CPA PROGRAM

FINANCIAL
REPORTING
FIFTH EDITION
Published 2019 by John Wiley & Sons Australia, Ltd,
42 McDougall Street, Milton Qld 4064,
on behalf of CPA Australia Ltd,
ABN 64 008 392 452
First edition published January 2010, updated July 2010, updated January 2011, reprinted July 2011, updated January 2012,
reprinted July 2012, updated January 2013, revised edition January 2013, reprinted July 2013, updated January 2014,
revised edition January 2015, updated July 2015, updated January 2016
Third edition published November 2016
Fourth edition published January 2018
Fifth edition published November 2019
© 2010–2019 CPA Australia Ltd (ABN 64 008 392 452). All rights reserved. This material is owned or licensed by CPA
Australia and is protected under Australian and international law. Except for personal and educational use in the CPA
Program, this material may not be reproduced or used in any other manner whatsoever without the express written
permission of CPA Australia. All reproduction requests should be made in writing and addressed to: Legal, CPA Australia,
Level 20, 28 Freshwater Place, Southbank, VIC 3006, or legal@cpaaustralia.com.au.
Edited and designed by John Wiley & Sons Australia, Ltd
Printed by Blue Star Print
ISBN 9780730381754
Authors
Nikole Gyles BCom (Hons) UTas, CA, CPA
Janice Loftus BBus NSWIT, MCom (Hons) UNSW, FCPA
Carmen Ridley BSc (Hons) Mathematics, FCA
Dean Hanlon BEc, GradDipCom, MCom (Hons), PhD Monash University, CPA, CA
Updates to the fifth edition
Sorin Daniliuc BEc (Hons) UAIC Iasi, PhD ANU, GradCertEd ANU, CPA
John Sweeting BEc, MEc, PhD, CPA, CA
Jeffrey Knapp BEc (Hons) (Macq), MPhil (UNSW), CA
Karyn Byrnes BBus (Accounting), CPA
Jennifer James BBus(Acc)Dist CQUni, BBus(Hons 1st class)Acc CQUni, CPA
Advisory panel
Peter Gerhardy (Ernst & Young)
Shan Goldsworthy (Shans Accounting Services)
Kris Peach (KPMG)
Daen Soukseun (Department of Transport, Planning and Local Infrastructure, Victoria)
Themin Suwardy (Singapore Management University)
Anne Vuong (National Australia Bank)
Mark Shying (CPA Australia)
Ram Subramanian (CPA Australia)
David Hardidge (Telstra)
CPA Program team
Yvette Absalom Adam Moretti
Victoria Altomare Ram Nagarajan
David Baird Venkat Narayanan
Shubala Barclay Isha Nehru
Nicola Drury Shari Serjeant
Jeannette Dyet Paul Shantapriyan
Yani Gouw Alisa Stephens
Kristy Grady Zina Suyat
Geraldine Howley Tiffany Tan
Elise Literski Seng Thiam Teh
Julie McArthur Helen Willoughby
ACKNOWLEDGEMENTS
This publication contains copyright © material and trademarks of the IFRS Foundation®. All rights
reserved. Used under licence from the IFRS Foundation®. Reproduction and use rights are strictly limited.
For more information about the IFRS Foundation and rights to use its material please visit www.ifrs.org.
Disclaimer: To the extent permitted by applicable law the Board and the IFRS Foundation expressly
disclaims all liability howsoever arising from this publication or any translation thereof whether in contract,
tort or otherwise (including, but not limited to, liability for any negligent act or omission) to any person
in respect of any claims or losses of any nature including direct, indirect, incidental or consequential loss,
punitive damages, penalties or costs.
Information contained in this publication does not constitute advice and should not be substituted for
the services of an appropriately qualified professional.
The IFRS Foundation logo, the IASB logo, the IFRS for SMEs logo, the “Hexagon Device”, “IFRS
Foundation”, “eIFRS”, “IAS”, “IASB”, “IFRS for SMEs”, “IASs”, “IFRS”, “IFRSs”, “International
Accounting Standards” and “International Financial Reporting Standards”, “IFRIC” and “SIC” are Trade
Marks of the IFRS Foundation.

MODULE 1
Figures 1.1–1.5, 1.7, Tables 1.2–1.6 and extracts: © 2019 CPA Australia Ltd; Figure 1.6 and extracts:
© Commonwealth of Australia 2019. All legislation herein is reproduced by permission but does not
purport to be the official or authorised version. It is subject to Commonwealth of Australia copyright.
The Copyright Act 1968 permits certain reproduction and publication of Commonwealth legislation. In
particular, s.182A of the Act enables a complete copy to be made by or on behalf of a particular person.
For reproduction or publication beyond that permitted by the Act, permission should be sought in writing
from the Commonwealth available from the Australian Accounting Standards Board. Requests in the first
instance should be addressed to the National Director, Australian Accounting Standards Board, PO Box
204, Collins Street West, Melbourne, Victoria, 8007; Table 1.1: © External Reporting Board New Zealand;
Tables 1.2–1.6: © 2019 CPA Australia Ltd.

MODULE 2
Figures 2.1–2.6 and Tables 2.1–2.4: © 2019 CPA Australia Ltd; Extracts: © BHP 2014, annual report.

MODULE 3
Figure 3.1: © Deloitte 2018, p. 6. This is an amended version of a diagram for which the original is available
from www.dart.deloitte.com/iGAAP; Figure 3.2: © 2019 CPA Australia Ltd; Extracts: © Commonwealth
of Australia 2019. All legislation herein is reproduced by permission but does not purport to be the official
or authorised version. It is subject to Commonwealth of Australia copyright. The Copyright Act 1968
permits certain reproduction and publication of Commonwealth legislation. In particular, s.182A of the Act
enables a complete copy to be made by or on behalf of a particular person. For reproduction or publication
beyond that permitted by the Act, permission should be sought in writing from the Commonwealth
available from the Australian Accounting Standards Board. Requests in the first instance should be
addressed to the National Director, Australian Accounting Standards Board, PO Box 204, Collins Street
West, Melbourne, Victoria, 8007; © Lennard, A. & Thompson, S. 1995, Provisions: Their Recognition,
Measurement and Disclosure in Financial Statements, Financial Accounting Standards Board, Norwalk,
paras 2.1.5–6. © Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA; © Stuart
Washington, 2002.

MODULE 4
Figures 4.1–4.2, 4.6–4.8 and Tables 4.5, 4.7–4.11, 4.14, 4.17: © 2019 CPA Australia Ltd; Tables 4.12–
4.13, 4.15–4.16 and extracts: © Amcor Limited 2018, Annual Report 2018, pp. 69, 70, 71, accessed May
2019, https://www.amcor.com/investors/financial-information/annual-reports.

ACKNOWLEDGEMENTS iii
MODULE 5
Figures 5.1–5.8 and Tables 5.1, 5.4: © 2019 CPA Australia Ltd; Extracts: © 2019 CPA Australia Ltd;
© Commonwealth of Australia 2019. All legislation herein is reproduced by permission but does not
purport to be the official or authorised version. It is subject to Commonwealth of Australia copyright.
The Copyright Act 1968 permits certain reproduction and publication of Commonwealth legislation. In
particular, s.182A of the Act enables a complete copy to be made by or on behalf of a particular person.
For reproduction or publication beyond that permitted by the Act, permission should be sought in writing
from the Commonwealth available from the Australian Accounting Standards Board. Requests in the first
instance should be addressed to the National Director, Australian Accounting Standards Board, PO Box
204, Collins Street West, Melbourne, Victoria, 8007.

MODULE 6
Figure 6.1: © IFRS; Figures 6.2, 6.4: © MNP 2016, An overview of IFRS 9 Financial Instruments
vs. IAS 39 Financial Instruments: Recognition and Measurement, January, p. 12, accessed July 2019,
https://www.mnp.ca/en/assurance-accounting/financial-reporting-library/ifrs-implementation-guide-an-o
verview-of-ifrs-9-vs-ias-39; Figure 6.3: © 2019 CPA Australia Ltd; Figure 6.5: © KPMG 2013,
First impressions: IFRS 9 2013 – Hedge accounting and transition, December, p. 33, accessed July
2019, https://home.kpmg.com/content/dam/kpmg/pdf/2013/12/First-Impressions-O-1312-IFRS9-Hedge-
accounting-and-transition.pdf; Figure 6.6: Reproduced by permission of EYGM Limited. © 2014 EYGM
Limited. All Rights Reserved; Extracts: © Commonwealth of Australia 2019. All legislation herein is
reproduced by permission but does not purport to be the official or authorised version. It is subject
to Commonwealth of Australia copyright. The Copyright Act 1968 permits certain reproduction and
publication of Commonwealth legislation. In particular, s.182A of the Act enables a complete copy to be
made by or on behalf of a particular person. For reproduction or publication beyond that permitted by
the Act, permission should be sought in writing from the Commonwealth available from the Australian
Accounting Standards Board. Requests in the first instance should be addressed to the National Director,
Australian Accounting Standards Board, PO Box 204, Collins Street West, Melbourne, Victoria, 8007;
© National Australia Bank 2018; © BHP Billiton 2018.

MODULE 7
Figures 7.1, 7.3–7.5 and Tables 7.2, 7.10–7.12: © 2019 CPA Australia Ltd; Figure 7.2: © Wiley 2020;
Extracts: Reproduced by permission of EYGM Limited. © 2008 EYGM Limited. All Rights Reserved;
© Australian Securities & Investments Commission 2015.

iv ACKNOWLEDGEMENTS
BRIEF CONTENTS
Subject Outline xii

Module 1: The Role and Importance of Financial Reporting 1

Module 2: Presentation of Financial Statements 57
Module 3: Revenue From Contracts with Customers; Provisions, Contingent Liabilities and Contingent
Assets 115
Module 4: Income Taxes 157
Module 5: Business Combinations and Group Accounting 217
Module 6: Financial Instruments 302
Module 7: Impairment of Assets 369

Appendix: Techworks Ltd 407

Glossary 452
Suggested Answers 458
Index 538
CONTENTS
Subject Outline xii
MODULE 1
The Role and Importance of
Financial Reporting 1
Preview 2
1.1 The role and importance of financial
reporting 2
The role of financial reporting 2
The importance of financial reporting 3
Understanding the international financial
reporting standards 5
Interaction between financial reporting and
the regulatory environment — who must
prepare general purpose financial
reports? 7
International initiatives to decrease financial
reporting complexity 9
1.2 The Conceptual Framework for
Financial Reporting 12
The purpose and application of the
Conceptual Framework 12
Objectives and limitations of general
purpose financial reporting 13
Principles established in the Conceptual
Framework 14
1.3 Qualitative characteristics of useful
financial information 15
Fundamental qualitative characteristics 15
Enhancing qualitative characteristics 18
The cost constraint on useful financial
reporting 20
Application of qualitative characteristics in
the International Financial Reporting
Standards 21
1.4 The elements of financial statements 21
Defining the elements of financial
statements 22
Criteria for recognising elements of financial
statements 25
Derecognition of assets and liabilities 26
Constraints on international consistency of
the application of recognition criteria
established by the Conceptual
Framework 26
1.5 Measurement of elements of financial
statements 27
Cost-based and value-based measures
used in the International Financial
Reporting Standards 27
Present value as a valuation technique 36
1.6 Application of measurement principles
in the International Financial
Reporting Standards 38
Leases 38
Employee benefits 43
Accounting for share-based payments 48
Investment property 49
Professional judgment 51
Disclosures 52
Review 55
References 55
Optional reading 56
MODULE 2
Presentation of Financial
Statements 57
Preview 58
Part A: Presentation of Financial Statements 60
Introduction 60
2.1 Complete set of financial statements 61
Components of a complete set of financial
statements 61
Segment reporting 63
Fair presentation and compliance with
International Financial Reporting
Standards 64
Other general features 65
2.2 Accounting policies 67
Selection of accounting policies 68
Consistency of accounting policies 69
Disclosure of accounting policies 69
Changes in accounting policies 70
2.3 Revision of accounting estimates and
correction of errors 72
Changes in accounting estimates 72
Material errors in a prior period 73
2.4 Events after the reporting period 75
Types of events after the reporting
period 75
Adjusting events 76
Non-adjusting events 76
Dividends declared after reporting
period 78
Going concern issues after reporting
period 78
2.5 The impact of technological
advancements on the presentation
of financial statements 79
Summary 79
Part B: Statement of Profit or Loss and Other
Comprehensive Income 82
Introduction 82
2.6 Presentation of comprehensive
income 82
2.7 The concept of other comprehensive
income and total comprehensive
income 83
2.8 IAS 1 — Disclosures and classification 84
Single statement (statement of P/L and
OCI) 84
Two statements (statement of profit or loss
and a statement of comprehensive
income) 85
2.9 Tips on how to analyse the statement
of profit or loss and other
comprehensive income 89
Summary 90
Part C: Statement of Changes in Equity 91
Introduction 91
2.10 IAS 1 Presentation of Financial
Statements: disclosures of changes
in equity 91
Summary 92
Part D: Statement of Financial Position 94
Introduction 94
2.11 Format of the statement of financial
position 94
2.12 Presentation of assets and liabilities 95
Current assets and current liabilities 95
2.13 IAS 1 Presentation of Financial
Statements: disclosures in the notes
to the statement of financial position 96
2.14 Tips on how to analyse a statement of
financial position 97
Summary 98
Part E: IAS 7 Statement of Cash Flows 99
Introduction 99
2.15 How does a statement of cash
flows assist users of the financial
statements? 99
2.16 Information to be disclosed 100
Cash and cash equivalents 100
Classification of cash flows 100
2.17 Common methods adopted on how
to prepare a statement of cash
flows 102
Formula method 103
Reporting cash flows on a net basis 104
Other information to be disclosed in the
statement of cash flow or notes 104
Consolidated financial statements 105
2.18 Tips on how to analyse the statement
of cash flows 105
Summary 106
Review 107
Case study data: Webprod Ltd 108
Section 1: Information relating to prior
reporting periods 108
Section 2: Information relating to the
manufacturing process of Webprod
Ltd 109
2.1 Retail inventory 109
2.2 Manufacturing inventory 109
Section 3: Non-current assets 110
3.1 Acquisitions and disposals 110
3.2 Depreciation and amortisation 110
3.3 Revaluation of land and buildings 110
Section 4: Wages and salaries 111
Section 5: Borrowing costs 111
Section 6: Change in accounting policy 111
Section 7: Revenue 111
7.1 Revenue recognition policy 111
7.2 Research and advisory services 111
7.3 Grants 111
Section 8: 30 June 20X7 trial balance 111
Assumed knowledge review questions 113
Reference 114
MODULE 3
Revenue From Contracts with
Customers; Provisions,
Contingent Liabilities and
Contingent Assets 115
Preview 116
Part A: Revenue from Contracts with
Customers 117
Introduction 117
Overview of IFRS 15 Revenue from
Contracts with Customers 118
3.1 Recognition of revenue 120
Step 1: Identify the contract(s) with the
customer 121
Step 2: Identify the performance
obligation(s) in the contract 123
Step 3: Determine the transaction price of
the contract 125
Step 4: Allocate the transaction price to
each performance obligation 131
Step 5: Recognise revenue when each
performance obligation is satisfied 133
3.2 Contract costs 136
Incremental costs of obtaining a
contract 136
Costs to fulfil a contract 137
Amortisation and impairment 137
3.3 Disclosure 138
Contracts with customers 138
Significant judgments in the application of
IFRS 15 Revenue from Contracts with
Customers 140
Assets recognised from contract costs 140
Summary 140
CONTENTS vii
 Part B: Provisions 142 Recognition rules for unused tax losses and
Introduction 142 unused tax credits 184
Scope of IAS 37 Provisions, Contingent 4.6 Recovery of tax losses 186
Liabilities and Contingent Assets 142 Reassessment of the carrying amounts of
Definition of provisions 143 deferred tax assets and liabilities 190
3.4 Recognition of provisions 143 Summary 190
3.5 Measurement of provisions 145 Part C: Special Considerations for Assets
Discounting 146 Measured at Revalued Amounts 192
3.6 IAS 37 Provisions, Contingent Liabili- Introduction 192
ties and Contingent Assets: 4.7 Assets carried at revalued amounts 192
Disclosure 147 4.8 Recognition of deferred tax on
Provisions 147 revaluation 193
Exemptions 149 Recovery of revalued assets through use or
3.7 Provisions and professional judgment 149 through sale 194
Summary 150 Additional guidance on recovery of
Part C: Contingent Liabilities and Contingent non-depreciable assets 197
Assets 151 Summary 198
Introduction 151 Part D: Financial Statement Presentation and
3.8 Contingent assets 151 Disclosure 199
3.9 Contingent liabilities 152 Introduction 199
Liabilities versus contingent liabilities 154 4.9 Presentation of current tax and
3.10 Contingencies and professional deferred tax 199
judgment 154 Offsetting tax assets and liabilities 201
Summary 155 4.10 Major components of tax expense 201
Review 155 4.11 Relationship between tax expense
References 156 (income) and accounting profit 203
Optional reading 156 4.12 Information about each type of
temporary difference 205
MODULE 4 Summary 207
Part E: Comprehensive Example 208
Income Taxes 157 Introduction 208
Preview 157 4.13 Case study: AAA Ltd 208
Part A: Income Tax Fundamentals 159 Background to AAA Ltd 209
Introduction 159 Deferred tax 209
4.1 Tax expense 160 Other deferred tax assets and
4.2 Current tax 161 liabilities 211
Calculating current tax 161 Taxable profit and current tax expense 212
Recognition of current tax 162 Illustrative disclosures 214
4.3 Deferred tax 163 Summary 215
Step 1: Determining the tax base of assets Review 215
and liabilities 166 References 216
Step 2: Compare the tax base to the
carrying amount to determine temporary
MODULE 5
differences 169
Step 3: Measure deferred tax assets and Business Combinations and
deferred tax liabilities 172
Summary 176
Group Accounting 217
Part B: Recognition of Deferred Tax Assets Preview 218
and Liabilities 178 Part A: Business Combinations 222
Introduction 178 Introduction 222
4.4 Recognition of deferred tax liabilities 178 5.1 Identifying a business combination 223
Initial recognition of goodwill arising from 5.2 The acquisition method 224
a business combination (IAS 12, (A) Identifying the acquirer 224
para. 15(a)) 178 (B) Determining the acquisition date 226
Initial recognition of other assets or liabilities (C) Recognising and measuring the
not in a business combination transaction identifiable assets acquired, the liabilities
(IAS 12, para. 15(b)) 179 assumed and any non-controlling interest
4.5 Recognition of deferred tax assets 179 in the acquiree 227
Recognition of deferred tax 183

viii CONTENTS
 (D) Recognising and measuring goodwill or
a gain from a bargain purchase 229
5.3 Applying the acquisition method
to different forms of business
combinations 233
1. Direct acquisition: purchase of assets
and liabilities of a business 233
2. Indirect acquisition: purchase of shares
(i.e. equity interests) of an entity 234
5.4 Deferred tax arising from a business
combination 235
Deferred tax related to assets and liabilities
acquired in a business combination 235
Deferred tax related to tax losses in a
business combination 236
5.5 Disclosures: business combinations 238
Summary 239
Part B: Consolidated Financial Statements 241
Introduction 241
5.6 Introduction to consolidated financial
statements 242
5.7 The group 243
Defining the group 243
Concept of control 243
5.8 Preparation of consolidated financial
statements 246
Parent with an equity interest in a
subsidiary 249
Revaluation of assets 250
Depreciation adjustments related to
revaluation of depreciable assets 252
Transactions within the group 254
Non-controlling interest 262
5.9 Disclosures: consolidated financial
statements 275
Consolidated statement of financial
position 275
Consolidated statement of profit or loss and
other comprehensive income 275
Consolidated statement of changes in
equity 276
Consolidated statement of cash flows 276
Notes including accounting policies and
explanatory notes 276
Summary 277
Part C: Investments in Associates 279
Introduction 279
5.10 Identifying associates 279
5.11 Use of equity method 280
5.12 Basis of equity method 281
5.13 Application of the equity method 283
Basic features 283
Identifying the share of the associate that
belongs to the investor 284
Recognising the initial investment at
cost 285
Recognising the dividends provided by the
associate 287
Recognising the investor’s share of the
associate post-acquisition other
comprehensive income 288
Transactions between associate and
investor (or its subsidiaries) 291
Investor’s share of losses 292
5.14 Disclosures for associates 293
Summary 294
Part D: Joint Arrangements — Overview 296
Review 297
Case studies 299
Assumed knowledge review 300
References 301
MODULE 6
Financial Instruments 302
Preview 302
Part A: What are Financial Instruments? 304
Introduction 304
6.1 Definition of a financial instrument 304
Financial assets 304
Financial liabilities 306
6.2 Liability or equity? 306
6.3 Contracts to buy or sell non-financial
items 307
6.4 Derivative financial instruments 308
Forward contracts 308
Futures contract 310
Option contract 310
Swap contracts 311
Interest rate swaps 311
Cross-currency swaps 311
Summary 312
Part B: Recognition and Derecognition of
Financial Assets and Financial
Liabilities 313
Introduction 313
6.5 Recognition of financial assets and
financial liabilities 313
6.6 Derecognition of financial assets and
financial liabilities 313
Derecognising financial assets 314
Transfers of financial assets 314
6.7 Derecognition of a financial liability 319
Summary 321
Part C: Classification of Financial Assets and
Financial Liabilities 323
Introduction 323
6.8 Classification of financial assets 323
Business model for managing financial
assets 324
Contractual cash flows that are solely
payments of principal and interest on the
principal amount outstanding 324
6.9 Classification of financial liabilities 326
Option to designate a financial liability at fair
value through profit or loss 327
CONTENTS ix
 Embedded derivatives 327
6.10 Reclassification 329
Summary 330
Part D: Measurement 331
Introduction 331
6.11 Initial measurement 331
6.12 Subsequent measurement of financial
assets 331
Impairment of financial assets carried at
amortised cost 332
Reclassification of financial assets 334
6.13 Subsequent measurement of financial
liabilities 335
6.14 Recognising gains and losses on
the subsequent measurement
of financial assets and liabilities 336
6.15 Investments in equity instruments 337
6.16 Liabilities designated at fair value
through profit or loss 338
6.17 Compound financial instruments 338
Summary 340
Part E: Hedge Accounting 342
Introduction 342
6.18 Hedging relationships 342
Hedging instruments 342
6.19 Accounting for hedging relationships 344
Types of hedges 345
6.20 Special accounting rules 353
Accounting for the time value of
options 353
6.21 Assessing hedge effectiveness 353
6.22 Discontinuing hedge relationships 354
6.23 Increased disclosures 354
Summary 354
Part F: Disclosure Issues 356
Introduction 356
6.24 Scope and level of disclosure 356
6.25 Significance of financial instruments
for financial position and
performance 356
6.26 Statement of financial position 357
6.27 Statement of profit or loss and other
comprehensive income 358
Other disclosures 359
Nature and extent of risks arising from
financial instruments 360
Credit risk 361
Liquidity risk 363
Market risk 364
Transfers of financial assets 365
Summary 365
Review 366
References 368
Optional reading 368
x CONTENTS
MODULE 7
Impairment of Assets 369
Preview 369
Part A: Impairment of Assets — an Overview 371
Introduction 371
7.1 Basic principles of impairment of
assets 371
Overview of impairment requirements 371
Why is impairment important for
users? 372
Key definitions 372
Scope of IAS 36 Impairment of Assets 373
7.2 Identifying assets that may be impaired 373
General requirements for an impairment
test 373
Specific requirements for certain intangible
assets and goodwill 374
Impairment indicators 375
Summary 377
Part B: Impairment of Individual Assets 378
Introduction 378
7.3 Measurement of recoverable amount 378
7.4 Fair value less costs of disposal 380
7.5 Value in use 381
Step 1: Estimating expected future cash
flows 381
Step 2: Determining an appropriate
discount rate 387
7.6 Recognising and measuring an
impairment loss 388
7.7 Reversals of impairment losses 389
Summary 390
Part C: Impairment of Cash-Generating Units 392
Introduction 392
7.8 Recoverable amount: individual
asset or cash-generating unit? 392
7.9 Identifying cash-generating units 393
7.10 Recoverable amount and carrying
amount of a cash-generating unit
(impairment of cash-generating units) 394
Allocating goodwill to cash-generating
units 395
Allocating corporate assets to cash
generating units 397
Impairment testing for cash-generating
units with goodwill 398
Timing of impairment tests for
cash-generating units with goodwill 398
Identifying and allocating an impairment
loss for cash-generating units with
goodwill 399
Impairment testing for intangible
assets 401
Reversal of impairment losses on
CGUs 401
Summary 402
Part D: IAS 36 Impairment of Assets— Summary 405
Disclosure 404 Review 406
Introduction 404 References 406
7.11 Disclosures of Impairment Losses and Optional reading 406
Reversals 404
7.12 Disclosures of estimates used to Appendix: Techworks Ltd 407
Glossary 452
measure recoverable amounts in
Suggested answers 458
cash-generating units 405
Index 538

CONTENTS xi
SUBJECT OUTLINE
INTRODUCTION
The purpose of this subject outline is to:
• provide important information to assist you in your studies
• define the aims, content and structure of the subject
• outline the learning materials and resources provided to support learning
• provide information about the exam and its structure.
The CPA Program is designed around five overarching learning objectives to produce future CPAs
who will:
• be technically skilled and solution driven
• be strategic leaders and business partners in a global environment
• be aware of the social impacts of accounting
• be adaptable to change
• be able to communicate and collaborate effectively.

BEFORE YOU BEGIN

Important Information
Please refer to the CPA Australia website for dates, fees, rules and regulations, and additional learning
support at www.cpaaustralia.com.au/cpaprogram.

SUBJECT DESCRIPTION
Financial Reporting
Financial Reporting is designed to provide you with financial reporting and business skills that are appli-
cable in an international professional environment. The subject is based on the International Financial
Reporting Standards (IFRSs), which are issued by the International Accounting Standards Board (IASB).
Many international jurisdictions have adopted or are progressively adopting the IFRSs.
In a competitive international environment, financial reporting provides users with information to for-
mulate corporate strategies, business plans and leadership initiatives. There is also a common acceptance of
IFRSs for communicating financial information, because they are internationally understood. This reduces
the cost of capital for the international reporting entities.
Financial reporting provides information for corporate leadership. Members of the accounting profes-
sion with financial reporting skills and knowledge provide business advice to board directors, analysts,
shareholders, creditors, colleagues and other stakeholders. Members of the accounting profession who
provide assurance services for financial reports also require a good understanding of the IFRSs. Directors
are also required to state that the financial statements are fairly stated. These examples reinforce the
importance of financial reporting. In addition to the completion of this subject, CPA Australia encourages
continuous professional learning in financial reporting, which is constantly evolving.
This subject’s technical content includes linkages with the other subjects in the CPA Program. Financial
reporting is a significant part of an entity’s governance and accountability process, issues that are covered
in the subject Ethics and Governance. Compliance with the IFRSs is important because it results in the
presentation of fairly stated financial statements. This presentation outcome is also the aim of audit and
assurance services. The assurance knowledge and audit skills are taught in the subject Advanced Audit
and Assurance. While taxation is covered in the subject Advanced Taxation, and while it is distinct from
financial reporting, the accounting for tax is recognised as material information and therefore included
in this subject. Financial reporting provides information about the business operations and the financial
results. As a result, there is a relevant topical link with the subject Contemporary Business Issues.

Subject Aims
The aims of the subject are to:
• demonstrate IFRSs requirements for the preparation of a full set of general purpose financial statements
• demonstrate IFRSs requirements for the recognition, measurement and disclosure of specific elements
of general purpose financial statements.

xii SUBJECT OUTLINE

SUBJECT OVERVIEW
General Objectives
On completion of this subject, you should be able to:
• explain the application and basis of selected IFRSs issued by the IASB
• apply IFRSs in the preparation of general purpose financial statements
• explain details relating to general purpose financial statements
• prepare general purpose financial statements for designated entities, including the exercise of profes-
sional judgment.

Module Descriptions
The subject is divided into seven modules. A brief outline of each module is provided below.
Module 1: The Role and Importance of Financial Reporting
This module considers the role and importance of financial reporting, particularly the need for gen-
eral purpose financial statements (GPFSs), and discusses the application of financial reporting in an
international context. It then discusses the role that the IASB Conceptual Framework for Financial
Reporting (Conceptual Framework) plays in financial reporting, including a discussion on the objective
and limitations of GPFSs as identified in the Conceptual Framework.
The module discusses the qualitative characteristics of financial information and the definitions,
recognition criteria and measurement of financial reporting items as outlined in the Conceptual Frame-
work. The concept of materiality and how it is applied to financial reporting is also addressed. This module
also examines the application of the measurement principles in International Financial Reporting Standards
(IFRSs) in the context of selected issues. IFRSs are developed based on the Conceptual Framework
as a consistent language for reporting that ensures that financial statements are understandable and can
be compared among entities. IFRSs are the global language of accounting standards. Measurement is
a complex and controversial aspect of accounting. In this module, alternative measurement bases are
studied, and the application of the mixed measurement model (based on cost and fair value) is examined.
Measurement issues are considered in the context of leases, employee benefits, share-based payments
and investment properties. The module also explores the importance of professional judgment in the
reporting process.
Module 2: Presentation of Financial Statements
This module covers the specific components and overall considerations that should be used when preparing
a full set of financial statements as required in IAS 1 Presentation of Financial Statements. Part A of this
module discusses events after the reporting period and briefly outlines the requirements of IAS 34 Interim
Financial Reporting and IFRS 8 Operating Segments. This module also considers IAS 8 Accounting
Policies, Changes in Accounting Estimates and Errors as preparers of financial statements must choose
accounting policies that are both relevant to decision making and reliable. Accounting policy choices
have a major influence on the results and financial position reported by an entity, and it is important for
comparability reasons that users are able to determine differences in financial performance or position,
due to the adoption of alternative accounting policies.
An important principle when preparing financial statements is that they must be prepared on the basis
of conditions in existence at the end of the reporting period. In the time between the end of the reporting
period and completion of the financial statements, events can occur that either:
• clarify or confirm conditions that existed at the end of the reporting period, or
• give rise to new conditions.
IAS 10 Events after the Reporting Period deals with how to treat these events when preparing the
financial statements. In some cases, an event after the reporting period will mean adjustments to the
financial statements are required. In other circumstances, an event after the reporting period may lead
to separate disclosure in the notes to the financial statements. Such note disclosures are necessary when
the information could influence the decisions of financial statement users.
Part B focuses on the reporting requirements of the individual financial statements that must be included
in the set of financial statements, beginning with the statement of P/L and OCI.
In relation to the statement of P/L and OCI, this module considers the requirements of IAS 1, which
specifies both:
• how an entity determines comprehensive income
• the information to be presented in the statement of P/L and OCI or in the notes to the financial statements.

SUBJECT OUTLINE xiii

 Part C discusses the statement of changes in equity, which discloses changes in each component of
equity and reconciles the opening and closing balances of the components. Changes in equity will include
comprehensive income and transactions with owners in their capacity as owners.
Part D deals with the statement of financial position. IAS 1 prescribes:
• how assets and liabilities must be presented
• how assets, liabilities and equity items must be classified
• which disclosures must be made on the face of the statement of financial position and in the notes to the
financial statements.
Finally, part E looks at the statement of cash flows, which helps users assess the entity’s ability to
generate cash flows and the timing and certainty of their generation (IAS 7, ‘Objective’). IAS 7 Statement of
Cash Flows deals with the preparation and presentation of a statement of cash flows and covers issues such
as the definition of cash and cash equivalents, classification of cash inflows and outflows, reconciliations
required and disclosure of information about cash flows.
Module 3: Revenue from Contracts with Customers; Provisions, Contingent Liabilities and Contingent
Assets
Module 3 considers IFRS 15 Revenue from Contracts with Customers as well as accounting for provisions,
contingent liabilities and contingent assets. Part A discusses the five-step model of revenue recognition
capable of general application to a variety of transactions and the required disclosures as outlined in
IFRS 15.
Part B discusses the requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
Accounting for provisions raises a number of recognition and measurement issues, particularly in relation
to the present obligation and reliable measurement criteria. Further, for provisions extending over more
than one reporting period, the issue of discounting future cash flows introduces further measurement issues,
including the appropriateness of the discount rate used.
Part C of this module discusses the recognition and measurement requirements in relation to contingent
assets and contingent liabilities. Although IAS 37 indicates that neither may be recognised in the statement
of financial position (with the exception of some contingent liabilities in a business combination), it
clarifies the nature of these potential obligations and benefits, and outlines disclosure requirements.
Overall, the main aim of IFRS 15 and IAS 37 is to ensure that the financial reporting of revenue
from contracts with customers, provisions, contingent liabilities and contingent assets is informative for
financial statement users. For example, the revenue-related disclosures under IFRS 15 provide users with
an understanding of the revenue practices of the entity. This understanding extends to how recognised
revenue is earned, at what stage of the activity the revenue is earned and when payment is typically received,
as well as to when and how remaining revenue from existing contracts will be recognised in the future.
IAS 37 ensures that appropriate recognition criteria and measurement principles are applied to provisions
recognised in financial statements. The standard also ensures that disclosures are sufficient to enable users
to understand the nature, timing and amount of provisions, contingent liabilities and contingent assets.
Module 4: Income Taxes
Module 4 begins with part A discussing the fundamentals of income tax as prescribed in IAS 12 Income
Taxes. The accounting treatment for income taxes is based on the balance sheet method, which focuses on
balance sheet items and requires consideration of the difference between the carrying amounts of those
items (as recognised in the balance sheet) and their underlying tax bases (as determined according to the
tax rates and tax laws enacted in the relevant jurisdiction). This difference gives rise to tax effects deferred
for the future, which should be recognised together with the current tax effects.
Part B examines the separate recognition rules (and limited recognition exceptions) for the recognition
of deferred tax assets and deferred tax liabilities in the financial statements.
Part C focuses on the special considerations for assets measured at revalued amounts and deals with the
recognition and measurement of deferred tax liabilities that arise from asset revaluations.
Part D illustrates the disclosure requirements that enables users of the financial statements to understand
and evaluate the impact of current tax and deferred tax on the financial position and performance of
the entity.
Part E Comprehensive example contains a comprehensive example illustrating the application of
IAS 12.

xiv SUBJECT OUTLINE

Module 5: Business Combinations and Group Accounting
The module begins by focusing on the general accounting principles and requirements applicable to IFRS 3
Business combinations where an investor acquires one or more businesses or obtains control of other
entities (i.e. establishing a parent–subsidiary relationship). IFRS 3 requires that all business combinations
within the scope of the standard, no matter the form, be accounted for using the acquisition method, which
involves the following four steps:
1. identifying the acquirer
2. determining the acquisition date
3. recognising and measuring the identifiable assets acquired, the liabilities assumed and any non-
controlling interest in the acquiree
4. recognising and measuring goodwill or a gain from a bargain purchase.
Part B of this module focuses on additional accounting requirements prescribed in IFRS 10 Consolidated
Financial Statements for those investments where the investor obtains control of other entities, giving rise
to parent–subsidiary relationships. The additional requirements addressed relate to the acquirer’s need to
prepare consolidated financial statements to show the financial performance, position and cash flows of the
acquirer/parent and the subsidiary from the perspective of the reporting entity created. The consolidated
financial statements reflect the economic impact of transactions where the economic entity as a whole
is involved with external parties, but does not include the effect of transactions within the economic
entity — because the users of financial statements need to know how well the entity is doing externally.
The accounting requirements from IFRS 3 described in part A are applicable in the preparation of the
consolidated financial statements in accordance with IFRS 10.
Part C focuses on investments where the investor obtains significant influence over the investee
(associate). It addresses two issues in accordance with IAS 28:
1. determining whether or not that relationship exists
2. specifying the requirements for applying the equity method to account for investments in associates.
Part D of this module provides a brief overview of the general principles and requirements for those
investments where the investor has joint control over a joint arrangement, distinguishing between joint
operations and joint ventures (IFRS 11).
Module 6: Financial Instruments
Module 6 examines the three accounting standards devoted to the accounting for financial instruments,
namely:
• IFRS 9 Financial Instruments — the recognition, derecognition and measurement of financial instru-
ments, including hedge accounting
• IAS 32 Financial Instruments: Presentation — the appropriate presentation of the financial instruments,
once recognised.
• IFRS 7 Financial Instruments: Disclosure — the appropriate information to disclose for both recognised
and unrecognised financial instruments.
It is not necessary to understand every aspect of these three standards. The focus of this module is
to highlight the general principles of these standards so users and preparers of financial statements have
a common frame of reference when analysing the implications of financial instruments on an entity’s
financial position, performance and long-term survival.
This module begins by defining ‘financial instruments’, and then addresses the recognition and
measurement of financial instruments. The next section discusses the appropriate presentation of financial
instruments. The module concludes with a brief review of disclosure requirements relating to financial
information.
Module 7: Impairment of Assets
This module discusses the requirements of IAS 36 Impairment of Assets, which specifically prescribes that
the carrying amount of an asset must not exceed it recoverable amount (the higher of an asset’s ‘fair value
less costs of disposal and it value in use’). IAS 36 requires an ‘impairment test’ be applied to compare an
asset’s carrying amount and its recoverable amount at a particular point in time.
Part A provides an overview of IAS 36, including the basic principles relating to the impairment of
assets and how to identify assets that may be impaired. Part B addresses the impairment of individual
assets, including (where required) the measurement of their recoverable amount. Part C considers the
impairment of groups of assets, or cash-generating units (CGUs), including how to identify CGUs and
apply the impairment requirements of IAS 36 to CGUs. Finally, in part D, the disclosure requirements of
IAS 36 are considered.

SUBJECT OUTLINE xv
Module Weightings and Study Time Requirements
Total hours of study for this subject will vary depending on your prior knowledge and experience of the
course content, your individual learning pace and style, and the degree to which your work commitments
allow you to work intensively or intermittently on the materials. You will need to work systematically
through the study guide and readings, attempt all the questions, and revise the learning materials for the
exam. The workload for this subject is the equivalent of that for a one-semester postgraduate unit.
An estimated 15 hours of study per week through the semester will be required for an average candidate.
Additional time may be required for revision. The ‘Weighting’ column in the following table provides an
indication of the emphasis placed on each module in the exam, while the ‘Recommended proportion of
study time’ column is a guide for you to allocate your study time for each module.
Do not underestimate the amount of time it will take to complete the subject.

TABLE 1 Module weightings and study time

Recommended
proportion of study time Weighting
Module (%) (%)

1. The Role and Importance of Financial Reporting 10 10

2. Presentation of Financial Statements 14 14

3. Revenue from Contracts with Customers; Provisions,

Contingent Liabilities and Contingent Assets 10 10

4. Income Taxes 18 18

5. Business Combinations and Group Accounting 24 24

6. Financial Instruments 14 14

7. Impairment of Assets 10 10

Exam Structure
The Financial Reporting exam is three hours and 15 minutes in duration and comprises multiple-choice and
short-answer questions. Multiple-choice questions include knowledge, application and problem-solving
questions that are designed to assess understanding of Financial Reporting principles. Short-answer
questions focus on the application of concepts and theories from the subject study materials to solve a
given problem.

LEARNING MATERIALS
Module Structure
These study materials form your central reference in the Financial Reporting subject. Where advised,
relevant sections of the CPA Australia Members’ Handbook and legislation are also examinable.
Learning Objectives
A set of objectives is included for each module in the study guide. These objectives provide a framework
for the learning materials and identify the main focus of the module. The objectives also describe what
candidates should be able to do after completing the module.
Assumed Knowledge
The assumed knowledge section will inform you of any prerequisite knowledge required.
Teaching Materials
The teaching materials will inform you of any additional resources and readings to be referred to in
conjunction with the module. Any material that is listed under ‘Readings’ in this section will be
examinable. Any readings that are listed as ‘optional’ will not be examined; they are provided if you
wish to explore a particular topic in more detail.
Preview
The preview outlines what will be covered in the module and how it relates to other modules in the subject.

xvi SUBJECT OUTLINE

Study Material
The study material is divided into parts and sections that will help you conceptualise the content and study
it in manageable portions. It is also important to appreciate the cumulative nature of the subject and to
follow the given sequence as closely as possible.
Case Study
Case study data and questions are included throughout the modules to help you apply theoretical knowledge
to real-life scenarios, requiring a deep understanding of the module content.
Examples
Examples are included throughout the study materials to demonstrate how concepts are applied to real-
world scenarios.
Explore Further
Explore further provides further information about topics that can be studied in more detail.
Study Material Activities
Question activities are included throughout the study materials to provide you with the opportunity, as you
progress through the subject, to assess your understanding of significant points and to stimulate further
thinking on particular issues. These questions are an integral part of your study and they should be fully
utilised to support your learning of the module content throughout the semester.
Completing the question activities should also form one part of your revision for the exam. It is evident
that candidates who achieve good results in the program and in their careers are those who are able to
think, review and analyse situations, and solve problems. The question activities will assist you to develop
these skills.
The question activities in the study materials are numbered and require you to prepare answers and
to compare those answers with the suggested answers at the end of the study guide. They test your
comprehension of specific sections of a module and provide immediate feedback on your performance
in comprehending the materials covered. Your answers to these questions do not contribute to your final
result, and you are not required to submit your answers for marking.
Summary
Each part features a Summary of the relevance to business of the concepts presented.
Key Points
The key points feature provides a Summary of the main learning objectives covered in the part and details
the relevant content in this regard.
Review
The review section places the module in context of the other modules studied and summarises the main
points.
References
The reference list details all sources cited in the study guide. You are not expected to follow up this source
material.
Suggested Answers
These are located at the end of the study guide and provide important feedback on the numbered revision
questions included in the module learning materials. Consider them as model answers for your reference.
To assess how well you have understood and applied the material supplied in the text, it is important to
write your answer before you compare it with the suggested answer.

My Online Learning and your eBook

My Online Learning is CPA Australia’s online learning platform, which provides you with access to a
variety of resources to help you with your study. We suggest you view the video ‘Insights for a great
semester of study’ on My Online Learning, which will provide you with some insights on how to plan
your semester. It will also take you on a guided tour of My Online Learning to show you how (and when)
to access the range of resources available.
You will find a wide range of subject-level and module-level resources on My Online Learning. Subject-
level resources are those that apply to the entire subject. These resources can be used at any time but

SUBJECT OUTLINE xvii

are most useful when you’ve completed all the modules for the entire subject — whereas module-level
resources should be used while you work through a particular module in the study guide.
You should refer to the journey map located on My Online Learning to see what module resources you
can access and in what order you should use them.
You can access My Online Learning from the CPA Australia website: cpaaustralia.com.au/
myonlinelearning.
Help Desk
For help when accessing My Online Learning, either:
• email MemberServices@cpaaustralia.com.au, or
• telephone 1300 73 73 73 (Australia) or +61 3 9606 9677 (international) between 8.30 am and 5.00 pm
(AEST) Monday to Friday during the semester.
eBook
An interactive eBook version of the study guide will be available through My Online Learning. The eBook
contains the full study guide and features instructional media and interactive questions embedded at the
point of learning. The media content includes animations of key diagrams from the study guide and video
interviews with leading business practitioners.

IFRS Compilation Handbook

Throughout this subject, we mostly apply the accounting standards, interpretations, supporting documents
as well as the Conceptual Framework for Financial Reporting as presented in the 2019 IFRS Standards
(Red Book) issued on 1 January 2019 and at times the more current version of the IFRS Standards,
interpretations, and the supporting documents.
All the relevant extracts from the IFRSs that are required for your study and exam purposes are presented
in this study guide. It is not compulsory to access, print or buy the IFRSs for your study or exam. If you
would like to explore the standards in more detail, you may consult the digital copy of the relevant IFRSs
provided on My Online Learning as the IFRS Compilation Handbook. All the relevant standards that have
been applied in this Study Guide have been collated in the IFRS Compilation Handbook. You are advised
against viewing the IFRSs from other sources.
CPA Australia encourages you to access the IASB’s website regularly, as it contains many relevant
resources for continuing professional development. However, the IFRSs on the IASB’s website may not
be aligned with the version of the IFRSs used for your study materials, due to frequent amendments to the
standards. You will be examined on the version of the standards used in this study guide, which are aligned
with IFRS Compilation Handbook provided on My Online Learning.
The IFRS Compilation Handbook is presented as a compilation and combination of the two parts
(outlined below) of the IFRS Red Book.
• Part A includes the Conceptual Framework, as well as all of the accounting standards and interpretations.
• Part B includes all of the supporting documents for the Conceptual Framework, accounting standards
and interpretations. These supporting documents include the basis of conclusions and, for some
accounting standards, the dissenting opinions, implementation guidance, details of amendments and
impacts on other accounting standards illustrative examples.
Rounding
In this subject, the questions and examples are sometimes rounded to the nearest dollar or thousands of
dollars. In financial reporting, rounding is used in preparing financial statements, but any requirement to
round is jurisdiction-specific and is not a requirement of the IFRSs. In this subject, where decimal places
are used, all rounding should be to two decimal places unless otherwise stated.

GENERAL EXAM INFORMATION

The Financial Reporting exam is three hours and 15 minutes in duration.
The Study guide is your central examinable resource. Where advised, relevant sections of the CPA
Australia Members’ Handbook and legislation are also examinable.
For information on what you can take into your exam, as well as your exam structure and mark
allocations, please refer to ‘Study Companion and Exam Mark Allocations’ in My Online Learning.

xviii SUBJECT OUTLINE

MODULE 1

THE ROLE AND

IMPORTANCE OF
FINANCIAL REPORTING
LEARNING OBJECTIVES

After completing this module, you should be able to:

1.1 explain the role and importance of financial reporting
1.2 explain the role of the IASB Conceptual Framework in financial reporting and accounting standards
1.3 describe the objective and limitations of general purpose financial reporting as identified in the Conceptual
Framework
1.4 explain the definitions of the elements of financial statements and recognition criteria adopted by the
Conceptual Framework
1.5 explain the application of the standards to the financial reporting process and apply specific standards
1.6 discuss and demonstrate the importance of professional judgment in the financial reporting process
1.7 explain the implications of using cost and fair value accounting
1.8 explain how materiality is assessed and determine the materiality of transactions.

ASSUMED KNOWLEDGE

It is assumed that, before commencing your study in this module, you are able to:
• explain the four primary financial statements, including their purpose and interrelationship
• prepare each of the four primary financial statements using the accrual method of accounting
• read and interpret International Financial Reporting Standards (IFRSs).

TEACHING MATERIALS

International Financial Reporting Standards (IFRSs), with a particular focus on the IASB Conceptual Framework
for Financial Reporting:
• IASB Conceptual Framework for Financial Reporting (2018)
• IFRS 2 Share-based Payment
• IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
• IFRS 9 Financial Instruments
• IFRS 13 Fair Value Measurement
• IFRS 16 Leases
• IAS 1 Presentation of Financial Statements
• IAS 2 Inventories
• IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
• IAS 16 Property, Plant and Equipment
• IAS 19 Employee Benefits
• IAS 36 Impairment of Assets
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets
• IAS 40 Investment Property
PREVIEW
Financial reporting is the process of documenting an entity’s financial status in the form of financial
reports/statements. The entity uses the prepared financial reports as a communication tool to assist users
with their decision making. There is a broad range of users, including shareholders, banks and other
creditors, competitors, employees and financial analysts — and they may have different information needs.
Therefore, to assist users in their decision making, it is critical that financial statements are prepared in
accordance with a financial reporting framework that recognises and endeavours to satisfy the needs of
these users.
This module considers the role and importance of financial reporting, particularly the need for
general purpose financial statements (GPFSs), and discusses the application of financial reporting in
an international context. It then discusses the role that the IASB Conceptual Framework for Financial
Reporting (Conceptual Framework) plays in financial reporting, including a discussion on the objective
and limitations of GPFSs as identified in the Conceptual Framework.
The module discusses the qualitative characteristics of financial information and the definitions, recog-
nition criteria and measurement of financial reporting items as outlined in the Conceptual Framework.
The concept of materiality and how it is applied to financial reporting is also addressed. This module also
examines the application of the measurement principles in International Financial Reporting Standards
(IFRSs) in the context of selected issues. IFRSs are developed based on the Conceptual Framework
as a consistent language for reporting that ensures that financial statements are understandable and can
be compared among entities. IFRSs are the global language of accounting standards. Measurement is
a complex and controversial aspect of accounting. In this module, alternative measurement bases are
studied, and the application of the mixed measurement model (based on cost and fair value) is examined.
Measurement issues are considered in the context of leases, employee benefits, share-based payments
and investment properties. The module also explores the importance of professional judgment in the
reporting process.

1.1 THE ROLE AND IMPORTANCE OF FINANCIAL

REPORTING
Financial reporting is a process that provides entities with an important communication tool to reach
out to external stakeholders (users) interested in their financial information for decision making. That
communication tool is represented by the general purpose financial statements prepared in accordance
with the Conceptual Framework and the accounting standards developed based on the framework. These
financial statements provide users with financial information about the entity, including its financial
position, financial performance and cash flows.

THE ROLE OF FINANCIAL REPORTING

The role of financial reporting is to provide users with information to enable them to achieve effective
decision making. It also provides a stewardship or accountability role by requiring managers to give an
account of how they have used the resources provided by those users. The stewardship role is particularly
important when there is a separation between ownership and management in an entity.
Effective financial reporting communicates the ‘story’ of the entity during the period so that the users
can understand what the entity has achieved and how it has achieved it. Improving the communication
effectiveness of financial statements is one of the central themes of the IASB’s standard-setting work
(IFRS Foundation 2016a).
The objective of general purpose financial reporting is to provide financial information about the
reporting entity that is useful to its primary users for making decisions about providing resources to the
entity. These decisions include:
• buying, selling or holding equity and debt instruments;
• providing or settling loans and other forms of credit; or
• exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the
entity’s resources (Conceptual Framework, para. 1.2).

Identification of the primary users of financial reports is crucial in determining the information that
should be disseminated through the financial reports to effectively satisfy their decision-making needs.

2 Financial Reporting
The IASB identifies primary users as those that provide equity or debt finance to the entity. Specifically,
the primary users of an entity’s financial information are existing and potential investors, lenders and other
creditors that must rely on general purpose financial reports for much of the information they need as they
may be unable to command information from an entity directly. (Conceptual Framework, paras 1.2 and
1.5). General purpose financial reports are directed to those primary users to provide information about
the economic resources of the entity, claims against the entity, and changes in those resources and claims,
which is necessary for these users to assess the entity for their decision making (Conceptual Framework,
para. 1.4).
Financial reports provide information about an entity’s financial position at a point in time. They also
provide information about an entity’s financial performance as a result of transactions and other events that
change the financial position during a reporting period (Conceptual Framework, paras 1.12–1.16). More
specifically, the statement of financial position (or balance sheet) provides information about the financial
position (i.e. the assets, liabilities and equity) of the entity at a point in time. The statement of profit or
loss and other comprehensive income (the statement of P/L and OCI) (also referred to as the ‘statement
of financial performance’ or just ‘profit or loss statement’) reports on the financial performance (i.e. the
income, expenses and profitability) for a reporting period on an accrual basis. The statement of cash flows
reports on the cash inflows and outflows of the entity for a reporting period on a cash basis. Changes
in the net assets, or equity, are reported in the statement of changes in equity. All individual financial
reports are prepared by an entity as at a particular point in time or for a particular reporting period, but the
presentation of financial reports is prescribed to ensure that they are comparable with the entity’s previous
financial statements and with the financial statements of other entities (IAS 1, para. 1).
Financial reporting via general purpose financial statements should not be seen as the only way for an
entity to communicate to external users. Other types of reporting, including investor updates, sustainability
reporting, corporate governance reporting and other prospective, or forward-looking, information, should
be considered as well. For example, when an entity is intending to list on a stock exchange, it would
normally be required to provide some forward-looking information to potential investors to help them
make their investment decision.
Technology advancements provide opportunities for various other methods of information dissemination
that, together with financial reporting via GPFSs, can be incorporated into a whole suite of reporting tools
to properly and efficiently address the information needs of users.

THE IMPORTANCE OF FINANCIAL REPORTING

Financial reporting is important because of the often significant level of resources under the responsibility
of managers and the financial impact of the decisions that users make from relying on the information pro-
vided in financial reports. This importance is reflected in company regulators and stock exchanges around
the world requiring financial statements to be prepared by entities as part of their reporting obligations.
The types of decisions that financial statements might be used for are highlighted in figure 1.1.

FIGURE 1.1 Financial statement user decisions

Shareholders Competitors

Should I invest money How has the company

in the company? performed in
comparison to its
competitors?

Suppliers Banks

Should I sell goods Should I lend money

to the company? to the company?

Source: CPA Australia 2019.

MODULE 1 The Role and Importance of Financial Reporting 3

Information Needs of the User
As previously mentioned, the primary users of financial information are existing and potential investors,
lenders and other creditors (Conceptual Framework, para. 1.5). Management of an entity also require
financial information for decision making, but they can obtain whatever information they need internally
and do not need to rely on general purpose financial reports (Conceptual Framework, para. 1.9). Other
users of financial information include regulators and members of the public, such as community groups
and potential employees; however, general purpose financial reports are not primarily directed to these
users (Conceptual Framework, para. 1.10). In the Conceptual Framework, it is the primary users that are
the focus of general purposes financial reports. Entities are required to prepare general purpose financial
reports specifically to assist their primary users in their decision making. However, the decisions facing
the primary users may give rise to varying or even conflicting information needs.
Consider, for example, lenders as users of financial statements. Lenders are interested in making an
assessment of an entity’s capacity to meet its interest and principal repayment obligations and the level
of risk associated with a loan. As investors invest equity, they are also interested in the assessment of risk
and the ability of the entity to service its debt, so that the entity can continue its operations and provide a
return to investors.
These varying information needs and the resulting information demands may give rise to different
preferences for the measurement of assets or the timing of the recognition of revenue. For example, lenders
may prefer a measure of the net realisable value of certain assets provided as security to assess whether
the security is sufficient in the event that the entity defaults on repayment. However, investors may prefer
measurement of those assets based on their value in use, which provides a better indication of the expected
benefits to be derived from the continued use of the assets.
The IASB’s approach to resolving conflicting user information needs is to provide the information
that will meet ‘the needs of the maximum number of primary users’ (Conceptual Framework, para. 1.8).
However, according to the IASB, focusing on common information needs does not prevent an entity from
providing additional information that may be useful to another sub-group of primary users (Conceptual
Framework, para. 1.8). It should also be noted that trying to meet the needs of the maximum number of
primary users may have different implications depending on the context. For example, for some entities,
investors may be the largest group of primary users, but for other entities, the largest group of primary
users may be lenders.
Conflicting information needs are shown in figure 1.2. The grey shaded area represents the common
information needs of the primary user groups. Conflict arises where the information needs do not overlap
(the navy shaded areas) or where the information needs of only two user groups are shared (the gold shaded
areas). The navy and gold shaded areas depict differing information needs, where choices made by standard
setters and preparers may result in the needs of some primary users being met at the expense of the needs
of other primary users.

FIGURE 1.2 Maximising the number of primary users whose information needs are met

Investors Lenders

Other creditors

Source: Adapted from IFRS Foundation 2019e, Conceptual Framework for Financial Reporting, paras 1.5–1.8, in IFRS Standards
issued at 1 January 2019, IFRS Foundation, London, p. A18. © CPA Australia 2019.

4 Financial Reporting
 QUESTION 1.1

According to the Conceptual Framework, who are the primary users of general purpose financial
reports, and why do you think they are regarded as the primary users?

QUESTION 1.2

Consider the following statement:

By focusing on the information needs of investors, lenders and other creditors, financial
reporting will not be useful for other users.

Do you agree or disagree? Give reasons for your answer.

UNDERSTANDING THE INTERNATIONAL FINANCIAL

REPORTING STANDARDS
In this module, the terms ‘financial reports’ and ‘financial reporting’ refer to general purpose financial
reports and general purpose financial reporting unless otherwise noted. GPFSs such as the statement
of P/L and OCI, statement of financial position, statement of changes in equity, and the statement of
cash flows and the notes make up the body of general purpose financial reports that are prepared for
external users.
The information included in GPFSs must comply with the International Financial Reporting Standards
(IFRSs) and achieve fair presentation in accordance with the definition and recognition criteria in the
Conceptual Framework. The Conceptual Framework is not a standard itself; therefore, it will not override
any IFRSs. If a conflict is identified between provisions of an IFRS and the Conceptual Framework, the
IFRS will take precedence. If any new provisions in the IFRSs depart from the Conceptual Framework,
the IASB will explain the departure in the Basis for Conclusions of the relevant standard. The IFRSs
are ‘an internationally recognised set of accounting standards that bring transparency, accountability and
efficiency to financial markets around the world’ (IFRS Foundation 2017a). IFRSs are used by most
publicly listed companies in over 140 jurisdictions. The Australian Accounting Standards Board adopted
the IFRSs for Australian entities required to report under the Corporations Act 2001 (Cwlth) (Corporations
Act) for annual reporting periods beginning on or after 1 January 2005.
There are two series of international accounting standards. The first series, the International Accounting
Standards (IASs), are those standards issued from 1973 to 2001, before the new International Accounting
Standards Board (IASB) was formed. The second series, the International Financial Reporting Standards
(IFRSs), are those standards issued under the IASB since 2001 and reflect the changes in accounting and
business practices since that date. Some IASs are still relevant today and have therefore remained under
their original IAS heading. An example is IAS 1 Presentation of Financial Statements.
AASB standards (AASBs) are the accounting standards developed by the Australian Accounting
Standards Board for all economic sectors in Australia. A specific numbering system has been used for the
AASBs to identify their connection to the international accounting standards. AASB standards numbered
by using one or two digits (from 1 to 99) are the equivalent of IFRSs. AASB standards numbered by using
three digits (from 101 to 999) are the equivalent of IASs; and AASB standards numbered with four digits
(from 1001 onwards) have no international equivalent (AASB 2019a). The AASBs, whilst complying with
the IFRSs, include additional paragraphs where reporting requirements differ for specific economic entities
such as Australian not-for-profit entities. These paragraphs have the prefix ‘AUS’ or ‘RDR’ (Reduced
Disclosure Requirements) and generally begin with words that highlight their limited applicability. For
example: ‘Notwithstanding paragraphs xx, in respect of not-for-profit entities . . . ’.
Each standard includes a statement at the beginning referring to its structure, main principles and terms,
and the context in which the standard should be read. Example 1.1 shows this statement as is included at
the beginning of IFRS 16 Leases.

MODULE 1 The Role and Importance of Financial Reporting 5

 EXAMPLE 1.1

Statement from IFRS 16 Leases

International Financial Reporting Standard 16 Leases (IFRS 16) is set out in paragraphs 1–103 and
Appendices A–D. All the paragraphs have equal authority. Paragraphs in bold type state the main
principles. Terms defined in Appendix A are in italics the first time that they appear in the Standard.
Definitions of other terms are given in the Glossary for International Financial Reporting Standards. The
Standard should be read in the context of its objective and the Basis for Conclusions, the Preface to IFRS
Standards and the Conceptual Framework for Financial Reporting. IAS 8 Accounting Policies, Changes
in Accounting Estimates and Errors provides a basis for selecting and applying accounting policies in the
absence of explicit guidance.
Source: IFRS Foundation 2019e, IFRS 16 Leases, in IFRS Standards issued at 1 January 2019, IFRS Foundation, London,
p. A801.

Each standard begins with statements on its Objective and Scope and includes a section for its Effective
Date (ED) and whether earlier adoption is permitted. Additional sections such as the Basis for Conclusions
(BC) and the Illustrative Examples (IE) accompany the standard but are not considered to be a part of the
standard. The BC section provides detailed explanations of the IASB’s considerations when developing
and/or updating the standard. The IE section is included for those standards requiring practical explanations
and may provide examples to demonstrate the application of the main principles of the standard. The IEs
are not meant to represent the only application of a particular aspect and are not intended to be industry-
specific. Example 1.2 is taken from the Illustrative Examples section of IFRS 16 Leases — it is Example 5
from that standard which works through identifying whether or not a lease exists for a truck rental contract.
When a member (or members) of the IASB does not approve the publication of a standard, that standard
will include a section called Dissenting Opinion (DO) which states the reasons for any member objections.

EXAMPLE 1.2

IFRS 16 Leases, Illustrative Example 5 — Truck Rental

Customer enters into a contract with Supplier for the use of a truck for one week to transport cargo
from New York to San Francisco. Supplier does not have substitution rights. Only cargo specified in the
contract is permitted to be transported on this truck for the period of the contract. The contract specifies
a maximum distance that the truck can be driven. Customer is able to choose the details of the journey
(speed, route, rest stops, etc.) within the parameters of the contract. Customer does not have the right to
continue using the truck after the specified trip is complete.
The cargo to be transported, and the timing and location of pick-up in New York and delivery in
San Francisco, are specified in the contract.
Customer is responsible for driving the truck from New York to San Francisco.
The contract contains a lease of a truck. Customer has the right to use the truck for the duration of the
specified trip.
There is an identified asset. The truck is explicitly specified in the contract, and Supplier does not have
the right to substitute the truck.
Customer has the right to control the use of the truck throughout the period of use because:
(a) Customer has the right to obtain substantially all of the economic benefits from use of the truck over
the period of use. Customer has exclusive use of the truck throughout the period of use.
(b) Customer has the right to direct the use of the truck because the conditions in B24(b)(i) exist. How and
for what purpose the truck will be used (i.e. the transportation of specified cargo from New York to
San Francisco within a specified timeframe) is predetermined in the contract. Customer directs the
use of the truck because it has the right to operate the truck (for example, speed, route, rest stops)
throughout the period of use. Customer makes all of the decisions about the use of the truck that can
be made during the period of use through its control of the operations of the truck.
Because the duration of the contract is one week, this lease meets the definition of a short-term lease.
Source: IFRS Foundation 2019e, IFRS 16 Leases, in IFRS Standards issued at 1 January 2019, IFRS Foundation, London,
p. B421.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, refer to IFRS 16 Leases, reading from the title page up to and including
paragraphs 1–4 of the standard. You may also refer to IFRS 16 IE section for further illustrative examples on the
application of the standard.

6 Financial Reporting
INTERACTION BETWEEN FINANCIAL REPORTING
AND THE REGULATORY ENVIRONMENT — WHO MUST
PREPARE GENERAL PURPOSE FINANCIAL REPORTS?
International Accounting Standards Board
General purpose financial reporting applies to reporting entities. The question of who must prepare general
purpose financial reports is a matter for governments and regulatory agencies of each jurisdiction that
adopts IFRS to decide. The Conceptual Framework therefore sets out a general definition of a reporting
entity at paragraph 3.10 as follows.
A reporting entity is an entity that is required, or chooses, to prepare financial statements. A reporting entity
can be a single entity or a portion of an entity or can comprise more than one entity. A reporting entity is
not necessarily a legal entity.

The IFRSs do not further clarify who must prepare general purpose financial reports. In jurisdictions
adopting IFRSs, legislation and other regulatory requirements usually require general purpose financial
reports from entities that have issued debt or equity securities traded in a public market. The IASB does
not, however, limit general purpose financial reporting to these entities. In this regard, the Conceptual
Framework indicates that a reporting entity can be any entity that has existing and potential investors,
lenders and other creditors who must rely on general purpose financial reports for much of the information
they need to make decisions about providing resources to the entity.
A reporting entity can be a for-profit entity or a not-for-profit entity. A reporting entity can operate in
the private sector or the public sector. Examples of for-profit private sector entities include companies,
partnership, and trading trusts. Examples of not-for-profit entities include registered clubs, associations,
charities and government departments. A reporting entity can be one entity or a group of entities comprising
a parent and its subsidiaries (Conceptual Framework, para. 3.11).
Whilst the IFRSs and the Conceptual Framework are also applied in the not-for-profit sector in some
jurisdictions, emphasis throughout this subject is generally on for-profit private sector entities whose equity
and/or debt securities are publicly listed in financial markets.

Australian Accounting Standards Board

In Australia, for-profit private sector entities are subject to the Conceptual Framework and must prepare
general purpose financial reports when they satisfy both of the following conditions:
1. they have public accountability (as defined in AASB 1053, Appendix A and B); and
2. they are required by legislation to comply with Australian Accounting Standards.
Other for-profit private sector entities may nonetheless elect to apply the Conceptual Framework and
prepare general purpose financial reports (AASB Conceptual Framework, para. Aus1.1).
Public Accountability
A for-profit private sector entity has public accountability if:
• it has debt or equity instruments (i.e. securities) that are traded in a public market or it in the process of
issuing securities for such trading; or
• ‘it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses’,
for example, banks, insurance companies, securities brokers/dealers and mutual funds (AASB 1053,
Appendix A).
Legislation
Part 2M.3 (Financial Reporting) of the Corporations Act requires an entity that is a disclosing entity,
public company, large proprietary company or registered scheme to prepare an annual financial report
(s. 292). The financial report must comply with Australian Accounting Standards when they are
applicable (s. 296).
A disclosing entity is an entity with enhanced disclosure securities on issue, which is similar to the
notion of public accountability (s. 111AC). A proprietary company is usually limited by shares and can
have no more than 50 shareholders. A large proprietary company is based on qualifying for two out of three
size thresholds for revenue, gross assets and number of employees (s. 45A). For financial years beginning
from 1 July 2019, the thresholds are revenue of $50 million or more, gross assets of $25 million or more,
and employees of 100 or more. A public company is a company other than a proprietary company (s. 9).

MODULE 1 The Role and Importance of Financial Reporting 7

 The financial reporting obligations of other types of entities are included in other federal or state-
based legislation. For example, for associations, the appropriate legislation is the relevant state-based
Incorporated Associations Act.
Two Tiers of General Purpose Financial Reporting
The Australian Accounting Standards Board has a two-tier model of general purpose financial reporting.
The two tiers are as follows (refer AASB 1053, para. 7; and AASB 2019b).
(a) Tier 1: Australian Accounting Standards; and
(b) Tier 2: Australian Accounting Standards — Reduced Disclosure Requirements.
Tier 1 general purpose financial reporting means an entity must satisfy all the recognition, measurement
and disclosure requirements in Australian Accounting Standards, which incorporates IFRSs (AASB 1053,
para. 8). Tier 1 applies to for-profit private sector entities with public accountability and Australian
Governments either at the federal, state, territory or local level (AASB 1053, para. 11).
Tier 2 general purpose financial reporting means an entity must satisfy all the recognition and mea-
surement requirements in Australian Accounting Standards but has substantially reduced disclosure
requirements (RDR) relative to Tier 1 (AASB 1053, para. 9). An example of RDR is the omission of
the requirement for disclosure of audit fees (AASB 1054, para. 10). Other examples of RDR relate
to accounting standards disclosures for financial instruments, income tax, and related parties (refer
AASB 112, para. 82; AASB 124, para.17; AASB 7, para. 9).
Tier 2 applies to entities in respect of which it is reasonable to expect the existence of users dependent on
general purpose financial reports for information which will be useful to them for making and evaluating
decisions about the allocation of scarce resources (AASB 1053, Appendix A, definition of reporting entity).
RDR is available to a wide range of entities that are required to prepare general purpose financial
statements in both the private and public sectors (refer AASB 1053, para. 13; AASB 2019c):
(a) for-profit private sector entities that do not have public accountability;
(b) not-for-profit private sector entities; and
(c) public sector entities . . . other than the Australian Government and State, Territory and Local
Governments.
Notwithstanding that RDR is available to an entity required to prepare a general purpose financial report,
it may still elect to apply Tier 1 and the full requirements of Australian Accounting Standards.
Refer to Note 1 ‘Summary of significant accounting policies’ in the notes to financial statements of
Techworks Ltd (see appendix). What type of financial statements have been prepared by Techworks Ltd?
What factors might explain the type of financial statements that have been prepared?
External Reporting Board of New Zealand
The External Reporting Board (XRB) of New Zealand also has a multi-tiered accounting standards frame-
work in which the nature of the entity determines the level of disclosure and compliance requirements.
Entities are categorised as either ‘for-profit’ entities or ‘public-benefit’ (not-for-profit) entities. Then
entities are subclassified based on whether they are publicly accountable for their financial reports, and/or
their size. This multi-tiered approach is summarised in table 1.1.

TABLE 1.1 External Reporting Board Accounting Standards Framework tiered approach

For-profit entities Public benefit entities

Accounting Accounting
Entities Standards Entities Standards

Tier 1 Publicly accountable NZ IFRS Publicly accountable PBE Standards

(as defined); or (as defined); or
Large (as defined) Large (as defined)
for-profit public
sector entities

Tier 2 Non-publicly NZ IFRS Reduced Non-publicly PBE Standards

accountable and non- Disclosure Regime accountable Reduced Disclosure
large for-profit public (NZ IFRS RDR) (as defined) and non- Regime (PBE
sector entities which large (as defined) Standards RDR)
elect to be in Tier 2 which elect to
be in Tier 2

8 Financial Reporting
 Tier 3 Non-publicly PBE Simple Format
accountable Reporting
(as defined) with Standard —
expenses ≤ $2 million Accrual (SFR-A)
which elect to be
in Tier 3

Tier 4 Entities allowed by PBE Simple Format

law to use cash Reporting
accounting which Standard —
elect to be in Tier 4 Cash (SFR-C)

Source: External Reporting Board (New Zealand) 2019, ‘Accounting standards framework: Overview’, accessed May 2019,
https://www.xrb.govt.nz/why-report/accounting-standards-framework.

Relevant legislation in New Zealand includes the Financial Markets Conduct Act 2013 (the FMC Act)
and the Financial Reporting Act 2013. The New Zealand definition of publicly accountable is similar to
the definition used in Australia, except that the Financial Markets Authority may also deem an entity to
be publicly accountable (s. 461K and s. 461L). A for-profit public sector entity will meet the definition
of large if it has total expenses of more than $30 million. For-profit private sector entities are defined as
large if they have total assets of greater than $60 million or revenue exceeding $30 million and therefore,
must prepare general purpose financial reports. These companies may elect to apply Tier 2 if they are not
publicly accountable.

Other Jurisdictions
In other jurisdictions, the appropriate legislation includes the Singapore Companies Act (Chapter 50)
2006 (Singapore) and the Companies Act 2016 (Malaysia). This legislation will specify the content
of the financial statements, the regularity of reporting and the basis on which the financial statements
are prepared.
Not all entities from jurisdictions that adopted IFRSs are required to prepare financial reports in
accordance with the IFRSs. An entity may use alternative bases for accounting if this is required or
permitted. For example, in Malaysia, eligible private entities comply with the Malaysian Private Entities
Reporting Standard (MPERS) rather than with the IFRSs. Alternatively, an entity that is not required to
report separately in accordance with the IFRSs may still need to provide information that must comply
with the IFRSs to a parent entity for inclusion in a set of consolidated financial statements. This module
and this subject will only address an entity’s obligations under the IFRSs.

INTERNATIONAL INITIATIVES TO DECREASE FINANCIAL

REPORTING COMPLEXITY
An ongoing criticism of financial reporting is the complexity of financial reports. Improving the commu-
nication effectiveness of disclosures in financial statements is a current focus of many accounting setters,
including the IASB (IFRS Foundation 2019b), and there are a growing number of initiatives to help combat
the issue, including:
• reducing differences in reporting standards among countries
• reducing reporting requirements of small and medium-sized entities
• catering to the information needs of multiple stakeholders
• improving the content and structure of the primary financial statements
• clarifying disclosure requirements and improving the usefulness of disclosures
• improving understanding of the existing requirements and helping entities make better materiality
judgments
• considering how management commentary outside the financial statements could better complement
and support the financial statements
• improving communication between preparers and users by enabling information to be delivered in an
electronic format.
IASB and other standard setters across the world made significant progress on the first three initiatives
listed — the following section provides further details.

MODULE 1 The Role and Importance of Financial Reporting 9

Reducing Differences in Reporting Standards Among Countries
Overall, the complexity in financial reporting has decreased due to increased acceptance of the IFRSs in
many parts of the world. More than 140 jurisdictions worldwide require the use of the IFRSs for their
publicly listed companies (IFRS Foundation 2019b).
The global acceptance of the IFRSs led to the commitment of the US Financial Accounting Standards
Board (FASB) to work with the IASB to explore the possibilities of the convergence of US Generally
Accepted Accounting Principles (GAAP) with the IFRSs. In 2007, the US Securities and Exchange
Commission (SEC) eliminated the requirement for foreign companies registered with the US SEC to
reconcile their IFRS-based financial statements to US GAAP. However, the US SEC does not permit
domestic issuers to adopt the IFRSs (SEC 2007).

Reducing Reporting Requirements of Small and Medium-sized Entities

The complexity of the full IFRSs led the IASB and accounting standards-setting bodies to specify less
complex standards for some entities. Examples of such reductions are as follows.
International Accounting Standards Board
To reduce the complexity of following the full IFRSs for small and medium-sized entities (SMEs), the
IASB has introduced the IFRS for SMEs. The IFRS for SMEs is described as being less complex than the
‘full’ IFRSs because:
• topics not relevant to SMEs, such as earnings per share, interim financial reporting and segment
reporting, are omitted
• many principles for recognising and measuring assets, liabilities, income and expenses in the full IFRSs
are simplified — for example, amortising goodwill; expensing all borrowings and development costs;
allowing the cost model for associates and jointly controlled entities; and providing undue cost or effort
exemptions for specific requirements
• significantly fewer disclosures are required (about a 90% reduction)
• the standards are written in clear, easily understandable language.
To further reduce the burden on SMEs, revisions to these standards are expected to be limited to once
every three years (IFRS Foundation 2019c).
Australian Accounting Standards Board
The AASB has not adopted IFRS’s for SMEs to date. In Australia, for-profit private sector entities may
prepare special purpose financial reports rather than GPFSs if they do not have public accountability or
meet the AASB 1053 definition of a reporting entity. Special purpose financial statements (SPFSs) are
prepared and presented in accordance with the specific information needs of the entity’s financial statement
users. In the case of a company with one shareholder that also provides debt finance to the company,
management may prepare SPFSs that dispense with many of the recognition, measurement and disclosure
requirements of Australian Accounting Standards.
An entity that lodges SPFSs with the Australian Securities and Investments Commission (ASIC) must
ensure that they comply with a minimum set of Australian Accounting Standards as follows.
• AASB 101 Presentation of Financial Statements
• AASB 107 Statement of Cash Flows
• AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors
• AASB 1048 Interpretation on and Application of Standards
• AASB 1053 Application of Tiers of Australian Accounting Standards
• AASB 1054 Australian Additional Disclosures
• AASB 1057 Application of Australian Accounting Standards
Entities that lodge special purpose financial reports with ASIC are also required to ensure that the
financial statements give ‘a true and fair’ view (s. 297 of the Corporations Act). In ASIC’s opinion,
SPFSs can only present a true and fair view if they apply all recognition and measurement requirements in
Australian Accounting Standards (e.g. depreciation, tax-effect accounting, leases, inventories, employee
benefits) (ASIC Regulatory Guide 85). ASIC’s Regulatory Guide does not have any legal status. Whilst
some entities that lodge SPFSs follow ASIC’s advice, others do not. In practice, there are many large
proprietary companies that choose to lodge SPFSs with ASIC based on the minimum standards approach
listed in this section.

10 Financial Reporting
 At the time of writing, the AASB is continuing to develop its financial reporting framework by
considering whether to extend the Conceptual Framework and general purpose financial reporting to
additional for-profit private sector entities. The AASB is likely to be particularly concerned with limiting
the use of SPFSs by large proprietary companies without public accountability that are considerable
enterprises (e.g. $500 million in revenue) rather than small or medium-sized entities.

Catering to the Information Needs of Multiple Stakeholders

One aspect of the current complexity in financial reporting, which has attracted the attention of accounting
standards-setting bodies worldwide, has resulted from the need to measure ‘performance’ from multiple
perspectives. This requirement cannot be met simply by the reporting of financial statements. A company’s
performance is a multifaceted measure. Therefore, there is a need for information such as the progress of
the company — in terms of strategy and plan — rather than financial measures such as profit, assets
and liabilities. Although the reporting of the strategy and plan is material to investors, lenders and other
stakeholders, there is no requirement to report this information in the IFRSs.
The increase in the reporting of non-mandatory information in annual reports (relative to the man-
dated financial information) makes financial reporting seem like a mere compliance exercise rather
than an exercise that communicates the information needs of multiple stakeholders (IFRS Foundation
2019d). To address this concern, some of the present research projects in progress across the world are
as follows.
International Accounting Standards Board
To assist entities to communicate their disclosures more effectively, the IASB engaged in a
research project around a so-called ‘Disclosure Initiative’ to develop better disclosure requirements in
accounting standards, around accounting policies and in general. The initial focus was IAS 1 Presentation
of Financial Statements, but the initiative evolved into developing guidance to the Board for setting
disclosure requirements in all standards starting with IAS 19 Employee Benefits and IFRS 13 Fair Value
Measurement. This research project is part of the Board’s wider series of initiatives under the theme ‘Better
Communication in Financial Reporting’.
Financial Reporting Council (UK)
To improve corporate reporting so that it provides a ‘clearer understanding of the underlying performance
of a company’ (FRC 2019), the FRC introduced the Financial Reporting Lab in 2011 as a forum for
companies and investors to solve contemporary reporting needs. The lab works with over 100 companies,
84 investment organisations and more than 300 retail investors with the aim of improving disclosures.
Two of the themes that the lab focuses on are ‘Digital Future’ and ‘Climate and Workforce Reporting’
(FRC 2019).
Technology Advancements
Technology advancements provide opportunities for other sources and methods for information to be
provided to the primary users of general purpose financial statements. The rapid pace of technological
advancements can be, at the same time, a source of challenges and opportunities for entities preparing
financial information, users consuming information and standard setters prescribing how the information
should be prepared and disseminated. As technology progresses, new items need to be recognised in
the financial statements (e.g. crypto-assets), new avenues become available to disseminate and consume
information (e.g. electronically instead of paper-based reports) and new techniques are used to analyse the
information (e.g. big data analytics with the use of artificial intelligence). IASB recognises these broad
implications of technology for financial reporting as part of the IFRS Foundation’s Technology Incentive
announced in November 2018. This initiative seeks to develop a strategic plan to address the impact of
technological advancements on financial reporting and standard setting.

Summary
Accounting standard-setters have had a renewed focus on reducing complexity in financial reporting.
However, challenges still exist regarding the development of an overarching disclosure model to measure
performance without increasing the complexity of financial reporting.

MODULE 1 The Role and Importance of Financial Reporting 11

1.2 THE CONCEPTUAL FRAMEWORK FOR
FINANCIAL REPORTING
In this section we examine the IASB Conceptual Framework for Financial Reporting (Conceptual
Framework).
The Conceptual Framework sets out the concepts that underlie the preparation and presentation of
financial statements for external users (Conceptual Framework, ‘Status and Purpose’).
In March 2018, the IASB issued a version of the Conceptual Framework that partially updated the
previous (2010) version. In this module and throughout this subject, only the 2018 version of the
Conceptual Framework, which is found in the IFRS Compilation Handbook, is considered.
The Conceptual Framework is structured as shown in table 1.2.

TABLE 1.2 Structure of the Conceptual Framework for Financial Reporting

Chapter Content

Status and Purpose • Provides a detailed description of the status and purpose of the Conceptual
Framework

1. Objective • Sets out the objective of general purpose financial reporting

2. Qualitative • Provides guidance on the qualitative characteristics of useful financial

characteristics information

3. Financial statements and • Describes the objective and scope of general purpose financial statements as
the reporting entity well as the reporting entity concept

4. Elements of financial • Provides the definitions of the elements of financial statements

statements

5. Recognition and • Sets out the recognition and derecognition criteria

derecognition

6. Measurement • Provides guidance on the measurement bases including historical cost and
current value

7. Presentation and • Provides guidance on classification, presentation and disclosure

disclosure

8. Concepts of capital and • Provides guidance on the concepts of capital and capital maintenance.
capital maintenance

Source: CPA Australia 2019.

The purpose and application of the Conceptual Framework will now be discussed, and its components
will be examined in detail.

THE PURPOSE AND APPLICATION OF THE CONCEPTUAL

FRAMEWORK
Having a common framework is an important foundation in guiding the development of accounting
standards and accounting practice. Moreover, accounting standards do not address all possible transactions
an entity may enter into. In these instances when the standards do not provide guidance, or sufficiently
specific guidance, it is the role of the Conceptual Framework to provide guidance to facilitate consistency
in the reporting of transactions and events.
The Conceptual Framework provides a formal frame of reference for:
• what types of transactions and events should be accounted for
• when the effects of transactions and events should be recognised
• how the effects of transactions and events should be measured
• how the effects of transactions and events should be summarised and presented in financial statements.

12 Financial Reporting
 For example, IAS 36 Impairment of Assets applies the principle that the carrying amount of an asset
should not exceed its recoverable amount. This principle is consistent with the concept of an asset adopted
in the Conceptual Framework:
a present economic resource controlled by the entity as a result of past events. An economic resource is a
right that has the potential to produce economic benefits (paras 4.3–4.4).

As an asset represents a resource that has the potential to produce future benefits, the amount at which it
is reported in the statement of financial position (i.e. its carrying amount) should not exceed the expected
benefits to be derived from the asset (i.e. the recoverable amount).
The Conceptual Framework can be applied in several ways, as shown in table 1.3.

TABLE 1.3 Applying the Conceptual Framework for Financial Reporting

Who is applying the

Conceptual Framework? How the Conceptual Framework is applied

Standard setters To develop accounting standards

Preparers To obtain guidance when issues that are not directly covered by a standard or
interpretation arise (specifically, IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors requires the Conceptual Framework to be considered when
there is an absence of a specific accounting standard or interpretation (IAS 8,
paras 10–11))

Auditors To help form an opinion on compliance with an IFRS

Users To better understand and interpret the financial reports they are reviewing

Source: CPA Australia 2019.

Where there is a conflict between an IFRS and the Conceptual Framework, the requirements of the
particular standard override those of the Conceptual Framework (para. SP1.2).

OBJECTIVES AND LIMITATIONS OF GENERAL PURPOSE

FINANCIAL REPORTING
The objective of general purpose financial reporting is to provide financial information to the primary
users to support their decision-making needs. In addition, general purpose financial reporting performs a
stewardship function, which involves reporting on how efficiently and effectively management has used the
resources entrusted to it (Conceptual Framework, paras 1.22–1.23). This emphasis on user decision making
in order to ascertain the information the entity should provide follows a decision-usefulness approach.
The decision-usefulness objective of financial reporting is probably the most important objective.
However, it is not possible for entities to provide all information about the financial position, performance
and changes in financial position to all users. Preparers of the general purpose financial statements are
required to exercise some judgment in deciding which information is required for the decision-usefulness
objective to be met. Consider the following problems.
• Lack of familiarity with new types of information. If users of financial statements are not familiar with an
item of information, it is difficult to assess its usefulness to their decision-making processes. Preparers
will then be faced with difficulties in trying to assess if the new item of information should be recognised
under an existing category in the financial reports or disclosed separately. Furthermore, some users may
not have the technical expertise to understand complex information; for example, information that is
based on finance principles such as present value calculations. This problem is especially relevant during
times of rapid technological advancement, where technologies may generate new items for which there
may not be sufficient guidance provided by accounting standard setters.
• Decision-usefulness may vary among users. The personal beliefs and values of users may determine the
information that they tend to use in their decision making. For example, some investors may consider
information about environmental performance to be relevant for their decision making, whereas others
might exclude it from their decision-making models. The differences in what users find relevant are also

MODULE 1 The Role and Importance of Financial Reporting 13

 likely to depend on the decision being made. For example, the information needs of customers deciding
whether to enter into a long-term purchase contract will differ from the needs of employee representative
groups negotiating remuneration and working conditions for employees.
• Capable of multiple interpretations. Preparers may have a different perception of what is useful
information to users than the users themselves. For example, using fair value as the measurement
basis for assets may be useful for investors to assess the entity’s future economic benefits likely to
be generated versus other entities; however, value in use may be considered by preparers as better
capturing the management’s plans and expectations regarding particular assets. These competing views
are difficult to reconcile under the currently specified decision-usefulness objective of general purpose
financial reporting.
• Time and cost constraints in preparing GPFSs. Due to time and cost constraints in preparing general
purpose financial reports, it is not possible for entities to provide all the useful information that will meet
all the varying needs of users. When a user requires specific information that has not been disclosed in
an entity’s financial reports, the IASB recommends the use of other sources such as ‘general economic
conditions and expectations, political events and political climate, and industry and company outlooks’
(Conceptual Framework, para. 1.6) to help gain a clearer understanding. The IASB also explains that
the financial reports are ‘not designed to show the value’ of the organisation but to help decision makers
make their own estimates as to its value (Conceptual Framework, para. 1.7). Nevertheless, the time and
cost constraints in preparing GPFSs can be reduced with the help of new technologies that are capable
of capturing, managing, processing and reporting on vast amounts of data.

QUESTION 1.3

Consider the following statement.

The decision-usefulness objective provides unambiguous guidance in resolving financial

reporting problems.

Do you agree? Give reasons for your answer.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 1.6–1.11 of the Conceptual Framework (in the IFRS
Compilation Handbook).

PRINCIPLES ESTABLISHED IN THE CONCEPTUAL

FRAMEWORK
There are two important assumptions established in the Conceptual Framework that form the foundation
of general purpose financial reporting. These are the assumption of the accrual basis of accounting and the
assumption that the entity is a going concern.

Accrual Basis
The accrual basis of accounting recognises the effects of transactions and other events when they occur
(which may not correspond to the time that cash is exchanged in response to a transaction) and reports
them in the financial statements in the periods to which they relate.
The accrual basis of accounting requires an entity to recognise revenues when they are earned rather
than when cash is received. Also, under the accrual basis of accounting, expenses are recognised when
they are incurred rather than when cash is paid. For example, an entity selling goods or services on credit
recognises the revenue and related expenses (cost of goods sold) incurred in earning that revenue when the
sale takes place, regardless of the timing of the cash inflow and cash outflow relating to that revenue and
those expenses. Also, the accrual basis requires an entity to recognise the depreciation of a non-current
asset (with a limited useful life) as the economic benefits of that asset are consumed or expire; an entity
does not account for the asset as an expense in the period in which it is acquired.

14 Financial Reporting
 The Conceptual Framework advocates for accrual basis of accounting as it considers that it provides
a better basis for assessing the entity’s past performance and predicting future performance than relying
only on financial statements prepared on a cash basis (Conceptual Framework, para. 1.17).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 1.17–1.19 of the Conceptual Framework.

QUESTION 1.4

In its first year of operations, Tower Ltd purchased and paid for widgets costing $50 000. During that
year, Tower Ltd sold 60% of the widgets. The widgets on hand at the end of the year cost $20 000.
The sales were on credit terms. Tower Ltd received $37 000 in cash from customers, and $3000
remained uncollected at the end of the year. During the last quarter of the first year of operations,
Tower Ltd entered into a property insurance contract for losses arising from fire or theft. The annual
premium of $4000 was paid in cash and the insurance expired nine months after the end of the
reporting period.
Calculate Tower Ltd’s profit for the first year of operations on an accrual basis and on a cash
basis. Explain the difference between the two measures. Which of the two profit measures is more
useful for assessing Tower Ltd’s performance during its first year of operations? Give reasons for
your answer.

Going Concern
Financial statements prepared in accordance with the going concern assumption presume that the entity
will continue to operate for the foreseeable future. The carrying amounts of assets and liabilities in the
statement of financial position are normally based on the going concern assumption. For example, the
carrying amount of property, plant and equipment — whether measured on a cost or fair value basis —
assumes that the carrying amount will be recoverable through the entity’s continuing operations. Some
assets, such as property and plant, may be stated at amounts that exceed their disposal value because the
entity expects to obtain greater economic benefits through the continued use of such an asset.
Where the going concern assumption is not appropriate (e.g. because of the entity’s intention or need
to wind up operations), the financial statements should be prepared on some other basis. The Conceptual
Framework does not specify an alternative basis. However, one approach may be to state assets at their net
realisable value — which in the case of certain intangible assets may be negligible — and liabilities at the
amount required for their immediate settlement.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraph 3.9 of the Conceptual Framework.

1.3 QUALITATIVE CHARACTERISTICS OF USEFUL

FINANCIAL INFORMATION
Chapter 2 of the Conceptual Framework focuses on the qualitative characteristics of financial information,
and it provides that in order to be useful, financial information must:
be relevant and faithfully represent what it purports to represent. The usefulness of financial information is
enhanced if it is comparable, verifiable, timely and understandable (Conceptual Framework, para. 2.4).

These qualitative characteristics are illustrated in figure 1.3.

FUNDAMENTAL QUALITATIVE CHARACTERISTICS

Relevance
Information is relevant when it is capable of influencing the decisions of users (Conceptual Framework,
para. 2.6). This influence can occur through the predictive value or the confirmatory value of financial
information, or both. Table 1.4 shows how relevant information helps users.

MODULE 1 The Role and Importance of Financial Reporting 15

 FIGURE 1.3 Qualitative characteristics of financial information

Relevance
Fundamental
qualitative
characteristics Faithful
representation

Comparability

Verifiability
Enhancing
qualitative
characteristics Timeliness

Understandability

Source: CPA Australia 2019.

TABLE 1.4 How relevant information helps users

The Conceptual Framework

requires relevant information How this relates to
that helps users . . . financial reporting An example

. . . in forming expectations This relates to the Financial information can be used

about the outcomes of past, predictive value of financial to predict the future cash flows
present and future events. information. of an entity and the timing and
uncertainty of those cash flows.

. . . in confirming or correcting their
past evaluations.
This is referred to as feedback, or
the confirmatory value of financial
information.
Expectations of future cash flows
can be compared with actual cash
flows when financial statements
relating to those future periods are
issued and the reasons for any
differences between expected cash
flows and actual cash flows are
investigated.

Source: CPA Australia 2019.

Materiality
Relevance also encompasses materiality. A subjective approach to materiality is adopted in the Concep-
tual Framework:
Information is material if omitting, misstating or obscuring it could reasonably be expected to influence
decisions that the primary users of general purpose financial reports . . . make on the basis of those reports,
which provide financial information about a specific reporting entity (para. 2.11).

Materiality is an aspect of relevance that can be affected by the nature or the size of an item of
financial information, or both. Some information will be considered material if it refers to amounts that
are considered large enough to influence the decision making of primary users. However, deciding what
is large enough to be material is a matter of professional judgment by preparers, as the Conceptual
Framework does not prescribe quantitative thresholds for materiality because the application of the concept
of materiality is considered to be entity-specific (Conceptual Framework, para. 2.11).

16 Financial Reporting
 Some other information may be material regardless of the amounts it refers to. Consider the
following examples.
• An entity may engage in transactions with its directors that involve amounts that are not material to
the entity. However, the disclosure of these related party transactions may be relevant to users’ needs,
irrespective of the amounts involved, because of the nature of the relationship between the directors and
the entity and their accountability to shareholders.
• An entity may engage in new activities, the results of which have little impact on profit at present.
However, the results may be relevant to the decision-making needs of users because they may affect the
users’ assessment of the entity’s future growth and risk profile.
In summary, whether information is material is a matter of judgment that depends on the facts and
circumstances of an entity. The IASB released a Practice Statement in 2017 that highlighted some ways in
which management can identify whether financial information is useful to the primary users (and therefore
material), and this is outlined in table 1.5.

TABLE 1.5 Identifying financial information useful to users of financial reports

Consideration Example

User expectations How users think the entity should be managed (i.e. stewardship) gathered through
discussions with users or from information that is publicly available

Management perspective Changing management perspective to think about decisions from the perspective
of the user (i.e. as if they were external users themselves and did not have the
internal knowledge held by management, for example, about key risks or key value
drivers)

Observing user or market For example, on particular transactions or disclosures issued by the entity or on
responses to information responses by external parties such as analysts

Source: Adapted from IFRS Foundation 2017, IFRS Practice Statement 2: Making Materiality Judgements, paras 21–23, pp. B856–
B857 accessed May 2019, www.ifrs.org/issued-standards/materiality-practice-statement. © CPA Australia 2019.

The Practice Statement is non-mandatory guidance developed by the IASB, and its application is not
required to state compliance with IFRS Standards. Notwithstanding the Conceptual Framework or the
IFRS Practice Statement 2, materiality is often gauged in practice using the quantitative thresholds of 5%
and 10% of some base amount: 10% or more indicates materiality, while 5% or less indicates immateriality.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 2.4–2.11 of the Conceptual Framework.

Faithful Representation
Together with relevance, faithful representation is a fundamental qualitative characteristic of useful
financial information according to the Conceptual Framework.
Faithful representation requires that financial information faithfully represent the effects of transactions
and events that they purport to represent (Conceptual Framework, para. 2.12). For example, the statement
of financial position should faithfully represent the effects of the events that give rise to assets, liabilities
and equity at a point in time, normally the end of the reporting period.
Ideally, faithful representation means that financial information is complete, neutral and free from
error. However, it is usually impractical to maximise these three characteristics simultaneously. Faithful
representation implies that there should be a fair representation of the economic outcomes of all
transactions and events that involve the entity. However, this assumes that there are accounting solutions
to all of the problems and financial reporting issues encountered by preparers of the financial reports. In
practice, difficulties in identifying the transactions and other events that must be accounted for, as well as in
applying or developing appropriate measurement and presentation techniques, can impede the achievement
of faithful representation.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 2.12–2.19 of the Conceptual Framework.

MODULE 1 The Role and Importance of Financial Reporting 17

Application of Fundamental Qualitative Characteristics
For information to be useful, it must be both relevant and faithfully represented. This may involve
professional judgment in making a trade-off between relevance and faithful representation. For example,
information about future cash flows expected to be derived from an asset may be highly relevant, but it
may be difficult to faithfully represent this aspect of the asset because of the inherent uncertainty of future
events. Paragraph 2.21 of the Conceptual Framework suggests a process for making such judgments as
follows.
1. Identify an economic phenomenon, information about which may be useful to decision makers.
2. Identify the information that would be most relevant about this phenomenon.
3. Determine if the information is available and can provide a faithful representation of the economic
phenomenon.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 2.20–2.22 of the Conceptual Framework.

QUESTION 1.5

Coalite Ltd participates in an emissions trading scheme. It holds emission trading allowances,
which provide a permit for a specified amount of carbon emissions for the year. If its operating pro-
cesses result in carbon emissions, Coalite Ltd must deliver sufficient emission trading allowances
to the government to ‘pay’ for the amount of carbon emitted during the year. If it does not hold
enough emission trading allowances, Coalite Ltd will need to buy more to settle its obligation to the
government. If the company’s holding of trading allowances is surplus to its needs, the allowances
may be sold.
Assume that in determining how to apply the fundamental qualitative characteristics, the chief
financial officer (CFO) of Coalite Ltd has completed the first step by identifying the emission trading
allowances held as being potentially useful to the users of the company’s financial statements.
(a) Identify the type of information about emission trading allowances that would be most relevant
if it were available and could be faithfully represented.
(b) Do you think the information that you suggested is likely to be available and able to be
represented faithfully? If not, what might be the next most relevant type of information about
the emission trading allowances?

ENHANCING QUALITATIVE CHARACTERISTICS

Comparability
Comparability is one of the four enhancing qualitative characteristics of financial information prescribed
in the Conceptual Framework. Financial information is more useful if it can be compared with similar
information about the same entity for another reporting period and with similar information about other
entities. The ability to compare financial statements over time is important to enable users to identify
trends in the entity’s financial position and performance. The ability to compare the financial statements
of different entities is important in assessing their relative financial position and performance.
Comparability also enables users to recognise similarities or differences between two sets of economic
phenomena. For example, an entity with an existing investment in Company A is deciding whether
to continue to invest in Company A or to move its investment to Company B. Comparable financial
information will help the investor in making the decision.
Consistency is seen as contributing to the goal of comparability. The Conceptual Framework refers to
the concept of consistency as ‘the use of the same methods for the same items’ (para. 2.26). This may be
in reference to the use of consistent methods either by different entities for the same period or by the same
entity over different periods.
Comparability is not satisfied by mere uniformity of accounting policies and methods. In fact,
the Conceptual Framework (para. 2.27) cautions against this view because it may result in dissimilar
items being treated or presented similarly. For example, assets that form part of continuing operations
differ from assets that form part of discontinued operations. Future economic benefits of assets that form
part of continuing operations are expected to be recovered mainly by the continued use in the ordinary
course of business. On the other hand, the future economic benefits of assets forming part of discontinued
operations are expected to be recovered through disposal rather than continued use. The adoption of
uniform accounting methods to represent economic information about assets that form part of continuing

18 Financial Reporting
operations and those that form part of discontinued operations would not enhance comparability. Such
methods would fail to reflect the differences in the way that economic benefits are expected to be derived
from the two types of assets.
Comparability of financial statements is enhanced by the disclosure of the accounting policies adopted
in preparing the financial statements and of any changes in those policies and their effects. Disclosure of
accounting policies is considered further in module 2.
Verifiability
Verifiability exists if knowledgeable and independent observers can reach a consensus that the information
is faithfully represented. As shown in table 1.6, verification may be direct or indirect.

TABLE 1.6 Form of verification

Form of verification Example

Direct Confirming the market price used to measure the fair value of an asset that is traded in
an active market

Indirect Checking the inputs and processes used to determine the reported information. For
example, verifying fair value with a model that checks inputs such as the contractual
cash flows and the choice of an appropriate interest rate, and the methodology or
rationale used to estimate fair value.
Consensus might refer to a range (e.g. an estimate of the fair value of a corporate
bond that is not traded in an active market as being between $940 and $970) but not
necessarily to a point estimate (e.g. the historical cost being $990). Verifiability can help
to assure users that financial information is faithfully represented.

Source: Adapted from IFRS Foundation 2019e, Conceptual Framework for Financial Reporting, para. 2.31, in IFRS Standards
issued at 1 January 2019, IFRS Foundation, London, p. A27. © CPA Australia 2019.

Timeliness
Timeliness enhances the relevance of information in GPFSs. Undue delays in reporting information may
reduce the relevance of that information to users’ decision making. Timeliness suggests that there is a need
for financial information at regular intervals, for example, half-year and annual financial reports.
The timeliness of financial information is critical for investment decisions. Unexpected events and
delayed news that impact negatively on the financial statements will normally result in a loss of confidence
and plummeting share prices within the investment market.
To maintain the timeliness of information reported in financial statements, it may be necessary to report
on the effects of a transaction or other event before all of the required information is available. Accordingly,
it may be necessary to use estimates instead of waiting until more directly observable information becomes
available, in which case the benefits from ensuring timeliness should be weighed against the costs of the
decrease in the reliability of the information. Technological advancements have improved the timeliness of
information disclosed because new technologies capture and disseminate information more quickly than
in the past.
Understandability
Understandability requires the information in financial statements to be clearly and concisely classified,
characterised and presented (Conceptual Framework, para. 2.34).
Understandability cannot be interpreted independently of the inherent capability of users of the
financial statements. Users are presumed to have reasonable knowledge of business and economic
activities (Conceptual Framework, para. 2.36). This implies that, for example, the informed user should
readily understand the measurement basis adopted for a particular financial statement item.
Information is not excluded from a financial report merely because it is difficult for users to understand
(Conceptual Framework, para. 2.35). This would be inconsistent with the characteristic of completeness
incorporated in faithful representation. Technological advancements may mean that information that was
previously difficult to understand can now be analysed with the help of artificial intelligence using
applications such as machine learning, thereby making more information suitable to be disclosed.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 2.34–2.36 of the Conceptual Framework.

MODULE 1 The Role and Importance of Financial Reporting 19

 QUESTION 1.6

The objectives of IFRS 13 Fair Value Measurement include establishing a common definition of fair
value and common guidance for fair value measurement. The standard prescribes the following fair
value measurement hierarchy (in descending order).
Level 1 Quoted price for an identical asset or liability
Level 2 Observable prices other than those included within Level 1
Level 3 Unobservable inputs for the asset or liability.
Explain how the enhancing qualitative characteristics, comparability and verifiability, are applied
in the requirements of IFRS 13.

Application of Enhancing Qualitative Characteristics

Although enhancing characteristics improve the relevance or faithful representation of information, they
do not make irrelevant or unfaithfully represented information useful. If information were omitted from
financial statements, rendering them incomplete (not representing faithfully the effects of all transactions
and effects affecting the entity), the consistent omission of that information over multiple periods may
provide comparability, but it would not make the information useful. For example, if an entity omitted
several material subsidiaries from its consolidated financial statements, repeating this omission in each
reporting period may provide comparability. However, financial statements that do not faithfully represent
the financial position and financial performance of the group that they report on are not useful for user
decision making.
Preparers need to exercise professional judgment in balancing the qualitative characteristics and in
assessing the relative importance of enhancing characteristics in different contexts. In selecting an
appropriate accounting policy, such as a measurement attribute, preparers may need to make a trade-
off between an enhancing qualitative characteristic and another qualitative characteristic. For instance,
the preparer may need to forego the enhancing qualitative characteristic of comparability to change an
accounting policy in the interests of providing more relevant or more faithfully represented information.
For example, an entity may adopt fair value measurement in order to provide more relevant information
at the expense of comparability with previous periods. Additional disclosures, such as the reason for and
effects of the change of accounting policy, and the restatement of reported comparative amounts may
improve comparability to assist users in making decisions about the particular entity.
Module 2 considers the application of comparability in IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors in the context of disclosure requirements for changes in accounting
policies.

THE COST CONSTRAINT ON USEFUL FINANCIAL REPORTING

While the cost constraint of preparing general purpose financial statements was identified as a limitation
of GPFSs in general, the Conceptual Framework addresses this concern at the end of Chapter 2, after
describing the qualitative characteristics of financial information. More specifically, paragraph 2.39 of the
Conceptual Framework notes that a pervasive constraint on financial reporting is the balance between the
costs of providing financial information (that include the costs of collecting, processing, verifying and
disseminating information) versus the benefits derived from providing such information.
Providing useful financial information facilitates the efficient functioning of capital markets and lowers
the cost of capital (Conceptual Framework, para. 2.41). The provision of relevant and faithfully represented
financial information enables users to make more informed decisions and to make their decisions more
confidently, which should generally benefit the entity providing that information. However, the cost of
meeting all information needs of all users is normally prohibitive, and therefore some information may
need to be left out from the statements. Materiality plays an important role in helping preparers and users
of financial reports decide what information needs to be provided. In addition, the IASB provides specific
exemptions within standards. For example, a lessee may elect to not apply lease recognition, measurement
and presentation requirements to leases of less than 12 months and where the asset being leased is of
low value (IFRS 16, paras 5–8). This exemption is allowed because the cost of obtaining the required
information may exceed the benefit of providing the information to users.
As technology progresses, the cost of financial reporting has the potential to decrease, while the benefits
of providing the information to users may increase as users may find new ways to analyse it. However,

20 Financial Reporting
 the benefits of providing information via the traditional means of GPFSs may also decrease as users have
access to additional sources of relevant information. For example, new technologies may allow users to
analyse the tone of voice and facial expressions of executives at analyst or shareholders meetings to make
decisions instead of relying on potentially out-dated financial information from GPFSs.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 2.39–2.43 of the Conceptual Framework.

APPLICATION OF QUALITATIVE CHARACTERISTICS IN THE

INTERNATIONAL FINANCIAL REPORTING STANDARDS
The qualitative characteristics are reflected in the underlying principles of the IFRSs. IAS 1 Presentation of
Financial Statements, paragraphs 15–24, refers to the Conceptual Framework definitions and recognition
criteria, objectives and qualitative characteristics. Specifically, IAS 1, paragraph 15, states:
Financial statements shall present fairly the financial position, financial performance and cash flows of
an entity. Fair presentation requires the faithful representation of the effects of transactions, other events
and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and
expenses set out in the [Conceptual Framework]. The application of IFRSs, with additional disclosure when
necessary, is presumed to result in financial statements that achieve a fair presentation.

1.4 THE ELEMENTS OF FINANCIAL STATEMENTS

Now that the fundamentals of financial reporting have been discussed, how the Conceptual Framework
addresses the elements that make up financial statements will be considered. The elements of financial
statements are assets, liabilities, equity, income and expenses. Figure 1.4 presents the key decisions relating
to the elements of the financial statements. The first two decisions (definition and recognition) will be
discussed in this section, while measurement and disclosure will be considered later in the module.

FIGURE 1.4 Key decision areas in accounting for transactions and other events

• Did a past event, or events, give rise to an item that satisfies

1. Definition
the definition of an element of financial statements?

• Does an item that meets the definition of an element need to be

2. Recognition
incorporated in financial statements?

• How to measure the items that are recognised in financial

3. Measurement
statements?

4. Disclosure/Presentation • How should items be disclosed or presented in financial

statements or notes to the accounts?

Source: CPA Australia 2019.

MODULE 1 The Role and Importance of Financial Reporting 21

DEFINING THE ELEMENTS OF FINANCIAL STATEMENTS
Assets
Note that the definitions of assets and liabilities are fundamental because the definitions of the other
elements flow from them. The Conceptual Framework defines an asset as:
a present economic resource controlled by the entity as a result of past events. An economic resource is a
right that has the potential to produce economic benefits (paras 4.3–4.4).

The three key components of the asset definition are:

1. it is a right
2. it has the potential to produce future economic benefits
3. the asset is controlled by the entity.
For an asset to exist, an entity must have the right to it, established by contract, legislation or other means.
The most common type of rights are the rights arising from legal ownership. While in principle, each of
an entity’s right is a separate asset, related rights are treated as a single asset (Conceptual Framework,
para. 4.11). Sometimes, it may be difficult to establish whether a right exists. In those cases, until the
existence uncertainty is clarified, it is uncertain whether an asset exists.
Only the rights that have the potential to produce future economic benefits for an entity beyond the
economic benefits available to other parties are to be treated as assets by that entity. Rights that everyone
can access and use to generate economic benefits (for example, rights of access to public goods) cannot
be considered assets by entities that use them.
For an entity to have control, it does not necessarily follow that the entity has ownership of the asset. For
example, IFRS 16 Leases requires a right-of-use asset to be recognised for a leased asset, even though the
entity does not own the underlying asset (e.g. a building). This is because the entity controls the benefits
arising from using the asset during the lease term.
Consider the following example. A mining company has responsibility for maintaining a private road
on land over which it holds a lease. The road provides access to the mine. Recently, the company paid for
the road to be resealed (resurfaced) at a cost of $3 million. The economic benefits from the resealed road
are expected to be obtained over several accounting periods, even though the association with income can
only be broadly or indirectly determined. In accordance with IAS 16 Property, Plant and Equipment, the
expenditure on resealing the road should be capitalised as part of the road. The new road surface enhances
the economic benefits that the company expects to obtain from the use of the road. Control has been
established because the resealed road is on land over which the company has obtained control by entering
into a lease. The costs of resealing the road should then be progressively recognised over the useful life of
the road as expenses (i.e. depreciation).
Assets are considered to result from past events. A past event normally occurs when the asset is
purchased or produced. However, assets may also arise in other circumstances. For example, an asset
may be gifted to the entity as part of a government grant program. It is important to draw the distinction
between past events and transactions or events that are expected to occur in the future. Future transactions
do not give rise to assets until such time as they occur. For instance, if an entity develops an operational
plan that requires the purchase of an item of machinery in six months, the definition of an asset is not met
until such time as the machinery is purchased.
It is important to note that the definition does not require the asset to be a physical asset. Many assets,
such as patents and copyrights, are intangible in nature. These assets give rise to future economic benefits
(in the form of royalties or sales) but do not have a physical form.

Liabilities
A liability is defined as:
a present obligation of the entity to transfer an economic resource as a result of past events (Concep-
tual Framework, para. 4.26).

The key components of the liability definition are:

1. the requirement for the entity to have a present obligation
2. the obligation is to transfer an economic resource
3. that the present obligation exists as a result of past events.

22 Financial Reporting
 A present obligation may be legally enforceable, or it may arise from normal business practice, custom
and a desire to maintain good business relationships or to act in an equitable manner. For example, an entity
selling goods may have a long time practice to accept the return of faulty goods for a full exchange, even
after the contractual warranty period has expired, to maintain favourable relationships with its customers.
Nevertheless, the present obligation should be strictly related to a transaction or other event that took place
in the past — in the previous example, that transaction is the sale of goods.
The transfer of economic resources is often referred to as the ‘settlement’ of a liability. Para-
graphs 4.39–4.40 of the Conceptual Framework provide examples of how a liability might be settled,
as shown in figure 1.5.

FIGURE 1.5 Examples of how a liability might be settled

Transfer of
other assets

Payment Liability Provision

of cash settlement of services

Replacement
Conversion of
of the obligation
the obligation
with another
to equity
obligation

Source: Adapted from IFRS Foundation 2019e, Conceptual Framework for Financial Reporting, paras 4.39–4.40, in IFRS
Standards issued at 1 January 2019, IFRS Foundation, London, p. A43. © CPA Australia 2019.

The conversion of an obligation to equity and the replacement of an obligation with another obligation
do not directly involve a transfer of economic resources. Consider, for example, the issue of shares to
debt-holders in settlement of a liability. The issue of shares would normally involve consideration passing
to the entity. If debt is settled by conversion to shares, the consideration ‘paid’ by the debt-holders is
the surrender of their debt claim against the entity. From the perspective of the entity issuing the shares,
the consideration is the discharge of the obligation for the debt. Instead of receiving an inflow of economic
resources in consideration for the issue of shares, it has avoided an outflow of resources. The economic
substance is the same as if the new shareholders had contributed cash or other economic resources for the
shares and those resources were used to settle the liability.
Liabilities only arise from a past event or transaction. For example, if an entity purchases an item of
equipment for $1 million and agrees to pay for the equipment in 90 days, the past event is purchasing the
asset (the equipment), and the entity has an obligation to pay for the equipment. It is important to note that
a decision by management to undertake a particular transaction in the future (e.g. to acquire a new item of
plant and equipment) does not, of itself, give rise to a liability.
Equity
Equity is defined as ‘the residual interest in the assets of the entity after deducting all its liabilities’
(Conceptual Framework, para. 4.63).
The definition of equity flows from the definitions of assets and liabilities. Equity is simply the
difference between assets and liabilities. Furthermore, the amount at which equity is shown in the statement

MODULE 1 The Role and Importance of Financial Reporting 23

of financial position is derived from the recognition and measurement of assets and liabilities. Figure 1.6
illustrates how equity changes during the reporting period because of an entity’s financial performance
and its contributions from, and distributions to, holders of equity claims.

FIGURE 1.6 How recognition links the elements of financial statements

Statement of financial position at beginning of reporting period

Assets minus liabilities equal equity

Statement(s) of financial performance

Income minus expenses

Changes in equity

Contributions from holders of equity claims minus distributions to

holders of equity claims

Statement of financial position at end of reporting period

Assets minus liabilities equal equity

Source: IFRS Foundation 2019e, Conceptual Framework for Financial Reporting, diagram 5.1, in IFRS Standards issued at
1 January 2019, IFRS Foundation, London, p. A51.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 4.63–4.67 of the Conceptual Framework.

Income
Income is defined as:
increases in assets, or decreases of liabilities, that result in increases in equity, other than those relating to
contributions from holders of equity claims (Conceptual Framework, para. 4.68).

The two essential characteristics of income are:

1. an increase in assets or a reduction in liabilities
2. an increase in equity, other than as a result of a contribution from owners.
Income does not arise from an increase in assets if there is a corresponding increase in liabilities because
there would not be an increase in equity. For example, if an entity receives revenue in advance of services
being provided, it would recognise an increase in assets (i.e. cash) and an equivalent increase in liabilities
(i.e. unearned revenue or revenue received in advance) representing the obligation to deliver services yet
to be rendered. Income does not arise until the liability is reduced. As the services are rendered, the entity
recognises income and a corresponding reduction in the liability.
Income refers to both revenue and gains. Revenue arises in the course of the ordinary activities of an
entity (e.g. through sales). Revenue from contracts with customers, a subset of revenue, is discussed in
module 3. Gains are those items that meet the definition of income that may or may not arise in the course
of ordinary activities of an entity (e.g. sale of a non-current asset). They are not a separate element in the
Conceptual Framework as they are not considered different in nature to revenue (Conceptual Framework,
para. 4.72).

Expenses
Expenses are defined as:
decreases in assets, or increases of liabilities, that result in decreases in equity, other than those relating to
distributions to holders of equity claims (Conceptual Framework, para. 4.69).

24 Financial Reporting
 The two essential characteristics of an expense are:
1. a decrease in assets or an increase in liabilities
2. a decrease in equity, other than those arising from distributions to holders of equity claims.
An expense is the opposite of income. An example of an expense is wages, which involve outflows
of cash and cash equivalents to employees for the provision of services. Depreciation is an example of
an expense involving the depletion of assets. The accrual of electricity charges gives rise to an expense
involving the incurrence of a liability.
The measurement of profit or loss is determined as the difference between income and expenses.
However, under the IFRSs, not all items that meet the definitions of income and expenses are recognised
as income or expenses used in the calculation of profit. For example, revaluation gains on property, plant
and equipment under the valuation model are required to be recognised in OCI and accumulated in equity,
unless a prior downward revaluation is being reversed (IAS 16 Property, Plant and Equipment). Gains and
losses that are recognised in other comprehensive income are reported in the statement of P/L and OCI in
accordance with IAS 1 Presentation of Financial Statements (refer to module 2).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 4.68–4.72 of the Conceptual Framework.

CRITERIA FOR RECOGNISING ELEMENTS OF FINANCIAL

STATEMENTS
Recognising elements of financial statements involves capturing, in words and with a monetary amount,
the items that meet the definition of an asset, a liability, equity, income or expenses, either alone or in
combination with other items that meet the same definition. The items recognised as assets, liabilities
and equity will then be depicted in the statement of financial position, while the recognised income and
expenses will be included in the statement of financial performance. The monetary amount at which an
asset, liability or equity is recognised in the statement of financial position is referred to as its carrying
amount (Conceptual Framework, para. 5.1). However, not all items that meet the definition of elements
of financial statements are recognised.
An asset or liability is recognised only if recognition of that asset or liability and of any resulting income,
expenses or changes in equity provides users of financial statements with information that is useful
(Conceptual Framework, para. 5.7).

As mentioned in Chapter 1 of the Conceptual Framework, information is considered useful if it is

relevant and faithfully represents what it is supposed to represent. As such, the recognition of an item that
meets the definition of an element of the financial statements is considered appropriate according to the
Conceptual Framework when it provides relevant information and a faithful representation of that element.
If it is uncertain whether the element exists or if the probability of an inflow or outflow of economic
benefits is low, the information provided by recognising that element may not be relevant; therefore, the
element may not need to be recognised. If there is measurement uncertainty with regards to the amount
to be recognised for an element of financial statements or if related elements are not properly captured in
the financial statements, the information provided by recognising that element may not result in a faithful
representation of elements of financial statements; therefore, the element may not need to be recognised.
In recognising the elements of financial statements, the cost constraint has to be taken into consideration
as well. ‘An asset or liability is recognised in the financial statements if the benefits of the information
provided to users of financial statements by recognition are likely to justify the costs of providing and using
that information’ (para. 5.8). If an item satisfying the definition of an asset or liability is not recognised,
an entity may still need to provide information about that item in the notes to the financial statements
(para. 5.11). As equity is defined as the residual interest in the assets of the entity after deducting all its
liabilities, changes in equity will be recognised whenever the change in recognised assets does not match
the change in recognised liabilities.
The recognition of income and expenses is based on the recognition of assets and liabilities to which
they relate. According to the Conceptual Framework, paragraph 5.4:
(a) the recognition of income occurs at the same time as:
(i) the initial recognition of an asset, or an increase in the carrying amount of an asset; or
(ii) the derecognition of a liability, or a decrease in the carrying amount of a liability.

MODULE 1 The Role and Importance of Financial Reporting 25

 (b) the recognition of expenses occurs at the same time as:
(i) the initial recognition of a liability, or an increase in the carrying amount of a liability; or
(ii) the derecognition of an asset, or a decrease in the carrying amount of an asset.
As seen in paragraph 5.4, income is recognised when there is a corresponding increase in assets (such
as an increase in accounts receivable), or a decrease in liabilities (such as a reduction in a liability
for unearned revenue). Similarly, the Conceptual Framework notes that the recognition of expenses is
simultaneous with the recognition of an increase in a liability or a reduction in an asset. For example, the
recognition of a cost of goods sold expense coincides with a reduction in the amount recognised as an asset
for inventory.
It should be noted that the link between the recognition of income and expenses and the changes in
assets and liabilities does not mean that all the changes in the recognised assets and liabilities will result in
income or expenses being recognised — some of the changes in recognised assets and liabilities may be
due to contributions from equity holders or distributions made to them. Furthermore, income and expenses
do not arise when there are corresponding amounts recognised to another asset or liability account that
result in no change to equity. For example, purchase of inventory on credit terms or receipt of cash for
trade receivables.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 5.1–5.25 of the Conceptual Framework.

The definitions and recognition criteria for assets, liabilities, income and expenses set out in the
Conceptual Framework are referenced in IAS 1, paragraph 15.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 15–24 of IAS 1 Presentation of Financial Statements.

DERECOGNITION OF ASSETS AND LIABILITIES

Derecognition is a concept that applies only to recognised assets and liabilities. According to the
Conceptual Framework, an item is normally derecognised when it no longer meets the definition of an
asset or a liability (para. 5.26):
(a) for an asset, derecognition normally occurs when the entity loses control of all or part of the recognised
asset; and
(b) for a liability, derecognition normally occurs when the entity no longer has a present obligation for all
or part of the recognised liability.

The requirements relating to derecognition are designed to ensure that the resulting information
faithfully represents any assets and liabilities retained after the transaction or other event that led to the
derecognition, as well as the change in assets and liabilities as a result of that transaction or other event
(para. 5.27).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 5.26–5.33 of the Conceptual Framework.

CONSTRAINTS ON INTERNATIONAL CONSISTENCY OF THE

APPLICATION OF RECOGNITION CRITERIA ESTABLISHED BY
THE CONCEPTUAL FRAMEWORK
The business and legal environments in which entities operate, and the social and political environment
within which standard setting occurs, may impose constraints on the consistent application of the
recognition criteria established in the Conceptual Framework across the world. Although the Conceptual
Framework establishes the general criteria, it does not necessarily remove the need for professional
judgment by accountants.
For technical reasons, it may not always be possible to have consistency between accounting standards
applicable in various countries and the Conceptual Framework, but inconsistency may also arise because
of the need to take economic constraints or consequences into consideration. The application of accounting
standards can have economic consequences that management and user groups consider disadvantageous.

26 Financial Reporting
 For example, an accounting standard might prohibit the recognition of certain intangible assets, or it
might reduce the incidence of their recognition by requiring that very stringent conditions be satisfied
before such assets are recognised. Applying such an accounting standard could reduce the reported profit of
some entities and increase the volatility of the reported profit of others. In turn, this could cause share prices
of the affected entities to fall because of investors’ perceptions that the risk of investing in such entities has
increased. Moreover, if managers’ salaries are based (even in part) on share prices, their remuneration may
also decrease. Economic consequences of this kind may lead to accounting standard setters departing from
a conceptually ‘pure’ approach outlined in the framework in order to satisfy interest groups who claim that
their interests would otherwise be adversely affected.
Other types of constraints include social and political constraints. These may arise because professional
accountants feel that their ability to exercise autonomy and judgment is constrained by the framework and
related standards. Political constraints may arise as external regulators seek to impose their own desires
on how reporting is performed.
A final constraint is based on human resources and cost. A considerable amount of time and cost is
required to apply the framework, and it is necessary to work with a wide range of stakeholders. Lack of
funding and time is often a constraint in this regard.

1.5 MEASUREMENT OF ELEMENTS OF

FINANCIAL STATEMENTS
After it has been determined that an event has resulted in an item that meets the definition of an element
of financial statements (item 1 of figure 1.4) and that the recognition criteria are satisfied (item 2 of
figure 1.4), the next decision is in relation to how the item should be measured (item 3 of figure 1.4).
In relation to assets and liabilities, there are two stages of the measurement decision:
1. how to measure the asset or liability at initial recognition
2. how to measure the asset or liability subsequent to initial recognition.
Changes in assets and liabilities affect the reported income, expenses and equity. Therefore, the mea-
surement bases chosen for assets and liabilities have clear implications for the amount of income and
expenses reported in financial statements. Different bases can be adopted in measuring the same item. For
example, the value in exchange of an asset may be measured at market price or at net realisable value.
Further, accounting measurement is problematic because various attributes of a particular element can be
measured in the same unit of measurement. For example, the value in use of an asset (an entity-specific
value) or its value in exchange can be measured using the same currency unit.
The Conceptual Framework defines measurement and identifies and describes alternative measurement
bases, before concluding with a description of the factors to consider when selecting a measurement
basis. In addition, accounting standards may state the measurement basis for a specific item; for example,
IAS 2 Inventory states the measurement basis for inventory at cost or net realisable value, whichever
is lower. Also, accounting standards may need to describe how to implement the measurement basis
prescribed in those standards (Conceptual Framework, para. 6.3).
The Conceptual Framework focuses on the following categories of measurement bases: historical cost
(including amortised cost) and current value (including fair value, value in use for assets and fulfilment
value for liabilities and current cost). The International Financial Reporting Standards refer to more
measurement bases, classified under the following categories: cost-based and value-based measures. The
measurement bases prescribed in IFRSs are going to be addressed next. Reference to the Conceptual
Framework will be included when the measurement bases prescribed in IFRSs overlap with those
measurement bases mentioned in this framework.

COST-BASED AND VALUE-BASED MEASURES USED IN THE

INTERNATIONAL FINANCIAL REPORTING STANDARDS
In broad terms, cost-based measures are based on entry prices. An entry price is the price paid to acquire
an asset or received to assume a liability (IFRS 13, para. 57). As such, the cost-based measures in
relation to assets include measures of the cost incurred by an entity to acquire an asset. Variations of
cost-based measures may adjust the cost for amortisation, depreciation or interest expense, as well as for
any accumulated impairment.

MODULE 1 The Role and Importance of Financial Reporting 27

 In relation to a liability, cost-based measures include the proceeds received in exchange for the
obligation, such as the proceeds of an issue of debentures, or the amounts of cash or cash equiva-
lents expected to be paid to satisfy the liability in the normal course of business (e.g. provision for
annual leave).
Value-based measures broadly include those measurement bases that require some form of valuation to
be undertaken, such as fair value. In practice, the distinction between cost-based and value-based measures
may have more to do with semantics than with substance. For example, to measure the cost of acquiring
an asset, it is necessary to measure the fair value of the purchase consideration. Figure 1.7 depicts the
key cost-based and value-based measures used in IASB pronouncements. The key characteristics of the
measures applied in the IFRSs are also described.

FIGURE 1.7 Measurement bases specified under International Accounting Standards Board pronouncements

Measurement bases under IASB pronouncements

Cost-based Value-based

Cost/historical cost Fair value

Amortised cost Current cost

Fair value less costs of disposal

Net realisable value

Present value
(measurement technique) Fulfilment value

Value in use

Source: CPA Australia 2019.

Cost/Historical Cost
The first cost-based measure shown in figure 1.7 is cost/historical cost. The Conceptual Framework uses
the term ‘historical cost’ to refer to the same concept described as ‘cost’ in various IFRSs. The definition
of ‘historical cost’ of an asset in the Conceptual Framework (para. 6.5) is:
the value of the costs incurred in acquiring or creating the asset, comprising the consideration paid to
acquire or create the asset plus transaction costs.

This definition is similar to the definition of cost used in a number of IASB pronouncements —
for example IAS 16 Property, Plant and Equipment, paragraph 6:
the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an
asset at the time of its acquisition or construction or, where applicable, the amount attributed to that asset
when initially recognised in accordance with the specific requirements of other IFRSs.

However, the Conceptual Framework extends its use of the concept of historical cost to liabilities, noting
that under historical cost, liabilities are recorded at:
the value of the consideration received to incur or take on the liability minus transaction costs (para. 6.5).

28 Financial Reporting
 While cost, or historical cost, is often applied to many classes of assets, such as property, plant and
equipment and most intangible assets, other measurement bases are also in common use. Present practice
is best described as a mixed measurement accounting model.
Advantages that have been claimed for the historical cost basis of accounting include that it is:
• easily understood — by users and preparers of financial statements
• relevant to decision making — as it is the value of the consideration given or received in exchange for
an asset or a liability
• reliable — historical cost provides evidence of the value of the item based on actual transactions with
external parties
• inexpensive to implement — the measurement of historical cost is linked to the occurrence of transactions
and is therefore readily available at little or no additional cost.
The following deficiencies have been attributed to the historical cost basis of accounting.
• Limited relevance to decision making
– Historical cost is merely a historical record of the consideration paid or received, not a forward-
looking measure. Therefore, it has limited predictive value.
– Historical cost results in the distortion of performance measurement caused by old costs being
associated with current revenues. In the case of assets, some critics argue that it is better to match the
benefit received from the asset against the cost expected to replace the asset, not the historical cost.
• Undermines the faithful representation of financial reports
– Under historical cost, the increase or decrease in value of assets and liabilities are recognised when
realised (i.e. when a future transaction occurs), not when the prices or other values of assets and
liabilities change while still held by the entity. Therefore, reflecting the true value of the assets and
liabilities will be affected by the selective timing of the sale of assets.
– Historical cost for an asset must be supplemented by additional rules that check to see whether the
amount is recoverable. This is necessary to ensure that the carrying amount of the asset (i.e. the
amount at which it is recognised in the statement of financial position) does not exceed the future
economic benefits that the entity expects to derive from the asset. By contrast, realisable value reflects
the market’s assessment of the recoverable amount of an asset.
– Historical cost does not satisfactorily deal with assets acquired for nil or nominal consideration. In
those cases, historical cost will probably not be indicative of the value of that asset to the entity.
– Costs incurred at various points in time are aggregated as though they are equivalent in economic terms.
– The historical cost of some items may have resulted from an arbitrary allocation of an overall
cost to assets, liabilities and expenses; for example, allocating overhead costs across items of
inventory. These allocations may be arbitrary and may undermine the representational faithfulness of
historical cost.
• Undermines the comparability of financial reports
– In the case of self-constructed assets, the costs incurred depend on the efficiency of the entity. For
example, if two companies were building identical assets, the less efficient of the two would incur
the higher costs. Users may conclude that the company with the higher cost base is superior to the
company that incurred the lesser costs to construct the asset.
• Problems with reliability
– There can be difficulties in objectively determining the historical cost when calculating the fair value
of the purchase consideration and other incidental costs.
– Historical cost reflects, at a minimum, management expectations of the recoverability of an asset,
rather than user expectations.
Refer to Note 1 ‘Summary of significant accounting policies’ in the notes to financial statements of
Techworks Ltd (see appendix). Provide a summary of how the assets and liabilities of Techworks have
been measured.

QUESTION 1.7

The Sydney Harbour Bridge was officially opened on 19 March 1932. The total cost of the bridge
was approximately 6.25 million Australian pounds ($13.5 million) and was eventually paid off in 1988
(Sydney Online 2017).
Explain some of the limitations of using historical cost for the subsequent measurement of the
Sydney Harbour Bridge.

MODULE 1 The Role and Importance of Financial Reporting 29

Amortised Cost
The second cost-based measure depicted in figure 1.7 is amortised cost. This is a measure applied to
certain financial assets and financial liabilities subsequent to initial recognition. Amortised cost is defined
in IFRS 9 Financial Instruments as:
the amount at which the financial asset or financial liability is measured at initial recognition minus the
principal repayments, plus or minus the cumulative amortisation using the effective interest method of any
difference between that initial amount and the maturity amount, and, for financial assets, adjusted for any
loss allowance (IFRS 9, Appendix A).

The effective interest method uses the effective interest rate to allocate interest income or interest
expense over the effective life of a financial asset or liability. The effective interest rate is the rate that
discounts the estimated future cash receipts or payments through the expected life of a financial asset or
liability to the net carrying amount of the financial asset or liability.
The Conceptual Framework treats amortised cost as a measure under the historical cost measure-
ment basis.
One way to apply a historical cost measurement basis to financial assets and financial liabilities is to
measure them at amortised cost. The amortised cost of a financial asset or financial liability reflects
estimates of future cash flows, discounted at a rate determined at initial recognition. For variable rate
instruments, the discount rate is updated to reflect changes in the variable rate. The amortised cost of
a financial asset or financial liability is updated over time to depict subsequent changes, such as the
accrual of interest, the impairment of a financial asset and receipts or payments (Conceptual Framework,
para. 6.9).

EXAMPLE 1.3

Initial Recognition
B Ltd issues a note payable with the following terms.
• Face amount (i.e. maturity value) of $100
• Repayable at the end of Year 2
• Coupon interest at the rate of 10% per period (year), which is payable at the end of each year
The issuer of the note is obligated to pay $10 interest at the end of Year 1 (t1 ) and $110, being interest
and principal, at the end of Year 2 (t2 ).
The financial liability will be recognised in Year 0 (t1 ) based on the issue price, which in this case will
be the face amount (i.e. maturity value). However, it is common for debt securities like the note payable
in this exercise to be issued at an amount other than face value. If the market expects a rate of return
greater than 10% for a debt security of equivalent risk, the issuer will need to discount the issue price so
that the holder effectively earns the expected rate of return.

EXAMPLE 1.4

Effective Interest Rate

Some of the facts from the previous example have been changed.
B Ltd issues a note payable with the following terms.
• Proceeds received on issue $96.62
• Maturity value of $100
• Repayable at the end of Year 2
• Coupon interest at the rate of 10% per period (year), which is payable at the end of each year
The issuer of the note is still obligated to pay $10 interest at the end of Year 1 (t1 ) and $110, being interest
and principal, at the end of Year 2 (t2 ).
However, based on the consideration received, the market rate of interest (i.e. the effective interest rate)
demanded by purchasers of the debt security was 12%. The effective interest rate is the rate at which the
present value (PV) of the contractual cash flows over the life of the debt security equals the initial carrying
amount based on the proceeds on issue of $96.62.
Based on the PV formula, the PV of the cash flows shown in this example, given an interest rate of
12% per annum, can be calculated as follows:

30 Financial Reporting
 FV
PV =
(1 + i)n
$10 $110
PV = +
1.12 1.122
PV = $8.93 + $87.69 = $96.62
Alternatively, the formula for the PV of an annuity may be used. In this case, the interest and principal
repayment are viewed as two streams of cash flows: an annuity of $10 per annum for two years, payable
in arrears; and a payment of $100 at the end of two years. The PV of the cash flows shown in this example,
given an interest rate of 12% per annum, can then be calculated as follows.
1 − 1/ (1 + i)n FV
PVA = CF × +
i (1 + i)n
1 − 1/1.122 $100
PV = $10 × +
0.12 1.122
PV = $16.90 + $79.72 = $96.62
The PV of the cash flows can also be calculated using a financial calculator as follows.
Procedure Key operation Display
Enter cash flow data [+/−]100 [FV] −100 = >FV −100.00
[+/−]10 [PMT] −10 = >PMT −10.00
12 [I/Y] 12 = > I/Y 12.00
2 [N] 2=>N 2.00
Calculate PV [COMP] PV PV = $96.62

EXAMPLE 1.5

Amortised Cost at Reporting Date

Continuing to use the information from the previous examples, now consider amortised cost at
reporting date.
The note is carried by the issuer at amortised cost.
At t1 , when discounted at the effective rate of interest, the PV of the remaining cash flows is $98.21
($110/1.12). The discounting procedure automatically takes into account any principal repayments that
have been made (at t1 , no principal repayments have occurred in relation to the debt security) and any
cumulative amortisation of the initial discount on issue, as required by the definition of amortised cost in
IFRS 9 Financial Instruments.
This is illustrated by the calculation for the period ended t1 in table 1.7.

TABLE 1.7 Amortisation schedule

Coupon Effective Discount Unamortised Carrying
interest interest amortised discount balance amount
Date (10%) (12%) $ $ $
t0 3.38(a) 96.62
t1 10.00(b) 11.59(c) 1.59(d) 1.79(e) 98.21(f)
t2 10.00(b) 11.79(g) 1.79(h) 100.00(i)
Total 20.00 23.38 3.38

(a) $100.00 − $96.62

(b) $100.00 × 0.10
(c) $96.62 × 0.12
(d) $11.59 − $10.00
(e) $3.38 − $1.59
(f) $96.62 + $1.59 = $100.00 − $1.79
(g) $98.21 × 0.12
(h) $11.79 − $10.00
(i) Before principal repayment
Source: CPA Australia 2019.

MODULE 1 The Role and Importance of Financial Reporting 31

 At the date of issue, the PV of the debt security at a discount rate of 12% was $96.62. That amount
will be recognised as part of the initial recognition of the financial liability as the original carrying amount.
The unamortised discount at t0 was the difference between the maturity value of the debt, $100, and the
issue price, $96.62, as shown in the first row in the amortisation schedule.
As shown in the second row in the amortisation schedule, the coupon interest of $10 was paid during
the period ended t1 , but the effective interest expense on the amount of cash raised on issue of the debt
was $11.59 ($96.62 × 0.12). The difference between the effective interest, $11.59, and the coupon interest,
$10, was the amortised discount for the period, $1.59. The unamortised discount at t1 was $1.79, which is
the difference between the balance of the unamortised discount at t0 and the discount that was amortised
for the period ended t1 . As there were no principal repayments until t2 , the amortised cost of the debt at
t1 was $98.21 ($96.62 + $1.59). This is the amount that will be recognised as the carrying amount of the
financial liability at the end of t1 using the amortised cost measure.

Fair Value
The first value-based measure shown in figure 1.7 is fair value. This is defined in IFRS 13 Fair Value
Measurement 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 (IFRS 13, para. 9).
The same definition is included in Conceptual Framework paragraph 6.12.
‘A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction
between market participants’ (IFRS 13, para. 15). The assumptions of an orderly transaction are identified
in IFRS 13 as follows.
A transaction that assumes exposure to the market for a period before the measurement date to allow for
marketing activities that are usual and customary for transactions involving such assets or liabilities; it is
not a forced transaction (e.g. a forced liquidation or distress sale) (IFRS 13, Appendix A).
The assumption of an orderly transaction is important for fair value. This enables fair value to reflect
an amount at which market participants would willingly exchange an item rather than a ‘liquidation’ or
‘fire-sale’ price that might be achieved in a forced sale if the vendor was financially distressed.
Fair value can be considered in terms of an entry price or exit price. The IFRS 13 definition, as well as the
Conceptual Framework definition, treats fair value as an exit price — the ‘price that would be received to
sell an asset or paid to transfer a liability.’ (IFRS 13, Appendix A). This can be compared to an entry price,
which is the ‘price paid to acquire an asset or received to assume a liability in an exchange transaction.’
(IFRS 13, Appendix A).
Neither the Conceptual Framework nor IFRS 13 prescribe the use of fair value. While the Conceptual
Framework describes the factors to consider when selecting it as a measurement basis, IFRS 13 establishes
a hierarchy for the measurement of fair value when another standard prescribes or permits its use. The
hierarchy ranks the inputs to valuation techniques based on their verifiability so as to enhance comparability
and consistency. The highest rank (Level 1) is given to inputs that reflect quoted market prices for
identical assets or liabilities, and the lowest rank (Level 3) is assigned to inputs that cannot be observed in
a market.
These levels are described as follows.
• Level 1 inputs: quoted price for an identical asset or liability. These inputs reflect quoted prices for
identical assets or liabilities in active markets. For example, if a blue chip ordinary share is valued, the
stock exchange price for the share is a Level 1 input. Note that the effective implementation of this level
requires careful consideration of the definition of ‘active markets’.
• Level 2 inputs: model with no significant unobservable inputs. Where Level 1 inputs are not available,
fair value is estimated using a model with no significant unobservable inputs. For example, the entity
may use quoted market prices for comparable assets, liabilities or equity instruments in active markets.
Other examples include option valuation models or PV techniques.
• Level 3 inputs: model with significant unobservable inputs. When quoted prices and other observable
inputs are not available, the entity uses inputs that are developed on the basis of the best information
available about the assumptions that market participants would use when pricing the asset or liability.
For example, unobservable inputs into a valuation model for residential mortgage-backed securities
include prepayment rates, probability of default and the severity of loss.

32 Financial Reporting
 Fair value is considered by many to be more relevant than cost-based measures. However, fair value has
been criticised for reasons such as:
• lack of relevance to decision making — fair value is not relevant in relation to assets that the entity does
not intend to sell, such as financial instruments that the entity intends to hold to maturity
• problems with reliability — fair value is not very reliable in relation to assets that are not traded in an
active market.

QUESTION 1.8

Stanley Ltd holds a parcel of Alpha B redeemable 7% cumulative preference shares issued by
Alpha Ltd. The Alpha B preference shares are unlisted. Stanley Ltd’s financial accountant measured
the value of the shares using the market price of Alpha A preference shares, which are listed,
redeemable, cumulative 5% preference shares, issued by Alpha Ltd. The Alpha A preference shares
have a very similar maturity date to the Alpha B preference shares. The accountant determined the
yield of the Alpha A preference shares by reference to the quoted price and to the timing and amount
of the contractual cash flows. The accountant then applied the same yield in a discounted cash flow
model, using the contractual cash flows of Alpha B preference shares.
Which input level has the accountant used to measure the fair value of the Alpha B preference
shares? Give reasons for your answer.

Current Cost
Current cost is the second value-based measure shown in figure 1.7.
The current cost of an asset is the cost of an equivalent asset at the measurement date, comprising the
consideration that would be paid at the measurement date plus the transaction costs that would be incurred
at that date . . . The current cost of a liability is the consideration that would be received for an equivalent
liability at the measurement date minus the transaction costs that would be incurred at that date [emphasis
added] (Conceptual Framework, para. 6.21).
In relation to assets, the definition implies that there are two concepts of current cost:
1. reproduction cost — current cost of replacing an existing asset with an identical one
2. replacement cost — current cost of replacing an existing asset with an asset of equivalent productive
capacity or service potential.
The current cost of replacing or reproducing an asset is commonly interpreted as the most economic
cost to replace the asset (IASB 2005, p. 97). Therefore, reproduction or replacement cost may differ from
historical cost where an entity could, through efficiencies, reproduce or replace the service potential of an
asset for an amount that differs from the fair value of the purchase consideration given to acquire the asset.
Current cost (more specifically, current replacement cost) is an example of an entry price valuation
technique.
In some instances, reproduction of an existing asset, such as a brand name, may not be feasible because
of its uniqueness. Difficulties may also arise with replacing an asset with one that provides equivalent
capacity because advances in technology may mean that any available replacement asset would increase
capacity. For example, it would be difficult to replace a computer without increasing capacity or service
potential because of the rapid advances in computer technology.
Current cost has been criticised on a number of grounds, including the following.
• Lack of relevance to decision making
– Current cost is not a measure of the value received but of the amount of the sacrifice that would be
required to replace an asset, and therefore, it has limited predictive value.
– Financial information based on current cost is difficult to interpret where an entity does not intend to
replace its assets.
– Current cost’s applicability to non-renewable or irreplaceable assets such as oil and gas reserves is
questionable.
– Current cost is not an independent measurement basis. It must be supplemented by additional rules
to ensure that the amount represented by current cost is recoverable.
• Reliability problems
– Reliability may be reduced by the need to identify assets of equivalent productive capacity or service
potential and by measuring their most economic current cost.

MODULE 1 The Role and Importance of Financial Reporting 33

 – There may be uncertainty about the reliability of measurement because replacement cost is an entity-
specific measure that depends on management’s strategies and intentions about the level of capacity
at which the asset is used.
• Comparability problems
– Management strategies and expectations with respect to the assets concerned (e.g. nature of the use
of a building and whether it is fully occupied) may change in response to changes in the business
environment or over time.
– There may be significant differences between entities in the determination of current cost.
The only IFRS that addresses the use of the current cost measurement basis is IAS 29 Financial
Reporting in Hyperinflationary Economies.

QUESTION 1.9

Refer to question 1.7 regarding the Sydney Harbour Bridge. How might using an alternative
measure, such as current cost, overcome the limitations of cost outlined in that question?

Fair Value Less Costs of Disposal

The third value-based measure shown in figure 1.7, fair value less costs of disposal, is a variant of fair
value used in some standards. For example, fair value less costs of disposal is used in IAS 36 Impairment of
Assets, which defines the recoverable amount of an asset or cash-generating unit as ‘the higher of its fair
value less costs of disposal and its value in use’ (IAS 36, para. 6). Costs of disposal are the ‘incremental
costs directly attributable to the disposal of an asset or cash-generating unit, excluding finance costs and
income tax expense’ (IAS 36, para. 6). Finance costs and income tax are similarly excluded from the
measurement of costs to sell by IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
(Appendix A).

Net Realisable Value

The fourth value-based measure shown in figure 1.7 is net realisable value. This approach measures
the economic benefits that an entity expects to derive from selling an asset in the ordinary course of
business. The use of net realisable value in financial reporting is largely restricted to its role in measuring
inventories at the lower of cost and net realisable value, in accordance with IAS 2 Inventories. Net
realisable value is:
the estimated selling price in the ordinary course of business less the estimated costs of completion and the
estimated costs necessary to make the sale (IAS 2, para. 6).
Applied to inventory, net realisable value is a measure of the net amount that the entity expects to derive
from the sale of the inventory in the ordinary course of business.
Net realisable value differs from fair value less costs to sell, which measures the amount that could be
obtained from selling the asset in its current state. Net realisable value measures the benefits that the entity
expects to realise from the asset in the ordinary course of business. If the inventory is in a complete state,
there is generally no difference between the two values. However, work-in-progress inventory would be
completed before being sold in the ordinary course of business. Accordingly, the net realisable value of
work-in-progress inventory usually differs from its fair value less costs to sell.
Net realisable value may also reflect entity-specific expectations regarding the estimated selling price
in the ordinary course of business, the estimated cost of completion and costs necessary to make the sale.
These expectations may not be in accordance with market expectations on which fair value would generally
be based. For example, a second-hand car dealer may sell a specific model of car for $10 000 in the normal
course of business. If the estimated costs to make the sale are nil, the net realisable value of the car to
the dealer is $10 000. The same car is available for sale on second-hand car websites for $8000, without
selling costs, through private sales, which may be used as an indicator of fair value. If the second-hand car
belongs to an entity whose main business is not to sell cars, the entity may recognise the car based on the
fair value of the car of $8000; if the second-hand car belongs to an entity whose main business is to sell
cars, the entity may recognise the car based on the net reliable value of the car of $10 000.

34 Financial Reporting
Fulfilment Value
The fifth value-based measurement shown in figure 1.7 is fulfilment value. It is defined in the Conceptual
Framework as follows.
Fulfilment value is the present value of the cash, or other economic resources, that an entity expects to be
obliged to transfer as it fulfils a liability. Those amounts of cash or other economic resources include not
only the amounts to be transferred to the liability counterparty, but also the amounts that the entity expects
to be obliged to transfer to other parties to enable it to fulfil the liability (para. 6.17).

The definition of fulfilment value used in the Conceptual Framework differs slightly from the concept
of the fair value of a liability described in the framework and used by the IASB in IFRS 13 Fair Value
Measurement. The fair value of a liability is the amount that would be paid to transfer a liability in an orderly
transaction between market participants at the measurement date. In contrast, the fulfilment value refers
to the amount that the entity expects to be obliged to transfer to settle the liability with the counterparty.
While fair value is determined based on market-participant assumptions, the fulfilment value of a
liability reflects entity-specific assumptions rather than assumptions by market participants, including
whether the entity should settle the liability using its own internal resources and the efficiency with which
an entity can settle a liability (which depends on the advantages and disadvantages that a particular entity
has relative to the market). In practice, there may sometimes be little difference between the assumptions
that market participants would use and those that an entity itself uses (para. 6.19).

Value in Use
The sixth and final value-based measure shown in figure 1.7 is value in use. This measure is defined in
IAS 36 (para. 6) as ‘the present value of future cash flows expected to be derived from an asset or cash-
generating unit’. The Conceptual Framework refers to a similar definition as follows.
Value in use is the present value of the cash flows, or other economic benefits, that an entity expects to
derive from the use of an asset and from its ultimate disposal (para. 6.17).

Value in use is also frequently referred to as the ‘entity-specific value’. The value in use should reflect
the estimated future cash flows that ‘the entity expects to derive from the asset’ (IAS 36, para. 30(a)).
However, other elements of the value-in-use computation may reflect market expectations rather than the
entity’s expectations. For example, the discount rate that is applied to the expected cash flows must reflect
the current market assessment of the time value of money and the risks specific to the asset for which the
future cash flow estimates have not been adjusted (IAS 36, para. 55).
The entity-specific value-in-use measurement basis has the following advantages.
• Management is in the best position to judge the expected amount, timing and risk of future cash
flows. Accordingly, financial statements are considered to be more relevant and reliable as they reflect
management’s intentions and expectations.
• Management would be held more accountable against measurements that reflect entity-specific man-
agement objectives.
The criticisms of the value-in-use basis of measurement include the following.
• Reliability problems
– Because value in use is normally calculated as the discounted future cash flows derived from the use
of an asset, it is specific to each entity and to each specific use. It therefore relates to only one specific
future course of action or combination of actions.
– Value in use is subjective and is not capable of being independently verified by others.
– The application of value in use to assets that do not generate contractual cash flows is problematic.
– An individual asset may work with other assets to generate cash flows. The measurement of value in
use of each asset results in the need to allocate expected cash flows across assets. These allocations
may be arbitrary.
• Understandability
– As cash flows are based on management expectations, while the discount rate used to calculate the
present value of those cash flows is based on market conditions, there seems to be a lack of clarity
regarding whether value in use should reflect management or market expectations.

MODULE 1 The Role and Importance of Financial Reporting 35

PRESENT VALUE AS A VALUATION TECHNIQUE
Figure 1.7 shows present value (PV) separately, as it is not a measurement basis; rather, it is a measurement
or valuation technique that can be used to estimate other measurement bases. For example, amortised cost
and value in use rely on present value calculations. Similarly, IFRS 13 Level 2 or Level 3 fair values
may be determined based on a present value technique (IFRS 13, para. 74). The present value technique
involves discounting a series of expected cash flows using an appropriate discount rate to control for the
time value of money and risk. As such, issues that arise in the application of the present value technique
include the:
• uncertainty of future cash flows
• selection of an appropriate discount rate.

Uncertainty of Future Cash Flows

The reliable measurement of the PV of individual assets and liabilities is problematic because future cash
flows often occur under conditions of uncertainty. Even for contractual amounts, future cash flows may
differ from those originally expected.
IAS 37 Provisions, Contingent Liabilities and Contingent Assets requires that the amount recognised as
a provision must be ‘the best estimate of the expenditure required to settle the present obligation at the end
of the reporting period’ (para. 36). This is often expressed as the amount required to settle the obligation
immediately or to transfer it to a third party. Where the effect of the time value of money is material,
the provision is measured as the PV of the expenditures expected to be required to settle the obligation
(para. 45). The role of uncertain future events must be taken into account where there is sufficient objective
evidence that they will occur (para. 48) and must be based on reasonable and supportable assumptions.
For example, where there is sufficient objective evidence that imminent changes in technology will reduce
the cost of settling obligations arising from a product warranty, such changes are taken into account in
measuring the provision.
A further difficulty can arise in determining the appropriate level of aggregation of cash flows. The need
to allocate cash flows to particular items when those cash flows are produced by the interaction of more
than one factor of production may introduce additional subjectivity into PV calculations. For example,
IAS 36 Impairment of Assets contains requirements and guidance for the measurement of value in use
when assessing the recoverable amount of an asset. When it is not possible to determine the recoverable
amount of an individual asset, IAS 36 (para. 66) requires the entity to determine the recoverable amount
for the cash-generating unit to which the asset belongs.

