Lease Accounting

LEASE ACCOUNTING
Email Print Twitter Facebook Linkedin Add This

RELATED LINKS
Multiple-choice questions
Read more articles from Accounting and Business
As we wait for a definitive leasing standard, Graham Holt explores the original 2013
exposure draft and the current state of play
Studying this technical article and answering the related questions can count towards
your verifiable CPD if you are following the unit route to CPD and the content is
relevant to your learning and development needs. One hour of learning equates to one
unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD
units.
Leasing is an important activity for many organisations with the majority of leases not
currently reported on a lessees statement of financial position. The existing accounting
models for leases require lessees and lessors to classify their leases as either finance
leases or operating leases and to account for those leases differently.
The existing standards have been criticised for failing to meet the needs of users of financial
statements because they do not always provide a faithful representation of leasing
transactions.
The exposure draft (ED), Leases (May 2013), attempted to solve the lease accounting
problem by requiring an entity to classify leases into two types type A and type B and
recognise both types on the statement of financial position. The ED was the result of a joint
project by the International Accounting Standards Board (IASB) and the US Financial
Accounting Standards Boards (FASB) (the boards).This article sets out the current
deliberations of the boards as at the end of 2014 and, therefore, as such, the final leasing
standard may vary from the discussions below.
The ED sets out that type A leases would normally mean that the underlying asset is not
property, while type B leases mean that the underlying asset is property. However, the entity
classifies a lease other than a property lease as type B if the lease term is for an insignificant
part of the total economic life of the asset; or the present value of the lease payments is
insignificant relative to the fair value of the underlying asset at the leases commencement
date.
Conversely, the entity classifies a property lease as type A if the lease term is for the major
part of the remaining economic life of the underlying asset; or the present value of the lease
payments accounts for substantially all of the fair value of the underlying asset at the
commencement date. At this date, the lessee discounts the lease payments using the rate the
lessor charges the lessee, or if that rate is unavailable, the lessees incremental borrowing
rate.
The lessee recognises the present value of lease payments as a liability. At the same time it
recognises a right-of-use (ROU) asset equal to the lease liability, plus any lease payments
made to the lessor at or before the commencement date, less any lease incentives received
from the lessor; and any initial direct costs incurred by the lessee. After the commencement
date, the liability is increased by the unwinding of interest and reduced by lease payments
made to the lessor.
A lessee will recognise in profit or loss, for type A leases, the unwinding of the discount on
the lease liability as interest and the amortisation of the ROU asset and, for type B leases, the
lease payments will be recognised in profit or loss on a straight-line basis over the lease term
and reflected in profit or loss as a single lease cost.
Following the feedback received on the ED, the FASB still remains supportive of the dualmodel approach to bringing leases on to the statement of financial position.
Under this approach, a lessee would account for most existing finance leases as type A leases
and most existing operating leases as type B leases. Both type A and B leases result in the
lessee recognising a ROU asset and a lease liability. However, the IASB has stated that
feedback on the 2013 ED indicates that the dual model is too complex and, therefore, has
opted currently for a single lessee model that is easy to understand. The IASB decided on a
single approach for lessee accounting where a lessee would account for all leases as type A
leases.
The boards decided that a lessor should determine lease classification (type A or type B) on
the basis of whether the lease is effectively a financing or a sale, rather than an operating
lease. A lessor would make that determination by assessing whether the lease transfers
substantially all the risks and rewards incidental to ownership of the underlying asset. A
lessor will be required to apply an approach substantially equivalent to existing International
Financial Reporting Standards (IFRS) finance lease accounting to all type A leases.
A lease is currently defined by the boards as a contract that conveys the right to use an asset
for a period of time in exchange for consideration. An entity would determine whether a
contract contains a lease by assessing whether the use of the asset is either explicitly or
implicitly specified and the customer controls the use of the asset. The definition of a lease
does not require the customer to have the ability to derive the benefits from directing the use
of an asset.
The boards have decided that the leases guidance should not include specific requirements
on materiality and retain the recognition and measurement exemption for a lessees shortterm leases (12 months or less) with the IASB specifically favouring a similar exemption for
leases of small assets for lessees.
The boards have decided that, when determining the lease term, an entity should consider all
relevant factors that may affect the decision to extend, or not to terminate, a lease. The lease
term should only be reassessed when a significant event occurs or there is a significant
change in circumstances that are within the control of the lessee. A lessor should not be
required to reassess the lease term.
Only variable lease payments that depend on an index or a rate should be included in the
initial measurement of leases and the IASB has determined that reassessment of variable
lease payments would only occur when the lessee re-measures the lease liability for other
reasons. A lessor will not be required to reassess variable lease payments that depend on an
index or a rate.
The definition of the discount rate remains unchanged as the rate implicit in the lease, as
does the requirement for a lessee to reassess the discount rate only when there is a change to
either the lease term or the assessment of whether the lessee is (or is not) reasonably certain
to exercise an option to purchase the asset.
A lease modification for both a lessee and a lessor should be accounted for as a new lease,
separate from the original lease, when:
1. the lease grants the lessee an additional right-of-use not included in the original lease,
and
2. the additional right-of-use is priced commensurate with its standalone price in the
context of that particular contract.
In terms of the initial direct costs for both lessors and lessees, they should include only
incremental costs that would not have incurred if the lease had not been executed. These
include commissions or payments made to existing tenants to obtain the lease. A lessor in a
type A lease should include initial direct costs in the initial measurement of the lease
receivable and they should be taken into account in determining the rate implicit in the lease.
A lessor in a type A lease who recognises selling profit at lease commencement should
recognise initial direct costs as an expense. A lessor in a type B lease should expense such
costs over the lease term on the same basis as lease income. A lessee should include initial
direct costs in the initial measurement of the right-of-use asset and amortise those costs over
the lease term.
The guidance in the ED has been retained for sale and leaseback transactions with a sale
having to meet the requirements of a sale as set out in IFRS 15. A buyer-lessor should
account for the purchase of the underlying asset consistent with the guidance that would
apply to the purchase of any non-financial asset.
This article sets out the deliberations of the IASB/FASB as regards lease accounting at the
end of December 2014. The IFRS is due for publication in 2015, but it seems that the FASB
and IASB will have differing views on several recognition and measurement issues when the
IFRS is finally published. There may yet however be further changes of opinion.
Graham Holt is director of professional studies at the accounting, finance and
economics department at Manchester Metropolitan University Business School
The FASB reThe FASB remains supportive of the dual-model approach to bringing leases on
to the statement of financial position mains supportive of the dual-model approach to
bringing leases on to the statement of financial position
ACCOUNTING FOR CHANGES
RELATED LINKS
Read more articles from Accounting and Business
Graham Holt discusses the IASBs application of effects analysis to new standards and any
material changes in existing standards
units.
This article was first published in the February 2015 international edition
of Accounting and Business magazine.
The introduction of a new accounting standard or a change in an accounting standard can
have a significant impact on an entity from an internal as well as an external perspective. As
a result, the International Accounting Standards Board (IASB) has recently agreed to conduct
an effects analysis before publishing any International Financial Reporting Standard
(IFRS).
When the IASB issues a new or significantly amended IFRS, it changes the way in which
financial statements show particular transactions or events. Changes in reporting
requirements always come with a cost.
The IASB uses discussion papers and the basis for conclusions to explain the steps taken to
ensure that a proposed IFRS has taken into account the costs and benefits of the new
reporting practice that it introduces.
WHATS THE IMPACT?
The IASB considers a variety of matters prior to the issue of a standard. These matters
include how the changes improve the comparability of financial information and the
assessment of the effect on an entitys future cashflows.
Further considerations include whether the changes will result in better economic decisionmaking, the likely compliance costs for preparers, and the potential cost for users of
extracting the data.
On application of the new IFRS, investors will be provided with different information on
which to base their decisions. Investors assessment of how management has discharged its
stewardship responsibilities could be changed as could the cost of the entitys capital. This,
in turn, could affect how investors vote at a shareholder meeting or influence their
investment decisions. New financial reporting requirements may call for the disclosure of
information that is of competitive advantage to third parties, which would be a cost to the
entity.
A change in an accounting standard could result in some entities no longer investing in
certain assets or change how they contract for some activities. For example, the comment
letters on the exposure draft on leases suggest that some entities would change their leasing
arrangements if operating leases had to be shown on the balance sheet with adverse
economic impacts including the loss of thousands of jobs.
Further IFRS-based financial statements are used in contracts or regulation. Banking
agreements often specify maximum debt levels or financial ratios that refer to figures
prepared in accordance with IFRS. New financial reporting requirements can affect those
ratios, with potential breach of contracts. Many jurisdictions have regulation that restricts the
amount that can be paid out in dividends, by reference to accounting profit. Further, some
governments use IFRS numbers for statistical and economic planning purposes and the data
as evidence for constraints on profitability in regulated industries.
Taxation is often calculated on the profit measured for financial reporting purposes. Where
IFRS is used as the basis for income tax, a change in a standard can affect the tax base. The
economic consequences of the link of accounting with tax liabilities can be significant. If the
US Financial Accounting Standards Board (FASB) were no longer to permit use of the last-in
first-out (LIFO) method, companies using LIFO would have to pay income taxes sooner
because of the higher cost of sales under LIFO. The impact has been estimated to be greater
than US$80bn if the tax law was not changed. However, neither the FASB nor the IASB base
accounting policy decisions on tax consequences.
Some jurisdictions require an impact assessment before a new standard, or an amendment to
a standard, is incorporated into the law. Such a review may take into account the increased
administrative burden on entities in that country or its consistency with local company law.
FINANCIAL STATEMENTS
On a micro level, where new and revised pronouncements are applied for the first time, there
can be an impact on the drafting of the financial statements. The financial statements will
need to reflect the new recognition, measurement and disclosure requirements. For example
IFRS 10, Consolidated financial statements, was amended for annual periods beginning on
or after 1 January 2014. This amendment provides an exemption from consolidation of
subsidiaries for entities that meet the definition of an investment entity, such as some
investment funds. Instead, such entities measure their investment in certain subsidiaries at
fair value through profit or loss in accordance with IFRS 9, Financial instruments, or IAS
39, Financial instruments: recognition and measurement. The consequences of this
amendment will be far-reaching for those entities.
IAS 8, Accounting policies, changes in accounting estimates and errors, contains a general
requirement that changes in accounting policies are fully retrospectively applied. However,
this does not apply where there are specific transitional provisions. For example, when first
applying IFRS 15, Revenue from contracts with customers, entities should apply the standard
in full for the current period, including retrospective application to all contracts that were not
yet complete at the beginning of that period.
For prior periods, the transition guidance allows entities an option to either:
1. apply IFRS 15 in full to prior periods (some limited practical expedients are
available)
2. retain prior period figures as reported under the previous standards, recognising the
cumulative effect of applying IFRS 15 as an adjustment to the opening balance of
equity as at the date of the beginning of the current reporting period.
Further, IAS 8 requires the disclosure of a number of matters about the new IFRS. These
include the title of the IFRS, the nature of the change in accounting policy, a description of
the transitional provisions, and the amount of the adjustment for each financial statement line
item that is affected.
Additionally, IAS 1, Presentation of financial statements, requires a third statement of
financial position to be presented if the entity retrospectively applies an accounting policy,
restates items or reclassifies items, and those adjustments had a material effect on the
information in the statement of financial position at the beginning of the comparative period.
IAS 33, Earnings per share, requires basic and diluted earnings per share (EPS) to be
adjusted for the impacts of adjustments resulting from changes in accounting policies
accounted for retrospectively, and IAS 8 requires the disclosure of the amount of such
adjustments. Where there are new accounting policies, the impact on the interim financial
statements will not be as great as on the year-end accounts. However, IAS 34, Interim
financial reporting, requires disclosure of the nature and effect of any change in accounting
policies and methods of computation.
ENTITY ASSESSMENT
The entity itself should prepare an impact assessment relating to the introduction of any new
IFRS. There may be significant changes to processes, systems and controls, and management
should communicate the impact to investors and other stakeholders. This would include
plans for disclosing the effects of new accounting standards that are issued but not yet
effective, as required by IAS 8. Audit committees have an important role in overseeing
implementation of any new standard in their organisations.
For example, under IFRS 15, an entity may need to evaluate its relationships with contract
counterparties to determine whether a vendor-customer relationship exists. Existing revenue
recognition policies will also need to be evaluated to determine whether any contracts within
the scope of IFRS 15 will be affected by the new requirements.
Where a new standard requires significantly more disclosures than current IFRS, the entity
may want to understand whether it has sufficient information to satisfy the new disclosure
requirements or whether new systems, processes and controls must be implemented to gather
such information and ensure its accuracy. The entity should choose a path to implementation
and establish responsibilities and deadlines. This may help to determine the accountability of
the implementation team and allow management to identify gaps in resources.
For example, IFRS 15 requires entities that select the full retrospective approach to apply the
standard to each year presented in the financial statements. This will require entities to begin
tracking revenue using the new standard from the current period to the effective date of 1
January 2017.
IMPLEMENTATION TIME
A key thing about recent standards is that the IASB has given entities a reasonable amount of
time to plan implementation. For example IFRS 9, Financial instruments, has an effective
date of 1 January 2018. However, insurance companies will need this time to plan
their implementation.
The new IFRS 9 standard includes revised guidance about the classification and
measurement of financial assets, including a new expected credit loss model for calculating
impairment. It also supplements the new general hedge accounting requirements that were
published in 2013.
Insurance companies will be greatly affected as they plan to adopt new standards on financial
instruments and insurance contracts. However, before insurers reach conclusions about how
they apply IFRS 9, they will want to consider its interaction with the forthcoming standard
on insurance contracts.
Accounting standards have economic effects, which can be beneficial for some entities and
detrimental to others. The IASBs evaluation of costs and benefits are by nature qualitative.
The quantitative effects should be anticipated by entities as they are the ones that will feel
them.
economics department at Manchester Metropolitan University Business Scho
GETTING THE PRIORITIES RIGHT
RELATED LINKS
Graham Holt explores the ESMAs common enforcement priorities for 2014 financial
statements
units.
The European Securities and Markets Authority (ESMA) has published the European
common enforcement priorities 2014 that represent the key focus for examinations of
the financial statements of listed companies by ESMA and European national
enforcers.
The common enforcement priorities for 2014 financial statements are:
preparation and presentation of consolidated financial statements and related
disclosures
financial reporting by entities with joint arrangements and related disclosures
recognition and measurement of deferred tax assets.
These topics have been highlighted because of significant changes to accounting practices as
a result of new standards, such as IFRS 10, Consolidated Financial Statements, IFRS 11,
Joint Arrangements, and IFRS 12, Disclosure of Interests in Other Entities, and the
challenges faced by issuers as a result of the current economc environment.
The latter refers to the difficulty of forecasting future taxable profits for the purpose of
determining deferred tax assets when there is a period of low economic growth. The
priorities were identified after discussions with European national enforcers with a view to
further increasing transparency in financial reports.
National enforcers might also set additional enforcement priorities. ESMA will report on its
priorities in 2015 and will review priorities identified in previous years. These include
requirements related to the impairment of financial and non-financial assets, fair value
measurement and disclosures on risks arising from financial instruments. In particular,
ESMA reminds issuers of the specific requirements related to using cashflow projections and
the disclosure of key assumptions when performing impairment tests of non-financial assets.
ESMA pointed out that its 2013 report on comparability of institutions financial statements
remains relevant to the 2014 financial statements. This report found that the required
disclosures under International Financial Reporting Standards (IFRS) were generally
observed, but also identified broad variations in the quality of the information provided.
ESMA defines the European common enforcement priorities in order to promote consistent
application of IFRS.
ESMA still feels that financial statements are cluttered with excessive disclosure due to their
general rather than entity-specific nature, or because they refer to transactions that are not
relevant for the issuer. Its aim is not necessarily a decrease in the number of items disclosed,
but rather clear and complete disclosures which are specific to an entity and necessary to
understand its financial position. Entities should avoid too much aggregation and allow users
to understand the consequences of economic events that affect the entity.
The requirements of IFRS 10, IFRS 11, IFRS 12, amended IAS 27, Separate Financial
Statements, and IAS 28, Investments in Associates and Joint Ventures, became mandatory in
the EU for periods starting on or after 1 January 2014.
IFRS 10 defines control as the situation when the investor is exposed, or has rights, to
variable returns from its involvement with the investee and has the ability to affect those
returns through its power over the investee. The principles relating to control are set out in
IFRS 10 and the application guidance. ESMA feels both the standard and the application
guidance should be considered when determining if control exists. This may require
significant judgment to be made and issuers should carefully explain the judgments made in
complex situations as required by IFRS 12.
IFRS 12 requires disclosures to enable users to understand the nature of the non-controlling
interests (NCI) in the groups activities and cashflows. Disclosures are expected to be
sufficient which includes disclosure of the operating segments material NCIs have been
allocated to.
ESMA stresses the importance of the materiality assessment as well as the issuers judgment
in determining the presentation of information. When a group presents a significant amount
of NCIs, none of which are individually significant, ESMA encourages issuers to disclose
and explain this. Issuers should disclose the nature and extent of any significant restrictions
on their ability to access assets and settle liabilities. The amount of significant cash and cash
equivalent balances held by the entity but not available for use by the group should also be
disclosed.
ESMA draws issuers attention to specific disclosure requirements with respect to the nature
of, and changes in, the risks associated with their interests in consolidated and
unconsolidated structured entities. IFRS 12 defines a structured entity as having been set up
so that any voting or similar rights are not the dominant factor in deciding who controls the
entity. For example, when voting rights relate only to administrative tasks and the relevant
activities are directed by contractual arrangements. A structured entity often has some or all
of the following features:
1. restricted activities
2. a narrow and well-defined objective
3. insufficient equity to permit the entity to finance its activities without subordinated
financial support
4. financing in the form of multiple contractually linked instruments to investors that
create concentrations of credit or other risks (tranches).
The principal uses of structured entities are to provide clients with access to specific
portfolios of assets and to provide market liquidity for clients through securitising financial
assets. Structured entities may be established as corporations, trusts or partnerships. They
generally finance the purchase of assets by issuing debt and equity securities that are
collateralised by and/or indexed to the assets held by the structured entities.
The debt and equity securities issued by structured entities may include varying levels of
subordination. Structured entities are consolidated when the substance of the relationship
between a group and the structured entities indicate that the entities are controlled by the
group. The disclosures for these entities are wider and deeper than for unstructured ones.
IFRS 11 sets out criteria which determines the classification of joint arrangements as either
joint operations or joint ventures. The basis of the classification is the rights and obligations
of the parties to the arrangement, rather than, as previously, the legal form. This requires
consideration of the structure, terms, conditions and the legal form of the arrangement, and
other facts and circumstances.
When assessing other facts and circumstances, the focus should be on whether they create
rights to the assets and obligations for the liabilities. It is possible for two joint arrangements
with similar characteristics to be classified differently depending on their structure.
The IFRS Interpretations Committee has considered various issues arising from the
implementation of IFRS 11, and ESMA has recommended that issuers review the findings of
these discussions when preparing their 2014 financial statements. ESMA expects issuers to
provide disclosures about significant judgments and assumptions regarding the joint
arrangement and information relating to the nature, extent and financial effects of its interests
in joint arrangements.
The first-time adoption of IFRS 10 and IFRS 11 might change the assessment as to whether
to consolidate an investee. This could be the case where a different conclusion is reached
over whether control is achieved by an investor holding less than a majority of voting rights
in an investee. If this is the case, the factors that led to the change should be disclosed and
the changes dealt with in accordance with IAS 8, Accounting Policies, Changes in
Accounting Estimates and Errors.
IAS 31 allowed the use of proportionate consolidation, outlawed by IFRS 11. A change of
accounting policy may occur as a result of joint ventures now being accounted for using the
equity method. IFRS 10 introduces an exception to the consolidation requirement for
investment entities. Issuers are expected to be very specific about how they arrived at any
judgment not to consolidate.
The current economic climate could result in the recognition of tax losses or the existence of
deductible temporary differences where perhaps impairments are not yet deductible for tax
purposes. The recognition of deferred tax assets requires detailed consideration of the carry
forward of unused tax losses, whether future taxable profits exist, and the need for disclosing
judgments made in these circumstances.
IAS 12, Income Taxes, limits the recognition of a deferred tax asset to the extent that future
taxable profits will probably be available against which the deductible temporary difference
can be utilised. IAS 12 says the existence of unused tax losses is strong evidence that future
taxable profit might not be available. Therefore, recent losses make the recognition of
deferred tax assets conditional on the existence of convincing other evidence.
The probability that future taxable profit will be available to utilise the unused tax losses will
need to be reviewed and if convincing evidence is available, there should be disclosure of the
amount of a deferred tax asset and the nature of the evidence. ESMA feels it is particularly
relevant to disclose the period used for the assessment of the recovery of a deferred tax asset
as well as the judgments made. ESMA also expects issuers to disclose their accounting
policy relating to material uncertain tax positions.
As well as ESMA, national enforcers will continue to focus on material issues in the
financial statements and will take corrective actions if material misstatements are identified.
IFRS 9 - THE FINAL VERSION
RELATED LINKS
Putting the IFRS 9 requirements which will affect all sectors, but mostly banks into
practice will be a challenge, says Graham Holt
units.
In July, the International Accounting Standards Board (IASB) completed its response to the
financial crisis by issuing the final version of IFRS 9, Financial Instruments. IFRS 9 sets out
a model for classification and measurement, an expected loss impairment model and a
transformed approach to hedge accounting. The IASB had previously issued versions of
IFRS 9 that introduced new classification and measurement requirements in 2009 and 2010
and a new hedge accounting model in 2013.
The latest publication consolidates the previous versions of the standard, and replaces IAS
39, Financial Instruments: Recognition and Measurement.
It also changes some of the requirements of the previous publications. IFRS 9 is effective for
annual periods beginning on or after 1 January 2018.
Classification determines how financial assets and financial liabilities are accounted for and
measured in financial statements. The requirements for impairment and hedge accounting are
based upon the instruments classification.
The standard introduces a principle-based system for the classification and measurement of
financial assets, which depends upon the entitys business model for managing the financial
asset and the financial assets contractual cashflow characteristics.
IFRS 9 utilises a single classification approach for all types of financial assets, which
includes those that contain embedded derivative features. Financial assets are now not
subject to complicated bifurcation requirements.
The business model approach refers to how an entity manages its financial assets in order to
generate cashflows either by collecting contractual cashflows, selling financial assets or
both. Financial assets are measured at amortised cost, where the business models objective
is to hold assets in order to collect contractual cashflows. The new standard clarifies the
existing guidance on the collection of the assets contractual cashflows.
When determining the applicability of this business model, an entity should consider past
and future sales information.
If an entity holds financial assets for sale, then it will fail the business model test for
accounting for the financial assets at amortised cost. However, sales activity is not
necessarily inconsistent with the business model if they are infrequent and insignificant in
value but, where these sales are frequent and significant in value, an entity needs to assess
whether such sales are consistent with an objective of collecting contractual cashflows.
The sales may be consistent with that objective if they are made close to the maturity of the
financial assets and the proceeds from the sales approximate the collection of the remaining
contractual cashflows.
For many entities, the assessment will be relatively straightforward, as their financial assets
may be simply trade receivables and bank deposits for which the amortised cost criteria are
likely to be met. For those entities with a broader range of financial assets such as investors
in debt securities, and insurance companies, the motivations behind the disposal of the assets
will have to be considered.
IFRS 9 includes a new measurement category whereby financial assets are measured at fair
value through other comprehensive income (FVTOCI).
This category is used when financial assets are held in a business model whose objective is
both collecting contractual cashflows and selling financial assets. Unlike the available-forsale criteria in IAS 39, the criteria for measuring at FVTOCI are based on the financial
assets cashflow characteristics and the entitys business model.
This business model will involve a greater frequency and volume of sales with the possible
objectives of managing liquidity or matching the duration of financial liabilities to the
duration of the assets they are funding.
This category was introduced because of the concerns raised by preparers who sold financial
assets in greater volume than was consistent with the previous business model and would,
without this category, have to record such assets at fair value through profit or loss.
(FVTPL).
Financial assets may qualify for amortised cost or FVOCI only if they give rise to solely
payments of principal and interest (SPPI) under the contractual cashflows characteristics
test. Many instruments have features that are not in line with the SPPI condition. IFRS 9
makes it clear that such features are disregarded if they are non-genuine or de minimis.
IFRS 9 now provides more guidance on SPPI. For contractual cashflows to be SPPI, they
must include returns that are consistent with the return on a basic lending arrangement to the
holder, which generally includes consideration for the time value of money, credit risk,
liquidity risk, a profit margin and consideration for costs associated with holding the
financial asset over time such as servicing costs. Thus if the contractual arrangement
includes a return for equity price risk, then this would be inconsistent with SPPI.
IFRS 9 introduces guidance on how the contractual cashflows characteristics assessment
applies to debt instruments that may contain a modified time value element; for example,
those instruments that may contain a variable interest rate.
These characteristics will result in an instrument failing the contractual cashflow
characteristics test if the resulting undiscounted contractual cashflows could be significantly
different from the undiscounted cashflows of a benchmark instrument that does not have
such features.
Interest rates set by a government or a regulatory authority are accepted as a proxy for the
consideration for the time value of money if those rates provide consideration that is
broadly consistent with consideration for the passage of time. Such cashflows are
considered SPPI as long as they do not introduce risk or volatility, which is inconsistent with
a basic lending arrangement.
Any financial assets not held in one of the two business models above are measured at
FVTPL, which is essentially a residual category. Also included in this category are financial
assets that are held for trading and those managed on a fair-value basis. Financial assets are
reclassified when the entitys business model for managing them changes. This is not
expected to occur frequently and it ensures that users of financial statements are provided
with information on the realisation of cashflows.
IAS 39 was felt to work well as regards the accounting for financial liabilities; therefore the
IASB felt there was little need for change. Thus most financial liabilities will continue to be
measured at amortised cost. IAS 39 also permitted entities to elect to measure financial
liabilities at fair value through profit or loss (fair-value option).
The changes introduced by IFRS 9 are restricted to those liabilities designated at FVTPL
using the fair-value option. Fair-value changes of these financial liabilities are presented in
other comprehensive income to the extent that they are attributable to the change in the
entitys own credit risk. If this would cause an accounting mismatch, then the total fair-value
change is presented in profit or loss.
This change is designed to eliminate volatility in profit or loss caused by changes in the
credit risk of financial liabilities that an entity has elected to measure at fair value.
IFRS 9 introduces an impairment model for financial assets that is based on expected losses
rather than incurred losses. It applies to amortised-cost financial assets and those categorised
as FVTOCI. It also applies to certain loan commitments, financial guarantees, lease
receivables and contract assets. An entity recognises expected credit losses at all times and
updates the assessment at each reporting date to reflect any changes in the credit risk. It is no
longer necessary for there to be a trigger event for credit losses to be recognised and the
same impairment model is used for all financial instruments that are impairment tested.
Other than purchased or originated credit-impaired financial assets, IFRS 9 requires entities
to measure expected credit losses by recognising a loss allowance equal to either:
1. 12-month expected credit losses. This measurement is required if the credit risk is low
at the reporting date or the credit risk has not increased significantly since initial
recognition.
2. Full lifetime expected credit losses. This measurement is required if the credit risk has
risen significantly since recognition and the resulting credit quality is not considered
to be low credit risk. Entities can elect for an accounting policy of always recognising
full lifetime expected losses for contract assets, trade receivables, and lease
receivables. When measuring expected credit losses, an entity should consider the
probability-weighted outcome, the time value of money and information that is
available without undue cost or effort.
IFRS 9 introduces a reformed model for hedge accounting with enhanced disclosures about
risk management activity. Under IFRS 9, a hedging relationship qualifies for hedge
accounting only if all of these criteria are met:
the hedging relationship consists only of eligible hedging instruments and eligible
hedged items
at its inception there is formal designation and documentation of the hedging
relationship and the entitys risk management objective and strategy for undertaking
the hedge
the relationship meets all of the hedge effectiveness requirements. The hedge
relationship must meet the effectiveness criteria at the beginning of each hedged
period to qualify for hedge accounting
there is an economic relationship between the hedged item and the hedging instrument
the effect of credit risk does not dominate the value changes that result from that
relationship
the hedge ratio of the hedging relationship is the same as that used in the economic
hedge.
IFRS 9 will affect all sectors through the introduction of an expected loss model for loan loss
provisioning, but will impact mostly on banks. It should give investors better insight into the
credit quality of all financial assets.
Putting the new requirements into practice by the effective date, however, will be quite a
challenge.
WHAT IS FAIR VALUE?
RELATED LINKS
An overview of the key concepts and practical guidance for SFRS 113 Fair Value
Measurement including valuation techniques
units.
For many years, preparers of financial statements have grappled with the issues associated
with measuring fair value because several financial reporting standards require (or permit)
reporting entities to measure (or disclose) assets or liabilities at fair value. Singapore FRS
113 Fair Value Measurement (SFRS 113) was issued to provide guidance about how to
measure fair value and information to be disclosed.
As this standard is to be applied prospectively for annual periods on or after 1 January 2013,
Singapore entities presenting financial statements from 2014 onwards will be affected.
SFRS 113 establishes how to measure fair value. It does not address which assets or
liabilities to measure at fair value, or when it must be performed.
The reporting entity must look to other financial standards in this regard.
This article is not intended to address comprehensively all of the detailed requirements of
this standard, but rather to provide an overview of the key concepts and practical guidance.
SCOPE
SFRS 113 applies whenever another financial reporting standard requires (or permits) the
measurement of fair value, including a measure that is based on fair value, i.e. fair value
less cost.
For example, SFRS 103 Business Combinations requires identifiable assets acquired and
liabilities assumed to be measured at fair value for purchase price allocation. Investment
properties are to be measured at fair value at each reporting date under SFRS 40 Investment
Property.
However, this standard does not apply to share-based payment and leasing transactions. Also,
measurements that are similar to fair value, but are not fair value (such as net realisable value
in SFRS 2 Inventories or value in use in SFRS 36 Impairment of Assets) are not applicable.
The term fair value is used throughout FRS. Given that there are few scope exclusions, this
standard is pervasive.
DEFINITION OF FAIR VALUE
Fair value is defined as the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date.
Fair value is a current exit price, not an entry price (see diagram, above).
The exit price for an asset (or liability) is conceptually different from its transaction price (or
entry price). While the exit and entry price may be identical in many situations, the
transaction price is not presumed to represent fair value. For example, the last transacted
price for a thinly traded quoted investment may not reflect fair value.
The exit price objective of a fair value measurement applies regardless of the reporting
entitys intent and/or ability to sell the asset (or transfer the liability). Fair value is the exit
price in the principal market, or in the absence, the most advantageous market.
Fair value is not based on how much an entity has to pay to settle a liability.
Instead, it should be based on how much the reporting entity has to pay a market participant
who is willing to take over the liability.
The transaction to sell the asset (or transfer the liability) is assumed to be orderly between
market participants under normal current market conditions. Information that becomes
known after measurement date is not normally taken into account.
Market participants are buyers and sellers in the principal (or most advantageous) market
who are: (i) independent of each other; (ii) knowledgeable about the asset or liability; and
(iii) able and willing to enter into a transaction for the asset or liability.
In other words, fair value is a market-based measurement, not an entity-specific
measurement. For example, synergies available to a specific buyer are not considered in the
valuation of an interest in an unquoted investment.
FAIR VALUE FRAMEWORK
Many of the key components used in the fair value framework are interrelated and their
interaction should be considered holistically. The overall process for determining fair value
under SFRS 113 may be illustrated by the diagram above.
In practice, navigating the fair value framework may be more straightforward for certain
types of assets (e.g. quoted investments) than for others (e.g. intangible assets).
The unit of account defines what is being measured for financial reporting and this is
normally determined by the applicable financial reporting standard. Fair value may need to
be measured for either a standalone asset (or liability) or a group of assets (or liabilities), i.e.
a cash-generating unit.
For example, a reporting entity that manages a group of financial assets and financial
liabilities with offsetting risks on the basis of its net exposure to market may elect to measure
the group based on the price that would be received to sell its net long position.
The principal market is the market for the asset (or liability) that has the greatest volume or
level of activity. To determine the principal market, management needs to evaluate the level
of activity in various markets. The market in which an entity normally transacts is presumed
to be the principal market.
In the absence of a principal market, management needs to identity the most advantageous
market, which is one that maximises the amount that would be received to sell the asset, after
taking into account transaction costs and transport costs.
The standard is clear that, if there is a principal market for the asset (or liability), the price in
that market represents fair value. The standard prohibits adjusting fair value for transaction
costs incurred, but it does require such transaction costs to be considered in determining the
most advantageous market. For example, agents commission, legal fees and stamp duty are
not deducted from the price used to fair value real estate.
There may be no known or observable market for an asset or liability. For example, there
may be no specific market for the sale of a CGU or intangible asset. In such cases,
management needs to develop a hypothetical market and identify potential market
participants.
The concepts of highest and best use and valuation premise are only applicable when
determining the fair value of non-financial assets e.g. property, plant and equipment.
The fair value hierarchy categorises the inputs used into three levels. A reporting entity is
required to maximise the use of Level 1 inputs (i.e. unadjusted prices in active markets, like
stock price quoted on SGX) and minimise the use of Level 3 inputs (i.e. unobservable
assumptions like projected cashflows). The best indication of fair value is a quoted price in
an active market. This categorisation is relevant for disclosure purposes.
While the availability of inputs might affect the valuation techniques selected to measure fair
value, the standard does not prioritise the use of one valuation approach over another.
VALUATION TECHNIQUES
Three valuation approaches are widely used to measure fair value, namely the market
approach, the income approach and the cost approach.
Market approach: The market approach is a widely used valuation technique and is defined
as uses prices and other relevant information generated by market transactions involving
identical or comparable assets or liabilities.
Valuation techniques consistent with the market approach use prices from observed
transactions for the same or similar assets e.g. P/E and P/EBIDTA multiples. Another
example of a market approach is matrix pricing, which is normally used to value certain
types of financial instruments e.g. debt securities estimated using transaction prices and other
relevant market information like coupon, maturity and credit rating.
Income approach: The income approach converts future cashflows or income and expenses
to a discounted amount. A fair value using this approach will reflect current market
expectations about future cashflows or income and expenses.
Valuation techniques include:
Present value techniques e.g. discount rate adjustment rate technique and expected
present value technique
Options pricing models e.g. Black-Scholes-Merton
Multi-period excess earnings method
Relief from royalties method
The standard does not limit the valuation techniques that are consistent with the income
approaches. It provides some application guidance, but only in relation to present value
techniques.
Cost approach: The cost approach reflects the amount that would be required currently to
replace the service capacity of an asset. This approach is often referred to as current
replacement cost and is typically used to measure the fair value of tangible assets such as
plant and equipment.
From the perspective of a market participant seller, the price that would be received for the
asset is based on the cost to a market participant buyer to acquire or construct a substitute
asset of comparable utility, adjusted for obsolescence.
Obsolescence is broader than depreciation and encompasses:
Physical deterioration
Functional/technological obsolescence
Economic obsolescence
These three approaches are consistent with generally accepted valuation methodologies used
outside financial reporting.
The determination of the appropriate technique(s) to be applied requires significant
judgment, sufficient knowledge of the asset (or liability) and an adequate level of expertise
regarding valuation techniques. Within a given approach, there may be a number of possible
valuation methods.
For instance, there are a number of different methods used to value intangible assets under
the income approach, namely the multi-period excess earnings method and the relief from
royalty method, depending on the nature of the asset.
Selection, application and evaluation of the valuation techniques can be complex. As such,
the reporting entity may need assistance from valuation professionals.
Regardless of the valuation technique(s) used, the objective of a fair value measurement
remains the same, that is, an exit price under current market conditions from the perspectives
of market participants.
PREMIUMS AND DISCOUNTS
In certain instances, selection of inputs could result in a premium or discount being
incorporated into the fair value measurement. The standard distinguishes between premiums
or discounts that reflect size as a characteristic (especially blockage factor), control
premium/discount for minority interest and discount for lack of marketability.
The standard explicitly prohibits the consideration of blockage discounts in fair value
measurement. Blockage discount is an adjustment to the quoted price of an asset because the
markets normal trading volume is not sufficient to absorb the quantity held by a reporting
entity.
When measuring the fair value of interest in private business, control premium/discount for
minority interest and discount for lack of marketability can be taken into consideration.
FAIR VALUE OF A LIABILITY
SFRS 113 applies to liabilities, both financial (e.g. debt obligation) and non-financial (e.g.
decommissioning liability), whenever a standard requires those instruments to be measured
at fair value. For example, in accordance with FRS 103 Business Combination, management
needs to determine the fair value of liabilities assumed when contemplating a purchase price
allocation.
The fair value measurement of a liability contemplates the transfer of the liability to a market
participant at the measurement date. The liability is assumed to continue (i.e. it is not settled
or extinguished), and the market participant to whom the liability is transferred would be
required to fulfil the obligation.
The fair value of a liability also reflects the effect of non-performance risk.
Non-performance risk is the risk that an obligation will not be fulfilled and includes the
reporting entitys own credit risk and other risks such as settlement risk.
For example, there is no observable price available for a decommissioning liability. Hence,
the reporting entity might consider the future cash outflows that a market participant would
expect to incur in fulfilling the obligation, discounted at a rate, which reflects the risk-free
rate and risk premium to reflect its credit risk, i.e. a present value technique.
CONCLUDING THOUGHTS
SFRS 113 provides a framework to estimating fair value. It is intended to reduce
inconsistencies and increase comparability in fair value measurements used in financial
reporting. However, it does not provide specific rules or detailed how to guidance. Hence,
judgment is involved in estimating fair value.
The effect of applying this standard is likely to vary from entity to entity.
In most cases, it will lead to a refinement of previous practice. However, in some cases, the
change may be more significant. For example, if a reporting entity did not consider the
highest and best use when revaluing its plant and equipment, adopting this standard could
result in a higher fair value than it would have previously determined.
Ong Woon Pheng is a partner at CAS Consultants Pte Ltd heading the financial
advisory services department
ALL CHANGE
RELATED LINKS
Dont be fooled; changes to IAS 16, IAS 38 and IFRS 11 will have a profound effect on
some entities, explains Graham Holt
units.
This article was first published in the July/August 2014 UK edition of Accounting and
Business magazine.
In May 2014, the International Accounting Standards Board (IASB) issued two amendments
to standards, entitled Clarification of Acceptable Methods of Depreciation and Amortisation
(Amendments to IAS 16 and IAS 38) and Accounting for Acquisitions of Interests in Joint
Operations (Amendments to IFRS 11). At first sight, these amendments may not seem to be
of significance; however, to some entities they will have a profound effect.
A variety of depreciation methods are used to allocate the depreciable amount of an asset
over its useful life. These methods include the straight-line method, the diminishing balance
method and the units of production method. The method used is selected on the basis of the
expected pattern of consumption of the expected future economic benefits and is applied
consistently, unless there is a change in the expected pattern of consumption.
The IASB decided to amend IAS 16, Property, Plant and Equipment, to address issues that
had arisen over the use of a revenue-based method for depreciating an asset. This is a method
that is based on revenues generated in an accounting period as a proportion of the total
revenues expected to be generated over the assets useful economic life.
CLARIFICATION
The total revenue takes into account any anticipated changes due to price inflation but the
IASB felt that inflation has no bearing on the way in which an asset is consumed. The
amendment came as a result of a request to clarify the meaning of consumption of the
expected future economic benefits embodied in the asset when deciding on the amortisation
method to be used for intangible assets of service concession arrangements. IAS 16 requires
the depreciation method to reflect the pattern in which the assets future economic benefits
are expected to be consumed by the entity.
Revenue may be a measurement of the output generated by the asset, but does not represent
the way in which an item of PPE is used. Such methods reflect a pattern of generation of
economic benefits that arise from the operation of the business of which an asset is part,
rather than the pattern of consumption of an assets expected future economic benefits.
The IASB concluded that a method of depreciation that is based on revenue generated from
an activity that includes the use of an asset is not appropriate, but that the diminishing
balance method is an accepted depreciation method. This has the capability of reflecting
accelerated consumption of the future economic benefits in the asset.
This latter conclusion regarding the diminishing balance method was a clarification due to
concerns raised by Committee members who questioned whether the proposed amendment,
given the influence of a pricing factor, would limit the ability to apply a diminishing balance
depreciation method to manufacturing equipment.
The original exposure draft proposed that there might be circumstances in which a revenuebased method gave the same result as a units-of-production method. This statement was
thought to contradict the proposed amendments and so was dropped.
The principle in IAS 38, Intangible Assets, is that an amortisation method should reflect the
pattern of consumption of the expected future economic benefits and not the pattern of
generation of expected future economic benefits. IAS 38 is therefore amended to introduce a
rebuttable presumption that a revenue-based amortisation method for intangible assets is
inappropriate for the same reasons as in IAS 16. However, there are limited circumstances
when this presumption can be overturned. They are where the intangible asset is expressed as
a measurement of revenue and where it can be demonstrated that revenue and the
consumption of the intangible asset is directly linked to the revenue generated from the asset.
Both standards now contain an explanation that expected future reductions in selling prices
might be indicative of an increased rate of consumption of the future economic benefits of
that asset. The amendments are effective for annual periods beginning on or after 1 January
2016 with earlier application permitted. Full retrospective application of the amendments
would have been too onerous for some entities.
OUTSTANDING ISSUES
In 2011, the IASB issued IFRS 11, Joint Arrangements, which introduced several changes.
Principally, there are now only two types of joint arrangements, which are joint ventures and
joint operations.
Further, proportionate consolidation is no longer permitted for arrangements classified as
joint ventures, as equity accounting has to be applied. Although the standard deals with most
issues arising out of the accounting for joint operations, there are certain matters that it does
not address. A key issue is accounting for the acquisition of an interest in a joint operation,
which represents a business. As both IFRS 11 and its predecessor, IAS 31, Joint Ventures, did
not deal with the issue, significant diversity in practice has occurred. The approaches used in
practice in accounting for a joint operation, which constituted a business, were as follows:
1. IFRS 3, Business Combinations, approach: identifiable assets and liabilities were
normally measured at fair value and goodwill recognised. Additionally, transaction
costs were not capitalised and deferred taxes were recognised on initial recognition of
assets and liabilities. The guidance in IFRS 3 was not followed where it was not
appropriate; for example, in this situation there would not be non-controlling interests.
2. Cost approach: the total cost of acquiring the interest in the joint operation was
allocated to the individual identifiable assets on the basis of their relative fair values.
The premium paid, if any, was allocated to the identifiable assets and not recognised
as goodwill. Transaction costs were capitalised and deferred taxes were not recognised
as per the exception in IAS 12, Income Taxes.
3. Hybrid approach: preparers in this group applied IFRS 3 and other IFRSs selectively
with the result that mainly identifiable assets and liabilities were measured at fair
value and goodwill was recognised.
Transaction costs were capitalised with contingent liabilities and deferred taxes generally not
recognised.
This diversity has led to different treatments of any premium paid on acquisition, recognition
or non-recognition of any deferred taxes arising on acquisition and acquisition costs being
capitalised or expensed.
As a result of the above diversity, the IFRS Interpretations Committee was asked to clarify
whether the acquirer of such interests in joint operations should apply the principles in IFRS
3 or whether the acquirer should account for it as a group of assets. The committee referred
the matter to the IASB, suggesting that the most appropriate approach was to apply the
relevant principles for business combinations in IFRS 3 and other IFRSs.
DEFINING A BUSINESS
One of the key judgments is whether the activities of the joint operation, or the set of
activities and assets contributed to the joint operation on its formation, represent a business
as defined by IFRS 3.
IFRS 3 defines a business as an integrated set of activities and assets that is capable of being
conducted and managed for the purpose of providing a return in the form of dividends, lower
costs or other economic benefits directly to investors or other owners, members or
participants.
Further guidance explains that a business is a series of inputs and processes applied to those
inputs that have the ability to create outputs. However, outputs are not required for the
activities to qualify as a business. An output should have the ability to provide a return in the
form of dividends, lower costs or other economic benefits to owners.
The assessment of whether a set of activities and assets represent a business is still extremely
judgmental.
As a result of the IASBs deliberations, an amendment to IFRS 11 has been made.
Accounting for Acquisitions of Interests in Joint Operations (Amendments to IFRS 11)
requires that the acquirer of an interest in a joint operation which constitutes a business, as
defined in IFRS 3, is required to apply all of the principles in IFRS 3 and other IFRSs with
the exception of those principles that conflict with the guidance in IFRS 11. As a result, a
joint operator that has acquired such an interest has to:
measure most identifiable assets and liabilities at fair value
expense acquisition-related costs (other than debt or equity issuance costs)
recognise deferred taxes
recognise any goodwill or bargain purchase gain
perform impairment tests for the cash-generating units to which goodwill has been
allocated
disclose information required relevant for business combinations.
The amendments apply to the acquisition of an interest in an existing joint operation and also
to the acquisition of an interest when a joint operation is formed. IFRS 1, First-time
Adoption of International Financial Reporting Standards, has also been amended to extend
the business combination exemptions. The amendments are effective for annual periods
beginning on or after 1 January 2016 and apply prospectively.
For some companies, the amendment will represent a significant change to current practice
and will present a number of challenges as a result of having to apply business combinations
accounting, while others relate to the nature of the proposed amendment itself. For example,
joint arrangements are common in the mining and metals sector; therefore any changes in the
accounting can have wide-ranging implications. Some key implications for those companies
are the increased time, cost and effort needed to determine fair values for the identifiable
assets acquired and liabilities assumed. This in turn will lead to changes in the profiles of the
financial statements and the need for more detailed record keeping.
Graham Holt is director of professional studies at the accounting, finance and economics
department at Manchester Metropolitan University Business School
CATERING TO USER DEMANDS
RELATED LINKS
There are some significant changes to previous ASB proposals in the standards bodys latest
plans to reshape financial reporting in the UK and Ireland, says Graham Holt
units.
This article was first published in the June 2014 UK edition of Accounting and Business
magazine.
For many years, regulators and standard-setters have grappled with the issue of how entities
should best present financial performance and not mislead the user. Many jurisdictions have
enforced a standard format for performance reporting, with no additional analysis permitted
on the face of the income statement. Others have allowed entities to adopt various methods
of conveying the nature of underlying or sustainable earnings.
Although financial statements are prepared in accordance with applicable financial reporting
standards, users are demanding more information and issuers seem willing to give users their
understanding of the financial information. This information varies from the disclosure of
additional key performance indicators of the business to providing more information on
individual items within the financial statements. These additional performance measures
(APMs) can assist users in making investment decisions, but they do have limitations.
COMMON PRACTICE
It is common practice for entities to present APMs, such as normalised profit, earnings
before interest and tax (EBIT) and earnings before interest, tax, depreciation and
amortisation (EBITDA). These alternative profit figures can appear in various

