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HENNIE vAN GREUNING
international
financial
reporting standards
A practical guide
fourth edition
International Financial
Reporting Standards
A Practical Guide
International Financial
Reporting Standards
A Practical Guide
Fourth Edition
Hennie van Greuning
THE WORLD BANK
Washington, D.C.
© 2006 The International Bank for Reconstruction and Development / The World Bank
1818 H Street, NW
Washington, DC 20433
Telephone 202-473-1000
Internet www.worldbank.org
E-mail [email protected]
All rights reserved.
1 2 3 4 09 08 07 06
The findings, interpretations, and conclusions expressed herein are those of the author(s) and
do not necessarily reflect the views of the Board of Executive Directors of the World Bank or
the governments they represent.
The World Bank does not guarantee the accuracy of the data included in this work. The
boundaries, colors, denominations, and other information shown on any map in this work
do not imply any judgment on the part of the World Bank concerning the legal status of any
territory or the endorsement or acceptance of such boundaries.
ISBN-10: 0-8213-6768-4
ISBN-13: 978-0-8213-6768-1
eISBN: 0-8213-6769-2
DOI: 10-1596/978-0-8213-6768-1
Rights and Permissions
The material in this work is copyrighted. Copying and/or transmitting portions or all of this
work without permission may be a violation of applicable law. The World Bank encourages
dissemination of its work and will normally grant permission promptly.
For permission to photocopy or reprint any part of this work, please send a request with
complete information to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers,
MA 01923, USA, telephone 978-750-8400, fax 978-750-4470, www.copyright.com.
All other queries on rights and licenses, including subsidiary rights, should be addressed to
the Office of the Publisher, World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax
202-522-2422, e-mail [email protected].
Library of Congress Cataloging-in-Publication Data has been requested.
Contents
Foreword
Acknowledgments
Introduction
PRESENTATION
Framework
IFRS 1
IAS 1
IAS 7
IAS 8
Framework for the Preparation and Presentation of Financial Statements
First-Time Adoption of IFRS
Presentation of Financial Statements
Cash Flow Statements
Accounting Policies, Changes in Accounting Estimates, and Errors
IFRS 3
IAS 27
IAS 28
IAS 31
IFRS 2
IFRS 4
IAS 2
IAS 11
IAS 12
IAS 16
IAS 17
IAS 18
IAS 19
IAS 20
IAS 21
IAS 23
IAS 36
GROUP STATEMENTS
Business Combinations
Consolidated and Separate Financial Statements
Investments in Associates
Interests in Joint Ventures
BALANCE SHEET AND INCOME STATEMENT
Share-Based Payment
Insurance Contracts
Inventories
Construction Contracts
Income Taxes
Property, Plant, and Equipment
Leases
Revenue
Employee Benefits
Accounting for Government Grants and Disclosure of Government Assistance
The Effects of Changes in Foreign Exchange Rates
Borrowing Costs
Impairment of Assets
PART I
Chapter 1
2
3
4
5
PART II
Chapter 6
7
8
9
PART III
Chapter 10
11
12
13
14
15
16
17
18
19
20
21
22
vii
viii
ix
1
3
11
15
31
41
47
49
60
68
74
81
83
91
96
105
114
124
136
149
157
166
171
178
185
v
vi
Table of Contents
Chapter 23
24
25
26
27
PART IV
Chapter 28
29
30
31
32
33
34
35
36
37
38
IAS 37
IAS 38
IAS 39
IAS 40
IAS 41
IFRS 5
IAS 10
IAS 14
IAS 24
IAS 26
IAS 29
IAS 32
IAS 33
IAS 34
IFRS 6
IFRS 7
Provisions, Contingent Liabilities, and Contingent Assets
Intangible Assets
Financial Instruments: Recognition and Measurement
Investment Property
Agriculture
DISCLOSURE
Noncurrent Assets Held for Sale and Discontinued Operations
Events After the Balance Sheet Date
Segment Reporting
Related-Party Disclosures
Accounting and Reporting by Retirement Benefit Plans
Financial Reporting in Hyperinflationary Economies
Financial Instruments: Presentation
Earnings per Share
Interim Financial Reporting
Exploration for and Evaluation of Mineral Resources
Financial Instruments: Disclosures
About the Author
192
198
203
218
224
233
235
240
243
248
252
256
261
264
273
278
284
299
Foreword
The publication of this fourth edition coincides with an acceleration in the convergence in
accounting standards that has been a feature of the international landscape in this field since | Hennie |
the global financial crisis of 1998. The events of that year prompted several international
organizations, including the World Bank and the International Monetary Fund, to launch a
cooperative initiative to strengthen the global financial architecture and to seek a longer-term
solution to the lack of transparency in financial information. International convergence in
accounting standards under the leadership of the International Accounting Standards Board
(IASB) and the Financial Accounting Standards Board (FASB) in the United States has now
progressed to the point where more than 100 countries currently subscribe to IFRS.
The rush towards convergence continues to produce a steady stream of revisions to account-
ing standards by both the IASB and FASB. For accountants, financial analysts, and other spe-
cialists, there is already a burgeoning technical literature explaining in detail the background
and intended application of these revisions. But until publication of the present work, a con-
solidated and simplified reference has been lacking.
This book, already translated into 13 languages in its earlier editions, seeks to fill this gap.
Each chapter briefly summarizes and explains a new or revised IFRS, the issue or issues the
standard addresses, the key underlying concepts, the appropriate accounting treatment, and
the associated requirements for presentation and disclosure. The text also covers financial
analysis and interpretation issues to better demonstrate the potential effect of the accounting
standards on business decisions. Simple examples in most chapters help further clarify the
material. It is our hope that this approach, in addition to providing a handy reference for
practitioners, will help relieve some of the tension experienced by nonspecialists when faced
with business decisions influenced by the new rules. The book should also assist national
regulators in comparing IFRS to country-specific practices, thereby encouraging even wider
local adoption of these already broadly accepted international standards.
Kenneth G. Lay, CFA
Deputy Treasurer
The World Bank
Washington, D.C.
June 2006
vii
Acknowledgments
The author is grateful to Mr. Ken Lay, deputy treasurer of the World Bank, who has sup-
ported this revised edition as a means to assist our client countries with a publication that
may facilitate understanding of International Financial Reporting Standards as well as
emphasizing the importance of financial analysis and interpretation of the information pro-
duced through application of these standards.
The Stalla Review for the CFA® Exam made a significant contribution to the previous edition
by providing copyright permission to adapt material and practice problems from their text-
books and questions database. Stalla Review is part of Becker Professional Review, a leading
provider of test preparation for the CPA, CFA®, and CMA exams. Two individuals from The
Stalla Review were very helpful—Frank Stalla and Peter Olinto.
I am grateful to the International Accounting Standards Committee Foundation for the use
of their examples in chapter 27 (IAS 41–Agriculture). In essence, this entire publication is a
tribute to the output of the International Accounting Standards Board. Deloitte Touche
Tohmatsu also allowed the use of two examples from their publications.
Jason Mitchell of the World Bank Treasury enhanced the introductory paragraphs of each
chapter by ensuring that the publication followed a consistent line of reasoning. Other col-
leagues in the World Bank Treasury shared their insights into the complexities of applying cer-
tain standards to the treasury environment. I benefited greatly from hours of conversation
with many colleagues, including Hamish Flett and Richard Williams.
Despite the extent and quality of the inputs that I have received, I am solely responsible for
the contents of this publication.
Hennie van Greuning
June 2006
viii
| Hennie |
Introduction
This text, based on three earlier publications that have already been translated into thirteen
languages, is an important contribution to expanding awareness and understanding of IFRS
around the world, with easy-to-read summaries of each Standard, and examples that illus-
trate accounting treatments and disclosure requirements.
TARGET AUDIENCE
A conscious decision has been taken to focus on the needs of executives and financial ana-
lysts in the private and public sectors who might not have a strong accounting background.
This publication summarizes each IFRS and IAS so managers and analysts can quickly obtain
a broad and basic overview of the key issues. A conscious decision was taken to exclude
detailed discussion of certain topics, in order to maintain the overall objective of providing a
useful tool to managers and financial analysts.
In addition to the short summaries, most chapters contain simple examples that emphasize
the practical application of some key concepts in a particular Standard. The reader without a
technical accounting background is therefore provided with the tools to participate in an
informed manner in discussions relating to the appropriateness or application of a particular
Standard in a given situation. The reader can also evaluate the effect that the application of
the principles of a given financial reporting standard will have on the financial results and
position of a division or of an entire enterprise.
STRUCTURE OF THIS PUBLICATION
Each chapter follows a common outline to facilitate discussion of each Standard.
1. Problems Addressed identifies the main objectives and the key issues of the Standard.
2. Scope of the Standard identifies the specific transactions and events covered by a
Standard. In certain instances, compliance with the requirements of a Standard is limit-
ed to a specified range of enterprises.
3. Key Concepts explains the usage and implications of key concepts and definitions.
4. Accounting Treatment lists the specific accounting principles, bases, conventions,
rules, and practices that should be adopted by an enterprise for compliance with a par-
ticular Standard. Recognition (initial recording) and measurement (subsequent valua-
tion) is specifically dealt with where appropriate.
ix
x
Introduction
5. Presentation and Disclosure describes the manner in which the financial and nonfi-
nancial items should be presented in the financial statements, as well as aspects that
should be disclosed in these financial statements—keeping in mind the needs of vari-
ous users. Users of financial statements include investors; employees; lenders; suppli-
ers or trade creditors; governments; tax and regulatory authorities; and the public.
6. Financial Analysis and Interpretation discusses items of interest to the financial ana-
lyst in chapters where such a discussion is deemed appropriate. It must be emphasized
that none of the discussion in these sections should be interpreted as a criticism of
IFRS. Where analytical preferences and practices are highlighted, it is to alert the reader
to the challenges still remaining along the road to convergence of international account-
ing practices and unequivocal adoption of IFRS.
7. Examples are included at the end of most chapters. These examples are intended as
further illustration of the concepts contained in the IFRS.
The author hopes that managers in the client countries of the World Bank will find this for-
mat useful in establishing accounting terminology, especially where certain terms are still in
the exploratory stage. Feedback in this regard is welcome.
CONTENT INCLUDED
All of the accounting Standards issued by the International Accounting Standards Board
(IASB) until 31 May 2006 are included in this publication. The IASB texts are the ultimate
authority—this publication constitutes a summary.
PARTI
Presentation
1
Framework for the
Preparation and Presentation
of Financial Statements
1.1
PROBLEMS ADDRESSED
An acceptable coherent framework of fundamental accounting principles is essential for prepar- | Hennie |
ing financial statements. The major reasons for providing the framework are to:
•
identify the essential concepts underlying the preparation and presentation of financial
statements;
• guide standards setters in developing accounting standards;
• assist preparers, auditors, and users to interpret the International Financial Reporting
Standards (IFRS); and
• provide principles as not all issues are covered by the IFRS.
1.2
SCOPE OF THE FRAMEWORK
The existing framework deals with the:
• objectives of financial statements,
• qualitative characteristics of financial statements,
• elements of financial statements,
• recognition of the elements of financial statements,
• measurement of the elements of financial statements, and
• concepts of capital and capital maintenance.
A future framework which is currently under discussion might deal with:
• objectives of financial reporting and qualitative characteristics of financial reporting
information,
initial and subsequent measurement
• elements of financial statements, recognition and measurement attributes
•
• the reporting entity
• presentation and disclosure (including reporting boundaries)
The framework is not a standard, but is used extensively by the IASB and by its interpreta-
tions committee, the IFRIC (International Financial Reporting Interpretations Committee).
3
4
Chapter 1 Framework for the Preparation and Presentation of Financial Statements
1.3
KEY CONCEPTS
OBJECTIVES OF FINANCIAL STATEMENTS
1.3.1 The objective of financial statements is to provide information about the financial
position (balance sheet), performance (income statement), and changes in financial posi-
tion (cash flow statement) of an entity; this information should be useful to a wide range of
users for the purpose of making economic decisions, focusing on users who cannot dictate
the information they should be getting.
1.3.2 Fair presentation is achieved through the provision of useful information (full disclo-
sure) in the financial statements, whereby transparency is secured. If one assumes that fair
presentation is equivalent to transparency, a secondary objective of financial statements can
be defined: to secure transparency through full disclosure and provide a fair presentation of
useful information for decision making purposes.
QUALITATIVE CHARACTERISTICS
1.3.3 Qualitative characteristics are the attributes that make the information provided in
financial statements useful to users:
• Relevance. Relevant information influences the economic decisions of users, helping
them to evaluate past, present, and future events or to confirm or correct their past
evaluations. The relevance of information is affected by its nature and materiality.
• Reliability. Reliable information is free from material error and bias and can be depend-
ed upon by users to represent faithfully that which it either purports to represent or
could reasonably be expected to represent. The following factors contribute to reliability:
faithful representation
substance over form
neutrality
prudence
completeness
• Comparability. Information should be presented in a consistent manner over time and
in a consistent manner between entities to enable users to make significant compar-
isons.
• Understandability. Information should be readily understandable by users who have a
basic knowledge of business, economic activities, and accounting, and who have a will-
ingness to study the information with reasonable diligence.
1.3.4 The following are the underlying assumptions of financial statements (see Figure 1.1
at end of chapter):
• Accrual basis. Effects of transactions and other events are recognized when they occur
(not when the cash flows). These effects are recorded and reported in the financial
statements of the periods to which they relate.
• Going concern. It is assumed that the entity will continue to operate for the foreseeable
future.
1.3.5 The following are constraints on providing relevant and reliable information:
• Timeliness. Undue delay in reporting could result in loss of relevance but improve reli-
ability.
| Hennie |
• Benefit versus cost. Benefits derived from information should exceed the cost of pro-
viding it.
Chapter 1 Framework for the Preparation and Presentation of Financial Statements
5
1.3.6 Balancing of qualitative characteristics. To meet the objectives of financial statements
and make them adequate for a particular environment, providers of information must
achieve an appropriate balance among qualitative characteristics.
1.3.7 The application of the principal qualitative characteristics and the appropriate
accounting standards normally results in financial statements that provide fair presentation.
1.3.8 Balancing qualitative characteristics: The aim is to achieve a balance among charac-
teristics in order to meet the objective of financial statements.
1.4
ACCOUNTING TREATMENT
ELEMENTS OF FINANCIAL STATEMENTS
1.4.1 The following elements of financial statements are directly related to the measure-
ment of the financial position:
• Assets. Resources controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity
• Liabilities. Present obligations of an entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of economic benefits
• Equity. Assets less liabilities (commonly known as shareholders’ funds)
1.4.2 The following elements of financial statements are directly related to the measurement
of performance:
• Income. Increases in economic benefits in the form of inflows or enhancements of
assets, or decreases of liabilities that result in an increase in equity (other than increases
resulting from contributions by owners). Income embraces revenue and gains.
• Expenses. Decreases in economic benefits in the form of outflows or depletion of
assets, or incurrences of liabilities that result in decreases in equity (other than decreas-
es because of distributions to owners).
INITIAL RECOGNITION OF ELEMENTS
1.4.3 A financial statement element (assets, liabilities,equity, income and expenses) should
be recognized in the financial statements if:
• It is probable that any future economic benefit associated with the item will flow to or
from the entity; and
• The item has a cost or value that can be measured with reliability.
SUBSEQUENT MEASUREMENT OF ELEMENTS
1.4.4 The following bases are used to different degrees and in varying combinations to mea-
sure elements of financial statements:
• Historical cost.
• Current cost.
• Realizable (settlement) value.
• Present value (fair market value).
Fair value has to be used in the measurement of financial instruments, but is available as a
choice for property, plant and equipment, intangible assets, and agricultural products.
6
Chapter 1 Framework for the Preparation and Presentation of Financial Statements
CAPITAL MAINTENANCE CONCEPTS
1.4.5 Concepts of capital and capital maintenance include:
• Financial capital. Capital is synonymous with net assets or equity; it is defined in
terms of nominal monetary units. Profit represents the increase in nominal money capi-
tal over the period.
• Physical capital. Capital is regarded as the operating capability; it is defined in terms of
productive capacity. Profit represents the increase in productive capacity over the period.
1.5
PRESENTATION AND DISCLOSURE: THE CASE FOR TRANSPARENT
FINANCIAL STATEMENT PREPARATION
1.5.1 The provision of transparent and useful information on market participants and their
transactions is essential for an orderly and efficient market, and it is one of the most impor-
tant preconditions for imposing market discipline. Left to themselves, markets cannot gen-
erate sufficient levels of disclosure. Market forces would normally balance the marginal ben-
efits and marginal costs of additional information disclosure and the end result might not be
what the market participants really need.
1.5.2 Financial and capital market liberalization trends of the 1980s, which brought increas-
ing volatility in financial markets, increased the need for information as a means to ensure | Hennie |
financial stability. In the 1990s, as financial and capital market liberalization increased, there
was mounting pressure for the provision of useful information in both the financial and pri-
vate sectors; minimum disclosure requirements now dictate the quality and quantity of infor-
mation that must be provided to the market participants and to the general public. Because
the provision of information is essential to promote the stability of the markets, regulatory
authorities also view the quality of information as a high priority. Once the quality of infor-
mation required by market participants and regulatory authorities is improved, entities
would do well to improve their own internal information systems to develop a reputation for
providing good quality information.
1.5.3 The public disclosure of information is predicated on the existence of good account-
ing standards and adequate disclosure methodology. This public disclosure normally
involves publication of relevant qualitative and quantitative information in annual financial
reports, which are often supplemented by interim financial statements and other relevant
information. The provision of information involves cost; therefore, when determining dis-
closure requirements, the usefulness of information for the public must be evaluated against
the cost to be borne by the entity.
1.5.4 The timing of disclosure is also important. Disclosure of negative information to a
public not yet sufficiently sophisticated to interpret the information can damage the entity in
question. When information is of inadequate quality or the users are not deemed capable to
properly interpret the information, or both, public disclosure requirements should be care-
fully phased in and progressively tightened. In the long run, a full disclosure regime is ben-
eficial, even if some problems are experienced in the short term, because the cost to the finan-
cial system of not being transparent is ultimately higher than the cost of being transparent.
TRANSPARENCY AND ACCOUNTABILITY
1.5.5 Transparency refers to the principle of creating an environment where information on
existing conditions, decisions, and actions are made accessible, visible, and understandable
to all market participants. Disclosure refers to the process and methodology of providing the
information and making policy decisions known through timely dissemination and open-
ness. Accountability refers to the need for market participants, including the authorities, to
justify their actions and policies and accept responsibility for their decisions and results.
Chapter 1 Framework for the Preparation and Presentation of Financial Statements
7
1.5.6 Transparency is necessary for the concept of accountability to take hold among the
major groups of market participants: borrowers and lenders; issuers and investors; and
national authorities and international financial institutions.
1.5.7 Transparency and accountability have become strongly debated topics in discussions
of economic policy over the past decade. Policymakers had become accustomed to secrecy.
Secrecy was viewed as a necessary ingredient for the exercise of authority, with an added
benefit of hiding the incompetence of policymakers. However, secrecy also prevents policies
from having the desired effects. The changed world economy and financial flows, which
brought increasing internationalization and interdependence, have put the transparency
issue at the forefront of economic policymaking. National governments, including central
banks, increasingly recognize that transparency (that is, the openness of policy) improves the
predictability and, hence, the efficiency of policy decisions. Transparency forces institutions
to face up to the reality of a situation and makes officials more responsible, especially if they
know they will have to justify their views, decisions, and actions afterwards. Timely policy | Hennie |
adjustments are therefore encouraged.