Selection of Appropriate Discount Rates

Another complexity in the application of the present value technique is the need to select an appropriate
discount rate. PV may be sensitive to the rate chosen for the purpose of discounting future amounts
to a PV.
According to contemporary finance theory, investors require a rate of return that is commensurate with
the systematic risk of an investment, irrespective of whether the investment is in a financial asset or a
project involving non-monetary assets. Therefore, for the purpose of project evaluation, managers should
use a current, market-determined, risk-adjusted discount rate that reflects the systematic risk of the asset,
or group of assets, concerned.
The total risk of an asset comprises systematic risk and unsystematic risk. Systematic risk is sometimes
referred to as market risk or non-diversifiable risk. Systematic risk relates to the extent that the variability
of the return earned on an asset, or group of assets, is due to economy-wide factors affecting all assets. It
can be contrasted with unsystematic risk, the risk that is specific to a particular asset due to that asset’s
unique features. Investors can drive asset-specific (unsystematic) risk towards zero by holding a diversified
portfolio of assets. However, systematic risk cannot be eliminated in this manner. Because investors can
eliminate unsystematic risk, equilibrium returns reflect only the risk-free rate plus a return for bearing
systematic risk in excess of the risk-free rate.
It is important to note that this conclusion emerges from the investor’s capacity to diversify, either
directly or via a mutual fund. It is unrelated to a producing entity’s capacity, or lack of capacity, to diversify
its investment projects. As investors can diversify their investments, diversification or lack thereof by
a producer does not add or reduce value for investors. Investors will not pay any more than the price
associated with the return required to compensate for systematic risk. This means that producing entities

36 Financial Reporting
should accept a project that has a positive net present value when the cash flows are discounted at a rate
adjusted for the systematic risk of the project. That is, each project has its own discount rate adjusted
for systematic risk.
There is a preference in accounting pronouncements for using discount rates that are risk-adjusted when
measuring the present values. For example, IAS 19 Employee Benefits states:
The rate used to discount post-employment benefit obligations (both funded and unfunded) shall be
determined by reference to market yields at the end of the reporting period on high quality corporate bonds.
For currencies for which there is no deep market in such high quality corporate bonds, the market yields
(at the end of the reporting period) on government bonds denominated in that currency shall be used. The
currency and term of the corporate bonds or government bonds shall be consistent with the currency and
estimated term of the post-employment benefit obligations (IAS 19, para. 83).

Another issue is whether to use a current market rate (whether risk-free or risk-adjusted) or the historical
interest rate implicit in the original transaction. Historical and current rates are now considered.
Historical Rates
In the context of a historical cost system, the historical interest rate implicit in the original contract is
usually considered to be the rate at which the cash flows specified in the contract are to be discounted. At
the date of issuing a financial instrument, the discount rate implicit in the original contract is the effective
rate demanded by lenders. Where a financial instrument is traded in an active market, the discount rate
implicit in the original contract is a market-determined, risk-adjusted discount rate, current at the date of
issue of the financial instrument.
Pronouncements that require the use of historical rates include IFRS 9 Financial Instruments. Certain
financial liabilities and assets are carried at amortised cost, using the effective-interest-rate method
(IFRS 9, paras 4.1.1 and 4.2.1 and Appendix A).
IFRS 16 Leases is another example of a pronouncement that requires the use of historical rates. More
specifically, IFRS 16 requires lease liabilities and receivables to be recognised initially by lessees and
lessors by discounting the relevant cash flows to present values using the interest rate implicit in the lease
(IFRS 16, paras 26 and 68).
Current Rates
Current rates are based on a discount rate that is current at the end of the reporting period. Current rates
may be adjusted for risks (unless risks are otherwise adjusted for in the estimated cash flows) and may
be market-determined. The use of current, market based, risk-adjusted rates in determining PV is more
consistent with a fair value approach to measurement because it reflects the rate that the market would use
to discount the expected future cash flows.
Examples of pronouncements that specify the use of current rates include:
• IAS 19 Employee Benefits. The standard adopts the position that employer obligations arising from
defined benefit plans and other long-term employee benefits, such as long service leave (LSL), are
measured at their present values at the end of the reporting period. The rate used to discount such
obligations is determined by reference to market yields on high-quality corporate bonds with equivalent
terms and currency at the end of the reporting period (para. 83).
• IAS 36 Impairment of Assets. This standard requires that the discount rate used in determining value in
use be a pre-tax rate that reflects current market assessments of the time value of money and the risks
specific to the asset for which the future cash flows have not been adjusted (para. 55).
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The standard requires provisions to be
measured at present value using ‘. . . a pre-tax rate (or rates) that reflect(s) current market assessments
of the time value of money and the risks specific to the liability’ (para. 47).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 6.1–6.95 of the Conceptual Framework.

MODULE 1 The Role and Importance of Financial Reporting 37

1.6 APPLICATION OF MEASUREMENT PRINCIPLES
IN THE INTERNATIONAL FINANCIAL REPORTING
STANDARDS
Accounting standards provide the practical mechanism for achieving the overall objectives of financial
reporting, as well as outlining how best to achieve as many qualitative characteristics as possible. By
specifying how accounting information should be treated and reported, different organisations can gain
considerably more consistency and understandability than would be achieved if they used their own
judgment when reporting their financial affairs. It also limits the scope for abuse and misreporting that may
arise when the economic self-interest of organisations or their managers interferes with objective reporting.
Moreover, accounting standards go beyond specifying how items must be reported; they provide detailed
discussion of why the mandated approaches are required.
This section will take a closer look at the mixed measurement model applied in the IFRSs. Mixed
measurement models are adopted in various forms with a focus on different measures and applications
to provide accounting policy choice and, in some instances, to determine the required measurement basis.
Where there is accounting policy choice, accountants have the ability to exercise judgment according to
the circumstances. At the same time, some degree of comparability in measurement is maintained through
the IFRSs.
This discussion will focus on the following selected IFRSs.
• IFRS 16 Leases
• IAS 19 Employee Benefits
• IFRS 2 Share-based Payment
• IAS 40 Investment Property
These standards have been selected because of their commercial relevance and their common application
in financial statements. The following discussion will also explain and highlight how different the
application of measurement principles can be.

LEASES
A new standard for leases was issued in 2016, replacing IAS 17. This new standard, IFRS 16 Leases, applies
to annual reporting periods beginning on or after 1 January 2019 but may be applied earlier by entities that
are applying IFRS 15 Revenue from Contracts with Customers before this date (IFRS 16, Appendix C,
para. C1). The objective of IFRS 16 is to provide the principles for ‘recognition, measurement, presentation
and disclosure of leases’ in a manner that faithfully represents the effect of leases on an entity’s financial
position, financial performance and cash flows (IFRS 16, para. 1). The parties to a lease contract are the
lessee and the lessor. The lessee is the entity that obtains the right to use the asset, and the lessor is the
entity that provides the right to use the asset (IFRS 16, Appendix A).
IFRS 16 requires entities to use professional judgment when determining if a lease exists and, if it
does, the impact it will have on the financial reporting of the entity. Each contract must be assessed at
its commencement to determine if it contains a lease. A contract contains a lease if it ‘conveys the right
to control the use of an identified asset for a period of time in exchange for consideration’ (IFRS 16,
para. 9). The period of time is commonly greater than 12 months, but it may also be expressed as an
‘amount of use’. For example, the number of units produced by the underlying asset. The existence of a
lease must be reassessed each time there is a change to the terms and conditions of the contract (IFRS 16,
paras 9–11).
Professional judgment must again be used in considering whether or not a lessee is ‘reasonably certain’
to exercise specific options that will impact the lease term and the measurement criteria. For example, the
lease term includes the ‘non-cancellable period’ plus periods covered by an option to ‘extend the lease if
the lessee is reasonably certain to exercise that option’ and to ‘terminate the lease if the lessee is reasonably
certain not to exercise that option’ (IFRS 16, para. 18).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 9–21 of IFRS 16.

38 Financial Reporting
Recognition Criteria for the Lessee
At the commencement date of a lease, the lessee recognises a right-of-use asset at cost and a lease liability
(IFRS 16, paras 22–23). A right-of-use asset is the asset specified in the lease contract that the lessee has
the right to use during the lease term. The recognition and measurement criteria for a lessee are summarised
in table 1.8.

TABLE 1.8 Recognition and measurement criteria for the lessee

Right-of-use asset† Lease liability‡

Initial measurement Initial measurement

‘The cost of the right-of-use asset shall comprise:
(a) the amount of the initial measurement of the lease
liability . . .;
(b) any lease payments made on or before the
commencement date, less any lease incentives
received;
(c) any initial direct costs incurred by the lessee; and
(d) an estimate of costs to be incurred by the lessee
in dismantling and removing the underlying asset,
restoring the site on which it is located or restoring
the underlying asset to the condition required by the
terms of the lease’ (IFRS 16, para. 24).
The lease liability is measured at the present value
of future lease payments, ‘discounted using the
interest rate implicit in the lease’, or using ‘the lessee’s
incremental borrowing rate’ if the implicit interest rate
cannot be easily determined (IFRS 16, para. 26).
Future lease payments include:
(a) ‘fixed payments . . . less any lease incentives
receivable;
(b) variable lease payments . . .;
(c) amounts expected to be payable by the lessee
under residual value guarantees;
(d) the exercise price of a purchase option if the lessee
is reasonably certain to exercise that option . . .; and
(e) payments of penalties for terminating the lease’
(IFRS 16, para. 27).

Subsequent measurement Subsequent measurement

Unless alternative measurement models (see ‘Alterna-
tives’) are applied, the lessee applies the cost model
under which the right-of-use asset is measured.
To apply a cost model:
• measure at cost less accumulated depreciation and
accumulated impairment losses
• adjust for any remeasurements of the lease liability
(IFRS 16, paras 29–30).
The lease liability is measured by:
(a) ‘increasing the carrying amount to reflect interest on
the lease liability;
(b) reducing the carrying amount to reflect the lease
payments made; and
(c) remeasuring the carrying amount to reflect any
reassessment or lease modifications . . . or to
reflect revised in-substance fixed lease payments’
(IFRS 16, para. 36).

Alternatives
Other measurement models may be used under the
following circumstances:
• ‘If a lessee applies the fair value model in IAS 40
Investment Property to its investment property’, then
the fair value model is applied to the right-of-use
assets.
• The revaluation model may be applied per IAS 16
Property, Plant and Equipment if the lessee has
applied that model to a class of property, plant and
equipment to which the right-of-use asset relates
(IFRS 16, paras 34–35).

† For further exploration of this topic, read paras 23–25 and 29–35 of IFRS 16.
‡ For further exploration of this topic, read paras 26–28 and 36–43 of IFRS 16.
Source: Adapted from IFRS Foundation 2019e, IFRS 16 Leases, in IFRS Standards issued at 1 January 2019, IFRS Foundation,
London, pp. A801–A846 and B411–B454.

There are two recognition exemptions available to lessees. They apply to ‘short-term leases’ and ‘low
value leases’ (IFRS 16, para. 5). A lease is considered short term if it is for no more than 12 months
(IFRS 16, Appendix A) and the short-term lease exemption can only be applied to a class of underlying
assets, not on the basis of the terms of each lease contract (IFRS 16, para. 8).

MODULE 1 The Role and Importance of Financial Reporting 39

 The assessment of whether the lease is a low value lease or not is based on the value of the underlying
asset when it is new (IFRS 16, Appendix B, para. B3) and cannot be applied to subleases (IFRS 16,
Appendix B, para. B7). The underlying asset is only of low value if:
(a) the lessee can benefit from use of the underlying asset on its own or together with other resources that
are readily available to the lessee; and
(b) the underlying asset is not highly dependent on, or highly interrelated with, other assets (IFRS 16,
Appendix B, para. B5).
Tablets and personal computers, telephones, and small items of office furniture are examples of
underlying assets of low value (IFRS 16, Appendix B, para. B8). The actual amount that constitutes a
low value is not specified in IFRS 16; however, BC100 of IFRS 16 states that the IASB’s view of low
value is ‘in the order of magnitude of US$5000 or less’.

EXAMPLE 1.6

Accounting for Leases by Lessee

On 30 June 20X4, A Ltd (lessor) leased a motor vehicle to B Ltd (lessee). At that date, the fair value of the
vehicle is $68 000, its estimated residual value at the end of the lease term is $10 000 and its economic
useful life is six years. The lease is cancellable but the lessee will incur a penalty equal to 24 months of
lease payments if it chooses this option. For the purposes of this example, we will assume the lessee
does not cancel the lease. There is no option for the lessee to purchase the vehicle at the end of the lease
term. The lease agreement cost A Ltd $2647 to set up and included the following details.

Annual lease payments (payable 30 June each year in advance) $19 800
Executory costs (included in annual lease payment)* $ 1 800
Residual value guarantee† $ 6 000
Unguaranteed residual value‡ $ 4 000
Lease term 4 years
Interest rate implicit in the lease 9%

* The executory costs relate to the reimbursement of insurance and maintenance costs which will be paid annually
by A Ltd.
† The residual value guarantee is the part of the estimated residual value that is guaranteed by the lessee according
to the lease agreement. It represents the value that the lessee guarantees that the underlying asset will be valued at when
the lease term ends and, as such, it is recognised as part of the lease payments by the lessee. If the residual value of
the underlying asset at the end of the lease term is below the guarantee and the asset is to be returned to the lessor, the
lessee is responsible to pay the difference to the lessor.
‡ The unguaranteed residual value is the part of the estimated residual value of the underlying asset at the end of the lease
that is not guaranteed by the lessee, but it may be guaranteed by a party related to the lessor. As such, the unguaranteed
residual value is recognised only by the lessor as part of the lease receipts that they are expecting to collect.
The first step for the lessee, B Ltd, is to determine the value of the right-of-use vehicle and the lease
liability to be recognised at the commencement date of the lease.
The value of the right-of-use vehicle is equal to the value of the lease liability plus any lease payments
made at the beginning of the lease term. The lease liability is the present value of the future lease payments
(including the guaranteed residual value to be paid at the end of the lease term). The present value of the
lease payments is calculated as follows.
Interest rate = 9% $ $
Payment in advance each year for remaining 3 years 18 000 45 563†
Guaranteed residual at end of 4 years 6 000 4 250‡
Lease liability = PV of future lease payments 49 813
Add: First payment in advance (30 June 20X4) 18 000
Cost of right-of-use asset 67 813
Add: PV of unguaranteed residual at end of 4 years 4 000 2 834‡
Total present value of lease 70 647
A quick reconciliation can be performed to confirm that the present value of the lease equals the fair value
of the underlying assets plus incidental direct costs.
Fair value 68 000
Incidental direct costs to lessor 2 647
FV + Incidental direct costs 70 647

† PV factor of an annuity at 9% over 3 years = 2.5313. $18 000 × 2.5313 = $45 563.
‡ PV factor of a lump sum in 4 years time at 9% = 0.7084. Guaranteed residual of $6000 × 0.7084 = $4250. Unguaranteed
residual of $4000 × 0.7084 = $2834.

40 Financial Reporting
 Once the values have been determined, the lessee can then prepare the following schedule of
lease payments.
Lease payments schedule for B Ltd (lessee)

Lease Interest Reduction Balance

payments† expense‡ in liability§ of liability||
30.06.20X4 49 813#
30.06.20X5 18 000 4 483 13 517 36 296
30.06.20X6 18 000 3 267 14 733 21 563
30.06.20X7 18 000 1 941 16 059 5 504
30.06.20X8 6 000 496 5 504
60 000 10 187 49 813

† Future lease payments of $18 000 payable in advance.

‡ Balance of liability each year × interest rate of 9%.
§ Lease payments less interest expense. The total must equal the initial lease liability recognised.
|| Balance of liability each year less the reduction in the liability.
# The PV of the total lease payments (also equal to the value of the right-of-use asset) less any payments made at
beginning of the lease term.

QUESTION 1.10

Using the information provided in example 1.6, prepare the journal entries to be recorded by the
lessee (B Ltd) throughout the lease term. Please provide a detailed answer.

Recognition Criteria for the Lessor

A lessor is required to classify each of its leases as either a finance lease or operating lease (IFRS 16,
para. 61). A finance lease is defined in Appendix A as ‘a lease that transfers substantially all the
risks and rewards incidental to ownership of an underlying asset’. An operating lease is defined in
Appendix A as ‘a lease which does not transfer substantially all the risks and rewards incidental to
ownership of an underlying asset’. It is the substance of the transaction rather than the form of the contract
that determines whether a lease is classified as a finance or operating lease.
Situations that lead to classification of a finance lease include:
• ownership is transferred to the lessee by the end of the lease term
• an option for the lessee to purchase the underlying asset at a price that is sufficiently lower than its fair
value at the date the option becomes exercisable for it to be reasonably certain
• the term of the lease is for the majority of the underlying asset’s economic life (Note: IFRS 16 does
not specify what constitutes the majority or ‘major part’ of the asset’s economic life. This would be a
matter of professional judgment and needs to consider the substance of the lease and whether or not
substantially all of the risks and benefits of ownership are transferred.)
• the present value of the lease payments amount to substantially all of the fair value of the underlying
asset
• the specialised nature of the underlying asset means only the lessee can use it without major
modifications
• the lease is cancellable and the lessor’s associated losses are to be incurred by the lessee thus indicating
a transfer of risks and rewards of the underlying asset to the lessee
• gains or losses from changes in the residual amount’s fair value are accrued to the lessee
• the lessee may continue the lease for another period with the rent amount ‘substantially lower’ than
market value (IFRS 16, paras 63–64).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 61–66 of IFRS 16.

Lessors of operating leases must recognise the lease payments as income on a straight-line or other
systematic basis if that is representative of the benefit pattern of the underlying asset. Initial direct
costs incurred in obtaining the operating lease are added to the carrying amount of the underlying asset

MODULE 1 The Role and Importance of Financial Reporting 41

and recognised as an expense over the lease term using the same basis as the lease income (IFRS 16,
paras 81–83). The recognition and measurement criteria for lessors are summarised in table 1.9.

TABLE 1.9 Recognition criteria for the lessor

Finance lease† Operating lease‡

Initial measurement Initial measurement

The net investment in the lease comprises: Lease payments received are recognised as income
• initial direct costs incurred by lessor ‘other than those on a straight-line or other systematic basis that is
incurred by manufacturer or dealer lessors’ (IFRS 16 representative of the pattern of benefit from the use of
Leases, para. 69) the underlying asset.
• fixed payments, less lease incentives payable Initial direct costs are added to the carrying amount of
• variable lease payments the underlying asset and recognised as an expense on
• residual value guarantees provided by the lessee or a the same basis as the lease income (IFRS 16,
third party paras 81–83).
• exercise price of purchase option if lessee is
reasonably certain they wish to exercise that option
• payments of penalties for terminating the lease
• any unguaranteed residual value accruing to the
lessor.
The interest rate implicit in the lease is used to measure
the net investment in the lease (IFRS 16, paras 68–70).
Specific recognition criteria for manufacturer or dealer
lessors are set out in IFRS 16 (paras 71–74).

Subsequent measurement Subsequent measurement

Finance income is recognised on a systematic basis
over the lease term. Lease payments are applied
against the gross investment to reduce the principal
amount and the unearned finance income (IFRS 16,
paras 75–78).
Depreciation is recognised as an expense in
accordance with IAS 16. The underlying asset should
be tested for impairment and any impairment loss
recognised in accordance with IAS 36 Impairment of
Assets (IFRS 16, paras 84–86).

† For further exploration of this topic, read paras 67–78 of IFRS 16.
‡ For further exploration of this topic, read paras 81–86 of IFRS 16.
Source: Adapted from IFRS Foundation 2019e, IFRS 16 Leases, in IFRS Standards issued at 1 January 2019, IFRS Foundation,
London, pp. A801–A846 and B411–B454.

EXAMPLE 1.7

Accounting for Leases by Lessor

This example uses the information provided in example 1.6.
The first step for the lessor is to determine if the lease is a finance lease or an operating lease, by applying
the guidance in paragraphs 63 and 64 of IFRS 16. This is to assess if the information (individually or in
combination) satisfied the criteria for classification as a finance lease.
• The lease agreement does not include an option for B Ltd to purchase the vehicle at the end of the
lease term. Therefore, the transfer of ownership test is not satisfied.
• The vehicle is not of a specialised nature that makes it useful only for B Ltd. Therefore, the specialised
nature test is not satisfied.
• The lease term is for four years, which is 66.67% of the vehicle’s useful economic life of six years.
Assuming the expected benefits of the vehicle are receivable evenly over its useful life, it could be
argued that the lease is for the majority of the underlying asset’s economic life. Therefore, the lease
term test is satisfied.
• The present value of the lease payments of $67 813 represents almost all of the fair value of the vehicle,
$68 000. Therefore, the present value test is satisfied.
• Although the lease agreement is cancellable, the monetary penalty of 24 months of lease payments, to
be incurred by B Ltd, indicates that the risks associated with the underlying asset have been transferred
to the lessee.
Professional judgment must be applied to determine if the listed indicators are showing if the vehicle
is under a finance or an operating lease. The main indicators are the:
• relatively low residual value at the end of the lease term
• majority of the fair value being covered in lease payments over a four-year period instead of the vehicle’s
full useful life of six years
• substantial monetary penalty for cancellation of the lease.

42 Financial Reporting
 Without further information, it would likely be concluded that the lease is a finance lease, as substantially
all the risks and rewards of the vehicle are to be passed to B Ltd.
Assuming A Ltd classifies the lease of the vehicle as a finance lease, A Ltd can now prepare a schedule
of lease receipts. The amount recognised by the lessor includes the unguaranteed residual value. The
calculations in example 1.6 show the present value of this amount to be $2834. Therefore, the full amount
receivable is $67 813 plus $2834 = $70 647.

Lease receipts schedule for A Ltd (lessor)

Lease Interest Reduction in Balance of

receipts† (i) revenue‡ (ii) receivable§ receivable||
30/06/20X4 (iii) (v) (iv)
# 70 647
30/06/20X4 18 000 18 000 52 647
30/06/20X5 18 000 4 738 13 262 39 385
30/06/20X6 18 000 3 545 14 455 24 930
30/06/20X7 18 000 2 244 15 756 9 174
30/06/20X8 10 000 826 9 174
82 000 11 353 70 647

† Four annual receipts payable in advance. Residual value on last day of lease term is the full amount of the residual
value ($6000 guaranteed; $4000 unguaranteed).
‡ Balance of receivable each year × interest rate of 9%.
§ Lease receipts less interest revenue. Total must equal the initial amount of the lease receivable.
|| Balance of receivable less the reduction in receivable.
# Initial receivable amount equals the fair value of $68 000 plus initial direct costs of $2647. This amount should also
equal the PV of the lease payments receivable (calculated in previous example) and the PV of the unguaranteed
residual value. As the unguaranteed residual value is not the responsibility of the lessee, its presence makes the
initial value of lease liability recognised by the lessee different from the initial value of lease receivable recognised
by the lessor.

QUESTION 1.11

Using the information provided in example 1.7, prepare the journal entries to be recorded by the
lessor (A Ltd) throughout the lease term. Please provide a detailed answer.

Presentation and Disclosure

There are presentation and disclosure requirements for the lessee and the lessor to assist users of financial
statements to determine the effect of leases on the entity’s financial situation. For a lessee, the right-of-
use assets and the lease liabilities shall be reported separately from other assets and liabilities in either the
financial statements or the notes. The exception to this is if the right-of-use asset is classified as investment
property, which shall be presented in the statement of financial position as investment property. Interest
incurred on the lease liability must be included as a component of finance costs and presented separately
from depreciation expense on the right-of-use asset.
Disclosure requirements for the lessor include additional qualitative and quantitative information
regarding the nature of their leasing activities and their risk management strategy for the rights they retain
in the underlying assets. These disclosure requirements are also dependent on whether the lease is classified
as a finance or operating lease.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 47–60 and 88–97 of IFRS 16.

EMPLOYEE BENEFITS
IAS 19 Employee Benefits prescribes the principles of accounting for employee benefits. The standard
defines employee benefits as ‘all forms of consideration given by an entity in exchange for service rendered
by employees or for the termination of employment’ (IAS 19, para. 8). These benefits can be short-term
or long-term employee benefits.

MODULE 1 The Role and Importance of Financial Reporting 43

Short-term Employee Benefits
Short-term employee benefits are defined as:
employee benefits (other than termination benefits) that are expected to be settled wholly before twelve
months after the end of the annual reporting period in which the employees render the related service
(IAS 19, para. 8).

Examples of short-term employee benefits include wages and salaries; profit-sharing and bonuses; non-
monetary benefits such as medical care; and short-term compensated absences such as annual leave and
sick leave (IAS 19, para. 9). The liability for short-term benefits should be measured at the undiscounted
amount expected to be paid on settlement of the obligation. Recognition of the liability will usually give
rise to a corresponding expense, although in some circumstances it may be included in the carrying amount
of an asset such as plant and equipment or inventory.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 9–11 of IAS 19.
Employees may be entitled to compensation for absences for a variety of reasons, including annual
leave, sick leave and long service leave (LSL). In accordance with paragraph 11 of IAS 19, short-term
compensated absences must be recognised at the undiscounted amount of employee benefit that the
entity expects to pay for the employees’ services. Compensated absences that are expected to be settled
beyond 12 months after the end of the reporting period are measured using the PV technique (IAS 19,
paras 153–155).
When compensated absences are considered, it is important to distinguish between:
• accumulating and non-accumulating benefits
• vesting and non-vesting benefits.
An accumulating compensated absence arises where the employees can carry forward their entitlements
to future periods. If the compensated absence does not accumulate, they lapse if not fully used within the
current period (IAS 19, para. 18).
An accumulating compensated absence may be vesting or non-vesting. A vesting benefit arises when
the employer is obligated to pay any unused benefits to the employee on their leaving the entity (IAS 19,
para. 15). That is, the employer is obligated to settle a vesting benefit, even if the employee resigns or their
employment is terminated. For vesting compensated absences, the employee will be paid either when the
leave is taken or on termination of employment.
If a compensated absence is non-accumulating, the cost of providing the benefit is not recognised until
the absence occurs (IAS 19, para. 13(b)). A liability is not recognised before leave is taken because the
employee’s service does not increase the amount of the leave benefit and benefits lapse as each year ends
(IAS 19, para. 18).
When a compensated absence is accumulating and vesting, a liability for accumulated compensated
absences is recognised, as employees render services that increase their entitlement to future compensation
(IAS 19, para. 13(a)). In accordance with IAS 19, the undiscounted amount of employee benefit is used
for accumulated unused compensated absence benefits that the entity expects to settle within 12 months
after the reporting period (paras 11–16).
For compensated absences that are accumulating but non-vesting, the employee is only compensated for
absences taken (e.g. in Australia this is usually the case with sick leave). On termination of employment, the
employee is not compensated for any unused entitlement. Despite this, it can be argued that the definition
of a liability is satisfied for unused benefits. That is, there has been a past event (rendering services) that
results in an obligation for accumulating, non-vesting compensated absences to be carried forward as part
of the employee’s benefits. However, whether a liability for an accumulating, non-vesting compensated
absence is recognised depends on the probability that a payment will be made. For this reason, IAS 19
specifies that entities should:
measure the expected cost of accumulating paid absences as the additional amount that the entity expects
to pay as a result of the unused entitlement that has accumulated at the end of the reporting period (IAS 19,
para. 16).

A liability for non-vesting compensated absences should be recognised only for that part of the
accumulated entitlement that is expected to result in additional payments to employees. The probability
that the leave will be taken affects the decision to recognise the liability and the amount of the liability, if
any, that is recognised.

44 Financial Reporting
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 11–18 of IAS 19, noting in particular the ‘Example Illustrating
Paragraphs 16 and 17’.

QUESTION 1.12

An entity has 500 employees who are provided with ten days sick leave for each year of service
on a non-vesting accumulating basis. At 30 June 20X6, 20% of employees had taken their full
entitlement of sick leave. The remaining employees had an average of 12 days’ accumulated leave.
Past experience indicates that:
• 20% of employees use all of their sick leave in the year in which they become entitled to it and
therefore have no accumulated sick leave at the end of the year
• 50% of the entity’s employees use six days of accumulated sick leave in years subsequent to
their accumulation
• 30% of employees take two days of accumulated sick leave in years subsequent to their
accumulation.
Assume that the average annual salary per employee is $40 000 and that employees have a five-
day working week.
(a) Measure the nominal amount of the provision for sick leave as at 30 June 20X6 in accordance
with IAS 19.
(b) Explain whether it is important to know the timing of the payments to employees for accumu-
lated sick leave in future reporting periods.

Long-term Employee Benefits

As a result of providing services during a particular reporting period, employees may receive benefits
several years later. These benefits may be settled:
• while the employee is still employed or upon resignation (e.g. LSL), or
• subsequent to the employee’s employment (e.g. superannuation benefits and other post-employment
benefits).
This module focuses on LSL to illustrate the application of measurement principles and techniques to
long-term employee benefits.
Long Service Leave
In some countries, including Australia, LSL is an entitlement that accrues to employees as they provide
services to an entity. This entitlement accrues with years of service. Under some industrial laws and
employment contracts, employees are legally entitled to be paid LSL after a certain number of years’
service have been completed (ten years is a typical benchmark). LSL should be recognised as a liability,
once the definition of liability has been satisfied.
In the past, some entities only recognised a liability or expense for LSL when employees became legally
entitled to LSL — that is, when the leave became vested. In effect, employees who were not legally entitled
were excluded in measuring the liability. However, consistent with the Conceptual Framework’s broader
definition of a liability, IAS 19 is based on the view that the definition of a liability or expense is satisfied
as soon as employees provide services that result in LSL entitlements. This is so, irrespective of whether
the employees are legally entitled to LSL.
LSL benefits are paid in reporting periods after the employees’ provision of services, often many years
into the future. Paragraph 155 of IAS 19 requires the amount of the liability for such long-term employee
benefits to be measured on a net basis as the PV of the obligation at the reporting date (see paras 56–98)
minus the fair value at the reporting date of plan assets (if any) out of which the obligations are to be
settled directly (see paras 113–119). According to paragraph 8 of IAS 19, plan assets that exist as part
of an employee benefit plan comprise assets held by the plan and qualifying insurance policies related to
the plan.
Entities estimate the number of employees who may become eligible for LSL, as well as the timing and
amount of the payment. Projected salary levels (e.g. inflation, salary increase and promotions) need to be
factored into the calculation. The estimated LSL payment is discounted to its PV at the reporting date.
In Australia, it would be rare for entities to hold assets in a long-term employee benefit fund to satisfy
LSL obligations. Therefore, this module focuses on the determination of the PV of the obligation.

MODULE 1 The Role and Importance of Financial Reporting 45

 In essence, the Projected Unit Credit Method determines the accumulated entitlement for service on
the basis of the ratio of the period of service completed up to the reporting date, to the periods of service
required to accumulate the total entitlement. For example, if an employee has served eight of the ten years
required for entitlement to LSL, the accumulated entitlement would be 80% of the total entitlement under
the Projected Unit Credit Method.
Determination of the timing and amount of future cash flows requires professional judgment and is often
based on actuarial assessment.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 56–69 of IAS 19, which describe and provide examples of
the Projected Unit Credit Method used to measure long-term employee benefits.
Many employees of an entity will have an insufficient length of service to be legally entitled to an LSL
payment at the reporting date. Nevertheless, a proportion of employees in this category will eventually
qualify for LSL. As a result, a probability assessment must be undertaken to estimate the number of
employees currently in this situation who will eventually be paid for LSL. IAS 19 provides no guidance
on this matter, leaving it to the preparer’s judgment.
Once the number of employees who will be paid LSL has been determined, the next task is to determine
the timing and amount of the payments that will result from services provided up to the reporting date.
To determine the future cash flows associated with LSL benefits, projected annual salary levels must be
estimated. The estimation of projected salaries is affected by the expected timing of payment of LSL and
involves consideration of factors such as inflation and promotions.
The estimated future LSL payments must be discounted to PV at the reporting date. The interest rate
used will have a significant effect on the measurement of an employer’s obligation for LSL. IAS 19 requires
that the discount rate used to measure LSL liabilities be determined by reference to current market yields
on high-quality corporate bonds. In currencies with no deep market for high-quality corporate bonds, the
interest rates attaching to government bonds must be used (IAS 19, para. 83). It should be noted that entities
operating in different countries will have to select discount rates appropriate to the country in which the
employee will be paid.

QUESTION 1.13

At 30 June 20X7, Maynot Ltd has 100 employees. For simplicity, assume that the employees have
the following periods of service.
Years of service Number of employees
2 10
4 40
8 30
10 10
15 10
100

The employees of Maynot Ltd are employed under an award that provides for LSL on the basis
of 90 calendar days after 13 years of service and nine days per year of service thereafter. After
ten years of service, employees are entitled to a pro rata payment if they resign or their employment
is terminated.
Outline the steps that you would need to take and the factors that you would need to consider in
determining Maynot Ltd’s liability for LSL.

Example 1.8 builds on the data in question 1.13.

EXAMPLE 1.8

Calculation of an Entity’s Liability for Long Service Leave

The following estimates of the likelihood that employees of Maynot Ltd will eventually take leave have
been determined by an actuary.

46 Financial Reporting
 Probability that an employee will
Years of service become entitled to LSL payments
1 0.20
2 0.20
3 0.25
4 0.40
5 0.40
6 0.70
7 0.75
8 0.90
9 0.95
10 1.00

As would be expected, the closer the employee is to completing the pre-entitlement period, the higher
is the probability of payment. From the provided actuarial calculations, it has been estimated that there is
a 70% probability that an employee with six years of service will be employed for a total of ten or more
years and will therefore become entitled to LSL. After nine years of service, it is estimated that there is
a 95% probability that the employee will become entitled (i.e. will stay with the entity for at least one
more year).
Based on the preceding probabilities, it can be estimated that, as at 30 June 20X7, the following number
of employees will eventually be eligible for LSL.

Years of Number of Estimated number of employees

service employees Probability who will become entitled to LSL
2 10 0.2 2
4 40 0.4 16
8 30 0.9 27
10 10 1.0 10
15 10 1.0 10
100 65

Note: Only the probabilities applicable to the current employees are used.
The next task is to determine the future payments for services performed up to the end of the reporting
period that will be made to the 65 employees who, it is estimated, will become entitled to receive LSL pay
in the future. This amount will depend on projected future wages and salaries, as well as experience with
employee departures and periods of service. It is necessary to make assumptions about when the leave
will be taken, as the payment will vary based on that, but also so that the time to settlement can be taken
into account in measuring the present value (PV) of the obligation. Employees do not necessarily take LSL
as soon as they become unconditionally entitled to do so. Some employees may be paid LSL before they
become fully entitled where the employment contract or legal environment allows for leave to be paid on
a pro rata basis if they resign or if the employment is terminated. Again, experience with leave patterns
will be a factor in estimating when LSL obligations will be settled.
Assume that the actuary has estimated that the employees who will become entitled to LSL will be paid
the following amounts in the following periods.

Amount expected
Years from Number of to be paid
30 June 20X7 employees $
2 15 120 000
5 20 200 000
10 20 300 000
15 10 200 000
65 820 000

The final issue is to determine appropriate discount rates to measure the payments at their PV.
This would involve selecting high-quality corporate bond rates with terms to maturity that match the terms
of the estimated cash payments. Again, for illustrative purposes, the discount rates in the second column
of the following table could have been made for Maynot Ltd. Each discount rate is used to determine the
relevant PV factor. The amount expected to be paid in the future is multiplied by the PV factor to calculate
the present value of the liability at the current reporting date. From the calculations shown in the following

MODULE 1 The Role and Importance of Financial Reporting 47

 table, an amount of $120 000 payable in two years time at a discount rate of 8% has a present value
of $102 881.
Amount
expected Present
Years from Discount to be paid Present value
30 June 20X7 rate† $ value factor‡ $
2 0.08 120 000 0.85734 102 881
5 0.09 200 000 0.64993 129 986
10 0.10 300 000 0.38554 115 662
15 0.10 200 000 0.23939 47 878
820 000 396 407

† These discount rates are illustrative market yields on high-quality corporate bonds for the appropriate
term.
‡ The PV factor is determined by using the discount rate indicated and the number of years to the
payment. This can be calculated using the following formula: 1/(1 + r)n , where r is the interest rate
and n is the number of periods to settlement.

Therefore, Maynot Ltd would recognise a liability for LSL of $396 407 as at 30 June 20X7.
Note: The liability for LSL includes amounts expected to be paid to employees who are not yet entitled
to LSL. Whether the obligation is settled and the amount payable is actually paid depend on uncertain
future events, including whether employees will continue in employment for a sufficient period to become
eligible for LSL. The estimation of future cash flows also requires estimation of projected salary levels. The
timing of the settlement may affect the level of projected salaries, as well as the relevant discount factor
because the liability is measured using PV techniques. This further illustrates some of the difficulties with
PV techniques.

ACCOUNTING FOR SHARE-BASED PAYMENTS

Share-based payments provide an interesting illustration of the difficulty of fair value measurement and its
implications. Accounting for share-based payments falls within the scope of IFRS 2 Share-based Payment.
A share-based payment transaction is:
a transaction in which the entity
(a) receives goods or services from the supplier of those goods or services (including an employee) in a
share-based payment arrangement, or
(b) incurs an obligation to settle the transaction with the supplier in a share-based payment arrangement
when another group entity receives those goods or services (IFRS 2, Appendix A).

Share-based payment transactions may be cash-settled or equity-settled.

In a cash-settled share-based payment transaction, the entity acquires goods or services by incurring
a liability to transfer cash or other assets, the amount of which is based on the price of the entity’s equity
instruments (IFRS 2, Appendix A). For example, an entity might agree to pay a cash bonus for employees’
services of 100 times the company’s share price. A transaction may therefore be a share-based transaction
even though there is no exchange of the entity’s equity instruments.
In an equity-settled share-based payment transaction, the entity acquires goods or services as
consideration for its own equity instruments, or it receives goods or services but has no obligation to settle
the transaction with the supplier (IFRS 2, Appendix A). Examples include employee shares and executive
stock options.
Goods or services acquired in a share-based payment transaction are recognised when the goods
are obtained or the services are received (IFRS 2, para. 7). For an equity-settled share-based payment
transaction, a corresponding increase in equity is recognised. For a cash-settled share-based payment
transaction, a corresponding increase in a liability is recognised.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 7–9 of IFRS 2. The definitions of terms used in the standard
are provided in IFRS 2, Appendix A.

48 Financial Reporting
 EXAMPLE 1.9

Performance Bonuses
Great Futures Ltd introduced performance-based remuneration for its senior executives as an incentive
to encourage and reward management performance and to align the interests of managers with those of
the shareholders. Subject to performance hurdles, including a return on equity of 10%, employees in the
incentive scheme receive a bonus. Bonuses are payable three months after the end of the reporting period.
For the year ended 30 June 20X9, performance hurdles were met by several executives.
The bonus payable to the chief executive officer (CEO) was determined as 1000 ordinary shares,
which vested immediately. The share price was $50 on this date. The bonuses payable to six other
executives were cash-based and calculated as 100 times the company’s average share price of $65 from
1 June 20X9 to 31 August 20X9.
The pro forma entry for the CEO’s bonus at 30 June 20X9 was as follows.

Dr Bonus expense 50 000

Cr Equity 50 000

The equity-settled share-based payment transaction resulted in an increase in expenses and a

corresponding increase in equity being recognised when the employee service was received.
The pro forma entry for the other executives’ bonuses at 30 June 20X9 was as follows.

Dr Bonus expense 39 000

Cr Liability 39 000

The cash-settled share-based payment transaction resulted in an increase in expenses and a corre-
sponding increase in liabilities being recognised when the employee service was received.

Measurement of Share-Based Payment Transactions

Share-based payment transactions are measured as follows.
• Equity-settled
– Measure the goods or services received and the corresponding increase in equity at the fair value of
the goods or services received, provided that the fair value can be estimated reliably. This is referred
to as directly measuring the goods and services.
– In some cases, the fair value of the goods or services received cannot be estimated reliably, such as for
transactions with employees and others providing similar services. Under these circumstances, the
fair value of the goods or services and the corresponding increase in equity are measured indirectly,
with reference to the fair value of the equity instruments granted.
• Cash-settled
– Measure the goods or services received and the liability incurred at the fair value of the liability.
– Until the liability is settled, it may be remeasured at the end of each reporting period and upon
settlement, with changes in the fair value of the liability recognised in P/L.
In the case of equity-settled share-based payment transactions, the fair value of the goods or services
acquired drives the measurement of equity, consistent with equity being the residual element in the
statement of financial position (i.e. the difference between assets and liabilities). However, if the fair value
of the goods or services acquired cannot be measured reliably, IFRS 2 departs from this approach and
requires indirect measurement based on the fair value of the equity instruments (IFRS 2, para. 10).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 10–13A and 30–33 of IFRS 2.

INVESTMENT PROPERTY
Investment property is defined in IAS 40 Investment Property, paragraph 5, as:

property (land or a building — or part of a building — or both) held (by the owner or by the lessee as a
right-of-use asset) to earn rentals or for capital appreciation or both, rather than for:
(a) use in the production or supply of goods or services or for administrative purposes; or
(b) sale in the ordinary course of business.

MODULE 1 The Role and Importance of Financial Reporting 49

 Examples of investment property described in IAS 40, paragraph 8, are:
(a) land held for long-term capital appreciation rather than for short-term sale in the ordinary course
of business.
(b) land held for a currently undetermined future use . . .
(c) a building owned by the entity (or a right-of-use asset relating to a building held by the entity) and leased
out under one or more operating leases.
(d) a building that is vacant but is held to be leased out under one or more operating leases.
(e) property that is being constructed or developed for future use as investment property.

IAS 40 prescribes a mixed measurement model based on the purpose and nature of the asset. An
entity may:
(a) choose either the fair value model or the cost model for all investment property backing liabilities that
pay a return linked directly to the fair value of . . . specified assets including that investment
property; and
(b) choose either the fair value model or the cost model for all other investment property, regardless of the
choice made in (a) (IAS 40, para. 32A).

Both measurement bases applied in IAS 40 Investment Property provide valuable information based
on the different fundamental qualitative characteristics. For example, the cost model provides faithful
representation but would, arguably, be less relevant in future reporting periods. The fair value model
provides the reverse relationship. This points to the difficulty of determining an appropriate measurement
basis for assets to provide useful financial information.
To provide some consistency in the measurement, IAS 40 requires the choice of measurement basis
(i.e. cost model or fair value model) to be applied across all of its investment property (para. 30). Moreover,
IAS 40 requires the entities that use the cost model for their investment property to also disclose the fair
value of that property (para. 32).
IAS 40 specifies the accounting for investment property as slightly distinct from property, plant and
equipment accounted for in accordance with IAS 16 Property Plant and Equipment — property, plant and
equipment being tangible assets that are used by an entity in the ‘production or supply of good or services,
for rental to others, or for administrative purposes’ (IAS 16, para. 6).
IAS 16 permits an entity to choose either the cost model or the revaluation model for property, plant
and equipment after the asset’s initial recognition. Where the revaluation model is the accounting policy,
the increase in the asset’s carrying amount is recognised in other comprehensive income (OCI) and is
accumulated in equity. A decrease in the carrying amount (not reversing a previous increase) is recognised
in P/L in a similar manner to the investment property. IAS 40 also allows entities to carry their investment
properties at either cost or fair value (IAS 40, para. 30). However, distinct from IAS 16, the fair value
model under IAS 40 results in the gains or losses arising from a change in the fair value of investment
property being recognised in P/L in the period in which it arises (IAS 40, para. 35).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 30–35 of IAS 40.

One of the enhancing qualitative characteristics in the Conceptual Framework is comparability.

Comparability refers to information as being more useful if it can be compared with similar information
about other entities and with similar information about the same entity for a comparable reporting period.
The accounting policy choice provided in IAS 40 in relation to the measurement of investment properties
is arguably inconsistent with the qualitative characteristic of comparability, as some entities will measure
investment properties at cost, whereas other entities will measure investment properties at fair value. The
cost and fair value of an investment property could be materially different.
The need for consistent information is addressed by requiring entities that choose to hold their investment
properties at cost to disclose the fair value of the investment properties in the notes to the financial
statements (IAS 40, para. 79(e)). This requirement helps to ensure that users have access to comparable
information.
Another measurement issue arises with the recognition of fair value movements on investment property
through P/L. Valid questions are often raised about whether these unrealised gains (which adjust the
carrying amount of the investment property) satisfy the definition and recognition criteria for an ‘asset’
in the Conceptual Framework. Questions may be raised about whether it is probable that the economic
benefits will flow to the entity because these gains may be reversed before the asset is realised.

50 Financial Reporting
 Furthermore, the usefulness of showing unrealised movements through P/L can be challenged, as the
result for the year is affected by fair value movements caused by factors external to the entity (e.g. market
and economic factors) rather than by the entity’s operational performance. Therefore, an entity’s financial
performance does not necessarily show the results of its operating activities.

PROFESSIONAL JUDGMENT
Financial reporting is not just a mechanical practice based on following specified rules. It is focused on
meeting the important objective of providing useful information for decision making, and this requires
careful thought and professional judgment when deciding how to deal with particular items. Instead
of a checklist approach, judgment is required to evaluate whether the overarching objective is being
met in the most appropriate way. An example of the application of judgment includes determining
the materiality of particular items. Professional judgment may often involve making a trade-off between
relevance and faithful representation, which are two qualitative characteristics that accounting information
should possess.
Professional judgment is an important characteristic of professional practice. It requires a combination
of conceptual and practical knowledge and is described as the ability to diagnose and solve complex,
unstructured values-based problems of the kind that arise in professional practice (Becker 1982). Pro-
fessionals are expected to make decisions based on an objective review of the relevant data rather than on
a choice of outcomes that suit the employer or client. In exercising professional judgment, professionals can
rely on technological advancements; for example, machine learning can be used to make quick predictions
informed by vast amounts of data and prepare and deliver relevant judgments faster and easier.
The selection and application of accounting policies, and the recording and communication of financial
information based on these decisions, are essential functions that require professional judgment. West
(2003) suggests that without judgment, accounting becomes nothing more than a book of rules for
compliance.
In general, the IFRSs reflect a principles-based approach rather than very specific rules about what must
be done. This provides significant scope for the exercise of judgment in the application of principles to
specific situations.
The Conceptual Framework and IFRSs have not been developed with the intention of eliminating
professional judgment. What frameworks do in this context is provide a coherent set of objectives,
assumptions, principles and concepts within which those judgments are made.
Accounting standards provide the principles that an entity needs to apply, but they do not provide all
of the answers as to how to apply them. For example, in accordance with IAS 16 Property, Plant and
Equipment, an entity is required to write off the cost of an asset over its useful life. Determining what the
useful life is requires professional judgment (para. 57). Another example is found in IFRS 7 Financial
Instruments: Disclosures, which indicates that the identification of concentrations of risk in relation to
financial instruments requires judgment that takes into account the circumstances of the entity (para. B8).

Applying Professional Judgment to Estimates and Accounting Policy

Professional judgment is particularly important in making estimates and in developing accounting policies.
In many circumstances, the exact amounts to be disclosed in the financial statements cannot be determined
and, therefore, estimates are required. This is acknowledged in paragraph 1.11 of the Conceptual
Framework, which states that ‘to a large extent, financial reports are based on estimates, judgments and
models rather than exact depictions’.
The combination of professional judgment and a disciplined approach to estimation ensures that the
information provided is still relevant and reliable (IAS 8, paras 8 and 10). This is also acknowledged in
the Conceptual Framework’s discussion on faithful representation, which suggests that a representation of
an estimate:
can be faithful if the amount is described clearly and accurately as being an estimate, the nature and
limitations of the estimating process are explained, and no errors have been made in selecting and applying
an appropriate process for developing the estimate (para. 2.18).

Paragraph 2.30 also allows for a range of probability estimates to be provided, rather than a single
amount, and to be regarded as verifiable.
It is important that the choice of accounting policies is aligned with estimates that are focused on
providing the most accurate and faithful representation of the organisation. There may be a temptation

MODULE 1 The Role and Importance of Financial Reporting 51

to select accounting policies or estimates that provide a particular viewpoint of the organisation, but
professional judgment and ethics must ensure that the selection made is the most suitable.
Preparers of financial reports need to refer to the Conceptual Framework when developing accounting
policies and estimates for which no specific accounting standard exists (IAS 8, para. 10), such as when
assessing whether a cost should be expensed or capitalised and determining the timing of recognition of
certain transactions.

DISCLOSURES
This module concludes by briefly considering the role of disclosures and how to determine when
disclosures are required. This provides a clear link to module 2, which focuses on the presentation of
the financial statements, including the disclosures required for each financial statement.
Effective disclosures play an important role in helping the decision making of users. Entities need to
ensure that their financial reporting disclosures are clear and effective in informing users as to the entity’s
financial performance during the year, as well as its financial position. Simply providing more information
to users is not sufficient to meet user needs, as disclosure overload is a concern for many users, especially
as large amounts of information are available due to technological advancements.

The Role and Purpose of Disclosures

‘Disclosure’ is a broad term and refers to items presented in the financial statements and in items disclosed
in the notes to the financial statements (IAS 1, para. 47). The role of these disclosures is linked to the
objective of financial reporting, which is to provide an account of the organisation so that users have
useful information with which to guide their decision making. The focus on disclosures transitions from
the theoretical discussion found in the Conceptual Framework to module 2 and how financial statements
are presented. The primary financial statements on their own are not sufficient for users to be able to
make informed decisions. Disclosures provide additional information and explanations to assist users in
understanding the financial statements.
Chapter 7 of the Conceptual Framework describes the general objectives and principles of disclosure,
linking disclosure back to the need to ensure that the information presented to users in the GPFSs is relevant
and provides a faithful representation of an entity’s assets, liabilities, equity, income and expenses, but also
is understandable and comparable. It also hints that IFRSs will include the specific disclosure requirements
that will need to be followed, and that those requirements will be developed to ensure a balance between:
(a) giving entities the flexibility to provide relevant information that faithfully represents the entity’s assets,
liabilities, equity, income and expenses; and
(b) requiring information that is comparable, both from period to period for a reporting entity and in a
single reporting period across entities (Conceptual Framework, para. 7.4).

The Conceptual Framework also establishes the principles based on which different elements of
financial statements can be classified, offset or aggregated in a way not to negatively impact on the use of
information disclosed.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 7.1–7.22 of the Conceptual Framework.

Criteria for Determining Whether Disclosure is Required

Notwithstanding the general disclosure principles established in the Conceptual Framework, information
is included in financial statements in accordance with the disclosure requirements of the accounting
standards. These are often linked to the definitions and recognition criteria that are discussed throughout
this module. In addition, IAS 1 Presentation of Financial Statements, paragraph 15, notes that compliance
with the IFRSs, with additional disclosures when necessary, is presumed to result in the fair presentation
of the financial statements. This is further expanded upon in IAS 1, paragraph 17:
In virtually all circumstances, an entity achieves a fair presentation by compliance with applicable IFRSs.
A fair presentation also requires an entity:
(a) to select and apply accounting policies in accordance with IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors. IAS 8 sets out a hierarchy of authoritative guidance that management
considers in the absence of an IFRS that specifically applies to an item.

52 Financial Reporting
 (b) to present information, including accounting policies, in a manner that provides relevant, reliable,
comparable and understandable information.
(c) to provide additional disclosures when compliance with the specific requirements in IFRSs is insuffi-
cient to enable users to understand the impact of particular transactions, other events and conditions on
the entity’s financial position and financial performance.

Management may believe that compliance with a specific requirement in an IFRS would be very
misleading. If the item is believed to be so misleading that it would conflict with the overall objective
of financial statements, the entity may depart from that requirement — that is, it may account for it in a
different manner. This departure is only permitted if the legal rules in that country or jurisdiction allow
it (IAS 1, para. 19). This situation is only considered to arise in extremely rare circumstances, and there
are specific disclosure obligations if an entity should consider this departure to be appropriate (para. 20).
It should be noted that, in Australia, the types of entities that are prohibited from such departures from a
requirement in an accounting standard are:
• entities for which the Corporations Act applies
• not-for-profit entities
• entities for which the reduced disclosure requirements apply (AASB 101, para. Aus19.1).

The Importance of a Consistent Approach to Disclosure

A consistent approach to disclosure can be clearly linked back to the Conceptual Framework’s qualitative
requirements of comparability and understandability.
Accounting provides powerful and useful information that can highlight managers’ poor performance
and stewardship. Organisations facing difficulty may be tempted to mask poor results by providing
information in a manner that is not easily interpreted or analysed. One method that may cause confusion
involves formally disclosing all relevant items but in such a manner that they are not easily compared to
previous periods or able to be properly understood.
This type of disclosure goes against the requirements of fair presentation and hinders the usefulness
of accounting information. Therefore, a consistent approach to disclosure must be maintained, and any
deviations should be clearly justified and carefully explained.
The key points covered in this module, and the learning objectives they align to, are below.

KEY POINTS

1.1 Explain the role and importance of financial reporting.

• The role of financial reporting is to provide users with information to enable them to achieve effective
decision making.
• The objective of general purpose financial reporting is to provide financial information about the
reporting entity that is useful to its primary users for making decisions about providing resources
to the entity.
• General purpose financial reporting applies to reporting entities. Reporting entities are entities that
are required, or choose, to prepare financial statements.
1.2 Explain the role of the IASB Conceptual Framework in financial reporting and accounting
standards.
• The Conceptual Framework is not a standard itself. If a conflict is identified between provisions of
an IFRS and the Conceptual Framework, the IFRS will take precedence.
• The AASB uses a two-tier model of general purpose financial reporting: Tier 1 — Australian
Accounting Standards and Tier 2 — Australian Accounting Standards with Reduced Disclosure
Requirements.
1.3 Describe the objective and limitations of general purpose financial reporting as identified in the
Conceptual Framework.
• The Conceptual Framework sets out the concepts that underlie the preparation and presentation
of financial statements for external users.
• The two important assumptions established in the Conceptual Framework are accrual basis of
accounting and going concern.
• The Conceptual Framework identifies two types of qualitative characteristics of financial informa-
tion: fundamental and enhancing.
• Fundamental qualitative characteristics consist of relevance and faithful representation.
• Enhancing qualitative characteristics consist of comparability, verifiability, timeliness, and under-
standability.

MODULE 1 The Role and Importance of Financial Reporting 53

 1.4 Explain the definitions of the elements of financial statements and recognition criteria adopted
by the Conceptual Framework.
• There are five elements of the financial statements: assets, liabilities, equity, income and expenses.
• The key components of an asset are that it is a right, it has the potential to produce future economic
benefits, and it is controlled by the entity.
• The key components of a liability are the requirement for the entity to have a present obligation, the
obligation is to transfer an economic benefit, and the present obligation exists as a result of past
events.
• The definition of equity flows from the definitions of assets and liabilities. Equity is simply the
difference between assets and liabilities and is derived from the recognition and measurement
of the assets and liabilities.
• The essential characteristics of income are an increase in assets or a reduction in liabilities, and an
increase in equity, other than as a result of a contribution from owners.
• The essential characteristics of an expense are a decrease in assets or an increase in liabilities, and
a decrease in equity, other than those arising from distributions to holders of equity claims.
• The elements of the financial statements are only recognised if they provide the users of the financial
statements with information that is useful. To be considered useful, the information must be relevant
and faithfully represent what it is supposed to represent.
• Derecognition applies only to recognised assets and liabilities. Assets are normally derecognised
when the entity loses control of the recognised asset. Liabilities are normally derecognised when
the entity no longer has a present obligation for all or part of the recognised liability.
1.5 Explain the application of the standards to the financial reporting process and apply
specific standards.
• IFRSs apply a mixed measurement model to provide accounting policy choice and, in some
instances, to determine the required measurement basis.
• In applying IFRS 16 Leases, the lessee recognises a right-of-use asset and lease liability unless
recognition exemptions for ‘short-term leases’ and ‘low value leases’ are applied.
• In applying IAS 19 Employee Benefits, long-term employee benefits are measured at the present
value of the obligation at the reporting date less the fair value of plan assets (if any) out of which the
obligation will be directly settled. The probability of settlement is reflected in the estimate of future
cash flows. The interest rate used to discount the future cash flows is determined by reference to
current market yields on high-quality corporate bonds, unless the obligation is in a currency that
does not have a deep market for corporate bonds.
• IFRS 2 Share-based Payment distinguishes between equity-settled and cash-settled share-based
payment transactions.
• IAS 40 Investment Property prescribes a mixed measurement model, allowing a choice between
cost and fair value, based on the purpose and nature of the asset.
• Disclosures are a requirement of the accounting standards that ensure additional information and
explanations are provided to assist users in understanding the financial statements.
1.6 Discuss and demonstrate the importance of professional judgment in the financial reporting
process.
• Professional judgment may often involve making a trade-off between relevance and faithful
representation.
• Professional judgment is particularly important in making estimates and in developing accounting
policies.
• The combination of professional judgment and a disciplined approach to estimation ensures that
the information provided is still relevant and faithfully represented.
• The mixed measurement model and accounting policy choice allow accountants to exercise
professional judgment in the measurement bases used according to the circumstances.
1.7 Explain the implications of using cost and fair value accounting.
• There are two stages of measurement for assets and liabilities: initial recognition and subsequent
recognition.
• Categories of measurement bases include historical cost (including amortised cost) and current
value (including fair value, value in use for assets, fulfilment value for liabilities, and current cost).
• The cost of an asset is the value of the costs incurred in acquiring or creating the asset, comprising
the consideration paid to acquire or create the asset plus transaction costs.
• Advantages of historical cost accounting include that the method is easily understood, relevant to
decision making, reliable and inexpensive to implement.
• Disadvantages of cost accounting include that this method has limited relevance to decision
making, undermines the faithful representation of financial reports, undermines the comparability
of financial reports and has problems with reliability.
• The fair value of an asset is the price that would be received to sell the asset in an orderly transaction
between market participants at the measurement date.

54 Financial Reporting
 • Fair value is considered by many to be more relevant than cost-based measures.
• The criticisms of fair value include its lack of relevance to decision making in relation to assets that
the entity does not intend to sell, and its problems with reliability in relation to assets that are not
traded in an active market.
1.8 Explain how materiality is assessed and determine the materiality of transactions.
• The Conceptual Framework adopts a subjective approach to materiality by stating that information
is material if omitting, misstating or obscuring it could reasonably be expected to influence
decisions made by the primary users of general purpose financial reports.

REVIEW
This module explained the role and importance of financial reporting as a communication tool for entities to
provide information to users to help with decision making. It discussed how financial reports are accessed
by a broad range of users, including shareholders, banks, competitors, employees and financial analysts. It
also considered the importance of an internationally accepted conceptual framework in creating financial
reports that meet the information needs of users.
The use of accounting standards as a consistent language for reporting enables financial statements
to be prepared that users will understand and be able to compare between entities. The IFRSs are the
global language of accounting standards. This module considered the role and importance of financial
reporting for users and discussed the application of reporting in an international context. It then discussed
the need for GPFSs, the role that the Conceptual Framework plays in financial reporting and the limitations
of frameworks.
A conceptual framework plays a key role in assisting users in their decision making by providing
consistency in the development of accounting standards and in providing a common set of definitions,
recognition principles and measurement principles. These act as a guide in accounting for transactions not
covered by accounting standards, including emerging financial reporting issues. A conceptual framework
also provides a source of legitimacy to the standard-setting process and enhances the consistency of
accounting standards. These benefits are subject to the economic, legal, social and political constraints
that apply to conceptual frameworks. Furthermore, there is a continuing need for professional judgment
in accounting.
In this module, the IASB’s Conceptual Framework for Financial Reporting was analysed. The major
components of the Conceptual Framework, including the qualitative characteristics of useful financial
information and the elements of financial statements, were examined. This module also addressed how
technological advancements can hinder or advance the decision-usefulness of accounting information
prepared using the principles set out by the Conceptual Framework and IFRS.
This module also discussed the different approaches to measuring the elements of financial statements
and applying the measurement bases to the measurement of liabilities and expenses for leases, employee
benefits, share-based payments and investment property.
The module concluded with a consideration of the purpose of disclosure to help meet the decision-
making needs of users. This discussion also provided a link to the module 2 discussion of the presentation
of financial statements.

REFERENCES
AARF & ASRB (Australian Accounting Research Foundation & Accounting Standards Review Board) 1990, Statement of
Accounting Concepts 1 (SAC 1): Definition of the Reporting Entity, AARF and ASRB, Melbourne, accessed May 2019,
https://www.aasb.gov.au/Pronouncements/Statements-of-accounting-concepts.aspx.
AASB (Australian Accounting Standards Board) 2019a, ‘Frequently asked questions’, accessed May 2019,
https://www.aasb.gov.au/About-the-AASB/Frequently-asked-questions.aspx.
AASB (Australian Accounting Standards Board) 2019b, ‘Reduced disclosure requirements’, accessed May 2019,
https://www.aasb.gov.au/Work-In-Progress/Reduced-Disclosure-Requirements.aspx.
AASB (Australian Accounting Standards Board) 2019c, ‘Tier 2 requirements’, accessed May 2019,
https://www.aasb.gov.au/Work-In-Progress/Reduced-Disclosure-Requirements/Tier-2-Requirements.aspx.
Becker, E. A. 1982, ‘Is public accounting a profession?’, The Woman CPA, vol. 44, no. 4, pp. 2–4.
External Reporting Board (New Zealand) 2019, ‘Accounting standards framework: Overview’, accessed May 2019,
https://www.xrb.govt.nz/why-report/accounting-standards-framework.

MODULE 1 The Role and Importance of Financial Reporting 55

FRC (Financial Reporting Council) 2019, ‘Financial Reporting Lab’, accessed May 2019,
https://www.frc.org.uk/investors/financial-reporting-lab.
IASB (International Accounting Standards Board) 2005, Measurement Bases for Financial Reporting — Measurement on Initial
Recognition, International Accounting Standards Committee Foundation, London.
IFRS Foundation 2016a, ‘IASB Chairman to prioritise communication effectiveness of financial statements during second term’,
30 June, accessed May 2019, http://www.ifrs.org/news-and-events/2016/06/iasb-chairman-prioritises-communication-in-
financial-statements.
IFRS Foundation 2016b, Better communication, 30 June, accessed May 2019, http://archive.ifrs.org/Features/Pages/Hans-
Hoogervorst-better-communication.aspx.
IFRS Foundation 2017, IFRS Practice Statement 2: Making Materiality Judgements, paras 21–23, pp. B856–B857, accessed May
2019, https://www.ifrs.org/issued-standards/materiality-practice-statement.
IFRS Foundation 2018, ‘The IFRS Foundation Technology Initiative’, 5 November, accessed May 2019,
https://www.ifrs.org/news-and-events/2018/11/the-ifrs-foundation-technology-initiative.
IFRS Foundation 2019a, ‘Why global accounting standards?’, accessed May 2019, https://www.ifrs.org/use-around-the-
world/why-global-accounting-standards.
IFRS Foundation 2019b, ‘Who uses IFRS Standards?’, accessed May 2019, https://www.ifrs.org/use-around-the-world/use-of-ifrs-
standards-by-jurisdiction.
IFRS Foundation 2019c, ‘The IFRS for SMEs Standard’, accessed May 2019, https://www.ifrs.org/issued-standards/ifrs-for-smes.
IFRS Foundation 2019d, ‘Discussion Paper — Disclosure Initiative — Principles of Disclosure’, accessed May 2019,
https://www.ifrs.org/projects/2019//principles-of-disclosure/#published-documents.
IFRS Foundation 2019e, IFRS Standards issued at 1 January 2019, IFRS Foundation, London.
SEC (Securities and Exchange Commission) 2007, ‘Acceptance from foreign private issuers of financial statements
prepared in accordance with international financial reporting standards without reconciliation to U.S.’, GAAP, Release
Nos. 33-8879; 34-57026; International Series Release No. 1306; File No. S7-13-07, December, accessed May 2019,
https://www.sec.gov/rules/final/2007/33-8879.pdf.
Sydney Online 2017, ‘Splendour and power of the Sydney Harbour Bridge’, accessed May 2019,
http://www.sydney.com.au/bridge.htm.
West, B. P. 2003, Professionalism and Accounting Rules, Routledge, New York.

OPTIONAL READING
ICAS (Institute of Chartered Accountants of Scotland) 2016, A Professional Judgement Framework for Financial Reporting
Decision Making, 2nd edn, ICAS, Edinburgh, accessed May 2019, https://www.icas.com/technical-resources/a-professional-
judgement-framework-for-financial-reporting.

56 Financial Reporting
MODULE 2

PRESENTATION OF
FINANCIAL STATEMENTS
LEARNING OBJECTIVES

After completing this module, you should be able to:

2.1 explain and apply the requirements of IAS 1 with respect to a complete set of financial statements and in
relation to the considerations for the presentation of financial statements
2.2 outline and explain the requirements of IAS 8 for the selection of accounting policies
2.3 explain and apply the accounting treatment and disclosure requirements of IAS 8 in relation to changes in
accounting policies, and changes in accounting estimates and errors
2.4 explain and discuss the required treatment for both adjusting and non-adjusting events occurring after the
reporting period in accordance with IAS 10
2.5 explain and apply the requirements of IAS 7 with respect to preparing a statement of cash flows
2.6 discuss how a statement of cash flows can assist users of the financial statements to assess the ability of
an entity to generate cash and cash equivalents.

ASSUMED KNOWLEDGE

It is assumed that before commencing your study in this module, you are able to:
• explain the four primary financial statements, including their purpose and interrelationship
• identify the content contained within each financial statement, including its structure and format
• identify the assumptions and doctrines underpinning the preparation and presentation of financial statements
• identify how a listed entity is required to identify and report its operating segments in the financial statements.

CASE STUDY DATA: WEBPROD LTD

Module 2 includes case study data in a separate section at the end of this module. This case study data will be
used for a number of questions throughout the module.

LEARNING RESOURCES

International Financial Reporting Standards (IFRSs):

• IAS 1 Presentation of Financial Statements
• IAS 7 Statement of Cash Flows
• IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
• IAS 10 Events after the Reporting Period
• IAS 34 Interim Financial Reporting
• IFRS 8 Operating Segments
Other resources:
• Digital content, such as videos and interactive activities in the e-text, support this module. You can access
this content on My Online Learning.

PREVIEW
Module 1 discussed the international financial reporting environment, including the stakeholders of
financial reports and the institutional arrangements for regulating financial reporting. As outlined in that
module, accountants often have to make decisions about how to report on complex arrangements and
transactions, such as the classification and measurement of financial instruments, revenue recognition and
accounting for business combinations. In making these decisions, accountants use the International Finan-
cial Reporting Standards (IFRSs) and the Conceptual Framework for Financial Reporting (Conceptual
Framework) for guidance. Module 1 contained a detailed discussion of the Conceptual Framework, as it
not only underpins the development of accounting standards but is also used to make accounting policy
decisions when no guidance is available from an IFRS. Module 2 commences the discussion of accounting
standards used in the preparation and presentation of general purpose financial statements.
As discussed in module 1, one of the qualitative characteristics that makes information useful to
users is comparability. To assess trends in an entity’s financial performance and position, users must be
able to compare the financial statements of the entity over time. Likewise, comparability is important
when evaluating the financial performance and position of an entity relative to other entities (Conceptual
Framework, para. 2.24). For this reason, module 2 commences by considering the requirements specified
in International Accounting Standard 1 Presentation of Financial Statements (IAS 1) for the preparation
and presentation of general purpose financial statements.
Paragraph 10 of IAS 1 specifies the components of a set of financial statements, which include:
• a statement of financial position
• a statement of profit or loss (P/L) and other comprehensive income (OCI)
• a statement of changes in equity
• a statement of cash flows
• explanatory notes (including accounting policies)
• comparative information with respect to the preceding period
• a statement of the financial position at the beginning of the preceding period when an accounting policy
is applied retrospectively or items in the financial statements are retrospectively restated or reclassified.
IAS 1 specifies the overall considerations that should be used when preparing financial statements.
These considerations include:
• fair presentation
• going concern
• accrual basis of accounting
• materiality and aggregation
• offsetting
• frequency of reporting
• comparative information
• consistency of presentation.
Each of these considerations is discussed later in the module.
IAS 1 requires a complete set of general purpose financial statements to disclose the accounting policies
used in preparing and presenting the financial statements. According to paragraph 10 of IAS 8 Accounting
Policies, Changes in Accounting Estimates and Errors (IAS 8), preparers of financial statements must
choose accounting policies that are both relevant to decision making and reliable. Accounting policy
choices have a major influence on the results and financial position reported by an entity, and it is
important for comparability reasons that users are able to determine differences in financial performance or
position, due to the adoption of alternative accounting policies. This module discusses IAS 8 as part of the
overall considerations in preparing and presenting general purpose financial statements. IAS 8 specifies
how to determine accounting policies and the disclosures required for accounting policies and changes
in accounting policies. In addition, IAS 8 deals with the accounting treatment of accounting estimates
revisions and error corrections, which can significantly affect the presentation of financial statements.

58 Financial Reporting
 Part A of this module discusses events after the reporting period and briefly outlines the requirements
of IAS 34 Interim Financial Reporting (IAS 34) and IFRS 8 Operating Segments (IFRS 8).
An important principle when preparing financial statements is that they must be prepared on the basis
of conditions in existence at the end of the reporting period. In the time between the end of the reporting
period and completion of the financial statements, events can occur that either:
• clarify or confirm conditions that existed at the end of the reporting period, or
• give rise to new conditions.
IAS 10 Events after the Reporting Period (IAS 10) deals with how to treat these events when preparing
the financial statements. In some cases, an event after the reporting period will mean adjustments to the
financial statements are required. In other circumstances, an event after the reporting period may lead to
separate disclosure in the notes to the financial statements. Such note disclosures are necessary when the
information could influence the decisions of financial statement users.
Part B focuses on the reporting requirements of the individual financial statements that must be included
in the set of financial statements, beginning with the statement of P/L and OCI.
In relation to the statement of P/L and OCI, this module considers the requirements of IAS 1, which
specifies both:
• how an entity determines comprehensive income
• the information to be presented in the statement of P/L and OCI or in the notes to the financial statements.
Part C discusses the statement of changes in equity, which discloses changes in each component of
equity and reconciles the opening and closing balances of the components. Changes in equity will include
comprehensive income and transactions with owners in their capacity as owners.
Part D deals with the statement of financial position. IAS 1 prescribes:
• how assets and liabilities must be presented
• how assets, liabilities and equity items must be classified
• which disclosures must be made in the statement of financial position and in the notes to the financial
statements.
Finally, part E looks at the statement of cash flows, which helps users assess the entity’s ability to
generate cash flows and the timing and certainty of their generation (IAS 7, ‘Objective’). IAS 7 Statement
of Cash Flows (IAS 7) deals with the preparation and presentation of a statement of cash flows and covers
issues such as the definition of cash and cash equivalents, classification of cash inflows and outflows,
reconciliations required and disclosure of information about cash flows.

MODULE 2 Presentation of Financial Statements 59

PART A: PRESENTATION OF
FINANCIAL STATEMENTS
INTRODUCTION
IAS 1 prescribes the basis for the presentation of general purpose financial statements. It sets out the overall
requirements for the presentation of financial statements together with guidelines for their structure and
minimum requirements for their content (IAS 1, para. 1).
Part A provides an overview of the requirements contained in IAS 1 for an entity to prepare and present
a ‘complete set of financial statements’. The application of IAS 1 in the Australian context is explained.
The requirements in IFRS 8 for reporting entities to disclose their operations according to segments are
briefly discussed.
Part A also covers the general features of financial statements described in IAS 1, including fair
presentation and compliance with IFRS, the going concern basis, the accrual basis, materiality and
aggregation, offsetting, frequency of reporting, and comparative information. The discussion then turns to
IAS 8, which governs how an entity selects and discloses its accounting policies used in the preparation and
presentation of the financial statements. Part A concludes by examining events arising after the reporting
period. IAS 10 deals with how to treat events and transactions that occur from the end of the reporting
period to the date that the financial report is signed off by the directors.

Relevant Paragraphs
To help you achieve the objectives outlined in the module preview, you may wish to read the relevant
paragraphs in the following accounting standards. Where specified, you will need to be able to apply the
following paragraphs.
IAS 1 Presentation of Financial Statements:
Subject Paragraphs
Complete set of financial statements 10–14
Fair presentation and compliance with IFRSs 15–24
Going concern 25–26
Accrual basis of accounting 27–28
Materiality and aggregation 29–31
Offsetting 32–35
Frequency of reporting 36–37
Comparative information 38–38D, 40A–44
Consistency of presentation 45–46

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors:

Subject Paragraphs
Selection and application of accounting policies 7–12
Consistency of accounting policies 13
Changes in accounting policies 14–27
Disclosure of changes in accounting policies 28–31
Changes in accounting estimates 32–40
Errors 41–42

IAS 10 Events after the Reporting Period:

Subject Paragraphs
Definitions 3
Adjusting events after the reporting period 8–9
Non-adjusting events after the reporting period 10–11
Dividends 12–13
Going concern 14–16
Disclosures 17–22

60 Financial Reporting
2.1 COMPLETE SET OF FINANCIAL STATEMENTS
COMPONENTS OF A COMPLETE SET OF
FINANCIAL STATEMENTS
IAS 1 applies to general purpose financial statements prepared in accordance with IFRSs. It states that:
The objective of financial statements is to provide information about the financial position, financial
performance and cash flows of an entity that is useful to a wide range of users in making economic decisions.
Financial statements also show the results of the management’s stewardship of the resources entrusted to
it (IAS 1, para. 9).
The financial statements provide the following information about an entity in order to satisfy this
stated objective:
• assets
• liabilities
• equity
• income and expenses, including gains and losses
• contributions by and distributions to owners in their capacity as owners
• cash flows.
The information in the financial statements, together with other information in the notes, assists users
to predict the entity’s future cash flows — especially the timing and certainty of cash flows.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraph 1.2 of the Conceptual Framework to remind
yourself of the objective of general purpose financial reporting as discussed in module 1. Think about the differences
between this objective and the objective outlined in paragraph 9 of IAS 1.

A complete set of financial statements as stated in paragraph 10 of IAS 1 contains:

• a statement of financial position as at the end of the period
• a statement of P/L and OCI for the period
• a statement of changes in equity for the period
• a statement of cash flows for the period
• notes, which include accounting policies and other explanatory information
• comparative information regarding the preceding period
• a statement of the financial position as at the beginning of the earliest comparative period when any of
the following occurs:
– an accounting policy is applied retrospectively
– items in the financial statements are retrospectively restated, or
– items in the financial statements are reclassified.
Figure 2.1 illustrates the complete set of financial statements required under IAS 1.

FIGURE 2.1 A complete set of financial statements

A complete set of financial statements

under IAS 1 comprises

Statement of
Statement of Statement of Statement of
profit or loss and other + + +
changes in equity financial position cash flows
comprehensive income

Notes to the accounts

Source: CPA Australia 2019.

MODULE 2 Presentation of Financial Statements 61

 Entities are permitted to use other appropriate titles for the financial statements (IAS 1, para. 10). One
example is using the title of balance sheet instead of statement of financial position. Another example
is using the title of statement of comprehensive income instead of statement of profit or loss and other
comprehensive income.
General purpose financial statements must present all the financial statements shown in figure 2.1. In
Australia, reporting entities are required to prepare and present general purpose financial statements.
However, the current definition of reporting entity applicable in Australia according to SAC 1 and
AASB 1053 allows entities to self-assess whether they are reporting entities and therefore required to
prepare general purpose financial statements. If an entity considers itself as a non-reporting entity due
to not satisfying the Australian definition of a reporting entity, it will normally prepare and present
special purpose financial statements (SPFSs) in accordance with the specific information needs of the
entity’s financial statement users. These non-reporting entities may lodge their SPFSs with the Australian
Securities and Investments Commission (ASIC), in which case they must still apply, as a minimum, the
disclosure requirements of the following set of Australian Accounting standards.
• AASB 101 Presentation of Financial Statements
• AASB 107 Statement of Cash Flows
• AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors
• AASB 1048 Interpretation on and Application of Standards
• AASB 1054 Australian Additional Disclosures, and
• AASB 1057 Application of Australian Accounting Standards
Entities that lodge special purpose financial reports with ASIC are also required to ensure that the
financial statements give ‘a true and fair’ view (s. 297 of the Corporations Act). According to ASIC,
SPFSs can only present a true and fair view if they apply all recognition and measurement requirements in
Australian Accounting Standards (e.g. depreciation, tax-effect accounting, leases, inventories, employee
benefits). There are many large proprietary companies that choose to lodge SPFSs with ASIC based on
the minimum standards approach shown. However, ASIC’s opinion does not have any legal status, with
some entities choosing to lodge their SPFSs without following ASIC’s advice. According to paragraph 9
of AASB 1054 Australian Additional Disclosures, an entity is required to disclose in its accounting policy
note whether the financial statements are general purpose or special purpose financial statements. As such,
users should be mindful of whether they are reading general purpose financial statements or special purpose
financial statements.
At the time of writing, the AASB is continuing to develop its financial reporting framework by
considering whether to adopt the definition of reporting entity from the IASB’s Conceptual Framework
and extend general purpose financial reporting to additional for-profit private sector entities. The AASB is
likely to be particularly concerned with limiting the use of SPFSs by large proprietary companies without
public accountability that are big-sized entities (e.g. $500 million in revenue) rather than small or medium-
sized entities.
An entity must give ‘equal prominence to all of the financial statements in a complete set of financial
statements’ (IAS 1, para. 11). For example, the statement of cash flows cannot be relegated to a note
disclosure or be presented as an appendix at the end of the notes. As will be discussed in further detail in
part B, IAS 1 allows alternative presentations for the statement of profit or loss and other comprehensive
income (IAS 1, para. 10A). The first alternative is a single statement with two sections, that is, one each
for the profit or loss and other comprehensive income. The second alternative is two statements, that is,
one statement for profit or loss and one statement for other comprehensive income.
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EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 10–11 of IAS 1.

The requirements of IAS 1 for a complete set of financial statements are also relevant for interim
financial reports (IAS 34, para. 5). IAS 34 does not specify which entities have to prepare interim financial
reports as this is usually specified by governments, stock exchange requirements and other regulators
(IAS 34, para. 1). In Australia, for example, according to section 302 of Corporation Act, disclosing entities
must prepare and present half-year financial reports. A disclosing entity is defined in the Corporations Act
as an entity that issues ‘enhanced disclosure’ (ED) securities (s. 111AC). For example, a company whose
shares are listed on the ASX is a disclosing entity. As a matter of fact, the ASX Listing Rules also require
all listed entities to prepare and present half-year financial reports. A half-year report contains condensed
financial statements and substantially reduced disclosure requirements in accordance with IAS 34.

62 Financial Reporting
 The objective of IAS 34 is to prescribe the minimum requirements of an interim financial report to
provide timely and reliable information that ‘improves the ability of investors, creditors and others to
understand an entity’s capacity to generate earnings and cash flows and its financial condition and liquidity’
(IAS 34, ‘Objectives’). Timely and reliable financial information are concepts that were discussed in
module 1. Paragraph 19 of IAS 34 requires entities that prepare an interim financial report to disclose their
compliance with the requirements of the standard, which includes the requirement of IAS 1 to comply
with IFRSs.
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EXPLORE FURTHER
If you wish to explore this topic further, you may now read the ‘Objective’ paragraph and paragraphs 1, 5 and 19 of
IAS 34.
In addition to the complete set of financial statements and the notes to the financial statements, entities
may provide additional information required by law or disclosed voluntarily. Paragraph 13 of IAS 1 notes
that many entities present a financial review by management, outside of the financial statements, to describe
the key features of an entity’s financial performance, financial position and the principal uncertainties it
faces. The review by management may include a review of:
• the main factors and influences determining an entity’s financial performance, including changes in the
environment in which the entity operates and how the entity is responding to those changes
• details about the entity’s sources of funding and its targeted ratio of liabilities to equity
• details of the entity’s resources not recognised in the financial statements.
Furthermore, many entities also present environmental reports and value-added statements that are
outside the financial statements. Reports and statements presented outside financial statements are outside
the scope of IFRSs (IAS 1, para. 14).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 13 and 14 of IAS 1 to expand on this discussion.

SEGMENT REPORTING
IFRSs also include disclosure requirements that assist users to unpack additional detail about the numbers
presented in the financial statements. Segment reporting in IFRS 8 involves presenting disaggregated
financial information in the notes to support an understanding of the aggregated financial information
in the financial statements. IFRS 8 applies to an entity that has publicly traded debt or equity instruments
on issue or that files, or is in the process of filing, its financial statements with a regulatory body for the
purpose of issuing instruments in a public market (IFRS 8, para. 2). In Australia, AASB 8 Operating
Segments applies to entities that are subject to Tier 1 reporting requirements.
IFRS 8 requires an entity to disclose information that enables users of its financial statements to evaluate
the nature and financial effects of the business activities that the entity engages in and the economic
environments in which it operates (IFRS 8, para. 20).
IFRS 8 requires disclosure of the:
• factors used to identify the entity’s reportable segments including the basis of organisation
(e.g. differences in products and services, geographical areas, regulatory environments, or some
combination thereof)
• judgments made by management if operating segments have been aggregated
• types of products and services that each reportable segment derives its revenues from (IFRS 8,
para. 22).
An operating segment is defined as a component of the entity that:
• undertakes business activities from which it may generate revenues and incur expenses
• has its operating result regularly reviewed by the chief operating decision maker within the entity, such
as the general manager, managing director or chief executive officer (CEO)
• has discrete financial information available (IFRS 8, para. 5).
The focus in IFRS 8, therefore, is to identify and report on operating segments effectively using the
same basis as the internal decision maker.
IFRS 8 typically requires an entity to disclose the following financial information for each reportable
segment:
• a measure of profit or loss
• a measure of total assets and liabilities

MODULE 2 Presentation of Financial Statements 63

 • revenues from external customers
• revenues from transactions with transactions from other operating segments
• interest revenue
• interest expense
• depreciation and amortisation
• material items of income and expense
• the interest in the profit or loss of associates and joint ventures accounted for by the equity method
• income tax expense or income
• material non-cash items other than depreciation and amortisation (IFRS 8, para. 23).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read Note 20 of the Techworks Ltd financial statements (in the
appendix of the Study guide and also available on My Online Learning), which provides information for the company’s
three reportable segments, namely:
• retail, IT consumables and electronics
• Software as a service (SaaS) ‘on demand’
• IT consulting and implementation.
As stated in Note 20, the reportable segments listed in this section have been identified by the company’s chief
operating decision maker as reportable operating segments. According to IFRS 8, information about reportable
segments:
• reflects the structure used by management to assess group performance
• is an allocation of items contained in the financial statements of the company to help users evaluate the financial
effects of the company’s business activities and the economic environments in which it is working.

FAIR PRESENTATION AND COMPLIANCE WITH

INTERNATIONAL FINANCIAL REPORTING STANDARDS
IAS 1 requires financial statements to present fairly the entity’s financial performance, financial position
and cash flows (IAS 1, para. 15). Fair presentation requires faithful representation of the effects of
transactions, other events and conditions in accordance with the definitions and recognition criteria for
assets, liabilities, income and expenses set out in the Conceptual Framework. The application of IFRSs,
with additional disclosures where necessary, is presumed to result in financial statements that are fairly
presented (IAS 1, para. 15).
IAS 1 requires entities with financial statements prepared in accordance with the IFRSs to make an
explicit and unreserved statement of such compliance in the notes to the accounts. In order to make this
statement, an entity must comply with all the requirements of IFRSs (IAS 1, para. 16).
IAS 1 states that an entity is not permitted to depart from a requirement in an IFRS except in the
extremely rare circumstance in which compliance would be so misleading that it would conflict with
the objective of financial statements set out in the Conceptual Framework, that is, to provide financial
information that is relevant and faithfully represents what it purports to represent. In this rare case, an
entity departs from the requirement in an IFRS only if permitted by its regulatory framework and with full
disclosure (IAS 1, para. 19).
An entity that departs from a requirement of an IFRS must make the following disclosures:
• a statement that management believes the departure provides financial statements that present fairly the
entity’s financial position, financial performance and cash flows
• that except for departing from a particular requirement to achieve a fair presentation, it has complied
with applicable IFRSs
• the title of the IFRS from which the entity has departed, the nature of the departure, including the
treatment that the IFRS requires and the treatment adopted, and the reasons why the IFRS treatment
would be misleading in the circumstances that it would conflict with the objective of the financial
statements stated in the Conceptual Framework
• the financial impact of the departure on each item in the financial statements that would have been
reported in complying with the requirement (IAS 1, para. 20).
IAS 1 makes it clear that adopting an accounting policy that is not permitted by an IFRS and
disclosing the details in the notes to the financial statements does not overcome non-compliance with an
IFRS (IAS 1, para. 18). In the Australian context, the Corporations Act requires that the financial statements
comply with accounting standards (s. 296). Also, if compliance with accounting standards does not provide

64 Financial Reporting
 a true and fair view, the Corporations Act requires an entity to provide additional disclosures necessary to
give a ‘true and fair’ view (s. 297).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 15–24 of IAS 1, which confirm and expand on
this discussion.

OTHER GENERAL FEATURES

In addition to requiring financial statements to be presented fairly, IAS 1 specifies a number of other general
features that must be complied with when preparing and presenting general purpose financial statements.
These include:
• going concern
• accrual basis
• materiality and aggregation
• offsetting
• frequency of reporting
• comparative information
• consistency.

Going Concern
While preparing the financial statements, management must make an assessment of an entity’s ability to
continue as a going concern. IAS 1 states as follows.
An entity shall prepare financial statements on a going concern basis unless management either intends to
liquidate the entity or to cease trading, or has no realistic alternative but to do so (IAS 1, para. 25).
There is no specific requirement in IAS 1 for the entity to disclose that it is considered a going
concern. This is an implicit assumption when preparing financial statements. However, where the entity
is not considered a going concern, this must be disclosed together with the reasons why the entity is
not considered a going concern and the basis on which the financial statements are prepared. If there is
significant uncertainty as to the continuity of an entity’s operations, but the financial statements are still
prepared on a going concern basis, then details of the uncertainty must be disclosed (IAS 1, para. 25).
In assessing whether an entity is a going concern, management should consider all available information
about the future — at least up until 12 months after the end of the reporting period (IAS 1, para. 26). In
particular, management should consider whether the entity will be able to discharge its debts as and when
they fall due. Where an entity is no longer considered a going concern, the financial statements would
normally be prepared on a realisable (or liquidation) basis.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 25 and 26 of IAS 1.

Accrual Basis
IAS 1 requires that, except for cash flow information, financial statements be prepared under accrual
accounting principles (IAS 1, para. 27). The accrual basis of accounting provides users with richer
information about the financial performance and financial position of an entity that would not otherwise
be available if the cash basis were used.
Under the accrual basis, items are recognised as assets, liabilities, equity, income and expenses when
they satisfy the definitions and recognition criteria in the Conceptual Framework (IAS 1, para. 28).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 27 and 28 of IAS 1.

Materiality and Aggregation

The financial statements are derived after processing large numbers of transactions or other events that are
aggregated into classes according to their nature or function. This process of aggregation and classification
is necessary to determine the line items presented in the financial statements or notes to the financial
statements (IAS 1, para. 30).

MODULE 2 Presentation of Financial Statements 65

 IAS 1 uses the concept of materiality to assist preparers to decide which items can be added together
and which must be separately reported. IAS 1 requires that:
An entity shall present separately each material class of similar items. An entity shall present separately
items of a dissimilar nature or function unless they are immaterial (IAS 1, para. 29).

In applying this requirement, an entity takes into consideration all the relevant facts and circumstances
(IAS 1, para. 30A). A specific disclosure requirement of an IFRS need not be applied if the information
resulting from that disclosure is immaterial (IAS 1, para. 31).
IAS 1 explains materiality in three parts as follows.
1. Information is material if it could reasonably be expected to influence the primary users of financial
statements decision making.
2. The nature or magnitude of information, or both, can have an effect on materiality. Whether information,
either individually or in combination with other information, is material in the context of its financial
statements taken as a whole must be assessed by the entity.
3. Information is obscured if it is communicated in a way that has a similar effect to omitting or misstating
that information. Examples include:
– the language used is vague or unclear
– information is scattered throughout the financial statements
– dissimilar items, transactions or other events are inappropriately aggregated
– similar items, transactions or events are inappropriately disaggregated
– the understandability of the financial statements is reduced by material information being hidden by
immaterial information (IAS 1, para. 7).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 29–31 of IAS 1.

Offsetting
Offsetting, or combining the balances, of assets and liabilities or income and expenses may result in the
loss of relevant information for financial statement users. Unless it reflects economic substance, offsetting
detracts from the ability of users to understand the transactions and other events and conditions that have
occurred (IAS 1, para. 33).
IAS 1 prohibits offsetting, except where it is required or permitted by an IFRS (IAS 1, para. 32).
Examples of permissible offsetting are as follows.
• IAS 12 Income Taxes (IAS 12) permits the offsetting of current tax assets and current tax liabilities in
the statement of financial position, provided that the entity: ‘(a) has a legally enforceable right to set off
the recognised amounts; and (b) intends either to settle on a net basis, or to realise the asset and settle
the liability simultaneously’ (IAS 12, para. 71).
• IFRS 15 Revenue from Contracts with Customers requires the amount of revenue recognised to be after
any trade discounts and volume rebates the entity allows (IAS 1, para. 34).
• Foreign exchange gains and losses or gains and loss on financial instruments held for trading should be
presented on a net basis, except if such gains and losses are separately material (IAS 1, para. 35).
It should be noted that reporting assets net of valuation allowances is not offsetting and is permissible
(IAS 1, para. 33). Examples include reporting receivables net of an allowance for doubtful debts or
inventories net of an allowance for obsolescence.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 32–35 of IAS 1.

Frequency of Reporting
An entity must present a complete set of financial statements at least annually (IAS 1, para. 36). If an
entity changes the end of its reporting period, then it may present financial statements for a shorter or
longer period than 12 months but the change, and the reason for the change, needs to be disclosed.
Entities may report using a 52-week period rather an annual period (IAS 1, para. 37). Entities such as
retailers usually prefer the 52-week period because it ensures comparability year-on-year for the number
of retail days during which they conducted their business.

66 Financial Reporting
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 36–37 of IAS 1.

Comparative Information
Enhancing the inter-period comparability allows users of the financial statements to assess trends in
financial information for predictive purposes (IAS 1, para. 43).
An entity must present comparative information regarding the preceding period for all amounts reported
in the current period’s financial statements, except when the IFRSs permit or require otherwise (IAS 1,
para. 38). Comparative information for narrative and descriptive information is also required if it is relevant
to understanding the current period financial statements.
The requirement for comparative information means that an entity will, as a minimum, present two
statements for each of the financial statements (IAS 1, para. 38A). For example, at least two statements of
financial position should be prepared: one for the current period and one for the prior period.
IAS 1 requires the presentation of a third statement of financial position as at the beginning of the
preceding period if:
• it applies an accounting policy retrospectively, makes a retrospective restatement of items in its financial
statements or reclassifies items in its financial statements
• the retrospective application, retrospective restatement or the reclassification has a material effect on
the information in the statement of financial position at the beginning (IAS 1, para. 40A).
Where items in the financial statements are reclassified, the comparative amounts should also be
reclassified, unless it is impracticable to do so (IAS 1, para. 41). Where it is impracticable, the entity
should disclose the reasons why and the ‘nature of the adjustments that would have been made if the
amounts had been reclassified’ (IAS 1, para. 42).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 38, 38A, 38B, 40A and 41–44 of IAS 1.

Consistency
Financial statements should be prepared on a consistent basis from one period to the next, as described in
paragraph 2.26 of the Conceptual Framework.
IAS 1 requires that an entity should retain the presentation and classification items in the financial
statements from one period to the next. The presentation and classification of items contained in the
financial statements should only be changed when:
• ‘a significant change’ has occurred in an entity’s operations, or after reviewing the entity’s financial
statements, management is of the opinion that a change in accounting policy is necessary to show a
more appropriate presentation or classification, or
• a change is required by an IFRS (IAS 1, para. 45).
A significant change on an entity’s operations might arise following the disposal of a major line of its
businesses (IAS 1, para. 46).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 45 and 46 of IAS 1.

2.2 ACCOUNTING POLICIES

A complete set of financial statements identified in IAS 1 includes notes that comprise ‘a summary of
significant accounting policies and other explanatory information’ (IAS 1, para. 10). For users to be able
to compare the financial statements of different entities across different reporting periods, it is important
that there is adequate disclosure of accounting policies. This will provide the necessary information for
users to make allowances for differences in the financial results that are due to different accounting policies
between different entities or differences for the same entity across time.

MODULE 2 Presentation of Financial Statements 67

.......................................................................................................................................................................................
EXPLORE FURTHER
Refer to Note 1 ‘Accounting policies’ in the notes to financial statements of the financial statement of Techworks Ltd.
Note how the accounting policies enable the financial statement user to determine the basis of preparation of
the financial report and the accounting policies adopted in relation to various items, such as the basis of accounting
(Note 1(b)), the basis of consolidation (Note 1(e)), plant and equipment (Note 1(k)) and revenue recognition (Note 1(p)),
to give a few examples.
If you wish to explore this topic further, you may now read paragraphs 2.24–2.29 of the Conceptual Framework,
which discuss the importance of the comparability characteristic.

SELECTION OF ACCOUNTING POLICIES

Accounting policies are defined as ‘the specific principles, bases, conventions, rules and practices applied
by an entity in preparing and presenting financial statements’ (IAS 8, para. 5). Examples of accounting
policies include whether to capitalise or expense borrowing costs and whether to value non-current assets
at cost or at fair value.
IAS 8 requires management to select and apply accounting policies using a hierarchy. According to
IAS 8, if an IFRS specifically applies to a transaction, other event or condition, the accounting policy
or policies applied to that item must be determined by applying the IFRS (IAS 8, para. 7). In addition,
the accounting policy must be determined by reference to any implementation guidance associated with a
relevant IFRS where it is mandatory (IAS 8, para. 9). It is important to note that IAS 8 defines IFRSs to
encompass standards and interpretations adopted by the IASB. They include:
• International Financial Reporting Standards (IFRSs)
• International Accounting Standards (IASs)
• Interpretations of accounting standards developed by the IFRSs Interpretations Committee (referred to
as IFRIC Interpretations)
• Standards Interpretations Committee Interpretations previously issued by the IASB (SIC Interpretations)
(IAS 8, para. 5).
Accordingly, an accounting policy for a particular transaction, event or condition must comply with any
relevant accounting standards (and consider any relevant implementation guidance issued by the IASB)
and IASB Interpretations.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read the definition of ‘International Financial Reporting Standards’
in paragraphs 5 and 7–9 of IAS 8.

Where specific IFRSs requirements do not apply to a transaction, other event or condition, IAS 8
requires management to use professional judgment and develop and apply accounting policies that result
in information that is:
(a) relevant to the economic decision-making needs of users; and
(b) reliable, in that the financial statements:
(i) represent faithfully the financial position, financial performance and cash flows of the entity;
(ii) reflect the economic substance of transactions, other events and conditions, and not merely the
legal form;
(iii) are neutral, ie free from bias;
(iv) are prudent; and
(v) are complete in all material respects (IAS 8, para. 10).

IAS 8 provides additional guidance on the selection of appropriate accounting policies if management
has to use professional judgment. Management is required to consider the applicability of other sources in
the following priority order:
1. the requirements in the IFRSs that deal with similar and related issues
2. the Conceptual Framework’s definitions, recognition criteria and measurement concepts for assets,
liabilities, income and expenses (IAS 8, para. 11).
In making the judgment, management may also refer to the pronouncements of other standard-setting
bodies that use a similar Conceptual Framework, other accounting literature and industry practice, but only
to the extent that these are consistent with the preceding two sources of guidance (IAS 8, para. 12).

68 Financial Reporting
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 10–12 of IAS 8.

CONSISTENCY OF ACCOUNTING POLICIES

Consistency of accounting policies allows users to compare the financial statements of an entity over time
to identify trends in financial position, financial performance and cash flows (IAS 8, para. 15).
IAS 8 requires that an entity must apply its accounting policies consistently for similar transactions, other
events and conditions unless an IFRS specifically requires or allows a categorisation of items for different
accounting policies (IAS 8, para. 13). For an example, IAS 16 Property, Plant and Equipment allows
different classes, or categories, of plant and equipment to be presented using a different measurement
basis. It is possible to recognise land and buildings using the fair value basis and office furniture using the
cost basis.

DISCLOSURE OF ACCOUNTING POLICIES

Accounting policies adopted by an entity can significantly affect the way profits and financial position
are reported. This influences economic decisions and other evaluations, including evaluations about the
discharge of managerial accountability by users of those statements. As such, it is important that users are
provided with information about those policies and changes therein.
IAS 1 requires that the notes to the financial statements present information about the specific accounting
policies used in the preparation of the financial statements (IAS 1, para. 112(a)). IAS 1 requires an
entity to:
disclose its significant accounting policies comprising:
(a) the measurement basis (or bases) used in preparing the financial statements; and
(b) the other accounting policies used that are relevant to an understanding of the financial statements
(IAS 1, para. 117).

If alternatives are allowed under IFRSs, the disclosure of the accounting policy used is considered
particularly useful. For example, measurement of plant at cost or fair value. An entity must consider
‘the nature of its operations and the policies that the users of its financial statements would expect to
be disclosed for that type of entity’ (IAS 1, para.119).
‘An accounting policy may be significant because of the nature of an entity’s operations even if the
amounts . . . are not material’ (IAS 1, para. 121).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read the following paragraphs of IAS 1:
• 112–117, which outline the requirements for the structure of the notes to the financial statements and the disclosure
requirements for accounting policies
• 118–121, which expand on the requirements of paragraph 117
• 122–124, which discuss the disclosure requirements for judgments that management has made in determining
accounting policies
• 125–127, which discuss the disclosure requirements relating to information concerning the key sources of
estimation uncertainty at the end of the reporting period, which may require adjustments to the amount of assets
or liabilities in the next financial year.

QUESTION 2.1

(a) Refer to Note 1 of the financial statements of Techworks Ltd. Explain how the summary complies
with the requirements of paragraphs 112 and 117 of IAS 1.
(b) Refer to the ‘Case study data’ section at the end of this module. Prepare the initial section of
the accounting policy notes relating to the significant accounting policies of Webprod Ltd.

MODULE 2 Presentation of Financial Statements 69

CHANGES IN ACCOUNTING POLICIES
IAS 8 permits an entity to change its accounting policies only if the change:
• is required by an IFRS; or
• results in the financial statements providing reliable and more relevant information about the effects of
transactions, other events or conditions on the entity’s financial position, financial performance or cash
flows (IAS 8, para. 14).

IAS 8 clarifies that:

the following are not changes in accounting policies:
(a) the application of an accounting policy for transactions, other events or conditions that differ in
substance from those previously occurring; and
(b) the application of a new accounting policy for transactions, other events or conditions that did not occur
previously or were immaterial (IAS 8, para. 16).

Where an entity changes an accounting policy because of a new IFRS, it must apply the transitional
provisions in the IFRS (IAS 8, para. 19(a)). When there are no transitional provisions in the IFRS, or the
entity is making a voluntary change in accounting policy, the accounting policy change must be made
retrospectively (IAS 8, para. 19(b)).
Retrospective application for voluntary changes in accounting policies ensures that the prior period
comparatives are comparable to current period financial statements. Retrospective application requires that
two adjustments must be made to the financial statements. First, the opening balance of each component
of equity affected by the change must be adjusted for the earliest prior period presented in the financial
statements. Second, the other comparative amounts disclosed for each prior period presented must be
restated as if the new policy had always been applied by the entity (IAS 8, para. 22).

EXAMPLE 2.1

Change in Accounting Policy

Capricorn Ltd is an Australian diamond wholesaler. It has a financial year-end of 30 June. Due to extreme
fluctuations in the price of diamonds, which it imports from all over the world, the cost of inventory has
become extremely volatile, and this volatility is expected to continue indefinitely in the future.
Due to these circumstances, on 1 July 20X5, in accordance with IAS 2 Inventories, Capricorn Ltd has
decided to voluntarily change its inventory valuation method from weighted average cost to first-in, first-
out (FIFO). The company’s directors believe that this change in accounting policy more accurately reflects
the economic substance and results in more relevant and reliable information.
The impact of this change in accounting policy resulted in an increase in the value of inventory on hand
by $26 000 at 30 June 20X5 and an increase of $52 000 at 30 June 20X4.
Assume that the company is unable to determine or calculate the impact of this change of accounting
policy from any date prior to 30 June 20X4.
As this represents a voluntary change in accounting policy, it must be accounted for retrospectively
(IAS 8, para. 19(b)). The first period for which retrospective application is practicable is 30 June 20X5.
For comparative figures for 30 June 20X4, this will involve restating the inventory balance upwards by
$52 000 with a corresponding change to closing inventory in the statement of P/L and OCI. This will wash
through as an adjustment to opening retained earnings in 20X5. For the year ended 30 June 20X5, closing
inventory will increase by $26 000 with a corresponding adjustment in the statement of P/L and OCI to
closing inventory. For the year ended 30 June 20X5, the effect on the change in inventory is –$26 000,
being the net effect of increasing opening inventory by $52 000 and decreasing closing inventory
by $26 000.
The following journal entries would need to be processed.

Dr Inventories (Statement of financial position — 30/6/X4) 52 000

Cr Cost of sales/Retained earnings (30/6/X4) 52 000

Dr Inventories (Statement of financial position — 30/6/X4) 26 000

Cr Closing inventories 30/6/X5 (Statement of P/L and OCI) 26 000

70 Financial Reporting
 Assume that the balances before the change in accounting policy are $0 and ignore tax. The financial
effects of recognising the change in accounting policy can be summarised as follows.
20X5 20X4
Statement of financial position
Inventories 26 000 52 000
Retained earnings 26 000 52 000
Statement of P/L and OCI
Change in inventories (26 000) 52 000
Profit before tax (26 000) 52 000

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 14–22 of IAS 8.

IAS 8 recognises that in some cases it may be ‘impracticable’ to adjust comparative information for
one or more prior periods (IAS 8, para. 23). For example, the data are no longer available or not able to
be collected. In this case, the new accounting policy must be applied from the earliest date practicable,
which may be the current reporting period, and a corresponding adjustment must be made to each affected
component of equity (IAS 8, para. 24).
For example, if it is not possible to determine exactly when the initial transaction was recorded in the
financial statements any catch-up revenue or expense amendments could be adjusted through opening
retained earnings of the current reporting period.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read:
• paragraphs 23–27 of IAS 8
• the definition of ‘impracticable’ in paragraph 5 of IAS 8
• the guidance on impracticability in relation to the retrospective application of a new accounting policy in
paragraphs 50–53 of IAS 8
• Example 3 in the ‘Guidance on implementing IAS 8 Accounting Policies, Changes in Accounting Estimates and
Errors’ (in the IFRS Compilation Handbook), which deals with the prospective application of a change in accounting
policy when retrospective application is impracticable.

Where an entity changes an accounting policy, it must not only apply the policy retrospectively (where
it is practical to do so and which involves making every reasonable effort to do so), but it must also make
several disclosures.
According to IAS 8, when the initial application of an IFRS has an effect on the current or prior period
or potentially a future period, an entity must disclose:
• the title of the IFRS
• the nature of the change in accounting policy
• for the current period and each prior period presented, the amount of the adjustment for each financial
statement item affected and the impact on earnings per share disclosures if applicable
• for periods before those presented, the amount of the adjustment to the extent practicable
• when there are transitional provisions, disclose this fact together with a description of the transitional
provisions and the effect they might have on future periods
• if retrospective application is impracticable, the circumstance that led to the existence of that condition,
and a description of how and when the change in accounting policy has been applied (IAS 8, para. 28).
According to IAS 8, when an entity makes a voluntary change in accounting policy that has an effect
on the current or prior period or potentially a future reporting period, the entity must disclose:
• the nature of the change in accounting policy
• the reasons why the change provides ‘reliable and more relevant information’
• the amount of adjustment for each financial statement item affected (current and prior period) and the
impact on earnings per share disclosures if applicable
• the amount of the adjustments relating to periods before those presented to the extent practicable

MODULE 2 Presentation of Financial Statements 71

 • advice (where applicable) that retrospective application is impracticable for a particular prior period or
for periods before those presented, the circumstance that led to the existence of that condition and a
description of how and from when the change has been applied (IAS 8, para. 29).
Finally, it should be noted that in some situations an entity may prepare financial statements that do
not comply with a new standard or interpretation because it is not effective until after the end of the
reporting period. In such situations, the entity should disclose this situation and provide information about
the potential impact of applying the new standard or interpretation (IAS 8, para. 30).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 28–31 of IAS 8. In addition, re-reading
paragraphs 19 and 22 of IAS 8 may be helpful.

QUESTION 2.2

(a) Refer to note 31(e) of the financial statements of JB Hi-Fi Limited for 30 June 2018 (available at
www.asx.com.au by searching announcements using code ‘jbh’).
Which accounting standards in the AASB series 1–100 have been identified by the directors
as those that have not been adopted? What effects did the directors expect in the future for the
accounting standards not yet adopted?
(b) Under section 334(5) of the Corporations Act, Australian companies have the option of
early adopting accounting standards. These are accounting standards that have been issued
by the IASB or AASB but do not apply until a future financial reporting period. Review
Note 1(c) ‘Accounting policies’ in the notes to financial statements of the financial statement
of Techworks Ltd. Has Techworks Ltd early adopted any AASB accounting standards?
(c) Refer to sections 5 and 6 of the ‘Case study data’ for Webprod Ltd. Prepare any disclosures
necessary to be included in the notes to the financial statements.

Refer to Note 1 ‘Summary of significant accounting policies’ in the notes to financial statements
of Techworks Ltd. What changes in accounting policies have been applied in the current year? What
significant management judgments have been made in applying the accounting policies?

2.3 REVISION OF ACCOUNTING ESTIMATES AND

CORRECTION OF ERRORS
CHANGES IN ACCOUNTING ESTIMATES
Uncertainties inherent in business activities means that many items included in financial statements involve
measurements that require estimations. Examples of estimates include:
• bad debts
• inventory obsolescence
• the fair value of financial assets and liabilities
• the useful lives of depreciable assets
• warranty obligations (IAS 8, para. 32).
Using estimates is an essential part of the preparation of financial statements (IAS 8, para. 33). The
nature of making an estimate means that as new information is received or new developments occur,
the estimate may have to be revised. Changes in accounting estimates should be distinguished from the
correction of errors because they do not relate to a prior period (IAS 8, para. 34).
According to IAS 8, a change of accounting estimate cannot be recognised retrospectively. It must be
recognised prospectively by including it in the profit or loss in:
• the period of the change, the current period, if the change affects that period only
• the period of the change and future periods, if the change affects both (IAS 8, para. 36).
The IAS 8 requirements in relation to changes in estimates operate as follows.
• Income and expense adjustments as a result of the revision must be recognised in either the current
reporting period or the current and future reporting periods, depending on which periods the change of
estimate affects (IAS 8, para. 36).

72 Financial Reporting
 • Where relevant, adjustments to assets, liabilities and equity items should be made in the reporting period
of the change of estimate (IAS 8, para. 37).
• Specific disclosures must be made of the nature and amount of the revision in the accounting estimate
where the change affects the current reporting period and, to the extent it is practicable, disclosure of
the effect on future reporting periods (IAS 8, para. 39).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 32–40 of IAS 8.

EXAMPLE 2.2

Change in an Accounting Estimate

In its accounts for the year ended 30 June 20X1, Totalconcept Ltd recorded an allowance for doubtful
debts of $24 000 in respect of one of its major customers who was experiencing financial difficulties.
This represented 40% of the total amount owing by the customer (total of $60 000). At the
time of preparing the 30 June 20X1 accounts, this allowance was considered correct and reason-
able. Totalconcept Ltd’s management expected that the balance ($36 000) would be received by
December 20X1.
However, by 30 September 20X1, the customer’s position had seriously deteriorated, and the manage-
ment of Totalconcept Ltd decided to revise the allowance for doubtful debts to $60 000.
This is an example of a change in an accounting estimate based on information available at the time a
transaction is recorded or reviewed. Estimating an allowance for doubtful debts is a routine accounting
exercise and likely to be subject to later revision. There is nothing to indicate that the initial allowance was
due to an error or omission made by the entity.
The increase of $36 000 in the allowance for doubtful debts is regarded as a change in an accounting
estimate and should be adjusted prospectively (not retrospectively) in the 20X2 accounts (i.e. by debiting
doubtful debts expense and crediting the allowance for doubtful debts for $36 000).

MATERIAL ERRORS IN A PRIOR PERIOD

From time to time, errors may arise in the recognition, measurement, presentation or disclosure in the
financial statements or notes to the financial statements (IAS 8, para. 41).
Financial statements are considered not to comply with the accounting standards if they ‘contain either
material errors or immaterial errors made intentionally to achieve a particular presentation of an entity’s
financial position, financial performance or cash flows’ (IAS 8, para. 41). Accordingly, material errors
made in a prior period must be corrected if the financial statements are to comply with IFRSs.
There may be times when a material error (i.e. a mistake) has been made in a previous financial period
that is not covered by the current financial statements (i.e. current year and previous year comparatives) but
is only discovered in the current reporting period. An example of a material error is realising in the current
period that land sold in a previous financial year was not accounted for correctly in the previous year’s
accounts. IAS 8 acknowledges that an error could include mathematical mistakes, mistakes in applying
accounting policies, oversights or misinterpretations of facts or fraud (IAS 8, para. 5).
When material errors are discovered in a reporting period subsequent to the reporting period(s) in which
the error occurred, IAS 8 requires retrospective correction of the error in the first set of financial statements
issued after the error’s discovery. The error must be corrected by either:
(a) restating the comparative amounts for the prior period(s) presented in which the error occurred; or
(b) if the error occurred before the earliest prior period presented, restating the opening balances of assets,
liabilities and equity for the earliest prior period presented (IAS 8, para. 42).
In other words, IAS 8 requires material errors relating to prior reporting periods to be corrected
retrospectively if this is practicable.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 41 and 42 of IAS 8 as well as Example 1 of
the ‘Guidance on implementing IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors’ (in the IFRS
Compilation Handbook), which illustrates a retrospective restatement of errors.

MODULE 2 Presentation of Financial Statements 73

 As with changes to accounting policies, IAS 8 requires that a ‘catch-up’ adjustment be made starting
from the date that the error was made. If this relates to the profit or loss of a period not covered by the
financial statements, then the adjustment is made to the opening balance of retained earnings.
However, IAS 8 recognises that in some cases it may be ‘impracticable’ to adjust comparative
information for one prior period or more (e.g. the data are longer available or cannot be collected).
In this case, the adjustment is made at the beginning of the current financial reporting period (IAS 8,
para. 47).
Furthermore, paragraphs 40A–40C of IAS 1 require that a three-column statement of financial position
be presented where a material error in a prior period affects the statement of financial position. The entity
must present the following statement of financial positions as at the:
• end of the current period
• end of the previous period (which is the same as the beginning of the current period)
• beginning of the earliest comparative period.
Finally, where a prior period error has been corrected in a reporting period, IAS 8 specifies disclosure
of information including:
(a) the nature of the prior period error;
(b) for each prior period presented, to the extent practicable, the amount of the correction:
(i) for each financial statement line item affected; and
(ii) if IAS 33 [Earnings per share] applies to the entity, for basic and diluted earnings per share;
(c) the amount of the correction at the beginning of the earliest prior period presented; and
(d) if retrospective restatement is impracticable for a particular prior period, the circumstances that led to
the existence of that condition and a description of how and from when the error has been corrected
(IAS 8, para. 49).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now:
• re-read the definition of ‘impracticable’ in paragraph 5 of IAS 8
• re-read the guidance on impracticability in relation to retrospective application and restatement of errors in
paragraphs 50–53 of IAS 8
• read paragraphs 43–49 of IAS 8.

EXAMPLE 2.3

Material Errors in a Prior Period

Mixmaster Ltd owns 10 000 shares of a company that is listed on a public stock exchange. This investment
asset is measured at fair value through profit or loss (FVPL).
During the preparation of the financial statements for the year ended 30 June 20X6, the financial
controller noted that the shares had not been marked to market (revalued) in the prior year.
Shares are held at $100 000 ($10 per share), which was the price paid when they were originally
purchased in March 20X5. The share price at 30 June 20X5 was $9.50, and the share price at 30 June
20X6 was $10.50.
This is an example of an accounting error, and therefore, a retrospective adjustment is required when
the error is discovered.
The error should be corrected by restating the comparative balances for 20X5. At 30 June 20X5, the
carrying amount of the shares was incorrectly shown as $100 000 but should have been recognised at fair
value of $95 000 (10 000 shares × $9.50). The following journal would need to be processed.

30 June 20X5
Dr Fair value movements in listed equities (P/L) 5 000
Cr Investment in shares (asset) 5 000

A detailed note disclosure is also required to explain this adjustment.

At 30 June 20X6, the fair value of the shares increased to $10.50 per share. The fair value is now
$105 000 (10 000 shares × $10.50). The journal entry required based on this adjustment is as follows.

30 June 20X6
Dr Investment in shares (asset) 10 000
Cr Fair value movements in listed equities (P/L) 10 000

74 Financial Reporting
 Assume other balances are $0 beforehand and ignore tax. The financial effects of correcting the error
can be summarised as follows.

20X6 20X5
Statement of financial position
Investment in shares 105 000 95 000
Retained earnings 5 000 (5 000)
Statement of P/L and OCI
Fair value movement 10 000 (5 000)
Profit before tax 10 000 (5 000)

2.4 EVENTS AFTER THE REPORTING PERIOD

It is important that financial statements reflect conditions that existed at the end of the reporting period.
The objective of IAS 10 is to prescribe when an entity should adjust its financial statements for events
occurring after the reporting period and the disclosures it should give about such events in the notes to the
financial statements (IAS 10, para. 1).
An event after the reporting period, or a subsequent event, is defined as a favourable or unfavourable
event occurring between the end of the reporting period and the date when the financial statements have
been authorised for issue (IAS 10, para. 3).
The date of authorisation is important because events after this date do not qualify as events after the
reporting period. In the case of a company, the date of authorisation is usually the date the directors sign
a Directors’ Declaration that is attached to the financial report. If an event occurs after the directors have
signed off, then IAS 10 does not apply, and the event will be recognised in the next reporting period.
The timeline in figure 2.2 illustrates the concept of events occurring after the reporting period and the
application of IAS 10.

FIGURE 2.2 Application of IAS 10 Events after the Reporting Period

IAS 10 applies IAS 10 does not apply

End of reporting Date that the board/directors

period ‘sign off’ the financial report
(e.g. 30 June) (e.g. 30 September)

Source: Based on IRFS Foundation 2019, IAS 10 Events after the Reporting Period, in 2019 IFRS Standards, IFRS Foundation,
London. © CPA Australia 2019.

Events after the reporting period are only reflected in the financial statements up to the date of
authorisation for issue. Therefore, it is important that this date is disclosed together with details of who
gave the authorisation (IAS 10, para. 17).

TYPES OF EVENTS AFTER THE REPORTING PERIOD

IAS 10 provides for two types of events that can occur after the reporting period:
1. those events that provide new or further evidence of conditions that existed at the end of the reporting
period (called an adjusting event)
2. those events that reflect conditions that were not in existence at the end of the reporting period, but
which arose for the first time after the end of the reporting period (called a non-adjusting event)
(IAS 10, para. 3).
These are illustrated in figure 2.3.

MODULE 2 Presentation of Financial Statements 75

 FIGURE 2.3 Types of events after the reporting period

Event after the reporting period

Adjusting events or Non-adjusting events

Events that require the financial Events that are required to be

statements to be adjusted disclosed as a note to the
(usually by way of a journal entry) financial statements

Source: CPA Australia 2019.

ADJUSTING EVENTS
An adjusting event is one that provides new or further evidence of conditions that existed at the end of
the reporting period. According to paragraph 8 of IAS 10, an entity shall adjust the financial statements to
reflect these events.
An adjusting event may provide additional information about items that existed at the end of the reporting
period, but for which the amount was uncertain and had to be estimated. The additional information after
the reporting period informs what the correct amount is for the financial statements.
Examples of adjusting events include:
• where a court case that was in existence, but had not been settled by the end of the reporting period, is
subsequently decided after the reporting period where the outcome is now known
• where an asset value has been estimated at the end of the reporting period, and further information has
become available after the reporting period that alters or changes the value of the asset — for example,
the ascertainment of selling prices for inventory items, after the reporting period, where those prices
were uncertain at the end of the reporting period, thereby affecting the determination of the carrying
amount of inventory items measured at net realisable values
• the determination after the reporting period of profit sharing or bonus payments, if the entity had a
present obligation for such payments arising from events occurring before the end of the reporting period
• the discovery of fraud or errors after the reporting period that reveals that the financial statements were
incorrect at the end of the reporting period.
In the case of adjusting events, IAS 10 requires an entity to update disclosures that relate to conditions
that existed at the end of the reporting period in light of the new information (IAS 10, para. 19).
If the new information relates to items presented in the financial statements, then this means posting a
journal entry to adjust the amounts recognised in the financial statements. An example is new information
about slow-selling stock that indicates the allowance for inventory obsolescence should be increased.
The entity would need to prepare a journal entry to record an increase in the allowance for inventory
obsolescence.
If the new information concerns information disclosed in the notes to the financial statements, then this
means making changes to the note disclosures. An example is a contingent liability disclosed in the notes
at the end of the reporting period for possible damages that may result from an in-progress court action by
a disgruntled customer. After the end of the reporting period but prior to the date of issue, evidence from
the court case may indicate a stronger likelihood of losing the case. The entity should update the disclosure
about the contingent liability to reflect this new information.

NON-ADJUSTING EVENTS
A non-adjusting event is one that provides new evidence of conditions that have arisen after the reporting
period. In other words, the information does not relate to a condition that existed at the end of the
reporting period.

76 Financial Reporting
 An entity must not adjust the amounts recognised in the financial statements to reflect non-adjusting
events (IAS 10, para. 10).
Examples of non-adjusting events are:
• a decline in the market value of investments after the reporting period and the date when the financial
statements are authorised for issue. The decline in market value does not normally relate to the
condition of the investments at the end of the reporting period but reflects circumstances that have
arisen subsequently
• a major business combination change after the reporting period (e.g. acquisition or disposal of
a subsidiary)
• announcing a plan to discontinue a business unit or operation after the reporting period
• major purchases or disposal of assets, or expropriation of major assets by government
• the destruction of a major production plant by a fire after the reporting period
• announcing or commencing the implementation of a major restructuring
• major share transactions (e.g. issuing new shares, bonus share issues) after the reporting period
• changes in tax rates or tax laws enacted or announced after the reporting period date that have a
significant effect on current and deferred tax assets and liabilities
• abnormally large changes in asset prices or foreign exchange rates after the reporting period
• entering into significant commitments or contingent liabilities
• commencing major litigation that arose solely from events that occurred after the reporting period
(IAS 10, paras 11 and 22).
In the case of non-adjusting events after the reporting period that are material, an entity should disclose
in the notes to the financial statements the nature of the event and an estimate of its financial effect, or a
statement that such an estimate cannot be made (IAS 10, para. 21).
Figure 2.4 illustrates how to distinguish between the two types of events after the reporting period,
namely adjusting and non-adjusting events.

FIGURE 2.4 Distinguishing between different types of events after the reporting period

YES Did the event occur NO

after the end of the
reporting period?

Did the event occur

NO before the authorisation YES Not an event after
date of the financial reporting period
statements?

Did the event reflect

Not an event after YES NO
conditions existing at
reporting period
the end of the
reporting period?

Adjusting event Non-adjusting event

Source: Based on IRFS Foundation 2019, IAS 10 Events after the Reporting Period, in 2019 IFRS Standards, IFRS Foundation,
London. © CPA Australia 2019.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 2–7 of IAS 10. Please now attempt
question 2.3 to apply your knowledge of this topic.

MODULE 2 Presentation of Financial Statements 77

 QUESTION 2.3

The following extract is from Note 36 of the 2014 annual report of BHP Group — known as BHP
Billiton at the time (statement of financial position date is 30 June 2014):

On 2 September 2014, legislation to repeal the [Minerals Resource Rent Tax] MRRT in Australia
received the support of both Houses of Parliament. The repeal will take effect at a later
date to be fixed by proclamation and therefore the MRRT will continue to apply until that
date. At 30 June 2014, the Group carried an MRRT deferred tax asset (net of income tax
consequences) of US$698 million. Subject to determination of the effective date, an income
tax charge approximating this amount is expected to be recognised in the 2015 financial year
(BHP Group 2014, p. 292).

Comment on whether the preceding event would be regarded as an ‘adjusting event after the
reporting period’ or a ‘non-adjusting event after the reporting period’.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 8–11, 19 and 21 of IAS 10 to confirm the
content of figure 2.4. Please now attempt question 2.4 to apply your knowledge of this topic.

QUESTION 2.4

Refer to Note 23 Subsequent Events in the notes to financial statements of the financial statement
of Techworks Ltd. This note refers to two events which have occurred after the 30 June year end
(but before the signing off of the financial report by the directors).
The two events disclosed in Note 23 are:
• renegotiation of the loan facility (and repayments) in August
• declaration of the dividend by the directors on 17 August.
Explain whether these two subsequent events are adjusting or non-adjusting events under
IAS 10.

DIVIDENDS DECLARED AFTER REPORTING PERIOD

Dividends may be declared after the end of the reporting period. IAS 10 requires that an entity should
not recognise those dividends as ‘a liability at the end of the reporting period’ even if the dividend was
declared from profits derived prior to the end of the reporting period (IAS 10, para. 12).
This is because such dividends fail the essential characteristic of a liability, that is, a present obligation
existing at the end of the reporting period (IAS 10, para. 13). As such, the dividends declared/payable shall
be regarded as a non-adjusting event and be disclosed in the notes to the financial statements.

GOING CONCERN ISSUES AFTER REPORTING PERIOD

IAS 10 does not permit an entity to prepare its financial statements on a going concern basis if management
determines after the reporting period that it either intends to liquidate the entity or cease trading, or has no
realistic alternative but to do so (IAS 10, para. 14).
If the event after the reporting period reveals that the entity is no longer a going concern, then the
financial statements should not be presented as if the entity is a going concern. IAS 10 effectively treats
the new information regarding going concern as an adjusting event. In this case, the financial statements
would have to be presented on the basis that the entity is not a going concern, for example, using
liquidation values.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 14–16 of IAS 10.
Paragraph 22 of IAS 10 provides several examples of non-adjusting events. If you wish to explore this topic further,
you may now read paragraphs 17–22. Please now attempt question 2.5 to apply your knowledge of this topic.

78 Financial Reporting
 QUESTION 2.5

Venturiac Holdings Ltd’s reporting period ends on 30 June, and the financial statements are
authorised for issue on 31 August. How should the following events be disclosed?
(a) On 30 July, a major drop in the price of shares means that the value of the Venturiac Holding’s
investments has declined by 25% since 30 June.
(b) A debtor who owed a significant sum of money as at 30 June was declared bankrupt on
18 August.
(c) A major explosion occurred on 20 July, causing significant losses for the company.

2.5 THE IMPACT OF TECHNOLOGICAL

ADVANCEMENTS ON THE PRESENTATION OF
FINANCIAL STATEMENTS
As discussed in module 1, timeliness is an important qualitative characteristic of financial information as
stated in the Conceptual Framework. However, it is traditionally expected that producing GPFSs involves
a significant period of time, during which the information included in those GPFSs may lose its ability
to influence decisions. That is the case because the current processes necessary to produce GPFSs still
involve, to a great extent, manually assembling and reviewing the financial reports.
It is common practice for financial statements to be released three months after the end of the reporting
period. As a consequence, even more work is needed to identify and recognise the effects of adjusting
and non-adjusting events to somehow still maintain reasonable timeliness of information disclosed. This
practice and the need to disclose events after the reporting period will potentially change in the near future
as technological advancements allow entities to prepare financial reports almost instantaneously with some
clever software solutions, provided that they record their data in a structured way.
Software companies like IBM, Oracle, SAP and many others are now offering powerful cloud-based
disclosure management applications that can automatically generate reports that combine an entity’s
structured financial data with narrative analysis. Those reports are not only prepared faster but can be
updated automatically as new events occur; they can also be subject to less human errors as human
intervention is kept at a minimum. The solutions began by focusing on helping entities to produce
digital reports in a machine-readable format known as XBRL (see www.xbrl.org/the-standard/what/an-
introduction-to-xbrl), but are continuously evolving. As more entities are embracing these software
solutions, users of financial information will benefit from having access to quality reports in a timely
manner. Moreover, they will be able to use software solutions based on artificial intelligence applications
like machine learning and deep learning to perform data analysis on the vast amounts of data that will be
readily available.

SUMMARY
IAS 1 specifies the components of a complete set of financial statements and the considerations that must
be taken into account when preparing the financial statements. These considerations include:
• compliance with IFRSs to present fairly the financial performance, financial position and cash flows of
an entity
• selection and disclosure of accounting policies
• assessment of whether the entity is a going concern
• use of the accrual basis of accounting
• use of materiality to determine which items should be separately disclosed
• need for consistency from one reporting period to the next
• comparative information.
This module covered the selection and disclosure of accounting policies in some detail. IAS 8 deals
with the selection of accounting policies and specifies that management should select accounting policies
that comply with standards and interpretations. Where there is no specific requirement in a standard or
interpretation, accounting policies must be selected and applied so that the resultant information is relevant
and reliable.

MODULE 2 Presentation of Financial Statements 79

 IAS 1 contains requirements for the disclosure of accounting policies, including:
• a description of the measurement basis or bases used
• a description of accounting policies necessary for an understanding of the financial report
• detailed information where material uncertainties exist as to whether the entity can continue as a going
concern or whether the financial report has been prepared on other than a going concern basis.
IAS 8 specifies that an entity can only change an accounting policy when this is required by a standard
or interpretation, or the change is necessary to provide reliable and more relevant information. Where
an entity changes an accounting policy because of a new standard or interpretation, it must apply the
transitional provisions of that standard or interpretation. When there are no transitional provisions in the
standard or interpretation, or the entity is making a voluntary change in accounting policy, the accounting
policy change must be made retrospectively. That is, IAS 8 requires the entity to:
• adjust the opening balance of each component of equity affected by the change for the earliest prior
period included in the financial statements
• restate any comparative amounts included in the financial statements as if the new policy had always
been applied.
Where an accounting policy change is made, the entity must disclose information — including the title
of the standard or interpretation (if a new standard or interpretation required the change), the nature of the
change, the reasons for the change and the amount of any adjustments made to the financial statements.
The final section of part A dealt with IAS 10. The standard identifies two types of events occurring after
the reporting period: adjusting and non-adjusting events. Where the event provides evidence of conditions
existing at the end of the reporting period, the financial statements must be adjusted to reflect this event.
Where the event does not relate to conditions existing at the end of the reporting period, disclosure in the
notes is only required where the information would affect the decisions of users.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

2.1 Explain and apply the requirements of IAS 1 with respect to a complete set of financial statements
and in relation to the considerations for the presentation of financial statements.
• A complete set of financial statements includes a statement of financial position, statement of profit
or loss and other comprehensive income, statement of changes in equity, statement of cash flows,
notes to the financial statements, and comparative information from the preceding reporting period.
• Segment reporting involves presenting disaggregated financial information in the notes to the
financial statements to support an understanding of the aggregated financial information in the
financial statements.
• Fair presentation of the financial statements requires faithful representation of the effects of
transactions, other events and conditions in accordance with the definitions and recognition criteria
for assets, liabilities, income and expenses set out in the Conceptual Framework.
• General features that must be complied with when preparing and presenting general purpose
financial statements include going concern, accrual basis, materiality and aggregation, offsetting,
frequency of reporting, comparative information, and consistency.
2.2 Outline and explain the requirements of IAS 8 for the selection of accounting policies.
• Accounting policies are the specific principles, bases, conventions, rules and practices applied by
an entity in preparing and presenting financial statements.
• International Financial Reporting Standards (IFRSs) have priority when determining the accounting
policies to be applied.
• An entity that prepares general purpose financial reports is required to disclose its significant
accounting policies in the notes to the financial statements to assist users in their decision making.
• An entity can change its accounting policies only if the change is either required by an IFRS or
results in the financial statements providing reliable and more relevant information about the effects
of transactions, other events or conditions on the entity’s financial position, financial performance or
cash flows.
2.3 Explain and apply the accounting treatment and disclosure requirements of IAS 8 in relation to
changes in accounting policies, and changes in accounting estimates and errors.
• Changes in accounting estimates are to be distinguished from the correction of errors as they do not
relate to a prior period and cannot be recognised retrospectively.
• Material errors made in a prior period must be corrected if the financial statements are to comply
with IFRSs.

80 Financial Reporting
 • When material errors are discovered in a reporting period subsequent to the reporting period(s) in
which the error occurred, IAS 8 requires retrospective correction of the error in the first set of financial
statements issued after the error’s discovery.
2.4 Explain and discuss the required treatment for both adjusting and non-adjusting events occur-
ring after the reporting period in accordance with IAS 10.
• IAS 10 distinguishes between two types of events occurring after the reporting period and before
the date of authorisation of the financial statements:
1. events that provide new or further evidence of conditions that existed at the end of the reporting
period are referred to as ‘adjusting events’
2. events that reflect conditions that were not in existence at the end of the reporting period, but
which arose for the first time after the end of the reporting period, referred to as ‘non-adjusting
events’.
• Dividends declared after the end of the reporting period are regarded as a non-adjusting event and
are to be disclosed as a note in the financial statements.

MODULE 2 Presentation of Financial Statements 81

PART B: STATEMENT OF PROFIT OR LOSS
AND OTHER COMPREHENSIVE INCOME
INTRODUCTION
The key indicator of a business entity’s financial performance is its reported profit or loss (P/L) figure.
Therefore, how profit is determined and the information that is disclosed concerning the determination of
profit or loss are central accounting issues. IAS 1 deals with these matters.
A more expansive notion of financial performance is comprehensive income, which equals the profit or
loss added together with other comprehensive income (OCI) for the period.
Part B discusses the composition of the statement of P/L and OCI, including what is required to be
included in the profit or loss and what is included in other comprehensive income.
Under IAS 1, an entity has the choice of presenting either a single statement of P/L and OCI or two
statements; for example, a statement of profit or loss and a statement of comprehensive income.

Relevant Paragraphs
To achieve the objectives of part B outlined in the module preview, read the relevant paragraphs in the
following accounting standard. Where specified, you need to be able to apply these paragraphs:
IAS 1 Presentation of Financial Statements:
Subject Paragraphs
Definitions 7
Complete set of financial statements 10–10A
Statement of profit or loss and other comprehensive income 81A–81B
Information to be presented in the profit or loss section or the statement of profit or loss 82
Information to be presented in the other comprehensive income section 82A–87
Profit or loss for the period 88–89
Other comprehensive income for the period 90–96
Information to be presented in the statement(s) of profit or loss and other comprehensive
income or in the notes 97–105

2.6 PRESENTATION OF COMPREHENSIVE INCOME

IAS 1 requires an entity to prepare and include a statement of P/L and OCI for the period in its complete
set of financial statements (IAS 1, para. 10).
IAS 1 requires an entity to present either:
1. a single statement of profit or loss and other comprehensive income with two sections presented
together, the first section for the profit or loss followed by the second section for other comprehensive
income, or
2. two statements — a separate statement of profit or loss (presenting components of profit or loss) which
must be immediately followed by a separate statement presenting comprehensive income (beginning
with the profit or loss and presenting components of other comprehensive income) (IAS 1, para. 10A).
IAS 1 allows an entity to use other titles for the statements (IAS 1, para. 10). For example, the statement
of profit or loss can instead have the title ‘income statement’. Similarly, an entity can use the term ‘net
income’ to describe the profit or loss (IAS 1, para. 8).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read the definitions of ‘profit or loss’, ‘other comprehensive
income’ and ‘total comprehensive income’ in paragraph 7 of IAS 1.

Figure 2.5 illustrates the:

• components of comprehensive income (items of profit or loss and items of other comprehensive income)
• relationship of the components to the presentation requirements of IAS 1
• link between comprehensive income and the statement of changes in equity (to be discussed in
part C).

82 Financial Reporting
 FIGURE 2.5 Components of comprehensive income and their presentation

Income Other comprehensive Total comprehensive

Less: Expenses income income –– changes in equity
= Profit or loss Items of income and other than transactions
Components (excludes other + expense not recognised in = with owners (para. 7)
comprehensive income) profit or loss as required
(para. 7) or permitted by other
IFRSs (para. 7)

Single statement of
profit or loss and other
Presentation comprehensive income
option 1: Statement of
Income
para. 10A –– changes in
Expenses
single statement equity
Profit or loss
Other comprehensive income
Total comprehensive income

Separate statement Statement of profit or loss

Presentation
of profit or loss and other comprehensive Statement of
option 2:
Income income changes in
para. 10A ––
Less: Expenses Profit or loss equity
two statements
Profit or loss Other comprehensive income
Total comprehensive income

Source: Based on IRFS Foundation 2019, IAS 1 Presentation of Financial Statements, in 2019 IFRS Standards, IFRS Foundation,
London. © CPA Australia 2019.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read the examples on presenting total comprehensive income
in the ‘Guidance on implementing IAS 1 Presentation of Financial Statements’ (in the IFRS Compilation Handbook).

2.7 THE CONCEPT OF OTHER COMPREHENSIVE

INCOME AND TOTAL COMPREHENSIVE INCOME
‘Other comprehensive income’ comprises items of income and expense (including reclassification adjust-
ments) that are not recognised in the profit or loss as required or permitted by IFRSs.
OCI is effectively the difference between total comprehensive income and the profit or loss for the
period. The IAS 1 definitions are as follows.
• Total comprehensive income is the change in equity during a period resulting from transactions and other
events, other than those changes resulting from transactions with owners in their capacity as owners.
• Profit or loss is the total of income less expenses, excluding the components of other comprehensive
income (IAS 1, para. 7).

IAS 1 states that the components of other comprehensive income include:

• gains and losses recognised in the revaluation surplus resulting from the revaluation of property, plant
and equipment under IAS 16 or intangible assets under IAS 38
• gains and losses from remeasurements of defined benefit plans under IAS 19
• gains and losses arising from translating the financial statements of a foreign operation under IAS 21
• gains and losses from investments in equity instruments designated as fair value through OCI under
IFRS 9
• gains and losses on other financial assets measured at fair value through OCI under IFRS 9

MODULE 2 Presentation of Financial Statements 83

• gains and losses on hedging instruments in a cash flow hedge and gains and losses on hedging
instruments for investments in equity instruments measured at fair value through OCI under IFRS 9
• changes in the value of the time value of options for certain option contracts designated as hedging
instruments under IFRS 9 (IAS 1, para. 7).
This study guide focuses on the following examples of other comprehensive income:
• changes in the revaluation surplus made in accordance with IAS 16 Property, Plant and Equipment
(paras 39 and 40)
• gains and losses from remeasuring equity instruments measured at fair value through OCI in accordance
with IFRS 9 Financial Instruments
• gains and losses arising from translating the financial statements of a foreign operation under IAS 21
The Effects of Changes in Foreign Exchange Rates (para. 48).
IAS 1 requires all income and expense items to be included in the determination of profit or loss for a
reporting period ‘unless an IFRS requires or permits otherwise’ (IAS 1, para. 88).
An entity recognises items outside the profit or loss of the current period in the following
circumstances:
• the correction of errors or changes in accounting policies in accordance with IAS 8
• other IFRSs require or permit items of income or expense to be excluded from profit or loss even though
the items meet the Conceptual Framework definition of income or expense (IAS 1, para. 89).
As discussed in part A, IAS 8 requires the retrospective application of changes in accounting policies
and the retrospective correction of errors. The adjustments for retrospective application are excluded from
the profit or loss for the current reporting period. Although dependent on the nature of the retrospective
application, the impact on the financial statements in the current period is reflected in the statement of
changes in equity via adjustments to the opening balances of equity items (often retained earnings).
In the case of revaluations of property, plant and equipment, IAS 16 requires an increase in an asset’s
carrying amount due to a revaluation to be recognised in OCI if it is not a reversal of a previous revaluation
decrease of the same asset (IAS 16, para. 39). If it is a reversal of a previous revaluation decrease, it is to
be recognised in P/L only, to the extent that it offsets the previous decrease (IAS 16, para. 39).
Conversely, IAS 16 requires a decrease in an asset’s carrying amount due to a revaluation to be
recognised in profit or loss if it is not a reversal of a previous revaluation increase of the same asset
(IAS 16, para. 40). If it is a reversal of a previous revaluation increase, it is to be recognised in OCI only
to the extent it offsets the previous increase (IAS 16, para. 40).
All changes in equity other than contributions by the owners (e.g. the issue of additional shares) and
reductions in equity (e.g. share buybacks and dividends paid) shall be recognised in the statement of P/L
and OCI. In the case of contributions by the owners (e.g. the issue of additional shares) and reductions in
equity (e.g. share buybacks and dividends paid), these transactions will be reflected directly in the statement
of changes in equity rather than in the statement of P/L and OCI.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read:
• the definition and associated discussion of ‘other comprehensive income’ in paragraph 7 of IAS 1
• paragraphs 88 and 89 of IAS 1.

2.8 IAS 1 — DISCLOSURES AND CLASSIFICATION

IAS 1 allows an entity a choice in presenting either:
• a single statement of P/L and OCI, or
• two statements (e.g. a separate statement of P/L and a separate statement of comprehensive income)
(IAS 1, para. 10A).

SINGLE STATEMENT (STATEMENT OF P/L AND OCI)

Under the first option, an entity presents a single statement of P/L and OCI. Many listed Australian
companies have adopted a ‘single-statement approach’, such as Cabcharge, The Reject Shop, Southern
Cross Media Group and the Mirvac Property Group.
According to IAS 1, the single statement approach requires two sections to be presented in the statement.
The first section is for the profit or loss, and the second section is for other comprehensive income.

84 Financial Reporting
 In addition to a section for the P/L and a section for OCI, the statement of P/L and OCI must
present the:
• profit or loss (para. 81A(a))
• total other comprehensive income (para. 81A(b))
• comprehensive income for the period, being the total of profit or loss and other comprehensive income
(para. 81A(c)).
The ‘total comprehensive income for the period’ transferred to the statement of changes in equity is,
therefore, the sum of the totals from the two sections calculated as follows.

Total comprehensive Profit or loss Other comprehensive

= +
income (after tax) income

Where an entity is presenting a consolidated statement of P/L and OCI, both the consolidated ‘profit or
loss’ for the period and the consolidated ‘comprehensive income’ for the period must be allocated between:
• non-controlling interests
• the parent entity’s owners.
The amounts of the allocations of consolidated profit or loss and consolidated comprehensive income
to each of these groups of shareholders must be presented as separate items (IAS 1, para. 81B).

TWO STATEMENTS (STATEMENT OF PROFIT OR LOSS AND A

STATEMENT OF COMPREHENSIVE INCOME)
Under the second option, an entity prepares two separate statements, for example:
• a statement of profit or loss
• a statement of comprehensive income.
The main difference between the single-statement approach and the two-statement approach is that
instead of showing both sections in one combined statement, there are two separate statements.
In the two-statement approach, the statement of P/L includes the entity’s incomes and expenses for
the period ending with the line ‘profit or loss for the period’. The statement of comprehensive income
commences with a line item for the profit or loss and then adds the OCI items. As in the case of the
single-statement approach, total comprehensive income is the sum of profit or loss for the period plus OCI
(IAS 1, para. 81A).
Many listed Australian companies, such as Harvey Norman Holdings, Wesfarmers, Qantas, Virgin
Australia, Woolworths, Telstra and JB Hi-Fi have adopted a two-statement approach. An advantage of
the two-statement approach is that there is more space to present income, expense and OCI items because
each statement usually has its own page.
In the two-statement approach, the statement of profit and loss must disclose the amounts for the
allocation of consolidated profit or loss between non-controlling interests and the parent entity’s owners
whereas the statement of comprehensive income must disclose the allocation for consolidated comprehen-
sive income (IAS 1, para. 81B).
The allocation of the consolidated profit or loss to the ownership interests of a corporate group will be
covered in module 5, which deals with consolidated financial statements.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 81A and 81B of IAS 1.

IAS 1 also contains disclosure and classification requirements for the single statement of P/L and OCI.
Next is a discussion of the following IAS 1 requirements:
• information to be presented with profit or loss
• classification of income and expenses
• separate disclosure of material income and expense items
• information to be presented with other comprehensive income.
Information Presented With Profit or Loss
The profit or loss for the period is determined as the difference between the income and expenses that must
be recognised in the profit or loss for the period.

MODULE 2 Presentation of Financial Statements 85

 IAS 1 specifically requires line items to be disclosed in the profit or loss section of a single-statement
P/L and OCI or in the statement of profit and loss if two statements are presented. The required line items
are listed in paragraph 82 of IAS 1 as:
(a) revenue, presenting separately:
(i) interest revenue calculated using the effective interest method; and
(ii) insurance revenue (see IFRS 17);
(aa) gains and losses arising from the derecognition of financial assets measured at amortised cost;
(ab) insurance service expenses from contracts issued within the scope of IFRS 17 (see IFRS 17);
(ac) income or expenses from reinsurance contracts held (see IFRS 17);
(b) finance costs;
(ba) impairment losses (including reversals of impairment losses or impairment gains) determined in
accordance with Section 5.5 of IFRS 9;
(bb) insurance finance income or expenses from contracts issued within the scope of IFRS 17
(see IFRS 17);
(bc) finance income or expenses from reinsurance contracts held (see IFRS 17);
(c) share of the profit or loss of associates and joint ventures accounted for using the equity method;
(ca) if a financial asset is reclassified out of the amortised cost measurement category so that it is measured
at fair value through the profit or loss, any gain or loss arising from a difference between the previous
amortised cost of the financial asset and its fair value at the reclassification date (as defined in IFRS 9);
(cb) if a financial asset is reclassified out of the fair value through other comprehensive income measurement
category so that it is measured at fair value through the profit or loss, any cumulative gain or loss
previously recognised in other comprehensive income that is reclassified to profit or loss;
(d) tax expense;
...
(ea) a single amount for the total of discontinued operations (see IFRS 5).

An entity must present additional line items, headings and subtotals when presenting the profit or loss
and other comprehensive income if such presentation is relevant to an understanding of the entity’s financial
performance (IAS 1, para. 85). As an example, a retailer would normally present line items for sales, cost
of sales and gross profit in its statement of profit or loss or statement of P/L and OCI.
IAS 1 prohibits the presentation of extraordinary items in the ‘statement(s) presenting profit or loss and
other comprehensive income or in the notes’ (IAS 1, para. 87). Previously, an item of income or expense
was regarded as extraordinary if it was outside the ordinary activities of the entity and not recurring in
nature. These extraordinary items were then presented separately from the profit or loss. Entities often
abused this provision and applied the term ‘extraordinary’ to any major write-downs or losses (e.g. bad
news was extraordinary). For this reason, IAS 1 now prohibits such abuse.

Expenses — Nature or Function?

IAS 1 requires an entity to present an analysis of expenses recognised in the profit or loss using a
classification system based on either the nature of the expenses or their function within the entity (IAS 1,
para. 99). The classification may be presented in the financial statement(s) or in the notes to the financial
statement(s), although entities are encouraged to present the classification in the financial statement(s)
(IAS 1, para. 100).
The choice between classification of expenses by nature or function is made based on whichever system
provides information that is reliable and more relevant (IAS 1, para. 99). In effect, classification by nature
means expenses are presented descriptively (what they are), whereas classification by function means
expenses are presented purposively (what role they have to the entity’s operations).
An example of classification of expenses by nature is:
• changes in inventories of finished goods and work in process
• raw materials and consumables used
• employee benefits expense
• depreciation and amortisation expense
• other expenses (IAS 1, para. 102).
Other line items that may arise when classifying expenses by nature include the following, insurance
expense, rent expense, electricity expense, advertising expense and audit expense.
Classification by function (also known as ‘cost of sales method’) classifies expenses according to their
function as part of cost of sales or, for example, the sales or administrative activities.

86 Financial Reporting
 An example of classification of expenses by function is:
• cost of sales
• distribution expenses
• administration expenses
• other expenses (IAS 1, para. 103).
When the expenses are classified based on the nature of the expense, employee benefit expenses would
be aggregated and presented as a single line item called, for example, ‘employee benefits expense’, which
communicates the nature of the expense to the user of the financial statements. In contrast, when expenses
are classified based on the function of the expense, employee benefit expenses would be allocated to the
respective functions to which the expenses relate (e.g. cost of sales, marketing expenses, administration
expenses), which communicates the function of the expense to the user of the financial statements.
The choice between nature and function is a matter of professional judgment and will depend on a
number of factors, including the nature of the entity and industry factors (IAS 1, para. 105). When expenses
are classified by function, the entity must disclose, in the notes, information about the nature of expenses,
including depreciation and amortisation expense and employee benefits expense (IAS 1, para. 104).

Separate Disclosure of Material Income and Expense Items

IAS 1 also requires an entity to separately disclose the nature and amounts of items of income and expense
that are material (IAS 1, para. 97). This additional level of disclosure assists financial report users to fully
understand the financial performance of an entity.
The determination of whether an item of income or expense is material is a matter of professional
judgment based on whether the information could reasonably be expected to influence decisions made
by the primary users of general purpose financial statements. Recall that matters of materiality require
consideration of the nature or magnitude of information, or both (IAS 1, para. 7).
IAS 1 provides examples of circumstances that would give rise to separate disclosures of material items
of income and expense:
• write-downs of inventories to net realisable value
• write-downs of property, plant and equipment to recoverable amount or reversals
• restructurings of the activities of an entity and reversals of any provisions
• disposals of property, plant and equipment
• disposals of investments
• discontinued operations
• litigation settlements
• other reversals of provisions (IAS 1, para. 98).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read:
• paragraphs 82–87 and paragraphs 97– 98 of IAS 1
• paragraphs 99–105 of IAS 1, which discuss and illustrate the classification of expenses in more detail
• the examples for the presentation of statements of P/L and OCI in the ‘Guidance on implementing IAS 1
Presentation of Financial Statements’, which illustrate the classification of expenses by function and nature
respectively (in the IFRS Compilation Handbook)
• paragraphs 110 and B87–B89 of IFRS 15, which contain the disclosure and classification requirements for revenue
• IFRS 15, Appendix A: Defined terms to compare the definitions of income and revenue.

Information Presented with Other Comprehensive Income

Information regarding other comprehensive income is presented in the second section of the single
statement of P/L and OCI or in the statement of comprehensive income if two statements are presented.
IAS 1 requires the applicable financial statement to present amounts for line items of other comprehen-
sive income for the period as:
• items of OCI classified by nature grouped into those where the items are subsequently reclassified to
the profit or loss and those that are not
• the share of OCI of associates and joint ventures accounted for using the equity method, separated into
those where the share of items is subsequently reclassified to the profit or loss and those that are not
(IAS 1, para. 82A).
First, the nature and amount of each item of OCI must be presented separately, including the share of
OCI of equity-accounted associates and joint ventures. Second, the items must be grouped into those that
will be reclassified subsequently to profit or loss when specific conditions are met and those that will not.

MODULE 2 Presentation of Financial Statements 87

Whether an item of OCI may be classified subsequently to the profit or loss is determined by the IFRS
relevant to the accounting for that item.
An example of an item of OCI that is subsequently reclassified to the profit or loss is gains/losses on
the translation of the financial statements of a foreign operation. When the foreign operation is held, the
translation gains/losses are recognised in OCI and accumulated in equity in a ‘foreign currency translation
reserve’. When the foreign operation is disposed of, IAS 21 requires the cumulative amount of exchange
differences to be reclassified from equity (OCI) to the profit or loss (IAS 21, para. 48).
An example of an item of OCI that is not subsequently reclassified to the profit or loss is revaluation
gains that arise from the application of fair value measurement to plant. When an item of plant on hand
is revalued above its cost-based amount, a gain is recognised in OCI and accumulated in equity in the
revaluation surplus. When that plant is disposed of, the cumulative amount of any revaluation gains in the
revaluation surplus may be transferred to retained earnings but cannot be reclassified from equity (OCI)
to profit or loss (IAS 16, para. 41).
IAS 1 requires an entity to disclose the amount of income tax relating to each item of comprehensive
income either in the applicable financial statement or in the notes to the financial statements (IAS 1,
para. 90). Items of other comprehensive income may be presented net of related tax or gross (before tax)
with an aggregate amount of tax disclosed for the OCI items in total (IAS 1, para. 91).
When the before tax approach is used, an entity will disclose the income tax relating to each item of OCI
in the notes to the financial statements. In the financial statement, however, income tax must be allocated
between the two groupings of OCI, that is, between those items that will be subsequently reclassified to
the profit or loss and those items that will not.
When the ‘net of tax’ approach is used, the amount of income tax relating to each item of OCI may be
disclosed either in the financial statement or in the notes to the financial statement.
IAS 1 also requires an entity to disclose reclassification adjustments related to components of other
comprehensive income (IAS 1, para. 92). Reclassification adjustments may be presented in the financial
statement or in the notes the financial statements (IAS 1, para. 94).
When an unrealised gain previously recognised in OCI is subsequently reclassified as a realised gain in
profit or loss, OCI must be reduced to avoid double counting the gain in the comprehensive income of the
current and preceding reporting periods (IAS 1, para. 93).

What Happens to the Totals in the Statement of Profit or Loss and

Other Comprehensive Income?
Both the net profit after income tax figure and the other comprehensive income figures are transferred to
the statement of changes in equity.
Table 2.1 illustrates this concept.
Relationship between statement of profit or loss and other comprehensive income and
TABLE 2.1 statement of changes in equity

Net profit after income tax Transferred to the ‘retained earnings’ column in the statement of changes
in equity.