communications, including company media releases and analyst briefings. Alternative profit
calculations normally exclude particular income and expense items from the profit figure
reported in the financial statements. Also, there could be the exclusion of income or expenses
that are considered irrelevant from the viewpoint of the impact on this years performance or
when considering the expected impact on future performance.
An example of the latter has been gains or losses from changes in the fair value of financial
instruments. The exclusion of interest and tax helps to distinguish between the results of the
entitys operations and the impact of financing and taxation.
These APMs can help enhance users understanding of the companys results and can be
important in assisting users in making investment decisions, as they allow them to gain a
better understanding of an entitys financial statements and evaluate the entity through the
eyes of the management. They can also be an important instrument for easier comparison of
entities in the same sector, market or economic area.
However, they can be misleading due to bias in calculation, inconsistency in the basis of
calculation from year to year, inaccurate classification of items and, as a result, a lack of
transparency. Often there is little information provided on how the alternative profit figure
has been calculated or how it reconciles with the profit reported in the financial statements.
The APMs are also often described in terms which are neither defined by issuers nor
included in professional literature and thus cannot be easily recognised by users.
APMs include:
all measures of financial performance not specifically defined by the applicable
financial reporting framework
all measures designed to illustrate the physical performance of the activity of an
issuers business
all measures disclosed to fulfil other disclosure requirements included in public
documents containing regulated information.
An example demonstrating the use of APMs is the financial statements of Telecom Italia
Group for the year ended 31 December 2011. These contained a variety of APMs as well as
the conventional financial performance measures laid down by International Financial
Reporting Standards. The non-IFRS APMs used in the Telecom Italia statements were:
EBITDA. Used by Telecom Italia as the financial target in its internal presentations
(business plans) and in its external presentations (to analysts and investors). The entity
regarded EBITDA as a useful unit of measurement for evaluating the operating performance
of the group and the parent.
Organic change in revenues, EBITDA and EBIT. These measures express changes in
revenues, EBITDA and EBIT, excluding the effects of the change in the scope of
consolidation, exchange differences and non-organic components constituted by nonrecurring items and other non-organic income and expenses. The organic change in revenues,
EBITDA and EBIT is also used in presentations to analysts and investors.
Net financial debt. Telecom Italia saw net financial debt as an accurate indicator of its
ability to meet its financial obligations. It is represented by gross financial debt less cash and
cash equivalents and other financial assets. The report on operations includes two tables
showing the amounts taken from the statement of financial position and used to calculate the
net financial debt of the group and parent.
Adjusted net financial debt. A new measure introduced by Telecom Italia to exclude effects
that are purely accounting in nature resulting from the fair value measurement of derivatives
and related financial assets and liabilities.
EVALUATING APMS
The International Accounting Standards Board (IASB) is undertaking an initiative to explore
how disclosures in IFRS financial reporting can be improved. The project has started to look
at possible ways to address the issues arising from the use of APMs. This initiative is made
up of a number of projects. It will consider such things as adding an explanation in IAS 1
that too much detail can obscure useful information and adding more explanations, with
examples, of how IAS 1 requirements are designed to shape financial statements instead of
specifying precise terms that must be used. This includes whether subtotals of IFRS numbers
such as EBIT and EBITDA should be acknowledged in IAS 1.
In the UK, the Financial Reporting Council supports the inclusion of APMs when users are
provided with additional useful, relevant information. In contrast, the Australian Financial
Reporting Council feels that such measures are outside the scope of the financial statements.
In 2012, the Financial Markets Authority (FMA) in the UK issued a guidance note on
disclosing APMs and other types of non-GAAP financial information, such as underlying
profits, EBIT and EBITDA.
APMs appear to be used by some issuers to present a confusing or optimistic picture of their
performance by removing negative aspects. There seems to be a strong demand for guidance
in this area, but there needs to be a balance between providing enough flexibility, while
ensuring users have the necessary information to judge the usefulness of the APMs.
To this end, the European Securities and Markets Authority (ESMA) has launched a
consultation on APMs. The aim is to improve the transparency and comparability of financial
information while reducing information asymmetry among the users of financial statements.
ESMA also wishes to improve coherency in APM use and presentation and restore
confidence in the accuracy and usefulness of financial information.
ESMA has therefore developed draft guidelines that address the concept and description of
APMs, guidance for the presentation of APMs and consistency in using APMs. The main
requirements are:
Issuers should define the APM used, the basis of calculation and give it a meaningful
label and context.
APMs should be reconciled to the financial statements.
APMs that are presented outside financial statements should be displayed with less
prominence.
An issuer should provide comparatives for APMs and the definition and calculation of
the APM should be consistent over time.
If an APM ceases to be used, the issuer should explain its removal and the reasons for
the newly defined APM.
However, these guidelines may not be practicable when the cost of providing this
information outweighs the benefit obtained or the information provided may not be useful to
users. Issuers will most likely incur both implementation costs and ongoing costs. Most of
the information required by the guidelines is already collected for internal management
purposes, but may not be in the format needed to satisfy the disclosure principles.
ESMA believes that the costs will not be significant because APMs should generally not
change over periods. Therefore, ongoing costs will relate almost exclusively to updating
information for every reporting period. ESMA believes that the application of these
guidelines will improve the understandability, relevance and comparability of APMs.
Application of the guidelines will enable users to understand the adjustments made by
management to figures presented in the financial statements. ESMA believes that this
information will help users to make better-grounded projections and estimates of future
cashflows and assist in equity analysis and valuations. The information provided by issuers
in complying with these guidelines will increase the level of disclosures, but should lead
issuers to provide more qualitative information. The national competent authorities will have
to implement these guidelines as part of their supervisory activities and provide a framework
against which they can require issuers to provide information about APMs.
ADDING VALUE
RELATED LINKS
The IASBs practice statement on management commentary and the MASBs SOP 3 provide
a framework, explains Ramesh Ruben Louis
units.
This article was first published in the June 2014 Malaysia edition of Accounting and
Business magazine.
The users of financial information come in all shapes and sizes, with distinct needs and
expectations. Many generally look for information that enables them to better understand
what has taken place in the organisation, as well as to get a sneak peak at its potential,
prospects and future plans.
With this in mind, the International Accounting Standards Board (IASB) issued a practice
statement on Management Commentary on 8 December 2010, thereafter issued in Malaysia
by the Malaysian Accounting Standards Board (MASB) as Statement of Principles 3
Management Commentary (SOP 3) on 28 February 2013, which is equivalent to the IASBs
International Financial Reporting Standard (IFRS) practice statement.
BACKGROUND
It is important to note that the practice statement/SOP 3 is not a financial reporting standard
but instead provides a broad, non-binding framework for the presentation of management
commentary to accompany financial statements prepared using IFRS/MFRS, which may also
be applied by
non-listed entities that prepare IFRS financial statements that include management
commentary.
A management commentary is a narrative report that provides information to interpret the
financial position, financial performance and cashflows of an entity. It also provides
management with an opportunity to explain its objectives and its strategies for achieving
those objectives. Users routinely use the type of information provided in management
commentary to help them evaluate an entitys prospects and its general risks, as well as the
success of managements strategies for achieving its stated objectives.
The underlying principle of management commentary is to provide managements view of
the entitys performance, position and progress; and to supplement and complement
information presented in the financial statements. This is best achieved when the
commentary is forward looking and provides qualitative characteristics that supplement and
complement information contained in the financial statements providing additional
explanations of amounts presented in the financial statements and including information that
is not presented there. Ultimately, the information should be useful for decision making.
Management commentary should be clearly identified and distinguished from other
information (say, in the annual report) and should incorporate a statement on the extent of
compliance with the practice statement/SOP 3.
The practice statement/SOP 3 sets out five key elements that are regarded as crucial
information for the understanding of the users.
PRESENTATION OF MANAGEMENT COMMENTARY
While the practice statement/SOP 3 sets out the principles, qualitative characteristics and
elements that are essential in providing users of financial reports with useful information, the
form and content of management commentary may vary by entity, depending on the
particular circumstances of their business, including the legal and economic circumstances of
individual jurisdictions. This flexible approach is envisaged to generate more meaningful
disclosure relating to matters that are most relevant to their individual circumstances.
Whatever the form chosen, the management commentary should:
address the principles and five key elements set out in the practice statement/SOP 3
be consistent with its related financial statements. For example, if the financial
statements include segment information, the information presented in the management
commentary should reflect that segmentation
avoid duplication of disclosures made in the notes to its financial statements in its
management commentary
avoid generic disclosures that do not relate to the practices and circumstances of
the entity and insignificant disclosures.
NATURE OF BUSINESS
Usually set forth as a starting point for users to assess and understand an entitys
performance, strategic options and prospects, this element encompasses a description of the
business to help users of the financial reports gain an understanding of the entity and the
external environment in which it operates. Among others, this would entail a discussion of
macro-level information such as:
1. the industries in which the entity operates
2. the entitys main markets and competitive position within those markets
3. significant features of the legal, regulatory and macroeconomic environments that
influence the entity and the markets in which the entity operates, and micro-level
information
4. the entitys main products, services, business processes and distribution methods
5. the entitys structure and how it creates value.
MANAGEMENTS OBJECTIVES AND STRATEGIES
Under this element, management should disclose information to enable users to assess the
strategies adopted by the entity and the likelihood that those strategies will be successful in
meeting managements stated objectives, including action to be undertaken and resources
that must be managed to deliver results. For example, information about how management of
a mobile phone company intends to address new technology, rapid consumer behaviour and
expectations, and its related threats and opportunities, provides users of financial reports
with insight that can help in their assessment of the entitys future performance.
Managements measurement of success and time frame to achieve those objective and
strategies should also be discussed.
Management should discuss significant changes in an entitys objectives and strategies from
the previous period or periods. Discussion of the relationship between objectives, strategy,
management actions and executive remuneration is also helpful.
The discussion in this section will likely not be lengthy as many entities would consider that
a detailed discussion would risk divulging commercially sensitive information and give away
competitive advantage.
RESOURCES, RISKS AND RELATIONSHIPS
An entitys value has a direct correlation to how it manages its resources, risks and
relationships. Therefore, information in these three areas would provide users with a better
appreciation of the entitys management capabilities.
Management should set out critical financial and non-financial resources (such as its
employees) available to the entity and how they are used in meeting managements stated
objectives as well as its long-term sustainability. Analysis of the adequacy of the entitys
capital structure, financial arrangements (whether or not recognised in the statement of
financial position), liquidity and cashflows, and human and intellectual capital resources, as
well as plans to address any surplus resources or identified and expected inadequacies, are
examples of disclosures that can provide useful information.
In terms of risks and disclosures about the entitys principal risk exposures (and changes),
coupled with its risk-mitigating strategy and how effective those are, would form the crux of
the discussion. This information is crucial to assess the risks faced by the entity and
possible/potential uncertainties. The key risks that should be included in the analysis would
be strategic, commercial, operational and financial, and should be discussed not only from
the perspective of adverse consequences but also in light of potential opportunities to the
entity, if managed properly. It would be imperative that the discussion on risks (and risk
management) be aligned with the entitys objectives and strategies.
Under this element, management should also identify significant relationships that the entity
has with its stakeholders, how these relationships are managed and how they are likely to
affect the performance and value of the entity.
RESULTS OF OPERATIONS AND PERFORMANCE
For many, this may likely be the highlight and focal point of the management commentary. It
is undeniable that many users of financial information look for supplementary and
complementary analysis that will enable them to make better sense of the main financial
statements, especially in terms of whether the entity has delivered results in line with
expectations and, implicitly, how well management has understood the entitys market,
executed its strategy and managed the entitys resources, risks and relationships.
It is quite common that the following information, where presented and discussed for the
current and prior periods, will equip users to meet those needs and concerns:
operating results and profitability
liquidity
shareholders value or returns
net worth and market values
debt management.
Many entities usually provide this information as financial highlights in their annual
reports.
Management should provide an analysis of the prospects of the entity, which may include
targets for financial and non-financial measures and, where quantified, the risks and
assumptions used.
CRITICAL PERFORMANCE MEASURES/INDICATORS
Users of financial information are more familiar with performance-related information that is
used and monitored by management to enable them to assess and evaluate the entitys
performance against stated objectives and strategies. To address this need, management
should disclose performance measures and indicators (both financial and non-financial) that
are used by management to assess progress against its stated objectives.
Some key pointers to take note of when discussing performance measures and indicators
include:
comparability with industry and/or in general
if there are changes from prior period, an explanation of why and how it has changed
any adjustments or variations from that presented in the main financial statements
definition and explanation of measures and indicators not defined or required by
IFRS/MFRS, including its relevance to users
reconciliation of measures and indicators with those that are presented in the main
financial statements.
CONCLUSION AND OUTLOOK
Management commentary is a component of a more coherent and integrated form of
reporting that sets out a context for better understanding and usefulness of financial
information, especially the financial statements. When prepared with the needs and concerns
of the users in mind, management commentaries will certainly add value to the financial
statements. With the issuance of MASBs SOP3 in 2013, it is hoped that the full benefits of
financial reporting will be further enhanced in Malaysia in the coming years.
Ramesh Ruben Louis is a professional trainer and consultant in audit and assurance, risk
management and corporate governance, corporate finance and public practice advisory
PROFIT, LOSS AND OCI
RELATED LINKS
Graham Holt explains what differentiates profit or loss from other comprehensive income
and where items should be presented
units.
The purpose of the statement of profit or loss and other comprehensive income (OCI) is to
show an entity's financial performance in a way that is useful to a wide range of users so they
may attempt to assess the future net cash inflows of an entity. The statement should be
classified and aggregated in a manner that makes it understandable and comparable.
International Financial Reporting Standards (IFRS) currently require that the statement be
presented as either one statement, being a combined statement of profit or loss and other
comprehensive income, or two statements, being the statement of profit or loss and the
statement of other comprehensive income. An entity has to show separately in OCI, those
items which would be reclassified (recycled) to profit or loss and those items which would
never be reclassified (recycled) to profit or loss. The related tax effects have to be allocated
to these sections.
Profit or loss includes all items of income or expense (including reclassification adjustments)
except those items of income or expense that are recognised in OCI as required or permitted
by IFRS.
Reclassification adjustments are amounts recycled to profit or loss in the current period that
were recognised in OCI in the current or previous periods. An example of items recognised
in OCI that may be reclassified to profit or loss are foreign currency gains on the disposal of
a foreign operation and realised gains or losses on cashflow hedges. Those items that may
not be reclassified are changes in a revaluation surplus under IAS 16, Property, Plant and
Equipment, and actuarial gains and losses on a defined benefit plan under IAS 19, Employee
Benefits.
However, there is a general lack of agreement about which items should be presented in
profit or loss and in OCI. The interaction between profit or loss and OCI is unclear,
especially the notion of reclassification and when or which OCI items should be reclassified.
A common misunderstanding is that the distinction is based on realised versus unrealised
gains. This lack of a consistent basis for determining how items should be presented has led
to an inconsistent use of OCI in IFRS. It may be difficult to deal with OCI on a conceptual
level since the International Accounting Standards Board (IASB) is finding it difficult to find
a sound conceptual basis.
However, there is urgent need for some guidance around this issue.
Opinions vary, but there is a feeling that OCI has become a 'dumping ground' for anything
controversial because of a lack of clear definition of what should be included in the
statement. Many users are thought to ignore OCI as the changes reported are not caused by
the operating flows used for predictive purposes.
Financial performance is not defined in the Conceptual Framework, but could be viewed as
reflecting the value the entity has generated in the period and this can be assessed from other
elements of the financial statements and not just the statement of comprehensive income.
Examples would be the statement of cashflows and disclosures relating to operating
segments. The presentation in profit or loss and OCI should allow a user to depict financial
performance, including the amount, timing and uncertainty of the entity's future net cash
inflows and how efficiently and effectively the entity's management have discharged their
duties regarding the resources of the entity.
There are several arguments for and against reclassification. If reclassification ceased, there
would be no need to define profit or loss, or any other total or subtotal in profit or loss, and
any presentation decisions can be left to specific IFRSs. It is argued that reclassification
protects the integrity of profit or loss and provides users with relevant information about a
transaction that occurred in the period. Additionally, it can improve comparability where
IFRS permits similar items to be recognised in either profit or loss or OCI.
Those against reclassification argue that the recycled amounts add to the complexity of
financial reporting, may lead to earnings management, and the reclassification adjustments
may not meet the definitions of income or expense in the period as the change in the asset or
liability may have occurred in a previous period.
The original logic for OCI was that it kept income-relevant items that possessed low
reliability from contaminating the earnings number.
Markets rely on profit or loss and it is widely used. The OCI figure is crucial because it can
distort common valuation techniques used by investors, such as the price/earnings ratio.
Thus, profit or loss needs to contain all information relevant to investors. Misuse of OCI
would undermine the credibility of net income. The use of OCI as a temporary holding for
cashflow hedging instruments and foreign currency translation is non-controversial.
However, other treatments such as the policy of IFRS 9 to allow value changes in equity
investments to go through OCI, are not accepted universally.
US GAAP will require value changes in all equity investments to go through profit or loss.
Accounting for actuarial gains and losses on defined benefit schemes are presented through
OCI and certain large US corporations have been hit hard with the losses incurred on these
schemes. The presentation of these items in OCI would have made no difference to the
ultimate settled liability, but if they had been presented in profit or loss the problem may
have been dealt with earlier. An assumption that an unrealised loss has little effect on the
business is an incorrect one.
The discussion paper on the Conceptual Framework considers three approaches to profit or
loss and reclassification. The first approach prohibits reclassification. The other approaches,
the narrow and broad approaches, require or permit reclassification. The narrow approach
allows recognition in OCI for bridging items or mismatched remeasurements, while the
broad approach has an additional category of 'transitory measurements' (for example,
remeasurement of a defined benefit obligation), which would allow the IASB greater
flexibility. The narrow approach significantly restricts the types of items that would be
eligible to be presented in OCI and gives the IASB little discretion when developing or
amending IFRSs.
A bridging item arises where the IASB determines that the statement of comprehensive
income would communicate more relevant information about financial performance if profit
or loss reflected a different measurement basis from that reflected in the statement of
financial position. For example, if a debt instrument is measured at fair value in the
statement of financial position, but is recognised in profit or loss using amortised cost, then
amounts previously reported in OCI should be reclassified into profit or loss on impairment
or disposal of the debt instrument.
The IASB argues that this is consistent with the amounts that would be recognised in profit
or loss if the debt instrument were to be measured at amortised cost.
A mismatched remeasurement arises where an item of income or expense represents an
economic phenomenon so incompletely that presenting that item in profit or loss would
provide information that has little relevance in assessing the entity's financial performance.
An example of this is when a derivative is used to hedge a forecast transaction; changes in
the fair value of the derivative may arise before the income or expense resulting from the
forecast transaction.
The argument is that before the results of the derivative and the hedged item can be matched
together, any gains or losses resulting from the remeasurement of the derivative, to the extent
that the hedge is effective and qualifies for hedge accounting, should be reported in OCI.
Subsequently those gains or losses are reclassified into profit or loss when the forecast
transaction affects profit or loss.
This allows users to see the results of the hedging relationship.
The IASB's preliminary view is that any requirement to present a profit or loss total or
subtotal could also result in some items being reclassified. The commonly suggested
attributes for differentiation between profit or loss and OCI (realised/unrealised, frequency of
occurrence, operating/non-operating, measurement certainty/uncertainty, realisation in the
short/long-term or outside management control) are difficult to distil into a set of principles.
Therefore, the IASB is suggesting two broad principles, namely:
1. Profit or loss provides the primary source of information about the return an entity has
made on its economic resources in a period.
2. To support profit or loss, OCI should only be used if it makes profit or loss more
relevant.
The IASB feels that changes in cost-based measures and gains or losses resulting from initial
recognition should not be presented in OCI and that the results of transactions, consumption
and impairments of assets and fulfilment of liabilities should be recognised in profit or loss
in the period in which they occur. As a performance measure, profit or loss is more used,
although there are a number of other performance measures derived from the statement of
profit or loss and OCI.
KEEPING UP TO DATE
RELATED LINKS
Graham Holt outlines the recent amendments made to nine International Financial Reporting
Standards
units.
In December 2013, the International Accounting Standards Board (IASB) issued two
tranches of 'annual improvements' to International Financial Reporting Standards (IFRS).
The improvements process is how the IASB adjusts IFRS in areas where the standards are
unclear. Although these amendments generally do not significantly change the application of
the standards, it is important for entities to determine any potential impact by reviewing their
accounting policies. The recent amendments contain 11 changes to nine standards.
IFRS 3, Business Combinations, currently says that contingent consideration must be
measured at fair value at the time of the business combination. If the amount of contingent
consideration changes as a result of a post-acquisition event, the accounting for the change
depends on whether the additional consideration is classified as an equity instrument, an
asset or liability. Currently, if the additional consideration is classified as an asset or liability
that is a financial instrument, gains and losses are recognised in either profit or loss or other
comprehensive income.
The amendment states that changes in the fair value of contingent consideration that is
classified as an asset or liability irrespective of whether it is a financial instrument are
recognised in profit or loss.
Thus contingent consideration cannot be measured at fair value through other comprehensive
income. This applies only to business combinations.
IFRS 3 has also been amended to clarify that both joint arrangements and joint ventures are
outside its scope. This applies only to the accounting in the financial statements of the joint
arrangement. IFRS 11, Joint Arrangements, introduced joint arrangements to replace the
concept of joint ventures, which is a type of joint arrangement within IFRS 11.
IFRS 3 is basically updated to reflect the change.
Joint arrangements are either joint operations or joint ventures. A joint operation is a joint
arrangement where the parties that have joint control have rights to the assets and liabilities;
a joint venture is a joint arrangement where the parties that have joint control have rights to
the net assets of the arrangement.
IFRS 11 requires the use of the equity method of accounting for interests in joint ventures
thereby eliminating the proportionate consolidation method.
The decision regarding whether a joint arrangement is a joint operation or a joint venture is
based on the parties' rights and obligations.
A further amendment, which is linked to IFRS 3, relates to IAS 40, Investment Property. Its
aim is to clarify that judgment is needed to determine whether the acquisition of investment
property is the acquisition of an asset or is a business combination within the scope of IFRS
3. The judgment is based on the guidance offered in IFRS 3.
The IFRS Interpretations Committee had reported that some practitioners considered both
standards to be mutually exclusive while others felt that an entity acquiring investment
property had to determine whether it met both definitions. IFRS 3 and IAS 40 are deemed
not to be mutually exclusive and IAS 40 is amended to state explicitly that judgment is
needed to determine whether the transaction is solely the acquisition of an investment
property or whether it is the acquisition of a group of assets or a business combination within
the scope of IFRS 3 that includes an investment property. The judgment is not based on IAS
40 but on the guidance in IFRS 3. The amendment does not help to determine whether an
acquisition is a purchase of a business or an asset as judgment is still required.
Vesting conditions are conditions imposed under a share-based payment arrangement that the
counterparty (an employee or third party) must satisfy to be entitled to receive cash, other
assets or equity instruments of the entity.
A 2008 amendment to IFRS 2 clarified that vesting conditions determine whether the entity
receives the services that result in the counterparty's entitlement and restricted the definition
of vesting conditions to include only service and performance conditions. All features of a
share-based payment arrangement other than service and performance conditions are
considered to be non-vesting conditions.
The improvement amends the definitions of vesting condition and market condition and adds
separate definitions for performance condition and service condition.
A performance target can be based on the activities of the entity, or another entity in the same
group, and can relate to the performance of the whole or part of the entity. A performance
condition must contain a service condition and be met while the counterparty renders the
service.
A market condition is a form of performance condition but a share market index target is a
non-vesting condition as it reflects the performance of other entities as well as those of the
group. If the counterparty ceases to provide service during the vesting period, and so does
not meet a service condition, then no expense is recognised for the services received and is
reversed. If there is vesting of an award on cessation of employment, then this obviously
does not apply.
IFRS 8, Operating Segments, states that two or more operating segments may be aggregated
into a single operating segment if aggregation is consistent with the core principles of the
standard, and as long as the segments have similar economic characteristics and are similar
in certain qualitative aspects.
The amendment requires disclosure of the judgments made by management in determining
the aggregation criteria including the nature of the similar economic characteristics. The
reconciliation of segment assets to total assets must be provided only if the reconciliation is
regularly reported to the chief operating decision maker (CODM).
The amendment arose as a result of a submission by the European Securities and Markets
Authority (ESMA) asking the IASB to consider the application of the aggregation criteria
and also the identification of the CODM as ESMA feels that the definition of the CODM
contains conflicting prerogatives (allocation of resources versus assessment of performance).
The IASB has clarified the position in IFRS 13, Fair Value Measurement, as regards shortterm receivables and payables. There was confusion over whether the ability to measure
these items at invoice amounts had been removed by IFRS 13 and amendments to IAS 39
and IFRS 9. It has been clarified that those elements that have no stated interest rates can be
shown at invoice amounts when the effect of discounting is immaterial. Entities will need to
assess what is meant by 'immaterial' in this context.
IAS 16, Property, Plant and Equipment, and IAS 38, Intangible Assets, provide two different
treatments for accumulated depreciation/amortisation at the date of a revaluation.
Accumulated depreciation/amortisation is either restated proportionately with the change in
the gross carrying amount of the asset, so that the carrying amount of the asset after
revaluation equals its revalued amount (the gross approach), or is eliminated against the
gross carrying amount of the asset and the net amount restated to the revalued amount of the
asset (the offset approach). Offset is often used for buildings and gross when an asset is
revalued by means of applying an index.
The restatement of accumulated depreciation proportionate to the gross carrying amount is
not possible when the residual value, the useful life or the depreciation method has been
changed before a revaluation.
The amendment to IAS 16 and IAS 38 states that when an item is revalued, the accumulated
depreciation is eliminated against the gross carrying amount of the asset and the net amount
is restated to the revalued amount of the asset. Alternatively, the gross carrying amount is
restated consistent with the revaluation of the carrying amount. The accumulated
depreciation is the difference between the gross and net carrying amounts. The gross
carrying amount may be restated by reference to observable market data or proportionately
to the change in the net carrying amount. The determination of the accumulated depreciation
does not depend on the selection of the valuation technique.
IFRS 13 includes a scope exception for measuring the fair value of a group of financial
assets and financial liabilities on a net basis. It was not clear whether this exception, known
as the 'portfolio exception', included all contracts within the scope of IAS 39 or IFRS 9,
which includes such things as commodity derivatives, which do not meet the definitions of
financial assets or financial liabilities in IAS 32. The IASB's intention was to include such
contracts in the portfolio exception.
The amendment clarifies that the portfolio exceptions can be applied to financial assets,
financial liabilities and other contracts within IAS 39 or IFRS 9, and not just to those
contracts that meet the definition of financial assets or liabilities.
IFRS 1, First-time Adoption of International Financial Reporting Standards, sets out the
procedures an entity must follow when it first adopts IFRS. The amendment allows an entity
to apply either an existing effective IFRS or a new or revised IFRS that is not yet mandatory
(provided that early application is permitted). However, the entity has to apply the same
version of the IFRS throughout the periods covered by those first IFRS financial statements.
This clarifies the meaning of 'effective IFRS' in IFRS 1.
Finally, IAS 24, Related Party Disclosures, is amended so that an entity that provides key
management personnel services is a related party and subject to the related party disclosures.
Some of these amendments are retrospective, some are effective immediately and some
prospectively from 1 July 2014. Earlier application is permitted without adopting all
amendments.
department at Manchester M ALL CHANGE
RELATED LINKS
Dont be fooled; changes to IAS 16, IAS 38 and IFRS 11 will have a profound effect on
some entities, explains Graham Holt
units.
This article was first published in the July/August 2014 UK edition of Accounting and
Business magazine.
In May 2014, the International Accounting Standards Board (IASB) issued two amendments
to standards, entitled Clarification of Acceptable Methods of Depreciation and Amortisation
(Amendments to IAS 16 and IAS 38) and Accounting for Acquisitions of Interests in Joint
Operations (Amendments to IFRS 11). At first sight, these amendments may not seem to be
of significance; however, to some entities they will have a profound effect.
A variety of depreciation methods are used to allocate the depreciable amount of an asset
over its useful life. These methods include the straight-line method, the diminishing balance
method and the units of production method. The method used is selected on the basis of the
expected pattern of consumption of the expected future economic benefits and is applied
consistently, unless there is a change in the expected pattern of consumption.
The IASB decided to amend IAS 16, Property, Plant and Equipment, to address issues that
had arisen over the use of a revenue-based method for depreciating an asset. This is a method
that is based on revenues generated in an accounting period as a proportion of the total
revenues expected to be generated over the assets useful economic life.
CLARIFICATION
The total revenue takes into account any anticipated changes due to price inflation but the
IASB felt that inflation has no bearing on the way in which an asset is consumed. The
amendment came as a result of a request to clarify the meaning of consumption of the
expected future economic benefits embodied in the asset when deciding on the amortisation
method to be used for intangible assets of service concession arrangements. IAS 16 requires
the depreciation method to reflect the pattern in which the assets future economic benefits
are expected to be consumed by the entity.
Revenue may be a measurement of the output generated by the asset, but does not represent
the way in which an item of PPE is used. Such methods reflect a pattern of generation of
economic benefits that arise from the operation of the business of which an asset is part,
rather than the pattern of consumption of an assets expected future economic benefits.
The IASB concluded that a method of depreciation that is based on revenue generated from
an activity that includes the use of an asset is not appropriate, but that the diminishing
balance method is an accepted depreciation method. This has the capability of reflecting
accelerated consumption of the future economic benefits in the asset.
This latter conclusion regarding the diminishing balance method was a clarification due to
concerns raised by Committee members who questioned whether the proposed amendment,
given the influence of a pricing factor, would limit the ability to apply a diminishing balance
depreciation method to manufacturing equipment.
The original exposure draft proposed that there might be circumstances in which a revenuebased method gave the same result as a units-of-production method. This statement was
thought to contradict the proposed amendments and so was dropped.
The principle in IAS 38, Intangible Assets, is that an amortisation method should reflect the
pattern of consumption of the expected future economic benefits and not the pattern of
generation of expected future economic benefits. IAS 38 is therefore amended to introduce a
rebuttable presumption that a revenue-based amortisation method for intangible assets is
inappropriate for the same reasons as in IAS 16. However, there are limited circumstances
when this presumption can be overturned. They are where the intangible asset is expressed as
a measurement of revenue and where it can be demonstrated that revenue and the
consumption of the intangible asset is directly linked to the revenue generated from the asset.
Both standards now contain an explanation that expected future reductions in selling prices
might be indicative of an increased rate of consumption of the future economic benefits of
that asset. The amendments are effective for annual periods beginning on or after 1 January
2016 with earlier application permitted. Full retrospective application of the amendments
would have been too onerous for some entities.
OUTSTANDING ISSUES
In 2011, the IASB issued IFRS 11, Joint Arrangements, which introduced several changes.
Principally, there are now only two types of joint arrangements, which are joint ventures and
joint operations.
Further, proportionate consolidation is no longer permitted for arrangements classified as
joint ventures, as equity accounting has to be applied. Although the standard deals with most
issues arising out of the accounting for joint operations, there are certain matters that it does
not address. A key issue is accounting for the acquisition of an interest in a joint operation,
which represents a business. As both IFRS 11 and its predecessor, IAS 31, Joint Ventures, did
not deal with the issue, significant diversity in practice has occurred. The approaches used in
practice in accounting for a joint operation, which constituted a business, were as follows:
1. IFRS 3, Business Combinations, approach: identifiable assets and liabilities were
normally measured at fair value and goodwill recognised. Additionally, transaction
costs were not capitalised and deferred taxes were recognised on initial recognition of
assets and liabilities. The guidance in IFRS 3 was not followed where it was not
appropriate; for example, in this situation there would not be non-controlling interests.
2. Cost approach: the total cost of acquiring the interest in the joint operation was
allocated to the individual identifiable assets on the basis of their relative fair values.
The premium paid, if any, was allocated to the identifiable assets and not recognised
as goodwill. Transaction costs were capitalised and deferred taxes were not recognised
as per the exception in IAS 12, Income Taxes.
3. Hybrid approach: preparers in this group applied IFRS 3 and other IFRSs selectively
with the result that mainly identifiable assets and liabilities were measured at fair
value and goodwill was recognised.
Transaction costs were capitalised with contingent liabilities and deferred taxes generally not
recognised.
This diversity has led to different treatments of any premium paid on acquisition, recognition
or non-recognition of any deferred taxes arising on acquisition and acquisition costs being
capitalised or expensed.
As a result of the above diversity, the IFRS Interpretations Committee was asked to clarify
whether the acquirer of such interests in joint operations should apply the principles in IFRS
3 or whether the acquirer should account for it as a group of assets. The committee referred
the matter to the IASB, suggesting that the most appropriate approach was to apply the
relevant principles for business combinations in IFRS 3 and other IFRSs.
DEFINING A BUSINESS
One of the key judgments is whether the activities of the joint operation, or the set of
activities and assets contributed to the joint operation on its formation, represent a business
as defined by IFRS 3.
IFRS 3 defines a business as an integrated set of activities and assets that is capable of being
conducted and managed for the purpose of providing a return in the form of dividends, lower
costs or other economic benefits directly to investors or other owners, members or
participants.
Further guidance explains that a business is a series of inputs and processes applied to those
inputs that have the ability to create outputs. However, outputs are not required for the
activities to qualify as a business. An output should have the ability to provide a return in the
form of dividends, lower costs or other economic benefits to owners.
The assessment of whether a set of activities and assets represent a business is still extremely
judgmental.
As a result of the IASBs deliberations, an amendment to IFRS 11 has been made.
Accounting for Acquisitions of Interests in Joint Operations (Amendments to IFRS 11)
requires that the acquirer of an interest in a joint operation which constitutes a business, as
defined in IFRS 3, is required to apply all of the principles in IFRS 3 and other IFRSs with
the exception of those principles that conflict with the guidance in IFRS 11. As a result, a
joint operator that has acquired such an interest has to:
measure most identifiable assets and liabilities at fair value
expense acquisition-related costs (other than debt or equity issuance costs)
recognise deferred taxes
recognise any goodwill or bargain purchase gain
perform impairment tests for the cash-generating units to which goodwill has been
allocated
disclose information required relevant for business combinations.
The amendments apply to the acquisition of an interest in an existing joint operation and also
to the acquisition of an interest when a joint operation is formed. IFRS 1, First-time
Adoption of International Financial Reporting Standards, has also been amended to extend
the business combination exemptions. The amendments are effective for annual periods
beginning on or after 1 January 2016 and apply prospectively.
For some companies, the amendment will represent a significant change to current practice
and will present a number of challenges as a result of having to apply business combinations
accounting, while others relate to the nature of the proposed amendment itself. For example,
joint arrangements are common in the mining and metals sector; therefore any changes in the
accounting can have wide-ranging implications. Some key implications for those companies
are the increased time, cost and effort needed to determine fair values for the identifiable
assets acquired and liabilities assumed. This in turn will lead to changes in the profiles of the
financial statements and the need for more detailed record keeping.
VEXED CONCEPT
RELATED LINKS
Uncomfortable questions are surfacing about the purpose and the nature of the equity method
of accounting. Graham Holt explains
units.
Equity accounting was originally used as a consolidation technique for subsidiaries at a time
when acquisition accounting was considered inappropriate because it showed assets and
liabilities not owned by the reporting entity.
The equity method evolved as a basis of reporting the performance of subsidiaries partly as it
was seen as more appropriate than cost.
International consensus on the equity method eventually led to an amended EU directive to
require the use of equity accounting for associates of an investor. Some European countries
questioned this amendment on the basis that it did not use acquisition accounting principles
to account for subsidiaries.
WHATS THE POINT?
In short, equity accounting has a long history and is currently used to account for associates
and joint ventures. However, IAS 28, Investments in Associates and Joint Ventures, does not
state what equity accounting is trying to portray. Under the equity method, on initial
recognition the investment in an associate or a joint venture is recognised at cost, and the
carrying amount increased or decreased to recognise the investors share of the profit or loss
of the investee after the date of acquisition.
Many of the principles applied in the equity method are similar to the consolidation
procedures described in IFRS 10, Consolidated Financial Statements. For example, under
equity accounting, profits are eliminated on intergroup transactions only to the extent of an
investors interest. This reflects a proprietary perspective to consolidation, as opposed to the
entity perspective of IFRS 10.
Although IAS 28 does not specifically state that IFRS 3, Business Combinations, should be
applied to an acquisition of an investee, it does refer to the acquisition accounting principles
in IFRS 3. For example, IAS 28 requires that goodwill relating to an associate or a joint
venture is included in the carrying amount of the investment. Amortisation of goodwill is not
permitted.
DUAL APPROACH
Equity accounting reflects a measurement approach as well as a consolidation approach. For
example, losses in excess of carrying value are not recognised in most circumstances after
the investor or joint venturers interest is reduced to zero, a liability is recognised only to the
extent that the investor or joint venturer has incurred legal or constructive obligations or
made payments on behalf of the investee.
The basis for conclusions in IAS 28 refers to the equity method as a way to measure an
investment in an associate and a joint venture. Thus, questions can be raised as to whether
equity accounting is a type of financial instruments valuation accounting or a one-line
consolidation.
There are a number of differences between consolidation and equity accounting that may
give a different result, including acquisition costs and loss-making subsidiaries. In the
consolidated financial statements, acquisition costs on a business combination are expensed
in the period they are incurred, but included in the cost of investment for equity accounting.
The consolidated financial statements include full recognition of losses of a subsidiary, but
under equity accounting an entity discontinues recognising losses once its share of the losses
equals or exceeds its interest.
Recent developments have helped preparers understand the thinking behind the equity
method. In December 2012, the International Accounting Standards Board (IASB) published
two exposure drafts for amending IAS 28 IAS 28, Equity Method: Share of Other Net
Asset Changes, and IAS 28, Sales or Contributions of Assets between an Investor and its
Associate or Joint Venture. The first dealt with how an investor should recognise its share of
changes in net assets of an investee not recognised in comprehensive income, while the
second dealt with the inconsistency between IFRS 10 and IAS 28 dealing with the sale or
contribution of assets between an investor and its investee.
There appears to be significant diversity in the way the equity method is applied in practice
mainly because of the two different concepts of measurement and consolidation
underpinning the method. The proposed amendments did not address this issue and were
seen as a short-term measure. Respondents felt it was important for the IASB to establish a
clear conceptual basis for the equity method.
SEPARATE STATEMENTS
Some jurisdictions require equity accounting to be used in the separate financial statements
of the parent company for investments in associates, joint ventures and subsidiaries. IAS 27,
Separate Financial Statements, does not currently permit this as the option was removed for
investments in separate financial statements in 2003. The IASB has been asked to restore this
option and issued an exposure draft in December 2013 entitled Equity Method in Separate
Financial Statements (Proposed amendments to IAS 27). The draft also requires the change
to be applied retrospectively if the entity elects to use the equity method.
Retrospective application for associates and joint ventures may not be a problem as the
equity accounting used in an entitys separate financial statements would be consistent with
its consolidated financial statements. However, there may be a problem with investments in
subsidiaries in areas such as impairment testing and foreign exchange.
There is some doubt about the objective of separate financial statements, as they are not
required in International Financial Reporting Standards (IFRS). In general, they are required
by local regulations or other financial statement users. IAS 27 points out that the focus of
such statements is on the financial performance of the assets as investments.
IAS 27 does not mandate which entities must produce separate financial statements for
public use. It applies when an entity prepares separate financial statements that comply with
IFRS.
Currently, financial statements in which the equity method is applied are not separate
financial statements. Similarly, the financial statements of an entity that does not have a
subsidiary, associate or joint venturers interest in a joint venture are not separate financial
statements.
When an entity prepares separate financial statements, investments in subsidiaries, associates
and jointly controlled entities are accounted for at cost or in accordance with IFRS 9,
Financial Instruments.
Investments accounted for at cost and classified as held for sale are accounted for in
accordance with IFRS 5, Non-current Assets Held for Sale and Discontinued Operations.
If an entity elects, as permitted by IAS 28, to measure its investments in associates or joint
ventures at fair value through profit or loss in accordance with IFRS 9, it has to account for
them in the same way in its separate financial statements. At present, therefore, companies
have to elect under IFRS to measure their investments in associates, joint ventures and
subsidiaries either at cost or to treat the investment as a financial instrument. The proposed
third option will lead to diversity in practice but perhaps more importantly, it raises the
question about the nature and purpose of equity accounting.
Respondents to the IASB exposure drafts are generally not in favour of introducing
accounting policy options in IFRS. The proposed change to IAS 27 will align the accounting
principles across boundaries but some respondents feel that the use of the equity method in
separate financial statements is inappropriate because the proposed amendment lacks a
conceptual basis.
If the main objective of the proposals is to improve the relevance of information, then the
IASB should first clarify what the equity method purports to achieve. The basis of the
argument of respondents opposing the introduction of the equity method is that it simply
reflects information already given in the consolidated financial statements and the
introduction of additional accounting policy options reduces the comparability of financial
information. Further it is felt that the IASB should investigate current practice in countries
with experience in applying the equity method before approving the change.
SOWING CONFUSION
The proposals could be seen as creating confusion about the purpose and nature of the
separate financial statements. Apart from the single-line presentation, consolidation rules
would apply, so additional questions are raised about the purpose and the nature of the
equity method.
The IASB feels including this option in IAS 27 would not involve any additional procedures
because the information can be obtained from the consolidated financial statements by
applying IFRS 10 and IAS 28.
Under the present proposals in the exposure draft, an entity could account for its investments
in subsidiaries using the equity method, its associates under IFRS 9 and its joint ventures at
cost. The proposed amendment affects IAS 28, which makes it imperative to consider
whether any consequential amendments reflect the intention of the amendment to IAS 27.
IR - THE NUTS AND BOLTS
RELATED LINKS
Graham Holt outlines the purpose of, and what's involved with, adopting the IIRC's new
integrated reporting framework
units.
The International Integrated Reporting Council (IIRC) has recently released a framework for
integrated reporting. This follows a three-month global consultation and trials in 25
countries. The framework establishes principles and concepts that govern the overall content
of an integrated report.
An integrated report sets out how the organisation's strategy, governance, performance and
prospects lead to the creation of value. There is no benchmarking for the above matters and
the report is aimed primarily at the private sector, but it could be adapted for public sector
and not-for-profit organisations.
The primary purpose of an integrated report is to explain to providers of financial capital
how an organisation creates value over time. An integrated report benefits all stakeholders
interested in a company's ability to create value, including employees, customers, suppliers,
business partners, local communities, legislators, regulators and policymakers, although it is
not directly aimed at all stakeholders. Providers of financial capital can have a significant
effect on the capital allocation and attempting to aim the report at all stakeholders would be
an impossible task and would reduce the focus and increase the length of the report. This
would be contrary to the objectives of the report, which is value creation.
Historical financial statements are essential in corporate reporting, particularly for
compliance purposes, but do not provide meaningful information regarding business value.
Users need a more forward-looking focus without the necessity of companies providing their
own forecasts.
Companies have recognised the benefits of showing a fuller picture of company value and a
more holistic view of the organisation. The International Integrated Reporting Framework
will encourage the preparation of a report that shows their performance against strategy,
explains the various capitals used and affected, and gives a longer-term view of the
organisation. The integrated report is creating the next generation of the annual report as it
enables stakeholders to make a more informed assessment of the organisation and its
prospects.
CULTURE CHANGE
The IIRC has set out a principle-based framework rather than specifying a detailed
disclosure and measurement standard. This enables each company to set out its own report
rather than adopt a checklist approach. The culture change should enable companies to
communicate their value creation better than the often boilerplate disclosures under
International Financial Reporting Standards (IFRS).
The report acts as a platform to explain what creates the underlying value in a business and
how management protects this value. This gives the report more business relevance than the
compliance-led approach currently used. Integrated reporting will not replace other forms of
reporting, but the vision is that preparers will pull together relevant information already
produced to explain the key drivers of their business's value.
Information will only be included in the report where it is material to the stakeholder's
assessment of the business. There were concerns that the term 'materiality' had a certain legal
connotation, with the result that some entities may feel they should include regulatory
information in the integrated report. However, the IIRC concluded that the term should
continue to be used in this context as it is well understood.
The integrated report aims to provide an insight into the company's resources and
relationships which are known as the capitals and how the company interacts with the
external environment and the capitals to create value. These capitals can be financial,
manufactured, intellectual, human, social and relationship, and natural capital, but companies
need not adopt these classifications. The purpose of this framework is to establish principles
and content that governs the report, and to explain the fundamental concepts that underpin
them. The report should be concise, reliable and complete, including all material matters,
both positive and negative, and presented in a balanced way without material error.
KEY COMPONENTS
Integrated reporting is built around the following key components:
1. Organisational overview and the external environment under which it operates.
2. Governance structure and how this supports its ability to create value.
3. Business model.
4. Risks and opportunities and how they are dealing with them and how they affect the
company's ability to create value.
5. Strategy and resource allocation.