1.5.8 In part, the case for greater transparency and accountability rests on the need for private
sector agents to understand and accept policy decisions that will affect their behavior. Greater
transparency improves the economic decisions made by other agents in the economy.
Transparency is also a means of fostering accountability, internal discipline, and better gover-
nance. Transparency and accountability improve the quality of decisionmaking in policymaking
institutions as well as in institutions whose own decisions depend on understanding and pre-
dicting the future decisions of policymaking institutions. If actions and decisions are visible and
understandable, monitoring costs are lowered. The general public will be better able to monitor
public sector institutions; shareholders and employees will be better able to monitor corporate
management; creditors will be better able to monitor borrowers, and depositors will be better
able to monitor banks. Therefore, poor decisions will not go unnoticed or unquestioned.
1.5.9 Transparency and accountability are mutually reinforcing. Transparency enhances
accountability by facilitating monitoring, and accountability enhances transparency by pro-
viding an incentive for agents to ensure that the reasons for their actions are properly dis-
seminated and understood. Together, transparency and accountability will impose a disci-
pline that improves the quality of decisionmaking in the public sector, and will lead to more
efficient policy by improving the private sector’s understanding of how policymakers could
react to various events in the future.
1.5.10 Transparency and accountability are not ends in themselves. They are designed to
assist in increasing economic performance and can improve the working of the international
financial markets by enhancing the quality of decision making and risk management of all
market participants, including official authorities. But they are not a panacea. In particular,
transparency does not change the nature or risks inherent in financial systems. It might not
prevent financial crises, but it could moderate market participants’ response to adverse
events. Transparency then helps market participants to anticipate and qualify bad news and
thereby lessens the probability of panic and contagion.
1.5.11 One must also note that there is a dichotomy between transparency and confiden-
tiality. The release of proprietary information might give competitors an unfair advantage, a
fact that deters market participants from full disclosure. Similarly, monitoring bodies fre-
quently obtain confidential information from entities. The release of such information could
have significant market implications. Under such circumstances, entities might be reluctant
to provide sensitive information without the condition of client confidentiality. However,
unilateral transparency and full disclosure contributes to a regime of transparency, which
will ultimately benefit all market participants, even if in the short term a transition to such a
regime creates discomfort for individual entities.
8
Chapter 1 Framework for the Preparation and Presentation of Financial Statements
TRANSPARENCY AND THE CONCEPTUAL ACCOUNTING FRAMEWORK
1.5.12 As stated in §1.3.1, the objective of financial statements is to provide information
about the financial position (balance sheet), performance (income statement), and changes
in financial position (cash flow statement) of an entity that is useful to a wide range of users
in making economic decisions. The transparency of financial statements is secured through
full disclosure and by providing fair presentation of useful information necessary for mak-
ing economic decisions to a wide range of users. In the context of public disclosure, financial
statements should be easily understandable for users to interpret. Whereas more information
is better than less, the provision of information is costly. Therefore, the net benefits of pro- | Hennie |
viding more transparency should be carefully evaluated by standard setters.
1.5.13 The adoption of internationally accepted financial reporting standards is a necessary
measure to facilitate transparency and contribute to proper interpretation of financial state-
ments.
1.5.14 In the context of fair presentation, no disclosure is probably better than disclosure of
misleading information. Figure 1.1 shows how transparency is secured through the
International Financial Reporting Standards (IFRS) framework.
Chapter 1 Framework for the Preparation and Presentation of Financial Statements
9
Figure 1.1 Transparency in Financial Statements Achieved through Compliance with IASB Framework
OBJECTIVE OF FINANCIAL STATEMENTS
To provide a fair presentation of:
• Financial position
• Financial performance
• Cash flows
TRANSPARENCY AND FAIR PRESENTATION
• Fair presentation achieved through providing useful information (full disclosure)
which secures transparency
• Fair presentation equates transparency
SECONDARY OBJECTIVE OF FINANCIAL STATEMENTS
To secure transparency through a fair presentation of useful information (full disclosure)
for decision making purposes
ATTRIBUTES OF USEFUL INFORMATION
Existing Framework
• Relevance
• Reliability
• Comparability
• Understandability
Constraints
• Timeliness
• Benefit vs. Cost
• Balancing the qualitative characteristics
Alternative Views
• Relevance
• Predictive Value
• Faithful Representation
• Free from Bias
• Verifiable
UNDERLYING ASSUMPTIONS
Accrual basis
Going concern
10
Chapter 1 Framework for the Preparation and Presentation of Financial Statements
EXAMPLE: FRAMEWORK FOR THE PREPARATION AND PRESENTATION
OF FINANCIAL STATEMENTS
EXAMPLE 1.1
Chemco Inc. is engaged in the production of chemical products and selling them locally. The
corporation wishes to extend its market and export some of its products. It has come to the
attention of the financial director that compliance with international environmental require-
ments is a significant precondition if it wishes to sell products overseas. Although the cor-
poration has during the past put in place a series of environmental policies, it is clear that it
is also common practice to have an environmental audit done from time to time, which will
cost approximately $120,000. The audit will encompass the following:
• Full review of all environmental policy directives
• Detailed analysis of compliance with these directives
• Report containing in-depth recommendations of those physical and policy changes that
would be necessary to meet international requirements
The financial director of Chemco Inc. has suggested that the $120,000 be capitalized as an
asset and then written off against the revenues generated from export activities so that the
matching of income and expense will occur.
EXPLANATION
The costs associated with the environmental audit can be capitalized only if they meet the def-
inition and recognition criteria for an asset. The IASB’s Framework does not allow the recog-
nition of items in the balance sheet that do not meet the definition or recognition criteria.
In order to recognize the costs of the audit as an asset, it should meet both the
• definition of an asset, and
• recognition criteria for an asset.
In order for the costs associated with the environmental audit to comply with the definition
of an asset (see §1.4.1), the following should be valid:
(i) The costs must give rise to a resource controlled by Chemco Inc.
(ii) The asset must arise from a past transaction or event, namely the audit.
(iii) The asset must be expected to give rise to a probable future economic benefit that will
flow to the corporation, namely the revenue from export sales.
The requirements in terms of (i) and (iii) are not met. Therefore, the entity cannot capitalize
these costs due to the absence of fixed orders and detailed analyses of expected economic
benefits.
In order to recognize the costs as an asset in the balance sheet, it has to comply with the
recognition criteria (see §1.4.3), namely:
| Hennie |
• The asset should have a cost that can be measured reliably.
• The expected inflow of future economic benefits must be probable.
In order to properly measure the carrying value of the asset, the corporation must be able to
demonstrate that further costs will be incurred that would give rise to future benefits.
However, the second requirement poses a problem because of insufficient evidence of the
probable inflow of economic benefits and would therefore again disqualify the costs once
again for capitalizing as an asset.
2 First-Time Adoption
of IFRS (IFRS 1)
2.1
PROBLEMS ADDRESSED
Specific issues occur with the first time adoption of IFRS. IFRS 1 aims to ensure that the enti-
ty’s first financial statements (including interim financial reports for that specific reporting
period) under IFRS provide a suitable starting point, are transparent to users, and are com-
parable over all periods presented.
2.2
SCOPE OF THE STANDARD
This Standard applies when an entity adopts IFRS for the first time by an explicit and unre-
served statement of compliance with IFRS.
The Standard specifically covers:
identification of the basis of reporting,
• comparable (prior period) information that is to be provided,
•
• retrospective application of IFRS information,
• formal identification of the reporting and the transition date.
The IFRS requires an entity to comply with each individual standard effective at the report-
ing date for its first IFRS-compliant financial statements. Subject to certain exceptions and
exemptions, IFRS should be applied retrospectively. Therefore, the comparative amounts,
including the opening balance sheet for the comparative period, should be restated from
national generally accepted accounting principles (GAAP) to IFRS.
2.3
KEY CONCEPTS
2.3.1 The reporting date is the balance sheet date of the first financial statements that
explicitly state that they comply with IFRS (for example, December 31, 2005).
2.3.2 The transition date is the date of the opening balance sheet for the prior year com-
parative financial statements (for example, January 1, 2004, if the reporting date is December
31, 2005).
11
12
Chapter 2 First-Time Adoption of IFRS (IFRS 1)
2.4
ACCOUNTING TREATMENT
OPENING BALANCE SHEET
2.4.1 The opening IFRS balance sheet as at the transition date should
• recognize all assets and liabilities whose recognition is required by IFRS; but
• not recognize items as assets or liabilities whose recognition is not permitted by IFRS.
2.4.2 With regard to event-driven fair values, if fair value had been used for some or all
assets and liabilities under a previous GAAP, these fair values can be used as the IFRS
“deemed costs” at date of measurement.
2.4.3 When preparing the opening balance sheet:
• Recognize all assets and liabilities whose recognition is required by IFRS. Examples of
changes from national GAAP are derivatives, leases, pension liabilities and assets, and
deferred tax on revalued assets. Adjustments required are debited or credited to equity.
• Remove assets and liabilities whose recognition is not permitted by IFRS. Examples of
changes from national GAAP are deferred hedging gains and losses, other deferred
costs, some internally generated intangible assets, and provisions. Adjustments
required are debited or credited to equity.
• Reclassify items that should be classified differently under IFRS. Examples of changes
from national GAAP are financial assets, financial liabilities, leasehold property, com-
pound financial instruments, and acquired intangible assets (reclassified to goodwill).
Adjustments required are reclassifications between balance sheet items.
• Apply IFRS in measuring assets and liabilities by using estimates that are consistent
with national GAAP estimates and conditions at the transition date. Examples of
changes from national GAAP are deferred taxes, pensions, depreciation, or impairment
of assets. Adjustments required are debited or credited to equity.
| Hennie |
2.4.4 Derecognition criteria of financial assets and liabilities are applied prospectively
from the transition date. Therefore, financial assets and financial liabilities which have been
derecognized under national GAAP are not reinstated. However:
• All derivatives and other interests retained after derecognition and existing at transi-
tion date must be recognized.
• All special purposed entities (SPE) controlled as at transition date must be consolidated.
Derecognition criteria can be applied retrospectively provided that the information needed
was obtained when initially accounting for the transactions.
2.4.5 Cumulative foreign currency translation differences on translation of financial state-
ments of a foreign operation can be deemed to be zero at transition date. Any subsequent
gain or loss on disposal of operation excludes pretransition date translation differences.
ASSETS
2.4.6 With regard to property plant and equipment, the following amounts can be used as
IFRS deemed cost:
• Fair value at transition date
• Pretransition date revaluations, if the revaluation was broadly comparable to either
• fair value, or
• (depreciated) cost adjusted for a general or specific price index
Chapter 2 First-Time Adoption of IFRS (IFRS 1)
13
2.4.7 With regard to investment property, the following amounts can be used as IFRS
“deemed cost” under the cost model:
• Fair value at transition date
• Pretransition date revaluations, if the revaluation was broadly comparable to either
• fair value, or
• (depreciated) cost adjusted for a general or specific price index
If a fair value model is used no exemption is granted.
2.4.8 With regard to intangible assets, the following amounts can be used as deemed cost,
provided that there is an active market for the assets:
• Fair value at transition date
• Pretransition date revaluations if the revaluation was broadly comparable to either
• fair value, or
• (depreciated) cost adjusted for general or specific price index
2.4.9 With regard to defined benefit plans, the full amount of the liability or asset must be
recognized, but deferrals of actuarial gains and losses at transition date can be set to zero. For
posttransition date actuarial gains and losses, one could apply the corridor approach or any
other acceptable method of accounting for such gains and losses.
2.4.10 Previously recognized financial instruments can be designated as trading or avail-
able for sale—from the transition date, rather than initial recognition.
2.4.11 Financial instruments comparatives for IAS 32 and IAS 39 need not be restated in
the first IFRS financial statements. Previous national GAAP should be applied to compara-
tive information for instruments covered by IAS 32 and IAS 39. The major adjustments to
comply with IAS 32 and IAS 39 must be disclosed, but need not be quantified. Adoption of
IAS 32 and IAS 39 should be treated as a change in accounting policy.
2.4.12 If the liability portion of a compound instrument is not outstanding at the transition
date an entity need not separate equity and liability components, thereby avoiding reclassi-
fications within equity.
2.4.13 Hedge accounting should be applied prospectively from the transition date, provid-
ed that hedging relationships are permitted by IAS 39 and that all designation, documenta-
tion, and effectiveness requirements are met from the transition date.
BUSINESS COMBINATIONS
2.4.14 It is not necessary to restate pretransition date business combinations. If any are restat-
ed, all later combinations must be restated. If information related to prior business combinations
are not restated, the same classification (acquisition, reverse acquisition, and uniting of interests)
must be retained. Previous GAAP carrying amounts are treated as deemed costs for IFRS pur-
poses. However, those IFRS assets and liabilities which are not recognized under national GAAP
must be recognized, and those which are not recognized under IFRS must be removed.
2.4.15 With regard to business combinations and resulting goodwill, if pretransition date | Hennie |
business combinations are not restated, then
• goodwill for contingent purchase consideration resolved before transition date should
be adjusted,
• any non-IFRS acquired intangible assets (not qualifying as goodwill) should be reclassified,
• an impairment test should be carried out on goodwill, and
• any existing negative goodwill should be credited to equity.
14
Chapter 2 First-Time Adoption of IFRS (IFRS 1)
2.4.16 Foreign currency translation and pretransition date goodwill and fair value adjust-
ments should be treated as assets and liabilities of the acquirer, not the acquiree. They are not
restated for postacquisition changes in exchange rates—either pre- or posttransition date.
EXEMPTIONS
2.4.17 Exemptions in respect of the retrospective application of IFRS, relate to the following:
• Business combinations prior to the transition date
• Fair value or revalued amounts, which can be taken as deemed costs
• Employee benefits
• Cumulative foreign currency translation differences, goodwill, and fair value adjustments
• Financial instruments, including hedge accounting
2.5
PRESENTATION AND DISCLOSURE
2.5.1 A statement should be made to the effect that the financial statements are being pre-
pared in terms of IFRS for the first time.
2.5.2 Prior information that cannot be easily converted to IFRS should be dealt with as follows:
• Any previous GAAP information should be prominently labeled as not being prepared
under IFRS.
• Where the adjustment to the opening balance of retained earnings cannot be reasonably
determined, that fact should be stated.
2.5.3 Where IFRS 1 permits a choice of transitional accounting policies, the policy selected
should be stated.
2.5.4 The way in which the transition from previous GAAP to IFRS has affected the report-
ed financial position, financial performance, and cash flows should be explained.
2.5.5 With regard to reporting date reconciliations from national GAAP (assume
December 31, 2005), the following must be disclosed:
• Equity reconciliation at the transition date (January 1, 2004) and at the end of the last
national GAAP period (December 31, 2004)
• Profit reconciliation for the last national GAAP period (December 31, 2004)
2.5.6 With regard to interim reporting reconciliations (assume interim report to June 30,
2005 and reporting date to be December 31, 2005), the following must be disclosed:
• Equity reconciliation at the transition date (January 1, 2004), at the prior year compara-
tive date (June 30, 2004), and at the end of last national GAAP period (December 31,
2004)
• Profit reconciliation for the last national GAAP period (December 31, 2004) and for the
prior year comparative date (June 30, 2004)
2.5.7 Impairment losses are disclosed as follows:
• Recognized or reversed on transition to IFRS
• IAS 36 disclosures as if recognized or reversed in period beginning on transition date
2.5.8 Use of fair values as deemed costs is as follows:
• Disclosed aggregate amounts for each line item
• Disclosed adjustment from national GAAP for each line item
3 Presentation of Financial
Statements (IAS 1)
3.1
PROBLEMS ADDRESSED
The objective of this Standard is to prescribe the basis for presentation of general purpose
financial statements and what is necessary for these statements to be in accord with IFRS. The
key issues are to ensure comparability both with the entity’s financial statements of previous
periods and with the financial statements of other entities. It also enables informed users to
rely on a formal definable structure and facilitates financial analysis.
3.2
SCOPE OF THE STANDARD
IAS 1 outlines:
• what constitutes a complete set of financial statements (namely balance sheet, income
statement, statement of changes in equity, cash flow statement and accounting policies
and notes),
• overall requirements for the presentation of financial statements including guidelines
for their structure,
• the distinction between current and non-current elements, and
• minimum requirements for financial statement content.
IAS 1 is currently under discussion in a new Exposure Draft, issued in March 2006, with first | Hennie |
comments due in July 2006. Performance reporting and the reporting of comprehensive
income are major issues to be dealt with and voluntary name changes are suggested for key
financial statements.
3.3
KEY CONCEPTS
3.3.1 Fair presentation. The financial statements should present fairly the financial posi-
tion, financial performance, and cash flows of the entity. Fair presentation requires the faith-
ful representation of the effects of transactions, other events, and conditions in accordance
with the definitions and recognition criteria for assets, liabilities, income, and expenses set
out in the Framework. The application of this IFRS is presumed to result in fair presentation.
3.3.2 Departure from the requirements of an IFRS is allowed only in the extremely rare cir-
cumstances in which the application of the IFRS would be so misleading as to conflict with
15
16
Chapter 3 Presentation of Financial Statements (IAS 1)
the objectives of financial statements. In such circumstances, the entity should disclose the
reasons for and the financial effect of the departure from the IFRS.
3.3.3 Current assets are:
• Assets expected to be realized or intended for sale or consumption in the entity’s nor-
mal operating cycle
• Assets held primarily for trading
• Assets expected to be realized within 12 months after the balance sheet date
• Cash or cash equivalents, unless restricted in use for at least 12 months
3.3.4 Current liabilities are:
• Liabilities expected to be settled in the entity’s normal operating cycle
• Liabilities held primarily for trading
• Liabilities due to be settled within 12 months after the balance sheet date
3.3.5 Noncurrent assets and liabilities are expected to be settled more than 12 months after
the balance sheet date.
3.3.6 The portion of noncurrent interest-bearing liabilities to be settled within 12 months
after the balance sheet date can be classified as noncurrent liabilities if
• the original term is greater than 12 months,
• it is the intention to refinance or reschedule the obligation, or
• the agreement to refinance or reschedule the obligation is completed on or before the
balance sheet date.
3.4
ACCOUNTING TREATMENT
3.4.1 Financial statements should provide information about an entity’s financial position,
performance, and cash flows, that is useful to a wide range of users for economic decision-
making.
3.4.2 Departure from the requirements of an IFRS is allowed only in the extremely rare cir-
cumstances in which the application of the IFRS would be so misleading as to conflict with the
objectives of financial statements. In such circumstances, the entity should disclose the reasons
for and the financial effect of the departure from the IFRS.
3.4.3 The presentation and classification of items should be consistent from one period to
another unless a change would result in a more appropriate presentation, or a change is
required by the IFRS.
3.4.4 A complete set of financial statements comprises the following:
• Balance sheet
• Income statement
• Statement of changes in equity
• Cash flow statement
• Accounting policies and notes
Entities are encouraged to furnish other related financial and nonfinancial information in
addition to the financial statements.
Chapter 3 Presentation of Financial Statements (IAS 1)
17
3.4.5 Fair presentation. The financial statements should present fairly the financial position,
financial performance, and cash flows of the entity.
• The following aspects should be addressed with regard to compliance with the IFRS:
• Compliance with the IFRS should be disclosed.