Items included in other Transferred to the ‘reserves’ column in the statement of changes in
comprehensive income equity.
For example, if there was a revaluation of an asset, this would be
transferred to the ‘reserves’ column in the statements of changes in
equity and end up in the ‘revaluation surplus’ (IAS 16, para. 39).
Similarly, any foreign exchange gains or losses arising in respect of
foreign operations would be transferred to the ‘reserves’ column in the
statements of changes in equity and end up in the ‘foreign currency
translation reserve’ as per IAS 21.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 82A and 90–96 of IAS 1. Also read the illustrative
statements of P/L and OCI in the ‘Guidance on implementing IAS 1 Presentation of Financial Statements’ (in the IFRS
Compilation Handbook) that demonstrate the two acceptable approaches to dealing with the disclosure of income
tax for components of OCI.

88 Financial Reporting
 QUESTION 2.6

Refer to section 8 of the ‘Case study data’. Prepare a single statement of P/L and OCI for
Webprod Ltd in accordance with paragraphs 10A, 81A and 82 of IAS 1.
Notes:
• There was a revaluation increase of buildings by $150 000, and a revaluation decrease of the land
by $230 000. This reduced the balance of revaluation surplus of Webprod Ltd by $80 000.
• For the purposes of this module, ignore any tax effects of revaluations because this topic is not
dealt with until module 4.
• Question 2.8 will consider an expanded income statement, after classification and other disclo-
sures have been discussed.

Refer to the financial statements of Techworks Ltd. Has a single statement or two statements been
used to report profit or loss and other comprehensive income? Have expenses been classified by nature
or function?

QUESTION 2.7

(a) Refer to the statement of P/L and OCI prepared in answering question 2.6. Explain whether
the revaluation loss included in OCI could result in a ‘reclassification adjustment’ in future
reporting periods.
(b) Where the financial statements of a foreign operation are translated for inclusion in the financial
statements of a reporting entity, the exchange differences arising from the translation are initially
recognised in OCI and accumulated in equity. On the disposal of the investment in the foreign
operation, the total foreign currency exchange difference accumulated in equity over the life of
the foreign operation is recognised in the profit or loss.
Assume that, at the date of disposal of an investment in a foreign operation, an entity had
recognised accumulated exchange difference gains net of tax through OCI of $7000 (pre-tax of
$10 000). Of the accumulated exchange difference gains, $2800 (pre-tax of $4000) related to the
current reporting period.
Using the net of tax approach, illustrate how the preceding information would be disclosed in
the statement of P/L and OCI for the reporting period when the disposal of the investment in the
foreign operation occurred.

QUESTION 2.8

(a) Refer to section 8 of the ‘Case study data’. Explain which items you would consider for separate
disclosure in the notes to the financial statements in accordance with paragraph 97 of IAS 1.
(b) Refer to section 8 of the ‘Case study data’. Prepare a single statement of P/L and OCI for
Webprod Ltd in accordance with the presentation, disclosure and classification requirements
of IAS 1.
Assume Webprod Ltd classifies expenses according to function.

2.9 TIPS ON HOW TO ANALYSE THE

STATEMENT OF PROFIT OR LOSS AND
OTHER COMPREHENSIVE INCOME
The purpose of the statement of P/L and OCI is to summarise the entity’s income and expenses during the
reporting period. However, it also shows unrealised gains and losses arising from transactions that result
in increases or decreases to equity other than contributions or withdrawals by the owners. The figures
comprising total comprehensive income are transferred to the various reserves in the statement of changes
in equity. Some tips on how to read, analyse and interpret the statement of P/L and OCI are summarised
as follows.

MODULE 2 Presentation of Financial Statements 89

1. Review the components of income. Has there been an increase or decrease in total revenue from the
previous reporting period? What are the main drivers for this increase or decrease? Refer to the notes
to the accounts for further information about income.
2. Review the components of expenses. How does the entity classify its expenses (by nature or function)?
Has there been an increase or decrease in expenses from the previous reporting period? What are the
main drivers for this increase or decrease? Are there any notable large movements or any one-off
material (non-recurring) expenses, such as impairment losses? Refer to the notes to the accounts for
further information about expenses.
3. Review the profit result for the period. Has the entity made a profit or a loss? How does this result
compare to the previous reporting period? What are the main drivers for the increase or decrease
in profit?
4. Review the OCI result. Are there any significant changes in items of comprehensive income (e.g. asset
revaluations) from the previous reporting period? What are the main drivers for these changes?
5. Overall performance. In your opinion, how well is the company performing? Did it perform better or
worse than the previous reporting period?

SUMMARY
IAS 1 specifies the requirements for:
• the presentation of profit or loss and OCI for a period
• disclosures to be made in the statement of P/L and OCI or notes to the financial statements.
IAS 1 adopts an all-inclusive view of comprehensive income and provides for separate disclosure of
certain items. In relation to the profit or loss, these items include finance costs, tax expense and profit
or loss. For OCI, each component must be separately disclosed along with the income tax relating to the
component and any reclassification adjustments.
.......................................................................................................................................................................................
EXPLORE FURTHER
You may wish to explore this topic further and review the illustrative statements of P/L and OCI (which are not part
of the standards) that are included in the ‘Guidance on implementing IAS 1 Presentation of Financial Statements’ (in
the IFRS Compilation Handbook).

The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

2.1 Explain and apply the requirements of IAS 1 with respect to a complete set of financial statements
and in relation to the considerations for the presentation of financial statements.
• An entity is required to present either a single statement of profit or loss and other comprehensive
income with the two sections presented together, or two statements — a separate statement of profit
or loss immediately followed by a separate statement of other comprehensive income.
• Other comprehensive income (OCI) comprises items of income and expense (including reclassifica-
tion adjustments) that are not recognised in the profit or loss as required or permitted by IFRSs. It is
effectively the difference between total comprehensive income and the profit or loss for the period.
• Examples of OCI include gains and losses from revaluating property, plant and equipment; remea-
suring equity instruments measured at fair value; and from foreign currency translation of financial
statements.
• A single-statement approach for the preparation of the statement of profit or loss (P/L) and other
comprehensive income (OCI) includes separate sections for the P/L and the OCI and must present
separate totals for P/L, OCI, and comprehensive income.
• A two-statement approach requires an entity to prepare two separate statements: (1) a statement of
profit or loss, and (2) a statement of comprehensive income.
• IAS 1 specifies which line items are to be presented in the statement of P/L and OCI.

90 Financial Reporting
PART C: STATEMENT OF CHANGES
IN EQUITY
INTRODUCTION
In addition to a statement of P/L and OCI, IAS 1 requires a complete set of general purpose financial
statements to include a statement of changes in equity, which discloses:
• the changes to each equity item arising from comprehensive income, transactions with owners and
retrospective adjustments in accordance with IAS 8
• a reconciliation between the opening and closing amounts of each component of equity for the period.
Part C discusses the composition of the statement of changes in equity, including the components of
what is required to be included in this statement.

Relevant Paragraphs
To achieve the objectives of part C outlined in the module preview, read the relevant paragraphs in the
following accounting standard. Where specified, you need to be able to apply these paragraphs:
IAS 1 Presentation of Financial Statements:

Subject Paragraphs
Information to be presented in the statement of changes in equity 106
Information to be presented in the statement of changes in equity or in the notes 106A–110

2.10 IAS 1 PRESENTATION OF FINANCIAL

STATEMENTS: DISCLOSURES OF CHANGES
IN EQUITY
A statement of changes in equity explains and reconciles the movement in the equity (net assets) of an
entity over a reporting period. The two primary sources of change in owners’ equity (and therefore net
assets) are:
• changes resulting from transactions with owners in their capacity as owners
• the total amount of income and expenses … generated by the entity’s activities (IAS 1, para. 109).

The statement of changes in equity requires disclosure of the total comprehensive income and its impact
on each relevant equity component, as detailed information relating to income and expenses is contained
in the statement of P/L and OCI.
IAS 1 requires an entity to present a statement of changes in equity, which contains the following
disclosures:
• total comprehensive income (allocated between non-controlling interests and owners of the parent
(para. 106(a))
• the effect on each component of equity of any retrospective adjustments required by IAS 8 (para. 106(b))
• a reconciliation between the opening and closing balance of each component of equity, with separate
disclosure of changes resulting from profit or loss, OCI and transactions with owners (para. 106(d)).
An entity must present for each component of equity affected by OCI, an analysis of the item either in
the statement of changes in equity or in the notes (IAS 1, para. 106A). This would include details such as
the source of the OCI, tax relating to the items involved and any non-controlling interest portion deducted.
An entity must also present the amount of dividends recognised as distributions to owners during a
reporting period and the related amount of dividends per share. Information relating to dividends can be
disclosed either in the statement of changes in equity or in the notes (IAS 1, para. 107).
A typical tabular format for the statement of changes in equity is shown in table 2.2.

MODULE 2 Presentation of Financial Statements 91

 TABLE 2.2 Tabular format for the statement of changes in equity

Share capital Reserves Retained earnings Total

Opening balance Opening balance Opening balance Opening balance

(sum of opening
balances)

+ Issue of share + Transfers to reserves from +/– Net profit (loss) after
capital retained earnings income tax (from income
– Transfers from reserves to statement)
retained earnings

+ Share options +/− Gains/(losses) on – Transfers to reserves from

exercised property revaluations retained earnings
+ Transfers from reserves to
retained earnings

+/– Restatement of prior period

balances (whether due to a
change in accounting policy,
adoption of new accounting
standard or a prior period
material error)

− Share buybacks/ +/− Exchange differences on − Dividends declared

return of capital translating foreign operations

= Closing balance = Closing balance = Closing balance Closing balance

(sum of closing
balances)

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read:
• paragraphs 106–110 of IAS 1
• the example statement of changes in equity in the ‘Guidance on implementing IAS 1 Presentation of Financial
Statements’ (in the IFRS Compilation Handbook), including the notes, which analyse the changes to equity items
as a result of OCI.

QUESTION 2.9

Refer to sections 1 and 8 of the ‘Case study data’. Prepare a statement of changes in equity in
accordance with paragraphs 106 and 107 of IAS 1 in the column format that reconciles the opening
and closing balances of each component of equity as illustrated in the ‘Guidance on implementing
IAS 1 Presentation of Financial Statements’ (in the IFRS Compilation Handbook).

SUMMARY
In addition to reconciling the opening and closing balances of each component, the statement of changes in
equity discloses all changes to each component of equity for a reporting period. This information enables
the user to understand why the equity (net assets) of an entity have increased or decreased, how much
of the change relates to comprehensive income and how much is from transactions with owners in their
capacity as owners.
The key points covered in this part, and the learning objectives they align to, are as follows.

92 Financial Reporting
KEY POINTS

2.1 Explain and apply the requirements of IAS 1 with respect to a complete set of financial statements
and in relation to the considerations for the presentation of financial statements.
• The two primary sources of change in owner’s equity are changes resulting from transactions with
owners in their capacity as owners and the total amount of income and expenses generated by the
entity’s activities.
• Total comprehensive income and its impact on each relevant equity component must be presented
in the statement of changes in equity.
• For each component of equity, the entity must present the opening and closing balances and any
increases and decreases during the reporting period.

MODULE 2 Presentation of Financial Statements 93

PART D: STATEMENT OF
FINANCIAL POSITION
INTRODUCTION
In addition to being interested in the financial performance of an entity, financial statement users are also
interested in its financial position. Information about the financial position is contained in the statement
of financial position or, as it is often referred to, the balance sheet. IAS 1 prescribes the:
• presentation requirements for assets and liabilities
• disclosure requirements for a statement of financial position and its components.
Part D discusses the composition of the statement of financial position, including the components of
what is required to be included in this statement.

Relevant Paragraphs
To achieve the objectives of part D outlined in the module preview, read the relevant paragraphs in the
following accounting standard. Where specified, you need to be able to apply these paragraphs:
IAS 1 Presentation of Financial Statements:

Subject Paragraphs
Information to be presented in the statement of financial position 54–59
Current/non-current distinction 60–65
Current assets 66–68
Current liabilities 69–76
Information to be presented either in the statement of financial position or in the notes 77–80A

2.11 FORMAT OF THE STATEMENT OF

FINANCIAL POSITION
IAS 1 does not stipulate a strict format for the statement of financial position, but it does stipulate the
minimum disclosures for the line items that are included in the statement (IAS 1, para. 54).
The minimum line items are summarised in table 2.3.

TABLE 2.3 Minimum line items required in the statement of financial position

Assets Liabilities Equity

• Property, plant and equipment
• Investment property
• Intangible assets
• Financial assets
• Insurance and reinsurance contracts
• Investments accounted for using the
equity method
• Biological assets
• Inventories
• Trade and other receivables
• Cash and cash equivalents
• Non-current assets classified as held
for sale
• Current tax assets
• Deferred tax assets
• Trade and other payables • Non-controlling interests
• Provisions presented within equity
• Financial liabilities • Issued capital and reserves
• Insurance and reinsurance attributable to owners of the
contracts parent
• Current tax liabilities
• Deferred tax liabilities
• Liabilities directly associated
with non-current assets
classified as held for sale

Source: CPA Australia 2019.

The line items in table 2.3 are the minimum disclosures required by IAS 1. An entity must add additional
line items in the statement of financial position when such presentation is relevant to an understanding of
the entity’s financial position (IAS 1, para. 55).

94 Financial Reporting
 An entity makes the judgment about whether to present additional line items on the basis of the:
• nature and liquidity of assets
• function of assets within the entity
• amounts, nature and timing of liabilities (IAS 1, para. 58).
An example of additional disclosures would be disaggregating the disclosure of property, plant
equipment in the statement of financial position showing separately property measured at fair value and
plant and equipment measured using the cost basis (IAS 1, para. 59).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 54–59 of IAS 1. Note that IAS 1 does not require
any particular format for a statement of financial position. The chosen format should not impair the understanding of
the information. Also refer to the illustrative statement of financial position in the ‘Guidance on implementing IAS 1
Presentation of Financial Statements’ (in the IFRS Compilation Handbook).

2.12 PRESENTATION OF ASSETS AND LIABILITIES

An entity must present current and non-current assets and current and non-current liabilities as separate
classifications in the statement of financial position except if a presentation based on liquidity provides
information that is reliable and more relevant. When the liquidity basis is applied, assets and liabilities
must be presented in the order of liquidity; for example, cash deposits would be presented before plant and
equipment (IAS, para. 60).
When an entity supplies goods and services within a clearly identifiable operating cycle, the current
and non-current classification system provides information that is reliable and more relevant because
it distinguishes between assets and liabilities circulating as working capital from those held for long-
term operations (IAS 1, para. 62). In contrast, financial institutions typically use the liquidity basis of
presentation because the solvency of such institutions is critical, and they do not provide services within
an operating cycle (IAS 1, para. 63). For example, Woolworths and Qantas, two major non-financial
Australian entities providing goods and services within a clearly identifiable operating cycle, present their
assets and liabilities using current and non-current categories. In contrast, ANZ and Westpac, two major
Australian banks, use the liquidity basis.
If an entity has an asset or liability line item that combines amounts due to be recovered or settled both
within and after 12 months of the reporting period, it must disclose the amount expected to be recovered or
settled after 12 months (IAS 1, para. 61). This disclosure is required irrespective of the presentation basis
used for assets and liabilities.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 60–65 of IAS 1, which confirm and expand on
this discussion. You may also wish to read ‘Guidance on implementing IAS 1 Presentation of Financial Statements’
(in the IFRS Compilation Handbook), which provides an example of the current/non-current presentation.

CURRENT ASSETS AND CURRENT LIABILITIES

An entity must classify an asset as current when it satisfies one or more of the following criteria.
• It expects to realise the asset, or intends to sell or consume it, in the entity’s normal operating cycle.
• It holds the asset primarily for trading purposes.
• It expects to realise the asset within 12 months after the reporting period.
• The asset is cash or a cash equivalent (as defined in IAS 7) unless the asset is restricted from being
exchanged or used by the entity for a least 12 months after the reporting period (IAS 1, para. 66).
According to IAS 1, paragraph 68, the ‘operating cycle of an entity is the time between the acquisition
of assets for processing and their realisation in cash or cash equivalents’. If an entity’s operating cycle is
not clearly identifiable, it is assumed to be 12 months. If there is a clearly identifiable operating cycle that
exceeds 12 months, the assets expected to be used during this cycle are classified as current. In other words,
a current asset does not always have to be used within 12 months. For example, an entity that engages in
long-term construction contracts (large buildings, bridges or airports) may have an operating cycle that is
longer than 12 months.

MODULE 2 Presentation of Financial Statements 95

 All assets not classified as current are to be classified as non-current assets. The term ‘non-current
assets’ is recommended, but IAS 1 permits other descriptions to be used for this category, such as ‘fixed
assets’ or ‘long-term assets’ (IAS 1, para. 67).
Examples of current assets include cash and cash equivalents, inventories, trade receivables, current
tax receivable, and prepayments. Examples of non-current assets include property, plant and equipment,
intangibles, investments and deferred tax.
An entity must classify a liability as current when it satisfies one or more of the following criteria.
• It expects to settle the liability in the entity’s normal operating cycle.
• It holds the liability primarily for trading purposes.
• The liability is due to be settled within 12 months after the reporting period.
• It does not have an unconditional right of deferring settlement beyond 12 months after the reporting
period (IAS 1, para. 69).
Current liabilities include those liabilities that are required or expected to be settled within 12 months
after the end of the reporting period. The period can be longer if the operating cycle exceeds 12 months. In
this regard, the same operating cycle applies to the classification of an entity’s assets and liabilities (IAS 1,
para. 70). Examples of current liabilities include a bank overdraft, trade payables, accruals for operating
costs like electricity and rent, and accruals for employee wages.
An entity normally includes the portion of long-term financial liabilities due for repayment within
12 months as a current liability (IAS 1, para. 71). An entity classifies its financial liabilities due to be
settled within 12 months as current even if:
(a) the original term was for a period longer than 12 months, and
(b) an agreement to refinance, or to reschedule payments, on a long-term basis is completed after the
reporting period and before the financial statements are authorised for issue (IAS 1, para. 72).

An agreement to refinance made after the reporting period, does not represent conditions that existed
at the end of the reporting period, and therefore, the amount is still current at that date. However, the
agreement may result in a disclosure in the notes as a non-adjusting event in accordance with IAS 10
(IAS 1, para. 76).
If an entity has the contractual right (i.e. discretion under an existing loan facility) to refinance an
obligation for at least 12 months after the reporting period and expects that this will happen, the obligation is
classified as non-current even if it is due within 12 months. If the entity has no such discretion to refinance,
the obligation is classified as current (IAS 1, para. 73).
In some instances, entities may breach loan conditions that cause an obligation to become due on
demand. The obligation is regarded as current even if the lender agrees not to demand repayment after
the reporting period (IAS 1, para. 74). However, before the end of the reporting period, if the lender comes
to an agreement with the entity that the lender will not demand repayment for at least 12 months after the
reporting period, the obligation can be classified as non-current (IAS 1, para. 75).
Liabilities that do not satisfy the criteria to be classified as current must be classified as non-current
liabilities (IAS 1, para. 69). Financial liabilities that provide financing on a long-term basis that are not
due for repayment within 12 months of the reporting period are non-current liabilities unless there are
unresolved breaches of covenants at the end of the reporting period (IAS 1, para. 71).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 66–76 of IAS 1, which discuss the current/non-
current presentation in more detail. In particular, note the events that would qualify for disclosure as non-adjusting
events in accordance with IAS 10 Events after the Reporting Period (IAS 1, para. 76).

2.13 IAS 1 PRESENTATION OF FINANCIAL

STATEMENTS: DISCLOSURES IN THE NOTES TO THE
STATEMENT OF FINANCIAL POSITION
An entity must disclose, either in the statement of financial position or the notes, further subclassifications
of the line items presented in a manner appropriate to an entity’s operations (IAS 1, para. 77).

96 Financial Reporting
 The disclosure of further subclassifications depend on the size, nature and function of the amounts
involved and are usually presented in the notes. Some subclassifications are required by other accounting
standards. IAS 1 provides examples of further subclassifications as:
• items of property, plant and equipment disaggregated into classes pursuant to IAS 16 such as office
equipment and motor vehicles (para. 78(a))
• receivables disaggregated into amount due from trade customers, related parties, prepayments and other
amounts (para. 78(b))
• inventories disaggregated pursuant to IAS 2 into finished goods, work-in-process and raw materials
(para. 78(c))
• provisions disaggregated into provisions for employee benefits and other provisions (para. 78(d))
• equity capital and reserves disaggregated into paid-up capital, retained earnings and other reserves
(para. 78(e)).
Furthermore, although IAS 1 prescribes disclosures to appear in the various financial statements, it does
not prescribe detailed disclosures for each of the various line items. For example, paragraph 54(g) of IAS 1
requires that inventories be disclosed as a separate line item in the statement of financial position. However,
the detailed requirements relating to the disclosure of inventories in the notes to the accounts can be found
in paragraph 36 of IAS 2 Inventories.
IAS 1 also specifies additional disclosures for equity items, including shares issued, rights attaching to
shares and details of reserves (IAS 1, paras 79 and 80). Some items listed, such as the par value per share,
are not relevant to all jurisdictions (e.g. Australia).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, read paragraphs 77–80 of IAS 1.

QUESTION 2.10

Refer to section 8 of the ‘Case study data’.

Prepare a statement of financial position for Webprod Ltd. You may want to refer to paragraph 54
of IAS 1 if you need to review the required line items. In addition, prepare notes to the statement of
financial position that:
• illustrate the composition of the items disclosed in the statement of financial position
• satisfy any relevant disclosure requirements. If you need to review the requirements, refer to
paragraph 79 of IAS 1.

Refer to the financial statements of Techworks Ltd. What line items have been presented in the
statement of financial position? Would it have been possible for Techworks to present additional detail
in the statement of financial position?

2.14 TIPS ON HOW TO ANALYSE A STATEMENT OF

FINANCIAL POSITION
The purpose of the statement of financial position is to summarise an entity’s assets, liabilities and equity.
The format of the statement of financial position is to disclose the entity’s assets and liabilities according to
a current/non-current classification. The equity figures in the statement of changes in equity flow through
to the equivalent lines in equity at the end of the statement of financial position.
Some tips on how to read, analyse and interpret the statement of financial position are summarised
as follows.
1. Review the value of total assets. Have total assets increased or decreased from the previous reporting
period? What are the drivers behind this increase or decrease? If total assets are increasing, this indicates
that the financial position has expanded (grown). Has the change been primarily as a result of changes
in current assets or non-current assets?
2. Review the value of total liabilities. Have total liabilities increased or decreased from the previous
reporting? What are the drivers behind this increase or decrease? If total liabilities are increasing, this
indicates that the entity has taken on more debt and has increased its gearing (leverage). Has the change
been primarily as a result of changes in current liabilities or non-current liabilities?

MODULE 2 Presentation of Financial Statements 97

3. Review the value of total equity (or net assets). Is total equity positive? If so, this indicates that the
company is a going concern. Has total equity increased from the previous reporting period? If so, this
indicates that the entity’s financial position has grown. The stage of the business’ life cycle will also
impact on this figure. More mature businesses are likely to have greater amount of retained earnings,
whereas start-ups may experience losses in the first years of trading.
4. Analyse the relationship between current assets and current liabilities. This is an indication of the
company’s liquidity position or the entity’s ability to be able to pay its short-term debts as and when
they fall. Are current assets greater than current liabilities? The general rule of thumb for the current
ratio is 2:1. This means that ideally current assets should be approximately two times larger than current
liabilities.
In reviewing a statement of financial position of a particular entity, it is always important to identify and
understand the risks of each asset. For example, in the case of a retailer, it is likely that inventories will
be the largest asset on the statement of financial position. In this case, the risk is one of obsolescence and
slow-moving stock.
In the case of an entity that has acquired businesses over the years and those with significant goodwill
and brand names, the impairment of intangibles is likely to be the most significant risk or concern.
Analyse the relationship between non-current liabilities and non-current assets. This provides an
indication of the entity’s gearing (leverage) position. Is the entity highly geared or lowly geared? If the
entity is highly geared (more debt than assets), this may limit the entity’s ability to borrow additional funds
to fund expansion or capital replacement requirements. If the entity has low gearing, it may be in a good
position to borrow monies from banks and financial institutions to fund expansion.

SUMMARY
IAS 1 specifies the requirements for:
• the presentation of assets and liabilities
• disclosures in either the statement of financial position or notes.
Assets and liabilities must be presented on a current/non-current basis, except where a liquidity
presentation provides information that is more relevant and reliable. Where the current/non-current
classification is used, a 12-month period after the reporting period or the entity’s operating cycle can be
used to identify current assets and liabilities.
IAS 1 contains disclosure requirements, including items that must appear in the statement of
financial position.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

2.1 Explain and apply the requirements of IAS 1 with respect to a complete set of financial statements
and in relation to the considerations for the presentation of financial statements.
• IAS 1 specifies the minimum disclosure requirements for the statement of financial position.
• An entity may make additional disclosures based on the nature, function and/or liquidity of assets,
and the amounts, nature and timing of liabilities.
• Assets and liabilities must be classified as current and non-current except if a presentation based on
liquidity provides information that is reliable and more relevant. If the liquidity basis is applied, then
assets and liabilities must be presented in order of liquidity.
• Further subclassifications of the line items presented in the statement of financial position are
required to be disclosed in the notes. Further disclosure depends on the size, nature and function of
the amounts involved.

98 Financial Reporting
PART E: IAS 7 STATEMENT OF
CASH FLOWS
INTRODUCTION
Part E discusses the composition of the statement of cash flows, including the format and presentation of
the statement and the various cash flows that are required to be disclosed when presenting the statement.
An entity is required to include a statement of cash flows in its complete set of financial statements
(IAS 1, para. 10(d); IAS 7, para. 1). The content and format of a statement of cash flows are governed by
IAS 7.
The objective of the statement of cash flows is to explain the movement in an entity’s cash and cash
equivalents over the reporting period. Information about an entity’s cash flows is useful in providing users
of the financial statements with a basis to assess the entity’s ability to generate cash flows and the needs
of the entity to utilise those cash flows (IAS 7, ‘Objective’).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 4 and 5 of IAS 7.

Relevant Paragraphs
To achieve the objectives of part E outlined in the module preview, read the relevant paragraphs in the
following accounting standard. Where specified, you need to be able to apply these paragraphs:
IAS 7 Statement of Cash Flows:
Subject Paragraphs
Scope 1–3
Benefits of cash flow information 4–5
Definitions 6
Cash and cash equivalents 7–9
Presentation of a statement of cash flows 10–17
Reporting cash flows from operating activities 18–20
Reporting cash flows from investing and financing activities 21
Reporting cash flows on a net basis 22–24
Interest and dividends 31–34
Taxes on income 35–36
Non-cash transactions 43
Changes in liabilities arising from financing activities 44A–44E
Components of cash and cash equivalents 45–47
Other disclosures 48–52

Assumed Knowledge
You should consult the ‘IAS 7 Statement of Cash Flows’ assumed knowledge review located at the end
of this module to check your understanding of the assumed knowledge for part E. If you need further
assistance with the assumed knowledge, you should consult the latest edition of an appropriate financial
accounting text, such as the following.
• Henderson, S., Peirson, G. et al., Issues in Financial Accounting, Pearson, Melbourne.
• Hoggett, J., Medlin, J. et al., Financial Accounting, John Wiley & Sons, Brisbane.
• Loftus, J., Leo, K. et al. Financial Reporting, John Wiley & Sons, Brisbane.

2.15 HOW DOES A STATEMENT OF CASH FLOWS

ASSIST USERS OF THE FINANCIAL STATEMENTS?
A statement of cash flows is useful for communicating information about an entity’s liquidity and solvency.
According to IAS 7, the information provided in a statement of cash flows may assist users in assessing
the ability of an entity to:
• generate cash flows in the future
• meet its financial commitments as they fall due, including the servicing of borrowings and payment
of dividends

MODULE 2 Presentation of Financial Statements 99

• fund changes in the scope and/or nature of its activities
• obtain external finance (IAS 7, paras 4 and 5).
It has also been suggested that a statement of cash flows is useful for:
• predicting future cash flows (both inflows and outflows)
• evaluating management decisions
• determining the ability to pay dividends to shareholders and repay debt — both interest and principal
— to creditors
• showing the relationship of net profit to changes in the cash balances
• assessing the quality of revenue and earnings by reference to its realisation in cash.
Of course, to assist in a full analysis, it would be more useful to review and analyse the statement of
cash flows over a number of years to enable trends to be analysed.

2.16 INFORMATION TO BE DISCLOSED

CASH AND CASH EQUIVALENTS
Cash flows are inflows and outflows of cash and cash equivalents (IAS 7, para. 6). It is necessary therefore
to determine the components of cash and cash equivalents in order to identify the cash flows to be
disclosed in the statement.
According to IAS 7, cash and cash equivalents are determined as follows.
• Cash comprises cash on hand and demand deposits.
• Cash equivalents are short term, highly liquid investments that are readily convertible to known amounts
of cash and which are subject to insignificant risk of changes in value (IAS 7, para. 6).
An investment normally only qualifies as a cash equivalent if it has a short maturity of three months or
less from the date of acquisition. Investments in equity securities do not qualify as cash equivalents (IAS 7,
para. 7). Bank overdrafts which are repayable on demand and fluctuate from being positive to overdrawn
are included as a component of cash and cash equivalents (IAS 7, para. 8).
The amount of cash and cash equivalents at the beginning and end of the reporting period are disclosed
in the statement of cash flows. An entity must disclose the components of cash and cash equivalents and
present a reconciliation to the amounts shown in the statement of cash flows with amounts reported in the
statement of financial position (IAS 7, para. 45).

CLASSIFICATION OF CASH FLOWS

The statement of cash flows must report cash flows during the period (both inflows and outflows) classified
by operating, investing and financing activities (IAS 7, para. 10). Figure 2.6 illustrates the classification
scheme for cash flows.

FIGURE 2.6 Classification of cash flows

Cash flows = Operating + Investing + Financing

Cash revenues Movements in Movements in debt

less cash expenses non-current assets and and equity
(i.e. cash profit) other investments
Source: CPA Australia 2019.

Operating Cash Flows

Cash flows from operating activities are those that relate to the principal revenue-producing activities of
the entity and which are not from investing or financing activities (IAS 7, para. 6). Operating cash flows
‘generally result from the transactions and other events that enter into the determination of profit or loss’
(IAS 7, para. 14).
Examples of cash inflows and outflows from operating activities are shown in table 2.4.

100 Financial Reporting

 TABLE 2.4 Examples of cash inflows and outflows from operating activities

Cash inflows Cash outflows

• Cash receipts from the sale of goods
• Cash receipts from rendering of services
• Cash receipts from royalties
• Cash receipts from fees, commissions and other
revenue (e.g. government grants)
• Cash receipts from contracts held for trading
• Refund of income tax
• Cash payments to suppliers for goods and services
• Cash payments to and on behalf of employees
• Cash payments from contracts held for trading
• Borrowing costs (interest paid)
• Income tax paid

Source: CPA Australia 2019.

An entity must report cash flows from operating activities using either the:
• direct method — in which major classes of gross cash receipts and gross cash payments are disclosed
• indirect method whereby profit or loss is adjusted for the effects of non-cash income and expenses,
accruals and items associated with investing and financing activities (IAS 7, para. 18).
The information shown in table 2.4 is consistent with reporting operating cash flows using the direct
method.
Interest paid and dividends received are usually regarded as an operating cash inflow for financial
institutions (IAS 7, para. 33). There is no consensus however, on the classification of these cash flows
for other entities. An entity may elect to classify these cash flow items under IAS 7 as follows.
• Interest paid may be classified as either an operating cash outflow or a financing cash outflow
(para. 33).
• Interest and dividends received may be classified as either operating cash inflows or investing cash
inflows (para. 33).
• Dividends paid may be classified either as a financing cash outflow or an operating cash outflow
(para. 34).
Consistent with IAS 7, this module recognises interest paid (borrowing costs) as an operating cash
outflow (table 2.4), interest received as an investing cash inflow (table 2.5), and dividends paid as a
financing cash outflow (table 2.6).

Investing Cash Flows

Cash flows from investing activities are those that relate to ‘the acquisition and disposal of long-term
assets and other investments not included in cash and cash equivalents’ of the entity (IAS 7, para. 6). Cash
outflows from investing activities result in the recognition of assets in the statement of financial position
(IAS 1, para. 16). The assets so recognised are usually non-current assets.
Accordingly, most investing cash inflows and outflows are identified by analysing the movements in the
non-current assets accounts in the statement of financial position.
Examples of cash inflows and outflows from investing activities are shown in table 2.5.

TABLE 2.5 Examples of cash inflows and outflows from investing activities

Cash inflows Cash outflows

• Cash receipts from sales of property, plant and
equipment
• Cash receipts from sales of intangibles
• Cash receipts from other long-term assets
• Cash receipts from sales of equity and debt
instruments of other entities (if not trading)
• Cash receipts from contracts for derivatives (if not for
trading or financing)
• Cash receipts from repayment of advances and loans
made to other parties
• Dividends received
• Cash payments to acquire or self-construct property,
plant and equipment
• Cash payments for intangibles including capitalised
development costs
• Cash payments for other long-term assets
• Cash payments to acquire equity or debt
instruments of other entities (if not for trading)
• Cash payments for interests in joint ventures
• Cash advances and loans made to other parties
• Cash payments from contracts for derivatives (if not
for trading or financing)

Source: CPA Australia 2019.

MODULE 2 Presentation of Financial Statements 101

Financing Cash Flows
Cash flows from financing activities are those ‘that result in changes in the size and composition of the
contributed equity and borrowings of the entity’ (IAS 7, para. 6).
Financing cash flows relate to the providers of capital to the entity, that is, debtholders and equity
participants (IAS 7, para. 17).
Examples of cash inflows and outflows from financing activities are shown in table 2.6.

TABLE 2.6 Examples of inflows and outflows from financing activities

Cash inflows Cash outflows

• Cash proceeds from issuing shares or other equity
instruments
• Cash proceeds from issuing short or long-term
borrowings including debentures, loans, notes,
and mortgages
• Cash payments to owners to acquire or redeem the
entity’s shares
• Cash repayments of amounts borrowed
• Cash payments by a lessee to reduce the
outstanding amount of a lease liability
• Dividends paid

Source: CPA Australia 2019.

EXAMPLE 2.4

Illustrative Example of a Statement of Cash Flows for the Reporting

Period Ended 30 June 20X7
ZHIVAGO HOLDINGS PTY LTD
$
Cash flows from operating activities (IAS 7, paras 10, 14, 18)
Receipts from customers 831 083
Payments to suppliers and employees (776 276)
Cash generated from operations 54 807
Interest paid (1 545)
Income tax paid (IAS 7, para. 35) (6 467)
Net cash flows from operating activities 46 795
Cash flows from investing activities (IAS 7, paras 10, 16, 21)
Interest received 57
Proceeds from sale of plant and equipment 231
Purchase of plant and equipment (17 119)
Net cash flows used in investing activities (16 831)
Cash flows from financing activities (IAS 7, paras 10, 17, 21)
Proceeds from borrowings 141 000
Repayment of borrowings (154 000)
Dividends paid (IAS 7, para. 31) (7 210)
Net cash flows used in financing activities (20 210)
Net increase in cash and cash equivalents 9 754
Cash and cash equivalents at the beginning of the period 7 572
Cash and cash equivalents at the end of the period 17 326

2.17 COMMON METHODS ADOPTED ON HOW TO

PREPARE A STATEMENT OF CASH FLOWS
The statement of P/L and OCI and statement of financial position are prepared under accrual accounting
concepts. Put simply, the basic aim of a statement of cash flows is to convert the figures prepared under
accrual accounting concepts to what they would be if they were prepared on a cash basis. In substance, the
statement of cash flows explains the change in assets and liabilities (net assets) during the period that is
attributable to cash transactions.

102 Financial Reporting

 A statement of cash flows involves making adjustments from accrual-based information, de-accruing
the figures and converting them to cash-based figures. In other words, the purpose of the statement of cash
flows is to determine the cash movements during the financial year.
There are three common methods used to prepare a statement of cash flows. These methods include the:
1. worksheet method (typically prepared in a spreadsheet tool such as Excel™)
2. formula method
3. ‘T’ account reconstruction method.
The assumed knowledge for this module is that participants are able to prepare a simple statement of
cash flows. The questions in (and later answers to) the ‘Assumed knowledge review questions’ section at
the end of this module illustrate the basic principles to be used when preparing a statement of cash flows.
Because the underlying data are relatively simple, the calculations and the statement of cash flows have
been completed without the aid of a worksheet. However, in more complicated situations, a worksheet is
considered a useful means of organising the necessary procedures. For the purposes of this module, the
formula method will be used in preparing the statement of cash flows.

FORMULA METHOD
The following is a brief summary of the formulas necessary to determine individual lines in the statement of
cash flows. Once again, it needs to be remembered that the figures in the financial statements are prepared
under accrual accounting principles, while the statement of cash flows is based on cash movements
(i.e. cash inflows and outflows) during the reporting period.
Some of the more common formulas used to determine cash flows include:
Receipts from customers
Opening balance of + Sales revenue − Bad debts − Closing balance of
trade receivables written off † trade receivables

† To determine the amount of bad debts written off, the following formula is relevant.

Bad debts written off

Opening balance + Doubtful debts expense (from P/L) − Closing balance
of allowance for of allowance for
doubtful debts doubtful debts

Inventory purchased on credit

Closing balance + Cost of goods (from P/L) − Opening balance
of inventories of inventories

Payments to suppliers and employees

Opening balance + Expenses (from P/L) + Inventory purchased − Closing balance
of trade payables on credit (from of trade payables
formula)

Income taxes paid

Opening balance of + Income tax expense (from P/L) − Closing balance of
income tax payable income tax payable

Purchase of property, plant and equipment (PPE)

Closing + Disposals (at cost) − Opening
balance of PPE balance of PPE

Dividends paid
Opening balance + Interim dividend + Final dividend − Closing balance
of final dividend of final dividend
payable (liability) payable (liability)

MODULE 2 Presentation of Financial Statements 103

REPORTING CASH FLOWS ON A NET BASIS
An entity must separately report major classes of gross cash receipts and gross cash payments (IAS 7,
paras 18 and 21). Normally, cash flows are reported on a gross basis; however, reporting cash flows on a
net basis is permitted in limited circumstances.
IAS 7 allows cash flows arising from operating, investing or financing activities to be reported on a net
basis as:
(a) cash receipts and payments on behalf of customers when the cash flows reflect the activities of the
customer rather than those of the entity; and
(b) cash receipts and payments for items in which the turnover is quick, the amounts are large, and the
maturities are short (IAS 7, para. 22).

Examples of cash receipts and payments on behalf of customers include funds held for customers by
an investment entity and rents collected by an agent on behalf of the owners of the properties (IAS 7,
para. 23).
Examples of cash receipts and payments for items with quick turnover and short maturity are principal
amounts relating to credit card customers and the purchase and sale of investments (IAS 7, para. 23A).
IAS 7 also sets out additional circumstances for netting by financial institutions (IAS 7, para. 24).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 23 and 23A of IAS 7, which contain examples
of cash flows that can be reported on a net basis.
Also relevant is paragraph 24 of IAS 7, which deals with the additional items of cash flows that may be presented
on a net basis by a financial institution.

OTHER INFORMATION TO BE DISCLOSED IN THE STATEMENT

OF CASH FLOW OR NOTES
Several other items of information must be disclosed in the statement of cash flows. These cash flow
items include interest and dividends, income taxes and loss of control of subsidiaries (IAS 7, paras 31, 35,
39 and 40).
Investing and financing transactions that do not require the use of cash (or cash equivalents) are excluded
from a statement of cash flows (IAS 7, para. 43). For example, an entity may acquire a block of land by
issuing shares. Although this involves the acquisition of an asset, it does not result in a cash outflow and,
therefore, will not be captured in the statement of cash flows. IAS 7 requires that non-cash transactions are
disclosed elsewhere in the financial statements or the notes in a way that provides all relevant information
about investing and financing activities (IAS 7, para. 44).
An entity is also required to disclose changes in liabilities arising from financing activities, including both
changes arising from cash flows and non-cash changes (IAS 7, para. 44A). The purpose of this requirement
is to ‘enable users of financial statements to evaluate changes in liabilities arising from financing activities’
(IAS 7, para. 44A). Liabilities arising from financing activities are those whose cash flows were, or whose
future cash flows will be, classified as financing activities in the statement of cash flows (IAS 7, para. 44C).
One way to fulfil the disclosure requirement is to provide a reconciliation between the opening and
closing balances in the statement of financial position for liabilities arising from financing activities
(IAS 7, para. 44D). This would include changes arising from cash flows, as well as non-cash changes
such as those arising from obtaining or losing control of subsidiaries or other businesses, the effect of
changes in foreign exchange rates, changes in fair values, and other changes (IAS 7, para. 44B).
An entity must also disclose the amount of significant cash and cash-equivalent balances held that are not
availableforusebythegroup(IAS7,para.48).Forexample,theremaybeexchangecontrolsorlegalrestrictions
in place that restrict the movement of cash (IAS 7, para. 49). This disclosure is important as it allows users
to make informed decisions regarding the liquidity of an entity. Another disclosure that is encouraged is the
amount of undrawn borrowing facilities that may be available for the future cash needs (IAS 7, para. 50).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read the illustrative examples of IAS 7 (in the IFRS Compilation
Handbook) to gain an overview of the suggested structure of the statement of cash flows and the additional
information that is required to be presented in the financial statements institution.

104 Financial Reporting

CONSOLIDATED FINANCIAL STATEMENTS
A parent entity in a group that is required to prepare a set of consolidated financial statements will include
a statement of cash flows that discloses the cash flows of the group. This module does not deal with the
complexities of preparing a consolidated statement of cash flows from raw data. However, please note that:
• consolidated cash flows should be reported net of cash flows among entities comprising the group
• foreign currency translation is required when a foreign subsidiary is a member of a domestic group and
a consolidated statement of cash flows is to be prepared.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 25–28 of IAS 7. Note that these paragraphs also
apply to foreign currency-denominated transactions of domestic reporting entities and to those of foreign subsidiaries
that are members of a domestic group. For the purpose of the Financial Reporting segment, be aware of the contents
of paragraphs 25–28, but you will not be required to apply these paragraphs to practical problems.

QUESTION 2.11

It is important to complete all previous case study questions before attempting this question.
Refer to sections 1–5, 7 and 8 of the ‘Case study data’.

Prepare a statement of cash flows and disclosures for Webprod Ltd for the year ended 30 June
20X7, using the direct method in accordance with paragraph 18(a) of IAS 7. In addition, prepare
a reconciliation between the profit for the period and the cash from operating activities (the
indirect method).

Note: Question 2.11 is a comprehensive question that combines many of the concepts discussed
in this section of the module. You can expect to take several hours to complete the set tasks.
Tip: Calculate the cash flows for each of the following activities (preferably in this order).

Cash flows from operating activities 1. Cash received from customers

2. Cash received from grants
3. Cash paid to suppliers
4. Cash paid to employees
5. Borrowing costs
6. Warranties paid
7. Income tax paid
Cash flows from investing activities 8. Interest received
9. Proceeds from sale of factory plant and equipment
10. Purchase of factory plant and equipment
11. Loan to director
12. Cash paid for product development costs
Cash flows from financing activities 13. Proceeds from funds borrowed
14. Dividends paid
15. Payment of bank loan
16. Payment of promissory notes

Refer to the financial statements of Techworks Ltd. Why does the balance of cash and cash equivalents
differ to the statement of financial position? Has interest received and interest paid been disclosed as
cash flows from operating activities, investing activities or financing activities?

2.18 TIPS ON HOW TO ANALYSE THE STATEMENT

OF CASH FLOWS
The purpose of the statement of cash flows is to analyse the movement between the opening and closing
balances of the entity’s cash and cash-equivalent accounts during the reporting period. The statement of
cash flows reveals the various sources of cash inflows and cash outflows of the entity during the reporting
period so that users can assess where the monies are coming from and where they are being spent.

MODULE 2 Presentation of Financial Statements 105

 Some tips on how to read, analyse and interpret the statement of cash flows are summarised as follows.
1. Review the cash balance at the end of the reporting period. Is this value positive? Is it greater than or
less than the balance at the beginning of the reporting period?
2. Review the cash flows from operating activities. This figure is essentially the entity’s cash profit figure.
Is this value positive? A positive value is a good sign that the entity has made a cash profit during
the reporting period. How does this value compare to the previous reporting periods’ cash flows from
operating activities? If the result for the current period is higher, this is a good sign as it indicates that
the entity’s cash profit has increased.
If the cash profit figure has decreased, this would firstly indicate that the entity has had a cash
loss during the current reporting period. The entity has spent more money on its operating day-to-day
activities than it has received. This is a less positive sign, as all entities should be looking to make an
underlying cash profit from their day-to-day business operations. As a general rule of thumb, the entity
should report a positive cash flow from operating expenses, and this amount should (in principle) be
enough to cover net cash used in investing and financing activities.
3. Review the cash flows from investing activities (i.e. purchasing and disposing of non-current assets and
investments). Is this value positive or negative? If negative, this indicates that the entity has invested in
non-current assets. This could mean that the entity is expanding its operations or that the entity may be
in the start-up or growth phase of the business life cycle.
4. Review the cash flows from financing activities (i.e. is the business funding the acquisition of assets
through debt or equity?) Review the increases or decreases in external borrowings. Has the entity
borrowed or paid back funds? Review the increases and decreases in equity. Has the entity paid
dividends or issued more shares to raise capital? How does the payout of dividends compare to
the net cash flow from operating activities? Has the entity paid out a high percentage of profits to
its shareholders, or has it retained the funds to cover operating costs and repayment of financing
arrangements?
5. Review the net increase or decrease in cash and cash equivalents. Is this value positive or negative?
A positive value indicates that the entity has retained (and banked) funds for the reporting period. This
also indicates that the entity has generated substantial cash profits from operating activities. This will
be particularly pleasing for shareholders who are interested in the ability of their investment to generate
positive returns.

SUMMARY
IAS 7 specifies the requirement for the presentation of a statement of cash flows to be included in the
general purpose financial statements of an entity. The statement is to display information about cash inflows
and outflows from operating, investing and financing activities.
Gross cash flows are to be presented in the statement of cash flows. IAS 7 permits cash flow from
operating activities to be reported in the statement of cash flows using either the direct or indirect method
(although the former is preferred).
Several items of information relevant to the operating, financing and investing activities of a reporting
entity are to be separately disclosed. These are to be disclosed in the notes to the financial statements of
which the statement of cash flows forms a part.
.......................................................................................................................................................................................
EXPLORE FURTHER
Re-read the list of objectives at the beginning of this module and make sure you have mastered all of these before
moving on.

The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

2.5 Explain and apply the requirements of IAS 7 with respect to preparing a statement of cash flows.
• Cash flows are inflows and outflows of cash and cash equivalents.
• Cash flows are classified into three activities: operating, investing and financing.
• Operating cash flows relate to the revenue-producing activities of the entity. They can be expressed
as ‘cash revenues less cash expenses = cash profit or loss’.

106 Financial Reporting

 • Investing cash flows relate to movements in non-current assets and other investments.
• Financing cash flows relate to movements in debt and equity.
• A statement of cash flows involves making adjustments from accrual-based information, de-accruing
the figures and converting them to cash-based figures.
• There are three common methods used to prepare a statement of cash flows: (1) the worksheet
method, (2) the formula method, and (3) the ‘T’ account reconstruction method.
2.6 Discuss how a statement of cash flows can assist users of the financial statements to assess
the ability of an entity to generate cash and cash equivalents.
• The information provided in a statement of cash flows may assist users in assessing the ability of
an entity to generate cash flows in the future, meet its financial commitments as they fall due, fund
changes in the scope and/or nature of its activities, and obtain external finance.

REVIEW
In module 2, the discussion has centred on the issues relating to the presentation of financial statements
and the preparation of the four financial statements: the statement of P/L and OCI, the statement of changes
in equity, the statement of financial position and the statement of cash flows. The following accounting
standards were considered as part of the discussion:
• IAS 1 Presentation of Financial Statements
• IAS 7 Statement of Cash Flows
• IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
• IAS 10 Events after the Reporting Period
• IAS 16 Property, Plant and Equipment
• IAS 34 Interim Financial Reporting
• IFRS 8 Operating Segments.
Part A discussed the overall considerations in preparing financial statements and the structure and
content of particular financial statements (as contained in IAS 1). As accounting policies are a key
determinant of the content of financial statements, the focus was on the IAS 8 requirements to disclose
the accounting policies of an entity and any changes made to such policies. Part A also discussed how
to deal with information that arises from events that occur in the time between the end of the reporting
period and the date the financial statements are authorised for issue. IAS 10 makes a distinction between
events that clarify conditions that existed at the end of the reporting period (information from such events is
incorporated into the financial statements) and those that indicate conditions that arose after the reporting
period (if material, information about their nature and financial effect is disclosed in the notes).
Part B discussed the statement of P/L and OCI. IAS 1 specifies disclosure requirements for items to be
included in the statement of P/L and OCI. In addition, IAS 1 sets accounting standards for the presentation
of profit (loss) and OCI. Total comprehensive income for a period is based on an ‘all-inclusive’ view of
profit. The disclosure requirements of IAS 1 include items such as revenue, finance costs, tax expense
and profit or loss. An illustrative statement of P/L and OCI is included in the ‘Guidance on implementing
IAS 1 Presentation of Financial Statements’ (in the IFRS Compilation Handbook).
Part C dealt with the statement of changes in equity. This statement requires the disclosure of the changes
to each equity component arising from comprehensive income, transactions with owners and retrospective
adjustments made in accordance with IAS 8. The statement must also contain a reconciliation between the
opening and closing amount of each equity item for the period.
Part D considered the statement of financial position. IAS 1 prescribes standards for the classification
of assets and liabilities. In addition, IAS 1 prescribes disclosure requirements for a statement of financial
position. An illustrative statement of financial position is included in the ‘Guidance on implementing
IAS 1 Presentation of Financial Statements’ (in the IFRS Compilation Handbook).
Part E considered the statement of cash flows. IAS 7 requires this statement to display information about
cash flows from operating, financing and investing activities. IAS 7 also requires the disclosure of several
items in the notes to the statement of cash flows, including:
• information about non-cash financing and investing activities
• details of the cash unavailable for use.

MODULE 2 Presentation of Financial Statements 107

CASE STUDY DATA: WEBPROD LTD
Webprod Ltd, a manufacturer of computer modems, was incorporated on 8 August 20X2. The company
also has two retail outlets through which it markets computer-related products. The accountant for
Webprod Ltd is currently preparing the company’s 20X7 financial statements.
The following sections will be referred to throughout module 2.

SECTION 1: INFORMATION RELATING TO PRIOR

REPORTING PERIODS
The statement of financial position of Webprod Ltd as at 30 June 20X6 was as follows.

$ $
Current assets
Cash at bank† 6 713
Trade receivables 467 840
Less: Allowance for doubtful debts (15 600) 452 240
Secured loan to director 22 000
Raw materials (at cost) 62 500
Work in process (at cost) 108 400
Finished goods — manufactured modems (at cost) 412 100
Retail inventory (at cost) 195 000
Prepayments 22 500
Total current assets 1 281 453
Non-current assets
Investment in debentures 100 000
Less: Unamortised debenture discount (1 713) 98 287
Secured loan to director 50 000
Patent rights 200 000
Less: Accumulated amortisation (30 000) 170 000
Land (at independent valuation 20X5) 1 200 000
Factory buildings (at independent valuation 20X5) 1 800 000
Less: Accumulated depreciation (200 000) 1 600 000
Factory plant and equipment (at cost) 865 400
Less: Accumulated depreciation (328 000) 537 400
Fixtures and fittings — retail outlets (at cost) 68 300
Less: Accumulated depreciation (23 700) 44 600
Total non-current assets 3 700 287
Total assets 4 981 740
Current liabilities
Trade payables 340 000
Accruals 124 000
Provision for employee benefits 84 500
Provisions for warranties 10 500
Dividend payable 60 000
Current tax payable 120 000
Bank loan — secured 100 000
Total current liabilities 839 000
Non-current liabilities
Provision for employee benefits 214 500
Provisions for warranties 35 000
Bank loan — secured‡ 900 000
Promissory notes§ 300 000
Preference shares|| 100 000
Total non-current liabilities 1 549 500
Total liabilities 2 388 500
Net assets 2 593 240

108 Financial Reporting

 $ $
Shareholders’ equity
Share capital|| 1 050 000
Revaluation surplus# 700 000
Retained earnings 843 240
Total shareholders’ equity 2 593 240

† Webprod Ltd has access to a bank overdraft of $200 000, which is secured by a first mortgage over Webprod Ltd’s land and
buildings. The interest rate on the overdraft is 8%.
‡ The bank loan commenced on 4 November 20X5 and is for a period of ten years at an effective interest rate of 7%. The bank
loan is secured by a first mortgage over Webprod Ltd’s land and buildings.
§ The promissory notes are backed by a bank standby facility of $200 000. The facility bears interest at 9%.
|| There are 50 000 redeemable fully paid preference shares that have been classified as debt. There are 1 500 000 fully paid
ordinary shares. Both classes of shares have no par value.
# The $700 000 revaluation surplus comprises $400 000 revaluation surplus in relation to land and $300 000 revaluation surplus in
relation to buildings.

SECTION 2: INFORMATION RELATING TO THE

MANUFACTURING PROCESS OF WEBPROD LTD
2.1 RETAIL INVENTORY
Webprod Ltd uses a perpetual inventory system for the inventory in its two retail stores. These stores stock
74 software products and 22 hardware products. Costs are assigned on a weighted-average cost basis. The
following information is relevant to the retail inventory of Webprod Ltd for the 20X7 reporting period.
• Purchases of retail inventory on credit were $2 563 200.
• Cost of retail inventory sold was $2 544 602.
• After the 30 June stocktake, a comparison of the weighted-average cost and net realisable value of each
item was undertaken. Net realisable value was estimated on the general pattern of sales and discounts.
However, because of the rapid change in the computer industry and a miscalculation in purchasing, it
was discovered that two lines of software and one line of hardware would have to be sold at substantial
discounts. As a result, these inventory items would have to be carried at net realisable value.
Retail inventory as at 30 June 20X7 was:
• at cost, $213 598
• allowance for inventory write-down, $24 921.

2.2 MANUFACTURING INVENTORY

Webprod Ltd maintains a job costing system for its manufacturing operations. Costs are assigned to
manufacturing inventory on a first-in-first-out (FIFO) basis. Raw materials on hand are carried at cost.
The cost of manufactured inventories and work in process includes an appropriate share of both variable
and fixed overheads.
Subsequent to the 30 June stocktake, a comparison of the cost and net realisable value of each item of
finished goods was undertaken. The net realisable value was estimated on the general pattern of sales and
discounts.
Information relating to manufacturing inventory for the 20X7 reporting period is set out as follows.

2.2.1 Raw Materials

Purchases of raw materials on credit amounted to $5 423 500, and raw materials on hand as at 30 June
20X7 cost $53 820.

2.2.2 Work in Process

• Raw materials allocated to work in process totalled $5 432 180.
• Direct labour allocated to work in process amounted to $2 494 803.
• Overhead allocated to work in process totalled $1 624 487.
• The cost of work in process on hand at 30 June 20X7 was $132 540.

MODULE 2 Presentation of Financial Statements 109

2.2.3 Finished Goods
During the financial year ending on 30 June 20X7, $9 527 330 of work in process was transferred from
work in process to finished goods. The cost of manufacturing inventory sold totalled $9 501 630. The cost
of finished goods on hand at 30 June amounted to $437 800.

SECTION 3: NON-CURRENT ASSETS

Note: The carrying amount of each non-current asset is included in section 1.

3.1 ACQUISITIONS AND DISPOSALS

The following information relates to acquisitions and disposals of non-current assets during the 20X7
financial year.
• On 20 August 20X6, retail fixtures and fittings were purchased at a cost of $8000.
• On 1 December 20X6, factory plant and equipment with a carrying amount of $63 000 (cost
$160 000) was sold for $88 000. The profit or loss on sale is based on the carrying amount of the
plant and equipment at the start of the reporting period.
• During the 20X7 reporting period, Webprod Ltd purchased $1 084 846 of factory plant and equipment;
$30 000 of this amount is included in the liability for accruals. See also section 5.

3.2 DEPRECIATION AND AMORTISATION

The depreciation and amortisation charges of Webprod Ltd during the 20X7 financial year are listed as:
• patent rights amortisation — $85 000
• factory buildings — $100 000 (included in factory overhead); also see section 3.3
• factory plant and equipment — $121 862 (included in factory overhead)
• retail fixtures and fittings — $10 254.

3.3 REVALUATION OF LAND AND BUILDINGS

Webprod Ltd adopts a policy of revaluing both its land and factory buildings annually to fair value, in
accordance with the revaluation model under IAS 16. The $700 000 revaluation surplus (IAS 16, para. 39)
as at 30 June 20X6 comprises a $400 000 revaluation increase in relation to land and a $300 000 revaluation
increase in relation to buildings.
I. Virgo, an independent valuer, carried out the revaluation as at 30 June 20X7 on the basis of the fair
value of the land and buildings from their existing use (being the highest and best use under IFRS 13 Fair
Value Measurement). Virgo determined that the value of the land and buildings was as follows.

$
Land 970 000
Buildings 1 650 000

The buildings had been depreciated by $100 000 during the 20X7 financial year and, hence, had an
accumulated depreciation of $300 000 as at 30 June 20X7.
The revaluation of the buildings at 30 June 20X7 resulted in an increase of the buildings value by
$150 000 (i.e. the difference between $1 650 000 — the fair value of the buildings as at 30 June 20X7 and
$1 500 000 — the value of the buildings of $1 800 000 – $300 000 accumulated depreciation of the
buildings as at 30 June 20X7).
The revaluation of the land resulted in a decrease of the land by $230 000 (i.e. $1 200 000 – $970 000)
as at 30 June 20X7. This required a reversal of the previous revaluation increase of land recognised in the
revaluation surplus of land (i.e. reduces the balance in the revaluation surplus of land from $400 000 as at
30 June 20X6 by $230 000, as per IAS 16, paragraph 40, giving rise to a balance in the revaluation surplus
of land as at 30 June 20X7 of $170 000).
Therefore, the revaluation of land and buildings at 30 June 20X7 resulted in a net revaluation decrease
during the year of $80 000 (i.e. buildings increased by $150 000 and land decreased by $230 000). For
the purposes of this module, ignore any tax effects of revaluations as this topic is not dealt with until
module 4. Therefore, assume the $80 000 is net of tax.

110 Financial Reporting

SECTION 4: WAGES AND SALARIES
The following information is relevant in preparing the 20X7 accounts of Webprod Ltd.
• During the 20X7 financial year, the total payments for wages and salaries, including annual leave,
totalled $3 250 000. Long service leave paid during the same period amounted to $22 000. Therefore,
total employee benefits paid were $3 272 000.
• Employee benefits to the value of $665 281 were allocated to overhead.

SECTION 5: BORROWING COSTS

The following information is relevant in relation to borrowing costs incurred by Webprod Ltd during 20X7.
• On 2 February 20X7, Webprod Ltd decided to construct a major item of manufacturing plant. By
30 June 20X7, Webprod Ltd had incurred $820 000 of expenditure on the manufacturing plant and
owed creditors $30 000 for materials used in the construction process. These amounts are included in
section 3.1 and include capitalised borrowing costs paid of $10 146.
• During 20X7, Webprod Ltd also incurred borrowing costs of $103 654, all of which have been paid. An
additional $4550 was prepaid (i.e. prepaid borrowing costs).

SECTION 6: CHANGE IN ACCOUNTING POLICY

In previous financial reporting periods, Webprod Ltd expensed all borrowing costs when incurred. Assume
that during the 20X7 reporting period, IAS 23 Borrowing Costs was re-issued. As a result, Webprod Ltd
changed its accounting policy on the treatment of borrowing costs so that borrowing costs relating to
qualifying assets are now capitalised. The accounting policy change has been made in accordance with the
transitional provisions of IAS 23.
For the purposes of the case study, assume that the transitional provisions require all borrowing costs
relating to qualifying assets incurred after the date the standard is applied to be capitalised with no
adjustments to the opening balances of the financial statements.

SECTION 7: REVENUE
7.1 REVENUE RECOGNITION POLICY
Webprod Ltd has adopted the requirements of IFRS 15 Revenue from Contracts with Customers as its
accounting policy for the recognition of revenue.

7.2 RESEARCH AND ADVISORY SERVICES

The principals of Webprod Ltd and several key employees had considerable knowledge and understanding
of the history of the development of telecommunications in Australia. Therefore, the company was
successful in securing a contract to provide research and advisory services. Revenue from these services
is recorded as ‘telecommunications project revenue’. Although the money has not yet been received,
$600 000 of revenue has been recognised during the 20X7 financial year.

7.3 GRANTS
On 1 January 20X7, Webprod Ltd won a $1 million AusIndustry R&D Start Grant for a computer software
project. The revenue from the grant has been recognised, but $250 000 of the grant has not yet been
received.

SECTION 8: 30 JUNE 20X7 TRIAL BALANCE

The following is a trial balance for Webprod Ltd as at 30 June 20X7 and incorporates all information
necessary to prepare the financial report.

MODULE 2 Presentation of Financial Statements 111

 Dr Cr
$ $
Sales 19 194 434
Cost of sales 12 046 232
Interest revenue 12 283
Telecommunications project revenue 600 000
Grant revenue 1 000 000
Profit on sale of factory plant and equipment 25 000
Loss on write-down of inventory 24 921
Under-applied overhead expense 87 500
Employee benefits — retail 166 320
Doubtful debts expense 5 400
Amortisation expense — patent 85 000
Depreciation expense — retail fixture and fittings 10 254
Borrowing costs expense 103 654
Damages expense 620 000
Warranties expense 12 300
Advertising campaign — new product 380 000
Audit fees 25 000
Consulting services — auditor 30 000
Selling expenses 2 415 000
Administrative expenses 3 530 077
Tax expense 387 018
Interim dividend 200 000
Final dividend 250 000

Current assets
Cash at bank 192 173
Trade receivables 723 210
Less: Allowance for doubtful debts 17 200
Grant receivable 250 000
Secured loan to director 28 000
Raw materials — at cost 53 820
Work in process — at cost 132 540
Finished goods — manufactured modems — at cost 437 800
Retail inventory — at cost 213 598
Allowance for inventory write-down 24 921
Prepaid borrowing costs 4 550
Prepayments 58 800

Non-current assets
Investment in debentures 100 000
Unamortised debenture discount 897
Secured loan to director 50 000
Product development costs (R&D) 380 000
Patent rights 200 000
Less: Accumulated amortisation 115 000
Land (at independent valuation 20X7) 970 000
Factory buildings (at independent valuation 20X7) 1 650 000
Less: Accumulated depreciation 0
Factory plant and equipment (at cost) 1 790 246
Less: Accumulated depreciation 352 862
Fixtures and fittings — retail outlets (at cost) 76 300
Less: Accumulated depreciation 33 954

Current liabilities
Trade payables 342 500
Accruals 163 000
Provision for employee benefits 110 000
Dividend payable 250 000
Current tax payable 387 018
Provision for warranties 11 000
Provision for damages 620 000
Bank loan — secured 100 000

112 Financial Reporting

 Dr Cr
$ $
Non-current liabilities
Provision for employee benefits 243 404
Provision for warranties 38 000
Bank loan — secured 800 000
Promissory notes 235 000
Loan — Finance Ltd 400 000
Preference shares 100 000

Shareholders’ equity
Share capital 1 050 000
Revaluation surplus 620 000
Retained earnings 843 240
27 689 713 27 689 713

Notes to trial balance:

1. On average, there is a $20 000 write-down of inventory for the annual reporting period.
2. Overhead has been under-applied in the last two reporting periods by an average of $100 000 per reporting period.
3. Share capital relates to the ordinary shares. The preference shares are classified as debt.
4. No executive of Webprod Ltd earns more than $100 000.
5. A tax rate of 30% applies. Tax effect accounting has not been applied.
6. The final dividend was declared prior to the end of the reporting period and does not require shareholder approval.
7. The product development expense (non-current asset) has met the conditions of paragraph 57 of IAS 38 Intangible Assets and is
recognised as an intangible asset in the statement of financial position.
8. On 15 January 20X7, Webprod Ltd was sued for infringement of a patent right. On 20 August 20X7, Webprod Ltd settled the
lawsuit for $620 000. A liability for damages has been recognised in the statement of financial position.

ASSUMED KNOWLEDGE REVIEW QUESTIONS

This assumed knowledge review is designed to test your understanding of concepts that are fundamental to
this module. Answers to the questions are included at the end of the review. If you experience difficulties
with the questions in this review, consult the latest edition of an appropriate financial accounting textbook.

QUESTION 1
Explain how to classify the following cash flows.
(a) Interest paid and interest received
(b) Income taxes paid
The following information relates to questions 2–5. These questions review how to prepare a statement
of cash flows for a non-trading entity. Their purpose is to help you judge the extent to which you should
consult an appropriate financial accounting text prior to commencing part E of the module 2 study guide.
The examples and questions in module 2 are more complex and require a basic familiarity with
preparing a statement of cash flows for a trading enterprise. If you believe it would be advantageous
to review your understanding of statements of cash flows in the context of a trading entity, you should
consult the latest edition of an appropriate text, such as the following.
• Henderson, S. & Peirson, G. et al. 2017, Issues in Financial Accounting, 16th edn, Pearson, Melbourne.
• Hoggett, J. R. & Medlin, J. et al. 2018, Financial Accounting, 10th edn, John Wiley & Sons, Brisbane.
• Loftus, J., Leo, K. et al. 2020, Financial Reporting, 3rd edn, John Wiley & Sons, Brisbane.
Before considering the questions, read paragraphs 18–20 of IAS 7 Statement of Cash Flows. Please
note that this material adopts the following disclosure approach.
• On the statement of cash flows, cash flows from operating activities will be reported using the direct
method (gross cash inflows and gross cash outflows from operating, investing and financing activities).
• The notes to the financial statements contain disclosure of the indirect method with a reconciliation
between profit for the year and cash flow from operating activities.
This approach is consistent with IAS 7, which encourages the use of the direct method (para. 19).
The following information relates to the activities of Management Services Ltd. (Note that it is an
abbreviated version of the requirements of IAS 1.)

MODULE 2 Presentation of Financial Statements 113

 MANAGEMENT SERVICES LTD
Statement of profit or loss and other comprehensive income
for the year ended 30 June 20X3
$ $
Revenues 500 000
Less: Expenses (excluding depreciation) 277 000
Depreciation expense 23 000 (300 000)
Profit before income tax 200 000
Less: Income tax expense (60 000)
Net profit after income tax 140 000

MANAGEMENT SERVICES LTD

Statement of financial position
at 30 June 20X3
20X3 20X2 Change
$ $ $
Cash at bank 37 000 49 000 (12 000)
Trade receivables 30 000 37 000 (7 000)
Prepaid expenses 6 000 5 000 1 000
Land and buildings 250 000 34 000 216 000
Less: Accumulated depreciation (33 000) (10 000) (23 000)
Total assets 290 000 115 000
Trade payables and accruals 40 000 6 000 34 000
Current tax payable 60 000 14 000 46 000
Debentures — 15 000 (15 000)
Share capital 40 000 40 000 —
Retained earnings 150 000 40 000 110 000
Net assets 290 000 115 000

QUESTION 2
Direct method of calculating and reporting cash flows from operating activities
Using the information provided for Management Services Ltd, calculate the net cash flows from operating
activities by adjusting sales, cost of sales, interest, and other items in the statement of P/L and OCI
for changes in assets and liabilities that affected the determination of profit and OCI (e.g. receivables,
payables). This is the second of the two techniques referred to in paragraph 19 of IAS 7.
The general principle that underlies the calculations is as follows. The gross cash inflow or outflow
relating to an item of revenue or expense is found by adjusting the dollar amount of items included in
the statement of P/L and OCI (excluding non-cash items, such as depreciation) by the change(s) in the
related statement of financial position item(s). The gross cash inflow or outflow may be found by direct
adjustment or by reconstruction of the related ledger accounts.
QUESTION 3
Indirect method of calculating and reporting cash flows from operating activities
Using the information provided for Management Services Ltd, reconcile the net cash provided by operating
activities to the net profit for the year. Provide brief reasons for each adjustment made to the profit for the
year. Comparative figures are not required.
QUESTION 4
Cash flows from investing activities and cash flows from financing activities
Using the information provided for Management Services Ltd, calculate the cash flows from investing
activities and the cash flows from financing activities.
QUESTION 5
Statement of cash flows
Using the information provided for Management Services Ltd, prepare a statement of cash flows using the
direct method in the form set out in the illustrative examples of IAS 7.

REFERENCE
BHP 2014, Value through Performance: Annual Report 2014, accessed July 2019,
https://www.bhp.com/%7E/media/bhp/documents/investors/annual-reports/bhpbillitonannualreport2014.pdf.

114 Financial Reporting

MODULE 3

REVENUE FROM
CONTRACTS WITH
CUSTOMERS;
PROVISIONS,
CONTINGENT
LIABILITIES AND
CONTINGENT ASSETS
LEARNING OBJECTIVES

The overall aim of this module is to provide you with a working knowledge of the issues associated with
accounting for revenue from contracts with customers, provisions, and contingent liabilities and contingent
assets.
After completing this module, you should be able to:
3.1 explain and apply the requirements of IFRS 15 with respect to contract(s) with customers
3.2 determine and allocate the transaction price of a contract to the performance obligation(s) of the contract
3.3 understand, and be able to apply, IAS 37 as it relates to a provision, contingent liability and contingent
asset, and recognise how they relate to the Conceptual Framework.

ASSUMED KNOWLEDGE

Before you begin your study of this module, it is assumed that you are familiar with:
• the definitions of assets, liabilities and income in the Conceptual Framework
• the recognition criteria for assets, liabilities and income in the Conceptual Framework
• journal entries to record assets, liabilities and income.

LEARNING RESOURCES

International Financial Reporting Standards (IFRSs), with a particular focus on the IASB Conceptual Framework
for Financial Reporting (2018):
• IASB Conceptual Framework for Financial Reporting (2018)
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets
• IFRS 15 Revenue from Contracts with Customers
PREVIEW
This module examines accounting for revenue from contracts with customers, as well as accounting for
provisions, contingent liabilities and contingent assets. These items have been an area of much discussion,
not only within the accounting profession but also among financial statement users, especially in relation
to satisfying their information needs.
International Financial Reporting Standard 15 Revenue from Contracts with Customers (IFRS 15) was
issued in 2014 in response to concerns about the previous accounting requirements related to revenue
recognition. More specifically, there were issues with the timing and amount of revenue recognised by
entities, the lack of comparability in the revenue recognition practices and the insufficient disclosure of
revenue-related information (IFRS 15 Basis for Conclusions, paragraphs BC2 and BC327).
IFRS 15 introduced a five-step model of revenue recognition capable of general application to a variety
of transactions and required detailed revenue-related disclosures. Part A of this module discusses the five-
step model and the disclosure requirements of IFRS 15.
The introduction of standards relating to provisions, contingent liabilities and contingent assets has also
led to a tightening of accounting practice. International Accounting Standard 37 Provisions, Contingent
Liabilities and Contingent Assets (IAS 37) was issued in 1998 effective for financial periods beginning
on or after 1 July 1999. IAS 37 significantly reduced the ability of entities to use provisions as a means
of managing the timing of the recognition of expenses, because the standard requires a present obligation
to exist before any provision (and related expense) can be recognised. Accounting for provisions raises
a number of recognition and measurement issues, particularly in relation to the present obligation and
reliable measurement criteria. Further, for provisions extending over more than one reporting period, the
issue of discounting future cash flows introduces further measurement issues, including the appropriateness
of the discount rate used. All these issues related to accounting for provisions are discussed in part B of
this module.
Part C of this module discusses the recognition and measurement requirements in relation to contingent
assets and contingent liabilities. Although IAS 37 indicates that neither may be recognised in the statement
of financial position (with the exception of some contingent liabilities in a business combination), it
clarifies the nature of these potential obligations and benefits and outlines disclosure requirements.
Overall, the main aim of IFRS 15 and IAS 37 is to ensure that the financial reporting of revenue
from contracts with customers, provisions, contingent liabilities and contingent assets is informative for
financial statement users. For example, the revenue-related disclosures under IFRS 15 provide users with
an understanding of the revenue practices of the entity. This understanding extends to how recognised
revenue is earned, at what stage of the activity the revenue is earned and when payment is typically received,
as well as to when and how remaining revenue from existing contracts will be recognised in the future.
IAS 37 ensures that appropriate recognition criteria and measurement principles are applied to provisions
recognised in financial statements. The standard also ensures that disclosures are sufficient to enable users
to understand the nature, timing and amount of provisions, contingent liabilities and contingent assets.

116 Financial Reporting

PART A: REVENUE FROM CONTRACTS
WITH CUSTOMERS
INTRODUCTION
Part A reviews the recognition and disclosure requirements of IFRS 15 Revenue from Contracts with
Customers. Previous revenue standards have been criticised, particularly in relation to a lack of clarity
and guidance in their application to more complex transactions, which has led entities to adopt incon-
sistent revenue recognition practices. Concerns have also been raised about the inadequate disclosure
requirements of previous revenue standards, which have contributed to financial statement users’ lack of
understanding about an entity’s revenue practices. With the objective of improving the financial reporting
of revenue, IFRS 15 establishes principles for reporting useful information to financial statement users
about the nature, amount, timing and uncertainty of revenue and cash flows from an entity’s contracts with
customers. The aim of these principles is to provide a framework of broad revenue recognition concepts
that can be consistently applied to a wide range of transactions and industries. The IFRS 15 principles also
aim to provide important information for financial statement users to make an informed assessment of an
entity’s revenue-earning capabilities.
A key indicator of an entity and its management’s current performance is the revenue generated from its
activities. Moreover, revenue that is to be generated in future periods acts as a signal of future performance.
Providing information about an entity’s current and future revenue from contracts with customers allows
users to understand how the entity is currently performing and its performance capacity in the future. Such
information is important to help financial statement users with their decision making. Existing and potential
investors in an entity, for example, require information on an entity’s revenue-earning capacity to evaluate
their potential return on investment and decide whether to buy, hold or sell shares in the entity. Lenders may
also rely on information about the entity’s revenue to assess the ability of the entity to pay back its loans.
Accordingly, it is critical that users have information on an entity’s revenue-earning activities. By unifying
the revenue recognition practices of entities and requiring detailed disclosures of revenue earned in the
current period and revenue from existing contracts to be earned in future periods, IFRS 15 helps financial
statement users to not only make more informed assessments of an entity’s revenue-earning capabilities,
but also of an entity’s performance relative to other entities.
Part A begins with an overview of IFRS 15, including an outline of its scope and effective date. The
recognition of revenue under IFRS 15 is then discussed, with an emphasis on the prescribed revenue
recognition model, which entities are to apply in determining the timing and amount of revenue to be
recognised. Part A concludes with a discussion on disclosure requirements relating to revenue from
contracts with customers.

Relevant Paragraphs
To assist in understanding of certain sections in this part, you may be referred to relevant paragraphs in
IFRS 15. You may wish to read these paragraphs as directed.
IFRS 15 Revenue from Contracts with Customers:
Subject Paragraphs
Objective 1–4
Scope 5–8
Identifying the contract 9–16
Combination of contracts 17
Contract modifications 18–21
Identifying performance obligations 22–30
Satisfaction of performance obligations 31–43
Determining the transaction price 47–72
Allocating the transaction price to performance obligations 73–86
Changes in the transaction price 87–90
Contract costs 91–104
Disclosure 110–129

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 117

OVERVIEW OF IFRS 15 REVENUE FROM CONTRACTS
WITH CUSTOMERS
The purpose of IFRS 15 is to overcome the deficiencies of previous revenue standards and provide a
comprehensive single model for revenue recognition that can be consistently applied by all entities to
their contracts with customers. Previous revenue standards contained little guidance on how to account
for transactions that generate revenues other than simple transactions. For example, consider an entity that
enters into a contract with a customer for the sale of goods that allows the customer for a specified period a
right of return of the goods purchased. In accounting for the sales contract, the entity needs to consider not
only when to recognise revenue, but also the amount to be recognised as revenue, because the customer is
expected to exercise, to some degree, its right of return. Previous revenue standards provided little guidance
to entities on how to account for these and other multiple-element arrangements. Another example refers
to software providers and other entities in the continuously growing technology sector where the previous
revenue standards did not provide clear guidance on the timing of revenue recognition, particularly in cases
where those entities provide multiple services to customers. As a consequence, entities supplemented the
limited guidance in IFRSs by applying the US Generally Accepted Accounting Principles (US GAAP),
which contain industry- and transaction-specific requirements. The US GAAP requirements, however,
have been acknowledged as containing inconsistencies in the recognition of revenue for economically
similar transactions (IFRS 15 Basis for Conclusions, para. BC3).
In addition, the disclosure requirements in previous revenue standards were criticised for not providing
sufficient information for users to understand the entity’s revenue practices, including the judgments and
estimates made in recognising that revenue. For example, feedback from users in the development of
IFRS 15 indicated that entities’ revenue-related disclosures were often generic or boilerplate in nature
or presented in isolation, with no explanation of how the revenue recognised related to other financial
statement information.
IFRS 15 was introduced to improve the financial reporting of revenue by:
• providing a more robust framework for addressing revenue recognition issues;
• improving comparability of revenue recognition practices across entities, industries, jurisdictions and
capital markets;
• simplifying the preparation of financial statements by reducing the amount of guidance to which entities
must refer; and
• requiring enhanced disclosures to help users of financial statements better understand the nature, amount,
timing and uncertainty of revenue that is recognised (IFRS 15 Basis for Conclusions, para. BC3).

To assist entities in applying IFRS 15, the new standard provides guidance on how to account for
numerous contract types and their elements, including:
• contracts with a right of return period
• contracts providing goods or services with warranties
• contracts in which a third party provides the goods or services to the customer (principal versus agent
considerations)
• contracts with options for customers to purchase additional goods or services at a discount or free
of charge
• customer prepayments and payment of non-fundable upfront fees
• licensing and repurchase agreements
• consignment and bill-and-hold arrangements.

Scope of IFRS 15
IFRS 15 applies to all contracts with customers, except those contracts that are (in their entirety or in part):
• lease contracts within the scope of IFRS 16 Leases;
• contracts within the scope of IFRS 17 Insurance Contracts. However, an entity may choose to apply
[IFRS 15] to insurance contracts that have as their primary purpose the provision of services for a fixed
fee in accordance with paragraph 8 of IFRS 17;
• financial instruments and other contractual rights or obligations within the scope of IFRS 9 Financial
Instruments, IFRS 10 Consolidated Financial Statements, IFRS 11 Joint Arrangements, IAS 27 Separate
Financial Statements and IAS 28 Investments in Associates and Joint Ventures; and
• non-monetary exchanges between entities in the same line of business to facilitate sales to customers or
potential customers (IFRS 15, para. 5).

118 Financial Reporting

 A contract with a customer may be partially within the scope of IFRS 15 and partially within the scope
of one of the above standards. In such cases, IFRS 15 applies as follows.
• If the other standards specify how to separate or initially measure one or more parts of the contract, then
an entity shall apply those separation or measurement requirements first. The transaction price of the
contract is then reduced by the amounts initially measured under the other standards, with the remaining
transaction price being accounted for under IFRS 15. The term ‘transaction price’ is discussed shortly.
• If the other standards do not specify how to separate or initially measure one or more parts of the contract,
then an entity shall apply IFRS 15 to the contract (IFRS 15, para. 7).

EXAMPLE 3.1

Scope of IFRS 15
An entity enters into a lease agreement (as the lessor) with another entity (the lessee) for the lease of
equipment. The annual payments made by the lessee include lease payments and a fee for ongoing
service and maintenance of the equipment, as provided by the lessor. From the perspective of the lessor,
the contract with the lessee is partially within the scope of IFRS 16 Leases (IFRS 16) (in relation to the
lease payments) and partially within IFRS 15 (in relation to the service and maintenance fee).
In accordance with paragraph 7 of IFRS 15, the lessor shall apply IFRS 16 first to measure the lease
receivable arising from the lease payments. This amount is deducted from the transaction price of the
lease agreement and the remaining amount, being the service and maintenance fee, is accounted for by
the lessor applying the revenue recognition model in IFRS 15.

The scope of IFRS 15 also extends to the recognition and measurement of gains and losses on the sale
of non-financial assets that are not an output of an entity’s ordinary activities. As such, IFRS 15 applies to
the sale of assets previously governed by IAS 16 Property, Plant and Equipment, IAS 38 Intangibles and
IAS 40 Investment Property.

Impact of IFRS 15
The impact of IFRS 15 varies by industry. For entities in some industries, there may be little change in
the timing and amount of revenue recognised. For entities in other industries, however, significant changes
may occur. Entities in the technology sectors were particularly affected, making IFRS 15 a prime example
of the IASB’s response to the various aspects of the recent technological advancements impact on the
accounting profession — in this case, by providing clear guidance to entities responsible for technological
advancements on how to account for their complex transactions. For instance, telecommunications entities
may provide customers with a ‘free’ handset that they can use in return for entering into a monthly payment
plan for a minimum period. The previous revenue standard, IAS 18 Revenue, provided little guidance on
how to recognise revenue from contracts for the bundled offer of a good and service. As a result, some
telecommunication entities recognised revenue from the sale of the monthly plans when the service was
provided and treated the cost of the handsets as a marketing expense. Others treated the handset as a cost
of acquiring the customer and amortised it over the minimum contract period. Neither of these options
is permitted under IFRS 15, and as a result, telecommunication entities must allocate the total contract
price between the sale of the handset and the monthly plan. This changed the timing of the recognition of
revenue, with revenue allocated to the handset now being recognised earlier (i.e. at the time of its sale).
Similar to entities in the telecommunications industry, those in the software development and technology
industries also need to allocate the contract price between the goods and/or services in a bundled offer.
Software entities may enter into contracts with customers for the implementation, customisation and testing
of software, with post-implementation support. Under IAS 18, software entities would have recognised
revenue by reference to the stage of completion of the transaction, including post-implementation services.
Under this approach, software entities would not have been required to allocate the total contract price
between each of the services provided. Rather, the revenue would have been recognised according to the
percentage of completion of the services as a whole. IFRS 15, however, requires the contract price to be
allocated to each distinct service, with revenue recognised when that service is completed. This altered the
timing of revenue recognised by software entities.
IFRS 15 also contains detailed requirements related to when a change in the terms of a contract should
be treated as a separate contract or as a modification to an existing contract. IAS 18, however, did not
provide such guidance, resulting in entities accounting for contract modifications differently. For entities
such as manufacturers, whose contracts can be modified to require the delivery of additional goods or

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 119

services to the customer at an increased price, IFRS 15 has the potential to change how they account for
revenue when a contract is modified.
Finally, IFRS 15 imposes stringent requirements that must be satisfied before revenue can be recognised
progressively over time. This has a particular impact on entities that have previously recognised revenue
on long-term contracts over time, such as various providers of enterprise technology solutions for their
licence revenue. If the IFRS 15 requirements are not satisfied, these entities would recognise revenue at a
point in time, for example, when the service is complete.
Overall, the practical implications of IFRS 15 are that the timing and amount of revenue recognised from
contracts with customers will change for some entities that have been applying previous revenue standards
(i.e. IAS 18 and IAS 11 Construction Contracts). This is because some entities will be required to alter their
accounting treatment of items such as contracts for bundled goods and services, contract modifications and
contracts that are satisfied over time. The additional requirements contained in IFRS 15 over the previous
revenue standards might be seen as likely to increase the workload of accountants trying to recognise
revenues from contracts with customers, but entities can mitigate this effect by implementing effective
technology solutions built on customer relationship management (CRM) systems to track revenue streams,
recognise revenue from multiple sources and automate allocations of transaction price, costs and discounts
to different customers and services provided.

3.1 RECOGNITION OF REVENUE

IFRS 15 establishes a framework for determining when to recognise revenue and how much revenue to
recognise. Within that framework, the core principle of IFRS 15 is that an entity should 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 in exchange for those goods or services’ (IFRS 15, para. 2).
To meet this core principle, an entity needs to adopt a five-step recognition model for each customer,
as illustrated by figure 3.1. The five-step model was summarised in the introductory paragraph IN7 of
IFRS 15 when the standard was first released in May 2014. Although the current form of IFRS 15 does
not include that paragraph, the five-step model still applies.

FIGURE 3.1 IFRS 15 Revenue from Contracts with Customers five-step model

STEP 1
Identify the contract(s) with the customer

STEP 2
Identify the performance obligation(s) in the contract

STEP 3
Determine the transaction price of the contract

STEP 4
Allocate the transaction price to each performance obligation

STEP 5
Recognise revenue when (or as) each performance
obligation is satisfied

Source: Deloitte 2018. This is an amended version of a diagram for which the original is available from www.dart.deloitte.com/
iGAAP.

120 Financial Reporting

 Step 1, step 2 and step 5 refer to recognition requirements, while step 3 and step 4 cover measurement
requirements. As such, these steps are not presented sequentially in IFRS 15, because in a manner
consistent with other IFRSs, IFRS 15 presents the requirements related to recognition, measurement,
presentation and disclosure sequentially.
When applying the five-step model, the entity must consider the terms of each contract and all relevant
facts and circumstances. The entity must also apply the five-step model consistently to contracts that are
similar in character and circumstance (IFRS 15, para. 3).
This section now looks at each step in detail.

STEP 1: IDENTIFY THE CONTRACT(S) WITH THE CUSTOMER

In carrying out step 1, an entity must identify its customers and then the contracts it has with its customers.
First, IFRS 15 defines a customer as ‘a party that has contracted with an entity to obtain goods or services
that are an output of the entity’s ordinary activities in exchange for consideration’ (IFRS 15, Appendix A).
Under this definition, not all parties with whom the entity enters into a contract are customers for IFRS 15
purposes: the definition is limited to those parties that obtain, in exchange for consideration, the output of
the entity’s ordinary activities. If the counterparty to a contract is not a customer, the contract is outside the
scope of IFRS 15. Second, a contract is ‘an agreement between two or more parties that creates enforceable
rights and obligations’ (IFRS 15, Appendix A). The agreement can be written, oral or implied by an
entity’s customary business practices. Provided the contract is within the scope of IFRS 15 (see ‘Scope of
IFRS 15’ in the part A ‘Introduction’ section of this module), an entity shall apply the requirements of
IFRS 15 to each contract that has all of the following attributes:
• the parties have approved the contract and are committed to perform their obligations
• the entity can identify each party’s rights regarding, and the payment terms for, the goods or services to
be transferred
• the contract has ‘commercial substance’ (i.e. should have an effect on future cash flows of the entity)
• it is probable that the entity will collect the consideration that it is entitled to in exchange for the goods
or services that it transfers to the customer (IFRS 15, para. 9).
Once the entity established that a contract has all the above attributes, it needs to apply IFRS 15 and
is not required to reassess whether these attributes remain present for the duration of the contract unless
there is an indication that the facts and circumstances have changed significantly. If the contract does not
have all of the above attributes, IFRS 15 does not apply. An entity, however, must continually reassess the
contract to determine whether all attributes are subsequently present. If they are all present, the entity can
proceed to step 2 of the five-step model for this contract.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 9–14 of IFRS 15.

EXAMPLE 3.2

Counterparty to a Contract is Not a Customer

A research centre enters into an agreement with a grantor that provides grants and sponsorship for
research activity. The agreement states the grantor cannot specify how any output from the research
activity will be used. This agreement is not a contract with a customer under IFRS 15 because the grantor
is not a customer of the research centre. As the grantor cannot specify how the output from the research
activity can be used, the grantor does not obtain the output of the research centre’s ordinary activities in
exchange for consideration (see IFRS 15, para. 6).

QUESTION 3.1

Consider whether the following constitutes a contract with a customer under IFRS 15, and explain
why it does or does not.
• A construction company enters into a three-year agreement with a property developer for
the construction of a shopping centre. After 12 months, the property developer experiences
significant financial difficulties and is unlikely to meet future commitments.

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 121

Combining Multiple Contracts
Paragraph 17 of IFRS 15 requires an entity to combine two or more contracts entered into at or near the
same time with the same customer and to account for them as one contract if at least one of the following
criteria is met:
• ‘the contracts are negotiated as a package with a single commercial objective’
• the consideration ‘to be paid in one contract depends on the price or performance of the other
contract’, or
• ‘the goods or services promised in the contracts (or some goods or services promised in each of the
contracts) are a single performance obligation’ (see ‘Step 2: Identify the performance obligation(s) in
the contract’ for the definition of a performance obligation).
However, if the entity reasonably expects that the financial statement effects of accounting for multiple
contracts as a single contract will be materially different from accounting for the contracts individually,
the entity is not required to combine multiple contracts into one contract (IFRS 15, para. 4).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 4 and 17 of IFRS 15.

Contract Modifications
A contract modification is a change in the scope or price (or both) of a contract that is approved by both
contracting parties. A contract modification exists when the contracting parties approve a modification that
creates new, or changes existing, enforceable rights and obligations of the parties. Like the contract itself,
the modification can be written, oral or implied by customary business practices (IFRS 15, para. 18).
Modification Accounted for as a Separate Contract
If the modification has been approved by both contracting parties, it shall be accounted for as a separate
contract if both of the following conditions are met:
• ‘the scope of the contract increases because of the addition of promised goods or services that are
distinct’ (IFRS 15, para. 20(a)) (see ‘Step 2: Identify the performance obligation(s) in the contract’
to understand what is meant by ‘distinct’ in this context)
• ‘the price of the contract increases by an amount of consideration that reflects the entity’s stand-alone
selling prices of the additional promised goods or services and any appropriate adjustments to that price
to reflect the circumstances of the particular contract’ (IFRS 15, para. 20(b)). An example of price
adjustment is when discounts are allowed to customers.
If both of these conditions are met, the entity will apply the remaining steps of the five-step model to the
contract modification, starting with step 2. The existing contract is unaffected by the contract modification,
as the revenue recognised to date under the existing contract (being the amounts associated with those
performance obligations already completed) is not adjusted. Future revenues related to the remaining
performance obligations under the existing contract will be accounted for under the existing contract.
Future revenues associated with the performance obligations remaining under the contract modification
will be accounted for separately.
Modification Not Accounted for as a Separate Contract
If neither of the conditions for a separate contract is met, how the contract modification is accounted
for depends on whether the remaining goods or services to be transferred under the existing contract are
distinct from those goods or services that were already transferred before the contract modification. The
three accounting approaches are outlined in the following scenarios:
1. If they are distinct, the contract modification is accounted for as a replacement of the existing contract
with the creation of a new contract.
2. If they are not distinct, the contract modification is accounted for as part of the existing contract.
3. If they are a combination of 1 and 2, the contract modification is accounted for as partly the creation of
a new contract and partly the modification of the existing contract (IFRS 15, para. 21).
These distinction scenarios determine whether an entity is required to adjust previously recognised
revenue because of the contract modification. Under scenario 1, revenue recognised to date under the
existing contract is not adjusted. After the modification, the consideration promised by the customer under
the existing contract that has yet to be recognised as revenue plus the consideration promised under the
contract modification are allocated to the remaining performance obligations in both the existing contract
and the contract modification. Remaining revenue is then recognised on a ‘prospective’ basis when these
performance obligations are completed.

122 Financial Reporting

 Under scenario 2, the entity retrospectively adjusts recognised revenue to reflect the contract modi-
fication’s effect on the transaction price and the entity’s progress towards completing the performance
obligation. This retrospective adjustment to recognised revenue would typically arise when the existing
contract relates to a single performance obligation that is partially satisfied at the time of the modification.
Depending on the modification’s effect on the transaction price and the extent of progress, the adjustment
may either increase or decrease recognised revenue. After the modification, revenue is recognised
according to the satisfaction of the single performance obligation.
Scenario 3 applies when an entity modifies an existing contract in which some of the remaining goods
or services to be transferred are distinct from those that have already been transferred. If this is the case,
the entity would adopt a combination of scenarios 1 and 2. In particular, the entity applies scenario 1 to
those goods or services that are distinct and scenario 2 to those that are not.

EXAMPLE 3.3

Contract Modification
An entity promises to sell 100 widgets to a customer over 12 months for a transaction price of $8000
($80 per widget). The customer obtains control of each widget at the time of transfer. After six months,
the entity had transferred control of 45 widgets to the customer under the existing contract. The contract
is modified as follows.
Scenario A: Contract Modification that is a Separate Contract
Require the delivery of an additional 40 widgets at an additional price of $3000 ($75 per widget).
The contract modification is a new contract that is separate from the existing contract. The scope of the
contract has increased due to the promise of additional widgets that are distinct from the existing widgets
(IFRS 15, para. 20(a)). Moreover, the price of the additional widgets reflects their stand-alone selling price
at the time of the modification (IFRS 15, para. 20(b)).
Under IFRS 15, no adjustment is made to revenue recognised on the 45 widgets that have been trans-
ferred to the customer ($3600). Following the modification, the entity will recognise revenue separately
for the 55 widgets remaining under the existing contract ($4400) and the 40 widgets remaining under the
additional contract ($3000).
Scenario B: Contract Modification that is Not a Separate Contract
Require the delivery of an additional 40 widgets. The entity agrees to a reduced price for $70 per widget
for the additional 40 widgets and all remaining widgets on the original contract. This price reflects the
higher volume purchased when considering both the original contract and the additional order.
The contract modification is a not accounted for as a separate contract because it fails to meet the
conditions in IFRS 15, para 20. The entity determines that the negotiated price of $70 per widget for
the additional widgets does not reflect the stand-alone selling price of the additional 40 widgets which is
$80 per widget. Because the remaining widgets to be delivered are distinct from those already transferred,
the entity applies the requirements in IFRS 15, paragraph 21(a) and accounts for the modification as a
termination of the original contract and the creation of a new contract.
Consequently, the amount recognised as revenue for the remaining widgets is $3850 ($70 × 55 widgets
not yet transferred under the original contract) + $2800 ($70 × 40 widgets to be transferred under the
contract modification).
Source: Based on IFRS Foundation 2019, IFRS 15 Revenue from Contracts with Customers, in IFRS Standards issued at
1 January 2019, IFRS Foundation, London, p. B339.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 18–22 of IFRS 15.

STEP 2: IDENTIFY THE PERFORMANCE OBLIGATION(S) IN

THE CONTRACT
Once the contract has been identified, the entity’s next step is to identify the performance obligation(s)
within the contract. This is done at the beginning of the contract and requires the entity to identify each
contractual promise to deliver goods or services to the customer. A promise constitutes a performance
obligation if it is for the transfer of either:
(a) a good or service (or a bundle of goods or services) that is distinct; or
(b) a series of distinct goods or services that are substantially the same and that have the same pattern of
transfer to the customer (IFRS 15, para. 22).

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 123

 Provided it is considered distinct, any good or service promised to a customer as a result of a contract
gives rise to a performance obligation. This applies whether the promise is explicit within the contract
or implied by the entity’s customary business practices. Promised goods or services may give rise to
a performance obligation even if the promise is incidental or part of an entity’s marketing campaign.
Examples include ‘free’ handsets provided by telecommunication entities, ‘free’ services promised as part
of a licence contract by a software developer (e.g. customisation, installation, customer support, updates,
cloud services) and customer loyalty points awarded by supermarkets, airlines and hotels.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 22, 24 and 25 of IFRS 15.

Determining What is Meant by ‘Distinct’

A good or service is considered distinct when:
(a) the customer can derive benefit from the good or service either on its own or together with other
resources that are readily available to the customer (IFRS 15, para. 27(a)), and
(b) the entity’s promise to transfer the good or service to the customer is separately identifiable from other
promises in the contract (IFRS 15, para. 27(b)).

Customer Deriving Benefit from the Good or Service

IFRS 15 states a customer can benefit from a good or service through its use, consumption or sale (for an
amount greater than its scrap value) or if it is otherwise held in a way that generates economic benefits.
A customer may be able to benefit from the good or service on its own or in conjunction with other readily
available resources. A readily available resource is a good or service that is acquired separately from the
entity or another party or a resource that the customer has already obtained from the entity under the
contract or from other transactions or events (IFRS 15, para. 28).
Separately Identifiable Promise to Transfer a Good or Service
For a good or service to be distinct, the promise to transfer the good or service must be separable from
other promises in the contract. A promise is separable if the nature of the promise, within the context of the
contract, is to transfer goods or services individually rather than as inputs to a combined item (or items).
Indicators that two or more promises to transfer goods or services are not separable include, but are not
limited to, the following:
(a) The entity provides a significant service of integrating the goods or services with other goods or services
promised in the contract into a combined item or items (IFRS 15, para. 29 (a)).
(b) One or more of the goods or services significantly modifies or customises, or is significantly modified
or customised by, one or more of the other goods or services promised in the contract (IFRS 15,
para. 29 (b)).
(c) The goods or services are highly interdependent or highly interrelated (IFRS 15, para. 29 (c)).

When the customer can derive benefit from a good or service that is separately identifiable, as per
IFRS 15, paragraphs 27(a) and 27(b), the good or service is considered to be distinct. The entity has a
separate performance obligation for each distinct good or service within the contract.
If either criterion under paragraph 27 is not satisfied, the good or service is not distinct. The entity will
then combine the good or service with other promised goods or services until the entity identifies a bundle
of goods or services that are distinct. This could include combining a good or service that is not considered
distinct with another good or service that could be considered distinct on its own.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 26–30 of IFRS 15.

EXAMPLE 3.4

Identifying Whether a Good or Service is Distinct

An entity enters into a contract to construct a library for a customer. As part of the contract, the entity is
responsible for providing various goods and services, including engineering, site clearance, material and
labour for the construction of the library, and overall project management services.

124 Financial Reporting

 Given the entity (or its competitors) can sell many of these goods or services separately to other
customers, it is likely the customer can benefit from the goods or services either on their own or
together with other readily available resources. As such, paragraph 27(a) of IFRS 15 is met. However,
paragraph 27(b) of IFRS 15 is not met because the individual goods and services are not distinct. This
is because the entity’s promise to transfer individual goods or services in the contract is not separately
identifiable from other promises in the contract; the entity ‘provides a significant service of integrating the
goods and services’ into a combined output — the library. As such, the goods and services constitute a
distinct bundle of goods and services, and the entity has a single performance obligation to construct the
library as per paragraph 29 of IFRS 15.
Source: Based on IFRS Foundation 2019, IFRS 15 Revenue from Contracts with Customers, in IFRS Standards issued at
1 January 2019, IFRS Foundation, London, pp. B344–B345.

QUESTION 3.2

A software developer enters into a contract with a customer to transfer a software licence,
provide an installation service, and provide software updates and technical support for a three-
year period. The entity also sells each of these components separately. Although unique to each
customer, the installation service does not significantly modify the software. The software functions
without the updates and the technical support.
Identify the performance obligation(s) within this contract.
Source: Based on IFRS Foundation 2019, IFRS 15 Revenue from Contracts with Customers, in IFRS Standards issued at
1 January 2019, IFRS Foundation, London, p. B346.

Series of Distinct Goods and Services that are Substantially the Same and
have the Same Pattern of Transfer
IFRS 15 permits an entity to account for a series of distinct goods or services that are substantially the same
and have the same pattern of transfer as a single performance obligation, provided the following criteria
are met:
• each distinct good or service in the series that the entity promises to transfer to the customer represents
a performance obligation to be satisfied over time
• the entity uses the same method to measure its progress towards satisfaction of the performance
obligation for each distinct good or service in the series (IFRS 15, para. 23).
As stated, these requirements apply to goods or services that are delivered consecutively rather than
concurrently. For example, they would apply to repetitive service contracts such as cleaning contracts
and contracts to deliver utilities such as electricity and gas. The concept of satisfaction of a performance
obligation is discussed in ‘Step 5: Recognise revenue when each performance obligation is satisfied’.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now re-read paragraph 22 and read paragraph 23 of IFRS 15.

STEP 3: DETERMINE THE TRANSACTION PRICE OF

THE CONTRACT
Determining the total transaction price of a contract is an important part of the five-step model. This is
because once the transaction price is determined, it is allocated among the performance obligations within
the contract (i.e. step 4) and is recognised as revenue when those performance obligations are satisfied
(i.e. step 5).
The transaction price is ‘the amount of consideration to which an entity expects to be entitled in
exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf
of third parties’ (IFRS 15, para. 47). It is the amount to which an entity expects to be entitled that constitutes
the transaction price. As such, it excludes amounts collected on behalf of another party, such as sales taxes
or in Australia, the GST (Goods and Services Tax).

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 125

 The transaction price may be affected by the nature, timing and amount of consideration promised by a
customer. When determining the transaction price, an entity shall consider the effects of:
• variable consideration, including any constraining estimates of that consideration
• the ‘existence of a significant financing component in the contract’
• non-cash consideration
• consideration that is payable to a customer (IFRS 15, para. 48).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 46–49 of IFRS 15.

Variable Consideration
The consideration promised in a contract with a customer may include fixed amounts, variable amounts or
both. If the consideration includes a variable amount, an entity ‘shall estimate the amount of consideration
to which [it] will be entitled in exchange for transferring the promised goods or services to a customer’
(IFRS 15, para. 50).
Paragraph 51 of IFRS 15 specifies examples of when consideration may vary. These include:
• discounts, rebates, refunds, credits and price concessions (whether explicit in the contract or implied
from an entity’s customary business practices, published policies or statements to the customer) offered
to customers, or
• incentives or performance bonuses offered to the entity on the occurrence of a future event, or penalties
imposed on the entity on the occurrence of a future event.

QUESTION 3.3

Consider whether the following performance payments constitute consideration of a fixed amount,
variable amount or a combination of both, and justify your answer.
• A construction company enters into a contract with a customer to build an office block. The
consideration promised by the customer is $1 500 000 with a $350 000 performance bonus if the
office block is completed within 18 months.
• A construction company enters into a contract with a customer to build a warehouse for $500 000.
The contract specifies that the warehouse is to be completed by 30 June 20X6, and that if it is
not completed by 31 August 20X6, the construction company incurs a $50 000 penalty.

Estimating Variable Consideration

An entity shall estimate variable consideration using either the ‘expected value’ or the ‘most likely amount’
method. An entity should choose the method that better predicts the amount of consideration to which it
will be entitled. An entity must apply the chosen method to that type of variable consideration consistently
throughout the contract. An entity is also required to apply the chosen method consistently to similar types
of variable consideration in other contracts. However, an entity is permitted to choose different methods
for estimating different types of variable consideration within one contract.
Under the expected-value method, the expected value of variable consideration is the sum of probability-
weighted amounts in a range of possible consideration amounts. This method requires an entity to
identify: (1) the possible outcomes of a contract; (2) the probability of each outcome occurring; and
(3) the consideration amount it is entitled to under each outcome. The sum of each probability-weighted
consideration amount the entity is entitled to under each outcome is the expected value of variable
consideration. The expected-value method may better predict variable consideration if the entity has a
large number of contracts with similar characteristics. The IFRS 15 Basis for Conclusions indicates that an
entity is not required to consider all possible outcomes because it may be costly to do so. Rather, a limited
number of discrete outcomes and their probabilities of likelihood can provide a reasonable estimate of
the expected value of variable consideration.
Under the most likely amount method, the expected value of variable consideration is the consideration
amount the entity is entitled to under the ‘most likely’ possible outcome of a contract. This amount is not
probability-weighted. Rather, an entity determines, from a range of possible outcomes, the outcome that is
most likely to occur. The consideration amount the entity is entitled to under this outcome is the expected
value of variable consideration. This method may be a better predictor of variable consideration than the

126 Financial Reporting

expected-value method if the contract has only two possible outcomes (e.g. an entity either achieves a
performance bonus or not).
IFRS 15 states:
An entity shall recognise a refund liability if the entity receives consideration from a customer and expects
to refund some or all of that consideration to the customer. A refund liability is measured at the amount
of consideration received (or receivable) for which the entity does not expect to be entitled (IFRS 15,
para. 55).

This refund liability amount is not included in the transaction price (IFRS 15, para. 55).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may read paragraphs 50–55 of IFRS 15.

Constraining Estimates of Variable Consideration

On estimating the amount of variable consideration within the transaction price, an entity needs to consider
the likelihood that this amount will be realised. Variable consideration that is too uncertain should not be
included in the transaction price. Variable consideration is included in the transaction price ‘only to the
extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised
will not occur when the uncertainty associated with the variable consideration is subsequently resolved’
(IFRS 15, para. 56).
‘Highly probable’ is defined as being ‘significantly more likely than probable’ (as defined in IFRS 5
Non-current Assets Held for Sale and Discontinued Operations, Appendix A). A significant reversal in the
amount of cumulative revenue recognised refers to a significant downward adjustment in the amount of
previously recognised revenue. When it is highly probable that a significant reversal will not subsequently
occur, variable consideration is included in the transaction price.
In assessing whether it is highly probable that a significant revenue reversal will not occur in a
subsequent reporting period, an entity should consider both the likelihood and magnitude of the revenue
reversal.
If the entity assesses that it is highly probable that including its variable consideration estimate will not
result in a significant revenue reversal, the amount is included in the transaction price. This assessment
must be done for each performance obligation that contains variable consideration. Further, the magnitude
of a possible revenue reversal should be assessed relative to the total consideration for each performance
obligation. For example, if the consideration for a single performance obligation includes both a fixed
and variable amount, the entity would assess the magnitude of a possible revenue reversal of the variable
amount relative to the total consideration (i.e. variable plus fixed consideration).
At the end of each reporting period, an entity must update the transaction price to reflect the amount
of consideration to which it expects to be entitled. This includes a reassessment of whether the variable
consideration is constrained and, if so, by what amount. After the reassessment, if it is highly probable that
a significant revenue reversal of all or some of the variable consideration will occur when the uncertainty
associated with the variable consideration is resolved in future periods, this amount is excluded from the
transaction price. This highly probable and significant reversal of the variable consideration requires a
change to the transaction price and any cumulative revenue recognised.
Similarly, at the end of each reporting period, an entity must adjust the refund liability amount for
changes in expectations about the amount of refunds. The corresponding adjustment is recognised as
revenue (or a decrease in revenue) if the refund liability amount decreases (or increases).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 56–58 of IFRS 15.

EXAMPLE 3.5

Estimating Variable Consideration and Determining Whether it is

Included in the Transaction Price
An entity enters into a contract with a customer to provide 100 gadgets at a price of $35 per gadget. Cash
is received when control of a gadget transfers. The contract explicitly states that the customer has the

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 127

 ability to return any unused gadgets within 30 days of transfer and receive a full refund. As the gadgets are
specific to the customer, the entity cannot resell the returned gadgets to another customer. The contract
will be completed before the end of the current reporting period. Based on past experience, the entity
attaches the following probabilities to the estimated number of gadgets the customer will return.

Probability
Gadgets returned of outcome Consideration entitled to
0 10% 100 gadgets × $35 × 10% = $ 350
1 20% 99 gadgets × $35 × 20% = $ 693
2 50% 98 gadgets × $35 × 50% = $1 715
3 10% 97 gadgets × $35 × 10% = $ 340
4 10% 96 gadgets × $35 × 10% = $ 336
Estimated variable consideration (probability-weighted) $3 434

Despite having a fixed price ($35 per gadget), the consideration is variable because the contract allows
the customer to return the gadgets. In estimating the amount of variable consideration, the entity would
use the expected-value method. Given there are more than two possible outcomes, the expected-value
method better predicts the amount of consideration to which the entity would be entitled in comparison
to the most likely amount method. As shown in the previous table, the expected-value method provides
an estimated variable consideration of $3434.
Whether the estimated amount of consideration is included in the transaction price depends on whether
it is highly probable that a significant revenue reversal will occur. Although the returns are outside the
entity’s influence, the entity has significant experience in estimating gadgets likely to be returned by this
customer. Also, the uncertainty will be resolved within a short time frame (i.e. 30 days). As such, the entity
concludes it is highly probable that a significant revenue reversal for the cumulative amount of revenue
recognised (i.e. $3434) will not occur when the uncertainty is resolved (i.e. over the 30-day return period).
Therefore, the transaction price is $3434. On transfer of control of the 100 gadgets, the entity recognises
revenue of $3434 and a refund liability of $66 ($3500 – $3434). At the end of the reporting period, the
entity will assess the number of gadgets actually returned and make a corresponding adjustment to the
amount of the refund liability and revenue recognised.
Although the entity would use the expected-value method given the circumstances that there are
more than two possible outcomes, the most likely amount method would have produced a similar result.
The most likely outcome is that the customer will return two gadgets, being 50%, which is the highest
probability outcome as shown above. Based on this outcome, the transaction price is $3430 (98 gadgets
× $35). On transfer of control of the 100 gadgets, the entity would recognise revenue of $3430 and a
refund liability of $70 ($3500 – $3430).
Source: Based on IFRS Foundation 2019, IFRS 15 Revenue from Contracts with Customers, in IFRS Standards issued at
1 January 2019, IFRS Foundation, London, pp. B360–B361.

Significant Financing Component in the Contract

The payment of consideration by a customer may not occur at the same time the entity transfers the
good or service to the customer. The consideration may be paid before or after the transfer occurs. When
consideration is paid in advance, the entity receives (from the customer) the benefit of financing the transfer
of the good or service. Alternatively, when consideration is paid in arrears, the customer receives (from
the entity) the benefit of financing the transfer.
When the benefit of financing is ‘significant’, the contract contains a significant financing component.
When a contract contains a significant financing component, the entity adjusts the promised amount of
consideration (and, therefore, the transaction price of the contract) for the effects of the time value of
money. A significant financing component may exist irrespective of whether the promise of financing is
explicitly stated in the contract or implied by the payment terms of the contract (IFRS 15, para. 60).
Under IFRS 15, an entity must assess, first, whether a contract contains a financing component and,
second, if it does, whether that component is significant to the contract. This assessment, however, is not
required when the period between the entity transferring a promised good or service to a customer and the
customer paying for the good or service is one year or less. If the assessment is not required, the financing
component (if any) is automatically considered to be not significant (IFRS 15, para. 63).
For those contracts in which the period between the transfer of the good or service and the payment
of consideration is greater than one year, the entity must consider all relevant facts and circumstances in

128 Financial Reporting

 assessing whether the contract contains a significant financing component. These facts and circumstances
include:
• the difference, if any, between the amount of promised consideration and the price that a customer would
have paid for the good or service if the customer had paid cash for the good or service at the time of
transfer (i.e. the cash selling price)
• the combined effect of: (1) the ‘expected length of time between when the entity transfers the promised
good or service to the customer and when the customer pays for the good or service’; and (2) ‘the
prevailing interest rates in the relevant market’ (IFRS 15, para. 61).
If the financing component is not considered to be significant, no adjustment is made to the transaction
price of the contract. If the financing component is considered to be significant, the entity adjusts the
amount of the promised consideration for the effects of the time value of money. This is achieved by
discounting the nominal amount of promised consideration to the cash selling price at the discount rate
that would be used if the entity and customer entered into a separate financing transaction. The discount
rate reflects ‘the credit characteristics of the party receiving financing in the contract’ (IFRS 15, para. 64).
In effect, if a contract contains a significant financing component, the contract conceptually consists of
two transactions: one for the exchange of a good or service and another for the financing of that good or
service. In this case, IFRS 15 requires each transaction to be accounted for separately. The entity recognises
revenue from contracts with customers as the portion of promised consideration that equals the cash selling
price. The entity recognises the difference between the nominal amount of promised consideration and the
cash selling price as interest revenue (if the entity benefits from financing) or interest expense (if the
customer benefits from financing). Revenue recognised from customers and interest revenue or interest
expense shall be presented separately in the statement of profit or loss and other comprehensive income
(statement of P/L and OCI). ‘Interest revenue or interest expense is recognised only to the extent that
a contract asset (or receivable) or a contract liability is recognised in accounting for a contract with a
customer’ (IFRS 15, para. 65).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 60, 61, 63–65 of IFRS 15.

EXAMPLE 3.6

Accounting for a Significant Financing Component in a Contract

A property developer enters into a contract with a customer to sell land, with control of the land transferring
to the customer when the contract is signed. The customer has no right to return the land once the contract
is signed. The cash selling price of the land is $50 000, which is the amount the customer would have paid
for the land if payment was required at the time of transfer. Payment, however, is required 24 months after
transfer at an amount of $57 781. The amount of $57 781 is the promised consideration of the contract.
Given the difference between the amount of promised consideration and the cash selling price ($7781
= $57 781 − $50 000), the length of time between transfer and payment (24 months), and prevailing market
interest rates, the contract includes a significant financing component in accordance with paragraph 61 of
IFRS 15. The contract includes an implicit interest rate of 7.5%, which the entity considers commensurate
with the rate ‘that would be reflected in a separate financing transaction between the entity and its
customer at contract inception’ (IFRS 15, para. 64).
The entity recognises revenue when control of the land transfers to the customer, as the entity does not
expect to refund some or all of that consideration to the customer. At the time of transfer, the journal entry
would be as follows.

Dr Receivable 50 000
Cr Revenue 50 000

The interest revenue will be recognised over the next 24 months as interest receivable at the end of
each year as follows.

Dr Interest receivable 3 750

Cr Interest revenue 3 750
End of Year 1.

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 129

 Dr Interest receivable 4 031
Cr Interest revenue 4 031
End of Year 2.

The final journal entry at the end of year 2, when the amount of $57 781 is received, should be as follows.

Dr Cash 57 781
Cr Receivable 50 000
Cr Interest receivable 7 781

Source: Based on IFRS Foundation 2019, IFRS 15 Revenue from Contracts with Customers, in IFRS Standards issued at
1 January 2019, IFRS Foundation, London, p. B367.

Non-cash Consideration
Customer consideration might be in the form of goods, services or other forms of non-cash consideration.
When a customer promises consideration in a form other than cash, the non-cash consideration should
be measured at fair value according to IFRS 13 Fair Value Measurement and included in the transaction
price. When fair value cannot be reasonably estimated, the non-cash consideration is measured as the stand-
alone selling price of the goods or services promised to the customer in exchange for the consideration
(IFRS 15, paras 66 and 67).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 66–69 of IFRS 15.

Consideration Payable to a Customer

Consideration may be payable by entities to their customers:
• in exchange for a distinct good or service that the customer transfers to the entity, or
• as an incentive provided by the entity to the customer to encourage the customer to purchase a good
or service from the entity (e.g. a credit, coupon, voucher, or free product or service that can be applied
against amounts owed to the entity).
Consideration payable to a customer in exchange for a distinct good or service is accounted for in the
same way that the entity accounts for other purchases from suppliers. However, when the consideration
payable exceeds the fair value of the distinct good or service, the entity accounts for the excess as a
reduction of the transaction price owed to the entity. If the entity cannot reasonably estimate the fair value of
the distinct good or service, all the consideration payable is accounted for as a reduction of the transaction
price owed to the entity. The effect of a reduced transaction price is a reduction in the revenue ultimately
recognised by the entity.
Consideration payable to encourage the customer to purchase a good or service is accounted for as a
reduction of the transaction price owed to the entity. This reduction will reduce the revenue recognised
by the entity from its contract with the customer by the amount of consideration that is payable to
the customer.
Consideration is considered payable to the customer when the recipient of the consideration is another
party that purchased the entity’s goods or services from the customer. For example, a car manufacturer
that offers final consumers 12 months of free car servicing would account for this as a reduction of the
transaction price of the contract with the car dealer that sold the car to the final consumer.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may read paragraphs 70–72 of IFRS 15.

EXAMPLE 3.7

Consideration Payable to a Customer

An entity that produces breakfast cereals enters into a one-year contract to sell boxes of cereal to a
customer that is a large supermarket chain. The customer commits to buying $5 000 000 worth of cereal
during the year. The contract requires the entity to make a non-refundable payment of $500 000 to the

130 Financial Reporting

 customer at the inception of the contract to compensate the customer for the changes it needs to make
to its shelving to accommodate the cereal boxes.
The $500 000 payment is not made in exchange for a distinct good or service that the customer
transfers to the entity. As such, in accordance with paragraph 70 of IFRS 15, the $500 000 payment is a
reduction of the transaction price. The transaction price is therefore $4 500 000 ($5 000 000 – $500 000),
which will be recognised as revenue on satisfaction of the performance obligation(s) (see ‘Step 4:
Allocate the transaction price to each performance obligation’ and ‘Step 5: Recognise revenue when
each performance obligation is satisfied’).

STEP 4: ALLOCATE THE TRANSACTION PRICE TO EACH

PERFORMANCE OBLIGATION
Under this step, the transaction price of the contract (as determined under step 3) is allocated to each
separate performance obligation in the contract (as determined under step 2). For contracts with a single
performance obligation, the allocation process is simple: the entire transaction price relates to the single
performance obligation. It is when the contract contains more than one performance obligation that the
apportionment of the transaction price to each separate performance obligation is necessary.
Recall that each separate performance obligation in a contract relates to a distinct good or service.
An entity shall allocate the transaction price to each performance obligation based on the stand-alone
selling price of the distinct good or service. To do this, an entity determines the stand-alone selling price
of each distinct good or service underlying each performance obligation in the contract. Once all stand-
alone selling prices have been determined, the entity allocates the transaction price in proportion to those
stand-alone selling prices (IFRS 15, para. 76).
The stand-alone selling price is the price (at the time of entering into the contract) for which an entity
would sell the distinct good or service separately to a customer. The ‘best evidence’ of the stand-alone
selling price is ‘the observable price’ from stand-alone sales of that good or service to similar customers
(IFRS 15, para. 77). If a stand-alone selling price is not directly observable, entities must estimate that
price. IFRS 15 does not preclude or prescribe any particular method for estimating the stand-alone selling
price. The estimation method, however, must provide a faithful representation of the price at which the
entity would sell the distinct good or service separately to the customer. When estimating a stand-alone
selling price:
. . . an entity shall consider all information (including market conditions, entity-specific factors and
information about the customer or class of customer) that is reasonably available to the entity. In doing
so, an entity should maximise the use of observable inputs and apply estimation methods consistently in
similar circumstances (IFRS 15, para. 78).

Under paragraph 79 of IFRS 15, the three suitable estimation methods (illustrated in figure 3.2)
include the following.
• Adjusted market assessment approach: An entity evaluates the market in which it sells goods or
services and estimates the price customers would be willing to pay for those goods or services, whether
provided by the entity or a competitor. Under this approach, an entity focuses on market conditions,
including supply of and customer demand for, the good or service; competitor pricing for the same or
similar good or service; and the entity’s share of the market.
• Expected cost plus a margin approach: An entity forecasts its expected costs of satisfying a
performance obligation and then adds an appropriate margin for that good or service. Under this
approach, the entity primarily focuses on entity-specific factors, including its internal cost structure
and pricing strategies and practices.
• Residual approach: An entity estimates the stand-alone selling price as the total transaction price less
the sum of the observable stand-alone selling prices of other goods or services promised in the contract.
Under this approach, when all but one of the stand-alone selling prices of promised goods or services
is directly observable, the stand-alone selling price of the good or service that is not observable is the
difference between the total transaction price and the sum of directly observable stand-alone selling
prices. An entity, however, may only use the residual approach for a good or service with a highly
variable selling price. Otherwise, the selling price is uncertain because the good or service has not
previously been sold on a stand-alone basis.

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 131

 FIGURE 3.2 Suitable methods for estimating the stand-alone selling price of a good or service

(a) Suitable methods for estimating the stand-alone selling price of a good or service

Adjusted market Expected cost plus

assessment approach a margin approach Residual approach

Forecast expected
Estimate the stand-
Evaluate the market costs of satisfying a
alone selling price
performance obligation

Calculate total transaction

Estimate the price Add an price less the sum of
customers would pay appropriate margin the observable stand-
alone selling prices

(b) Factors that influence the stand-alone selling price estimate under each method

Adjusted market Expected cost plus

Residual approach
assessment approach a margin approach

Market conditions,
Entity-specific factors
supply and demand, High variable
such as internal cost
competitor pricing, selling price
structure and pricing
market share

Source: CPA Australia 2019.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may read paragraphs 76–79 of IFRS 15.

Allocation of a Discount
A discount exists when the sum of the stand-alone selling prices of the distinct goods or services in the
contract exceeds the promised consideration in a contract. Consistent with the proportionate allocation of
the transaction price to each performance obligation in the contract (as discussed previously), an entity
must allocate a discount proportionately to all performance obligations in the contract. However, if the
entity has observable evidence that the entire discount relates to one or more, but not all, performance
obligations in a contract, it will allocate the entire discount to those specific performance obligations
only (i.e. not to all obligations). The entity has observable evidence when both of the following criteria
are met.
• The entity regularly sells each (or bundles of each) distinct good or service in the contract on a stand-
alone basis and regularly at a discount to the stand-alone selling price.
• The discount in the contract is substantially the same as the discount regularly given on a stand-alone
basis.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may read paragraphs 81 and 82 of IFRS 15.

EXAMPLE 3.8

Allocating a Discount
An entity regularly sells scarves, gloves and woollen hats individually, thereby establishing the following
stand-alone selling prices.

132 Financial Reporting

 $
Scarves 40
Gloves 55
Hats 45
Total 140

In addition, the entity regularly sells gloves and hats together for $60.
The entity enters into a contract with a customer to sell all three products in exchange for $100. The entity
will satisfy the performance obligations of each of the products at different times. The contract includes a
discount of $40 on the overall transaction. Because the entity regularly sells gloves and hats together for
$60 and scarves for $40, it has observable evidence that the entire discount should be allocated to the
promises to transfer the gloves and hats (as per IFRS 15, para. 82).
If the entity transfers control of the gloves and hats at the same time, the entity could account for the
transfer of these products as a single performance obligation. As such, the entity could allocate $60 of
the transaction price to the single performance obligation and recognise revenue of $60 when the gloves
and hats simultaneously are transferred to the customer. When the entity transfers control of the scarves,
the entity can allocate $40 of the transaction price to this performance obligation and recognise revenue
of $40 at this time.
If the contract requires the entity to transfer control of the gloves and hats at different times, then the
allocated amount of $60 is allocated to the gloves and hats individually, based on their stand-alone selling
price. The amount of $40 is also allocated to the stand-alone selling price of the scarves. Allocations are
as follows.

Product Allocated transaction price

$
Gloves 33 ($55/$100 stand-alone selling price × $60)
Hats 27 ($45/$100 stand-alone selling price × $60)
Scarves 40
Total 100

Source: Based on IFRS Foundation 2019, IFRS 15 Revenue from Contracts with Customers, in IFRS Standards issued at
1 January 2019, IFRS Foundation, London, pp. B370–B372.

Allocation of Variable Consideration

Generally speaking, an entity is to allocate the variable consideration in a transaction price proportionately
to all performance obligations in the contract. IFRS 15, however, acknowledges that this may not always be
appropriate (IFRS 15, para. 84). For example, consider an entity that enters into a contract with a customer
to provide two distinct goods at different times. Each distinct good constitutes a separate performance
obligation. A bonus is payable by the customer to the entity on timely delivery of the second good. The
bonus constitutes variable consideration, and it would be inappropriate to allocate it to both performance
obligations given that it relates to the second performance obligation only.

STEP 5: RECOGNISE REVENUE WHEN EACH PERFORMANCE

OBLIGATION IS SATISFIED
Recall that, under step 4, an entity allocates the transaction price of the contract to each separate
performance obligation in the contract. Under step 5, the portion of the transaction price allocated to
a performance obligation is recognised as revenue when (or as) the entity satisfies that performance
obligation. Under IFRS 15, a performance obligation is satisfied when a promised good or service is
transferred to the customer. A good or service is considered to be transferred when the customer ‘obtains
control’ of that good or service (IFRS 15, para. 31). According to IFRS 15, a good or service is an asset
to a customer: the standard states, ‘control of an asset refers to the ability to direct the use of, and obtain
substantially all of the remaining benefits from, the asset’ (IFRS 15, para. 33). The benefits of an asset are
the potential cash inflows or savings in cash outflows obtained directly or indirectly from the asset.
Transferring control of a promised good or service (and, therefore, concurrently satisfying a performance
obligation) could occur over time or at a point in time. At the time of entering into a contract, an entity
must determine whether it will satisfy the performance obligation over time or at a point in time. If a
performance obligation will not meet the criteria to be satisfied over time, it is considered to be satisfied
at a point in time.

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 133

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 31–33 of IFRS 15.

Performance Obligations Satisfied Over Time

A performance obligation is satisfied over time if one of the following criteria is met:
(a) the customer simultaneously receives and consumes the benefits provided by the entity’s performance
as the entity performs;
(b) the entity’s performance creates or enhances an asset that the customer controls as the asset is created
or enhanced; or
(c) the entity’s performance does not create an asset with an alternative use to the entity and the entity has
an enforceable right to payment for performance completed to date (IFRS 15, para. 35).

If any of these three criteria are met, the entity transfers control of the good or service over time while
concurrently satisfying the performance obligation. The transaction price allocated to the performance
obligation is recognised as revenue gradually as the performance obligation is increasingly completed
over time. Each criterion will now be examined in turn.
Customer Simultaneously Receives and Consumes the Benefits of the Entity’s Performance
This criterion implies that the entity’s performance creates an asset only momentarily, as the asset is
simultaneously created, received and consumed by the customer while the entity performs. As such, this
criterion applies only to services and not goods, as a customer cannot simultaneously receive and consume
a good while it is being produced. Not all service-type performance obligations, however, provide benefits
that are simultaneously received and consumed by the customer while the entity performs. For instance,
asset managers are unlikely to recognise performance fees in full until they are crystallised or no longer
subject to claw-back. In those types of situations, this criterion does not apply.
For some service-type performance obligations, the customer’s receipt and simultaneous consumption
of the benefits of the entity’s performance can be readily identified. Examples include performance
obligations where routine or recurring services are promised, such as cleaning services or transaction
processing services (IFRS 15, para. B3). For other service-type performance obligations, it may be unclear
whether the customer simultaneously receives and consumes the benefits of the entity’s performance over
time. If unclear, the entity will determine whether another entity would need to substantially re-perform
the work it has completed to date if that other entity were to fulfil the remaining performance obligation
to the customer. If substantial re-performance is not required, the performance obligation is satisfied over
time (IFRS 15, para. B4).
Customer Controls the Asset as it is Being Created or Enhanced
Under this criterion, control of an asset is transferred over time if the entity’s performance creates or
enhances an asset that a customer controls as the asset is created or enhanced. The meaning of ‘control’ is
the same as that discussed earlier. The asset being created or enhanced can be either tangible or intangible.
For example, an entity enters into a contract with a single performance obligation to construct a building
on the customer’s land. In that case, the customer generally controls any work in progress as the building
is constructed. Because the customer controls the work in progress, it is obtaining benefits of the goods
and services the entity is providing. As a result, the performance obligation is satisfied over time.
Entity’s Performance does not Create an Asset with an Alternative Use, and the Entity has a Right to
Payment for Performance Completed to Date
This criterion has two components: (1) the entity’s performance does not create an asset with an alternative
use to the entity; and (2) the entity has an enforceable right to payment for performance completed to date.
Both components must be present for this criterion to be met. Each component will now be considered
in turn.
Alternative use
When the entity’s performance creates an asset with an alternative use to the entity, the entity could direct
the asset to another customer. The customer does not control the asset as it is being created because it
cannot restrict the entity from directing that asset to another customer. An example of alternative use
is the production of identical inventory items that the entity can substitute across different contracts
with customers.

134 Financial Reporting

 The entity is less likely to have an alternative use for a highly customised asset that is created for a
customer. The entity would likely need to incur significant costs to rework the asset for another customer,
or need to sell it at a significantly reduced price. As a result, control of the asset could be considered to be
transferred over time (provided the entity also has a right to payment for performance completed to date).
Right to payment
Once it has been established that the asset does not have an alternative use to the entity, the entity must
have a right to payment for performance completed to date. An entity has a right to payment if it is entitled
to an amount that compensates it for its performance completed to date should the customer or another
party terminate the contract for reasons other than the entity’s failure to perform as promised.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 35–37 of IFRS 15.

Measuring Progress on Performance Obligations Satisfied Over Time

When an entity determines that a performance obligation is satisfied over time (i.e. any of the three criteria
in IFRS 15, paragraph 35, are met), the entity ‘shall recognise revenue over time by measuring the progress
towards complete satisfaction of that performance obligation’ (IFRS 15, para. 39). An entity applies a
single method of measuring progress for each performance obligation, with the chosen method being the
one that best depicts the ‘entity’s performance in transferring control of goods or services promised to a
customer’ (IFRS 15, para. 39). According to paragraph 40 of IFRS 15, once the method has been chosen,
an entity cannot change the method of measuring progress and must apply it consistently from inception
until complete satisfaction of the performance obligation.
IFRS 15 specifies two types of methods of measuring progress on performance obligations that are
satisfied over time: output methods and input methods. In choosing an appropriate method for measuring
progress, an entity must consider the nature of the good or service that it promised to transfer to the
customer (IFRS 15, para. 41). Output methods recognise revenue based on direct measurements of
the value (to the customer) of the goods or services transferred to date relative to the remaining goods
or services promised under the contract. Examples of output methods include surveying performance
completed to date, appraising results or milestones achieved, determining time elapsed under the contract
and measuring units produced or delivered to date (IFRS 15, para. B15).
Input methods recognise revenue based on the entity’s efforts or inputs towards satisfying a perfor-
mance obligation relative to the total expected inputs to satisfy the performance obligation. Examples of
input methods include measuring (to date) resources consumed, labour hours expended, costs incurred,
time elapsed under the contract or machine hours used (IFRS 15, para. B18).
Using the chosen output or input method, at the end of each reporting period, an entity measures its
progress towards complete satisfaction of a performance obligation satisfied over time. When an entity
is closer to completely satisfying the performance obligation than the previous period, the change in the
measure of progress is recognised as revenue in the current reporting period. The change in the measure of
progress is also disclosed as a change in estimate in accordance with IAS 8 Accounting Policies, Changes
in Accounting Estimates and Errors (IAS 8).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 39–43 of IFRS 15.

Performance Obligations Satisfied at a Point in Time

If none of the three criteria for recognising revenue over time are met, an entity must recognise revenue
at a point in time. The time to recognise revenue is when the entity transfers control of the asset to the
customer. The meaning of ‘control’ is the same as that discussed earlier. At the time control is transferred,
the performance obligation is satisfied.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraph 38 of IFRS 15.

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 135

 EXAMPLE 3.9

Determining Whether a Performance Obligation is Satisfied Over Time

or at a Point in Time
An entity enters into a contract with a customer to provide a consulting service on how to improve pro-
duction process efficiency and, on completing the consultation, a final recommendation. The consulting
service with final recommendation constitutes a single performance obligation. The customer benefits
from the entity’s performance once complete and the final recommendation is made; benefit does not
occur while the entity performs. As such, the customer does not simultaneously receive and consume the
benefits provided by the entity’s performance as the entity performs, per paragraph 35(a) of IFRS 15. As
this criterion is not satisfied, the performance obligation is not satisfied over time but, rather, at a point in
time. The entity recognises revenue on completing the consultation.

3.2 CONTRACT COSTS

In certain instances, IFRS 15 permits an entity to recognise the following as assets:
1. the incremental costs of obtaining a contract with a customer
2. the costs to fulfil a contract with a customer.
Each of these types of contract costs will now be considered in turn.

INCREMENTAL COSTS OF OBTAINING A CONTRACT

Under paragraph 91 of IFRS 15, the incremental costs of obtaining a contract shall be recognised as an asset
if the entity expects to recover those costs. There are two aspects to this recognition requirement. First,
the costs of obtaining a contract are ‘incremental’, and, second, the entity expects to recover these costs.
Costs of obtaining a contract are incremental if they would not have been incurred had the contract not
been obtained (IFRS 15, para. 92), while recovery of these costs may be either direct (i.e. reimbursement
by the customer under the terms of the contract) or indirect (i.e. incorporated into the profit margin of the
contract). Costs of obtaining a contract that are not incremental (i.e. costs incurred regardless of whether
the contract was obtained) are recognised as an expense when incurred, unless they are chargeable to the
customer regardless of whether the contract is obtained (IFRS 15, para. 93).
For expediency, IFRS 15 permits an entity to recognise the incremental costs of obtaining a contract as
an expense when those costs are incurred, even though they would otherwise qualify for asset recognition
if the asset’s amortisation period is up to one year (IFRS 15, para. 94).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 91–94 of IFRS 15.

QUESTION 3.4

A consulting services entity wins a tender process to provide consulting services to a new customer.
The contract is for two years with an option for the entity to extend the contract for another year.
The entity intends on exercising this option. The entity incurs the following costs to obtain the
contract.

$
Legal fees to lodge tender 25 000
Travel costs to deliver proposal 20 000
Sales commission to employees for obtaining the contract 12 500
Total costs incurred 57 500

As part of the agreement with the lawyer involved in preparing the tender, $10 000 is payable
regardless of whether the tender is successful. The remaining $15 000 in legal fees becomes
payable on the success of the tender. All legal fees are borne by the entity and not recoverable

136 Financial Reporting

 from the customer. What amount should the entity recognise as an asset for the incremental costs
of obtaining the contract?

Source: Based on IFRS Foundation 2019, IFRS 15 Revenue from Contracts with Customers, in IFRS Standards issued at
1 January 2019, IFRS Foundation, London, p. B376.

COSTS TO FULFIL A CONTRACT

In determining the accounting treatment for costs incurred in fulfilling a contract with a customer, an entity
must first establish whether these costs are within the scope of another standard. If the costs incurred
are within the scope of another standard, IFRS 15 states that an entity shall account for those costs in
accordance with that standard (IFRS 15, para. 96). IFRS 15 provides examples of other standards that may
apply to costs incurred in fulfilling a contract, including IAS 2 Inventories, IAS 16 Property, Plant and
Equipment and IAS 38 Intangible Assets.
If the costs incurred are not within the scope of another standard, an entity recognises an asset from the
incurred costs only if all of the following criteria are met:
• the costs ‘relate directly to a contract or to an anticipated contract that the entity can specifically identify’
(e.g. direct labour, direct materials, allocation of overheads that relate directly to the contract, costs
explicitly chargeable to the customer under the contract, and other costs that are incurred only because
an entity entered into the contract)
• the costs ‘generate or enhance resources of the entity that will be used in satisfying . . . performance
obligations in the future’
• the costs ‘are expected to be recovered’ (IFRS 15, para. 95).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 95–98 of IFRS 15.

AMORTISATION AND IMPAIRMENT

Under IFRS 15, an asset recognised from the incremental costs of obtaining a contract or from the costs
to fulfil a contract is subject to amortisation and impairment. Amortisation shall occur ‘on a systematic
basis that is consistent with the transfer to the customer of the goods or services to which the asset relates’
(IFRS 15, para. 99). Generally speaking, unless the asset relates to a particular performance obligation
within the contract, the amortisation period will be the life of the contract. When there is a significant
change in the entity’s expected timing of transfer to the customer of the goods or services to which the
asset relates, the entity updates the amortisation to reflect the change. This may arise, for example, if the
entity renews a contract for an additional period that was not anticipated at contract inception. This type
of change is accounted for as a change in accounting estimate under IAS 8 (IFRS 15, para. 100).
An entity recognises an impairment loss to the extent that the carrying amount of the asset that is
recognised exceeds ‘the remaining amount of consideration that the entity expects to receive in exchange
for the goods or services to which the asset relates’, less the yet-to-be-incurred costs ‘that relate directly
to providing those goods or services’ (IFRS 15, para. 101). When an entity determines the amount of
consideration it expects to receive, the principles for determining the transaction price are to be used (see
‘Step 3: Determine the transaction price of the contract’).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 99–102 of IFRS 15.

EXAMPLE 3.10

Determining the Amortisation Period of an Asset Recognised for

Contract Costs
Based on the information provided in question 3.4, the amortisation period for the asset recognised is
three years. This is consistent with the transfer of services to the customer to which the asset relates, as

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 137

 the entity intends on extending the contract at contract inception. Given the asset amount ($12 500) and
amortisation period (three years), amortisation is $4167 per year.
If the entity does not exercise the option to extend the contract at the end of the second year,
the remaining unamortised amount will be amortised immediately and accounted for as a change in
accounting estimate under IAS 8.

3.3 DISCLOSURE
As discussed in the Introduction, before IFRS 15, it has been argued that disclosures made by entities
under previous IFRSs in relation to revenue were inadequate for financial statement users to understand
the entity’s revenue recognition practices. Entities’ revenue-related disclosures were criticised for being
generic or boilerplate in nature, in that they provided little information that was useful to users,
including insufficient explanations of the judgments and estimates made in recognising that revenue or
the relationship between the revenue recognised and other financial statement information.
To overcome these deficiencies, the objective of the IFRS 15 disclosure requirements is:
. . . for an entity to disclose sufficient information to enable users of financial statements to understand the
nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers
(IFRS 15, para. 110).

To achieve this objective, IFRS 15 requires an entity to disclose qualitative and quantitative information
about all of the following:
• its contracts with customers
• the significant judgments, and changes in judgments, made in applying IFRS 15 to those contracts
• any assets recognised from the incremental costs of obtaining a contract or the costs to fulfil a contract.
Each of these disclosure requirements is now examined in turn.

CONTRACTS WITH CUSTOMERS

The majority of the disclosures required under IFRS 15 relate to an entity’s contracts with customers. In
relation to contracts with customers, an entity must disclose disaggregated revenue from contracts with
customers, contract balances, performance obligations and the transaction price allocated to remaining
performance obligations.

Disaggregation of Revenue
Under IFRS 15, an entity must disclose revenue recognised from contracts with customers that has been
disaggregated into categories ‘that depict how the nature, amount, timing, and uncertainty of revenue
and cash flows are affected by economic factors’ (IFRS 15, para. 114). IFRS 15 provides guidance on
how entities might disaggregate revenue for financial statement users to assist users in understanding
the composition of revenue from contracts with customers that is recognised in the current period. This
guidance includes the following examples of categories:
(a) type of good or service (for example, major product lines);
(b) geographical region (for example, country or region);
(c) market or type of customer (for example, government and non-government customers);
(d) type of contract (for example, fixed-price and time-and-materials contracts);
(e) contract duration (for example, short-term and long-term contracts);
(f)timing of transfer of goods or services (for example, revenue from goods or services transferred to
customers at a point in time and revenue from goods or services transferred over time); and
(g) sales channels (for example, goods sold directly to consumers and goods sold through intermediaries)
(IFRS 15, para. B89).

Contract Balances
In relation to contract balances, an entity must disclose all of the following:
• the opening and closing balances of receivables, contract assets and contract liabilities from contracts
with customers
• revenue recognised in the reporting period that was included in the contract liabilities opening balance

138 Financial Reporting

• revenue recognised in the reporting period from performance obligations that were either completely or
partially satisfied in previous periods (IFRS 15, para. 116).
A contract liability arises when an entity has received consideration (or has an unconditional right to
receive consideration from the customer before the entity transfers a good or service to the customer. It is
the obligation to transfer the good or service that is a contract liability. The unconditional right to receive
compensation from a customer constitutes a receivable. Further, ‘[a] right to consideration is unconditional
if only the passage of time is required before payment of that consideration is due’ (IFRS 15, para. 108).
This is distinct from a contract asset, which is ‘[a]n entity’s right to consideration in exchange for goods
or services that the entity has transferred to a customer when that right is conditioned on something other
than the passage of time (for example, the entity’s future performance)’ (IFRS 15, Appendix A). IFRS 15
makes the distinction between receivables and contract assets to enable users to differentiate between an
unconditional and conditional right to receive consideration.
Disclosures about an entity’s contract balances help users understand the relationship between the
revenue recognised and changes in the balances of an entity’s contract assets and liabilities during a
reporting period (IFRS 15 Basis for Conclusions, para. BC341). For example, disclosing the opening
balances of contract liabilities will help users understand the amount of revenue that will be recognised
during the current period, while disclosing the opening balances of contract assets will provide them with
an understanding of the amounts that will be transferred to accounts receivable or collected as cash during
the period (IFRS 15 Basis for Conclusions, para. BC343).

Performance Obligations
In relation to performance obligations, an entity must disclose a description of all of the following:
• ‘when the entity typically satisfies its performance obligations’ (e.g. on shipment, on delivery, as services
are rendered or when they are completed)
• ‘the significant payment terms’ (e.g. when payment is due, whether the contract includes a significant
financing component, and whether the amount of consideration is variable or its estimate is constrained)
• ‘the nature of the goods or services that the entity has promised to transfer’
• ‘obligations for returns, refunds and other similar obligations’
• ‘types of warranties and related obligations’ (IFRS 15, para. 119).

Transaction Price Allocated to Remaining Performance Obligations

The final disclosure requirement related to contracts with customers requires an entity to disclose the
amount of the transaction price that is allocated to the unsatisfied performance obligations in a contract
(whether partial or complete) at the end of the reporting period. An entity must also provide an explanation
of when it expects to recognise as revenue the transaction price amount allocated to the unsatisfied
performance obligations. This explanation can be either quantitative (e.g. amounts to be recognised as
revenue according to specified time bands) or qualitative (IFRS 15, para. 120).
These disclosure requirements provide users with information about the amount and timing of revenue
that an entity expects to recognise from the remaining performance obligations in its existing contracts
with customers (IFRS 15 Basis for Conclusions, para. BC350).

EXAMPLE 3.11

Disclosure of the Transaction Price Allocated to Remaining

Performance Obligations
On 30 June 20X6, an entity enters into a three-year contract with a customer to provide office maintenance
services. The services are to be provided as and when needed, capped at a maximum of two visits per
month over the next three years. The customer pays a fixed amount of $300 per month for the services.
The transaction price of the contract is $10 800. The performance obligation under the contract is satisfied
over time, and the entity uses a time-based output method in measuring progress towards complete
satisfaction of the performance obligation.
In accordance with paragraph 120 of IFRS 15, the entity is required to disclose at the end of each
reporting period the amount of the transaction price allocated to the unsatisfied performance obligation,
which is yet to be recognised as revenue. The entity chooses to explain when it expects to recognise the
amount as revenue using quantitative time bands. As such, for the reporting period ending 31 December
20X6, the following information is disclosed.

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 139

 20X7 20X8 20X9 Total
$ $ $ $

Revenue expected to be recognised on this contract

as of 31 December 20X6 3600† 3600† 1800‡ 9000

† $300 per month × 12 months

‡ $300 per month × 6 months

Source: Based on IFRS Foundation 2019, IFRS 15 Revenue from Contracts with Customers, in IFRS Standards issued at
1 January 2019, IFRS Foundation, London, pp. B381–B382.

SIGNIFICANT JUDGMENTS IN THE APPLICATION OF IFRS 15

REVENUE FROM CONTRACTS WITH CUSTOMERS
An entity is required to disclose and explain the judgments and changes in judgments used to deter-
mine the:
• ‘timing of satisfaction of performance obligations’
• ‘transaction price and amounts allocated to performance obligations’ (IFRS 15, para. 123).
Disclosure of the estimates and judgments made by an entity in determining the transaction price,
allocating the transaction price to performance obligations, and determining when performance obligations
are satisfied allows users to assess the quality of earnings reported by the entity.

ASSETS RECOGNISED FROM CONTRACT COSTS

In relation to assets recognised from the costs to obtain or fulfil a contract with a customer, an entity must:
• provide a description of the judgments made in determining the amount of the costs, and of the
amortisation method used for each reporting period
• disclose the closing balances of the assets recognised
• disclose the amount of amortisation and any impairment losses recognised in the reporting period
(IFRS 15, paras 127 and 128).
Refer to Note 2 ‘Income’ in the notes to financial statements of Techworks Ltd. What is the
disaggregated revenue of Techworks?

SUMMARY
This part focused on accounting for revenue from contracts with customers under IFRS 15.
Previous revenue standards have been criticised for a lack of comparability in the revenue recognition
practices being used by entities and the disclosure of insufficient revenue-related information. A conse-
quence of these shortcomings has been that financial statement users have been unable to make consistent
and accurate assessments about an entity’s revenue-earning activities.
As a key indicator of an entity’s, and management’s, performance is the revenue it generates, it is
important for users and preparers of financial statements to have an understanding of how revenue is
to be measured and recognised in the entity’s financial statements. By introducing a five-step model of
revenue recognition capable of general application to a variety of transactions and by requiring more
detailed revenue-related disclosures, IFRS 15 enhances the financial reporting of revenue.
IFRS 15 establishes principles for reporting useful information to financial statement users about the
nature, amount, timing and uncertainty of revenue and cash flows from an entity’s contracts with customers.
These principles provide a framework of broad revenue recognition concepts that can be consistently
applied across entities and encourage providing information to users so that they can make informed
assessments of an entity’s performance relative to other entities.
The key points covered in this part, and the learning objectives they align to, are as follows.

140 Financial Reporting

KEY POINTS

3.1 Explain and apply the requirements of IFRS 15 with respect to contract(s) with customers.
• The core principle of IFRS 15 is that an entity should 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 in exchange for those goods or services.
• The five-step recognition model for revenue from contracts with customers is as follows.
– Step 1: Identify the contract(s) with the customer.
– Step 2: Identify the performance obligation(s) in the contract.
– Step 3: Determine the transaction price of the contract.
– Step 4: Allocate the transaction price to each performance obligation.
– Step 5: Recognise revenue when each performance obligation is satisfied.
• Assets recognised from the incremental costs of obtaining a contract or from the costs to fulfil a
contract are subject to amortisation and impairment.
• The objective of disclosure requirements under IFRS 15 is for an entity to disclose sufficient
information to enable users of financial statements to understand the nature, amount, timing and
uncertainty of revenue and cash flows arising from contracts with customers.
3.2 Determine and allocate the transaction price of a contract to the performance obligation(s) of
the contract.
• The transaction price is the amount of consideration an entity expects to be entitled to in exchange
for transferring promised goods or services to a customer.
• The transaction price excludes amounts collected on behalf of third parties, such at the Goods and
Services Tax in Australia.
• The transaction price may be affected by the nature, timing and amount of consideration promised
by a customer. The following can affect the transaction price: variable consideration, the existence
of a significant financing component in the contract, non-cash consideration, and the consideration
that is payable to a customer.
• There are three methods suitable for estimating the stand-alone selling price: adjusted market
assessment approach; expected cost plus a margin approach; and residual approach.
• Output methods and input methods are the two types of methods of measuring progress on
performance obligations that are satisfied over a period of time.

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 141

PART B: PROVISIONS
INTRODUCTION
Part B reviews issues relating to the recognition, measurement and disclosure of provisions, including
the requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets (IAS 37). IAS 37
outlines specific existence, recognition and measurement criteria to be applied to provisions; it also requires
extensive disclosures. The recognition of provisions, and the disclosure of information about their nature
and the timing, amount and likelihood of any resulting outflows, provides financial statement users with
a greater understanding of an entity’s existing obligations. However, opportunities exist for managers to
exploit the uncertainty and subjectivity of provisions when recognising and measuring them, in order to
manipulate reported accounting numbers.
This part begins with the definition of a provision, followed by a discussion on key aspects of
the recognition of provisions. Measurement issues are then discussed, including how to deal with risks
and uncertainties, as well as the use of probability in measurement. Part B concludes with a discussion on
disclosure requirements relating to provisions.

Relevant Paragraphs
To assist in understanding of certain sections in this part, you may be referred to relevant paragraphs in
IAS 37. You may wish to read these paragraphs as directed.
IAS 37 Provisions, Contingent Liabilities and Contingent Assets:
Subject Paragraphs
Scope 1–9
Definitions 10–13
Recognition 14–35
Measurement 36–52
Disclosure 84–92

SCOPE OF IAS 37 PROVISIONS, CONTINGENT LIABILITIES

AND CONTINGENT ASSETS
IAS 37 applies to all provisions (and to contingent liabilities and contingent assets discussed in part C)
other than those that:
• result from executory contracts, except for onerous contracts
• are covered by another standard (IAS 37, para. 1).
Executory contracts are ‘contracts under which neither party has performed any of its obligations or
both parties have partially performed their obligations to an equal extent’ (IAS 37, para. 3).
Importantly, IAS 37 ‘does not apply to financial instruments (including guarantees) that are within the
scope of IFRS 9 Financial Instruments’ (IAS 37, para. 2). Financial instruments are covered in module 6.
Other provisions, contingent liabilities and contingent assets that are covered by other standards are:
• income taxes (IAS 12 Income Taxes)
• leases (IFRS 16 Leases), except any lease that becomes onerous before its commencement date,
or short-term leases and leases where the underlying asset is of low value and that the lease has
become onerous
• employee benefits (IAS 19 Employee Benefits)
• insurance contracts within the scope of IFRS 17 Insurance Contracts. For example, product warranties
issued by another party for goods sold by a manufacturer, dealer or retailer (IFRS 17, para. B26(g))
• contingent consideration of an acquirer in a business combination (IFRS 3 Business Combinations)
• revenue from contracts with customers (IFRS 15 Revenue from Contracts with Customers) (IAS 37,
para. 5).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 1–9 of IAS 37.