6. Performance and achievement of strategic objectives for the period and outcomes.
7. Outlook and challenges facing the company and their implications.
8. The basis of presentation needs to be determined, including what matters are to be
included in the integrated report and how the elements are quantified or evaluated.
The framework does not require discrete sections to be compiled in the report, but there
should be a high-level review to ensure that all relevant aspects are included. The linkage
across the above content can create a key storyline and can determine the major elements of
the report, such that the information relevant to each company would be different.
An integrated report should provide insight into the nature and quality of the organisation's
relationships with its key stakeholders, including how and to what extent the organisation
understands, takes into account and responds to their needs and interests. Furthermore, the
report should be consistent over time to enable comparison with other entities.
An integrated report may be prepared in response to existing compliance requirements; for
example, a management commentary. Where that report is also prepared according to the
framework or even beyond the framework, it can be considered an integrated report. An
integrated report may be either a standalone report or be included as a distinguishable part of
another report or communication. For example, it can be included in the company's financial
statements.
NATURE OF VALUE
The IIRC considered the nature of value and value creation. These terms can include the total
of all the capitals, the benefit captured by the company, the market value or cashflows of the
organisation, and the successful achievement of the company's objectives. However, the
conclusion reached was that the framework should not define value from any one particular
perspective, because value depends upon the individual company's own perspective. It can
be shown through movement of capital and can be defined as value created for the company
or for others. An integrated report should not attempt to quantify value, as assessments of
value are left to those using the report.
Many respondents felt that there should be a requirement for a statement from those 'charged
with governance' acknowledging their responsibility for the integrated report in order to
ensure the reliability and credibility of the integrated report. Additionally it would increase
the accountability for the content of the report.
The IIRC feels that the inclusion of such a statement may result in additional liability
concerns, such as inconsistency with regulatory requirements in certain jurisdictions and
could lead to a higher level of legal liability. The IIRC also felt that the above issues might
result in a slower take-up of the report and decided that those 'charged with governance'
should, in time, be required to acknowledge their responsibility for the integrated report,
while at the same time recognising that reports in which they were not involved would lack
credibility.
There has been discussion about whether the framework constitutes suitable criteria for
report preparation and for assurance. The questions asked concerned measurement standards
to be used for the information reported and how a preparer can ascertain the completeness of
the report.
FUTURE DISCLOSURES
There were concerns over the ability to assess future disclosures, and recommendations were
made that specific criteria should be used for measurement, the range of outcomes and the
need for any confidence intervals to be disclosed. The preparation of an integrated report
requires judgment, but there is a requirement for the report to describe its basis of
preparation and presentation, including the significant frameworks and methods used to
quantify or evaluate material matters. Also included is the disclosure of a summary of how
the company determined the materiality limits and a description of the reporting boundaries.
The IIRC has stated that the prescription of specific key KPIs (key performance indicators)
and measurement methods is beyond the scope of a principles-based framework. The
framework contains information on the principle-based approach and indicates that there is a
need to include quantitative indicators whenever practicable and possible. Additionally,
consistency of measurement methods across different reports is of paramount importance.
There is outline guidance on the selection of suitable quantitative indicators.
A company should consider how to describe the disclosures without causing a significant
loss of competitive advantage. The entity will consider what advantage a competitor could
actually gain from information in the integrated report, and will balance this against the need
for disclosure.
Companies struggle to communicate value through traditional reporting. The framework can
prove an effective tool for businesses looking to shift their reporting focus from annual
financial performance to long-term shareholder value creation. The framework will be
attractive to companies who wish to develop their narrative reporting around the business
model to explain how the business has been developed.
FINANCIAL CSI IS ON THE RISE
RELATED LINKS
Forensic accountants use investigative, accounting and auditing skills to expose corporate
fraud, and caseloads are soaring globally
units.
This article was first published in the March 2012 UK edition of Accounting and
Business magazine.
When the going gets tough, the tough get going! Unfortunately, this is also true when it
comes to corporate fraud. Read any fraud survey or report and you are likely to come across
a disturbing common finding - that fraud is on the rise.
EY's Asia-Pacific Fraud Survey 2013 reported that: 'Across the Asia-Pacific area comprising Australia, China, Indonesia, Malaysia, New Zealand, South Korea, Singapore
and Vietnam - fraudulent practices are on the rise, and there is a disconnect between the
policies that are in place and how they are applied in practice.
'Overall, one in five respondents considers bribery and corruption to be widespread in their
home countries. In the rapid-growth markets where growth is relatively high but systems and
procedures are typically less developed - such as China, Indonesia, Malaysia and Vietnam the figure is close to one in two.'
The recently released KPMG Malaysia Fraud, Bribery and Corruption Survey 2013 found
that 89 percentage of its survey respondents felt that the extent of fraud had increased over
the past three years, while 94 percentage said they believed that frauds had become more
sophisticated and 85 percentage agreed that frauds are increasingly becoming aligned to
industry and more targeted to certain business processes.
With fraud on the rise, the need and demand for the specialist skills and services of forensic
accounting professionals has also been growing in recent years. A 2011 Forensic and
Valuation Services Trend Survey conducted by the American Institute of CPAs found that 79
percentage of respondents expected to see a greater demand for such services in the next two
to five years.
Not surprisingly, all sizes of organisations and industries said that they expected to see more
litigation and regulatory enforcement within the next two to five years, and 80 percentage of
respondents saw this as a future trend. A resounding 83 percentage said they used internal
resources to support their forensic practice while 24 percentage had taken on more internal
forensic professionals in their practices.
THE DEFINITION OF FORENSIC ACCOUNTING
Forensic accounting is a science that deals with the application of accounting facts and
theories gathered through auditing methods and procedures to resolve legal problems.
Forensic accounting professionals' analyses of corporate accounts have a primary objective
of resolving a dispute and, given that 'forensic' means 'suitable for use in a court of law', it is
to that standard and potential outcome that they generally work.
Forensic accounting is very different from conventional auditing: the specialisation