• Compliance with all requirements of each standard is compulsory.
• Disclosure does not rectify inappropriate accounting treatments.
• Premature compliance with an IFRS should be mentioned.
3.4.6 Financial statements should be presented on a going concern basis unless manage-
ment intends to liquidate the entity or cease trading. If not presented on a going concern
basis, the fact and rationale for not using it should be disclosed. Uncertainties related to | Hennie |
events and conditions that cast significant doubt on the entity’s ability to continue as a going
concern should be disclosed.
3.4.7 The accrual basis for presentation should be used, except for the cash flow statement.
3.4.8 Aggregation of immaterial items of a similar nature and function is allowed. Material
items should not be aggregated.
3.4.9 Assets and liabilities should not be offset unless allowed by the IFRS (see Chapter 35
[IAS 32]). However, immaterial gains, losses, and related expenses arising from similar trans-
actions and events can be offset.
3.4.10 With regard to comparative information, the following aspects are presented:
• Numerical information in respect of the previous period
• Relevant narrative and descriptive information
3.5
PRESENTATION AND DISCLOSURE
3.5.1 Identification and period to which the statements relate, including:
• Financial statements should be clearly distinguished from other information.
• Each component should be clearly identified.
• The following should be prominently displayed:
• Name of reporting entity
• Own statements distinct from group statements
• Reporting date or period
• Reporting currency
• Level of precision.
3.5.2 The balance sheet provides information about the financial position of the entity. It
should distinguish between major categories and classifications of assets and liabilities.
3.5.3 Current or noncurrent distinction. The balance sheet should normally distinguish
between current and noncurrent assets, and between current and noncurrent liabilities.
Disclose amounts to be recovered or settled within 12 months.
3.5.4 Liquidity based presentation. Where a presentation based on liquidity provides more
relevant and reliable information (for example, in the case of a bank or similar financial insti-
18
Chapter 3 Presentation of Financial Statements (IAS 1)
tution), assets and liabilities should be presented in the order in which they can or might be
required to be liquidated.
3.5.5. Current assets are:
• Assets expected to be realized or intended for sale or consumption in the entity’s nor-
mal operating cycle
• Assets held primarily for trading
• Assets expected to be realized within 12 months after the balance sheet date
• Cash or cash equivalents unless restricted in use for at least 12 months
3.5.6 Current liabilities are:
• Liabilities expected to be settled in the entity’s normal operating cycle
• Liabilities held primarily for trading
• Liabilities due to be settled within 12 months after the balance sheet date
3.5.7 Long-term interest-bearing liabilities to be settled within 12 months after the balance
sheet date can be classified as noncurrent liabilities if:
• The original term of the liability is greater than 12 months
• It is the intention to refinance or reschedule the obligation
• The agreement to refinance or reschedule the obligation is completed on or before the
balance sheet date
3.5.8 Capital disclosures encompass the following:
• The entity’s objectives, policies, and processes for managing capital
• Quantitative data about what the entity regards as capital
• Whether the entity complies with any capital (adequacy) requirements
• Consequences of noncompliance with capital requirements where applicable
• For each class of share capital:
• Number of shares authorized
• Number of shares issued and fully paid
• Number of shares issued and not fully paid
• Par value per share, or that it has no par value
• Reconciliation of shares at beginning and end of year
• Rights, preferences, and restrictions attached to that class
• Shares in the entity held by entity, subsidiaries, or associates
• Reserved for issue under options and sales contracts
Chapter 3 Presentation of Financial Statements (IAS 1)
19
3.5.9 Minimum information on the face of the balance sheet:
Assets
Liabilities
Trade and other payables
Provisions
Financial liabilities
Current tax liabilities
Deferred tax liabilities
Reserves
Minority interest
Parent shareholders’ equity
Liabilities included in disposal groups
held for sale
Property, plant, and equipment | Hennie |
Investment property
Intangible assets
Financial assets
Investments accounted for by the
equity method
Biological assets
Deferred tax assets
Inventories
Trade and other receivables
Current tax assets
Cash and cash equivalents
Assets held for sale (see IFRS 5)
Assets included in disposal groups
held for sale (see IFRS 5)
3.5.10 Other information on the face of the balance sheet or in notes:
• Nature and purpose of each reserve
• Shareholders for dividend not formally approved for payment
• Amount of cumulative preference dividend not recognized.
3.5.11 Information about performance of the entity should be provided in the income state-
ment. Minimum information on the face of the income statement includes:
• Revenue
• Finance costs
• Share of profits or losses of associates and joint ventures
• Tax expense
• Discontinued operations
• Profit or loss
• Profit or loss attributable to minority interest
• Profit or loss attributable to equity shareholders of parent
3.5.12 Other information on the face of the income statement or in notes includes:
• Analysis of expenses based on nature or their function (see Example at end of chapter)
• If classified by function, disclosure of the following:
• Depreciation charges for tangible assets
• Amortization charges for intangible assets
• Employee benefits expense
• Dividends recognized and the related amount per share
• Extraordinary Items. IFRS no longer allow the presentation of any items of income
or expense as extraordinary items.
20
Chapter 3 Presentation of Financial Statements (IAS 1)
3.5.13 The statement of changes in equity reflects information about the increase or
decrease in net assets or wealth.
3.5.14 Minimum information on the face of the changes in equity statement includes:
• Profit or loss for the period
• Each item of income or expense recognized directly in equity
• Total of above two items showing separately amounts attributable to minority share-
holders and parent shareholders
• Effects of changes in accounting policy
• Effects of correction of errors
3.5.15 Other information on the face of the changes in equity statement or in notes
includes:
• Capital transactions with owners and distributions to owners
• Reconciliation of the balance of accumulated profit or loss at beginning and end of the
year
• Reconciliation of the carrying amount of each class of equity capital, share premium,
and each reserve at beginning and end of the period
3.5.16 For a discussion of the cash flow statement refer to IAS 7 (Chapter 4).
3.5.17 Accounting policies and notes include information that must be provided in a sys-
tematic manner and cross-referenced from the face of the financial statements to the notes:
Disclosure of accounting policies
• Measurement bases used in preparing financial statements
• Each accounting policy used even if it is not covered by the IFRS
• Judgments made in applying accounting policies that have the most significant effect
on the amounts recognized in the financial statements
Estimation Uncertainty
• Key assumptions about the future and other key sources of estimation uncertainty that
have a significant risk of causing material adjustment to the carrying amount of assets
and liabilities within the next year
3.5.18 Other disclosures include the following:
• Domicile of the entity
• Legal form of the entity
• Country of incorporation
• Registered office or business address, or both
• Nature of operations or principal activities, or both
• Name of the parent and ultimate parent
3.6
FINANCIAL ANALYSIS AND INTERPRETATION
3.6.1 Financial analysis is the discipline whereby analytical tools are applied to financial
statements and other financial data in order to interpret trends and relationships in a consis-
tent and disciplined manner. In essence, the analyst is in the business of converting data into
information, and thereby assisting in a diagnostic process that has as its objective the screen-
ing and forecasting of information.
Chapter 3 Presentation of Financial Statements (IAS 1)
21
3.6.2 The financial analyst who is interested in assessing the value or creditworthiness of an | Hennie |
entity is required to estimate its future cash flows, assess the risks associated with those esti-
mates, and determine the proper discount rate that should be applied to those estimates. The
objective of the IFRS financial statements is to provide information which is useful to users in
making economic decisions. However, IFRS financial statements do not contain all the informa-
tion that an individual user might need to perform all of the above tasks, because they largely
portray the effects of past events and do not necessarily provide nonfinancial information. IFRS
financial statements do contain data about the past performance of an entity (its income and
cash flows), as well as its current financial condition (assets and liabilities) that are useful in
assessing future prospects and risks. The financial analyst must be capable of using the financial
statements in conjunction with other information in order to reach valid investment conclusions.
3.6.3 The notes to financial statements are an integral part of the IFRS financial reporting
process. They provide important detailed disclosures required by IFRS, as well as other infor-
mation provided voluntarily by management. The notes include information on such topics
as the following:
• Specific accounting policies that were used in compiling the financial statements
• Terms of debt agreements
• Lease information
• Off-balance sheet financing
• Breakdowns of operations by important segments
• Contingent assets and liabilities
• Detailed pension plan disclosure
3.6.4 Supplementary schedules can be provided in financial reports to present additional
information that can be beneficial to users. These schedules include such information as the
5-year performance record of a company, a breakdown of unit sales by product line, a listing
of mineral reserves, and so forth.
3.6.5 The management of publicly traded companies in certain jurisdictions, such as the
United States, is required to provide a discussion and analysis of the company’s operations
and prospects. This discussion normally includes:
• A review of the company’s financial condition and its operating results
• An assessment of the significant effects of currently known trends, events, and uncer-
tainties on the company’s liquidity, capital resources, and operating results
• The capital resources available to the firm and its liquidity
• Extraordinary or unusual events (including discontinued operations) that have a mate-
rial effect on the company
• A review of the performance of the operating segments of the business that have a sig-
nificant impact on the business or its finances
The publication of such a report is encouraged, but is currently not required by IFRS.
3.6.6 Ratio analysis is used by analysts and managers to assess company performance and
status. Ratios are not meaningful when used on their own, which is why trend analysis (the
monitoring of a ratio or group of ratios over time) and comparative analysis (the comparison
of a specific ratio for a group of companies in a sector, or for different sectors) is preferred by
financial analysts. Another analytical technique of great value is relative analysis, which is
achieved through the conversion of all balance sheet (or income statement items) to a per-
centage of a given balance sheet (or income statement) item.
3.6.7 Although financial analysts use a variety of subgroupings to describe their analysis,
the following classifications of risk and performance are often used:
22
Chapter 3 Presentation of Financial Statements (IAS 1)
• Liquidity. An indication of the entity’s ability to repay its short-term liabilities, mea-
sured by evaluating components of current assets and current liabilities
• Solvency. The risk related to the volatility of income flows often described as business
risk (resulting from the volatility related to operating income, sales, and operating
leverage) and financial risk (resulting from the impact of the use of debt on equity
returns as measured by debt ratios and cash flow coverage)
| Hennie |
• Operational efficiency. Determination of the extent to which an entity uses its assets
and capital efficiently, as measured by asset and equity turnover
• Growth. The rate at which an entity can grow as determined by its retention of profits
and its profitability measured by return on equity (ROE)
• Profitability. An indication of how a company’s profit margins relate to sales, average
capital, and average common equity. Profitability can be further analyzed through the
use of the Du Pont analysis
3.6.8 Some have questioned the usefulness of financial statement analysis in a world where
capital markets are said to be efficient. After all, they say, an efficient market is forward look-
ing, whereas the analysis of financial statements is a look at the past. However, the value of
financial analysis is that it enables the analyst to gain insights that can assist in making for-
ward-looking projections required by an efficient market. Financial ratios serve the following
purposes:
• They provide insights into the microeconomic relationships within a firm that help ana-
lysts project earnings and free cash flow (which is necessary to determine entity value
and creditworthiness).
• They provide insights into a firm’s financial flexibility, which is its ability to obtain the
cash required to meet financial obligations or to make asset acquisitions, even if unex-
pected circumstances should develop. Financial flexibility requires a firm to possess
financial strength (a level and trend of financial ratios that meet or exceed industry
norms); lines of credit; or assets that can be easily used as a means of obtaining cash,
either by their outright sale or by using them as collateral.
• They provide a means of evaluating management’s ability. Key performance ratios,
such as the return on equity, can serve as quantitative measures for ranking manage-
ment’s ability relative to a peer group.
3.6.9 Financial ratio analysis is limited by:
• The use of alternative accounting methods. Accounting methods play an important
role in the interpretation of financial ratios. It should be remembered that ratios are
usually based on data taken from financial statements. Such data are generated via
accounting procedures that might not be comparable among firms, because firms have
latitude in the choice of accounting methods. This lack of consistency across firms
makes comparability difficult to analyze and limits the usefulness of ratio analysis. The
various accounting alternatives currently found (but not necessarily allowed by IFRS)
include the following:
• First-in-first-out (FIFO) or last-in-first-out (LIFO) inventory valuation methods
• Cost or equity methods of accounting for unconsolidated associates
• Straight-line or accelerated consumption pattern methods of depreciation
• Capitalized or operating lease treatment
The use of IFRS seeks to make the financial statements of different entities compara-
ble and so overcome these difficulties.
• The homogeneity of a firm’s operating activities. Many firms are diversified with
divisions operating in different industries. This makes it difficult to find comparable
industry ratios to use for comparison purposes. It is better to examine industry-specific
ratios by lines of business.
Chapter 3 Presentation of Financial Statements (IAS 1)
23
• The need to determine whether the results of the ratio analysis are consistent. One
set of ratios might show a problem and another set might prove that this problem is
short–term in nature, with strong long-term prospects.
• The need to use judgment. The analyst must use judgment when performing ratio
analysis. A key issue is whether a ratio for a firm is within a reasonable range for an
industry, with this range being determined by the analyst. Although financial ratios are
used to help assess the growth potential and risk of a business they cannot be used
alone to directly value a company or determine its creditworthiness. The entire opera-
tion of the business must be examined, and the external economic and industry setting | Hennie |
in which it is operating must be considered when interpreting financial ratios.
3.6.10 Financial ratios mean little by themselves. Their meaning can only be gleaned by
using them in the context of other information. In addition to the items mentioned in 3.6.9
above, an analyst should evaluate financial ratios based on:
• Experience. An analyst with experience obtains a feel for the right ratio relationships.
• Company goals. Actual ratios can be compared with company objectives to determine
if the objectives are being attained.
• Industry norms (cross-sectional analysis). A company can be compared with others in
its industry by relating its financial ratios to industry norms or a subset of the compa-
nies in an industry. When industry norms are used to make judgments, care must be
taken, because:
• Many ratios are industry specific, but not all ratios are important to all industries.
Table 3.1 Manipulation of earnings via accounting methods that distort the principles of IFRS
Financial Statement Item
Aggressive Treatment
(bending the intention of IFRS)
Revenue
Inventory
Aggressive accruals
FIFO-IFRS treatment
Depreciation
Straight line (usual under IFRS) with
Warranties or bad debts
Amortization period
Discretionary expenses
Contingencies
Management compensation
Prior period adjustments
Change in auditors
Costs
higher salvage value
High estimates
Longer or increasing
Deferred
Footnote only
Accounting earnings as basis
Frequent
Frequent
Capitalize
“Conservative” Treatment
Installment sales or cost recovery
LIFO (where allowed—not allowed per
IFRS anymore)
Accelerated consumption pattern-
methods (lower salvage value)
Low estimates
Shorter or decreasing
Incurred
Accrue
Economic earnings as basis
Infrequent
Infrequent
Expense
• Differences in corporate strategies can affect certain financial ratios. (It is a good
practice to compare the financial ratios of a company with those of its major com-
petitors. Typically, the analyst should be wary of companies whose financial ratios
are too far above or below industry norms.)
• Economic conditions. Financial ratios tend to improve when the economy is strong
and to weaken during recessions. Therefore, financial ratios should be examined in
light of the phase of the economy’s business cycle.
24
Chapter 3 Presentation of Financial Statements (IAS 1)
• Trend (time-series analysis). The trend of a ratio, which shows whether it is improving
or deteriorating, is as important as its current absolute level.
3.6.11 The more aggressive the accounting methods, the lower the quality of earnings; the
lower the quality of earnings, the higher the risk assessment; the higher the risk assessment,
the lower the value of the company being analyzed (Table 3.1).
Table 3.2 Ratio categories
1. Liquidity
2. Solvency (Business and Financial Risk Analysis)
Enumerator
Denominator
Enumerator
Denominator
Current
Current assets
Current
liabilities
Business risk (coeff
of variation)
Standard deviation
of operating income
income
Quick
Cash + marketable
Current
securities +
receivables
liabilities
Cash
Cash + marketable
Current
Business risk
(coefficient of
variation) – net
income
Standard deviation
of net income
Mean net
income
securities
liabilities
Sales variability
Standard deviation
Mean sales
Average
receivables
Receivables
turnover
Average
inventory
Inventory
turnover
Average
trade
payables
Payables
turnover
Receivables Net annual sales
turnover
365
Average
receivables
collection
period
Inventory Cost of goods sold
turnover
Average
inventory
processing
period
Payables
turnover
Payables
payment
period
Cash
conversion
cycle
365
Cost of goods sold
365
Average receivables
collection period +
average inventory
processing period
payables payment
period
Operating
leverage
Financial risk
of sales
Mean of absolute value
Percentage
of % change in
Operating expenses
(%) change
in sales
Volatility caused
by firm’s use
of debt
Debt-equity
Total long-term debt
Total equity
Long-term
debt ratio
Total long-term debt
Total long-term
Total debt ratio
Total debt
Interest coverage
EBIT (Earnings before
interest and taxes)
Fixed financial | Hennie |
cost coverage
EBIT
Fixed charge
coverage
EBIT + lease payments
Cash flow to
interest expense
Net income + depreciation
expense + increase in
deferred taxes
Cash flow coverage
of fixed financial
cost coverage
Traditional cash flow +
interest expense +
one-third of lease
payments
Cash flow to
long-term debt
Cash flow to
total debt
Net income + depreciation
expense + increase in
deferred taxes
Net income + depreciation
expense + increase in
deferred taxes
capital
Total capital
Interest expense
Interest expense
+ one-third of
lease payments
Interest payments
+ lease payments
+ preferred
dividends /
(1 – tax rate)
Interest expense
Interest expense +
one-third of
lease payments
Book value of
long-term debt
Total debt
Chapter 3 Presentation of Financial Statements (IAS 1)
25
3.6.12 Table 3.2 provides an overview of some of the ratios that can be calculated using
each of the classification areas discussed above.
3.6.13 When performing an analysis for specific purposes, various elements from different
ratio classification groupings can be combined as seen in Table 3.3.