142 Financial Reporting

DEFINITION OF PROVISIONS
Provisions are a subset of liabilities; therefore, to properly understand provisions, it is helpful to revisit
the definition of a liability. The IASB Conceptual Framework for Financial Reporting (Conceptual
Framework) defines a liability as:
. . . a present obligation of the entity to transfer an economic resource as a result of past events (Conceptual
Framework, para. 4.26).

A provision is defined in IAS 37 as a ‘liability of uncertain timing or amount’ (IAS 37, para. 10). A key
aspect of this definition is the requirement that uncertainty exists. However, not all uncertainties give rise
to a provision. An estimate of timing or amount does not automatically result in uncertainty. For example,
estimates used to determine the depreciation of property, plant and equipment over the period of use do
not make depreciation a provision. The precise pattern in which economic benefits are consumed may be
uncertain, but the fact that economic benefits of the asset will eventually be consumed is not uncertain.
When there is a significant level of certainty (i.e. an insignificant level of uncertainty), the amount is
not recognised as a provision but as a liability. Examples of these types of liabilities are borrowings, trade
creditors and accruals.
In cases where the degree of uncertainty in relation to the timing or amount of the liability cannot be
measured with sufficient reliability, the amount is classified as a contingent liability (discussed in part C
of this module).

QUESTION 3.5

With reference to the scope of IAS 37 and the definition of a provision, identify which of the following
is likely to be a provision within the scope of IAS 37, and which is likely to be another form of liability
and explain why.
• An obligation to repair or replace goods sold if they are determined to be faulty
• A warranty provided for a television sold by a retailer
• Annual leave

3.4 RECOGNITION OF PROVISIONS

IAS 37 requires the following conditions to be met for a provision to be recognised:
(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required to settle the
obligation; and
(c) a reliable estimate can be made of the amount of the obligation (IAS 37, para. 14).

Present Obligation and Past Event

The first recognition criterion in paragraph 14 of IAS 37 requires the entity to have a present obligation
‘as a result of a past event’. The importance of this recognition criterion was outlined by the G4+1 Group
of accounting standard setters:
If the trigger point for recognition is set too early, the result would be to recognise a liability and an expense
where none exist, thus reducing the relevance and reliability of the financial statements. A provision could
be recognised for expenditures that, in the event, are never made. The effect would be to misstate both the
entity’s financial position (by recording a liability that does not actually exist) and its financial performance
(by recognising an expense in one accounting period and income in another in relation to amounts that are
never actually paid or received).
Conversely, it would be incorrect not to provide for expenditures that are clearly unavoidable, result
from past events, and are measurable with a high degree of reliability simply on the grounds that the
outflow of cash or other resources will not occur until a future date. Failure to recognise a provision in
such circumstances would result in the financial statements not portraying faithfully either the expenses
incurred in the accounting period or the liabilities of the entity at the statement of financial position date.

Source: Lennard, A. & Thompson, S. 1995, Provisions: Their Recognition, Measurement and Disclosure in Financial Statements,
Financial Accounting Standards Board, Norwalk, paras 2.1.5–6. © Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT
06856, USA. Reproduced with permission.

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 143

 The standard setters believed that it will normally be clear whether a past event has given rise to a present
obligation that should be recognised in the statement of financial position. However, in rare cases it may
not be clear whether a present obligation exists. In such cases, IAS 37 provides the following guidance:
[A] past event is deemed to give rise to a present obligation if, taking account of all available evidence, it
is more likely than not that a present obligation exists at the end of the reporting period (IAS 37, para. 15).

Such evidence is not limited only to what is available at the closing date of the financial statements; it
specifically includes information from events that may occur between the end of the reporting period and
the time of completion of the financial report.
The Conceptual Framework notes that an obligation ‘is a duty or responsibility that an entity has no
practical ability to avoid.’ (Conceptual Framework, para. 4.29). Obligations may be legally enforceable
as a consequence of a binding contract or statutory requirement (Conceptual Framework, para. 4.31). The
obligation must involve another party to whom the obligation is owed — that is, a third party. For a present
obligation to exist, the entity must have no realistic alternative to settling the obligation created by the
event (IAS 37, para. 17).
The most common form of present obligation is a legal obligation, in which an external party has a
present legal right to force the entity to pay or perform. However, it may also be a constructive obligation
to the extent that there is a valid expectation in other parties that the entity will discharge the obligation.
Consistent with the Conceptual Framework definition of a liability, a constructive obligation is defined in
IAS 37 as:
. . . an obligation that derives from an entity’s actions where:
(a) by an established pattern of past practice, published policies or a sufficiently specific current statement,
the entity has indicated to other parties that it will accept certain responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of those other parties that it will
discharge those responsibilities (IAS 37, para. 10).

By including constructive obligations as a form of present obligation, the Conceptual Framework

extends the definition of liabilities beyond the issue of legal enforceability (Conceptual Framework,
para. 4.31). The definition includes liabilities arising from normal business practice or custom, a desire to
maintain good business relations or a desire to act in an equitable manner (e.g. habitually providing staff
with bonus payments or performing environmental remediation to a standard higher than that required by
law), but not from a contractual agreement with another entity.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 15–22 of IAS 37, as well as the implementation
guidance — ‘Guidance on Implementing IAS 37’, ‘C. Examples: recognition’, ‘Example 2B. Contaminated land and
constructive obligation’ — in the IFRS Compilation Handbook.

Probable Outflow of Economic Benefits

The second criterion in paragraph 14 of IAS 37 for the recognition of provisions is that ‘it is probable that
an outflow of resources embodying economic benefits will be required to settle the obligation’. This occurs
when the outflow of resources or another event is more likely than not to occur. That is, ‘the probability
that the event will occur is greater than the probability that it will not’ (IAS 37, para. 23). Where there
are a number of similar obligations, such as warranty obligations arising from product sales, the class of
obligations is considered as a whole in determining whether an outflow of resources is probable (IAS 37,
para. 24).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 23 and 24 of IAS 37.

Reliable Measurement
The third recognition criterion in paragraph 14 of IAS 37 is that ‘a reliable estimate can be made
of the amount of the obligation’. IAS 37 notes that:
. . . except in extremely rare cases, an entity will be able to determine a range of possible outcomes and can
therefore make an estimate of the obligation that is sufficiently reliable to use in recognising a provision
(IAS 37, para. 25).

144 Financial Reporting

 Consequently, a provision is considered to be capable of being reliably measured even if a number of
possible outcomes exist.
The use of reasonable estimates is an essential part of the preparation of financial statements and does
not undermine the usefulness of the statements (Conceptual Framework, para. 5.19).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 25 and 26 of IAS 37.

QUESTION 3.6

A manufacturer gives warranties at the time of sale to purchasers of its product. Under the
terms of the contract for sale, the manufacturer undertakes to remedy, by repair or replacement,
manufacturing defects that become apparent within three years from the date of sale. As this is the
first year that the warranty has been available, there is no data from the entity to indicate whether
there will be claims under the warranties. However, industry research suggests that it is likely that
such claims will be forthcoming.
Should the manufacturer recognise a provision in accordance with the requirements of IAS 37?
Why or why not?

3.5 MEASUREMENT OF PROVISIONS

One of the more difficult aspects of accounting for provisions is determining the amount to be recognised
in the financial statements given the inherent uncertainty surrounding provisions.
As the actual amount of sacrifice of economic resources is often not known with certainty (by definition),
estimates of the provisions are required to be made.
IAS 37 requires that:
. . . the amount recognised as a provision shall be the best estimate of the expenditure required to settle the
present obligation at the end of the reporting period (IAS 37, para. 36).

The best estimate is the amount that an entity would rationally pay either to settle the obligation at
that date or to transfer it to a third party at that time. The estimation requirements differ depending on
whether the provision involves a large population of items or a single obligation, and are outlined in IAS 37
as follows.
• ‘Where the provision being measured involves a large population of items, the obligation is estimated by
weighting all possible outcomes by their associated probabilities. The name for this statistical method
of estimation is “expected value”’ (IAS 37, para. 39).
• ‘Where a single obligation is being measured, the individual most likely outcome may be the best
estimate of the liability’ (IAS 37, para. 40).
With regard to determining best estimates, IAS 37 suggests that the most appropriate estimate of the
provision is determined by using:
. . . the judgement of the management of the entity, supplemented by experience of similar transactions and,
in some cases, reports from independent experts. The evidence considered includes any additional evidence
provided by events after the reporting period (IAS 37, para. 38).

IAS 37 states that ‘where there is a continuous range of possible outcomes, and each point in that range
is as likely as any other, the mid-point of the range is used’ (IAS 37, para. 39).
These criteria are consistent with the enhancing qualitative characteristic of verifiability. As noted in
paragraph 2.30 of the Conceptual Framework, ‘quantified information need not be a single point estimate
to be verifiable. A range of possible amounts and the related probabilities can also be verified’.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 36–40 of IAS 37.

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 145

 EXAMPLE 3.12

Calculation of Best Estimate

Part A: Large population of items
An entity faces 100 warranty claims relating to a faulty widget. The entity’s management has determined
there is 30% likelihood that each of these claims is unsubstantiated and will not cost the entity anything.
There is 70% likelihood that the cost of each claim will be $100.
According to the expected value method, the best estimate of the provision can be calculated as
70% × 100 × $100 = $7000.
Part B: Single obligation
Now assume that the same entity is facing a single warranty claim with the same probabilities as in part A.
In such circumstances, IAS 37 requires the individual most likely outcome be used to calculate the amount
of the provision. In this example, the most likely outcome is that $100 will be paid to settle the warranty
claim. As such, the cost of $100 is the most likely outcome because it has a 70% chance of occurring,
whereas there is a 30% chance of no payout being required.
Therefore, $100 would be the amount required to be recognised in accordance with IAS 37.

DISCOUNTING
Example 3.12 ignored the effect of discounting. However, IAS 37 requires that:
. . . where the effect of the time value of money is material, the amount of a provision shall be the present
value of the expenditures expected to be required to settle the obligation (IAS 37, para. 45).

Consequently, provisions are discounted when the effect of this discounting is material. The discount
rate should be a pre-tax rate that reflects ‘current market assessments of the time value of money and the
risks specific to the liability. The discount rate(s) shall not reflect risks for which the future cash flow
estimates have been adjusted’ (IAS 37, para. 47).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 45–47 of IAS 37.

IAS 37 also notes that risks and uncertainties should be taken into account in reaching the best estimate
of a provision. It cautions, however, that ‘uncertainty does not justify the creation of excessive provisions
or a deliberate overstatement of liabilities’ (IAS 37, para. 43).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 42–44 of IAS 37.

It should be noted that when the sacrifice of economic resources depends on the use of technology
(for example, for cleaning up a site in the future), the estimated amount should be based on the existing
technology (IAS 37, para. 49). Even if the technology is normally expected to improve over time and new
technologies will likely decrease the costs necessary to perform a specific action required, IAS 37 does
not allow entities to estimate the amount recognised for provisions based on expected costs to be incurred
with technologies that do not exist at the time the estimation is made.

QUESTION 3.7

Refer to the background material in question 3.6.

The entity has now been operating its warranty for five years, and reliable data exists to suggest
the following.
• If minor defects occur in all products sold, repair costs of $2 million would result.
• If major defects are detected in all products, costs of $5 million would result.
• The manufacturer’s past experience and future expectations indicate that each year 80% of the
goods sold will have no defects, 15% of the goods sold will have minor defects, and 5% of the
goods sold will have major defects.
Calculate the expected value of the cost of repairs in accordance with the requirements of IAS 37.
Ignore both income tax and the effect of discounting.

146 Financial Reporting

3.6 IAS 37 PROVISIONS, CONTINGENT LIABILITIES
AND CONTINGENT ASSETS: DISCLOSURE
PROVISIONS
IAS 37 includes a number of disclosure requirements relating to provisions, which assist financial
statement users to understand the reasons, uncertainty and subjectivity behind the recognised end-of-
period carrying amount. As discussed in greater detail shortly, subjectivity in recognising and measuring
provisions makes them a potential tool for entities to manage their earnings, where earnings management
is the manipulation of revenue and expense to smooth out profit fluctuations or to achieve a predetermined
(and often an overstated) profit result. The disclosure requirements of IAS 37 aim to reduce the ability of
entities to use provisions as a means of earnings management. The key disclosures required by IAS 37
relating to provisions are outlined as follows:
For each class of provision, an entity shall disclose:
(a) the carrying amount at the beginning and end of the period;
(b) additional provisions made in the period, including increases to existing provisions;
(c) amounts used (i.e. incurred and charged against the provision) during the period;
(d) unused amounts reversed during the period; and
(e) the increase during the period in the discounted amount arising from the passage of time and the effect
of any change in the discount rate.
Comparative information is not required.
An entity shall disclose the following for each class of provision:
(a) a brief description of the nature of the obligation and the expected timing of any resulting outflows of
economic benefits;
(b) an indication of the uncertainties about the amount or timing of those outflows. Where necessary to
provide adequate information, an entity shall disclose the major assumptions made concerning future
events, as addressed in paragraph 48; and
(c) the amount of any expected reimbursement, stating the amount of any asset that has been recognised
for that expected reimbursement (IAS 37, paras 84 and 85).

Question 3.8 requires a review of the provisions disclosures included in the notes of an entity’s financial
statements.

QUESTION 3.8

Review Note 14 ‘Provisions’ of the Spring Valley Ltd’s financial statements. Focusing on the
Provision for warranties class of provisions, highlight how Spring Valley Ltd has complied with
the requirements of paragraph 85 of IAS 37 in this disclosure.
14. Provisions
20X2 20X1
$’000 $’000
Current
Provision for warranties 670 492
Provision for legal claim 2 500 0
Provision for restructuring 564 0
3 734 492

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 147

 Provision for Provision for Provision for Total
warranties legal claim restructuring provisions
$’000 $’000 $’000 $’000
Gross carrying amount
Balance at 1 July 20X1 492 0 0 492
Charged/(credited) to profit or loss:
• Additional provisions recognised 385 2 500 564 3 449
• Unwinding of discount 23 23
Amounts used during the year (230) 0 0 (230)
Balance at 30 June 20X2 670 2 500 564 3 734
Gross carrying amount
Balance at 1 July 20X0 436 0 0 436
Charged/(credited) to profit or loss:
• Additional provisions recognised 405 0 0 405
• Unwinding of discount 21 0 0 21
Amounts used during the year (370) 0 0 (370)
Balance at 30 June 20X1 492 0 0 492

Spring Valley Ltd — Notes to the financial statements for the year ended 30 June 20X2
Provision for warranties
Provision is made for estimated warranty claims in respect of products sold which are still under
warranty at the end of the reporting period.
These claims are expected to be settled in the next financial year.
Management estimates the provision based on historical warranty claim information and any
recent trends that may suggest future claims could differ from historical amounts.
Provision for legal claim
A provision for legal claim has been recognised for damages payable to a customer of the
production division, following an unfavourable judgment handed down against the group by
the New South Wales Supreme Court in May 20X2.
Provision for restructuring
The reduced demand for products and services in regional and remote areas required a reassess-
ment of the size and geographic distribution of staff and facilities, resulting in a loss of jobs. The pro-
vision for restructuring includes costs associated with the voluntary redundancy compensation
package of $564 367 and other direct costs associated with closure of premises. The provision
remaining on the statement of financial position at balance date is expected to be fully utilised
before 30 June 20X3.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 84 and 85 of IAS 37.

QUESTION 3.9

Consider the following quote.

At present, banks create provisions to meet the costs of . . . restructuring. When analysts
analyse these, they classify them as significant items so that they appear below the operating
profit line; this ensures the cost of these provisions disappears from their calculations of the
operating profit. By over-provisioning with below-the-line significant items in a good year, the
company can use the over-provisions during a bad year when there are additional write-offs.
The write-offs do not appear in the operating profit (Washington 2002, p. 74).

Explain how the disclosure requirements contained in IAS 37 reduce the ability of entities
to engage in earnings management through the increase and then subsequent write-back of
provisions.

148 Financial Reporting

EXEMPTIONS
Although the disclosure requirements of IAS 37 are more extensive than many entities would like, the
standard does provide some relief from compliance with the requirements. This relief includes when:
. . . disclosure of some or all of the information required . . . can be expected to prejudice seriously the
position of the entity in a dispute with other parties on the subject matter of the provision, contingent
liability or contingent asset (IAS 37, para. 92).

IAS 37 notes that this exemption would occur only in extremely rare cases and, therefore, cannot be
used to circumvent the disclosure requirements. Also, even when the exemption is applicable, the general
nature of the dispute, together with the fact and reason why that information has not been disclosed, must
be stated.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraph 92 of IAS 37.

3.7 PROVISIONS AND PROFESSIONAL JUDGMENT

An entity’s accountant is required to exercise professional judgment in determining whether an obligation
constitutes a provision. If it is a provision, professional judgment is also required in measuring the
provision. As mentioned in module 1, professional judgment is likely to be easier to exercise in the future
as technological advancements ensure that the accountants have the necessary information to make proper
judgments. Nevertheless, the need for professional judgment introduces discretion and subjectivity into
financial reporting, which creates potential pressures from management for the accountant to manipulate
reported accounting numbers, including engaging in earnings management.
For example, a distinguishing feature between provisions and other types of liabilities, such as trade
payables, is the degree of uncertainty in the timing or amount of the obligation. Recall that it is when the
level of uncertainty is significant that the obligation is recognised as a provision. When deciding on the
degree of uncertainty, an accountant is required to exercise professional judgment.
Professional judgment is also required in the measurement of provisions. Recall that IAS 37 states that
the best estimate is to be used to measure provisions. The best estimate includes the use of either the
‘expected-value’ method or the ‘most likely outcome’ method. The inputs used to derive the best estimate
under either method, namely the likelihood of an outcome or outcomes occurring, are often subject to the
discretion of an entity’s management. Management may exploit this discretion to understate provisions,
and thereby reduce the entity’s total liabilities. An accountant must exercise professional judgment in
ensuring that these inputs can be verified.

EXAMPLE 3.13

Discretion in the Calculation of Best Estimate

Continuing on from example 3.12, now assume that management has revised its estimates so that there
is 45% likelihood that each of the warranty claims is unsubstantiated and 55% likelihood that the cost of
each claim will be $100.
According to the expected-value method, the best estimate of the provision is now $5500 (55% × 100 ×
$100 = $5500), which is $1500 lower compared with the original estimate in example 3.12.
The use of professional judgment in recognising and measuring provisions not only enables manipula-
tion of reported liabilities in the statement of financial position, but also creates opportunities for earnings
management. This is because the understatement of provisions also results in an understatement of
the corresponding expense, and in so doing, overstates reported profit for the current period. Using
example 3.13 to illustrate this, both the warranty provision and warranty expense would be $1500 lower
compared with their original amounts in example 3.12 due to management’s revised estimates. Exercising
discretion in the recognition and measurement of provisions, therefore, simultaneously affects an entity’s
reported financial position and its profit. Nevertheless, technological advancements that involve the use of
artificial intelligence (AI), machine learning and deep learning, coupled with vast amounts of data that will
be available to users to perform AI-assisted data analytics, will probably limit the opportunities for earnings
management as the users will automatically detect any potential misstatements or manipulations.

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 149

SUMMARY
This part focused on accounting for provisions under IAS 37.
IAS 37 outlines specific criteria to be applied to provisions in their recognition and measurement
and requires extensive disclosures. The recognition of provisions provides financial statement users with
an understanding of the entity’s existing obligations. The disclosure of information about the nature of
provisions and the timing, amount and likelihood of any resulting outflows assists users to understand
the reasons, uncertainty and subjectivity behind the recognised end-of-period carrying amount. It is the
presence of this uncertainty and subjectivity that enables managers to manipulate reported accounting
numbers. The discretion exercised in measuring provisions creates opportunities for managers to understate
provisions in the statement of financial position and the corresponding expense, thereby, overstating
reported profit. While the measurement of provisions is subject to an entity’s accountant verifying that
management’s estimates are neutral and free of error, financial statement users should be mindful of
subjectivity in the measurement of provisions.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

3.3 Understand, and be able to apply, IAS 37 as it relates to a provision, contingent liability and
contingent asset, and recognise how they relate to the Conceptual Framework.
• The level of uncertainty in the timing or amount determines whether a ‘provision’ or a ‘liability’ is
recognised.
• A provision is recognised when an entity has a present obligation as a result of a past event, it is
probable that an outflow of economic benefits will be required to settle the obligation, and a reliable
estimate can be made of the amount of the obligation.
• The amount to be recognised as a provision shall be the best estimate of the expenditure required
to settle the present obligation at the end of the reporting period.
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets outlines specific disclosure require-
ments for each class of provision.

150 Financial Reporting

PART C: CONTINGENT LIABILITIES AND
CONTINGENT ASSETS
INTRODUCTION
Part C reviews the requirements of IAS 37 in relation to contingent liabilities and contingent assets. The
objective of the standard is to assist users in assessing the nature and amount of contingent assets and
contingent liabilities, as well as the uncertainties that are expected to affect their outcomes. The standard’s
ultimate aim is to ensure consistent reporting practices, even though recognition of contingent liabilities
and contingent assets is prohibited in the financial statements and note disclosure is generally required.

Relevant Paragraphs
To assist in understanding of certain sections in this part, you may be referred to relevant paragraphs in
IAS 37. You may wish to read these paragraphs as directed.
IAS 37 Provisions, Contingent Liabilities and Contingent Assets:

Subject Paragraphs
Scope 1–9
Definitions 10–13
Recognition 16–35
Disclosure 86–92

3.8 CONTINGENT ASSETS

The definition of contingent assets in IAS 37 is based on the definition of assets provided in the
Conceptual Framework. However, the definition overcomes some of the difficulties associated with the
recognition criteria.
A contingent asset is defined in IAS 37 as:
. . . a possible asset that arises from past events and whose existence will be confirmed only by the
occurrence or non-occurrence of one or more uncertain future events not wholly within the control of
the entity (IAS 37, para. 10).

An example of a contingent asset provided by IAS 37 is ‘a claim that an entity is pursuing through legal
processes, where the outcome is uncertain’ (IAS 37, para. 32). Another example is a buyer entitled to a
full cash refund for faulty products purchased, who has made a refund claim during the warranty period,
but the supplier is disputing the claim, and the dispute is being decided by an independent arbiter. Until
the dispute has been settled, the buyer has a contingent asset.
Contingent assets are not recognised in the statement of financial position. They are disclosed in the
notes to the financial statements.
A possible asset is identified and disclosed in accordance with IAS 37. It is a contingent asset
if, after all the available evidence has been considered, the existence of an asset is still unclear and
will not be clarified until an uncertain future event that is not wholly within the control of the entity
occurs or fails to occur. In relation to the second part of the definition — dealing with probability —
IAS 37 only requires disclosure when the inflow of economic benefits is probable.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 31–35 of IAS 37.

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 151

 Table 3.1 summarises the key requirements of IAS 37 in relation to contingent assets.

TABLE 3.1 Application of probability criteria to contingent assets

Probability of inflow of Accounting treatment in accordance with IAS 37 Provisions, Contingent

economic benefits Liabilities and Contingent Assets

Virtually certain It is appropriate to recognise the asset where the realisation of income is virtually
certain as the asset is not a contingent asset (IAS 37, para. 33).

Probable but not If there is a possible asset for which future benefits are probable, but not virtually
virtually certain certain, no asset is recognised (IAS 37, para. 31), but a contingent asset is disclosed
(IAS 37, para. 89).

Not probable If there is a possible asset for which the probability that future benefits will eventuate
is not probable, no asset is recognised (IAS 37, para. 31) and no disclosure is required
for the contingent asset (IAS 37, para. 89).

Source: Adapted from IFRS Foundation 2019, IAS 37 Provisions, Contingent Liabilities and Contingent Assets, in IFRS Standards
issued at 1 January 2019, IFRS Foundation, London, p. B736.

.......................................................................................................................................................................................
EXPLORE FURTHER
The section titled ‘A. Tables — Provisions, contingent liabilities, contingent assets and reimbursements’ under
’Guidance on Implementing IAS 37’ in the IFRS Compilation Handbook provides a useful summary of these
requirements.
If you wish to explore this topic further, you may now read this section of ‘Guidance on Implementing IAS 37’
(focusing on the contingent assets portion) in the IFRS Compilation Handbook.

QUESTION 3.10

Identify two further examples of contingent assets. For each example, explain why the item would
be a contingent asset rather than being recognised as an asset. Do you believe that the reporting
of contingent assets affects the decisions of equity investors or other finance providers? Why or
why not?

IAS 37 requires disclosure of the nature of the contingent assets at the end of the reporting period and,
where practicable, an estimate of their financial effect. Estimates of contingent assets are measured using
the principles set out for the measurement of provisions in paragraphs 36–52 of IAS 37 (IAS 37, para. 89).

3.9 CONTINGENT LIABILITIES

IAS 37 adopts a broad concept of contingent liabilities. Contingent liabilities are defined as:
(a) a possible obligation that arises from past events and whose existence will be confirmed only by the
occurrence or non-occurrence of one or more uncertain future events not wholly within the control of
the entity; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be required to
settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability (IAS 37, para. 10).

IAS 37 explains that only those contingent liabilities described under (a) in the definition provided in
paragraph 10 of the standard are entirely contingent in nature. However, the standard setters have adopted
the view that it is useful to treat present obligations that may not result in a probable outflow of resources
or for which an amount cannot be measured reliably as contingent liabilities.
Contingent liabilities, like contingent assets, are not recognised in the statement of financial position.
IAS 37 requires the disclosure of contingent liabilities unless the possibility of an outflow of resources is
remote (IAS 37, para. 28).

152 Financial Reporting

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 12–13 and 27–30 of IAS 37 and the section
titled ‘A. Tables — Provisions, contingent liabilities, contingent assets and reimbursements’ (focusing on the provisions
and contingent liabilities portion) under ‘Guidance on Implementing IAS 37’ in the IFRS Compilation Handbook.

Table 3.2 summarises the key requirements of IAS 37 in relation to provisions and contingent liabilities.

TABLE 3.2 Application of probability criteria to provisions and contingent liabilities

Obligation and probability of outflow Accounting treatment in accordance with IAS 37

of economic benefits Provisions, Contingent Liabilities and Contingent Assets

Present obligation that probably requires an A provision is recognised (IAS 37, para. 14)
outflow of resources Disclosures are required for the provision (IAS 37,
para. 84–85)

Possible obligation or present obligation that No provision is recognised (IAS 37, para. 27)
may, but probably will not, require an outflow Disclosed as a contingent liability (IAS 37, para. 86)
of resources

Possible obligation or present obligation where No provision is recognised (IAS 37, para. 27)
the likelihood of outflow of resources is remote No disclosure is required (IAS 37, para. 86)

Extremely rare case where there is a liability, No provision is recognised (IAS 37, para. 27)
but it cannot be measured reliably Disclosed as a contingent liability (IAS 37, para. 86)

Source: Adapted from IFRS Foundation 2019, IAS 37 Provisions, Contingent Liabilities and Contingent Assets, in IFRS Standards
issued at 1 January 2019, IFRS Foundation, London, p. B736.

Remember from the definition in paragraph 10 of IAS 37, a contingent liability will exist in the
event of:
1. a possible obligation to be confirmed by uncertain future events
2. a present obligation where the future sacrifice of economic benefits is not probable, or
3. a present obligation with a probable future sacrifice of economic benefits that is not reliably measurable.
It is only when the probability of future sacrifice is higher than remote that the contingent liability will
be disclosed in a note to the financial statements. In the context of event (3), this is satisfied as the future
sacrifice is probable. For events (1) and (2), however, an assessment must be made as to the degree to
which the future sacrifice is unlikely. If it is remote, then no disclosure is required.
A provision, however, exists in the event of a present obligation with a probable future sacrifice of
economic benefits, where a reliable estimate of the amount of the obligation can be made. A provision
is clearly distinct from event (1), which relates to a possible obligation, and event (2), where the future
sacrifice is not probable. As such, a provision most closely resembles event (3). The distinction, however,
is whether the estimate is sufficiently reliable to warrant recognition. If the answer is ‘yes’, it is a provision.
If the answer is ‘no’, as per event (3), it is disclosed as a contingent liability.

EXAMPLE 3.14

Determining When to Disclose a Contingent Liability

Legal proceedings are commenced seeking damages from an entity due to food poisoning, possibly
caused by products sold by the entity. The entity disputes liability, and the entity’s lawyers initially advise
that it is probable that the entity will not be found liable. At this point in time, a possible obligation (as per
contingent liability event (1)) exists that will be disclosed as a contingent liability unless the probability of
future sacrifice is remote.
If, however, owing to developments in the case it becomes probable that the entity will be found liable,
but the amount of damages to be awarded cannot be measured with sufficient reliability, a contingent
liability still exists (as per event (3)). Disclosure will be required as the future sacrifice is probable and,
thus, cannot be considered remote.

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 153

 To extend this example, if a reliable estimate could be made of the damages to be awarded, the present
obligation would no longer be a contingent liability under event (3), but rather would be recognised as
a provision.
Source: Based on IFRS Foundation 2019, IAS 37 Provisions, Contingent Liabilities and Contingent Assets, in IFRS
Standards issued at 1 January 2019, IFRS Foundation, London, p. B742.

‘Guidance on Implementing IAS 37’ in the IFRS Compilation Handbook (p. B738) provides a decision
tree that clearly differentiates between the requirements for the recognition of an item as a provision,
disclosure of the item as a contingent liability or non-disclosure of the item.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read ‘Guidance on Implementing IAS 37’ (in the IFRS Compilation
Handbook).

LIABILITIES VERSUS CONTINGENT LIABILITIES

When it is determined whether a liability or a contingent liability exists, it will normally be clear whether
a past event has given rise to a present obligation. In rare cases where there is uncertainty, the entity must
consider all available evidence, including, where necessary, the opinions of experts. This will also include
information from events occurring between the end of the reporting period and the time the financial
statements are completed. Where the existence of a present obligation is still unclear — and this will only
be confirmed by the occurrence or non-occurrence of some future event outside the control of the entity —
a possible obligation is identified and treated as a contingent liability.
For a past event to give rise to an obligation, the Conceptual Framework requires the entity to have no
practical ability to avoid the obligation. This is normally the case where the settlement of the obligation
is legally enforceable as a consequence of a binding contract or statutory requirement. An obligation may
also arise as a result of custom, a desire to maintain good business relations or a desire to act in an equitable
manner. These obligations arise where valid expectations that the entity will discharge the obligation are
created in other parties.

3.10 CONTINGENCIES AND PROFESSIONAL

JUDGMENT
An accountant must exercise professional judgment in determining whether an item should be recognised
as a financial statement element or whether it constitutes a contingency. For example, an accountant must
assess whether, after all available evidence has been considered, it is clear that an asset exists. If it is
clear, the asset must be recognised in the statement of financial position in accordance with IFRSs/IASs
and the Conceptual Framework. However, if the existence of the asset is uncertain, the accountant must
then exercise professional judgment in determining whether the inflow of economic benefits is probable,
which then requires disclosure of the contingent asset.
Similarly, professional judgment is required by an accountant in concluding whether a liability or
contingent liability exists, and if it is a contingent liability, whether the liability is to be disclosed. An
accountant must decide whether an obligation is a possible or present obligation. If it is a possible
obligation, a contingent liability exists and must be disclosed. If it is a present obligation, the accountant
must determine whether an outflow of resources is probable and whether the amount of the obligation is
reliably measurable. When an outflow is probable and the amount is reliably measurable, a liability must
be recognised. However, when an outflow is not probable or the amount cannot be measured reliably,
the obligation is a contingent liability that must be disclosed provided the likelihood of future sacrifice
is higher than remote. When deciding on the nature of the obligation, the probability of an outflow
occurring and whether the amount of an obligation is reliably measurable, an accountant is required to
exercise professional judgment. The consequence of exercising this judgment is whether the obligation
is recognised, disclosed or not reported.
When a contingency is required to be disclosed, an accountant must also exercise discretion in deciding
the extent to which potentially sensitive information is made public. For example, an entity subject to
a strong legal claim that has been brought against it, where the outcome is uncertain, has a contingent

154 Financial Reporting

liability. In applying the disclosure requirements of paragraph 86 of IAS 37, the entity must disclose a
brief description of the legal claim and, where practicable, best estimate of the amount required to settle
the claim, an indication of any uncertainties surrounding the amount or timing of the settlement, and the
possibility of reimbursement through insurance. An entity, however, will be reluctant to give extensive
details about the legal claim for fear of prejudicing the outcome or jeopardising settlement negotiations.
Moreover, while an entity has commercial reasons for disclosing confidence in their ability to defend
the claim, this may be misleading to financial statement users. An accountant must, therefore, exercise
professional judgment in ensuring IAS 37 disclosure requirements are met, but not at the cost of releasing
sensitive information that would prove harmful to the entity.

SUMMARY
This part reviewed the requirements of IAS 37 in relation to contingent liabilities and contingent assets.
The objective of IAS 37 is to assist users in assessing the nature and amount of contingent assets
and contingent liabilities of an entity. Through the disclosure of information on contingent assets and
contingent liabilities, financial statement users are made aware of assets and liabilities that, while not
recognised in the entity’s financial statements, may affect an entity’s financial position in the future, and,
in so doing, enable users to make more informed decisions.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

3.3 Understand, and be able to apply, IAS 37 as it relates to a provision, contingent liability and
contingent asset, and recognise how they relate to the Conceptual Framework.
• Contingent assets and contingent liabilities are not recognised in the statement of financial position
but are disclosed in the notes to the financial statements.
• The probability criteria to be applied to contingent assets considers the probability of an inflow of
economic benefits to the entity. There are three levels of probability: virtually certain; probably but
not virtually certain; and not probable.
• The probability criteria to be applied to contingent liabilities considers the type of obligation and the
probability of an outflow of economic benefits from the entity. There are four levels of probability:
– present obligation that probably requires an outflow of resources
– possible obligation or present obligation that may, but probably will not, require an outflow
of resources
– possible obligation or present obligation where the likelihood of outflow of resources is remote
– extremely rare case where there is a liability, but it cannot be measured reliably.

REVIEW
This module examined the requirements of both IFRS 15, in relation to the recognition of revenue from
customers, and IAS 37, in relation to accounting for provisions, contingent liabilities and contingent assets.
In part A, the five-step model for revenue recognition was discussed, beginning with a discussion on
identifying whether a contract with a customer exists. Given the presence of such a contract, part A then
explored identifying the performance obligation(s) within the contract and quantifying the transaction price
of the contract. How to allocate the transaction price to each performance obligation was then considered,
followed by when to recognise revenue under the contract. Finally, the accounting treatment of contract
costs and the disclosure requirements of IFRS 15 were reviewed — the aim of the disclosures under
IFRS 15 being to provide financial statement users with an understanding of the revenue practices of
the entity.
In part B, provisions were discussed and identified as a subset of liabilities. The definition and
recognition criteria for liabilities were reviewed as a basis for understanding the requirements for the
recognition of provisions. The disclosures relating to provisions were described, as well as how they assist
users in understanding the reasons behind, and the uncertainty of, the recognised amount.
Contingent liabilities and contingent assets were covered in part C. The relationship between assets
and contingent assets was explored, and a summary of the requirements for the disclosure of contingent

MODULE 3 Contracts Revenue, Provisions, Contingent Liabilities and Assets 155

assets was provided. Contingent assets are not recognised in the statement of financial position but are
disclosed in the notes if the inflow of future economic benefits is probable. Contingent liabilities were also
discussed. IAS 37 prohibits the recognition of contingent liabilities in the statement of financial position,
but they should be disclosed in the notes unless the probability of any outflow in settlement is remote.
These disclosures provide users with a better understanding of the assets, whether recognised or contingent,
and liabilities, whether arising from possible or present obligations, of an entity.

REFERENCES
Deloitte 2018, ‘Revenue from contracts with customers: a guide to IFRS 15’, March, accessed 6 May 2019, https://www.iasplus
.com/en/news/2018/03/deloittes-guide-to-ifrs-15.
Lennard, A. & Thompson, S. 1995, Provisions: Their Recognition, Measurement and Disclosure in Financial Statements,
Financial Accounting Standards Board, Norwalk.
Washington, S. 2002, ‘Smooth accusations’, Business Review Weekly, 24 October, pp. 74–5.

OPTIONAL READING
IFRS Foundation 2019, 2019 IFRS Standards, IFRS Foundation, London.

156 Financial Reporting

MODULE 4

INCOME TAXES
LEARNING OBJECTIVES

After completing this module, you should be able to:

4.1 explain the terms ‘taxable temporary differences’ and ‘deductible temporary differences’
4.2 apply the requirements of IAS 12 with respect to current and deferred tax assets and liabilities
4.3 apply the tax rates and tax bases that are consistent with the manner of recovery or settlement of an asset
or liability
4.4 apply the probability recognition criterion for deductible temporary differences, unused tax losses and
unused tax credits
4.5 account for the recognition and reversal of deferred tax assets arising from deductible temporary
differences, unused tax losses and unused tax credits
4.6 determine the deferred tax consequences of revaluing property, plant and equipment
4.7 apply the requirements of IAS 12 with respect to financial statement presentation and disclosure
requirements.

ASSUMED KNOWLEDGE

It is assumed that, before commencing your study of this module, you are able to:
• explain the difference between cash and accrual methods of accounting
• prepare each of the four primary financial statements using the accrual method of accounting.

LEARNING RESOURCES

International Financial Reporting Standards (IFRSs):

• IAS 1 Presentation of Financial Statements
• IAS 12 Income Taxes
• IAS 16 Property, Plant and Equipment
Other resources:
• Comprehensive example: To explain the rationale and application of IAS 12, there is a comprehensive example
in part E. You should familiarise yourself with the data in this example.
• Digital content, such as videos and interactive activities in the e-text, support this module. You can access
this task on My Online Learning.
Unless otherwise indicated, a tax rate of 30% has been adopted throughout this module.

PREVIEW
Income taxes are incurred by entities in most countries according to the tax rates and tax laws of the relevant
jurisdiction.
Income taxes normally give rise to an income tax expense and some related income tax assets and
liabilities that should be recognised in the financial statements. As those items can be significant for many
entities, it is important for users and preparers of financial statements to have a clear understanding of the
way they are calculated and recognised in the financial statements. Due to technological advancements
and the development of powerful software programs for accounting and taxation, most of the procedures
that will be described in this module are automated. However, it is still paramount for users and preparers
to understand the principles and the processes used in the calculation of income tax to be able to use the
information provided by the computer software to make decisions.
The accounting treatment for income taxes is prescribed in IAS 12 Income Taxes and is based on the
so-called ‘balance sheet method’. The name of this method comes from the fact that it focuses on balance
sheet (or statement of financial position) items (i.e. assets and liabilities) and requires consideration of
the difference between the carrying amounts of those items (as recognised in the statement of financial
position and their underlying tax bases (as determined according to the tax rates and tax laws enacted in
the relevant jurisdiction). This difference gives rise to tax effects deferred for the future, which should be
recognised together with the current tax effects.
In general terms, the use of the balance sheet method of accounting for income taxes will result in the
entity recognising the current and future tax consequences of:
• transactions and other events of the current period that are recognised in an entity’s financial statements
• the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in an
entity’s statement of financial position.
This module discusses the rationale underpinning the balance sheet method of accounting for income
tax and examines the fundamentals of this approach. More specifically, the module provides guidance and
illustrative examples as to the recognition and measurement of tax consequences in current and deferred
tax expense (tax income), tax assets and tax liabilities.
The following is a brief overview of the structure of the module.
• Part A Income tax fundamentals — discusses the core principle of IAS 12 and explores the nature of the
income tax items recognised in the financial statements and the practical approach to their determination.
• Part B Recognition of deferred tax assets and liabilities — examines the separate recognition rules (and
limited recognition exceptions) for the recognition of deferred tax assets and deferred tax liabilities in
the financial statements.
• Part C Special considerations for assets measured at revalued amounts — deals with the recognition and
measurement of deferred tax liabilities that arise when assets are carried at revalued amounts.
• Part D Financial statement presentation and disclosure — illustrates the disclosure requirements that
enable users of the financial statements to understand and evaluate the impact of current tax and deferred
tax on the financial position and performance of the entity.
• Part E Comprehensive example — contains a comprehensive example illustrating the application of
IAS 12.

158 Financial Reporting

PART A: INCOME TAX FUNDAMENTALS
INTRODUCTION
Part A of this module examines the fundamentals of accounting for income tax under IAS 12.
As explained in the Preview to the module, the core principle of IAS 12 is that the financial statements
should recognise the current and future tax consequences of:
(a) the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in an
entity’s statement of financial position; and
(b) transactions and other events of the current period that are recognised in an entity’s financial statements
(IAS 12, ‘Objective’).
These current and future tax consequences are reflected in the financial statements as ‘current tax
liability’, ‘current tax assets’, ‘deferred tax assets’, ‘deferred tax liabilities’ and ‘tax expense (tax income)’.
The definition of those items as provided in IAS 12 are included in table 4.1, while table 4.2 presents an
example of those items disclosed in the financial statements.

TABLE 4.1 Income tax line items in financial statements

Current tax liability The amount of tax payable to the taxation authorities for current and prior periods, to
the extent unpaid at the end of the financial year (IAS 12, para. 12).

Current tax asset The amount of tax already paid in respect of current and prior periods that exceeds
the amount due for those periods (IAS 12, para. 12).

Deferred tax assets
The ‘amounts of income taxes recoverable in future periods in respect of:
(a) deductible temporary differences [which are future deductible amounts that will
result from the realisation of assets or the settlement of liabilities];
(b) the carryforward of unused tax losses; and
(c) the carryforward of unused tax credits’ (IAS 12, para. 5).

Deferred tax liabilities The ‘amounts of income taxes payable in future periods in respect of taxable
temporary differences [which are future taxable amounts that will result from the
realisation of assets or the settlement of liabilities]’ (IAS 12, para. 5).

Tax expense (tax income) The ‘aggregate amount included in the determination of profit or loss for the period in
respect of current tax and deferred tax’ (IAS 12, para. 5).

Source: Adapted from IFRS Foundation 2019, IAS 12 Income Taxes, para. 5, in IFRS Standards as issued at 1 January 2019, IFRS
Foundation, London, pp. A1047, A1049.

TABLE 4.2 Financial statement extracts

Statement of profit or loss and other comprehensive income
for the year ended 30 June 20X1
20X1 20X0
$ $
Income 975 000 857 000
Expenses (325 000) (232 000)
Profit before income tax 650 000 625 000
Tax expense (195 000) (187 500)
Profit for the year 455 000 437 500

Statement of financial position

at 30 June 20X1
20X1 20X0
$ $
Current assets
Cash 433 500 143 000
Trade and other receivables 375 500 216 000
Non-current assets
Property, plant and equipment 1 450 000 1 410 000
Deferred tax assets 15 000 13 500
Total assets 2 274 000 1 782 500
(continued)

MODULE 4 Income Taxes 159

 TABLE 4.2 (continued)

20X1 20X0
$ $
Current liabilities
Trade and other payables 115 000 95 000
Current tax liability 191 500 185 000
Provisions 35 000 30 000
Non-current liabilities
Borrowings 500 000 500 000
Deferred tax liabilities 65 000 60 000
Provisions 15 000 15 000
Total liabilities 921 500 885 000
Net assets 1 352 500 897 500

Source: CPA Australia 2019.

Part A explores the nature of these income tax items recognised in the financial statements and
the practical approach to their determination. The fundamentals outlined in part A are essential to
understanding the more advanced concepts addressed in parts B–E.
Relevant Paragraphs
To assist in achieving the objectives of part A outlined in the module preview, you may wish to read
the following paragraphs of IAS 12. Where specified, you need to be able to apply these paragraphs as
referenced in this module.

Subject Paragraphs
Definitions 5–6
Tax base 7–11
Recognition of current tax liabilities and current tax assets 12–14
Recognition of deferred tax liabilities and deferred tax assets 15–18
Deductible temporary differences 24–25, 26(a), 26(b), 26(d), 27–31
Measurement 46–56
Recognition of current and deferred tax 57–60
Illustrative Examples (in the IFRS Compilation Handbook) Part A (paragraphs 1–11)
Part B (paragraphs 1–8)
Part C (paragraphs 1–4)
Example 2

4.1 TAX EXPENSE

As illustrated in the financial statement extracts in table 4.2, tax expense is presented as a separate line item
in the statement of profit or loss and other comprehensive income (statement of P/L and OCI). Tax expense
comprises two components (i.e. ‘current tax expense’ and ‘deferred tax expense’). Each component is
calculated separately and then aggregated to determine ‘tax expense’ for the reporting period. It is possible
for the amounts recognised under tax expense (current, deferred or total) to be negative, in which case they
are described as tax income.
This is illustrated in figure 4.1.

FIGURE 4.1 Tax expense (income)

Tax expense Current tax expense Deferred tax expense

= +
(Tax income) (Current tax income) (Deferred tax income)

Amount of income tax Movement in deferred

payable for the period tax assets and
(determined from tax liabilities for the
return) recognised in period recognised
profit or loss in the profit or loss

Source: CPA Australia 2019.

160 Financial Reporting

 As outlined in the Objective of IAS 12, the rationale for the recognition of ‘deferred tax expense’ (in
addition to the recognition of ‘current tax expense’), together with the associated ‘deferred tax assets’ and
‘deferred tax liabilities’, is that:
• It is inherent in the recognition of an asset or liability that the reporting entity expects to recover or settle
the carrying amount of that asset or liability (IAS 12, ‘Objective’).
• If it is probable that recovery or settlement of that carrying amount will make future tax payments larger
(smaller) than they would be if such recovery or settlement were to have no tax consequences, this
Standard requires an entity to recognise a deferred tax liability (deferred tax asset), with certain limited
exceptions (IAS 12, ‘Objective’).

From a conceptual perspective, recognising the future tax consequences of the expected recovery
(settlement) of the carrying amounts of assets (liabilities) recognised in the statement of financial position,
together with the current tax consequences of any transactions or events that took place during the current
period, provides a more complete picture of the financial position and financial performance of the entity.
A detailed discussion of the determination of current tax and deferred tax (and the associated deferred
tax assets and deferred tax liabilities) is contained in the following sections.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read the definitions of the following terms in paragraphs 5
and 6 of IAS 12: tax expense (tax income), current tax, deferred tax liabilities and deferred tax assets.

4.2 CURRENT TAX

As illustrated in figure 4.1, the first component of tax expense (income) is current tax.
Current tax is the ‘amount of income taxes payable (recoverable) in respect of taxable profit (tax loss)
for the period’ (IAS 12, para. 5).
The key steps for accounting for current tax are shown in table 4.3.

TABLE 4.3 Key steps in accounting for current tax

Step 1 Calculate the ‘amount expected to be paid to (recovered from) the taxation authorities, using
the tax rates (and tax laws) that have been enacted or substantively enacted by the end of the
reporting period’ (IAS 12, para. 46).

Step 2 Recognise the amount of current tax in P/L for the period, in OCI, or directly in equity, as
appropriate (IAS 12, para. 58(a)).

Source: Adapted from IFRS Foundation 2019, IAS 12 Income Taxes, paras 46, 58, in IFRS Standards as issued at 1 January 2019,
IFRS Foundation, London, pp. A1062, A1068.

Each step will now be discussed.

CALCULATING CURRENT TAX

From a practical perspective, taxable profit (tax loss) is generally calculated:
• directly, by applying the relevant tax laws to the transactions and other events of the current reporting
period to determine the difference between assessable income and allowable deductions, or
• indirectly, by adjusting the accounting profit of the current reporting period for differences between
accounting and tax treatments of items recognised in the accounting profit.
The indirect approach of adjusting the accounting profit to determine taxable profit (tax loss) is the more
common approach used in practice.
After determining the taxable profit (tax loss), the current tax is determined by simply multiplying it
with the relevant tax rate. The calculation of the current tax, starting with the calculation of the taxable
profit using the indirect approach, is illustrated in example 4.1.

MODULE 4 Income Taxes 161

 EXAMPLE 4.1

Calculate Taxable Profit by Adjusting the Accounting Profit for the

Reporting Period
The statement of P/L and OCI of Hi-sales Ltd for the financial year ending 30 June 20X0 included the
following items.

$ $
Income
Sales 2 540 000
Expenses
Cost of goods sold 1 735 000
Depreciation — equipment 12 000
Other expenses 40 000 (1 787 000)
Profit before tax 753 000

Some additional information is provided as follows.

• For tax purposes, depreciation on the plant and equipment for the current period is $14 000.
• ‘Other expenses’ of $40 000 includes entertainment expenses that are not deductible for tax purposes
of $3000.
The taxable profit of Hi-sales Ltd can be calculated as follows.

$
Profit before tax 753 000
Add:
Non-deductible entertainment expenses†
756 000
Less:
Excess of tax depreciation deduction over accounting depreciation expense‡ 2 000
Taxable profit 754 000

†
The entertainment expense of $3000 is non-deductible and will not be included when determining taxable profit. This is
an example of a non-temporary difference, which must be added back to accounting profit.
‡
Depreciation expense for accounting purposes is $12 000 but for tax purposes is $14 000. Therefore, an additional $2000
of depreciation must be deducted from accounting profit in calculating taxable profit.

Assume that the tax rate is 30%. We calculate current tax by multiplying taxable profit by the tax rate
($754 000 × 30% = $226 200). The journal entry for current tax liability is as follows.

Dr Current tax expense 226 200

Cr Current tax payable 226 200

RECOGNITION OF CURRENT TAX

Current tax is normally recognised as income or as an expense in P/L. More specifically, IAS 12 (para. 58)
states the following with regards to the recognition of current (and deferred) tax.
Current and deferred tax shall be recognised as income or an expense and included in profit or loss for the
period, except to the extent that the tax arises from:
(a) a transaction or event which is recognised, in the same or a different period, outside profit or loss, either
in other comprehensive income or directly in equity . . . ; or
(b) a business combination (other than the acquisition by an investment entity, as defined in IFRS 10
Consolidated Financial Statements, of a subsidiary that is required to be measured at fair value through
profit or loss) . . . (IAS 12, para. 58).

162 Financial Reporting

 For transactions and any other event that generate items recognised outside P/L, IAS 12 (para. 61A)
requires that the current and deferred tax consequences shall be recognised outside of P/L as well. Current
tax and deferred tax that relates to such items are recognised:
• in OCI where the item is recognised in OCI
• directly in equity where the item is recognised directly in equity (IAS 12, para. 61A).
The accounting treatment of tax effects arising from a business combination will be discussed in
module 5.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 58 and 61A of IAS 12.

In addition to recognising the amount of current tax in P/L for the period, in OCI, or directly in equity (as
discussed), an entity must also recognise the amount payable to (refundable from) the taxation authorities
as an asset or liability, as follows.
• Current tax for current and prior periods shall, to the extent unpaid, be recognised as a liability. If the
amount already paid in respect of current and prior periods exceeds the amount due for those periods,
the excess shall be recognised as an asset (IAS 12, para. 12).
• The benefit relating to a tax loss that can be carried back to recover current tax of a previous period shall
be recognised as an asset (IAS 12, para. 13).

This is illustrated in example 4.2.

EXAMPLE 4.2

Recognition of a Current Tax Liability

Using the data from example 4.1, current tax of Hi-sales Ltd for the financial year ending 30 June 20X0
was determined to be $226 200. Assume that, in addition to the information provided, the relevant tax
laws required Hi-sales Ltd to pay tax instalments during the financial year ending 30 June 20X0 based on
Hi-sales’ estimate of its taxable profit for the year. Based on Hi-sales’ estimate of its taxable profit for the
financial year ending 30 June 20X0, instalments amounting to $185 000 were paid to the relevant taxation
authority prior to 30 June 20X0.
Using the provided information, the current tax liability recognised by Hi-sales Ltd in the statement of
financial position at 30 June 20X0 would be $41 200 ($226 200 – $185 000).

Dr Current tax expense 185 000

Cr Cash 185 000
Journal entry for instalments paid.

Dr Current tax expense 41 200

Cr Current tax liability 41 200
Journal entry for current tax liability.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 12–14 of IAS 12.

4.3 DEFERRED TAX

As illustrated in figure 4.1, the second component of tax expense (income) is deferred tax, which
is capturing the movement in deferred tax assets and deferred tax liabilities for the reporting period
recognised in P/L.
In principle, deferred tax represents the future tax consequences (as distinct from current tax conse-
quences) of the future recovery of assets and the future settlement of liabilities (IAS 12, ‘Objective’).
As such, the recognition and measurement of deferred tax requires an assessment of those future tax
consequences.
The key steps required to recognise and measure deferred tax are shown in table 4.4.

MODULE 4 Income Taxes 163

 TABLE 4.4 Key steps for calculating deferred tax

Step 1 Determine the tax base of assets and liabilities (IAS 12, paras 7–11).

Step 2 Compare the tax base with the carrying amount of assets and liabilities to determine taxable
temporary differences and deductible temporary differences (IAS 12, para. 5).

Step 3 Measure deferred tax assets (arising from deductible temporary differences) and deferred tax
liabilities (arising from taxable temporary differences) (IAS 12, paras 46–56).

Step 4 Recognise the movement in the deferred tax assets (arising from deductible temporary differences)
and deferred tax liabilities (arising from taxable temporary differences) as deferred tax, taking into
account the limited recognition exceptions (IAS 12, paras 15–45).

Source: Adapted from IFRS Foundation 2019, IAS 12 Income Taxes, in IFRS Standards as issued at 1 January 2019, IFRS
Foundation, London, pp. A1047–A1067.

Each of these steps is discussed in turn. Steps 1 to 3 are discussed in the remainder of part A, and
step 4 is discussed in part B.
In order to implement these steps, it is important to understand the terms ‘carrying amount’, ‘tax base’,
‘temporary difference’, ‘deferred tax assets’ and ‘deferred tax liabilities’. Except for carrying amount,
these terms are defined in paragraph 5 of IAS 12. Their basic meanings are as follows.

Carrying Amount
The carrying amount is the amount at which an asset or liability is recognised in the statement of financial
position. For an asset, this is the amount which is recognised ‘after deducting any accumulated depreciation
and accumulated impairment losses’ (IAS 16, para. 6).

Tax Base
The tax base of an asset or liability is the ‘amount attributed to that asset or liability for tax purposes’
(IAS 12, para. 5). The tax base can also be described as the written-down value, or carrying amount, of the
asset or liability for tax purposes. To assist with understanding the term, it may be helpful to assume the
existence of a hypothetical statement of financial position for tax purposes.
For example, assume that an entity acquires an item of equipment for $10 000, and the applicable tax
laws allow the entity to claim future tax deductions equal to the $10 000 original cost of the equipment
(by way of tax-deductible depreciation). Under this scenario, at the date of acquisition the tax base of the
equipment is $10 000.

Temporary Difference
A temporary difference is the difference ‘between the carrying amount of an asset or liability in the
statement of financial position and its tax base’ (IAS 12, para. 5). These differences will reverse over time
and, as they increase or decrease, they will affect deferred tax balances.
A temporary difference reflects the future tax consequences of realising an asset or settling a liability
(i.e. the extent to which the realisation of an asset or the settlement of a liability will result in future taxable
income or future tax deduction).
For example, assume that the carrying amount of an item of equipment is $10 000, and the tax base
(determined under the applicable tax laws) is $8000. Under this scenario, the temporary difference is
$2000 ($10 000 – $8000). This reflects that there are future tax consequences of realising the carrying
amount of the asset (i.e. future taxable amounts will occur).
Temporary differences are classified as either ‘deductible temporary differences’ or ‘taxable temporary
differences’. These terms are defined as follows.
Taxable Temporary Difference
Taxable temporary differences are temporary differences that ‘will result in taxable amounts in
determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is
recovered or settled’ (IAS 12, para. 5).
For example, assume that the carrying amount of land is $750 000, and its tax base (determined under
the applicable tax laws) is $500 000. Under this scenario, the temporary difference is $250 000. As this

164 Financial Reporting

temporary difference will result in taxable amounts of a future period (when the asset is realised), because
the entity creates taxable income, the temporary difference is classified as ‘taxable temporary difference’.
Deductible Temporary Difference
Deductible temporary differences are temporary differences that ‘will result in amounts that are
deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the asset
or liability is recovered or settled’ (IAS 12, para. 5).
For example, assume that the carrying amount of an employee benefit liability is $120 000, and its tax
base is $nil (determined under the applicable tax laws). Under this scenario, the temporary difference
is $120 000. As this temporary difference will result in deductible amounts in a future period (when the
liability is settled), because the entity is entitled to deduct the amounts from taxable income (reduce taxable
income), the temporary difference is classified as a ‘deductible temporary difference’.

Deferred Tax Assets

These are amounts of income taxes recoverable in future periods. They arise from deductible temporary
differences and the carry-forward of unused tax losses or tax credits (IAS 12, para. 5). This reflects the net
difference between the accounting treatment and tax treatment of transactions.

Deferred Tax Liabilities

These are amounts of income taxes payable in the future and arise from taxable temporary differences
(IAS 12, para. 5).
These definitions lead to the formulas shown in figure 4.2.

FIGURE 4.2 Temporary differences and deferred tax assets/liabilities

Temporary Carrying amount of Tax bases of assets

= –
differences assets or liabilities or liabilities

Deferred tax Temporary

= × Tax rate
assets/liabilities differences

Source: CPA Australia 2019.

Example 4.3 provides an illustration of those concepts, following the steps described in table 4.4 in
calculating and recognising deferred tax.

EXAMPLE 4.3

Calculating and Recognising the Deferred Tax Related to Settling a

Liability in the Future
An entity recognises a liability and related expense for employee benefits in 20X1 of $20 000, which
remains unsettled at the end of the financial year (30 June 20X1), and the entity will obtain a tax deduction
for the $20 000 expense at the time of settlement (i.e. when paid in cash in a future period).
Step 1: Determining the tax base of the liability.
No amount is attributed to the employee benefit liability for tax purposes because the tax deduction is
based on cash outgoings. Therefore, the tax base of the employee benefit liability is zero.
Step 2: Compare the tax base of the liability with the carrying amount to determine any
temporary differences.
The carrying amount (or book value) of the employee benefit liability is $20 000. Therefore, a temporary
difference of $20 000 arises between the book value and the tax base of the employee benefit liability. The
temporary difference is a deductible temporary difference because the future settlement of the employee
benefit liability will result in a future deductible amount.

MODULE 4 Income Taxes 165

 Step 3: Measure the deferred tax asset arising from the deductible temporary difference.
There is a deferred tax asset of $6 000 equal to the deductible temporary difference of $20 000 multiplied
by the tax rate of 30%.
Step 4: Recognise the deferred tax asset as deferred tax.
The deferred tax asset arising from the deductible temporary difference for the employee benefit liability
will be recognised at the end of the 20X1 period together with other temporary differences. If it is the only
temporary difference, then the journal entry is as follows.

Dr Deferred tax asset 6 000

Cr Deferred tax income 6 000

From the perspective of the statement of financial position, at 30 June 20X1, the entity will recognise
the employee benefit liability of $20 000 and a deferred tax asset of $6000. In combination, this reflects
the ‘after tax’ effect of the transaction on the financial position of the entity.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read the definitions of ‘tax base’, ‘temporary differences’,
‘deferred tax assets’ and ‘deferred tax liabilities’ in paragraph 5 of IAS 12.

While working through the remainder of this module, it is useful to keep in mind that the objective of
calculating the tax base is to determine, for each item concerned, whether a deferred tax amount arises.
As noted previously, the fundamental principle for determining whether deferred tax amounts arise is
as follows.
. . . an entity shall, with certain limited exceptions, recognise a deferred tax liability (asset) whenever
recovery or settlement of the carrying amount of an asset or liability would make future tax payments
larger (smaller) than they would be if such recovery or settlement were to have no tax consequences . . .
(IAS 12, para. 10).

STEP 1: DETERMINING THE TAX BASE OF ASSETS

AND LIABILITIES
The Tax Base of Assets
The tax base of an asset is the ‘amount that will be deductible for tax purposes against any taxable
economic benefits that will flow to an entity when it recovers the carrying amount of the asset. If those
economic benefits will not be taxable, the tax base of the asset is equal to its carrying amount’ (IAS 12,
para. 7).
Figure 4.3 illustrates the formula that can be applied in calculating the tax base of an asset. This formula
is based on paragraph 5.1 of the now superseded AASB 1020 Income Taxes, however it is still applicable.

FIGURE 4.3 Tax base of an asset

Future
Tax base Carrying Future taxable
= + deductible –
of an asset amount amounts
amounts

Source: Based on AASB (Australian Accounting Standards Board) 1999, AASB 1020 Income Taxes, para. 5.1, p. 24, accessed
November 2017, http://www.aasb.gov.au/admin/file/content102/c3/AASB1020_12-99.pdf.

In the formula in figure 4.3:

• the carrying amount is the amount recognised in the financial statements; it is net of any measurement
adjustments (e.g. allowance for doubtful debts)
• the future deductible amounts are the allowable tax deductions that would arise from the realisation of
the carrying amount of the asset (i.e. the total tax deductions that can be claimed against the asset in
the future)

166 Financial Reporting

• the future taxable amounts are the taxable amounts that would arise from the realisation of the carrying
amount of the asset; it is equal to the carrying amount of the asset unless the economic benefits are not
taxable, in which case the future taxable amount is zero.
The formula shown in figure 4.3 can be applied to determine the tax base of any asset. The formula in
figure 4.3 has the benefit of being able to demonstrate that the difference between the tax base and the
carrying amount of an asset is always equal to the difference between the future deductible and future
taxable amounts associated with that asset that generate deductible or taxable temporary differences.
However, it can be replaced by a much simpler alternative method as described in figure 4.4. This simpler
alternative method of calculating the tax base described in figure 4.4 will be used throughout the module
(except for the complex examples covered in part C, for which it is more appropriate to use the formula in
figure 4.3).

FIGURE 4.4 Tax base of an asset — alternative method

1. Future economic benefits are taxable Tax base = future deductible amount

2. Future economic benefits are not taxable Tax base = carrying amount

Source: CPA Australia 2019.

Example 4.4 outlines two scenarios for calculating the tax base of an asset.

EXAMPLE 4.4

Calculating the Tax Base of Assets

Scenario 1 (IAS 12, para. 7, example 1)
A machine cost $100. Depreciation of $30 has already been expensed for accounting purposes and
deducted for tax purposes in the current and prior periods — that is, the accounting treatment and tax
treatment are the same.
In this scenario, when the entity uses the asset it generates economic benefits in the form of revenue.
The revenue generated by using the machine is taxable.
Future deductible amounts are calculated as original cost less accumulated tax depreciation deductions
($100 – $30 = $70). This remaining cost of $70 will be tax deductible in future periods, either as depreciation
or through a deduction on disposal.
Therefore, as the future economic benefits, in the form of revenue, are taxable, the tax base of the
machine is determined as follows.

[1] Tax base = Future deductible amount = $70

The carrying amount is calculated as original cost ($100) less accumulated accounting depreciation
($30) = $70. This is the net amount that would be recorded in the financial statements. Therefore, in this
scenario, the tax base is equal to the carrying amount of the asset.
Scenario 2
An item of plant was purchased two years ago for $100. This plant is being depreciated on a straight-line
basis for accounting purposes over a four-year period and on a straight-line basis for tax purposes over a
five-year period. There is no residual value for either tax or accounting purposes. The income generated
by the plant is included in taxable profit (loss), and tax depreciation is deductible for tax purposes.
In this scenario, when the entity uses the asset, it generates economic benefits in the form of revenue.
The revenue generated by using the plant is taxable.
Future deductible amounts are amounts that were not yet claimed as deductions out of the original cost
and they will be calculated as original cost ($100) less accumulated tax depreciation deductions ($100/5
× 2 = $40) = $60.
Therefore, as the future economic benefits, in the form of revenue, are taxable, the tax base of the plant
is determined as follows.

[1] Tax base = Future deductible amount = $60

MODULE 4 Income Taxes 167

 The carrying amount is calculated as original cost ($100) less accumulated accounting depreciation
($100/4 × 2 = $50) = $50. This is the net amount that would be recorded in the financial statements.
Therefore, in this scenario, the tax base is not equal to the carrying amount of the asset.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read examples 2–5 in paragraph 7 of IAS 12.

QUESTION 4.1

Calculate the tax base for the following assets.

(a) An item of inventory was purchased during the year for $250. The cost of the inventory for
both accounting and tax purposes is $250. The tax cost of the inventory will be included in the
determination of taxable profit (tax loss) as a deduction when the inventory is sold. The income
from the sale of inventory is taxable when the inventory is sold.
(b) Trade receivables have a carrying amount of $250 with no allowance for doubtful debts. The
related revenue has already been included in taxable profit (tax loss).

The Tax Base of Liabilities

The tax base of a liability is ‘its carrying amount, less any amount that will be deductible for tax purposes
in respect of that liability in future periods. In the case of revenue which is received in advance, the tax
base of the resulting liability is its carrying amount, less any amount of the revenue that will not be taxable
in future periods’ (IAS 12, para. 8).
The formulas in figure 4.5 may be helpful in performing the calculation to determine the tax base of a
liability. (These formulas are based on the method described in IAS 12, para. 8.)

FIGURE 4.5 Tax base of a liability

Tax base of a
Future
liability that is not Carrying
= – deductible
revenue received amount
amounts
in advance

Tax base of Amount of

Carrying
revenue received = – revenue not taxable
amount
in advance in the future

Source: Based on IFRS Foundation 2019, IAS 12 Income Taxes, para. 8, in IFRS Standards as issued at 1 January 2019, IFRS
Foundation, London, p. A1048.

For example, if a current liability with a carrying amount of $100 relates to expenses that will be
deductible for tax purposes when settled (i.e. when paid), the tax base of the current liability is nil.

Carrying Future deductible

Tax base
= amount – amounts
Nil
100 100

An example of revenue received in advance is interest revenue received in advance with a carrying
amount of $50. The related interest revenue is taxed on a cash basis (i.e. when received). The tax base of
the interest revenue received in advance is nil. The $50 is not taxable in the future because it was already
taxed when the cash was received.

168 Financial Reporting

 Carrying Amount of revenue
Tax base
= amount – not taxable in the future
Nil
50 50

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read examples 2–5 in paragraph 8 of IAS 12.

QUESTION 4.2

Calculate the tax base for the following liabilities.

(a) Employee benefits have a carrying amount of $100. The employee benefits are deductible on a
cash basis (i.e. when paid).
(b) A loan payable has a carrying amount of $250. The repayment of the loan will have no tax
consequences.
(c) Revenue received in advance has a carrying amount of $400. The amount was taxed on a cash
basis (i.e. when received).

STEP 2: COMPARE THE TAX BASE TO THE CARRYING

AMOUNT TO DETERMINE TEMPORARY DIFFERENCES
A temporary difference is the ‘difference between the carrying amount of an asset or liability in the
statement of financial position and its tax base’ (IAS 12, para. 5).
This is illustrated in figure 4.6.

FIGURE 4.6 Calculating the temporary difference

Temporary Carrying
= – Tax base
difference amount

Source: CPA Australia 2019.

Therefore, temporary differences are identified by:

• comparing the carrying amount (in the statement of financial position) of each asset and liability with
its tax base
• identifying all items that have a carrying amount of $nil (i.e. are not reported in the statement of financial
position) but have a tax base. For example, research costs that are expensed when incurred (i.e. no asset
is recorded) but which are deductible for tax purposes in a subsequent reporting period.
Using a worksheet format to present the statement of financial position and tax base will assist in
identifying taxable and deductible temporary differences. This is illustrated in table 4.5.

TABLE 4.5 Illustrative worksheet extract

Taxable Deductible
Carrying temporary temporary
amount Tax base difference difference
Assets and liabilities $ $ $ $
Cash 10 000 10 000 — —
Trade receivables 75 000 80 000 — $5 000
Inventories 115 000 115 000 — —
Plant and equipment 1 250 000 1 050 000 200 000 —
Trade payables 60 000 60 000 — —
Provisions 5 000 nil — 5 000
Borrowings 750 000 750 000 — —

Source: CPA Australia 2019.

MODULE 4 Income Taxes 169

 The term temporary refers to the fact that such differences originate in a reporting period and reverse
in one or more later reporting periods. All temporary differences reverse over time. For example, using
the data included in table 4.5, the deductible temporary difference of $5000 that arises in relation to the
provision will reverse when the provision is settled.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraph 17 of IAS 12, and Illustrative Examples (in
the IFRS Compilation Handbook) part A (paragraphs 1–11), part B (paragraphs 1–8) and part C (paragraphs 1–4) of
IAS 12.

Table 4.6 summarises the relationship between the carrying amounts of assets and liabilities, the tax
base, and deferred tax assets and liabilities.

TABLE 4.6 Relationship between carrying amount, tax base and temporary differences

Statement of financial position

Asset Liability

Carrying amount > tax base 1 Taxable temporary difference 4 Deductible temporary difference

Carrying amount < tax base 2 Deductible temporary difference 5 Taxable temporary difference

Carrying amount = tax base 3 None 6 None

Source: Adapted from CPA 2016.

To understand the rationale for the six relationships in table 4.6, it is necessary to recall some of the key
concepts already discussed. We will explore these concepts further and begin by considering relationships
between the carrying amount and the tax base for assets (cases 1 to 3 in table 4.6).

Assets
The first three relationships outlined in table 4.6 in regard to assets are explained in table 4.7.

TABLE 4.7 Assets — relationship between carrying amount, tax base and temporary differences

Assets

Is there a difference between the What are the future tax conse- Do the future tax consequences give
carrying amount and the quences of recovering the asset rise to a temporary difference?
tax base? at its carrying amount?

1. Carrying amount > tax base The future taxable amounts from Yes. A taxable temporary difference
recovery of the asset (through use arises.
or sale, discussed later) exceed
future deductible amounts.

2. Carrying amount < tax base The future deductible amounts Yes. A deductible temporary
exceed the future taxable amounts difference arises.
from recovery of the asset (through
use or sale).

3. Carrying amount = tax base Either there are no future tax No temporary difference arises.
consequences, or the future
deductible and future taxable
amounts are equal.

Source: CPA Australia 2019.

The tax base of an asset is the ‘amount that will be deductible for tax purposes against any taxable
economic benefits that will flow to an entity when it recovers the carrying amount of the asset’ (IAS 12,
para. 7). When an entity recovers the carrying amount of the item by using an asset, it generates revenue
that is taxable. If the tax base is lower than the carrying amount, then the entity will be expected to pay tax
on that difference in the future; therefore, a taxable temporary difference exists, giving rise to a deferred

170 Financial Reporting

tax liability. If the tax base is greater than the carrying amount, then the entity will be expected to enjoy
deductions greater than the taxable amounts in the future; therefore, a deductible temporary difference
exists, giving rise to a deferred tax asset.
For example, assume that the taxable amount estimated to be generated by the entity in the future when
the carrying amount of an asset is recovered is $80 (equal to its carrying amount). If the total depreciation
that it will be able to deduct from this amount for tax purposes (i.e. the tax base) is only $70, the entity
will still pay income tax with respect to the difference of $10 when it recovers the carrying amount of the
asset. Therefore, a taxable temporary difference of $10 exists as the carrying amount of the asset is greater
than the tax base ($80 > $70).
This relationship can be viewed as follows.

Future deductible
Tax base
= amounts
70
70

Temporary Carrying
difference = amount – Tax base 70
10 80

As an extension of this analysis, paragraph 7 of IAS 12 explains that where the future economic benefits
from recovering an asset are not taxable, the tax base of the asset is equal to its carrying amount. In such
circumstances, there is no temporary difference. For example, where the recovery of an asset such as a
loan receivable does not have any future tax consequences (i.e. the recovery of the principal is not taxable
and there are no future deductions), a temporary difference does not exist.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraph 7 of IAS 12 and refer to example 5 (which is
below paragraph 7).

Liabilities
The tax base of a liability is its carrying amount less future deductible amounts arising from the liability.
Therefore, if the settlement of the amount of the liability is fully tax deductible in the future, the tax base
will be $nil.
Table 4.8 explains the second set of relationships outlined in table 4.6 (numbers 4 to 6) in relation
to liabilities.

TABLE 4.8 Liabilities — relationship between carrying amount, tax base and temporary differences

Liabilities

Is there a difference between the What are the future tax conse- Do the future tax consequences give
carrying amount and the quences of settling the liability at rise to a temporary difference?
tax base? its carrying amount?

4. Carrying amount > tax base There will be future deductible Yes. A deductible temporary
benefits from settling the liability. difference arises.

5. Carrying amount < tax base There will be future taxable amounts Yes. A taxable temporary difference
arising when the liability is settled. arises.

6. Carrying amount = tax base Either there are no future tax No temporary difference arises.
consequences, or the future
deductible and future taxable
amounts are equal.

Source: CPA Australia 2019.

MODULE 4 Income Taxes 171

 For example, if a liability with a carrying amount of $100 is deductible for tax purposes at the time of
settlement, the liability has a tax base of $nil. Given the carrying amount of $100 > tax base of nil, there
will be future deductible benefits from settling the liability and a deductible temporary difference arises.

STEP 3: MEASURE DEFERRED TAX ASSETS AND DEFERRED

TAX LIABILITIES
Once temporary differences have been determined, the related deferred tax assets and deferred tax
liabilities can be calculated using the appropriate tax rate as shown in figure 4.7.

FIGURE 4.7 Calculating deferred tax asset and deferred tax liability

Deductible
Deferred
temporary × Tax rate =
tax asset
difference

Taxable
Deferred
temporary × Tax rate =
tax liability
difference

Source: CPA Australia 2019.

The deductible temporary differences will give rise to deferred tax assets as the entity will be able to
enjoy tax benefits in the form of tax deductions, while taxable temporary differences will give rise to
deferred tax payable because the entity will have more tax liabilities in the future.
In some cases, determining the tax base for assets or liabilities and their related temporary differences
may not be straightforward. As a consequence, it would be difficult to calculate any deferred tax assets
or liabilities. To deal with those cases, IAS 12, paragraph 10 recommends that entities consider the
fundamental principle upon which IAS 12 is based: ‘that an entity shall, with certain limited exceptions,
recognise a deferred tax asset (liability) whenever recovery or settlement of the carrying amount of an
asset or liability would make future tax payments smaller (larger) than they would be if such recovery or
settlement were to have no tax consequences.’
This fundamental principle can be expressed in simple terms to mean that:
• if an asset or liability has an expected future taxable amount greater than the future deductions that can
be claimed against it, a taxable temporary difference exists for which a deferred tax liability will be
recognised
• if an asset or liability has an expected future taxable amount lower than the future deductions that can
be claimed against it, a deductible temporary difference exists for which a deferred tax asset will be
recognised.
Calculating the temporary differences and the amounts to be recognised under the related deferred tax
assets and liabilities in this way removes the need for performing step 1 in the calculation of deferred tax
(i.e. determining the tax bases).

QUESTION 4.3

Refer to IAS 12, paragraph 7, example 3.

Assume that the carrying amount of the trade receivables in the example is $80. The $80 is net of
expected doubtful debts of $20.
(a) Use the fundamental principle from paragraph 10 of IAS 12 to explain why a deferred tax asset
arises for this transaction.
(b) What is the amount of the temporary difference implied by your answer to requirement (a)?
(c) Explain which cell of table 4.6 this amended example falls into.

172 Financial Reporting

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 15–17 of IAS 12, noting that for the time being
we will defer discussion of the exceptions mentioned in paragraph 15. You may also wish to read items 4 and 5 of
part A of Illustrative Examples to IAS 12 (in the IFRS Compilation Handbook).

QUESTION 4.4

Part A (adapted from part A of the Illustrative Examples to IAS 12)

(a) Using the fundamental principle from paragraph 10 of IAS 12, explain why a deferred tax liability
should be recognised in relation to the following scenarios.

Development costs
Development costs of $1000 that are recognised as an asset (i.e. capitalised) and will be
amortised to the statement of P/L and OCI. The costs were deducted in determining taxable
profit when they were incurred (i.e. when the cash was paid).

Prepaid expenses
Prepaid expenses (recognised as an asset for accounting purposes) of $1000 that have
already been deducted in determining the taxable profit in the period in which they were
paid.

(b) Using the relevant formulas, determine the tax base, the temporary difference and the deferred
tax asset or liability associated with the items in requirement (a).

Part B
A liability that was to be settled in units of a foreign currency was recognised in the reporting
currency financial statements of an entity at $100. Due to movements in the exchange rate between
the reporting currency and the foreign currency, the liability was remeasured by $20 to $120.
The increase in the carrying amount of the liability was taken into account as a foreign exchange
loss when measuring accounting profit before tax for the current year. However, the loss is not
deductible against taxable profit until foreign currency is acquired to settle the liability in future.
(a) Use the fundamental principle from paragraph 10 of IAS 12 to explain why a deferred tax asset
arises for this transaction.
(b) What is the amount of the temporary difference implied by your answer to requirement (a)?
(c) Apply the relevant formulas to calculate the tax base for this liability after its remeasurement
and the temporary difference created.
(d) Apply the relevant formula to calculate the deferred tax asset created as the result of the
remeasurement of the liability.

Refer to Note 5 ‘Income tax’ in the notes to financial statements of Techworks Ltd. What items in the
statement of financial position give rise to deferred tax? Explain how the deferred tax arises.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read example 2 ‘Deferred tax assets and liabilities’ under
‘Illustrative computations and presentations’ in part C of the Illustrative Examples in IAS 12 (in the IFRS Compilation
Handbook, pp. B587–B595).

Appropriate Tax Rates to be Used in the Calculation of Deferred Tax Assets

and Liabilities
According to IAS 12, the measurement of deferred tax assets and deferred tax liabilities (which arise from
deductible temporary differences and taxable temporary differences) must reflect the expected manner of
the recovery (settlement) of the underlying asset (liability) and the tax rates that will apply in the period
when the underlying asset (liability) is realised (settled).
The relevant requirements of IAS 12 that give effect to this principle are as follows.
• Deferred tax assets and liabilities shall be measured at the tax rates that are expected to apply to the
period when the asset is realised or the liability is settled, based on tax rates (and tax laws) that have
been enacted or substantively enacted by the end of the reporting period (IAS 12, para. 47).
• The measurement of deferred tax liabilities and deferred tax assets shall reflect the tax consequences
that would follow from the manner in which the entity expects, at the end of the reporting period, to
recover or settle the carrying amount of its assets and liabilities (IAS 12, para. 51).

MODULE 4 Income Taxes 173

 IAS 12 does not define, or specify, the conditions for substantive enactment of tax rates. Rather, IAS 12
(para. 48) states that:
Current and deferred tax assets and liabilities are usually measured using the tax rates (and tax laws)
that have been enacted. However, in some jurisdictions, announcements of tax rates (and tax laws) by
the government have the substantive effect of actual enactment, which may follow the announcement by a
period of several months. In these circumstances, tax assets and liabilities are measured using the announced
tax rate (and tax laws).

Accordingly, substantive enactment is determined by the legal framework of a jurisdiction.

Further, paragraph 51A of IAS 12 explains that, in some tax jurisdictions, the amount of tax ultimately
payable or recoverable may depend on the manner in which an entity recovers (settles) the carrying amount
of an asset (liability). The manner of recovery (settlement) may affect either or both of:
(a) the tax rate that is to be applied, or
(b) the tax base of the item.
In such cases, IAS 12 requires an entity to measure the deferred tax liability or deferred tax asset using
the tax rate and the tax base that are consistent with the expected manner of recovery or settlement.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 46 to 51A of IAS 12.

These concepts are illustrated in examples 4.5 and 4.6.

EXAMPLE 4.5

The Manner of Recovery Affects the Tax Rate

Entity D owns an item of plant and equipment that has a carrying amount of $100 000 and a tax base of
$60 000. In the tax jurisdiction of Entity D, a tax rate of 20% applies if the plant and equipment is sold,
and a tax rate of 30% applies to other income (i.e. if the asset is recovered through use). Entity D would
recognise a deferred tax liability of:
• $8000 ($40 000 × 20%) if it expects to sell the plant and equipment (without further use), or
• $12 000 ($40 000 × 30%) if it expects to recover the carrying amount of the plant and equipment
through use.
It is possible to have different tax consequences for an asset, depending on whether an asset is
expected to be held for use or sold without further use. Capital tax consequences such as those arising
from sale of plant and equipment (without further use) are often referred to as capital gains tax (CGT).
The CGT consequences may differ from income tax consequences — that is, the CGT cost base may be
different from the tax base of the asset if it is recovered through use. The CGT cost base may also be
different from the cost of the asset recognised for accounting purposes. Any difference between the CGT
cost base and the carrying amount of an asset affects the tax base of an item, and therefore also has an
impact on the calculation of deferred tax consequences.

EXAMPLE 4.6

The Manner of Recovery Affects the Tax Base

Entity F owns a building. The building was originally purchased by Entity F for $100 000. For accounting
purposes, the building is depreciated on a straight-line basis over five years, and for tax purposes, the
building is depreciated on a straight-line basis over four years. Tax depreciation is deductible each year.
The building has no residual value.
In the jurisdiction in which Entity F operates, the CGT cost base of the building (the amount deductible
against any taxable proceeds on sale) is $120 000.

174 Financial Reporting

 Scenario 1 — Asset to be Held for Use
At the end of year one, the entity expects to continue to use the asset for the next four years. Entity F
would then record the following balances.

Accounting Tax
$‘000 $‘000
Cost 100 100
Less: Accumulated depreciation 20 25
Carrying amount/Tax base 80 75

Assuming that Entity F expects to continue to use the asset, the revenue generated through the use of
the asset will be taxable. At the end of year one, the tax base of the building can be calculated as follows
(refer to figure 4.4).

Tax base Future

=
of an asset deductible amounts

75 = 75

Scenario 2 — Asset to be Sold

At the end of year one, the entity expects to sell the asset in year three. At the end of the year,
Entity F would then record the following balances (assuming that the depreciation deductions reduce
the CGT cost base of the asset).
Accounting Tax
$‘000 $‘000
Cost 100 120 (CGT cost base)
Less: Depreciation 20 25
Carrying amount/Tax base 80 95

Assuming that Entity F expects to sell the asset, the revenue generated through the sale of the asset
will be taxable. At the end of year one the tax base of the building can be calculated as follows (refer to
figure 4.4).

Tax base Future

=
of an asset deductible amounts

95 = 95

Discounting of Deferred Tax Assets and Deferred Tax Liabilities is

Not Permitted
Deferred tax assets and deferred tax liabilities are expected to be recovered or settled at dates in the
future. It may seem appropriate that these amounts should be discounted to their present values at each
reporting date; however, IAS 12 does not permit such discounting (IAS 12, para. 53) for the reasons given in
paragraph 54. Nevertheless, where the carrying amount of an asset or liability is determined on a discounted
basis, any temporary difference together with the related deferred tax asset or deferred tax liability will be
determined based on those discounted amounts. The temporary difference, and therefore the deferred tax

MODULE 4 Income Taxes 175

 asset or deferred tax liability, is to be determined on the basis of the discounted values recognised in the
carrying amount of the asset or liability.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 53 and 54 of IAS 12.

SUMMARY
The core principle of IAS 12 is that the financial statements should recognise the current and future tax
consequences of:
• transactions and other events of the current period that are recognised in an entity’s financial statements
• the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in an
entity’s statement of financial position.
These current and future tax consequences are reflected in the financial statements as ‘current tax
liability, ‘current tax assets’, ‘deferred tax assets’, ‘deferred tax liabilities’ and ‘tax expense (income)’
(refer back to table 4.1 earlier in the module).
Tax expense (income) for a period comprises current tax expense (income) together with deferred tax
expense (income). Current tax expense (income) is the portion of current tax payable (recoverable) that is
recognised in the current period. Deferred tax expense (income) reflects movement in deferred tax assets
and deferred tax liabilities recognised in the statement of profit or loss and other comprehensive income.
A taxable temporary difference is a temporary difference that will result in taxable amounts in the future
when the carrying amount of an asset or liability is recovered or settled. As such, future tax payments are
larger, resulting in the recognition of a deferred tax liability.
A deductible temporary difference is a temporary difference that will result in deductible amounts in
the future when the carrying amount of an asset or liability is recovered or settled. As such, future tax
payments are smaller, resulting in the recognition of a deferred tax asset.
A deferred tax liability arises when recovery or settlement of the carrying amount of an asset or liability
will have tax consequences that cause future tax payments to be larger than they would have been in the
absence of those tax consequences.
A deferred tax asset arises when recovery or settlement of the carrying amount of an asset or liability
will have tax consequences that cause future tax payments to be smaller than they would have been in the
absence of those tax consequences.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

4.1 Explain the terms ‘taxable temporary differences’ and ‘deductible temporary differences’.
• Income tax expense is the aggregate amount included in the determination of profit or loss for the
period in respect of current tax and deferred tax.
• Current tax is the amount of income taxes payable (recoverable) in respect of taxable profit (tax loss)
for the period.
• Deferred tax is the movement in deferred tax assets and liabilities for the period recognised in the
profit or loss.
• Taxable temporary differences are the temporary differences that will result in taxable amounts in
determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability
is recovered or settled.
• Deductible temporary differences are the temporary differences that will result in amounts that are
deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the
asset or liability is recovered or settled.
4.2 Apply the requirements of IAS 12 with respect to current and deferred tax assets and liabilities.
• The core principle of IAS 12 Income Taxes is that the financial statements should recognise the
current and future tax consequences of:
– the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in
an entity’s statement of financial position
– transactions and other events of the current period that are recognised in an entity’s financial
statements.

176 Financial Reporting

 • Taxable profit (tax loss) can be calculated directly by applying the relevant tax laws to the transactions
and other events of the current reporting period to determine the difference between assessable
income and allowable deductions.
• Taxable profit (tax loss) can be calculated indirectly by adjusting the accounting profit of the current
reporting period for differences between accounting and tax treatments of items recognised in the
accounting profit.
4.3 Apply the tax rates and tax bases that are consistent with the manner of recovery or settlement
of an asset or liability.
• Key steps in accounting for current tax are as follows.
– Step 1: Calculate the amount expected to be paid to (recovered from) the taxation authorities,
using the tax rates (and tax laws) that have been enacted or substantively enacted by the end of
the reporting period.
– Step 2: Recognise the amount of current tax in P/L for the period, in OCI, or directly in equity, as
appropriate.
• Key steps for calculating deferred tax are as follows.
– Step 1: Determine the tax base of assets and liabilities.
– Step 2: Compare the tax base with the carrying amount of assets and liabilities to determine
taxable temporary differences and deductible temporary differences.
– Step 3: Measure deferred tax assets (arising from deductible temporary differences) and deferred
tax liabilities (arising from taxable temporary differences).
– Step 4: Recognise the movement in the deferred tax assets (arising from deductible temporary
differences) and deferred tax liabilities (arising from taxable temporary differences) as deferred
tax, taking into account the limited recognition exceptions, in P/L for the period, in OCI, or directly
in equity, as appropriate.
• The tax base of a liability that is not in the nature of unearned income is the carrying amount, less
any amount that will be deductible for tax purposes in respect of that liability in future periods.
• The tax base of a liability that is in the nature of unearned income is the carrying amount less any
amount that will not be included in taxable profit in future periods.
• The tax base of an asset is the amount that will be deductible for tax purposes against any taxable
economic benefits that will flow to an entity when it recovers the carrying amount of the asset. If
those economic benefits will not be taxable, the tax base of the asset is equal to its carrying amount.

MODULE 4 Income Taxes 177

PART B: RECOGNITION OF DEFERRED TAX
ASSETS AND LIABILITIES
INTRODUCTION
As outlined in table 4.4 in part A, there are four key steps required to recognise and measure deferred tax.
Part B of the module discusses step 4.
IAS 12 requires an entity to recognise deferred tax assets and deferred tax liabilities, with certain limited
exceptions. IAS 12 also prescribes separate recognition rules (and limited recognition exceptions) for
deferred tax assets and deferred tax liabilities.
Each will be discussed and considered in this part of the module.

Relevant Paragraphs
To assist in achieving the objectives of part B, you may wish to read the following paragraphs of IAS 12.
Where specified, you need to be able to apply these paragraphs as referenced in this module.

Subject Paragraphs
Recognition of deferred tax liabilities and deferred tax assets 15–16
Initial recognition of an asset or liability 22(c)
Deductible temporary differences 24–25, 26(a), 26(b), 26(d), 27–31
Unused tax losses and unused tax credits 34–36
Reassessment of unrecognised deferred tax assets 37
Measurement 46–56
Recognition of current tax and deferred tax 57–60

4.4 RECOGNITION OF DEFERRED TAX LIABILITIES

As explained in paragraph 15 of IAS 12, a deferred tax liability must be recognised for all taxable temporary
differences, except for certain limited exceptions that will be discussed in this section.
Under the IAS 12, paragraph 15 exceptions, deferred tax liabilities are not recognised when they
arise from:
(a) the initial recognition of goodwill; or
(b) the initial recognition of an asset or liability in a transaction which:
(i) is not a business combination; and
(ii) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss) . . .
(IAS 12, para. 15).

Each of these two recognition exceptions is now discussed.

INITIAL RECOGNITION OF GOODWILL ARISING FROM A

BUSINESS COMBINATION (IAS 12, PARA. 15(A))
Goodwill arising from a business combination is recognised and measured in accordance with IFRS 3
Business Combinations.
Many taxation authorities do not allow reductions in the carrying amount of goodwill as a deductible
expense in determining taxable profit. Moreover, in such jurisdictions, the cost of goodwill is often not
deductible when a subsidiary disposes of its underlying business. In such jurisdictions, goodwill has a tax
base of nil. Any difference between the carrying amount of goodwill and its tax base of nil is a taxable
temporary difference. However, [IAS 12] does not permit the recognition of the resulting deferred tax
liability because goodwill is measured as a residual and the recognition of the deferred tax liability would
increase the carrying amount of goodwill (IAS 12, para. 21).

178 Financial Reporting

INITIAL RECOGNITION OF OTHER ASSETS OR LIABILITIES
NOT IN A BUSINESS COMBINATION TRANSACTION (IAS 12,
PARA. 15(B))
A temporary difference may arise on initial recognition of an asset or liability if, for example, part or all
of the cost of an asset will not be deductible for tax purposes.
[I]f the transaction is not a business combination, and affects neither accounting profit nor taxable profit,
an entity would, in the absence of the exemption provided by paragraphs 15 and 24, recognise the resulting
deferred tax liability or asset and adjust the carrying amount of the asset or liability by the same amount.
Such adjustments would make the financial statements less transparent. Therefore, [IAS 12] does not permit
an entity to recognise the resulting deferred tax liability or asset, either on initial recognition or subsequently
. . . Furthermore, an entity does not recognise subsequent changes in the unrecognised deferred tax liability
or asset as the asset is depreciated (IAS 12, para. 22(c)).

For example, an entity purchases an item of machinery for $100; however, the maximum deduction
available for items of machinery of this type has been limited by the taxation authority to $60 per item of
machinery.
As a result of the recognition exemption contained in paragraph 15(b), deferred tax liabilities are not
recognised and the journal entry to record the acquisition of the item of machinery is as follows.

Dr Machinery (property, plant and equipment) 100

Cr Cash/accounts payable 100

In the absence of the exemption contained in paragraph 15(b), the journal entry to record the acquisition
of the item of machinery would have been as follows.

Dr Machinery (property, plant and equipment) 112

(Cost $100 + Deferred tax ($40 × 30%))
Cr Deferred tax liability ($40 × 30%) 12
Cr Cash/accounts payable 100

However, IAS 12, paragraph 22(c) does not permit an entity to recognise the resulting deferred tax
liability or asset, either on initial recognition or subsequently, as such adjustments would make the financial
statements less transparent and potentially misleading.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraph 22(c) of IAS 12, including the related example.

Paragraph 39 of IAS 12 also includes an exemption for a deferred tax liability for taxable temporary
differences associated with investments in subsidiaries, branches and associates, and interests in joint
arrangements in certain circumstances. Understanding this exemption is outside the scope of this module.

4.5 RECOGNITION OF DEFERRED TAX ASSETS

Deferred tax assets may arise from:
• deductible temporary differences
• unused tax losses and unused tax credits.
As explained in paragraph 24 of IAS 12, a deferred tax asset must be recognised for all deductible
temporary differences to the extent that it is probable that taxable profit will be available against which
the deductible temporary difference can be utilised, except for certain limited exclusions.
Similarly, paragraph 34 of IAS 12 explains that a deferred tax asset shall be recognised for the carry-
forward of unused tax losses and unused tax credits to the extent that it is probable that future taxable profit
will be available against which the unused tax losses and unused tax credits can be utilised.
These recognition rules (and the limited recognition exceptions) are now discussed.

MODULE 4 Income Taxes 179

Recognition Rules for Deductible Temporary Differences
When applying the recognition criteria to deferred tax assets arising from deductible temporary differences
(IAS 12, para. 24) consideration must be given to:
• whether any of the specific recognition exceptions apply
• the probability that taxable profit will be available against which the deductible temporary difference
can be utilised.
Each of these matters is now discussed separately.
Recognition Exceptions
In specified circumstances, deferred tax assets may not be recognised for certain deductible temporary
differences. Specifically, deferred tax assets are not recognised when the related deductible temporary
differences arise from the initial recognition of an asset or liability in a transaction that:
(a) is not a business combination; and
(b) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss) (IAS 12,
para. 24).

These restrictions mirror the restrictions that apply to the recognition of deferred tax liabilities under
paragraph 15(b) of IAS 12. For example, an entity purchases an asset at a cost of $1000. For tax purposes,
on initial recognition, the asset has a tax base of $1200 (under the relevant tax laws). As a result of the
recognition exemption contained in paragraph 24, the entity does not recognise a deferred tax asset for the
difference between the initial carrying amount of the asset and the tax base.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraph 33 of IAS 12, including the related example.

Paragraph 44 of IAS 12 also includes an exemption for a deferred tax asset for deductible temporary
differences associated with investments in subsidiaries, branches and associates, and interests in joint
arrangements in certain circumstances — similar to paragraph 39 for deferred tax liabilities. Again,
understanding this exemption is outside the scope of this module.

Application of the Probable Criterion

A deferred tax asset arising from a deductible temporary difference is recognised only if it is probable
that future economic benefit associated with the item will flow to the entity. The probability of the flow
of economic benefits to the entity from the reversal of deductible temporary differences is dependent on
the probability of future taxable profits, against which the related deductible temporary difference can be
deducted (IAS 12, paras 24 and 27).
IAS 12 does not include a definition of ‘probable’. Guidance on the generally accepted meaning
of ‘probable’ is contained in IAS 37 Provisions, Contingent Liabilities and Contingent Assets, which
states that:
. . . an outflow of resources or other event is regarded as probable if the event is more likely than not to
occur, that is, the probability that the event will occur is greater than the probability that it will not . . .
(IAS 37, para. 23).

IAS 37 indicates that the definition in paragraph 23 is not necessarily applicable to other standards.
However, the appendix A of IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
also contains a similar definition, identifying probable to mean ‘more likely than not’. As such, it is
reasonable to use this definition to assist in understanding the application of paragraphs 24 and 27 of
IAS 12. Therefore, a deferred tax asset will be recognised for a deductible temporary difference if it is
more likely than not that the entity will earn sufficient taxable profits against which the related deductible
temporary difference can be deducted in the future.
To determine whether the probable criterion is satisfied, the preparers will need to exercise professional
judgment. As described in module 1, the reliability of the professional judgment by preparers can be
improved with the help of artificial intelligence and other technological advancements. Deep learning
software can be used to analyse thousands of transactions to instantly and accurately identify the likelihood
of incurring future tax liabilities or benefitting from future tax deductions.

180 Financial Reporting

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 24, 25 and 27 of IAS 12 to review the deferred
tax asset recognition requirements.

Paragraph 28 of IAS 12 explains that a primary source of taxable profit is the reversal of taxable
temporary differences. When a taxable temporary difference reverses, taxable amounts arise and are
included in taxable profit. A deductible temporary difference can then be used against the resulting
taxable profit.
Further guidance is contained in paragraph 29 of IAS 12, which explains that when there are insufficient
taxable temporary differences, the deferred tax asset is recognised to the extent that:
• it is probable that there will be other taxable profit, after allowing for future taxable profit required in
order to utilise future deductible temporary differences, or
• the entity can create taxable profit by using tax planning opportunities.
Tax planning opportunities are ‘actions that the entity would take to create or increase taxable income
in a particular period before the expiry of a tax loss or tax credit carry-forward’ (IAS 12, para. 30).
This relationship is shown diagrammatically in figure 4.8.

FIGURE 4.8 Tax planning relationships

Yes
Are there sufficient taxable temporary differences?

No
Yes
Is it probable that there will be other taxable profit available?

No
Yes
Can the entity create taxable profit by using tax planning opportunities?

No
Recognise deferred
Do NOT recognise deferred tax asset tax asset

Source: Based on IAS 12, para. 36. © CPA Australia 2019.

Accounting treatment for an entity with a history of tax losses is discussed later in this module when
addressing the recognition rules related to unused tax losses and unused tax credits in IAS 12.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 28–31 to confirm your understanding of when
the probability recognition criterion is satisfied for deferred tax assets.

Examples 4.7 and 4.8 illustrate how the ‘probability criterion’ would be satisfied for the recognition of
the deferred tax asset arising from a deductible temporary difference.

EXAMPLE 4.7

Probability of the Future Utilisation of Deductible Temporary Differences

(Scenario 1)
The records of HIJ Investments PLC as at 31 December 20X1 show the following.
Warranty Obligations — Deductible Temporary Difference
• A deductible temporary difference of $60 000 relating to warranty obligations, which was expected to
reverse in the future reporting periods, as follows.
– $20 000 in 20X2 (i.e. leaving a remaining deductible temporary difference of $40 000)
– $40 000 in 20X3 (i.e. leaving a $nil remaining deductible temporary difference)
Receivables — Taxable Temporary Difference
• A taxable temporary difference of $100 000, relating to a receivable for credit sales that were recognised
in the measurement of accounting profit in the year ended 31 December 20X1. The receivable is
recognised for accounting purposes when the performance obligation is satisfied by the transfer of

MODULE 4 Income Taxes 181

 control of the promised goods to the customer. For the purposes of this illustration, we will assume that
the income is taxed when the cash is received.
• It was expected that this taxable temporary difference of $100 000 would reverse on receipt of cash in
future reporting periods, as follows.
– $45 000 in 20X2 (i.e. leaving a remaining taxable temporary difference of $55 000)
– $55 000 in 20X3 (i.e. leaving a $nil remaining taxable temporary difference)
• There were no other transactions in 20X1, 20X2 and 20X3.
• Taxable profit for the year ended 31 December 20X1 was $nil.
• The entity does not have a history of tax losses.
Recognising a Deferred Tax Asset
The deductible temporary difference originating during the period ended 31 December 20X1 gives rise
to a deferred tax asset of $18 000 ($60 000 × 30%). Applying the requirements of paragraph 24 of
IAS 12, this deferred tax asset should be recognised in full if ‘it is probable that taxable profit will be
available against which the deductible temporary difference can be utilised’.

Reversal of deductible Reversal of taxable

Year temporary difference temporary difference Result
20X2 20 000 45 000 DTD < TTD
20X3 40 000 55 000 DTD < TTD
Total 60 000 100 000

The analysis here shows that the expected reversals of the taxable temporary difference in years
20X2 ($45 000) and 20X3 ($55 000) are greater than the expected reversals of the deductible temporary
difference in each of these years ($20 000 and $40 000 respectively).
This means that the expected taxable profits in each of 20X2 and 20X3, arising from the reversal of the
taxable temporary difference, are sufficient to absorb the amounts of the deductible temporary difference
that reverses in each period. As a consequence, HIJ Investments PLC should recognise a deferred tax
asset of $18 000 ($60 000 × 30%) as at 31 December 20X1.
Using the language of paragraph 28(a) of IAS 12, it is probable that sufficient taxable profit will
be available, because there are ‘sufficient taxable temporary differences relating to the same taxation
authority and the same taxable entity which are expected to reverse in the same period as the expected
reversal of the deductible temporary difference’.

EXAMPLE 4.8

Probability of the Future Utilisation of Deductible Temporary Differences

(Scenario 2)
It should be noted that this example adopts very similar data to that used in example 4.7. The key points
of difference are that the data for this example assumes that the deductible temporary difference will be
reversed in full in 20X2 and an additional $55 000 is expected as future deductible expenses in 20X3.
The records of HIJ Investments PLC as at 31 December 20X1 show the following.
Warranty Obligations — Deductible Temporary Difference
• A deductible temporary difference of $60 000 relating to warranty obligations, which was expected to
reverse in full in 20X2 (i.e. leaving a $nil remaining deductible temporary difference).
Receivables — Taxable Temporary Difference
• A taxable temporary difference of $100 000, relating to a receivable for credit sales that were recognised
in the measurement of accounting profit in the year ended 31 December 20X1. The receivable is
recognised for accounting purposes when the performance obligation is satisfied. For the purposes
of this illustration, we will assume that the income is taxed when the cash is received.
• It was expected that the taxable temporary difference would reverse on receipt of cash in future reporting
periods, as follows.
– $45 000 in 20X2 (i.e. leaving a remaining taxable temporary difference of $55 000)
– $55 000 in 20X3 (i.e. leaving a $nil remaining taxable temporary difference)
• Other expenses that were expected to be deductible for tax purposes during 20X3 were $55 000.
• There were no other transactions in 20X1, 20X2 and 20X3.
• Taxable profit for the year ended 31 December 20X1 was $nil.

182 Financial Reporting

 • Tax losses can be carried forward for offset against future taxable income for only one year. The carry-
back of tax losses is not permitted.
• HIJ Investments PLC does not have a history of tax losses.
Recognising a Deferred Tax Asset
In this case, the deductible temporary difference of $60 000 is expected to reverse in full in 20X2. However,
the amount of taxable profit arising from the reversal of the taxable temporary difference in 20X2 is only
$45 000, and the reversal of the taxable temporary differences in 20X3 is equal to the other deductible
expenses in 20X3 (i.e. taxable profit for 20X3 is expected to be $nil). Therefore, the expected taxable
profit in 20X2 and 20X3 is not sufficient to absorb the full amount of the deductible temporary difference.
On this basis, paragraph 24 of IAS 12 has not been satisfied.
As only $45 000 of the deductible temporary difference can be used against the taxable temporary
difference in 20X2, and there are no taxable temporary differences in excess of the future deductions in
20X3, the amount of the deferred tax asset that can be recognised at 31 December 20X1 is restricted
to $13 500 ($45 000 × 30%), leaving $15 000 ($60 000 – $45 000) of the deductible temporary difference
unrecognised.

QUESTION 4.5

(a) Using the data and analysis in example 4.8, present the income tax journal entries for
31 December 20X1.
(b) Assume that the tax legislation allows for the carrying back of tax losses for deduction from
taxable income of the three years before the year of the tax loss. Explain whether or not you
would recognise the full amount of the deferred tax asset as at 31 December 20X1.

RECOGNITION OF DEFERRED TAX

Deferred tax expense (income) arises from the recognition of the movement in deferred tax assets and
deferred tax liabilities in step 4, recognising deferred tax.
As discussed in part A of this module (in relation to the recognition of current tax), the principle adopted
by IAS 12 (para. 12) to account for the tax effects of a transaction or other event (e.g. the recognition of
current tax and deferred tax) is that accounting for tax should be consistent with the accounting treatment
of the transaction or event itself.
For example, deferred tax is recognised in P/L (i.e. included in the amount of tax expense (tax income)
for the reporting period) to the extent that it relates to items of income and expense recognised in P/L for
the reporting period.
However, deferred tax can also relate to gains or losses recognised in OCI, items recognised directly
in equity or business combination transactions. In these circumstances, deferred tax is recognised in OCI,
directly in equity or as part of accounting for the business combination respectively, to the extent that it
relates to such items or transactions.
Paragraphs 58 to 68C of IAS 12 describe this principle, with the main requirements contained in
paragraph 58 and 61A as discussed with regards to the recognition of current tax in part A of this module.
The recognition of deferred tax outside of P/L will be discussed further in part C of this module.
(Business combinations and investment entities are covered in module 5.)

QUESTION 4.6

Lowsales Ltd has the following extract from its statement of financial position as at 30 June 20X1.

$
Cash 97 000
Accounts receivable (net) 234 000
Prepaid rent 4 000
Inventory 228 000
Equipment (net) 48 000
Total assets 611 000

MODULE 4 Income Taxes 183

 $
Accounts payable 67 000
Revenue received in advance 18 000
Bank loan 100 000
Foreign currency loan payable 32 000
Employee benefits liability 65 000
Total liabilities 282 000

The following information is relevant for Lowsales Ltd.

1. Revenue received in advance is recognised in the statement of financial position of
Lowsales Ltd and will be recognised in the statement of P/L and OCI in a later reporting period
(i.e. as the revenue is earned). It is included in taxable profit in 20X1 (i.e. it is taxed on a
cash basis).
2. The employee benefits liability increases with additional employee expenses and decreases
when the liability is paid. Lowsales Ltd receives a tax deduction when employee benefits
are paid.
3. For tax purposes, deductions can only be claimed for bad debts written off. At 30 June 20X1, the
allowance for doubtful debts was $11 000. Doubtful debts expense was $5000 for the year ended
30 June 20X1. The revenue relating to the accounts receivable has already been taxed.
4. The equipment was originally purchased four years ago for $80 000. The equipment is being
depreciated for tax purposes over eight years and for accounting purposes over ten years.
5. The foreign currency loan payable was originally drawn down at $33 000. The $1000 foreign
exchange gain included in the statement of P/L and OCI is not included in taxable profit until
the loan is settled.
6. Prepaid rent has increased by $2000 during the year. This additional outlay can be claimed as a
tax deduction as incurred (i.e. when it is paid).
7. There are no future tax consequences associated with the cash, accounts payable or inventory
assets.
Assume that Lowsales has an opening deferred tax asset balance of $16 200 and opening deferred
tax liability balance of $2400. Lowsales’ taxable profit for the financial year ending 30 June 20X1 is
$331 000. Assume a tax rate of 30%.
(a) Calculate the relevant tax bases for assets and liabilities for Lowsales for the financial year
ended 30 June 20X1.
(b) Prepare the deferred tax worksheet (deferred tax assets, liabilities and expense) for Lowsales
for the financial year ended 30 June 20X1.
(c) Prepare the income tax journal entry for Lowsales for the financial year ended 30 June 20X1.

RECOGNITION RULES FOR UNUSED TAX LOSSES AND

UNUSED TAX CREDITS
Deferred tax assets also arise when the taxation legislation within a particular jurisdiction allows an entity
to carry forward unused tax losses and tax credits for use against later years’ profits — that is, to use prior
period tax losses and tax credits to reduce tax payable in future periods.
The taxation legislation usually contains several provisions and exceptions, which would need to be
carefully considered to determine the extent to which unused tax losses and unused tax credits may be
carried forward and utilised against future taxable profit.
Deferred tax assets arising from unused tax losses and unused tax credits should be recognised on the
same basis as other deferred tax assets. That is, to the extent that ‘it is probable that future taxable profit
will be available against which the unused tax losses and unused tax credits can be utilised’ (IAS 12,
para. 34).
When applying the probability criterion to unused tax losses or tax credits, IAS 12 states that the
existence of unused tax losses is strong evidence that future taxable profit may not be available. In this
regard, IAS 12 explains further that ‘when an entity has a history of recent losses, the entity recognises
a deferred tax asset arising from unused tax losses or tax credits only to the extent that the entity has
sufficient taxable temporary differences or there is convincing other evidence that sufficient taxable profit
will be available against which the unused tax losses or unused tax credits can be utilised by the entity’
(IAS 12, para. 35).
When assessing the probability that taxable profit will be available against which the unused tax losses
or unused tax credits can be utilised, IAS 12 requires that an entity considers the following criteria.

184 Financial Reporting

 (a) whether the entity has sufficient taxable temporary differences relating to the same taxation authority
and the same taxable entity, which will result in taxable amounts against which the unused tax losses
or unused tax credits can be utilised before they expire;
(b) whether it is probable that the entity will have taxable profits before the unused tax losses or unused
tax credits expire;
(c) whether the unused tax losses result from identifiable causes which are unlikely to recur; and
(d) whether tax planning opportunities (see paragraph 30) are available to the entity that will create taxable
profit in the period in which the unused tax losses or unused tax credits can be utilised.
To the extent that it is not probable that taxable profit will be available against which the unused tax losses
or unused tax credits can be utilised, the deferred tax asset is not recognised (IAS 12, para. 36).
Examples 4.9 and 4.10 use two different scenarios to illustrate the assessment of whether it is probable
there will be sufficient future taxable profit available to utilise unused tax losses.

EXAMPLE 4.9

Assessing the Probability of Future Utilisation of Unused

Tax Losses (Scenario 1)
An entity’s taxable profit for 20X2, and expected taxable profit for 20X3, are as set out in the following
table.
Expected taxable Actual taxable
profit 20X3 profit 20X2
Taxable profit $ $
Taxable income 75 000 80 000
Allowable deductions
Settlement of warranty obligations (35 000) (95 000)
Other (40 000)
Taxable profit (loss) nil (15 000)

The table shows a tax loss for 20X2 of $15 000. This example assumes that tax losses can be carried
forward for offset against future taxable profit for only one year and carry-back of tax losses is not
permitted.
On this basis, a deferred tax asset can be recognised for the $15 000 tax loss in 20X2 at 31 December
20X2 to the extent that it is probable that taxable profit will be available during the one-year tax loss
carry-forward period (i.e. by 31 December 20X3).
However, as illustrated by the table, the expected taxable profit for 20X3 is $nil. Although the tax loss is
available for carrying forward, there is insufficient expected taxable profit during the carry-forward period
against which to use the tax loss from 20X2.
Therefore, no deferred tax asset can be recognised for the $15 000 tax loss at 31 December 20X2.

EXAMPLE 4.10

Assessing the Probability of Future Utilisation of Unused

Tax Losses (Scenario 2)
Use the same assumptions as example 4.9, but now assume that the allowable deductions for 20X3 are
only due to the settlement of warranty obligations of $35 000. There are no other allowable deductions in
20X3. Given the amended assumption for this entity, taxable profit for 20X2, and expected taxable profit
for 20X3, are as set out in the following table.
Expected taxable Actual taxable
profit 20X3 profit 20X2
Taxable profit $ $
Taxable income 75 000 80 000
Allowable deductions
Settlement of warranty obligations (35 000) (95 000)
Taxable profit (loss) 40 000 (15 000)
Less: Credit for tax loss carried forward (15 000)
Taxable profit after carrying forward tax losses 25 000

MODULE 4 Income Taxes 185

 This table shows a tax loss for 20X2 of $15 000. As outlined in example 4.9, this example assumes that
tax losses can be carried forward for offset against future taxable profit for only one year and carry-back
of tax losses is not permitted.
On this basis, a deferred tax asset arising from the $15 000 tax loss in 20X2 can be recognised at
31 December 20X2 to the extent that it is probable that taxable profit will be available during the one-year
tax loss carry-forward period.
As illustrated in the table for this scenario, the expected taxable profit for 20X3 is $40 000 and this is
sufficient to use the $15 000 tax loss from 20X2. Therefore, a deferred tax asset should be recognised for
the $15 000 tax loss at 31 December 20X2.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 34–36 of IAS 12.

4.6 RECOVERY OF TAX LOSSES

The previous section of this module discussed the recognition of a deferred tax asset arising from a tax
loss in the year in which the tax loss was generated.
This section discusses the accounting treatment of the subsequent recovery of tax losses (i.e. utilising
carry-forward tax losses to reduce taxable profit in subsequent reporting periods).
The core principle of IAS 12 is that the accounting treatment of the recovery of tax losses must be
consistent with the accounting treatment applied in the tax loss period. More specifically, the accounting
treatment of the recovery of tax losses is dependent on whether or not the tax losses were previously
recognised as a deferred tax asset.
The practical application of this core principle is that when tax losses are recovered, the benefit from
the recovery of those losses is allocated:
• first to tax losses for which no deferred tax asset was previously recognised (which, in effect, results in
the recognition of tax income)
• second to tax losses for which a deferred tax asset was previously recognised (which, in effect, results
in the reduction of the previously recognised deferred tax asset).
These principles are illustrated in table 4.9 and in examples 4.11 and 4.12.

TABLE 4.9 Recognising and recovering tax losses

Probability criterion Pro forma journal entry for

satisfied? Recognition Recovery recovery of tax losses

Probability criterion A deferred tax asset is On recovery of the tax Dr Deferred tax expense
for recognition is not not recognised in the loss, the current tax Cr Current tax income
satisfied loss year, as it is not income and associated
See example 4.11 probable that there DTA are recognised,
would be sufficient simultaneous with the
taxable profit against derecognition of the DTA
which the unused tax and associated deferred
losses could be utilised. tax expense. The entry
is usually presented as a
combined journal entry,
omitting the offsetting
entries to recognise and
derecognise the DTA.

Probability criterion A deferred tax asset is The deferred tax asset Dr Deferred tax expense
for recognition is recognised in the year is realised when the tax Cr Deferred tax asset
satisfied (either by of the loss. losses are recovered.
taxable temporary Therefore, the benefit of
differences or other the tax losses recovered,
sources) the savings in the outflow
See example 4.12 of resources for tax
payments, is recognised
as a reduction in the
deferred tax asset.

Source: CPA Australia 2019.

186 Financial Reporting

 It should be noted that the journal entry for recovery of tax losses in the first scenario (i.e. probability
criterion not satisfied) can be seen as the net of two journal entries as follows.
Dr Deferred tax asset
Cr Current tax income
Initial recognition of the deferred tax asset.

Dr Deferred tax expense

Cr Deferred tax asset
Subsequent realisation of the deferred tax asset.

As both of these journal entries would be recognised in the same period, there is no requirement to
separately recognise the debit (Dr) and credit (Cr) to the deferred tax asset.

EXAMPLE 4.11

Probability Recognition Criterion Not Satisfied

The following assumptions are applicable for TL Ltd.
(a) The tax return of TL Ltd for the period ended 30 June 20X1 revealed a tax loss of $60 000.
(b) Tax losses were available for carry-forward for an indefinite period for use against future taxable profit.
(c) As at 30 June 20X1, there is no convincing evidence that there would be future taxable profits against
which the $60 000 tax loss can be utilised during the tax loss carry-forward period.
(d) Taxable profit for the period ended 30 June 20X2 was $100 000.
(e) There were no movements in temporary differences during the years ended 30 June 20X1 and
30 June 20X2.
(f) The tax rate is 30%.
(g) Reconciliations between accounting profit before tax and taxable profit (loss) for the periods ended
30 June 20X1 and 30 June 20X2 were as follows.

Year ended Year ended

30 June 20X2 30 June 20X1
$ $
Accounting profit (loss) before tax 110 000 (65 000)
Adjustments for movements in non-temporary
differences and excluded temporary differences
Statutory fines for breaching environmental laws 5 000
Exempt dividends (10 000)
Adjustments for movements in
temporary differences — —
Taxable profit (loss) before utilising tax losses 100 000 (60 000)
Tax losses recovered (60 000)
Taxable profit (loss) after utilising tax losses 40 000 (60 000)

Tax Loss Reporting Period Ended 30 June 20X1

As at 30 June 20X1 there were no taxable temporary differences against which the tax losses could be
used. Nor was there convincing other evidence that there would be sufficient taxable profits arising from
other sources during the tax loss carry-forward period. Therefore, under paragraph 34 of IAS 12, the entity
is unable to recognise a deferred tax asset as at 30 June 20X1.
Recovery Period Ended 30 June 20X2
During the year ended 30 June 20X2, taxable profit before utilising tax losses was $100 000. As the
probability criterion for recognition of the deferred tax asset was not satisfied for the reporting period
ended 30 June 20X1, the entity recognises the benefit of any tax losses recovered as current tax income.
The journal entries at 30 June 20X2 are:
• Tax losses recovered of $60 000, which would give rise to the following entry.

Dr Deferred tax expense 18 000

Cr Current tax income 18 000

MODULE 4 Income Taxes 187

 • Taxable profit of $40 000, which would give rise to the following entry.

Dr Current tax expense 12 000

Cr Current tax payable 12 000

Combining these two entries would give the following.

Dr Tax expense 12 000

Cr Current tax payable 12 000

As explained in part A of this module, and illustrated in figure 4.1, ‘tax expense’ is the sum of ‘current tax’
and ‘deferred tax’ recognised in the P/L for the period. In this example, tax expense of $12 000 (illustrated
by combining the two entries) is the net amount of deferred tax expense of $18 000 (from the first entry),
current tax income of $18 000 (from the first entry) and current tax expense of $12 000 (from the second
entry). The tax expense of $12 000 comprises deferred tax expense of $18 000 and net current tax income
of $6000 because the current tax expense is offset against the current tax income.

EXAMPLE 4.12

Probability Recognition Criterion Satisfied

This example uses the same facts outlined in example 4.11 but assumes there is convincing evidence
that there would be sufficient taxable profits arising during the tax loss carry-forward period to use the
carry-forward tax losses.
Tax Loss Reporting Period Ended 30 June 20X1
As at 30 June 20X1, it was probable that there would be sufficient taxable profits during the tax loss carry-
forward period to use any carry-forward tax losses in the future. Paragraph 34 of IAS 12 allows the entity
to recognise a deferred tax asset of $18 000 ($60 000 × 30%) on that date.
The journal entry required at 30 June 20X1 is as follows.

Dr Deferred tax asset 18 000

Cr Current tax income 18 000

The credit entry is against ‘current tax income’ rather than ‘deferred tax income’, as the tax income
arises as a consequence of the tax loss from the calculation of current tax payable (refundable).
Recovery Period Ended 30 June 20X2
During the period ended 30 June 20X2, taxable profit (loss) before utilising tax losses was $100 000.
Consequently, the 20X1 tax loss of $60 000 was recovered in full.
Recall that when tax losses are recovered, the benefit from the recovery of those losses is allocated:
• first to tax losses for which no deferred tax asset was previously recognised
• second to tax losses for which a deferred tax asset was previously recognised.
In this example, a deferred tax asset was previously recognised for the whole of the tax losses that
were incurred during the year ended 30 June 20X1. Since the deferred tax asset has been realised in full,
$18 000 is credited to the deferred tax asset balance. The corresponding debit is to deferred tax expense.
Taxable profit for the period ended 30 June 20X2, after taking into account the tax losses recovered,
was $40 000, giving rise to tax payable and current income tax expense of $12 000 ($40 000 × 30%).
The journal entries required are shown as follows.
• Tax losses recovered were $60 000, which would give rise to the following entry.

Dr Deferred tax expense 18 000

Cr Deferred tax asset 18 000

• Taxable profit was $40 000, which would give rise to the following entry.

Dr Current tax expense 12 000

Cr Current tax payable 12 000

188 Financial Reporting

 Combining these two entries would give the following.

Dr Tax expense 30 000

Cr Deferred tax asset 18 000
Cr Current tax payable 12 000

As explained in part A of this module, and illustrated in figure 4.1, ‘tax expense’ is the sum of ‘current tax’
and ‘deferred tax’ recognised in the P/L for the period. In this example, tax expense of $30 000 (illustrated
by combining the two entries) is the sum of deferred tax expense of $18 000 (from the first entry) and
current tax expense of $12 000 (from the second entry).

Question 4.7 deals with a more complicated set of circumstances than those discussed in examples 4.11
and 4.12.

QUESTION 4.7

This is a very challenging question. It is recommended that you have a good understanding of the
concepts discussed earlier in this module before attempting this question.
Using the following data, prepare tax-effect journal entries for Bayside Ltd for each of the years
ended 30 June 20X9, 30 June 20Y0 and 30 June 20Y1.
Prior to the beginning of the 20X9 financial year, Bayside Ltd had recognised a deferred tax liability
of $600 relating to a taxable temporary difference of $2000. The taxable temporary difference is the
cumulative difference between the amounts of accelerated depreciation deducted for tax purposes
and the amounts of straight-line depreciation expense for accounting purposes.
Summary of key amounts for the years ended 30 June 20X9 – 30 June 20Y1:
Year ended Year ended Year ended
30 June 20X9 30 June 20Y0 30 June 20Y1
$ $ $
(1) (2) (3)
1. Accounting profit (loss) before
income tax (6 000) 2 800 7 700
2. Less: Additional tax depreciation (1 000) (800) (700)
3. Taxable profit (loss) before utilising
unused tax losses (7 000) 2 000 7 000
4. Less: Tax losses recovered this period 0 2 000 5 000
5. Taxable profit (loss) (7 000) 0 2 000
6. Current tax payable 0 0 600

The following key items are provided in the table.

• Bayside Ltd incurred a tax loss of $7000 during the period ended 30 June 20X9 (row 3 of
column 1).
• The differences between accounting profit (loss) before income tax and taxable profit (loss)
arise from using accelerated depreciation for tax purposes and straight-line depreciation for
accounting purposes. The extra amounts of tax depreciation allowed each year are deducted
in row 2.
• Row 3 of column 2 shows that for the year ended 30 June 20Y0, taxable profit, before utilising
unused tax losses, was $2000. The corresponding amount for the year ended 30 June 20Y1 was
$7000.
• The taxable temporary differences that arose from the additional tax depreciation, shown in row
2 for each of the three years, were expected to reverse before the end of the seven-year tax loss
carry-forward period that commenced on 30 June 20X9.
For 30 June 20X9 and 30 June 20Y0, Bayside was unable to establish that it was probable
that there would be future taxable profits in excess of taxable profits from the reversal of taxable
temporary differences.
The taxation legislation does not provide for the carry-back of tax losses.
The tax rate is 30%.

MODULE 4 Income Taxes 189

REASSESSMENT OF THE CARRYING AMOUNTS OF
DEFERRED TAX ASSETS AND LIABILITIES
IAS 12 contains several requirements relating to the reassessment of the carrying amounts of deferred tax
assets and liabilities.
First, ‘[t]he entity recognises a previously unrecognised deferred tax asset to the extent that it has become
probable that future taxable profit will allow the deferred tax asset to be recovered’ (IAS 12, para. 37).
Second, IAS 12, paragraph 56 explains that the carrying amount of a deferred tax asset should be reduced
to the extent that it is no longer probable that there will be sufficient taxable profit to allow realisation of
the asset. A reduction is reversed to the extent that it has subsequently become probable that there will be
sufficient taxable profit to allow realisation of the asset.
Paragraph 60 of IAS 12 states that the carrying amount of a deferred tax asset may change following a
reassessment of the expected recoverability of the item. Paragraph 60 also states that the carrying amounts
of deferred tax assets and deferred tax liabilities may change following:
(a) a change in tax rates or tax laws;
(b) a reassessment of the recoverability of deferred tax assets; or
(c) a change in the expected manner of recovery of an asset (IAS 12, para. 60).

When the balances of deferred tax assets and liabilities change, deferred tax income or expense arises.
The resulting deferred tax income or expense should be recognised in P/L, unless it relates to items
previously recognised in OCI or directly recognised in equity.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 37, 56 and 60 of IAS 12.

QUESTION 4.8

An entity is finalising its financial statements for the year ended 30 June 20Y0. Before 30 June 20Y0,
the government announced that the tax rate was to be amended from 40% to 45% of taxable profit
from 30 September 20Y0.
The legislation to amend the tax rate has not yet been approved by the legislature. However, the
government has a significant majority and it is usual, in the tax jurisdiction concerned, to regard
an announcement of a change in the tax rate as having the substantive effect of actual enactment
(i.e. it is substantively enacted).
After performing the income tax calculations at the rate of 40%, the entity has the following
temporary differences and deferred tax asset and deferred tax liability balances.

$
Aggregate deductible temporary differences 200 000
Deferred tax asset 80 000
Aggregate taxable temporary differences 150 000
Deferred tax liability 60 000

Of the deferred tax liability balance, $28 000 related to a taxable temporary difference of $70 000
($70 000 × 40%). This associated deferred tax expense had previously been recognised in OCI.
The entity reviewed the carrying amount of the asset in accordance with paragraph 56 of IAS 12
and determined that it was probable that sufficient taxable profit to allow utilisation of the deferred
tax asset would be available in the future.
Present the journal entries necessary to give effect to paragraph 60 of IAS 12.

SUMMARY
Part B of this module discussed the recognition of deferred tax assets and deferred tax liabilities.
Deferred tax liabilities are recognised for all taxable temporary differences, with certain limited
exceptions, as described in IAS 12, paragraphs 15 and 39.

190 Financial Reporting

 Deferred tax assets are recognised to the extent that it is probable that future taxable profit will be
available against which the deferred tax asset can be used, with certain limited exceptions, as described in
IAS 12, paragraphs 24, 34 and 44.
A primary source of taxable profit against which the deferred tax asset can be used is the taxable amounts
that arise when taxable temporary differences reverse. Therefore, a deferred asset is normally recognised if
there are sufficient taxable temporary differences against which the deferred asset (arising from deductible
temporary differences or unused tax losses and credits) can be used.
When an entity does not have sufficient taxable temporary differences, recognition of the deferred tax
asset depends on the probability of future taxable profits in excess of profits arising from the reversal of
existing future taxable temporary differences.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

4.4 Apply the probability recognition criterion for deductible temporary differences, unused tax
losses and unused tax credits.
• Deferred tax liabilities must be recognised for all taxable temporary differences, except for certain
limited exceptions.
• Exceptions to the recognition of deferred tax liabilities include the initial recognition of goodwill and
the initial recognition of an asset or liability in a transaction that is not a business combination and
does not affect the accounting or taxable profit.
• Deferred tax assets may arise from deductible temporary differences, unused tax losses and unused
tax credits.
• A deferred tax asset must be recognised for all deductible temporary differences to the extent that
it is probable that taxable profit will be available against which the deductible temporary difference
can be utilised, except for certain limited exclusions.
• Exceptions to the recognition of deferred tax assets include the initial recognition of an asset or
liability in a transaction that is not a business combination and does not affect the accounting or
taxable profit.
• Deferred tax assets arising from unused tax losses and unused tax credits should be recognised to
the extent that it is probable that future taxable profit will be available against which the unused tax
losses and unused tax credits can be utilised.
4.5 Account for the recognition and reversal of deferred tax assets arising from deductible temporary
differences, unused tax losses and unused tax credits.
• Deferred tax expense (income) arises from the recognition and movement in deferred tax assets and
deferred tax liabilities.
• When tax losses are recovered, the benefit from the recovery of those losses is allocated:
– first to tax losses for which no deferred tax asset was previously recognised (which, in effect,
results in the recognition of tax income)
– second to tax losses for which a deferred tax asset was previously recognised (which, in effect,
results in the reduction of the previously recognised deferred tax asset).
• An entity recognises a previously unrecognised deferred tax asset to the extent that it has become
probable that future taxable profit will allow the deferred tax asset to be recovered.
• The carrying amount of a deferred tax asset should be reduced to the extent that it is no longer
probable that there will be sufficient taxable profit to allow realisation of the asset.

MODULE 4 Income Taxes 191

PART C: SPECIAL CONSIDERATIONS
FOR ASSETS MEASURED AT
REVALUED AMOUNTS
INTRODUCTION
Recall from part A of this module that temporary differences are determined by comparing the carrying
amount of assets and liabilities to the tax base. Part C of this module deals with temporary differences that
arise when assets are carried at revalued amounts and the tax base is not adjusted by an amount equivalent
to the revaluation.

Relevant Paragraphs
To assist in achieving the objectives of part C, you may wish to read the following paragraphs of IAS 12
and IAS 16 Property, Plant and Equipment. Where specified, you need to be able to apply these paragraphs
as referenced in this module.

Subject Paragraphs
IAS 12
Taxable temporary differences 18(b), 20, 26(d)
Measurement 51, 51A, 51B
Recognition of current and deferred tax 58, 61A, 62(a)
Illustrative Examples (in the IFRS Compilation Handbook) Part A (items 10, 11)
Part B (item 8)
IAS 16
Revaluation model 39–40

4.7 ASSETS CARRIED AT REVALUED AMOUNTS

International Financial Reporting Standards (IFRSs) permit a range of assets to be carried at fair value or
revalued amount. For example, according to paragraph 31 of IAS 16, after the initial recognition, an item
of property, plant and equipment may ‘be carried at a revalued amount, being its fair value at the date of
revaluation, less any subsequent accumulated depreciation and subsequent impairment losses’.
Paragraph 20 of IAS 12 explains that whether a temporary difference arises when an asset is revalued
depends on how a revaluation is treated in the relevant tax jurisdiction.
As discussed earlier in this module, the difference between the carrying amount of a revalued asset and
its tax base is a taxable or deductible temporary difference that gives rise to a deferred tax liability or
deferred tax asset.
When an asset is revalued, there are two possibilities.
1. The tax base of the asset is adjusted by the same amount as the change in the carrying amount of the
asset. Therefore, no temporary difference arises because of the revaluation.
2. The tax base of the asset is not adjusted, or it is adjusted by an amount that differs from the amount by
which the asset was revalued. In this case, a taxable or deductible temporary difference arises.
This is illustrated in example 4.13.

EXAMPLE 4.13

The Effects of a Revaluation

Assume that prior to an upwards revaluation, the tax base and the carrying amount of an asset are each
$100. The asset is revalued upwards to its fair value of $180 for accounting purposes, and the tax base
is adjusted by the same amount (in accordance with the tax laws of the relevant jurisdiction). The tax rate
is 30%.

192 Financial Reporting

 As the tax base is adjusted by the revaluation amount, no temporary difference arises. The temporary
difference immediately before and after the revaluation is nil, as shown in the following illustration.
Before revaluation After revaluation
$ $
Carrying amount 100 180
Tax base 100 180
Temporary difference nil nil

QUESTION 4.9

Using the same facts as example 4.13, assume that in the tax jurisdiction concerned, the amount of
the tax deduction is not altered in response to a revaluation. Therefore, the tax base is not adjusted
and remains at $100.
Calculate the taxable temporary difference immediately before and after the revaluation.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 18(b), 20 and 26(d) of IAS 12. Note that the
circumstances in question 4.9, where the tax base is not adjusted by the revaluation amount, are consistent with the
requirements of paragraph 26(d).
The module will now address the requirements for accounting for deferred tax arising from both a
revaluation increase and decrease.

4.8 RECOGNITION OF DEFERRED TAX

ON REVALUATION
As discussed in part B of this module, the principle adopted by IAS 12 to account for the tax effects of a
transaction or other event (e.g. the recognition of current tax and deferred tax) is that accounting for tax
should be consistent with the accounting treatment of the transaction or event itself.
In this regard, paragraph 58(a) of IAS 12 requires that current or deferred tax be recognised as income
or expense, except when the tax relates to items that are credited or charged either to OCI or directly to
equity. When the tax relates to items that are recognised in OCI, the current and deferred tax is recognised
in OCI. Similarly, paragraph 61A of IAS 12 requires that where the current and deferred tax relates to
items that are recognised directly in equity, current and deferred tax is recognised directly in equity.
None of the examples in this module relate to items recognised directly in equity. The examples relate
to the revaluation of assets that are recognised in OCI and accumulated in equity.
The required accounting treatment following a revaluation is outlined in paragraphs 39 and 40 of
IAS 16.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 39 and 40 of IAS 16.

Following the requirements of paragraph 39 of IAS 16, a revaluation increase should be recognised as an
increase in OCI and accumulated in equity as a revaluation surplus, unless it reverses a previous decrement
in respect of that asset previously recognised in P/L.
Using the same facts as question 4.9, the revaluation increase would be recognised in OCI (and
accumulated in equity as a revaluation surplus), while considering the tax effect as follows.

Dr Asset 80
Cr Other comprehensive income — revaluation surplus 80
To recognise the revaluation increment before tax effects.

MODULE 4 Income Taxes 193

 Dr Other comprehensive income — revaluation surplus 24
Cr Deferred tax liability 24
To recognise the tax effect of the revaluation as deferred tax in other
comprehensive income ($80 × 30% tax rate = $24).

Note the after-tax amount of the revaluation recognised in the revaluation surplus is $80 – $24 = $56.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 58, 61A and 62(a) of IAS 12. You may also
read items 10 and 11 in part A and item 8 of part B of the Illustrative Examples to IAS 12 (in the IFRS Compilation
Handbook).

It should be noted that IAS 16 offers entities the option to transfer to retained earnings a part of the
revaluation surplus recognised for their revalued assets as they are used in the business (IAS 16, para. 41).
In terms of the tax effect of this treatment, paragraph 64 of IAS 12 states that:
IAS 16 does not specify whether an entity should transfer each year from revaluation surplus to retained
earnings an amount equal to the difference between the depreciation or amortisation on a revalued asset
and the depreciation or amortisation based on the cost of that asset. If an entity makes such a transfer, the
amount transferred is net of any related deferred tax. Similar considerations apply to transfers made on
disposal of an item of property, plant or equipment.

RECOVERY OF REVALUED ASSETS THROUGH USE OR

THROUGH SALE
Following the requirements of paragraph 51 of IAS 12, calculating the tax base is based on how an
‘entity expects, at the end of the reporting period, to recover or settle the carrying amounts of its assets
and liabilities’. For an asset, the expectation may be to hold the asset (e.g. using an item of plant
in manufacturing operations) or sell the asset (e.g. disposing of plant that is no longer required for
manufacturing operations). In some jurisdictions, there are differences between the tax treatment of assets
held for use in the business and assets held for sale; consequently, in those jurisdictions, the tax base and
the related temporary differences may differ based on the method chosen to generate future economic
benefits from the asset. This is illustrated in example 4.14, in relation to determining the amount of the
temporary difference arising from the revaluation of a depreciable asset.

EXAMPLE 4.14

The Amount of the Temporary Difference Impacted by the Expected

Manner of Recovery of a Revalued Depreciable Asset
A depreciable asset, with an initial cost of $100, is revalued to a new carrying amount of $150. Immediately
prior to the revaluation, the carrying amount of the asset was $80 and the future deductible amount
on recovery of the asset was the tax written-down amount of $70 (cost of $100 less $30 cumulative
depreciation previously allowed for tax purposes). The capital gains tax cost base (future taxable amount
if recovery of the asset is by sale) is $120 (where applicable).
Note: The capital gains tax cost base of $120 has been provided for illustrative purposes only — it is
not necessary to know how the capital gains tax base was determined. The capital gains tax cost base
is applicable where the expected recovery of the carrying amount is through sale and capital gains tax is
applicable. If the carrying amount of the asset is recovered by use, then capital gain is not applicable.
Recovery of Carrying Amount by Using the Revalued Asset to the End of its Useful Life
Recall that the tax base of an asset is the ‘amount that will be deductible for tax purposes against any
taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset’
(IAS 12, para. 7). Refer to figure 4.3 for the formula for calculating the tax base of an asset.
When an entity first purchases an asset, it will recognise it with a tax base often equal to the initial cost.
The entity will then depreciate the asset for tax purposes based on the cost, claiming tax depreciation
every period as a tax deduction. These deductions reduce the tax base of the asset so that the tax base

194 Financial Reporting

at the end of every period reflects what was not yet claimed as a tax deduction out of the initial cost of the
asset (i.e. the initial cost less the cumulative amount already claimed as deductions for tax depreciation).
When the carrying amount is expected to be recovered by using the asset to provide goods and services
for resale, the entity is likely to generate future taxable income through use equal to the revalued carrying
amount (i.e. $150 in this exercise). The future amount deductible against that taxable income is the tax
base of $70 (tax written-down amount). The tax base is not affected by the revaluation in this case.
The difference between expected future taxable income and future deductions will give rise to a taxable
temporary difference of $80.
The carrying amount of the asset, together with the tax base and the temporary difference are presented
in the following formulas.

Future
Tax base
= deductible
of an asset
amounts

70 = 70

Carrying Temporary
– Tax base =
amount difference

150 – 70 = 80

The entity would recognise a deferred tax liability of $24 ($80 × 30%) for the taxable temporary difference
presented if it expects to recover the carrying amount by using the asset.
In accordance with paragraph 61A of IAS 12, only the amount of deferred tax relating to the revaluation
is recognised in OCI. If the asset had not been revalued, the deferred tax liability would have been $3
(relating to the taxable temporary difference that existed prior to revaluation between the carrying amount
($80) and tax base ($70)). The increase in deferred tax liability from $3 to $24 is due to the revaluation;
therefore, $21 is recognised as deferred tax in OCI, while the original deferred tax ($3) based on the taxable
temporary difference prior to revaluation would have been recognised in P/L.
Recovery of Carrying Amount by Selling the Revalued Asset
When the carrying amount is expected to be recovered by selling the asset, the entity may sell the asset
for more than the tax base, in which case it will recover some, if not all, of the previously deducted tax
depreciation. In general, if the asset is sold for more than its initial cost, the entity is essentially recovering
all the tax deductions previously claimed. In many jurisdictions, the proceeds of sale are taxable to the
extent that they reflect tax depreciation recovered. In this example, the entity has claimed deductions for
tax depreciation of $30. If the entity expects to sell the asset for $150 (the revalued amount), the entity will
in effect fully ‘recover’ the $30 tax depreciation previously claimed as tax deductions and will be taxed on
that amount of $30. However, capital gains tax may also apply and will be discussed next.
Capital gains reflect the excess of the sale proceeds over the initial cost of an asset. Basically, the
proceeds on sale of an asset can be divided into a capital gain component and a recovery of cost
component. If the asset is sold for the revalued amount of $150, the capital gain is $50 and the rest
is the recovery of cost component.
Where an entity expects to recover the carrying amount by selling the asset, there are two possible
scenarios as follows.
1. There is no capital gains tax applicable; therefore, if the asset will be sold for the revalued amount of
$150, the capital gain of $50 (the excess of the sale proceeds of $150 over the initial cost of $100) will
be exempt from income tax.

MODULE 4 Income Taxes 195

 2. Capital gains tax applies; therefore, if the asset will be sold for the revalued amount of $150, the capital
gain of $30 (the excess of the sale proceeds of $150 over the capital gains tax cost base of $120) will
be subject to income tax.
As described above, if capital gains tax applies, the tax will be applicable to the difference between
the sale proceeds and the capital gains tax cost base. Determining the capital gains tax cost base, which
might be different from initial cost, is beyond the scope of this module.
Each of these scenarios is now considered.
Note: In both scenarios, the asset remains on hand; the scenarios only assume that the expected
recovery of the carrying amount is through sale. If the asset had been sold, the asset no longer exists and
the tax base and carrying amount will both be $nil and any pre-existing deferred tax liability is reversed.
1. Capital Gains Tax Not Applicable
In a regime in which there is no capital gains tax, if the asset is sold for the revalued amount of $150,
the capital gain of $50 (the excess of the sale proceeds of $150 over the initial cost of $100) is exempt
from income tax. In other words, the tax rate applicable to sale proceeds in excess of the initial cost is, in
substance, nil. The other component of the sale proceeds (i.e. the recovery of cost) is taxed at the normal
tax rate.
As such, when the carrying amount is expected to be recovered by selling the asset and capital gains
taxes are not applicable, the entity is likely to generate future taxable income through sale equal to the
initial cost (i.e. $100 in this exercise). The future amount deductible against that taxable income is the tax
deductions that were not yet claimed as tax depreciation (i.e. $70). The difference between expected
future taxable income and future deductions will give rise to a taxable temporary difference of $30
($100 initial cost less $70 written-down amount).
Therefore, the deferred tax liability is $30 × 30% = $9. This represents, in essence, the tax payable in
the future due to the recovery through sale of the tax depreciation claimed as deductions.
This may be contrasted with the treatment on recovery of the carrying amount by using the asset. In that
case, as shown earlier, the deferred tax liability was $24 as the related temporary difference was based
on the total gain on revaluation of the asset and not just on the initial cost.
2. Capital Gains Tax Applicable
In a regime where capital gains tax applies, if the asset is sold for the revalued amount of $150, the total
capital gain is $50; however, only the excess of the sale proceeds of $150 over the capital gains tax cost
base of $120 is taxable. In addition to the capital gain, the fact that this is also a depreciable asset means
that any tax depreciation recovered on the sale of the asset is also taxable. In this example, $30 of the
capital gain and $30 of tax depreciation recovered are taxable.
Therefore, the $150 sales proceeds from the asset (equal to the revalued carrying amount of the asset)
can be divided into:
• a taxable capital gain component of $30 (being the difference between the sales proceeds of $150 and
the capital gains tax cost base of $120)
• an exempt capital gain component of $20 (being the difference between the original cost of $100 and
CGT cost base of $120)
• a recovery of the original cost of $100.
As such, when the carrying amount is expected to be recovered by selling the asset and capital
gains taxes are applicable, the entity is likely to generate future taxable income through sale equal to
the taxable capital gain component of $30 plus the initial cost of $100. The future amount deductible
against that taxable income is the tax deductions that were not yet claimed as tax depreciation (i.e. $70).
The difference between expected future taxable income and future deductions will give rise to a taxable
temporary difference of $60.
As a result, the deferred tax liability is $60 × 30% = $18. This represents, in essence, the tax payable in
the future due to the recovery through sale of the tax depreciation claimed as deductions ($30), together
with the capital gains tax payable ($150 – $120 = $30).

QUESTION 4.10

Present the journal entry required to recognise the deferred tax liability applicable to the revaluation
recognised in example 4.14, under the assumption that the revaluation increase was credited to OCI
and accumulated in equity as a revaluation surplus, if:
(a) the carrying amount of the asset was recovered by using the asset to the end of its useful life
(b) the carrying amount of the asset was recovered by selling the asset and capital gains tax is
applicable.

196 Financial Reporting

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraph 51A, example B, in IAS 12. This example is
intended to illustrate how the expected manner of recovery of the carrying amount of an item of property, plant and
equipment may affect the tax rate applicable when an entity recovers the carrying amount and the amount of tax that
is ultimately payable or recoverable.

ADDITIONAL GUIDANCE ON RECOVERY OF

NON-DEPRECIABLE ASSETS
As discussed, the amount of tax payable is affected by the manner of recovery of an asset. An entity
may realise the future economic benefits of an asset either through use or through sale. Nevertheless,
paragraph 51B of IAS 12 states that, in relation to a non-depreciable asset revalued in accordance with
IAS 16, the tax consequences to consider (including the tax rates to apply to calculate the deferred tax)
are those that would follow from the recovery of the carrying amount of that asset through sale. This is
illustrated in example 4.15, in relation to determining the amount of the temporary difference arising from
the revaluation of a non-depreciable asset.

EXAMPLE 4.15

The Amount of the Temporary Difference Impacted by the Expected

Manner of Recovery (Non-depreciable Asset)
A piece of land, which is held for use, has a carrying amount and cost of $100. The land is revalued by
$50 to $150. The tax law specifies that the tax rate applicable to the taxable amount derived from sale is
20%. The tax rate applicable to the taxable amount derived from using the asset is 30%.
As the revalued land is a non-depreciable asset, the tax rate that is applicable when calculating any
deferred tax implications is the tax rate applicable from sale (i.e. 20%).
Using the formula in figure 4.3 for the tax base of an asset:

Future
Tax base Carrying Future taxable
deductible
of an asset = amount + – amounts
amounts
100 150 150
100

The same result is obtained if we apply the simplified alternative method described in figure 4.4. As the
economic benefits are taxable, the tax base can be calculated as follows.

Future
Tax base
deductible
of an asset =
amounts
100
100

The future deductible amounts are $100, being the initial cost of the asset. After the revaluation, the
resulting temporary difference is taxed at a rate of 20%. This is summarised in the following table.

Deferred tax liability after revaluation

After revaluation
$
Carrying amount of land 150
Tax base (100)
Temporary difference 50
Tax rate 20%
Deferred tax liability 10

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraph 51B of IAS 12.

MODULE 4 Income Taxes 197

SUMMARY
Whether a temporary difference arises when an asset is revalued depends on how a revaluation increase or
decrease is treated in the relevant tax jurisdiction.
A taxable or deductible temporary difference arises when the tax base is not adjusted or is adjusted by
an amount that differs from the amount by which the asset was revalued.
The accounting treatment of deferred tax resulting from a revaluation follows the treatment of the
revaluation surplus. A revaluation amount may be treated either as income or expense, or as a credit or
debit to OCI and accumulated in equity as a revaluation surplus. IAS 12 requires that:
current tax and deferred tax that relates to items that are recognised, in the same or a different period:
(a) in other comprehensive income, shall be recognised in other comprehensive income . . .
(b) directly in equity, shall be recognised directly in equity (IAS 12, para. 61A).

The manner of recovery of an asset may affect the tax rate and/or the temporary differences recognised at
the end of a period for that asset. IAS 12 requires that deferred tax assets and liabilities should be measured
using the tax rates and temporary differences that are consistent with the expected manner of recovery of
the entity’s assets.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

4.6 Determine the deferred tax consequences of revaluing property, plant and equipment.
• There are two possibilities when as asset is revalued as follows.
1. The tax base of the asset is adjusted by the same amount as the change in the carrying amount
of the asset. Therefore, no temporary difference arises because of the revaluation.
2. The tax base of the asset is not adjusted, or it is adjusted by an amount that differs from the amount
by which the asset was revalued. In this case, a taxable or deductible temporary difference arises.
• IAS 12 requires that current or deferred tax be recognised as income or expense, except when the
tax relates to items that are credited or charged either to OCI or directly to equity. Therefore, if the
revaluation of the asset is recognised in OCI, then the related deferred tax is recognised in OCI.

198 Financial Reporting

PART D: FINANCIAL STATEMENT
PRESENTATION AND DISCLOSURE
INTRODUCTION
As discussed in part A of this module, the application of the principles for accounting for income taxes
prescribed by IAS 12 will result in the entity recognising the current and future tax consequences of:
• transactions and other events of the current period that are recognised in an entity’s financial statements
• the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in an
entity’s statement of financial position.
The objective of the presentation and disclosure requirements of IAS 12 is to disclose information that
enables users of the financial statements to understand and evaluate the impact of current tax and deferred
tax on the financial position and performance of the entity.
The presentation and disclosure requirements of IAS 12 focus primarily on the presentation of tax
balances in the statement of financial position and the disclosure of information about the following
matters:
• major components of tax expense (tax income)
• relationship between tax expense (tax income) and accounting profit
• particulars of temporary differences that give rise to the recognition of deferred tax assets and the
deferred tax liabilities
• particulars of temporary differences, unused tax losses and unused tax credits for which no deferred tax
asset was recognised (i.e. because the probability criterion was not satisfied).

Relevant Paragraphs
To assist in achieving the objectives of part D, you may wish to read the following paragraphs of
IAS 1 and IAS 12. Where specified, you need to be able to apply these paragraphs as referenced throughout
the module.
Subject Paragraphs
IAS 1
Information to be presented in the statement of financial position 54, 56
Disclosure 82
IAS 12
Presentation 71–77
Disclosure 79–88

4.9 PRESENTATION OF CURRENT TAX AND

DEFERRED TAX
Current tax assets and liabilities and deferred tax assets and liabilities are presented in separate line items
in the statement of financial position as required by paragraphs 54(n) and 54(o) of IAS 1 Presentation of
Financial Statements.
This is illustrated in the financial statement extract in table 4.10.

TABLE 4.10 Financial statement extract showing current and deferred tax assets and liabilities
Statement of financial position at 30 June 20X1
20X1 20X0
$ $
Current assets
Cash 433 500 143 000
Trade and other receivables 375 500 216 000
Non-current assets
Property, plant and equipment 1 450 000 1 410 000
Deferred tax assets 15 000 13 500
Total assets 2 274 000 1 782 500
(continued)

MODULE 4 Income Taxes 199

 TABLE 4.10 (continued)

20X1 20X0
$ $
Current liabilities
Trade and other payables (115 000) (95 000)
Current tax liabilities (191 500) (185 000)
Provisions (35 000) (30 000)
Non-current liabilities
Borrowings (500 000) (500 000)
Deferred tax liabilities (65 000) (60 000)
Provisions (15 000) (15 000)
Total liabilities (921 500) (885 000)
Net assets 1 352 500 897 500

Source: CPA Australia 2019.

Further, paragraph 56 of IAS 1 prohibits the classification of deferred tax assets and deferred tax
liabilities as current assets or liabilities.
Example 4.16 illustrates the presentation of tax liabilities in the statement of financial position.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 54, 56 and 82 of IAS 1.

EXAMPLE 4.16

Presentation of Tax Liabilities in the Statement of Financial Position

The following assumptions are relevant when preparing the disclosures for ABC Ltd.
(a) ABC Ltd received a statutory fine of $50 000 for a violation of environmental laws. This fine is non-
deductible in the relevant tax jurisdiction.
(b) A receivable of $100 000 for accrued interest revenue, associated with loans advanced to borrowers,
was recognised in the statement of financial position of ABC Ltd as at 30 June 20X9. The revenue
is taxable when received in cash during the year ended 30 June 20Y0. This advance gave rise to a
temporary difference in 20X9, which is reversed in 20Y0.
(c) Other information about taxable profit and accounting profit before tax was as follows.