integrates investigative, accounting and auditing skills. Forensic accounting professionals
look at documents, and financial and other data in a critical manner in order to draw
conclusions and calculate values or indicators to identify irregular patterns and/or suspicious
transactions. They do not merely look at the numbers, but rather behind and in between
them, and they try to assess what the patterns and trends suggest. This analysis is then used
to gather qualified evidence.
THE FORENSIC ACCOUNTING PROCESS
Forensic accounting and fraud investigation entails a methodological process of collecting
and compiling financial data that can be used in the court of law or internally within an
organisation.
An investigation is usually triggered by a suspicion or indications of irregularity (also known
as 'red flags') such as unusual increases in purchases, major fluctuations in operating
expenses, unexplained claims, increasing complaints from customers on quality of
goods/services, and so on.
It is uncommon for forensic accounting to be carried out as a routine procedure or endeavour
in an organisation, but having some form of forensic accounting/investigative approach (or
anti-fraud programme) as part of an organisation's risk management programme is gaining a
following.
The initial step that a forensic accountant takes is reconstructing a probable method, or trail,
with supporting evidence of how the suspicious event took place. This is sometimes referred
to as the 'dead body theory' approach.
At this juncture, it is imperative that forensic accountants consider the fraud triangle when
devising theories of how (and even why) the potential fraudulent event/transaction
transpired.
Once a number of possible theories are on the table, they have to be validated somehow. One
way is to conduct interviews with potential suspects, witnesses and other informants. It is
crucial that the forensic accounting professional is methodical in order to garner as much
information as possible.
The primary purpose of most interviews is to gather evidence through facts and other
information supplied by witnesses. Interviewers should obtain background information about
the witnesses, the subject matter of the investigation, and the potential suspects.
Efforts should be made during the interviews to identify new records or evidence, and
additional witnesses.
Interviews should strive to obtain answers to the basic questions: who, what, where, when,
how and why. The key ground rules in performing an effective interview include:
exercise courtesy and respect with interviewees
if documents or exhibits are to be used, they must be carefully collated before the
interview, preferably using copies of documents as opposed to originals
when arranging an interview, choose a location to ensure privacy and to minimise
interruptions, and note that it is recommended that only one person be interviewed at a
time
ensure your interviewee has access to an exit that is not blocked by the interviewers.
This is a safety consideration, but may also subtly highlight the voluntary nature of
statements given
as preparation, interviewers should thoroughly review the appropriate data, documents
and information relating to the subject matter of the interview
all relevant parties, including the interviewee, should consent to any audio or video
recording of the interview
take notes during the interview, and dictate and clean them up within a day or two
while it is fresh in your mind.
After building up the case (or validating the developed theories) through information
obtained from the interviews, a forensic accounting professional will be able to narrow down
the search/scope for the 'hard' evidence by performing analytical procedures such as
financial, ratio, operating cashflow and trend analyses to look for irregular patterns and
abnormalities, as well as transactions outside the ordinary course of business.
This approach enables the forensic accountant to zero in on specific transactions, timelines
or areas (such as type of activity, department or persons) where the potential incriminating
evidence can be found.
A common analytical tool that has been incorporated into many forensic software tools is
Benford's Law. It looks at an entire account to determine if the numbers fall into the expected
distribution. Most accounting-related data can be expected to conform to a Benford
distribution because typical accounts comprise transactions that result from combining
numbers.
For example, accounts receivable is the number of items sold multiplied by the price per
item. Benford's Law will apply to almost any natural data set (e.g. payment amounts), but not
to a limited-by-definition category (e.g. payment amounts between $50 and $100) or to
predetermined data sets (e.g. customer or social security numbers).
Once the suspected transactions or evidence that substantiates the potential fraud have been
isolated, the evidence has to be retrieved and evaluated to ensure that it qualifies for use in
further action, be it disciplinary or prosecutable in nature. A high standard is usually applied
for this, whereby it must be able to stand the scrutiny of law.
Therefore it is crucial that the evidence gathered satisfies:
1. intent - to show motive for the act committed