3. Operational Efficiency (Activity)
5. Profitability
Enumerator
Denominator
Enumerator
Denominator
Total asset
turnover
Fixed asset
turnover
Equity
turnover
Net sales
Net sales
Net sales
Average net
net assets
Average total
fixed assets
Average
equity
4. Growth
Sustainable
growth rate
Enumerator
Denominator
Retention rate
of earning
reinvested
(RR) * (ROE)
RR (retention Dividends
declared
rate)
Operating
income
after taxes
Return on
equity – ROE
Net income –
preferred
dividends
Average
common
equity
Payout ratio
Common
dividends
declared
Net income –
preferred
dividends
Gross profit margin
Gross profit
Operating profit margin Operating profit
Net sales
Net sales
(EBIT)
Net profit margin
Net income
Net sales
Return on total capital
Net income +
Average total capital
interest expense
Return on total equity
Net income
Average total equity
Return on common
equity
Net income –
Average common
preferred dividends
equity
Net income
Equity
Du Pont 1:
ROE (y/e figures)
* Total asset
turnover
* Equity (financial
leverage) multiplier
Du Pont 2:
ROE (y/e figures) =
operating profit margin
Sales
Assets
EBIT
* Total asset turnover
Sales
– Interest expense rate
Interest expense
* Financial leverage
(equity) multiplier
Assets
* Tax retention rate
1-t
Assets
Equity
Sales
Assets
Assets
Equity
2
6
Table 3.3 Combining Ratios for Specific Analytical Purposes
Purpose of
analysis
Stock / equity
valuation
Liquidity
Solvency (Business and
financial risk analysis)
Operational
efficiency (activity)
Ratio Used
Debt/equity
Interest coverage
Business risk (coefficient of variation of
operating earnings)
Business risk (coefficient of variation)
– net income
Sales variability
Systematic risk (Beta)
Sales / Earnings growth rates
Cash flow growth rate
Growth
Profitability
External Liquidity
Dividend payout
rate
Return on equity
– ROE
Market price to book
value
RR (retention rate)
Return on common
equity
Market price to cash
flow
Market price to sales
Risk measurement
Current ratio
Total debt ratio
Dividend payout
rate
Asset size
Market value of
stock outstanding
Working capital
to total assets
Cash flow to total debt
Interest coverage
Cash flow to total debt
Business risk (coefficient of variation of
operating earnings / operating profit
margins)
Credit analysis
for bond ratings
Long-term debt ratio
Equity turnover
Total debt ratio
Working capital
to sales ratio
Cash flow to total debt
Total asset turnover
Cash flow coverage of fixed financial cost
Cash flow to interest expense
Interest coverage
Variability of sales / net income and ROA
Net profit margin
(ROE)
Market value of
stock outstanding
Return on Assets
Par value of bonds
Operating profit
margin
Return on equity – ROE
Forecasting
bankruptcy
Current
Cash flow to total debt
Total asset turnover
Return on Assets
Market value of stock
to book value of debt
Cash
Cash flow to LT debt
Working capital
to sales ratio
Total debt ratio
Total debt to total assets
Other—not
used above
Quick (acid test)
Operating leverage
Fixed asset turnover
Sustainable
growth rate
Receivables
turnover
Financial risk (volatility caused by firm’s
use of debt)
| Hennie |
Fixed financial cost coverage
Fixed charge coverage
Average
receivables
collection period
Inventory
turnover
Average inventory
processing period
Payables turnover
Payables payment
period
Cash conversion
cycle
Return on Assets
EBIT to total assets
Retained earnings
to total assets
Gross profit margin
Operating profit
margin
Return on total capital
Return on total capital
including leases
Du Pont 1
Du Pont 2
Number of securities
traded per day
Bid / Asked spread
Percentage of
outstanding securities
traded per day
2
7
28
Chapter 3 Presentation of Financial Statements (IAS 1)
EXAMPLE: PRESENTATION OF FINANCIAL STATEMENTS
EXAMPLE 3.1
Elrali Inc. is a manufacturing entity. The following is a summary of the income and expens-
es for the year ending March 31, 20X7:
Gross turnover
Cost of sales of finished goods
Materials used
Labor
Variable production overhead costs allocated
Fixed production overhead costs allocated
Packing materials
Cost of finished goods manufactured
Opening inventories finished goods
Closing inventories finished goods
Distribution costs
Administrative expenses
Other operating expenses
Investment income
Rental income
Finance costs
Write-down of cost of materials to net realizable value
Over-recovery of fixed production overhead costs
Abnormal spillage of materials
Income tax expense
$
7,500,000
3,995,100
910,100
1,200,000
800,000
845,000
310,000
4,065,100
70,000
(140,000)
718,800
929,100
587,100
124,800
60,100
234,000
25,000
41,000
15,000
319,700
Depreciation and amortization charges included in the fixed production overheads amount-
ed to $418,000, and those included in administrative expenses amounted to $205,000. Total
salaries and other staff costs included in administrative expenses amounted to $689,300.
Chapter 3 Presentation of Financial Statements (IAS 1)
29
EXPLANATION
The following income statements could be prepared based on the two alternative classifica-
tions of income and expenses allowed by IAS 1:
Elrali Inc. Income Statement for the Year Ending March 31, 20X7
1. CLASSIFICATION OF EXPENSES BY FUNCTION
Revenue
Cost of sales (Calculation a)
Gross profit
Other income (Calculation b)
Distribution costs
Administrative expenses
Other expenses
Finance costs
Profit before tax
Income tax expense
Profit for the period
$
7,500,000
(3,994,100)
3,505,900
184,900
(718,800)
(929,100)
(587,100)
(234,000)
1,221,800
(319,700)
902,100
Elrali Inc. Income Statement for the Year Ending March 31, 20X7
2. CLASSIFICATION OF EXPENSES BY NATURE
Revenue
Other income (Calculation b)
Changes in inventories of finished goods and work in progress
Work performed by the enterprise and capitalized (Calculation c)
Raw material and consumables used (Calculation d)
Staff costs (Calculation e)
Depreciation and amortization expenses (418 + 205)
Other expenses (Calculation f)
Finance costs
Profit before tax
Income tax expense
Profit for the period
$
7,500,000
184,900
70,000
(1,186,000)
(1,260,100)
(1,889,300)
(623,000)
(1,340,700)
(234,000)
1,221,800
(319,700)
902,100
Continued on next page
30
Chapter 3 Presentation of Financial Statements (IAS 1)
Example 3.1 (continued)
Calculations
a. Cost of sales
Amount given
Write-down to net realizable value
Over-recovery of fixed production overheads
Abnormal materials spillage
b. Other income
Investment income
Rental income
c. Work performed and capitalized
Variable production overheads
Fixed production overheads (845–41)
Depreciation separately disclosed
d. Raw materials consumed
Materials used
Packing material
Write-down to net realizable value
Abnormal spillage
e. Staff costs
Labor
Other staff costs
f. Other expenses
Distribution costs given
Administrative costs given
Operating costs given
Staff costs shown in calculation e
Depreciation separately shown
$
3,995,100
25,000
(41,000)
15,000
3,994,100
124,800
60,100
184,900
800,000
804,000
(418,000)
1,186,000
910,100
310,000
25,000
15,000
1,260,100
1,200,000
689,300
1,889,300
718,800
929,100
587,100
(689,300)
(205,000)
1,340,700
4 Cash Flow Statements (IAS 7)
4.1
PROBLEMS ADDRESSED
The cash flow statement is a separate financial statement that mainly provides users with
additional information so that they can evaluate the solvency and liquidity of the entity. | Hennie |
Other reasons why cash flows are relevant are that it allows users to identify the:
• movement in cash balances for the period,
• timing and certainty of cash flows,
• ability of the entity to generate cash and cash equivalents, and
• prediction of future cash flows (useful for valuation models).
4.2
SCOPE OF THE STANDARD
All entities are required to present a cash flow statement that reports cash flows during the
reporting period. Either the direct or the indirect method can be used. Cash and cash equiv-
alents must be defined. Cash flows must be classified as follows:
• Operating activities.
• Investing activities.
• Financing activities.
4.3
KEY CONCEPTS
4.3.1 An entity should present a cash flow statement that reports cash flows during the
reporting period, classified by operating, financing, and investing activities.
4.3.2 Cash flows are inflows and outflows of cash and cash equivalents.
4.3.3 Cash comprises
• cash on hand, and
• demand deposits (net of bank overdrafts repayable on demand).
4.3.4 Cash equivalents are short term, highly liquid investments (such as short-term debt secu-
rities) that readily convert to cash and that are subject to an insignificant risk of changes in value.
31
32
Chapter 4 Cash Flow Statements (IAS 7)
4.3.5 Operating activities are principal revenue-producing activities and other activities
that do not include investing or financing activities.
4.3.6 Investing activities are acquisition and disposal of long-term assets and other invest-
ments not included as cash equivalent investments.
4.3.7 Financing activities are activities that change the size and composition of the equity
capital and borrowings.
4.4
ACCOUNTING TREATMENT
4.4.1 Cash flows from operating activities are reported using either the direct or indirect
method:
• Direct method
• Major classes of gross cash receipts and gross cash payments (for example, sales cost
of sales, purchases, and employee benefits ) are disclosed.
• Indirect method
• Profit and loss for the period is adjusted for
• effects of noncash transactions,
• deferrals or accruals, and
• investing or financing cash flows.
4.4.2 Cash flows from investing activities are reported as follows:
• Major classes of gross cash receipts and gross cash payments are reported separately.
• The aggregate cash flows from acquisitions or disposals of subsidiaries and other busi-
ness units are classified as investing.
4.4.3 Cash flows from financing activities are reported by separately listing major classes
of gross cash receipts and gross cash payments.
4.4.4 The following cash flows can be reported on a net basis:
• Cash flows on behalf of customers
• Items for which the turnover is quick, the amounts large, and maturities short (for
example, purchase and sale of investments)
4.4.5 Interest and dividends paid should be treated consistently as either operating or
financing activities. Interest and dividends received are treated as investing inflows.
However, in the case of financial institutions, interest paid and dividends received are usu-
ally classified as operating cash flows.
4.4.6 Cash flows from taxes on income are normally classified as operating (unless specifi-
cally identified with financing or investing).
4.4.7 A foreign exchange transaction is recorded in the functional currency using the
exchange rate at the date of the cash flow.
4.4.8 Foreign operations’ cash flows are translated at exchange rates on dates of cash flows.
4.4.9 When entities are equity- or cost-accounted, only actual cash flows from them (for
example, dividends received) are shown in the cash flow statement.
4.4.10 Cash flows from joint ventures are proportionately included in the cash flow statement.
4.5
PRESENTATION AND DISCLOSURE
Chapter 4 Cash Flow Statements (IAS 7)
33
4.5.1 The following should be shown in aggregate in respect of both the purchase and sale
of a subsidiary or business unit:
• Total purchase or disposal consideration
• Purchase or disposal consideration paid in cash and equivalents | Hennie |
• Amount of cash and equivalents in the entity acquired or disposed
• Amount of assets and liabilities other than cash and equivalents in the entity acquired
or disposed.
4.5.2 The following should be disclosed:
• Cash and cash equivalents in the cash flow statement and a reconciliation with the
equivalent items in the balance sheet
• Details about noncash investing and financing transactions (for example, conversion of
debt to equity)
• Amount of cash and equivalents that are not available for use by the group
• Amount of undrawn borrowing facilities available for future operating activities and to
settle capital commitments (indicating any restrictions)
• Aggregate amount of cash flows from each of the three activities related to interest in
joint ventures
• Amount of cash flows arising from each of the three activities (operating, etc.) regard-
ing each reported business and geographical segment
• Distinction between the cash flows that represent an increase in operating capacity and
those that represent the maintenance of it.
4.6
FINANCIAL ANALYSIS AND INTERPRETATION
4.6.1 The IFRS statement of cash flows shows the sources of the cash inflows received by an
entity during an accounting period, and the purposes for which cash was used. The state-
ment is an integral part of the analysis of a business because it enables the analyst to deter-
mine the following:
• The ability of a company to generate cash from its operations
• The cash consequences of investing and financing decisions
• The effects of management’s decisions about financial policy
• The sustainability of a firm’s cash-generating capability
• How well operating cash flow correlates with net income
• The impact of accounting policies on the quality of earnings
• Information about the liquidity and long-term solvency of a firm
• Whether or not the going concern assumption is reasonable
• The ability of a firm to finance its growth from internally generated funds
4.6.2 Because cash inflows and outflows are objective facts, the data presented in the state-
ment of cash flows represent economic reality. The statement reconciles the increase or
decrease in a company’s cash and cash equivalents that occurred during the accounting peri-
od (an objectively verifiable fact). Nevertheless, this statement must be read while keeping
the following in mind:
• There are analysts who believe that accounting rules are developed primarily to pro-
mote comparability, rather than to reflect economic reality. Even if this view were to be
34
Chapter 4 Cash Flow Statements (IAS 7)
considered harsh, it is a fact that too much flexibility in accounting can present
problems for analysts who are primarily interested in assessing a company’s future
cash-generating capability from operations.
• As with income statement data, cash flows can be erratic from period to period, reflect-
ing random, cyclical, and seasonal transactions involving cash, as well as sectoral
trends. It can be difficult to decipher important long-term trends from less meaningful
short-term fluctuations in such data.
4.6.3 Financial analysts can use the IFRS cash flow statement to help them determine other
measures that they wish to use in their analysis, for example free cash flow, which is often
used by analysts to determine the value of a firm. Defining free cash flow is not an easy task,
because there are many different measures that are commonly called free cash flow.
4.6.4 Discretionary free cash flow is the cash that is available for discretionary purposes.
According to this definition, free cash flow is the cash generated from operating activities,
less the capital expenditures required to maintain the current level of operations. Therefore,
the analyst must identify that part of the capital expenditure included in investing cash flows
that relates to maintaining the current level of operations—a formidable task. Any excess
cash flow can be used for discretionary purposes (for example, to pay dividends, reduce
debt, improve solvency, or to expand and improve the business). IFRS therefore requires dis- | Hennie |
closure of expenditures into those expenditures that were required to maintain the current
level of operations and those that were undertaken to expand or improve the business.
4.6.5 Free cash flow available to owners measures the ability of a firm to pay dividends to
its owners. In this case, all of the cash used for investing activities (capital expenditures,
acquisitions, and long-term investments) is subtracted from the cash generated from operat-
ing activities. In effect, this definition states that the firm should be able to pay out as divi-
dends cash from operations that is left over after the firm makes the investments that man-
agement deems necessary to maintain and grow current operations.
4.6.6 Generally, the cash generated from operating activities is greater than net income for a
well-managed, financially healthy company; if it is not, the analyst should be suspicious of the
company’s solvency. Growth companies often have negative free cash flows because their
rapid growth requires high capital expenditures and other investments. Mature companies
often have positive free cash flows, whereas declining firms often have significantly positive
free cash flows because their lack of growth means a low level of capital expenditures. High
and growing free cash flows, therefore, are not necessarily positive or negative; much depends
upon the stage of the industry life cycle in which a company is operating. This is why the free
cash flow has to be assessed in conjunction with the income prospects of the firm.
4.6.7 Many valuation models use cash flow from operations, thus giving management an
incentive to record inflows as operating (normal and recurring), and outflows as either relat-
ed to investing or financing. Other areas where management discretionary choices could
influence the presentation of cash flows follow:
• Payment of taxes. Management has a vested interest in reducing current-year pay-
ments of taxes by choosing accounting methods on the tax return that are likely to
defer tax payments to the future.
• Discretionary expenses. Management can manipulate cash flow from operations by
timing the payment or incurring certain discretionary expenses such as research and
development, repairs and maintenance, and so on. Cash inflows from operations can
also be increased by the timing of the receipt of deposits on long-term contracts.
• Leasing. The entire cash out-flow of an operating lease reduces the cash flow from
operations; for a capital lease, the cash payment is allocated between operating and
financing, thus increasing cash flow from operations.
EXAMPLES: CASH FLOW STATEMENTS
Chapter 4 Cash Flow Statements (IAS 7)
35
EXAMPLE 4.1
During the year ending 20X1, ABC Company completed the following transactions:
1. Purchased a new machine for $13.0 million
2. Paid cash dividends totaling $8.0 million
3. Purchased Treasury stock (own shares) totaling $45.0 million
4. Spent $27.0 million on operating expenses, of which $10.0 million was paid in cash and
the remainder put on credit
Which of the following correctly classifies each of the above transaction items on the operat-
ing, investing, and financing activities on the statement of cash flows?
Transaction 1
Transaction 2
Transaction 3
Transaction 4
a.
Investing in flow
Operating outflow Financing outflow All expenses—
operating outflow
b.
Financing outflow Financing outflow Investing outflow
Cash paid (only)—
operating outflow
c.
Investing outflow
Financing outflow Financing outflow Cash paid (only)—
operating outflow
d.
Financing inflow
Operating outflow Financing inflow
Cash paid (only)—
operating outflow
EXPLANATION
Choice c. is correct. Each transaction had both the proper statement of cash flow activity and
the correct cash inflow or outflow direction.
Choice a. is incorrect. This choice incorrectly classifies the cash flow activities for transactions
1, 2, and 4.
Choice b. is incorrect. This choice incorrectly classifies the cash flow activities for transactions
1 and 3.
Choice d. is incorrect. This choice incorrectly classifies the cash flow activities for transactions | Hennie |
1, 2, and 3.
Note: Dividends are sometimes classified as an operating cash flow.
36
Chapter 4 Cash Flow Statements (IAS 7)
EXAMPLE 4.2
Gibson Entities had the following financial data for the year ended December 31, 2002:
Capital expenditures
Dividends declared
Net income
Common stock issued
Increase in accounts receivable
Depreciation and amortization
Proceeds from sale of assets
Gain on sale of assets
millions of $
75.0
1.2
17.0
33.0
12.0
3.5
6.0
0.5
Based on the above, what is the ending cash balance at December 31, 2002, assuming an open-
ing cash balance of $47.0 million?
a. $13.0 million
b. $17.8 million
c. $19.0 million
d. $43.0 million
EXPLANATION
Choice c. is correct. The answer is based on the following calculation:
Operating cash flow
Net income
Depreciation and amortization
Gain on sale of assets
Increase in accounts receivable
Operating cash flow
Investing cash flow
Capital expenditures
Proceeds from sale of assets
Investing cash outflow
Financing cash flow
Common stock issued
Financing cash inflow
Net change in cash (8 – 69 + 33)
Beginning cash
Ending cash
millions of $
17.0
3.5
(0.5)
(12.0)
8.0
(75.0)
6.0
(69.0)
33.0
33.0
(28.0)
47.0
19.0
Note that the dividends had only been declared, not paid.
Chapter 4 Cash Flow Statements (IAS 7)
37
EXAMPLE 4.3
The following are the abridged annual financial statements of Linco Inc.
Income Statement for the Year Ending September 30, 20X4
Revenue
Cost of sales
Gross profit
Administrative expenses
Operating expenses
Profit from operations
Finance cost
Profit before tax
Income tax expense
Profit for the period
$
850,000
(637,500)
212,500
(28,100)
(73,600)
110,800
(15,800)
95,000
(44,000)
51,000
Statement of Changes in Equity for the Year Ending September 30, 20X4
Share
capital ($)
Revaluation
reserve ($)
Accumulated
profit ($)
Total ($)
Balance—beginning
of the year
Revaluation of
buildings
Profit for
the period
Dividends paid
Repayment of
share capital
Balance—end
of the year
120,000
121,000
241,000
20,000
51,000
(25,000)
20,000
51,000
(25,000)
(20,000)
(20,000)
100,000
20,000
147,000
267,000
Continued on next page
38
Chapter 4 Cash Flow Statements (IAS 7)
Example 4.3 (continued)
Balance Sheet at September 30, 20X4
20X4 ($)
20X3 ($)
Noncurrent Assets
Property, plant, and equipment
Office buildings
Machinery
Motor vehicles
Long-term loans to directors
Current Assets
Inventories
Debtors
Prepaid Expenses
Bank
Total Assets
Equity and Liabilities
Capital and Reserves
Share Capital
Revaluation Reserve
Accumulated Profits
Noncurrent Liabilities
Long-Term Borrowings
Current Liabilities
Creditors
Bank
Taxation Due
Total Equity and Liabilities
250,000
35,000
6,000
64,000
355,000
82,000
63,000
21,000
–
166,000
521,000
100,000
20,000
147,000
267,000
220,000
20,000
4,000
60,000
304,000
42,000
43,000
16,000
6,000
107,000
411,000
120,000
–
121,000
241,000
99,000
125,000
72,000
43,000
40,000
155,000
521,000
35,000
–
10,000
45,000
411,000
Additional information
1. The following depreciation charges are included in operating expenses:
Machinery
Motor vehicles
$25,000
$ 2,000
2. Fully depreciated machinery with an original cost price of $15,000 was sold for $5,000
during the year. The profit is included in operating expenses.