Period ended Period ended

30 June 20Y0 30 June 20X9
$ $
Accounting profit before tax 750 000 600 000
Add/(less): Interest revenue 100 000 (100 000)
Add: Amounts in addition to the interest revenue
recognised in the measurement of accounting
profit before tax
Statutory fines for violation of environmental laws 50 000
Taxable profit 850 000 550 000
Current tax payable (taxable profit × 30%) 255 000 165 000

Using this information, the amounts of the current tax liability and the deferred tax liability presented in
the statement of financial position are as follows.
Statement of financial position extracts
30 June 20Y0 30 June 20X9
$ $
Tax liabilities
Current liabilities
Current tax payable 255 000 165 000
Non-current liabilities
Deferred tax liability 0 30 000

200 Financial Reporting

OFFSETTING TAX ASSETS AND LIABILITIES
Although current tax assets and liabilities are separately recognised and measured, they are required to be
presented as a single net amount (i.e. net asset or net liability) in the statement of financial position when
certain specified criteria are satisfied (as follows).
IAS 12 requires that current tax assets (tax recoverable from the taxation authority) and current tax
liabilities (tax payable) are offset when the entity:
(a) has a legally enforceable right to set off the recognised amounts; and
(b) intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously
(IAS 12, para. 71).
Similar requirements also apply to the presentation of deferred tax assets and liabilities in the statement
of financial position (as follows).
IAS 12 requires deferred tax assets and deferred tax liabilities to be offset when:
(a) the entity has a legally enforceable right to set off current tax assets against current tax liabilities
[discussed in the previous section]; and
(b) the deferred tax assets and the deferred tax liabilities relate to income taxes levied by the same taxation
authority (IAS 12, para. 74).
In all other circumstances the amounts must be presented in the statement of financial position on a
gross basis (i.e. the statement of financial position will include two separate line items — ‘deferred tax
assets’ and ‘deferred tax liabilities’).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 71–77 of IAS 12.

4.10 MAJOR COMPONENTS OF TAX EXPENSE

Tax expense (tax income) is presented as a single line item in the profit and loss section of the statement
of P/L and OCI as required by paragraph 82(d) of IAS 1.
This is illustrated in the financial statement extract in table 4.11.

TABLE 4.11 Financial statement extract showing tax expense line item
Statement of profit or loss and other comprehensive income
for the year ended 30 June 20X1
20X1 20X0
$ $
Income 975 000 857 000
Expenses (325 000) (232 000)
Profit before income tax 650 000 625 000
Tax expense (195 000) (187 500)
Profit for the year 455 000 437 500

Source: CPA Australia 2019.

In order to provide more useful information to the users of financial statements, paragraph 79 of IAS 12
requires the major components of tax expense (tax income) to be disclosed separately. This information is
usually disclosed in the notes to the financial statements.
Examples of components of tax expense (tax income) are included in paragraph 80 of IAS 12.
An example of the note disclosure of the major components of tax expense (income) is shown in
table 4.12.
TABLE 4.12 Major components of income tax expense (income)
Income tax expense for the year
US$ million 2018 2017
Current tax (expense)/benefit
Current period (223.6) (177.8)
(continued)

MODULE 4 Income Taxes 201

 TABLE 4.12 (continued)

US$ million 2018 2017

Adjustments to current tax expense relating to prior periods 22.9 (3.6)
Tax losses, tax credits and temporary differences not recognised for book
in prior years now recouped [i.e. recovered] 8.4 3.4
Total current tax (expense)/benefit (192.3) (178.0)
Deferred tax (expense)/benefit
Origination and reversal of temporary differences 10.2 35.7
Adjustments to deferred tax expense relating to prior period (15.8) 6.7
Tax losses and credits derecognised (5.2) (15.4)
Change in applicable tax rates 57.8 (0.7)
Total deferred tax (expense)/benefit 47.0 26.3
Total income tax (expense)/benefit (145.3) (151.7)

Source: Amcor Limited 2018, Annual Report 2018, p. 69, accessed May 2019, https://www.amcor.com/investors/financial-
information/annual-reports.

The extract from the Amcor Limited 2018 Annual Report discloses the major components of income
tax expense for the 2018 reporting period (and the comparative reporting period) and further distinguishes
between ‘current tax’ and ‘deferred tax’, which together make up the aggregate tax expense for the
reporting period.
The disclosure of the major components of tax expense (tax income) is illustrated in example 4.17.

EXAMPLE 4.17

Disclosing the Major Components of Tax Expense (Income)

This example uses the data outlined in example 4.12.
On the basis of the data outlined in example 4.12, and applying the requirements of paragraph 79 of
IAS 12, the major components of tax expense (income) for the financial year ended 30 June 20Y0 are
as follows.

30 June 20Y0
Major components of tax income $
Major components of tax expense (income)
Current tax expense (income)
Tax on taxable profit 12 000
Tax benefit from recovery of previously unrecognised tax
losses — (IAS 12, para. 80(e)) —
Current tax expense (income) — (IAS 12, para. 80(a)) 12 000
Deferred tax expense (income)
Deferred tax expense (income) relating to origination and reversal of temporary
differences — (IAS 12, para. 80(c)) —
Deferred tax expense relating to recovery of previously unrecognised tax losses —
Deferred tax expense relating to recovery of previously recognised tax losses 18 000
Deferred tax expense (income) on recognition of deferred tax assets —
Tax benefit arising from previously unrecognised tax losses reducing deferred
tax expense — (IAS 12, para. 80(f)) —
Deferred tax expense (income) 18 000
Tax expense (income) 30 000

202 Financial Reporting

4.11 RELATIONSHIP BETWEEN TAX EXPENSE
(INCOME) AND ACCOUNTING PROFIT
As noted and illustrated previously, profit or loss for the reporting period and tax expense (tax income) are
presented as single line items in the statement of P/L and OCI as required by paragraph 82(d) of IAS 1.
In order to fully understand the financial performance of the entity, it is important for users of the
financial statements to understand the relationship between tax expense (income) and profit or loss for the
reporting period (i.e. accounting profit).
Accordingly, paragraph 81(c) of IAS 12 requires that an explanation of the relationship between tax
expense (income) and accounting profit be provided in the notes to the financial statements.
An example of the note disclosure of the relationship between tax expense (income) and accounting
profit is shown in table 4.13.

TABLE 4.13 Relationship between tax expense (income) and accounting profit
Numerical reconciliation of income tax expense to prima facie tax payable
US$ million 2018 2017
Profit before related income tax expense 880.7 765.7
Tax at the Australian tax rate of 30% (2017: 30%) (264.2) (229.7)
Tax effect of amounts which are not deductible/(taxable) in calculating
taxable income:
Net items non-deductible/non-assessable for tax 7.6 12.2
Previously unrecognised tax losses, tax credits and temporary differences now
used to reduce income tax expense 8.4 3.4
Tax losses and credits derecognised (5.2) (15.4)
Effect of local tax rate change 57.8 (0.7)
Underprovision in prior period 7.1 3.1
Foreign earnings taxed at rates other than 30% 43.2 75.4
Total income tax expense (145.3) (151.7)

Source: Amcor Limited 2018, Annual Report 2018, p. 70, accessed May 2019, https://www.amcor.com/investors/financial-
information/annual-reports.
This extract from the Amcor Limited 2018 Annual Report discloses the relationship between tax
expense and accounting profit by presenting a reconciliation from accounting profit (described as ‘profit
before related income tax expense’) to total income tax expense. Please note that the amounts included in
the reconciliation are presented on a ‘tax effective basis’ (i.e. at the 30% Australian tax rate).
The determination of the relevant information to be disclosed in the notes to the financial statements to
explain the relationship between tax expense (income) and accounting profit is commonly undertaken as
a two-step process, as shown in table 4.14.

TABLE 4.14 Key steps for preparing the tax reconciliation

Step 1 Reconcile accounting profit to taxable profit (i.e. understand the differences between the
accounting treatment and the tax treatment).

Step 2 Determine and present the relationship between tax expense (income) and accounting profit.

Source: CPA Australia 2019.

These two steps are illustrated in examples 4.18 and 4.19.

EXAMPLE 4.18

Reconcile Accounting Profit to Taxable Profit

Using the data from example 4.16, a reconciliation of accounting profit to taxable profit is shown in the
first two columns of the accompanying table.
This reconciliation helps to identify and understand the differences between accounting treatment and
tax treatment in order to prepare the explanation of the relationship between tax expense and accounting
profit. Column (3) shows the effect of the tax rate on each of the figures in column (2). These are described
in column (4). The initial focus will be on columns (1) and (2).

MODULE 4 Income Taxes 203

 Period ended 30 June 20X9
(2) × 30%
$ $
(1) (2) (3) (4)
Accounting profit before tax 600 000 180 000 Prima facie tax
Tax effect of expenses that are not deductible
in determining taxable profit:
Add: Non-deductible statutory fines 50 000 15 000
Accounting profit adjusted for non-
deductible expenses 650 000 195 000 Tax expense
Movements in temporary differences
Less: Interest revenue (100 000) (30 000) Deferred tax expense
Taxable profit 550 000 165 000 Current tax expense†
†
Tax expense – Deferred tax expense = Current tax expense.

As indicated by the descriptions in column (1), the reconciliation begins by adding back to (deducting
from) accounting profit before tax any items of income or expense that cause taxable profit to be greater
(less) than accounting profit.
In relation to the final two columns, it is convenient to first check that the amount shown in column (3)
for tax expense does satisfy the definition of this item. This can be done by reading column (3) from the
bottom upwards and seeing that tax expense of $195 000 is the sum of current tax expense of $165 000
and deferred tax expense of $30 000, as defined earlier. Note that the numerical value of tax expense is
the result of the tax rate and accounting profit before tax adjusted for non-temporary differences, although
tax expense is not defined in this way. These relationships will always apply, except when tax losses are
involved. This complication will be dealt with later.
Reading down column (3), the tax expense of $195 000 is $15 000 greater than the prima facie tax of
$180 000 (where ‘prima facie’ tax is calculated as the accounting profit before tax multiplied by the 30%
applicable tax rate), as a consequence of the non-deductibility of the statutory fines.

EXAMPLE 4.19

Presenting the Relationship Between Tax Expense and Accounting Profit

IAS 12 requires the:

explanation of the relationship between tax expense (income) and accounting profit be provided in
either or both of the following two forms:
(i) a numerical reconciliation between tax expense (income) and the product of accounting profit
multiplied by the applicable tax rate(s), disclosing also the basis on which the applicable tax
rate(s) is (are) computed, or
(ii) a numerical reconciliation between the average effective tax rate and the applicable tax rate,
disclosing also the basis on which the applicable tax rate is computed (IAS 12, para. 81(c)).

Using the data from example 4.16, this example illustrates the two methods of presentation.
Presentation Method 1: Reconciliation Between Tax Expense and the Product of
Accounting Profit Multiplied by the Applicable Tax Rate

30 June 20Y0 30 June 20X9

$ $
Accounting profit before tax 750 000 600 000
Tax at the applicable tax rate of 30% 225 000 180 000
Tax effect of expenses that are not deductible in
determining taxable profit:
Statutory fines — 15 000†
Tax expense 225 000 195 000

†
Amount of the statutory fine × the applicable income tax rate = $50 000 × 30%.

The applicable tax rate is the notional income tax rate of 30%.

204 Financial Reporting

 Presentation Method 2: Reconciliation Between the Average Effective Tax Rate and
the Applicable Tax Rate

30 June 20Y0 30 June 20X9

% %
Applicable tax rate 30.0 30.0
Tax effect of expenses that are not deductible in
determining taxable profit:
Statutory fines — 2.5†
Average effective tax rate 30.0 32.5‡

† Tax effect/accounting profit before tax = $15 000/$600 000.

‡ Tax expense/accounting profit before tax = $195 000/$600 000.

The applicable tax rate is the notional income tax rate of 30%.

4.12 INFORMATION ABOUT EACH TYPE OF

TEMPORARY DIFFERENCE
As discussed in part A of this module, temporary differences result in the recognition of deferred tax assets
and deferred tax liabilities in the statement of financial position, and the movement in deferred tax assets
and liabilities is included as a component of tax expense (income) for the reporting period.
Accordingly, it is important for the users of the financial statements to understand the nature and amount
of each type of temporary difference.

Recognised Deferred Tax Assets and Deferred Tax Liabilities

IAS 12 requires the following information to be disclosed in respect of each type of temporary difference:
(i) the amount of the deferred tax assets and liabilities recognised in the statement of financial position
for each period presented;
(ii) the amount of the deferred tax income or expense recognised in profit or loss, if this is not apparent
from the changes in the amounts recognised in the statement of financial position (IAS 12, para. 81(g)).

An example note disclosure is shown in table 4.15.

TABLE 4.15 Information about each type of temporary difference

Deferred tax assets and liabilities reconciliation
Deferred tax relates to the following:
Statement of
financial position Income statement
US$ million 2018 2017 2018 2017
Property, plant and equipment (205.9) (239.3) 33.4 15.3
Impairment of trade receivables 4.3 6.4 (2.1) 2.8
Intangibles (63.4) (133.2) 69.0 24.6
Valuation of inventories 5.8 5.3 0.5 (3.7)
Employee benefits 56.4 93.0 (28.3) (3.5)
Provisions 5.2 45.1 (39.7) 16.3
Financial instruments at fair value and net investment
hedges 17.7 2.2 7.7 4.5
Tax losses carried forward 32.2 24.5 8.2 (9.4)
Accruals and other items 50.7 47.3 (1.7) 12.0
Deferred tax (expense)/benefit 47.0 26.3
Net deferred tax assets/(liabilities) (97.0) (148.7)

Source: Amcor Limited 2018, Annual Report 2018, p. 71, accessed May 2019, https://www.amcor.com/investors/financial-
information/annual-reports.

This extract from the Amcor Limited 2018 Annual Report discloses information about each temporary
difference that resulted in the recognition of deferred tax assets and deferred tax liabilities for 2018

MODULE 4 Income Taxes 205

(and for the comparative financial year). For example, looking at the first line of the note disclosures in
table 4.15, temporary differences arising from property, plant and equipment resulted in the recognition
of a deferred tax liability of $205.9 million for 2018 (and $239.3 million for 2017).
Example 4.20 illustrates the recognition of taxable temporary differences.

EXAMPLE 4.20

Recognising Taxable Temporary Differences

Using the data from example 4.16, the amounts of deferred tax assets and deferred tax liabilities
recognised in the statement of financial position would be as follows.

30 June 20Y0 30 June 20X9

$ $
Taxable temporary differences
Interest receivable 0 30 000
Deferred tax liability 0 30 000

Unrecognised deferred tax assets and deferred tax liabilities

Paragraph 81(e) of IAS 12 requires the disclosure of the ‘amount (and expiry date, if any) of deductible
temporary differences, unused tax losses, and unused tax credits for which no deferred tax asset is
recognised in the statement of financial position’.
An example note disclosure is shown in table 4.16.

TABLE 4.16 Unrecognised deferred tax assets and deferred tax liabilities
US$ million 2018 2017
Unused tax losses for which no deferred tax asset has been recognised(1) 820.0 716.4
Potential tax benefits on unused tax losses at applicable rates of tax 214.8 207.9
Unrecognised tax credits 48.0 25.9
Deductible temporary differences not recognised 7.3 21.4
Total unrecognised deferred tax assets 270.1 265.2
(1)
Unused tax losses have been incurred by entities in various jurisdictions. Deferred tax assets have not been recognised in respect
of these items because it is not probable that future taxable profit will be available in those jurisdictions against which the Group
can utilise the benefits.
Source: Amcor Limited 2018, Annual Report 2018, p. 71, accessed May 2019, https://www.amcor.com/investors/financial-
information/annual-reports.

The following extract from the Amcor Limited 2018 Annual Report (p. 71) discloses information
about unrecognised deferred tax assets and deferred tax liabilities for 2018 (and for the comparative
financial year).
A deferred tax liability on differences that result from translating financial statements of the Group’s
subsidiaries only arises in the event of a disposal. It is not expected in the foreseeable future to dispose
of any subsidiary or associate and no such deferred tax liability is therefore recognised.
When retained earnings of subsidiaries are distributed upstream to Amcor Limited or other parent
entities, withholding taxes may be payable to various foreign countries. These amounts are not expected to
be significant and the Group controls when and if this deferred tax liability arises. No significant deferred
tax liabilities are thus recognised on unremitted earnings.

The note indicates that Amcor Limited had unused tax losses of $820.0 million for 2018 for which
a deferred tax asset was not recognised. In this regard, the footnote explains that the unused tax losses
were not recognised as a deferred tax asset ‘because it is not probable that future taxable profit will be
available . . . against which the Group can utilise the benefits’ (Amcor Limited 2018, p. 71).
It should be noted that the disclosure requirements with regards to income tax are numerous
and, coupled with the strict requirements in terms of measuring and recognising income tax items,
makes the process of achieving compliance by preparers a bit challenging. Implementing technologies

206 Financial Reporting

like Ernst & Young (EY)’s Automated Ledger Review Tool (https://www.ey.com/uk/en/services/tax/
ey-alert-compliance-transformation) may allow entities to capture and present the tax-related information
more efficiently, more accurately and ensuring a high level of compliance.

SUMMARY
The objective of the presentation and disclosure requirements of IAS 12 is to disclose information that
enables users of the financial statements to understand and evaluate the impact of current tax and deferred
tax on the financial position and performance of the entity.
IAS 12 requires the presentation and disclosure of several items of information about income tax. The
presentation and disclosures discussed in part D included:
• major components of tax expense (tax income)
• relationship between tax expense (tax income) and accounting profit
• particulars of temporary differences that give rise to the recognition of deferred tax assets and the
deferred tax liabilities
• particulars of temporary differences, unused tax losses and unused tax credits for which no deferred tax
asset was recognised (i.e. because the ‘probability criterion’ was not satisfied).
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

4.7 Apply the requirements of IAS 12 with respect to financial statement presentation and disclosure
requirements.
• Current tax assets and liabilities and deferred tax assets and liabilities are presented in separate line
items in the statement of financial position.
• Current tax assets and liabilities can be presented as a single net amount (i.e. net asset or net liability)
in the statement of financial position when the following criteria are satisfied.
– The entity has a legally enforceable right to set off the recognised amounts.
– The entity intends to settle on a net basis, or to realise the assets and settle the liability
simultaneously.
• Deferred tax assets and liabilities can be offset in the statement of financial position when:
– the entity has a legally enforceable right to set off current tax assets against current tax liabilities
– the deferred tax assets and the deferred tax liabilities relate to income taxes levied by the same
taxation authority.
• The major components of tax expense (tax income) are to be disclosed separately in the notes to
the financial statements.
• An explanation of the relationship between accounting profit and tax expense (income) must be
provided in the notes to the financial statements.
• IAS 12 requires particular disclosures to be included in the notes to the financial statements for each
type of temporary difference.
• IAS 12 also requires the disclosure of the amount (and expiry date, if any) of deductible temporary
differences, unused tax losses, and unused tax credits for which no deferred tax asset is recognised
in the statement of financial position.

MODULE 4 Income Taxes 207

PART E: COMPREHENSIVE EXAMPLE
INTRODUCTION
Part E of this module looks at a comprehensive example illustrating the application of IAS 12. A thorough
understanding of parts A–D is required before beginning part E.
.......................................................................................................................................................................................
EXPLORE FURTHER
Digital content, such as videos and interactive activities in the e-text, support this module. You can access this content
on My Online Learning.

4.13 CASE STUDY: AAA LTD

The AAA Ltd case study is a comprehensive example that deals with an entity over a three-year period:
20X0, 20X1 and 20X2. The comprehensive example covers the concepts addressed in this module. Specific
considerations covered include:
• recognition and measurement of deferred tax assets and liabilities
• recognition of deferred tax on revaluation
• goodwill
• tax losses, and recovery of tax losses
• presentation and disclosure requirements.

Relevant Paragraphs
To assist in achieving the objectives of part E, you may wish to read the following paragraphs of
IAS 1, IAS 12 and IAS 16. Where specified, you need to be able to apply these paragraphs as referenced in
this module.

Subject Paragraphs
IAS 1
Information to be presented in the statement of financial position 54, 56
Disclosure 82
IAS 12
Definitions 5–6
Tax base 7–11
Recognition of current tax liabilities and current tax assets 12–14
Recognition of deferred tax liabilities and deferred tax assets 15–17
Taxable temporary differences 18(b), 20
Initial recognition of an asset or liability 22(c)
Deductible temporary differences 24–25, 26(a), 26(b), 26(d), 27–31
Unused tax losses and unused tax credits 34–36
Reassessment of unrecognised deferred tax assets 37
Measurement 46–56
Recognition of current tax and deferred tax 57–60
Items recognised outside profit or loss 61A, 62(a)
Presentation 71–77
Disclosure 79–88
IAS 16
Revaluation model 39–40

208 Financial Reporting

BACKGROUND TO AAA LTD
The records of AAA Ltd as at 31 December 20X0–31 December 20X2 revealed the following.
(a) A deferred tax liability of $30 000 relating to a taxable temporary difference of $100 000. The
temporary difference related to a receivable that was recognised in the measurement of accounting
profit in the year ended 31 December 20X0. It was expected that the temporary difference would
reverse on receipt of cash in future reporting periods, as follows.

20X1 $45 000

20X2 $55 000

(b) A deductible temporary difference of $15 000 relating to warranty obligations, which was expected to
reverse in the future reporting periods, as follows.

20X1 $ 5 000
20X2 $10 000

(c) During the financial year ended 31 December 20X0, AAA Ltd received a statutory fine of $6000 for a
violation of environmental laws. This fine was non-deductible in the relevant tax jurisdiction. The fine
was paid in the financial year ended 31 December 20X1.
(d) On 1 January 20X0, AAA Ltd purchased buildings at cost of $40 000. The tax base of the buildings
before depreciation was also $40 000.
(e) Buildings were depreciated at 20% per year on a straight-line basis for accounting purposes and at
25% per year on a straight-line basis for tax purposes. The carrying amount of the buildings was
expected to be recovered through use.
(f) On 1 January 20X2, the building was revalued to $45 000 and the entity estimated that the remaining
useful life of the building was five years from the date of the revaluation. The revaluation did not affect
the taxable profit in 20X2, and the tax base of the building was not adjusted to reflect the revaluation.
(g) The entity did not have a history of losses.
(h) AAA Ltd had recognised goodwill of $10 000 in its statement of financial position. Goodwill would
only be expensed if impaired.
(i) Accounting profit was as follows.

20X0 $ 75 000
20X1 $ 95 000
20X2 $110 000

(j) There were no other transactions in 20X0, 20X1 and 20X2.

(k) The tax rate was 30%.
(l) The entity also had the following assets and liabilities, with their tax bases equal to the accounting
carrying amounts.

20X2 20X1 20X0

$ $ $
Inventory 2 000 2 000 2 000
Investments 33 000 33 000 33 000
Plant and equipment 10 000 10 000 10 000
Accounts payable 500 500 500
Long-term debt 20 000 20 000 20 000

DEFERRED TAX
The first step in determining the deferred tax effects is to calculate the deferred tax liability associated with
the buildings. Using the information in the ‘Background to AAA Ltd’ section discussed earlier in part E,
the deferred tax liability can be calculated for the periods ending 31 December 20X0 and 31 December
20X1. This calculation is as follows.

MODULE 4 Income Taxes 209

Calculation of Deferred Tax Liability on Buildings
Taxable Deferred
Carrying temporary Deferred tax expense
amount Tax base difference tax liability (income)
Year $ $ $ $ $
01/01/X0 40 000 40 000 0 0 0
31/12/X0 32 000 30 000 2 000 600 600
31/12/X1 24 000 20 000 4 000 1 200 600

This calculation may also be demonstrated as follows.

31/12/X0 $ $
Carrying amount 32 000
Less: Tax base — Cost 40 000
— Tax depreciation (10 000) (30 000)
Taxable temporary difference 2 000

Multiplying the taxable temporary difference of $2000 × 30% tax rate, the deferred tax liability is $600.

31/12/X1 $ $
Carrying amount 24 000
Less: Tax base — Cost 40 000
— Tax depreciation (20 000) (20 000)
Taxable temporary difference 4 000

By multiplying the taxable temporary difference of $4000 by the tax rate of 30%, it is determined that
the deferred tax liability increases to $1200. The movement for the year is $600, which is reflected in
deferred tax expense.
At 1 January 20X2, the building was revalued and the estimated useful life adjusted (see note (f) in
the ‘Background to AAA Ltd’ section). Following the revaluation, the deferred tax liability calculation is
shown in table 4.17.

TABLE 4.17 Calculation of deferred tax liability following revaluation

Taxable Deferred
Carrying temporary Deferred tax expense
amount Tax base difference tax liability (income)
Year $ $ $ $ $
01/01/X2 45 000 20 000 25 000 7 500 6 300†
31/12/X2 36 000 10 000 26 000 7 800 300†
†
On 1/01/20X2, the building was revalued from its carrying amount of $24 000 to $45 000 — a revaluation increase of $21 000
resulting in a movement of $6300 in deferred tax liability and deferred tax expense (recognised in other comprehensive income
(OCI)). The deferred tax expense of $6300 (recognised in OCI) is calculated as the tax rate of 30% multiplied by the revaluation
increase of $21 000. Recall from part C, in accordance with paragraph 61 of IAS 12, the $6300 will be debited to OCI and
accumulated in equity.
Source: CPA Australia 2019.

This calculation may also be demonstrated as follows.

31/12/X2 $ $
Carrying amount 36 000
Less: Tax base — Cost 40 000
— Tax depreciation (30 000) (10 000)
Taxable temporary difference 26 000

By multiplying the taxable temporary difference of $26 000 by the 30% tax rate, it is determined that
the deferred tax liability is $7800. Therefore, the deferred tax liability has increased by $300 since the
beginning of the year. This is recognised in deferred tax expense.

210 Financial Reporting

 Confirm that the total deferred tax liability of $7800 at 31 December 20X2 will reverse over the
remaining four-year useful life of the asset.

QUESTION 4.11

Assume that the carrying amount and the recoverable amount through sale is $45 000 as at
31 December 20X2. Using the information in table 4.17 as at 31 December 20X2, outline how the
calculations would differ if:
(a) the asset was expected to be recovered through sale and capital gains tax was not applicable
(b) the asset was expected to be recovered through sale and capital gains tax was applicable.

OTHER DEFERRED TAX ASSETS AND LIABILITIES

This module has stated that, to implement the balance sheet method of accounting for income tax, all
taxable and deductible temporary differences are identified by:
• comparing carrying amount of each asset and liability from the statement of financial position with its
tax base
• identifying all items that have a carrying amount of $nil in the statement of financial position but
nevertheless have a tax base.
Table 4.18 illustrates one method of identifying all taxable and deductible temporary differences.
The table lists the carrying amounts of the assets and liabilities, their tax bases and the two temporary
differences: taxable and deductible. Reference to table 4.6 may assist with the determination of the
relationship between the carrying amount and the tax base. The bottom section of the table shows the
calculation of the deferred tax asset and liability for the year.

TABLE 4.18 AAA Ltd’s Deferred tax assets and liabilities as at 31 December 20X0

Taxable Deductible
Carrying temporary temporary
amount Tax base difference difference
$ $ $ $
Receivable 100 000 — 100 000
Inventory 2 000 2 000
Investments 33 000 33 000
Buildings 32 000 30 000 2 000
Plant and equipment 10 000 10 000
Goodwill† 10 000 10 000
Accounts payable 500 500
Fines payable‡ 6 000 6 000
Warranty obligations 15 000 — 15 000
Long-term debt 20 000 20 000
Total 102 000 15 000
Deferred tax liability (taxable temporary differences × 30% tax rate) 30 600
Deferred tax asset (deductible temporary differences × 4 500
30% tax rate)
†
IAS 12 Income Tax does not permit the recognition of a deferred tax liability relating to goodwill (IAS 12, para. 15(a)). Therefore,
no taxable or deductible temporary difference should be recognised for goodwill.
‡
The fine is not deductible for tax purposes; therefore, the tax base is equal to its carrying amount.
Source: CPA Australia 2019.

You can confirm the tax bases listed in the second column of the table by referring to paragraphs 7 and
8 of IAS 12 or to the examples in this module. At the same time, you can confirm the taxable temporary
difference for buildings as outlined in tables 4.7 and 4.8. Also note that there are no opening deferred tax
asset or deferred tax liability balances. If such balances did exist at the beginning of the year, these would
need to be considered when constructing the statement of financial position.

MODULE 4 Income Taxes 211

 QUESTION 4.12

Part A
Construct a table identifying all taxable and deductible temporary differences for AAA Ltd for
the year ending 31 December 20X1, and a table identifying all taxable and deductible temporary
differences for AAA Ltd for the year ending 31 December 20X2.
The tables should include the carrying amounts of the assets and liabilities, their corresponding
tax bases and the two types of temporary differences: taxable and deductible. The bottom section
of the table should illustrate the calculation of the deferred tax asset and liability for the year.

Part B
How would the answer for the year ended 31 December 20X2 differ if the tax rate changed from
30% to 25% in 20X2?

TAXABLE PROFIT AND CURRENT TAX EXPENSE

Having calculated the deferred tax for each of the three years, it is now possible to perform the current tax
expense calculation, as shown in table 4.19.

TABLE 4.19 Calculation of current tax expense

Period ended 31 December 20X0
(2) × 30%
$ $
(1) (2) (3) (4)
Accounting profit before tax 75 000 22 500 Prima facie tax
Adjustment for non-temporary
differences and excluded temporary
differences
Statutory fines 6 000 1 800
Accounting profit adjusted for non-
temporary and excluded temporary
differences 81 000 24 300 Tax expense
Movements in temporary differences
Add: Warranty obligations 15 000
Accounting depreciation 8 000
Less: Receivables (100 000)
Tax depreciation (10 000) (26 100) Deferred tax expense
Taxable profit (loss) (6 000) (1 800) Current tax income

For the period ended 31 December 20X0, a taxable loss results. A deferred tax asset may be recognised to
the extent that it is probable that future taxable profit will be available against which the deferred tax asset can be
used. A primary source of taxable profit is the reversal of taxable temporary differences.
In this example, the expected reversal of the taxable temporary difference in each of years 20X1 and 20X2 is
greater than the expected reversals of the deductible temporary difference in each of these years. This means
that the expected taxable profits in each of 20X1 and 20X2, arising from the reversal of the taxable temporary
differences, are sufficient to absorb the amounts of the deductible temporary differences that reverse in each
period. As a consequence, AAA Ltd should recognise a deferred tax asset of $1800 ($6000 × 30%) as at
31 December 20X0.

212 Financial Reporting

 Period ended 31 December 20X1
(2) × 30%
$ $
(1) (2) (3) (4)
Accounting profit before tax 95 000 28 500 Prima facie tax
Adjustment for non-temporary
differences and excluded temporary
— —
differences
Accounting profit adjusted for non-
temporary and excluded temporary
differences 95 000 28 500 Tax expense
Movements in temporary differences
Add: Receivable 45 000
Accounting depreciation 8 000
Less: Warranty obligations (5 000)
Tax depreciation (10 000)
Recovery of previously recognised tax losses (6 000) 9 600 Deferred tax income
Taxable profit (loss) 127 000 38 100 Current tax expense

Period ended 31 December 20X2

(2) × 30%
$ $
(1) (2) (3) (4)
Accounting profit before tax 110 000 33 000 Prima facie tax
Adjustment for non-temporary
differences and excluded temporary
— —
differences
Accounting profit adjusted for non-
temporary and excluded temporary
differences 110 000 33 000 Tax expense
Movements in temporary differences
Add: Receivable 55 000
Accounting depreciation 9 000
Less: Warranty obligations (10 000)
Tax depreciation (10 000) 13 200 Deferred tax income
Taxable profit (loss) 154 000 46 200 Current tax expense

Note that this table does not include the tax effects of items recognised in OCI. In this example, the revaluation
of the building on 1 January 20X2 increased deferred tax liability by $6300 and the corresponding deferred tax
expense was recognised in OCI. As the revaluation is not recognised in P/L, the tax effect of the revaluation is not
included in the amount for deferred tax income.
At 31 December 20X2, the net movement in deferred tax liability is $6900 ($14 700 – $7800). However, it has
two parts: deferred tax expense recognised in OCI $6300 (Dr) and deferred tax income recognised in P/L of
$13 200 (Cr).
Source: CPA Australia 2019.

QUESTION 4.13

How would the answer for the year ended 31 December 20X0 in table 4.19 differ if the entity had a
history of losses?

MODULE 4 Income Taxes 213

ILLUSTRATIVE DISCLOSURES
Major Components of Tax Expense (Income)
The disclosures required by IAS 12, paragraphs 79 and 80, are illustrated as follows.

31 Dec 20X2 31 Dec 20X1 31 Dec 20X0

Major components of tax expense (income) $ $ $
Current tax expense (income) 46 200 38 100 (1 800)
Deferred tax expense (income) relating to the
origination and reversal of temporary differences (13 200) (9 600) 26 100
Tax expense 33 000 28 500 24 300

Statement of Financial Position

The disclosures required by paragraph 54(n) and 54(o) of IAS 1 are illustrated as follows.

31 Dec 20X2 31 Dec 20X1 31 Dec 20X0

Statement of financial position extracts $ $ $
Tax liabilities
Current tax payable 46 200 38 100
Deferred tax liability 7 800‡ 14 700 24 300†
Tax assets
Deferred tax asset — — —
†
The $24 300 includes the $1800 deferred tax asset resulting from the tax losses and the $26 100 net deferred tax
liability.
‡
The $7800 includes the $1200 deferred tax liability existing at 31 December 20X1 and the $6300 additional deferred
tax liability arising on revaluation of the asset (30% × $21 000 revaluation increase) and the additional $300 deferred
tax liability arising from depreciation differences between accounting and tax. Recall from part C, in accordance
with paragraph 61 of IAS 12, the $6300 additional deferred tax liability arising from the revaluation of the asset will
be debited to OCI accumulated in equity in the revaluation surplus.

Relationship Between Tax Expense and Accounting Profit

The disclosures required by IAS 12, paragraph 81(c)(i), are illustrated as follows.

Relationship between tax expense and 31 Dec 20X2 31 Dec 20X1 31 Dec 20X0
accounting profit $ $ $
Accounting profit before tax 110 000 95 000 75 000
Tax at the applicable tax rate of 30% 33 000 28 500 22 500
Tax effect of expenses that are not deductible in
determining taxable profit
Statutory fines 0 0 1 800
Tax expense 33 000 28 500 24 300

IAS 12, paragraph 81(c)(ii), allows that this disclosure may alternatively be made on a percentage basis.

Information About Each Type of Temporary Difference

Since the amount of deferred tax income and expense recognised in P/L for the current year is apparent
from changes in the amounts recognised in the statement of financial position, the following information
satisfies the disclosure requirements of IAS 12, paragraph 81(g).

214 Financial Reporting

 The amounts of deferred tax assets and deferred tax liabilities recognised in the statement of financial
position would be as follows.

31 Dec 20X2 31 Dec 20X1 31 Dec 20X0

$ $ $
Taxable temporary differences
Buildings 7 800 1 200 600
Receivable 0 16 500 30 000
Deferred tax liability 7 800‡ 17 700 30 600

Deductible temporary differences

Warranty obligations 0 3 000 4 500
Deferred tax asset 0 3 000‡ 4 500†

†
Refer to table 4.18 for calculation.
‡
Refer to question 4.12 suggested answer for calculation.

SUMMARY
Part E of this module has worked through a comprehensive example that illustrates the specific applications
of IAS 12, including:
• recognition and measurement of deferred tax assets and liabilities
• recognition of deferred tax on revaluation
• goodwill
• tax losses and recovery of tax losses
• presentation and disclosure requirements.
.......................................................................................................................................................................................
EXPLORE FURTHER
Digital content, such as videos and interactive activities in the e-text, support this module. You can access this content
on My Online Learning.

REVIEW
This module focused on accounting for income tax under IAS 12.
Income taxes normally give rise to an income tax expense and some related income tax assets and
liabilities that should be recognised in the financial statements. As those items can be significant for many
entities, it is important for users and preparers of financial statements to have a clear understanding of the
way they are calculated and recognised in the financial statements.
The accounting treatment for income taxes prescribed in IAS 12 is based on the balance sheet method.
The name of this method comes from the fact that it focuses on balance sheet (or statement of financial
position) items (i.e. assets and liabilities) and requires consideration of the difference between the carrying
amounts of those items (as recognised in the statement of financial position) and their underlying tax bases
(as determined according to the tax rates and tax laws enacted in the relevant jurisdiction). This difference
gives rise to tax effects deferred for the future, which should be recognised together with the current
tax effects.
As discussed in part A of this module, the core principle of IAS 12 is that the financial statements should
recognise the current and future tax consequences of:
• transactions and other events of the current period that are recognised in an entity’s financial statements
• the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in an
entity’s statement of financial position.
From a conceptual perspective, the recognition of the current tax consequences, together with future
tax consequences of the expected recovery (settlement) of the carrying amounts of assets (liabilities)
recognised in the statement of financial position provides a more complete picture of the financial position
and financial performance of the entity.

MODULE 4 Income Taxes 215

 These current and future tax consequences are reflected in the financial statements, as shown in table 4.1
earlier in the module; refer back to table 4.1 to refresh your memory on income tax line items in financial
statements.
As discussed in part B of this module, IAS 12 requires an entity to recognise deferred tax assets and
deferred tax liabilities, with certain limited exceptions.
In accordance with these recognition rules (and limited recognition exceptions):
• a deferred tax liability must be recognised for all taxable temporary differences, except for certain
limited exclusions
• a deferred tax asset must be recognised for all deductible temporary differences to the extent that it is
probable that taxable profit will be available against which the deductible temporary difference can be
utilised, except for certain limited exclusions.
As discussed in part D of this module, the presentation and disclosure requirements of IAS 12 focus
primarily on the presentation of tax balances in the statement of financial position and the disclosure of
information about the following matters:
• major components of tax expense (tax income)
• relationship between tax expense (tax income) and accounting profit
• particulars of temporary differences that give rise to the recognition of deferred tax assets and deferred
tax liabilities
• particulars of temporary differences, unused tax losses and unused tax credits for which no deferred tax
asset was recognised (i.e. because the probability criterion was not satisfied).
The objective of the presentation and disclosure requirements of IAS 12 is to disclose information that
enables users of the financial statements to understand and evaluate the impact of current tax and deferred
tax on the financial position and performance of the entity.

REFERENCES
Amcor Limited 2018, Annual Report 2018, accessed May 2019, https://www.amcor.com/investors/financial-information/annual-
reports.
CPA 2016, ‘IAS 12 Income Taxes: Fact sheet’, accessed May 2019, https://www.grantthornton.com.au/globalassets/1.-member-
firms/australian-website/technical-publications/ifrs/gtal_2016_factsheet-ias12-income-taxes.pdf.

216 Financial Reporting

MODULE 5

BUSINESS
COMBINATIONS AND
GROUP ACCOUNTING
LEARNING OBJECTIVES

After completing this module, you should be able to:

5.1 identify a business combination, discuss the forms that it may take and analyse issues relating to different
business combinations
5.2 discuss and apply the acquisition method to a business combination, including the IFRS 3 requirements
for recognising and measuring goodwill
5.3 apply the accounting for the deferred taxation impact of a business combination
5.4 explain the concept of control and analyse specific scenarios to outline how the existence of control
is determined
5.5 explain and prepare consolidation worksheet entries, including the revaluation of assets subject to
depreciation and transactions within the group
5.6 explain the concept of ‘non-controlling interest’ and prepare a consolidation worksheet that includes the
appropriate adjustment entries and allows for non-controlling interests
5.7 explain and apply the disclosure requirements of both IAS 1 Presentation of Financial Statements for
consolidated financial statements and IFRS 12 Disclosure of Interests in Other Entities for interests in
subsidiaries, associates and joint arrangements
5.8 determine whether significant influence exists in specific scenarios and evaluate whether consolidation
is required
5.9 account for associates using the equity method
5.10 define a joint arrangement and explain the accounting requirements of IFRS 11.

ASSUMED KNOWLEDGE

It is assumed that before commencing your study of this module, you are able to:
• understand the concept of cost of acquisition
• apply the cost method to a single asset, or a number of assets (but not a business)
• understand the concept of consolidated financial statements
• understand the design and purpose of a consolidation worksheet (Note: A consolidation worksheet is pre-
pared each financial year using the financial information of the parent entity and its subsidiaries. Accordingly,
the adjustment entries in the consolidation worksheet do not carry over from period to period and must be
determined and incorporated into the consolidation worksheet each financial year)
• determine whether an acquisition of a subsidiary involves purchased goodwill or a gain on bargain purchase
(Note: Only purchased goodwill will be addressed in this module)
• prepare a consolidation pre-acquisition elimination entry at the acquisition date that involves the revaluation
of assets and recognition of goodwill.
To help you test your understanding of some aspects of assumed knowledge, two questions are included in
the ‘Assumed knowledge review’ at the end of this module. It is strongly recommended that you answer these
questions when directed to do so.
The concepts considered as assumed knowledge are examinable.
LEARNING RESOURCES

International Financial Reporting Standards (IFRSs):

• IFRS 3 Business Combinations
• IFRS 10 Consolidated Financial Statements
• IFRS 11 Joint Arrangements
• IFRS 12 Disclosure of Interests in Other Entities
• IAS 1 Presentation of Financial Statements
• IAS 2 Inventories
• IAS 12 Income Taxes
• IAS 16 Property, Plant and Equipment
• IAS 27 Separate Financial Statements
• IAS 28 Investments in Associates and Joint Ventures
• IAS 36 Impairment of Assets
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets
• IAS 38 Intangible Assets
Other resources:
• Digital content, such as videos and interactive activities in the e-text, support this module. You can access
this task on My Online Learning.

PREVIEW
As part of their strategic objectives, many entities are involved in investment activities to grow or diversify
their operations. Their investments can include:
• acquiring a business or some businesses of other entities (e.g. on 13 May 2019, nib Holdings Ltd (nib)
acquired the travel insurance business of QBE Insurance Group Ltd (QBE))
• establishing relationships with other entities through:
– acquiring shares in other entities (e.g. on 16 April 2018, HelloWorld Travel Ltd (HelloWorld Travel)
acquired the entire share capital of Flight Systems Pty Ltd (Flight Systems), a Sydney-based provider
of custom computer programming services)
– setting up joint arrangements (e.g. on 18 November 2018, the University of Queensland and the
Indian Institute of Technology formed a joint venture to launch an international joint PhD program).
Each of those options comes with its own advantages and disadvantages. To ensure that the strategic
objectives of the investment can be achieved, due diligence must be performed when making such
investment decisions. For example, acquisition of a business with all its assets and liabilities may be the
most appropriate investment for an investor that needs to use the acquired assets in its own business.
Acquiring shares in other entities operating in growth markets with high barriers to entry may be
the most appropriate way for investors to gain exposure to those markets, with the level of exposure
sought influencing the level of equity interest acquired. Finally, setting up joint arrangements may be an
appropriate way to share scarce resources among business partners in search of a common goal, while
protecting themselves against a high level of risks. These investments are particularly popular during
times of rapid technological advancements when entities engage in acquisitions or joint arrangements
with entities that developed new technologies; thus, preserving or enhancing their competitive advantage
by allowing quick access to those technologies, rather than waiting for them to be developed in-house.
When an entity has grown or diversified through either of these means, based on the underlying principle
of accounting it will need to prepare financial statements for users to be able to understand the financial
impact of those investments on the entity’s financial position, performance and cash flows. In preparing
the financial statements, alternative accounting treatments are required, both at the time of the initial
investment and subsequently, according to the type of investment undertaken.

218 Financial Reporting

 If these investments involve acquiring a business or some businesses of other entities, the investor will
directly get ownership over the assets and liabilities of the acquired businesses; as such, the accounting
treatment at the time of the initial investment and subsequently will involve recognising those items in the
investor’s own financial statements, together with any other of its own assets and liabilities. For example,
after nib acquired the travel insurance business of QBE, nib recognised the assets and liabilities acquired
in its own financial statements. Figure 5.1 shows a company acquiring two businesses that become integral
parts of the acquirer’s businesses.

FIGURE 5.1 Acquisition of multiple businesses by a company

Business Business
A A

Company Company

Business Business
B B

Source: CPA Australia 2019.

If the investor establishes relationships with other entities through acquiring shares in other entities or
setting up a joint arrangement as a joint venture, the investor, in essence, is acquiring a single asset:
the investment account. As such, the accounting treatment at the time of the initial investment will
involve recognising the investment account in the investor’s financial statements based on the consideration
transferred. For example, after HelloWorld Travel acquired the share capital of Flight Systems, HelloWorld
Travel recognised its investment in Flight Systems in an investment asset account based on how much it
paid for the shares acquired.
If the investor establishes relationships with other entities through setting up a joint arrangement as a
joint operation, it essentially acquires a share of the individual accounts of the joint operation. As such, the
accounting treatment at the time of the initial investment will involve recognising in the investor’s financial
statements the investor’s share of the individual accounts of the joint operation. For example, if two entities
establish a 50:50 joint operation that gives them joint control over the assets and liabilities contributed to
that operation, and one entity contributes cash of $1 000 000 while the other entity contributes plant and
equipment recognised at its fair value of $1 000 000, each entity will recognise its share (50%) of the
individual assets of the joint operation in their own financial statements (i.e. cash of $500 000 and plant
and equipment of $500 000).
The subsequent accounting treatment of the relationships established with other entities is dependent
upon the type of relationship created. This module considers three types of relationships established by
the investor with other entities (shown in figure 5.2):
1. parent–subsidiary relationship, established through investments where the investor (parent) obtains
control over other entities (i.e. wholly and partially owned subsidiaries, depending on whether the parent
has 100% of the shares in the subsidiary or less)
2. investor–associate relationship, established through investments where the investor obtains significant
influence over other entities (i.e. associates)
3. joint arrangements, established through investments where the investor obtains joint control over other
entities (i.e. joint operations and joint ventures, depending on whether the investor has joint rights over
the assets and liabilities of the arrangement or only over the net assets).

MODULE 5 Business Combinations and Group Accounting 219

 FIGURE 5.2 Types of relationships established by a company with other entities

Company

Associate

Control Significant Joint control

influence

Wholly owned Partially owned Joint Joint

subsidiary subsidiary venture operation

Source: CPA Australia 2019.

There are eight international financial reporting standards that provide guidance on various aspects of
accounting for these investment activities.
1. IFRS 3 Business Combinations — specifies the accounting requirements for acquisitions of one or more
businesses and for investments where the investor obtains control over other entities.
2. IFRS 9 Financial Instruments — specifies the accounting requirements for investments in shares and
other financial instruments not covered by other accounting standards that deal with specific types of
investments (as listed in points 3, 4 and 6). (Note: IAS 32 Financial Instruments: Presentation and
IFRS 7 Financial Instruments: Disclosures are also relevant to the presentation and disclosures relating
to investments in this category.)
3. IFRS 10 Consolidated Financial Statements — specifies the additional accounting requirements for the
preparation of consolidated financial statements for investments where the investor obtains control over
other entities.
4. IFRS 11 Joint Arrangements — specifies the accounting requirements for investments where the
investor obtains joint control over a joint arrangement that is either a joint operation or a joint venture.
5. IFRS 12 Disclosure of Interests in Other Entities — specifies the disclosure of information relating to
investments in subsidiaries, associates, joint arrangements and unconsolidated structured entities.
6. IAS 24 Related Party Disclosures — specifies the disclosure of information about relationships
and transactions with related parties including, among other parties, subsidiaries, associates and
joint arrangements.
7. IAS 27 Separate Financial Statements — specifies the accounting requirements for investments in
subsidiaries, associates and joint ventures when the investor prepares separate financial statements.
8. IAS 28 Investments in Associates and Joint Ventures — specifies the accounting requirements for
investments in entities over which the investor has either significant influence (associates) or that are
regarded as joint ventures in IFRS 11.
IFRS 9 will be dealt with in module 6. The remaining accounting standards from the preceding list are
addressed in this module, with discussion of the overriding principles on which these accounting standards
were developed. IAS 24 requires disclosures regarding the effect of transactions between related parties
(e.g. between parent and subsidiary, investor and associate) to enable users to better assess the investor’s
operations and the risks and opportunities it may face, but it will not be discussed further as it is beyond
the scope of this material.
Part A of this module focuses on the general accounting principles and requirements applicable,
according to IFRS 3, to those investments where an investor acquires one or more businesses (e.g. nib
acquiring the travel insurance business of QBE) or obtains control of other entities (i.e. establishing a
parent–subsidiary relationship). Those investments are denoted as business combinations.
The remaining parts of this module focus solely on those relationships established by a company with
other entities, as per figure 5.2. Part B of this module focuses on additional accounting requirements
prescribed in IFRS 10 for those investments where the investor obtains control of other entities, giving rise
to parent–subsidiary relationships. The additional requirements addressed in part B relate to the acquirer’s

220 Financial Reporting

need to prepare consolidated financial statements to show the financial performance, position and cash
flows of the acquirer/parent and the subsidiary from the perspective of the reporting entity created. The
Conceptual Framework states that ‘a reporting entity can be a single entity or a portion of an entity or can
comprise more than one entity’ (para. 3.10). The Conceptual Framework further states that ‘if a reporting
entity comprises both the parent and its subsidiaries, the reporting entity’s financial statements are referred
to as ‘consolidated financial statements’ (para. 3.11). The consolidated financial statements reflect the
economic impact of transactions where the economic entity as a whole is involved with external parties,
but does not include the effect of transactions within the economic entity — because the users of financial
statements need to know how well the entity is doing externally. Note that the accounting requirements
from IFRS 3 described in part A are applicable in the preparation of the consolidated financial statements
in accordance with IFRS 10.
Part C focuses on investments where the investor obtains significant influence over the investee
(associate). It addresses two issues in accordance with IAS 28:
1. determining whether or not that relationship exists
2. specifying the requirements for applying the equity method to account for investments in associates.
Part D of this module provides a brief overview of the general principles and requirements for those
investments where the investor has joint control over a joint arrangement, distinguishing between joint
operations and joint ventures (IFRS 11).
Parts B, C and D also address the disclosure requirements for investors that have an investment
in subsidiaries, associates and joint arrangements, respectively. These requirements are included in
IFRS 12.
Table 5.1 provides a summary of the accounting treatment requirements for all the investment types
discussed previously (and illustrated by figures 5.1 and 5.2), both at the time of the initial investment
and after.

TABLE 5.1 Accounting treatment of different investment types

Section(s)
Accounting rules addressing
addressing this At the time of initial After the initial this type of
Investment type type of investment investment investment investment

Acquiring IFRS 3 Recognise the assets Recognise the assets A

businesses and liabilities of the and liabilities of the
business acquired in business acquired
the investor’s accounts in the investor’s
accounts

Obtaining control IFRS 3, 10, 12; Recognise an Prepare consolidated A, B

over other entities IAS 24 investment asset in the financial statements
investor’s accounts

Obtaining IAS 24, 28 Recognise an Use the equity C

significant investment asset in the method of accounting
influence over investor’s accounts to recognise changes
other entities in the investment
account

Setting up a joint IFRS 11, 12; Recognise an Use the equity D

venture IAS 24, 28 investment asset in the method of accounting
investor’s accounts to recognise changes
in the investment
account

Setting up a joint IFRS 11,12; Recognise the investor’s Recognise the D

operation IAS 24 share of the assets and investor’s share of the
liabilities of the joint assets and liabilities
operation of the joint operation

Source: CPA Australia 2019.

MODULE 5 Business Combinations and Group Accounting 221

PART A: BUSINESS COMBINATIONS
INTRODUCTION
Many entities, no matter how big or small, at some point will try to expand by obtaining control over other
businesses, including whole entities, that is, via business combinations. Due to legal, tax, regulatory or
other reasons, a business combination may be structured in a variety of ways, including the following.
• An entity acquires the assets and liabilities of a business of another entity.
• An entity obtains control of another entity through the purchase of shares (equity interests) in that entity.
• An entity obtains control of another entity through other means than the purchase of shares (equity
interests) in that entity (e.g. by contract alone).
• A new entity is formed to obtain control through the purchase of shares in other entities.
• A stapled entity is listed on the securities exchange. A stapled entity comprises several legal entities that
are stapled (combined) together so that purchasers of the ‘stapled’ shares become investors in all the
legal entities (e.g. Westfield Group, which staples together Westfield Holdings shares, Westfield Trust
units and Westfield America Trust units).
• Dual-listed entities where the operations of two entities listed on different securities exchanges are
combined and managed via a contractual arrangement so that investors in each of the entities share in
the performance of the combined operations of both entities (e.g. Rio Tinto Ltd in Australia and Rio
Tinto plc in the United Kingdom).
This module considers the first two bullet points specified in the preceding list, as these are two of the
most common scenarios. As in figure 5.3, these two types of business combinations are categorised as:
1. direct acquisition: acquiring the assets and liabilities (i.e. net assets) of another business that does
not represent a separate legal entity or subsequently ceases to exist as a separate legal entity (e.g. the
acquisition by nib of the travel insurance business of QBE)
2. indirect acquisition: acquiring the shares of another separate legal entity in order to obtain control over
that entity, in which case a parent–subsidiary relationship arises (e.g. the acquisition by HelloWorld
Travel of the entire share capital of Flight Systems).

FIGURE 5.3 Business combinations

Business combinations

Investor acquires the assets and Investor acquires shares in another

liabilities of one or more businesses entity and obtains control

Direct acquisition Indirect acquisition

Source: CPA Australia 2019.

According to IFRS 3, where a business combination occurs, it is very important to first identify the
acquirer (i.e. the entity that obtains control, whether directly or indirectly), as it has to disclose information
that enables users to assess the nature and financial impact of the acquisition (in our examples, the acquirers
are nib and HelloWorld Travel). Hence, IFRS 3 requires an acquirer to be identified and the combination to
be accounted for using the acquisition method. This method results in information that shows the financial
impact of the business combination on the acquirer by identifying what was acquired in exchange for the
consideration transferred. More specifically, under this method, an acquirer recognises the identifiable
assets acquired, liabilities assumed and any non-controlling interests in the acquiree, and then identifies
any difference at acquisition date between:
(a) the fair value of the consideration transferred plus any non-controlling interest plus the fair value of
any previously held equity interest in the acquiree
(b) the fair value of the identifiable net assets acquired (IFRS 3, para. 32).
This difference will be recognised as goodwill if the amount in (a) is greater than the amount in (b). If
the opposite situation arises, the difference is considered to be a gain on bargain purchase and recognised
as part of profit or loss. As the latter is not common in practice, this module will only focus on situations

222 Financial Reporting

where goodwill arises as a result of a business combination. IFRS 3 specifies measurement and disclosure
requirements for goodwill, both at the acquisition date and subsequently.
Note that the preceding formula for the calculation of goodwill essentially applies only in the case of
an indirect acquisition; in the case of a direct acquisition, there won’t be any non-controlling interest or
previously held equity interest in the acquiree, and therefore the goodwill can be calculated as the simple
difference between the acquisition-date fair values of:
(a) the consideration transferred
(b) the identifiable net assets acquired.
When a business combination is an indirect acquisition (i.e. it involves a purchase of shares that leads
to a parent–subsidiary relationship), in accordance with the requirements of IFRS 10, a set of consolidated
financial statements must be prepared that include the aggregated (combined) financial performance,
financial position and cash flows of the parent and its subsidiary/ies.
The additional requirements related to the preparation of the consolidated financial statements are
considered in part B of this module.

Relevant Paragraphs
To assist in understanding the material presented in part A, you may wish to read the following paragraphs
of IFRS 3. Where specified, you need to be able to apply these paragraphs referenced in this module.

Subject Paragraphs
Objective 1
Scope 2
Identifying a business combination 3
The acquisition method 4–53
Identifying the acquirer 6–7
Determining the acquisition date 8–9
Recognising and measuring the identifiable assets acquired, liabilities assumed
and any non-controlling interest in the acquiree 10–31
Recognising and measuring goodwill or a gain from a bargain purchase 32–40
Measurement period 45–50
Determining what is part of the business combination transaction 51–53
Subsequent measurement and accounting 54–57
Disclosures 59–63
Defined terms Appendix A

5.1 IDENTIFYING A BUSINESS COMBINATION

A business combination is ‘[a] transaction or other event in which an acquirer obtains control of one or
more businesses’ (IFRS 3, Appendix A). Business combinations can be as simple as buying a franchise
from the franchisor, but also include transactions referred to as ‘true mergers’ or ‘mergers of equals’.
The business/es over which the acquirer obtains control is (are collectively) referred to as the acquiree.
A business is defined in Appendix A of IFRS 3 as ‘an integrated set of activities and assets that is capable
of being conducted and managed for the purpose of providing goods or services to customers, generating
investment income (such as dividends or interest) or generating other income from ordinary activities’.
It is important to note that the integrated set of assets and processes is required to be capable of resulting
in economic benefits to be recognised as a business and not actually required to produce these benefits yet.
For example, a start-up entity that is still developing a product or is trying to find a market for its products
can still be classified as a business. Also, the assessment of whether the assets and liabilities acquired
constitute a business is based on the situation existing at acquisition date; instances where those assets and
liabilities are then sold to other parties (i.e. essentially breaking up the business after acquisition) do not
indicate that a business combination did not take place at acquisition date, they just show that the business
combination was short-lived.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read the definitions of ‘acquirer’, ‘acquiree’, ‘business’, ‘business
combination’ and ‘equity interests’ in IFRS 3, Appendix A, and ‘control’ in paragraphs 6–8, and ‘control of an investee’
in IFRS 10, Appendix A.

MODULE 5 Business Combinations and Group Accounting 223

 QUESTION 5.1

Indicate which of the following acquisitions represent a business combination. Select one or more
options from the following list. Justify your answer for each option.
(a) A Ltd acquires inventory from B Ltd on a regular basis.
(b) A Ltd acquires plant and equipment from B Ltd as a one-off transaction.
(c) A Ltd acquires some inventory from B Ltd that it then sells to C Ltd and some plant and
equipment that it then sells to D Ltd.
(d) A Ltd acquires a bundle of assets from B Ltd that includes, among others, cash, inventories,
a brand name, plant and equipment, land and buildings that are used together to produce and
market a blood pressure monitor.
(e) A Ltd acquires the entire share capital of B Ltd from its old shareholders.

5.2 THE ACQUISITION METHOD

IFRS 3 requires that all business combinations within the scope of the standard, no matter the form,
be accounted for using the acquisition method. That is because the substance of these transactions
(i.e. obtaining control over other businesses) is the same; only the form varies. A business combination
involving businesses or entities under common control is not subject to the acquisition method because it
is not within the scope of the standard (IFRS 3, para. 2).
The acquisition method is applied at acquisition date. As outlined in IFRS 3, paragraph 5, the application
of the acquisition method involves four steps:
(a) identifying the acquirer;
(b) determining the acquisition date;
(c) recognising and measuring the identifiable assets acquired, the liabilities assumed and any non-
controlling interest in the acquiree; and
(d) recognising and measuring goodwill or a gain from a bargain purchase.

It should be noted here that the acquisition method is consistent with the way accounting in general
deals with transactions in which assets are acquired and liabilities are assumed or incurred (IFRS 3 Basis
for Conclusions, para. BC24).

(A) IDENTIFYING THE ACQUIRER

The financial impact of a business combination is likely to be more significant for the entity that obtains
control in such a transaction or event, so the users of financial information need to focus on the acquirer.
Consequently, the acquisition method views the business combination from the acquirer’s perspective, so
it is fitting that the first step in applying this method is identifying the acquirer. In the case of a direct
acquisition, the acquirer is the entity that receives the assets and liabilities acquired. In the case of an
indirect acquisition, the guidance in IFRS 10 related to the concept of control is used to identify the acquirer
(IFRS 3, para. 7). As such, IFRS 10, paragraph 7 specifies the essential criteria of control that must be
satisfied by the acquirer (investor) in order to be considered as having control over the acquiree (investee),
that is:
• 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 investor’s returns . . .

It is normally assumed that an investor has control over the investee when it holds more than 50%
of the equity interests that carry voting rights in the investee. However, control can exist even when the
investor holds a lower percentage of those equity interests (e.g. when the investor holds 49% of the equity
interests that carry voting rights in the investee, while the other 51% is held by a few hundred individual
shareholders, each holding less than 1%, who do not regularly attend meetings where voting power can be
exercised). The concept of control and its application is discussed in detail in part B of this module in the
context of whether a parent–subsidiary relationship exists.
Based on the guidance provided in IFRS 10 with regards to the criteria of control, determining which
entity is the acquirer in an indirect acquisition is a matter of professional judgment. When the application

224 Financial Reporting

of the guidance on control in IFRS 10 does not clearly indicate which entity is the acquirer in an indirect
acquisition, IFRS 3 includes additional guidance in paragraphs B14–B15 (see table 5.2).

TABLE 5.2 Identifying an acquirer

Business combination effected The acquirer is usually

• primarily by transferring cash or other assets • the entity that transfers the cash or other assets

• by incurring liabilities • the entity that incurs the liabilities

• primarily by exchanging equity interests • the entity that issues the equity interests

Source: Adapted from IFRS Foundation 2019, IFRS 3 Business Combinations, paras B14–B15, in IFRS Standards as issued at
1 January 2019, IFRS Foundation, London, p. A219.

IFRS 3 states that if a business combination involves an exchange of equity interests, the entity issuing
shares is normally the acquirer (IFRS 3, para. B15). Since this may not always be the case, as in a reverse
acquisition, all the facts and circumstances must be considered in assessing who is the acquirer in a
business combination.
Note: This module does not deal with accounting for reverse acquisitions considered in IFRS 3,
paragraph B19.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 3, paragraph B15 to expand on the facts and
circumstances that should also be considered in identifying the acquirer in a business combination effected by
exchanging equity interests.

IFRS 3, paragraphs B16 and B17 provide some additional guidance to assist in identifying the acquirer
in a business combination, including consideration of:
• the relative size of the combining entities, with the largest party normally being the acquirer (e.g. when
a large player in an industry decides to combine its business with one of its competitors of considerably
smaller size, it is normally assumed that the larger entity is the acquirer, taking over the ‘little guy’)
• the entity that initiated the combination.
Further guidance in paragraph B18 specifies that a ‘new entity formed to effect a business combination
is not necessarily the acquirer’ because this entity was created to manage the combined entities and did
not play any part in the negotiations between the combining entities; instead, one of the combining entities
should be identified as the acquirer.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read the following paragraphs of IFRS 3:
• B16–B18
• BC93–BC101, which discuss the IASB’s Basis for Conclusions on IFRS 3 in relation to identifying the acquirer
(in the IFRS Compilation Handbook).

QUESTION 5.2

Refer to the following business combinations and discuss the factors that need to be taken into
account when determining the acquirers in the combinations.
(a)
A Ltd B Ltd

A Ltd acquired 90%

of the shares and
voting rights in
B Ltd for cash.

MODULE 5 Business Combinations and Group Accounting 225

 (b)
D Ltd

100% 100% 100%

A Ltd B Ltd C Ltd

A new entity, D Ltd, was formed and acquired all

the shares in A Ltd, B Ltd and C Ltd by issuing
shares in D Ltd.
(c) 100%
A Ltd B Ltd

Prior to the acquisition of shares in B Ltd, A Ltd had 500 000 shares on issue
(fair value of $5) and B Ltd had 400 000 on issue (fair value of $10).
To acquire the shares in B Ltd, A Ltd issued 800 000 shares to the shareholders of B Ltd.

(B) DETERMINING THE ACQUISITION DATE

The acquisition date is the date on which the acquirer obtains control of the acquiree (IFRS 3, para. 8).
For a direct acquisition, that may be the date when the contract of the sale of the business by the acquiree
is signed. For an indirect acquisition, that may be the date when enough shares in the acquiree that give
majority voting power are held by the acquirer.

EXAMPLE 5.1

Determining the Acquisition Date

As part of the history of the acquisition of B Ltd (B) by A Ltd (A), the following information is available
(assume that all the shares in B carry voting rights).
• On 15/08/20X1, A acquired 3.6% of the shares in B.
• On 31/08/20X2, A acquired a further 18.9% interest in B.
• On 17/11/20X3, A managed to convince a major shareholder in B to sell its ownership interest of 35.5%
to A, with the shares being transferred to A on that day.
We assume that there are no other facts and circumstances that may suggest when A controls B. As
such, we have to rely on the guidance that assumes that the party holding 50% of the voting rights has
control. On 15/08/20X1, A had only 3.6% of the voting rights in B, while on 31/08/20X2, the voting rights
held by A increased to 22.5%, which is still not enough to suggest the existence of control. However, on
17/11/20X3, the interest by A becomes 58%, enough to give A control over B. As such, the acquisition
date is 17/11/20X3. Figure 5.4 shows the timeline of the events related to the acquisition of B’s shares by
A and the total ownership interest by A at specific times.

FIGURE 5.4 Timeline for A’s acquisition of B’s shares

3.6% 22.5% 58%

01/01 01/01 01/01 01/01

20X1 20X2 20X3 20X4
Source: CPA Australia 2019.

In the further examples and questions contained in this module, the acquisition date will always
be provided.

226 Financial Reporting

(C) RECOGNISING AND MEASURING THE IDENTIFIABLE
ASSETS ACQUIRED, THE LIABILITIES ASSUMED AND ANY
NON-CONTROLLING INTEREST IN THE ACQUIREE
Recognition
In order to be recognised in a business combination, an identifiable asset or liability normally needs to be
one that is capable of being individually identified and separately recognised in the statement of financial
position because it meets the following recognition criteria.
• It meets, at the acquisition date, the definition of an asset or liability in the IASC’s Framework for
the Preparation and Presentation of Financial Statements adopted in 2001 (rather than the definition
in IASB’s Conceptual Framework for Financial Reporting issued in 2018) according to IFRS 3,
paragraph 11, footnote 1.
• It must be part of what the acquirer and the acquiree exchanged in the business combination transaction,
rather than a result of separate transactions.
A number of exceptions to this principle are discussed shortly.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 3, paragraphs 10–14.

Identifiable assets acquired may include items such as inventory, receivables, property, plant and
equipment and intangible assets. If an acquired asset cannot be individually identified and recognised
(e.g. customer satisfaction or employees’ satisfaction), by definition it is regarded as part of the goodwill
of the acquired business, which will be recognised in step 4 of the acquisition method.
Identifiable liabilities assumed may include, among others, items such as accounts payable, loans and
taxes payable.
Note that the recognition of the identifiable assets acquired and liabilities assumed is not limited to
the identifiable assets and the liabilities that were previously recognised by the acquiree. Given that the
acquisition method views the acquisition from the acquirer’s perspective, additional identifiable assets
or liabilities may be recognised in this step. For example, the acquiree may have some intangible assets
that were generated internally — according to IAS 38, they may not be able to be recognised by the
acquiree prior to the business combination; however, they should be recognised by the acquirer as part of
the identifiable assets acquired as long as they satisfy either a:
• separability criterion, or
• contractual–legal criterion.
The separability criterion is fulfilled if the intangible asset can be separated from the entity and sold,
rented, transferred, licensed or exchanged. The contractual–legal criterion relates to control over the asset
via contractual or legal rights, regardless of whether or not the rights are transferable or separable from the
entity or other rights (IAS 38, para. 12; IFRS 3, para. B32).

EXAMPLE 5.2

Recognising the Identifiable Assets Acquired and Liabilities Assumed

Assume that A Ltd (A) acquired the business of B Ltd (B), which ran a store in a sought-after location that
ensured customers enjoy shopping there. At acquisition date, the fair values of the assets and liabilities
presented in the statement of financial position prepared by B are:
• accounts receivable — $400 000
• inventory — $600 000
• plant and equipment — $2 000 000
• land and buildings — $7 000 000
• accounts payable — $500 000
• bank loan — $4 500 000.
In addition, A identified that B had a trademark with a fair value of $1 000 000 not recognised in its
financial statements. Also, customer satisfaction with B was extremely good due to the after-sale service
that B provided, and customers were willing to pay more for a product sold by B, even though there were
cheaper options available on the market.

MODULE 5 Business Combinations and Group Accounting 227

 When recognising the identifiable assets acquired and liabilities assumed, A will recognise the various
assets and liabilities already recorded by B prior to the acquisition, as well as the trademark not previously
recognised. The location of the store and the customer satisfaction may bring economic benefits, but
they cannot be separately identified and recognised; therefore, they may only be included in the goodwill
recognised on acquisition.

QUESTION 5.3

The managing director of a company subject to a takeover offer argued that the price offered by
the potential acquirer was inadequate because it did not reflect the value of some items such
as the company’s brands, competitive position and market strength.
Which of these items could be recognised as an identifiable asset and which would form part of
‘goodwill’ in accordance with IFRS 3?

The non-controlling interest is the equity in the acquiree/subsidiary that is not controlled by the
acquirer/parent. For example, a non-controlling interest would exist where the acquirer owns 70% of
the issued capital of the acquiree. In this example, the non-controlling interest shareholders own 30% of
the share capital of the acquiree. Note that the non-controlling interest in the acquiree is only recognised
in business combinations structured as indirect acquisitions.

Measurement
IFRS 3 requires that identifiable assets acquired and liabilities assumed are measured at their acquisition-
date fair values (IFRS 3, para. 18). Adoption of this measurement basis by IFRS 3 is necessary in order
to capture the future cash flow potential resulting from the acquisition and to provide more relevant
information to users of financial statements. For example, if an identifiable asset acquired is measured
based on its original cost to the acquiree, it may not reflect the true value of the asset from the perspective of
the acquirer (i.e. the amount it is willing to pay for it, which approximates the amount of future economic
benefits expected to be extracted from it); as such, the users may be misled in their assessment of the
potential benefits brought by the assets acquired.
Measurement of some identifiable assets acquired at fair value may be difficult. For example, acqui-
sitions of businesses that developed new technologies and are at the forefront of the recent rapid
technological advancements may involve the need to recognise and measure a large amount of unique
intangible assets for which the fair value cannot be easily determined. The measurement of those assets
will require professional judgment based on all the facts and circumstances that existed at acquisition date.
An acquirer is allowed a measurement period not exceeding 12 months to obtain information concerning
all the facts and circumstances that existed at acquisition date. An acquirer must report provisional amounts
for items where the accounting is still incomplete at a reporting date (IFRS 3, para. 45).

Exceptions
IFRS 3 includes a number of exceptions to the recognition or measurement principles presented in the
preceding paragraphs. These are summarised in table 5.3. Note that an understanding of the specific
recognition and measurement requirements for each of these exceptions is not required for this module.

TABLE 5.3 Exceptions to recognition or measurement principles

Exceptions to the recognition principle IFRS 3 requirements

Contingent liabilities The acquirer shall recognise a contingent liability if it is a

present obligation that arises from past events and its fair
value can be measured reliably, even if it is not probable.
These requirements are contrary to IAS 37 Provisions,
Contingent Liabilities and Contingent Assets.

228 Financial Reporting

 Exceptions to the measurement principles IFRS 3 requirements

Reacquired rights Measured on the basis of the remaining contractual term

of the related contract, regardless of whether market
participants would consider potential contractual renewals.

Share-based payment awards Measured in accordance with the method in IFRS 2 Share-
based Payment.

Assets held for sale Measured in accordance with IFRS 5 Non-current Assets
Held for Sale and Discontinued Operations.

Exceptions to both the recognition and

measurement principles IFRS 3 requirements

Income taxes Recognised and measured in accordance with the

requirements of IAS 12 Income Taxes.

Employee benefits Recognised and measured in accordance with the

requirements of IAS 19 Employee Benefits.

Indemnification assets Recognised and measured on the same basis as the

indemnified item.

Leases in which the acquiree is the lessee Recognised and measured in accordance with the
requirements of IFRS 16 Leases.

Source: Adapted from IFRS Foundation 2019, IFRS 3 Business Combinations, in IFRS Standards as issued at 1 January 2019, IFRS
Foundation, London, pp. A197–A199.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 3, paragraphs 21–31.

EXAMPLE 5.3

Recognising and Measuring the Identifiable Assets Acquired and

Liabilities Assumed
In addition to the facts presented in example 5.2, A Ltd (A) assumed a contingent liability disclosed in the
notes of the financial statements of B Ltd (B). This contingent liability related to a lawsuit by a customer
who fell in the store due to a slippery floor. Even though it was not probable that the lawsuit would be lost
as it was discovered that the customer was not paying attention to the hazard signs erected at the time
of the accident, A needed to recognise it as part of the liabilities assumed as a result of the acquisition.
The measurement of it would be based on an estimation of potential damages awarded to the customer
by the court.

QUESTION 5.4

Would all identifiable assets and liabilities recognised by an acquirer be included in the statement
of financial position of the acquiree prior to acquisition?

(D) RECOGNISING AND MEASURING GOODWILL OR A

GAIN FROM A BARGAIN PURCHASE
Goodwill is measured at acquisition date as the fair value of the consideration transferred plus the amount
of any non-controlling interest, plus the fair value of any previously held equity interest in the acquiree, less
the fair value of the identifiable net assets acquired (IFRS 3, para. 32). It represents future economic benefits
other than those expected to arise from the identifiable assets acquired and comprises assets that cannot

MODULE 5 Business Combinations and Group Accounting 229

be separately recognised and/or sold (i.e. unidentifiable assets). In the cases of business combinations
involving businesses at the forefront of technological advancements, the amount of goodwill that will be
recognised by the acquirer can be quite substantial given the amount of know-how and technical skills of
the human capital present in the acquired business that may not be able to be separately identified as an
identifiable asset.
Note that the existence of any previously held equity interest in the acquiree implies an acquisition made
in stages. While this module does not subsequently address accounting for acquisitions made in stages,
you need to be able to determine goodwill where there is a previously held equity interest.

QUESTION 5.5

Provide examples of unidentifiable assets that may contribute to the goodwill of a business.

Identifying and Measuring Consideration

IFRS 3, paragraph 37 discusses how consideration transferred in a business combination is measured at
fair value, calculated as the acquisition-date fair values of the:
• assets transferred by the acquirer
• liabilities incurred by the acquirer with respect to the former owners of the acquiree
• equity interests issued by the acquirer.
Any acquisition-related costs incurred in a business combination are not considered part of the
consideration transferred. That is because these costs are incurred in separate transactions that involved
entities other than the acquiree or its owners. Those costs are required to be accounted for as expenses
in the period in which the costs are incurred — with the exception of costs to issue debt or equity
securities, which are recognised in accordance with IAS 32 Financial Instruments: Presentation and
IFRS 9. Acquisition-related costs include finder’s fees; advisory, legal, accounting, valuation and other
professional or consulting fees; general administrative costs, including the costs of maintaining an internal
acquisitions department; and costs of registering and issuing debt and equity securities (IFRS 3, para. 53).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read:
• IFRS 3, paragraph 53, which discusses acquisition-related costs
• the definition of ‘fair value’ in IFRS 3, Appendix A.

EXAMPLE 5.4

Identifying and Measuring Consideration

Assume that A Ltd (A) acquired all the assets and liabilities that constitute a business from B Ltd (B). As
part of the consideration transferred, A transferred:
• $1 000 000 in cash, with $400 000 raised from a debt issue that attracted 5% interest per year
• other assets previously recorded by A at $300 000, but with a fair value of $500 000 at acquisition date
• shares in A that it issued with a value of $700 000, incurring $50 000 as share issue costs.
Note that A used the services of a financial adviser to help in the negotiations with B and paid $150 000
for those services.
To identify and measure the consideration transferred, A needed to separate it from the acquisition-
related costs. In this case, those costs were:
• interest incurred on the debt issue, which would be treated as a part of finance expenses
• share issue costs, which would be treated as a reduction in share capital
• remuneration of the financial adviser, which would be treated as part of expenses for the period.
In turn, consideration transferred would be recognised at fair value of $2 200 000, calculated as:
• $1 000 000 in cash
• $500 000 in other assets
• $700 000 in shares.

230 Financial Reporting

 QUESTION 5.6

(a) If an entity has an acquisitions department, would the costs associated with running the
department be included in the cost of a business combination?
(b) On 1 April 20X5, Investor Ltd (Investor) signed an agreement to acquire all the shares of Investee
Ltd and, in return, to issue 100 000 of its own shares. The terms of the agreement were fulfilled
on 30 June 20X5, when the shares were transferred. Consulting fees relating to the combination
were $10 000. These costs were paid by Investor.
The last sale of Investor shares took place in December 20X4 at a price of $4.50 per share.
The estimated fair value of the shares at 30 June 20X5 was $5.00 per share.
(i) Calculate the consideration transferred for the investment acquired by Investor, explaining
your reasoning.
(ii) Provide pro forma journal entries for Investor to account for the acquisition of the investment
and the payment of the costs attributable to the investment.

Identifying and Measuring Non-controlling Interest

As previously discussed, non-controlling interest is the equity in the acquiree not owned by the acquirer.
It represents an ownership interest in the acquiree by shareholders other than the acquirer.
IFRS 3, paragraph 19 allows an accounting policy choice, on an acquisition-by-acquisition basis, for
the measurement of a non-controlling interest in the acquiree. There are two options available to measure
the non-controlling interest in the acquiree at acquisition date:
1. ‘full goodwill’ method — at the fair value of the equity interests that the non-controlling interest has in
the acquiree
2. ‘partial goodwill’ method — at the non-controlling interest’s proportionate share of the fair value of the
acquiree’s identifiable net assets.
The measurement of the non-controlling interest at the fair value of the shares held by the non-controlling
interest shareholders is known as the ‘full goodwill’ method. The reason for this is that in the calculation
of goodwill, the total fair value of the acquiree (i.e. subsidiary), being the fair value of the consideration
transferred by the acquirer plus the fair value of the non-controlling interest plus the fair value of any
previously held interest by the acquirer, is compared with the total fair value of the identifiable net assets
in the acquiree. The difference is ‘full goodwill’. In essence, this method measures the total goodwill of
the business combination at acquisition date, including:
• goodwill for the acquirer, calculated as the fair value of the consideration transferred by the acquirer
plus the fair value of any previously held interest by the acquirer minus the acquirer’s proportionate
share of the fair value of the acquiree’s identifiable net assets
• goodwill for the non-controlling interest, calculated as the fair value of the equity interests that the non-
controlling interest has in the acquiree minus the non-controlling interest’s proportionate share of the
fair value of the acquiree’s identifiable net assets.
Where the non-controlling interest is measured using its proportionate share of the acquiree’s identifiable
net assets, essentially only the acquirer’s share of the goodwill is recognised in the business combination
(see preceding ‘goodwill for the acquirer’ bullet point for a discussion of calculation). For this reason, this
second choice is referred to as the ‘partial goodwill’ method. Under this method, the value assigned to the
non-controlling interest is lower than under the full goodwill method because it does not recognise any
goodwill for the non-controlling interest.
It is important to note that the per-share fair value of the non-controlling interest in the acquiree cannot be
measured based on the per-share fair value of the consideration transferred by the acquirer at acquisition
date. The per-share fair value of the consideration transferred by the acquirer at acquisition date may
include a control premium that the acquirer is willing to pay on top of the normal per-share fair value
of the shares in the acquiree to gain control; alternatively, the per-share fair value of the non-controlling
interest in the acquiree may include a discount, as those shares do not give control as control rests with the
acquirer (IFRS 3, para. B45).
Example 5.5 illustrates how goodwill is calculated with a non-controlling interest applying the two
options permitted by IFRS 3, paragraph 19.

MODULE 5 Business Combinations and Group Accounting 231

 EXAMPLE 5.5

Calculation of Goodwill with Non-controlling Interest

On 1 July 20X7, Entity A acquired 30% of the shares in Entity B for $30 000. On 1 July 20X8, Entity A
acquired a further 50% interest in Entity B for $77 000, which gave it control. Entity B has 140 000 shares
issued, with a fair value of $1 per share. At 1 July 20X8, the fair value of Entity B’s identifiable net assets
is $110 000.
Goodwill at 1 July 20X8 is calculated as follows.

NCI calculated
NCI calculated as a percentage
at fair value of of fair value of
equity interests identifiable net assets
held (full goodwill) (partial goodwill)
Fair value of consideration transferred by acquirer 77 000 77 000
Non-controlling interest (20%)† 28 000‡ 22 000§
Fair value of previously held interest by acquirer (30%) 42 000 42 000||
147 000 141 000
Fair value of identifiable net assets in Entity B 110 000 110 000
Goodwill 37 000 31 000

NCI = non-controlling interest

†
The NCI at 1 July 20X8 is 20% given that Entity A has an 80% interest (30% previously held plus 50% acquired on
1 July 20X8) in Entity B.
‡
Under the full goodwill method, the NCI is measured as the fair value of the equity interests that the NCI has in Entity B:
20% × 140 000 shares @ $1 per share = $28 000.
§
Under the partial goodwill method, the NCI is measured as the proportionate share of the fair value of Entity B’s
identifiable net assets (20% × $110 000 = $22 000).
||
The fair value at 1 July 20X8 of the previously held interest of 30% that Entity A had in Entity B is 30% × 140 000 shares
@ $1 per share = $42 000.

Under the partial goodwill method, goodwill can also be calculated as follows.

NCI calculated as a
percentage of fair
value of identifiable net
assets (partial goodwill)
Fair value of consideration transferred by acquirer 77 000
Fair value of previously held interest by acquirer (30%) 42 000
119 000
Fair value of identifiable net assets in Entity B 110 000
Interest held by the acquirer (30% + 50%) 80%
88 000
Goodwill 31 000

Example 5.5 demonstrates how goodwill can differ, depending on the method used to measure the
non-controlling interest. In this case, the difference between goodwill recognised under the full goodwill
method (i.e. $37 000) versus the partial method (i.e. $31 000) is $6000, which also represents the
difference between the fair value of the equity interests that the non-controlling interest has in the acquiree
(i.e.$28 000)andthenon-controllinginterest‘sproportionateshareofthefairvalueoftheacquiree’sidentifiable
net assets (i.e. $22 000) — this difference is essentially the goodwill for the non-controlling interest.
Note also that the per-share fair value of the non-controlling interest (i.e. $1.00) is different from the
per-share fair value of the consideration transferred by the acquirer (i.e. $77 000/(50% × 140 000) = $1.10)
as the consideration transferred includes a control premium of $0.10 per share.
Non-controlling interest is addressed in more detail later in part B of this module when IFRS 10 is
discussed. For the remainder of part A, goodwill is calculated as the consideration transferred less the fair
value of the identifiable net assets acquired.

232 Financial Reporting

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 3:
• paragraphs 32–33
• paragraphs B44 and B45, which expand on the discussion regarding the acquiree’s non-controlling interest.

Measurement and Recording of Goodwill Subsequent to the

Date of Purchase
Goodwill is not permitted to be amortised and, instead, it is required to be tested annually for impairment in
accordance with IAS 36. As a consequence, subsequent to the date of purchase, goodwill will be adjusted
for impairment losses (IFRS 3, para. B63(a)). Impairment of goodwill is discussed in module 7.

5.3 APPLYING THE ACQUISITION METHOD TO

DIFFERENT FORMS OF BUSINESS COMBINATIONS
It is important to note that the form of business combination creates accounting differences when applying
the acquisition method, as the subsequent discussion will highlight.

1. DIRECT ACQUISITION: PURCHASE OF ASSETS AND

LIABILITIES OF A BUSINESS
Acquiring the assets and liabilities constituting a business results in transferring these items directly to
the acquirer, which can use them in its own business, generally without any restrictions imposed by other
parties. As such, the acquirer will need to recognise them in its financial statements in a similar way
to an acquisition of individual assets. One distinction, however, is when the business acquired includes
unidentifiable assets like customer relationships or employee morale — unidentifiable assets can only
be recognised if acquired as part of a business, in which case they will be collectively recognised under
goodwill acquired.
As previously mentioned, it is important to note that the assets and liabilities acquired as part of a
business may also include identifiable assets and liabilities previously not recognised by the acquiree. From
the acquirer’s perspective, those assets and liabilities represent items that it now owns and, therefore, they
need to be separately recognised.

EXAMPLE 5.6

Applying the Acquisition Method for a Direct Acquisition

Refer to the data in example 5.2. Assuming that the consideration transferred by A Ltd (A) to acquire all
the assets and liabilities in B Ltd (B) was $8 000 000 paid in cash, A would have to recognise goodwill
(presumably attributable to B’s store location and customer satisfaction) as the difference between the
fair value of consideration transferred and the fair value of the identifiable net assets in B. The fair value
of the identifiable net assets in B would be calculated as follows.

Fair value of total identifiable assets recorded by B $10 000 000

Add: Fair value of identifiable assets not previously recorded by B 1 000 000
Less: Fair value of total identifiable liabilities in B (5 000 000)
Fair value of total identifiable net assets of B $ 6 000 000

Therefore, the goodwill on acquisition is:

Fair value of consideration transferred by acquirer $8 000 000
Less: Fair value of total identifiable net assets in B (6 000 000)
Goodwill $2 000 000

MODULE 5 Business Combinations and Group Accounting 233

 The journal entry posted by A in its own records to recognise the acquisition of all the assets and
liabilities of B would be as follows.

Dr Accounts receivable 400 000

Dr Inventory 600 000
Dr Plant and equipment 2 000 000
Dr Land and buildings 7 000 000
Dr Trademark 1 000 000
Dr Goodwill 2 000 000
Cr Accounts payable 500 000
Cr Bank loan 4 500 000
Cr Bank 8 000 000

QUESTION 5.7

Using the same data as in example 5.6 and assuming that a contingent liability for a damages claim
exists in the notes of B as suggested in example 5.3 (A measures it at the fair value of $1 000 000),
prepare and explain the journal entry posted by A to recognise the acquisition of the assets and
liabilities of B. Assume no tax effect.

2. INDIRECT ACQUISITION: PURCHASE OF SHARES

(I.E. EQUITY INTERESTS) OF AN ENTITY
Acquiring the equity interests of another entity that gives the acquirer control over that other entity results
in the acquirer, in essence, purchasing a single asset: an investment in the shares of the acquiree. As such,
the acquirer can only recognise this new asset in its financial statements. However, this type of acquisition
results in a parent–subsidiary relationship, with the acquirer being the parent and the acquiree being the
subsidiary. This relationship gives rise to the need to prepare a set of consolidated financial statements for
the group of entities, which includes the parent and its subsidiary, to provide users with information about
the combined financial performance, position and cash flows of the group. The consolidated financial
statements will include the assets and liabilities of the subsidiary in a similar way as they would have been
recognised in the acquirer’s statements if they were directly acquired by the acquirer. That means that the
consolidated financial statements need to recognise:
• any unidentifiable assets like customer relationships or employee morale as goodwill acquired
• any identifiable assets and liabilities previously not recognised by the acquiree.
If the acquirer in an indirect acquisition is required to present separate financial statements, IAS 27,
paragraph 10 states that the investment in the shares of the acquiree should be accounted in the financial
statements of the acquirer/parent either:
• at cost;
• in accordance with IFRS 9; or
• using the equity method as described in IAS 28.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IAS 27:
• paragraph 4, the definition of ‘separate financial statements’
• paragraph 10 (assume that the investment is not classified as held for sale).

The examples and questions in module 5 assume that the parent carries the investment in its financial
statements at cost.

234 Financial Reporting

 EXAMPLE 5.7

Applying the Acquisition Method for an Indirect Acquisition

Using the same data as in example 5.6, but assuming that A Ltd (A) acquired all the shares in B Ltd (B)
instead of directly acquiring the assets and liabilities, the journal entry posted by A in its own accounts to
recognise the business combination would be as follows.

Dr Investment in B 8 000 000

Cr Bank 8 000 000

Note that the amounts recognised under the acquisition method for all the identifiable assets and
liabilities of B at acquisition date and for the goodwill will be exactly the same as in example 5.6. However,
only the consolidated financial statements, where those items will be recognised, will reflect those values;
A cannot recognise those items in its own financial statements as it did not acquire them directly — A only
acquired directly the investment in shares.

QUESTION 5.8

Refer to the journal entries posted in examples 5.6 and 5.7. Discuss the impact of those entries of the
individual accounts of A and identify which one provides more information to the users interested
in B.

Please note that notwithstanding these differences discussed in points 1 and 2 of this section, both
forms of business combinations still comply with the requirement in IFRS 3 to account for a business
combination, no matter its form, by applying the acquisition method. Those differences just mean that the
acquisition method is applied:
• in the acquirer’s own financial statements in the case of a direct acquisition
• in the consolidated financial statements in the case of an indirect acquisition.

5.4 DEFERRED TAX ARISING FROM A

BUSINESS COMBINATION
DEFERRED TAX RELATED TO ASSETS AND LIABILITIES
ACQUIRED IN A BUSINESS COMBINATION
As discussed, IFRS 3 requires identifiable assets and liabilities acquired in a business combination to be
measured at fair value at acquisition date. As such, temporary differences arise when the tax base of the
asset acquired or liability assumed is either not affected, or is affected differently compared to the carrying
amount, by the business combination (IAS 12, para. 19). For example, in an indirect acquisition, assume
equipment of the acquiree/subsidiary is recognised at its fair value of $100 000 at acquisition date. The
carrying amount and tax base prior to the acquisition were $70 000, and the tax base does not change as a
result of the revaluation on acquisition. This would give rise to a taxable temporary difference of $30 000
at acquisition date calculated as the difference between the new carrying amount and the tax base (the
concepts of tax base and temporary difference were discussed in module 4). As a result, the acquirer would
recognise a deferred tax liability of $9000 (assuming a tax rate of 30%) as part of the liabilities assumed. As
another example, in a direct acquisition this time, an acquirer recognises an assumed provision for warranty
expenses from an acquired business. The fair value of this provision is $50 000, which is recognised as
the carrying amount in the statements of the acquirer. For tax purposes, the warranty costs will only be
deductible when the entity pays the claims, and therefore, the tax base is nil. Compared to the carrying
amount, this gives rise to a deductible temporary difference of $50 000, for which the acquirer will have
to recognise a deferred tax asset of $15 000 as part of the assets acquired (assuming a tax rate of 30%).
Recognising additional deferred tax assets and liabilities in a business combination affects the amount
of goodwill recognised (IAS 12, paras 19 and 66). The fair value of the identifiable net assets will increase

MODULE 5 Business Combinations and Group Accounting 235

(if a deferred tax asset is recognised) or decrease (if a deferred tax liability is recognised). This impacts on
the goodwill — that is, the difference between the fair value of the consideration transferred and the fair
value of the identifiable net assets.
While deferred tax assets and liabilities can arise from measuring identifiable assets and liabilities at fair
value in a business combination, IAS 12 prohibits the recognition of a deferred tax liability arising from
goodwill (IAS 12, paras 15 and 21). This is because goodwill is a residual, and, as such, creates a mutual
dependence between the recognition of a deferred tax liability relating to it and its measurement. As a
deferred tax liability is an identifiable liability, recognition of a deferred tax liability for goodwill would
decrease the fair value of the identifiable net assets by the amount of the deferred tax liability, which
then increases the amount of goodwill. This would create the need to reassess the amount of deferred tax
liability relating to goodwill and so on in an endless loop.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IAS 12, paragraphs 15, 19, 21 and 66.

DEFERRED TAX RELATED TO TAX LOSSES IN A

BUSINESS COMBINATION
As a result of a business combination, the acquirer may recognise a deferred tax asset for tax losses that it
had previously considered not recoverable. For example, tax losses of the acquirer may now be able to be
offset against future taxable profit of the acquiree. As it relates to tax losses of the acquirer, the deferred
tax asset recognised cannot be identified as part of the assets acquired and, therefore, does not impact on
goodwill (IAS 12, para. 67).
At the date of a business combination, an acquiree may have potential benefits from tax losses or
other deferred tax assets. If the acquirer considers it is probable that these benefits will be realised, it
will recognise them as part of the assets acquired; hence, they are taken into account when determining
goodwill. However, if the acquirer considers that it is not probable that those potential tax benefits
of the acquiree would be realised after acquisition, it won’t recognise them as part of the business
combination. Nevertheless, if those unrecognised tax benefits of the acquiree are eventually realised after
acquisition, IAS 12, paragraph 68(b) requires the acquirer to recognise them in profit or loss (P/L) (or in
other comprehensive income (OCI) if those tax benefits relate to items recognised in OCI according to
paragraph 61A).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IAS 12, paragraphs 66–68. Note: You will not be required
to deal with the application of the requirements of IAS 12, paragraph 68 for deferred tax assets not recognised at the
acquisition date.

EXAMPLE 5.8

Purchase of a Business from Another Entity with No Deferred Tax Effects

On 1 January 20X9, Large Ltd (Large) agreed to purchase the assets and liabilities of Small Ltd (Small)
for $400 000 cash plus 50 000 ordinary shares in Large. The shares of Large were currently traded on the
stock exchange for $4.50 each. It was not expected that the proposed issue would affect this price. The
statement of financial position for Small at the date of purchase is presented here.
SMALL LTD
Statement of financial position
as at 1 January 20X9
$000 $000 $000
Assets Liabilities
Trade receivables 100 Bank overdraft 30
Inventory 220 Trade payables and loans 400 430
Land and buildings Equity
(net of accumulated depreciation) 630 Retained earnings 420
Issued capital 100 520
950 950

236 Financial Reporting

 To determine goodwill, it is first necessary to measure the fair value of the consideration transferred. In
this case, that is equal to $625 000 calculated as follows.

$000
Cash 400
Fair value of shares issued (50 000 @ $4.50) 225
Fair value of consideration transferred 625

Next, the acquisition-date fair values of the identifiable assets acquired and liabilities assumed are
considered. Large has determined the following fair values.

$000
Trade receivables 95
Inventory 200
Land and buildings 700
Bank overdraft (30)
Trade payables and loans (400)
Fair value of identifiable net assets 565

As the assets were acquired by Large in a direct acquisition, it is assumed that the amount they were
initially recognised at establishes their tax base for Large. In addition, it is assumed that there are no
taxable or deductible temporary differences arising from the acquired liabilities, as their tax base and fair
value (i.e. carrying amount) are equal due to their nature. Hence, Large does not need to recognise a
deferred tax asset or liability from the business combination.
The goodwill purchased by Large can now be measured in accordance with IFRS 3, paragraph 32 as
follows.

$000
Fair value of consideration transferred 625
Less: Fair value of identifiable net assets (565)
Goodwill 60

The goodwill of $60 000 will be recognised in the statement of financial position of Large as a non-
current asset.

QUESTION 5.9

Prepare a pro forma general journal entry to reflect the acquisition of Small’s assets and liabilities
by Large, based on the data in example 5.8.

In example 5.8, the tax bases of each of the assets were considered to be equal to their fair values and
there were no taxable or deductible temporary differences arising from the acquired liabilities given their
nature, so no tax effect was recorded. Example 5.9 deals with a scenario where the tax bases differ from
the fair values of the net assets acquired.

EXAMPLE 5.9

Purchase of a Business from Another Entity with Deferred Tax Effects

On 1 July 20X9, High Ltd (High) purchased the business of Low Ltd (Low). The consideration transferred
was $2 800 000 in cash.
Low disclosed in the notes to its financial statements a contingent liability with a fair value of $300 000.
The liability was contingent as it was not probable that an outflow of resources would occur and, therefore,
was not recognised as a liability prior to the acquisition. On acquisition, in accordance with IFRS 3, High

MODULE 5 Business Combinations and Group Accounting 237

 recognised a liability for this contingent liability in its statement of financial position even though it was
not probable. In addition, as the tax base of this liability was $0 (carrying amount $300 000 less future
deductible amount of $300 000), there was a deductible temporary difference of $300 000. Therefore, a
deferred tax asset of $90 000 ($300 000 × 30%) also had to be recognised by High in relation to this
provision as part of the accounting for the business combination.
Apart from the contingent liability and the related deferred tax asset, High had determined that the fair
values of the other identifiable net assets of Low at the acquisition date included the following.

$000
Trade receivables 200
Inventory 850
Plant and equipment 2 600
Trade payables (100)
Loans (890)
2 660

It is assumed that on the acquisition of the previously recognised assets, the tax base will be equal to
their fair values and no deferred assets or liabilities will be recognised in relation to them. Also, there are
no taxable or deductible temporary differences arising from the acquired liabilities that were previously
recognised by Low given their nature.
Therefore, the fair value of the identifiable net assets in Low at the acquisition date would be determined
as follows.

$000
Fair value of previously recognised identifiable net assets 2 660
Less: Fair value of contingent liability (300)
Add: Deferred tax asset relating to contingent liability 90
Fair value of identifiable net assets in the acquiree 2 450

The goodwill would be calculated as follows.

$000
Fair value of the consideration transferred 2 800
Less: Fair value of identifiable net assets in the acquiree (2 450)
Goodwill 350

QUESTION 5.10

Based on the data in example 5.9, prepare a pro forma journal entry for High to reflect the acquisition
of Low’s assets and liabilities.

5.5 DISCLOSURES: BUSINESS COMBINATIONS

IFRS 3 includes extensive disclosure requirements to enable financial statement users to evaluate the
financial effects of the acquirer’s business combinations that occur either during the current reporting
period, or after the end of the reporting period but before the financial statements are authorised for
issue. IFRS 3, paragraph 61 also requires disclosures to enable ‘users to evaluate the financial effects of
adjustments recognised in the current reporting period that relate to business combinations that occurred
in the period or previous reporting periods’.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 3, paragraphs 59–63 and B64–B67, which detail the
specific disclosure requirements of IFRS 3.

238 Financial Reporting

SUMMARY
IFRS 3 specifies the requirements for accounting for business combinations that involve an acquirer
obtaining control of another business (or businesses). This part of the module considered two common
approaches to undertaking a business combination:
1. direct acquisition: purchasing the assets and liabilities that constitute a business from another entity
2. indirect acquisition: acquiring the shares of another entity to obtain control over the assets and liabilities
or business of that entity.
In accordance with IFRS 3, all business combinations must be accounted for by using the acquisition
method, which involves four steps:
1. identifying the acquirer
2. determining the acquisition date
3. recognising and measuring the identifiable assets acquired, the liabilities assumed and any non-
controlling interest in the acquiree
4. recognising and measuring goodwill or a gain from a bargain purchase.
The acquisition method requires the acquirer of a business to recognise the assets acquired and liabilities
assumed at their acquisition-date fair values. If the combination involves acquiring control of another entity
via the acquisition of shares in that entity (i.e. indirect acquisition) and the acquirer does not acquire all
of the shares in the subsidiary, the non-controlling interest also needs to be measured at acquisition date.
IFRS 3 permits the non-controlling interest to be measured either at fair value or by using its proportionate
share of the subsidiary’s identifiable net assets.
After measuring the identifiable net assets acquired and the non-controlling interest, the acquirer
measures the difference between:
• the acquisition-date fair value of the consideration transferred plus any non-controlling interest plus the
acquisition-date fair value of any previously held equity interest in the acquiree, and
• the acquisition-date fair value of the identifiable net assets in the acquiree.
While the difference will generally be recognised as goodwill, in rare instances there may be a gain from
a bargain purchase that must be recognised in profit or loss.
When a combination involves a purchase of assets and liabilities that constitute a business (i.e. direct
acquisition), IFRS 3 is to be applied in the acquirer’s financial statements. When a combination involves
a purchase of shares that leads to a parent–subsidiary relationship (i.e. indirect acquisition), a set of
consolidated financial statements must be prepared in accordance with the requirements of IFRS 10.
IFRS 10 is dealt with in part B. IFRS 3 is to be applied in the consolidated financial statements.
Deferred tax effects can arise as a result of a business combination due to:
• the revaluation of identifiable assets and liabilities to fair value at acquisition date
• the recognition of recoverable tax losses or other tax credits.
IFRS 3 includes disclosure requirements to enable financial statement users to evaluate the financial
effects of the acquirer’s business combinations that occurred during the reporting period, or after the end
of the reporting period but before the financial statements are authorised for issue.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

5.1 Identify a business combination, discuss the forms that it may take and analyse issues relating
to different business combinations.
• A business combination is a transaction or other event in which an acquirer obtains control of one
or more businesses.
• Business combinations include buying a franchise from the franchisor, true mergers or mergers of
equals.
5.2 Discuss and apply the acquisition method to a business combination, including the IFRS 3
requirements for recognising and measuring goodwill.
• The acquisition method is applied at the acquisition date and involves four steps as follows.
1. Identifying the acquirer.
2. Determining the acquisition date.
3. Recognising and measuring the identifiable assets acquired, the liabilities assumed and any non-
controlling interest in the acquiree; and
4. Recognising and measuring goodwill or a gain from a bargain purchase.

MODULE 5 Business Combinations and Group Accounting 239

 • Direct acquisition method: transferring the assets and liabilities acquired directly to the acquirer.
Unidentifiable assets acquired are recognised under goodwill.
• Indirect acquisition method: Acquiring the equity interests of another entity that gives the acquirer
control over that other entity. This method results in a parent-subsidiary relationship between the
entities and requires consolidated financial statements to be prepared for the group of entities.
• Consolidated financial statements need to recognise any unidentifiable assets like customer relation-
ships or employee morale as goodwill acquired, and any identifiable assets and liabilities previously
not recognised by the acquiree.
5.3 Apply the accounting for the deferred taxation impact of a business combination.
• Identifiable assets and liabilities acquired in a business combination are to be measured at fair value
at acquisition date.
• Temporary differences arise when the tax base of the asset acquired or liability assumed is either not
affected, or is affected differently compared to the carrying amount, by the business combination.
• IAS 12 prohibits a deferred tax liability arising from goodwill.
• As a result of a business combination, the acquirer’s tax losses may be able to be offset against
future taxable profit of the acquiree.
5.7 Explain and apply the disclosure requirements of both IAS 1 Presentation of Financial Statements
for consolidated financial statements and IFRS 12 Disclosure of Interests in Other Entities for
interests in subsidiaries, associates and joint arrangements.
• IFRS 3 includes extensive disclosure requirements to enable financial statement users to evaluate the
financial effects of the acquirer’s business combinations that occur either during the current reporting
period, or after the end of the reporting period but before the financial statements are authorised
for issue.

240 Financial Reporting

PART B: CONSOLIDATED
FINANCIAL STATEMENTS
INTRODUCTION
Part A of this module dealt with the accounting requirements for business combinations in general
(i.e. arising from direct and indirect acquisitions). Part B deals with the specific case of an indirect
acquisition and examines additional accounting requirements for the preparation of consolidated financial
statements. It examines IFRS 10 and the disclosure requirements for interests in subsidiaries contained in
IFRS 12.
IFRS 10 is concerned with establishing the principles for the preparation and presentation of financial
statements of a group when an investment by the investor in another entity creates a parent–subsidiary
relationship. These consolidated financial statements present the assets, liabilities, equity, income,
expenses and cash flows of the parent and its subsidiaries as those of a single economic entity (as
opposed to legal entity) (IFRS 10, para. 1 and definition of ‘consolidated financial statements’ in
Appendix A). Consolidated financial statements are useful to various financial statement users, both
internal and external to the economic entity. Senior management and directors of the parent entity
are interested in understanding the contribution of the acquiree’s (i.e. subsidiary’s) activities to group
performance. Consolidated financial statements provide this information by reporting the post-acquisition
results of the subsidiary and the complete results of the acquirer (i.e. the parent). External users, such as
existing and potential investors, analysts and creditors, are also interested in understanding the subsidiary’s
contribution to group performance. Such interest might be particularly so in the first year or two after
acquisition.
IFRS 12 applies to entities that have an interest in one of the following: subsidiaries, joint arrangements,
associates or unconsolidated structured entities (IFRS 12, para. 5). If an entity has an interest in
subsidiaries, the standard requires the entity to disclose information that enables users ‘to evaluate (a) the
nature of, and risks associated with, its interests in the subsidiaries; and (b) the effects of those interests on
its financial position, financial performance and cash flows’ (IFRS 12, para. 1). To achieve this objective,
IFRS 12 requires disclosure of information concerning:
• significant judgments and assumptions in determining that the entity has control of another entity
• details of an entity’s interests in subsidiaries, which include details such as the composition of the group
and non-controlling interests’ share of the group’s performance and cash flow.

Relevant Paragraphs
To assist you in achieving the objectives for part B of this module, you may wish to read the following
paragraphs of IFRS 10 and IFRS 12. Where specified, you need to be able to apply these paragraphs.

Subject Paragraphs
IFRS 10Consolidated Financial Statements
Objective 1–3
Scope 4
Control 5–9
Power 10–14
Returns 15–16
Link between power and returns 17–18
Accounting requirements 19–24
Determining whether an entity is an investment entity 27–30
Investment entities: Exception to consolidation 31–33
Defined terms Appendix A
Application guidance Appendix B
Assessing control B2–28, B34–50, B55–B72
Consolidation procedures B86
Uniform accounting policies B87
Measurement B88
Potential voting rights B89–B91
Reporting date B92–B93
Non-controlling interests B94–B95

MODULE 5 Business Combinations and Group Accounting 241

 IFRS 12 Disclosure of Interests in Other Entities
Objective 1–4
Scope 5
Significant judgements and assumptions 7–9
Interests in subsidiaries 10–19
Application guidance B10

5.6 INTRODUCTION TO CONSOLIDATED

FINANCIAL STATEMENTS
The purpose of consolidated financial statements is to disclose the financial performance, financial position
and cash flows of a group of interrelated entities that operate as a single economic entity (but not a
single legal entity). IFRS 10 is primarily concerned with establishing the principles for the preparation
of consolidated financial statements. A group is defined in IFRS 10, Appendix A, as a ‘parent and its
subsidiaries’.
According to the Conceptual Framework, a reporting entity ‘can be a single entity or a portion of an
entity or can comprise more than one entity . . . not necessarily a legal entity’ (para. 3.10). When a parent
entity has control over a subsidiary entity the reporting entity consists of both the parent and its subsidiaries
and the financial statements prepared by the reporting entity are referred to as ‘consolidated financial
statements’ (para. 3.11).
In essence, the overriding principle that applies in the preparation of consolidated financial statements
is that these statements need to show how the financial position, financial performance and cash flows of
the group are impacted by transactions with other entities. As the entities within the group are considered
an integral part of the group, the investments between themselves and the effect of transactions between
them (i.e. intra-group transactions) should be eliminated. A group can be thought of as similar to a single
company that has numerous departments. As the company does not disclose in its financial statements
the effect of transactions between internal departments, a group should not disclose, for example, intra-
group investments, intra-group receivables and payables or intra-group profits and losses. This is because,
as a single entity, the group cannot have investments in itself, receivables from itself, payables to itself
or profits and losses generated from within. The consolidated financial statements should recognise the
assets, liabilities, equity, income, expenses and cash flows of all the entities within the group as they are
impacted by transactions with external parties only.
The consolidated financial statements are prepared in order to provide easy-to-access information about
the group’s risks and opportunities that would otherwise be difficult to assess if only the separate financial
statements of the entities within the group were prepared. Also, by eliminating the effects of intra-group
transactions that may not be at arm’s-length prices (instead at prices that may benefit an entity in the group
to the detriment of the other in order to shift some income, expenses, assets or liabilities), external parties
looking to transact with an entity get a better understanding of the true financial position and performance
of the group. For example, lenders to an entity within the group may not only be interested in the financial
position and performance of that entity, but may also be interested in the financial position and performance
of the whole group to assess whether the borrower will be able to pay back the debts when they fall due.
In this regard, debts incurred by an entity in the group are often subject to cross-guarantees from the other
entities within the group.
.......................................................................................................................................................................................
EXPLORE FURTHER
For the purpose of this module, the terms ‘economic entity’ and ‘group’ have the same meaning and are
interchangeable. If you wish to explore this topic further, you may now read IFRS 10, paragraphs 1–3, which discuss
the objective of the standard. You may also wish to review the following definitions in IFRS 10, Appendix A:
• ‘parent’
• ‘subsidiary’
• ‘group’
• ‘consolidated financial statements’.

In determining which entities are part of a group, the standard relies on the criterion of control. If one
entity controls another entity, a ‘parent–subsidiary’ relationship is deemed to exist. IFRS 10 requires parent
entities to prepare a single set of consolidated financial statements for the group unless it satisfies certain
restrictive conditions that are outlined in paragraph 4 of the standard.

242 Financial Reporting

 Broadly, IFRS 10 is concerned with two issues:
1. defining the group
2. preparing consolidated financial statements.
As indicated in part A of this module, IFRS 3 is relevant to the second of these issues.

5.7 THE GROUP

DEFINING THE GROUP
Where one entity controls another entity, this gives rise to a parent–subsidiary relationship and establishes
a group for financial reporting purposes (IFRS 10, Appendix A ‘Defined terms’).
The focus of reporting (the group or economic entity) can be visualised as in figure 5.5.

FIGURE 5.5 Concept of the group

Group

Parent Subsidiary
Controls
entity entity

Source: CPA Australia 2019.

A group can be of different shapes and sizes and, while it may include a minimum of two entities, there
is no upper limit of how many entities can form a group. The entities within the group may be listed on a
stock exchange or not.
As indicated in the diagram, ‘control’ is used to define the group. Specifying control as the criterion for
the need to prepare consolidated financial statements has several important consequences, including:
• the legal form of the members of the economic entity is irrelevant
• equal applicability in both the public and the private sectors
• a broad concept of group (the nature of the entity or lack of ownership rights is not a limiting factor).
It should not be inferred that the use of control implies that information concerning ownership interest
lacks relevance to users. For this reason, information concerning the levels of equity attributable to the
ownership group of the parent entity and to the non-controlling interest is disclosed.

CONCEPT OF CONTROL
IFRS 10 requires that consolidated financial statements be prepared where a parent entity controls an
investee (i.e. a subsidiary entity). IFRS 10 (para. 7) specifies the three essential criteria of control, all of
which must be satisfied by the investor in order to be considered to have control over the investee:
1. ‘power over the investee’
2. ‘exposure, or rights, to variable returns from its involvement with the investee’
3. ‘the ability to use its power over the investee to affect the amount of the investor’s returns’ (IFRS 10,
para. 7).
Figure 5.6 demonstrates the concept of control.

FIGURE 5.6 The essential attributes of control

Ability to use power to affect the

investor’s variable returns
Power Variable returns

Source: CPA Australia 2019.

Professional judgment has to be exercised when assessing whether or not control exists, and the
assessment must take into account all facts and circumstances (IFRS 10, para. 8). Significant judgments
and assumptions made in determining whether control exists must be disclosed in accordance with
paragraph 7(a) of IFRS 12.

MODULE 5 Business Combinations and Group Accounting 243

 IFRS 10 provides detailed guidance to help the investor make an assessment of the existence of control.
Only the key aspects of this guidance will be discussed.

Power Over an Investee

Appendix A of IFRS 10 defines power as the current ability to direct the activities that significantly affect
the investee’s returns. Those activities are denoted as relevant activities (Appendix A) and include a
range of operating and financial activities, such as selling and purchasing goods and services, acquiring
and disposing of assets, and determining a funding structure (IFRS 10, para. B11). Relevant activities may
change over time and depend on the purpose and design of the investee.
The ability to direct the relevant activities of an investee arises from existing rights (IFRS 10, para. 11),
and these rights can be:
• voting rights
• rights to ‘appoint, reassign or remove [the] investee’s key management personnel’
• contractual rights (IFRS 10, para. B15).
The rights must be substantive in that the investor has the practical ability to exercise the rights when
decisions about relevant activities are being made. A right is not substantive if there are barriers to
exercising the right, such as legal or regulatory requirements (IFRS 10, paras B22 and B23). Examples
of such barriers include restrictive terms and conditions attached to the rights that make them unlikely to
be exercised. Also, rights that are purely protective — that is, rights that just protect the interest of the
holder (e.g. the right of a secured creditor to take possession of the assets over which the debt is secured
if the borrower (investee) fails to pay back the debt when it falls due) — cannot be considered as giving
power over the investee.
Importantly, the investor has to have the current ability to direct the relevant activities for power to exist
(IFRS 10, para. 12), but that does not mean that it has to be exercised; the fact that the investor does not
exercise its current ability to direct the relevant activities of the investee does not mean that power does
not exist.
In many cases, the assessment of power will be straightforward. For example, in most circumstances,
the relevant activities of the investee are directed by the board of directors of the investee. If the investor
holds the majority of the voting shares in an investee (more than 50%), the investor will have the current
ability to appoint the directors of the investee, who in turn direct the investee’s relevant activities (IFRS 10,
para. B35). In such cases, the investor has power over the investee. However, there are other circumstances
where the relevant activities of the investee are directed by the government or a liquidator (IFRS 10,
para. B37) and, therefore, the investor may have the majority of voting rights but may not have power.
For example, when an entity is not able to pay its debts when they fall due and cannot be saved by an
administrator appointed by the court or its creditors, the entity needs to be placed under the control of a
liquidator. In those cases, the directors relinquish their decision-making powers, and so does the investor
that had a controlling interest (i.e. the majority of voting rights) before the liquidation proceedings started.
Just as an investor that holds the majority of the voting shares in an investee may not have power, there
may be cases where an investor that holds less than the majority of the voting shares is considered to have
power when other factors are taken into account. These factors (IFRS 10, para. B38) could include:
• the investor’s contractual arrangements with other vote holders which give the investor power
(IFRS 10, para. B39). For example, an investor holding 40% of the voting rights in an investee may have
a current contractual agreement with another voting rights holder that has 15% of the voting rights; if
that contractual agreement establishes that the other vote holder will always vote with the investor in
meetings where decisions are made about relevant activities of the investee, the investor is considered
to control the investee
• the investor’s rights from other contractual arrangements (e.g. contractual rights to direct certain relevant
activities) (IFRS 10, para. B40). For example, if an investor has a contractual right to direct a type of
relevant activity, an assessment has to be made about whether the relevant activity significantly affects
the investee’s returns. If so, the investor is deemed to have control over the investee
• the size of the investor’s voting rights relative to the size and dispersion and apathy of other vote holders
(IFRS 10, paras B41–B45). For example, if an investor holds 40% of the voting rights in an investee and
all the other voting rights holders each hold less than 0.1% and do not normally attend meetings where
decisions about relevant activities are made, the investor may have control

244 Financial Reporting

• the investor’s potential voting rights (IFRS 10, paras B47–B50). For example, an investor will have
control over an investee if it holds 30% of the voting rights in the investee and also options that can be
exercised currently to increase its percentage of voting rights above 50%
• a combination of the previous four factors.
Therefore, it is important to consider all the facts and circumstances when assessing the existence
of power, including performing a detailed analysis of voting rights held by other parties and existing
contractual arrangements (IFRS 10, para. 11).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 10, paragraphs 10–14, B9–B18, and B34–B50.

Exposure, or Rights, to Variable Returns from an Investee

The second essential criterion for control is that the investor must be ‘exposed, or has rights, to variable
returns from its involvement with the investee’. In essence, this requires that the investor’s returns (either
positive or negative) have the potential to vary with the performance of the investee (IFRS 10, para. 15).
Examples of such returns include:
• dividends that will vary with the investee’s profit
• changes in value of investor’s investment
• performance fees or remuneration for managing the investee’s assets
• other returns from the investor and investee combining operating functions, such as economies of scale,
cost savings and access to intellectual property (IFRS 10, para. B57).
It should be noted that other parties, apart from the investor that has control, can also share in the returns
of the investee (IFRS 10, para. 16). For example, where an investee is only partly owned by an investor
(e.g. the investor holds 60% of the ownership interest that carries voting rights), both the investor and
the holders of the remaining interest (i.e. non-controlling interest shareholders) share in the returns of the
investee. However, in order to have control, the other attributes of control have to exist (e.g. the party that
shares in the returns of the investee must also have power over the investee arising from substantive rights).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 10, paragraphs 15–16 and B55–B57.

Link Between Power and Variable Returns

The final essential criterion for control to exist is that the investor should be able to use its power to
affect the variable returns it receives from its involvement with the investee (IFRS 10, para. 17). That is,
the investor can use its current ability to direct the investee’s relevant activities so that it receives greater
positive returns or limits negative returns.
This link between power and returns is necessary to distinguish an investor that has control over an
investee from an agent with decision-making rights over an investee that is acting on behalf of an investor
(IFRS 10, para. 18). An agent is a party engaged to act on behalf of another party (i.e. the principal) who
will benefit from the agent’s activities. As such, an agent cannot control an investee (IFRS 10, para. B58).
However, if an investor has delegated decision-making rights to an agent, the investor must treat these
rights as if they were its own rights when determining whether it has control over an investee (IFRS 10,
para. B59). IFRS 10, paragraph B60 specifies that the following factors should be considered when a
decision maker determines whether it is a principal or an agent:
• the scope of its decision-making authority over the investee (e.g. discretion over various relevant
activities)
• rights held by other parties (e.g. do other parties have the right to remove the decision maker?)
• entitlements to remuneration (e.g. the more the remuneration varies with the performance of the investee,
the more likely it is that the decision maker is a principal)
• exposure of the decision maker to variability of returns from other interests held in the investee (i.e. the
greater the size and variability of return associated with the interests of the investor, the more likely it
is that the decision maker is a principal).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 10, paragraphs 17–18 and B58–B72.

MODULE 5 Business Combinations and Group Accounting 245

Exception to Consolidation of Subsidiaries — Investment Entities
In October 2012, the IASB issued amendments to IFRS 10 to exempt a parent that is an investment
entity from consolidating its subsidiaries or applying IFRS 3. Instead of consolidating the subsidiary, the
investment entity needs to measure its investment in the subsidiary at fair value, with changes in fair value
being included in the P/L in accordance with IFRS 9 (IFRS 10, para. 31). The reason for this exception
is that these entities acquire the shares of other entities mainly in order to benefit from the increase in the
value of those shares and are not interested in exercising the control rights obtained through the investment.
These investments are normally held for sale, so it is fitting they be recognised at fair value as that represents
the economic benefit to be extracted from them, with any increases recognised directly in the P/L.
To determine whether a parent is an investment entity, IFRS 10 provides guidance in the form of a
definition and a discussion of typical characteristics of such entities.
IFRS 10, paragraph 27 defines an investment entity as an entity that:
• acquires funds from investors for the purpose of providing investment management services to those
investors
• has an objective to invest funds for its investors to solely provide returns from investment income, capital
appreciation, or both
• primarily measures and assesses performance of its investments on a fair value basis.
Typical characteristics of an investment entity include:
• having more than one investment
• having more than one investor
• investors are not related to the investment entity
• ownership interests are in the form of equity or similar interests (IFRS 10, para. 28).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 10, paragraphs 4B and 27–33.

QUESTION 5.11

(a) ‘X Ltd (X) owns 60% of the share capital of Y Ltd (Y). Thus, Y is a subsidiary of X.’ Explain whether
you agree with this statement, providing reasons for your answer.
(b) ‘X has 44% of the voting rights in Y. The other 56% of voting rights in Y are held by several
hundred shareholders who are geographically dispersed. No other shareholder owns more than
1% of the voting rights in Y. In general, few of the other shareholders attend annual general
meetings. There are no arrangements between shareholders for making collective decisions.’
Explain whether X is likely to control Y.
(c) Would it make any difference to your answer to (b), if, apart from X, there were only two other
shareholders in Y, each with a 28% shareholding interest?
(d) Provide two examples of where an investor could have the majority of voting rights but no power.

5.8 PREPARATION OF CONSOLIDATED

FINANCIAL STATEMENTS
In essence, a set of consolidated financial statements is prepared to provide information concerning the
combined financial performance, financial position and cash flows of the group of entities. Consolidated
financial statements are prepared by aggregating the financial statements of each of the entities in the
group, subject to a series of adjustments required by IFRS 10. The reasons behind those adjustments stem
from the fact that the consolidated financial statements should regard the group of entities as a separate
economic entity for which the investment in itself and transactions between internal parts of it should not
be considered as having an impact on its financial performance, financial position and cash flows.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read the scope exclusions contained in IFRS 10, paragraph 4.

246 Financial Reporting

 Combining the financial statements of separate entities (through what is known as the consolidation
process) is usually not a simple matter. Numerous issues have to be addressed before the consolidated
financial statements can be prepared. Consideration of these issues often results in a series of adjustments
being carried out in the first two stages of the consolidation process.
The initial stage involves adjusting the financial statements of individual entities where they have not
been prepared on a common basis. In particular, adjustments at this stage are required where the individual
entities used dissimilar:
• accounting policies, or
• reporting period ending dates.
These adjustments are necessary because the information that is to be aggregated needs to be comparable
to ensure that the end-of-period aggregation is meaningful and not misleading. As with individual financial
statements, the consolidated financial statements reflect income, expenses and cash flows for a particular
accounting period and assets, liabilities and equity as at the end of a particular accounting period. If the end
of the accounting period considered by a parent is different from that considered by a subsidiary within
the group, without an adjustment to unify reporting dates the carrying amount of assets and liabilities
will be measured at, and income, expenses and cash flows measured over, different points in time, which
may mislead users. If the individual entities used different accounting policies to account for similar
transactions, similar items may be treated differently (one entity may measure the cost of inventories using
the first-in, first-out formula, while the other entity may use the weighted average cost formula) and the
aggregated amounts will be difficult to interpret.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 10, paragraphs 19, B87, B92 and B93, which discuss
the adjustments required to the financial statements of entities within the group prior to consolidation. Note that for the
purposes of this module, it will be assumed that subsidiaries have prepared their financial statements using uniform
accounting policies and reporting periods ending on the same date as the group. Hence, no adjustments will be
required for dissimilar accounting policies or reporting periods ending on different dates.

The second stage combines the financial statements of the individual entities in order to present the
information as it would have been prepared for a single economic entity. After adjusting for differences in
reporting dates and accounting policies, the financial statements of individual entities must be combined to
reflect the financial performance and position of the group (IFRS 10, para. B86(a)). This is carried out using
a consolidation worksheet, which is not only a means of aggregation but also permits further adjustments
to be made. The worksheet adjustments are necessary to refocus the accounting entity perspective from the
individual entities (the initial data) to the group as a separate entity (the consolidated financial statements).
However, it should be noted that the worksheet is separate from the records of the individual entities and
the financial statements of the individual entities will not be affected by it. The reason for using a separate
worksheet is that the individual entities are still separate legal entities from the other entities within the
group and their records should still include the results of transacting with those other entities.
Adjustments at this stage are required where:
(a) the parent entity holds an equity interest in a subsidiary, recognised in an investment account in the
parent’s financial statement
(b) the subsidiary’s identifiable assets or liabilities were not recorded at fair value at acquisition date in
the subsidiary’s accounts and they still exist as at the beginning of the current period
(c) transactions have taken place between members of the group and their financial effects are still
recognised in the assets, liabilities, income or expenses of the individual entities during the
current period.
The adjustments required in the preceding points (a) and (b) are referred to in this module as the
pre-acquisition entries because they are adjustments affecting items present at acquisition date. These
adjustments will also include an adjustment to the pre-acquisition equity recorded by the subsidiary (as
the fair value adjustments are recognising the true value of the subsidiary’s net assets at acquisition), out
of which the parent share will next be eliminated, together with the parent investment in the subsidiary. A
detailed explanation of the need to eliminate the pre-acquisition equity of the subsidiary on consolidation
is included next.

MODULE 5 Business Combinations and Group Accounting 247

 It should be noted that before starting to prepare journal entries to record the adjustments required in
(a) and (b), a so-called ‘acquisition analysis’ can be undertaken that mirrors step (c) and step (d) of the
acquisition method (discussed under the subheading ‘The acquisition method’ in part A of this module)
by calculating/measuring at acquisition date the:
• fair value of the identifiable net assets in the subsidiary
• fair value of consideration transferred
• fair value of the previously held interest by the parent in the subsidiary (if any)
• value of the non-controlling interest in the subsidiary (if any), and, as a result,
• value of goodwill.
Example 5.10 relates to a simple case where the acquisition analysis does not need to address the
calculation of the fair value of the previously held interest or the value of the non-controlling interest,
as the acquirer acquired its entire ownership interest of 100% of the shares in the subsidiary at acquisition
date. It is based on data from case study 5.1. If you wish to explore this topic further, you may now read
points 1–3 of case study 5.1 in the ‘Case studies’ section.

EXAMPLE 5.10

Acquisition Analysis
In case study 5.1, the consideration transferred is $230 000. This must be compared with the fair
values of the identifiable assets acquired and liabilities assumed to determine whether there is any
goodwill acquired.
Point 2 of case study 5.1 is the equity section of Subsidiary Ltd (Subsidiary), which will also be
encountered in subsequent examples in this module. The purpose of this information is twofold.
1. It provides the amount of the book value of the net assets (i.e. assets minus liabilities) recorded by
Subsidiary (by definition, this is equal to the amount of equity), which is then adjusted for the recognition
of previously unrecognised identifiable assets and liabilities (net of tax), fair value adjustments (net of
tax) and adjustments for recognised goodwill from previous acquisitions to calculate the fair value of
identifiable net assets and in determining goodwill.
2. It provides the pre-acquisition equity accounts recorded by Subsidiary that must be eliminated
(together with the business combination reserve recorded in the consolidation worksheet to recognise
fair value adjustments other than those posted directly in the subsidiary’s accounts) as part of the
pre-acquisition elimination entry.
In case study 5.1, the book value of the net assets of Subsidiary, derived from the book value of the
equity, is $180 000. It is assumed that Subsidiary does not have any goodwill previously recorded (from
any previous acquisitions where it acted as an acquirer), meaning that all its net assets are identifiable.
Also, it is assumed that all identifiable assets are recorded by Subsidiary in its own accounts prior to the
acquisition. With these assumptions in place, the book value of equity of $180 000 is equal to the book
value of identifiable net assets. However, this amount includes plant recorded at acquisition date at its
book value ($60 000), not its fair value ($80 000). As discussed in part A of this module, the revaluation of
the plant by $20 000 in a business combination will give rise to a deferred tax liability of $6000 ($20 000
× 30%). This is because, from a group’s perspective, the carrying amount of the plant will be increased
by $20 000, but its tax base will remain constant, and this results in a taxable temporary difference of
$20 000 and a deferred tax liability of $6000.
Therefore, the fair value of the identifiable assets acquired less the liabilities assumed for Subsidiary is
calculated as follows.

$
Book value of identifiable net assets of Subsidiary 180 000
Add: Increase in plant to fair value 20 000
Less: Deferred tax liability — revaluation of plant (6 000)
Fair value of identifiable net assets of Subsidiary 194 000

As this example considers that the parent acquired 100% of the shares in Subsidiary in one transaction,
there is no non-controlling interest or previously held interest. The goodwill is then simply calculated by
comparing the fair value of the consideration transferred ($230 000) with the fair value of the identifiable
net assets of Subsidiary ($194 000). Therefore, the goodwill acquired by the group is $36 000.

248 Financial Reporting

PARENT WITH AN EQUITY INTEREST IN A SUBSIDIARY
Where the parent entity has an equity interest representing shares acquired in the subsidiary, the parent
will recognise in its own accounts an investment asset account based on the consideration transferred for
those shares. This asset must be eliminated in full on consolidation, together with the parent’s share of
the subsidiary’s pre-acquisition equity (IFRS 10, para. B86(b)). The elimination of the investment in the
subsidiary recognised as an asset in the parent’s accounts is necessary because, from the group’s perspective
as a separate economic entity, the group’s assets cannot recognise investments in itself.
An explanation for the elimination of the parent’s share of the subsidiary’s pre-acquisition equity comes
from the fact that profits and other comprehensive income (recognised in reserves) from an investment
can only be earned after the investment occurs, and therefore, only the post-acquisition changes in the
subsidiary’s equity can be included in the consolidated equity.
If the parent owns 100% of the share capital in the subsidiary, the equity of the group at acquisition date
should be equal only to the equity of the parent at acquisition date.
Example 5.11, based on data from case study 5.1 in the ‘Case studies’ section, demonstrates that in the
absence of non-controlling interest in the subsidiary, the consolidated equity of the group at the acquisition
date should be equal to the equity of the parent.

EXAMPLE 5.11

Consolidated Equity at Acquisition Date when Parent has Full

Ownership Interest in the Subsidiary
In addition to the data in case study 5.1, this example assumes that the following information is recorded
in the individual statements of financial position of Parent Ltd (Parent) and Subsidiary Ltd (Subsidiary).
• For Parent: the total assets were recorded as $1 230 000 (that includes the amount for its investment
in Subsidiary, i.e. $230 000) and total liabilities as $400 000, resulting in total equity of $830 000
(i.e. $1 230 000 – $400 000).
• For Subsidiary: the total assets were recorded as $500 000 and total liabilities as $320 000, resulting
in total equity of $180 000 (i.e. $500 000 – $320 000), recognised as issued capital of $100 000 and
retained earnings of $80 000.
If we want to calculate the equity of the group and demonstrate that it is equal to the equity of Parent
only, we first calculate the consolidated assets and consolidated liabilities, with the difference giving us
the consolidated equity.
In terms of consolidated assets, we can start by adding together the total assets of Parent plus the
total assets of Subsidiary (i.e. $1 230 000 + $500 000 = $1 730 000). This amount should be adjusted as
it includes the intra-group investment recognised by Parent based on the consideration transferred of
$230 000. This amount should also be adjusted for the fair value adjustment regarding the plant of
Subsidiary undervalued at acquisition date (i.e. by adding $20 000) and for the goodwill on acquisition
(i.e. by adding a further $36 000, the goodwill determined in example 5.10). Therefore, the consolidated
assets amount is $1 556 000 ($1 730 000 – $230 000 + $20 000 + $36 000 = $1 556 000).
In terms of consolidated liabilities, we can start by adding together the total liabilities of Parent plus the
total liabilities of Subsidiary (i.e. $400 000 + $320 000 = $720 000). This amount should be adjusted for
the deferred tax liability (a part of the liabilities of the group) that arise from the revaluation of the plant
on consolidation of $6000 (30% × $20 000). Therefore, the consolidated liabilities amount is $726 000,
and as the equity is the residual of assets after subtracting liabilities, the consolidated equity is equal to
$830 000 ($1 556 000 – $726 000), which is equal to Parent’s equity only.
Remember that consolidation starts by adding together the items of the individual entities within the
group — that applies to the equity accounts as well. While the equity of Subsidiary at acquisition date
can be added to the equity of Parent, the preceding result shows that it should then be eliminated as part
of the consolidation adjustment so that at acquisition date the consolidated equity only recognises the
equity of Parent.

.......................................................................................................................................................................................
EXPLORE FURTHER
As stated in the ‘Assumed knowledge’ section, it is assumed that, from your undergraduate knowledge, you can
prepare a basic pre-acquisition elimination entry.
Finally, to ensure that you can prepare a pre-acquisition elimination entry at the acquisition date that deals with the
revaluation of non-current assets and goodwill, please refer to the ‘Assumed knowledge review’ at the end of this
module and attempt question 1.

MODULE 5 Business Combinations and Group Accounting 249

REVALUATION OF ASSETS
When the parent gains control of another entity, the group is deemed to have acquired the net assets of
that entity. Hence, IFRS 3 needs to be applied in the consolidated financial statements. As a consequence,
the identifiable assets and liabilities of the subsidiary should be reflected in the consolidated financial
statements at fair value at the acquisition date.
If the identifiable assets and liabilities are not recorded in the subsidiary’s financial statements at
fair value at acquisition date, fair value adjustments should normally be recorded in the consolidation
worksheet. For some assets, accounting standards may allow fair value adjustments to be recorded in
the subsidiary’s accounts at acquisition date instead (e.g. non-current assets like plant and equipment,
where revaluation can be recorded according to IAS 16 Property, Plant and Equipment). For other assets
(e.g. current assets like inventory), fair value adjustments should be recorded in the consolidation
worksheet. For example, paragraph 9 of IAS 2 Inventories requires the inventory to be recorded at the
lowest of the cost and the net realisable value, where net reliable value is the fair value minus the costs
to sell. If the fair value of the subsidiary’s inventory at acquisition date is greater than the value of the
inventory recorded by the subsidiary according to IAS 2, the adjustment cannot take place in the financial
statements of the subsidiary because IAS 2 will be contravened, and therefore, it will be recognised in the
consolidation worksheet instead.
Note: As discussed in part A of this module, measuring an asset or liability in a business combination at
fair value with no equivalent adjustment to its tax base leads to an additional temporary difference and the
recognition of an increase in a deferred tax asset or liability. This tax effect should be recognised no matter
whether fair value adjustments were posted in the subsidiary’s accounts or in the consolidation worksheet.

EXAMPLE 5.12A

Revaluation of Assets
On 1 March 20X3, Holding Ltd (Holding) signed an agreement with the shareholders of Subsidiary Ltd
(Subsidiary) to acquire the entire issued capital (12 000 shares, at $1.00 per share) of that company.
Holding agreed to issue five Holding shares for every two Subsidiary shares. Subsidiary was to continue
to operate its business as a subsidiary of Holding.
The terms of the agreement were fulfilled on 30 June 20X3 when the share transfer took place.
Immediately prior to settlement, the statements of financial position for the companies involved were
as follows.

Holding Subsidiary
$000 $000
Issued capital 80 12
Retained earnings 140 83
Liabilities 50 25
270 120
Current assets 40 30
Non-current assets 230 90
270 120

At 30 June 20X3, it was determined that the fair values and the tax bases of the net assets of
Subsidiary were as follows.

Fair value Tax base

$000 $000
Current assets 40 30
Non-current assets 110 90
Liabilities (25) (25)
125 95

The non-current assets were revalued to their individual fair values in the accounting records of
Subsidiary at the same date. The current assets were revalued to their individual fair values in the
consolidation worksheet.
At 30 June 20X3, the shares issued by Holding to the shareholders of Subsidiary traded on the securities
exchange at $5.00 per share.

250 Financial Reporting

QUESTION 5.12

Using the data from example 5.12:

(a) calculate the fair value of the consideration transferred
(b) provide a pro forma journal entry for Holding to account for the acquisition of Subsidiary’s shares
(c) provide a pro forma journal entry for Subsidiary for the revaluation of its non-current assets to
fair value and a consolidation journal entry for the revaluation of the current assets of Subsidiary
to fair value
(d) explain whether the group has purchased goodwill and, if so, calculate the amount of purchased
goodwill
(e) provide the pre-acquisition elimination entry.

EXAMPLE 5.12B

Revaluation of Assets
If Holding prepared a consolidation worksheet on 30 June 20X3, after the pro forma journal entries referred
to in question 5.12 had been processed, it would appear as follows.
Consolidation worksheet 30 June 20X3
Eliminations
& adjustments
Holding Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Issued capital 230† 12 12 230
Retained earnings 140 83 83 140
Revaluation surplus 14‡ 14
Business combination reserve 7 7‡
Deferred tax liability 6‡ 3‡ 9
Liabilities 50 25 75
420 140 454

Current assets 40 30 10‡ 80

Investment in Subsidiary 150 150 —
Non-current assets 230 110 340
Goodwill 34 34
420 140 160 160 454
†
Original issued capital ($80 000) plus shares issued at fair value to the shareholders of Subsidiary (30 000 @ $5.00 per
share = $150 000).
‡
As the non-current assets were revalued in the subsidiary’s accounts, a revaluation surplus and a related deferred tax
liability were recorded in the subsidiary’s financial statements. As the current assets were revalued in the consolidation
worksheet, the current assets still appear as $30 000 in the subsidiary’s account, but the increase in their value and a related
business combination reserve, together with the associated deferred tax liability, were recorded into the worksheet.
The worksheet illustrates that:
• the acquirer, Holding, includes its interest in the acquiree in its own financial statements as an asset
called ‘Investment in Subsidiary’
• the identifiable net assets of the subsidiary are recorded at their individual fair values in the consolidated
column, as a result of the revaluation being posted either in the subsidiary’s accounts (for non-current
assets in this example) or as an adjustment in the consolidation worksheet (for current assets in
this example)
• a deferred tax liability is recognised due to temporary differences arising on the revaluation of the net
assets of the subsidiary
• on acquisition of the subsidiary, goodwill has been treated as a consolidated adjustment as it is the
group that has acquired the business of the subsidiary
• the ‘Investment in Subsidiary’ account is eliminated, together with the elimination of the shareholder’s
equity of the subsidiary at acquisition date (that includes the revaluation surplus and the business
combination reserve recognised on revaluation of the identifiable net assets of the subsidiary) and the
recognition of goodwill.

MODULE 5 Business Combinations and Group Accounting 251

 Note: The examples in the remainder of this topic will assume that all revaluations of subsidiary assets
where their carrying amounts were different from their fair value at acquisition date are posted in the
consolidation worksheet and not in the subsidiary’s accounts.

QUESTION 5.13

Using the information in case study 5.1 and example 5.10, prepare a consolidation worksheet
adjusting entry as at the acquisition date to record the elimination of the investment account and
of the pre-acquisition equity of the subsidiary. Explain the rationale for your entries.

DEPRECIATION ADJUSTMENTS RELATED TO REVALUATION

OF DEPRECIABLE ASSETS
When, in accordance with IFRS 3, a depreciable non-current asset has to be revalued to fair value
at the acquisition date in the consolidation worksheet, further consolidation adjustments will have to
be undertaken in subsequent reporting periods to adjust the depreciation charges. The subsidiary’s
depreciation expense will be based on the amount of the asset recorded in its financial statements. However,
the group will need to recognise a consolidation depreciation expense based on the fair value of the
non-current asset recorded in the consolidated financial statements (IFRS 10, para. B88), and therefore,
an adjustment to depreciation expense will be needed. As this adjustment will impact total expenses
recognised by the group and, therefore, consolidated profit, a tax effect adjustment will also need to be
posted. In other words, as the upwards revaluation reverses through depreciation adjustments, so too does
the associated deferred tax liability.
The adjustments to depreciation expense and the related tax effect need to take into account the current
period adjustments and the previous period adjustments that will be recorded against retained earnings. In
addition, the gain or loss recorded in the financial statements of the subsidiary, when the asset is disposed of,
should be adjusted, on consolidation, to reflect the gain or loss to the group (again, a tax effect adjustment
will have to be prepared).
Example 5.13 relates to the pre-acquisition entries in the case of an acquisition that involved revaluation
of depreciable assets and depreciation adjustments after the acquisition date. It is based on data from case
study 5.1. If you wish to explore this topic further, you may now read point 4 of case study 5.1, which
relates to the depreciation of the plant. Think about the depreciation expense that would be recorded in the
financial statements in Subsidiary and the depreciation expense that should be recorded by the group.

EXAMPLE 5.13

Depreciation Adjustments Related to Revaluation of Depreciable Assets

Consider the data from case study 5.1. As discussed in the answer to question 5.13, based also
on case study 5.1, the pre-acquisition elimination entry at acquisition date has resulted in the plant
of Subsidiary Ltd (Subsidiary) being measured at fair value of $80 000 in the consolidated financial
statements. Subsequent consolidation adjustments in the next periods will have to take into account the
fact that the amount of depreciation recorded by Subsidiary (based on the cost of the asset to Subsidiary)
will differ from the depreciation that will have to be recorded by the group (based on the fair value of the
asset at acquisition).
Subsidiary estimates the remaining useful life of the plant to be five years, with a zero scrap value at
the end of this time. The group will have the same estimate of useful life and residual value as Subsidiary.
Like Subsidiary, the group will also use the straight-line depreciation method for this type of plant, as the
manner in which Subsidiary uses up the service potential of the asset also reflects the way the group is
using it up. Therefore, the depreciation expense for the plant in the financial statements of Subsidiary
is $12 000 per year ($60 000/5 years), while in the consolidated statement of profit or loss and other
comprehensive income (statement of P/L and OCI) of the group, the required depreciation expense is
$16 000 ($80 000/5 years). As a result, the consolidation adjustment after the acquisition date will have to
allow for this increase in depreciation expense every year.

252 Financial Reporting

 In the statement of financial position of Subsidiary prepared at 30 June 20X1 (i.e. one year after the
acquisition date), the plant is recorded at historical cost to that entity ($100 000) less related accumulated
depreciation ($52 000 = $40 000 + $12 000). This information is entered into the consolidation worksheet
used to prepare the financial statements of the group. A consolidation adjustment is required so that
the consolidated financial statements reflect the cost of the plant to the group ($80 000) and the related
accumulated depreciation for the group ($16 000 — it does not include the accumulated depreciation
recorded prior to the acquisition as it was considered to be written off when revalued at acquisition date).
Therefore, the consolidation worksheet entries for 30 June 20X1 would be as follows.
1. Revaluation of plant to fair value (same as the entry at acquisition date)

Dr Accumulated depreciation 40 000

Cr Plant 20 000
Cr Deferred tax liability 6 000
Cr Business combination reserve 14 000

At the acquisition date (1 July 20X0):

• the financial statements of Subsidiary recorded plant at cost of $100 000, less accumulated
depreciation of $40 000. See point 3 of case study 5.1.
• Parent Ltd (Parent) considered that the plant owned by Subsidiary had a fair value of $80 000.
In accordance with IFRS 3, the plant must be initially measured at $80 000 (i.e. fair value) in the
consolidated financial statements. See point 3 of case study 5.1.
Therefore, the consolidation worksheet entry (consolidation adjustment) prepared at acquisition
date must decrease the gross carrying value of the plant by $20 000 (i.e. from $100 000 down to
$80 000) and decrease accumulated depreciation by $40 000 (i.e. from $40 000 down to $nil). This is
reflected in the consolidation worksheet entry (consolidated adjustment) as a debit to accumulated
depreciation of $40 000 and a credit to the gross carrying value of plant of $20 000. As this entry
posted at acquisition date does not carry over to other periods, given it does not affect the individual
statement of the subsidiary, it needs to be repeated at 30 June 20X1 to make sure the asset value
is adjusted to fair value in the consolidated statements. However, a further adjustment is needed for
the year since acquisition date to the depreciation expense recognised by the subsidiary.
2. Depreciation entry and associated tax effect

Dr Depreciation expense 4 000

Cr Accumulated depreciation 4 000
Dr Deferred tax liability 1 200
Cr Income tax expense 1 200

The adjustment to the depreciation expense for the current year ended 30 June 20X1 ensures that:
• the depreciation expense is recorded in the consolidated financial statements as $16 000, being
the amount of $12 000 recognised by the subsidiary plus the debit adjustment now posted against
depreciation expense of $4000
• the accumulated depreciation is also recorded from the group’s perspective as $16 000, being the
amount of $52 000 recognised by the subsidiary minus the debit adjustment of $40 000 from the first
entry above recognising the revaluation of plant to fair value plus the credit adjustment now posted
against accumulated depreciation of $4000.
The increase of $4000 in depreciation reduces the group’s profit before tax. Hence, the income
tax expense of the group has to be reduced by $1200 ($4000 × 30%). The deferred tax liability of
the group is reduced by $1200, from $6000, recognised in the first entry above for the revaluation of
the plant to $4800, as the taxable temporary difference relating to the plant at 30 June 20X1 is now
$16 000. That is, the carrying amount of the plant for the group at 30 June 20X1 is $64 000 (cost of
$80 000 less accumulated depreciation of $16 000), while, if it is assumed that the tax depreciation
is equal to the accounting depreciation for this plant, its tax base is $48 000 (the future deductible
amount via Subsidiary). As the asset is used in the business, the additional future taxable economic
benefits recognised on revaluation (i.e. $20 000) remaining are decreased (by 1 divided by the asset’s
useful life, i.e. 1/5 of $20 000 = $4000) and, with that, so are the related future tax effects (i.e. $4000
× 30%).

MODULE 5 Business Combinations and Group Accounting 253

 A consolidation worksheet would reveal, in part, the following.
Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Plant 100 20 80
Less: Accumulated depreciation (52) 40 4 (16)
48 64
Depreciation expense 12 4 16

Please note that the preceding consolidation worksheet only presents the adjustments that impact
on plant, accumulated depreciation and depreciation expense accounts. A full worksheet is not
prepared as further information is not provided about the other accounts of Parent and Subsidiary
that will be needed in the preparation of that worksheet.
3. Pre-acquisition elimination entry

Dr Issued capital 100 000

Dr Retained earnings (opening balance) 80 000
Dr Business combination reserve 14 000
Dr Goodwill 36 000
Cr Investment in Subsidiary 230 000

The preceding entry eliminates the investment by the parent in the subsidiary and the pre-acquisition
equity of the subsidiary at acquisition date (that includes the business combination reserve recognised
on revaluation of plant) and recognises the goodwill on acquisition. Even though this is the entry that
would be prepared at acquisition date, it is repeated unchanged at 30 June 20X1 because:
• the entry prepared at acquisition date does not carry over
• there are no movements that affect the accounts originally included in the entry.

QUESTION 5.14

(a) Using points 3 and 4 of case study 5.1 and the information from example 5.10, prepare a
consolidation worksheet adjusting entry for the year ended 30 June 20X2. Explain the rationale
for account(s) that differ(s) from the 30 June 20X1 entry discussed previously.
(b) Refer to point 5 of case study 5.1, which relates to the sale of the plant. Prepare a consolidation
adjusting entry for the year ending 30 June 20X3. Explain the rationale for accounts debited and
credited that differ from (a).
(c) Provide the consolidation adjusting entry that would be necessary in years subsequent to the
year ended 30 June 20X3. Explain the rationale for accounts debited and credited that differ
from (b).

.......................................................................................................................................................................................
EXPLORE FURTHER
Digital content, such as videos and interactive activities in the e-text, support this module. You can access this content
on My Online Learning.

TRANSACTIONS WITHIN THE GROUP

The content of consolidated financial statements is determined by focusing on the group as a single
economic entity. IFRS 10, paragraph B86(c) reinforces the financial accounting concept that requires that
before preparing consolidated financial statements, the scope or boundary of the entity for which they
are prepared (i.e. the group) must first be determined. Such denotations limit the content of the resulting
financial reports to reflect only transactions involving the group and parties external to it. Internal events
are ignored.
From the individual entity’s point of view, a transaction involving another member of the group is
an external event to be reported in the financial statements of that entity. From the perspective of the

254 Financial Reporting

group, the same transaction is an ‘internal’ one and should be eliminated from the consolidated financial
statements. An intra-group transaction is, from the perspective of the group, a similar transaction as a
transaction between two departments of a single entity. Figure 5.7 illustrates these important consolidation
concepts.

FIGURE 5.7 Transactions within the group

Group

External Internal External

transaction –– transactions — transaction ––
included in eliminate included in
group financial group financial
statements statements
Parent Subsidiary

Source: CPA Australia 2019.

Therefore, as part of the consolidation process, after the initial adjustments are made in the pre-
acquisition entries discussed previously, the group must eliminate in full all the effects of intra-group
transactions. That may involve adjusting the amounts recognised for assets, liabilities, income and expenses
to reflect only the impact of transactions with external parties. Eliminating the effects of intra-group
(internal) transactions is achieved via adjusting entries in the consolidation worksheet. In essence, this
worksheet adjustment reverses the effect of the original entries processed by the individual entities involved
in those transactions so that the consolidated financial statements reflect only transactions between the
group and parties external to the group.
It should be noted that the effects of a transaction ‘within the group’ may carry forward in the individual
statements of the parties involved to future periods that come after the period when the original intra-
group transaction took place. Therefore, an intra-group transaction from a period may not only require
adjusting entries in the consolidation worksheet prepared at the end of that period, but also in the subsequent
accounting periods, to eliminate any account balances still affected. That is because the worksheet
adjustment from one period does not carry over to the next, as at the end of each period, the consolidation
process starts with adding together the financial statements of the group entities that are not affected by
prior periods’ consolidation adjustments. For example, if an intra-group loan from a previous period is still
unpaid at the end of the current period, the balance of the loan still needs to be eliminated on consolidation
from the loan receivable and loan payable.
However, the general accounting requirement that income and expense accounts are closed to retained
earnings at the end of the period may help eliminate the need for further consolidation adjustments related
to some intra-group transactions. For example, the interest expense and interest revenue on an intra-group
loan for the current period will need to be eliminated on consolidation, but the interest expense and interest
revenue from previous periods will not. This is because they are already eliminated by aggregating the
retained earnings accounts of the entities that recognised a decrease and an increase in retained earnings
respectively for the interest expense and interest revenue on the loan, which were closed to retained
earnings at the end of the previous periods.

