 308, 314
Indirect method 38
Input methods 231
Inspection asset 130
Insurance contracts
Aggregation of 399
 Derecognition 405
Discount rates used 401
Estimated future cash flows 400
Initial recognition 399
Modification 404
Policy changes 405
Risk adjustments 401
Subsequent measurement 402
Types of 398
Intangible assets
Accounting for 153
Acquired 155
Cost model 158
Derecognition of 160
Exchanged 157
Government grants 157
Internal 156
Related issues 162
Revaluation of 158
Types of 152
Integral view 80
Intent to resell 193
Interests in other entities 103
Interim financial report 75
Interim period 75
Interim period restatements 79
Intrinsic value 284
Inventory
Cost flow assumption 110
Costing 113
Overview of 108
Investing activities 35
Investment property
Accounting for 168
Cost model 170
Derecognition 172
Fair value 169
 Overview of 167
Transfers 171

Joint arrangement 91
Joint arrangement, interests in 105
Joint control 91
Joint operation 92
Joint venture 92
Joint venture, investment in 96

Land depreciation 144

Land improvements 144
Last in, first out method 115
Lattice model 282
Lease
Components 377, 379
Liability 381
Modifications 383
Nature of 374
Recognition 381
Term 379
Levy accounting 206
Licensing 245

Manufacturing overhead 121

Market approach 351
Market method 353
Matching principle 7
Materiality principle 7
Member share in cooperative entity 101
Mid-month convention 136
Mineral resources
Accounting for 422
Presentation 424
Monetary unit principle 8
Multi-employer plan 265
Multi-period income statement 26
Multi-step income statement 24

Net investment hedge 334

Net monetary position 62
Net realizable value 124
Noncash consideration 222
Nonrefundable upfront fees 247
Notes 30

Observable inputs 349

Obsolete inventory, accounting for 124
Offsetting concept 11
Operating activities 34
Operating lease 387
Operating segment 83
Option for additional purchases 243
Orderly transaction 348
Other comprehensive income 18
Output methods 231
Overburden 423
Overhead allocation 121
Overhead rate 122
Owner-occupied property 167

Paid absences 263

Partial period treatment 375
Past service cost 272
Payments to customers 222
Performance obligations 213
Periodic inventory system 111
Perpetual inventory system 112
Post-employment benefits 265
Preference shares 322
Present value 5
Presentation by function 20
Presentation by nature 20
Price allocations 224
Price changes, subsequent 227
Price discounts 225
Principal market 348
Principal versus agent 248
Profit sharing plans 264
Progress completion method 230
Progress measurement 233
Projected unit credit method 268
Property, plant, and equipment 129
Provisions
Accounting for 201
Overview of 199
Restructuring 203
Puttable instruments 322

Reacquired rights 309, 314

Recognition 4
Refund liabilities 223
Reimbursements, accounting for 206
Related parties
Disclosures 393
Overview of 392
Reliability principle 8
Reload feature 281
Replacement parts 130
Repurchase agreements 249
Residual approach 225
Restructuring provision 203
Retail inventory method 118
Revaluation model 132
Revenue recognition
Consistency 234
Disclosures 257
Final step 228
Revenue recognition principle 8
Revenue reversal 217
Reverse acquisition 312
Right of return 233
Right of substitution 375

Sale and leaseback 388

Salvage value 135
Segment disclosure 86
Separate financial statements 51
Service concessions, overview of 426
Servicing assets and liabilities 338
Settlement value 5
Share-based payment
Cash alternative 287
Cash settled 286
Equity settled 279
Overview 279
Significant influence 96
Single-step income statement 23
Standard costing 116
Statement of cash flow disclosures 42
Statement of cash flows 34
Statement of cash flows, preparation of 40
Statement of changes in equity 29
Statement of financial position 11
Statement of profit or loss 18
Step acquisition 311
Straight-line depreciation 137
Stripping costs, accounting for 423
Subsidiaries, interests in 104
Sum of the years’ digits depreciation 138

Tax asset recoverability 301

Tax base 291
Tax planning opportunity 296
Tax status, change in 301
Taxable temporary difference 293
Termination benefits 273
Time period principle 8
Time value of money 219

Unconsolidated structured entity 106

Unexercised customer rights 251
Units of production method 143
Unobservable inputs 349
Unrecognized firm commitment 335
Unused tax credits 297
Unused tax losses 297
Useful life 135

Value in use 178

Variable consideration 216, 227
Variable overhead cost 108

Warranties 252
Waste electrical liabilities 429
Web site costs 161
Weighted-average method 115
Weighted-average shares 67
Work in process accounting 126