3. The financial manager mentions that the accountants allege the company is heading for
a possible liquidity crisis. According to him, the company struggled to meet its short-
term obligations during the current year.
Chapter 4 Cash Flow Statements (IAS 7)
39
EXPLANATION
The cash flow statement would be presented as follows if the direct method were used for
its preparation:
Linco Inc. Cash Flow Statement for the Year Ending September 30, 20X4
Cash Flows from Operating Activities
Cash Receipts from Customers (Calculation E)
Cash Payments to Suppliers and Employees (Calculation F)
Net Cash Generated By Operations
Interest Paid
Taxation Paid (Calculation D)
Dividends Paid
Cash Flows from Investing Activities
Purchases of Property, Plant and Equipment (Calc. A, B, C)
Proceeds on Sale of Machinery
Loans to Directors
Cash Flows from Financing Activities
Decrease in Long-Term Loan (125–99)
Repayment of Share Capital
Net Decrease in Bank Balance for the Period
Bank Balance at Beginning of the Year | Hennie |
Overdraft at End of the Year
$
830,000
(725,200)
104,800
(15,800)
(14,000)
(25,000)
50,000
(54,000)
5,000
(4,000)
(53,000)
(26,000)
(20,000)
(46,000)
(49,000)
6,000
(43,000)
Commentary
1. The total increase in creditors was used to partially finance the increase in working capi-
tal.
2. The rest of the increase in working capital as well as the interest paid, taxation paid, and
dividends paid were financed by cash generated from operations.
3. The remaining balance of cash generated by operating activities and the proceeds on the
sale of fixed assets were used to finance the purchase of fixed assets.
4. The overdrawn bank account was used for the repayment of share capital and the
redemption of the long-term loan.
Continued on next page
40
Chapter 4 Cash Flow Statements (IAS 7)
Example 4.3 (continued)
Calculations
a. Office Buildings
Balance at Beginning of Year
Revaluation
Purchases (Balancing Figure)
Balance at End of the Year
b. Machinery
Balance at Beginning of Year
Depreciation
Purchases (Balancing Figure)
Balance at End of the Year
c. Vehicles
Balance at Beginning of Year
Depreciation
Purchases (Balancing Figure)
Balance at End of the Year
d. Taxation
Amount Due at Beginning of Year
Charge in Income Statement
Paid in Cash (Balancing Figure)
Amount Due at End of the Year
e. Cash Receipts from Customers
Sales
Increase in Debtors (63–43)
f. Cash Payments to Suppliers and Employees
Cost of Sales
Administrative Expenses
Operating Expenses
Adjusted for Noncash Flow Items:
Depreciation
Profit on Sale of Machinery
Increase in Inventories (82–42)
Increase in Creditors (72–35)
Increase in Prepaid Expenses (21–16)
$
220,000
20,000
10,000
250,000
20,000
(25,000)
40,000
35,000
4,000
(2,000)
4,000
6,000
10,000
44,000
(14,000)
40,000
850,000
(20,000)
830,000
637,500
28,100
73,600
(27,000)
5,000
40,000
(37,000)
5,000
725,200
5 Accounting Policies,
Changes in Accounting
Estimates, and Errors (IAS 8)
5.1
PROBLEMS ADDRESSED
This Standard prescribes the criteria for selecting and changing accounting policies, changes
in accounting estimates, and correction of errors. The Standard aims at enhancing the rele-
vance, reliability, and comparability of an entity’s financial statements.
5.2
SCOPE OF THE STANDARD
This Standard covers situations where the entity:
• is selecting and applying accounting policies,
• is accounting for changes in accounting policies,
• has changes in accounting estimates, and
• has corrections of prior-period errors.
5.3
KEY CONCEPTS
5.3.1 Accounting policies are specific principles, bases, conventions, rules, and practices
applied by an entity in preparing and presenting financial statements.
5.3.2 Changes in accounting estimates are adjustments of an asset’s or liability’s carrying
amount or the amount of the periodic consumption of an asset that result from the assess-
ment of the present status of, and expected future benefits and obligations associated with,
assets and liabilities. Changes in accounting estimates result from new information or new
developments and, accordingly, are not corrections of errors. For example, a change in the
method of depreciation results from new information about the use of the related asset and
is, therefore, a change in accounting estimate.
5.3.3 Prior-period errors are omissions from and misstatements in the entity’s financial
statements for one or more prior periods, arising from a failure to use, or a misuse of, reliable
information that
• was available when prior period financial statements were authorized for issue, or
• could reasonably have been obtained and taken into account in the preparation and
presentation of those financial statements.
41
42
Chapter 5 Accounting Policies, Changes in Accounting Estimates, and Errors (IAS 8)
Such errors include the effects of
• mathematical mistakes,
• mistakes in applying accounting policies,
• oversights or misinterpretations of facts, or
• fraud.
5.3.4 Omissions or misstatements are material if they could, individually or collectively, influ-
ence users’ economic decisions that are taken (or made) on the basis of the financial statements.
5.3.5 Impracticable changes are requirements that an entity cannot apply after making | Hennie |
every reasonable effort to do so. The application of a change in accounting policy or retro-
spective correction of an error becomes impracticable when
• effects are not determinable;
• assumptions about management intent in prior period are required; and
• it is impossible to distinguish information about circumstances in a prior period and
information that was available in that period from other information.
5.4
ACCOUNTING TREATMENT
5.4.1 When a Standard or an Interpretation specifically applies to a transaction, other
event, or condition, the accounting policy or policies applied to that item should be deter-
mined (chosen) by applying the Standard or Interpretation, considering any implementation
guidance issued by the IASB for that Standard or Interpretation.
5.4.2 In the absence of specific guidance on accounting policies (that is, a Standard or an
Interpretation that specifically applies to a transaction, other event or condition), manage-
ment should use its judgment in developing and applying an accounting policy that results
in relevant and reliable information. In making the judgment, management should consider
the applicability in the following order:
• The requirements and guidance in Standards and Interpretations dealing with similar
and related issues
• The definitions, recognition criteria and measurement concepts for assets, liabilities,
income, and expenses in the Framework
To the extent that they do not conflict with the above, management may also consider:
• The most recent pronouncements of other standard-setting bodies that use a similar
conceptual framework
• Other accounting literature and accepted industry practices
5.4.3 Accounting policies are applied consistently for similar transactions, other events
and conditions (unless a Standard or Interpretation requires or permits categorization, for
which different policies may be appropriate).
5.4.4 A change in accounting policy is allowed only under one of the following conditions:
• The change is required by a Standard or Interpretation
• The change will provide reliable and more relevant information about the effects of
transactions, other events and conditions.
5.4.5 When a change in accounting policy results from application of a new Standard or
Interpretation:
Chapter 5 Accounting Policies, Changes in Accounting Estimates, and Errors (IAS 8)
43
• Any specific transitional provisions in the Standard or Interpretation should be followed.
• If there are no specific transitional provisions, they should be applied in same way as
voluntary change.
5.4.6 A voluntary change in accounting policies is applied as follows:
• Policies are applied retrospectively as though the new policy had always applied
unless it is impracticable to do so.
• Opening balances are adjusted at the earliest period presented.
• Policies are applied prospectively if it is impracticable to restate prior periods or to
adjust opening balances.
5.4.7 Carrying amounts of asset, liability, or equity should be adjusted when changes in
accounting estimates necessitate a change in assets, liabilities, or equity.
5.4.8 Other changes in accounting estimates should be included in the profit or loss in the
period of the change or in the period of change and future periods if the change affects both.
5.4.9 Financial statements do not comply with IFRS if they contain prior-period material
errors. In the first set of financial statements authorized for issue after their discovery an enti-
ty should correct material prior-period errors retrospectively by
• restating the comparative amounts for the prior period or periods presented in which
the error occurred, or
• restating the opening balances of assets, liabilities, and equity for the earliest prior peri-
od presented.
5.5
PRESENTATION AND DISCLOSURE
5.5.1 If an entity makes a voluntary change in accounting policies, it should disclose:
• Nature of change
• Reason or reasons why new policy provides reliable and more relevant information
• Adjustment in current and each prior period presented | Hennie |
• Adjustment to basic and diluted earnings per share
• Adjustment to periods prior to those presented
5.5.2 When initial application of a Standard or an Interpretation has or could have an effect
on the current period or any prior period, except that it is impracticable to determine the
amount of the adjustment, an entity should disclose:
• The title of the Standard or Interpretation
• That the change in accounting policy is made in accordance with its transitional provi-
sions (when applicable)
• The nature of the change in accounting policy
• A description of the transitional provisions (when applicable)
• The transitional provisions that might have an effect on future periods (when applicable)
5.5.3 In considering an impending change in accounting policy, an entity should disclose:
• Pending implementation of a new standard
• Known or reasonably estimable information relevant to assessing the possible impact
of new standards
44
Chapter 5 Accounting Policies, Changes in Accounting Estimates, and Errors (IAS 8)
5.5.4 With reference to a change in accounting estimates, an entity should disclose:
• Nature of the change in estimate
• Amount of the change and its effect on the current and future periods
If estimating the future effect is impracticable that fact should be disclosed.
5.5.5 In considering prior period errors, an entity should disclose:
• Nature of the error
• Amount of correction in each prior period presented and the line items affected
• Correction to basic and diluted earnings per share
• Amount of correction at beginning of earliest period presented
• Correction relating to periods prior to those presented
5.6
FINANCIAL ANALYSIS AND INTERPRETATION
5.6.1 Analysts find it useful to break reported earnings down into recurring and nonrecur-
ring income or losses. Recurring income is similar to permanent or sustainable income,
whereas nonrecurring income is considered to be random and unsustainable. Even so-called
nonrecurring events tend to recur from time to time. Therefore, analysts often exclude the
effects of nonrecurring items when performing a short-term analysis of an entity (such as
estimating next year’s earnings). They also might include them on some average (per year)
basis for longer-term analyses.
5.6.2 The analyst should be aware that, when it comes to reporting nonrecurring income,
IFRS do not distinguish between items that are and are not likely to recur. Furthermore, IFRS
do not permit any items to be classified as extraordinary items.
5.6.3 However, IFRS do require the disclosure of all material information that is relevant to
an understanding of an entity’s performance. It is up to the analyst to use this information
together with information from outside sources and management interviews to determine to
what extent reported profit reflects sustainable income and to what extent it reflects nonre-
curring items.
5.6.4 Analysts generally need to identify such items as:
• Changes in accounting policies
• Changes in estimates
• Errors
• Unusual or infrequent items
• Discontinued operations (see chapter 28)
Chapter 5 Accounting Policies, Changes in Accounting Estimates, and Errors (IAS 8)
45
EXAMPLES: ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES, AND ERRORS
EXAMPLE 5.1
Which of the following items is not included in an IFRS income statement for the current
period?
a. The effects of corrections of prior period errors
b. Income and gains or losses from discontinued operations
c. Income or losses arising from extraordinary items
d. Adjustments resulting from changes in accounting policies.
EXPLANATION
Choice a. is incorrect. An entity should correct material prior period errors retrospectively in
the first set of financial statements authorized for issue after their discovery by
• restating the comparative amounts for the prior period or periods presented in which
the error occurred, or
• restating the opening balances of assets, liabilities, and equity for the earliest prior peri-
od presented.
Choice b. is correct. Income and losses from discontinued operations (net of taxes) is shown | Hennie |
on a separate line of the income statement, called Income (Loss) from Discontinued
Operations (see IFRS 5).
Choice c. is incorrect. The items are included in the income statement but they are not shown
as extraordinary items. (Extraordinary items are not separately classified under IAS 1.)
Choice d. is incorrect. Adjustments from changes in accounting policies should be applied ret-
rospectively as if though the new policy had always applied. Opening balances are adjusted
at the earliest period where feasible, when amounts prior to that period cannot be restated.
46
Chapter 5 Accounting Policies, Changes in Accounting Estimates, and Errors (IAS 8)
EXAMPLE 5.2
Unicurio Inc. is a manufacturer of curios that are sold at international airports. The follow-
ing transactions and events occurred during the year under review:
a. As of the beginning of the year, the remaining useful life of the plant and equipment was
reassessed as 4 years rather than 7 years.
b. Bonuses of $12 million, compared with $2.3 million in the previous year, had been paid
to employees. The financial manager explained that a new incentive scheme was adopt-
ed whereby all employees shared in increased sales.
c. There was a $1.25 million profit on the nationalization of land.
d. During the year the corporation was responsible for the formation of the ECA
Foundation, which donates funds to welfare organizations. This foundation forms part
of the corporation’s social investment program. The company contributed $7 million to
the fund.
EXPLANATION
Each of the transactions and events mentioned above would be treated as follows in the
income statement for the current year:
1. A change in the useful life of plants and equipment is a change in accounting estimate
and is applied prospectively. Therefore, the carrying amount of the plant and equipment
is written off over 4 years rather than 7 years. All the effects of the change are included
in profit or loss. The nature and amount of the change should be disclosed.
2. The item is included in profit or loss. Given its nature and size, it may need to be dis-
closed separately.
3. The profit is included in profit or loss (that is, it is not an “extraordinary item”).
4. The contribution is included in profit or loss. It is disclosed separately if it is material.
PARTII
Group
Statements
6 Business Combinations (IFRS 3)
6.1
PROBLEMS ADDRESSED
Many business operations take place within the context of a group structure that involves
many interrelated companies and entities. This Standard prescribes the accounting treatment
for business combinations where control is established. It is directed principally to a group
of entities where the acquirer is the parent entity and the acquiree a subsidiary. The prime
objective of IFRS 3 is to specify the relevant accounting treatment for all business combina-
tions acquired, regardless of how control is achieved.
The IFRS framework for dealing with equity and other securities investments is outlined in
Table 6.1.
Table 6.1 Accounting treatment of various securities acquisitions
Percentage Ownership
Accounting Treatment
IFRS Reference
Acquisition of Securities
Less than 20%
Between 20–50%
More than 50%
Other
Fair value
Equity accounting
Consolidation and
business combinations
Joint ventures
Business combinations
IAS 39
IAS 28
IAS 27
IAS 31
IFRS 3
6.2
SCOPE OF THE STANDARD
IFRS 3 addresses the following points:
• The focus is on the accounting treatment at date of acquisition.
• All business combinations should be accounted for by applying the purchase method
of accounting.
• The initial measurement of the identifiable assets acquired as well as liabilities and con-
tingent liabilities assumed in a business should be at fair value.
• The recognition of liabilities for terminating or reducing the activities.
49
50
Chapter 6 Business Combinations (IFRS 3)
• The accounting for goodwill and intangible assets acquired in a business combination.
This IFRS does not apply to the following:
• Business combinations in which separate entities or businesses are brought together to
| Hennie |
form a joint venture
• Business combinations involving entities or businesses under common control
• Business combinations involving two or more mutual entities
• Business combinations in which separate entities or businesses are brought together to
form a reporting entity by contract alone without the obtaining of an ownership inter-
est (for example, a dual listed corporation)
6.3
KEY CONCEPTS
6.3.1 A business combination is the bringing together of separate entities into one eco-
nomic entity as a result of one entity obtaining control over the net assets and operations of
another entity.
6.3.2 The purchase method views a business combination from the perspective of the com-
bining entity that is identified as the acquirer. The acquirer purchases net assets and recog-
nizes the assets acquired and liabilities and contingent liabilities assumed, including those
not previously recognized by the acquiree.
6.3.3 Non-controlling interest is that portion of a subsidiary attributable to equity interests
that are not owned, directly or indirectly through subsidiaries, by the parent. It is disclosed
as equity in consolidated financial statements.
6.3.4 A subsidiary is an entity—including an unincorporated entity such as a partnership—
that is controlled by another entity, known as the parent.
6.3.5 Control is the power to govern the financial and operating policies of an entity or
business to obtain benefits from its activities.
6.3.6 Fair value is the amount for which an asset could be exchanged, or a liability settled,
between knowledgeable, willing parties in an arm’s length transaction.
6.3.7 Goodwill is the future economic benefits arising from assets that are not capable of
being individually identified and separately recognized.
6.4
ACCOUNTING TREATMENT
6.4.1 This Standard requires an acquirer to be identified for every business combination
within its scope. The acquirer is the combining entity that obtains control of the other com-
bining entities or businesses.
6.4.2 An acquisition should be accounted for by use of the purchase method of accounting.
From the date of acquisition, an acquirer should incorporate into the income statement the
results of operations of the acquiree, and recognize in the balance sheet the identifiable assets,
liabilities, and contingent liabilities of the acquiree and any goodwill arising from the acqui-
sition. Applying the purchase method involves the following steps:
• Identifying an acquirer
• Measuring the cost of the business combination
Chapter 6 Business Combinations (IFRS 3)
51
• Allocating, at the acquisition date, the cost of the business combination to the assets
acquired and liabilities and contingent liabilities assumed
6.4.3 The cost of acquisition carried by the acquirer is the aggregate of the fair values of
assets given, liabilities incurred or assumed, and equity instruments issued by the acquirer,
in exchange for control of the acquiree, at the date of exchange. It includes directly attribut-
able costs but not professional fees or the costs of issuing debt or equity securities used to set-
tle the consideration.
6.4.4 The identifiable assets, liabilities, and contingent liabilities acquired should be those
of the acquiree that existed at the date of acquisition.
6.4.5 Intangible assets should be recognized as acquired assets if they meet the definition of
an intangible asset in IAS 38.
6.4.6 If the initial accounting for a business combination can be determined only provision-
ally because either the fair values to be assigned or the cost of the combination can be deter-
mined only provisionally, the acquirer should account for the combination using those provi-
sional values. The acquirer should recognize any adjustments to those provisional values as
a result of completing the initial accounting within twelve months of the acquisition date.
6.4.7 The identifiable assets, liabilities, and contingent liabilities acquired should be mea-
sured at their fair values at the date of acquisition. Any minority interest should be stated at | Hennie |
the minority’s proportion of their fair values.
6.4.8 The excess of the cost of acquisition over the acquirer and non-controlling interest in the
fair value of the identifiable assets and liabilities acquired is described as goodwill and is rec-
ognized as an asset.
6.4.9 Goodwill should be tested for impairment annually. Goodwill is not amortized.
6.4.10 The excess of the acquirer’s interest in the fair value of the identifiable assets and lia-
bilities acquired over the cost of acquisition is a gain and is recognized in profit or loss. It is
not recognized on the balance sheet as negative goodwill. However, before any gain is rec-
ognized, the acquirer should reassess the cost of acquisition and the fair values attributed to
the acquiree’s identifiable assets, liabilities, and contingent liabilities.
6.5
PRESENTATION AND DISCLOSURE
6.5.1 The acquirer should disclose information that enables users of its financial statements
to evaluate the nature and financial effect of business combinations that were effected dur-
ing the period and before the financial statements are authorized for issue (in aggregate
where immaterial). This information includes:
• Names and descriptions of the combining entities or businesses
• Acquisition date
• Percentage of voting equity instruments acquired
• Cost of the combination and a description of the components of that cost, such as the
number of equity instruments issued or issuable; and the fair value of those instru-
ments as well as the basis for determining that fair value
• Details of any operations the entity has decided to dispose of as a result of the
combination
• Amounts recognized at the acquisition date for each class of the acquiree’s assets, liabil-
ities, and contingent liabilities
52
Chapter 6 Business Combinations (IFRS 3)
• Amount of any excess (negative goodwill) recognized in profit or loss, and the line
item in the income statement in which the excess is recognized
• A description of factors that contributed to goodwill
• A description of each intangible asset that was not recognized separately from goodwill
• The amount of the acquiree’s profit or loss since the acquisition date included in the
acquirer’s profit or loss for the period
• The revenue and profit and loss of the combined entity for the period as though the
acquisition date for all business combinations effected during the period had been the
beginning of that period
6.5.2 Information to enable users to evaluate the effects of adjustments that relate to prior
business combinations should be disclosed.