Realisation of Profit or Loss by Group

Some intra-group transactions, such as the sale of inventory or non-current assets, may involve eliminating
profits or losses recorded by the parent or subsidiary. That is because those profits or losses are unrealised
from the group’s perspective. Those profits or losses would be recognised as realised by the group when
the assets involving the intra-group profits or losses were either sold to a party external to the group or
when the group consumed a part of the future economic benefits of the assets and recognised that via
depreciation or amortisation. Therefore, profit from some intra-group transactions will be recognised in
the financial statements of the individual entities within the group in reporting periods that may differ from
when that profit is eventually recognised in the consolidated financial statements.
The central focus of this recognition test is the direct, or indirect, involvement of a party external to
the group. In relation to inventory, a direct involvement occurs when the inventory is subsequently sold
to that external party. For example, if some inventory was sold intra-group for $20 000, while the original

MODULE 5 Business Combinations and Group Accounting 255

cost paid to an external supplier was $15 000, to the extent that this inventory is still with the group, the
profit of $5000 is considered unrealised from the group’s perspective. However, once the inventory is
sold to external parties, let’s say for $22 000, the group should recognise a profit of $7000 (i.e. $22 000 –
the original cost of $15 000), which can be seen to comprise the unrealised intra-group profit of $5000
plus an additional $2000 recognised when the intra-group buyer sells the inventory to external parties
(i.e. $22 000 – $20 000). As such, the profit on the intra-group profit is now realised from the group’s
perceptive.
With depreciable assets transferred within the group, external parties are involved indirectly when the
goods or services produced by the asset are sold outside the group. As the depreciation is supposed to reflect
the use of the depreciable assets to produce goods or services that will be sold to external parties, it is said
that the unrealised profit of intra-group transfers of depreciable assets is realised through depreciation. In
essence, as the depreciated part of the asset cannot be used in the business any more, it is equivalent to
having been sold to external parties, and therefore, the part of the intra-group profit proportional to how
much of the asset was depreciated since it was sold intra-group is now considered to be realised.
For example, if a depreciable non-current asset purchased from an external entity for $100 000 is sold
immediately intra-group for $130 000, the intra-group profit of $30 000 is considered unrealised from the
group’s perspective. However, assuming that the useful life of the asset is five years, with economic benefits
from the asset to be consumed evenly, at the end of one full year after the intra-group sale, one-fifth of
the asset’s economic benefits have been consumed. As such, profit of $6000 ($30 000/5 years) each year
can be considered realised and recognised in the group’s accounts. Note that the group does not recognise
this as directly affecting profit; rather, the depreciation expense recognised by the intra-group buyer of
$26 000 ($130 000/5 years), being overstated from the point of view of the group (which will only recognise
$20 000, based on the original cost of $100 000/5 years), will be adjusted on consolidation, resulting in
a decrease in depreciation expense by $6000 that will indirectly affect the profit, increasing it by $6000
($26 000 – $20 000) each year.
Not all intra-group transactions generate unrealised profits from the group’s perspective. Intra-group
transactions that result in an equal and offsetting amount recognised in the current period under revenue and
expense items do not have a net impact on the profit or loss obtained. As such, there is no unrealised profit
that needs to be eliminated on consolidation, but that does not mean that there won’t be any eliminations
required. The individual expense and revenue accounts will still need to be adjusted to eliminate the intra-
group amounts.
For example, when management services are provided within the group for $40 000, the provider entity
recognises revenue of $40 000, while the entity receiving the services records an expense for the same
amount. If the provider and receiving entity recognise profits for the whole period of $100 000 and $80 000
respectively, inclusive of those intra-group revenues and expenses, the aggregated amount for profit will be
$180 000. To eliminate the effects of the intra-group transaction, the adjusted profits of the entities would
be $60 000 (i.e. $100 000 – $40 000) and $120 000 ($80 000 + $40 000) and aggregating those amounts
would give us the same result as before. As such, it is said that the aggregated profit of $180 000 does not
include unrealised profits. Nevertheless, adjustments will still be required in the current period to make
sure that the revenues and expenses are not overstated from the group’s perspective.
Other transactions in this category include intra-group dividends and interest.
Table 5.4 summarises the accounting treatment of intra-group transactions.

TABLE 5.4 Accounting treatment of intra-group transactions

Original Unrealised profit (recognised by legal

transaction entity) Profit recognised by group

Intra-group sale of Eliminate unrealised intra-group profit
inventory or loss in the period of sale and any
remaining unrealised profit in later
reporting periods while the inventory
remains in the group.
If held as inventory by the purchaser within
the group — recognise profit or loss when
the inventory is sold to party external to
group.
If held as depreciable asset by the pur-
chaser within the group — recognise profit
or loss consistent with the depreciation
allocation of asset.

256 Financial Reporting

 Intra-group sale of
depreciable asset
Eliminate unrealised intra-group profit
or loss in the period of sale and any
remaining unrealised profit in subsequent
reporting periods while the asset remains
in the group.
If used as depreciable asset by the pur-
chaser within the group — recognise profit
or loss consistent with the depreciation
allocation of asset.
If the depreciable asset becomes inventory
for the purchaser within the group —
recognise profit or loss when the inventory
is sold to party external to group.

Intra-group No unrealised profit. Eliminate relevant Not applicable.

provision of income and expense items.
services

Payment of Eliminate dividend income and retained Not applicable.

dividend by earnings appropriation.
subsidiary

Intra-group interest No unrealised profit. Eliminate relevant Not applicable.

income and expense items.

Source: CPA Australia 2019.

However, the examples in table 5.4 are conventions that help explain the shortcuts that can be applied
in preparing the adjusting entries for intra-group transactions. It is important to note that unrealised profits
arise only from intra-group sales of assets for a profit. After such an intra-group transaction, the amount
recognised by the entity holding the assets within the group is overstated from the group’s perspective. That
is because when an asset is sold within the group for a profit, it will be recorded in the financial statements
of the individual entity holding the asset at an amount that differs from the amount that should be recorded
in the consolidated financial statements, being the original cost to the group, adjusted for depreciation (if
applicable) based on that cost. The difference will be equal to the unrealised profit. When eliminating an
unrealised profit, it is important to make sure that the value of the asset incorporating that profit is adjusted
for the unrealised amount.
.......................................................................................................................................................................................
EXPLORE FURTHER
This module assumes you can prepare consolidation elimination entries that deal with intra-group transactions
excluding tax effects.
To test your understanding of intra-group transactions consolidation elimination entries, you may attempt
question 2 of the ‘Assumed knowledge review’ at the end of the module. If you wish to explore this topic further, you
may now read IFRS 10, paragraph B86(c).

Tax Effects of Intra-group Transactions

One consideration when eliminating transactions within the group is whether there are any tax effects
to be accounted for in accordance with IAS 12 (discussed in module 4). Profit from some intra-group
transactions will be recognised in the financial statements of the individual entities within the group in
reporting periods that may differ from when that profit is eventually recognised in the consolidated financial
statements. This suggests the need for tax adjustments from the group’s perspective. If a profit is recognised
in a period by an individual entity and not by the group, that results in an income tax expense recognised by
the individual entity that should be eliminated on consolidation. Also, in that case, as the individual entity
pays the tax on this profit, that represents a prepayment of tax from the group’s perspective. Therefore,
when the profit is eventually realised in the future by the group, the tax will not have to be paid again. That
is equivalent to having a tax benefit deferred for the future until the profit becomes realised. The deferred
tax benefit will be recognised by the group as a deferred tax asset when eliminating the income tax expense
on the unrealised profit.
For example, if inventory is sold intra-group at a profit of $20 000, the seller will recognise that profit in
its individual records, and it will pay tax of $6000 on it (assuming the tax rate of 30%). However, as long
as the entire inventory is still on hand with the intra-group buyer, from the group’s perspective, the tax
should not have been paid yet and should be recognised as a prepayment of tax that will bring tax benefits
in the future.

MODULE 5 Business Combinations and Group Accounting 257

 Therefore:
• the income tax expense recognised by the intra-group seller will be eliminated on consolidation as it
was not yet incurred from the group’s perspective
• a deferred tax asset will be recognised to show that when the profit is realised from the group’s
perspective, the tax on it will not have to be paid again. That is, a deductible temporary difference
originates when the intra-group seller pays tax, which subsequently reverses when the group realises
profit on the sale of inventory.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 10, paragraph B86(c).

Example 5.14 relates to case study 5.2. Example 5.14 demonstrates the application of the principles
of accounting for intra-group transactions in the context of the sale of inventory within the group. These
principles include the need to:
• eliminate intra-group profits or losses until realised via the involvement of a party external to the group
• measure the asset transferred within the group at the cost to the group
• account for deferred tax assets or deferred tax liabilities arising from measuring assets transferred within
the group at the cost to the group.

EXAMPLE 5.14

Intra-group Transactions — Sale of Inventory

In case study 5.2, the parent entity sold inventory to a subsidiary for $40 000 on 1 June 20X3. The cost of
the inventory to the parent was $30 000.
As previously discussed, for a proper understanding of the consolidation adjustment necessary to
eliminate the effects of the intra-group transaction, it is important to understand what the effects really
are. To achieve this, first consider the entries that were posted in the individual financial records of the
parent entity and the subsidiary as a result of this transaction.
Entry processed by the parent (1 June 20X3):

Dr Bank 40 000
Dr Cost of goods sold 30 000
Cr Sales 40 000
Cr Inventory 30 000

Entry processed by the subsidiary (1 June 20X3):

Dr Inventory 40 000
Cr Bank 40 000

The entry processed by the parent records both the sale of inventory at the selling price (Dr Bank
$40 000 and Cr Sales $40 000) and the outflow of inventory at the cost price (Dr Cost of goods sold
$30 000 and Cr Inventory $30 000). The entry processed by the subsidiary records the cash purchase of
inventory from the parent at the price charged by the parent (Dr Inventory $40 000 and Cr Bank $40 000).
From a group perspective, starting with the Bank account, given that a credit and a debit was recognised
in the individual accounts for the same amount, the net effect is nil and, therefore, there is no need for
adjustment. Next, the cost of goods sold and sales revenue need to be eliminated in full, which results
in an overall decrease in profit of $10 000 (the elimination of cost of goods sold decreases the expenses,
which increases the profit by $30 000, but the elimination of sales revenue decreases the profit by $40 000).
The decrease in profit has tax effects that will be recognised by decreasing the income tax expense and
recognising a deferred tax asset for the deductible temporary difference arising from the tax paid by the
parent on the unrealised intra-group profit. With regards to the inventory account, the parent recognises
that it transferred the items to the subsidiary, so that inventory will disappear from its accounts and appear
in the subsidiary accounts, but the amount recognised is $40 000 (the price paid intra-group). However, if
this transaction did not take place from the group’s perspective, that means that the inventory should still
be recorded at the original cost of $30 000. As such, the inventory is overstated (by $10 000, being the
unrealised profit) and should be adjusted. These consolidation adjustments are presented as follows.

258 Financial Reporting

 Consolidation journal entries (1 June 20X3):

Dr Sales 40 000
Cr Cost of goods sold 30 000
Cr Inventory 10 000
Dr Deferred tax asset 3 000
Cr Income tax expense 3 000

These adjustments can also be visualised in the following consolidation worksheet, which includes only
the affected accounts (a tax rate of 30% is used).

Consolidation worksheet (1 June 20X3)

Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $ $ $ $ $
Statement of profit or loss
Sales 40 000 40 000 —
Less: Cost of goods sold (30 000) 30 000 —
Gross profit 10 000 —

Profit before tax 10 000 —

Income tax expense (3 000) 3 000 —
Profit after tax 7 000 —

Statement of financial position

Inventory 40 000 10 000 30 000
Deferred tax asset 3 000 3 000

Notes
• The consolidated statement of P/L and OCI does not include the sales revenue and cost of goods sold
that did not result from a transaction with parties external to the group.
• Inventory is measured in the consolidated statement of financial position at the original cost to the
group, and not at the cost to the subsidiary, which is based on the price paid intra-group and includes
the profit recognised by the parent from the sale within the group.
• As the profit on the sale is not recognised by the group, this requires the income tax expense of the
group to be reduced (a credit of $3000: 30% of the unrealised profit of $10 000).
• The group has recognised a ‘deferred tax asset’ because the tax expense on the unrealised profit is a
prepaid tax that will give rise to a tax benefit in the future when the profit will be realised from the point
of view of the group.
In case study 5.2, the inventory was still on hand at the end of the financial year 30 June 20X3, so there
are no other transactions that may be impacted by this original intra-group transaction. Note that if the
inventory was sold to an external party, the entries processed by the subsidiary to recognise the external
sale would consider the cost of goods sold based on the price paid intra-group, so cost of goods sold
would also be affected by the intra-group sale and therefore would need to be adjusted.
If, for example, 50% of the inventory was sold by the subsidiary to an external party for $24 000 by
30 June 20X3, the subsidiary would record the following additional entry.

Dr Bank 24 000
Dr Cost of goods sold 20 000
Cr Sales 24 000
Cr Inventory 20 000

As the Bank and Sales accounts recognise the proceeds received from an external party, they do not
need to be adjusted. However, from the group’s perspective, the cost of goods sold now should only
recognise the cost of the inventory sold to external parties based on the original cost of that inventory prior
to the intra-group transfer (i.e. 50% of $30 000 = $15 000). Therefore, the adjustment on consolidation will
initially just need to reverse the debit to cost of goods sold and the credit to inventory by $5000 ($20 000 –
$15 000). However, as that adjustment will increase the profit before tax (and knowing that the intra-group
profit has been realised in proportion of 50%), a tax effect adjustment entry will also need to be posted on

MODULE 5 Business Combinations and Group Accounting 259

 consolidation to reverse the tax effect for the realised profit. In particular, the tax effect adjustment entry
records the partial reversal of the deductible temporary difference that arose from the intra-group sale,
as profit has now been realised from the sale of inventory to an external party. These adjustments can be
visualised in the following consolidation worksheet, which also includes the previous adjustments posted
to eliminate the initial effects of the intra-group transaction.

Consolidation worksheet (30 June 20X3)

Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $ $ $ $ $
Statement of profit or loss
Sales 40 000 24 000 40 000 24 000
Less: Cost of goods sold (30 000) (20 000) 30 000
5 000 (15 000)
Gross profit 10 000 4 000 9 000

Profit before tax 10 000 4 000 9 000

Income tax expense (3 000) (1 200) 1 500 3 000 (2 700)
Profit after tax 7 000 2 800 6 300

Statement of financial position

Inventory 20 000 5 000 10 000 15 000
Deferred tax asset 3 000 1 500 1 500

Notes
• The consolidated statement of P/L and OCI includes only the sales revenue from the external sale
($24 000) and cost of goods sold to external parties based on the original cost of that inventory to the
group (50% of $30 000).
• Inventory remaining is measured in the consolidated statement of financial position at the original cost
to the group (50% of $30 000), and not at the cost to the subsidiary, which is based on the price paid
intra-group and includes the profit recognised by the parent from the sale within the group and not yet
realised.
• As the profit is recognised by the group as $9000, this requires the income tax expense of the group to
be $2700.
• The group has recognised a ‘deferred tax asset’ because the tax expense on the unrealised profit is a
prepaid tax that will give rise to a tax benefit in the future when the profit will be realised from the point
of view of the group (50% of the original deferred tax asset of $3000).
Note that when some of the inventory previously sold intra-group is then sold to external parties, there
are two sets of adjustments posted in the consolidation worksheet:
• adjustments for the initial intra-group transaction
• adjustments for the external transaction recorded based on the prices paid intra-group.
These adjustments can be combined into only one set of adjustments by aggregating the amounts that
both the parent and subsidiary would have recorded in the accounts affected as a result of both internal
and external transactions and then adjusting the aggregated amounts, if needed, to the amounts that
should be reported in the consolidated financial statements from the group’s perspective.
The aggregated amount in the Bank line item recognises the price received from an external party
and, therefore, there is no adjustment needed. The aggregated amount in the Sales line item reflects
the amount of sales recorded by the parent from the intra-group sale ($40 000) and the amount of
sales recorded by the subsidiary from the external sale ($20 000). As only the external sales should be
recognised in the consolidated financial statements, the Sales line item should be decreased by the
amount of intra-group sales (Dr Sales $40 000). Also, from the group’s perspective, the Cost of goods
sold line item should only recognise the cost of the inventory sold to external parties based on the
original cost of that inventory prior to the intra-group transfer (i.e. 50% of $30 000 = $15 000). As the
parent recorded $30 000 as the cost of goods sold from the intra-group sale, while the subsidiary also
recorded $20 000 as the cost of goods sold from the external sale, the aggregated amount recognised
by the parent and subsidiary will be $50 000. Therefore, in order to make sure the consolidated Cost
of goods sold line item only reflects the cost to the group of inventory sold externally of $15 000, a
consolidation adjustment is needed to decrease the aggregated amount by $35 000 (Cr Cost of goods
sold $35 000). The aggregated amount remaining in Inventory will only include the amount recognised for
inventory still held by the subsidiary, but that will be based on the price paid intra-group for that inventory
($20 000). As the inventory remaining inside the group should be recorded from the group’s perspective

260 Financial Reporting

 based on the initial cost (50% x $30 000 = $15 000), an adjustment on consolidation is needed to bring
the aggregated amount to the correct consolidated amount (Cr Inventory $5000). As the adjustments to
Sales and Cost of goods sold will effectively reduce the profit by $5000 (i.e. the unrealised profit, 50% x
$10 000), a tax effect adjustment entry will also need to be posted on consolidation to recognise that the
tax paid on the unrealised profit is essentially a tax prepayment from the group’s perspective (Dr Deferred
tax asset $1500; Cr Income tax expense $1500). These adjustments are presented as follows, both as
consolidation entries and as part of the consolidation worksheet.
Consolidation journal entries (30 June 20X3):

Dr Sales 40 000
Cr Cost of goods sold 35 000
Cr Inventory 5 000
Dr Deferred tax asset 1 500
Cr Income tax expense 1 500

Consolidation worksheet (30 June 20X3)

Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $ $ $ $ $
Statement of profit or loss
Sales 40 000 24 000 40 000 24 000
Less: Cost of goods sold (30 000) (20 000) 35 000 (15 000)
Gross profit 10 000 4 000 9 000

Profit before tax 10 000 4 000 9 000

Income tax expense (3 000) (1 200) 1 500 (2 700)
Profit after tax 7 000 2 800 6 300

Statement of financial position

Inventory 20 000 5 000 15 000
Deferred tax asset 1 500 1 500

QUESTION 5.15

(a) Refer to case study 5.2 and use assumption 1. Prepare pro forma consolidation worksheet
entries for the year ended 30 June 20X4. Explain the rationale for your entries.
(b) Refer to case study 5.2 and use assumption 2. Prepare pro forma consolidation worksheet
entries for the year ended 30 June 20X4. Explain the rationale for your entries.
(c) Assume that on 1 July 20X2, a subsidiary sold to its parent entity an item of plant for $50 000.
The plant had cost the subsidiary $100 000 and had a carrying amount of $40 000. While the
subsidiary had depreciated the plant using the reducing-balance method at a rate of 30%, the
parent entity is depreciating the plant on a straight-line basis over five years with a zero scrap
value at the end of its useful life.
Prepare pro forma consolidation worksheet entries for the financial years ending 30 June
20X3 and 30 June 20X4 to account for this transaction from the group’s point of view. Assume
a tax rate of 30% and explain the rationale for your pro forma entries. (Hint: First think about
the entries that would be processed in the accounting records of the parent and subsidiary as
a result of the transaction.)

MODULE 5 Business Combinations and Group Accounting 261

.......................................................................................................................................................................................
EXPLORE FURTHER
Digital content, such as videos and interactive activities in the e-text, support this module. You can access this content
on My Online Learning.

NON-CONTROLLING INTEREST
So far, the discussion has focused primarily on the preparation of consolidated financial statements for
parent entities that have 100% ownership interest in a subsidiary. Another situation is when a parent entity
owns less than the total issued capital of a subsidiary. In this situation, a non-controlling interest exists
that should be recognised in the consolidated financial statements.
For example, a non-controlling interest would exist where the parent entity owned 70% of the issued
capital of a subsidiary. The equity participants (i.e. the shareholders or owners) in the parent entity have an
interest in the group through their direct interest in the parent and an indirect interest (via the investment)
in the subsidiary. The holders of the other 30% of the issued capital of the subsidiary have an interest in
the group through their investment in the subsidiary. This is illustrated in figure 5.8.

FIGURE 5.8 Non-controlling interest

Parent entity Non-controlling

owners interest

100% Group 30%

Parent entity 70% Subsidiary

Source: CPA Australia 2019.

Although not explicitly stated, IFRS 10 uses the ‘entity concept’ (also referred to as ‘economic entity
concept’) of consolidation, and as a consequence, a non-controlling interest is classified as part of
consolidated equity. This module does not discuss the alternative concepts of consolidation. However, you
should appreciate that historically there has been debate about whether non-controlling interest should be
classified as equity or liabilities.
The important features of the entity concept of consolidation are:
• all assets, liabilities, income and expenses of a similar nature in the financial statements of entities within
the group are combined, subject to any required consolidation adjustments
• the effects of transactions within the group are eliminated in full
• the non-controlling interest is classified as an equity participant in the group
• the non-controlling interest is entitled to the respective proportionate interest in the equity of the
subsidiary after making adjustments for unrealised profits and losses of the subsidiary arising from
intra-group transactions.
The first two features listed have already been discussed in this module. Using the entity concept of
consolidation, the existence of a non-controlling interest requires three modifications to the consolidation
process. These affect:
1. the pre-acquisition elimination entry
2. the treatment of dividends paid by the subsidiary
3. the measurement and disclosure of the non-controlling interest in the consolidated financial statements.

1. Pre-acquisition Elimination Entry

Where the parent entity acquires less than a 100% interest in the subsidiary, the consolidation pre-
acquisition elimination entry should eliminate the carrying amount of the parent’s investment in
the subsidiary and the parent’s portion of equity in the subsidiary at the acquisition date (IFRS 10,
para. B86(b)). The elimination of the investment in the subsidiary recognised as an asset in the parent’s
accounts is necessary because, from the group’s perspective as a separate economic entity, the group’s
assets cannot recognise investments in itself. The reason for the elimination of the parent’s share of the
subsidiary’s equity was discussed earlier in this module under the subheading ‘Parent with an equity
interest in a subsidiary’.

262 Financial Reporting

 The pre-acquisition equity balances of the subsidiary not eliminated on consolidation represent the non-
controlling interest in the fair value of the net assets of the subsidiary at the acquisition date and form part
of its equity in the group.
Example 5.15 illustrates the pre-acquisition elimination entry where the parent entity acquires less than
a 100% interest in the subsidiary. The purpose of this example is to demonstrate the key consolidation
principle that the parent entity’s share of equity of the subsidiary at acquisition date must be eliminated
as part of the pre-acquisition elimination entry. This principle is applied both at acquisition date and
in subsequent reporting periods. The amount of pre-acquisition equity of the subsidiary remaining after
this elimination entry is the non-controlling interest’s share of the equity of the group at acquisition date
(ignoring intra-group transactions — to be discussed shortly).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 10, paragraph B86(b).

EXAMPLE 5.15

Non-controlling Interest — Consolidation Pre-acquisition

Elimination Entry
On 1 July 20X2, Parent Ltd (Parent) purchased 70% of the shares of Subsidiary Ltd (Subsidiary) for
$160 000. At the acquisition date, the equity section of Subsidiary contained the following accounts.
$
Issued capital 100 000
Retained earnings 100 000
200 000

Assuming that all the assets and liabilities of Subsidiary recognised prior to the acquisition are identifiable
and are recorded at fair value, the goodwill on consolidation would be calculated as follows.
$
Consideration transferred 160 000
Non-controlling interest (30% of $200 000) 60 000
220 000
Less: Fair value of identifiable net assets (200 000)
Goodwill 20 000

The non-controlling interest in the group at the acquisition date is measured as its share of the fair value
of the identifiable net assets of Subsidiary. Hence, the non-controlling interest equals 30% of $200 000 or
$60 000.
The pre-acquisition entry to eliminate the parent’s share of the subsidiary’s pre-acquisition equity is
presented as follows.

Dr Issued capital 70 000

Dr Retained earnings 70 000
Dr Goodwill 20 000
Cr Investment in Subsidiary 160 000

The following worksheet illustrates this pre-acquisition entry and the allocation of consolidated equity
between the non-controlling interest and parent equity interest. For the purpose of the worksheet it has
been assumed that, at the acquisition date, the equity of Parent was as follows.
$
Issued capital 300 000
Retained earnings 200 000
500 000

MODULE 5 Business Combinations and Group Accounting 263

 Eliminations &
adjustments
Non- Parent
controlling equity-
Parent Subsidiary Dr Cr Consolidated interest interest
Accounts $000 $000 $000 $000 $000 $000 $000
Issued capital 300 100 70 330 30 300
Retained earnings 200 100 70 230 30 200
500 200 560 60 500

Other net assets 340 200 540

Investment in
Subsidiary 160 160 —
Goodwill 20 20
500 200 160 160 560

Notes
• The pre-acquisition entry eliminates the investment account recognised by the parent and the parent
entity’s share of pre-acquisition equity in the subsidiary at the acquisition date, as well as recognising
goodwill on consolidation.
• The amount of the net assets of the group is $560 000, which includes the goodwill of $20 000.
• There are two groups of shareholders who have an interest in the group: the parent shareholders and the
non-controlling interest. At the acquisition date, the parent shareholders’ interest in the consolidated
net assets is the equity of Parent, $500 000. The non-controlling interest’s share of the consolidated
net assets is reflected in its 30% interest in the equity of Subsidiary — that is, 30% of $200 000 or
$60 000. This amount reflects its share of the fair value of the net assets of Subsidiary. Remember,
Parent’s share of the equity of Subsidiary at the acquisition date has been eliminated on consolidation.

QUESTION 5.16

To extend example 5.15, assume that:

(a) during the 20X3 financial year, Parent and Subsidiary recorded profits of $100 000 and
$50 000 respectively
(b) neither company paid, or declared, a dividend during the 20X3 financial year — the increase in
each company’s retained earnings during this year is equal to its 20X3 profit.
Complete the following consolidation worksheet.
Eliminations
& adjustments
Non- Parent
controlling equity
Parent Subsidiary Dr Cr Consolidated interest interest
Accounts $000 $000 $000 $000 $000 $000 $000
Issued capital 300 100
Retained earnings 300 150
600 250
Other net assets 440 250
Investment in
Subsidiary 160
Goodwill
600 250

264 Financial Reporting

 Example 5.15 accounted for the business combination at the acquisition date by applying the acquisition
method in accordance with IFRS 3. That is:
• the identifiable net assets of the subsidiary were measured at their acquisition-date fair values (IFRS 3,
para. 18)
• the non-controlling interest was measured at its proportionate share of the fair value of the subsidiary’s
identifiable net assets at the acquisition date (IFRS 3, para. 19)
• goodwill was measured at the acquisition date as the difference between the fair value of the considera-
tion transferred by the parent plus the non-controlling interest in the subsidiary less the fair value of the
identifiable net assets of the subsidiary (IFRS 3, para. 32).
In example 5.15, the net assets of the subsidiary were measured at fair value on the acquisi-
tion date. Where the net assets of the subsidiary are not measured at fair value at acquisition date,
consolidation adjustment entries are required to achieve this. After accounting for any tax effects by
recognising a deferred tax liability, the after-tax consolidation revaluation is recognised in a business
combination reserve.
In earlier examples, the pre-acquisition entry eliminated the business combination reserve in full, as
the parent owned 100% of the equity of the subsidiary. Where there is a non-controlling interest, the
pre-acquisition entry eliminates the parent’s share of the business combination reserve. The remainder of
the reserve is included in the non-controlling interest’s share of the consolidated equity. That is, at the
acquisition date, the non-controlling interest is equal to its share of the subsidiary’s recorded equity plus
its share of the business combination reserve. This is equal to the non-controlling interest in the fair value
of the identifiable net assets of the subsidiary at the date of the acquisition (IFRS 3, para. 19).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 3, paragraphs 18, 19 and 32. For the purposes of
this module, assume that where a non-controlling interest is involved, the net assets of the subsidiary are measured
at their fair values at the acquisition date.

2. Dividends Paid by Subsidiary

This consolidation adjustment entry will only eliminate the dividend paid/payable within the group
(i.e. by the subsidiary to the parent), as only that represents intra-group dividends. The proportion of
dividend paid/payable by the subsidiary to the non-controlling interest shareholders will not be eliminated
because a party external to the group is involved. Elimination entries 6 and 7 of example 5.17, which
follows shortly, illustrate the elimination entries required where a final dividend is payable by a subsidiary
and there is a non-controlling interest involved.

3. Measurement of Non-controlling Interest

The presentation of any non-controlling interest in the consolidated statement of financial position within
equity is required by paragraph 22 of IFRS 10 and paragraph 54(q) of IAS 1. The non-controlling interest
must be presented separately from the equity of the owners of the parent.
Paragraph 81B of IAS 1 requires the profit or loss and other comprehensive income to be allocated to
the owners of the parent and to the non-controlling interest.
The non-controlling interest in the net assets of consolidated subsidiaries should consist of:
• the amount of the non-controlling interest at the date of the original combination calculated in
accordance with IFRS 3 (i.e. pre-acquisition equity)
• the non-controlling interest’s share of changes in equity since the date of the combination (i.e. post-
acquisition changes in equity).
At acquisition, the non-controlling interest is measured at its share of the fair value of the identifiable
net assets of the subsidiary (one available option in accordance with IFRS 3, para. 19). IFRS 10 does not
indicate how to measure the non-controlling interest’s share of movements in equity. However, the general
principle is that the non-controlling interest should be measured as its portion of the aggregate amount of
the equity of the subsidiaries adjusted for unrealised profits or losses of subsidiaries.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 10, paragraphs 22 and B94.

The rationale for requiring a non-controlling interest to be adjusted for the unrealised profits or losses
of a subsidiary stems from the entity concept of consolidation, which sees a non-controlling interest as an

MODULE 5 Business Combinations and Group Accounting 265

owner in the group. Determining a non-controlling interest focuses on its share of the equity of the group,
not its share of the equity recorded in the financial statements of the subsidiary. The equity of the group
is affected by the elimination of intra-group profits or losses. As such, the calculation of a non-controlling
interest must also be adjusted for unrealised profits or losses relevant to it. To determine which intra-
group transactions affect the measurement of a non-controlling interest, there are two important points
to remember.
First, as a non-controlling interest has an interest in the group via the subsidiary, only intra-group
transactions that affect the subsidiary’s equity require adjustment. Thus, the original intra-group transaction
leading to unrealised profits or losses must have been from the subsidiary. For example, if the subsidiary
sold plant at a profit to the parent, the profit would be reflected in the P/L and retained earnings of the
subsidiary. However, from the group’s perspective, this profit is unrealised and should be eliminated. Thus,
the profit or loss and relevant income and expense items in the financial statements of the subsidiary must
be adjusted for the unrealised profit on the plant to reflect the profit recognised by the group. This adjusted
subsidiary profit then forms the basis of calculation for the non-controlling interest. It is important to
remember that if the intra-group transaction has been a sale of plant from the parent to the subsidiary, there
is no effect on the equity of the subsidiary (only on the equity of the parent), and the non-controlling interest
has no interest in the parent. Therefore, for the intra-group transactions from the parent to the subsidiary,
no adjustments are required to the subsidiary equity-account balances to enable the non-controlling interest
to be calculated.
The second point to note is the requirement to understand which transactions lead to unrealised profits
or losses from the perspective of the group. As previously discussed, unrealised profits or losses only arise
through an intra-group sale of assets such as inventory, plant and land. Profits or losses from the intra-
group sale of those assets are realised by the group when a party external to the group is involved. For
other intra-group transactions (interest and services), it is assumed, from a practical viewpoint, that the
profits or losses are realised immediately as the net effect of those transactions on the consolidated profit
is nil.
In summary, measuring the amount of non-controlling interest in a consolidated equity item involves
applying the relevant non-controlling interest percentage to the book value of the subsidiary equity account
involved, adjusted where relevant for realised/unrealised profits/losses that resulted from a sale of an asset
from the subsidiary to the parent.
Example 5.16 demonstrates the application of this measurement principle where there is an intra-group
sale of inventory resulting in an unrealised profit. Question 5.17, following example 5.16, applies the
measurement principle for non-controlling interests in the subsequent reporting period when the inventory
is sold to parties external to the group and the profit is realised.
Example 5.16 relates to case study 5.3 contained in the ‘Case studies’ section and focuses on the data
for the year ended 30 June 20X4.

EXAMPLE 5.16

Measurement of Non-controlling Interest

Example 5.16 is concerned with measuring the non-controlling interest in the following consolidated items:
opening retained earnings, profit for the year and closing retained earnings.
As the parent owns 70% of the shares in the subsidiary, the non-controlling interest is entitled to 30%
of the subsidiary’s equity as it is reflected in the consolidated equity.
To determine the non-controlling interest in the consolidated opening retained earnings, the starting
point is the opening retained earnings of Subsidiary Ltd (Subsidiary). The next consideration is to
determine whether there have been any transactions that have impacted on the opening retained earnings
of Subsidiary but have been eliminated on consolidation. In case study 5.3, there are no fair value
adjustments for assets or liabilities not recorded at fair value at acquisition date and no unrealised
profits/losses carried forward from the year ended 30 June 20X3. Hence, there is no need to make any
adjustments to the opening retained earnings in the financial statements of Subsidiary.
Non-controlling interest in opening retained earnings account:
= 30% of opening retained earnings balance in financial statements of Subsidiary
= 30% of $40 000
= $12 000
To measure the non-controlling interest in the consolidated profit, the starting point is again the relevant
item in the financial statements of Subsidiary, that is, the profit of Subsidiary. Then, it is necessary to

266 Financial Reporting

 determine whether there have been any transactions that have affected the profit of Subsidiary but have
been eliminated on consolidation.
Case study 5.3 contains three intra-group transactions for the year ended 30 June 20X4. Both the sale
of the inventory from Subsidiary to Parent Ltd (Parent) and the sale of the plant from Parent to Subsidiary
would require the elimination of unrealised profits from the group’s perspective. There is no unrealised
profit on the provision of management services. From Subsidiary’s point of view, the profit on the sale
of inventory is the only one of the three transactions that has impacted on its 20X4 profit but not on the
consolidated profit. Hence, this item should be taken into account when calculating the non-controlling
interest in the consolidated profit. The non-controlling interest has an interest in the consolidated profits
via the profits of Subsidiary, but the profit on the sale of inventory to Parent has been eliminated by the
group. The non-controlling interest can only receive its share of the profit of Subsidiary when it is included
in the consolidated profit of the group.
Non-controlling interest in profit:
= 30% of (Profit in financial statements of Subsidiary – Unrealised after-tax profits made by Subsidiary)
= 30% of (Profit in financial statements of Subsidiary – Unrealised profit on sale of inventory + Tax effect
of unrealised profit)
= 30% of ($200 000 – $40 000 + $12 000)
= 30% of $172 000
= $51 600
As the unrealised profit on the sale of inventory from Subsidiary to Parent has been eliminated from the
consolidated profit, it must have also been eliminated from the consolidated closing retained earnings.
Hence, the unrealised profit must be taken into account when determining the non-controlling interest’s
share of the consolidated closing retained earnings.
Non-controlling interest in closing retained earnings:
= 30% of (Closing retained earnings of Subsidiary – Unrealised after-tax profits made by Subsidiary)
= 30% of (Closing retained earnings of Subsidiary – Unrealised profit on sale of inventory + Tax effect
of unrealised profit)
= 30% of ($140 000 – $40 000 + $12 000)
= 30% of $112 000
= $33 600
An alternative way of reconciling the non-controlling interest in closing retained earnings is by using the
individual items making up the balance:
= Non-controlling interest in opening retained earnings + Non-controlling interest in profit – Non-
controlling interest in dividends
= $12 000 + $51 600 – $30 000 (30% of $100 000)
= $33 600

QUESTION 5.17

Refer to case study 5.3. Using data for the year ended 30 June 20X5, measure the non-controlling
interest in the following: opening retained earnings, profit and closing retained earnings.

.......................................................................................................................................................................................
EXPLORE FURTHER
Digital content, such as videos and interactive activities in the e-text, support this module. You can access this content
on My Online Learning.

Example 5.17 relates to case study 5.4. You may now read the data in case study 5.4 in the ‘Case
studies’ section.
The purpose of example 5.17 is to provide an overview example that demonstrates the application of
the following consolidation principles:
• elimination of the investment in the subsidiary and the parent’s share of the equity of the subsidiary at
acquisition date
• elimination in full of all intra-group assets, liabilities, revenues and expenses including profits or losses
on the transfer of assets within the group
• measurement of non-controlling interest by applying the non-controlling interest percentage to the
carrying amount of the subsidiary equity adjusted for unrealised/realised profits or losses from the sale
of an asset from the subsidiary to the parent.

MODULE 5 Business Combinations and Group Accounting 267

 EXAMPLE 5.17

Comprehensive Consolidation
The first task is to analyse the case study 5.4 data and prepare consolidation elimination entries. The
elimination entries and their rationale are outlined here.
1. On 1 July 20X0, Parent Ltd (Parent) purchased 70% of the issued capital of Subsidiary Ltd (Subsidiary)
for $120 000. An extract from the equity section of the statement of financial position of Subsidiary at
the acquisition date reveals the following.

$
Issued capital 100 000
Retained earnings 50 000
150 000

At the acquisition date, the identifiable net assets of Subsidiary were recorded at fair value. Thus, the
fair value of identifiable net assets at the acquisition date is equal to the value of total equity recorded
in the statement of financial position of Subsidiary (assuming no goodwill previously recorded). The
value of non-controlling interest at acquisition date is calculated based on the proportionate share of
identifiable net assets.
Goodwill on consolidation would be calculated as follows:

$
Fair value of consideration transferred 120 000
Non-controlling interest (30% of $150 000) 45 000
165 000
Less: Fair value of identifiable net assets (150 000)
Goodwill 15 000

In accordance with IFRS 10, paragraph B86(b), the investment in the subsidiary must be eliminated
in full, together with the parent’s share of the subsidiary’s equity. Therefore, the following pre-acquisition
elimination entry (1) is required.

Dr Issued capital 70 000

Dr Retained earnings (opening balance) 35 000
Dr Goodwill 15 000
Cr Investment in Subsidiary 120 000

2. During the financial year ended 30 June 20X1, Parent sold inventory with a cost of $5000 to Subsidiary
for $9000. The inventory was still on hand as at 30 June 20X1.
The entry processed by Parent for the sale of the inventory would be as follows.

Dr Bank 9 000
Dr Cost of goods sold 5 000
Cr Sales 9 000
Cr Inventory 5 000

The entry processed by Subsidiary for the purchase of the inventory would be as follows.

Dr Inventory 9 000
Cr Bank 9 000

From the group’s perspective, these entries do not relate to parties external to the group and, hence,
the effect should not be reflected in the consolidated financial statements. That is, the intra-group sale
and cost of goods sold must be eliminated (which eliminates the profit on the transaction) and the

268 Financial Reporting

 inventory must be restated to the cost to the group. Therefore, the following consolidation elimination
entry (2a) is required.

Dr Sales 9 000
Cr Cost of goods sold 5 000
Cr Inventory 4 000

To explain each line of this entry, the debit to Sales eliminates the credit to Sales recorded by Parent
upon the sale of inventory to Subsidiary. Similarly, the credit to Cost of goods sold eliminates the debit
to Cost of goods sold previously recorded by Parent at the time of sale. The credit to Inventory of
$4000 offsets the ‘net’ debit to Inventory recorded by both Parent and Subsidiary at the time of sale
(i.e. $9000 debit recorded by Subsidiary minus $5000 credit recorded by Parent equals $4000 ‘net’
debit) and makes sure that inventory is recorded at the original cost to the group. No entry is required
for Bank as the debit recorded by Parent at the time of sale has already been offset by the credit
recorded by Subsidiary.
This consolidation elimination entry requires the following tax effect entry (2b).

Dr Deferred tax asset 1 200

Cr Income tax expense 1 200

As the group has eliminated $4000 of unrealised profit (i.e. by debiting Sales of $9000 and crediting
Cost of goods sold of $5000), the income tax expense of the group must be reduced by $1200 (30%
of $4000). As such, the unrealised after-tax profit on sale of inventory is $2800 ($4000 – $1200). The
deferred tax asset of $1200 arises because the tax paid on the intra-group profit by the parent is a
prepayment of tax from the group’s perspective, giving rise to a tax benefit available for the future
(i.e. the group will not have to pay tax again when profit will be realised for the group).
3. Over the financial year, Parent had charged Subsidiary $3000 for services rendered. The services had
not been paid for by the end of the financial year.
Parent processed the following entry for the services rendered.

Dr Trade receivables 3 000

Cr Other income 3 000

Subsidiary processed the following entry for the services received.

Dr Expenses 3 000
Cr Trade payables 3 000

From the group’s perspective, this transaction is an internal one and must be eliminated. Therefore,
the following consolidation elimination entries (3 and 4) are required.

Consolidation elimination entry 3:

Dr Other income 3 000

Cr Expenses 3 000

Consolidation elimination entry 4:

Dr Trade payables 3 000

Cr Trade receivables 3 000

Note: There is no tax effect for these elimination entries, as they do not have any net impact on
the consolidated profit. This is because the amount of ‘Other income’ eliminated equals the amount of
‘Expenses’ eliminated, meaning that the effect of these elimination entries on consolidated profit is nil.

MODULE 5 Business Combinations and Group Accounting 269

 4. On 30 June 20X1, Subsidiary sold plant to Parent for $16 000 at a loss of $4000. The plant had a
remaining useful life of two years with a scrap value of $2000 at the end of that time.
Subsidiary processed the following entry for the sale of the plant.

Dr Bank 16 000
Dr Other income (loss) 4 000
Cr Plant 20 000

Note: The plant was sold for $16 000 at a loss of $4000. The carrying amount of the plant
in Subsidiary’s statements was, therefore, $20 000 (Carrying amount $20 000 – Sale price $16 000 =
$4000 loss).
Parent processed the following entry for the purchase of the plant.

Dr Plant 16 000
Cr Bank 16 000

From the group’s perspective, the intra-group loss on the sale of the plant should be eliminated
and the amount of the plant should be increased to the cost to the group. Therefore, the following
consolidation elimination entry (5a) is required.

Dr Plant 4 000
Cr Other income 4 000

In this entry, the debit to Plant of $4000 offsets the ‘net’ credit to Plant recorded by both Parent and
Subsidiary at the time of sale (i.e. $20 000 credit recorded by Subsidiary minus $16 000 debit recorded
by Parent equals $4000 ‘net’ debit) and brings the Plant to the original carrying amount. The credit to
Other income eliminates the debit to Other income previously recorded by Subsidiary at the time of
sale to recognise the loss. No entry is required for Bank as the debit recorded by Parent at the time of
sale has already been offset by the credit recorded by Subsidiary.
The preceding elimination entry requires the following tax effect entry (5b).

Dr Income tax expense 1 200

Cr Deferred tax liability 1 200

As the group has eliminated the unrealised loss of $4000, the consolidated profit increases and the
income tax expense of the group must be increased by $1200 (30% of $4000). As such, the unrealised
after-tax loss on plant is $2800 ($4000 – $1200). In addition, the group has a deferred tax liability of
$1200. That is, the group does not have to pay the tax itself, but the individual entities will pay it when
their profit does not include this loss. In other words, as a result of the increase in the carrying amount
of Plant in elimination entry (5a), a taxable temporary difference arises and, consequently, gives rise to
a deferred tax liability.
The elimination of an intra-group profit or loss on sale of plant usually also gives rise to a
consolidation depreciation adjustment. However, a depreciation adjustment is not required in this
example because the plant was transferred at the end of the reporting period and, therefore, it was
not yet subject to a depreciation that would have been affected by the intra-group sale. A depreciation
adjustment will be required in the next reporting period when the plant is used by the entity that
purchased it intra-group.
5. On 30 June 20X1, Subsidiary declared a final dividend of $10 000. Parent recognises dividend income
when it is receivable.
Subsidiary processed the following entry for the dividend declared.

Dr Final dividend (retained earnings) 10 000

Cr Final dividend payable 10 000

270 Financial Reporting

 Parent processed the following entry in relation to the dividend declared by Subsidiary.

Dr Dividend receivable 7 000

Cr Dividend income† 7 000
†
Parent owns 70% of the shares in Subsidiary and, therefore, is entitled to 70% of the final
dividend declared by Subsidiary. The remaining 30% is owned by the non-controlling interest
shareholders.

From the group’s perspective, the effects of the intra-group dividend should be eliminated.
Therefore, the following consolidation elimination entries (6 and 7) are required.

Consolidation elimination entry 6:

Dr Dividend income 7 000

Cr Final dividend (retained earnings) 7 000

Consolidation elimination entry 7:

Dr Final dividend payable 7 000

Cr Dividend receivable 7 000

There are no tax consequences for these consolidation elimination entries related to the dividend
because the dividend is tax-free to Parent, and the income tax expense of Parent will reflect this. Note
that entry 7 does not eliminate the non-controlling interest’s share in the dividend (i.e. 30% × $10 000
= $3000) because this relates to shareholders external to the group.
After determining the consolidation elimination entries for this comprehensive example that were
discussed on the preceding pages, these can now be processed in the consolidation worksheet.
The following consolidation worksheet is prepared and includes the non-controlling interest allocation
(the calculation of non-controlling interest is discussed after the worksheet). The financial statement
amounts of Parent and Subsidiary are pre-determined. Notes in the worksheet refer to the numbered
consolidation elimination entries in bold that were discussed in the preceding pages.

Eliminations
& adjustments
Non- Parent
controlling equity-
Parent Subsidiary Dr Cr Consolidated interest interest
Accounts $000 $000 $000 $000 $000 $000 $000
Sales 320 95 9(2a) 406†
Less: Cost of
goods sold (150) (35) 5(2a) (180)
Gross profit 170 60 226
Less: Expenses (80) (16) 3(3) (93)
90 44 133
Dividend income 7 7(6) —
Other income 3 (4) 3(3) 4(5a) —
Profit before tax 100 40 133
Less: Income tax
expense (30) (12) 1.2(5b) 1.2(2b) (42)
Profit for the year 70 28 91 9.24 81.76
Retained earnings
1 July 20X0 220 50 35(1) 235 15 220
290 78 326 24.24 301.76

MODULE 5 Business Combinations and Group Accounting 271

 Eliminations
& adjustments
Non- Parent
controlling equity-
Parent Subsidiary Dr Cr Consolidated interest interest
Accounts $000 $000 $000 $000 $000 $000 $000
Less: Final
dividend (20) (10) 7(6) (23) (3) (20)
Retained earnings
30 June 20X1 270 68 303 21.24 281.76

Issued capital 400 100 70(1) 430 30 400

Total equity 733 51.24 681.76
Liabilities
Trade payables 20 11 3(4) 28
Final dividend
payable 20 10 7(7) 23
Other 84 50 134
Deferred tax
liability 1.2(5b) 1.2

Total equity and

liabilities 794 239 919.2
Current assets
Dividend
receivable 7 7(7) —
Trade
receivables 35 14 3(4) 46
Inventory 60 25 4(2a) 81
Other 100 30 130
Non-current
assets
Plant (net) 250 100 4(5a) 354
Other 222 70 292
Investment in
Subsidiary 120 120(1) —
Goodwill 15(1) 15
Deferred tax
asset 1.2(2b) 1.2
Total assets 794 239 155.4(2a) 155.4 919.2

†
Parent’s sales of $320 000 + Subsidiary’s sales of $95 000 – Elimination (debit) of $9000 = Consolidated sales of
$406 000. This approach is applicable throughout the worksheet based on normal debit and credit rules.
Calculation of Non-controlling Interest
• Non-controlling interest in Subsidiary’s opening retained earnings:
= 30% of opening retained earnings balance in financial statements of Subsidiary
= 30% of $50 000
= $15 000
The opening retained earnings of Subsidiary represents the balance of this item at the acquisition
date. No intra-group transactions from Subsidiary to Parent had taken place.
• Non-controlling interest in Subsidiary’s profit after tax for the year (adjusted for profit or loss on intra-
group transactions):
= 30% of (Profit for the year in financial statements of Subsidiary – (+) Unrealised after-tax profits (losses)
made by Subsidiary + (–) Realised after-tax profits (losses) made by Subsidiary)
= 30% of (Profit for the year in financial statements of Subsidiary + Unrealised after-tax loss on plant)
= 30% of ($28 000 + ($4000 – $1200))
= 30% of $30 800
= $9240
Remember that the measurement of non-controlling interest involves applying the relevant
non-controlling interest percentage to the carrying amount of the subsidiary equity adjusted for un-
realised/realised profits/losses that resulted from a sale of an asset from the subsidiary to the parent. For

272 Financial Reporting

 the comprehensive example, the relevant non-controlling interest percentage is 30%. The focus is on
the non-controlling interest share of profit and, therefore, the appropriate starting point is the profit
for the year in the financial statements of the subsidiary ($28 000).
However, the profit of Subsidiary includes the after-tax loss on the sale of the plant by Subsidiary
to Parent. From the group’s perspective, this was an internal transaction and the unrealised loss and
associated tax effects were eliminated (refer to entries 5a and 5b in the consolidation worksheet). As the
group has not recognised the loss (net of tax), the non-controlling interest should not be allocated a share
of this item. The profit of Subsidiary is adjusted by adding back the unrealised loss and eliminating the
associated tax effects that resulted from the sale of the plant by Subsidiary to Parent.
Note: Even though the intra-group sale of inventory is reflected in the statement of financial position
of Subsidiary, Parent recorded the profit on the sale. Hence, the non-controlling interest shareholders of
Subsidiary have no interest in this profit or its elimination.
• Non-controlling interest in Subsidiary’s closing retained earnings:
This amount can be calculated in two ways:
1. The calculations of the individual items making up the closing balance of retained earnings:
= Non-controlling interest in Subsidiary’s opening retained earnings + Non-controlling interest in
Subsidiary’s profit after tax (adjusted for profit or loss on intra-group transactions) – Non-
controlling interest in final dividend declared by Subsidiary:
= $15 000 + $9240 – (30% of $10 000)
= $15 000 + $9240 – $3000
= $21 240
2. Using the closing balance of the retained earnings of Subsidiary – (+) Any after-tax unrealised profits
(losses) made by Subsidiary:
= 30% of ($68 000 + ($4000 – $1200))
= 30% of ($68 000 + $2800)
= 30% of $70 800
= $21 240
The loss on the sale of the plant by Subsidiary to Parent is included in the closing retained earnings
balance of Subsidiary via Subsidiary’s profit. The loss is unrealised from the group’s point of view.
Therefore, determining the non-controlling interest in the closing retained earnings of the group by
starting with the closing balance of the retained earnings of Subsidiary requires an adjustment (add-
back) for the unrealised loss, net of the tax effect.
• Non-controlling interest in Subsidiary’s issued capital:
= 30% of $100 000
= $30 000
• Non-controlling interest in statement of financial position:
= Non-controlling interest in Subsidiary’s issued capital (refer to prior calculation) + Non-controlling
interest in Subsidiary’s closing retained earnings (refer to prior calculation) + Non-controlling
interest in Subsidiary’s reserves
= $30 000 + $21 240 + $0
= $51 240
Note that as the net assets of Subsidiary were recorded at fair value, there is no business combination
reserve. If there was, the non-controlling interest share of this item would also have to be taken into
account.

QUESTION 5.18

Question 5.18 extends example 5.17. One year later, on 30 June 20X2, the following information and
worksheet data were available for Parent and Subsidiary.
Required
(a) Complete the consolidation worksheet. (Note: Remember to use any relevant information
relating to the 20X1 year from the comprehensive example (example 5.17).
(b) Explain how the non-controlling interest was arrived at.
Additional information
1. During the financial year ended 30 June 20X2, half of the inventory sold by Parent to Subsidiary in
the previous financial year was sold to parties external to the group. On 15 June 20X2, Subsidiary
sold inventory to Parent for $8000 that had cost $4000. Parent still had this inventory on hand at
the end of the financial year.
2. Over the financial year, Parent had charged Subsidiary $4000 for services rendered; $1000 of the
services had not been paid for by the end of the financial year.

MODULE 5 Business Combinations and Group Accounting 273

 3. The plant sold by Subsidiary to Parent on 30 June 20X1 was depreciated by $7000 in the financial
statements of Parent during the 20X2 financial year. That is, a straight-line basis of depreciation
was adopted.
4. During the financial year, Subsidiary paid an interim dividend of $10 000. On 30 June 20X2,
Subsidiary declared a final dividend of $10 000. Parent recognises dividend income when it
is receivable.
5. The directors of Parent and Subsidiary decided to transfer $20 000 and $10 000 respectively from
their respective pre-acquisition retained earnings to a general reserve.
6. Assume a tax rate of 30%.
Eliminations &
adjustments
Non- Parent
controlling equity-
Accounts Parent Subsidiary Dr Cr Consolidated interest interest
$000 $000 $000 $000 $000 $000 $000
Sales 400 150
Less: Cost of
goods sold (210) (70)

Gross profit 190 80

Less: Expenses (88) (30)
102 50
Dividend income 14 —
Other income 4 —
Profit before tax 120 50
Less: Income tax
expense (36) (15)
Profit for the year 84 35
Retained earnings
1 July 20X1 270 68
354 103
Less:
Interim dividend (10) (10)
Final dividend (20) (10)
Transfer to
general reserve (20) (10)

Retained earnings
30 June 20X2 304 73
Issued capital 400 100
General reserve 20 10
Total equity 724 183
Liabilities
Trade payables 25 15
Final dividend
payable 20 10
Other 79 52
Deferred tax
liability
Total equity and
liabilities 848 260
Current assets
Dividend
receivable 7
Trade 40 18
receivables
Inventory 65 22
Other 171 60

274 Financial Reporting

 Non-current
assets
Plant (net) 230 90
Other 215 70
Investment in
Subsidiary 120
Goodwill
Deferred tax
asset
Total assets 848 260

5.9 DISCLOSURES: CONSOLIDATED

FINANCIAL STATEMENTS
To conform with the requirements of IAS 1, paragraph 10, consolidated financial statements would
comprise the following five items.
1. Consolidated statement of financial position
2. Consolidated statement of profit or loss and other comprehensive income
3. Consolidated statement of changes in equity
4. Consolidated statement of cash flows (in accordance with IAS 7 Statement of Cash Flows)
5. Notes including accounting policies and explanatory notes

CONSOLIDATED STATEMENT OF FINANCIAL POSITION

Consistent with the entity concept, a consolidated statement of financial position should recognise all
the assets and liabilities under the control of the group, and any non-controlling interest (if relevant) has
to be displayed as part of equity. As discussed previously, IFRS 10 requires the consolidated statement
of financial position to separately recognise the equity attributable to the owners of the parent and that
attributable to the non-controlling interest (IFRS 10, para. 22). The consolidated statement of financial
position should comply with the disclosure requirements of IAS 1, paragraph 54.
.......................................................................................................................................................................................
EXPLORE FURTHER
Before continuing, if you wish to explore this topic further, you may read:
• IFRS 10, paragraph 22
• IAS 1, paragraph 54 to review the disclosures required in a statement of financial position
• the example of a consolidated statement of financial position in part I of the ‘Guidance on implementing IAS 1
Presentation of Financial Statements’ section of IAS 1 (in the IFRS Compilation Handbook).

CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND

OTHER COMPREHENSIVE INCOME
IAS 1 requires a complete set of financial statements to include a statement of P/L and OCI (IAS 1,
para. 10). A consolidated statement of P/L and OCI must present both the components of the profit or
loss and the components of other comprehensive income (IAS 1, paras 82 and 82A). IAS 1 also requires
the statement of P/L and OCI to disclose both the non-controlling interests share and the owners of the
parent share of:
• profit or loss for the period
• total comprehensive income for the period (IAS 1, para. 81B).

MODULE 5 Business Combinations and Group Accounting 275

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read:
• IAS 1, paragraphs 81A, 81B, 82 and 82A to review the disclosures required for a statement of P/L and OCI
• the examples of a consolidated statement of P/L and OCI in part I of the ‘Guidance on implementing IAS 1
Presentation of Financial Statements’ section of IAS 1 (note the non-controlling interest disclosures) (in the IFRS
Compilation Handbook).

CONSOLIDATED STATEMENT OF CHANGES IN EQUITY

Changes in the group’s equity during the reporting period should be presented in a consolidated statement
of changes in equity that complies with the disclosure requirements of IAS 1, paragraphs 106, 106A and
107. The statement of changes in equity must present the total comprehensive income and the amounts
attributable to the non-controlling interests and the owners of the parent (IAS 1, para. 106(a)).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read:
• IAS 1, paragraphs 106 and 107 to review the disclosures required for a statement of changes in equity
• the examples of a consolidated statement of changes in equity in part I of the ‘Guidance on implementing IAS 1
Presentation of Financial Statements’ section of IAS 1 (note the non-controlling interest disclosures) (in the IFRS
Compilation Handbook).

QUESTION 5.19

Refer to the worksheet prepared in answering question 5.18 and the information in example 5.17 to
prepare the following statements in accordance with the disclosure requirements of IAS 1.
(a) Prepare a consolidated statement of P/L and OCI.
(b) Prepare a consolidated statement of changes in equity.
(c) Prepare a consolidated statement of financial position.

CONSOLIDATED STATEMENT OF CASH FLOWS

Another financial statement the group is required to prepare is a consolidated statement of cash flows.
This will have to be prepared in accordance with IAS 7. The preparation of the consolidated statement of
cash flows should follow a similar approach to that shown for the consolidated statement of profit or loss
and other comprehensive income. However, instead of entries to eliminate income and expenses, it may be
necessary to eliminate certain cash flow amounts from intra-group cash transactions. For example, cash
receipts from customers and cash payments to suppliers relating to an intra-group sale of inventory.

NOTES INCLUDING ACCOUNTING POLICIES AND

EXPLANATORY NOTES
In addition to the disclosures required by IAS 1, IFRS 12 requires entities to disclose information about
interests in subsidiaries. The general objective of IFRS 12 is to help financial statement users to assess:
(a) the nature of, and risks involved with, [an entity’s] interests in other entities; and
(b) the effects of those interests on the entity’s financial position, financial performance and cash flows
(IFRS 12, para. 1).

To satisfy the objective of IFRS 12, entities with an interest in a subsidiary must disclose information
that focuses on:
• significant judgments and assumptions in determining that control exists over the other entity (IFRS 12,
paras 7–9)
• the composition of the group and the interests that non-controlling interests have in the group’s activities
and cash flows (IFRS 12, paras 10(a) and 12)
• details of any restrictions on the entity being able to access or use the group’s assets or settle its liabilities
(IFRS 12, paras 10(b)(i) and 13)

276 Financial Reporting

 • the consequences of changes in the entity’s ownership interest in a subsidiary which did not lead to a
loss of control (IFRS 12, paras 10(b)(iii) and 18)
• the consequences of the entity losing control of a subsidiary (IFRS 12, paras 10(b)(iv) and 19).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 12, paragraphs 1, 7–13, 18 and 19.

SUMMARY
IFRS 10 specifies the requirements for the preparation of consolidated financial statements based on
the underlying principle to present the financial performance, position and the financing and investing
activities of a group (comprising the parent entity and all of its subsidiaries) as a separate economic entity.
Consolidated financial statements are prepared by aggregating the financial statements of entities
comprising the group. This aggregation process may involve a number of adjustments including:
• adjusting the financial statements of individual entities where they have been prepared using dissimilar
accounting policies or reporting periods ending on different dates
• elimination of pre-acquisition equity balances (after revaluation of subsidiary assets to fair value) of a
subsidiary where the parent entity has an ownership interest in the subsidiary
• elimination of the effects of all transactions between all entities within the group.
Where a parent entity has less than 100% ownership in its subsidiaries, the non-controlling interest must
be measured by aggregating its proportionate share in the equity of the subsidiaries after adjusting for the
unrealised profits or losses of the subsidiaries.
The disclosure requirements for consolidated financial statements are contained in:
• IAS 1
• IFRS 10, paragraph 22 — non-controlling interests
• IFRS 12 — additional disclosures apart from the financial statements.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

5.1 Identify a business combination, discuss the forms that it may take and analyse issues relating
to different business combinations.
• IFRS 10 establishes the principles for the preparation and presentation of financial statements of a
group when an investment by the investor in another entity creates a parent–subsidiary relationship.
• The purpose of consolidated financial statements is to disclose the financial performance, financial
position and cash flows of a group of interrelated entities that operate as a single economic entity
(but not a single legal entity).
• The consolidated financial statements show how the group is impacted by transactions with
other entities. That is, the effects of intra-group transactions are eliminated from the consolidated
financial statements.
• Consolidated financial statements should regard the group of entities as a separate economic entity
for which the investment and transactions within the group are not considered to have an impact on
its financial performance, financial position and cash flows.
5.4 Explain the concept of control and analyse specific scenarios to outline how the existence of
control is determined.
• ‘Control’ is the main criterion that specifies the existence of a group.
• In order for the investor to be considered to have control over the investee, all three essential criteria
of control must be satisfied:
1. power over the investee
2. exposure, or rights, to variable returns from its involvement with the investee, and
3. the ability to use its power over the investee to affect the amount of the investor’s returns.
5.5 Explain and prepare consolidation worksheet entries, including the revaluation of assets subject
to depreciation and transactions within the group.
• Consolidated financial statements are prepared by aggregating the financial statements of each of
the entities in the group, subject to a series of adjustments required by IFRS 10. This is carried
out using a consolidation worksheet. The worksheet adjustments are necessary to refocus the
accounting entity perspective from the individual entities (the initial data) to the group as a separate

MODULE 5 Business Combinations and Group Accounting 277

 entity (the consolidated financial statements). The worksheet is separate from the records of the
individual entities and the financial statements of the individual entities will not be affected by it.
• The initial stage of the consolidation process involves adjusting the financial statements of the
individual entities where they have not been prepared on a common basis. That is, adjustments are
required when the entities have used dissimilar accounting policies and/or reporting period ending
dates.
• The second stage combines the financial statements of the individual entities in order to present
the information as it would have been prepared for a single economic entity. This requires adjust-
ments for:
– pre-acquisition entries where:
– the parent entity holds an equity interest in a subsidiary, recognised in an investment account
in the parent’s financial statement
– the subsidiary’s identifiable assets or liabilities were not recorded at fair value at acquisition date
in the subsidiary’s accounts and they still exist as at the beginning of the current period, and
– post-acquisition entries where:
– transactions have taken place between members of the group and their financial effects are
still recognised in the assets, liabilities, income or expenses of the individual entities during the
current period – adjusting for intra-group transactions.
5.6 Explain the concept of ‘non-controlling interest’ and prepare a consolidation worksheet that
includes the appropriate adjustment entries and allows for non-controlling interests.
• IFRS 10 uses the entity concept of consolidation which involves the following important features.
– All assets, liabilities, income and expenses of a similar nature in the financial statements of entities
within the group are combined, subject to any required consolidation adjustments.
– The effects of transactions within the group are eliminated in full.
– The non-controlling interest is classified as an equity participant in the group.
– The non-controlling interest is calculated using the respective proportionate interest in the equity of
the subsidiary after making adjustments for unrealised profits and losses of the subsidiary arising
from intra-group transactions.
5.7 Explain and apply the disclosure requirements of both IAS 1 Presentation of Financial Statements
for consolidated financial statements and IFRS 12 Disclosure of Interests in Other Entities for
interests in subsidiaries, associates and joint arrangements.
• IFRS 10 requires the consolidated financial statements to separately recognise the equity attributable
to the owners of the parent and that attributable to the non-controlling interest.
• Additional disclosure requirements regarding interests in subsidiaries are set out in IFRS 12
Disclosure of Interests in Oher Entities.

278 Financial Reporting

PART C: INVESTMENTS IN ASSOCIATES
INTRODUCTION
Part C is concerned with accounting for investments in other entities that do not lead to control, but
provide the investor with significant influence over the investee. Significant influence is defined in
IAS 28, paragraph 3 as ‘the power to participate in the financial and operating policy decisions of the
investee but is not control or joint control of those policies’. The investee in this type of relationship is
known as an associate. The equity method was developed to account for such investments, and it involves
recognising the investor’s share of the post-acquisition change in net assets (i.e. equity) of the associate.
As such, it provides more information than just recognising the investment based on cost, but less than
what would be provided if the consolidation method were used. The equity method is often referred to as
a ‘one-line consolidation’ method because the entries prepared (to recognise the investor’s share of the net
assets of the associate at acquisition date and any changes thereof) are recorded to recognise a single asset
(investment in associate) in its statement of financial position, with many of the procedures used mirroring
the consolidation procedures described in IFRS 10 (but without being entirely consistent with them —
more on that later). Moreover, the profit or loss of the investor includes its share of the profit or loss of the
investee (presented as a line item of income), and the OCI of the investor includes its share of OCI of the
investee (presented as a line item of OCI).
IAS 28 prescribes how to account for investments in associates using the equity method (IAS 28,
para. 1). IFRS 12 specifies the disclosure requirements where an entity has an interest in an associate. These
accounting standards will be addressed in this section from the perspective of the underlying principles
applicable when accounting for investments in associates.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read the IAS 28 CPA/Grant Thornton Factsheet (available
at https://www.grantthornton.com.au/globalassets/1.-member-firms/australian-website/technical-publications/ifrs/
gtal_2016_factsheet-ias28-investments-in-associates-and-joint-ventures.pdf) which expands on this discussion.
You may also wish to read IAS 28, paragraph 11, which outlines the rationale for using the equity method to provide
additional information to financial statements users where an investor has significant influence or joint control over
another entity.

Relevant Paragraphs
To assist you in achieving the objectives specified in this module, you may wish to read these paragraphs.
Where specified, you need to be able to apply the following paragraphs of IAS 28 and IFRS 12.

Subject Paragraphs
IAS 28 Investments in Associates and Joint Ventures
Objective 1
Scope 2
Definitions 3–4
Significant influence 5–9
Equity method 10–15
Application of the equity method 16–39
IFRS 12 Disclosure of Interests in Other Entities
Objective 1–4
Significant judgements and assumptions 7–9
Interests in joint arrangements and associates 20–23
Appendix B: Application guidance B12, B14–B16

In addition, you must be familiar with and, where appropriate, able to apply IFRS 3, paragraphs 32–40.

5.10 IDENTIFYING ASSOCIATES

If an investor has the power to take part in decisions regarding the financial and operating policies of
the investee, but it doesn’t control the investee, it is said to have significant influence over the investee
(IAS 28, para. 3). Importantly, it is the power to participate, regardless of whether it is active participation
or a passive investment. To recognise the close relationship that exists in this situation between the investor
and the investee, the investee is identified as being an associate of the investor.

MODULE 5 Business Combinations and Group Accounting 279

 IAS 28, paragraphs 5–9 expand on the principle captured in this definition by providing guidance for
the determination of whether an investor has significant influence over an investee.
Significant influence would normally stem from the investor having 20% or more of the voting power,
unless it can be clearly demonstrated that significant influence is not held by the entity (IAS 28, para. 5).
As significant influence is distinct from control and control normally exists when the investor has 50% or
more of the voting power, it follows that significant influence normally requires a voting power between
20% and 50%. It is important to note that the 20% test, as with the whole question of determining whether
significant influence exists, should be decided in light of all prevailing circumstances. That is, substance
should prevail over form. Significant judgments and assumptions made in determining whether significant
influence exists must be disclosed in accordance with IFRS 12, paragraph 7(b).
Even though the investor may hold more than 20% of the voting power, the absence of significant
influence may stop the investor from gaining board representation, thereby denying participation in the
decision-making processes of the investee. Likewise, the investor may have significant influence but still
not hold 20% of the voting power. As an example, voting power may be widely distributed among other
equity holders, allowing the investor sufficient command to influence the election of directors (similar to
the situation discussed in the context of factors influencing control in part B). Alternatively, significant
influence may exist because the investor is a major supplier of essential technical information.
Finally, in some situations, an entity owns share options or other instruments that are convertible into
ordinary shares, or has similar instruments, which, if exercised or converted, would increase the entity’s
voting power, or reduce another entity’s voting power, over the financial and operating policies of another
entity.
Therefore, when assessing whether an entity has significant influence, the existence and effect of such
potential voting rights should be taken into account. However, this assessment will only take into account
potential voting rights that are presently exercisable or presently convertible (IAS 28, para. 7). Potential
voting rights that cannot be exercised or converted until a future date should not be taken into account.
Consideration of potential voting rights in determining significant influence requires judgment, although
this does not extend to determining:
• management’s intention to exercise or convert the financial instrument
• the financial ability of the entity to exercise or convert the financial instrument (IAS 28, para. 8).
IAS 28, paragraph 6 lists some of the other factors that, singly or in combination, may indicate that the
investor has significant influence, including:
• representation on the board of directors or equivalent governing body of the investee;
• participation in policy making processes . . .;
• material transactions between the entity and its investee;
• interchange of managerial personnel; or
• provision of essential technical information (IAS 28, para. 6).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read:
• the definitions of ‘associate’ and ‘significant influence’ contained in IAS 28, paragraph 3
• IAS 28, paragraphs 5–9.
In addition, you may also wish to read IFRS 12, paragraphs 7–9, which deal with the disclosure of significant
judgments and assumptions made in determining significant influence.

QUESTION 5.20

Comment on whether the following accounting policy is in accordance with IAS 28:
Associates are those entities in which the group has a shareholding between 20% and 50% of
the issued capital.

5.11 USE OF EQUITY METHOD

IAS 28, paragraph 16 requires an investment in an associate to be accounted for using the equity method,
subject to the exemptions specified in paragraphs 17–19.

280 Financial Reporting

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IAS 28, paragraphs 17–19.

It should also be noted that if the investor does not prepare consolidated financial statements (because it
does not have investments in subsidiaries), then the investment in the associate is accounted for using the
equity method in the only financial statements that the investor has to prepare (i.e. their own). However,
if the investor is a parent for some subsidiaries and therefore prepares consolidated financial statements,
the investment account in the associate should appear in the consolidated financial statements as if the
equity method of accounting was applied to account for it. This implies that the investment account may
be recognised under another method (e.g. cost method) in the individual accounts of the investor and, on
consolidation, adjustments will be posted to adjust the accounts impacted so that they reflect the investment
as it would have been accounted for using the equity method.
This module assumes that the investor prepares consolidated financial statements and applies the equity
method for associates in those financial statements. In addition, the module assumes that the investor
accounts for the investment in the associate in its own financial statements using the cost method.

5.12 BASIS OF EQUITY METHOD

The focus of part C of this module is the equity method, which involves recognising the investment in the
associate originally at cost and then adjusting its carrying amount for the investor’s share of any changes
post-acquisition in the associate’s equity, including changes that result from the associate’s profit or loss,
dividends and other comprehensive income (IAS 28, para. 3).
Note: The investment in an associate in the manner described here will usually give rise to a taxable
temporary difference post-acquisition between the carrying amount of the investment (that will be
increased by the investor’s share of post-acquisition increases in the equity of the investee) and its tax
base (often its original cost). This module does not deal with any deferred tax liability that arises for the
investment in an associate.
Prior to discussing in detail the application of the equity method, it is appropriate to briefly consider the
methodology underlying the equity method. This is done in the following paragraphs by comparing it to
the cost method.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IAS 28, paragraph 10, which briefly discusses ‘the equity
method’.

There are two key differences between accounting for an investment using the cost method versus the
equity method.
First, the cost method recognises the investment as an asset in the investor’s accounts based on the
amount originally invested in the associate, while the amount recognised under the equity method for the
investment asset is the amount originally invested plus the investor’s share of all undistributed profits or
losses and OCI in the periods after acquisition (i.e. items that essentially cause changes in the investee’s
equity). OCI includes items such as changes in revaluation surpluses, or exchange difference gains and
losses on translating the financial statements of a foreign operation.
The second key difference between accounting for an investment using the cost method and the equity
method is that, under the cost method, dividends received by the investor from the investee will be treated
as dividend income, while when applying the equity method, they form part of calculating the changes in
the investee’s equity that will impact on the carrying amount of the investment, as already discussed.
These differences illustrate that the focus of the equity method is on the investor’s share of, and changes
in, the equity (net assets) of an associate. By using the equity method, the equity investment is measured
at the cost of acquisition plus the investor’s share of post-acquisition changes in the equity (net assets) of
the associate.
The previous discussion also helps identify the reasons for the equity method being the preferred method
in accounting for an equity investment that brings significant influence over an investee. First of all, as the
investor has significant influence over the investee, the investor is entitled to a share of the performance
(i.e. post-acquisition profits) of the investee, which should increase the investor’s overall performance.

MODULE 5 Business Combinations and Group Accounting 281

The equity method, as opposed to the cost method, requires the investor to recognise its share of the
associate’s performance and, therefore, helps provide more informative disclosures about the investor’s
own performance. Only recognising the investor’s share of the investee’s profits distributed via dividends
(according to the cost method) may not adequately reflect the investee’s performance that should be
allocated to the investor. For example, if the associate does not declare any dividends, it does not mean
that the investor cannot benefit from the performance of the associate.

EXAMPLE 5.18

Comparison of Cost Method and Equity Method

Assume that Investor Ltd (Investor) purchased 30% of the issued capital of Investee Ltd (Investee) for
$30 000 on 1 July 20X1. At that date, the statement of financial position of Investee was as follows.

$ $
Issued capital 50 000
Net assets 100 000 Retained earnings 50 000
100 000 100 000

The net assets of Investee (assuming all are identifiable) were measured at their fair value. Therefore,
the consideration paid by Investor equalled its share of the identifiable net assets (i.e. 30% × $100 000)
and no goodwill was purchased. In the financial statements of Investor, the asset ‘Investment in Investee’
would be recorded at $30 000.
Assume a tax rate of 30%.
The statement of P/L and OCI of Investee for the financial year ended 30 June 20X2 revealed:
• a profit of $50 000
• a dividend payment of $15 000
• OCI of $7000 after tax relating to the revaluation of a non-current asset by $10 000 (the revaluation
reflects an increase in the fair value of a non-current asset since 1 July 20X1 and will be accumulated
in revaluation surplus).
The statement of financial position of Investee as at 30 June 20X2 revealed the following.

$ $
Issued capital 50 000
Retained earnings 85 000†
Net assets 142 000‡ Revaluation surplus 7 000
142 000 142 000

†
$50 000 + $50 000 (profit) – $15 000 (dividend) = $85 000.
‡
$100 000 + $50 000 (profit) – $15 000 (cash dividend) + $10 000 (revaluation) – $3000 (deferred tax liability related to
the revaluation).

If Investor accounted for the investment in Investee using the cost method, two items would be
recognised in the financial statements of Investor for the financial year ended 30 June 20X2:
1. an asset, ‘Investment in Investee’, of $30 000
2. a dividend income of $4500 (30% of $15 000).
In contrast, the focus of the equity method is on the investor’s share of post-acquisition changes in
equity (net assets) of the associate. At 30 June 20X2, Investor’s 30% share of the net assets of Investee
of $142 000 is $42 600, and under the equity method, that is the amount that should be recognised by
the investor in the ‘Investment in Investee’ account. Another way of deriving this amount is to view the
calculation in the following manner.

$
Opening investment 30 000
Add: Share of profit 15 000
Share of other comprehensive income (asset revaluation) 2 100
47 100
Less: Share of dividend received (4 500)
42 600

The original investment of $30 000 represents Investor’s payment for 30% of the net assets/equity of
Investee at the acquisition date (issued capital $50 000 and retained earnings of $50 000). Changes in the

282 Financial Reporting

 equity/net assets of Investee since that date are reflected in changes to retained earnings and reserves.
Therefore, Investor’s share of these changes is reflected in the equity-accounted amount of its investment
in Investee.
Note: All the changes in the investee’s post-acquisition profits, losses and other comprehensive income
are considered after the tax effect as only the after-tax changes in those items affect the investee’s equity.
Journals to adjust the measurement of the investment from the cost basis to the equity basis are as
follows.

Dr Investment in associate 17 100

Cr Share of associate’s profit 15 000
Cr Share of associate’s OCI 2 100

Dr Dividend income 4 500

Cr Investment in associate 4 500

Example 5.18 illustrates that the underlying principle of the equity method is to measure the
investor’s share of post-acquisition changes in the equity of the associate. Further, changes to the
amount of the equity-accounted investment from the amount originally recognised at acquisition can be
explained through the post-acquisition changes in equity (net assets) in the associate. The three principal
changes are:
1. the profit or loss for the reporting period
2. payment of dividends (which decrease equity/net assets)
3. changes in the investee’s equity that have been included in the investee’s other comprehensive income
(e.g. revaluations in assets from their fair value at acquisition).
.......................................................................................................................................................................................
EXPLORE FURTHER
You may find it helpful to re-read IAS 28, paragraph 10 to confirm this discussion. In addition, you may also wish to
read paragraph 11, which outlines the rationale for implementing the equity method.

5.13 APPLICATION OF THE EQUITY METHOD

BASIC FEATURES
The equity method displays the following basic features:
• the initial investment is brought to account at cost (any goodwill on acquisition is not separately disclosed
as it is included in the cost)
• the investment carrying amount is adjusted for the investor’s share of associate post-acquisition profits
and losses (to recognise the future economic benefits that may manifest in dividends paid by the investee
to the investor)
• the investor’s share of associate post-acquisition profits and losses is also recognised in the investor’s
profit or loss (as the investor has the power to participate in the associate’s decision making, it is
considered that they are entitled to account for their equity interest in the profit obtained by the associate)
• the investment carrying amount is reduced by all dividends received or receivable from the associate (as
the economic benefits from the profits of the associate are received)
• the investment carrying amount is also adjusted for the investor’s share of post-acquisition changes in
the associate’s other comprehensive income after tax (which will be reflected in the equity (net assets)
of the associate).
The investor’s share of associate post-acquisition profits and losses is not based on the associate post-
acquisition profits and losses as they are recorded in the associate’s accounts. The recorded profits and
losses are subject to a series of adjustments before they can be allocated to the investor. These may include
adjustments for:
• cumulative preference dividends
• the identifiable assets and liabilities of the associate not recorded at fair value at acquisition date
• inter-entity transactions between the associate and the investor or any other associate or subsidiary of
the investor.

MODULE 5 Business Combinations and Group Accounting 283

 Where an associate has cumulative preference shares held by parties other than the investor, the
dividends attached to these shares must be deducted from the profit of the associate for the year when
calculating the investor’s share of associate profits. This applies irrespective of whether the dividends
have been declared by the associate (IAS 28, para. 37). That is because these dividends will have to be
paid eventually from the profits of the associate, and therefore, the part of these profits that is related
to those dividends will not be available to be allocated to the investor. For example, let’s assume that
A Ltd (A) acquired 30% of the ordinary share capital of B Ltd (B) and B is considered to be an associate
of A. B has cumulative preference shares (not owned by A) that are entitled to total annual dividends of
$10 000. The profit after tax of B for the year ended 30 June 20X2 was $50 000. In these circumstances,
the investor’s share of investee post-acquisition profits will be $12 000 (i.e. 30% × ($50 000 − $10 000)).
Adjustments to the associate’s profit or loss before it is allocated to the investor may need to include
adjustments for the associate’s identifiable assets that were not recorded at fair value at acquisition date.
That is because the investor’s profit post-acquisition may be overstated/understated when those identifiable
assets are sold or depreciated and the fair value increments/decrements are realised in full or partially. For
example, if the associate had some inventory undervalued by $10 000 at acquisition date (i.e. its carrying
amount was $40 000, while the fair value is $50 000) that it sold in the period after acquisition for $80 000,
the associate’s profit would include profit from the sale of inventory of $40 000 (i.e. $80 000 − Carrying
amount of $40 000). However, this profit would be overstated from the investor’s perspective as from its
point of view, the profit should be $30 000 (i.e. $80 000 − Fair value of $50 000). Therefore, the investor
would need to adjust the associate’s profits for the fair value increment at acquisition date of $10 000 before
recognising its share as part of the carrying amount of the investment and its own profits.
Inter-entity transactions involving assets transferred among the investor, its associates or subsidiaries
may generate profits or losses that are recognised in the recorded profits of the associate or the investor.
However, to the extent that those assets are still held at the end of the period by the entities participating
in these transactions, the profits are considered unrealised from the investor’s perspective, just like
the profits from intra-group transactions discussed under the consolidation procedures. As such, these
unrealised profits from inter-entity transactions should be eliminated from the associate’s profits before
allocating them to the investor. IAS 28, paragraph 28 specifically deals with this issue and requires both
‘upstream’ (from associate to investor or its consolidated subsidiaries) and ‘downstream’ (from investor or
its consolidated subsidiaries to associate) transactions to be eliminated to the extent of the investor’s share
of the associate’s profits or losses.
The principal features of the equity method are reviewed and illustrated shortly by looking at:
• identifying the share of the associate that belongs to the investor
• recognising the initial investment at cost
• recognising the investor’s share of the associate post-acquisition profits and losses
• recognising the dividends provided by the associate
• recognising the investor’s share of the associate post-acquisition other comprehensive income.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IAS 28, paragraphs 33–36, which deal with the issues
that relate to the investor and associate having reporting periods that end on different dates, or different accounting
policies.

Consistent with the approach adopted when discussing the preparation of consolidated financial
statements earlier in this module, assume for the purposes of this module that the investor and associate
have consistent accounting policies and that their reporting periods end on the same date.

IDENTIFYING THE SHARE OF THE ASSOCIATE THAT

BELONGS TO THE INVESTOR
In order to implement the equity method, it is necessary to calculate the investor’s share of a number
of items contained in the financial statements of the associate. The investor’s share of these items
is determined in accordance with the present ownership interest. This ownership interest needs to be
distinguished from the investor’s voting power, which is an important factor in determining whether
significant influence exists, but it is not considered when calculating the investor’s share of the associate’s
post-acquisition equity.

284 Financial Reporting

 The ownership interest represents the percentage of the associate’s shares held by the investor, directly
or indirectly through its subsidiaries. Therefore, if an investor is a parent in a group, the ownership interest
by that investor should recognise all of the associate’s shares held by any entity within the group. However,
the equity interests held by other associates of the investor or its subsidiaries are ignored (IAS 28, para. 27).
Potential ownership interests arising from options, or other instruments that are convertible into shares, are
not included except under the special circumstances outlined in paragraph 13 (IAS 28, para. 12).
Any interests held to obtain a specified distribution, but with no other rights (e.g. non-participating,
cumulative preference shares), should be excluded from the calculation of ownership interest. Holders of
these interests have no rights to participate in profits in excess of their stated distribution rate, or in the
distribution of associate assets in excess of their contributed capital. Therefore, they are not deemed to be
equivalent to an ownership interest or provide a share of the profits or net assets of the investee.

QUESTION 5.21

(a) Refer to the following diagram. The percentages included in the diagram represent the per-
centage of shares held. What is the total ownership interest by Investor in Z Ltd (Z), both direct
and indirect?

Investor (W Ltd)

80% 30%

Subsidiary (X Ltd) 5% Associate (Y Ltd)

25% 10%

Associate (Z Ltd)

(b) Does the level of ownership interest you have calculated in (a) determine whether or not Z is an
associate of Investor? Justify your answer.
(c) Will your answer to (b) be different if the percentages included in the diagram also represent
voting power? Justify your answer.

RECOGNISING THE INITIAL INVESTMENT AT COST

As indicated in the definition of ‘the equity method’ contained in IAS 28, paragraph 3, the investment
in an associate should initially be recognised at cost. This amount is the consideration transferred by the
investor, and it may be different from the investor’s share of the fair value of the net assets of the associate.
Similar to the case of business combinations discussed in part A of this module, it is possible to calculate the
difference between the consideration transferred and the investor’s share of the fair value of the identifiable
net assets of the associate as goodwill (if positive) or gain on bargain purchase, otherwise known as excess
on acquisition (if negative). Note that gain on bargain purchase is not addressed in this module as it is
rarely seen in practice.
Goodwill must be determined on acquisition in accordance with IFRS 3. To determine the amount of
goodwill, the investor first notionally adjusts the net assets of the associate to their fair value. Any positive
difference between the cost of the investment and the investor’s share of the notionally adjusted fair values
is regarded as goodwill.
As goodwill represents the excess of the consideration transferred over the investor’s share of the fair
value of the identifiable net assets of the associate, it is already recognised as part of the cost in the
investment account. After acquisition, goodwill continues to be reflected in the carrying amount of the
investment. Moreover, consistent with IFRS 3, it must not be amortised and, hence, does not impact on
the investor’s share of the associate’s profit (IAS 28, para. 32(a)). The goodwill included in the carrying
amount of the investment is not tested for impairment in its own right. Instead, the total carrying amount
of the investment in the associate is assessed for impairment in accordance with IAS 36 (IAS 28, para. 42).

MODULE 5 Business Combinations and Group Accounting 285

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IAS 28, paragraphs 32 and 42.

EXAMPLE 5.19

Equity Method — Notional Determination of Goodwill

Assume that, on 1 July 20X4, Investor Ltd (Investor) acquired 30 000 ordinary shares in Investee Ltd
(Investee) for $55 000. At that date the equity/net assets of Investee was as follows.

$
Issued capital (100 000 shares issued) 100 000
Retained earnings 36 000
Net assets 136 000

Investor estimated that, based on fair value, the assets of Investee were undervalued by $20 000; $8000
of this amount related to non-depreciable assets and $12 000 to depreciable assets. Investor used its
influence to have these assets revalued in the accounting records of Investee, which was considered to
be an associate. This revaluation led to an increase in revaluation surplus (via OCI) of $14 000 (increase in
assets of $20 000 less recognition of deferred tax liability of $6000).
Investor would have an asset in its statement of financial position described as ‘Investment in associate,
$55 000’. This would form the initial carrying amount for the same item when using the equity method.
Investor would need to identify whether goodwill had been acquired by comparing the consideration
transferred (i.e. the cost that is originally recognised as the carrying amount of the investment at acquisition
date) with its share of the identifiable net assets of Investee at their fair values as follows.

$
The net assets of Investee at their fair values ($136 000 + $14 000) 150 000
Cost (carrying amount of investment) 55 000
Less: Investor’s share of identifiable net assets (30%† of $150 000) (45 000)
Goodwill 10 000
†
Purchased 30 000 of the 100 000 ordinary shares issued.

QUESTION 5.22

Use the data from example 5.19 to answer (a) and (b).
(a) Comment on the treatment of the goodwill, both at the time of the investment and in subsequent
accounting periods, under the equity method.
(b) Investee revalued its assets to their fair value at the acquisition date. What is the effect of this
revaluation on the equity-accounted investment immediately after acquisition (if prepared at
that time) and in subsequent accounting periods?

Recognising the Investor’s Share of the Associate Post-acquisition Profits

and Losses
Assume the same facts of example 5.18 except that profits of $50 000 and dividends of $15 000 apply for
each year 20X2 and 20X3. In order to apply the equity method as at 30 June 20X3, the following journal
entries would be necessary.
1. Share of Current Post-acquisition Profit

Dr Investment in associate 15 000

Cr Share of profit or loss of associates 15 000

286 Financial Reporting

The amount for this entry is calculated as 30% of the 20X3 profit of $50 000. The entry reflects
the information that must be recorded in the statement of P/L and OCI in accordance with IAS 1,
paragraph 82(c). Additional information about the investor’s share of the profit or loss of associates is
required to be disclosed by IFRS 12. Given the closeness of their relationship, whereby the investor is able
to influence the amount of variable returns that they can obtain from their investment in the associate, the
investor is allowed to recognise its share of the associate’s profit as increasing the value of its investment,
even though that share of the profits is not yet distributed to the investor via dividends (and may never be).
Remember that this module assumes that the investor prepares consolidated financial statements and
applies the equity method for associates in those financial statements. In addition, it assumes that the
investor accounts for the investment in the associate in its own financial statements using the cost method.
As such, the investment account in the individual accounts of the investor does not recognise the investor’s
share of profits, and therefore, the preceding entry is posted on the consolidation worksheet.
2. Share of Previous Post-acquisition Profits

Dr Investment in associate 10 500

Cr Retained earnings (opening balance) 10 500

The amount for this entry is calculated as 30% of undistributed profits from 20X2 of $35 000. As discussed
in part B of this module, consolidation worksheet entries from previous periods do not carry over to the
current period. Considering that the previous periods’ profits were recognised in those previous periods
in similar journal entries as in list entry 1, to recognise the share of previous post-acquisition profits in a
current period, the investment account is still debited, but the credit will be recognised against retained
earnings (opening balance) as that account should recognise the investor’s profit that originated from the
previous periods’ post-acquisition profits. Also, it is important to note that the amount recognised in this
journal entry represents the investor’s share of the previous post-acquisition profits of the associate not
yet distributed via dividends. The adjustment for dividends is necessary as the investor is interested in the
overall increase in the associate’s equity, after some equity was distributed via dividends.

RECOGNISING THE DIVIDENDS PROVIDED BY

THE ASSOCIATE
As just discussed, dividends represent a decrease in the associate’s equity, and under the equity method,
the investor should recognise a decrease in the investment account as a result. This module has assumed
that the investor is accounting for the investment in the associate at cost in its own financial statements.
Hence, in the records of the investor, dividend income from associates would be accounted for as revenue
in the following way.

Dr Bank/dividend receivable† 4 500

Cr Dividend income 4 500
†
Depending on whether the dividend has been paid or is payable by the associate.

The amount for this entry is calculated as 30% of $15 000. To avoid double counting when applying
the equity method, the consolidated financial statements cannot include as part of the investor’s profit
dividend income from the associate (recognised in the individual account of the investor when applying
the cost method, according to the preceding journal entry) and the investor’s share of the profit or loss of the
associate (which includes that dividend and was recognised on consolidation, according to consolidation
worksheet entries 1 and 2 on post-acquisition profits). Therefore, to apply the equity method in its
consolidated financial statements, the following consolidation worksheet entry would be necessary.

Dr Dividend income 4 500

Cr Investment in associate 4 500

MODULE 5 Business Combinations and Group Accounting 287

RECOGNISING THE INVESTOR’S SHARE OF THE ASSOCIATE
POST-ACQUISITION OTHER COMPREHENSIVE INCOME
Again, assume the same facts as example 5.18 except that an after-tax revaluation increment of $7000
applies in both years 20X2 and 20X3. The associate post-acquisition OCI is normally recognised under
reserves. As discussed in module 2, OCI will include items of income and expenses that IFRSs require to
be recognised in OCI. Once recognised in OCI, these items of income and expenses are then accumulated
in equity via a reserve (e.g. revaluation surplus).
Therefore, in order to recognise the investor’s share, an examination of the post-acquisition changes in
the reserves is required. Where a change in post-acquisition reserves should be equity-accounted for by
the investor (as it reflects the associate’s OCI post-acquisition), the following entry is necessary for the
investor’s share (in this case assuming an increase in reserves).

Dr Investment in associate 4 200

Cr Share of other comprehensive income (OCI) 2 100
Cr Revaluation surplus/reserve 2 100

IAS 1 requires the presentation of any share of the other comprehensive income of associates (IAS 1,
para. 82A).
Note that in order for the change in the reserve to be recognised for the investor, it must not already
be reflected in the carrying amount of the investment. Hence, any transfer to reserves from the retained
earnings account can be ignored and treated as if still part of the retained earnings. The amount in the retained
earnings account transferred out would already be reflected in the carrying amount of the investment, either
via purchase consideration (pre-acquisition profits) or as a share of post-acquisition profits.
It is also important to note that the cost of the investor’s investment in the associate (the initial amount of
the equity-accounted investment) takes into account the fair value of the associate’s assets at the acquisition
date. Therefore, the investor should exclude from its share of other comprehensive income of the associate
any changes in the fair value of the associate’s assets that are included in the initial cost of the investment.

EXAMPLE 5.20

Application of Equity Method in Consolidated Financial Statements

Example 5.20 is an extension of example 5.19, where Investor Ltd (Investor) acquired 30 000 ordi-
nary shares (30%) in Investee Ltd (Investee) on 1 July 20X4. Investor accounts for the investment
in the associate at cost in its financial statements and by the equity method in its consolidated
financial statements.
Assume that during the year ending 30 June 20X5, the following information was available for Investee.

$000
Profit before tax 120
Less: Income tax expense (36)
Profit for the year 84
Retained earnings 01 July 20X4 36
120
Dividends paid (50)
Retained earnings 30 June 20X5 70

288 Financial Reporting

 The abridged statement of financial position as at 30 June 20X5 of Investee was as follows.

$000
Issued capital 100
Retained earnings 70
Revaluation surplus 14
Liabilities 106
290
Assets 290
290

As Investor accounts for the investment in Investee at cost in its financial statements, it would:
• account for the dividend received ($15 000) as dividend income in its financial statements
• not process an entry for its share of the profits of Investee in its financial statements.
The financial statements of Investor included the following information.

Investor
$000
Profit before tax† 315
Less: Income tax expense (90)
Profit for the year 225
Retained earnings 01 July 20X4 100
325
Dividends paid (140)
Retained earnings 30 June 20X5 185
†
Includes dividend income from Investee of $15 000. Note that no tax is payable on the
dividend income for the purposes of this example.

The abridged statement of financial position of Investor as at 30 June 20X5 was as follows.

$000
Issued capital 600
Retained earnings 185
Revaluation surplus 60
Liabilities 270
1 115
Investment in Investee 55
Other assets 1 060
1 115

The following journal entries would be recorded by Investor.

Dr Investment in Investee 25.2

Cr Share of profit of associate 25.2
Dr Dividend income 15
Cr Investment in Investee 15

The following consolidation worksheet would be prepared by Investor to equity-account for its
investment in Investee. (Note: The financial statements of subsidiaries and their related consolidation
elimination entries have been ignored to focus on the effect of the equity adjustment entries.)

MODULE 5 Business Combinations and Group Accounting 289

 Eliminations & adjustments
Investor Dr Cr Consolidated
Accounts $000 $000 $000 $000
Dividend income 15 15† —
Other items of revenue and
expense in determining profit 300 300
Share of profits or loss of
associates 25.2‡ 25.2
Profit before tax 315 325.2
Less: Income tax expense (90) (90)
Profit for the year 225 235.2
Retained earnings 01.07.X4 100 100
325 335.2
Less: Dividends paid (140) (140)
Retained earnings 30.06.X5 185 195.2
Issued capital 600 600
Revaluation surplus 60 60
Liabilities 270 270
1 115 1 125.2
Investment in Investee 55 25.2‡ 15† 65.2
Other assets 1 060 1 060
1 115 1 125.2

Notes: Adjusting entries

†
Elimination of dividends paid by Investee.
‡
Share of after-tax profit of associate (30% of $84 000).
The equity-accounted amount of the investment can be reconciled as follows.

$
The net assets of Investee ($100 000 + $70 000 + $14 000) 184 000

Investor’s share of net assets of Investee (30% of $184 000) 55 200

Add: Goodwill 10 000
Carrying amount of investment 65 200

Alternatively:

$
Investor’s original investment 55 000
Add: Share of profit 25 200
80 200
Less: Share of dividends paid (15 000)
Carrying amount of the investment 65 200

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IAS 1, paragraph 82.

QUESTION 5.23

Using the information in example 5.20, prepare financial statements for Investor that comply with
the disclosure requirements of IAS 1.

290 Financial Reporting

TRANSACTIONS BETWEEN ASSOCIATE AND INVESTOR
(OR ITS SUBSIDIARIES)
Part B of this module discussed the requirement of IFRS 10 to eliminate in full unrealised profits or losses
on transactions between members of the group. As already discussed in this part (part C) of the module and
confirmed in IAS 28, paragraph 26, many of the procedures appropriate for the equity method are similar
to consolidation procedures. To be consistent, transactions between the associate and investor (including
its consolidated subsidiaries) should be eliminated. This is reinforced by IAS 28, paragraph 28, which
requires that where an associate is equity-accounted for, unrealised profits and losses from both ‘upstream’
and ‘downstream’ transactions between the investor (or its consolidated subsidiaries) and associate should
be eliminated to the extent of the investor’s ownership interest in the associate.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IAS 28, paragraphs 26 and 28.

Note: This module does not deal with transactions between associates in a group.
In relation to transactions between the associate and the investor (or its consolidated subsidiaries), the
following approach is adopted:
• only transactions involving unrealised profits and losses require elimination, taking into consideration
the related tax effect
• the elimination is in proportion to the investor’s ownership interest in the associate
• the elimination adjustments are only calculation adjustments with the result being recorded against two
accounts — ‘investment in associates’ and ‘share of profits of associates’.

EXAMPLE 5.21

Transactions Between Investor and Associate

Using the data from example 5.20, assume that the following additional events/transactions took place
during the year ended 30 June 20X5.
• Investee Ltd (Investee) revalued land upwards by $20 000, net of tax effect (this revaluation was not
reflected in Investor’s cost of acquisition).
• Investor Ltd (Investor) sold $15 000 (original cost $5000) of inventory to Investee — all inventory is still
on hand at 30 June 20X5.
Assuming, for illustrative purposes, that the tax rate is 30%, the journal entries recorded by Investor
would be as follows.

Dr Investment in Investee 25.2

Cr Share of profit of associate 25.2
Dr Investment in Investee 6
Cr Revaluation surplus 6
Dr Share of profit in associate 2.1
Cr Investment in Investee 2.1
Dr Dividend income 15
Cr Investment in Investee 15

MODULE 5 Business Combinations and Group Accounting 291

 Investor would prepare the following consolidation worksheet.
Eliminations & adjustments
Investor Dr Cr Consolidated
Accounts $000 $000 $000 $000
Dividend income 15 15† —
Other items of revenue and
expense in determining profit 300 300
Share of profits or loss of
associates 2.1‡ 25.2§ 23.1
Profit before tax 315 323.1
Less: Income tax expense (90) (90)
Profit for the year 225 233.1
Retained earnings 01.07.X4 100 100
325 333.1
Less: Dividends paid (140) (140)
Retained earnings 30.06.X5 185 193.1
Issued capital 600 600
Revaluation surplus 60 6|| 66
Liabilities 270 270
1 115 1 129.1
Investment in Investee 55 25.2§ 15†
6§ 2.1‡ 69.1
Other assets 1 060 1 060
1 115 48.3 48.3 1 129.1

Notes: Adjusting entries

†
Elimination of dividends paid by Investee.
‡
Elimination of unrealised profit on inventory on a net basis. That is, the only accounts affected are ‘Investment in Investee’
and ‘Share of profit or loss of associates’. The elimination reflects the investor’s ownership interest (30%) in the unrealised
profit after tax of $7000 (($10 000 × (1 –.30)).
§
Share of profit of associate.
||
Investor’s share of the revaluation of land by Investee. The increase in the revaluation reserve would be recognised in the
statement of P/L and OCI as OCI.
Note: The elimination of unrealised profit on inventory is not against the individual accounts affected as would be the case with
a consolidation adjustment for unrealised profits or losses.

QUESTION 5.24

(a) Using the information in example 5.21, prepare a single consolidated statement of P/L and OCI
for Investor in accordance with IAS 1, paragraphs 10A and 82.
(b) What difference would it make if the inventory was sold from Investee to Investor?
(c) Reconcile the equity-accounted investment in Investee of $69 100 to Investor’s share of the net
assets shown in the statement of financial position of Investee.

INVESTOR’S SHARE OF LOSSES

In preceding examples and questions, the associate has earned a profit. Where the associate incurs a loss,
application of the equity method requires a reduction in the equity-accounted amount of the investor’s
investment and recognition of the investor’s share of the associate’s loss.
Losses recognised under the equity method are applied first to the investment in ordinary shares and,
if this is exceeded, the losses are then applied to the other components (long-term receivables, loans,
preference shares) of the investor’s interest in the associate in reverse order of priority in liquidation
(IAS 28, para. 38). Therefore, the investor’s entry to recognise a 30% interest in current period losses of
$50 000 would be as follows.

292 Financial Reporting

 Dr Share of profits or losses of associates 15 000
Cr Investment in ordinary shares/
preference shares 15 000

Where the share of the associate’s losses exceeds the investor’s interest (carrying amount of investment
in associate, preference shares and long-term receivables or loans), the investor discontinues recognising
those losses (IAS 28, para. 38). Therefore, the equity method would cease, and the investment would
be recorded at zero. Additional losses would only be provided for (a liability recognised) where the
investor has an obligation to make payments on behalf of the associate (IAS 28, para. 39). Moreover,
when application of the equity method recommences, the investor’s share of associate profits can only be
recognised after offsetting the investor’s share of losses not previously recognised (IAS 28, para. 39).
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IAS 28, paragraphs 38 and 39. In addition, you may also
wish to read:
• IAS 28, paragraphs 22–24, which discuss the discontinuation of the equity method where the investee ceases to
be an associate
• IFRS 12, paragraph 22(c), which relates to the disclosure of unrecognised losses.

QUESTION 5.25

On 1 July 20X6, the consolidated financial statements of Investor contained an asset, ‘Investment
in associate’, of $30 000. For the financial year ended 30 June 20X7 the associate incurred a loss
of $150 000, while for the 20X8 financial year it earned a profit of $80 000. Investor owns 30% of the
issued capital of the associate.
Ignoring income tax effects, prepare consolidation worksheet entries for the 20X7 and 20X8
financial years to equity-account for Investor’s share of profits and losses. Determine the amount
of the investment in the associate as at 30 June 20X7 and 30 June 20X8.

5.14 DISCLOSURES FOR ASSOCIATES

IAS 1 requires the following line items to be separately presented in the financial statements of investors
with associates:
• in the statement of financial position — ‘investments accounted for using the equity method’ (IAS 1,
para. 54(e))
• in the P/L section — ‘share of the profit or loss of associates and joint ventures accounted for using the
equity method’ (IAS 1, para. 82(c))
• in the OCI section — line item for each item of OCI including ‘share of the other comprehensive income
of associates and joint ventures accounted for using the equity method’ (IAS 1, para. 82A).
In addition to the disclosures required by IAS 1, IFRS 12 requires entities to disclose information about
interests in joint arrangements and associates. As discussed in Section B, the objective of IFRS 12 is to
help financial statement users to assess:
(a) the nature of, and risks involved with, [an entity’s] interests in other entities
(b) the effects of those interests on the entity’s financial position, financial performance and cash flows
(IFRS 12, para. 1).

To satisfy the objective of IFRS 12, entities need to disclose:

• significant judgments and assumptions made in determining that the entity has significant influence over
another entity (IFRS 12, para. 7(b))
• financial and other information for entities that are determined to be associates (IFRS 12, para. 20).

MODULE 5 Business Combinations and Group Accounting 293

 IFRS 12, paragraph 20 requires entities with interests in associates to disclose information that
focuses on:
• the nature, extent and financial effects of its interests in associates including contractual arrangements
with other investors in the associates (IFRS 12, paras 20(a), 21 and 22)
• the nature of, and changes in, the risks related to interests in associates (IFRS 12, paras 20(b) and 23).
IFRS 12, paragraphs 21 to 23 contain extensive disclosure requirements that include information
such as:
• details of each material associate (name, nature of its relationship with the entity, principal place of
business, proportion of ownership interest held by the entity)
• financial information for material associates (whether investment in the associate is measured using
equity method or fair value, summarised financial information)
• nature and extent of any significant restrictions on the associate paying dividend to entity or repaying
loans and advances
• unrecognised share of losses if the entity has ceased to apply the equity method
• contingent liabilities incurred in relation to associates.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 12, paragraphs 1, 7–9, and 20−23.

SUMMARY
IAS 28 deals with the measurement and presentation of information concerning investments in associated
entities. IAS 28 prescribes that an investment in an associate should be accounted for using the equity
method of accounting. In essence, applying the equity method results in the investment being recorded at
the investor’s share of the associate’s net assets.
Both IAS 1 and IFRS 12 prescribe disclosures for investments in associates. These disclosures include:
• the investor’s share of profits or losses and share of other comprehensive income from associates
• carrying amount of investments in associates
• significant judgments and assumptions made in determining that the entity has significant influence over
another entity
• extensive disclosure for material associates, including summarised financial information for these
associates.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

5.7 Explain and apply the disclosure requirements of both IAS 1 Presentation of Financial Statements
for consolidated financial statements and IFRS 12 Disclosure of Interests in Other Entities for
interests in subsidiaries, associates and joint arrangements.
• IAS 1 requires the following separate line item disclosures in the financial statements of investors
with associates.
– Statement of financial position — investments accounted for using the equity method
– P/L — share of the profit or loss of associates and joint ventures accounted for using the equity
method
– OCI — each item of OCI including the share of the other comprehensive income of associates and
joint ventures accounted for using the equity method
5.8 Determine whether significant influence exists in specific scenarios and evaluate whether
consolidation is required.
• Significant influence normally stems from the investor having between 20% and 50% of the voting
power of the associate.
• Other factors that may indicate the investor has significant influence include:
– representation on the board of directors or equivalent governing body of the investee
– participation in policy making processes
– material transactions between the entity and its investee
– interchange of managerial personnel, or
– provision of essential technical information.

294 Financial Reporting

5.9 Account for associates using the equity method.
• The equity method is used for accounting for investments in associates where the investor has
significant influence over the investee.
• The equity method is often referred to as a ‘one-line consolidation’ method.
• If the investor does not prepare consolidated financial statements (because it does not have
investments in subsidiaries), then the investment in the associate is accounted for using the equity
method in the investor’s financial statements.
• If the investor does prepare consolidated financial statements, the investment account in the asso-
ciate (if recognised using the cost method) should appear in the consolidated financial statements
as if the equity method of accounting had been applied.
• The basis of the equity method is that it involves recognising the investment in the associate originally
at cost and then adjusting its carrying amount for the investor’s share of any changes post-acquisition
in the associate’s equity, including changes that result from the associate’s profit or loss, dividends
and other comprehensive income.
• Two key differences between accounting for an investment using the cost method versus the
equity method.
1. Cost method recognises the investment as an asset in the investor’s accounts based on the
amount originally invested in the associate. The equity method for the investment asset is the
amount originally invested plus the investor’s share of all undistributed profits or losses and OCI
in the periods after acquisition (i.e. items that essentially cause changes in the investee’s equity).
2. Under the cost method, dividends received by the investor from the investee will be treated
as dividend income. Under the equity method, dividends received form part of calculating the
changes in the investee’s equity that will impact on the carrying amount of the investment.
• The basic features of the equity method are:
– the initial investment is brought to account at cost (any goodwill on acquisition is not separately
disclosed as it is included in the cost)
– the investment carrying amount is adjusted for the investor’s share of associate post-acquisition
profits and losses
– the investor’s share of associate post-acquisition profits and losses is also recognised in the
investor’s profit or loss
– the investment carrying amount is reduced by all dividends received or receivable from the
associate
– the investment carrying amount is also adjusted for the investor’s share of post-acquisition
changes in the associate’s OCI after.
• The investor’s ownership interest represents the percentage of the associate’s shares held by the
investor, directly or indirectly through its subsidiaries. Any interests held to obtain a specified
distribution, but with no other rights (e.g. non-participating, cumulative preference shares), should
be excluded from the calculation of ownership interest.

MODULE 5 Business Combinations and Group Accounting 295

PART D: JOINT ARRANGEMENTS —
OVERVIEW
Having discussed accounting for interests in subsidiaries (part B) and interests in associates (part C), this
module concludes by providing a brief overview of accounting for interests in joint arrangements. In May
2011, the IASB, in addition to issuing IFRS 10, also replaced IAS 31 Interests in Joint Ventures with
IFRS 11.
A joint arrangement is defined by IFRS 11 as an ‘arrangement of which two or more parties have joint
control’ (IFRS 11, para. 4). There are two essential characteristics of a joint arrangement:
• the parties to the arrangement must be bound by a contractual agreement in relation to the terms on
which the parties participate in the activities of the arrangement
• the contractual agreement gives rise to two or more parties having joint control of the arrangement
(IFRS 11, para. 5).
Consistent with the principle of control in IFRS 10 (discussed in part B of this module), joint control
only arises when decisions relating to the relevant activities of the arrangement require the unanimous
consent of the parties who share control (IFRS 11, para. B6). The need for unanimous consent makes
joint control weaker than the control that may establish a parent−subsidiary relationship where the parent
has full control over the subsidiary. This is because a parent is able to exercise control of a subsidiary
unilaterally without being dependent on obtaining the consent of other parties, which is necessary in
a joint arrangement. Joint control, however, is considered to establish a stronger relationship than that
resulted from significant influence, as the parties to a joint arrangement control (albeit jointly) decisions
made in relation to the joint arrangement, while an investor can only participate in decisions in relation to
the investee.
Joint arrangements are quite common in the mining and real estate industries, where such an arrangement
is preferable to operating individually or to large scale acquisitions that may be difficult to fund due to
limited capital and debt finance. Joint arrangements allow sharing the risks related to capital investment
and other project risks. For example, in the mining industry, the risks of underperformance and even
bankruptcy are very high due to a relatively low probability of finding economically recoverable resources.
Mining companies need financial resources to secure future production via investments in their exploration
activities and development of mining sites in situations where revenue is yet to be generated. It is extremely
difficult for them to get access to those resources from lenders. Establishing a joint arrangement where
two or more such entities ‘share the load’ — by contributing assets, expertise/specialised knowledge or
other resources with a view to sharing the output — may be extremely beneficial, even though it comes
with its own set of problems, including a potential withdrawal of one party after the agreement has been
signed (e.g. on 11 June 2015, Australian Mines Ltd entered into a joint venture agreement with Lodestar
Minerals Ltd, only to withdraw on 21 December 2015 due to failure to find significant base metal deposits
in the tenements at Ned’s Creek that comprised the joint venture). The characteristics of joint control may
also result in a joint arrangement that is difficult to manage as there may be uncertainty about who makes
the major decisions. Nevertheless, there are some success stories.

EXAMPLE 5.22

Examples of Successful Joint Arrangements

The Gippsland Basin joint venture was established on 28 May 1964 when Esso Australia Resources Pty
Ltd (Esso), a subsidiary of ExxonMobil, and BHP Billiton Petroleum (Bass Strait) Pty Ltd, a subsidiary of
BHP Billiton (now BHP Group), signed an agreement for oil and gas exploration off Victoria’s Gippsland
coast, and the agreement is still ongoing; as of 2019, the Gippsland Basin joint venture was meeting
between 40% and 50% of the east coast Australian domestic gas demand (ExxonMobil 2019).
A similar success story is represented by the Channar Mining joint venture in the Western Australia’s
Pilbara region established in 1987 between Rio Tinto and Sinosteel Corporation Ltd, with the agreement
extended for the third time on 24 November 2017 to cover production totalling 290 million tonnes of iron
ore (originally 200 million tonnes) (Rio Tinto 2017).

296 Financial Reporting

 Once it has been determined that the entity has an interest in a joint arrangement, IFRS 11 requires the
joint arrangement to be classified as either a ‘joint operation’ or a ‘joint venture’ (IFRS 11, para. 14). A
joint arrangement is deemed a joint venture if the parties that have joint control have rights to the net assets
of the arrangement (IFRS 11, para. 16). An arrangement is considered a joint operation when the parties
that have joint control have rights to the assets of, and obligations for the liabilities of, the arrangement
(IFRS 11, para. 15).
The accounting treatment of those two forms will be different. As a joint operation involves an
arrangement where the joint operators have a right to the assets of, and obligation for the liabilities of,
the joint arrangement, IFRS 11 requires the joint operator to recognise individually its share of the assets,
liabilities, revenues and expenses that arise from its interest in the joint operation (IFRS 11, paras 20
and 21). These items will be accounted for in accordance with relevant IFRSs. As a joint venture involves
the joint venturers having an interest in the net assets of the arrangement, IFRS 11 requires the joint venturer
to recognise its interest in the arrangement as an investment to be accounted for using the equity method
in accordance with IAS 28 (para. 24). The equity method was discussed in part C of this module.
As indicated by the preceding discussion, the classification of whether a joint arrangement is a joint
operation or joint venture depends on an assessment of the rights and obligations that arise from the entity’s
involvement in the arrangement. Therefore, an assessment of the rights and obligations of individual parties
to the arrangement to capture the economic substance of the arrangement helps ensure consistency in
accounting and, therefore, enhanced comparability of financial statements.
This assessment involves professional judgment, and IFRS 11, paragraph 17 requires the entity to
consider factors such as:
• the legal form of the arrangement
• the terms agreed in the contractual arrangement
• other facts and circumstances when relevant.
Finally, it should be noted that the disclosure requirements of IFRS 12, discussed in part C in relation
to associates, also apply to joint arrangements.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read IFRS 11, paragraphs 4–25.

The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

5.10 Define a joint arrangement and explain the accounting requirements of IFRS 11.
• The two essential characteristics of joint arrangements are:
1. the parties to the arrangement must be bound by a contractual agreement in relation to the terms
on which the parties participate in the activities of the arrangement
2. the contractual agreement gives rise to two or more parties having joint control of the arrangement.
• Joint arrangements are common in the mining and real estate industries where large scale acquisi-
tions may be difficult due to limited capital and debt finance.
• Joint arrangements allow capital investment risks and project-related risks to be shared.
• The entities in the joint arrangement ‘share the load’ by contributing assets, expertise/specialised
knowledge, or other resources, with a view to sharing the output.
• IFRS 12 specifies the disclosures required for interests in joint arrangements.

REVIEW
This module focused on accounting for business combinations under IFRS 3, accounting for investments
in associates under IAS 28, as well as accounting for other investments where the investor has joint control
over a joint arrangement under IFRS 11.
As part of their strategic objectives, many entities are involved in investment activities to grow or
diversify their operations through various means, including acquiring a business or some businesses of
other entities, acquiring shares in other entities or setting up joint arrangements. When an entity has grown
or diversified through either of these means, based on the underlying principle of accounting it will need
to prepare financial statements for users to be able to understand the financial impact of those investments

MODULE 5 Business Combinations and Group Accounting 297

on the entity’s financial position, performance and cash flows. In preparing the financial statements,
alternative accounting treatments are required, both at the time of the initial investment and subsequently,
according to the type of investment undertaken.
If these investments involve acquiring a business or some businesses of other entities, the investor will
directly get ownership over the assets and liabilities of the acquired businesses; as such, the accounting
treatment at the time of the initial investment and subsequently will involve recognising those items in the
investor’s own financial statements, together with any other of its own assets and liabilities.
If the investor establishes relationships with other entities through acquiring shares in other entities
or setting up a joint arrangement as a joint venture, the investor, in essence, is acquiring a single
asset: the investment account. As such, the accounting treatment at the time of the initial investment
will involve recognising the investment account in the investor’s financial statements based on the
consideration transferred.
If the investor establishes relationships with other entities through setting up a joint arrangement as a
joint operation, it essentially acquires a share of the individual accounts of the joint operation. As such, the
accounting treatment at the time of the initial investment will involve recognising in the investor’s financial
statements the investor’s share of the individual accounts of the joint operation.
Part A of this module focused on the general accounting principles and requirements applicable,
according to IFRS 3, to those investments where an investor acquires one or more businesses or obtains
control of other entities (i.e. establishing a parent–subsidiary relationship). Those investments are denoted
as business combinations. As discussed in part A of this module, in accordance with IFRS 3, all business
combinations must be accounted for by using the acquisition method, which involves four steps:
1. identifying the acquirer
2. determining the acquisition date
3. recognising and measuring the identifiable assets acquired, the liabilities assumed and any non-
controlling interest in the acquiree
4. recognising and measuring goodwill or a gain from a bargain purchase.
Part B of this module focused on additional accounting requirements prescribed in IFRS 10 for
those investments where the investor obtains control of other entities, giving rise to parent–subsidiary
relationships. The additional requirements addressed in part B relate to the acquirer’s need to prepare
consolidated financial statements to show the financial performance, position and cash flows of the
acquirer/parent and the subsidiary from the perspective of the combined economic entity created. As
discussed in part B of this module, consolidated financial statements are prepared by aggregating the
financial statements of entities comprising the group. This aggregation process may involve a number of
adjustments, including:
• adjusting the financial statements of individual entities where they have been prepared using dissimilar
accounting policies or reporting periods ending on different dates
• elimination of pre-acquisition equity balances (after revaluation of subsidiary assets to fair value) of a
subsidiary where the parent entity has an ownership interest in the subsidiary
• elimination of the effects of all transactions between all entities within the group.
Also, as discussed in part B of this module, where a parent entity has less than 100% ownership in its
subsidiaries, the non-controlling interest must be measured by aggregating its proportionate share in the
equity of the subsidiaries after adjusting for the unrealised profits or losses of the subsidiaries.
Part C focused on investments where the investor obtains significant influence over the investee
(associate). It addressed two issues in accordance with IAS 28:
1. determining whether or not that relationship exists
2. specifying the requirements for applying the equity method to account for investments in associates.
As discussed in part C of this module, IAS 28 prescribes that an investment in an associate should be
accounted for using the equity method of accounting. In essence, applying the equity method results in the
investment being recorded at the investor’s share of the associate’s net assets.
Part D of this module provided a brief overview of the general principles and requirements for those
investments where the investor has joint control over a joint arrangement, distinguishing between joint
operations and joint ventures (IFRS 11).
Parts B, C and D also addressed the disclosure requirements for investors that have an investment in
subsidiaries, associates and joint arrangements, respectively. These requirements are included in IAS 1,
IFRS 10 and IFRS 12.

298 Financial Reporting

CASE STUDIES
CASE STUDY 5.1
1. On 1 July 20X0, Parent Ltd (Parent) purchased all the shares of Subsidiary Ltd (Subsidiary)
for $230 000.
2. At the acquisition date, the equity section of Subsidiary contained the following accounts.

$
Issued capital 100 000
Retained earnings 80 000
180 000

3. Parent considered that the plant owned by Subsidiary had a fair value of $80 000. An extract from the
financial statements of Subsidiary revealed the following.

$ $
Plant (at cost) 100 000
Less: Accumulated depreciation (40 000) 60 000

4. Subsidiary estimated the remaining useful life of the plant to be five years with a scrap value of $0 at
the end of this time. Subsidiary used the straight-line depreciation method for this type of plant.
5. Assume the plant was sold on 1 July 20X2 for $40 000 to an external party.
6. Assume that the provisions of IAS 12 in relation to the revaluation of assets in a business combination
are applied. The tax rate is 30%.

CASE STUDY 5.2

On 1 June 20X3, a parent entity sold inventory to a subsidiary for $40 000. The cost of the inventory to the
parent was $30 000. Assume a tax rate of 30%. The inventory was still on hand at the end of the financial
year 30 June 20X3.
Assumptions:
1. All of the inventory held by the subsidiary as at 30 June 20X3 was sold to parties external to the group
in July 20X3 for $50 000.
2. Half of the inventory held by the subsidiary as at 30 June 20X3 was sold to parties external to the group
by 30 June 20X4 for $25 000. The rest was sold to external parties by 30 June 20X5.

CASE STUDY 5.3

Year ended 30 June 20X4
Parent Ltd (Parent) owns 70% of the issued capital of Subsidiary Ltd (Subsidiary). During the year ended
30 June 20X4:
• Subsidiary sold inventory to Parent at a profit of $40 000 (the inventory was still on hand at
30 June 20X4)
• Parent sold plant to Subsidiary for $50 000 at a profit of $10 000 (the plant was still on hand at
30 June 20X4)
• Subsidiary provided Parent with management services for which it charged $30 000.
The plant was sold by Parent to Subsidiary on 1 July 20X3 and was depreciated on a straight-line basis.
The plant had a useful life of five years with a scrap value of $0 at the end of that period.

MODULE 5 Business Combinations and Group Accounting 299

 The following items were extracted from the consolidation worksheet for the year ended
30 June 20X4.

Parent Subsidiary
$ $
Profit for the year 400 000 200 000
Add: Opening retained earnings 60 000 40 000
460 000 240 000
Less: Dividends paid (180 000) (100 000)
Closing retained earnings 280 000 140 000

Assume a tax rate of 30%.

Year ended 30 June 20X5
Assume that all of the inventory purchased by Parent from Subsidiary in the year ended 30 June 20X4
was sold to parties external to the group during the financial year ended on 30 June 20X5. Moreover,
assume that the following items were extracted from the consolidation worksheet for the year ended
30 June 20X5.
Parent Subsidiary
$ $
Profit for the year 350 000 100 000
Add: Opening retained earnings 280 000 140 000
630 000 240 000
Less: Dividends paid (150 000) (50 000)
Closing retained earnings 480 000 190 000

CASE STUDY 5.4

On 1 July 20X0, Parent Ltd (Parent) purchased 70% of the issued capital of Subsidiary Ltd (Subsidiary)
for $120 000. An extract from the equity section of the statement of financial position of Subsidiary at the
acquisition date revealed the following.

$
Issued capital 100 000
Retained earnings 50 000
150 000

At the acquisition date, the identifiable net assets of Subsidiary were recorded at fair value.
The following events were relevant in preparing the consolidated financial statements for the year ended
30 June 20X1.
• During the financial year ending 30 June 20X1, Parent sold inventory that had cost $5000 to Subsidiary
for $9000. The inventory was still on hand as at 30 June 20X1.
• Over the financial year ending 30 June 20X1, Parent charged Subsidiary $3000 for services rendered.
The services were not paid for by the end of the financial year.
• On 30 June 20X1, Subsidiary sold plant to Parent for $16 000 at a loss of $4000. The plant had a
remaining useful life of two years with a residual value of $2000.
• On 30 June 20X1, Subsidiary declared a final dividend of $10 000. Parent recognised dividend income
when it became receivable.
• A tax rate of 30% is assumed.
• Assume that the dividends paid by Subsidiary to Parent were tax free.

ASSUMED KNOWLEDGE REVIEW

QUESTION 1
On 1 March 20X3, Holding Ltd (Holding) signed an agreement with the shareholders of Subsidiary Ltd
(Subsidiary) to acquire the entire issued capital (12 000 shares) of that company. Holding agreed to issue

300 Financial Reporting

five Holding shares for every two Subsidiary shares. Subsidiary was to continue to operate its business as
a subsidiary of Holding.
The terms of the agreement were fulfilled on 30 June 20X3, when the share transfer took place.
Immediately prior to settlement, the statements of financial position for the companies were as follows.

Holding Subsidiary
$000 $000
Issued capital 80 12
Retained earnings 140 83
Liabilities 50 25
270 120
Current assets 40 30
Non-current assets 230 90
270 120

At 30 June 20X3, it was determined that the fair values and the tax bases of the net assets of Subsidiary
were as follows.

Fair value Tax base

$000 $000
Current assets 30 30
Non-current assets 120 90
Liabilities (25) (25)
125 95

At 30 June 20X3, the shares issued by Holding to the shareholders of Subsidiary traded on the securities
exchange at $5.00 per share.
Prepare a consolidation worksheet assuming that, at acquisition date, Subsidiary had:
(a) revalued its non-current assets to their fair value in its own financial records
(b) used a consolidation adjustment to revalue the assets to their fair values.
QUESTION 2
(a) On 15 June 20X3, a subsidiary sold inventory to its parent for $20 000. The cost of the inventory to
the subsidiary was $10 000. Ignore tax effects.
(i) Prepare a consolidation elimination entry for the year ended 30 June 20X3, assuming that all
inventory was on hand with the parent at the end of the financial year.
(ii) Prepare a consolidation elimination entry for the year ended 30 June 20X3, assuming that half of
the inventory was sold by the parent during the year for $16 000.
(iii) Using the information in (ii), prepare a consolidation elimination entry for the financial year
ending 30 June 20X4. Assume that all the remaining intra-group inventory was sold to external
parties for $16 000 by 30 June 20X4.
(b) During the year ended 30 June 20X5, a parent entity provided management services to its subsidiary
for $25 000. At 30 June 20X5, the subsidiary still owed the parent entity for $5000 of these services.
Prepare a consolidation elimination entry for the year ended 30 June 20X5.
(c) On 30 June 20X7, a wholly owned subsidiary of a parent declared a dividend of $10 000. The parent
entity recognises dividend income on an accrual basis. Prepare a consolidation elimination entry for
the year ended 30 June 20X7.

REFERENCES
ExxonMobil 2019, ‘Gippsland Basin Joint Venture: Energy for Australia’, About us, accessed May 2019,
https://www.exxonmobil.com.au/en-au/company/who-we-are/gippsland-basin-joint-venture-energy-for-australia.
IASB (International Accounting Standards Board) 2019, International Financial Reporting Standards, IASB, London.
Rio Tinto 2017, ‘Rio Tinto and Sinosteel extend Channar Mining Joint Venture’, Media release, 24 November, accessed May
2019, http://www.riotinto.com/media/media-releases-237_23611.aspx.

MODULE 5 Business Combinations and Group Accounting 301

MODULE 6

FINANCIAL
INSTRUMENTS
LEARNING OBJECTIVES

After completing this module, you should be able to:

6.1 identify a ‘financial instrument’ and explain the difference between primary and derivative financial
instruments
6.2 explain and apply the criteria for the recognition and derecognition of financial assets and financial liabilities
associated with financial instruments
6.3 explain and apply the approach to the classification, reclassification and measurement of financial assets
and financial liabilities
6.4 identify the requirements in IFRS 9 for the use of hedge accounting
6.5 explain and apply the fair value hedge and cash flow hedge methods to simple examples
6.6 explain how compound financial instruments are to be measured and recognised
6.7 explain the key disclosures required for financial instruments under IFRS 7.

ASSUMED KNOWLEDGE

Before you begin your study of this module, it is assumed that you are familiar with:
• the definition of an asset as defined in the Conceptual Framework
• the definition of a liability as defined in the Conceptual Framework
• the definition of equity as defined in the Conceptual Framework.

LEARNING RESOURCES

International Financial Reporting Standards (IFRSs) and the International Accounting Standards Board (IASB):
• IFRS 7 Financial Instruments: Disclosure
• IFRS 9 Financial Instruments
• IAS 32 Financial Instruments: Presentation

PREVIEW
Financial instruments are at the core of almost every business, being a key component of an entity’s
prospects of remaining a going concern because they directly affect one of an entity’s most fundamental
resources: cash. Some businesses are only ever concerned with simple financial instruments, such as trade
payables and receivables. Other businesses delve into extremely complex financial instruments, such as
residential mortgage-backed securities, interest rate swaps, forward exchange contracts and credit default
swaps, to name a few.
Some financial instruments can have an immediate effect on cash flows while others have a delayed,
and sometimes magnified, impact. Understanding an entity’s exposure to various financial instruments
is necessary for a user to determine if that entity will remain a going concern. Furthermore, the types
of financial instruments an entity deals with provide insight into management’s risk appetite, which can
further inform user analysis.
There are three accounting standards devoted to accounting for financial instruments, mainly due to
the complexity surrounding some of those instruments. The three standards deal with different issues in
relation to financial instruments, namely:
• the recognition, derecognition and measurement of financial instruments — these, together with hedge
accounting, are the focus of IFRS 9 Financial Instruments (IFRS 9)
• the appropriate presentation of the financial instruments, once recognised — this is the focus of IAS 32
Financial Instruments: Presentation (IAS 32)
• the appropriate information to disclose for both recognised and unrecognised financial instruments —
this is covered in IFRS 7 Financial Instruments: Disclosure (IFRS 7).
It is not necessary to understand every aspect of these three standards. In practice, both preparers
and users would specialise in an area of financial instruments accounting, for example in hedging or
in determining whether an instrument should be classified as debt or equity. The key, however, is that
preparers and users understand the general principles of these standards so that they have a common frame
of reference when analysing the implications of financial instruments on an entity’s financial position,
performance and long-term survival.
This module begins by defining ‘financial instruments’, and then addresses the recognition and
measurement of financial instruments. The next section discusses the appropriate presentation of finan-
cial instruments. The module concludes with a brief review of disclosure requirements relating to
financial information.
The global financial crisis (GFC) brought about significant debate on the accounting treatment
of financial instruments under the old IAS 39 Financial Instruments: Recognition and Measurement
(IAS 39). In response, the IASB was asked to review the recognition and measurement of financial
instruments as a matter of urgency. On completion of the IASB’s major financial instruments project in
July 2014, the IASB issued IFRS 9 Financial Instruments to replace IAS 39.

MODULE 6 Financial Instruments 303

PART A: WHAT ARE
FINANCIAL INSTRUMENTS?
INTRODUCTION
Financial instruments are instruments that at their core affect the cash flows of an entity. They can be
simple, such as cash, or they can be much more complicated, such as foreign currency interest rate swaps.
The majority of financial instruments are created through legal contracts that are the product of intense
negotiations. Cash, however, is not explicitly a contract with another party to provide an entity with future
economic benefits, yet cash is a financial instrument. The diversity of instruments has added significant
complexity to financial markets and to the accounting standards that are meant to specify the accounting
requirements for those instruments.
Arising from this complexity is an equally complex definition of a financial instrument in IAS 32. The
definition was crafted in an attempt to capture all different types of financial instruments, including those
that might only exist in a small number of global organisations. Nevertheless, for anyone to understand
how financial instruments are accounted for, a firm grasp of the definition of a financial instrument is
required.
This part of the module primarily focuses on IAS 32, which contains the definition of financial
instruments and the guidance for classifying financial instruments.

Relevant Paragraphs
To assist in understanding of certain sections in this part, you may be referred to relevant paragraphs in
IFRS 9. You may wish to read these paragraphs as directed.

6.1 DEFINITION OF A FINANCIAL INSTRUMENT

A financial instrument is defined in a deceptively simple manner. According to IAS 32, a financial
instrument ‘is any contract that gives rise to a financial asset for one entity and a financial liability or
equity instrument of another entity’ (IAS 32, para. 11). Notice how the definition specifically requires two
entities. A financial instrument cannot exist if there are no external parties to the contract. An entity cannot
expect cash from itself and owe itself cash at the same time.
For example, the sale of goods on credit creates a financial instrument, namely a financial asset for the
seller (i.e. the right to receive cash for the goods sold) and a financial liability for the purchaser (i.e. the
obligation to pay cash for the goods purchased).
The definition of a financial instrument refers to three key concepts:
1. financial assets
2. financial liabilities
3. equity instruments.
Each of these concepts is covered in this part. Note that financial instruments could be either ‘primary’
financial instruments or ‘derivative’ financial instruments. This part considers primary instruments before
discussing derivative instruments.

FINANCIAL ASSETS
According to paragraph 11 of IAS 32, a financial asset is an asset that is:
(a) cash
(b) an equity instrument of another entity
(c) a contractual right . . .; or
(d) a contract that will or may be settled in the entity’s own equity instruments.

When an entity recognises and discloses a financial asset, it is showing that the asset in some way fits
in any of the categories listed in IAS 32, paragraph 11.

304 Financial Reporting

.......................................................................................................................................................................................
EXPLORE FURTHER
You may wish to refer to paragraph 11 of IAS 32 for the exact definition of a financial asset.

Cash
Cash, being any money an entity holds, is the simplest example of a financial asset.

Equity Instruments in Another Entity

The definition of financial assets and, as you will see shortly, the definition of financial liabilities, contain
reference to equity instruments. IAS 32 defines an equity instrument as ‘any contract that evidences a
residual interest in the assets of an entity after deducting all of its liabilities’ (IAS 32, para.11). Shares
traded on a securities exchange are examples of equity instruments. Any shares an entity owns in another
entity are financial assets.

Contractual Rights
Contractual rights can be a tricky aspect of the definition of financial assets. Contracts that convey the right
to receive cash or exchange financial assets and financial liabilities with another entity under potentially
favourable terms meet the definition of a financial asset. Some examples include:
(a) trade receivables
(b) loans receivable (i.e. for entities — such as banks — that lend money)
(c) instruments settled with government bonds.
All of these examples entitle an entity to receive cash or another financial asset. In the case where
an entity receives government bonds on settlement of a contract, those bonds further entitle the entity to
receive cash from the government that issued them. Therefore, the original instrument is classified as a
financial asset.

Settlement in the Entity’s Own Equity Instruments

This aspect of the definition of a financial asset can be difficult to understand because it refers to an entity
receiving its own equity instruments in settlement of a contract. Instruments that may be settled in this
manner are relatively rare. Both the definitions of a financial asset and a financial liability that consider
contracts with settlement in the entity’s own equity instruments include a reference to a so-called ‘fixed-
for-fixed’ test. The basis for this test is to determine whether the instrument represents an equity interest;
that is, whether it represents a residual interest in the net assets of the entity. If the contractual features
of the instrument allow a fixed dollar amount to be settled with a fixed number of the entity’s own equity
instruments, the financial instrument will pass the fixed-for-fixed test and will be recognised as an equity
instrument. If, on the other hand, the contract allows the settlement of a fixed dollar amount with a variable
number of the entity’s own equity instruments, that financial instrument fails the fixed-for-fixed test, and
therefore, can be recognised as creating a financial asset or a financial liability. Consider example 6.1,
which illustrates how the ‘fixed-for-fixed’ test applies to a financial instrument.

EXAMPLE 6.1

Settling Instruments with the Entity’s Own Equity Instruments

An entity is considering two funding scenarios and how they would be reflected in their financial
statements. The two scenarios are similar but differ in terms of settlement with either:
(a) a variable number of the entity’s own shares, the value of which is equal to a fixed currency amount
(b) a fixed number of the entity’s own shares, the value of which will vary depending on the share price.
In the first scenario, the entity is required to pay a variable number of its own equity instruments to the
value of a fixed dollar amount. Consider the following table, which illustrates the scenario where the entity
is obliged to settle the contract with a variable number of shares to a value equal to $1000.

Number of shares Total value ($)

Period Share price ($) ($1000/share price) (Price × number of shares)
20X1 0.50 2 000 1 000
20X2 0.80 1 250 1 000
20X3 1.25 800 1 000

MODULE 6 Financial Instruments 305

 It is evident in the preceding table that the effect of the contractual terms is that the entity is exposed
only to a fixed value of $1000. In other words, when the entity is required to settle the debt, it could
purchase $1000 worth of its own shares and settle its debt with those shares. In this case, the contract
allows the settlement of a fixed dollar amount of debt with a variable number of the entity’s own equity
instruments. Therefore, the financial instrument fails the fixed-for-fixed test and it won’t be classified as
an equity instrument — it would likely be classified as a liability as it reflects an obligation for the entity
(part C discusses this in more detail).
In the second scenario, the entity is required to settle the debt with a fixed number of its own shares
(i.e. 1000).

Number of shares Total value ($)

Period Share price ($) (fixed at 1000) (Price × number of shares)
20X1 0.50 1 000 500
20X2 0.80 1 000 800
20X3 1.25 1 000 1 250

Now the entity is exposed to a variable value that corresponds to the entity’s performance. The risk
the instrument brings to the entity evidences a residual interest in the net assets of the entity. In this
case, the contract allows the settlement of a fixed dollar amount of debt with a fixed number of shares.
Consequently, the financial instrument passes the fixed-for-fixed test and would likely be classified as an
equity instrument (part C discusses this in more detail).

This discussion has generalised some of the aspects a preparer needs to consider when analysing a
contract, such as whether it is a derivative or a compound instrument. These topics, including how to
account for them, are covered in more detail later in this module.

FINANCIAL LIABILITIES
According to paragraph 11 of IAS 32, a financial liability is a liability that is:
(a) ‘a contractual obligation’
(b) ‘a contract that will or may be settled in an entity’s own equity instruments’.
.......................................................................................................................................................................................
EXPLORE FURTHER
You may wish to refer to paragraph 11 of IAS 32 for the exact definition of a financial liability.

With regards to what constitutes a contractual obligation in the context of the definition for a financial
liability, you can refer to the previous discussion about contractual rights, but read it in the context of the
counterparty to those examples. This mirroring is intentional and reflects the IASB’s general effort to seek
symmetrical accounting treatment for all entities. This means that when one entity recognises a financial
asset, another entity will recognise a financial liability. However, as you will soon find out, this is not
always the case. Some examples of financial liabilities that are contractual obligations include:
(a) trade payables
(b) loans payable (e.g. borrowings from a bank).
Where an entity has the option to settle a liability in its own equity instruments, that option needs to
be assessed against the fixed-for-fixed test discussed earlier. If the financial instrument fails the fixed-for-
fixed test — that is, the entity is obliged to settle a fixed dollar amount by delivering a variable amount of
its own equity instruments — that financial instrument meets the definition of a financial liability.

6.2 LIABILITY OR EQUITY?

An important area of professional judgment, and potentially career specialisation, is that of classifying a
financial instrument as either a liability or as an equity interest.
This classification is particularly important because it affects the presentation of claims against an entity.
Classifying an instrument as a liability implies that the entity is obliged to transfer economic resources at
some time before liquidation, whereas classifying it as an equity interest indicates a claim that may only
be settled at liquidation, if at all.

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 Some financial statement users are particularly interested in an entity’s liquidity. They are concerned
about whether the entity has enough resources to settle the claims against it if and when they fall due.
Incorrectly presenting a financial instrument — as either a liability or as equity — can have serious
consequences on the assessment of an entity’s liquidity.
The basic principle of classifying a financial instrument as a liability or as equity is expressed in
paragraph 16 of IAS 32. Essentially, if a financial instrument does, or could, require the entity ‘to deliver
cash, or another financial asset, to another entity’, that instrument is a financial liability. However, if
a financial instrument requires the entity to deliver a fixed number of shares to settle a fixed dollar
amount (i.e. passes the fixed-for-fixed test), that financial instrument will be classified as equity. IAS 32
provides two exceptions to the fixed-for-fixed test, which mean that some instruments that fail the test are
nonetheless classified as equity. For the purposes of this subject, however, it is not necessary to understand
these exceptions but merely to know that they exist.

QUESTION 6.1

Angel Investor Pty Ltd (the investor) enters into a contract with Easy Business Ltd (the borrower)
to provide a $100 000 loan. Because the investor expects the borrower’s business to grow
substantially, the investor requires the borrower to settle the instrument in five years with 10 000 of
the borrower’s own equity instruments. Consider the following questions.
(a) Does this instrument meet the definition of a financial instrument? Explain your answer.
(b) If the instrument is a financial instrument, how would Angel Investor Pty Ltd and Easy
Business Ltd classify this instrument?

Refer to the financial statements of Techworks Ltd. What items in the statement of financial position
are financial instruments?
Some financial instruments contain elements of both a financial liability and of an equity instrument.
An example is convertible notes, where the lender has the option to either accept repayment of the notes
at maturity or convert the notes into shares of the issuer. Such an instrument is classified by the issuer
into its separate components of liability and equity. The liability component represents the possible cash
settlement feature, while the equity component represents the possible equity instrument settlement feature.
Measurement of these types of financial instruments is covered later in this module.

6.3 CONTRACTS TO BUY OR SELL

NON-FINANCIAL ITEMS
Contracts to buy or sell non-financial items are financial instruments when they are expected to be settled
net in cash, or for another financial instrument, or by exchanging financial instruments. However, if an
entity enters into such a contract and continues to hold it for the purpose of receipt or delivery of the non-
financial items — in accordance with its expected purchase, sale or usage requirements — that contract is
not a financial instrument (IFRS 9, para. 2.4). This follows because the contractual right of one party is to
receive a non-financial asset, and the obligation of another party is to deliver the non-financial asset, not a
financial asset. This exception is frequently referred to as the ‘own use’ exception. A simple example of an
‘own use’ contract is when a non-financial item, such as raw materials required in the production process,
is ordered six months in advance of the required delivery.
However, it should be noted that IFRS 9, paragraph 2.5 allows a contract to buy or sell a non-financial
item to be irrevocably designated as measured at fair value through the statement of profit or loss
(P/L), even if it qualifies for the ‘own use’ exemption. This designation is available only at inception
of the contract and only if it eliminates or significantly reduces an accounting mismatch that would
otherwise arise.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 11 and AG3–AG23 of IAS 32.

MODULE 6 Financial Instruments 307

6.4 DERIVATIVE FINANCIAL INSTRUMENTS
To this point, this part has explained primary financial instruments.
IFRS 9, Appendix A, defines a derivative financial instrument as having all three of the
following characteristics.
(a) Its value changes in response to the change in a specified interest rate, financial instrument price,
commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other
variable, provided in the case of a non-financial variable that the variable is not specific to a party to
the contract (sometimes called the ‘underlying’).
(b) It requires no initial net investment or an initial net investment that is smaller than would be required
for other types of contracts that would be expected to have a similar response to changes in market
factors.
(c) It is settled at a future date.

A derivative financial instrument derives its value from some other financial or non-financial item, or a
combination of these. For example, a derivative might derive its value from an agreed future price of gold
as compared to the current price of gold. Typically, derivatives will have a zero fair value at inception.
However, over time, as market prices move, the value of the derivative will increase or decrease.
All derivatives have, at a minimum, the following fundamental features:
• an issuer
• a holder
• an underlying item
• settlement and maturity dates.
A derivative contract might have a single combined settlement and maturity date, which means the
contract is settled at maturity. This is common for forward contracts where the contract establishes rights
and obligations that are performed at a specific date in the future. Other contracts might have multiple
settlement dates in addition to the final maturity date. This is common for swap contracts that establish
rights and obligations at specified time intervals during the life of the contract.
The next sections will briefly identify the characteristics of four common types of derivative instruments:
• forward contracts
• futures contracts
• option contracts
• swap contracts.
You are not required to have a detailed knowledge of the technical details of these financial instruments,
but rather a broad understanding of how these instruments work and the rights and obligations associated
with each. This understanding is required in order to comprehend the accounting issues associated with
such instruments.

FORWARD CONTRACTS
A forward exchange contract arises where two parties agree, at a point in time, to carry out the terms of
the contract at a specified time in the future. It is a contractual arrangement commonly used in business.
Example 6.2 describes a simple forward contract.

EXAMPLE 6.2

A Simple Forward Contract

Shanghai Global Air Transport (SGAT) has an ongoing aviation fuel supply contract with Chinese Fuel
Services Company. The contract guarantees SGAT its fuel needs but requires payment at current market
prices. SGAT is therefore exposed to significant risk arising from changes to the fuel price.
SGAT anticipates that it will need a significant amount of fuel from August 20X1 through to December
20X1. The increased fuel required is a result of an increase in demand for parcel shipping to the United
States for its holiday season.
In January 20X1, when the jet fuel price is $50 per barrel, SGAT negotiates a forward contract with
International Shipping Hedging Company (the issuer). In the contract, SGAT (the holder) agrees to pay the
current forward price of $55 per barrel for 1000 barrels of jet fuel (the underlying item) in July 20X1 (the

308 Financial Reporting

combined settlement and maturity date). Accordingly, the issuer agrees to pay the market price in cash on
maturity. Assume that the market price at maturity is $60. The contract will be settled net in cash because
SGAT is not seeking physical fuel from the issuer, but rather SGAT is seeking to fix the price of its future
fuel purchase.
The value of the forward contract is derived from the changes in the forward price until maturity and
reflects differences between the price the holder agreed to pay and the forward price (i.e. the expected
market price at maturity) at a particular point in time. At inception of the contract, the agreed price is the
current forward price, and therefore, the contract starts with a zero value. Over time, however, the forward
price will fluctuate as the expectations change about the market price at maturity and that will give rise to a
difference with the agreed price that will be reflected in the value of the forward contract. If that difference
continues to exist to maturity, the parties to the contract will be required to exchange cash.
The following graph illustrates the convergence of the forward price and the market price in relation to
the agreed price for the forward contract between International Shipping Hedging Company and SGAT.

Jet fuel price USD per barrel

75

70

65

60
Price

55

50

45

40
Jan 20X1 Feb 20X1 Mar 20X1 Apr 20X1 May 20X1 Jun 20X1 July 20X1
Time
Market price Forward price Agreed price

The graph illustrates that the market price on maturity ($60) is higher than the agreed price ($55).
Therefore, the issuer (International Shipping Hedging Company) is required to pay the holder (SGAT) the
difference between the market price and the agreed price.
While the forward contract is settled net, the contract does have two ‘legs’: a pay leg and a receive
leg. If the contract was not settled net (which is exceedingly rare), SGAT would pay $55 per barrel for
1000 barrels to the issuer, and the issuer would pay the market price of $60 per barrel for 1000 barrels
to SGAT.

Forward for 1000

barrels of jet fuel

Pay agreed price Receive market price

for fuel for fuel

Visualising the contract with a pay leg and a receive leg is particularly useful for swaps, which are
discussed later.
In the preceding illustration, as the market price is higher than the agreed price, the holder of the
derivative (SGAT) will receive the difference between the market price and the agreed rate, and the
derivative will be an asset for SGAT. On the other hand, if the market price is lower than the agreed
price, SGAT will need to pay to the issuer the difference between the two prices, and the derivative will
be a liability for SGAT.

MODULE 6 Financial Instruments 309

FUTURES CONTRACT
A futures contract is a contract to buy or sell a stated quantity of a specified item, on a specified date
in the future, at a set price. The contract is with a futures exchange, which acts as a clearing house. For
example, in Australia the exchange is the Australian Securities Exchange (ASX), in Japan one exchange
is the Tokyo Stock Exchange (TSE), and in Singapore it is the Singapore Exchange (SGX).
When a contract is first acquired, the exchange requires payment of a margin deposit, which is a
proportion of the total value of the contract. From this date, the contract is continually revalued to its current
market price. As a result, if the value of a contract position decreases to a deficit position, additional cash
payments to the exchange will be required.
Open positions (where a party has only purchased or sold a futures contract) in a futures market are not
generally settled by physical delivery but by the trader entering an opposite position in the market before
maturity of the contract to close out the position. This closing out of a position avoids the need to make or
take delivery of unavailable or unwanted items, although it does not avoid the possibility of being required
to absorb substantial losses in closing out a position.
In Australia, the SPI 200 futures index is a futures contract, the value of which is based on the overall
market performance of the top 200 shares listed on the ASX. Entities can buy or sell these contracts
depending on how they see the market moving in the future. Some use the SPI 200 futures index as a
signal as to the likely movements of the physical share market for the top 200 Australian listed companies.
Similar indices exist on both the TSE and SGX.
A simple example is Company X buying a futures contract to purchase a commodity, such as sugar, in
12 months’ time at a fixed price of $0.40 per kilogram. During the 12-month period, there is a dramatic
increase in the price of sugar and, at the end of the 12 months, the current market price is $1.00 per kilogram.
At this date, Company X is only required to pay $0.40 per kilogram instead of the current market price
of $1.00.
The main differences between a forward contract and a futures contract are summarised in table 6.1.

TABLE 6.1 Forward and futures contract differences

Forward contract Futures contract

1. Item traded Delivered Not normally delivered.

2. Contract Non-standardised, not Standardised, traded in an exchange market.

exchange traded

3. Contract revaluation Fair value determined The fair value is determined based on market value
based on forward rates (IFRS 13, Level 1 inputs) via bid/offer quotes on the
for similar instruments exchange. The exchange revalues the contract daily to
for remaining term the end-of-day market price; the changes are adjusted
(IFRS 13, Fair Value against the cash margin deposit required from traders
Measurement, at the start of the futures contract. Any losses must be
Level 2 inputs) settled daily via margin calls on the holder.

Source: CPA Australia 2019.

OPTION CONTRACT
An option contract is a derivative instrument that gives the holder of the contract the right but not the
obligation to buy or sell an asset from or to the issuer (commonly called the ‘writer’) of the contract on or
before a specified date. The writer of the contract is obliged to buy or sell the asset from or to the holder
once the option is exercised. The underlying asset can be anything of value.
The contract includes the following details:
• the exercise price, which is the amount at which the asset may be bought or sold
• whether the option gives the holder the right to buy (call option) or the right to sell (put option) the
underlying asset at the exercise price
• the maturity or expiration date — an option that can be exercised at any time up to a certain date is
called an American-type option, whereas an option that can only be exercised at a certain date is called
a European-type option
• the name of the underlying asset
• the number of units of the asset that may be bought or sold with the option.

310 Financial Reporting

 An option contract differs from forward and futures contracts in that the option holder has the right but
not the obligation to perform under the contract. The holder of a forward or a futures contract must either
deliver according to the terms of the contract or close out the position by taking an opposite position.
An option contract can be a specially tailored contract called ‘over-the-counter’ (OTC), or it can be
traded on an exchange. An OTC contract provides more flexibility as to the amount and timing. While
exchange-traded options are highly standardised, they provide more liquidity, as they can be bought
and sold via the exchange. The ASX trades options in the shares of over 70 of Australia’s largest listed
companies. For example, one can buy a call option on Wesfarmers shares that gives the holder of the option
the right to buy Wesfarmers shares at the exercise price specified in the option contract.

QUESTION 6.2

Compare and contrast how forward contracts and option contracts protect entities from price risk.
Which type of contract might an entity prefer to use to limit price risk?

SWAP CONTRACTS
A swap contract is an arrangement whereby two parties contractually agree to swap or exchange one
stream of cash flows for another, over a period of time. Swap contracts are very popular for managing cash
flow risk. In general, there are two major types of swaps: interest rate swaps and cross-currency swaps.
In interest rate swaps, entities swap fixed interest payment cash flows for variable interest payment cash
flows. Cross-currency swaps also allow entities to access financing in countries they otherwise would not
have the ability to borrow in.

INTEREST RATE SWAPS

Interest rate swaps generally involve two parties swapping fixed and floating-rate interest obligations
based on an underlying notional principal. Under a fixed-rate loan, the interest rate is fixed for a certain
period. Under a floating-rate loan, the interest rate is variable during the loan period. Example 6.3 describes
a fixed to variable interest rate swap.