2. method - how and what was done in committing the fraudulent act
3. persons - who committed the act (including any accomplices)
4. quantified - the impact of the act to the organisation/victim.
The nature of evidence may include documents detailing or depicting the act (such as
forgery), oral testimony (confessions from suspects, witnesses/experts), audio/video
recordings, electronic data capture and so on.
There are many occasions where the incriminating evidence may be electronic or digital in
nature, such as emails, electronically transmitted transactions or correspondences, or even
files and information that have been deliberately deleted with a view to disguising a
fraudulent act.
In such instances, it often becomes necessary to employ computer forensic tools, as the
evidence is lying within computer hard drives, and on networks or other electronic
equipment. Such investigations are often described as the autopsy of a computer hard disk
drive because specialised software tools and techniques are required to analyse the various
levels at which data is stored after the fact/transaction.
The objective of computer forensics is to provide digital evidence of a specific or general
activity. It is important to note that when it comes to using computer forensic tools, it is not a
good idea to use freeware as its integrity is questionable in a court of law and could even
corrupt data.
Following the gathering of qualified evidence, it is crucial that it is properly preserved and
safe custody is ensured, as illustrated in the diagram below.
A MATTER OF LAW
Whether an act of fraud has been committed is ultimately determined by law. This is why
forensic accounting (including evidence-gathering) must be conducted in a manner suitable
for a court of law. Given the requirement for this 'high standard', the entire forensic process
must be completed in a proper manner and not 'tainted', as this can lead the facts and
evidence presented to become inadmissible. These standards include:
it must be performed by qualified, competent, independent and experienced personnel
or experts
the entire process - from the red flags, interviews and analysis to qualified evidence must be properly documented
due care must be exercised during the investigation, such as obtaining the necessary
consents and approvals, with no coercion, threats or force in obtaining information,
testimonies or confessions; and obtaining warrants, subpoenas or court orders, where
relevant, to proceed with a search, interview or interrogation
compliance with relevant laws, especially those relating to privacy

maintenance of a strong chain of custody over evidence gathered.
Forensic accounting professionals need to keep up to date with laws relating to evidence in
their respective jurisdictions, such as the Evidence Act 1950 in Malaysia and the Evidence
Act (Chapter 97) 1997 in Singapore, so as to be aware of what is expected when it comes to
'accepted' evidence in a court of law. This avoids the possibility of being 'disqualified' on a
technicality.
CONCLUSION
There are clear indications that fraud is not fizzling out any time soon, and it is undeniable
that the need for forensic accounting will be greater in the future.
Factors such as uncertainties in the marketplace, technological advancements in business,
increasing concerns and regulations by regulators, enhanced scrutiny over experts, changes
in legislation relating to evidence as well as emerging new tactics in committing fraud by
'new-age' fraudsters mean that the scope of the forensic accounting professional's role is
broadening, and the challenges that they face will be greater.
Forensic accounting needs to evolve and be a step ahead of the game.
Ramesh Ruben Louis is a professional trainer and consultant in audit & assurance, risk
management & corporate governance, corporate finance and public practice advisory
TRANSPARENT AND CONSISTENT
RELATED LINKS
Transparency and the consistent application of IFRS in financial reporting are key to making
financial markets work smoothly
units.
The European Securities and Markets Authority (ESMA) has recently published its annual
statement defining the European common enforcement priorities for 2013 financial
statements. The aim is to try to foster transparency and the consistent application of IFRS
(International Financial Reporting Standards) to help the financial markets function.
With the help of European national enforcers, ESMA has identified several financial
reporting topics that should be considered in the preparation of the financial statements of
listed companies for the year ending 31 December 2013. Those topics are:
1. impairment of non-financial assets
2. measurement and disclosure of post-employment benefit obligations
3. fair value measurement and disclosure
4. disclosures related to significant accounting policies, judgments and estimates
5. measurement of financial instruments and disclosure of related risk with relevance to
financial institutions.
Not surprisingly, ESMA says that national regulators may also focus on additional relevant
topics. It issued a similar statement a year ago and post-employment benefit obligations
appears on both listings. ESMA builds on its 2012 statement by emphasising the need for
transparency and the importance of appropriate and consistent application of recognition,
measurement and disclosure principles. ESMA and the European national enforcers will
monitor and assess the application of IFRS requirements relating to the items in this
statement.
These European common enforcement priorities will be incorporated into the reviews
performed by national enforcers. The guidelines are not statutory, but ESMA hopes that
awareness campaigns will lead national regulators to take account of the new priorities. The
watchdog will also monitor national regulators' application of the priorities and will publish
progress reviews to encourage national regulators to comply.
Users of financial statement have expressed concerns over the use of 'boilerplate' disclosures
for transactions that are not relevant or are immaterial to the entity. The view is that entities
should disclose only applicable accounting policies and focus on entity-specific information
rather than quoting extensively from IFRS.
IMPAIRMENT OF NON-FINANCIAL ASSETS
Continued slow economic growth in Europe could indicate that non-financial assets will
continue to generate lower than expected cashflows especially in those industries
experiencing a downturn in fortunes. In 2012, ESMA suggested paying particular attention to
the valuation of goodwill and intangible assets with indefinite life spans.
This year, it has again included the impairment of non-financial assets in the common
enforcement priorities with a focus on certain specific areas. These areas are cashflow
projections, disclosure of key assumptions and judgments, and appropriate disclosure of
sensitivity analysis for material goodwill and intangible assets with indefinite useful lives.
In measuring value-in-use, cashflow projections should be based on reasonable and
supportable assumptions that represent the best estimate of the range of future economic
conditions. IAS 36, Impairment of Assets, points out that greater weight should be given to
external evidence when determining the best estimate of cashflow projections. IAS 36 says
entities should assess the reasonableness of the assumptions on which cashflow projections
are based. Each key assumption should be consistent with external sources of information, or
how these assumptions differ from experience or external sources of information should be
disclosed.
ESMA considers that disclosures made by entities are often uninformative because they are
only provided at an aggregate level and not at the level of the cash-generating unit. Financial
statements generally are not providing disclosures that are entity-specific or appropriately
disaggregated.
ESMA has reviewed 2012 financial statements, and the disclosures relating to the sensitivity
analysis of goodwill or other intangible assets with indefinite useful lives are poor. IAS 36
requires disclosures on the sensitivity of the key assumptions to change when determining
the recoverable amount.
Entities have regularly used the assertion that 'no reasonable possible change in a key
assumption would result in an impairment loss'. ESMA believes that this disclosure does not
give users sufficient detail to allow them to assess sensitivity properly.
MEASUREMENT OF POST-EMPLOYMENT BENEFIT OBLIGATIONS
IAS 19, Employee Benefits, requires the discount rate applied to post-employment benefit
obligations to be determined using market yields based on high-quality corporate bonds.
'High quality' reflects absolute credit quality and not that of a given collection of corporate
bonds.
The policy for determining the discount rate should be applied consistently over time and a
reduction in the number of high-quality corporate bonds should not normally result in a
change to this policy.
The International Accounting Standards Board (IASB) has tentatively decided to amend IAS
19 to clarify that the depth of the bond market should be assessed and this should be at the
currency level and not at the country level.
In jurisdictions where there is no deep market in these bonds, the standard requires that
market yields on government bonds should be used. ESMA expects issuers to use an
approach consistent with this amendment.
There is an additional reminder by ESMA regarding the importance of disclosing the
significant actuarial assumptions used in determining the present value of the defined benefit
obligation and the related sensitivity analysis. The discount rate is a significant actuarial
assumption, the details of which should be disclosed together with any disaggregation
information on plans and the fair value of the plan assets where the level of risk of those
plans is different.
FAIR VALUE
ESMA has indicated that entities should assess the impact of the requirements of IFRS 13,
Fair Value Measurement. In particular, the effect of non-performance risk should be reflected
in the value of a liability. As an example, the fair value of a derivative liability should
incorporate the entity's own credit risk. ESMA emphasises the need for proper recognition of
counterparty credit risk when determining the fair value of financial instruments and
providing relevant disclosure.
IFRS 13 requires all valuation techniques to maximise the use of relevant observable inputs,
which should be consistent with the asset or liability's characteristics. In some cases, a
premium or discount to the market value may be applied but it should be consistent with the
nature of the asset or liability.
ESMA stresses the need to provide disclosures related to fair value, particularly when the
measurement is based on significant unobservable inputs (level 3). The more unobservable
the data, the more important that uncertainties are clearly identified. Further, IFRS 13 (and
ESMA) requires entities to categorise measurements into each level of the fair value
hierarchy.
SIGNIFICANT ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES
ESMA expects issuers to focus on the quality and completeness of disclosures relevant to the
entity's financial statements. These should be entity-specific and not boilerplate. ESMA
believes that disclosures could be improved in the following areas: significant accounting
policies, judgments made by management, sources of estimation uncertainty, going concern,
sensitivities, and new standards issued but not yet effective.
Significant accounting policies and management judgments could be included in the
financial statements in order of materiality and significance. IAS 1, Presentation of
Financial Statements, requires disclosure of estimation uncertainties with a significant risk
of being adjusted in the next year.
ESMA reiterates that disclosure of new standards that have been issued but are not yet
effective (IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors) is
relevant where the new standard could have a material impact on the financial statements.
TOPICS RELATED TO FINANCIAL INSTRUMENTS
Transparency and comparability of financial reporting of financial institutions is in the
interest of market participants. ESMA states that issuers should ensure that they meet the
requirements of IFRS 7, Financial Instruments: Disclosures, for qualitative and quantitative
disclosures and assess whether there is objective evidence of impairment while disclosing
sufficient detail to provide a comprehensive picture of the liquidity risk and funding needs of
the entity.
Disclosures should enable users to evaluate the nature and extent of risks, and the elements
related to the valuation of financial instruments, the latter reflecting economic reality.
Experience during the financial crisis showed diverging accounting treatments in relation to
forbearance practices. Forbaearance occurs where the terms of the loan are modified due to
the borrower's financial difficulties. ESMA expects issuers to provide quantitative