6.5.3 Disclosure is required of all information neccessary to evaluate changes in the carrying
amount of goodwill during the period
BUSINESS COMBINATIONS AFTER THE BALANCE SHEET DATE
As much of the disclosures (as is practicable) mentioned above should be furnished for all
business combinations effected after balance sheet date. If it is impracticable to disclose any
of this information, this fact should be disclosed.
6.6
FINANCIAL ANALYSIS AND INTERPRETATION
6.6.1 When one entity seeks to obtain control over the net assets (assets less liabilities) of
another, there are a number of ways that this control can be achieved from a legal perspec-
tive: merger, consolidation, tender offer, and so forth. Business combinations occur in one of
two ways.
• In an acquisition of net assets, some (or all) of the assets and liabilities of one entity
are directly acquired by another
• With an equity (stock) acquisition one entity (the parent) acquires control of more than
50 percent of the voting common stock of another entity (the subsidiary). Both entities
can continue as separate legal entities, producing their own independent set of finan-
cial statements, or they can be merged in some way.
Under IFRS 3, the same accounting principles apply to both these ways of carrying out the
combination.
6.6.2 Under the purchase method, the acquisition price must be allocated to all of the
acquired company’s identifiable tangible and intangible assets, liabilities, and contingent lia- | Hennie |
bilities. The assets and liabilities of the acquired entity are combined into the financial state-
ments of the acquiring firm at their fair values on the acquisition date. Because the acquirer’s
assets and liabilities, measured at their historical costs, are combined with the acquired com-
pany’s assets and liabilities, measured at their fair market value on the acquisition date, the
acquirer’s pre- and postmerger balance sheets might not be easily comparable.
6.6.3 The fair value of long-term debt acquired on a business combination is the present
value of the principal and interest payments over the remaining life of the debt which has
been discounted using current market interest rates. Therefore, the fair value of the acquiree’s
debt that was issued at interest rates below current rates will be lower than the amount rec-
ognized on the acquiree’s balance sheet. Conversely, the fair value of the acquiree’s debt will
be higher than the amount recognized on the acquiree’s financial statements if the interest
rate on the debt is higher than current interest rates.
Chapter 6 Business Combinations (IFRS 3)
53
6.6.4 The cost of acquisition is compared with the fair values of the acquiree’s assets, liabili-
ties, and contingent liabilities and any excess is recognized as goodwill. If the fair market value
of the acquiree’s assets, liabilities and contingent liabilities is greater than the cost of acquisition
(effectively resulting in negative goodwill), IFRS 3 requires that the excess be reported as a gain.
6.6.5 The purchase method of accounting can be summarized by the following steps:
1. The cost of acquisition is determined.
2. The fair value of the acquiree’s assets is determined.
3. The fair value of the acquiree’s liabilities and contingent liabilities is determined.
4. The fair market value of the acquired company’s net assets equals the difference
between the fair market values of the acquired firm’s assets and liabilities.
Fair Market Value
of Acquired Firm’s Net Assets
=
Fair Market Value
of Acquired Firm’s Assets
–
Fair Market Value
of Acquired Firm’s Liabilities
and Contingent Liabilities
5. Calculate the new goodwill arising from the purchase as follows:
Goodwill
=
Purchase
Price
–
Fair Market Value
of Acquired Firm’s Net Assets,
Liabilities, and Contingent Liabilities
6. The book value of the acquirer’s assets and liabilities should be combined with the fair
values of the acquiree’s assets, liabilities, and contingent liabilities.
7. Any goodwill should be recognized as an asset in the combined entity’s balance sheet.
8. The acquired company’s net assets should not be combined with the acquiring compa-
ny’s equity because the acquired company ceases to exist (separately in the combined
financial statements) after the acquisition. Therefore, the acquired firm’s net worth is
eliminated (replaced with the market value of the shares issued by the acquirer).
6.6.6 In applying the purchase method, the income statement and the cash flow statements
will include the operating performance of the acquiree from the date of the acquisition for-
ward. Operating results prior to the acquisition are not restated and remain the same as his-
torically reported by the acquirer. Consequently, the financial statements (balance sheet,
income statement, and cash flow statement) of the acquirer will not be comparable before
and after the merger, but will reflect the reality of the merger.
6.6.7 Despite the sound principles incorporated in IFRS 3, many analysts believe that the
determination of fair values involve considerable management discretion. Values for intan-
gible assets such as computer software might not be easily validated when analyzing pur-
chase acquisitions.
6.6.8 Management judgment can be particularly apparent in the allocation of excess pur-
chase price (after all other allocations to assets and liabilities). If, for example, the remaining
excess purchase price is allocated to goodwill, there will be no impact on the firm’s net | Hennie |
income, because goodwill is not amortized (but is tested for impairment). If the excess were
to be allocated to fixed assets, depreciation would rise, thus reducing net income and pro-
ducing incorrect financial statements.
54
Chapter 6 Business Combinations (IFRS 3)
6.6.9 Under the purchase method, the acquirer’s gross margin usually decreases in the year
of the combination (assuming the combination does not occur near the end of the year)
because the write-up of the acquired firm’s inventory will almost immediately increase the
cost of goods sold. However, in the year following the combination the gross margin might
increase, reflecting the fact that the cost of goods sold decreases after the higher-cost inven-
tory has been sold. Under some unique circumstances, for instance when an entity purchas-
es another for less than book value, the effect on the ratios can be the reverse of what is com-
monly found. Therefore, there are no absolutes in using ratios, and analysts need to assess
the calculated ratios carefully in order to determine the real effect.
6.6.10 This points to an important analytical problem. Earnings, earnings per share, the
growth rate of these variables, rates of return on equity, profit margins, debt-to-equity ratios,
and other important financial ratios have no objective meaning. There is no rule of thumb
that the ratios will always appear better under the purchase method or any other method that
might be allowed in non-IASB jurisdictions. The financial ratios must be interpreted in light
of the accounting principle that is employed to construct the financial statements, as well as
the substance of the business combination.
6.6.11 One technique an analyst can use in his or her review of a company is to examine
cash flow. Cash flow, being an objective measure (in contrast to accounting measures such as
earnings that are subjectively related to the accounting methods used to determine them), is
less affected by the accounting methods used. Therefore, it is often instructive to compare
companies, and to examine the performance of the same company over time, in terms of cash
flow.
6.6.12 Over the years, goodwill has become one of the most controversial topics in account-
ing. Goodwill cannot be measured directly. Its value is generally determined through
appraisals, which are based on appraiser assumptions. As such, the value of goodwill is sub-
jectively determined.
6.6.13 The subject of recognizing goodwill in financial statements has found both propo-
nents and opponents among professionals. The proponents of goodwill recognition assert
that goodwill is the “present value of excess returns that a company is able to earn.” This
group claims that determining the present value of these excess returns is analogous to deter-
mining the present value of future cash flows associated with other assets and projects.
Opponents of goodwill recognition claim that the prices paid for acquisitions often turn out
to be based on unrealistic expectations, thereby leading to future write-offs of goodwill.
6.6.14 Both arguments have merit. Many companies are able to earn excess returns on their
investments. As such, the prices of the common shares of these companies should sell at a
premium to the book value of their tangible assets. Consequently, investors who buy the
common shares of such companies are paying for the intangible assets (reputation, brand
name, and so forth).
6.6.15 There are companies that earn low returns on investment despite the anticipated
excess returns indicated by the presence of a goodwill balance. The common share prices of
these companies tend to fall below book value because their assets are overvalued. Therefore,
it should be clear that simply paying a price in excess of the fair market value of the acquired
firm’s net assets does not guarantee that the acquiring company will continue earning excess
returns.
6.6.16 In short, analysts should distinguish between accounting goodwill and economic | Hennie |
goodwill. Economic goodwill is based on the economic performance of the entity, whereas
accounting goodwill is based on accounting standards. Economic goodwill is what should
Chapter 6 Business Combinations (IFRS 3)
55
concern analysts and investors. So, when analyzing a company’s financial statements, it is
imperative that the analysts remove goodwill from the balance sheet. Any excess returns that
the company earns will be reflected in the price of its common shares.
6.6.17 Under IFRS 3, goodwill should be capitalized and tested for impairment annually.
Goodwill is not amortized. Impairment of goodwill is a noncash expense. However, the
impairment of goodwill does affect reported net income. When goodwill is charged against
income in the current period, current reported income decreases, but future reported income
should increase when the asset is written off or no longer impaired. This also leads to
reduced net assets and reduced shareholders’ equity on the one hand, but improved return
on assets, asset turnover ratios, return on equity, and equity turnover ratios on the other
hand.
6.6.18 Even when the marketplace reacts indifferently to these impairment write-offs, it is
an analyst’s responsibility to carefully review a company’s goodwill to determine whether or
not it has been impaired.
6.6.19 Goodwill can significantly impact the comparability of financial statements between
companies using different accounting methods. As such, an analyst should remove any dis-
tortion that goodwill, its recognition, amortization, and impairment might create by adjust-
ing the company’s financial statements. Adjustments should be made by:
• Computing financial ratios using balance sheet data that exclude goodwill
• Reviewing operating trends using data that exclude the amortization of goodwill or
impairment to goodwill charges
• Evaluating future business acquisitions by taking into account the purchase price paid
relative to the net assets and earnings prospects of the acquired firm
56
Chapter 6 Business Combinations (IFRS 3)
EXAMPLES: BUSINESS COMBINATIONS
EXAMPLE 6.1
H Ltd. acquired a 70 percent interest in the equity shares of F Ltd. for an amount of $750,000
on January 1, 20X1. The abridged balance sheets of both companies at the date of acquisition
were as follows:
Identifiable Assets
Investment in F Ltd.
Equity
Identifiable Liabilities
H Ltd.
$’000
8,200
750
8,950
6,000
2,950
8,950
F Ltd.
$’000
2,000
–
2,000
1,200
800
2,000
The fair value of the identifiable assets of F Ltd. amounts to $2,800,000 and the fair value of
its liabilities is $800,000. Demonstrate the results of the acquisition.
EXPLANATION
Fair Value of Assets Less Liabilities
Minority Interest
Fair Value of Net Acquisition
Cost of Acquisition
Gain
Minority
$’000
360
240
600
H Ltd.
$’000
2,000
600
1,400
(750)
650
The abridged consolidated balance sheet at the date of acquisition will appear as follows:
Assets
Shareholders’ Equity
Minority Interest
Liabilities
a = 8,200 + 2,800
b = 6,000 + 650 (gain included in profit or loss)
c = 2,950 + 800
$’000
11,000a
6,650b
600
3,750c
11,000
Chapter 6 Business Combinations (IFRS 3)
57
EXAMPLE 6.2
Big Company is buying Small for $100,000 plus the assumption of all of Small’s liabilities.
Indicate what cash balance and goodwill amount would be shown on the consolidated bal-
ance sheet.
Assume that Big Company is planning to fund the acquisition using cash of $10,000 and new
borrowings of $90,000 (long-term debt).
Preacquisition balance sheets
$
Big
20,000
40,000
20,000
80,000
120,000
–
200,000
22,000
3,000
25,000
$
Small
3,000
10,000
8,000
21,000
50,000
–
71,000
10,000
1,000
11,000
$
Small
(FMV)
3,000
15,000
8,000
26,000
60,000
–
86,000
10,000
1,000
11,000
Cash
Inventory
Accounts receivable
Current assets
Property, plant,
and equipment
Goodwill
Total assets
Accounts payable
Accrued liabilities
Current liabilities
Long-term Debt
25,000
10,000
10,000
Common stock
Paid-in capital
Retained earnings
Total equity
Total
Common stock
Par value
Market value
10,000
40,000
100,000
150,000
200,000
10
80
1,000
9,000
40,000
50,000
71,000
2
8
65,000
86,000
Continued on next page
58
| Hennie |
Chapter 6 Business Combinations (IFRS 3)
Example 6.2 (continued)
Postacquisition balance sheets (purchase method)
Cash
Inventory
Accounts
Receivable
Current assets
Investment in subsidiary
Property, plant,
and equipment
Goodwill
Total assets
Accounts payable
Accrued liabilities
Current liabilities
$
Big
10,000
40,000
20,000
80,000
100,000
120,000
–
290,000
22,000
3,000
25,000
$
Small
3,000
10,000
8,000
21,000
50,000
–
71,000
10,000
1,000
11,000
$
Small (FMV)
3,000
15,000
8,000
26,000
60,000
–
86,000
10,000
1,000
11,000
Long-term debt
115,000
10,000
10,000
Common stock
Paid-in capital
Retained earnings
Total equity
Total
Common stock
Par value
Market value
10,000
40,000
100,000
150,000
290,000
10
80
1,000
9,000
40,000
50,000
71,000
2
8
65,000
86,000
EXAMPLE 6.2.A
Using the purchase method, Big’s postacquisition consolidated balance sheet will reflect a cash
balance of:
a. $13,000
c. $23,000
b. $20,000
d. $33,000
EXPLANATION 2A
Choice a. is correct. In a purchase method business combination, add the cash balances of the
two companies together and deduct any cash paid out as part of the purchase. Here the two
companies have $20,000 + $3,000 = $23,000 less $10,000 paid as part of the purchase leaving
a balance of $13,000.
Chapter 6 Business Combinations (IFRS 3)
59
EXAMPLE 6.2.B
Using the information provided, complete the consolidated balance sheet.
EXPLANATION
Completed postacquisition balance sheets (purchase method)
Cash
Inventory
Accounts
Receivable
Current assets
Investment in
Subsidiary
Property, plant,
and equipment
Goodwill
Total assets
Accounts
Payable
Accrued
Liabilities
Current
Liabilities
$
Big
10,000
40,000
20,000
80,000
100,000
120,000
–
290,000
$
Small
3,000
10,000
8,000
21,000
50,000
–
71,000
$
Small
(FMV)
3,000
15,000
8,000
26,000
60,000
–
86,000
22,000
10,000
10,000
3,000
1,000
1,000
25,000
11,000
11,000
Long-term debt
115,000
10,000
10,000
Common stock
Paid-in capital
Retained
Earnings
Total equity
Total
Common stock
Par value
Market value
10,000
40,000
100,000
150,000
290,000
10
80
1,000
9,000
40,000
50,000
71,000
2
8
10,000
40,000
65,000
(65,000) (c)
86,000
25,000
$
$
Adjustments
Consolidated
–100,000
35,000 (b)
25,000
13,000
55,000
28,000
96,000
180,000
35,000
311,000
32,000
4,000
36,000
125,000
100,000
150,000
311,000
Note: The goodwill is the difference between the consideration, including debt assumed, and
the fair market value of assets. In this case, the fair market value of Small’s assets is $86,000.
The consideration paid is $121,000 – $10,000 (cash) + $90,000 (debt issued) + $21,000 (liabili-
ties assumed, including Small’s accounts payable, accrued liabilities, and long-term debt).
The net difference between the $121,000 paid and the fair market value of the assets of
$86,000 is the goodwill of $35,000.
7 Consolidated and Separate
Financial Statements (IAS 27)
7.1
PROBLEMS ADDRESSED
Users of the financial statements of a parent entity need information about the financial posi-
tion, results of operations, and changes in financial position of the group as a whole. Hence,
the main objective of IAS 27 is to ensure that consolidated financial statements incorporating
all subsidiaries, jointly controlled entities, and associates are provided by such parent enti-
ties.
7.2
SCOPE OF THE STANDARD
This Standard’s main requirements are:
• Necessary aspects for control to be established.
• The preparation and presentation of consolidated financial statements for a group of
entities under the control of a parent; and
• The accounting for investments in subsidiaries, jointly controlled entities, and associ-
ates when an entity elects to—or is required by local regulations to—present separate
financial statements.
7.3
KEY CONCEPTS
7.3.1 Consolidated financial statements are the financial statements of a group presented
as financial statements of a single economic entity.
7.3.2 Control is the power to govern the financial and operating policies of an entity in
order to obtain benefits from the entity’s activities. The existence of control is generally evi-
denced by one of the following:
• Ownership. Parent owning (directly or indirectly through subsidiaries) of more than 50
percent of the voting power
• Voting rights. Power over more than 50 percent of the voting rights by virtue of an
| Hennie |
agreement with other investors
• Policies. Power to govern the financial and operating policies of the entity under a
statute or agreement
60
Chapter 7 Consolidated and Separate Financial Statements (IAS 27)
61
• Board of directors. Power to appoint or remove the majority of the members of the
board of directors
• Voting rights of directors. Power to cast the majority of votes at meetings of the board
7.3.3 A group is a parent and all of the parent’s subsidiaries.
7.3.4 A parent is an entity that has one or more subsidiaries.
7.3.5 Minority interest is that portion of the profit or loss, and net assets of a subsidiary
attributable to equity interests that are not owned, directly or indirectly through subsidiaries,
by the parent.
7.3.6 Separate financial statements are those presented by a parent, an investor in an asso-
ciate, or a venturer in a jointly controlled entity in which the investments are accounted for
on the basis of the direct equity interest rather than on the basis of the reported results and
net assets of the investees.
7.3.7 A subsidiary is an entity—including an unincorporated entity such as a partnership—
that is controlled by another entity (known as the parent).
7.3.8 Cost method of accounting is the recognition of the investment at cost and that of
income only to the extent that the investor receives distributions from accumulated profits of
the investee arising after the date of acquisition. Distributions received in excess of such prof-
its are regarded as a recovery of investment and are recognized as a reduction of the cost of
the investment.
7.4
ACCOUNTING TREATMENT
7.4.1 A parent should present consolidated financial statements as if the group were a sin-
gle entity. Consolidated financial statements should include
• the parent and all its foreign and domestic subsidiaries (including those that have dis-
similar activities),
• special purpose entities if the substance of relationship indicates control,
• subsidiaries that are classified as “held for sale,” and
• subsidiaries held by venture capital entities, mutual funds, unit trusts, and similar entities.
7.4.2 The preparation of consolidated financial statements involves the combination of the
financial statements of the parent and its subsidiaries on a line-by-line basis by adding
together like items of assets, liabilities, equity, income, and expenses. Other basic procedures
include the following:
• The carrying amount of the parent’s investment and its portion of equity of each sub-
sidiary are eliminated in accordance with the procedures of IFRS 3.
• Minority interests in the net assets of consolidated subsidiaries are identified and pre-
sented separately as part of equity.
• Intragroup balances and intragroup transactions are eliminated in full.
• Minority interests in the profit or loss of subsidiaries for the period are identified but
are not deducted from profit for the period.
• Consolidated profits are adjusted for the subsidiary’s cumulative preferred dividends,
whether or not dividends have been declared.
• An investment is accounted for in terms of IAS 39 from the date that it ceases to be a
subsidiary and does not subsequently become an associate.
62
Chapter 7 Consolidated and Separate Financial Statements (IAS 27)
• The losses applicable to the minority interest might exceed the minority investor’s
interest in the equity of the subsidiary. The excess is charged against the majority inter-
est except to the extent that the minority has a binding obligation to, and is able to,
make good on the losses.