EXAMPLE 6.3

Fixed to Variable Interest Rate Swap

Assume that Credit Union A has issued $1 million of loans (for three-year terms) to customers at fixed rates
because this is what their customers wanted. However, all of Credit Union A’s deposits are at variable rates
of interest. If interest rates rise, Credit Union A will suffer losses because it will have to pay a higher rate
of interest on deposits but will only receive a fixed rate of interest from the loans. In another state, Credit
Union B has $1 million of fixed-rate deposits for three years, and all of its loans are at variable rates of
interest. If interest rates fall, Credit Union B will suffer losses because it will have to pay its depositors a
fixed rate of interest and will receive less from borrowers as it reduces the variable rate of interest on loans.
Both credit unions would be better off if they agreed to the following swap arrangement. Credit Union A
pays a fixed rate of interest to Credit Union B (based on $1 million), and Credit Union B pays a variable
rate of interest to Credit Union A (based on $1 million). The notional principal amount is never exchanged
between the counterparties. The only exchange of money is the difference in interest payments from one
party to the other.

CROSS-CURRENCY SWAPS
Unlike interest rate swaps, a cross-currency swap involves the exchange of principal and interest payments
for a loan in one currency for principal and interest payments in another currency. The currency principals
are normally exchanged at the outset of the swap and re-exchanged at its conclusion.
As with an interest rate swap, the reasons for cross-currency swaps can be found in the comparative
advantage of some parties to borrow funds in certain countries. For example, assume a US company has

MODULE 6 Financial Instruments 311

 borrowed Australian dollars (AUD) in the Eurobond market and agreed to pay lenders a fixed rate of 4%.
The US company then executes a cross-currency swap with a US bank to:
• exchange the AUD proceeds in return for USD proceeds at inception
• pay the US bank a floating rate of interest based on USD LIBOR (London InterBank Offer Rate) plus
1% over the life of the loan
• receive from the US bank a fixed AUD interest amount of 4% over the life of the loan
• pay the initial USD proceeds back to the bank on maturity in exchange for receipt of AUD proceeds
from the bank.
The cross-currency swap has been utilised by the US company to effectively convert the AUD fixed
Eurobond into a USD loan at LIBOR plus 1% loan. This enables the US company to save 0.5% because
a similar USD bond in the US market would incur an interest charge of USD LIBOR plus 1.5% over the
same term.
.......................................................................................................................................................................................
EXPLORE FURTHER
You should now study Appendix A ‘Defined terms’ in IFRS 9 and consult the financial instruments glossaries listed
under ‘Learning resources’ when you are unsure of the meaning of any term.

SUMMARY
Part A of this module has introduced the topic of financial instruments. To master the accounting treatment
for financial instruments, it is necessary to understand the nature and characteristics of such instruments.
Part A has discussed the definitions from the accounting standards of a financial instrument, financial
asset, financial liability and equity instrument, and has looked at different types of financial instruments
(starting with primary instruments, through to the more complex derivative instruments). Part A discussed
the derivative financial instruments in detail, as it is the derivatives that create the more complex accounting
problems. It examined the characteristics of forwards, futures, option and swap contracts as the main types
of derivative financial instruments. While it is not essential to be an expert in derivatives, it is important to
have a general understanding of those contracts.
Part B considers the recognition, derecognition and measurement principles associated with financial
instruments, as detailed in IFRS 9.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

6.1 Identify a financial instrument and explain the difference between primary and derivative financial
instruments.
• A financial instrument is any contract that gives rise to a financial asset for one entity and a financial
liability or equity instrument of another entity.
• Examples of a financial asset include cash, an equity instrument in another entity, a contractual right,
or a contract settled in the entity’s own equity instruments.
• Examples of contractual rights include trade receivables, loans receivable, and instruments settled
with government bonds.
• Examples of a financial liability include trade payables and loans payable (including a bank loan).
• An example of an equity instrument is shares that are traded on a securities exchange.
• A derivative financial instrument has all of the following three characteristics.
– Its value changes in response to the change in a specified interest rate, price or other variable that
is not specific to a party to the contract.
– It requires either no initial net investment, or the initial net investment is smaller than would be
required for similar contracts expected to respond to changes in market forces.
– It is settled at a future date.
• Fundamental features of derivates are an issuer, a holder, an underlying item, and settlement and
maturity dates.
• There are four common types of derivative instruments: forward contracts, futures contracts, option
contracts, and swap contracts.
• Contracts to buy or sell non-financial items satisfy the definition of a financial instrument when
they are expected to be settled net in cash, or for another financial instrument, or by exchanging
financial instruments.
• The ‘own-use’ exception occurs when an entity enters into a contract such as purchasing raw
materials required for production six months in advance of requiring them.

312 Financial Reporting

PART B: RECOGNITION AND
DERECOGNITION OF FINANCIAL ASSETS
AND FINANCIAL LIABILITIES
INTRODUCTION
Part B begins by examining whether all financial instruments should result in the recognition of financial
assets and financial liabilities, applying the principles from IFRS 9. Further, this part looks at the conditions
under which financial assets and financial liabilities should be removed from the statement of financial
position (i.e. derecognised).

Relevant Paragraphs
To assist in understanding certain sections in part B, you may be referred to relevant paragraphs in
IFRS 7, IFRS 9 or IAS 32. You may wish to read these sections as directed.

6.5 RECOGNITION OF FINANCIAL ASSETS AND

FINANCIAL LIABILITIES
Paragraph 3.1.1 of IFRS 9 requires an entity to recognise a financial asset or financial liability whenever
it becomes party to the contractual provisions of a financial instrument. As such, all financial instruments
should result in the recognition of financial assets or financial liabilities. However, this may not always
result in the reporting of an amount on the statement of financial position because at inception the fair
value of the financial instrument could be zero (as is the case with many derivative instruments). Also,
paragraph 42 of IAS 32 requires the financial asset and financial liability to be set off under certain
conditions, which most derivatives will normally satisfy.
The normal recognition criteria — as stated in the Conceptual Framework — apply to the recognition
of financial assets and financial liabilities arising from financial instruments. As discussed in module 1,
according to paragraph 5.7 of the Conceptual Framework:
An asset or liability is recognised only if recognition of that asset or liability and of any resulting income,
expenses or changes in equity provides users of financial statements with information that is useful.

6.6 DERECOGNITION OF FINANCIAL ASSETS AND

FINANCIAL LIABILITIES
The recognition requirements for financial assets and financial liabilities resulting from financial instru-
ments are quite easy to satisfy, and therefore relatively simple to understand. However, IFRS 9 specifies
very strict requirements for the derecognition of financial assets and financial liabilities. The strict
requirements arise partly because the IASB tries to limit the opportunity for an entity to restructure its
contracts in such a way that it could obtain financing without recognising a liability for that financing.
However, these strict requirements may cause some issues of their own. For example, an entity might
transfer practically all of the contractual cash flows of a financial asset or a financial liability by using a new
financial instrument, except for some key contractual rights or obligations. Those remaining contractual
rights or obligations, under the strict requirements for derecognition, could very well cause the entity to
continue to recognise the original financial instrument, together with the new financial instrument.
Understanding IFRS 9’s derecognition requirements is important for both preparers and users of
financial statements. If an entity cannot derecognise a financial instrument for which practically all of the
contractual cash flows were transferred to a new instrument, and instead is required to continue recognising
the instrument and also recognise the new one, users need to understand how this transfer affects the entity’s
future cash flows.

MODULE 6 Financial Instruments 313

DERECOGNISING FINANCIAL ASSETS
The issue of when to derecognise a financial asset is addressed in paragraphs 3.2.3 to 3.2.23 of
IFRS 9. This section of IFRS 9 has been amended on several occasions, reflecting the complexity involved.
Paragraph 3.2.3 of IFRS 9 states that a financial asset shall be removed from a statement of financial
position when:
• ‘the contractual rights to the cash flows from the financial asset expire’ (e.g. the entity collects all
amounts owing from debtors or from borrowers), or
• the entity transfers the financial assets in accordance with conditions specified in paragraphs 3.2.4 and
3.2.5, and the transfer qualifies for derecognition in accordance with paragraph 3.2.6 (discussed in the
next section).
When an entity considers derecognising a financial asset, IFRS 9 requires an assessment of whether
the entire financial asset should be derecognised or only a part of it. Paragraph 3.2.2 of IFRS 9 outlines
three straightforward conditions under which the derecognition requirements apply only to a part of a
financial asset. These conditions relate to situations where agreements have transferred the rights to only a
portion of the cash flows from a particular financial asset or groups of financial assets. Paragraph 3.2.2 of
IFRS 9 essentially states that an entity will apply the derecognition criteria to only part of the financial
asset where the agreement transfers rights pertaining to a part of the asset that is:
(a) a specifically identified cash flow or cash flows (such as the principal repayment portion of principal
and interest repayments)
(b) a pro rata portion of all cash flows (such as 50% of all cash collected), or
(c) a pro rata portion of specifically identified cash flows (such as 50% of the principal repayment portion
of principal and interest repayments).
Otherwise, the entity applies the derecognition criteria to the whole instrument.
In terms of the derecognition criteria, the transfers of financial assets that may or may not qualify for
derecognition are addressed next.

TRANSFERS OF FINANCIAL ASSETS

When an entity transfers a financial asset to another entity under any arrangement, it is either going to
record a sale of the financial asset or the creation of a collateralised borrowing, as evidenced by the two
following alternative journal entries.

Sale of Financial Assets

Dr Cash XXXX
Cr Financial asset XXXX

The sale may also be accompanied by a gain or loss on sale, and this would be part of the journal entry
(see example 6.4).

Borrowing
Dr Cash XXXX
Cr Loan payable XXXX

EXAMPLE 6.4

Sale of Financial Assets

Company T is deemed to have sold financial assets measured at amortised cost to Company P, and the
details are as follows.

$
Financial assets carrying amounts 500 000
Cash received 600 000

314 Financial Reporting

 Journal entry recorded in Company T is as follows.

Dr Cash 600 000

Cr Financial assets 500 000
Cr Gain on sale (P/L) 100 000
The entry to record the sale of the financial assets.

If a sale is recorded, the financial asset needs to be derecognised. The critical issue in assessing whether
transfers of financial assets qualify as a sale is determining whether the transfer meets the requirement of
transferring substantially all the risks and rewards of ownership. When an entity transfers financial assets
to a third party for cash and has no continuing involvement in the financial assets, a sale has occurred
as it has transferred substantially all the risks and rewards of ownership. Hence, the entity will apply the
sale of financial asset accounting to this transaction and derecognise the financial asset transferred. The
complication arises when the purported sale is accompanied by certain conditions.

EXAMPLE 6.5

Sale of Financial Assets with Certain Conditions

Consider the following two cases.
(a) ABC sells a financial asset to XYZ, with a carrying amount of $100 000 for $150 000.
(b) Assuming the same details outlined in (a), ABC enters an agreement with XYZ whereby ABC will
repurchase the financial asset from XYZ in six months for $175 000.
Are the two cases the same? Should ABC record a sale in both cases?
(a) Clearly the two cases are different. In the first case, ABC has sold the financial asset and the journal
entry to record the sale of a financial asset and a gain on sale would be as follows.

Dr Cash 150 000

Cr Financial assets 100 000
Cr Gain on sale (P/L) 50 000

(b) In the second case, ABC is clearly committed to repurchasing the financial asset in six months. The
sale does not qualify for derecognition of the financial asset because ABC is still exposed to the risks
and rewards of ownership. To record a sale and a gain, and then record the purchase of the same
financial asset at an increased value, would not be accounting for the substance of the transaction
between the two entities. The journal entry for this second case should reflect the economic substance
of the transaction. Initially, this would be to record a loan from XYZ as follows.

Dr Cash 150 000

Cr Loan payable 150 000
To record a loan from XYZ.

And then six months later, the journal entry should record the repayment to XYZ as follows.

Dr Loan payable 150 000

Dr Interest expense 25 000
Cr Cash 175 000

In the second case of example 6.5, the sale does not qualify for derecognition because ABC is still
exposed to the risks and rewards of ownership. Therefore, the journal entries will reflect the economic
substance of the transactions (i.e. that it is a loan). ABC has borrowed $150 000. When an amount of
$175 000 is subsequently paid, the additional $25 000 is treated as an interest expense as shown in the
second journal entry that is dated six months later. However, if ABC agreed to repurchase the financial
asset in six months at the fair value at that time instead of the fixed amount of $175 000, then XYZ will be

MODULE 6 Financial Instruments 315

subject to the variability of returns from holding the financial asset, and therefore ABC should recognise
a sale when transferring the financial asset to XYZ.
Another complicated situation arises in cases where an entity transfers its debtors to a third party, but
it guarantees to reimburse the third party for all bad debts. One option is to view the two transactions as
one. Therefore, the transferor is still effectively exposed to substantially all the risks associated with the
debtors, as the major risk from debtors is the risk of not collecting the amounts owing. This is consistent
with a ‘substance over form’ approach and, using this argument, the transferor should not record a sale but
should record a loan.
Alternatively, the second transaction is recorded separately as a guarantee, in the same way as an
independent party not connected with the debtors would record a guarantee. IFRS 9 argues that where
the transferor is still exposed to substantially all the risks of ownership, a sale has not occurred. Instead,
the transaction should be recorded in the books of the transferor as a loan.
The scenarios discussed apply the principle of an assessment about the transfer of the risks and rewards
of ownership in deciding whether the transaction should be recorded as a sale of the financial asset.
Paragraphs 3.2.4 to 3.2.6 in IFRS 9 provide guidance for the assessment relating to the transfer of a financial
asset. These paragraphs deal with situations where an entity has either:
• transferred the contractual rights to receive cash flows of the financial asset, or
• retained the contractual rights to receive the cash flows but then passed these cash flows to another entity
(a ‘pass-through’ arrangement).
A pass-through arrangement occurs where the transferor continues to receive cash flows from a
transferred financial asset but simply passes the cash flows through to another unrelated entity. Pass-
through arrangements are common where it is difficult to transfer the legal title to a financial asset. For
example, in order to transfer legal title, an entity might need to notify and obtain agreement from all
counterparties to the sale. This could be onerous, in which case the entity enters into a contract to transfer
the cash flows instead. Paragraph 3.2.5 of IFRS 9 specifies the conditions for an arrangement to meet the
test of a pass-through arrangement. These conditions are that:
• the transferor has no obligation to pay any amounts to the transferee unless it collects equivalent amounts
from the financial asset
• the transferor is prohibited from selling or pledging the transferred asset
• the transferor has an obligation to pass the cash flows to the transferee without material delay.
Paragraph 3.2.6 of IFRS 9 deals with situations where an entity actually transfers a financial asset and
requires an entity to assess the extent to which the risks and rewards of ownership of the financial asset
were also transferred. Based on this assessment by the entity, it requires that:
• where substantially all risks and rewards of ownership are transferred, the financial asset is
derecognised. If the transferor retains any rights or obligations, new assets or liabilities are recognised.
• where an entity retains substantially all risks and rewards of ownership, the financial asset is
not derecognised.
• where the entity neither retains nor transfers substantially all the risks and rewards of ownership, a
decision is made about the control of the financial asset. Generally, the test for loss of control relates to
the transferee’s ability to sell or pledge approximately the full fair value of the transferred asset. Where
the transferee is free to do this, the transferor has lost control of the transferred asset; the financial asset
is derecognised, and any new rights or obligations arising from the transfer are separately recognised.
• where the transferor retains control, the entity shall continue to recognise the financial asset to the extent
of the continuing involvement in the financial asset.

Transfers that Qualify for Derecognition of an Existing Financial Asset and

Recognition of a New Financial Asset or Liability
Some transactions involving a transfer of financial assets may also result in the creation of a new financial
asset or financial liability. In such cases, paragraphs 3.2.10 and 3.2.11 of IFRS 9 state that an entity should
recognise the new financial asset or financial liability at fair value. Any gain or loss is determined as the
difference between the proceeds and:
A the carrying amount of the financial asset sold
plus B the fair value of any new financial liability assumed
minus C the fair value of any new financial asset acquired
plus or minus D any adjustment to fair value of the financial asset sold, previously recognised in
other comprehensive income.

316 Financial Reporting

 As a formula, this would be shown as:
Gain (Loss) = Proceeds – (A + B – C +(–) D) if fair value increase (decrease) previously
reported as other comprehensive income
Recall from module 2, the statement of profit or loss and other comprehensive income presents:
Profit or loss (P/L) + Other comprehensive income (OCI) = Total comprehensive income
The entry to derecognise a financial asset is to remove the carrying amount of the financial asset and
record the proceeds received or receivable. This entry may well result in a gain or loss that is recognised
in P/L.

EXAMPLE 6.6

Transfer of Financial Asset with Derecognition

Belhop Enterprises Ltd (Belhop) transfers certain receivables with a carrying amount of $900 000 (made
up of gross receivables of $950 000 and allowance for doubtful debts of $50 000) to Debt Factoring Ltd
(Debt Factoring) for $950 000. Belhop guarantees Debt Factoring for default losses for receivables up to
$20 000. Actual losses in excess of this amount will be assumed by Debt Factoring. Therefore, Belhop
has transferred the risks and rewards with the receivables (beyond $20 000) to Debt Factoring, meaning
that Belhop has lost control of the receivables and, therefore, a sale is recorded. Recorded journal entries
for Belhop, assuming the fair value of the guarantee is measured as $20 000, are as follows.

Dr Cash 950 000

Dr Allowance for doubtful debts 50 000
Cr Receivables 950 000
Cr Guarantee liability 20 000
Cr Gain on sale (P/L) 30 000

This entry records the sale of financial assets and the recognition of a guarantee for losses on the
receivables sold.
The gain on sale was calculated based on the previously provided formula as follows.
Proceeds 950 000
minus A 900 000, carrying amount of financial assets sold
minus B 20 000, the financial guarantee liability assumed
plus C 0, the entity does not acquire any new financial assets
minus D 0, the receivables were carried at cost, no adjustments were recognised in OCI
Gain $950 000 – ($900 000 + $20 000) = $30 000
This is better expressed as follows.
Gain = Proceeds $950 000 – (A carrying amount financial assets $900 000 – B financial
guarantee assumed $20 000) + C new financial assets $0 +/– D adjustment in OCI $0 = $30 000

QUESTION 6.3

MCL Pty Ltd (MCL) is a wholesaler of chemicals and a distributor of imported soaps and perfumes.
In the three financial years up to 30 June 20X6, the company reported losses totalling $6.4 million.
These losses were largely due to the adverse effects of a devaluation of the AUD and the impact of
significantly increased price competition from the other chemical wholesalers in the region.
To sustain operations during this period, MCL had substantially increased its level of leverage
to a record high as at 30 June 20X6. However, continued trading difficulties throughout the 20X7
financial year necessitated a further inflow of borrowed funds to meet pressing commitments.
In May 20X7, after having increased leverage to a level equivalent to the debt-to-total-assets
covenant in the company’s debenture trust deed, it was apparent that MCL’s financial plight was
desperate. Although the January 20X7 purchases on credit had not been settled, it was evident that
no additional equity funds would be forthcoming, at least in the short term, owing to the company’s
recent results and precarious statement of financial position.
The chief executive of MCL was very anxious when approaching International Co-op Loans
Centre (‘International’), a newly established financial institution in the region. International had
adopted a high profile since launching its operations in February 20X7 and projected a ‘glossy’

MODULE 6 Financial Instruments 317

 image in its marketing campaigns. After a series of meetings with International’s management in
the last week of May, an unusual arrangement was entered into by the two parties on 2 June 20X7.
• MCL sold 35% ($500 000) of its trading stock to International for a $2 million immediate
cash settlement.
• MCL agreed to buy back the same stock in three months for $2.4 million.
• The trading stock sold to International was to remain in MCL’s warehouse. A monthly rental fee
of $200 was payable to MCL for the space made available for this purpose.
MCL’s statement of profit or loss and other comprehensive income (statement of P/L and OCI)
looked much healthier for the 20X7 financial year, with a profit of $82 500 after including the
$1.5 million gain from the sale of trading stock to International.
Although MCL did not show a liability in respect to the transaction for the year ended
30 June 20X7, there was a footnote reference in the accounts to contracts entered into for the
purchase of trading stock.
How should MCL record the transaction on 2 June 20X7? Prepare the appropriate journal entry.
For the purposes of this exercise, ignore the rent received by MCL.

Accounting for Transfers that do not Qualify for Derecognition

Paragraph 3.2.15 of IFRS 9 provides guidance as to the appropriate accounting for transfers that do not
qualify for derecognition. It requires entities to account for a transferred financial asset in its entirety as a
collateralised borrowing. This means the entity should recognise a loan equal to the consideration received
for the transferred financial asset that is not derecognised. Paragraph 3.2.22 of IFRS 9 further indicates
that a transferred asset that is not derecognised, and any associated liability, shall not be offset. In addition,
IFRS 7 requires certain disclosures about such transactions, as discussed in part F of this module.

Continuing Involvement in Transferred Assets

Paragraphs 3.2.16 to 3.2.21 of IFRS 9 deal with transfers where the entity neither transfers nor retains
substantially all the risks and rewards of ownership of a transferred asset, but retains control of the
transferred asset; the entity continues to recognise the transferred asset to the extent of its continuing
involvement in the financial asset. For example, a continuing involvement occurs in all of the following
situations.
• The transferor transfers $5 million of debtors to another entity but guarantees the transferee for all losses
due to bad debts up to $1 million. In this case, the continuing involvement is the guaranteeing of the
debtors. Similar to example 6.6, the $5 million debtors balance is derecognised, and at the same time,
the transferor will recognise a financial liability for $1 million.
• The transferor writes a put option for the transferee for the $5 million of debtors. This option allows
the transferee (being the holder of the option), at its discretion, to require the transferor to repurchase
(or ‘put’) the debtors at any time before the option’s maturity. In this case, none of the debtors is to be
derecognised, as the transferor has a continuing involvement with the total amount of debtors transferred.
The extent of the involvement with written put options measured at fair value is the lower of the fair value
of the transferred financial asset and the option exercise price. It is important to note the transferor/writer
of a put option sells to another party the right but not the obligation to sell an underlying commodity
(in this case debtors) to the writer of the option for a specified price.
The continuing involvement may result from the contractual provisions in the initial transaction or may
arise in a separate transaction (i.e. an option).

EXAMPLE 6.7

Transfer of Financial Asset Without Derecognition

ABC Ltd (ABC) sells to XYZ Ltd (XYZ) unlisted shares in PQR Ltd (PQR) for $100 000. The unlisted
shares have a carrying amount of $80 000 in the books of ABC and are estimated to have a fair value
of approximately $80 000. In another transaction, ABC agrees to repurchase the shares in three months
for $110 000. The value of PQR shares has remained static for the past two years.

318 Financial Reporting

 Analysis
ABC has a continuing involvement in the PQR shares and is required to repurchase the shares at a price
that includes a premium over the initial transfer price resembling a lender’s return. Therefore, the transfer
fails the derecognition rules. The entry to record the transaction in the books of ABC is as follows.

Dr Cash 100 000

Cr Loan payable 100 000

(This records a loan payable to XYZ while the financial asset, PQR shares, continues to be recognised
in the financial statements of ABC.)
Three months later, the entry in the books of ABC to record the repayment of the loan and interest to
XYZ is as follows.

Dr Loan payable 100 000

Dr Interest expense 10 000
Cr Cash 110 000

XYZ would not recognise the PQR shares as an asset but would recognise a receivable due from ABC.

IFRS 9, Appendix B, paragraph B3.2.1 includes a flowchart that summarises the circumstances under
which a transferred asset can or cannot be derecognised, as shown in figure 6.1.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 3.2.1–3.2.21 and B3.2.1–B3.2.13 of IFRS 9.

Transfers with Collateral

Paragraph 3.2.23 of IFRS 9 outlines requirements when a transferor of a financial asset provides non-cash
collateral to a transferee. The transferor will normally carry the collateral in its financial statements as an
asset until the transferor defaults. Where the transferee can sell or repledge the collateral, the transferor
shall reclassify the collateral separately from other assets so that a reader of its financial statements would
be alerted to the status of the collateral. Where the transferee sells the collateral, the transferee shall
recognise a liability measured at fair value for its obligation to return the collateral. Where the transferor
defaults, the transferor shall derecognise the collateral, and the transferee shall recognise the collateral as
its asset initially measured at fair value if not already sold — if the transferee already sold the collateral,
the transferee will derecognise the liability recognised for the obligation to return the collateral.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 3.2.22–23 and B3.2.14–B3.2.17 of
IFRS 9. The examples in paragraph B3.2.16 provide useful guidance in the application of the derecognition principles
in IFRS 9.

6.7 DERECOGNITION OF A FINANCIAL LIABILITY

The extinguishment of financial liabilities normally occurs when the debtor pays cash or other financial
assets to the creditor and is therefore relieved of its obligation for the liability. Alternatively, the debtor
can be released from the liability either by a court or by the creditor. As such, paragraph 3.3.1 of
IFRS 9 states that a financial liability is extinguished when the obligation is discharged or cancelled,
or when it expires. Paragraph 3.3.2 of IFRS 9 states that, where there are substantial modifications
to an existing debt instrument or where a new debt instrument with substantially different terms is
issued to replace an existing debt instrument, the old debt should be extinguished. The recording of
the extinguishment of the old debt may result in the recognition of a gain or loss in accordance with
paragraph 3.3.2 of IFRS 9.

MODULE 6 Financial Instruments 319

 FIGURE 6.1 Circumstances under which a transferred asset can or cannot be derecognised

Consolidate all subsidiaries [Paragraph 3.2.1]

Determine whether the derecognition principles below are applied to

a part or all of an asset (or group of similar assets) [Paragraph 3.2.2]

Have the rights to the

cash flows from the asset expired? Derecognise the asset
[Paragraph 3.2.3(a)] Yes

No

Has the entity transferred

its rights to receive the cash
flows from the asset?
[Paragraph 3.2.4(a)]

No

Has the entity assumed

an obligation to pay the cash flows
Yes from the asset that meets the Continue to recognise the asset
conditions in paragraph 3.2.5? No
[Paragraph 3.2.4(b)]

Yes

Has the entity transferred

substantially all risks and rewards? Derecognise the asset
[Paragraph 3.2.6(a)] Yes

No

Has the entity retained

substantially all risks and rewards? Continue to recognise the asset
[Paragraph 3.2.6(b)] Yes

No

Has the entity retained

control of asset? Derecognise the asset
[Paragraph 3.2.6(c)] No

Yes

Continue to recognise the asset to the extent of the entity’s

continuing involvement

Source: IFRS Foundation 2019, IFRS 9 Financial Instruments, in IFRS Standards issues at 1 January 2019, IFRS Foundation,
London, appendix B, para. B3.2.1.

320 Financial Reporting

 EXAMPLE 6.8

Modification of a Financial Liability

Lim Lam Ltd (Lim Lam) has experienced a delay in a construction project resulting in short-term difficulties
in meeting loan payments. This results in Lim Lam agreeing to a significant restructure of its current loan
arrangement with its bank. The current carrying amount of the loan is $500 000. The bank agrees to extend
the term of the loan from one to two years and increase the interest rate by 10%. The fair value of the loan
is now $560 000.
The journal entry to record this transaction is as follows.

Dr Loss on loan restructure 60 000

Dr Original loan payable 500 000
Cr New loan payable 560 000

As there have been significant modifications to the original loan, in accordance with IFRS 9,
paragraph 3.3.2, the old loan is extinguished, replaced by the new loan recognised at fair value.

There are also transactions involving debt defeasance where a debtor transfers assets into a separate
entity established solely to repay the creditor with the proceeds of the transferred assets. Such transactions
are generally referred to as ‘in-substance defeasance’. Should such a transaction be accounted for as an
extinguishment of the financial liabilities? Paragraph B3.3.3 of IFRS 9 states that, in those cases, unless
there is a legal release of the debtor, the financial liability has not been extinguished.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may read paragraphs 3.3.1–3.3.4 and B3.3.1–B3.3.7 of IFRS 9. Please
now attempt question 6.4 to apply your knowledge of this topic.

QUESTION 6.4

(a) A bank agrees to accept shares in Won Ton Ltd (Won Ton) in settlement of an outstanding loan.
The loan amount outstanding is $235 000. Two hundred thousand shares in Won Ton are issued
to the bank. The fair value of the shares in Won Ton on the date of the agreement is $1 for
each share.
What is the journal entry in the books of Won Ton to record this transaction?
(b) Shin Nee Ltd (Shin Nee) establishes a trust and transfers $1 million to the trust for the purposes
of servicing a $1.3 million loan to a bank.
Show how Shin Nee should record this transaction and explain your reasoning.

SUMMARY
Part B discussed the recognition and derecognition principles associated with financial instruments as
specified in IFRS 9. Points covered include the following.
• Financial assets and financial liabilities arising from financial instruments are recognised when the entity
becomes a party to the contract.
• Financial assets should only be derecognised when an entity loses control of the economic benefits
either through the expiry or transfer of the economic benefits.
• Financial liabilities should only be derecognised when the obligation is extinguished.
Part C will now cover the classification of financial assets and financial liabilities, as outlined in
IFRS 9.
The key points covered in this part, and the learning objectives they align to, are as follows.

MODULE 6 Financial Instruments 321

 KEY POINTS

6.2 Explain and apply the criteria for the recognition and derecognition of financial assets and
financial liabilities associated with financial instruments.
• The normal recognition criteria for assets and liabilities, as specified in the Conceptual Framework,
apply for the recognition of financial assets and financial liabilities.
• An entity is required to recognise a financial asset or financial liability whenever it becomes party to
the contractual provisions of a financial instrument.
• IFRS 9 outlines very specific requirements for the derecognition of financial assets and financial
liabilities.
• A financial asset shall be removed from a statement of financial position when:
– the contractual rights to the cash flows from the financial asset, or
– the entity transfers the financial assets in accordance with conditions specified in IFRS 9
paragraphs 3.2.4 and 3.2.5, and the transfer qualifies for derecognition in accordance with
paragraph 3.2.6.
• A financial liability is normally derecognised when the debtor pays cash or other financial assets to
the creditor and is therefore relieved of its obligation for the liability. The debtor can also be relieved
of its obligation by the court of by the creditor.
• A financial liability can also be derecognised when there are substantial modifications to an existing
debt instrument or where a new debt instrument with substantially different terms is issued.

322 Financial Reporting

PART C: CLASSIFICATION OF FINANCIAL
ASSETS AND FINANCIAL LIABILITIES
INTRODUCTION
Part C addresses the principles from IFRS 9 regarding the classification of financial assets and financial
liabilities, which affects how these assets and liabilities are to be measured. This part concludes with the
rules for reclassification of financial assets and financial liabilities.

Relevant Paragraphs
To assist in understanding certain sections in this part, you may be referred to relevant paragraphs in
IFRS 9 or IAS 32. You may wish to read these paragraphs as directed.

6.8 CLASSIFICATION OF FINANCIAL ASSETS

Paragraph 4.1.1 of IFRS 9 requires entities to classify financial assets, upon initial recognition, into two
categories that reflect their subsequent measurement:
• financial assets to be subsequently measured at amortised cost
• financial assets to be subsequently measured at fair value through OCI or through P/L.
The classification should be based on both:
(a) the entity’s business model for managing the financial assets
(b) the contractual cash flow characteristics of the financial asset (IFRS 9, para. 4.1.1).

Paragraph 4.1.2 of IFRS 9 requires entities to measure a financial asset at amortised cost when both of
the following conditions are met:
(a) the financial asset is held within a business model whose objective is to hold financial assets in order
to collect the contractual cash flows and
(b) the contractual terms of the financial asset give rise on specified dates to cash flows that are solely
payments of principal and interest on the principal amount outstanding.

Paragraph 4.1.2A of IFRS 9 states a financial asset is to be measured at fair value through OCI (FVOCI)
when both of the following conditions are met:
(a) the financial asset is held within a business model whose objective is achieved by both collecting
contractual cash flows and selling financial assets.
(b) the contractual terms of the financial asset give rise on specified dates to cash flows that are solely
payments of principal and interest on the principal amount outstanding.

The distinction between paragraphs 4.1.2 and 4.1.2A of IFRS 9, and whether a financial asset is
measured at amortised cost or at fair value through OCI, is based on the entity’s business model for
managing financial assets to generate cash flows. When the objective of the business model is to hold
a portfolio of financial assets in order to collect contractual cash flows, a financial asset in that portfolio is
to be measured at amortised cost. When the objective of the business model is to both collect contractual
cash flows and sell financial assets from a portfolio, a financial asset in that portfolio is to be measured at
fair value through OCI. Further discussion of an entity’s business model for managing financial assets is
provided in the next section.
Paragraph 4.1.4 of IFRS 9 states that a financial asset will be measured at fair value through P/L (FVTPL)
in cases where it does not meet the requirements listed earlier in this section to be measured at amortised
cost or at fair value through OCI. However, when an entity has an investment in equity instruments, rather
than measuring the investment at fair value through P/L, the entity can make an irrevocable election to
recognise the investment as a financial asset measured at fair value through OCI. However, an entity
cannot choose this option for investments in equity instruments that are held for trading, or for the
contingent consideration in a business combination to which IFRS 3 applies (IFRS 9, para. 5.7.5). Business
combinations were discussed in module 5.
Note also that it is possible to classify a financial asset as subsequently measured at fair value through
P/L without considering the entity’s business model or the contractual characteristics of the financial asset.

MODULE 6 Financial Instruments 323

This exemption is specified under paragraph 4.1.5 of IFRS 9 and it is only allowed if applying the fair value
through P/L ‘eliminates or significantly reduces a measurement or recognition inconsistency (sometimes
referred to as an ‘accounting mismatch’) that would otherwise arise from measuring assets or liabilities or
recognising the gains and losses on them on different bases’. For example, a financial asset is measured
at fair value through P/L, and a related liability is measured at amortised cost. This inconsistency may
arise because the current measurement model is a mixed attribute model, whereby some elements may
be measured at cost and others at fair value. As a result, there may be measurement inconsistency when
the assets and liabilities are closely linked, as they would be for an insurer. In such a case, the entity
can elect to use fair value through P/L and avoid the measurement inconsistency, but this is an irrevocable
decision. The designation does not have to be applied to all financial assets but must be applied consistently
each period to those financial assets so designated. It may also be applied to groups of financial assets.
Figure 6.2 summarises the financial assets categories under IFRS 9.

BUSINESS MODEL FOR MANAGING FINANCIAL ASSETS

The linking of classification with an entity’s business model for managing financial assets is consistent
with the approach used by the IASB in other standards, such as IFRS 8 Operating Segments. The term
‘business model’ is not defined in IFRS 9, but it is described in paragraph B4.1.1 as the entity’s ‘business
model as determined by the entity’s key management personnel’.
As it is possible for an entity to hold portfolios of financial assets with different objectives, the business
model for managing financial assets is normally decided on a portfolio-by-portfolio basis.

EXAMPLE 6.9

Multiple Business Models

The key management personnel of Split Money Maker Ltd (Split) have formulated two business models,
one to hold financial instruments to collect their contractual cash flows (the ‘hold’ model) and another
to trade financial instruments for speculative, profit-making, purposes (the ‘trade’ model). Split holds
investments in government treasury notes under the ‘hold’ model to collect their contractual cash flows.
It also has investments in shares that it actively trades on a regular basis under the ‘trade’ model, trying
to make gains from price movements. Each of these models is distinct, and the financial instruments
allocated to each model will have different classification options available dependent on the model used
to manage them.
IFRS 9 allows entities to sell financial assets from a portfolio classified as ‘held with the intention to
collect the contractual cash flows’, provided such sales are not a frequent occurrence and, where they
are, that the entity reassesses the classification (para. B4.1.3B). IFRS 9 does not define ‘frequent’ or
‘infrequent’. In a similar way, sales may align with the objective of holding financial assets to collect
contractual cash flows if they are made close to the maturity and the proceeds from the sales do not
differ significantly from the collection of the remaining contractual cash flows (IFRS 9, para. B4.1.3B).

CONTRACTUAL CASH FLOWS THAT ARE SOLELY PAYMENTS

OF PRINCIPAL AND INTEREST ON THE PRINCIPAL AMOUNT
OUTSTANDING
IFRS 9, paragraph 4.1.3(b), states that ‘interest consists of consideration for the time value of money, for
the credit risk associated with the principal amount outstanding during a particular period of time and for
other basic lending risks and costs, as well as a profit margin’. Where interest represents more than this,
the financial asset cannot be classified as measured at amortised cost.
Paragraph B4.1.9 of IFRS 9 discusses leverage and describes it as ‘a contractual cash flow characteristic
of some financial assets [that] increases the variability of the contractual cash flows’, with the result that
they cannot be considered payments of interest. Stand-alone option, forward and swap contracts have this
cash flow characteristic, and therefore they do not meet the test of contractual cash flows that represent
solely payments of interest and principal — as a consequence, the financial assets resulting from these
contracts cannot be classified as measured at amortised cost or at fair value through OCI.
Paragraphs B4.1.13 and B4.1.14 of IFRS 9 provide further examples of instruments that would meet the
test of contractual cash flows that do represent solely payments of interest and principal, and others that
do not meet the test.

324 Financial Reporting

 FIGURE 6.2 Summary of financial asset categories as per IFRS 9 Financial Instruments classification requirements

The following decision tree may be used to determine the appropriate classification of a financial asset consistent with IFRS 9.

Debt investments (including hybrid contracts) Derivatives* Equity investments*

SPPI NO YES Is the equity

Are the financial asset’s contractual cash flows solely
test investment
payments of principal and interest?
held for trading?
YES

Is the financial asset

Is the financial asset
held in a business
Business held in a business NO NO
model whose objective NO
model model whose objective
is to collect contractual
test is to collect contractual
cash flows and sell
cash flows?
financial assets?

YES YES NO Was the FVOCI option

elected?
Was a FVTPL election made to eliminate or significantly YES
reduce an accounting mismatch?
YES
NO NO

Amortised cost FVOCI FVOCI

FVTPL
(with recycling) (no recycling)
• Credit impairment, interest revenue and • Credit impairment, interest revenue and • All changes in fair value are recognised • All changes in fair value are recognised
foreign exchange gains or losses are foreign exchange gains or losses are through P/L through OCI
recognised in P/L recognised in P/L • Generally, dividends are recognised
• On derecognition of asset, gains or • Other gains and losses are recognised in P/L
losses are recoignised in P/L in OCI • On derecognition, cannot reclassify
• On derecognition, the cumulative gains gains or losses to P/L (i.e. no recycling
or losses in OCI are reclassified to P/L is allowed)
(i.e. recycling)
* Assuming the contractual terms of the financial asset do not give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount
outstanding. This is generally the case for equity investments and derivatives; hence, we recommend this simplified approach to the classification of these instruments.
Source: MNP 2016, An overview of IFRS 9 Financial Instruments vs. IAS 39 Financial Instruments: Recognition and Measurement, January, p. 5, accessed July 2019, https://www.mnp.ca/en/assurance-
accounting/financial-reporting-library/ifrs-implementation-guide-an-overview-of-ifrs-9-vs-ias-39.

MODULE 6 Financial Instruments 325

 EXAMPLE 6.10

Contractual Cash Flows Test

1. James and Kellee agree to a variable rate loan of $500 000 to finance the acquisition of a house. The
variable rate of interest is reset each month based on LIBOR (London Interbank Offered Rate).
2. Troy and Megan also agree to a variable rate loan of $500 000 to finance the acquisition of a house.
The variable rate of interest is reset each month based on 1.5 times LIBOR.
The loan to James and Kellee would satisfy the sole payments of interest and principal test in
IFRS 9, but the loan to Troy and Megan would not. The reset rate of 1.5 times LIBOR introduces leverage
and means the payments Troy and Megan will make on their loan are more than just payment of interest
and principal.
Paragraphs B4.1.10–B4.1.11 of IFRS 9 discuss the impact of early repayment, extensions to repayment
and changes to the payments during the life of the instrument. In all cases, the test to apply is: Do
the payments still represent solely payments of interest and principal before and after the changes to
the conditions?

QUESTION 6.5

Determine whether the following instruments satisfy the sole payments of interest and principal
requirement in IFRS 9.
(a) A bond that is convertible into shares of the issuer and the return on the bond is linked to the
return on the issuer’s shares.
(b) A variable rate loan where the rate is reset every three months based on movements in the
CPI index.

EXAMPLE 6.11

Business Model and Contractual Cash Flows Test

Entity A must fund a major purchase of machinery ($10m) in four years’ time as part of a capital renewal
program. To fund the program, the CFO is considering two approaches to investing the surplus funds prior
to the capital expenditure and seeks your input as financial controller in the accounting classification for
each approach. The approaches are as follows.
1. To invest in 90-day bank bills, which are continuously rolled into new bills until the capital expenditure
funds are required. Some bills may be sold dependent on the timing of the capital expenditure. However,
any gains or losses would be insignificant due to the short-term nature of the bills.
2. To invest in medium- to long-term bonds so as to optimise interest income, and then sell these bonds
when the capital expenditure funds are required.
As financial controller, you advise that the first approach would be classified as amortised cost as the
contractual cash flows consist of solely interest and principal, and the business objective is solely to
collect interest and principal. It is expected that there may be some sales at the end of the program,
but the gains and losses will be insignificant and effectively reflect the proceeds that would approximate
the collection of the remaining contractual cash flows. However, the second approach would cause the
financial asset to be classified as fair value through OCI because, while the contractual cash flows consist
of solely interest and principal, the business objective is to both collect the cash flows and sell the assets
so as to optimise income.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 4.1.1–4.1.5, B4.1.1–B4.1.19 and B4.1.27–
B4.1.36 of IFRS 9.

6.9 CLASSIFICATION OF FINANCIAL LIABILITIES

Paragraph 4.2.1 of IFRS 9 requires all financial liabilities to be classified and subsequently measured at
amortised cost, except for:
(a) ‘financial liabilities at fair value through profit or loss. Such liabilities, including derivatives . . . shall
be subsequently measured at fair value’ through P/L.

326 Financial Reporting

(b) ‘financial liabilities that arise when a transfer of a financial asset [as discussed in part B] does not
qualify for derecognition or when the continuing involvement approach applies’. The example in part
B — where the transferor transfers $5 million worth of debtors to another entity but guarantees the
transferee for all losses due to bad debts up to $1 million — gives rise to a financial liability for the
transferor of $1 million.
(c) financial guarantee contracts as defined in Appendix A, which refers to a guarantee where the guarantor
is now required to make payments to the lender due to some form of default by the original borrower.
Such contracts are to be measured — unless paragraphs (a) or (b) of this section apply — at the higher
of the amount determined in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent
Assets and the amount initially recognised.
(d) ‘commitments to provide a loan at a below-market interest rate’. The commitments are measured —
unless paragraph (a) of this section applies — in a similar way to the financial guarantee contracts
described under (c).
(e) contingent consideration of an acquirer in a business combination to which IFRS 3 Business
Combinations applies. Such contingent consideration shall subsequently be measured at fair value
with changes recognised in P/L.

OPTION TO DESIGNATE A FINANCIAL LIABILITY AT FAIR

VALUE THROUGH PROFIT OR LOSS
Paragraph 4.2.2(a) of IFRS 9 allows entities to classify a financial liability to be measured at fair value
through P/L where ‘it eliminates or significantly reduces measurement or recognition inconsistency that
would otherwise arise from measuring assets and liabilities or recognising gains and losses on different
bases’. This is consistent with the treatment of financial assets.
Paragraph 4.2.2(b) of IFRS 9 allows the same irrevocable decision to be made where ‘a group of financial
liabilities or a group of financial assets and financial liabilities is managed and its performance evaluated on
a fair value basis, in accordance with a documented risk management or investment strategy’. An example
would be a superannuation fund or a property trust that holds assets used entirely to meet the obligations of
the entity. Hence, the key management personnel of the entity use fair values as the only relevant measure
and actively manage its assets and liabilities based on movements in fair values.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 4.2.1–4.2.2 and B4.1.27–B4.1.36 of IFRS 9.

EMBEDDED DERIVATIVES
Derivatives are classified as at fair value through P/L unless the derivative is subject to hedge accounting.
Classifying a derivative at fair value through P/L means it is measured at fair value with gains or losses
arising from changes in fair value recognised in profit or loss. Derivatives can also be embedded in financial
assets or financial liabilities, as well as non-financial contracts. Embedded derivatives have specific
accounting requirements under IFRS 9.

What is an Embedded Derivative?

The terminology for assessing the accounting treatment of an embedded derivative is summarised in
table 6.2. An embedded derivative is a component of a hybrid instrument that also includes a non-derivative
host contract. A host contract can take any form of contract, including a sale or purchase agreement.

TABLE 6.2 Embedded derivative terminology

Component Terminology

Derivative Embedded derivative

Non-derivative Host contract

Total Hybrid instrument

Source: CPA Australia 2019.

MODULE 6 Financial Instruments 327

 In accordance with IFRS 9, it must be determined whether an embedded derivative needs to be separated
from the host contract and recognised at fair value through P/L.

Do Embedded Derivatives Need to be Separated?

Not all embedded derivatives need to be separated from the host contract. Under IFRS 9, there is
no separation of embedded derivatives in financial assets if the financial asset does not meet the
separation criteria.
The process of identifying embedded derivatives and determining whether they need to be separated in
accordance with paragraph 4.3.3 of IFRS 9 is determined by the following questions.
• Is the host contract measured at fair value through P/L?
• Does the embedded derivative meet the definition of a derivative on a stand-alone basis?
• Is the embedded derivative clearly and closely related to the host contract?
The process is summarised in figure 6.3 and described in the following text.

FIGURE 6.3 Identifying embedded derivatives

2.
3.
1. Does the
Is the embedded
Is the host No embedded Yes No Separate
derivative closely
contract fair derivative meet the accounting
related to the
valued? definition on a
host contract?
stand-alone basis?

Yes No Yes

No separate accounting under IFRS 9 Financial Instruments

Source: CPA Australia 2019.

• Step 1: Is the host contract fair valued?

If a host contract is already classified as at fair value through P/L, there is no need to separate the
embedded derivative. The value of the embedded derivative will already be reflected in the value of the
host contract.
• Step 2: Does the embedded derivative meet the definition of a derivative on a stand-alone basis?
Does the potential embedded derivative that has been identified meet the definition of a derivative on
its own? For example, a CPI clause in a lease agreement would be regarded as an embedded derivative
because it satisfies the three characteristics of the definition of a derivative IFRS 9, Appendix A.
• Step 3: Is the embedded derivative closely related to the host contract?
The embedded derivative does not need to be separated when it is closely related to the host contract.
Assessing whether the embedded derivative is closely related requires an analysis of the economic
characteristics and risks of the host contract to determine whether the embedded derivative changes
the nature of the risks involved in the host contract.
If an embedded derivative is not closely related to the host contract, it must be separated from the host
contract and accounted for at fair value through P/L. If the embedded derivative is separated, the host
contract must also be accounted for in accordance with the appropriate IFRS.
For example, company Hybrid issues a three-year debt instrument with a principal amount of
$10 000 000 indexed to the share price of Company No-relative, which is a publicly-traded company
not related in any way to Hybrid. At maturity, the holder of the instrument will receive the principal
amount (plus any appreciation or minus any depreciation in the fair value of 200 000 shares of Company
No-relative) with changes in fair value measured from the date of the issuance of the debt instrument.
No separate interest payments are made. The last sale price at the issuance date of Company No-relative
shares, to which the debt instrument is indexed, is $50 per share.
The instrument is not itself a derivative because it requires an initial net investment equal to the notional
amount of $10 000 000. The derivative definition in IFRS 9 Appendix A states that one of the characteristics
of a derivative is that it requires no initial net investment or ‘an initial net investment that is smaller than

328 Financial Reporting

would be required for other types of contracts that would be expected to have a similar response to changes
in market factors’ (IFRS 9, para. BA.3).
The host contract is a debt instrument because the instrument has a stated maturity and the issuer is
obligated to pay the holder an amount determined by reference to the share price of Company No-relative
at maturity. Also, the holder has none of the rights of a shareholder, such as the ability to vote at company
annual general meetings or receive dividend distributions. This is similar to issuing a debenture bond.
The embedded derivative is an equity-based derivative that:
• would satisfy the definition of a stand-alone derivative
• is not economically closely related to the debt instrument, and hence must be separated from the host
contract unless the host contract is classified at fair value through profit or loss.
IFRS 9, paragraph 4.3.5, permits the entire hybrid contract to be accounted for at fair value through P/L,
except where the embedded derivative does not significantly alter cash flows or where it is clear that the
embedded derivative and the host contract are closely related. Where an entity is required but unable to
separate an embedded derivative from its host contract, either at acquisition or at a subsequent reporting
date, it should account for the whole instrument at fair value through P/L. Cases where the embedded
derivative cannot be separated from the host contract include, but are not limited to, situations where the
market for the derivative does not exist, making it impossible to value the embedded derivative in isolation.
The following example illustrates two embedded derivative scenarios, with the embedded derivative and
the host contract being closely related and not closely related, respectively.

EXAMPLE 6.12

Examples of Embedded Derivatives

The Australian Government Department of Defence enters into a contract to purchase military equipment
from a US supplier. The supplier is willing to accept payment in a fixed amount of USD or the Malaysian
ringgit equivalent of the USD amount, and so offers these payment alternatives to the Australian
Government. The government analyses the accounting impact of each payment option and determines:
1. the fixed payment of USD creates a USD currency derivative, as the amount of Australian currency
required to settle the contract will depend on movements in the AUD/USD exchange rate. In this case,
the embedded derivative is closely related to the host contract, as the payment is made in the functional
currency of the supplier and this currency risk is what would normally be expected when purchasing
from a US supplier.
2. the Malaysian ringgit payment option adds a currency which is not the functional currency of the buyer
or the seller. Therefore, the embedded derivative would not be closely related to the host contract and
would have to be accounted for separately under IFRS 9. This would mean carrying the embedded
derivative at fair value, taking changes in fair value to P/L.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 4.3.1–4.3.7 and B4.3.1–B4.3.10 of IFRS 9.

6.10 RECLASSIFICATION
In IFRS 9, the only circumstance where it is permissible to reclassify a financial asset is where an
entity changes its business model for managing the financial asset (IFRS 9, para. 4.4.1). It is stated that
this is expected to be rare and paragraph B4.4.1 of IFRS 9 provides two examples of a change in a
business model. Also, paragraph B4.4.3 of IFRS 9 provides examples of situations where reclassification
of financial assets is not permitted as they do not qualify as a change in a business model:
• where an entity transfers financial assets between different portfolios
• where a market for financial assets temporarily disappears
• where an entity changes its intention to hold a financial asset.
Financial liabilities are not permitted to be reclassified, as stated in IFRS 9, paragraph 4.4.2.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 4.4.1–4.4.3 and B4.4.1–B4.4.3 of IFRS 9.

MODULE 6 Financial Instruments 329

SUMMARY
Part C discussed the classification of financial assets and financial liabilities. Financial assets are classified
as financial assets to be subsequently measured at amortised cost, fair value through OCI or fair value
through P/L. To be classified as a financial asset to be subsequently measured at amortised cost, the
financial asset must be held within a business model whose objective is to hold financial assets in order to
collect contractual cash flows, and the contractual terms of the financial asset must give rise on specified
dates to cash flows that are solely payments of principal and interest on the principal amount. All other
financial assets are classified at fair value. The exception is where an irrevocable decision is taken to
classify a financial asset that would otherwise qualify to be subsequently measured at amortised cost, at
fair value through P/L in order to eliminate an accounting mismatch.
Financial liabilities are classified at either amortised cost or fair value through P/L. A financial liability
is classified as fair value through P/L if by doing so, an accounting mismatch is eliminated.
The other categories of financial liabilities include financial guarantee contracts and commitments to
provide a loan at a below-market interest rate.
Part C also discussed embedded derivatives and considered their treatment when the host contract is, as
well as when it is not, a financial asset within the scope of IFRS 9. Part C concluded by specifying that
reclassification of financial assets is only permitted when there is a change in the entity’s business model
for managing financial assets, and that reclassification is not permitted for financial liabilities.
Having studied the classification of financial assets and liabilities, part D now turns to the measurement
of financial assets and liabilities, as outlined in IFRS 9.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

6.3 Explain and apply the approach to the classification, reclassification and measurement of
financial assets and financial liabilities.
• Classifying a financial instrument as either a liability or equity requires professional judgment as it
affects the presentation of claims against an entity.
• Incorrectly classifying a financial instrument can have serious consequences on the assessment of
an entity’s liquidity.
• Classifying an instrument as a liability implies that the entity is obliged to transfer economic resources
at some future date.
• If the instrument requires the entity to deliver a fixed number of its own shares to settle a fixed dollar
amount (the fixed-for-fixed test), the instrument is classified as equity.
• The classification of financial assets is based on both the entity’s business model for managing the
financial assets, and the contractual cash flow characteristics of the financial asset.
• There are two categories of financial assets that reflect their subsequent measurement:
– financial assets subsequently measured at amortised cost
– financial assets subsequently measured at fair value through P/L or OCI.
• All financial liabilities are to be classified and subsequently measured at amortised cost, except for:
– financial liabilities at fair value through P/L
– financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition,
or when the continuing involvement approach applies.
• A financial asset can only be reclassified when an entity changes its business model for managing
the financial asset.
• Situations that do not qualify as a change in a business model include:
– where an entity transfers financial assets between different portfolios
– where a market for financial assets temporarily disappears
– where an entity changes its intention to hold a financial asset.
• Financial liabilities are not permitted to be reclassified.

330 Financial Reporting

PART D: MEASUREMENT
INTRODUCTION
Part C looked at the classification of financial assets and financial liabilities, which in turn determines
the appropriate measurement method. Part D now considers the measurement of financial assets, financial
liabilities and equity instruments, referencing the principles from IFRS 9 where relevant.

Relevant Paragraphs
To assist in understanding certain sections in this part, you may be referred to relevant paragraphs in
IFRS 9, IFRS 7 or IAS 32. You may wish to read these paragraphs as directed.

6.11 INITIAL MEASUREMENT

Paragraph 5.1.1 of IFRS 9 states that all financial assets and financial liabilities should be initially
measured at fair value. For financial instruments that are not subsequently measured at fair value through
P/L, the initial amount recognised shall include transaction costs that are directly attributable to the
acquisition or issue of the financial asset or financial liability. Such transaction costs are added to the
fair value for a financial asset and deducted from the fair value for a financial liability.
IFRS 9 does not include a definition of ‘fair value’. It refers to the term being defined in other accounting
standards, such as IFRS 13. Fair value is defined, in paragraph 9 and Appendix A of IFRS 13 Fair Value
Measurement, 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’. The term ‘fair value’ is also used in other
standards and is a term with which one should be familiar.
Fair value, including the requirements of IFRS 13, is discussed in detail in module 1. IFRS 13 prescribes
a fair value measurement hierarchy, which includes three levels for inputs to fair value measurement.
• Level 1 inputs refer to quoted prices for identical assets in active markets.
• Level 2 inputs refer to inputs such as a quoted price for comparable assets where there are no significant
unobservable inputs.
• Level 3 inputs refer to inputs that must be estimated based on valuation models where there are
significant unobservable inputs.
Paragraph 5.1.1A of IFRS 9 directs readers to paragraph B5.1.2A for the way to account for any financial
asset or financial liability that has a fair value different from the transaction price (i.e. the fair value of the
consideration transferred). Essentially, there are two possible treatments when this arises, as follows.
1. Where there are no unobservable inputs in the valuation, such that the fair value is determined by
reference to an active market price for an identical asset or liability (this is a Level 1 measure of fair
value) or another valuation technique that uses observable inputs, then the difference between the fair
value and the transaction price is recognised as a gain or loss.
2. In all other cases, the difference is deferred and recognised over time based on the change in a factor
such as the unwinding of a discount over time.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 5.1.1–5.1.1A and B5.1.1–B5.1.2A of IFRS 9.

6.12 SUBSEQUENT MEASUREMENT OF

FINANCIAL ASSETS
The subsequent measurement of financial assets is determined by their classification, which was discussed
in part C and is summarised in figure 6.2. Impairment of financial assets and any related foreign exchange
gains or losses will always be recognised in P/L. All other changes in the fair value will be recognised in P/L
only for financial assets designated as subsequently measured at FVTPL. For financial assets designated
as subsequently measured at FVOCI, the other changes in the fair value will be recognised in OCI. For
the subsequent measurement of financial assets measured at amortised cost, while changes in the fair
value other than impairment and any related foreign exchange gains or losses will not be recognised, it is
important to determine the effective interest rate for impairment testing. Example 6.13 shows how this is
normally done.

MODULE 6 Financial Instruments 331

 EXAMPLE 6.13

Calculating the Effective Interest Rate for an Instrument

Measured at Amortised Cost
The effective interest rate is simply a discount rate that discounts all future cash flows to the amount of
cash received or paid at the present date. Calculating the effective interest rate of a financial instrument
is relatively simple in concept, but unfortunately, there is no simple formula to calculate it. Financial
calculators, computer software, and trial and error are the primary methods for calculating the rate.
Consider a bank that lends money and charges an establishment fee. If the bank intends to measure this
instrument at amortised cost, that establishment fee must be included in the calculation of the effective
interest rate of the instrument. If the bank lent JPY 1000 for two years at an interest rate of 2% and charged
an additional JPY 10 as an establishment fee to establish the loan, the effective interest rate would be
determined by solving the following discounting formula.

1 1 1
1010 = 20 × + 20 × + 1000 ×
[ 1 + RATE ] [ (1 + RATE) 2 ] [ (1 + RATE)2 ]
Using the original interest rate of 2% does not work because that discounts to JPY 1000. The effective
interest rate will need to be lower than 2% in order to increase the present value (PV) of the cash flows to
the amount received at the present date (i.e. JPY 1010). Using a rate of 1% provides a discounted value
of JPY 1020, so clearly 1% is too low. Splitting the difference between the two rates and using a rate of
1.5% gives a discounted value that, when rounded up, equals JPY 1010. Using the Goal Seek function in
Microsoft Excel (or a financial calculator) yields an exact rate of 1.49%.
Example 6.14 illustrates how the effective interest rate is used in amortised cost measurement.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 5.4.1–5.4.3 of IFRS 9.

IMPAIRMENT OF FINANCIAL ASSETS CARRIED AT

AMORTISED COST
An asset is impaired when its carrying amount is greater than its recoverable amount. This applies to both
financial and non-financial assets. Impairment losses for non-financial assets are dealt with in IAS 36
Impairment of Assets (discussed in module 7). The requirements for impairment of financial assets carried
at amortised cost are a bit stricter. For these financial assets, an entity needs to recognise impairment for
expected credit losses, even if there is currently no indication of impairment (IFRS 9, para. 5.5.1).
Accounting for impairment of financial assets carried at amortised cost is intended to prevent financial
assets being carried at values that might no longer represent their true value, given changes in economic
factors. Considering that financial assets at amortised cost are those the entity intends to collect cash flows
from, it is vitally important that users are able to assess whether those cash flows will actually flow to the
entity. Consider a bank with a large mortgage portfolio. If a significant portion of that portfolio resided
in an economic area experiencing a significant downturn, the bank might not collect all the cash flows it
intended. From a user perspective, this should be reflected through impairment.
Impairment proceeds on a three-stage basis dependent on the credit status of the financial instrument.
• Stage 1 — If the credit risk has not increased significantly since initial recognition, then 12 months of
expected credit losses are recognised (IFRS 9, para. 5.5.5). Effective interest is calculated on the gross
amortised cost base (IFRS 9, para. 5.4.1).
• Stage 2 — If the risk of default has significantly increased since the initial recognition, an entity is
required to recognise the ‘lifetime expected credit losses’ on a financial instrument (IFRS 9, para. 5.5.3).
Effective interest is calculated on the gross amortised cost base (IFRS 9, para. 5.4.1).
• Stage 3 — If the financial instrument is ‘credit impaired’, an entity is required to recognise the ‘lifetime
expected credit losses’ on a financial instrument. Effective interest is calculated net of impairment losses
(IFRS 9, para. 5.4.1b).
The three-stage impairment model prescribed by IFRS 9 for financial instruments is summarised in
figure 6.4.

332 Financial Reporting

 FIGURE 6.4 IFRS 9 impairment approach

Overview of Impairment Requirements Under the New IFRS 9 Expected Loss Model
The following diagram provides a high-level overview of the general IFRS 9 impairment approach

STAGE 1 STAGE 2 STAGE 3

Level of No significant increase in Significant increase in

credit risk credit risk since initial credit risk since initial Credit-impaired
deterioration recognition recognition

Impairment 12-month expected

Lifetime expected credit losses
recognition credit losses

Interest
Gross basis Net basis
recognition

Decrease in Increase in
credit risk credit risk
Source: MNP 2016, An overview of IFRS 9 Financial Instruments vs. IAS 39 Financial Instruments: Recognition and Measurement,
January, p. 12, accessed July 2019, https://www.mnp.ca/en/assurance-accounting/financial-reporting-library/ifrs-implementation-
guide-an-overview-of-ifrs-9-vs-ias-39.

EXAMPLE 6.14

Impairment of a Financial Asset

An entity has a note receivable and, in June 20X2, it is notified by the issuer that it will only be able to pay
$110 000 at maturity. It is unlikely that the entity will receive any more after this date. The entity’s initial
estimate of 12 months of credit losses is $2000. The following details are available.

$
Issue price of the note on 1/07/20X0 100 000
Maturity value of the note on 30/06/20X3 133 100

No interest is paid on the note. The effective interest rate is the rate that discounts $133 100 in three
years to a PV of $100 000 — that is 10%.
The following journal entries are recorded for the note.

1/07/20X0
Dr Note receivable 100 000
Cr Cash 100 000

Record the acquisition of the note at fair value at the issue date (according to IFRS 9, para. 5.1.1). This
is also equal to PV of the maturity value of $133 100, calculated based on the effective interest rate.

30/06/20X1 (reporting date)

Dr Note receivable 10 000
Cr Interest revenue 10 000

MODULE 6 Financial Instruments 333

 The value of the note increases to $110 000, which is the PV of $133 100 due in two years. The increase
represents interest revenue.

30/06/20X1
Dr Impairment loss 2 000
Cr Provision for expected credit loss 2 000

As credit risk has not increased significantly, under Stage 1 record the 12 months of expected
credit losses.

30/06/20X2 (reporting date)

Dr Note receivable 11 000
Cr Interest revenue 11 000

The value of the note increases to $121 000, which is the PV of $133 100 due in one year.

30/06/20X2
Dr Provision for expected credit loss 2 000
Cr Impairment loss 2 000

Reverse expected credit loss provision as the instrument is in Stage 3 and raise an impairment loss, as
shown next.

30/06/20X2
Dr Impairment loss 21 000
Cr Provision for impairment 21 000

As the counterparty is ‘credit impaired’ under Stage 3, impairment loss is based on the expected
recovery using the initial discount rate of 10%, based on final expected cash flow of $110 000. PV at
30 June 20X2 is $100 000.

30/06/20X3 (reporting date)

Dr Cash 110 000
Dr Provision for impairment 21 000
Cr Interest revenue 10 000
Cr Note receivable 121 000

Proceeds are recovered as advised. Impairment loss provision is eliminated, and interest is earned at
the effective interest rate recognised at inception.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 5.4.1, 5.5.1, 5.5.3 and 5.5.5 and definition of
‘credit impaired financial asset’ and ‘credit loss’ Appendix A of IFRS 9.

RECLASSIFICATION OF FINANCIAL ASSETS

The requirements for reclassification of financial assets are straightforward and covered in
paragraphs 5.6.1–5.6.3 of IFRS 9. Where an entity satisfies the rule for reclassification — that is, where
there is a new business model for managing the financial assets — it shall:
• not restate any previously recognised gains and losses
• where a financial asset is reclassified to fair value, measure fair value at the date of reclassification and
recognise any gain or loss in P/L
• where a financial asset is reclassified to amortised cost, recognise the fair value at the reclassification
date as the new carrying amount.

334 Financial Reporting

6.13 SUBSEQUENT MEASUREMENT OF FINANCIAL
LIABILITIES
The subsequent measurement of financial liabilities is also determined by their classification, which was
discussed in part C and is summarised in table 6.3.

TABLE 6.3 Measurement requirements of IFRS 9 Financial Instruments for financial liabilities

Financial liability Measurement

Financial liabilities Amortised cost

Financial liabilities at fair value through P/L Fair value

Financial guarantee contracts Higher of the amount determined from applying the impairment
provisions under IFRS 9 and the amount initially recognised less
cumulative income recognised in accordance with IFRS 15

Loan commitments at below-market Higher of the amount determined from applying the impairment
interest rates provisions under IFRS 9 and the amount initially recognised less
cumulative income recognised in accordance with IFRS 15

Financial liability designated as a hedged Apply the hedge accounting rules from IFRS 9, which are covered
item in part E

Source: Adapted from IFRS Foundation 2019, IFRS 9 Financial Instruments, in IFRS Standards issued at 1 January 2019, IFRS
Foundation, London.

EXAMPLE 6.15

Amortised Cost Measurement of a Financial Liability

China General Manufacturing Company (CGMC) requires additional funding to expand its product
offerings into Australia. Accordingly, on 1 January 20X3, it obtains a three-year loan of 5 000 000 Chinese
Yuan (CNY) from a bank at an interest rate of 4.5%. Interest payments are made annually in arrears.
CGMC is required to pay CNY 180 000 to establish the loan, which the bank deducts from the loan amount
advanced.
CGMC measures the loan at amortised cost and notes that the CNY 180 000 establishment fee is an
integral part of the effective interest rate of the loan. CGMC decides to amortise the establishment fee
over the life of the loan and must, therefore, adjust the 4.5% real interest rate to account for this additional
expenditure.
Using the formula and financial tools as described in example 6.13, CGMC calculates the effective
interest rate that discounts all future cash flows to the amortised cost of the loan of CNY 4 820 000 (which is
the loan amount net of transaction costs in accordance with paragraph 5.1.1 of IFRS 9) to be approximately
5.8%. However, for the purposes of the calculations in the following table, the unrounded rate of 5.8429%
is used due to its higher accuracy. Candidates are not expected to calculate this rate in the exam.
The following table summarises the carrying amount of the loan, the interest expense and contractual
repayment amounts at the end of all three years.

Year Opening balance Repayment Interest expense Closing balance

20X3 4 820 000 (225 000) 281 627 4 876 627
20X4 4 876 627 (225 000) 284 936 4 936 563
20X5 4 936 563 (225 000) 288 437 5 000 000

On initial recognition of the loan, CGMC recognises the cash received (net of the establishment fee) and
the corresponding liability at fair value less the transaction costs.

1 January 20X3
Dr Cash 4 820 000
Cr Financial liability 4 820 000

On 31 December 20X3, CGMC calculates the effective interest expense on the loan based on its
amortised cost. This is 5.8% × 4 820 000 = 281 627. The cash interest payment is based on the stated

MODULE 6 Financial Instruments 335

 interest rate on the loan amount: 4.5% × 5 000 000 = 225 000. The difference of 56 627 is the amortisation
of the loan establishment fee in year one.

31 December 20X3
Dr Interest expense 281 627
Cr Cash 225 000
Cr Financial liability 56 627

This process is repeated in the next year, based on the new amortised cost of the loan arising from the
preceding journal entry: CNY 4 820 000 + 56 627 = 4 876 627.

31 December 20X4
Dr Interest expense 284 936
Cr Cash 225 000
Cr Financial liability 59 936

In the final year, this process is repeated again, but CGMC then repays the principal amount of
CNY 5 000 000.

31 December 20X5
Dr Interest expense 288 437
Cr Cash 225 000
Cr Financial liability 63 437
To record the interest payment and interest expense on
the loan.
Dr Financial liability 5 000 000
Cr Cash 5 000 000
To recognise the repayment of the loan.

Note that in each year the carrying amount of the loan is gradually increased to the final amount that
will be repayable.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 5.3.1–5.3.2 of IFRS 9.

6.14 RECOGNISING GAINS AND LOSSES ON THE

SUBSEQUENT MEASUREMENT OF FINANCIAL
ASSETS AND LIABILITIES
When a financial asset or a financial liability is measured at fair value, the changes in fair value must be
reported in the P/L for the period unless:
• it is part of a hedging relationship, in which case the hedge accounting rules in IFRS 9 (as discussed in
part E) are applied
• it is a financial asset held within a business model whose objective is to both collect contractual cash
flows and sell financial assets, and its contractual terms give rise on specified dates to cash flows that
are solely payments of principal and interest on the principal amount
• it is an investment in an equity instrument, and the entity has elected to report gains and losses in OCI
(equity instruments will be discussed next in this section), or
• it is a financial liability measured at fair value through P/L, and the gain or loss arises from changes in
the credit risk, which must be reported in OCI (this issue is discussed towards the end of this section).
For financial assets and financial liabilities carried at amortised cost and which are not part of a hedging
relationship, gains and losses are recognised in the normal manner when the financial assets and financial
liabilities are derecognised or impaired or reclassified in accordance with paragraph 5.6.2 of IFRS 9. The
amortisation process allows for the recognition of gains and losses associated with any premium or discount
at the date of acquisition.

336 Financial Reporting

 For financial liabilities and financial assets that are hedged items, hedge accounting (as set out in
IFRS 9) must be used.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 5.7.1–5.7.4 of IFRS 9. Please now attempt
question 6.6 to apply your knowledge of this topic.

QUESTION 6.6

Jolly Frog Ltd (Jolly Frog) has a portfolio of debt securities that it has been carrying at amortised
cost, as it met the rules in IFRS 9 based on its intent to hold the securities and collect the cash
flows over the terms of the debt securities. On 1 April 20X8, Jolly Frog acquired a financial services
section (Tadpole). Tadpole will have responsibility for managing the securities by selling and buying
based on price movements.
(a) Jolly Frog wants to apply fair value to the securities since the acquisition of Tadpole. Do you
think Jolly Frog meets the requirements in paragraph 4.4.1 of IFRS 9? Explain your answer.
(b) Assume Jolly Frog meets the requirement to change to fair value. Prepare the journal entry
for reclassification of the securities by Jolly Frog using the following data, explaining your
reasoning. For the purposes of this question, the impairment requirements of IFRS 9 do
not apply.
$
Cost of securities at 1 January 20X7 100 000
Recoverable value of securities at 30 June 20X7 90 000
Allowance for impairment loss 10 000
Fair value of securities at 1 April 20X8 115 000

6.15 INVESTMENTS IN EQUITY INSTRUMENTS

Many entities have investments in other entities. Provided the investment is in an equity instrument
(e.g. ordinary shares) — as defined in IAS 32, which was discussed in part A of this module — it will
be classified according to the decision tree in figure 6.2 (that summarises the requirements of IFRS 9 with
regards to the classification of financial instruments) as a financial asset to be subsequently measured at fair
value through OCI or through P/L. This classification is according to paragraph B5.2.3 of IFRS 9 that states
that all investments in equity instruments are to be measured at fair value, except in limited circumstances
where they can be measured at cost if it can be determined that cost is an appropriate estimate of fair value.
Paragraph B5.2.4 of IFRS 9 lists indicators that would capture situations where cost is not an appropriate
estimate of fair value. Such indicators include when the investee is performing significantly better or
worse than normal, or when the investee experiences significant internal problems, such as fraud — in
all these situations, cost cannot be used to measure the equity investment and the fair value will need to be
used instead.
According to the decision tree in figure 6.2, if the investment in equity instruments is held for trading,
it needs to be measured at fair value through P/L. ‘Held for trading’ is defined in IFRS 9, Appendix A
‘Defined terms’, and reflects the concept of active and frequent buying and selling with the objective
of generating a profit from short-term fluctuations in price or dealer’s margin. If the investment in equity
instruments is not held for trading, paragraph 5.7.5 of IFRS 9 allows entities to make an irrevocable election
to report subsequent changes in fair value in OCI. The irrevocable election can be made for each equity
investment an entity has and does not have to apply to the entire class of investments in equity instruments.
If that election is not made, then the equity investment is to be measured at fair value through P/L, even if
it is not held for trading.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 5.7.5–5.7.6, B5.2.3–B5.2.6 and B5.7.1 of
IFRS 9.

MODULE 6 Financial Instruments 337

6.16 LIABILITIES DESIGNATED AT FAIR VALUE
THROUGH PROFIT OR LOSS
Paragraph 5.7.7 of IFRS 9 provides the requirements for the treatment of liabilities designated as at fair
value through P/L. Part (a) of the paragraph requires entities to report the part of the change in the fair
value of such liabilities (other than financial guarantees and loan commitments) that is due to changes in
the credit risk in OCI. Part (b) requires the remaining amount of the change in fair value to be recognised
in P/L.
Credit risk is defined in Appendix A of IFRS 7 as ‘the risk that one party to a financial instrument will
cause a financial loss for the other party by failing to discharge an obligation’. The disclosure requirements
about credit risk are covered in part F. Please note that in the context used in IFRS 9, it is the credit
risk of the financial liability that is the focus — not the credit risk of an entity overall. For example, if
ABC Ltd issues secured and unsecured debt instruments, the credit risk of each instrument will be different
even though they are issued by the same entity. The unsecured debt would be a higher credit risk than the
secured debt.
Appendix B to IFRS 9 points out that credit risk is different from the asset-performance risk
(IFRS 9, para. B5.7.14). To explain the concept of asset-performance risk, Appendix B to IFRS 9 provides
an example of a special purpose entity (SPE) whose securities are offering returns based entirely on
the cash flows of the SPE’s underlying assets. When such assets perform poorly, the returns to the SPE
investors will decline. This is due to poor performing assets and not credit risk, and so the entire change
of the fair value of the liability to the SPE investors would be taken to P/L.
Paragraphs B5.7.16–B5.7.20 of IFRS 9 detail how the credit risk of a financial liability is to be measured
so that an entity is able to separate the fair value changes of a financial liability into an amount due to credit
risk (that should be recognised in OCI) and an amount due other factors (that should be recognised in P/L).
As an exception to the accounting treatment just outlined, if separating the changes in fair value related
to credit risk would create or enlarge an accounting mismatch in the P/L, then the entity shall present all
of the fair value changes in P/L.
The application of these measurement rules to a practical example is beyond the scope of this module.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 5.7.7 and B5.7.13–B5.7.20 of IFRS 9.

6.17 COMPOUND FINANCIAL INSTRUMENTS

Compound financial instruments, which were referred to earlier in this module, consist of both liability
and equity components. An example of a compound financial instrument is a debenture bond with an
option to convert into an ordinary share by the holder, either at a certain date or at any time up to a certain
date. Such an instrument contains a liability component and an equity component.
Component parts of a compound financial instrument are separately classified (IAS 32, para. 28).
According to IAS 32, it is more a matter of substance rather than legal form that liabilities and equity
interests are established by one financial instrument rather than two or more separate instruments
(paras 15 and 18).
IAS 32 requires issuers of instruments such as convertible notes to classify the components as a financial
liability (i.e. a contractual arrangement to deliver cash or other financial assets) and as an equity instrument
(i.e. an option to buy shares of the issuer). Once the component parts are recognised on the statement of
financial position, the classification is not revised, irrespective of the probability of conversion of the
right to purchase shares. If a convertible note is converted into ordinary shares, the equity component
(established when the notes were first issued) can be reclassified so that the amount becomes part of
distributable reserves. The liability component is extinguished with the issue of new shares.
Component parts are accounted for separately since issuing a financial instrument, like a convertible
note, is in substance the same as issuing debt and options to purchase ordinary shares. For example, imagine
that an entity issues two types of notes, each with a face value of $1000 and an interest rate of 6%, and
both maturing at the same time. The only difference is that one includes an option for the holder to convert
the note to ordinary shares in the entity at any time up to the maturity date, while the other did not include
such an option. Would you pay the same price for both notes?

338 Financial Reporting

 The note with the option to convert to shares will command a higher price, which demonstrates that
the option has a value. This is the major argument for the ‘component parts’ accounting approach for
compound financial instruments. As such, IFRSs require the issuer to account separately for the component
parts of compound financial instruments. The holder must account for such financial instruments in
accordance with IFRS 9, as discussed earlier in this module under ‘Embedded derivatives’.
IFRS 9 requires separate measurement of the component parts. IAS 32 requires entities to first measure
the value of the liability component, and the difference between the fair value of the compound instrument
and the value of the liability component is allocated to the equity component. No gain or loss is recognised
at the time of issue. This means that, at inception, the sum of the individual component values must equal
the value of the instrument as a whole.

EXAMPLE 6.16

Initial Measurement of a Compound Instrument

An entity issues 1000 convertible instruments on 1 July 20X6, at a face value of $500 per instrument. The
instruments mature in three years and pay 5% interest annually, in arrears. Each instrument is convertible
into 500 equity instruments at maturity, at the option of the holder. If the holder does not convert the
instrument, the entity will redeem it for face value of $500. At the time the instrument is issued, the
prevailing market interest rate for a similar instrument (without the conversion feature) is 7%.
Applying paragraph 28 of IAS 32, the entity determines it has issued a compound financial instrument
that has components of both equity and a liability. To split these components, the entity needs to determine
the fair value of the liability component as discounted using the prevailing market rate of interest.
Present Value of the Debt Component
The debt component is comprised of two cash flow streams:
• repaying the face value of the instrument (the principal) at the end of three years
• paying the annual interest coupons.
The fair value of the principal is calculated as follows.

1
$500 000 × = $408 149
[ (1 + 0.07)3 ]
The fair value of the coupon interest payments is calculated as follows.

1 1 1
$25 000 × + + = $65 608
([ (1 + 0.07)1 ] [ (1 + 0.07)2 ] [ (1 + 0.07)3 ])
Therefore, the total value of the liability component is $408 149 + $65 608 = $473 757.
Value of the Equity Component
Clearly, the entity received $500 000 when it issued these instruments (1000 instruments at $500 per
instrument = $500 000), but the value of the liability is only $473 757. The difference of $26 243 is the
value of the conversion option, which is classified as equity.
The journal entry to record the issue of the instruments on 1 July 20X6 is as follows.

1 July 20X6
Dr Cash 500 000
Cr Financial liability 473 757
Cr Equity 26 243

The equity component is never revalued. However, the liability component is subsequently accounted
for as any other financial liability. Its carrying amount will gradually accrete interest, at the prevailing market
interest rate, until it reaches its redemption amount of $500 000 at the end of its three-year life.
On maturity, assume all holders convert their instruments into equity. On conversion, the entity
extinguishes the liability with a corresponding issue of new equity.

30 June 20X9
Dr Financial liability 500 000
Cr Equity 500 000

MODULE 6 Financial Instruments 339

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 28–32, AG30–AG35 and Illustrative
Example 9 of IAS 32.

SUMMARY
Part D discussed the measurement of financial assets (including impairment), financial liabilities, invest-
ments in equity instruments and compound financial instruments. The measurement of the financial
assets and financial liabilities (upon initial recognition) is at fair value, plus or minus transaction costs,
when the financial asset or liability is not measured at fair value. Subsequent to acquisition, financial
assets and financial liabilities are measured according to their classification, as discussed in part C. For
financial assets and financial liabilities that are part of a hedging relationship, the hedge accounting rules in
IFRS 9 apply.
The gains and losses from remeasurement to fair value are included in P/L for all financial assets and
liabilities classified as at fair value through P/L, unless:
• the financial asset or liability is part of a hedge
• it is an investment in an equity instrument where the entity has made an irrevocable decision to classify
such gains and losses in OCI, or
• it is a financial liability designated as at fair value through P/L, and the change is due to credit risk of
the financial liability.
Entities have an irrevocable option to elect to report changes in fair value of an equity instrument in OCI
rather than P/L. This election is made on each investment.
The fair value changes for financial liabilities designated as at fair value through P/L are reported in
P/L except where a portion of the fair value change is due to changes in the credit risk of that liability, in
which case such gains or losses are reported in OCI. The only exception to this requirement arises when
the reporting of such gains or losses in OCI results in an accounting mismatch in P/L.
Gains and losses on financial guarantee contracts and loan commitments are reported in full in P/L.
Part E examines the requirements for hedge accounting in accordance with the principles in IFRS 9.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

6.3 Explain and apply the approach to the classification, reclassification and measurement of
financial assets and financial liabilities.
Initial measurement
• All financial assets and financial liabilities should be initially measured at fair value.
• For financial instruments which are not subsequently measured at fair value through P/L, the initial
amount recognised shall include transaction costs that are directly attributable to the acquisition or
issue of the financial asset or financial liability.
• There are three levels for inputs to fair value measurement.
– Level 1 inputs refer to quoted prices for identical assets in active markets.
– Level 2 inputs refer to inputs such as a quoted price for comparable assets where there are no
significant unobservable inputs.
– Level 3 inputs refer to inputs that must be estimated based on valuation models where there are
significant unobservable inputs.
• For financial assets and financial liabilities carried at amortised cost and which are not part of a
hedging relationship, gains and losses are recognised in the normal manner when the financial assets
and financial liabilities are derecognised, impaired or reclassified.
Subsequent measurement of financial assets
• Subsequent measurement of financial assets is determined by their classification.
• The effective interest rate must be determined for financial assets measured at amortised cost.
• For financial assets carried at amortised cost, an entity needs to recognise impairment for expected
credit losses, even if there is currently no indication of impairment.
• The three-stage impairment approach is as follows.
– Stage 1 – there is no significant increase in credit risk since the initial recognition.
– Stage 2 – there is a significant increase in credit risk since the initial recognition.
– Stage 3 – the credit has been impaired.

340 Financial Reporting

 Subsequent measurement of financial liabilities
• Subsequent measurement of financial liabilities is also determined by their classification.
Investments in equity investments
• All investments in equity instruments are to be measured at fair value, except in limited circumstances
where they can be measured at cost if it can be determined that cost is an appropriate estimate of
fair value.
• For financial assets or financial liabilities measured at fair value, the changes in fair value must be
reported in the P/L for the period unless specific situations are present.
• Fair value changes of such liabilities (other than financial guarantees and loan commitments) that is
due to changes in the credit risk are required to be reported in OCI. The remaining amount of the
change in fair value is to be recognised in P/L.
6.6 Explain how compound financial instruments are to be measured and recognised.
• Compound financial instruments consist of both liability and equity components and are separately
classified.
• Once the component parts are recognised on the statement of financial position, the classification
is not revised, irrespective of the probability of conversion of the right to purchase shares.
• IAS 32 requires entities to first measure the value of the liability component, and the difference
between the fair value of the compound instrument and the value of the liability component is
allocated to the equity component. No gain or loss is recognised at the time of issue.

MODULE 6 Financial Instruments 341

PART E: HEDGE ACCOUNTING
INTRODUCTION
Part E considers the issues in relation to hedge accounting in accordance with IFRS 9.
Hedging is an activity that many organisations undertake. Hedging is prevalent in many industries,
including aviation, construction, transport and financial markets. Where resources or inputs to processes
have volatile pricing, entities seek to reduce their exposure to that risk. Hedging is not an exercise in
speculation; it is the process of strategically minimising exposure to risk. For this reason, hedge accounting
is very prescriptive and closely related to financial risk management.
Hedging refers to designating a financial instrument as an offset against the change in fair value or cash
flows of a hedged item, or group of items with similar characteristics, in a hedging relationship. Interest rate
and foreign currency risk are two common risks against which entities may wish to hedge their exposure.
To apply hedge accounting, an entity must comply with the requirements of IFRS, including compliance
with the qualifying criteria in IFRS 9, paragraph 6.4.1. These criteria impose somewhat prescriptive
documentation obligations on entities in respect of hedging relationships. In addition, there must be
regular effectiveness assessments showing that an effective hedging relationship continues. These aspects
of hedging are discussed later.
For simplicity, this part of the module discusses only simple financial instruments, such as payables or
receivables and forward contracts, when examining hedging by the use of foreign currency contracts.
Most of the principles that need to be applied for hedge accounting can be illustrated using simple forward
contracts as examples.
For hedge accounting to be contemplated, both of the following need to occur:
• on designation date, there is a qualifying hedged item, hedging instrument and hedge risk
• an economic relationship exists between changes in the fair values of the hedge instrument and the
hedged position; that is, the hedge is prospectively assessed as effective.

Relevant Paragraphs
To assist in understanding certain sections in this part, you may be referred to paragraphs 6.1.1–6.1.2 and
6.4.1 in IFRS 9. You may wish to read these paragraphs as directed.

6.18 HEDGING RELATIONSHIPS

A hedging relationship is a designated arrangement in which an entity manages risks that could affect P/L,
or, in some cases, OCI.
A hedging relationship requires both:
(a) a hedging instrument
(b) a hedged item — this can be a risk component arising from a risk exposure, the entire risk exposure,
or a group of similar risk exposures.

HEDGING INSTRUMENTS
According to paragraphs 6.2.1–6.2.2 of IFRS 9, for a financial instrument to be a qualifying hedging
instrument, it must be either:
• a derivative that is measured at fair value through P/L (as discussed in part D), except for a written option
in some particular circumstances, or
• a non-derivative financial asset or financial liability that is measured at fair value through P/L, except
for a financial liability designated as fair value through P/L, where changes in fair value attributable to
changes in credit risk are presented in OCI (as discussed in part D). For a hedge of foreign currency
risk, the foreign currency risk component of a non-derivative financial asset or financial liability may
be designated as a hedging instrument, provided it is not an investment in an equity instrument that the
entity has elected to designate as fair value through OCI (as discussed in part D).
Derivative instruments are instruments such as interest rate options and futures, currency swaps, and
interest rate swaps. Any of these instruments could be designated as a hedging instrument but could equally
be carried to collect cash flows or be held for another purpose. It is the intention of management that, in
part, determines whether a financial instrument is to be regarded as a hedging instrument.

342 Financial Reporting

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 6.2.1–6.2.3 and B6.3.1–B6.3.6 of IFRS 9.

Hedged Items
A hedged item can be:
• a recognised asset or liability
• an unrecognised firm commitment
• a highly probable forecast transaction, or
• a net investment in a foreign operation.
The hedged item can be either a single item or a group of items (subject to the group of items meeting
specified conditions). A hedged item can also be a component of such an item or group of items.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 6.3.1–6.3.7 of IFRS 9.

Hedging Risk Components

Paragraph 6.3.7 of IFRS 9 permits the hedging of various financial risks (e.g. foreign exchange, interest,
and commodity) or components of them.
Foreign exchange risk arises when an entity is committed to pay (receive) units of foreign currency —
where there will be a loss (or gain) if the reporting currency falls (or rises) relative to the foreign currency.
To protect against exposure to foreign currency losses, an entity may enter into hedging transactions.
These transactions may involve foreign currency contracts (e.g. forward contracts, hedge contracts, futures
contracts or foreign currency options) or other foreign currency transactions (e.g. investing in a foreign
currency physical asset to hedge a long-term foreign currency liability, or relying on natural hedges such
as matching of foreign currency revenue streams with foreign currency payments).
For example, an Australian entity sells goods to a customer in Hong Kong, with payment in Hong Kong
dollars (HKDs) in 28 days. The transaction means the Australian entity is exposed to changes in exchange
rates over the 28 days. If the value of the AUD appreciates, the Australian company receives fewer AUDs,
but if the AUD depreciates, the entity receives more AUDs. The entity can enter into a forward exchange
contract to sell the HKDs it receives in 28 days. It has effectively hedged its position. Changes in the
value of the forward exchange contract should effectively offset changes in the value of the underlying
receivable.
The designation of risk components of hedged items can only occur if they are separately identifiable
and reliably measurable, irrespective of whether the item that includes the risk component is a financial or
non-financial item. The determination of being able to separately identify and reliably measure appropriate
risk components requires an evaluation of the relevant facts and circumstances. Figure 6.5 provides an
overview of evaluating hedge risks.

EXAMPLE 6.17

Identifying a Risk Component

Tokyo Optics has a raw material supply contract with a supplier in Malaysia. The contract contains a
foreign currency exchange clause whereby the Japanese Yen and Malaysian Ringgit exchange rate is
contractually specified and reset to market rates only once every four months.
Tokyo Optics determines that there are a number of risks components associated with this contract.
These risk components are:
(a) foreign currency risk
(b) raw material price risk.
Tokyo Optics concludes that the foreign currency risk is separately identifiable and reliably measurable
because the Japanese Yen and Malaysian Ringgit are liquid currencies in the international market.
However, the specific raw materials that Tokyo Optics uses are highly specialised and are not actively
traded. Therefore, the raw material price risk cannot be identified as a risk component.

MODULE 6 Financial Instruments 343

 FIGURE 6.5 Evaluating hedge risks

Evaluating whether a risk is separately identifiable

No
Is there a contract? Risk is not
Is the risk separately separately
considered in pricing the No identifiable
Yes hedged item based on an
analysis of the related
Does the contract No market structure? (not a permitted
specify how the risk is hedged risk)
priced into the contract?
Yes
Yes

Risk is separately identifiable

(permitted hedged risk if also ‘reliably measurable’)

Evaluating whether a risk is reliably measurable

Are the inputs to No Are the unobservable No

measuring the effect of inputs insignificant to Risk is not reliably
the risk observable? the measurement? measurable

Yes Yes (not a permitted

hedged risk)

Risk is reliably measurable

(permitted hedged risk)

Source: KPMG 2013, First impressions: IFRS 9 (2013) – Hedge accounting and transition, December, p. 33, accessed July 2019,
https://home.kpmg.com/content/dam/kpmg/pdf/2013/12/First-Impressions-O-1312-IFRS9-Hedge-accounting-and-transition.pdf

QUESTION 6.7

Should the following be considered hedged items under IFRS 9?

(a) A company has signed a contract to purchase goods from a supplier in South Korea in six
months. The company enters a forward exchange contract to buy wons (the currency of South
Korea) in six months.
(b) A company has a potential customer located in France who is considering the purchase of one
of its high-powered luxury ferries within the next six months. The company enters a forward
exchange contract to sell euros in six months.

6.19 ACCOUNTING FOR HEDGING RELATIONSHIPS

The criteria adopted in IFRS 9 to identify whether a hedging relationship qualifies for hedge accounting
are stated in paragraph 6.4.1. The criteria that should be met are that:
• the ‘relationship consists only of eligible hedging instruments and eligible hedged items’
• there is formal designation and documentation at the inception of the hedging relationship about the
hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge
• ‘there is an economic relationship between the hedged item and the hedging instrument’

344 Financial Reporting

 • ‘the effect of credit risk does not dominate the value changes that result from that economic relationship’
• the hedge ratio of the hedging relationship is the same as the ratio between the hedged item and the
quantity of the hedging instrument that ‘the entity actually uses to hedge that quantity of hedged item’.
However, the hedge ratio cannot be set in such a way that it would give rise to an accounting outcome
that is inconsistent with the purpose of hedge accounting.
The hedge accounting model in IFRS 9 employs a principles-based approach that is based on an entity’s
risk management strategy. This means the entity’s financial statements should be more reflective of the
entity’s actual risk management activities. Reflecting the economic substance and actions of an entity in
relation to transactions is one of the primary goals of financial reporting.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 6.4.1 and B6.4.1–B6.4.19 of IFRS 9.

Figure 6.6 summarises the required steps for designating a hedging relationship.

FIGURE 6.6 How to achieve hedge accounting

Define risk management (RM)

strategy and objective

Identify eligible hedged item(s) and

eligible hedging instruments

No
Is there an economic relationship between
hedged item and hedging instrument?

Yes

Yes
Does the effect of the credit risk
dominate the fair value changes?

No

Base hedge ratio on the actual

quantities used for risk management

Yes
Does the hedge ratio reflect an imbalance
To avoid that would create hedge ineffectiveness?
ineffectiveness,
the ratio may have
to differ from
the one used in RM. Formal designation and
documentation

Source: EY 2014, Hedge Accounting under IFRS 9, p. 31, accessed July 2019, http://www.ey.com/Publication/vwLUAssets/
Applying_IFRS:_Hedge_accounting_under_IFRS_9/$File/Applying_Hedging_Feb2014.pdf.

TYPES OF HEDGES
Paragraph 6.5.2 of IFRS 9 defines three types of hedges. Regardless of the type of hedge used, the hedging
instrument will always be measured at fair value. Measurement of the hedged item differs depending on
the type of hedge applied. The three hedge types are as follows.
• ‘Fair value hedge: a hedge of the exposure to changes in fair value of a recognised asset or liability or
an unrecognised firm commitment’ to buy or sell resources, or to a portion of such an asset, liability or
firm commitment. There also must be the potential for this risk to affect profit or loss. For example, the

MODULE 6 Financial Instruments 345

 value of a fixed-rate loan increases for the borrower if interest rates decline. A hedge against this risk is
described as a fair value hedge.
• ‘Cash flow hedge: a hedge of the exposure to variability in cash flows that is attributable to a particular
risk associated with all or [some] of a recognised asset or liability (such as all or some future interest
payments on variable-rate debt) or a highly probable forecast transaction, and could affect profit or loss’.
• ‘Hedge of a net investment in a foreign operation’.
Finally, the standard permits a choice when hedging firm commitments for foreign exchange risk. They
may be designated as a fair value or cash flow hedge.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 6.5.1–6.5.7 and B6.5.1–B6.5.3 of IFRS 9.

Fair Value Hedges

For fair value hedges, the hedging instrument and the hedged item are normally measured at fair value
through P/L. Therefore, any mismatch between the fair value movements of the hedged item and hedging
instrument is automatically recognised in P/L. However, if the hedged item is an equity instrument
measured at fair value through OCI (as discussed in part D), the fair value movement of the hedged item
is also recorded in OCI.
Special hedge accounting treatments are prescribed for hedges of unrecognised firm commitments and
hedges of financial instruments measured at amortised cost. Those hedging relationships are slightly more
complex, and an understanding of them is beyond the purposes of this module.
The accounting treatment for fair value hedges is specified in IFRS 9, paragraphs 6.5.8 to 6.5.10.

EXAMPLE 6.18

Fixed-to-floating Interest Rate Swap

Interest rate swaps that convert fixed interest cash flows into variable interest cash flows are commonly
used in fair value hedges. Note that, as discussed later, this type of swap cannot be used in a cash flow
hedge because it does not limit cash flow variability; in fact, it increases cash flow variability.
A bank might issue a new fixed-rate loan that it cannot measure at amortised cost because of the facts
and circumstances attached to the loan. Consequently, the bank measures the loan at fair value through
P/L. Being a fixed-rate loan measured at fair value, the bank needs to discount all future cash flows at the
prevailing market rate of interest. That market rate of interest fluctuates and, as the market rate of interest
increases, the fair value of the loan decreases, and vice versa. This is illustrated in the following chart.

Fair value of fixed rate loan compared with new loans

entered into at market rates

y2

y
Fair value

x2 x Market interest rate

Considering this chart, if the fixed-rate loan is issued when the market interest rate is ‘x’, its
corresponding fair value will be ‘y’. If the market rate of interest decreases to x2, the fair value of the
fixed-rate loan will increase to y2. Similarly, if the market rate of interest increases, the fair value of the
loan will decrease.

346 Financial Reporting

 The fair value of the loan decreases when the market interest rates rise because other banks could issue
new loans that provide greater interest returns when compared with the returns provided by the fixed-rate
loan discussed here. Similarly, the fair value of the loan increases when market rates decline because the
fixed-rate loan discussed here provides greater returns to the holder than what other banks could offer
using market interest rates.
In light of this fair value volatility, the bank does not want the fair value movements of this loan to distort
the stability of its balance sheet. The bank decides to enter into a fixed-for-floating interest rate swap with
another bank. The terms of the fixed-for-floating swap are such that they perfectly match the terms of
the loan. The fair value movements of this swap would be the exact opposite to those illustrated in the
previous diagram. If the fair value of the loan increased by AUD 100 000, the fair value of the swap would
decrease by AUD 100 000. This is because the bank has entered into a contract to pay another bank
fixed interest cash flows in exchange for variable cash flows. Therefore, if the bank is paying less in fixed
interest payments than it is receiving in variable interest payments (because market rates are higher than
the fixed rate on the loan), the fair value of the swap will be an asset. Contrast this with the loan where
the higher market interest rates cause the fair value of the loan to decrease.
Fair value

Fair value of fixed rate loan

Fair value of interest rate swap

Market interest rate

Entering into a fair value hedge with this swap allows the bank to reduce the volatility associated with
fair value movements on its balance sheet.

Extension of Fair Value Option

The IFRS 9 hedge accounting model extends the use of the fair value option in two common risk
management activities, to provide an alternative to formal hedge accounting while providing a similar
accounting result. These activities are as follows.
(a) Use of credit derivatives in hedging
When an entity uses a credit derivative, measured at fair value through P/L, to manage credit risk of all
or a portion of credit exposure on a financial asset or liability, it may designate all or a portion of the
credit exposure at fair value through P/L, provided the name and seniority of the financial instrument
referenced in the credit derivative matches the hedged credit exposure.
(b) Own-use contracts
Paragraph 2.5 of IFRS 9 permits entities to account for ‘own-use’ contracts (i.e. contracts to buy or sell
non-financial items for own use) at fair value through P/L, if that eliminates an accounting mismatch
— as previously covered in part A under the topic ‘Contracts to buy or sell non-financial items’.
As an example, a wholesaler of electricity in Australia sells fixed-price electricity contracts for two years
to industrial customers. It then buys electricity at spot prices from the market and hedges the spot price
risk by entering into fixed-price swap contracts with an electricity-generating company. Economically, this
enables the wholesaler to fix its purchase price of electricity and thus lock in a gross margin. To achieve
a smooth accounting result, the company could adopt formal cash flow hedge accounting for the swap
contracts or, as an alternative, could apply the fair value of own-use contracts option to simply measure
the customer contracts at fair value. This latter approach would mean that the fair value changes of the
customer’s contracts would offset the fair value changes of the swap contract in the P/L. The fair value

MODULE 6 Financial Instruments 347

of own-use contracts may be a simpler accounting approach when the wholesaler manages the customer
contracts on a portfolio approach.

EXAMPLE 6.19

Hedge Against Change in Fair Value of Existing Inventory

Company A maintains an inventory of 5000 barrels of oil and wants to hedge the risk of changes in the
price of oil. On 1 July 20X7, Company A purchases a forward derivative instrument to fix the price of oil
at the current price of $40 per barrel. The forward instrument matures on 31 December 20X8. Company
A complies with all of the hedge documentation and effectiveness requirements.
The following table summarises the market data used in the journal entries that follow. In this case, the
cost of purchasing the forward instrument is nil.

Fair value Fair value of Hedged value of inventory

of inventory the contract (fair value of inventory +
Spot price (5000 × (5000 × [$40 fair value of contract +
of oil spot price) – spot price]) cash from the contract)
Period $ $ $ $
1 July 20X7 40 200 000 0 200 000
31 December 20X7 30 150 000 50 000 200 000
31 December 20X8 25 125 000 75 000 200 000

1 July 20X7
No entry as the fair value of the forward contract is zero.
31 December 20X7
Dr Forward derivative contract 50 000
Cr Gain (P/L) 50 000
To record the increase in the fair value of the derivative.
Dr Loss (P/L) 50 000
Cr Oil inventory 50 000
To record the decrease in the fair value of the oil inventory.

At 31 December 20X8, the derivative matures and its fair value has increased by $25 000, while the fair
value of the oil inventory has decreased by $25 000.

31 December 20X8
Dr Forward derivative contract 25 000
Cr Gain (P/L) 25 000
To record the increase in the fair value of the derivative.
Dr Loss (P/L) 25 000
Cr Oil inventory 25 000
To record the decrease in the fair value of the oil inventory.
Dr Cash 75 000
Cr Forward derivative contract 75 000
To record the receipt of payment from the forward derivative
contract debtor.

Note how, at the start of the hedge, Company A had $200 000 of assets. At the end of the hedge
relationship, the value of the oil inventory decreased by $75 000, but the entity received that decrease in
cash when the derivative matured. Therefore, the entity still has $200 000 of assets, but it is now a mix of
cash and inventory. Company A has protected itself from the significant decrease in the price of oil from
$40 per barrel to $25 per barrel.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 6.5.8–6.5.10 of IFRS 9.

348 Financial Reporting

Cash Flow Hedges
A cash flow hedge is intended to protect an entity against the unfavourable impact on future cash flows
from a change in, say, interest rates or exchange rates. For example, an entity with a variable rate loan will
be required to pay higher interest payments if interest rates increase. Accordingly, the entity is subject to
cash flow risk in the form of higher interest payments from an increase in interest rates.

EXAMPLE 6.20

Floating-to-fixed Interest Rate Swap

Consider the same bank as was discussed in example 6.18, but in this case, the bank has issued a variable
rate loan to a customer. The bank notes that the interest receipts (cash flows) associated with this loan
will vary in response to changes in the variable loan rate.
The bank decides to protect itself from that cash flow variability by entering into a floating-for-fixed
interest rate swap. This swap allows the bank to make floating interest rate payments in exchange for
fixed interest rate receipts. The bank sets the terms of the swap to perfectly match those of the loan. As
a result, the bank has effectively converted the variable rate cash flows from the loan into fixed-rate cash
flows using the swap.

The accounting for cash flow hedges under IFRS 9, paragraph 6.5.11 is more complex than accounting
for fair value hedges. Unlike a fair value hedge, it is not possible to attribute a fair value to the hedged item
of a cash flow hedge, such as a series of interest payments. Therefore, to account for a qualifying cash
flow hedge under IFRS 9, the changes in the fair value of the hedging instrument are recognised in OCI
and accumulated in an equity reserve (usually referred to as the cash flow hedge reserve). The amount
accumulated in the cash flow hedge reserve is subsequently removed from equity. IFRS 9 prescribes
three different accounting treatments for removing the amount accumulated in the cash flow hedge reserve
depending on the situation, as the following discussion explains.
In example 6.20, the fair value gains and losses on the hedging instrument — that is, the interest rate swap
— would be recognised in OCI and accumulated in the cash flow hedge reserve. The amount accumulated
in the cash flow hedge reserve would subsequently be reclassified to P/L when the interest income is
recognised in P/L. Thus, the net effect on P/L is similar to fixed interest income.
To ensure only legitimate amounts are recorded in the cash flow hedge reserve via OCI, only the
‘effective’ portion of the fair value changes on the cash flow hedging instrument can be deferred in the
hedge reserve. The ‘effective’ component is defined as the lower of (in absolute amounts):
• ‘the cumulative gain or loss on the hedging instrument from inception of the hedge’, or
• ‘the cumulative change in fair value (present value) on the hedged item . . . from inception of the hedge’
(IFRS 9, para. 6.5.11(a)).
The cumulative change in fair value of the hedged item is calculated as the present value of the
cumulative changes in the expected hedged cash flows — for example, the present value of the cumulative
changes in the expected future interest payments that form the hedged item of the cash flow hedge. Work
through example 6.21 to better understand this calculation.
Also, the ‘effective’ component in a cash flow hedge is determined based on a ‘lower of’ test. This is
because it is considered acceptable to be under-hedged in a cash flow hedge, whereas being over-hedged in
a cash flow hedge results in ineffectiveness, which is recognised immediately in profit or loss. For example,
assume that in example 6.20 the swap’s cumulative change in fair value is $100, but the cumulative change
in the fair value of the hedged item (calculated as the present value of the cumulative change in interest
receipts) is negative $90. Then the effective portion is $90 and the $10 surplus on the swap’s fair value
change is the ineffective portion, which is recognised in P/L.
The amount accumulated in the cash flow hedge reserve is subsequently removed from equity in the
following three ways.
1. If the cash flow hedge was either a hedge of a forecast transaction (e.g. purchase of inventory) that
results in the recognition of a non-financial asset (e.g. inventory) or liability, the amount is transferred
to the initial cost or other carrying amount of the asset or liability.
2. The amount is reclassified to P/L in the same period or periods as the cash flows from the hedged item
occur (for cash flow hedges other than those covered by (1)).
3. If the amount in the hedge reserve is a loss and the entity does not expect the loss to be recovered in the
future, then the amount is immediately reclassified to P/L.

MODULE 6 Financial Instruments 349

 An example of (1) is demonstrated in example 6.21; (2) would be utilised for the fact set in
example 6.20; and (3) would be a situation where a loss has been deferred on a cash flow hedge for
an inventory purchase, but the ultimate forecast gross margin on the inventory is insufficient to cover the
accumulated loss in the cash flow hedge reserve.

EXAMPLE 6.21

Hedge of a Purchase of Inventory

Because the demand for foreign parts for computer printers was rising rapidly, on 2 May 20X9 Domestic
Ltd (Domestic) entered into a non-cancellable purchase commitment for 5000 items to be shipped on
30 June 20X9. The total price for the shipment was FC 1 000 000, to be paid in FC on the date of shipment.
(FC represents a foreign currency, not specified in the example.)
On 2 May 20X9, Domestic entered into a forward foreign exchange contract to receive FC 1 000 000
from a foreign currency broker on 30 June 20X9, and pay $310 000 to settle the foreign currency contract.
The purpose of the hedge is to fix the amount of cash payable for the inventory at $310 000. The hedging
instrument is designated in its entirety in the hedging relationship. Splitting the forward element of the
forward contract is discussed later.
The company prepares monthly accounts for all foreign currency hedges as cash flow hedges. Assume
the company complies with all of the hedge documentation and effectiveness requirements.

Exchange rates
Forward rate for delivery
Spot rate of FC on 30 June 20X9
2 May FC1 = $0.30 FC1 = $0.31
31 May FC1 = $0.31 FC1 = $0.32
30 June FC1 = $0.33 FC1 = $0.33

Analysis of the Economic Effects of the Hedge Transaction and Purchase Transaction
The economic effects of the hedge can be determined by analysing the exchange differences that result
from the hedge transaction. Please note that this is a simplified calculation for illustrative purposes, so
there has been no discounting involved. In addition, for hedge accounting with forward contracts, there
is a choice of including time value or excluding time value; in this example we have included time value.
Finally, when hedging a firm commitment for foreign exchange risk, the company has a choice to classify
the hedge as a cash flow hedge or fair value hedge; in this example the company has elected to classify
the hedge as a cash flow hedge.

Foreign currency payable (hedged item)

Forward rate Expected cash flows Movement gain/(loss)
2 May FC1 = $0.31 310 000 —
31 May FC1 = $0.32 320 000 (10 000)
30 June FC1 = $0.33 330 000 (10 000)
Total (20 000)

The expected cash flows of the purchase of inventory are based on the forward exchange rate at
inception. Hence, at the inception of the hedge, it was expected that the purchase would cost $310 000.
At 31 May the cumulative change in the expected cash flow of the hedged item was negative $10 000
because the forward exchange rate at 31 May to 30 June had changed to FC1 = $0.32.

FC forward contract (hedge instrument)

Forward rate for Forward Forward contract Forward gain/(loss)
delivery on FC contract (FC (AUD payable)
on 30 June 20X9 units receivable) FC1 = $0.31
2 May FC1 = $0.31 310 000 310 000 —
31 May FC1 = $0.32 320 000 310 000 10 000†
30 June FC1 = $0.33 330 000 310 000 10 000‡
Total movement 20 000

† Calculated as $320 000 – $310 000 = $10 000.

‡ Calculated as $330 000 – $310 000 – $10 000 (already recognised) = $10 000.

350 Financial Reporting

 The fair value movements in the FC forward contract reflect the change in forward rate for delivery of FC
on 30 June. For example, if Domestic had entered into the forward exchange contract on 31 May rather
than 2 May, the forward rate ‘locked in’ for the delivery of FC on 30 June would have been FC1 = $0.32.
That is, the entity would have paid a total of $320 000 instead of $310 000. The entity would have paid an
additional $10 000 ($320 000 – $310 000) on 31 May, as compared to the actual forward rate locked in on
2 May. Therefore, as the forward contract is a financial asset (from Domestic’s perspective), it recognises
a gain on the contract at 31 May.
The following table summarises the movements in the hedged item and the hedging instrument.

Movement in the Movement in the

hedged item (firm hedging instrument Net
commitment) FC (forward contract) movement
$ $ $
2 May — — —
31 May (10 000) 10 000 —
30 June (10 000) 10 000 —

Notice that at the end of the hedging relationship, the amount of AUD to pay for the inventory would
be $330 000 (FC 1 000 000 × $0.33 spot rate). However, the forward contract is in a receivable position of
$20 000. Consequently, Domestic pays $330 000 for the inventory and receives $20 000 from the broker.
Domestic’s overall cost of the inventory was $310 000, the amount it locked in on 2 May 20X9. This
outcome is what hedging aims to achieve — the minimisation of risk.
This hedge, as with all hedges, has two sides: an obligation to make a payment to the broker and a
receivable from the broker.
In this example, the obligation is to pay an agreed number of dollars. It remains fixed at the agreed
number of dollars, and its measurement is not affected by changes in the exchange rate. In this case, the
receivable is the right to receive a fixed number of FC units. This receivable will change in accordance
with IAS 21 The Effects of Changes in Foreign Exchange Rates as the exchange rate varies.
The journal entries will reflect the sequence of the underlying economic events (and requirements of
IFRS 9) as follows.

Date Event Entry

2 May Signing of forward contract 1
31 May Remeasure FC forward contract 2
30 June Settlement of FC contract 3
Receipt of inventory 4
Transfer from equity 5

Journal Entries
On 2 May, the forward foreign exchange contract with the broker is signed. This establishes the right to
receive foreign currency from the foreign currency broker on 30 June 20X9 (to enable settlement of the
foreign currency trade payable on the same date) and the obligation to pay the broker at a fixed forward
rate of $0.31 for FC.
2 May — Entry (1): Forward contract signed
No entry is required, as the right to receive foreign currency is equal to the obligation to pay the broker.
That is, the fair value of the forward contract on initial recognition is zero.
31 May — Entry (2): Remeasure FC forward contract

Dr FC forward contract 10 000

Cr Cash flow hedge reserve 10 000
To restate $ equivalent of receivable from broker. The
change is recognised as other comprehensive income
and accumulates in equity.

The fair value of the forward contract has increased by $10 000, and the expected cash flows of the
hedged item have decreased by $10 000. Therefore, the entire change in the forward contract is considered
effective and included in the cash flow hedge reserve.

MODULE 6 Financial Instruments 351

 30 June — Entry (3): Settlement of FC contract (net basis)

Dr Cash 20 000
Cr FC forward contract 10 000
Cr Cash flow hedge reserve 10 000
To record settlement of the FC forward contract and
recognise its increase in value from 31 May.

31 June — Entry (4): Receipt of inventory

Dr Inventory 330 000

Cr Cash 330 000
Acquisition of inventory recorded at purchase price
(FC 1m × $0.33).

30 June — Entry (5): Transfer from equity

Dr Cash flow hedge reserve 20 000

Cr Inventory 20 000
To restate $ cost of inventory and transfer amount
previously recognised as OCI from equity.

As can be seen from the preceding journal entries, the purchase of the inventory is recorded at $310 000
($330 000 – $20 000). This is the purchase of inventory at the spot rate on 30 June, adjusted for the gains
on the cash flow hedge previously recognised in OCI and deferred in the cash flow hedge reserve (part
of equity).
The cash would need to be used to acquire FC 1m at the spot rate on 30 June, which would then be
used to pay the FC payable of $330 000.
Before leaving this example, confirm that the net amount of cash paid ($330 000 – $20 000 = $310 000)
to purchase the inventory is equal to the forward rate at the date of entering the hedge (FC 1m × $0.31).
Therefore, the cash flow hedge was effective in fixing the amount of cash to be paid for the purchase
of inventory.

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 6.5.11–6.5.12 of IFRS 9.

Foreign Currency Denominated Liability, which Hedges an Entity’s Net

Investment in a Foreign Operation
A net investment in a foreign entity is defined in IAS 21 The Effects of Changes in Foreign Exchange Rates.
An entity may decide to hedge against untoward exchange differences stemming from its net investment in
a foreign operation. One form that a hedge could take is a foreign currency denominated liability to offset
the foreign currency denominated asset (investment). As the exchange rate fluctuates, the gain (or loss) on
the asset will be offset by the loss (or gain) on the liability.
IFRS 9, paragraph 6.5.13, states that hedges of an entity’s net investment are accounted for in a similar
manner to cash flow hedges. So, the portion considered to be an effective hedge is included in OCI, and
the ineffective portion is recognised in P/L. This accounting only occurs at the consolidated level.
The cumulative amount recognised in equity (foreign currency translation reserve) is reclassified to P/L
on the disposal or part disposal of the foreign operation. Accounting for a disposal or part disposal of a
foreign operation, in accordance with IAS 21, was addressed in module 2.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 6.5.13–6.5.14 of IFRS 9.

352 Financial Reporting

6.20 SPECIAL ACCOUNTING RULES
ACCOUNTING FOR THE TIME VALUE OF OPTIONS
Option pricing is an incredibly complex area of finance. For the purposes of this discussion, however, it is
sufficient to understand that an option’s price is made up of two components:
(a) an intrinsic value — this is the difference between the current spot price of the option’s underlying
item and the strike price in the option
(b) the time value of the option — this component broadly reflects the amount of time remaining until the
option’s expiry and the probability of the option expiring on favourable terms.
An option’s time value gradually decreases as the option approaches its exercise date. This decline in
time value appears visually similar to the convergence of spot and forward rates shown in part A.
Paragraph 6.2.4 of IFRS 9 permits an entity to designate only the changes in the intrinsic value of the
option in a hedging relationship.
IFRS 9, paragraph 6.5.15, permits the time value component of an option to be accounted for as a cost of
hedging, depending on whether the hedged item is transaction based (e.g. a hedge of a forecast transaction)
or time-period-based (e.g. a hedge of interest rate risk on a three-year loan).
Where the hedged item is ‘transaction related’ (e.g. sales), the time value of the hedging instrument
(e.g. foreign exchange option) is reversed from equity at the same time as the transaction is recognised.
The reversal may be to P/L, or as an adjustment to the carrying value of the hedged item.
For a hedged item that is ‘time period related’ (e.g. debt), the time value of the hedging instrument
(e.g. an interest rate cap) is reversed over the same period as those of the hedged item, specifically the
period when cash flows from the hedged item affect P/L. This is usually done on a straight-line basis.

Amortisation of Forward Element of Forward Contracts

Similar to accounting for the time value of options, IFRS 9, paragraph 6.5.16, allows the recognition of the
forward element of a forward contract that existed at inception of a hedging relationship, to be accounted
in the same way as the time component of option contracts.
In part A, the difference between the forward price and the spot price was illustrated. That difference is
referred to as the forward element of the forward contract and, similar to the time value of an option, this
gradually declines as the forward contract approaches maturity.

Spreads
Basis spreads are charged in cross-currency swaps as a way of balancing the supply and demand of
currencies. IFRS 9, paragraph 6.5.16, specifically allows foreign currency basis spread in foreign currency
derivatives to be treated similarly to the forward element in a forward contract.

Derivatives may be Included as Part of the Hedged Item

Economic exposures frequently have more than one risk — for example, crude oil has commodity price
risk and foreign currency risk. Even though these two risks can be managed together, entities often use
different risk management strategies for the commodity price risk and the foreign currency risk. IFRS 9,
paragraph 6.3.4, permits a derivative to be aggregated together with the non-derivative hedged item. This
creates a new qualifying hedged item referred to as an ‘aggregated exposure’. Consider an exporter of
crude oil: under IFRS 9, an entity is able to hedge the aggregated USD exposure created by the forecast
sale of oil, as well as a derivative taken out to fix the price of the crude oil.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 6.6.1–6.6.6 of IFRS 9.

6.21 ASSESSING HEDGE EFFECTIVENESS

Under IFRS 9, a hedge is considered to be an effective hedge when:
(i) there is an economic relationship between the hedged item and the hedging instrument [That is, the
hedging instrument and the hedged item have values that generally move in the opposite direction
because of the same risk, which is the hedged risk] . . .

MODULE 6 Financial Instruments 353

 (ii) the effect of credit risk does not dominate the value changes that result from the economic
relationship . . .
(iii) the hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged
item that the entity actually hedges and the quantity of the hedging instrument that the entity actually
uses to hedge that quantity of hedged item. [There is an exception in that the] designation shall not
reflect an imbalance between the weightings of the hedged item and the hedging instrument that
would create hedge ineffectiveness (irrespective of whether recognised or not) that could result in
an accounting outcome that would be inconsistent with the purpose of hedge accounting (IFRS 9,
para. 6.4.1(c)).

It is a requirement that the hedge is effective at designation and thereafter. At a minimum, the assessment
must occur at the earlier of (a) each reporting date, or (b) a significant change in circumstances that affects
the hedge effectiveness requirements.
Hedges are not likely to be perfect in that there will not usually be a 100% offset between the hedged item
and the hedging instrument. While IFRS 9 does not specify a means of measurement, hedge effectiveness
is typically determined on an objectives-based test that focuses on the economic relationship between
the hedged item and hedging instrument, and the effect of credit risk on that economic relationship.
Furthermore, entities are required to state what they consider an effective hedge to be, and this needs
to be aligned with the economic realities of the hedge relationship and approved treasury policy/strategy.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 6.4.1 and B6.4.1–B6.4.19 of IFRS 9.

6.22 DISCONTINUING HEDGE RELATIONSHIPS

Under IFRS 9, a hedging relationship is discontinued when:
1. the hedging instrument expires, is sold or terminated, or
2. the forecast cash flow hedge is no longer expected to occur.
However, an organisation cannot voluntarily de-designate a hedge relationship (as outlined in item 2 of
the previous paragraph).
If cash flow hedge accounting is discontinued, the amount accumulated in the cash flow hedge reserve:
• remains in equity if the hedged future cash flows are still expected to occur, or
• is reclassified to P/L if the hedged cash flows are no longer expected to occur (IFRS 9, para. 6.5.6).

6.23 INCREASED DISCLOSURES

Along with the changes in IFRS 9, IFRS 7 disclosures have been modified to require disclosures
of information on risk exposures being hedged, and for which hedge accounting is applied. Specific
disclosures will include:
• a description of the risk management strategy
• the cash flows from hedging activities
• the impact that hedge accounting will have on the financial statements.
These are discussed in more detail in part F.

SUMMARY
IFRS 9 permits the use of hedge accounting when a hedging instrument is an effective hedge of a hedged
item. This gives rise to the concept of hedge accounting, where the principle is to recognise the changes
in the fair value of hedge instruments in the same period in which the changes in the fair value of the
hedged position are recognised. IFRS 9 identifies fair value hedges, cash flow hedges and hedges of a
net investment in a foreign entity. Gains and losses on fair value hedges are reported in P/L. Gains and
losses on effective cash flow hedges are initially recognised in OCI, then later reclassified from equity and
reported in P/L when the hedged item is sold, terminated or expired. The concept of matching underlies
hedge accounting.
The key points covered in this part, and the learning objectives they align to, are as follows.

354 Financial Reporting

KEY POINTS

6.4 Identify the requirements in IFRS 9 for the use of hedge accounting.
• Hedge accounting must be used for financial liabilities and financial assets that are hedged items.
• A hedging relationship is a designated arrangement in which an entity manages risks that could affect
P/L, or, in some cases, OCI.
• A hedging relationship requires both a hedging instrument and a hedged item.
• A qualifying hedging instrument must be either:
– a derivative measured at fair value through P/L, or
– a non-derivative financial asset or financial liability measured at fair value through P/L, except for
a financial liability designated as fair value through P/L, where changes in fair value attributable to
changes in credit risk are presented in OCI.
• Examples of derivative instruments that could be designated as a hedging instrument are interest
rate options and futures, currency swaps, and interest rate swaps.
• A hedged item can be a recognised asset or liability, an unrecognised firm commitment, a highly
probable forecast transaction, or a net investment in a foreign operation.
• IFRS 9 allows an entity to hedge various financial risks such as foreign exchange, interest, and
commodity, or components of each.
• Regardless of the type of hedge used, the hedging instrument will always be measured at fair value.
• A hedging relationship is discontinued when either the hedging instrument expires, is sold or
terminated, or when the forecast cash flow hedge is no longer expected to occur.
6.5 Explain and apply the fair value hedge and cash flow hedge methods to simple examples.
• Fair value hedges are hedges of the exposure to changes in fair value of a recognised asset, liability or
an unrecognised firm commitment to buy or sell resources, or to a portion of such an asset, liability or
firm commitment.
• For fair value hedges, there must be the potential for the risk to affect profit or loss.
• An example of a fair value hedge is the risk of the value of a fixed-rate loan increasing for the borrower
if interest rates decline.
• Cash flow hedges are hedges of the exposure to variability in cash flows that is attributable to
a particular risk with some or all of a recognised asset or liability, or a highly probable forecast
transaction that could affect profit or loss.
• An example of a cash flow hedge is the risk of variability in future interest payments on a variable
rate debt.
6.7 Explain the key disclosures required for financial instruments under IFRS 7.
• Disclosure requirements for hedge accounting are specified in IFRS 9 along with modified disclosure
requirements in IFRS 7.

MODULE 6 Financial Instruments 355

PART F: DISCLOSURE ISSUES
INTRODUCTION
The initial approach of most standard-setting bodies to the perceived problems and risks associated with
financial instruments was to require extensive disclosure. This approach can be supported on the basis of
the assumption of market efficiency, which suggests that, where information is disclosed, the market will
adjust, immediately incorporating the information in the market prices.
IAS 32 Financial Instruments: Disclosure and Presentation was first issued in 1995 and was revised
twice before being renamed in 2005 as IAS 32 Financial Instruments: Presentation, following the
publication of IFRS 7 Financial Instruments: Disclosures. IFRS 7 also replaces IAS 30 Disclosures in
the Financial Statements of Banks and Similar Financial Institutions. IFRS 7 contains detailed disclosure
requirements that apply to all financial instruments. With the introduction of IFRS 9 (that covers the
recognition, derecognition, classification and measurement issues as discussed earlier in this module),
the disclosures in IFRS 7 were enhanced to complement the improvements in the accounting for financial
instruments.
This section discusses the disclosures required regarding financial instruments according to IFRS 7.
Careful attention to the relevant disclosures is warranted as directors and accountants have been sued in
the past for not correctly disclosing the risks of financial instruments.

Relevant Paragraphs
To assist in understanding certain sections in this part, you may be referred to the relevant paragraphs in
IFRS 7.

6.24 SCOPE AND LEVEL OF DISCLOSURE

The risks that businesses are subject to are generally categorised as either business risk or financial risk.
Financial instruments are used by many entities to help manage some of these risks, yet also have the
potential to create risks for the entity. Some commentators argue that the increase in the use of complex
and highly risky financial instruments was a contributing factor to the global financial crisis in 2008.
The types of risks for which IFRS 7 requires disclosure relate to all financial instruments, irrespective
of whether they are recognised in the financial statements in accordance with IFRS 9, as discussed in
part B, or are unrecognised (e.g. some loan commitments).
IFRS 7 does not specify a format of how the information on the types of risks should be presented.
IFRS 7 requires disclosures by class of financial instrument. Entities can group financial instruments
into classes that are appropriate to the nature of the information disclosed and the characteristics of the
instruments. Yet, the application guidance — in paragraph B2 of IFRS 7 — indicates that, as a minimum,
financial assets measured at amortised cost shall be grouped separately from those measured at fair value.
Where the grouping for the disclosure requirements of IFRS 7 differs from the grouping of such instruments
in the statement of financial position, sufficient information must be provided to allow the two to be
reconciled.
Paragraph B3 of IFRS 7, in the application guidance, discusses how much detail an entity should provide
in order to comply with IFRS 7. This requires a balance between providing excessive disclosures that
disguise or bury important information, and aggregating data to the point where important differences
between individual transactions are obscured.

6.25 SIGNIFICANCE OF FINANCIAL INSTRUMENTS

FOR FINANCIAL POSITION AND PERFORMANCE
Paragraph 7 of IFRS 7 is very general, as it requires an entity to:
disclose information that enables users of its financial statements to evaluate the significance of financial
instruments for its financial position and performance.

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6.26 STATEMENT OF FINANCIAL POSITION
The requirements for disclosures in respect of the statement of financial position are specified in
paragraphs 8–15 and 17–19 of IFRS 7, and include the following.
• Categories of financial assets and financial liabilities
The categories of financial assets and financial liabilities are those used in IFRS 9, which were discussed
in part C. IFRS 7 requires the carrying amounts for each of the categories for financial assets and for
financial liabilities to be disclosed in the statement of financial position or the notes.
• Financial assets at fair value through profit or loss (recall that this is one of the groups of financial
assets for measurement purposes in IFRS 9)
Paragraph 9 of IFRS 7 requires specific disclosures about any financial asset (or group of financial
assets) that an entity has designated at fair value through P/L. First, an entity must disclose the maximum
exposure to credit risk of the financial asset, and the extent to which credit derivatives, if any, mitigate
this exposure. Second, paragraph 9 also requires an entity to provide information about the amount
of change in the fair value (both during the period and cumulatively) of the financial asset that is
due to a change in credit risk, as distinct from changes that are due to changes in market conditions
(e.g. changes in interest or exchange rates). Finally, an entity must disclose the change in fair value of
any mitigating credit derivative that has occurred during the period and cumulatively since the financial
asset was designated.
• Financial liabilities at fair value through profit or loss
Paragraphs 10, 10A and 11 of IFRS 7 require various disclosures concerning financial liabilities
designated as at fair value through P/L.
Where an entity has to report changes in fair value in OCI attributable to credit risk changes, an entity
is required to disclose:
– the cumulative amount of the fair value changes that are attributable to changes in the credit risk of
that liability
– the ‘difference between the financial liability’s carrying amount and the amount the entity would be
contractually required to pay at maturity to the holder of the obligation’
– ‘any transfers of the cumulative gain or loss within equity during the period, including the reason for
such transfers’
– if a liability is derecognised during the period, the amount in OCI that was realised at that time
(IFRS 7, para. 10(a)–(d)).
Where all the changes in fair value are reported in P/L, an entity must disclose changes for the period
plus the cumulative changes. The carrying amount and amount to settle the financial liability must also
be disclosed.
Paragraph 11 of IFRS 7 requires various disclosures about the methodology used to comply with the
requirements in IFRS 9 in relation to this issue, such as the measurement of gains and losses attributable
to credit risk.
• Investments in equity securities where gains and losses are reported in OCI
Entities must disclose the instruments designated at fair value through OCI, the reason for using this
category, the fair value at the end of the period and any dividends received during the period (IFRS 7,
para. 11A). They must also disclose when they sell such securities, reasons for the sale, fair value at the
date of sale and the cumulative gain/loss at the time of sale (IFRS 7, para. 11B).
• Reclassification
Paragraph 12B of IFRS 7 specifies that if any financial asset is reclassified in accordance with
IFRS 9, the entity is required to disclose the date of reclassification and the amount reclassified, together
with an explanation of the change in the business model that caused the reclassification. The intent
here is to ensure that entities do not use the option to swap categories in order to achieve a better
accounting outcome. This disclosure alerts users to (and may discourage the entity from pursuing) this
possible strategy.
Paragraph 12C of IFRS 7 requires entities to disclose (for financial assets reclassified to amortised
cost) the effective interest rate and the interest income from the date of the reclassification until it is
derecognised. For financial assets reclassified to amortised cost since the last reporting period, an entity
must disclose the fair value at the time of reclassification and the amount of fair value gain or loss
that would have been recognised had the financial asset remained at fair value through P/L category
(IFRS 7, para. 12D). This enables users to assess the impact of the reclassification on financial
performance.

MODULE 6 Financial Instruments 357

• Offsetting financial assets and financial liabilities
Paragraphs 13A–13F of IFRS 7 include disclosures that supplement the other disclosure requirements
of IFRS 7 and are required for all recognised financial instruments that are set off in accordance with
paragraph 42 of IAS 32. The disclosures also apply to recognised financial instruments that are subject
to an enforceable master netting arrangement or other similar agreement, irrespective of whether they
are set off in accordance with paragraph 42 of IAS 32.
Master netting arrangements occur when an entity enters into an agreement with a counterparty that,
in the event of default by the counterparty, allows the entity to offset all amounts with the counterparty
and settle the net amount outstanding. Such arrangements reduce the credit risk as they do not generally
result in an offset of balance sheet assets and liabilities, as transactions are usually settled on a gross
basis. Banks commonly use such arrangements to reduce their credit risk, as illustrated in an extract of
NAB’s financial statements provided as follows.

The Group further restricts its exposure to credit losses by entering into master netting arrangements
with counterparties with which it undertakes a significant volume of transactions. Master netting
arrangements do not generally result in an offset of balance sheet assets and liabilities, as transactions
are usually settled on a gross basis. However, the credit risk associated with favourable contracts is
reduced by a master netting arrangement to the extent that if a counterparty failed to meet its obligations
in accordance with agreed terms, all amounts with a counterparty are terminated and settled on a net
basis (NAB 2018, pp. 109–110).

The disclosures listed in paragraph 13C of IFRS 7 are intended to assist the users of financial
statements in assessing the impact of such potential offsetting arrangements on the financial position of
the entity.
• Collateral
Paragraphs 14 and 15 of IFRS 7 require disclosures in respect of the carrying amount of financial
assets it has pledged as collateral, including amounts that have been reclassified in accordance with
paragraph 3.2.23(a) in IFRS 9 and the terms and conditions of the collateral. Where an entity holds
collateral and is permitted to sell or repledge the collateral, it must provide details about the fair value
of such collateral — including the fair value of any sold or repledged collateral — and the terms and
conditions.
• Compound financial instruments with multiple embedded derivatives
Disclosure of any such instruments the entity may have is required.
• Defaults and breaches
Paragraphs 18 and 19 of IFRS 7 require entities to disclose details of any defaults or breaches of loans
payable during the period. This includes details of where the default was remedied by a renegotiation
of the loan payable before the financial statements were authorised for issue.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 8–11B, 12B–15 and 17–19 of IFRS 7.

6.27 STATEMENT OF PROFIT OR LOSS AND OTHER

COMPREHENSIVE INCOME
The requirements for disclosures in respect of the statement of P/L and OCI are specified in IFRS 7,
paragraphs 20 and 20A, and require entities to disclose certain information about the following items of
income, expense, gains or losses.
• ‘Net gains or losses on financial assets or financial liabilities measured at fair value through profit or
loss, showing separately those . . .:
– designated as such upon initial recognition or subsequently in accordance with paragraph 6.7.1 of
IFRS 9 . . .
– mandatorily measured at fair value in accordance with IFRS 9.’
• Net gains or losses on financial assets or financial liabilities measured at amortised cost.
• Net gains or losses on financial assets measured at fair value through OCI.
• Net gains of losses from investments in equity instruments measured at fair value through OCI.

358 Financial Reporting

 • Total interest revenue and total interest expense for financial assets or financial liabilities that are not
measured at fair value through P/L.
• Fee income and fee expense (except for amounts included in the calculation of the effective interest
rate) from financial assets or financial liabilities that are not measured at fair value through P/L or from
trust and fiduciary activities. This is an important activity of many financial institutions and may be a
significant source of fee income.
• A separate analysis of the gains and losses arising from the derecognition of financial assets measured
at amortised cost and the reasons for the derecognition.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 20 and 20A of IFRS 7.

OTHER DISCLOSURES
The additional disclosure requirements discussed in this section are provided in paragraphs 21–29 of
IFRS 7 and relate to the following matters.
• Accounting policies
An entity must provide a summary of significant accounting policies, the measurement method(s)
used in preparing the financial statements, and any other accounting policies used that are relevant to
understanding the statements (IAS 1 Presentation of Financial Statements, para. 117). This requirement
is quite subjective, and it is quite difficult for an auditor to make an assessment of an entity’s compliance
with this requirement.
• Hedge accounting
Paragraphs 21A–24F of IFRS 7 require certain disclosures in respect of risk exposures that an entity
hedges and for which it chooses to apply hedge accounting. Given the importance of hedging and the
potential for entities to pursue income-smoothing strategies through hedges, IFRS 7 requires disclosures
of substantial details about the entity’s hedges, including:
– the risk management strategy and how it is applied when designing the hedges
– how the hedges may affect the amount, timing and uncertainty of future cash flows
– the impact that hedge accounting has had on the financial statements
– details of hedging instruments
– how the entity determines the economic relationship for assessing hedge effectiveness
– how the entity establishes the hedge ratio and what the sources of hedge ineffectiveness are
– the nature of risks being hedged
– substantial details about cash flow hedges
– changes in fair values for fair value hedges (for both the hedging instruments and the hedged items),
together with any ineffectiveness of cash flow hedges and hedges of net investments in foreign
operations recognised in P/L.
• Credit exposure
Paragraph 24G of IFRS 7 requires certain disclosures about any financial instruments or part of financial
instruments that are measured at fair value through P/L because the entity uses a credit derivative to
manage the credit risk.
• Fair value
Paragraph 25 of IFRS 7 requires an entity to disclose information about fair value for each class of
financial assets and financial liabilities in a way that permits it to be compared with its carrying amount.
Paragraph 28 of IFRS 7 deals with the procedure followed where the fair value of a financial asset or
financial liability, as determined by a valuation technique such as net PV, differs from the amount paid
or received at inception, as described in B5.1.2A(b) of IFRS 9. If this occurs, IFRS 7 requires disclosure
of the accounting policy for recognising that difference in P/L, and of the total amount yet to be
recognised in P/L at the beginning and end of the period.
The only exceptions to the requirement to disclose fair values for classes of financial assets and
financial liabilities listed in paragraph 29 of IFRS 7 are:
– where the carrying amount is a reasonable approximation of fair value — for example, accounts
receivable or accounts payable, or
– lease liabilities.

MODULE 6 Financial Instruments 359

.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 21–29 of IFRS 7.

QUESTION 6.8

Discuss possible reasons for the required disclosures in paragraph 28 of IFRS 7.

NATURE AND EXTENT OF RISKS ARISING FROM

FINANCIAL INSTRUMENTS
All businesses are subject to various types of risks that are generally categorised either as business risk
or financial risk. Financial instruments and, in particular, derivative instruments are used by many entities
to help manage some of these risks. Yet, financial instruments can also create risks for the entity. It is
appropriate here to discuss what is meant by the term ‘risk’. While there is a tendency to think that risk
refers to the possibility of a loss, it also includes the possibility of gains. Hence, there is downside and
upside risk. Risk is defined as the degree of variance in a set of numbers, with a greater degree of variance
representing a higher level of risk. Given the tendency to associate the word ‘risk’ with the potential for
loss, perhaps standard setters should use phrases such as ‘potential losses’ and ‘opportunities’ (Schrand &
Elliott 1998, p. 280).
This risk disclosure deals with how well the organisation has established procedures and internal controls
to deal with its transactions involving financial instruments and, in particular, derivatives. It is important
that a business understands the purpose of derivative financial instruments and that adequate controls are
in place to control such transactions. Many of the large and spectacular losses associated with derivative
instruments involved poor operational procedures in relation to such instruments.
Metallgesellschaft AG, once the fourth-largest company in Germany, incurred huge losses on its oil
trading in the futures market. The company took positions in the futures market such that it was betting
on oil prices increasing, and when they declined, the company suffered huge losses and almost went into
receivership. It adopted unhedged positions and suffered the consequences.
Orange County in the United States also incurred huge losses when its treasurer borrowed US$14 billion
and started trading in derivative securities. The treasurer gambled that interest rates would remain stable or
fall, but they increased. The losses suffered by the county resulted in the loss of 3000 jobs. In the aftermath
of this fiasco, it was found that the county was in breach of its legal position when it borrowed such large
sums of money and its trading in derivatives may also have been illegal.
Barings is probably the most publicised case involving derivatives and huge losses. The rogue trader,
Nick Leeson, who was jailed for fraud, was involved in writing options to raise cash to service margin
calls on futures contracts that he acquired in the hope that the Nikkei 225 stock index would rise. Instead,
the index fell and the company faced bankruptcy. The fact that Leeson was able to carry out his activities
for three years before being discovered raised serious questions about Barings’ internal control procedures
(McClintock 1996).
Disclosures that assist users to assess the risks associated with financial instruments involve statements
by the company that outline its objectives for using financial instruments. IFRS 7 requires disclosures
about the entity’s objectives in using derivative financial instruments, as standard-setters consider some
disclosure about the entity’s objectives in using derivative instruments to be important information for the
users of general purpose financial statements.
Further, an explicit requirement to disclose the entity’s objectives in using derivative instruments focuses
senior management’s attention on such transactions, which may contribute to more effective knowledge
of and control over derivatives. While some entities make strategic choices not to hedge foreign exchange
risks, it is important that users are made aware of the specific policy the entity’s management has in respect
of managing risks, including maintaining unhedged foreign exchange exposure.
However, it is unlikely that such a requirement would have prevented the problems experienced by
Barings, which also involved a lack of control over certain key individuals. They certainly would not have
prevented the turmoil seen on global financial markets created by the global financial crisis.

360 Financial Reporting

 An entity is required to disclose information that enables users to evaluate the nature and extent of
risks arising from its financial instruments (IFRS 7, para. 31). Paragraphs 33–42 of IFRS 7 outline both
qualitative and quantitative disclosures which are meant to provide users with information about the typical
(but not necessarily all) risks that arise from financial instruments, and how they are being managed.
An entity is required to describe its exposure to risk from financial instruments and how the exposure
arises (IFRS 7, para. 33), including a discussion of the entity’s financial management objectives and
policies, its policy for managing risk and the methods used to measure the risk. It is also necessary to
report in each period any changes to the risk or policies used to measure and manage the risk.
The minimum quantitative disclosures in paragraphs 34 to 42 of IFRS 7 relate to:
• credit risk
• liquidity risk
• market risk.
Paragraph 34 of IFRS 7 requires a summary of the quantitative data about an entity’s exposure to each
type of risk arising from financial instruments. The information shall be based on that presented to key
management personnel, which include the board of directors and the CEO. Where this information does
not capture all material risks, further disclosure is required. If there are any concentrations of risks not
revealed by the preceding disclosures, these must be separately disclosed.

CREDIT RISK
‘Credit risk’ is defined in Appendix A of IFRS 7 as ‘the risk that one party to a financial instrument will
cause a financial loss for the other party by failing to discharge an obligation’.

Financial Assets that are Subject to Impairment Requirements

The objective of these credit risk disclosures is to enable users to understand the effect of credit risk on
the amount, timing and uncertainty of future cash flows. Accordingly, the new disclosures are significant
and cover credit management practices, quantitative and qualitative information, and details of the entity’s
credit exposure.
Each entity will need to use judgment on how much to disclose, areas of emphasis, the degree of
aggregation or disaggregation as well as any additional information required to assess the information
disclosed. The following is a summary of disclosures.

Credit Risk Management Practices

Paragraphs 35F–35G of IFRS 7 require an entity to explain its credit risk management practices, and how
they relate to the recognition and measurement of expected credit losses. Accordingly, it should disclose
information that enables users to understand and evaluate credit risk management, including:
• how it has determined whether credit risk has increased significantly since initial recognition, including:
– whether financial instruments are considered to have low credit risk, and if so, how
– whether the presumption that financial assets over 30 days past due has been rebutted, and if so,
how (i.e. why it is not being assumed that a significant increase in credit risk has occurred since
initial recognition)
• the entity’s definition of ‘default’
• how the instruments were grouped if a collective basis was used to measure credit risk
• the entity’s definition of ‘credit-impaired’
• the entity’s ‘write-off’ policy
• the impact of modifications to contractual cash flows on credit risk assessment.
An entity should also explain the inputs, assumptions and estimation techniques used to generate the
impairment amounts for IFRS 9, including:
(a) the basis of inputs and assumptions and the estimation techniques used to:
(i) measure the 12-month and lifetime expected credit losses;
(ii) determine whether the credit risk of financial instruments has increased significantly since initial
recognition; and
(iii) determine whether a financial asset is a ‘credit-impaired’ financial asset.
(b) how forward-looking information [including macroeconomic data] has been incorporated into the deter-
mination of expected credit losses
(c) changes in the estimation techniques or significant assumptions . . . and the reasons for these changes.

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Quantitative and Qualitative Information about Amounts Arising from
Expected Credit Losses
Under IFRS 7, paragraphs 35H–35L, an entity should explain the changes in the loss allowance along with
reasons for the changes, including presenting a reconciliation of the opening balance of the loss allowance
to the closing balance. A table should be prepared for each relevant class of financial instruments, showing
the changes for the period in:
• the loss allowance measured at an amount equal to 12-month expected credit losses
• the loss allowance measured at an amount equal to lifetime expected credit losses.
An explanation should also be provided as to how significant changes in the gross carrying amount of
financial assets contributed to changes in the loss allowance.
In addition, if there were modifications to contractual cash flows on financial assets not derecognised
during the period, there should be disclosure on the impact of these on the measurement of the credit loss
allowance.
To understand the impact of collateral and other credit enhancements on the amounts of expected credit
losses, the following should be disclosed:
• the maximum exposure to credit risk at the end of the reporting period without consideration of collateral
held or other credit enhancements
• a description of the nature and quality of collateral held as security and other credit enhancements, any
changes to the quality of collateral due to changing policies, and information on losses not recognised
due to collateral held
• quantitative information about the collateral held as security and other credit enhancements on financial
assets that are credit-impaired at the reporting date.
For financial assets, the maximum exposure to credit risk is typically the gross carrying amount, net of
any amounts offset in accordance with IAS 32 and any impairment losses recognised in accordance with
IFRS 9 (IFRS 7, para. B9).
Finally, any financial assets that were written off during the reporting period and are still subject to
enforcement activity should be disclosed.

Credit Risk Exposure

Users should be able to assess an entity’s credit risk exposure and understand any significant credit
risk concentrations. Therefore, under IFRS 7, paragraph 35M, an entity should disclose, by ‘credit risk
rating grades’, the gross carrying amount of financial assets and the exposure to credit risk on loan
commitments and financial guarantee contracts. This information should be provided accordingly to how
the loss allowance is measured:
• 12-month expected credit losses
• lifetime expected credit losses
• financial assets that were credit-impaired when purchased or originated.
Credit risk rating grades are ratings of credit risk based on the risk of a default occurring (IFRS 7,
Appendix A). The credit risk rating grades used should be consistent with how the entity reports credit
risk internally to key management personnel. If, for a class of financial assets, past due data is the only
counterparty information available and this is used to assess whether credit risk has increased significantly
since initial recognition, an analysis by past due status should be provided.
A concentration of credit risk occurs when counterparties (individually or collectively) are significantly
based in a single geographical region, operate in the same industry or have similar economic characteristics
with the result that their default risk would be affected in the same fashion by changes in economic or other
conditions (IFRS 7, para. B8H).

Financial Assets that are not Subject to Impairment Requirements

Paragraph 36 of IFRS 7 requires the following disclosures about credit risk for financial instruments that
are not subject to the impairment requirements of IFRS 9:
• the maximum credit risk without taking into account any collateral
• a description of any collateral and other credit enhancements.

362 Financial Reporting

 EXAMPLE 6.22

Credit Exposure
A bank estimates its credit exposure to a company under a derivative contract to be $1 000 000. The bank
is a secured creditor with a fixed charge over assets owned by the company with a current market value
of $1 000 000. Despite the fact that the bank ranks before unsecured creditors in the event of default
and it is likely that most of the assets would be recovered through realisation of the security, IFRS 7,
paragraph 36, requires the $1 000 000 to be shown as the amount of the bank’s credit exposure.

Collateral and Other Credit Enhancements

Paragraph 38 of IFRS 7 deals with collateral — or other enhancements an entity may have access to — that
reduce the credit risk of some of its financial or non-financial assets. To help users of financial statements
to assess the entity’s exposure to credit risk, the entity must disclose:
• ‘the nature and carrying amount of any assets’ that it takes possession of during the period, as a result
of having the collateral or credit enhancements, provided that such items meet the recognition criteria
for assets, and
• ‘when the assets are not readily convertible into cash, its policies for disposing of such assets or for
using them in its operations’.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 35A–38 of IFRS 7.

LIQUIDITY RISK
Liquidity risk is defined in Appendix A of IFRS 7 as ‘the risk that an entity will encounter difficulty
in meeting obligations associated with financial liabilities that are settled by delivering cash or another
financial asset’.
Disclosures on credit risk assist in partially assessing the liquidity risk relating to the prospect of a
counterparty defaulting. Additional disclosures about the location of counterparties and whether real-time
settlements are used would be relevant.
Paragraph 39 of IFRS 7 requires an entity to provide a maturity analysis for financial liabilities that
shows the remaining contractual maturities and a description of how it manages the inherent liquidity risk.
In its 2018 annual report (p. 186), BHP Billiton (now known as BHP Group) provided the following
disclosure in relation to liquidity risk.
Liquidity risk
The Group’s liquidity risk arises from the possibility that it may not be able to settle or meet its obligations
as they fall due and is managed as part of the portfolio risk management strategy. Operational, capital and
regulatory requirements are considered in the management of liquidity risk, in conjunction with short- and
long-term forecast information.
Recognising the cyclical volatility of operating cash flows, the Group has defined minimum target cash
and liquidity buffers to be maintained to mitigate liquidity risk and support operations through the cycle.
The Group’s strong credit profile, diversified funding sources, its minimum cash buffer and its committed
credit facilities ensure that sufficient liquid funds are maintained to meet its daily cash requirements. The
Group’s policy on counterparty credit exposure ensures that only counterparties of an investment grade
credit standing are used for the investment of any excess cash.
Standard & Poor’s credit rating of the Group remained at the A level with stable outlook throughout
FY2018. Moody’s maintained their credit rating for the group of A3 with positive outlook throughout
FY2018.
There were no defaults on loans payable during the period.

Details of the Group’s unused credit facilities followed this note in BHP’s Annual Report.
The listing of liabilities (and assets) in order of liquidity in the statement of financial position will assist
users in assessing the liquidity position of an entity. However, if a more accurate assessment of its liquidity,

MODULE 6 Financial Instruments 363

 and hence solvency position, is to be ascertained, it is necessary for additional information to be disclosed
about the maturities of the various liabilities (and assets).
While the standard does not mandate the time periods to use, paragraph B11 of IFRS 7, in the application
guidance, mentions that appropriate time periods may be:
• up to one month
• from one to three months
• from three months to one year
• from one to five years.
The grouping of liabilities (and assets) into different maturities could be on the basis of either the normal
expected repayment (collection) period, which is often earlier than the legal repayment (collection) time
stipulated in the contract or agreement. While the use of expected or effective dates would be more relevant
for users of financial statements, as it is based more on what happens in practice, the use of contractual
repayment periods would normally provide more reliable information. Paragraph 39(a) of IFRS 7 requires
the use of contractual dates.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraph 39 of IFRS 7.

MARKET RISK
Market risk is defined in Appendix A of IFRS 7 as:
the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes
in market prices. Market risk comprises currency risk, interest rate risk and other price risk.

Other price risk is also defined in Appendix A of IFRS 7 as:

the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes
in market prices (other than those arising from interest rate or currency risk), whether those changes are
caused by factors specific to the individual financial instrument or its issuer or factors affecting all similar
financial instruments traded in the market.

Paragraph 40(a) of IFRS 7 requires the disclosure of ‘a sensitivity analysis for each type of market risk
to which the entity is exposed at the end of the reporting period, showing how profit or loss and equity
would have been affected by changes in the relevant risk variable that were reasonably possible at that
date’. Such a requirement appears very broad without specific guidelines, but only requires the use of
reasonably possible estimates for interest rates, interest rate risk and exchange rates for currency risk.
For example, assume that an entity has $1 million in variable rate loans and that, at reporting date, the
interest rate is 8%. This means an interest payment for the year of $80 000. If, at reporting date, it was
reasonable to expect an interest rate rise or fall in the next 12 months of a magnitude of 10%, interest rates
could vary from 7.2% to 8.8%. This would result in interest payments ranging from $72 000 to $88 000.
The impact of this on profit and equity would be an increase or decrease of $8000. Entities must also
disclose the methods and assumptions used in the sensitivity analysis and any changes since the last period
(IFRS 7, paras 40(b) and 40(c)).
BHP Billiton (now BHP Group) in its Annual Report 2018 (p. 188) provided the following sensitivity
analysis to comply with paragraph 40 of IFRS 7.
The principal non-functional currencies to which the Group is exposed are the Australian dollar, the Euro,
the Pound sterling and the Chilean peso; however, 88 per cent (2017: 86 per cent) of the Group’s net
financial liabilities are denominated in US dollars. Based on the Group’s net financial assets and liabilities
as at 30 June 2018, a weakening of the US dollar against these currencies (one cent strengthening in
Australian dollar, one cent strengthening in Euro, one penny strengthening in Pound sterling and 10 pesos
strengthening in Chilean peso), with all other variables held constant, would decrease the Group’s equity
and profit after taxation by US$10 million (2017: decrease of US $16 million).

Given that the 2018 profit before tax for BHP Billiton was approximately US$14.75 billion, the amounts
reported in the sensitivity analysis are immaterial and will have no impact on a user’s decisions about
buying or selling shares in BHP Billiton (now BHP Group).