information on the effects of forbearance, enabling investors to assess the level of
impairment of financial assets.
ESMA also expects disclosure of the accounting policies applied to financial assets that have
been assessed individually for impairment but for which no objective evidence of
impairment was available. The purpose of this disclosure is to allow users to assess credit
risk.
Entities should also disclose the time bands in the maturity analysis and include maturity
analysis of financial assets held for managing liquidity risk.
ESMA is attempting to foster consistent application of accounting standards while ensuring
the transparency and accuracy of financial information. As noted above, ESMA and the
national regulators will monitor the application of the IFRS requirements outlined in the
priorities, with national regulators incorporating them into their reviews and taking
corrective actions where appropriate. Auditors and issuers ignore the guidance at their peril.
REALIGNING THE FRAMEWORK
RELATED LINKS
Graham Holt examines the discussion paper on the conceptual framework for financial
reporting issued by the IASB in July
units.
In July 2013 the International Accounting Standards Board (IASB) issued a discussion paper
on a new version of its conceptual framework, which provides the fundamental basis for
development of International Financial Reporting Standards (IFRS).
The discussion paper gives users and preparers of financial statements an opportunity to
offer input into the direction of financial reporting standards. The paper sets out the
fundamental principles of accounting necessary to develop robust and consistent standards.
While it lacks the immediacy of other IASB proposals, it will nevertheless be a significant
long-term influence on the direction that accounting standards will take.
The paper introduces revised thinking on the reporting of financial performance, the
measurement of assets and liabilities, and presentation and disclosure. The paper proposes
that the primary purpose of the framework - which underpins the accounting standards - is to
identify consistent principles that the IASB can use in developing and revising those
standards. The framework may also help in understanding and interpreting the standards.
The IASB framework was originally published in the late 1980s. In 2010 two chapters of a
new framework were issued: Chapter 1, The Objective of General Purpose Financial
Reporting, and Chapter 3, Qualitative Characteristics of Useful Financial Information.
There are no plans for a fundamental reconsideration of these chapters. The concept of a
reporting entity is not considered in the discussion paper because the exposure draft of 2010
is to be used, with related feedback, in developing guidance in this area.
The discussion paper proposes to redefine assets and liabilities as:
An asset is a present economic resource controlled by the entity because of past
events.
A liability is a present obligation of the entity to transfer an economic resource
because of past events.
An 'economic resource', it should be noted, is a right, or other source of value, that is capable
of producing economic benefits.
Currently the definitions of assets and liabilities require a probable expectation of future
economic benefits or resource outflow. The IASB's initial view is that the definitions of
assets and liabilities should not require an expected or probable inflow or outflow as it
should be sufficient that a resource or obligation can produce or result in a transfer of
economic benefits. Thus, a guarantee could qualify as a liability even though the obligation
to transfer resources is conditional. However, the measurement of an asset or liability will be
affected by the potential outcome. The IASB still believes that a liability should not be
defined as limited to obligations that are enforceable against the entity.
Under the discussion paper, constructive obligations would qualify as liabilities. Liabilities
would not arise where there is an economic necessity to transfer an economic resource unless
there is an obligation to do so. Thus a group reconstruction would not necessarily create a
liability.
However, the IASB believes that certain avoidable obligations could qualify as a liability for example, directors' bonuses depending on employment conditions. No decision has been
made on whether the definition of a liability should be limited to obligations that the entity
has no practical ability to avoid or should include conditional obligations resulting from past
events.
The discussion paper sets out that the framework's definition of control should be in line with
its definition of an asset. An entity controls an economic resource if it has the present ability
to direct the resource's use so as to obtain economic benefits from it. The exposure draft on
revenue recognition uses the phrase 'substantially all' when referring to benefits from the
asset but the IASB feels this phrase in this context would be confusing as an entity would
recognise only the rights which it controls. For example, if an entity has the right to use
machinery on one working day per week, then it should recognise 20% of the economic
benefits (assuming a five-day working week) as it does not have all or substantially all of the
economic benefits of the machinery.
The discussion paper proposes that equity remain defined as being equal to assets less
liabilities. However, the paper does propose that an entity be required to present a detailed
statement of changes in equity that provides more information regarding different classes of
equity, and the transfers between these different classes.
The distinction between equity and liabilities focuses on the definition of a liability. The
current guidance on the difference between equity and liability is complicated. The paper
identifies two types of approach: narrow equity and strict obligation.
The narrow equity approach treats equity as being only the residual class issued, with
changes in the measurement of other equity claims recognised in profit or loss.
Under the strict obligation approach, all equity claims are classified as equity with
obligations to deliver cash or assets being classified as liabilities. Any changes in the
measurement of equity claims would be shown in the statement of changes in equity.
If the latter approach were adopted, certain transactions (eg the issuance of a variable
number of equity shares worth a fixed monetary amount) currently classed as liabilities
would not be so designated because they do not involve an obligation to transfer cash or
assets.
The IASB has come to the view that the objective of measurement is to contribute to the
faithful representation of relevant information about the resources of the entity, claims
against the entity and changes in resources and claims, and about how efficiently and
effectively the entity's management and governing board have discharged their
responsibilities to use the entity's resources. The IASB believes that a single measurement
basis may not provide the most relevant information for users.
When selecting the measurement basis, the information that measurement will produce in
both the statement of financial position and the statement of profit or loss and other
comprehensive income (OCI) should be considered. Further, the selection of a measurement
of a particular asset or a particular liability should depend on how that asset contributes to
the entity's future cashflows and how the entity will settle or fulfil that liability.
NARROW AND BROAD
The current framework does not contain principles to determine the items to be recognised in
profit or loss, and in OCI and whether, and when, items can be recycled from OCI to profit
or loss. In terms of what items would be included in OCI, the paper proposes two
approaches: 'narrow' and 'broad'.
Under the narrow approach, OCI would include bridging items and mismatched
remeasurements. OCI would be used to bridge a measurement difference between the
statement of financial position and the statement of profit or loss. This would include, for
example, investments in financial instruments with profit or losses reported through OCI.
Mismatched remeasurements occur when the item of income or expense represents the
effects of part of a linked set of assets, liabilities or past or planned transactions. It represents
their effect so incompletely that, in the opinion of the IASB, the item provides little relevant
information about the return the entity has made on its economic resources in the period.
An example is a cashflow hedge where fair value gains and losses are deferred in OCI until
the hedged transaction affects profit or loss. The paper suggests that under the narrow OCI
approach, an entity should subsequently have to recycle amounts from OCI to profit or loss;
and under the mismatched remeasurements approach the amount should be recycled when
the item can be presented with the matched item.
The issue that arises here is that, under the narrow approach, the treatment of certain items
would be inconsistent with current IFRS - eg revaluation gains and losses for property, plant
and equipment.
The paper also sets out a third category - 'transitory remeasurements'. These are
remeasurements of long-term assets and liabilities that are likely to reverse or significantly
change over time. These items would be shown in OCI - for example, the remeasurement of
a net defined pension benefit liability or asset. The IASB would decide in each IFRS whether
a transitory remeasurement should be subsequently recycled. However, the IASB has not yet
determined which approach it will use.
RECOGNITION
Recognition and derecognition deals with the principles and criteria for assets and liabilities
to be included or removed from an entity's financial statements. The paper sets out to bring
this into line with the principles used in IASB's current projects. It proposes that assets and
liabilities should be recognised by an entity, unless that results in irrelevant information, the
costs outweigh the benefits, or the measure of information does not represent the transaction
faithfully enough.
Derecognition is not currently addressed in the framework and the paper proposes
derecognition should occur when the recognition criteria are no longer met. The question for
the IASB is whether to replace the current concept based on the loss of the economic risks
and benefits of the asset with the concept based on the loss of control over the legal rights
comprised in the asset. A concept based on control over the legal rights could result in
several items going off balance sheet.
Proposed revisions to the disclosure framework include the objective of the primary financial
statements, the objective of the notes to the financial statements, materiality and
communication principles. The IASB has also identified both short-term and long-term steps
for addressing disclosure requirements in existing IFRS.
These proposals are an attempt to make the conceptual framework a blueprint for developing
consistent, high-quality, principles-based accounting standards. It is important that there is
dialogue about the whole of IFRS and for the IASB to achieve buy-in to its core principles
by enabling constituents to help shape the future of IFRS.
Graham Holt is associate dean and head of the accounting, finance and economics
ARE YOU COMPLYING?
RELATED LINKS
Following research by ESMA, the regulatory bodies are focusing on key aspects of IAS 36,
says Graham Holt
units.
IAS 36, Impairment of Assets, describes the procedures that an entity should follow to
ensure that it carries its assets at no more than their recoverable amount, which is effectively
the higher of the amount to be realised through using or selling the asset. When the carrying
amount of asset exceeds the recoverable amount, the asset is considered to be impaired and
the entity recognises an impairment loss. Goodwill acquired in a business combination or
intangible assets with indefinite useful lives have to be tested for impairment at least on an
annual basis. The standard details the circumstances when an impairment loss should be
reversed, although this is not possible for goodwill.
For the purposes of impairment testing, goodwill should be allocated to the cash-generating
units (CGU) or groups of CGUs benefiting from goodwill. Such group of units should not be
larger than an operating segment before aggregation. For any asset, an impairment test has to
be carried out at each reporting date if there is any indicator of impairment. IAS 36 gives a
list of common indicators of impairment such as increases in market interest rates, market
capitalisation falling below net asset carrying value or the economic performance of an asset
being worse than projected in internal budgets.
Detailed disclosures, including the circumstances that have led to impairment are required in
relation to each CGU with significant amounts of goodwill and other intangible assets. These
include the key assumptions on which management has based cashflow projections, a
description of management's approach to determining the values of each key assumption,
terminal growth rates and discount rates as well as sensitivity analysis where a reasonable
change in a key assumption would lead to impairment.
Additionally, the International Accounting Standards Board (IASB) has recently published
Recoverable Amount Disclosures for Non-Financial Assets (Amendments to IAS 36). These
narrow amendments to IAS 36 detail the disclosure of information about the recoverable
amount of impaired assets if that amount is based on fair value less costs of disposal. When
developing IFRS 13, Fair Value Measurement, the IASB decided to change IAS 36 to
require disclosures about the recoverable amount of impaired assets. The recent amendment
limits the scope of those disclosures to the recoverable amount of impaired assets that is
based on fair value less costs of disposal. The amendments are to be applied retrospectively
for annual periods beginning on or after 1 January 2014 with earlier application permitted.
In January 2013,the European Securities and Markets Authority (ESMA) issued a report on
the accounting practices relating to impairment testing of goodwill and other intangible
assets. ESMA reviewed the nature of disclosures in the 2011 IFRS financial statements of a
sample of 235 companies with material amounts of goodwill. Similarly, a recent research
report by the Centre for Financial Analysis and Reporting Research (CeFARR) at the Cass
Business School entitled Accounting for asset impairment: a test for IFRS compliance
across Europe reviewed the compliance of European listed companies' as regards IAS 36.
The authors, Hami Amiraslani, George E Iatridis and Peter F Pope, investigated the degree of
compliance with IFRS by analysing impairment disclosures during 2010/11, relating to nonfinancial assets within a sample of over 4,000 listed companies from the European Union
plus Norway and Switzerland.
The two reports make interesting reading and there is some consistency in their conclusions.
The findings of the CeFARR research contextualise the ESMA report. CeFARR found that
compliance with some impairment disclosure requirements varied quite considerably
suggesting inconsistency in the application of IFRS. Compliance with impairment disclosure
requirements that required greater managerial involvement was less rigorous than those
requirements with low effort required. This leads to a tendency to use boilerplate description,
which helps reduce the cost of compliance. There appears to be considerable variation across
European countries in compliance with some impairment disclosure requirements.
CeFARR found that the quality of impairment reporting is better in companies whose
jurisdiction has a strong regulatory and institutional infrastructure. They placed the UK and
Ireland in this category. However, impairment disclosures seem to be of lower quality in
jurisdictions where there is a weaker regulatory regime. They further conclude that
companies operating in a strong regulatory and enforcement setting appear to recognise
impairment losses on a timelier basis. These findings could have implications for future
investment decisions in terms of lower risk in certain jurisdictions.
In the current economic and financial crisis, assets in many industries are likely to generate
lower than expected cashflows with the result that their carrying amount is greater than their
recoverable amount with the result that impairment losses are required. However, ESMA
found that the material impairment losses of goodwill reported in 2011 were limited to a
small number of companies, and these were mainly in the financial services and
telecommunication industries. Overall impairment losses on goodwill in 2011 amounted to
only 5percent of goodwill recognised in the 2010 IFRS financial statements.
An indication of impairment could be a fall in market capitalisation below the carrying value
of equity. An equity/market capitalisation ratio above 100percent is one of the external
sources of information indicating that assets may be impaired, and should be considered in
assessing the realistic values of key assumptions used in impairment testing. ESMA reported
that the average equity/market capitalisation ratio of its sample rose from 100percent at 2010
year-end to 145percent at 2011 year-end and further, that as at 31 December 2011, 43percent
of the sample showed a market capitalisation below equity compared to 30percent in 2010.
Of these entities, 47percent recognised impairment losses on goodwill in their 2011 IFRS
financial statements.
ESMA feels that the increased equity/market capitalisation ratio and relatively limited
impairment losses call into question whether the level of impairment in 2011 appropriately
reflects the effects of the financial and economic crisis. As CeFARR found, in many cases
the disclosures relating to impairment were of a boilerplate nature and not entity-specific due
to a failure to comply with the requirements of the standard and possibly IAS 36 not
providing specific enough detail, especially as regards the nature of the sensitivity analysis.
As a result of the ESMA review, they have identified five problem areas:
1 Key assumptions of management
In the ESMA sample, only 60percent of the entities discussed the key assumptions used for
cashflow forecasts other than the discount rate and growth rate used in the impairment
testing and half of these entities did not provide the relevant entity-specific information.
2 Sensitivity analysis
ESMA has identified different practices with regard to disclosures on sensitivity analysis.
Only half of the entities presented a sensitivity analysis where the book value of their net
assets exceeded their market capitalisation. This is a surprisingly low figure considering that
this is an indication of impairment.
3 Determination of recoverable amount
'Value in use' is used by most entities for goodwill impairment testing purposes and
60percent of entities used discounting to calculate 'fair value less costs to sell'. Thus a
significant number of entities estimate the recoverable amount using discounted cashflows.
IAS 36 requires different criteria for cashflows when using value in use or fair value less
costs to sell to determine the recoverable amount. One would expect that third party
information would prevail over entity based assumptions when determining 'fair value less
costs to sell' in this way.
4 Determination of growth rates
IAS 36 states that for periods beyond those covered by the most recent budgets and
forecasts, they should be based on extrapolations using a steady or declining growth rate
unless an increasing rate can be justified. ESMA found that more than 15percent of issuers
disclosed a long-term growth rate above 3percent which, given the current economic
environment, is optimistic and probably unrealistic.
5 Disclosure of an average discount rate
ESMA found that 25percent of issuers in the sample disclosed an average discount rate,
rather than a specific discount rate on each material cash-generating unit. The applied
discount rate has a major impact on the calculation of value in use. Therefore separate
discount rates should be disclosed and used which fit the risk profile of each CGU. The
disclosure of a single average discount rate for all CGUs obscures relevant information.
As a result of the above, ESMA and the national regulatory authorities are focusing on
certain key aspects of IAS 36. The key areas include the application by entities of the rules re
impairment testing of goodwill and other intangible assets, the reasonableness of cashflow
forecasts, the key assumptions used in the impairment test and the relevance and
appropriateness of the sensitivity analysis provided. ESMA expects issuers and their auditors
to consider the findings of their review when preparing and auditing the IFRS financial
statements. ESMA also expects national regulatory authorities to take appropriate
enforcement actions where needed.
Graham Holt is associate dean and head of the accounting, finance and economics
DEFINING MOMENT
RELATED LINKS
IAS 32 sets out to bring some much needed clarity to the definitions of assets and liabilities
in relation to debt instruments, explains Graham Holt
The difference between debt and equity in an entitys statement of financial position is not
easy to distinguish for preparers of financial statements. Many financial instruments have
both features, with the result that this can lead to inconsistency of reporting.
The International Accounting Standards Board (IASB) agreed with respondents from its
public consultation on its agenda (December 2012 report) that it needs greater clarity in its
definitions of assets and liabilities for debt instruments. This should therefore help eliminate
some uncertainty when accounting for assets and financial liabilities or non-financial
liabilities. The respondents felt that defining the nature of liabilities would advance the
IASBs thinking on distinguishing between financial instruments that should be classified as
equity and those instruments that should be classified as liabilities.
The objective of IAS 32, Presentation, is to establish principles for presenting financial
instruments as liabilities or equity and for offsetting financial assets and liabilities. The
classification of a financial instrument by the issuer as either debt or equity can have a
significant impact on the entitys gearing ratio, reported earnings, and debt covenants. Equity
classification can avoid such an impact, but may be perceived negatively if it is seen as
diluting existing equity interests. The distinction between debt and equity is also relevant
where an entity issues financial instruments to raise funds to settle a business combination
using cash or as part consideration in a business combination. Understanding the nature of

the classification rules and potential effects is critical for management and must be borne in
mind when evaluating alternative financing options. Liability classification normally results
in any payments being treated as interest and charged to earnings, which may affect the
entitys ability to pay dividends on its equity shares.
The key feature of debt is that the issuer is obliged to deliver either cash or another financial
asset to the holder. The contractual obligation may arise from a requirement to repay
principal or interest or dividends. Such a contractual obligation may be established explicitly
or indirectly, but through the terms of the agreement. For example, a bond that requires the
issuer to make interest payments and redeem the bond for cash is classified as debt. In
contrast, equity is any contract that evidences a residual interest in the entitys assets after
deducting all of its liabilities. A financial instrument is an equity instrument only if the
instrument includes no contractual obligation to deliver cash or another financial asset to
another entity and if the instrument will or may be settled in the issuers own equity
instruments.
For instance, ordinary shares, where all the payments are at the discretion of the issuer, are
classified as equity of the issuer. The classification is not quite as simple as it seems. For
example, preference shares required to be converted into a fixed number of ordinary shares
on a fixed date or on the occurrence of an event certain to occur should be classified as
equity.
A contract is not an equity instrument solely because it may result in the receipt or delivery
of the entitys own equity instruments. The classification of this type of contract is dependent
on whether there is variability in either the number of equity shares delivered or variability in
the amount of cash or financial assets received. A contract that will be settled by the entity
receiving or delivering a fixed number of its own equity instruments in exchange for a fixed
amount of cash or another financial asset is an equity instrument. This has been called the
fixed for fixed requirement. However, if there is any variability in the amount of cash or
own equity instruments that will be delivered or received, then such a contract is a financial
asset or liability as applicable.
For example, where a contract requires the entity to deliver as many of the entitys own
equity instruments as are equal in value to a certain amount, the holder of the contract would
be indifferent whether it received cash or shares to the value of that amount. Thus, this
contract would be treated as debt.
Other factors, which may result in an instrument being classified as debt, are:
is redemption at the option of the instrument holder
is there a limited life to the instrument
is redemption triggered by a future uncertain event that is beyond the control of both
the holder and issuer of the instrument, and
are dividends non-discretionary.

Similarly, other factors, which may result in the instrument being classified as equity, are
whether the shares are non-redeemable, whether there is no liquidation date or where the
dividends are discretionary.
The classification of the financial instrument as either a liability or as equity is based on the
principle of substance over form. Two exceptions from this principle are certain puttable
instruments meeting specific criteria and certain obligations arising on liquidation. Some
instruments have been structured with the intention of achieving particular tax, accounting or
regulatory outcomes with the effect that their substance can be difficult to evaluate.
The entity must make the decision as to the classification of the instrument at the time that
the instrument is initially recognised. The classification is not subsequently changed based
on changed circumstances. For example, this means that a redeemable preference share
where the holder can request redemption is accounted for as debt even though legally it may
be a share of the issuer.
In determining whether a mandatorily redeemable preference share is a financial liability or
an equity instrument, it is necessary to examine the particular contractual rights attached to
the instruments principal and return elements. The critical feature that distinguishes a
liability from an equity instrument is the fact that the issuer does not have an unconditional
right to avoid delivering cash or another financial asset to settle a contractual obligation.
Such a contractual obligation could be established explicitly or indirectly. However, the
obligation must be established through the terms and conditions of the financial instrument.
Economic necessity does not result in a financial liability being classified as a liability. Also
a restriction on the ability of an entity to satisfy a contractual obligation, such as the
company not having sufficient distributable profits or reserves, does not negate the entitys
contractual obligation.
Some instruments are structured to contain elements of both a liability and equity in a single
instrument. Such instruments for example, bonds that are convertible into a fixed number
of equity shares and carry interest are accounted for as separate liability and equity
components. Split accounting is used to measure the liability and the equity components
upon initial recognition of the instrument. This method allocates the fair value of the
consideration for the compound instrument into its liability and equity components. The fair
value of the consideration in respect of the liability component is measured at the fair value
of a similar liability that does not have any associated equity conversion option. The equity
component is assigned the residual amount.
IAS 32 requires an entity to offset a financial asset and financial liability in the statement of
financial position only when the entity currently has a legally enforceable right of set-off and
intends either to settle the asset and liability on a net basis or to realise the asset and settle the
liability simultaneously. An amendment to IAS 32 has clarified that the right of set-off must
not be contingent on a future event and must be immediately available. It also must be
legally enforceable for all the parties in the normal course of business, as well as in the event
of default, insolvency or bankruptcy. Netting agreements where the legal right of offset is
only enforceable on the occurrence of some future event, such as default of a party, do not
meet the offsetting requirements.
Rights issues can still be classified as equity when the price is denominated in a currency
other than the entitys functional currency. The price of the right is denominated in
currencies other than the issuers functional currency when the entity is listed in more than
one jurisdiction or is required to do so by law or regulation. A fixed price in a non-functional
currency would normally fail the fixed number of shares for a fixed amount of cash
requirement in IAS 32 to be treated as an equity instrument. As a result, it is treated as an
exception in IAS 32.
Two measurement categories exist for financial liabilities: fair value through profit or loss
(FVTPL) and amortised cost. Financial liabilities held for trading are measured at FVTPL,
and all other financial liabilities are measured at amortised cost unless the fair value option is
applied.
The IASB and US Financial Accounting Standards Board have been working on a project to
replace IAS 32 and converge IFRS and US GAAP for a number of years. The Financial
instruments with characteristics of equity project (FICE) resulted in a discussion paper in
2008, but has been put on hold.
Graham Holt is an examiner for ACCA, and associate dean and head of the accounting,
finance and economics department at Manchester Metropolitan University Business School
A MATTER OF PROFESSIONAL JUDGMENT
RELATED LINKS
The selection of accounting policy and estimation techniques is intended to aid
comparability and consistency in financial statements. However, International Financial
Reporting Standards (IFRS) also place particular emphasis on the need to take into account
qualitative characteristics and the use of professional judgment when preparing the financial
statements. Although IFRS may appear prescriptive, the achievement of all the objectives for
a set of financial statements will rely on the skills of the preparer.
units.
This article was first published in the September 2012 UK edition of Accounting and
Business magazine.
The International Accounting Standards Board (IASB) Framework indicates that the
objective of financial statements is the provision of information that is useful to a wide range
of users. Readers of the accounts may be interested in using financial information for making
political decisions as well as economic ones. Different entities may have a range of readers
and thus the assessment of the common needs of users should be informed by the entity's
experience of their readership. On this basis, the entity should select accounting policies and
estimation techniques that disclose and present financial information that best assists
effective decision-making, without reducing the usefulness of the financial statements for
other readers. The question arises as to how these policies should be selected when moving
to IFRS and what happens if the estimation techniques used are proven to be invalid.
Entities should follow the requirements of IAS 8, Accounting Policies, Changes in
Accounting Estimates and Errors, when selecting or changing accounting policies, changing
estimation techniques and correcting errors. An entity should determine the accounting
policy to be applied to an item with direct reference to IFRS but accounting policies need not
be applied if the effect of applying them would be immaterial. Users of the financial
statements are assumed to have a reasonable knowledge of accounting and will use
reasonable diligence in reading the financial statements. Considerations of materiality will
need to reflect this assumed knowledge.
IAS 1, Presentation of Financial Statements, requires that an entity whose financial
statements comply with IFRS should make an explicit and unreserved statement of such
compliance in the notes. Inappropriate accounting policies are not rectified either by
disclosure of the accounting policies used, or by notes or explanatory material. IAS 1
acknowledges that, in extremely rare circumstances, management may conclude that
compliance with an IFRS requirement would be so misleading that it would conflict with the
objective of financial statements set out in the Framework. In such a case, the entity is
required to depart from the IFRS requirement, with detailed disclosure of the nature, reasons
and impact of the departure.
IMMATERIAL DEPARTURES
IAS 8 also notes that it is inappropriate to make or leave uncorrected immaterial departures
from IFRS to achieve a particular position. For example, where the revaluation model is used
in IAS 16, Property, Plant and Equipment, it might be immaterial to revalue plant and
equipment. However, the understatement of depreciation that may result might allow an
entity to break even when full compliance with IAS 16 would have resulted in a loss being
recognised.
Where IFRS does not specifically apply to a transaction, judgment should be used in
developing or applying an accounting policy, which results in financial information that is
relevant to the decision-making and assessment needs of users. IFRS also requires that
policies are reliable and is prudent. In making that judgment, entities must refer to guidance
in IFRS which deals with similar issues and then subsequently to definitions and criteria in
the Framework.
Additionally, entities can refer to recent pronouncements of other standard setters that use
similar conceptual frameworks. Entities should select and apply their accounting policies
consistently for similar transactions. If IFRS specifically permits different accounting

policies for categories of similar items, an entity should apply an appropriate policy for each
of the categories in question and apply these consistently for each category. A change in
accounting policy should only be made if the change is required by IFRS, or it will result in
the financial statements providing reliable and more relevant financial information.
Significant changes in policy other than those specified by IFRS should be relatively rare.
IFRS specifies the accounting policies for a high percentage of the typical transactions that
are faced by entities. There are therefore limited opportunities for an entity to choose an
accounting policy, as opposed to a basis for estimating figures that will satisfy such a policy.
IAS 8 states that the introduction of an accounting policy to account for transactions where
circumstances have changed are not a change in accounting policy. Similarly, a policy for
transactions that did not occur previously or that were immaterial is not a change in policy
and therefore would be applied prospectively.
A change in accounting policy is applied retrospectively unless there are transitional
arrangements in place. Transitional provisions are often included in new or revised standards
and may not require full retrospective application. Sometimes it is difficult to achieve
comparability of prior periods with the current period where, for example, data might not
have been collected in the prior periods to allow retrospective application. Restating
comparative information for prior periods often requires complex and detailed estimation.
This, in itself, does not prevent reliable adjustments.
When making estimates for prior periods, the basis of estimation should reflect the
circumstances that existed at the time and it becomes increasingly difficult to define those
circumstances with the passage of time. Estimates and circumstances might be influenced by
knowledge of events and circumstances that have arisen since the prior period.
IAS 8 does not permit the use of hindsight when applying a new accounting policy, either in
making assumptions about what management's intentions would have been in a prior period
or in estimating amounts to be recognised, measured or disclosed in a prior period. When it
is impracticable to determine the effect of a change in accounting policy on comparative
information, the entity is required to apply the new policy to the carrying amounts of the
assets and liabilities as at the beginning of the earliest period for which retrospective
application is practicable. This could actually be the current period but the entity should
attempt to apply the policy from the earliest date possible.
Where the basis of measurement for the amount to be recognised is uncertain, an entity will
use an estimation technique, which is a normal part of the preparation of the financial
statements without undermining their reliability.
Estimates involve judgments based on the latest available, reliable information and are
applied in determining the useful lives of property, plant and equipment, provisions, fair
values of financial assets and liabilities and actuarial assumptions relating to defined benefit
pension schemes.
Accounting estimates need to be distinguished from accounting policies as the effect of a
change in an estimate is reflected in the Statement of Comprehensive Income, whereas a
change in accounting policy will generally require a prior period adjustment. If there is a
change in the circumstances on which the estimate was based or new information has arisen
or more experience relating to the estimation process has occurred, then the estimate may
need to be changed. A change in the measurement basis is not a change in an accounting
estimate, but is a change in accounting policy. For example, if there is a move from historical
cost to fair value, this is a change in accounting policy but a change in the method of
depreciation is a change in accounting estimate.
A change in accounting estimates should be recognised from the date of change, which may
only impact on the current period or may impact the current and future periods. IAS 8 states
that financial statements do not comply with IFRS if they contain material errors or
immaterial errors that have been made intentionally to achieve a particular presentation.
Material prior period errors must be corrected by retrospective restatement, in the first
financial statements issued following their discovery unless it is impracticable to determine
either the period or the specific effects of the error. As with retrospective application of an
accounting policy, when an entity makes a retrospective restatement, or when it reclassifies
items, it should present an additional balance sheet at the beginning of the earliest
comparative period. However, it is thought that entities may choose to omit the additional
balance sheet (and related notes) if there is no impact on that balance sheet and this fact is
disclosed.
AMENDMENT TO IAS 1
The IASB has amended the requirements in IAS 1 relating to the additional balance sheet.
Where an entity has applied an accounting policy retrospectively and this has a material
effect on the information in the balance sheet at the beginning of the preceding period, it is
required to present that balance sheet. However, under the amended standard, which applies
for annual periods beginning on or after 1 January 2013, the entity need not present the
related notes to the additional balance sheet. The amendment clarifies that the additional
balance sheet is given as at the beginning of the preceding period regardless of whether an
entity's financial statements present comparative information for earlier periods.
As previously mentioned, the use of hindsight is not permitted in correcting material errors.
For example, if there were a prior period error relating to a provision calculated for
decontamination costs in a building, information relating to the subsequent discovery of
subsidence on the same site would be disregarded in calculating that particular provision.
IAS 8 states that the correction of a prior period error is excluded from the Statement of
Comprehensive Income for the current period in which the error is discovered. However, if
there is a correction to the extent that the amount attributable to a prior period cannot be
determined, it is included in the current period Comprehensive Income Statement which
means that prior periods may be partially adjusted but fully adjusted by the end of the current
period. The correction of errors is different from changes in accounting estimates. Due to the
complexity of IFRS, there is a high likelihood that the judgments used at the time of
transition may result in prior period adjustments and changes in estimates. As can be seen
from the above, the solution to these corrective actions is not always straightforward.
PREPARING FOR CHANGE