7.4.3 Consolidated financial statements should be prepared using uniform accounting poli-
cies for like transactions and events.
7.4.4 Investments in subsidiaries should be accounted for in a parent entity’s separate
financial statements (if any) either
• at cost, or
• as financial assets in accordance with IAS 39.
7.4.5 When the reporting dates of the parent and subsidiaries differ, adjustments are made
for significant transactions or events that occur between those dates. The difference should | Hennie |
be no more than 3 months.
7.4.6 Consolidated financial statements need not be presented in the case of a wholly
owned subsidiary or a virtually wholly owned subsidiary (with unanimous approval of
minority shareholders) if
• debt or equity instruments are not traded in a public market;
• it did not file—or is not filing—financial statements with securities commission; and
• its ultimate parent publishes IFRS-consolidated financial statements.
7.5
PRESENTATION AND DISCLOSURE
7.5.1 Consolidated financial statements should include:
• Nature of the relationship when the parent does not own (directly or indirectly) more
than 50 percent of the voting power
• Name of an entity in which more than 50 percent of the voting power is owned (direct-
ly or indirectly), but which, because of the absence of control, is not a subsidiary
7.5.2 Where the parent does not present consolidated financial statements, include:
• the fact that exemption from publishing consolidated financial statements has been
used;
• the name and country of incorporation of parent that publishes consolidated financial
statement;
• the list of subsidiaries, associates, and joint ventures; and
• the method used to account for subsidiaries, associates and joint ventures.
7.5.3 In the parent’s separate financial statements, the following should be stated:
• List of subsidiaries, associates, and joint ventures
• Method used to account for subsidiaries, associates and joint ventures
7.6
FINANCIAL ANALYSIS AND INTERPRETATION (See also Section 6.6)
7.6.1 IAS 27 requires that the financial statements of a parent company and the financial
statements of the subsidiaries that it controls be consolidated. Control of a subsidiary is pre-
sumed when the parent company owns more than 50 percent of the voting stock of a sub-
Chapter 7 Consolidated and Separate Financial Statements (IAS 27)
63
sidiary unless control does not exist in spite of the parent’s ownership of a majority of the vot-
ing stock of the subsidiary.
7.6.2 The process of consolidation begins with the balance sheets and income statements of
the parent and the subsidiary constructed as separate entities. The parent’s financial state-
ments recognize the subsidiary as an asset called an investment in subsidiary and any div-
idends received from the subsidiary as income from subsidiaries.
7.6.3 With the financial statements of the parent and subsidiary combined, the consolidat-
ed financial statements fully reflect the financial results and financial position of the parent
and subsidiary. Consolidation does, however, pose problems:
• Combined financial statements of entities in totally different businesses limits analysis
of operations and trends of both the parent and the subsidiary—a problem overcome
somewhat by segment information.
• Regulatory or debt restrictions might not be easily discernible on the consolidated
financial statements.
64
Chapter 7 Consolidated and Separate Financial Statements (IAS 27)
EXAMPLES: CONSOLIDATED FINANCIAL STATEMENTS AND ACCOUNTING
FOR INVESTMENTS IN SUBSIDIARIES
EXAMPLE 7.1
The following amounts of profit after tax relate to the Alpha group of entities:
Alpha Inc.
Beta Inc.
Charlie Inc.
Delta Inc.
Echo Inc.
$
150,000
40,000
25,000
60,000
80,000
Alpha Inc. owns 75 percent of the voting power in Beta Inc. and 30 percent of the voting
power in Charlie Inc.
Beta Inc. also owns 30 percent of the voting power in Charlie Inc. and 25 percent of the vot-
ing power in Echo Inc.
Charlie Inc. owns 40 percent of the voting power in Delta Inc.
Issues
What is the status of each entity in the group and how is the minority share in the group profit
after tax calculated?
EXPLANATION
Beta Inc. and Charlie Inc. are both subsidiaries of Alpha Inc. which owns, directly or indi-
rectly through a subsidiary, more than 50 percent of the voting power in the entities.
Charlie Inc. and Echo Inc. are deemed to be associates of Beta Inc., whereas Delta Inc. is deemed
to be an associate of Charlie Inc. unless it can be demonstrated that significant influence does | Hennie |
not exist.
The minority interest in the group profit after tax is calculated as follows:
$
$
Profit after tax of Charlie Inc.
Own
Equity accounted:
Delta Inc. (40% ¥ 60,000)
25,000
24,000
49,000
Minority interest of 40%
19,600
Profit after tax of Beta Inc.
Own
Equity accounted:
Charlie Inc. (30% ¥ 49,000)
Echo Inc. (25% ¥ 80,000)
Minority interest of 25%
40,000
14,700
20,000
74,700
18,675
38,275
Chapter 7 Consolidated and Separate Financial Statements (IAS 27)
65
EXAMPLE 7.2
A European parent company, with subsidiaries in various countries, follows the accounting
policy of FIFO costing for all inventories in the group. It has recently acquired a controlling
interest in a foreign subsidiary that uses LIFO because of the tax benefits.
How is this aspect dealt with on consolidation?
EXPLANATION
IAS 27 requires consolidated financial statements to be prepared using uniform accounting
policies However, it does not demand that an entity in the group change its method of
accounting in its separate financial statements to that method which is adopted for the group.
Therefore, on consolidation appropriate adjustments must be made to the financial state-
ments of the foreign subsidiary to convert the carrying amount of inventories to a FIFO-
based amount.
66
Chapter 7 Consolidated and Separate Financial Statements (IAS 27)
EXAMPLE 7.3
Below are the balance sheet and income statements of a parent company and an 80
percent–owned subsidiary. The table depicts the method and adjustments required to con-
struct the consolidated financial statements. All allocations that cannot be accounted for in
any other way are attributed to goodwill.
Parent Only ($)
Subsidiary Only ($)
Adjustments ($)
Consolidated ($)
Cash
Receivables
From Others
From Subsidiary
Inventories
Plant and Equipment
Investments
In Others
In Subsidiary
Total Assets
Accounts Payable
To Others
To Parent
Long-Term Debt
Minority Interest
Common Stock
Paid-in Capital
Retained Earnings
Total Liabilities and Capital
50
320
30
600
1,000
800
360
3,160
250
1,350
100
300
1,160
3,160
120
20
100
500
40
780
100
30
200
40
160
250
780
170
340
—
700
1,500
840
—
3,550
350
—
1,550
90 (4)
100 (5)
300 (5)
1,160 (5)
3,550
(30) (1)
(360) (2)(3)
(390)
(30) (1)
90 (2)(3)
(40) (2)(3)
(160) (2)(3)
(250) (2)(3)
(390)
EXPLANATION 7.3.A
(1) The Intercompany receivables or payables are eliminated against each other so they do
not affect the consolidated group’s assets and liabilities.
(2) Investment in Subsidiary
Less 80% of Subsidiary’s equity
.80 ($40 + $160 + $250)
Goodwill from Consolidation
$360
360
$ 0
(3) This represents the pro rata share of the book value of the subsidiary’s equity (its com-
mon stock, paid-in capital, and retained earnings) that is not owned by the parent: 20%
of $450 = $90.
(4) Note that the Minority Interest is an explicit item only on the consolidated balance
sheet.
(5) Note that the equity of the consolidated group is the same as the equity of the parent,
which is the public entity.
Chapter 7 Consolidated and Separate Financial Statements (IAS 27)
67
Parent Only ($)
Subsidiary Only ($)
Adjustments ($)
Consolidated ($)
Sales to Outside Entities
Receipts from Subsidiary
Total Revenues
Costs of Goods Sold
Other Expenses
Payments to Parent
Minority Interest (1)
Pretax Income
Tax Expense (30%)
Income from Operations
Net Income from
Unconsolidated Subsidiaries
Net Income
2,800
500
3,300
1,800
200
—
1,300
390
910
28
938
1,000
1,000
400
50
500
50
15
35
35
(500) (2)
(500)
(500) (2)
10 (3)
(10)
(3) (3)
(7) (3)(4)
(28) (4)
(35)
3,800
—
3,800
2,200
250
—
10
1,340
402
938
—
938 (5)
EXPLANATION 7.3.B
(1) Sometimes Minority Interest ($10) is shown after taxes, in which case it would be
reported as $7 and placed below the Tax Expense line.
(2) The receipts from or payable by the subsidiary ($500) are eliminated against each other
and do not appear on the consolidated income statement.
(3) The pro forma share of the pretax income of the subsidiary that does not accrue to the
parent is reported as a Minority Interest expense on the consolidated income statement.
It is computed as follows:
20% of $50 = $10
Note that the calculation could have also been done on an after-tax basis:
| Hennie |
20% of $35 = $7
(4) The net income of the subsidiary is eliminated against the net Minority Interest expense
and the Net Income from Unconsolidated Subsidiaries account on the parent-only
income statement. This elimination is accounted for using the following journal entries:
Minority Interest (net of taxes)
Parent’s Net Income from Unconsolidated Subsidiaries
Subsidiary Net Income
$7
$28
$35
(5) The consolidated net income of the parent (the public entity) equals the parent-only net
income computed using the equity method. This is because the parent-only statement
includes the parent’s share of the net income from the (unconsolidated) subsidiary, just
as for the consolidated income.
8 Investments in Associates (IAS 28)
8.1
PROBLEMS ADDRESSED
Associate entities are distinct from subsidiaries in that the influence and ownership of asso-
ciates by the parent entity is not as extensive as for subsidiaries (IAS 27). The main issue is
identifying the amount of influence needed for an entity to be classified as an associate.
Conceptually this is considered as significant influence and practically this is done through
the degree of ownership (see Table 6.1). A conjunct issue of IAS 28 is what the appropriate
accounting treatment should be for the parent’s investment in the associate.
8.2
SCOPE OF THE STANDARD
IAS 28 applies to each investment in an associate. The main requirements are:
• Identification and requirements for the significant influence test.
• Prescription of the equity method of accounting for associates (which captures the parent’s
interest in the in the earnings and the underlying assets and liabilities of the associate).
The Standard does not apply to joint ventures, or entities that are subsidiaries.
The following entities could account for investments in associates as (a) associates in accor-
dance with IAS 28 or (b) held for trading financial assets in accordance with IAS 39:
• Venture capital organizations.
• Mutual funds.
• Unit trusts and similar entities.
• Investment-linked insurance funds.
8.3
KEY CONCEPTS
8.3.1 Equity method of accounting is accounting whereby the investment is initially rec-
ognized at cost and adjusted thereafter for the postacquisition change in the investor’s share
of net assets of the investee. The profit or loss of the investor includes the investor’s share of
the profit or loss of the investee.
8.3.2 An associate is an entity (including an unincorporated entity such as a partnership)
over which the investor has significant influence, and that is neither a subsidiary nor an inter-
est in a joint venture.
68
Chapter 8 Investments in Associates (IAS 28)
69
8.3.3 Significant influence is the power to participate in the financial and operating policy
decisions of the investee but is not control or joint control over those policies. If an investor
holds, directly or indirectly through subsidiaries, 20 percent or more of the voting power of
the investee it is presumed that the investor has significant influence, unless it can be clearly
demonstrated that this is not the case. Existence of significant influence is evidenced by, inter
alia, the following:
• Representation on the board of directors or governing body
• Participation in policymaking processes
• Material transactions between parties
• Interchange of managerial personnel
• Provision of essential technical information
8.3.4 Control is the power to govern the financial and operating policies of an entity to
obtain benefits from its activities.
8.3.5 Joint control is the contractually agreed sharing of control over an economic activity.
8.3.6 A subsidiary is an entity—including an unincorporated entity such as a partnership—
that is controlled by another entity (known as the parent).
8.3.7 Consolidated financial statements are the financial statements of a group presented
as those of a single economic entity.
8.3.8 Separate financial statements are those presented by a parent, an investor in an asso-
ciate, or a venturer in a jointly controlled entity, in which the investments are accounted for | Hennie |
on the basis of the direct equity interest rather than on the basis of the reported results and
net assets of the investees.
8.4
ACCOUNTING TREATMENT
8.4.1 An investment in an associate should be accounted for, in the consolidated financial
statements of the investor and in any separate financial statements, using the equity method:
8.4.2 Equity accounting should commence from the date that the investee meets the defin-
ition of an associate. Equity accounting should be discontinued when
• the investor ceases to have significant influence, but retains whole or part of the invest-
ment; and
• the associate operates under severe long-term restrictions that significantly impair its
ability to transfer funds.
8.4.3 The equity method is applied as follows:
• Initial measurement is applied at cost (excluding borrowing costs as per IAS 23).
• Subsequent measurement is adjusted for postacquisition change in the investor’s
share of
• the net assets of the associate share of profit or loss included in income statement, and
• the share of other changes included in equity.
8.4.4 Many procedures for the equity method are similar to consolidation procedures, such
as the following:
• Eliminating intragroup profits and losses arising from transactions between the
investor and the investee
70
Chapter 8 Investments in Associates (IAS 28)
• Identifying the goodwill portion of the purchase price
• Amortization of goodwill
• Adjustments for depreciation of depreciable assets, based on their fair values
• Adjustments for the effect of cross holdings
• Using uniform accounting policies
8.4.5 The investor computes its share of profits or losses after adjusting for the cumulative
preferred dividends, whether or not they have been declared. The investor recognizes losses
of an associate until the investment is zero. Further losses are only provided for to the extent
of guarantees given by the investor.
8.4.6 The same principles outlined with regard to consolidating subsidiaries should be fol-
lowed when equity accounting—namely, using the most recent financial statements and
using uniform accounting policies for the investor and the investee; if reporting dates differ,
make adjustments for significant events after the balance sheet date of the associate.
8.4.7 With regard to impairment of an investment, the investor applies IAS 39 to determine
whether it is necessary to recognize any impairment loss. If the application of IAS 39 indi-
cates that the investment may be impaired, the investor applies IAS 36 to determine the value
in use of the associate.
8.5
PRESENTATION AND DISCLOSURE
8.5.1 Balance sheet and notes should include:
• Investment in associates shown as a separate item on the face and classified as noncurrent
• An appropriate list and description of significant associates, including
• name,
• nature of the business, and
• proportion of ownership interest or proportion of voting power (if different from the
ownership interest).
• If the investor does not present consolidated financial statements and does not equity-
account the investment, a description of what the effect would have been had the equi-
ty method been applied should be disclosed.
• If it is not practicable to calculate adjustments when associate (associates) uses account-
ing policies other than those adopted by investor, the fact should be mentioned.
• The investor’s share of the contingent liabilities and capital commitments of an associ-
ate for which it is contingently liable.
8.5.2 Income statement and notes should include the investor’s share of:
profits and losses for the period
prior period items
The investor’s share of the profit or loss of such associates, and the carrying amount of those
investments, should be separately disclosed. The investor’s share of any discontinued opera-
tions of such associates should also be separately disclosed, as follows:
• Its share of the contingent liabilities of an associate incurred jointly with other investors
• Those contingent liabilities that arise because the investor is severally liable for all or
| Hennie |
part of the liabilities of the associate.
Chapter 8 Investments in Associates (IAS 28)
71
8.5.3 Accounting policies. Disclose the method used to account for:
associates
goodwill and negative goodwill
amortization period for goodwill
8.5.4 The fair value of investments in associates for which there are published price quota-
tions should be disclosed.
8.5.5 Summarized financial information of associates, including the aggregated amounts of
assets
liabilities
revenues
profit or loss, should be provided.
8.5.6 The following disclosures should also be made:
• The reasons for deviating from the significant influence presumptions
• The reporting date of the financial statements of an associate, when such financial
statements are used in applying the equity method and are as of a reporting date or for
a period that is different from that of the investor, and the reason for using a different
reporting date or different period
• The nature and extent of any significant restrictions (for example, resulting from bor-
rowing arrangements or regulatory requirements) on the ability of associates to transfer
funds to the investor in the form of cash dividends, or repayment of loans or advances
• The unrecognized share of losses of an associate, both for the period and cumulatively,
if an investor has discontinued recognition of its share of losses of an associate
8.6
FINANCIAL ANALYSIS AND INTERPRETATION
8.6.1 Under the equity method, the investment in an associate is initially recognized at cost
and the carrying amount is increased or decreased to recognize the investor’s share of the
profit or loss of the investee after the date of acquisition. The investor’s share of the profit or
loss of the investee is recognized in the investor’s profit or loss. Distributions received from
an investee reduce the carrying amount of the investment.
8.6.2 Adjustments to the carrying amount might also be necessary for changes in the
investor’s proportionate interest in the investee arising from changes in the investee’s equi-
ty that have not been recognized in the investee’s profit or loss. Such changes include those
arising from the revaluation of property, plant, and equipment and from foreign exchange
translation differences. The investor’s share of those changes is recognized directly in equity
of the investor.
72
Chapter 8 Investments in Associates (IAS 28)
EXAMPLE: ACCOUNTING FOR INVESTMENTS IN ASSOCIATES
EXAMPLE 8.1
Dolo Inc. acquired a 40 percent interest in the ordinary shares of Nutro Inc. on the date of
incorporation, January 1, 20X0, for an amount of $220,000. This enabled Dolo Inc. to exercise
significant influence over Nutro Inc. On December 31, 20X3, the shareholders’ equity of
Nutro Inc. was as follows:
Ordinary issued share capital
Reserves
Accumulated profit
$
550,000
180,000
650,000
1,380,000
The following abstracts were taken from the financial statements of Nutro Inc. for the year
ending December 31, 20X4:
Income statement
Profit after tax
Extraordinary item
Net profit for the period
Statement of changes in equity
Accumulated profits at beginning of the year
Net profit for the period
Dividends paid
Accumulated profits at end of the year
$
228,000
(12,000)
216,000
650,000
216,000
(80,000)
786,000
In November 20X4, Dolo Inc. sold inventories to Nutro Inc. for the first time. The total sales
amounted to $50,000 and Dolo Inc. earned a profit of $10,000 on the transaction. None of the
inventories had been sold by Nutro Inc. by December 31. The income tax rate is 30 percent.
Chapter 8 Investments in Associates (IAS 28)
73
EXPLANATION
The application of the equity method would result in the carrying amount of the investment
in Nutro Inc. being reflected as follows:
Original cost
Postacquisition profits accounted for at beginning of the year
[40% ¥ (180,000 + 650,000)]
Carrying amount on January 1, 20X4
Attributable portion of net profit for the period (Calculation a)
Dividends received (40% ¥ 80,000)
Calculation a
Attributable portion of net profit
Net profit (40% ¥ 216,000)
After-tax effect of unrealized profit [40% ¥ (70% ¥ 10,000)]
All
$
220,000
332,000
552,000
83,600
(32,000)
603,600
$
86,400
(2,800)
83,600
| Hennie |
9 Interests in Joint Ventures (IAS 31)
9.1
PROBLEMS ADDRESSED
Joint ventures occur where there is an arrangement to undertake an activity where control is
shared jointly. This is different from arrangements where a parent has sole control or there is
significant influence. The overall objective of IAS 31 is to provide users with information con-
cerning the investing owners’ (venturers’) interest in the earnings and the underlying net
assets of the joint venture.
9.2
SCOPE OF THE STANDARD
This IAS applies to all interests in joint ventures and the reporting of their assets, liabilities,
income, and expenses, regardless of the joint ventures’ structures or forms. The Standard
specifically outlines:
• The characteristics necessary to be classified as a joint venture.
• The distinction between jointly controlled operations, assets and entities and the specif-
ic accounting requirements for each.