RELATED LINKS
The International Accounting Standards Board (IASB) is developing a group of projects that
are likely to affect financial statements ending in 2015. However, in the meantime, there
have been some amendments to International Financial Reporting Standards (IFRS) which
affect year ends in 2012 and others that come into effect from 1 January 2013. Although
these amendments have been in existence for a while, entities should ensure that the
amendments do not slip under their corporate reporting radar.
This article was first published in the July 2012 UK edition of Accounting and Business
magazine.
units.
There are amendments which relate to December 2012 year ends. For example, an
amendment to IFRS 1, First-time Adoption of International Financial Reporting Standards,
eliminates the need for companies adopting IFRS for the first time to restate de-recognition
transactions that occurred before the date of transition to IFRS and provides guidance on
how an entity should resume presenting financial statements in accordance with IFRS after a
period when the entity was unable to comply with IFRSs because its functional currency was
subject to severe hyperinflation. An amendment to IFRS 7, Financial Instruments:
Disclosures, introduces some additional disclosures that apply on the transfer of financial
assets. The amendments allow users of financial statements to improve their understanding
of transfer transactions of financial assets, for example, securitisations, including
understanding the possible effects of any risks that may remain with the entity that
transferred the assets. The amendments also require additional disclosures if a
disproportionate amount of transfer transactions are undertaken around the end of a reporting
period.
IAS 12, Income Taxes, requires an entity to measure the deferred tax relating to an asset
depending on whether the entity expects to recover the carrying amount of the asset through
use or sale. It can be subjective when assessing whether recovery will be through use or
through sale when the asset is measured using the fair value model in IAS 40, Investment
Property. The amendment provides a solution to the problem by introducing a presumption
that recovery of the carrying amount will normally be through sale.
In addition, there is an amendment to IAS 1, Presentation of Financial Statements, which
applies from 1 July 2012. The amendments to IAS 1 retain the 'one or two statement'
approach at the option of the entity and only revise the way other comprehensive income
(OCI) is presented, requiring separate subtotals for those elements which may be 'recycled'
(for example, cashflow hedging and foreign currency translation) and those elements that
will not (for example, fair value through OCI items under IFRS 9, Financial Instruments).
The revisions made to IAS 19, Employee Benefits, are significant, and will impact most
entities. They come into effect from 1 January 2013. The revisions change the recognition
and measurement of defined benefit pensions expense and termination benefits and the
disclosures required. In particular, actuarial gains and losses can no longer be deferred using
the corridor approach.
New and revised standards on group accounting were published in 2011. IFRS 10,
Consolidated Financial Statements, replaces IAS 27, Consolidated and Separate Financial
Statements and SIC-12, Consolidation - Special Purpose Entities and sets out a single
consolidation model that identifies control as the basis for consolidation for all types of
entities. IFRS 11, Joint Arrangements, establishes principles for the financial reporting by
parties to a joint arrangement, and replaces IAS 31, Interests in Joint Ventures, and SIC-13,
Jointly Controlled Entities, Non-monetary Contributions by Venturers. IFRS 11 reduces the
types of joint arrangement to joint operations and joint ventures, and prohibits the use of
proportional consolidation. IFRS 12, Disclosure of Interests in Other Entities, combines,
enhances and replaces the disclosure requirements for subsidiaries, joint arrangements,
associates and unconsolidated structured entities.
In addition, IAS 27, Separate Financial Statements, now has the objective of setting
standards to be applied in accounting for investments in subsidiaries, joint ventures, and
associates when an entity elects, or is required by local regulation, to present separate (nonconsolidated) financial statements. Financial statements in which the equity method is
applied are not separate financial statements. IAS 28, Investments in Associates and Joint
Ventures, covers equity accounting for joint ventures as well as associates. IAS 28's objective
is to prescribe the accounting for investments in associates and set out the requirements for
the application of the equity method when accounting for investments in associates and joint
ventures.
All of the new group accounting standards have to be implemented together and apply from
1 January 2013. They can be adopted with immediate effect (subject to EU endorsement for
European entities), but only if they are all applied at the same time. The European Financial
Reporting Advisory Group (EFRAG) supports the adoption of the standards and
recommends their endorsement. However, it does not support the mandatory effective date of
1 January 2013; the field-tests it has conducted provided evidence that some financial
institutions would need more time to implement IFRS 10, IFRS 11 and IFRS 12 in a manner
that brings reliable financial reporting to capital markets. EFRAG recommends the
mandatory effective date of the standards to be 1 January 2014.
A number of current IFRSs require entities to measure or disclose the fair value of assets,
liabilities or their own equity instruments. The fair value measurement requirements and the
disclosures about fair value in those standards do not always give a clear measurement or
disclosure objective. IFRS 13, Fair Value Measurement, published in May 2011, deals with
this issue. The new requirements apply from 1 January 2013, but can be adopted with
immediate effect, again subject to EU endorsement for European entities.
In addition to the changes which will have an immediate impact, there is potential for
significant change in practice because of current exposure drafts. The comment period for
the updated exposure draft, Revenue From Contracts With Customers, closed recently. Most
respondents agreed with many of the proposals, but some expressed concerns over the lack
of clarity on how to identify separate performance obligations, the performing of the onerous
assessment at the performance obligation level, and the volume of disclosures. The IASB
and US Financial Accounting Standards Board (FASB) are beginning revisions and have
indicated the effective date will be no earlier than 2015.
The FASB and IASB are proposing to fundamentally change the accounting for leases and
are attempting to issue a second exposure draft by the end of 2012. The boards are proposing
a 'right-of-use model' for lessees in which all leases are recognised on the statement of
financial position at the commencement of the lease. A lessee would recognise an asset for
the right to use the underlying asset and a liability to make lease payments.
The two key factors in initially measuring the right-of-use asset and lease liability are the
lease term and lease payments. The lease term is to be the non-cancellable lease period, plus
any renewal periods for which there is a significant economic incentive for the lessee to
exercise the renewal option. Similarly, a lessor accounting model is proposed. Under this
method, a lessor would derecognise the underlying asset leased and recognise a lease
receivable measured as the present value of the future lease payments and residual asset
measured on an allocated-cost basis. A lessor's lease of investment property would utilise
existing operating lease accounting but this is still in discussion by the Boards.
IFRS 9, Financial Instruments, is being developed in three phases: classification and
measurement, impairment and hedging. The IASB agreed in late 2011 to look at limited
modifications to IFRS 9 for classification and measurement. This arose because of
application issues with IFRS 9 the need to consider the interaction between IFRS 9 and the
decisions being made on the insurance project, and consistency with the FASB's model on
the classification and measurement of financial instruments. In December 2011 the IASB
issued Mandatory Effective Date of IFRS 9 and Transition Disclosures, which amends IFRS
9 to require application for annual periods beginning on or after 1 January 2015, rather than
1 January 2013. Early application of IFRS 9 is still permitted. IFRS 9 is also amended so that
it does not require the restatement of comparative period financial statements for the initial
application of the classification and measurement requirements of IFRS 9, but instead
requires modified disclosures on transition to IFRS 9.
AMORTISED COST
To date, the Boards have decided that an entity should assess the cashflow characteristics of
financial assets and its business model to determine which financial assets should be
classified and measured at amortised cost. If the business model's objective is to hold the
assets in order to collect contractual cashflows, then amortised cost is used.
All financial instruments are initially measured at fair value plus or minus, in the case of a
financial asset or financial liability not at fair value through profit or loss, transaction costs.
A measurement category other than fair value through profit or loss can be used if the
contractual terms of the financial asset result in cashflows that are solely payments of
principal and interest on the principal amounts outstanding. The existing requirement under
IFRS 9 that prevents the splitting of embedded derivatives from financial assets is to be
retained. The IASB intends to expand IFRS 9 to add new requirements for impairment of
financial assets measured at amortised cost, and hedge accounting. The Boards are
continuing their discussions on development of the three-bucket expected credit loss
impairment model. The IASB expects to publish an exposure draft in the second half of
2012.
It can be seen that when reviewing and preparing financial statements, difficulties arise in
ensuring compliance with all of the various amendments being issued, deciding whether to
adopt a standard early and determining whether the jurisdiction has actually approved the
standard for use.
ALL CHANGE FOR REVENUE ACCOUNTING? - JUNE 2012
RELATED LINKS
As contractual agreements become increasingly complex, the IASB and FASB are proposing
significant changes, explain Shariq Barmaky and Mohamed Ghamazy
units.
This article was first published in the June 2012 Singapore edition of Accounting and
Business magazine.
Studying this technical article and answering the related questions can count towards your
verifiable CPD if you are following the unit route to CPD and the content is relevant to your
learning and development needs. One hour of learning equates to one unit of CPD. We'd
suggest that you use this as a guide when allocating yourself CPD units.
Some of us were still in school when IAS 11, Construction Contracts and IAS 18, Revenue
were issued in 1993. Since then, a number of amendments have been made to both IAS 11
and IAS 18 as a consequence of other new or amended International Financial Reporting
Standards (IFRSs), and a number of revenue-related interpretations were issued, for example
IFRIC 13, Customer Loyalty Programmes; IFRIC 15, Agreements for the Construction of
Real Estate and IFRIC 18, Transfers of Assets from Customers.
However, these amendments and interpretations do not necessarily change the principles in
IAS 11 and IAS 18. Therefore, essentially, we have been relying on the same principles for
revenue accounting for almost 20 years, and any significant change is expected to have
significant effects.
REASONS FOR THE PROPOSED CHANGES TO REVENUE ACCOUNTING
The aforementioned standards and interpretations have been criticised as being difficult to
apply to complex transactions. It should be noted that business transactions and contractual
agreements have become increasingly complex over the years. Possible reasons for this
criticism include lack of guidance for multiple element sales contracts and diversity in the
interpretation of the meaning of continuous transfer when applying IFRIC 15.
Enter exposure draft (ED), Revenue from Contracts with Customers. This ED is a result of a
joint project between the International Accounting Standards Board (IASB) and the Financial
Accounting Standards Board, and one of the objectives in issuing it is to address the
aforementioned weaknesses in the current revenue standards. When issued as a standard, the
ED will replace the current revenue standards.
The proposals in the ED are meant to be the single standard to be referred to for revenue
recognition applicable to a range of industries, companies and geographical boundaries and
thus have far-reaching effects. In acknowledgement of this, the boards have hosted numerous
outreach activities involving auditors, preparers, regulators and users from multiple
jurisdictions.
In fact, the boards issued the ED twice this was unprecedented. The first ED was issued in
June 2010 and nearly 1,000 comment letters were received. In response, the boards decided
to revise many detailed aspects of the 2010 proposals, although the underlying conceptual
basis is unchanged. As a result of these changes, and the importance of the revenue line item
to users of financial statements, the boards decided to expose the revised ED in 2011. The
comment period for the ED ended on 13 March 2012.
SUMMARY OF KEY CHANGES
The EDs core principle is that an entity shall recognise revenue to depict the transfer of
promised goods or services to customers in an amount that reflects the consideration to
which the entity expects to be entitled to in exchange for those goods or services. The
impact of the proposals on revenue accounting is outlined below.
IDENTIFYING CONTRACTS WITH CUSTOMERS
The proposals would apply to an entitys contracts with customers other than those within
the scope of the leasing, insurance or financial instruments standards and non-monetary
exchanges between entities in the same line of business, to facilitate sales to customers or
potential customers other than the parties to the exchange.
The ED provides specific criteria for entities to consider in determining whether a contract
exists. A contract can be written, oral or implied and must create enforceable rights and
obligations between two or more parties.
The implication of this is that entities will need to identify all customer contracts and
understand their key terms to ensure that the new revenue model is appropriately applied.
This may include understanding the practices and processes for establishing contracts in an
entitys legal jurisdiction and the customary business practices of an entity and its industry.
MULTIPLE ELEMENT CONTRACTS
The ED lays out specific criteria as to when the individual element of goods and services in a
contract should be considered separate revenue elements for accounting purposes,
specifically when the entity regularly sells the good or service separately or when the
customer can benefit from the good or service either on its own or together with other
resources that are readily available to the customer.
The ED uses the term performance obligations (POs) to identify each of those different
revenue elements. The ED also includes criteria as to when multiple elements of goods and
services are considered one PO, specifically when the elements are highly interrelated,
integrated and the bundle is highly customised or modified. These proposed criteria are
helpful over current revenue standards as they provide criteria to entities on how many
revenue items there are in a single contract.
The implication of the above is that some entities may identify more or less POs as
compared with current practice. In addition, where some entities account for a bundle of
goods and services as separate revenue streams (or one revenue stream) in current practice,
they may end up having to combine those different elements of goods and services as one PO
(or split them up into various POs).
In all the above cases, since entities may only recognise revenue as each PO is fulfilled,
entities may experience changes to the timing of revenue recognition as a result of the
proposals.
The ED also prescribes the method of allocating the transaction price for a contract to the
individual elements in the POs, ie based on relative standalone selling prices of each PO
in the contract, which is largely similar to the relative fair values approach in current
practice. The proposals are helpful in determining the amount of revenue to be recognised as
each PO is fulfilled, as current revenue standards are silent in this respect.
CONTRACT MODIFICATIONS
For certain industries, modifications to the scope or pricing of a contract may be a norm for
example, variation orders. The ED specifies that, depending on whether certain criteria are
met, such modifications may be accounted for either as separate contracts or part of the
existing contract. There is no clear guidance for this under the current revenue standards.
A modification may be a separate contract if the modification results in a separate PO with
pricing that is largely independent of the existing contract. Otherwise the modification
is accounted for as part of the existing contract. In the latter case, the accounting gets a bit
complicated depending on whether the modification is on prices alone, on POs alone, or
both. This may change the timing and amount of revenue recognised.
The above proposals may require careful consideration by, for example, entities that engage
in construction of assets or professional services.
POS SATISFIED OVER TIME
The ED provides guidance that an entity must consider in determining whether a PO is
satisfied continuously over time. This will have a bearing on whether the stage of completion
method of revenue accounting can be applied to a PO and is a significant issue faced by
many entities under the current revenue standards. The ED appears to articulate two broad
concepts on this.
First, this happens when the entitys performance creates or enhances an asset that the
customer controls as it is created or enhanced.
Second, this happens when the entitys performance does not create an asset with alternative
use to the entity for example, the contract does not allow the entity to sell the work in
progress to another customer or the work in progress is highly customised and would not be
suitable for another customer and at least one of the following criteria is met:
the customer simultaneously receives and consumes the benefit as the entity performs
each task;
another entity would not need to substantially reperform the work completed to date if
that other entity were to fulfil the remaining obligation to the customer (without
having access to work in progress or any other asset controlled by the entity); or
the entity has a right to payment (assuming that the seller complies fully with its
contractual obligations) for performance completed to date and expects to fulfil the
contract as promised. If the customer cannot cancel the contract, or the full contract
price is payable on cancellation, this would appear to meet the criteria. If the contract
can be cancelled by the customer and a fixed amount is payable on cancellation, which
is lower than the total contract price, this may not be considered to be sufficient to
compensate for performance to date and therefore may not satisfy this criterion.
From the above, there is a subtle but significant shift in focus for construction-type activity.
The existing guidance in IAS 11 and IFRIC 15 focuses on whether an item is being
constructed to a customer-specific design. The ED instead focuses on whether the asset
under construction has alternative use to the entity. This may result in a different analysis in
some cases, particularly for some property contracts.
WARRANTIES
The ED specifies that in some cases, warranties may constitute a separate PO to be
accounted for as a separate revenue stream, instead of as a selling cost under current practice.
This happens when the customer has the option to purchase the warranty separately, or when
the warranty provides a service beyond assuring a good or service complies with agreed-on
specifications. This may change the timing and amount of revenue recognised, particularly
when the warranty price is significant and warranty term is for long extended periods.
PRESENTATION OF CREDIT LOSSES
Where entities currently present credit losses relating to bad debts as an expense, the ED
specifies that such credit losses will be presented as a separate line item adjacent to the
revenue line in the income statement. This may have an impact on key performance
indicators, for example gross margin ratios.
ONEROUS POS
The ED specifies that POs that are to be satisfied over a period greater than one year would
be evaluated on whether they are onerous POs. This is a test similar to tests of onerous
contracts under IAS 37, Provisions, Contingent Liabilities and Contingent Assets, except that
it is done at a PO level instead of at the contract level. An implication is that a day one
onerous provision is required on a multiple-element contract that is profitable as a whole, but
has one onerous PO among other profitable POs within the same contract. Entities will need
to evaluate each of their multiple-element contracts for such onerous day one losses.
CONTRACT COSTS
Costs associated with obtaining and fulfilling a contract are capitalised under the ED when
certain criteria are met. This may require new policies, processes and data in order to capture
and amortise these costs.
TRANSITION AND EFFECTIVE DATES
An entity would be required to apply the proposed revenue standard retrospectively, subject
to the several optional reliefs. The IASB will not make a final decision on the effective date
of the new standard until it completes its deliberations on the revised proposals in 2012.
However, the IASB tentatively decided that the effective date of the proposed standard
would not be earlier than for annual reporting periods beginning on or after 1 January 2015.
OTHER IMPLICATIONS
Entities may need to review their internal information systems to determine whether there is
a need to modify their internal systems, controls and processes to gather necessary
information to comply with the new disclosure requirements and changes in revenue
recognition and cost capitalisation in a consistent manner.
Entities may need to assess the implications of any potential changes to the presentation of
financial results on key performance indicators (for example, gross margin ratios), covenants
and existing contracts (for example, remuneration agreements). Entities may also need to
consider if there are any further tax implications from the revised proposals. Stakeholder
education may be necessary to explain any potential changes to the financial statements.
Entities will need to consider the effects of the revised proposals as they negotiate new
contractual arrangements and modify existing agreements.
The application of various aspects of the revised proposal will require judgment and
estimation.
CONCLUDING COMMENTS
The ED has been subject to significant debate, in particular around the area of continuous
transfer of control. It will be interesting to see the outcome of the boards deliberation on
these areas and how the final standard will be worded. At the time of writing, the boards
have indicated that the final standard will be issued either in 2012 or 2013. Entities will have
to start setting aside resources to carefully consider the implications of the requirements in
the final standard.
Shariq Barmaky is partner and Mohamed Ghamazy is senior manager at Deloitte
Singapores IFRS Centre of Excellence
CURRENT OR NON-CURRENT LIABILITY?
RELATED LINKS
units.
There have recently been some major breaches of debt covenants reported by companies, but
the issue then arises as to how this liability is reported. The question is whether the liability
is a current or non-current liability and how to present the liability in the statement of
financial position.
IAS 1, Presentation of Financial Statements, paragraph 60 stipulates that an entity should
present current and non-current liabilities as separate classifications in its statement of
financial position, except when a presentation based on liquidity provides more relevant and
reliable information. Whatever the method of presentation, an entity should disclose the
amount expected to be settled after more than 12 months and less than 12 months.
When an entity supplies goods and services with an identifiable operating cycle, separate
classification of current and non-current liabilities highlight liabilities due for settlement in
the period. Information regarding the realisation of liabilities is useful in assessing the
solvency of an entity as IFRS 7, Financial Instruments: Disclosures, requires disclosure of
the maturity dates of financial liabilities. Financial liabilities include trade and other
payables. If a liability category combines amounts that will be settled after 12 months with
liabilities that will be settled within 12 months, note disclosure is required which separates
the longer-term amounts from the 12-month amounts.
Paragraph 69ad of IAS 1 states that liabilities are to be classified as current if any one of
four specified conditions is met. The conditions are:
a) It expects to settle the liability in its current operating cycle
b) It holds the liability primarily for trading
c) The liability is due to be settled within 12 months
d) It does not have an unconditional right to defer settlement of the liability for at least 12
months after the reporting period.
All other liabilities are to be classified as non-current. IFRS 7 does not deal with the
classification of financial liabilities but the disclosure of information that enables users to
evaluate the nature and extent of risks arising from financial liabilities to which the entity is
exposed.
IFRS 9, Financial Instruments, deals with the classification and measurement of financial
liabilities. In October 2010, the International Accounting Standards Board (IASB) published
additions to the first part of IFRS 9 on classification and measurement of financial liabilities.
The requirements in IAS 39 regarding the classification and measurement of financial
liabilities have been retained, including the related application and implementation guidance.
This means that there are two measurement categories for financial liabilities, which are fair
value through profit or loss (FVTPL) and amortised cost. The criteria for designating a
financial liability at FVTPL also remain unchanged.
Some current liabilities such as trade payables and employee costs are part of the normal
working capital of the entity and the entity classifies the amounts as current even if they are
to be settled outside of the 12-month period. There are some current liabilities that are not
part of the working capital cycle but are due for settlement within 12 months or are held for
trading. Financial liabilities are an example of this fact.
Financial liabilities are classified as current when they are due for settlement within 12
months, even if the original term was for a longer period than 12 months and an agreement
to refinance on a long-term basis is completed after the reporting date but before the
financial statements are authorised for issue.
CASE STUDY 1
An entity operates in the oil industry. It is constructing and operating an oil rig, which is
financed partly by a loan raised in 2010 and the entity classified the loan correctly as a noncurrent liability in accordance with paragraph 69 of IAS 1. In the statement of financial
position at 31 December 2011, the entity reclassified the loan as a current liability.
In the 2011 financial statements, the entity disclosed, as an event after the reporting period,
that the loan had been settled with cash received under an oil production agreement. The
entity also disclosed that a letter of intent in connection with the agreement had been signed
by the end of the 2011 financial year. In the directors' report for the year, the entity stated that
the loan was classified as a current liability due to the fact that the loan had been settled in
February 2012 when the oil production agreement became legally binding. The original
settlement date was 31 December 2015. The entity stated that it had reclassified the loan in
accordance with IFRS 7, Financial Instruments: Disclosures.
SOLUTION
IFRS 7 applies only to information disclosed in the financial statements and not to the
classification of liabilities. Therefore, the standard is not relevant. The classification of the
loan as a current liability does not comply with paragraph 69 of IAS 1. In respect of the 2011
financial statements, the oil production agreement, effective in February 2012, was a nonadjusting event after the reporting period as determined in accordance with IAS 10, Events
After the Reporting Period.
It can be concluded that the loan should have been classified as a non-current liability in the
2011 statement of financial position because the entity did not meet any of the conditions set
out in paragraph 69ad of IAS 1:
a) The project loan is not a liability which would be settled in the issuer's normal operating
cycle (paragraph 69a). The loan is a financial liability providing financing on a long-term
basis. It is not part of the working capital used in the entity's normal operating cycle.
b) The issuer did not hold the loan primarily for the purpose of trading but for the purpose of
financing the construction of the oilrig (paragraph 69b).
c) The loan was not due to be settled within 12 months after the reporting period (paragraph
69c).
d) The entity had an unconditional right to defer settlement of the liability for at least 12
months after the reporting period, because the loan was not due to be settled within 12
months after the reporting period (paragraph 69d).
Paragraphs 7476 of the standard address the consequences of a breach of a provision of a
long-term loan agreement on or before the end of the reporting period with the effect that the
liability becomes payable on demand. In this case, the liability is classified as current, even if
the lender has agreed, after the reporting period and before the authorisation of the financial
statements for issue, not to demand payment as a consequence of the breach.
Under IAS 1, a liability is classified as current as the entity does not have an unconditional
right to defer settlement of the liability for at least 12 months after the reporting period.
However, the liability is classified as non-current if the lender agreed by the reporting date to
provide a period of grace ending at least 12 months after the end of the reporting period,
within which the entity can rectify the breach and during which the lender cannot demand
immediate repayment.
CASE STUDY 2
In December 2010, an entity agreed a 10-year leasing agreement with a leasing company and
undertook to comply with certain covenants during the term of the lease agreement. The
agreement stipulated that, in the event of a failure by the entity to fulfil any of the contractual
obligations, or having failed to rectify any such breach within a one-month period, the lessor
had the right to terminate the leasing agreement.
In such a case, the entity would have to pay all unpaid amounts due before the termination of
the agreements. As at 31 December 2011, the entity was not in compliance with the
covenants stipulated in the leasing agreement. It was additionally established that on 31
January 2012, the entity was still not in compliance with the specified leasing covenants. In
the 2011 consolidated financial statements, the debt relating to the leasing company was
classified as non-current in accordance with the payment schedules included in the original
agreement. The entity had received, from the lessor, a notification confirming the failure to
comply with the covenants as of 31 December 2011. Thus, as at 31 December 2011, having
failed to fulfil the contractual obligations and being in breach of relevant covenant, the
leasing company was entitled to require the entity to repay the debts immediately.
SOLUTION
The entity's presentation of the debt as a non-current liability is not in accordance with IAS
1, paragraph 60 that specifies the circumstances in which liabilities are to be classified as
current. The amounts outstanding in respect of this arrangement at 31 December 2011 should
have been disclosed as a current liability. IAS 1 stipulates that a liability shall be classified as
current where it is due to be settled within 12 months after the reporting date, and the entity
does not have an unconditional right to defer settlement of the liability for at least 12 months
after the end of the reporting period.
CONCLUSION
Accounting for liabilities may appear to some to be relatively straightforward but simple
rules can have significant effects on corporate financial statements.
HOW TO MEASURE FAIR VALUE
RELATED LINKS
The IASB's IFRS13 standard offers guidance for determining exactly what constitutes the
fair value of an asset or liability, and how wntities should go about measuring it
units.
This article was first published in the October 2011 edition of Accounting and
Business magazine.
The International Accounting Standards Board (IASB) has recently completed a joint project
with the Financial Accounting Standards Board (FASB) on fair value measurement. The
result is IFRS 13, Fair Value Measurement. The standard defines fair value, establishes a
framework for measuring it, and requires significant disclosures relating to it.
The IASB wanted to enhance disclosures for fair value so that users could better assess the
valuation techniques and inputs used to measure it. There are no new requirements in IFRS
13 about when fair value accounting is required - the IASB is relying on guidance on fair
value measurements in existing standards. Although IFRS 13 moves International Financial
Reporting Standards (IFRS) and US GAAP closer on how to measure fair value, differences
remain about when fair value measurements are required and the recognition of gains or
losses on initial recognition.
The guidance in IFRS 13 does not apply to transactions dealt with by certain standards (such
as share-based payment transactions in IFRS 2, Share-based Payment, and leasing
transactions in IAS 17, Leases) nor to measurements that are similar to fair value but are not
fair value (such as net realisable value calculations in IAS 2, Inventories, or value in use
calculations in IAS 36, Impairment of Assets).
IFRS 13 applies therefore to fair value measurements that are required or permitted by those
standards not scoped out by IFRS 13. It replaces the inconsistent guidance found in various
IFRSs with a single source of guidance on measurement of fair value, and has an effective
date of 1 January 2013. The standard is applied prospectively and can be adopted early.
THE EXIT PRICE
Fair value has a different meaning depending on the context and usage. The IASB's
definition of fair value is: the price that would be received to sell an asset or paid to transfer
a liability in an orderly transaction between market participants at the measurement date. In
other words, it is an exit price.
Fair value is focused on the assumptions of the marketplace and is not entity-specific. It
therefore takes into account any assumptions about risk. It is measured using the same
assumptions and taking into account the same characteristics of the asset or liability as
market participants would. Such characteristics include the condition and location of the
asset and any restrictions on its sale or use.
The basic principles thus remain similar to current IFRS, but if an entity did not use these
principles before IFRS 13, it could result in significant change. For example, if an entity's
view of fair value did not take into account the highest and best use of the asset when
revaluing its property, plant and equipment, then IFRS 13 could result in a higher fair value.
It is not a relevant argument in the valuation process for the entity to insist that prices are too
low relative to its own valuation of the asset and that it would be unwilling to sell at such
low prices. The prices to be used are those in 'an orderly transaction' - one that assumes
exposure to the market for a period before the date of measurement to allow for normal
marketing activities and to ensure that it is not a forced transaction.
If the transaction is not 'orderly' there will not have been enough time to create competition,
and potential buyers may reduce the price that they are willing to pay. Similarly, if a seller is
forced to accept a price in a short period of time, then the price may not be representative.
However, it does not follow that a market with few transactions is not an orderly one. If there
has been competitive price tension, and sufficient time and information about the asset, then
the market may return a fair value for the asset.
UNIT OF ACCOUNT
The unit of account to be employed for measuring fair value is not specified by IFRS 13, but
is determined by the individual standard. A 'unit of account' is the single asset or liability or a
group of assets or liabilities.
The characteristic of an asset or liability must be distinguished from a characteristic arising
from the holding of an asset or liability by an entity. An example is where an entity has to
sell a large block of shares at a discount to the market price. This discount is a characteristic
of holding the asset rather than of the asset itself and should not be taken into account when
fair-valuing the asset.
WHICH MARKET?
Fair value measurement assumes that the transaction to sell the asset or transfer the liability
takes place in the principal market for the asset or liability or, in the absence of a principal
market, in the most advantageous market for the asset or liability. The principal market is the
one with the greatest volume and level of activity for the asset or liability that can be
accessed by the entity.
The most advantageous market is the one that maximises the amount that would be received
for the asset or paid to extinguish the liability after transport and transaction costs. Often
these markets would be the same.
Sensibly, an entity does not have to carry out an exhaustive search to identify either market
but should take into account all available information. Although transaction costs are taken
into account when identifying the most advantageous market, the fair value is not after
adjustment for transaction costs because these costs are a characteristic of the transaction,
not the asset or liability.
If location is a factor, then the market price is adjusted for the costs incurred to transport the
asset to that market. Market participants must be independent of each other and
knowledgeable, and able and willing to enter into transactions.
IFRS 13 sets out a valuation approach that refers to a broad range of techniques. These
techniques are threefold: the market, income and cost approaches.
When measuring fair value, the entity is required to maximise the use of observable inputs
and minimise the use of unobservable inputs. To this end, the standard introduces a fair value
hierarchy, which prioritises the inputs into the fair value measurement process.
Fair value measurements are categorised into a three-level hierarchy, based on the type of
inputs to the valuation techniques used, as follows.
INPUT HIERARCHY
Level 1 inputs are unadjusted quoted prices in active markets for items identical to the asset
or liability being measured. As with current IFRS, if there is a quoted price in an active
market, an entity uses that price without adjustment when measuring fair value. An example
of this would be prices quoted on a stock exchange. The entity needs to be able to access the
market at the measurement date.
Active markets are ones where transactions take place with sufficient frequency and volume
for pricing information to be provided. An alternative method may be used where it is
expedient, and the standard sets out criteria where this may be applicable.
For example, it may be that the price quoted in an active market does not represent fair value
at the measurement date, a situation which may occur when a significant event such as a
business reorganisation or combination takes place after the close of the market.
Determining whether a fair value measurement is a level 2 or level 3 input depends on
whether the inputs are observable or unobservable, and on their significance.
Level 2 inputs are inputs other than quoted prices in level 1 that are observable for that asset
or liability. They are quoted assets or liabilities for similar items in active markets or
supported by market data for example, interest rates, credit spreads or yield curves.
Adjustments may be needed to level 2 inputs, and if these are significant, the fair value may
need to be classified as level 3.
Level 3 inputs are unobservable inputs, which should be used as a minimum. Where
situations occur when relevant inputs are not observable, they must be developed to reflect
the assumptions that market participants would use when determining an appropriate price
for the asset or liability.
The entity should maximise the use of relevant observable inputs and minimise the use of
unobservable ones. The general principle of using an exit price remains and IFRS 13 does
not preclude an entity from using its own data. For example, cashflow forecasts may be used
to value an entity that is not listed. Each fair value measurement is categorised on the basis
of the lowest level input that is significant to it.
VALUATION CONCEPTS
IFRS 13 also sets out certain valuation concepts to assist in the determination of fair value.
For non-financial assets only, fair value is decided based on the highest and best use of the
asset as determined by a market participant.
The fair value of a liability or the entity's own equity assumes it is transferred to a market
participant on the measurement date. Often there is no observable market to provide pricing
information and the highest and best use is not applicable.
The fair value is then based on the perspective of a market participant who holds the
identical instrument as an asset. If there is no corresponding asset, a valuation technique is
used, as is the case with a decommissioning activity.
The fair value of a liability reflects the non-performance risk based on the entity's own credit
standing plus any compensation for risk and profit margin a market participant might require
to undertake the activity. Transaction price is not always the best indicator of fair value at
recognition because entry and exit prices are conceptually different.
DISCLOSURE
The guidance includes enhanced disclosure requirements that could result in more work for
reporting entities. Required disclosures include:
information about the hierarchy level into which fair value measurements fall;
transfers between levels 1 and 2;
methods and inputs to the fair value measurements and changes in valuation
techniques; and
additional disclosures for level 3 measurements that include a reconciliation of
opening and closing balances, and quantitative information about unobservable inputs
and assumptions used.
This article is merely a snapshot of a standard that will require a significant amount of work
by entities simply to understand the nature of the principles and concepts involved.
Graham Holt is an examiner for ACCA and executive head of the accounting and finance
division at Manchester Metropolitan University Business School
IAS 19 - THE CHANGES AND EFFECTS
RELATED LINKS
Graham Holt examines the implications for financial statements of the IASBs decision to
amend IAS 19 in an attempt to improve accounting for post-employment benefits
units.
This article was first published in the August 2011 edition of Accounting and Business
magazine.
The International Accounting Standards Board (IASB) has completed a project to improve
the accounting for pensions and other post-employment benefits by issuing an amended
version of IAS 19, Employee Benefits. The changes will have a significant effect on financial
statements.
The Board has decided to eliminate the option to defer the recognition of gains and losses,
known as the 'corridor approach', to streamline the presentation of changes in assets and
liabilities arising from defined benefit plans, and to enhance the disclosure requirements for
defined benefit plans.
The project forms part of the Memorandum of Understanding between the IASB and the
Financial Accounting Standards Board, the US national standard-setter, and by the
elimination of the corridor method, it further aligns IFRS and US GAAP.
Defined benefit pension commitments often represent an entitys largest single financial
liability. The amendments to IAS 19 are designed to make users of financial statements
aware of the risks associated with those commitments; in particular, by requiring the surplus
or deficit of a pension fund to be detailed in the financial statements. Under the revised IAS
19, an entity should recognise all changes, including actuarial gains and losses, unvested past
service costs, settlements and curtailments in a net-defined benefit liability (asset) when they
occur. The measurement of obligations should reflect the substance of arrangements where
the employer's exposure is limited or where the employer can use contributions from
employees to meet a deficit. This might reduce the defined benefit obligation, but
determining the substance of such arrangements may require significant judgment to be used.
The standard renames actuarial gains and losses as 'remeasurements' and they will be
recognised immediately in 'other comprehensive income'. Actuarial gains and losses can no
longer be deferred using the corridor approach or recognised in profit or loss. As a result, this
may cause volatility in the statement of financial position and other comprehensive income
(OCI).
Actuarial gains and losses can vary significantly from period to period, as they include not
only changes in estimates regarding employee turnover and life expectancy, but also
investment gains and losses, and the impact of changes in discount rates. Now all changes in
the value of defined benefit plans will be recognised as they occur. Remeasurements
recognised in OCI cannot be recycled through profit or loss in subsequent periods.
In a similar way as actuarial gains and losses, past-service costs are recognised in the period
of a plan amendment with unvested benefits no longer spread over the future-service period.
A curtailment now occurs only when an entity reduces significantly the number of
employees.
The annual expense for a defined benefit plan includes the net interest expense or income,
calculated by applying the discount rate to the net defined benefit asset or liability. This
value replaces the finance charge and expected return on plan assets, where income is
credited with the expected long-term yield on the assets in the fund. This may increase the
annual benefit expense. There is no connection now between the assets held by a pension
scheme and the return on assets in earnings.
In summary, the revised IAS 19 disaggregates changes in the net defined benefit liability
(asset) into service cost, finance cost and remeasurement components, showing service cost
and finance cost components in the profit or loss, and the remeasurements component in
other comprehensive income.
The revised standard gives less flexibility in the presentation of items in income statements.
The benefit cost is split between current-service cost and benefit changes, which include
past-service cost, settlements and curtailments and finance expense or income. This
information can be disclosed in the income statement or in the notes.
Additional disclosures are required to present the characteristics of benefit plans, the
amounts recognised in the financial statements, and the risks arising from defined benefit
plans and multi-employer plans. The objectives and principles underlying disclosures are
now required and the result may be more extensive disclosure and more subjectivity in
determining that disclosure.
The distinction between short-term and other long-term employee benefits is now based on
the expected timing of a settlement rather than employee entitlement. The classification is
determined in accordance with IAS 1 and reflects whether an entity has the unconditional
ability to defer payment for more than a year, regardless of when the obligation is expected
to be settled. Changes in the carrying amount of liabilities for other long-term employment
benefits will continue to be recognised in profit or loss.
Taxes related to benefit plans should be included either in the return on assets or the
calculation of the benefit obligation, depending on their nature. If a benefit has a futureservice obligation, then it is not a termination benefit. As a result, the number of
arrangements that meet the definition of termination benefits will be reduced. A liability for a
termination benefit is only recognised when the entity cannot withdraw the offer of the
termination benefit or recognises any related restructuring costs.
IMPACT AND CONSEQUENCES
The IASB's decisions are likely to impact on entities in different ways, depending upon the
types of employee benefits that they provide and the manner in which they currently account
for such benefits. For example, some entities with significant defined benefit plans will
experience 'accounting mismatches' with respect to the accounting for expenses associated
with a defined benefit liability, including service cost, any past-service cost and interest
expense and returns on plan assets under the new requirements compared to the accounting
for defined benefit obligations under the current IAS 19 approach.
Another change is that, in the event of some or all of the schemes liabilities being
extinguished through a one-off cash payment, the full cost will need to be included in profit
or loss expense, even if the transaction occurred outside the pension scheme.
This change is particularly relevant for enhanced transfer value incentive exercises, whereby
a cash inducement is offered to members to encourage them to transfer out of the pension
scheme. If cash is offered directly to a former employee as part of an enhanced transfer
package, it would probably be recorded as a general expense, but now it would be combined
with the pension assets transferred to show the true cost.
Under the current standard, expenses associated with running a pension scheme are usually
netted off against the return on assets. This has the effect that the expected, rather than
actual, expenses in each year are charged to the profit or loss. In future, companies will need
to disclose these expenses separately, meaning that actual rather than estimated expenses will
flow through to the profit or loss. This could increase attention to the cost of running defined
benefit schemes in the future.
The new rules on recognition of gains and losses may mean that companies can change the
way in which pension fund assets are invested. Pension companies invest in equities with the
knowledge that gains and losses can be smoothed over the working lives of employees if the
entity chooses to do so. The removal of the corridor approach may mean that companies will
review whether taking risk in equity schemes will affect shareholder value, as moving out of
equities into bonds tends to lead to stability in key performance indicators. The amended IAS
19 may lead to greater transparency in financial statements by increasing the disclosure of
the costs and risks associated with schemes, and making it easier to compare the impact of
pension costs on reported profits between entities.
Previously, entities could record a gain each year based on the expected return on pension
scheme investments rather than the actual return. With pension schemes traditionally
investing in riskier assets such as equities, this has often meant entities can use this to
recognise 'soft' profits.
Observers indicate that the new accounting standard will increase pension costs, as the
expected return has traditionally been higher than the net interest. The de-risking in pension
plans could lead to lower returns and lower interest on the plan assets for members. This may
mean increases in contributions to compensate for this.
Phase two of the IAS 19 revision is set to change the definition of defined benefit plans. The
method currently used for defining pension plans is not ideal, but it could be better than a
complicated calculation, which includes evaluating options. With commentators estimating
that the amendments are likely to reduce the reported earnings of UK companies by around
GBP10bn, further changes will come as an unwelcome blow to many entities.
division at Manchester M OFF BALANCE SHEET ACTIVITIES