The following entities may account for investments in joint ventures as joint ventures in
accordance with IAS 31 or as held for trading financial assets in accordance with IAS 39:
• Venture capital organizations.
• Mutual funds.
• Unit trusts and similar entities.
• Investment-linked insurance funds.
9.3
KEY CONCEPTS
9.3.1 A joint venture is a contractual arrangement whereby two or more parties undertake
an economic activity that is subject to joint control.
9.3.2 The following are characteristics of all joint ventures:
• Two or more venturers are bound by a contractual arrangement.
• A joint venture establishes joint control; that is, the contractually agreed sharing of con-
trol over a joint venture is such that not one of the parties can exercise unilateral control.
• A venturer is a party to a joint venture and has joint control over that joint venture.
74
Chapter 9 Interests in Joint Ventures (IAS 31)
75
9.3.3 The existence of a contractual arrangement distinguishes joint ventures from associ-
ates. It is usually in writing and deals with such matters as:
• Activity, duration, and reporting
• Appointment of a board of directors or equivalent body and voting rights
• Capital contributions by venturers
• Sharing by the venturers of the output, income, expenses, or results of the joint venture
9.3.4 IAS 31 identifies three forms of joint ventures, namely jointly controlled operations,
jointly controlled assets, and jointly controlled entities.
9.3.5 Jointly controlled operations involve the use of resources of the venturers; they do
not establish separate structures. An example is when two or more parties combine resources
and efforts to manufacture, market, and jointly sell a product.
9.3.6 Jointly controlled assets refer to some joint ventures that involve the joint control and
ownership of one or more assets acquired for and dedicated to the purpose of the joint ven-
ture (for example, factories sharing the same railway line). The establishment of a separate
entity is unnecessary.
9.3.7 Jointly controlled entities are joint ventures that are conducted through a separate
entity in which each venturer owns an interest. An example is when two entities combine
their activities in a particular line of business by transferring assets and liabilities into a joint
venture.
9.3.8 Proportionate consolidation is a method of accounting whereby a venturer’s share of
each of the assets, liabilities, income, and expenses of a jointly controlled entity is combined
line by line with similar items in the venturer’s financial statements or reported as separate
line items in the venturer’s financial statements.
9.3.9 Separate financial statements are those presented by a parent, an investor in an asso-
ciate, or a venturer in a jointly controlled entity, in which the investments are accounted for
on the basis of the direct equity interest rather than on the basis of the reported results and
net assets of the investees.
9.4
ACCOUNTING TREATMENT
9.4.1 In respect of its interests in jointly controlled operations, a venturer should recognize
in its separate and consolidated financial statements
| Hennie |
• the assets that it controls,
• the liabilities that it incurs,
• the expenses that it incurs, and
• its share of the income that it earns from the joint venture.
9.4.2 In respect of its interests in jointly controlled assets a venturer should recognize in its
separate and consolidated financial statements
• its share of the assets,
• any liabilities that it has incurred,
• its share of any liabilities incurred jointly with the other venturers in relation to the
joint venture,
76
Chapter 9 Interests in Joint Ventures (IAS 31)
• any income it receives from the joint venture,
• its share of any expenses incurred by the joint venture, and
• any expenses that it has incurred in respect of its interest in the joint venture.
9.4.3 An entity should account for its interest as a venturer in jointly controlled entities
using one of the following two treatments:
1. Proportionate consolidation, whereby a venturer’s share of each of the assets, liabili-
ties, income, expenses, and cash flows of a jointly controlled entity is combined with
similar items of the venturer or reported separately. The following principles apply:
• Two formats could be used, namely
• combining items line by line, or
• listing separate line items.
• The interests in the joint ventures are included in consolidated financial statements
for the venturer, even if it has no subsidiaries.
• Proportionate consolidation is commenced when the venturer acquires joint control.
• Proportionate consolidation ceases when the venturer loses joint control.
• Many procedures for proportionate consolidation are similar to consolidation proce-
dures, described in IAS 27.
• Assets and liabilities can only be offset if
• a legal right to set-off exists; and
• there is an expectation of realizing an asset or settling a liability on a net basis.
2. The equity method is an allowed alternative but is not recommended. The method
should be discontinued when joint control or significant influence is lost by the venturer.
9.4.4 The following general accounting considerations apply:
• Transactions between a venturer and a joint venture are treated as follows:
• The venturer’s share of unrealized profits on sales or contribution of assets to a joint
venture is eliminated.
• Full unrealized loss on sale or contribution of assets to a joint venture is eliminated.
• The venturer’s share of profits or losses on sales of assets by a joint venture to the
venturer is eliminated.
• An investor in a joint venture that does not have joint control should report its interest
in a joint venture in the consolidated financial statements in terms of IAS 39 or, if it has
significant influence, in terms of IAS 28.
• Operators or managers of a joint venture should account for any fees as revenue in
terms of IAS 18.
9.5
PRESENTATION AND DISCLOSURE
9.5.1 The following contingent liabilities (IAS 37) should be shown separately from others:
• Incurred jointly with other venturers
• Share of a joint venture’s contingent liabilities
• Contingencies for liabilities of other venturers
9.5.2 Amount of commitments shown separately include:
• Incurred jointly with other venturers
• Share of a joint venture’s commitments
Chapter 9 Interests in Joint Ventures (IAS 31)
77
9.5.3 Present a listing of significant joint ventures, including:
• Names
• A description of the interests in all joint ventures
• The proportion of ownership
9.5.4 A venturer that uses the line-by-line reporting format or the equity method should
disclose aggregate amounts of each of the current assets, long-term assets, current liabilities,
long-term liabilities, income, and expenses related to the joint ventures.
9.5.5 A venturer not issuing consolidated financial statements (because it has no sub-
sidiaries) should nevertheless disclose the above information.
9.6
FINANCIAL ANALYSIS AND INTERPRETATION
9.6.1 Entities can form joint ventures in which none of the entities own more than 50 per-
cent of the voting rights in the joint venture. This enables every member of the venturing | Hennie |
group to use the equity method of accounting for unconsolidated affiliates to report their
share of the activities of the joint ventures. They can also use proportionate consolidation—
and each one need not use the same method.
9.6.2 If they use the equity method, joint ventures enable firms to report lower debt-to-equity
ratios and higher interest coverage ratios, although this does not affect the return on equity.
9.6.3 Forming joint ventures also affects the cash flow reported by the sponsoring group of
firms. When the equity method of accounting for jointly controlled entities is used, monies
exchanged between a parent and the jointly controlled entities are reported as income or
expenses, whereas in consolidation accounting any cash flows that are internal to members
of the consolidated group are not reported separately.
78
Chapter 9 Interests in Joint Ventures (IAS 31)
EXAMPLES: FINANCIAL REPORTING OF INTERESTS IN JOINT VENTURES
EXAMPLE 9.1
Techno Inc. was incorporated after three independent engineering corporations decided to
pool their knowledge to implement and market new technology. The three corporations
acquired the following interests in the equity capital of Techno Inc. on the date of its incor-
poration:
• Electro Inc.
• Mechan Inc.
• Civil Inc.
30%
40%
30%
The following information was taken from the financial statements of Techno Inc. as well as
one of the owners, Mechan Inc.
Abridged income statement for the year ending June 30, 20X1
Mechan Inc.
($’000)
Techno Inc.
($’000)
Revenue
Cost of Sales
Gross profit
Other operating income
Operating costs
Profit before tax
Income tax expense
Net profit for the period
3,100
(1,800)
1,300
150
(850)
600
(250)
350
980
(610)
370
–
(170)
200
(90)
110
Mechan Inc. sold inventories with an invoice value of $600,000 to Techno Inc. during the year.
Included in Techno Inc.’s inventories June 30, 20X1, is an amount of $240,000, which is inven-
tory purchased from Mechan Inc. at a profit markup of 20 percent. The income tax rate is 30
percent.
Techno Inc. paid an administration fee of $120,000 to Mechan Inc. during the year. This
amount is included under “Other operating income.”
EXPLANATION
In order to combine the results of Techno Inc. with those of Mechan Inc. the following issues
would need to be resolved:
• Is Techno Inc. an associate or joint venture for financial reporting purposes?
• Which is the appropriate method for reporting the results of Techno in the financial
statements of Mechan?
• How are the above transactions between the entities to be recorded and presented for
financial reporting purposes in the consolidated income statement?
First issue
The existence of a contractual agreement, whereby the parties involved undertake an eco-
nomic activity subject to joint control, distinguishes a joint venture from an associate. No one
of the ventures should be able to exercise unilateral control. However, in the event that no
Chapter 9 Interests in Joint Ventures (IAS 31)
79
contractual agreement exists, the investment would be regarded as being an associate
because the investor holds more than 20 percent of the voting power and is therefore pre-
sumed to have significant influence over the investee.
Second issue
If Techno Inc. is regarded as a joint venture, the proportionate consolidation method or the
equity method must be used. However, if Techno Inc. is regarded as an associate, the equity
method would be used.
Third issue
It is assumed that Techno Inc. is a joint venture for purposes of this illustration.
Consolidated Income Statement for the Year Ending June 30, 20X1
Revenue (Calculation a)
Cost of sales (Calculation b)
Gross profit
Other operating income (Calculation c)
Operating costs (Calculation d)
Profit before tax
Income tax expense (Calculation e)
Net profit for the period
$’000
3,252
(1,820)
1,432
102
(870)
664
(281)
383
Remarks
• The proportionate consolidation method is applied by adding 40 percent of the income
statement items of Techno Inc. to those of Mechan Inc.
• The transactions between the corporations are then dealt with by recording the follow-
| Hennie |
ing consolidation journal entries:
Sales (40% ¥ 600)
Cost of sales
(Eliminating intra-group sales)
Cost of sales (40% ¥ 20/120 ¥ 240)
Inventories
(Eliminating unrealized profit in inventory)
Deferred taxation (B/S) (30% ¥ 16)
Income tax expense (I/S)
(Taxation effect on elimination of unrealized profit)
Dr
($’000)
240
Cr
($’000)
240
16
4.8
16
4.8
Note: The administration fee is eliminated by reducing other operating income with Mechan
Inc.’s portion of the total fee, namely $48,000, and reducing operating expenses accordingly.
The net effect on the consolidated profit is nil.
Continued on next page
80
Chapter 9 Interests in Joint Ventures (IAS 31)
Example 9.1 (continued)
Calculations
a. Sales
Mechan
Intragroup sales (40% ¥ 600)
Techno (40% ¥ 980)
b. Cost of sales
Mechan
Intragroup sales
Unrealized profit (40% ¥ 20/120 ¥ 240)
Techno (40% ¥ 610)
c. Other operating income
Mechan
Intragroup fee (40% ¥ 120)
d. Operating costs
Mechan
Techno (40% ¥ 170)
Intragroup fee (40% ¥ 120)
e.
Income tax expense
Mechan
Unrealized profit (30% ¥ 16 rounded up)
Techno (40% ¥ 90)
$’000
3,100
(240)
392
3,252
1,800
(240)
16
244
1,820
150
(48)
102
850
68
(48)
870
250
(5)
36
281
PARTIII
Balance Sheet
and Income
Statement
10 Share-Based Payment (IFRS 2)
10.1
PROBLEMS ADDRESSED
Share-based payments occur when an entity uses a transfer of shares instead of satisfying an
obligation using conventional cash. The standard covers situations where the entity makes
any share-based payment transaction, including transactions with employees or other parties
to be settled in cash, equity, or the entity’s equity instruments. The main issues relate to if and
when the share-based payment should be recognized and when these transactions should be
reflected as expenses in the income statement.
10.2
SCOPE OF THE STANDARD
This IFRS should be applied for all share-based payment transactions. IFRS 2 is therefore
broader than just employee share options, because it also deals with the issuance of shares
(and rights to shares) in return for services and goods. The Standard specifically covers:
• The criteria for defining a share-based payment.
• The distinction and accounting for the various types of share-based payments namely:
equity settled, cash settled and transactions in which the entity receives or acquires
goods or services and where there is an option to settle via equity instruments.
• That an entity should reflect in its profit and loss and financial position the effects of
share-based payment transactions; these transactions include expenses associated with
transactions in which employees receive share options.
10.3
KEY CONCEPTS
10.3.1 A share-based payment transaction is a transaction in which the entity receives
goods or services as consideration for equity instruments of the entity (including shares or
share options), or acquires goods or services by incurring liabilities to the supplier of those
goods or services for amounts that are based on the price of the entity’s shares or other equi-
ty instruments of the entity. Share-based payment transactions include transactions where
the terms of the arrangement provide either the entity or the supplier of those goods or ser-
vices with a choice of whether the entity settles the transaction in cash (or other assets) or
through the issuance of equity instruments
83
84
Chapter 10 Share-Based Payment (IFRS 2)
10.3.2 An equity-settled share-based payment transaction is a share-based payment trans-
action in which the entity receives goods or services (including shares or share options) as
consideration for the entity’s equity instruments. An equity instrument is a contract that evi-
dences a residual interest in the assets of an entity after deducting all of its liabilities. An equi-
ty instrument granted is the right to an equity instrument of the entity conferred by the enti-
ty on another party, under a share-based payment arrangement.
10.3.3 A cash-settled share-based payment transaction is a share-based payment transac-
tion in which the entity acquires goods or services by incurring a liability to transfer cash or | Hennie |
other assets to the supplier of those goods or services for amounts that are based on the price
or value of the entity’s shares or other equity instruments.
10.3.4 The grant date is the date at which the entity and another party (including an
employee) agree to a share-based payment arrangement. At grant date the entity confers on
the counterparty the right to cash, other assets, or the entity’s equity instruments, provided
that the specified vesting conditions are met.
10.3.5 Employees and others providing similar services are individuals who render per-
sonal or similar services to the entity.
10.3.6 Under a share-based payment arrangement, a counterparty’s right to receive the
entity’s cash, other assets, or equity instruments vests upon satisfaction of any specified vest-
ing conditions. Vesting conditions include service conditions. The vesting period is the peri-
od during which all the specified vesting conditions of a share-based payment arrangement
should be satisfied.
10.3.7 Fair value is the amount for which an asset could be exchanged; a liability settled; or
an equity instrument granted could be exchanged between knowledgeable, willing parties in
an arm’s length transaction.
10.3.8 Intrinsic value is the difference between the fair value of the shares to which the
counterparty has the right to subscribe or which it has the right to receive, and the price the
counterparty is required to pay for those shares.
10.3.9 Market condition is a condition that is related to the market price of the entity’s
equity instruments.
10.3.10 A share option is a contract that gives the holder the right but not the obligation to
subscribe to the entity’s shares at a fixed or determinable price for a specified period of time.
10.4
ACCOUNTING TREATMENT
10.4.1 Share-based payments could be
• cash settled, that is, by a cash payment based on the value of equity instruments;
• equity settled, that is, by the issue of equity instruments; or
• cash or equity settlement (by choice of the entity or supplier)
10.4.2 An entity should recognize the goods or services received or acquired in a share-
based payment transaction when it obtains the goods or as the services are received.
Chapter 10 Share-Based Payment (IFRS 2)
85
10.4.3 Share-based payment transactions should be measured at
• the fair value of the goods or services received in the case of all third party, nonem-
ployee transactions, unless it is not possible to measure the fair value of those goods or
services reliably; or
• the fair value of the equity instruments in all other cases, including all employee
transactions.
EQUITY-SETTLED SHARE-BASED PAYMENT TRANSACTIONS
10.4.4 The fair value of the equity instruments issued or to be issued should be measured
• at grant date for transactions with employees and others providing similar services; and
• at the date on which the entity receives the goods or the counterparty renders the ser-
vices in all other cases.
10.4.5 The fair value of the equity instruments issued or to be issued should be based on
market prices, taking into account market vesting conditions (for example, market prices or
reference to an index) but not other vesting conditions (for example, service periods). Listed
shares should be measured at market price. Options should be measured
• on the basis of the market price of any equivalent traded options; or
• using an option pricing model in the absence of such market prices; or
• at intrinsic value when they cannot be measured reliably on the basis of market prices
or on the basis of an option pricing model.
10.4.6 In the rare cases where the entity is required to measure the equity instruments at
their intrinsic value, it remeasures the instruments at each reporting date until final settle-
ment and recognizes any change in intrinsic value in profit or loss.
10.4.7 The entity should recognize an asset (for example, inventory) or an expense (for
example, services received or employee benefits) and a corresponding increase in equity if | Hennie |
the goods or services were received in an equity-settled share-based payment transaction.
Therefore, an entity recognizes an asset or expense and a corresponding increase in equity
• on grant date if there are no vesting conditions or if the goods or services have already
been received;
• as the services are rendered if nonemployee services are rendered over a period; or
• over the vesting period for employee and other share-based payment transactions
where there is a vesting period.
10.4.8 If the equity instruments granted do not vest until the counterparty completes a
specified period of service, the amount recognized should be adjusted over any vesting peri-
od for changes in the estimate of the number of securities that will be issued but not for
changes in the fair value of those securities. Therefore, on vesting date the amount recog-
nized is the exact number of securities that can be issued as of that date, measured at the fair
value of those securities at grant date.
10.4.9 If the entity cancels or settles a grant of equity instruments during the vesting peri-
od (other than a grant cancelled by forfeiture when the vesting conditions are not satisfied):
• The entity accounts for the cancellation or settlement as an acceleration of vesting by
recognizing immediately the amount that otherwise would have been recognized over
the remainder of the vesting period.
• The entity recognizes in equity any payment made to the employee on the cancellation
or settlement to the extent that the payment does not exceed the fair value at repur-
chase date of the equity instruments granted.
86
Chapter 10 Share-Based Payment (IFRS 2)
• The entity recognizes as an expense the excess of any payment made to the employee
on the cancellation or settlement over the fair value at repurchase date of the equity
instruments granted.
• The entity accounts for new equity instruments granted to the employee as replace-
ment equity instruments for the cancelled equity instruments as a modification of the
original grant of equity instruments. The difference between the fair value of the
replacement equity instruments and the net fair value of the cancelled equity instru-
ments at the date the replacement equity instruments are granted is recognized as an
expense.
CASH-SETTLED SHARE-BASED PAYMENT TRANSACTION
10.4.10 The entity should recognize an asset (for example, inventory) or an expense (for
example, services received or employee benefits) and a liability if the goods or services were
received in a cash-settled share-based payment transaction.
10.4.11 Until the liability is settled, the entity should remeasure the fair value of the liabil-
ity at each reporting date and at the date of settlement, with any changes in fair value recog-
nized in profit or loss for the period.
SHARE-BASED PAYMENT TRANSACTIONS WITH CASH ALTERNATIVES
10.4.12 For share-based payment transactions in which the terms of the arrangement pro-
vide either the entity or the counterparty with the choice of whether the entity settles the
transaction in cash (or other assets) or by issuing equity instruments, the entity should
account for that transaction, or the components of that transaction, as a cash-settled share-
based payment transaction if, and to the extent that, the entity has incurred a liability to set-
tle in cash or other assets, or as an equity-settled share-based payment transaction if, and to
the extent that, no such liability has been incurred.
10.5
PRESENTATION AND DISCLOSURE
10.5.1 An entity should disclose information that enables users of the financial statements
to understand the effect of share-based payment transactions on the entity’s profit or loss
for the period and on its financial position.
10.5.2 An entity should disclose information that enables users of the financial statements
to understand the nature and extent of share-based payment arrangements that existed dur-
ing the period.
10.5.3 An entity should provide a description of
| Hennie |
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