RELATED LINKS
Graham Holt examines three recently issued standards - IFRS 10, 11 and 12 - that complte
improvements made by the IASB in response to the financial crisis
units.
This article was first published in the July 2010 edition of Accounting and
Business magazine.
The International Accounting Standards Board (IASB) has recently issued three standards:
IFRS 10, Consolidated Financial Statements, IFRS 11, Joint Arrangements and IFRS 12,
Disclosure of Interests in Other Entities. The issuance of these standards completes IASBs
improvements to the accounting requirements for off balance sheet activities and joint
arrangements.
The standards bring into broad alignment the accounting treatment for off balance sheet
activities in International Financial Reporting Standards (IFRSs) and US generally accepted
accounting principles (GAAP), and are the IASBs response to the financial crisis.
IFRS 10 replaces all of the consolidation guidance in IAS 27, Consolidated and Separate
Financial Statements, and SIC 12, Consolidation Special Purpose Entities, although the
portion of IAS 27 that deals with separate financial statements remains. The old standard has
been renamed IAS 27, Separate Financial Statements.
IFRS 11 replaces IAS 31, Interests in Joint Ventures, and SIC 13, Jointly Controlled Entities
Non-Monetary Contributions by Venturers. And IFRS 12 replaces the disclosure
requirements that used to be found in IAS 28, Investments in Associates and Joint Ventures.
IFRS 10: CONTROL AND POWER
IFRS 10 makes the concept of control the determining factor in whether an entity should be
included within the consolidated financial statements of the parent company, thus building
on existing principles. Guidance has been added to the standard to determine the nature of
control in cases where assessment is difficult.
IFRS 10 introduces a single consolidation model for all entities based on control, irrespective
of the nature of the investee. Control is based on whether an investor has power over the
investee; exposure, or rights, to variable returns from its involvement with the investee; and
the ability to use its power over the investee to affect the amount of the returns. Thus the
definition focuses on the need to have both power and variable returns for control to be
present.
Control is assessed on a continuous basis as facts and circumstances change. A change in
market conditions brings about a reassessment of control only if it changes one of the
elements of control. The revised definition of control replaces not only the definition and
guidance in IAS 27 but also the four indicators of control in SIC 12. The accounting
requirements for consolidated financial statements have been transferred from IAS 27 to
IFRS 10.
Power is the current ability to direct the activities that significantly influence returns, which
can be positive, negative or both. The determination of power is based on current facts and
circumstances, is continuously assessed and is a two-step process.
First, the investor considers all the facts and circumstances of the case, including the size of
its holding and the dispersion of holdings.
Second, the investor considers whether other shareholders are passive by nature and if the
investee is controlled by rights other than voting power, which are the facts normally used to
assess power.
If after this latter step there is no clear conclusion, then the investor does not control the
entity. An investor with more than 50% of the voting rights would meet the power criteria if
there were no restrictions, but even if it held less than the majority of the voting rights an
investor could still have power in certain cases.
In the latter case, such things as agreements with other vote holders, other contractual
agreements, potential voting rights and de facto power would have to be considered. IFRS 10
provides guidance on participating and protective rights, and brings the notion of de facto
control firmly within the guidance.
To have control, an investor needs to have the ability to use its power to affect returns for the
investors benefit.
The standard also requires an investor with decision-making rights to determine if it is acting
as a principal or an agent. Such factors as whether any remuneration is at arms length
have to be considered. If an investor acts as an agent, it would not have the requisite power,
so the entity would not be consolidated.
Because the new standards may change which entities are included in consolidated financial
statements, deal structures may also change. Significant judgment may be required to
determine whether another entity is controlled, and data may have to be gathered about other
shareholders and past voting patterns. Private equity funds, asset managers and some
insurance companies will have to assess whether they are principals or agents and therefore
whether they have to consolidate their investments.
An entity holding options to acquire additional voting interests or which owns a minority of
voting rights will also need to consider the new rules.
IFRS 11: RIGHTS AND OBLIGATIONS

IFRS 11, Joint Arrangements, provides for a more realistic reflection of joint arrangements
by focusing on the rights and obligations of the arrangement, rather than its legal form. The
standard addresses inconsistencies in the reporting of joint arrangements by requiring a
single method to account for interests in jointly controlled entities.
A joint arrangement is one where two or more parties contractually agree to share control.
Joint control exists only when the decisions about activities that significantly affect the
returns of an arrangement require the unanimous consent of the parties sharing control.
All parties to a joint arrangement should recognise their rights and obligations arising from
the arrangement. The structure and form of the arrangement is only one of the factors in
assessing each partys rights and obligations; the terms and conditions agreed by the parties
and other relevant facts and circumstances should also be considered.
Joint arrangements are either joint operations or joint ventures. A joint operation gives the
parties direct rights to the assets and the liabilities of the arrangement; those parties are
called joint operators. A joint operator will recognise its interest based on its direct rights and
obligations rather than on its participation interest.
A joint operator needs to recognise:
its assets, including its share of any assets held jointly
its liabilities, including its share of any liabilities incurred jointly
its revenue from the sale of its share of the output of the joint operation
its share of the revenue from the sale of the output by the joint operation, and
its expenses, including its share of any expenses incurred jointly.
A joint venturer, on the other hand, recognises its interest as an investment and accounts for
that investment using the equity method in accordance with IAS 28, Investments in
Associates and Joint Ventures, unless it is exempt from applying the equity method.
A party that participates in, but does not have joint control of, a joint venture accounts for its
interest in the arrangement in accordance with IFRS 9, Financial Instruments. However, if it
has significant influence over the joint venture, it must account for it in accordance with IAS
28.
Accordingly, a joint venture gives the parties rights to the net assets and profit or loss of the
venture. A joint venturer does not have rights to individual assets or obligations for
individual liabilities of the joint venture.
Entities can no longer account for an interest in a joint venture using the proportionate
consolidation method but must use the equity method. Entities will need to assess their
arrangements to determine whether they have invested in a joint operation or a joint venture
on adoption of the new standard.
Also, some entities that previously equity-accounted their investments may need to account
for their share of assets and liabilities now that there is less focus on the structure of the
arrangement.
The transition provisions of IFRS 11 require entities to apply the new rules at the start of the
earliest period presented on adoption. Entities in mining, extraction, oil and gas, and real
estate and construction, where joint arrangements are common, might feel the biggest
impact.
IFRS 12: DISCLOSURES
FRS 12, Disclosure of Interests in Other Entities, sets out the required disclosures for entities
reporting under the two new standards, IFRS 10 and IFRS 11. It replaces the disclosure
requirements currently found in IAS 28. The new standard requires entities to disclose
information that helps users evaluate the nature, risks and financial effects associated with
the entitys interests in subsidiaries, associates, joint arrangements and unconsolidated
structured entities.
To meet this objective, disclosures are required in the following areas:
a) Significant judgments and assumptions used by the entity in determining that it controls
another entity, has joint control of an arrangement or exerts significant influence over
another entity, and the type of joint arrangement when the arrangement has been structured
through a separate vehicle.
b) The entitys interests in subsidiaries, in order to allow users to understand, for example,
the composition of the group or to evaluate the nature and extent of significant restrictions on
its ability to access or use assets, and settle liabilities, of the group.
c) The entitys interests in joint arrangements and associates, so users can evaluate, for
example, the nature, extent and financial effects of its interests in joint arrangements and
associates, and the nature of, and changes in, risks associated with its interests in joint
ventures and associates.
d) The entitys interests in unconsolidated structured entities.
The objective of IFRS 12 is for an entity to disclose information that helps users of its
financial statements evaluate the nature of it's involvement with other entities and the effects
of that involvement on its financial position. IFRS 12 is likely to increase the amount of
information in financial statements about an entitys relationships with the other parties.
The new standards are effective for annual periods beginning on or after 1 January 2013.
Earlier application is permitted if the entire package of standards is adopted at the same time.
division at Manchester Metropolitan University Business School
etropolitan University Business School

Lease Accounting

Diunggah oleh

Informasi Dokumen

Hak Cipta

Format Tersedia

Bagikan dokumen Ini

Bagikan atau Tanam Dokumen

Opsi Berbagi

Apakah menurut Anda dokumen ini bermanfaat?

Apakah konten ini tidak pantas?

Hak Cipta:

Format Tersedia

Lease Accounting

Diunggah oleh

Hak Cipta:

Format Tersedia

LEASE ACCOUNTING

Email Print Twitter Facebook Linkedin Add This

amortisation (EBITDA). These alternative profit figures can appear in various

5. Strategy and resource allocation.

Forensic accounting is very different from conventional auditing: the specialisation

1. intent - to show motive for the act committed

compliance with relevant laws, especially those relating to privacy

the borrower's financial difficulties. ESMA expects issuers to provide quantitative

using cash or as part consideration in a business combination. Understanding the nature of

are dividends non-discretionary.

consistently for similar transactions. If IFRS specifically permits different accounting

PREPARING FOR CHANGE

Email Print Twitter Facebook Linkedin Add This

IFRS 11: RIGHTS AND OBLIGATIONS

Anda mungkin juga menyukai