364 Financial Reporting

 As the appropriate disclosures to assist users in their assessment of market risk are more problematic
than for credit risk, many large organisations now calculate a ‘value at risk’ measure. Where an entity
does produce a value at risk that reflects the interdependencies between risk variables — such as interest
rates and exchange rates — and uses it to manage financial risks, it may use such disclosures to satisfy the
requirements of paragraph 41 of IFRS 7.
A ‘value at risk’ measure involves an assessment of potential losses for a portfolio of on-statement-
of-financial-position positions and off-statement-of-financial-position financial instrument hedges due to
adverse movements in market risk factors over a certain holding period. It involves assumed changes
in market conditions together with probabilities and calculation of value at risk under differing market
conditions. Disclosure of information about value at risk should be of benefit to users in their assessment
of market risk, and this is the reason IFRS 7 permits such disclosures in place of the sensitivity analysis
required in paragraph 40(a) of IFRS 7.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 40–42 of IFRS 7.

TRANSFERS OF FINANCIAL ASSETS

As noted in part B, IFRS 9 provides guidelines on when financial assets can be removed from the statement
of financial position. Paragraphs 42A–42H of IFRS 7 require disclosures of transactions involving the
transfer of financial assets that fail the derecognition requirements of IFRS 9. The two possible types of
transactions are:
1. where an entity transfers only part of a financial asset, such as a portion of its receivables
2. where an entity transfers the entire amount of financial assets but maintains a continuing involvement,
such as when an entity transfers all of its receivables but guarantees the acquirer for a portion of
uncollectible accounts.
The purpose of these disclosures is to allow users to be aware of the transfer and the resultant liabilities
that the entity may have assumed as a result of the transfer failing the derecognition test.
An entity shall disclose the amounts of such liabilities, and if the entity partially satisfies the derecog-
nition test, disclosure is required of the amount of assets it continues to recognise and the total carrying
amount of the original assets.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraphs 42A–42H of IFRS 7. Please now attempt
question 6.9 to apply your knowledge of this topic.

QUESTION 6.9

Why are disclosures about transfers of financial assets that fail the derecognition criteria in IFRS 9
important to users of financial statements?

SUMMARY
Part F examined the relevant disclosures for financial instruments. Under IFRS 7, entities are required
to make extensive disclosures in relation to financial instruments. These include disclosures about the
significance of financial instruments for financial position and financial performance in respect of the
statement of financial position, the statement of P/L and OCI, and the statement of changes in equity.
Additional disclosures about financial instruments are also required for:
• significant accounting policies
• risk management
• hedge accounting
• fair value
• credit risk
• liquidity risk

MODULE 6 Financial Instruments 365

• market risk
• transfers of financial assets.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

6.7 Explain the key disclosures required for financial instruments under IFRS 7.
• IFRS 7 Financial Instruments: Disclosures contains detailed disclosure requirements that apply to all
financial instruments.
• All types of risks related to financial instruments must be disclosed irrespective of whether they are
recognised in the financial statements or are unrecognised.
• The disclosures must be presented by class of financial instrument.
• Statement of financial position disclosures include:
– categories of financial assets and financial liabilities
– financial assets at fair value through profit or loss
– financial liabilities at fair value through profit or loss
– investments in equity securities where gains and losses are reported in OCI
– reclassifications and offsetting
– collateral pledges
– compound financial instruments with multiple embedded derivatives
– defaults and breaches.
• Statement of P/L and OCI disclosures include:
– net gains or losses on financial assets or financial liabilities measured at fair value through P/L,
amortised cost, and fair value through OCI
– net gains or losses from investment in equity instruments measured at fair value through OCI
– total interest revenues and expenses for financial assets or financial liabilities not measured at fair
value through P/L
– specific fee income and expenses
– gains and losses arising from the derecognition of financial assets measured at amortised cost
and the reasons for the derecognition.
• Other disclosure requirements relate to accounting policies, hedge accounting, credit exposure, and
fair value.
• Entities must also disclose its exposure to the following types of risks: credit risk, liquidity risk, and
market risk.
• Any transactions that involve the transfer of financial assets that fail the derecognition requirements
must also be disclosed.

REVIEW
Module 6 considered many complex and difficult issues. While it is not expected that the module will
provide everything required to be an expert in accounting for financial instruments, especially for derivative
financial instruments, it should provide a basic understanding of accounting for financial instruments. To
this end, part A examined the characteristics of some basic derivative financial instruments — namely,
forwards, swaps, options and futures contracts.
Part A also considered the distinction between a financial liability and an equity instrument, concluding
that the substance of the instrument, and not its form, should dictate the appropriate classification. Where
there is no present obligation for the issuer of a financial instrument to sacrifice economic benefits in the
future, the instrument should be classified as equity. Financial instruments that are settled by an issuer
issuing its own equity instruments are classified as a financial liability when the number of ordinary shares
to be issued is variable, and as equity when the number of ordinary shares to be issued is fixed.
Part B of the module then focused on the recognition and derecognition issues associated with
financial instruments specified in IFRS 9. Financial assets and financial liabilities arising from financial
instruments are recognised when the entity becomes a party to the contract. Financial assets should only be
derecognised when an entity loses control of the economic benefits arising from the assets either through
the expiry or transfer of the economic benefits. Financial liabilities should only be derecognised when the
obligation is extinguished.
Part C considered the classification of financial assets and financial liabilities. Financial assets are
classified as measured at amortised cost or fair value. To be classified as measured at amortised cost, the

366 Financial Reporting

financial asset must be held within a business model whose objective is to hold assets in order to collect
contractual cash flows, and the contractual terms of the financial asset should give rise on specified dates
to cash flows that are solely payments of principal and interest on the principal amount.
All other financial assets are classified as measured at fair value through OCI except where an irrevocable
decision is taken to classify them as measured at fair value through P/L due to an accounting mismatch.
As discussed in part B, financial liabilities are classified at amortised cost, except for liabilities as at fair
value through P/L or financial liabilities that arise when a transfer of a financial asset does not qualify for
derecognition. The other categories are financial guarantee contracts and commitments to provide a loan at
a below-market interest rate. Part C concluded with a discussion on embedded derivatives and considered
the treatment both when the host contract is, and is not, an asset within the scope of IFRS 9.
Part D turned to the measurement of financial assets, financial liabilities and investments in equity
instruments. It explained that the measurement of the financial assets and financial liabilities upon initial
recognition is at fair value plus or minus transaction costs when the financial asset or liability is not
measured at fair value. Subsequent to acquisition, financial assets and financial liabilities are measured
according to their classification as discussed in part C. For financial assets and financial liabilities that are
part of a hedging relationship, the hedge accounting rules in IFRS 9 apply.
Turning to subsequent measurement, part D showed that the gains and losses from remeasurement to
fair value are included in P/L for all financial assets and liabilities classified as at fair value through P/L
except when:
• the financial asset or liability is part of a hedge
• it is an investment in an equity instrument where the entity has made an irrevocable decision to classify
such gains and losses in OCI, or
• it is a financial liability designated as at fair value through P/L, and the change is due to credit risk of
the financial liability.
Module 6 also explained that entities have an irrevocable option in respect of equity instruments to elect
to report changes in fair value in OCI rather than P/L. This election is made on each investment. The fair
value changes for financial liabilities designated as at fair value through P/L are reported in P/L except
where a portion of the fair value change is due to changes in the credit risk of that liability, in which case
such gains or losses are reported in OCI. The only exception to this requirement occurs when the reporting
of such gains or losses in OCI results in an accounting mismatch in P/L. Gains and losses on financial
guarantee contracts and loan commitments are reported in full in P/L.
Next was a discussion of hedge accounting in part E of the module. This part illustrated that entities are
able to designate almost any recognised asset or liability as a hedging instrument against risks arising from
a hedged item. The hedged item can be a recognised asset or liability, an unrecognised firm commitment,
a forecast transaction, or a net investment in a foreign operation. The hedged item may also be a risk
component arising from any of these elements. Hedging relationships can be either fair value hedges, cash
flow hedges or hedges of a net investment in a foreign operation. All hedges must continue to be effective
on a prospective basis to qualify for hedge accounting. If a hedge is no longer assessed as effective, hedge
accounting must be discontinued.
The final section, part F, outlined the appropriate disclosures in respect of financial instruments,
including the requirements of IFRS 7. The disclosures about the significance of financial instruments for
financial position and financial performance in respect of the statement of financial position, the statement
of P/L and OCI, and statement of changes in equity are required. Additional disclosures about financial
instruments are also required for:
• significant accounting policies
• risk management
• hedge accounting
• fair value
• credit risk
• liquidity risk
• market risk
• transfers of financial assets.
This module illustrated the core principles of accounting for financial instruments, which is one of the
more complicated areas of financial reporting. Some of the complexity arises from the need to understand
concepts of finance and valuation. However, these topics can be mastered with further exposure to them
and a desire to learn more.

MODULE 6 Financial Instruments 367

REFERENCES
BHP Billiton (BHP) 2018, Annual Report 2018, accessed July 2019, https://www.bhp.com/investor-centre/annual-report-2018.
Ernst & Young 2014, Hedge Accounting under IFRS 9, accessed July 2019, http://www.ey.com/Publication/vwLUAssets/
Applying_IFRS:_Hedge_accounting_under_IFRS_9/$File/Applying_Hedging_Feb2014.pdf.
KPMG 2013, First Impressions: IFRS 9 (2013) — Hedge Accounting and Transition, December, accessed May 2019, https://home.
kpmg.com/content/dam/kpmg/pdf/2013/12/First-Impressions-O-1312-IFRS9-Hedge-accounting-and-transition.pdf.
McClintock, B. 1996, ‘International financial instability and the financial derivatives market’, Journal of Economic Issues, vol. 30,
no. 1, pp. 13–33.
MNP 2016, An overview of IFRS 9 Financial Instruments vs. IAS 39 Financial Instruments: Recognition and Measurement,
January, p. 5, accessed July 2019, https://www.mnp.ca/en/assurance-accounting/financial-reporting-library/ifrs-implementation-
guide-an-overview-of-ifrs-9-vs-ias-39.
National Australia Bank (NAB) 2018, Annual Financial Report 2018, accessed July 2019, https://capital.nab.com.au/
docs/2018_NAB_Annual_Financial_Report.pdf.
Schrand, C. M. & Elliott, J. A. 1998, ‘Risk and financial reporting: A summary of the discussion at the 1997 AAA/FASB
Conference’, Accounting Horizons, vol. 12, no. 3, pp. 271–82.

OPTIONAL READING
CPA 2016, IFRS 9 Financial instruments: Fact sheet, accessed July 2019, https://www.cpaaustralia.com.au/~/media/corporate/
allfiles/document/professional-resources/ifrs-factsheets/factsheet-ifrs9-financial-instruments.pdf?la=.
Deloitte International 2016, GAAP Holdings Limited: Model Financial Statements for the Year Ended 31 December 2016 (With
Early Adoption of IFRS 9), accessed July 2019, https://www.iasplus.com/en/publications/global/models-checklists/2016/ifrs-
mfs-2016-ifrs-9.
Deloitte International 2019, GAAP Bank Limited: Illustrative disclosures under IFRS 7 as amended by IFRS 9, accessed July 2019,
https://www.iasplus.com/en/publications/global/other/illustrative-disclosures.
Ernst & Young 2014, Impairment of Financial Instruments under IFRS 9 December 2014, accessed July 2019,
http://www.ey.com/Publication/vwLUAssets/Applying_IFRS:_Impairment_of_financial_instruments_under_IFRS_9/$FILE/
Apply-FI-Dec2014.pdf.
Ernst & Young 2018, Good Bank (International) Limited: illustrative disclosures for IFRS 9 – impairment and transition,
December, accessed July 2019, https://www.ey.com/Publication/vwLUAssets/ey-ctools-good-bank-nov2017/$FILE/CTools-
Good-Bank-Nov2017.pdf.
IAS Plus, Heads up — IFRS 9 gets a new hedge accounting model, accessed July 2019,
http://www.iasplus.com/en/publications/us/heads-up/2013/hedging.
PwC 2016, Practical guide: general hedge accounting, November, accessed July 2019, https://www.pwc.com/gx/en/audit-
services/ifrs/publications/ifrs-9/practical-general-hedge-accounting.pdf.

368 Financial Reporting

MODULE 7

IMPAIRMENT OF ASSETS
LEARNING OBJECTIVES

After completing this module, you should be able to:

7.1 explain the key issues in accounting for the impairment of assets
7.2 identify the types of assets to which IAS 36 applies
7.3 evaluate whether an impairment test must be undertaken under IAS 36
7.4 explain and apply the requirements of IAS 36 in relation to:
– the calculation of recoverable amount
– recognising and measuring an impairment loss for an individual asset
– the reversals of impairment losses
7.5 explain and apply the requirements of IAS 36 in relation to:
– the identification of CGUs
– recognising and measuring an impairment loss for CGUs and goodwill.

ASSUMED KNOWLEDGE

Before you begin your study of this module, it is assumed that you are familiar with:
• the concept of depreciation under IAS 16 Property, Plant and Equipment and amortisation under IAS 38
Intangible Assets
• recognition criteria for intangible assets under IAS 38 Intangible Assets
• the concept and treatment of goodwill under IFRS 3 Business Combinations, as discussed in module 5
• basic present value techniques.

LEARNING RESOURCES

International Financial Reporting Standards (IFRSs):

• IAS 16 Property, Plant and Equipment
• IAS 36 Impairment of Assets
• IAS 38 Intangible Assets
• IFRS 3 Business Combinations
• IFRS 8 Operating Segments
• IFRS 13 Fair Value Measurement

PREVIEW
Module 1 discussed the different measurement bases available under IFRSs for various assets. The module
noted that cost, or historical cost, is the most common measurement basis used for assets at their initial
recognition and addressed a variety of other measurement bases that are available for the subsequent
measurement of assets. Despite the variety of measurement bases available in general, some IFRSs
prescribe strict requirements regarding the subsequent measurement of assets and their carrying amounts.
For example, IAS 36 Impairment of Assets (IAS 36) prescribes that the carrying amount of an asset must
not exceed its recoverable amount (IAS 36, para. 1). An asset’s recoverable amount is the higher of an
asset’s ‘fair value less costs of disposal and its value in use’ (IAS 36, para. 6).
To ensure that the carrying amount of an asset does not exceed its recoverable amount, IAS 36 prescribes
the so-called ‘impairment test’ to compare at a particular point in time the carrying amount of the asset
with its recoverable amount. IAS 36 sets out when an entity needs to perform an impairment test and
how to perform it. If, as a result of the impairment test, it is determined that the carrying amount of the
asset exceeds its recoverable amount, the difference will be recognised as an impairment loss according to
IAS 36, and the carrying amount of the asset will need to be reduced by that impairment loss. IAS 36
prescribes the recognition of any impairment losses, as well as their reversal, and also includes specific
disclosure requirements for when assets are impaired.
IAS 36 applies to non-financial assets that are within its scope. This module addresses all the main
requirements of IAS 36 mentioned above. More specifically, part A provides an overview of IAS 36,
including the basic principles relating to the impairment of assets and how to identify assets that may be
impaired. Part B addresses the impairment of individual assets, including, where required, the measurement
of their recoverable amount. Part C considers the impairment of groups of assets, or cash-generating units
(CGUs), including how to identify CGUs and apply the impairment requirements of IAS 36 to CGUs.
Finally, in part D, the disclosure requirements of IAS 36 are considered.

Relevant Paragraphs from IAS 36 Impairment of Assets

To assist in achieving the objectives of this module, you may wish to read the following paragraphs of
IAS 36. Where specified, you need to be able to apply these paragraphs as referenced throughout
the module.

Subject Paragraphs
Scope 2–5
Definitions 6
Identifying an asset that may be impaired 7–17
Measuring recoverable amount 18–57
Measuring the recoverable amount of an intangible asset
with an indefinite useful life 24
Fair value less costs of disposal 28–29
Value in use 30–57
Recognising and measuring an impairment loss 58–64
CGUs and goodwill 65–108
Identifying the cash-generating unit to which an asset belongs 66–73
Recoverable amount and carrying amount of a cash-generating unit 74–103
Impairment loss for a cash-generating unit 104–108
Reversing an impairment loss 109–125
Reversing an impairment loss for an individual asset 117–121
Reversing an impairment loss for a cash-generating unit 122–123
Reversing an impairment loss for goodwill 124–125
Disclosure 126–137
Appendix A: Using present value techniques to measure value in use A1–A21

370 Financial Reporting

PART A: IMPAIRMENT OF ASSETS — AN
OVERVIEW
INTRODUCTION
Part A provides an overview of the requirements for impairment of assets as set out in IAS 36. The issues
considered in this part include the basic principles relating to the impairment of assets, key terms specified
in IAS 36, the scope of IAS 36, and how to identify whether an asset may be impaired.

7.1 BASIC PRINCIPLES OF IMPAIRMENT OF ASSETS

OVERVIEW OF IMPAIRMENT REQUIREMENTS
As noted earlier, IAS 36 prescribes that the carrying amount of an asset (tangible, intangible or goodwill)
must not exceed its recoverable amount. The definition of recoverable amount, considered in further detail
below, reflects these two ways in which the carrying amount of an asset can be recovered (i.e. through
ongoing use or sale).
An impairment is recognised to the extent that an asset’s carrying amount exceeds its recoverable
amount. An example of how an impairment can arise is shown in figure 7.1. In this example, an item of
high-tech machinery is purchased at the end of Year 1 for $200 000. At the date of purchase, the carrying
amount and the recoverable amount of the machine are equal. The machine is depreciated on a straight-line
basis over ten years (i.e. the annual depreciation recognised against the machine is $20 000). Therefore,
one year from the date of purchase, the machine has a carrying amount of $180 000 ($200 000 – $20 000).
On the other hand, due to advancements in technology, the entity estimates the recoverable amount of the
machine one year from the date of purchase to be $80 000. As a result, the machine is considered impaired
because its recoverable amount is less than its carrying amount.

FIGURE 7.1 Carrying amount of the machine versus recoverable amount

$250 000
Carrying amount

$200 000 Recoverable amount

$150 000

$100 000

$50 000

$0
Year 1 Year 2
Source: CPA Australia 2019.

An impairment loss of $100 000 must be recognised to reduce the carrying amount of the machine from
$180 000 to $80 000, as reflected in the following journal entry.

Dr Impairment loss (expense) 100 000

Cr Accumulated impairment losses (contra-asset) 100 000

The future annual depreciation charge is subsequently based on the carrying amount of the machine
after recognising the impairment loss: $80 000/9 years = $8889 per annum (assume that the remaining
useful life is still nine years after the impairment).

MODULE 7 Impairment of Assets 371

WHY IS IMPAIRMENT IMPORTANT FOR USERS?
Impairment is essentially recognition by an entity of a decrease in value of its assets. However, the
implications of impairment for users of financial reports — such as existing and potential investors, lenders
and other creditors — may be far reaching when assessing the entity’s financial position and performance.
When faced with a significant impairment of an entity’s assets, users may raise the following questions.
• If an entity has recognised an impairment loss, what does this indicate about past management decisions?
Did management pay too much for assets or did the cost of developing an asset exceed the actual benefits
from the asset?
• What is the impact of an impairment loss on an entity’s key financial ratios (such as the current ratio,
debt–equity ratio or net interest cover ratio), which are important to users in comparing the financial
performance of the entity over time or with its peers?
• What is the impact of an impairment loss on the future earnings of the entity?
• Is the amount of the impairment loss appropriate? Are further impairment losses likely and, if so, what
is their potential financial impact?
• Is the timing of the impairment loss appropriate? Does the reporting of the impairment loss coincide
with the release of other bad news? Or is it management’s attempt to ‘clean up’ the balance sheet (which
sometimes occurs when a new management team is appointed)?
Example 7.1 demonstrates a case of significant impairment losses recognised by Woolworths, one of
the biggest Australian retailers. Those impairment losses would have raised some of the questions above
in the minds of Woolworths’ existing and potential investors, lenders or other creditors.

EXAMPLE 7.1

Woolworths Reports Significant Impairment Losses in its 2019 Results

In August 2019, the Australian retailer Woolworths — which owns retail businesses such as Woolworths
supermarkets, BIG W and Endeavour Drinks as well as various hospitality businesses — released its 2019
full-year financial results which included a number of significant impairment write downs, including:
• $166 million for the BIG W network of stores, $110 million of which relates to impairment of centrally
held plant and equipment, and $56 million relating to the impairment of store plant and equipment. This
impairment loss reflects a more conservative level of margin recovery expected from BIG W, taking into
account both current trading and the outlook for the broader sector, including the continued customer
shift to online.
• $21 million for Summergate, a China-based wine and drinks distributor within Endeavour Drinks, relating
to the impairment of goodwill and other intangibles.
Source: Adapted from Woolworths Group 2019, 2019 Annual Report, 29 August, p. 89, accessed October 2019, https://www.
woolworthsgroup.com.au/content/Document/ASX%20announcements/2019/WOW_AR19_Interactive_PDF.pdf.

The above example shows that impairment losses can be substantial and not only triggered by the
internal events of an organisation. Entire industries can be exposed to overstated asset values as historical
assumptions about asset values are challenged by changing environments — that will result in asset
impairments that should be recognised by most, if not all, entities in those industries.

KEY DEFINITIONS
Paragraph 6 of IAS 36 includes a number of key definitions in relation to impairment, as shown in
table 7.1. These definitions will be addressed throughout this module.

TABLE 7.1 Impairment definitions

Carrying amount ‘The amount at which an asset is recognised after deducting any accumulated
depreciation (amortisation) and accumulated impairment losses thereon’

Recoverable amount ‘The higher of its fair value less costs of disposal and its value in use’
of an asset or a CGU

Fair value ‘The price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date’ (see IFRS
13 Fair Value Measurement)

372 Financial Reporting

 Costs of disposal ‘Incremental costs directly attributable to the disposal of an asset or cash-generating
unit, excluding finance costs and income tax expense’

Value in use ‘The present value of the future cash flows expected to be derived from an asset or
cash-generating unit’

Cash-generating unit ‘The smallest identifiable group of assets that generates cash inflows that are largely
(CGU) independent of the cash inflows from other assets or groups of assets’ (discussed in
part C)

Source: Adapted from IFRS Foundation 2019, IAS 36 Impairment of Assets, para. 6, in IFRS Standards issued at 1 January 2019,
IFRS Foundation, London, pp. A1374–A1375.
.......................................................................................................................................................................................
EXPLORE FURTHER
If you wish to explore this topic further, you may now read paragraph 6 of IAS 36.

SCOPE OF IAS 36 IMPAIRMENT OF ASSETS

The impairment requirements of IAS 36 apply to a broad range of non-financial assets summarised in
table 7.2. Non-financial assets excluded from the scope of IAS 36 are subject to the measurement require-
ments of other IFRSs. In addition, financial assets, such as receivables, are subject to the measurement
requirements of IFRS 9 Financial Instruments described in module 6.

TABLE 7.2 Scope of IAS 36 Impairment of Assets

Applies to: Does not apply to:

All assets, regardless of whether they are: • Inventories

• current or non-current • Assets arising from construction contracts
• tangible or intangible • Deferred tax assets (refer to module 4)
• measured at cost or revalued amount (i.e. fair • Assets arising from employee benefits
value) unless specifically excluded • Financial assets within the scope of IFRS 9 (refer to
module 6)
Examples of assets IAS 36 applies to include: • Investment property measured at fair value
• property, plant and equipment • Biological assets related to agricultural activity that are
• intangible assets (purchased or internally measured at fair value less costs of disposal
generated) and goodwill • Contracts within the scope of IFRS 17 Insurance Contracts
• investments in subsidiaries, associates and that are assets
joint ventures • Non-current assets (or disposal groups) classified as held
• investment property measured at cost for sale under IFRS 5 Non-current Assets Held for Sale
and Discontinued Operations

Source: CPA Australia 2019.

.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 2–5 of IAS 36.

7.2 IDENTIFYING ASSETS THAT MAY BE IMPAIRED

GENERAL REQUIREMENTS FOR AN IMPAIRMENT TEST
Estimating the recoverable amount of an asset or group of assets at the end of each reporting period can be
costly and time consuming. In recognition of this potential burden, IAS 36 adopts a two-step impairment
testing procedure for all assets within its scope, except for certain intangible assets and goodwill where
specific requirements (discussed shortly) must be applied.
The first step of this procedure is to determine whether there is any indication that an asset is impaired
(IAS 36, para. 9). In this step, a variety of indicators are considered — they are described in the section
in this module entitled ‘Impairment indicators’. If there is an indication of impairment, then the second
step, being to formally estimate the recoverable amount of the asset, must be completed. If no impairment
exists, then the procedure ends with no impairment recognised.

MODULE 7 Impairment of Assets 373

.......................................................................................................................................................................................
EXPLORE FURTHER
Note that when IAS 36 specifies requirements as to when the recoverable amount must be determined, or how to
measure the recoverable amount, a reference to the term ‘an asset’ applies equally to an individual asset or CGU
(IAS 36, para. 7).
To explore this topic further, read paragraphs 7–9 of IAS 36.

SPECIFIC REQUIREMENTS FOR CERTAIN INTANGIBLE

ASSETS AND GOODWILL
Intangible assets with indefinite useful lives or that are not yet available for use, and goodwill, are not
amortised under IFRSs. An intangible asset is defined in IAS 38 Intangible Assets as ‘an identifiable non-
monetary asset without physical substance’ (para. 8). As explained in paragraph 9 of IAS 38, entities often
expend resources on the acquisition, development, maintenance or enhancement of intangible resources,
such as brand names, publishing titles, technical knowledge and intellectual property. Paragraph 9 lists
examples of common items that make up intangible resources, including computer software, patents,
copyrights, customer lists and motion picture films. As these assets are not amortised, or their future
economic benefits might be subject to greater uncertainty, there is a higher risk that their carrying amount
might be overstated. IAS 36, therefore, requires the recoverable amounts of these assets to be estimated
once a year regardless of whether there is an indication of impairment (IAS 36, para. 10). Table 7.3
summarises the assets to which these additional impairment requirements apply and the timing of the
determination of their recoverable amounts.
.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 51–64 of IAS 38.

TABLE 7.3 Assets with additional impairment requirements

Asset Example Timing of recoverable amount estimate

Intangible assets with Brand name with no At any time during an annual period, provided
indefinite useful lives foreseeable limit on its it is done at the same time each year,
useful life irrespective of whether there is any indication
of impairment (IAS 36, para. 10)
Intangible assets not yet Computer software being
available for use developed in-house

Goodwill acquired in a At any time during an annual period, provided

business combination it is done at the same time each year (IAS 36,
para. 96)

Source: Adapted from IFRS Foundation 2019, IAS 36 Impairment of Assets, paras 10, 96, in IFRS Standards issued at 1 January
2019, IFRS Foundation, London, pp. A1376, A1392.

To reduce the burden of formally estimating the recoverable amounts of intangible assets with indefinite
useful lives, IAS 36 paragraph 24 provides that:
the most recent detailed calculation of such an asset’s recoverable amount made in a preceding period may
be used . . . in the current period, provided all the following conditions are met:
(a) if the intangible asset does not generate cash inflows from continuing use that are largely independent
of those from other assets or groups of assets and is therefore tested for impairment as part of the
cash-generating unit to which it belongs [refer to ‘Part C: Impairment of cash-generating units’ in this
module], the assets and liabilities making up that unit have not changed significantly since the most
recent recoverable amount calculation;
(b) the most recent recoverable amount calculation resulted in an amount that exceeded the asset’s carrying
amount by a substantial margin; and
(c) based on an analysis of events that have occurred and circumstances that have changed since the most
recent recoverable amount calculation, the likelihood that a current recoverable amount determination
would be less than the asset’s carrying amount is remote (IAS 36, para. 24).

374 Financial Reporting

.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 10–11, 24 and 96 of IAS 36.

IMPAIRMENT INDICATORS
IAS 36 provides a list of external indicators (IAS 36, para. 12(a)–(d)), internal indicators (IAS 36,
para. 12(e)–(g)), and other impairment indicators (IAS 36, para. 12(h)) that, at a minimum, an entity
must consider when assessing whether an asset is impaired. An entity may also identify its own indicators
that an asset may be impaired (IAS 36, para. 13). Also note that most of the indicators are more appropriate
to assess an individual asset than a CGU of which they may be a part (refer to ‘Part C: Impairment of cash-
generating units’). Tables 7.4 and 7.5 summarise key external and internal indicators as listed in IAS 36.

TABLE 7.4 Indicators of impairment based on external information sources

Indicator Explanation Example

Significant ‘[T]here are observable indications A property experiences a significant decline in its
decline in that the asset’s value has declined market value due to deterioration in local economic
asset’s value during the period significantly more conditions.
than would be expected as a result
of the passage of time or normal
use’ (IAS 36, para. 12(a)).
Significant ‘[S]ignificant changes with an A competitor announces a new product whose price
adverse adverse effect on an entity have significantly undercuts the price at which the entity
changes in taken place during the period, or can sell its product, or a regulatory change occurs
environment will take place in the near future, which restricts the market for an entity’s product. In
or market in the technological, market, either case, this change adversely affects the demand
economic or legal environment for the output produced by an asset or CGU.
in which the entity operates or in
the market to which an asset is
dedicated’ (IAS 36, para. 12(b)).
Increases in ‘[M]arket interest rates or An entity owns shares in a subsidiary. The market
interest rates other market rates of return on in which the subsidiary operates has recently
or other market investments have increased during experienced an increase in uncertainty due to
rates of return the period, and those increases economic factors. This uncertainty has resulted
on investments are likely to affect the discount rate in investors increasing the rate of return they
used in calculating an asset’s value expect from investments similar to the subsidiary
in use and decrease the asset’s to compensate them for the additional risks.
recoverable amount materially’ (IAS Note: An increase in market rates does not
36, para. 12(c)). automatically mean that an asset or a CGU is impaired
(IAS 36, para. 16). For example, an increase in short-
term interest rates may not materially affect the
recoverable amount of an asset held as a long-term
investment. Alternatively, previous analysis may have
shown that an asset’s recoverable amount is not
sensitive to an increase in market rates because the
cash flows from the asset adjust to compensate for
increases in market rates.
Market ‘[T]he carrying amount of the net An entity owns shares in an associate that is listed
capitalisation assets of the entity is more than its on a stock exchange. The market capitalisation of
exceeded market capitalisation’ (IAS 36, this investment (estimated by multiplying the number
para. 12(d)). of shares owned by the current share price) is much
lower than the carrying amount of the entity’s share of
the underlying net assets of the associate.
Note: Care needs to be taken in using this indicator,
as the market capitalisation of an entity may reflect
a range of factors that are not indicative of the
impairment of an asset. Further, the entity may have
evidence that the asset is not sensitive to a decline in
its market capitalisation.

Source: Based on IFRS Foundation 2019, IAS 36 Impairment of Assets, paras 12, 16, in IFRS Standards issued at 1 January 2019,
IFRS Foundation, London, pp. A1376–A1378.

MODULE 7 Impairment of Assets 375

 TABLE 7.5 Indicators of impairment based on internal information sources

Indicator Explanation Example

Obsolescence or ‘[E]vidence is available of obsolescence An item of machinery becomes

physical damage or physical damage of an asset’ (IAS 36, outdated due to technological change.
para. 12(e)).

Change in asset use ‘[S]ignificant changes with an adverse An entity has assets used to
effect on the entity have taken place manufacture facsimile equipment.
during the period, or are expected to Due to the increased use of electronic
take place in the near future, in the communication (email, etc.), the entity
extent to which, or the manner in which, has decided to withdraw from the
an asset is used or is expected to be facsimile manufacturing market.
used. These changes include the asset
becoming idle, plans to discontinue or
restructure the operation to which an
asset belongs, plans to dispose of an
asset before the previously expected
date, and reassessing the useful life of an
asset as finite rather than indefinite’
(IAS 36, para. 12(f)).

Economic performance ‘[E]vidence is available from internal The net cash inflows from an asset
of asset worse than reporting that indicates that the economic are lower than the net cash inflows
expected performance of an asset is, or will be, forecast for that asset when it was
worse than expected’ (IAS 36, originally purchased.
para. 12(g)).

Source: Based on IFRS Foundation 2019, IAS 36 Impairment of Assets, para. 12, in IFRS Standards issued at 1 January 2019, IFRS
Foundation, London, p. A1377.
As noted in module 5, in assessing whether there is any indication that an investment in a subsidiary,
joint venture or associate may be impaired after the payment of a dividend, an investor should consider
any available evidence that indicates that:
(i) the carrying amount of the investment in the separate financial statements exceeds the carrying
amounts in the consolidated financial statements of the investee’s net assets, including associated
goodwill; or
(ii) the dividend exceeds the total comprehensive income of the subsidiary, joint venture or associate in
the period the dividend is declared (IAS 36, para. 12(h)).

.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 12–17 of IAS 36.

QUESTION 7.1

Consider the situations below and comment on whether a formal estimate of the recoverable
amount of each entity’s assets is required. Explain your answer with reference to IAS 36.
(a) An asset of A Ltd has a history of profitable use within A Ltd’s operations and is currently
profitable. The most recent results of A Ltd show that the cash outflows related to operating
the asset are 20% higher than originally budgeted.
(b) B Ltd manufactures computer chips for use in domestic appliances. One of B Ltd’s competitors
recently announced that it had developed a new generation of computer chips, which allows
the competitor to reduce its cost to manufacture chips by 15%.
(c) C Ltd operates in the gaming industry. Recent government regulations are expected to increase
competition in the sector, potentially resulting in a loss of market share. In anticipation of this
increased competition, C Ltd plans to diversify its operations into hospitality and entertainment
activities. This diversification is expected to compensate the entity for the potential loss of its
market share in the gaming sector.
(d) The ordinary shares of D Ltd are listed on the stock exchange. The market capitalisation of
D Ltd at its most recent reporting date was $50 million. The carrying amount of D Ltd’s net
assets at that date was $47 million.

376 Financial Reporting

 (e) E Ltd has significant operations in Country X. Country X has recently been affected by a natural
disaster. Although the operations of E Ltd were not directly affected by the natural disaster,
many of its suppliers were significantly affected and have ceased operations indefinitely. As a
consequence, the plant of E Ltd can operate at only half its normal capacity for the next three
years due to the lack of supplies.

Refer to the financial statements of Techworks Ltd. What items in the statement of financial position
have the directors tested for impairment?

SUMMARY
Part A provided an overview of the IAS 36 requirements with a discussion of the basic principles relating
to the impairment of assets, including timing of impairment testing. Most importantly, IAS 36 identifies
that an asset is impaired when its carrying amount exceeds its recoverable amount. This part introduced
the concepts of recoverable amount, fair value less costs of disposal and value in use. It also discussed the
scope of the standard. This part also noted that users of financial information pay particular attention to
impairment in evaluating the financial performance and position of an entity.
Part A also briefly discussed the way in which an entity can assess whether assets are impaired through
the use of external, internal and other indicators of impairment.
Part B will consider the procedures prescribed in IAS 36 to estimate the recoverable amount and account
for the impairment of assets on an individual asset basis.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

7.1 Explain the key issues in accounting for the impairment of assets.
• The carrying amount of an asset (tangible, intangible or goodwill) must not exceed its recoverable
amount.
• The carrying amount of an asset can be recovered through ongoing use or sale.
• An impairment is recognised to the extent that an asset’s carrying amount exceeds its recoverable
amount.
• Impairment is essentially recognition by an entity of a decrease in value of its assets.
7.2 Identify the types of assets to which IAS 36 applies.
• IAS 36 applies to all non-financial assets regardless of whether they are current or non-current,
tangible or intangible, or measured at cost or revalued amount (i.e. fair value) unless specifically
excluded.
• Two-step approach as follows.
1. Determine whether there is any indication that an asset is impaired.
2. Estimate the recoverable amount of the asset.
• Intangible assets with indefinite useful lives or that are not yet available for use, and goodwill, are
not amortised. Specific impairment rules apply to these assets.
7.3 Evaluate whether an impairment test must be undertaken under IAS 36.
• Impairment indicators include:
– significant decline in asset’s value
– significant adverse changes in environment or market
– increases in interest rates or other market rates of return on investments
– market capitalisation exceeded
– obsolescence or physical damage
– change in asset use
– economic performance of asset worse than expected.

MODULE 7 Impairment of Assets 377

PART B: IMPAIRMENT OF INDIVIDUAL
ASSETS
INTRODUCTION
Part B deals with the impairment of individual assets. The impairment of CGUs will be discussed in
part C.
When there is an indication that an asset may be impaired, IAS 36 requires an entity to make a formal
estimate of the asset’s recoverable amount so that this amount can be compared to its carrying amount.
An asset (or a CGU) is impaired when its recoverable amount is less than its carrying amount (IAS 36,
para. 8). The key issues considered in part B include the measurement of recoverable amount and how to
calculate and recognise an impairment loss or the reversal of a previous impairment loss.

7.3 MEASUREMENT OF RECOVERABLE AMOUNT

As stated previously, ‘recoverable amount’ is the higher of an asset’s ‘fair value less costs of disposal and
its value in use’ (IAS 36, para. 6). This definition of recoverable amount reflects the view that the economic
benefits embodied in an asset can be recovered through either its sale or use. Rational management of an
asset will try to generate the higher return.
To assess impairment, the carrying amount of an asset is then compared to its recoverable amount.
Diagrammatically, this is shown in figure 7.2.

FIGURE 7.2 Carrying amount of an asset compared to its recoverable amount

Step 1: Determine Recoverable amount

equal to the higher of

Fair value less and Value in use

costs of disposal

Step 2: Compare Recoverable amount and Carrying amount

If recoverable amount < carrying amount, an impairment loss has occurred.

If recoverable amount > carrying amount, no further action is required
Source: Loftus, J., Leo, K., Daniliuc, S., Boys, N., Luke, B., Ang, H. & Byrnes, K. 2020, Financial Reporting, 3rd edn, Wiley,
Brisbane, p. 216.

EXAMPLE 7.2

Asset Impairment
The board of directors of Brown Ltd (Brown) is concerned about the potential impairment of the company’s
three major assets under IAS 36. The directors have requested that Brown’s management prepare a report
for the board’s consideration that estimates the fair value less costs of disposal and the value in use of
these assets, and includes commentary about whether (and to what extent) any impairment of the assets
will be required. A summary of management’s findings are as follows.

378 Financial Reporting

 Fair value
less costs Value Recoverable Carrying
of disposal in use amount amount
Asset $ $ $ $ Conclusion
1 200 000 240 000 240 000 210 000 No impairment write-down
is required.
2 100 000 90 000 100 000 85 000 No impairment write-down
is required.
3 300 000 280 000 300 000 340 000 An impairment write-down
of $40 000 is required.

Although ‘recoverable amount’ is defined as ‘the higher of fair value less costs of disposal and value in
use’, this does not mean that it is always necessary to estimate both these measures, as in the above example.
It is only necessary to demonstrate that one of these measures exceeds an asset’s carrying amount in order
to conclude that an asset is not impaired (IAS 36, para. 19). For example, if it is known that an asset’s
fair value less costs of disposal exceeds the asset’s carrying amount, it is not necessary to estimate the
asset’s value in use, and vice versa. Estimating an asset’s fair value less costs of disposal is often more
straightforward than estimating its value in use. However, if no reliable estimate of fair value less costs of
disposal is available, the recoverable amount is measured by reference to the value in use. These concepts
will now be discussed.
.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 18–21 of IAS 36.

Recoverable amount is estimated on an individual asset basis where an asset generates its own cash
inflows that are largely independent of the cash inflows generated by other assets or groups of assets.
For example, the cash inflows from an investment property measured at cost may be determinable on an
individual asset basis.
Commonly, an asset works with other assets to generate cash inflows — that is, as part of a CGU. When
this situation exists, IAS 36 requires the recoverable amount to be determined for the CGU to which the
asset belongs (see ‘Part C: Impairment of cash-generating units’). However, the recoverable amount is
determined on an individual asset basis if:
(a) the asset’s fair value less costs of disposal is higher than its carrying amount; or
(b) the asset’s value in use can be estimated to be close to its fair value less costs of disposal and fair value
less costs of disposal can be measured (IAS 36, para. 22).

In these circumstances, the recoverable amount is estimated on an individual asset basis even though
the asset may form part of the carrying amount of a CGU.
For example, although it may form part of a CGU, an asset, such as a motor vehicle or item of machinery,
may be able to be sold on a secondary market. In this case, the fair value less costs of disposal of the asset
in that market may be used to estimate the asset’s recoverable amount, in accordance with the requirements
in paragraph 22 of IAS 36.
Recall from part A that the recoverable amount of intangible assets that have an indefinite useful life and
intangible assets that are not yet available for use must be determined once a year regardless of whether
there is an indication of impairment. This determination must be made on an individual asset basis unless,
in accordance with the preceding discussion, the asset is tested as part of the CGU to which it belongs.
By contrast, goodwill is always tested as part of the CGU(s) to which it has been allocated, in accordance
with the procedures set out in IAS 36. This is because goodwill generates cash inflows only when used
with other assets. The impairment of goodwill is discussed in part C.
.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 22–24 of IAS 36.

MODULE 7 Impairment of Assets 379

 QUESTION 7.2

In developing IAS 36, the International Accounting Standards Committee (IASC) — the predecessor
to the current IASB — rejected a number of other proposals for the definition of ‘recoverable
amount’, including basing the definition on:
(a) the sum of undiscounted cash flows expected to be derived from an asset
(b) fair value
(c) value in use.
The basis for the IASC decision is set out in paragraphs BCZ9–BCZ22 of IAS 36. What were the
IASC’s principal objections to these alternative definitions of ‘recoverable amount’?

7.4 FAIR VALUE LESS COSTS OF DISPOSAL

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’ (IAS 36, para. 6). Further
guidance on the determination of fair value is contained in IFRS 13 Fair Value Measurement (IFRS 13).
Costs of disposal are ‘incremental costs directly attributable to the disposal of an asset or cash-generating
unit, excluding finance costs and income tax expense’ (IAS 36, para. 6). The requirement that these costs
be ‘incremental’ means that they are only incurred if the asset is disposed of (refer to IAS 36, para. 28).
Examples of items included in and excluded from costs of disposal are shown in table 7.6.

TABLE 7.6 Items included in and excluded from costs of disposal

Examples of items included in costs of disposal Examples of items excluded from costs of disposal

• Legal costs • Interest expense incurred in financing the purchase of

• Stamp duty and similar transaction taxes an asset to be disposed of
• Costs to remove an asset from a particular location to • Income tax incurred on an asset’s disposal
effect a disposal • Employee termination benefits incurred due to
• Costs to prepare an asset for its disposal employee redundancies that occur after the asset
is disposed of
• Restructuring costs incurred after the asset is
disposed of

Source: Adapted from IFRS Foundation 2019, IAS 36 Impairment of Assets, paras 6, 28, in IFRS Standards issued at 1 January
2019, IFRS Foundation, London, pp. A1374–5, A1380.

Where the disposal of an asset also requires the buyer to assume a liability, the fair value of the asset
and liability needs to be determined together (in effect, the net fair value needs to be determined) and then
adjusted by the costs of disposal (IAS 36, paras 6 and 28).
.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 28–29 of IAS 36.

EXAMPLE 7.3

Fair Value Less Costs of Disposal of an Asset

North Ltd (North) owns specialised dredging equipment used in deepening commercial waterways.
Because of the specialised nature of the equipment, an active market does not exist for these assets.
Based on recent similar transactions involving other companies (and after making appropriate adjustments
for differences between the types and conditions of the equipment sold), an expert valuer has estimated
that $1 million could be obtained from selling the equipment in an orderly sale.
Government levies of $5000 would be payable by North on the sale of the equipment. In addition, North
would be required to cover the estimated costs of $15 000 to dismantle and transport the equipment to a
potential buyer. North has not provided for these costs. The services of two specially trained employees
of North would be terminated if the equipment were to be sold. The termination benefits payable to these

380 Financial Reporting

 employees would be in the order of $30 000. Legal fees of $12 000 would also be incurred in selling the
equipment. The fee charged by the expert valuer for performing the valuation was $7000.
The fair value less costs of disposal of the equipment under IAS 36 is calculated as follows.
$
Gross proceeds 1 000 000
Less:
Government levies (5 000)
Dismantling and transport costs (15 000)
Legal fees (12 000)
Valuation fee (7 000)
Fair value less costs of disposal 961 000

Note: In accordance with paragraph 28 of IAS 36, the costs of disposal do not include the termination
benefits of $30 000 payable to the employees of North.

7.5 VALUE IN USE

Value in use is defined as ‘the present value of the future cash flows expected to be derived from an asset or
CGU’ (IAS 36, para. 6). Therefore, value in use is an entity-specific measurement because the cash flows
and discount rate will depend on the way the entity plans to use the asset (or CGU).
Estimating the value in use of an asset (or a CGU) involves two steps.
• Step 1: ‘estimating the future cash inflows and outflows expected to be derived from the continuing use
of an asset (or a CGU) and from its ultimate disposal’ (IAS 36, para. 31(a)).
• Step 2: ‘applying the appropriate discount rate to those future cash flows’ so that they are stated in
present value terms (IAS 36, para. 31(b)).
The estimation of future expected cash flows and the determination of an appropriate discount rate
represent areas of significant professional judgment under IAS 36.

STEP 1: ESTIMATING EXPECTED FUTURE CASH FLOWS

Expected cash flows are vulnerable to changes in the economic environment, and changes in cash flow
estimates can give rise to the impairment of assets. This is illustrated in the extract below.
Testing for impairment during financial crises and recession
The most important impact of the credit crunch by far will be on cash flows. This is particularly true for
next year’s cash flows as these have an immediate and often cumulative effect on the impairment test. Cash
inflows (sales) may decline when growth stagnates, or even falls. And they will be less certain as there is
more risk. This will mean greater effort is needed to update cash flows properly and not just to roll forward
those from last year. Projections that are backward-looking, e.g. those that base sales on last year or the
last several years, will no longer be appropriate in declining markets. It is natural to assume a worst case
scenario of no growth, but for many companies, that will not be realistic and sales will actually be lower.
Cash outflows will also be affected by increased input costs and must be updated appropriately (Ernst &
Young 2008, p. 4).

A simple illustration of the calculation of the value in use of an asset is provided in example 7.4.

EXAMPLE 7.4

Calculating the Value in Use of an Asset — Traditional Approach

South Ltd (South) has developed leading-edge software that detects and removes unsolicited emails
(spam) that are often received by computer systems. The expected useful life of the asset is five years.
South’s management has estimated the following future net cash flows from the expected sale of its
software product over the next five years.

MODULE 7 Impairment of Assets 381

 Future cash flows
Year $
20X6 230 000
20X7 253 000
20X8 273 000
20X9 290 000
20Y0 304 000

A discount rate of 15% is considered appropriate for the cash flows associated with this product.
The value in use of the product can be estimated in accordance with IAS 36 by calculating the present
value of the expected future cash flows based on the discount rate of 15%. This can be done using a
financial calculator as described in module 1 when addressing present value calculations.
The present value of future cash flows can also be estimated by multiplying each of the future cash
flows by the respective present value factor as follows.

Discounted
Future cash flows Present value factor future cash flows
Year $ at 15% discount rate $
20X6 230 000 0.86957 200 001
20X7 253 000 0.75614 191 303
20X8 273 000 0.65752 179 503
20X9 290 000 0.57175 165 808
20Y0 304 000 0.49718 151 143
Value in use 887 758

Note that the present value factor is calculated using the following formula: 1/(1 + k)n, where k = discount
rate and n = number of periods to settlement. For 20X6, this will be 1/1.151 = 0.86957.
The value in use is simply the sum of the present values of the estimated future cash flows.

Factors to Consider in Value in Use Calculations

The following five elements, or factors, in table 7.7 are considered when calculating the value in use of an
asset (IAS 36, para. 30).

TABLE 7.7 Elements included in value in use

Element Considered when estimating:

‘[A]n estimate of the future cash flows the entity expects to Future cash flows
derive from an asset’ (IAS 36, para. 30 (a))

‘[E]xpectations about possible variations in the amount or Future cash flows or discount rate
timing of those future cash flows’ (IAS 36, para. 30(b))

‘[T]he time value of money, represented by the current market Discount rate
risk-free rate of interest’ (IAS 36, para. 30(c))

‘[T]he price for bearing the uncertainty inherent in the asset’ Future cash flows or discount rate
(IAS 36, para. 30(d))

‘[O]ther factors, such as illiquidity, that market participants Future cash flows or discount rate
would reflect in pricing the future cash flows the entity expects
to derive from the asset’ (IAS 36, para. 30(e))

Source: Based on IFRS Foundation 2019, IAS 36 Impairment of Assets, para. 30, in IFRS Standards issued at 1 January 2019, IFRS
Foundation, London, p. A1380.

382 Financial Reporting

 Each of these factors may be influenced by changes in the economic environment. The factors identified
in paragraph 30(b), (d) and (e) of IAS 36 can be reflected as either adjustments to the discount rate
(traditional approach) or as adjustments to the future cash flows (expected cash flow approach — refer
to IAS 36, Appendix A). Each approach will now be discussed.

Traditional Approach
The traditional approach involves adjustments for the factors in table 7.7 by incorporating those factors
into the discount rate. A disadvantage of the traditional approach is that it depends on identifying an
interest rate that is proportionate to the asset risk. This, in turn, depends on finding an asset with
similar risk characteristics to the one being measured and being able to observe the interest rate on
that other asset. Therefore, the traditional approach is difficult to apply where no market for the asset
exists or in circumstances where there are no assets with similar characteristics. The traditional approach
is demonstrated in example 7.4 where the single most likely cash flow is estimated for each year and
discounted using a single discount rate for the useful life of the asset.

Expected Cash Flow Approach

The expected cash flow approach involves adjusting the future cash flows for the factors in table 7.7. This
approach is based on forming expectations about possible cash flows rather than about the single most
likely cash flow. To arrive at the present value of the overall expected cash flows, possible cash flows are
assigned probabilities. The expected cash flow approach is generally regarded as providing better estimates
than the traditional approach. However, a disadvantage is that the calculations under the expected cash flow
approach can be more complex. Paragraph A12 of IAS 36 notes that the ‘expected cash flow approach is
subject to a cost-benefit constraint’. The expected cash flow approach is demonstrated in example 7.5.

EXAMPLE 7.5

Calculating the Value in Use of an Asset – Expected Cash Flow Approach

North-East is expecting a cash flow of $50,000 from the use of a machine, but the timing of the cash flow
is uncertain. The $50,000 may be received in one year, two years or three years, with probabilities of 20%,
50% and 30%, respectively. The discount rate over the next three years is also uncertain with North-East
estimating the following rates: one year — 3%; two years — 4%, three years — 5%. The expected present
value of the cash flow is calculated as follows.

Present value of $50 000 in 1 year at 3% $48 545

Probability 20% $ 9 709
Present value of $50 000 in 2 years at 4% $46 230
Probability 50% $23 115
Present value of $50 000 in 3 years at 5% $43 190
Probability 30% $12 957
Expected present value $45 781

.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 30–32 and A1–A14 in Appendix A of IAS 36. Appendix A to IAS 36 is
an integral part of the standard. It provides guidance on the use of present value techniques in measuring value in
use. Pay particular attention to paragraph A3, which outlines the general principles for present value measurement.

Estimating Future Cash Flows

IAS 36 contains guidance on estimating future cash flows. A summary of this guidance is provided in
table 7.8.

MODULE 7 Impairment of Assets 383

 TABLE 7.8 Principles for estimating future cash flows

Requirement Principles

Base cash flow projections • Based ‘on reasonable and supportable assumptions that represent
management’s best estimate of the range of economic conditions
that will exist over the remaining useful life of the asset’ (IAS 36,
para. 33(a))
• ‘Greater weight should be given to external evidence’, rather than
management expectations (IAS 36, para. 33(a))
• Based on the ‘most recent financial budgets/forecasts approved by
management’ (IAS 36, para. 33(b))
• Must exclude cash flows ‘expected to arise from future restructur-
ings or from improving or enhancing the asset’s performance’
(IAS 36, para. 33(b))
• Must ‘cover a maximum period of five years, unless a longer period
can be justified’ (IAS 36, para. 33(b))
• Cash flow projections must take into account management’s
accuracy in estimating past cash flows

Cash flows beyond the budget/forecast • Estimated by ‘extrapolating the projections based on the budgets/
period forecasts using a steady or declining growth rate for subsequent
years, unless an increasing rate can be justified’ (IAS 36, para. 33(c))
• Growth rate to ‘not exceed the long-term average growth rate for
the products, industries or country . . . in which the entity
operates . . . unless a higher rate can be justified’ (IAS 36,
para. 33(c))

Source: Based on IFRS Foundation 2019, IAS 36 Impairment of Assets, paras 33, 36, in IFRS Standards issued at 1 January 2019,
IFRS Foundation, London, p. A1381.

.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 33–38 of IAS 36.

EXAMPLE 7.6

Calculation of Value in Use – Estimating Future Cash Flows

West Ltd (West) operates a manufacturing plant, which has a useful life of 12 years. At the end of 20X5,
the first year of operation of the manufacturing plant, West estimates the plant’s future net cash flows for
a period of five years as follows.
Future
cash flows
Year $
20X6 230 000
20X7 253 000
20X8 273 000
20X9 290 000
20Y0 304 000

From these forecasts, West then estimates the plant’s future net cash flows for a period beyond the first
five years by extrapolating the projections based on the expected growth rate of cash flows for subsequent
years. For 20Y1, West estimates that the growth rate of cash flows from its product will be 3%, which is
lower than the long-term growth rate for the industry in which it operates. The cash flows are expected to
further decline in the next years, essentially meaning that there will be negative growth rates. Cash flows
for 20Y1–20Y6 are calculated using the following formula: Previous year cash flows × (1 + k), where k =
the growth rate. In 20Y1, this will be $304 000 × 1.03 = $313 120. In 20Y2, this will be $313 120 × 0.98 =
$306 858.

384 Financial Reporting

 Future cash flows
Year Long-term growth rates $
20Y1 3% 313 120
20Y2 –2% 306 858
20Y3 –6% 288 446
20Y4 –15% 245 179
20Y5 –25% 183 884
20Y6 –67% 60 682

A discount rate of 15% is considered appropriate for the cash flows associated with this product. The
value in use of the product will then be estimated in accordance with IAS 36 as follows.
Future Discounted
Long-term cash flows Present value factor future cash flows
Year growth rates $ at 15% discount rate $
20X6 230 000 0.86957 200 000
20X7 253 000 0.75614 191 303
20X8 273 000 0.65752 179 503
20X9 290 000 0.57175 165 808
20Y0 304 000 0.49718 151 143
20Y1 3% 313 120 0.43233 135 371
20Y2 –2% 306 858 0.37594 115 360
20Y3 –6% 288 446 0.32690 94 293
20Y4 –15% 245 179 0.28426 69 695
20Y5 –25% 183 884 0.24719 45 454
20Y6 –67% 60 682 0.21494 13 043
Value in use 1 360 973

Source: Adapted from IFRS Foundation 2019, IAS 36 Impairment of Assets, in IFRS Standards issues at 1 January 2019,
IFRS Foundation, London, pp. B709.

Composition of Estimates of Future Cash Flows

The estimated future cash flows include certain cash flows, while excluding others. The cash flows that
are normally included and excluded are summarised in table 7.9.

TABLE 7.9 Composition of future cash flows

Cash flows included Cash flows excluded

• ‘[C]ash inflows from the continuing use of asset’
(IAS 36, para. 39(a))
• ‘[C]ash outflows that are necessarily incurred to
generate the cash inflows from continuing use
of the asset (including cash outflows to prepare
the asset for sale)’ (IAS 36, para. 39(b))
• ‘[N]et cash, if any, to be received (or paid) for
the disposal of the asset flows at end of its
useful life’ (IAS 36, para. 39(c))
• ‘[C]ash inflows from assets that generate cash inflows that
are largely independent of the cash inflows from the asset
under review’ (e.g. financial assets such as receivables
that generate their own cash inflows) (IAS 36, para. 43(a))
• Cash outflows relating to obligations for which a liability
has been recognised (e.g. payables, pensions or
provisions) (IAS 36, para. 43(b))
• Cash outflows relating to ‘a future restructuring to which
an entity is not yet committed’ (IAS 36, para. 44(a))
• Future capital expenditures that will improve or enhance
the performance of the asset beyond its current condition
(IAS 36, para. 44(b))
• ‘Cash inflows or outflows from financing activities’ (IAS 36,
paras 50(a) and 51)
• ‘Income tax receipts or payments’ relating to the asset
(IAS 36, paras 50(b) and 51)

Source: Based on IFRS Foundation 2019, IAS 36 Impairment of Assets, paras 39, 43, 44, 50, 51, in IFRS Standards issued at
1 January 2019, IFRS Foundation, London, pp. A1382–A1384.

MODULE 7 Impairment of Assets 385

Inflation
Cash flows used in calculating value in use may be estimated in real terms (excluding the effect of inflation)
or nominal terms (including the effect of inflation). Example 7.7 illustrates this difference.

EXAMPLE 7.7

Nominal and Real Rent

If future cash flows are estimated in nominal terms, this means that the estimated future cash flows
are the amounts that an entity expects to pay or receive. For example, if rental income is currently
$100 per annum, inflation is expected to be 5%, and rent is expected to increase with inflation, the nominal
estimated cash flow for next year is $105, while in real terms the cash flow would be $100.

The discount rate applied to the cash flows should be consistent with the estimates of cash flows.
Therefore, if cash flows are estimated in nominal terms, then the discount rate includes the effect of general
inflation. By contrast, if cash flows are estimated in real terms, the discount rate is adjusted to exclude the
effect of general inflation. IAS 36 does not express a preference for which method should be used.
In addition to general inflation, specific price inflation reflects price increases or decreases that are
particular to an asset. Specific price inflation would be reflected in the cash flows whether expressed in
real or nominal terms.
Figure 7.3 summarises these concepts.

FIGURE 7.3 Estimating cash flows in real or nominal terms

Effects of price increases included in discount rate Future cash flows

attributable to inflation are ... estimated in nominal terms

excluded from
discount rate

Future cash flows estimated

in real terms (but include
future specific price changes)
Source: CPA Australia 2019.

.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 39–41, 43–44 and 50–51 of IAS 36.

Current Asset Condition

Future cash flows are ‘estimated for the asset in its current condition’ (IAS 36, para. 44). Therefore,
future cash outflows necessary to maintain the asset in its current condition are included in the value
in use calculation. This would include routine capital expenditures that were envisaged when the asset was
committed to its current use. For example, if an item of machinery is expected to provide 100 000 hours of
service, then the expected cash outflows for routine maintenance necessary to achieve that level of service
is included in the future cash outflows.
As mentioned in table 7.9, estimated future cash inflows or outflows arising from future restructuring
to which an entity is not yet committed, or future capital expenditures that will improve or enhance
the performance of the asset beyond its current condition, are excluded from value in use calculations
(IAS 36, para. 44). For example, a major upgrade of an item of machinery to enhance that machinery’s
level of service beyond its current level (e.g. 100 000 hours in the above example) to which the entity
is not yet committed would not be included in the future cash flows. When an entity is committed to a
restructuring according to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, any increase
in cash inflows expected to result from such a restructuring, as well as the cash outflows of the restructuring
itself, are included in value in use calculations.

386 Financial Reporting

.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 44–49 in the IAS 36. You may also read paragraphs IE54–IE61
(example 6) from the implementation guidance that accompany IAS 36 (in the IFRS Compilation Handbook).
Example 6 demonstrates how future improvements and enhancements affect value in use calculations. Please note
that the example ignores tax effects.

Disposal Value
The disposal value of an asset at the end of its useful life reflects ‘the amount that an entity expects to obtain
from the disposal of the asset in an arm’s length transaction between knowledgeable, willing parties, after
deducting the estimated costs of disposal’ (IAS 36, para. 52). In effect, this value reflects the net fair value
of the asset at the time of disposal.
In estimating disposal value, an entity uses current prices and costs, as at the date of the value in use
estimate, for similar assets that have reached the end of their useful lives and been used in a similar manner
to that in which the asset is expected to be used (IAS 36, para. 53). Further, if an entity has expressed its
value in use calculation in nominal terms, it will be necessary for the current prices and costs of similar
assets to be adjusted for ‘future price increases due to general inflation and specific future price increases
or decreases’ (IAS 36, para. 53(b)). This means that general and specific price inflation is included in the
disposal value estimate. In contrast, if the entity expresses its value in use calculation in real terms, the
disposal value would exclude general inflation but include specific price inflation.
.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 52–53A of IAS 36.

Foreign Currency Cash Flows

An asset may generate future cash flows in a foreign currency. In this situation, IAS 36 requires the future
cash flows to be estimated ‘in the currency in which they will be generated and then discounted at a rate
appropriate for that currency’ (IAS 36, para. 54). The resulting present value is then translated ‘using the
spot exchange rate at the date of the value in use calculation’ (IAS 36, para. 54).
.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraph 54 of IAS 36.

STEP 2: DETERMINING AN APPROPRIATE DISCOUNT RATE

Once the cash flows that an entity expects to derive from the use of an asset have been estimated, the present
value of those cash flows must be determined by applying an appropriate discount rate to those cash flows.
The discount rate applied to the cash flows should be consistent with the estimates of cash flows. ‘Interest
rates used to discount cash flows [discount rate] should not reflect risks for which the estimated cash flows
have been adjusted’ (IAS 36, para. A15).
The discount rate must be a pre-tax rate and reflect the ‘current market assessments of (a) the time value
of money; and (b) the risks specific to the asset for which the future cash flow estimates have not been
adjusted’ (IAS 36, para. 55). This means that the entity must consider the market’s view of these matters
rather than impose its own view.
An asset-specific rate that reflects the market’s view may come from various sources, including market
rates of return used for similar assets in current market transactions or the weighted average cost of capital
(WACC) of a listed entity with a single asset (or portfolio of assets) similar to the asset under review.
In practice, current market rates of return may only be observable for a limited range of assets, such as
property. Where an asset-specific rate is not available, IAS 36 specifies in Appendix A that the following
‘surrogate’ (substitute) rates can be used:
(a) the entity’s weighted average cost of capital determined using techniques such as the Capital Asset
Pricing Model [CAPM];
(b) the entity’s incremental borrowing rate; and
(c) other market borrowing rates (IAS 36, para. A17).

(Note: Candidates are not expected to have a detailed understanding of CAPM for the purposes of
this module.)

MODULE 7 Impairment of Assets 387

 These ‘surrogate’ rates must be adjusted:
(a) to reflect the way that the market would assess the specific risks associated with the asset’s estimated
cash flows; and
(b) to exclude risks that are not relevant to the asset’s estimated cash flows or for which the estimated cash
flows have already been adjusted (IAS 36, para. A18).

The discount rate must be independent of the entity’s capital structure and the way that it has financed
the purchase of the asset. This is consistent with the IAS 36 requirement that estimated ‘future cash flows
shall not include cash inflows or outflows from financing activities’ (IAS 36, para. 50).
.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 55–57 of IAS 36, as well as paragraphs A15–A21 in Appendix A to
IAS 36.

QUESTION 7.3

East Ltd (East) owns a machine used in the manufacture of steering wheels, which are sold directly
to major car manufacturers.
• The machine was purchased on 1 January 20X3 at a cost of $500 000 through a vendor financing
arrangement on which interest is being charged at the rate of 10% per annum.
• During the year ended 31 December 20X4, East sold 10 000 steering wheels at a selling price of
$190 per wheel.
• The most recent financial budget approved by East’s management, covering the period 1 January
20X5–31 December 20X9, indicates that the company expects to sell each steering wheel for $200
during 20X5, the price rising in later years in line with a forecast inflation of 3% per annum.
• During the year ended 31 December 20X5, East expects to sell 10 000 steering wheels. This
number is forecast to increase by 5% each year until 31 December 20X9.
• East estimates that each steering wheel costs $160 to manufacture, which includes $110 variable
costs, $30 share of fixed overheads and $20 transport costs.
• Costs are expected to rise by 1% during 20X6, and then by 2% per annum until 31 December
20X9.
• During 20X7, the machine will be subject to regular maintenance costing $50 000.
• In 20X5, East expects to invest in new technology costing $100 000. This technology will reduce
the variable costs of manufacturing each steering wheel from $110 to $100 and the share
of fixed overheads from $30 to $15 (subject to the availability of technology, which is still
under development).
• East is depreciating the machine using the straight-line method over the machine’s ten-year
estimated useful life. The current estimate (based on similar assets that have reached the end
of their useful lives) of the disposal proceeds from selling the machine is $80 000 net of disposal
costs. East expects to dispose of the machine at the end of December 20X9.
• East applies the traditional approach and has determined a pre-tax discount rate of 8%, which
reflects the market’s assessment of the time value of money and the risks associated with
this asset.
Assume a tax rate of 30%. What is the value in use of the machine in accordance with IAS 36?
Assume that the amounts and rates above have been adjusted for inflation.

7.6 RECOGNISING AND MEASURING AN

IMPAIRMENT LOSS
An impairment loss is recognised to the extent that an asset’s carrying amount exceeds its recoverable
amount (IAS 36, para. 59). This loss is immediately recognised in profit or loss (P/L) unless the asset is
carried at a revalued amount (IAS 36, paras 60 and 61).
If the asset is carried at a revalued amount under another standard, any impairment loss of the revalued
asset is treated as a revaluation decrease under that other standard (IAS 36, para. 60). This means that any
impairment loss is dealt with in two steps. First, the loss is recognised in other comprehensive income
(OCI) as a reduction in the asset revaluation surplus to the extent that the loss is covered by (i.e. not

388 Financial Reporting

exceeds) the surplus. Then, any amount not covered by the surplus is charged to P/L (IAS 36, para. 61).
Essentially, the impairment loss is treated as a reversal of a previous revaluation increment in this case.
IAS 36 does not specifically comment on how the carrying amount of an asset should be adjusted
for impairment losses — in effect, it does not state what the ‘credit entry’ should be. In example 7.8,
the accumulated impairment loss account, which has similar properties to an accumulated depreciation
account, has been credited. This is consistent with the requirement in paragraph 73(d) of IAS 16 Property,
Plant and Equipment, which states that entities must disclose, for each class of property, plant and
equipment, ‘the gross carrying amount and the accumulated depreciation (aggregated with accumulated
impairment losses) at the beginning and end of the period’. A similar provision exists for intangible assets
in paragraph 118(c) of IAS 38. These two standards imply that there is no requirement to set the balance
of accumulated depreciation or amortisation against the gross amount of the asset or to create a specific
impairment account. Rather, an account such as ‘accumulated depreciation and impairment losses’ may
be sufficient. Note that the ‘credit entry’ can also be made directly to the asset that is impaired.

EXAMPLE 7.8

Recognising an Impairment Loss

On 31 December 20X1, an entity acquired an asset for $100 000. This cost is depreciated over 20 years
using the straight-line method ($5000 depreciation charged each year).
The recoverable amount of the asset at 31 December 20X3 is estimated to be $80 000. As at
31 December 20X3, an impairment loss of $10 000 needs to be recognised, based on the difference
between the carrying amount of the asset of $90 000 ($100 000 less two years’ depreciation at $5000 per
annum) and its recoverable amount of $80 000. Depreciation is then charged at $4444 (i.e. $80 000/
18 years) on a continuing basis.

Dr Impairment loss (expense) 10 000

Cr Accumulated impairment losses† 10 000
†
Alternatively, the credit entry could have been processed against the asset account.

Once an impairment loss on an asset is recognised, any subsequent depreciation or amortisation is

based on the revised recoverable amount (IAS 36, para. 63).

.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 58–64 of IAS 36.

7.7 REVERSALS OF IMPAIRMENT LOSSES

IAS 36 requires entities to review whether a previously recognised loss may have reversed, either wholly or
partially (IAS 36, para. 110). If any indication of reversal exists, the entity is required to formally estimate
an asset’s recoverable amount.
The factors to consider when assessing whether impairment losses have reversed are the opposite kind
of factors to those that provided indications of the original impairment. For example, an indication that an
impairment loss has reversed occurs when:
• ‘there are observable indications that the asset’s value has increased significantly during the period’
(IAS 36, para. 111(a)), or
• ‘evidence is available from internal reporting that indicates that the economic performance of the asset
is, or will be, better than expected’ (IAS 36, para. 111(e)).
There are constraints on the amount of a reversal of an impairment loss that can be recognised. A reversal
is limited to the lower of the:
• recoverable amount
• carrying amount of the asset, net of amortisation or depreciation, had no impairment been recognised
(IAS 36, para. 117).
A further constraint on impairment reversal is that a previously recognised impairment loss on goodwill
can never be reversed. ‘An impairment loss recognised for goodwill shall not be reversed in a subsequent
period’ (IAS 36, para. 124). The reason for this is that any increase in goodwill would most likely be

MODULE 7 Impairment of Assets 389

an increase in internally generated goodwill, rather than the reversal of the impairment loss that was
previously recognised (IAS 36, para. 125). It would be difficult, or even impossible, to distinguish events
or circumstances contributing to the reversal of the previously impaired goodwill from goodwill generated
internally subsequent to the business combination that gave rise to the acquired goodwill. This requirement
is linked to the prohibition on recognising internally generated goodwill in paragraph 48 of IAS 38.
A reversal of an impairment loss for an asset measured at cost is recognised in P/L. In contrast, the
reversal of an impairment loss for an asset measured at a revalued amount (such as property, plant and
equipment measured at fair value) is recognised as a reversal of a revaluation decrement.
Example 7.9 illustrates the application of these impairment loss reversal requirements.

EXAMPLE 7.9

Reversal of an Impairment Loss

Assume the facts of example 7.8, and then consider the following additional facts.
At 31 December 20X4, a favourable reassessment of the recoverable amount of the asset occurs to the
extent that the recoverable amount is now estimated to be $88 000. This needs to be compared with the
carrying amount (net of depreciation) of the asset at 31 December 20X4 if the original impairment were
not recognised. In this case, this would be the original cost of $100 000 less three years of depreciation
at $5000 per annum, or $85 000.
The carrying amount before the reversal is calculated as follows.
$
Asset — original cost 100 000
Less: Accumulated impairment losses 10 000
Less: Accumulated depreciation 14 444
Carrying amount 75 556

Under IAS 36, the asset should be written up to the lower of:
• its revised recoverable amount (i.e. $88 000), or
• the carrying amount (net of depreciation) of the asset if the original impairment loss were not recognised
(i.e. $85 000).
The carrying amount, assuming no previous impairment, is as follows.
$
Asset — original cost 100 000
Less: Accumulated depreciation 15 000
Carrying amount 85 000

The asset cannot be written up beyond what the carrying amount would have been if the asset had not
previously been impaired. Therefore, the asset can only be written up to $85 000, being $9444 ($85 000 –
$75 556). This is done via the following journal entry.

Dr Accumulated impairment losses 9 444

Cr Impairment loss — reversal (profit or loss) 9 444

.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 109–121 of IAS 36.

SUMMARY
Part B considered the impairment of individual assets. It also outlined the requirements of IAS 36 in
relation to the calculation of recoverable amount. The recoverable amount is the higher of either fair value
less costs of disposal or value in use. Value in use estimates are dependent on estimating future cash flows
and appropriate discount rates to take into account the time value of money. Finally, impairment losses
need to be reviewed and adjusted annually.

390 Financial Reporting

 Part C will consider the procedures in IAS 36 to estimate the recoverable amount and account for the
impairment of CGUs and goodwill.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

7.4 Explain and apply the requirements of IAS 36 in relation to:

– the calculation of recoverable amount
• When there is an indication that an asset may be impaired, IAS 36 requires an entity to make a formal
estimate of the asset’s recoverable amount so that this amount can be compared to its carrying
amount.
• If recoverable amount < carrying amount, an impairment loss has occurred.
• If recoverable amount > carrying amount, no further action is required.
– recognising and measuring an impairment loss for an individual asset.
Fair value less costs of disposal
• Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement.
• Costs of disposal are incremental costs directly attributable to the disposal of an asset or cash-
generating unit, excluding finance costs and income tax expense. ‘Incremental’ means they are only
incurred if the asset is disposed of.
• Costs of disposal include legal costs, stamp duty, preparation and removal costs to effect a disposal.
Value in use
• Value in use is the present value of the future cash flows expected to be derived from an asset or
CGU. It is therefore an entity-specific measurement.
• Two steps to estimating value in use:
1. estimating the future cash inflows and outflows expected to be derived from the continuing use
of an asset (or a CGU) and from its ultimate disposal
2. applying the appropriate discount rate to those future cash flows so that they are stated in present
value terms.
• There are five elements to consider when calculating the value in use of an asset:
1. estimate of the future cash flows the entity expects to derive from an asset
2. expectations about possible variations in the amount or timing of those future cash flows
3. time value of money, represented by the current market risk-free rate of interest
4. the price for bearing the uncertainty inherent in the asset
5. other factors, such as illiquidity, that market participants would reflect in pricing the future cash
flows the entity expects to derive from the asset
• There are two approaches to determining the five elements:
1. traditional approach — adjusting the discount rate
2. expected cash flow approach — adjusting the future cash flows
• Cash flows used in calculating value in use may be estimated in real terms (excluding the effect of
inflation) or nominal terms (including the effect of inflation).
Recognising and measuring an impairment loss
• An impairment loss is immediately recognised in profit or loss (P/L) unless the asset is carried at a
revalued amount.
• If an asset is carried at a revalued amount, any impairment loss is dealt with in two steps as follows.
1. The impairment loss is recognised in OCI as a reduction in the asset revaluation surplus to the
extent that the loss is covered by (i.e. not exceeds) the surplus.
2. Any amount not covered by the surplus is charged to P/L.
– the reversals of impairment losses
• An indication that an impairment loss has reversed occurs when:
– there are observable indications that the asset’s value has increased significantly during the
period, or
– evidence is available from internal reporting that indicates that the economic performance of the
asset is, or will be, better than expected.
• A reversal is limited to the lower of the recoverable amount; and the carrying amount of the asset,
net of amortisation or depreciation, had no impairment been recognised.
• Impairment losses recognised for goodwill are not to be reversed in a subsequent period.

MODULE 7 Impairment of Assets 391

PART C: IMPAIRMENT OF
CASH-GENERATING UNITS
INTRODUCTION
A CGU is ‘the smallest identifiable group of assets that generates cash inflows that are largely independent
of the cash inflows from other assets or groups of assets’ (IAS 36, para. 6). CGUs are relevant for
impairment testing when the recoverable amount of an asset is unable to be individually determined
(IAS 36, para. 66). Goodwill is an example of an asset for which the recoverable amount is unable to
be individually determined and, therefore, it will only be tested for impairment as part of a CGU.
Part C addresses how to identify CGUs and determine their carrying amount, including how to identify
corporate assets that form part of a CGU. Part C also considers the requirements of IAS 36 relating to
the allocation of goodwill and corporate assets to CGUs and the impairment testing of assets, including
goodwill, as part of the CGU to which they belong.
The IAS 36 principles for identifying potential impairment of individual assets that were considered
in part B apply equally to CGUs (IAS 36, para. 7). Therefore, where there is an indication that a CGU
may be impaired, a formal estimate of the recoverable amount of the CGU must be undertaken (IAS 36,
para. 8). The recoverable amount of a CGU is the higher of the CGU’s fair value less costs of disposal and
its value in use (IAS 36, para. 18). Recoverable amount is then compared to the CGU’s carrying amount.
An impairment is recognised if the carrying amount of the CGU exceeds its recoverable amount.

7.8 RECOVERABLE AMOUNT: INDIVIDUAL ASSET

OR CASH-GENERATING UNIT?
A determination must be made on whether the recoverable amount of an asset, for which there is an
indication of impairment, is estimated on an individual asset basis or as part of the CGU to which the
asset belongs. IAS 36 requires the recoverable amount to be determined on an individual asset basis
(IAS 36, para. 66), unless this is not possible because:
(a) the asset’s value in use cannot be estimated to be close to its fair value less costs of disposal; and
(b) the asset does not generate cash inflows that are largely independent of those from other assets (IAS
36, para. 67).

Where conditions (a) and (b) apply, the recoverable amount of the asset is estimated as part of the CGU
to which it belongs. This decision scenario is also summarised in figure 7.4.

FIGURE 7.4 Decision scenario for estimating recoverable amount on individual asset or cash-generating
unit basis

Can the asset’s value in use be Yes

Calculate recoverable amount

estimated to be close to its fair value

for the individual asset

less costs to sell? (IAS 36, para. 67)

No

Does the asset generate cash Yes

inflows largely independent of
other assets? (IAS 36, para. 67)

No

Calculate recoverable amount for CGU

Source: CPA Australia 2019.

392 Financial Reporting

 IAS 36 illustrates this decision scenario by reference to a mining entity that owns a private railway
to support its mining activities. The railway, by itself, does not generate its own cash inflows. Rather, it
is the combination of the railway and other assets associated with the mine that generates independent
cash inflows. Therefore, condition paragraph 67(b) of IAS 36 is satisfied. Further, although the railway
could be sold for its scrap value, that amount is likely to be different to its value in use as part of the
mine of which it is a part (i.e. IAS 36, para. 67(a)). This is because the collective benefits of using the
railway together with the other mining assets could result in the value in use of the railway not being close
to its fair value less costs of disposal. Therefore, as conditions (a) and (b) are satisfied, the recoverable
amount of the railway is tested as part of the CGU to which it belongs, that is, the mine as a whole
(IAS 36, para. 67).

7.9 IDENTIFYING CASH-GENERATING UNITS

As provided earlier, IAS 36 defines a CGU as ‘the smallest identifiable group of assets that generates cash
inflows that are largely independent of the cash inflows from other assets or groups of assets’ (IAS 36,
para. 6). This definition requires entities to consider the lowest level of aggregation of assets that work
together to generate cash inflows.
IAS 36 cautions that although cash inflows may be associated with a particular asset, they may not be
able to be earned independently of other assets. To illustrate this point, IAS 36 cites the example of a bus
company that provides services on five routes under contract to a municipality. One of these routes operates
at a significant loss. However, as the bus company does not have the option to withdraw its services from
any of the routes (including the unprofitable route) because of the contract in place, the CGU for each
route is the bus company as a whole (IAS 36, para. 68).
The identification of CGUs involves professional judgment. As a guide, the following key factors should
be considered.
• At what level does management monitor the entity’s operations? For example, is it by product lines,
businesses or geographical areas?
• At what level does ‘management make decisions about continuing or disposing of the entity’s assets and
operations’ (IAS 36, para. 69)?
IAS 36 also includes a specific requirement for assets that have an active market for the output they
produce (refer to IAS 36, para. 70). An active market is defined in IFRS 13 as:
. . . a market in which transactions for the asset or liability take place with sufficient frequency and volume
to provide pricing information on an ongoing basis (IFRS 13, Appendix A).

If there is an active market for the output produced by an asset or group of assets, the assets concerned
are always identified as a CGU, ‘even if some or all of the output is used internally’ (IAS 36, para. 70).
For example, an entity may have established a business unit that is involved in the smelting of aluminium
(an ‘upstream unit’). It may also have another business that processes the aluminium into value-added
products (a ‘downstream unit’). If an active market exists for the product of the upstream unit, that unit
must be identified as a CGU, even though some or all of the output of the upstream unit may be used by
the downstream unit.
Value in use calculations arising from internal transfers of product must be based on an arm’s length
transfer price when estimating cash flows for the relevant CGUs (IAS 36, para. 70). This requirement has
particular application to vertically integrated operations, such as the ‘upstream’ and ‘downstream’ units in
the example.
Once CGUs are identified, they are consistently applied across reporting periods, unless a change is
warranted, such as a company restructure (IAS 36, para. 72).
.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 6 and 66–73 of IAS 36.

MODULE 7 Impairment of Assets 393

 QUESTION 7.4

This question requires the appropriate CGU to be identified using situations based on the
illustrative examples section that accompanies IAS 36 described in paragraphs IE1–IE10 in the
IFRS Compilation Handbook.
(a) Retail store chain

Store X belongs to a retail store chain, M. X makes all its retail purchases through M’s
purchasing centre. Pricing, marketing, advertising and human resources policies (except
for hiring X’s cashiers and sales staff) are decided by M. M also owns five other stores in
the same city as X (although in different neighbourhoods) and 20 stores in other cities. All
stores are managed in the same way as X. X and four other stores were purchased five
years ago, and goodwill was recognised (IAS 36, para. IE1).

Is X a CGU?
(b) Plant for an intermediate step in a production process

A significant raw material used for plant Y’s final production is an intermediate product
bought from plant X of the same entity. X’s products are sold to Y at a transfer price that
passes all margins to X. Eighty per cent of Y’s final production is sold to customers outside
of the entity. Sixty per cent of X’s final production is sold to Y, and the remaining 40 per
cent is sold to customers outside of the entity (IAS 36, para. IE5).

For each of the following cases, what are the CGUs for X and Y?
Case 1: X could sell the products it sells to Y in an active market. Internal transfer prices are
higher than market prices.
Case 2: There is no active market for the products X sells to Y.

7.10 RECOVERABLE AMOUNT AND CARRYING

AMOUNT OF A CASH-GENERATING UNIT
(IMPAIRMENT OF CASH-GENERATING UNITS)
As defined in the introduction to part C, the recoverable amount of a CGU is the higher of its ‘fair value
less costs of disposal and its value in use’ (IAS 36, para. 18). Determining the carrying amount of a CGU
and allocating the amount of any impairment loss to individual assets within that CGU are often more
complicated than for individual assets.
The carrying amount of a CGU must be determined consistently with the way in which its recoverable
amount is determined (IAS 36, para. 75). To this end, the carrying amount of a CGU is determined as
illustrated in figure 7.5, constructed based on IAS 36, paragraphs 76 and 80.

FIGURE 7.5 Carrying amount of a cash-generating unit

Assets allocated
Assets directly Purchased
CGU carrying on reasonable
= attributed to + + goodwill expected
amount and consistent
CGU to benefit CGU
basis to CGU

Note: Do not
include liabilities
For example, corporate
assets allocable
on such basis
Two exceptions to this
rule apply
Source: CPA Australia 2019.

394 Financial Reporting

 The two exceptions, referred to in figure 7.5, where the carrying amount of a CGU would include
liabilities are:
1. when the potential sale of a CGU would require a buyer to assume a liability (or liabilities) — in this
case, the recognised liability would be deducted from the CGU’s value in use and its carrying amount
(IAS 36, para. 78)
2. when it is only practical to determine the recoverable amount of a CGU by including assets
(e.g. receivables and other financial assets) or liabilities (e.g. payables, pensions or other provisions)
(IAS 36, para. 79). This may tend to occur for CGUs that are large in size relative to the entity. In this
case, the carrying amount of the CGU is increased for those assets and decreased for those liabilities.
IAS 36 highlights the importance of including in the CGU all assets that contribute to the cash inflows
or cash outflows of the CGU. Otherwise, the carrying amount of the CGU may be understated and may
not appear to be impaired when, in fact, it is impaired (IAS 36, para. 77).
Some assets that contribute to the cash flows of a CGU may not be capable of being allocated to that
CGU on a reasonable and consistent basis as they may contribute to the cash flows of multiple CGUs. This
includes corporate assets and goodwill (IAS 36, para. 77).
.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 74–79 of IAS 36.

ALLOCATING GOODWILL TO CASH-GENERATING UNITS

As goodwill works with other assets to generate economic benefits, its carrying amount must be allocated
to each CGU that is expected to benefit from the goodwill. The requirements summarised in table 7.10
apply when allocating goodwill to a CGU.

TABLE 7.10 Requirements for allocating goodwill to cash-generating units

Requirement Comments

Goodwill is allocated to a CGU (or group of CGUs)
expected to benefit from an acquisition (IAS 36,
para. 80).
This requirement applies regardless of whether the
acquiree’s other assets or liabilities that gave rise to
the goodwill are assigned to the same CGU (or group of
CGUs) to which the goodwill has been allocated.
Changes to the goodwill allocation are only possible
where an entity later reorganises its reporting structure
‘in a way that changes the composition of one or more’
CGUs (IAS 36, para. 87).

Where the initial allocation of goodwill is not
completed before the end of the annual reporting
period in which the business combination that gave
rise to that goodwill occurs, the initial allocation must
be completed before the end of the next annual
reporting period (IAS 36, para. 84).
The impact of certain business combinations may only
be able to be determined provisionally at the end of
the reporting period in which the business combination
occurs. For example, the cost of a business combination
may depend on future events, such as the market price
of the acquirer’s equity instruments being offered as
purchase consideration.
The acquirer accounts for the business combination,
including any goodwill, using those provisional values
(IAS 36, para. 85). Note that, at this stage, goodwill has
not yet been allocated to a CGU.
The provisional values must be finalised within 12
months of the acquisition date (IAS 36, para. 85(b)).
Adjustments to finalise the amount of goodwill must
be made, including allocating that amount to a CGU
(or group of CGUs), ‘before the end of the first annual
period beginning after the acquisition date’ (IAS 36,
para. 84).

Goodwill is allocated to ‘the lowest level’ at which This is consistent with the approach in IAS 36 by which
the entity monitors goodwill ‘for internal management goodwill is tested for impairment through the ‘eyes of
purposes’ (IAS 36, para. 80(a)). management’ (IAS 36, para. 82).

(continued)

MODULE 7 Impairment of Assets 395

 TABLE 7.10 (continued)

Requirement Comments

The CGU (or group of CGUs) to which goodwill is An operating segment is defined in IFRS 8 Operating
allocated cannot be larger than an operating segment Segments, paragraph 5.
(IAS 36, para. 80(b)).

When a CGU to which goodwill has been allocated This impacts on the carrying amount of the operation
includes a number of operations, and one of those disposed of and, therefore, any gain or loss on the
operations is disposed of, it may be necessary to disposal of that operation.
consider whether a portion of the goodwill relates
to the operation that has been disposed of (IAS 36,
para. 86(a)).
This portion of goodwill is determined ‘on the basis of
the relative values . . . disposed of and the portion of
the [CGU] retained, unless the entity can demonstrate
that some other method better reflects the goodwill
associated with the operation disposed of’ (IAS 36,
para. 86(b)).

Source: CPA Australia 2019.

Example 7.10 illustrates the allocation of goodwill to CGUs.

EXAMPLE 7.10

Identifying Cash-Generating Units for Allocation of Goodwill

Entity P has two operating segments, Country A and Country B. Each segment consists of the following
four divisions.
1. Manufacturing (M)
2. Retail (R)
3. Telecommunications (T)
4. Commercial Property (C)
Entity P acquires 100% of Q Ltd (Q) and recognises goodwill of $40 as a result of this acquisition.
Q operates in Country B. Goodwill arising from the acquisition of Q is expected to equally benefit all
four divisions.
Each division has discrete cash inflows. Financial information, including the goodwill allocation from the
purchase of Q, is reviewed by management at the division level. Management also regularly reviews the
operating results of each division.
Each division is a CGU. Therefore, management is required to assess goodwill impairment for each
division separately.
The identifiable assets of Q are property, plant and equipment of $90. These assets can be allocated
on a reasonable and consistent basis equally to M and R.
The goodwill of $40 arising from this acquisition is expected to equally benefit all four divisions (CGUs):
M, R, T and C. This division level also corresponds with the lowest level at which the goodwill will be
monitored by P for internal management purposes. For the purposes of impairment testing under IAS 36,
the following allocations are made.
M R T C
$ $ $ $
Net assets of P Ltd in Country B
(pre-acquisition) 100 100 100 100
Net identifiable assets of Q Ltd 45 45 — —
Goodwill arising on acquisition of Q Ltd 10 10 10 10
Carrying amount of CGU 155 155 110 110

CGU Groups
Assume that there was no basis on which to allocate the goodwill to each of the CGUs. In this situation, it
may be necessary to allocate goodwill to a group of CGUs. For example, the M and R CGUs may form one
group (a ‘larger’ CGU), and the T and C CGUs may form another group, or ‘larger’ CGU. The recoverable
amount of the CGU groups would then be compared to their carrying amount (including the carrying

396 Financial Reporting

 amount of goodwill allocated). Assuming that the goodwill equally benefited the two ‘larger’ CGUs, the
following allocations would be made.
M R M&R T C T&C
$ $ $ $ $ $
Net assets of P Ltd in Country B
(pre-acquisition) 100 100 200 100 100 200
Net identifiable assets of Q Ltd 45 45 90 — — —
Goodwill arising on acquisition of Q Ltd — — 20 — — 20
Carrying amount of CGU(s) 145 145 310 100 100 220

.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 80–87 of IAS 36.

ALLOCATING CORPORATE ASSETS TO CASH

GENERATING UNITS
Corporate assets are assets other than goodwill that contribute to the future cash flows of multiple
CGUs at the same time. Examples of corporate assets include the head office of an entity, information
technology (IT) infrastructure and research facilities. The key characteristics of corporate assets are that:
• ‘they do not generate cash inflows independently from other assets or groups of assets’ (similar to
purchased goodwill)
• ‘their carrying amount cannot be fully attributed to the [CGU] under review’ (IAS 36, para. 100).
If it is possible to establish that the fair value less costs of disposal of a corporate asset is greater than its
carrying amount, no impairment exists. However, it may still be necessary to allocate the carrying amount
of that corporate asset to a CGU in order to correctly determine the carrying amount of that CGU.
If there is an indication that a corporate asset may be impaired, the recoverable amount of the corporate
asset will need to be determined as part of the CGU (or group of CGUs) to which it belongs.
When allocating a corporate asset to a CGU, the requirements shown in table 7.11 apply.

TABLE 7.11 Requirements for allocating a corporate asset to a cash-generating unit

Requirement Comments

If the carrying amount of a corporate asset can be This enables the carrying amount of a CGU (or
allocated to a CGU(s) ‘on a reasonable and consistent CGUs), including any portion of a corporate asset,
basis’, then do so (IAS 36, para. 102(a)). to be compared to their recoverable amount and any
impairment loss recognised (IAS 36, para. 102(a)).

If the carrying amount of a corporate asset is not These requirements are demonstrated in example 8
allocable on a reasonable and consistent basis to a (paras IE69–IE79) in the ‘Illustrative examples’ section of
CGU (or CGUs), then: IAS 36 (IFRS Compilation Handbook).
1. test the carrying amount of the CGU, excluding
the corporate asset, for impairment and
recognise any impairment loss (IAS 36,
para. 102(b)(i))
2. determine the smallest group of CGUs to which
the corporate asset can be allocated, test for
impairment at this level and recognise any
impairment loss (IAS 36, paras 102(b)(ii)–(iii)).

Source: CPA Australia 2019.

.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 100–103 of IAS 36.

MODULE 7 Impairment of Assets 397

IMPAIRMENT TESTING FOR CASH-GENERATING UNITS
WITH GOODWILL
As previously mentioned, in the acquisition of a business that gives rise to purchased goodwill, that
goodwill needs to be allocated to the CGU, or group of CGUs, expected to benefit from the goodwill
(this is discussed in further detail in this section). The CGU, or group of CGUs, to which goodwill is
allocated may be different from the CGU, or group of CGUs, to which other assets that make up the
acquired business are allocated.
When goodwill relates to a CGU but has not been allocated to that CGU (i.e. it was allocated to
a group of CGUs to which that CGU belongs), the CGU — excluding any goodwill — is tested for
impairment whenever there is an indication that the CGU may be impaired (IAS 36, para. 88). This is
the same screening procedure required for testing individual assets for impairment (IAS 36, para. 9).
Where there is an indication that impairment may exist, the carrying amount of the CGU — excluding any
goodwill — is compared to its recoverable amount, and any impairment loss recognised. After this
impairment test is performed on that CGU, a further impairment test may be performed on the entire
group of CGUs to which that CGU belongs and to which the goodwill has been allocated.
The impairment testing procedures for CGUs to which goodwill has been allocated are stricter. IAS 36
requires a formal estimate at least once per year of the recoverable amount of a CGU (or group of CGUs)
to which goodwill has been allocated, regardless of whether there is any indication that the CGU (or group
of CGUs) may be impaired (IAS 36, para. 10(b)).
Similarly, the recoverable amount of a CGU that includes any intangible asset that has an indefinite
useful life or is not yet available for use must be formally estimated at least once per year, regardless of
whether there is any indication that the CGU may be impaired (IAS 36, para. 10(a)).
IAS 36 also requires that the recoverable amount of a CGU (or group of CGUs) to which goodwill
has been allocated must be formally estimated whenever there is an indication that the CGU (or group of
CGUs) may be impaired (para. 90).
.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 9–10 and 88–90 of IAS 36.

TIMING OF IMPAIRMENT TESTS FOR CASH-GENERATING

UNITS WITH GOODWILL
In accordance with paragraph 96 of IAS 36, the requirements in table 7.12 apply to the annual testing of
goodwill for impairment.

TABLE 7.12 Timing of impairment tests for cash-generating units with goodwill

Scenario Timing of annual impairment test

CGU (or group of CGUs) to which goodwill
has been allocated
CGU (or group of CGUs) to which goodwill
that arose from a current year business
combination has been allocated
Any time during the year, but must be at the same time each year
Different CGUs may be tested for impairment at different times
throughout the year
Before the end of the current year

Source: CPA Australia 2019.

If there is an indication of impairment of an asset other than goodwill within a CGU that includes
goodwill, the asset is tested for impairment first, and any impairment loss is recognised on that individual
asset before the entire CGU is tested for impairment. This ensures that the carrying amount of individual
assets included in a CGU is appropriate before being included in the impairment test for the entire CGU.
Similarly, if there is an indication of impairment of a CGU that forms part of a group of CGUs to which
goodwill has been allocated, impairment testing procedures are applied to the individual CGU before being
applied to the group of CGUs (IAS 36, para. 97).
To reduce the burden on preparers of having to estimate the recoverable amount each period, when
performing the impairment test on a CGU (or group of CGUs) to which goodwill has been allocated, the

398 Financial Reporting

most recent detailed calculation made in a preceding period of the recoverable amount of a CGU to which
goodwill has been allocated may be used (IAS 36, para. 99), provided that the following conditions are
satisfied:
(a) the assets and liabilities making up the unit have not changed significantly since the most recent
recoverable amount calculation;
(b) the most recent recoverable amount calculation resulted in an amount that exceeded the carrying amount
of the unit by a substantial margin; and
(c) based on an analysis of events that have occurred and circumstances that have changed since the most
recent recoverable amount calculation, the likelihood that a current recoverable amount determination
would be less than the current carrying amount of the unit is remote (IAS 36, para. 99).

.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 96–99 of IAS 36.

IDENTIFYING AND ALLOCATING AN IMPAIRMENT LOSS

FOR CASH-GENERATING UNITS WITH GOODWILL
An impairment loss exists if the carrying amount of a CGU (or group of CGUs) to which goodwill or a
corporate asset has been allocated exceeds its recoverable amount.
The process of allocating any impairment loss is as follows.
1. the carrying amount of any goodwill allocated to the CGU (or group of CGUs) is reduced — this is
consistent with the view that the asset most likely to be impaired is goodwill
2. the remainder of any impairment loss is allocated on a pro rata basis to other assets in the CGU (or
group of CGUs) on the basis of their carrying amount in that CGU (or group of CGUs) (IAS 36,
para. 104).
Note that although impairment testing to determine the extent of any impairment loss for an asset
is undertaken at a CGU level, the reductions in carrying amounts are treated as impairment losses on
individual assets included in the CGU (IAS 36, para. 104).
IAS 36 places an important constraint on the amount of an impairment loss that can be allocated to an
individual asset. The standard provides that the carrying amount of an asset cannot be reduced below the
highest of:
• its fair value less costs of disposal (if these costs are measurable)
• its value in use (if this can be determined)
• zero (IAS 36, para. 105).
This constraint means that the amount of an impairment loss that would otherwise have been allocated
to a particular asset in a CGU must be allocated on a pro rata basis to other assets of the CGU.
.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 104–108 of IAS 36.

EXAMPLE 7.11

Impairment Loss for a Cash-Generating Unit

An entity has identified an impairment loss of $20 000 relating to one of its CGUs. The relevant details
of the carrying amount of each asset in the CGU (assets A, B, C and D), as well as the allocation of the
impairment loss to each asset based on the asset’s proportional carrying amount, are as follows.
Carrying Share of Carrying amount after initial
amount Percentage of total impairment loss impairment loss allocation
Asset $ carrying amount $ $
A 30 000 23% 4 600 25 400
B 25 000 19% 3 800 21 200
C 60 000 46% 9 200 50 800
D 15 000 12% 2 400 12 600
Total 130 000 100% 20 000 110 000

MODULE 7 Impairment of Assets 399

 However, asset C has an estimated fair value less costs of disposal of $55 000. According to
paragraph 105(a) of IAS 36, the extent of the impairment loss for asset C is limited to $5000 (i.e. $60 000
– $55 000).
The remaining impairment loss of $4200 (i.e. $55 000 – $50 800) that is attributable to asset C must,
therefore, be allocated to the remaining assets in the CGU based on those assets’ proportional carrying
amounts after the impairment loss, as determined above. Therefore:
Carrying amount after Percentage Carrying amount after
initial impairment of total Share of final impairment
loss allocation carrying impairment loss loss allocation
Asset $ amount $ $
A 25 400 43% 1 806 23 594
B 21 200 36% 1 512 19 688
D 12 600 21% 882 11 718
Total 59 200 100% 4 200 55 000

The requirement that any impairment loss be allocated first against any goodwill is a matter of some
controversy. For example, it can be argued that this procedure is arbitrary and fails to adequately consider
whether other identifiable assets are impaired. Other objections relate to the application of the value in use
test to goodwill. This is considered in question 7.5.

QUESTION 7.5

Three members of the IASB dissented to the issuing of IAS 36. The members’ concerns are set out
as dissenting opinions in paragraphs DO1–DO10 of IAS 36 found in the IFRS Compilation Handbook.
What were the two key concerns raised in the members’ dissenting opinions?

The requirements for impairment testing of CGUs to which goodwill has been allocated are illustrated
in example 7.12. This material has been adapted from example 2 (paras IE23–IE32) in the ‘Illustrative
examples’ section of IAS 36 included in the IFRS Compilation Handbook.

EXAMPLE 7.12

Impairment Testing for Cash-Generating Units to Which Goodwill

Has Been Allocated
At the end of 20X0, entity T acquires 100% of the net assets of entity M for $10 000. M has manufacturing
plants in three countries (Country A, Country B and Country C). Each plant is considered a CGU.
Activities in each country also represent the lowest level at which the goodwill is monitored for internal
management purposes.
The goodwill is determined as the difference between the purchase price of the activities in each
country, as specified in the purchase agreement, and the fair value of the net identifiable assets of
M (the identifiable assets acquired and the liabilities assumed) at acquisition date in accordance with
IFRS 3 Business Combinations. At the end of 20X0, the allocation of the fair value of the net identifiable
assets of M and goodwill to the respective CGUs is as follows.
Allocation of Fair value of net
purchase price identifiable assets Goodwill
$ $ $
Activities in Country A 3 000 2 000 1 000
Activities in Country B 2 000 1 500 500
Activities in Country C 5 000 3 500 1 500
Total 10 000 7 000 3 000

Because goodwill has been allocated to the activities in each country, each of those activities must be
tested for impairment once a year, or more frequently if there is any indication that they may be impaired.

400 Financial Reporting

 The recoverable amounts (i.e. the higher of the value in use and fair value less costs of disposal) of the
CGUs are determined on the basis of value in use calculations. At the end of 20X0 and 20X1, the value in
use of each CGU exceeds its carrying amount. Therefore, the activities in each country and the goodwill
allocated to those activities are not regarded as impaired in either of those years.
At the beginning of 20X2, a new government is elected in Country A and immediately passes legislation
significantly restricting exports of T’s main product. As a result, and for the foreseeable future, T’s
production in Country A will need to be cut by 40%. The significant export restrictions and the resulting
decreased production require T to estimate the recoverable amount of the Country A operations at the
beginning of 20X2.
T uses straight-line depreciation over a 12-year life for the identifiable assets of Country A and
anticipates no residual value. Therefore, the carrying amounts of the assets of Country A at the beginning
of 20X2 are as follows.
Fair value of
identifiable assets Goodwill Total
$ $ $
Cost 2 000 1 000 3 000
Accumulated depreciation (167) — (167)
Carrying amount 1 833 1 000 2 833

T determines that the value in use of the Country A CGU at the beginning of 20X2 is $1360. This is
$1473 less than the carrying amount (i.e. $2833 – $1360). The fair values of the assets of Country A
are not individually determinable. As the carrying amount exceeds the recoverable amount by $1473, T
recognises an impairment loss of $1473 immediately in P/L. The first step is to reduce to zero the carrying
amount of the goodwill that relates to the Country A operations before reducing the carrying amount of
the other identifiable assets within the Country A CGU.
As at the beginning of 20X2, the carrying amounts of the assets of the Country A CGU after allocation
of the $1473 impairment loss are as follows.
Fair value of
identifiable assets Goodwill Total
$ $ $
Cost 2 000 1 000 3 000
Accumulated depreciation (167) — (167)
Carrying amount 1 833 1 000 2 833
Impairment loss (473) (1 000) (1 473)
Adjusted carrying amount 1 360 — 1 360

Source: Adapted from IFRS Foundation 2019, IAS 36 Impairment of Assets, in IFRS Standards issued at 1 January 2019,
IFRS Foundation, London, pp. B707–B709.

IMPAIRMENT TESTING FOR INTANGIBLE ASSETS

Impairment testing for intangible assets is similar to impairment testing for goodwill, with the following
differences.
• Previously recognised impairment losses may be reversed (IAS 36, para. 114).
• Intangible assets should be allocated to individual CGUs rather than to groups of CGUs, unless the
intangible asset meets the definition of a ‘corporate asset’.
• Impairment losses are not allocated to intangible assets first. Rather, they are allocated on a pro rata
basis to all assets in the CGU (IAS 36, paras 104 and 105).

REVERSAL OF IMPAIRMENT LOSSES ON CGUS

Part B of this module discussed the requirements for reversal of impairment losses for individual assets.
Those requirements apply equally to CGUs. The reversal of an impairment loss for a CGU is allocated to
the assets of the CGU, except for goodwill, on a pro rata basis according to the carrying amounts of those
assets. Those reversals are treated as reversals of impairment losses on individual assets (refer to part B of
this module).
When a reversal of an impairment loss for a CGU is allocated, the carrying amount of an asset cannot
be increased above the lower of its recoverable amount and the carrying amount if no impairment loss was

MODULE 7 Impairment of Assets 401

 recognised in previous years. Any remaining reversal not otherwise allocated to the asset is allocated on a
pro rata basis to the other assets of the CGU other than goodwill.
.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 122–125 of IAS 36.

SUMMARY
Part C addressed how to identify CGUs and to determine the carrying amount of CGUs, including how
to allocate goodwill and corporate assets when testing CGUs for impairment. Corporate assets are assets
other than goodwill that contribute to the future cash flows of both the CGU under review and other CGUs.
Examples of corporate assets include the head office of an entity or a division of an entity, IT infrastructure
and research facilities. The remainder of part C considered the requirements of IAS 36 relating to the
impairment testing of assets, including goodwill, as part of the CGU to which they relate. If the carrying
amount of a CGU (or group of CGUs) to which goodwill or a corporate asset has been allocated exceeds
its recoverable amount, an impairment loss exists. The impairment loss is allocated to reduce the carrying
amount of the assets of the CGU (or group of CGUs), in the following order.
1. The carrying amount of any goodwill allocated to the CGU (or group of CGUs) is reduced.
2. The other assets of the CGU (or group of CGUs) are allocated on a pro rata basis based on the carrying
amount of each asset in the unit.
Part C concluded with a brief discussion of the reversal of impairment losses on CGUs.
Part D now considers the disclosure requirements of IAS 36.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

7.5 Explain and apply the requirements of IAS 36 in relation to:

– the identification of CGUs
• A CGU is the smallest identifiable group of assets that generates cash inflows that are largely
independent of the cash inflows from other assets or groups of assets.
• CGUs are relevant for impairment testing when the recoverable amount of an asset is unable to be
individually determined.
• Determining the recoverable amount on an individual asset basis may not be possible because:
– the asset’s value in use cannot be estimated to be close to its fair value less costs of disposal; and
– the asset does not generate cash inflows that are largely independent of those from other assets.
• Identifying a CGU requires professional judgment. The following key factors are to be considered.
– The level of management monitoring on the entity’s operations. For example, product lines,
businesses or geographical areas.
– The level of management decision-making about continuing or disposing the entity’s assets and
operations.
– Whether or not an active market exists for the group of assets.
– recognising and measuring an impairment loss for CGUs and goodwill.
• Carrying amount of CGU = Assets directly attributed to CGU + Assets allocated on reasonable and
consistent basis to CGU + Purchased goodwill expected to benefit CGU.
• Liabilities are not included in the calculation of a CGU’s carrying amount, except when:
– the potential sale of a CGU would require a buyer to assume a liability(ies).
– it is only practical to determine the recoverable amount of a CGU by including assets (e.g.
receivables and other financial assets) or liabilities (e.g. payables, pensions or other provisions).
• IAS 36 contains specific requirements for the allocation of goodwill to a CGU.
• Consideration must be given to the size of the CGU and whether or not the goodwill allocation has
been completed before the end of the annual reporting in which the business combination occurred.
• Corporate assets contribute to the future cash flows of multiple CGUs at the same time.
• Key characteristics of corporate assets are:
– they do not generate cash inflows independently from other assets or groups of assets
– their carrying amount cannot be fully attributed to the CGU under review.
• If there is no impairment to a corporate asset it may still be necessary to allocate the carrying amount
of the corporate asset to a CGU in order to accurately determine the carrying amount of that CGU.

402 Financial Reporting

• If there is an indication of impairment of a corporate asset, its recoverable amount is to be determined
as part of the CGU.
• IAS 36 requires a formal estimate at least once a year of the recoverable amount of a CGU (or group
of CGUs) to which goodwill has been allocated, regardless of whether there is any indication that the
CGU (or group of CGUs) may be impaired.
• Identifying and allocating an impairment loss for cash-generating units with goodwill
• The process of allocating any impairment loss of a CGU with goodwill is as follows.
1. The carrying amount of any goodwill allocated to the CGU (or group of CGUs) is reduced.
2. The remainder of any impairment loss is allocated on a pro rata basis to other assets in the CGU
(or group of CGUs) on the basis of their carrying amount in that CGU (or group of CGUs).
• When allocating an impairment loss to an individual asset within the CGU, IAS 36 states that the
carrying amount cannot be reduced below the highest of: its fair value less costs of disposal; its
value in use; or zero.
• Impairment testing for intangible assets is similar to impairment testing for goodwill, with the following
differences.
– Previously recognised impairment losses may be reversed.
– Intangible assets should be allocated to individual CGUs rather than to groups of CGUs.
– Impairment losses are not allocated to intangible assets first.
• The reversal of an impairment loss for a CGU is allocated to the assets of the CGU, except for
goodwill, on a pro rata basis according to the carrying amounts of those assets.
• When allocating a reversal of an impairment loss for a CGU, the carrying amount of an asset cannot
be increased above the lower of its recoverable amount and the carrying amount if no impairment
loss was recognised in previous years.

MODULE 7 Impairment of Assets 403

PART D: IAS 36 IMPAIRMENT OF
ASSETS—DISCLOSURE
INTRODUCTION
The disclosures required by IAS 36 regarding impairment are extensive. They can be grouped into the
following two broad categories:
1. disclosures that are designed to inform users of financial reports about actual impairment losses that
have occurred during the reporting period and any reversals of impairment losses
2. disclosures of the estimates that are used to measure the recoverable amounts of CGUs that contain
goodwill or indefinite life intangibles; that is, those intangible assets that have ‘no foreseeable limit to
the period over which the asset is expected to generate net cash flows for the entity’ (IAS 38 Intangible
Assets, para. 88).
The disclosures in each of these categories are discussed below.

7.11 DISCLOSURES OF IMPAIRMENT LOSSES

AND REVERSALS
IAS 36 requires numerous disclosures when an entity recognises an impairment loss in its financial report.
For example, for each class of assets, the financial report must disclose the following:
(a) the amount of impairment losses recognised in profit or loss during the period and the line item(s) of
the statement of comprehensive income in which those impairment losses are included.
(b) the amount of reversals of impairment losses recognised in profit or loss during the period and the line
item(s) of the statement of comprehensive income in which those impairment losses are reversed.
(c) the amount of impairment losses on revalued assets recognised in other comprehensive income [equity]
during the period.
(d) the amount of reversals of impairment losses on revalued assets recognised in other comprehensive
income during the period (IAS 36, para. 126).

These disclosures can be combined with those required by other IFRSs. For example, disclosures
regarding impairment losses (or reversals) can be included as reconciling items in the reconciliation of
the carrying amount of each class of property, plant and equipment, at the beginning and end of the period,
required by paragraph 73(e) of IAS 16.
An entity that reports segment information under IFRS 8 is required to disclose the following for each
reportable segment:
(a) the amount of impairment losses recognised in profit or loss and in other comprehensive income during
the period.
(b) the amount of reversals of impairment losses recognised in profit or loss and in other comprehensive
income during the period (IAS 36, para. 129).

For an individual asset or CGU in respect of which an impairment loss has been recognised, or reversed,
during a period, the following disclosures are required by paragraph 130 of IAS 36:
• events and circumstances (e.g. internal or external to the entity) that resulted in the need for the
impairment loss (or reversal)
• the amount recognised or reversed
• the nature of the impaired asset and, for an entity that reports segment information under IFRS 8, the
reportable segment to which the asset has been allocated
• for a CGU:
– a description of the CGU (e.g. whether it is a product line or geographical area)
– the amount of the impairment loss recognised or reversed by class of assets and, for an entity that
reports segment information under IFRS 8, the amount recognised or reversed by reportable segment
– if the assets that make up a CGU have changed since the last time the recoverable amount of that
CGU was estimated, a description of how the composition of assets has changed and the reasons for
the change

404 Financial Reporting

 • the recoverable amount of the asset or CGU and whether this is based on fair value less costs of disposal
or value in use
• if recoverable amount is based on fair value less costs of disposal:
– details regarding the fair value measurement (e.g. the level of the fair value hierarchy in IFRS 13
to which the fair value measurement is categorised and, for certain levels within that hierarchy, key
assumptions made in estimating fair value)
• if recoverable amount is based on value in use, the discount rate(s) used in estimating both the current
and previous (if any) value in use.
.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 126–133 of IAS 36.

7.12 DISCLOSURES OF ESTIMATES USED TO

MEASURE RECOVERABLE AMOUNTS IN
CASH-GENERATING UNITS
When an entity has goodwill or intangible assets with an indefinite useful life, IAS 36 requires significant
additional disclosures. This reflects the greater level of uncertainty surrounding the recoverable amount of
these assets. Disclosures include the key assumptions made by management in estimating the future cash
flows of such assets. Such assumptions may involve management exercising high levels of professional
judgment and, therefore, it is important that detailed disclosures are provided for users to understand the
financial information provided to them.
.......................................................................................................................................................................................
EXPLORE FURTHER
To explore this topic further, read paragraphs 134–137 of IAS 36.

The Australian Securities & Investments Commission’s (ASIC) review of the June 2018 financial reports
of Australian entities indicates the corporate regulator’s concern that a number of entities are not making the
required disclosures, including key assumptions, such as discount rates and growth rates, and the valuation
techniques and inputs used to determine fair value (ASIC 2019).

SUMMARY
IAS 36 includes requirements for extensive disclosures of impairment losses, including estimates used to
measure the recoverable amounts of CGUs containing goodwill or indefinite useful life intangibles.
The key points covered in this part, and the learning objectives they align to, are below.

KEY POINTS

7.4, 7.5 Explain and apply the requirements of IAS 36.

• IAS 36 requires two broad categories for disclosures of asset impairments:
1. disclosures that are designed to inform users of financial reports about actual impairment
losses that have occurred during the reporting period and any reversals of impairment losses
2. disclosures of the estimates that are used to measure the recoverable amounts of CGUs that
contain goodwill or indefinite life intangibles.

MODULE 7 Impairment of Assets 405

REVIEW
This module examined the procedures set out in IAS 36 for ensuring that assets are not carried in excess of
their recoverable amounts. Impairment testing is critical to financial reporting, particularly in a changing
economic environment. As noted by ASIC (2015):
Financial reports should provide useful and meaningful information for investors and other users of those
financial reports so that they can be confident and informed in making investment and other decisions.
Non-financial assets are often significant assets of a company. The value attributed to these assets may
affect not only the company’s reported financial position, but also its reported performance.

Part A provided an introduction to the impairment of assets, including the key issues that need to be
resolved when applying the impairment requirements. The impairment requirements set out in IAS 36
are seen as being applicable to a broad range of non-financial assets. With the exception of goodwill and
certain intangible assets, IAS 36 allows assets first to be reviewed for indications of impairment before a
formal estimate of recoverable amount is made (assuming an indication of impairment exists).
Part B examined how IAS 36 prefers that recoverable amount be estimated on an individual asset basis.
The detailed requirements for measuring the recoverable amount of an asset were then considered. In
determining the recoverable amount, the value in use was seen as being potentially more difficult to
estimate than fair value less costs of disposal. Part B also examined the requirements of IAS 36 that must
be met to recognise an impairment loss on an individual asset or reversals of previous impairment losses.
In practice, the recoverable amount may only be determinable for groups of assets (referred to as CGUs)
rather than for individual assets. The identification of CGUs, and the challenges associated with testing
corporate assets and goodwill for impairment, were considered in part C.
Part D looked at the extensive disclosures specified by IAS 36, which must be made in relation to actual
impairment losses and the estimates used to measure the recoverable amount of CGUs containing goodwill
or indefinite life intangibles. These disclosures continue to attract the interest of corporate regulators as
entities seem unwilling to provide all the disclosures required.

REFERENCES
ASIC (Australian Securities & Investments Commission) 2015, ‘Impairment of non-financial assets: Materials for directors’,
Information Sheet 203, accessed May 2019, https://asic.gov.au/regulatory-resources/financial-reporting-and-audit/directors-
and-financial-reporting/impairment-of-non-financial-assets-materials-for-directors/.
ASIC (Australian Securities & Investments Commission) 2019, ‘19-014MR Findings from 30 June 2018 financial reports’, 25
January, accessed May 2019, https://asic.gov.au/about-asic/news-centre/find-a-media-release/2019-releases/19-014mr-findings-
from-30-june-2018-financial-reports/.
Ernst & Young 2008, ‘Testing for impairment during financial crises and recession’, IFRS Outlook, October, accessed July 2019,
https://www.eyjapan.jp/services/assurance/ifrs/issue/ifrs-outlook/pdf/ifrs-outlook-2008-10-E.pdf.
Ernst & Young 2010, Impairment Accounting—The Basics of IAS 36 Impairment of Assets, EYGM Limited, accessed May 2019,
https://www.ey.com/Publication/vwLUAssets/Impairment_accounting_the_basics_of_IAS_36_Impairment_of_Assets/$FILE/
Impairment_accounting_IAS_36.pdf.
Grant Thornton 2014, Impairment of Assets: A Guide to Applying IAS 36 in Practice, March, accessed May 2019,
https://www.grantthornton.mk/insights/articles/Applying-IAS-36-in-practice/.
Woolworths Group 2019, 2019 Annual Report, 29 August, accessed October 2019, https://www.woolworthsgroup.com.au/
content/Document/ASX%20announcements/2019/WOW_AR19_Interactive_PDF.pdf.

OPTIONAL READING
Ernst & Young 2011, IAS 36 Impairment Testing—Practical issues, EYGM Limited, accessed May 2019, http://www.
powertechexposed.com/IAS_36_impairment_testing_GL_IFRS.pdf.
IFRS Foundation 2019, IFRS Standards issued at 1 January 2019, IFRS Foundation, London.

406 Financial Reporting

APPENDIX: TECHWORKS LTD
CASE STUDY
Requirements
Prepare general purpose financial statements for Techworks Ltd (Techworks) for the year ended
31 December 20X2. Comparative information has been provided and should be completed also, except
for the statement of cash flows. Certain note disclosures have already been completed for you.

Techworks Ltd: Background

You have been provided with the following information for Techworks for the year ended 31 December
20X2.
Techworks is an unlisted public company. Techworks does not have any subsidiaries and therefore is
not required to prepare consolidated financial statements. Note the following.
• Techworks has elected to apply Tier 1 reporting requirements in preparing general purpose financial
statements in accordance with AASB 1053 Application of Tiers of Australian Accounting Standards.
• The Company has elected to adopt a one-statement approach to preparing the ‘Statement of profit or
loss and other comprehensive income’.
• The Company has elected to classify its expenses by nature.
• The Company is applying IFRS 16 Leases for the first time.
• There have been no other changes in accounting policies, errors nor any changes in accounting estimates
during 20X2.
None of the property, plant or equipment owned by Techworks is classified as held for sale, and all
assets have carrying amounts based on historic cost.
An extract of the additions included on the fixed asset register are as follows.
20X2 additions 20X1 additions
Furniture, equipment and fittings Furniture, equipment and fittings
Office chairs x 10 $ 1 250 Book cases x 2 $ 2 000
Filing cabinet 5 000 Computer monitor stands x 20 1 000
Desks x 10 5 000 Binding machine 5 000
Boardroom table 4 750 New server 60 185
Drawers x 10 4 000 Laminating machine 4 000
High speed printer, copier and
fax x 4 97 719
Total furniture, equipment and Total furniture, equipment and
fittings $117 719 fittings $72 185

20X2 additions 20X1 additions

Motor vehicles — owned Motor vehicles — owned
New Commodores x 3 $ 74 400 New Commodores x 6 $138 654
New truck 285 984
New vans x 3 97 417
Total motor vehicles — owned $ 74 400 Total motor vehicles — owned $522 055
Motor vehicles — leased Motor vehicles — leased
New Commodores x 3 $ 74 400 New vans x 3 $ 83 901
New vans x 8 259 780
New Barinas x 3 178 345
Total motor vehicles — leased $512 525 Total motor vehicles — leased $ 83 901

An extract of the written down value of disposals included on the fixed asset register is as follows.
20X2 disposals 20X1 disposals
Motor vehicles — owned Motor vehicles — owned
Cost $182 926
Accumulated depreciation 28 662

APPENDIX 407
 20X2 disposals 20X1 disposals
Motor vehicles — leased Motor vehicles — leased
Cost $166 556
Accumulated depreciation 56 626

Additional Information
1. Techworks receives revenue from providing technical support services to small- and medium-sized
enterprises. Techworks’ right to payment for services already rendered is conditional only on the
passage of time. At the end of the financial period it did not have any contract assets. The contract
liability relates to services to be provided during the next reporting period.
2. The total proceeds on sale received for the above disposals amounted to $195 000.
3. Assume that term deposits satisfy the definition of cash equivalents, due to the short-term nature
(i.e. all have a maturity of less than 90 days).
4. The computer software relates to software being developed. No amortisation has been provided as the
software is not yet complete. Once completed, it will be amortised over its estimated useful life.
5. Audit fees within the trial balance relate entirely to current year audit fee expenses paid or payable to
an auditor.
6. The opening balance of the allowance for doubtful debts at 1 January 20X1 is $476 906.
7. The retained earnings balance at 1 January 20X1 was $960 520.
8. Cash receipts from customers for 31 December 20X2 totalled $5 935 790, whilst cash payments to
suppliers and employees totalled $4 573 318.
9. Income tax paid to the taxation authority during the 20X2 income year amounted to $99 349. Assume
a corporate tax rate of 30%. Non-deductible expenses for tax purposes during the 20X2 income year
amounted to $79 833 (20X1: $19 358).
10. All capital issued by Techworks is fully paid up. Holders of ordinary shares are entitled to receive
dividends as declared from time to time and are entitled to one vote per share at shareholders’ meetings.
In the event of winding up of the company, ordinary shareholders rank after all other shareholders and
creditors and are fully entitled to any proceeds on liquidation.
11. Total overdraft facilities available to Techworks at 31 December 20X2 are $900 000 (20X1: $900 000).
12. Techworks is refurbishing its offices and has signed a contract at 31 December 20X2 for an external
firm to manage and perform the refurbishment works. The works are due to be completed over a
two-year period and instalments will be paid equally over this period. The total value of the contract
is $200 000.
13. Techworks does not have any short-term leases or low-value assets that are leased. The leases for
Techworks also do not have any variable lease payments.
14. Assume no goods and services tax.
Related Party Information
Techworks has three directors, who receive the following remuneration.
Director name Remuneration 20X2 20X1
Mr Ingelby Director’s fees $ 9 000 $ 8 000
Superannuation $10 000 $10 000
Mrs Barwick Director’s fees $ 4 000 $ 3 000
20X1 bonus to be paid on 12/8/20X1 $ 4 000 —
20X1 bonus to be paid on 31/7/20X2 $ 4 000 —
Miss Thornaby Share options $ 6 000 —

Techworks also has an executive team comprising the following staff who have authority and responsi-
bility for planning, directing and controlling the activities of the entity:
Executive name and title Remuneration 20X2 20X1
Mr Smith Salary $100 000 $ 80 000
Chief Executive Officer 20X1 bonus to be paid 12/8/20X1 — $ 20 000
20X2 bonus to be paid 12/8/20X2 $ 10 000 —
Loan provided to Mr Smith 1/1/20X2 to be $ 20 000 —
fully repaid in one payment at 30/6/20X2. —
This loan is secured over Mr Smith’s home,
and is the first loan issued to a KMP.

408 APPENDIX
 Mrs Hills Salary $ 80 000 $65 000
Chief Finance Officer Subsidised medical benefit $ 5 000 $ 5 000
Mr Newham Redundancy $ 52 000 —
Chief Operating Officer Salary — $75 000

Techworks uses the advertising services of Brookfield Ltd (Brookfield), an entity with significant
influence over Techworks. Brookfield has significant influence over Techworks as Mr Ingelby and Mrs
Barwick are also directors in Brookfield (IAS 128, para. 6(a)). The total expenses during the year were
$108 625 (20X1: $31 000) with an outstanding balance at the reporting date of $109 552 (20X1: $93 938).

Financial Instrument Information

At 31 December 20X2, Techworks had $1 450 000 (20X1: $650 000) cash balance on deposit with
Australia Bank attracting an interest rate of 2% (20X1: 2.5%). They also had borrowings of $900 000
(20X1: $900 000) with interest accruing at 7% (20X1: 7.5%).
Management considers a 0.5% (i.e. 50 basis points) increase in interest rates and 0.25% (i.e. 25 basis
points) decrease in interest rates as reasonably possible in the next 12 months. The reasonably possible
movements are based on current economic indicators and discussions with Techworks financiers.

Techworks Ltd: Trial Balance

Trial balance 20X2 20X1
$ $
1105 Petty cash 2 500 2 500
1110 Cash at bank 1 450 000 650 000
1115 BPAY account 6 199 21 159
1120 Term deposit (less than 90 days) 10 000 10 000
1125 Accounts receivable 6 957 738 6 889 809
1130 Allowance for doubtful debts (620 037) (488 976)
1140 Deferred tax asset 543 375 594 968
1145 Prepayments 74 451 80 760
1148 Office buildings — leased 735 350 —
1149 Accumulated depreciation — leased office buildings (147 070) —
1150 Furniture, equipment and fittings 189 904 72 185
1155 Accumulated depreciation — furniture, equipment and fittings (19 936) (1 151)
1160 Motor vehicles — leased 732 857 386 888
1165 Accumulated depreciation — leased motor vehicles (66 976) (57 925)
1170 Motor vehicles 490 057 598 583
1175 Accumulated depreciation — motor vehicles (52 072) (58 782)
1180 Computer software costs capitalised 228 273 103 000

2205 Accounts payable (730 423) (1 409 512)

2210 Lease liability — current (258 724) (57 113)
2215 Lease liability — non-current (1 008 563) (200 850)
2220 Intercompany payable to Brookfield Ltd (current) (109 552) (93 988)
2225 Bank overdraft (900 000) (900 000)
2230 Accrued expenses (134 345) (78 933)
2235 Accrued audit fees (22 000) (24 000)
2240 Contract liability (1 155 944) (995 224)
2245 Income tax payable (559 771) (241 967)
2250 Provision for long service leave — non-current (68 072) (61 623)
2255 Provision for long service leave — current (12 399) (10 988)
2260 Provision for annual leave (509 811) (489 295)

3305 Issued capital (2 042 367) (2 042 367)

3310 Retained earnings (2 197 158) (960 520)
3311 Retained earnings — initial application of IFRS 16 22 147
4405 Service fee income (5 842 999) (5 493 282)
4410 Interest revenue (60 000) (31 250)

5505 Salaries and wages 1 787 368 1 938 525

5510 Commissions to staff 204 544 —
5515 Bonuses/incentives to staff 113 221 —

APPENDIX 409
 Trial balance 20X2 20X1
$ $
5520 Annual leave 55 171 23 819
5525 Payroll tax 153 920 75 439
5530 Superannuation 691 521 446 461
5535 Workers compensation 38 991 32 087
5540 Advertising 33 315 127 573
5545 Audit fees 98 778 86 988
5550 Depreciation — furniture, equipment and fittings 18 785 1 151
5555 Depreciation — motor vehicles — owned 21 952 54 512
5560 Depreciation — leased motor vehicles 65 677 32 478
5561 Depreciation — leased office buildings 147 070 —
5565 Doubtful debts 131 061 12 070
5570 Electricity 29 875 26 487
5575 Entertainment 45 787 26 874
5580 Insurance 11 950 26 558
5585 Interest on leased assets 80 057 6 778
5590 Interest on overdraft 74 936 68 939
5595 Legal fees 151 233 160 121
5600 Loss on sale of assets 69 194 —
5605 Marketing costs 7 314 16 893
5610 Promotional costs 512 525 83 901
5615 Rent — 171 041
5625 Security 12 455 11 257
5630 Sponsorships 0 242 156
5635 Subscriptions 2 587 1 454
5640 Telephone 25 787 24 578
5645 Travel 21 548 32 112
5650 Income tax expense 468 746 557 642
Net profit for the year after income tax 827 631 1 236 638

Techworks Ltd: Financial Statements Template

Statement of profit or loss and other comprehensive income
for the year ended 31 December 20X2
20X2 20X1
Notes $ $
Income
Revenue from continuing operations 2
Interest revenue
Expenses from operating activities
Employee costs 3
Advertising and marketing costs
Occupancy costs
Legal and professional costs
Administration and other
Impairment loss on trade receivables
Depreciation and amortisation 3
Loss on sale of non-current assets 3
Finance costs 3
Profit before income tax
Less: Income tax/(expense) 5
Profit after tax from continuing operations
Other comprehensive income (net of tax)
Total comprehensive income for the period
attributable to members of Techworks Ltd

410 APPENDIX
 The statement of profit or loss and other comprehensive income is to be read in conjunction with the
attached notes.
Statement of financial position
as at 31 December 20X2
20X2 20X1
Notes $ $
ASSETS
Current assets
Cash and cash equivalents 6
Trade and other receivables 7
Other current assets 8
Total current assets
Non-current assets
Property, plant and equipment 9
Intangible assets 10
Deferred tax assets 5(c)
Total non-current assets
Total assets
LIABILITIES
Current liabilities
Trade and other payables 11
Borrowings 13
Lease liabilities 15
Contract liability 14
Current tax payable
Employee benefits 12
Total current liabilities

Non-current liabilities
Lease liabilities 15
Employee benefits 12
Total non-current liabilities
Total liabilities
Net assets

SHAREHOLDERS’ EQUITY
Issued capital 16
Retained earnings
Total shareholders’ equity

The statement of financial position is to be read in conjunction with the attached notes.

Statement of changes in equity

for the year ended 31 December 20X2
Attributable to equity holders of Techworks
Issued Retained
capital earnings Total
$ $ $
At 1 January 20X1
Total comprehensive income for the year
Closing balance as at 31 December 20X1

At 1 January 20X2
Adjustment for initial application of IFRS 16
Total comprehensive income for the year
Closing balance as at 31 December 20X2

The statement of changes in equity is to be read in conjunction with the attached notes.

APPENDIX 411
 Statement of cash flows
for the year ended 31 December 20X2

20X2 20X11
Notes $ $

Cash flows from operating activities

Cash receipts from customers
Cash paid to suppliers and employees
Cash generated from operations
Interest paid
Income taxes paid
Net cash flows from operating activities 17(b)

Cash flows from investing activities

Proceeds from sale of property, plant and equipment
Proceeds from settlement of KMP loan
Purchase of intangible assets
Purchase of property, plant and equipment
Payment for origination of KMP loan
Interest received
Net cash used in investing activities

Cash flows from financing activities

Payment of lease liabilities

Net cash used in financing activities

Net increase in cash and cash equivalents

Cash and cash equivalents at beginning of the year 17(a)

Cash and cash equivalents at end of the year 17(a)

1 Insufficient information is provided to complete the comparative statement of cash flows for 20X1.
The statement of cash flows is to be read in conjunction with the attached notes.

Techworks Ltd: Notes to the Financial Statements

Note Contents

1 Summary of significant accounting policies

2 Income
3 Expenses included in net profit from continuing operations
4 Franking credits*
5 Income tax
6 Cash and cash equivalents
7 Trade and other receivables
8 Other current assets
9 Property, plant and equipment
10 Intangible assets
11 Trade and other payables
12 Employee benefits liabilities
13 Borrowings
14 Contract liability
15 Lease liabilities
16 Issued capital
17 Statement of cash flows
18 Subsequent events
19 Contingent liabilities
20 Financial instruments
21 Auditor’s remuneration*
22 Related party transactions
23 Capital expenditure commitments

* Australian specific terminology/disclosure note.

412 APPENDIX
Notes to the Financial Statements
For the year ended 31 December 20X2

1. Summary of Significant Accounting Policies

(a) Nature of operations
Techworks is a for-profit entity. The principal activities of the Company are:
• consulting services for the design of information technology (IT) systems, telecommunication
systems strategies, and IT security
• IT outsourcing services including for payroll and accounts payable transaction processing
The Company operates in Australia and provides its services primarily to small- and medium-sized
enterprises (SMEs).
(b) Statement of compliance
Techworks is a limited liability company incorporated and domiciled in Australia. The address of its
registered office and its principal place of business is Level 2, 635 Sedgefield Road, Acklam, Central
Australia, 9000.
The financial statements are general purpose financial statements that have been prepared in
accordance with the requirements of the Corporations Act 2001, Australian Accounting Standards
and other authoritative pronouncements of the Australian Accounting Standards Board (AASB).
The Company has elected to apply Tier 1 reporting requirements in preparing general purpose
financial statements in accordance with AASB 1053 Application of Tiers of Australian Accounting
Standards. The Company’s compliance with Australian Accounting Standards therefore results in full
compliance with the International Financial Reporting Standards (IFRSs) as issued by the International
Accounting Standards Board (IASB).
The financial statements were authorised for issue by the Board of Directors of Techworks at a
directors’ meeting on 4 April 20X3.
(c) Basis of preparation
(i) Presentation
The financial statements are presented in Australian dollars which is the company’s functional
currency. Amounts disclosed relate to the company unless otherwise stated. The financial statements
have been prepared on an accrual basis and under the historical cost convention.
When required by accounting standards, comparative figures have been adjusted to conform to
changes in presentation for the current financial year.
(ii) New standards adopted
The Company adopted IFRS 16 Leases effective 1 January 20X2. IFRS 16 Leases replaces
IAS 17 Leases together with three Interpretations: IFRIC Interpretation 4 Determining whether
an Arrangement contains a Lease; SIC Interpretation 15 Operating Leases — Incentives; and SIC
Interpretation 127 Evaluating the Substance of Transactions Involving the Legal Form of a Lease.
The adoption of IFRS 16 has resulted in the Company recognising right-to-use assets and
related lease liabilities in respect of office building leases formerly classified as operating leases.
IFRS 16 has been applied to the office building leases by recognising the cumulative effect of
applying the standard for the first time as an adjustment to the opening balance of retained earnings
for the current period. The prior period comparative has not been restated.
The Company elected not to include initial direct costs in the initial measurement of the right-
of-use asset for office building leases in existence at the date of initial application. The Company
also elected to measure the right-of-use assets at an amount equal to the lease liability adjusted
for any prepaid or accrued lease payments that existed at that date.
Instead of performing an impairment review on the right-of-use assets at the date of initial
application, the Company has relied on its historic assessment as to whether leases were onerous
immediately before the date of initial application of IFRS 16.
The right-of-use asset and lease liability for the Company’s motor vehicle leases, which were
previously classified as finance leases, has been measured at the date of initial application using
the same amounts as under IAS 17 immediately beforehand.
The weighted average incremental borrowing rate applied to office building lease liabilities
recognised on initial application of IFRS 16 was 6.5%.

APPENDIX 413
 The following is a reconciliation of the financial statement line items from IAS 17 to IFRS 16
at 1 January 20X2.

Property,
plant and Lease Retained
equipment liabilities earnings
$ $ $
Carrying amount at 31 December 20X1 939 798 257 963 2 197 158
Reclassification of office building leases 735 350 757 497 (22 147)
Carrying amount at 1 January 20X2 1 675 148 1 015 460 2 175 011

The following is a reconciliation of the total operating lease commitments for office buildings
at 31 December 20X1 to the lease liabilities for office buildings recognised at 1 January 20X2.
$
Total operating lease commitments for office buildings disclosed at 31 December 20X1 911 400
Discounted using the incremental borrowing rate (153 903)
Finance leases for motor vehicles at 31 December 20X1 257 963
Total lease liabilities recognised under IFRS 16 at 1 January 20X2 1 015 460

(iii) Amended standards adopted

The Company adopted revised accounting standards and amendments effective at the beginning
of the current year as follows.
• IFRIC Interpretation 23 Uncertainty over Income Tax Treatments
• IASB ‘Annual Improvements to IFRS Standards 2015–2017 Cycle’
These amended standards do not have a material impact on the financial statements.
(iv) Amended standards not yet effective and not adopted early
The Company has not early adopted revised accounting standards and amendments that are not
effective at the beginning of the current year as follows.
• IASB ‘Definition of a Business (Amendments to IFRS 3)’
• IASB ‘Definition of Material (Amendments to IAS 1 and IAS 8)’
• IASB ‘Amendments to References to the Conceptual Framework in IFRS Standards’
In the next financial year, these amendments will be adopted for the first time but are not
expected to have material impact on the financial statements.
(d) Significant management judgements in applying accounting policies
When preparing the financial statements, management is required to make judgments, estimates and
assumptions about the recognition and measurement of assets, liabilities, income and expenses. The
estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting
estimates are recognised in the period in which the estimate is revised if the revision affects only
that period or in the period of the revision and future periods.
The management judgments and information about estimates and assumptions that may have the
most significant effect on the financial statements are set out below. The estimates and assumptions
are based on historical experience and various other factors that are believed to be reasonable under the
circumstance, the results of which form the basis of making the judgments. Actual results may differ
substantially from estimates.
(i) Recognition of consulting service revenues
Consulting service revenues are recognised over time and the amount of revenue recognised in the
reporting period depends on management judgment of the extent to which performance obligations
have been met.
(ii) Capitalisation of internally developed software
Management judgment is exercised to determine the research and development phases of a
customised software project and whether the recognition requirements for the capitalisation of
development costs are met. Management monitors whether the recognition requirements continue
to be met after capitalisation and whether there are any indicators that capitalised costs may
be impaired.

414 APPENDIX
 (iii) Recognition of deferred tax assets
The extent to which deferred tax assets are recognised is based on management’s assessment of
the probability that future taxable income will be available against which deductible temporary
differences and carried forward tax losses can be utilised.
(iv) Impairment of financial assets
Trade receivables include amounts receivable from debtors who have fallen outside their payment
terms. Trade receivables are measured after an allowance that reflects the management’s best
estimate of uncollectible debts. The measurement of the allowance is based on an ageing analysis
that incorporates the Company’s previous experience of the realisation of customer debts.
(v) Impairment of non-financial assets
When there is an indication of impairment, management estimates the recoverable amount of each
asset or cash-generating unit based on expected future cash flows and an appropriate risk-adjusted
discount rate. Assumptions about future operating results and the determination of discount rates
involve estimation uncertainty.
(vi) Useful lives of depreciable assets
Management reviews its estimate of the useful lives of depreciable assets at each reporting date,
based on the expected utility of the assets. Uncertainties in these estimates relate to technological
obsolescence that may change the utility of certain software and IT equipment.
(e) Significant accounting policies
The following significant accounting policies have been adopted in the preparation and presentation
of the financial statements. The accounting policies are consistent with those applied in the prior year,
except the accounting for leases.
(i) Revenue
Revenue arises from the provision of services, which are earned from providing software- and
hardware-related services, including consulting. In determining whether to recognise revenue, the
Company follows a 5-step process as follows.
• Step 1:Identifying the contract with a custom
• Step 2: Identifying the performance obligation
• Step 3: Determining the transaction price
• Step 4: Allocating the transaction price to the performance obligations
• Step 5: Recognising revenue when/as performance obligation(s) are satisfied
Revenue from the rendering of consulting services is recognised over time as the Company
satisfies the performance obligations by transferring the promised services to customers. The
Company invoices customers monthly as work progresses. Any amounts that remain unbilled
to consulting service customers at the end of the financial year are presented in the statement
of financial position as accounts receivable because performance obligations have been met and
only the passage of time is required before the receipt of amounts will be due.
The Company recognises contract liabilities for consideration received from consulting services
customers in respect of unsatisfied performance obligations and reports the amount outstanding
at financial year end in the statement of financial position.
The Company also generates revenue from providing IT outsourcing services to customers in
exchange for a fixed monthly fee. This revenue is recognised on a straight-line basis over the term
of each contract. As the amount of work required to perform under these contracts does not vary
significantly from month-to-month, the straight-line method presents a faithful depiction of the
transfer of the services.
(ii) Interest revenue
Interest revenue is recognised on an accrual basis using the effective interest method.
(iii) Operating expenses
Operating expenses are recognised in profit or loss upon utilisation of the service or at the date
of their origin. Employee costs include payroll tax and superannuation contributions made by the
Company to the employees’ nominated superannuation funds.
(iv) Borrowing costs
Borrowing costs that are directly attributable to the acquisition or production of a qualifying asset
are capitalised as part of the cost of that asset until such time that the asset is ready for its intended
use. All other borrowing costs are recognised as an expense in the period in which they are incurred
and reported as finance costs in the statement of profit or loss and other comprehensive income.
The Company treats the finance costs paid as operating cash flows.

APPENDIX 415
 (v) Income tax
Income tax expense is recognised in profit or loss and comprises the sum of current tax and
deferred tax not recognised in other comprehensive income or directly in equity.
Current tax is calculated by reference to the amount of income taxes payable or recoverable
in respect of the taxable profit or loss for the period, which differs from profit or loss in the
financial statements. Current tax is calculated using tax rates and tax laws that have been enacted
or substantively enacted by the end of the reporting period. The current tax liability represents
those obligations to the Australian Taxation Office (ATO) and other fiscal authorities relating to
the current or prior reporting periods that are unpaid at the reporting date.
Deferred tax is calculated using the liability method on temporary differences between the
carrying amounts of assets and liabilities and their tax bases. Changes in deferred tax assets or
liabilities are recognised as a component of tax income or expense in profit or loss, except where
they relate to items that are recognised in other comprehensive income or directly in equity, in
which case the related deferred tax is also recognised in other comprehensive income or equity,
respectively.
Deferred tax assets are recognised to the extent that it is probable that they will be able to be
utilised against future taxable income, based on the Company’s forecast of future operating results,
which is adjusted for significant non-taxable income and expenses and specific limits to the use
of any unused tax loss or credit.
Deferred tax assets and liabilities are calculated, without discounting, at tax rates that are
expected to apply to their respective period of realisation, provided they are enacted or substan-
tively enacted by the end of the reporting period.
Deferred tax assets and liabilities are offset only when the Company has a right and intention
to set off current tax assets and liabilities from the same taxation authority.
(vi) Cash and cash equivalents
Cash and cash equivalents comprise cash at bank and in hand and short-term deposits with an
original maturity of three months or less, which are convertible to known amounts of cash and
are subject to an insignificant risk of change in value. Bank overdrafts form an integral part of
the Company’s cash management function and are included as a component of cash and cash
equivalents shown in the statement of cash flows.
(vii) Trade receivables
Trade receivables are recognised when the Company satisfies performance obligations by trans-
ferring promised services to customers. Trade receivables do not contain a significant financing
component and are initially measured at the transaction price in accordance with IFRS 15 Revenue
from Contracts with Customers. Trade receivables are subsequently measured at amortised cost
because they are held within a business model where the objective is to collect the contractual cash
flows. No interest is charged to trade receivables. The effect of discounting is omitted because it
is immaterial.
The Company uses a simplified approach in accounting for the loss allowance on trade
receivables. The allowance is recorded at an amount equal to the expected lifetime credit
losses based on historical experience, external indicators and forward-looking information. The
Company assesses impairment of trade receivables on a collective basis as they possess credit risk
characteristics based on the days past due. The Company allows 2% for amounts that are 30 to
60 days past due, 4% for amounts that are between 60 and 90 days past due, and 6% for amounts
more than 90 days past due.
Trade receivables are written off when there is no reasonable expectation of recovery. In this
regard, the Company writes off any amounts that are more than 180 days past due if the customer
fails to engage on making alternative payment arrangements for their debt.
Adjustments made to the carrying amount of the allowance account for impairment are recog-
nised in profit or loss. When a trade receivable is deemed uncollectible, it is written off against the
allowance account. Subsequent recoveries of amounts previously written off are credited against
the allowance account. In a subsequent period, if the amount of the impairment loss decreases
and the decrease can be related objectively to an event occurring after the impairment was
recognised, the previously recognised impairment loss is reversed through profit or loss.
(viii) Internally developed software
Expenditure on the research phase of projects to develop new customised software for IT and
telecommunication systems is recognised as an expense as incurred.

416 APPENDIX
 Costs that are directly attributable to a project’s development phase are recognised as intangible
assets, provided they meet the following recognition requirements.
• The development costs can be measured reliably.
• The project is technically and commercially feasible.
• The Company intends to complete the project and has the resources to do so.
• The Company has the capability to use or sell the software.
• The software will generate probable future economic benefits.
Development costs not meeting the above criteria for capitalisation are expensed as incurred.
Directly attributable costs include employee costs incurred on software development together
with an appropriate portion of relevant overheads and borrowing costs.
Internally generated software recognised as an intangible asset that is in use is amortised over
its useful life ranging from 3–5 years. Internally generated software recognised as an intangible
asset that is not yet complete or ready for use is not amortised, but is subject to impairment testing
as described below.
(ix) Plant and equipment
The Company’s property, plant and equipment is comprised of IT equipment, fittings, furniture,
motor vehicles and of right-of-use assets for office buildings and motor vehicles.
Items of property, plant and equipment are initially recognised at acquisition cost including any
costs directly attributable to bringing the assets to the location and condition necessary for them
to be capable of operating in the manner intended by management.
Items of property, plant and equipment are subsequently measured at cost less accumulated
depreciation and impairment losses.
Depreciation is recognised on a straight-line basis to write down the cost less estimated
residual value. The following depreciation rates are used in the calculation of depreciation of
plant and equipment.
• IT equipment: 2–5 years
• Fittings and furniture: 3–12 years
• Motor vehicles owned: 3–5 years
• Motor vehicles leased: 3–6 years
• Office buildings lease: 5 years
The estimated useful lives, residual values and depreciation method are reviewed at the end of
each reporting period.
An item of property, plant and equipment is derecognised upon disposal or when no further
future economic benefits are expected from its use or disposal. Gain or losses arising on the
disposal of property, plant and equipment are determined as the difference between the disposal
proceeds and the carrying amount of the assets. The gains or losses are recognised in profit or loss
within other income or expenses respectively.
(x) Right-of-use assets
The Company’s lease agreements for office buildings and motor vehicle qualify as leases as
defined in IFRS 16 because the:
• contracts contain an identified motor vehicle that is explicitly identified
• Company has the right to obtain substantially all the economic benefits from use of the identified
motor vehicle throughout the period of use.
• Company has the right to direct the use of the identified motor vehicle throughout the period
of use.
At the lease commencement date, the Company recognises a right-of-use asset and a lease
liability on the statement of financial position.
The right-of-use asset is measured at cost, which is made up of the initial measurement of the
lease liability, any initial direct costs incurred and any lease payments made in advance of the
lease commencement date (net of any incentives received).
The Company depreciates the right-of-use assets on a straight-line basis from the lease
commencement date to the end of the lease term.
At the commencement date, the Company measures the lease liability at the present value of
the lease payments unpaid at that date, discounted using the interest rate implicit in the lease.

APPENDIX 417
 Lease payments included in the measurement of the lease liability are made up of fixed
payments, amounts expected to be payable under a residual value guarantee and payments arising
from options reasonably certain to be exercised.
Subsequent to initial measurement, the liability is reduced for payments made and increased
for interest. It is remeasured to reflect any reassessment or modification, or if there are changes in
in-substance fixed payments.
When the lease liability is remeasured, the corresponding adjustment is reflected in the right-
of-use asset, or profit or loss if the right-of-use asset is already reduced to zero.
In the statement of financial position, right-of-use assets have been included in property, plant
and equipment and lease liabilities have been included in trade and other payables.
(xi) Impairment testing of non-financial assets
At the end of each reporting period, the Company reviews the carrying amounts of its tangible and
intangible assets, including right-of-use assets, to determine whether there is any indication that
those assets have suffered an impairment loss.
If any indication of impairment exists, the recoverable amount of the asset is estimated in order
to determine the extent of the impairment loss (if any). Where the asset does not generate cash
flows that are independent from other assets, the Company estimates the recoverable amount of
the cash-generating unit to which the asset belongs.
Intangible assets not yet available for use are tested for impairment annually and wherever there
is an indication that the assets may be impaired.
(xii) Trade and other payables
Trade and other payables are recognised when the Company becomes obliged to make future
payments resulting from the purchase of goods and services. The amounts are unsecured and are
usually paid within 30 days of recognition.
(xiii) Employee benefits liability
Short-term employee benefits are benefits, other than termination benefits, that are expected to
be settled wholly within 12 months after the end of the period in which the employees render the
related service. Examples of such benefits include wages and salaries, non-monetary benefits and
accumulating sick leave. Short-term employee benefits are measured at the undiscounted amounts
expected to be paid when the liabilities are settled.
Long-term employee benefits are benefits for annual leave and long service leave that are not
expected to be settled wholly within 12 months after the end of the period in which the employees
render the related service. They are measured at the present value of the expected future payments
to be made to employees. The expected future payments incorporate anticipated future wage and
salary levels, experience of employee departures and periods of service, and are discounted at
rates determined by reference to market yields at the end of the reporting period on high-quality
corporate bonds that have maturity dates that approximate the timing of the estimated future cash
outflows. Any re-measurements arising from experience adjustments and changes in assumptions
are recognised in profit or loss in the periods in which the changes occur.
The Company presents employee benefit obligations as current liabilities in the statement
of financial position if it does not have an unconditional right to defer settlement for at least
12 months after the reporting period, irrespective of when the actual settlement is expected to
take place.
(xiv) Borrowings
Borrowings are initially measured at fair value, net of transaction costs. Borrowings are sub-
sequently measured at amortised cost using the effective interest method, with interest expense
recognised on an effective yield basis.
(xv) Equity and reserves
Share capital is recognised at the fair value of the consideration received by the Company for
ordinary shares issued. Transaction costs arising on the issue of ordinary shares are recognised
directly in equity as a deduction from share capital net of any related income tax benefits.
Retained earnings includes all current and prior period profits less dividend distributions to
ordinary shareholders.

418 APPENDIX
2. Income
(a) Revenue from services
Revenue from services consists of the following.
20X2 20X1
$ $
Consulting services transferred over time 5 094 595 4 955 449
Fixed monthly fees from IT outsourcing 748 404 537 833
Total services revenue 5 842 999 5 493 282

Consulting services revenue for 20X2 includes $943 127 (20X1: $687 724) that was recognised in
the contract liability balance at the beginning of the financial year.
The following aggregated amounts of transaction prices relate to performance obligations from
existing contracts that are unsatisfied or partially unsatisfied as at 31 December 20X2.
2021 2020 Total
$ $ $
Revenue expected to be recognised 121 110 458 120 579 230

(b) Finance income

Finance income consists of the following.
20X2 20X1
$ $
Interest revenue
Financial instruments measured at amortised cost:
— Bank deposits
Total finance income

3. Expenses Included in Net Profit From Continuing Operations

20X2 20X1
$ $
Net profit before income tax includes the following specific expenses.

Employee benefits expense

Salary and wages expense
Contributed superannuation
Other employment costs
Total employment costs

Depreciation of plant and equipment

Right-of-use assets for office buildings
Right-of-use assets for motor vehicles
Motor vehicles owned
Equipment, fittings and furniture
Total depreciation

Occupancy costs
Rent
Electricity
Total occupancy costs

Finance costs
Interest on bank overdrafts and loans*
Interest expense on lease liabilities
Total finance costs

(Gain)/loss on disposal of assets

* The weighted average interest rate on funds borrowed generally is 5.8% p.a. (20X1: 6.6% p.a.).

APPENDIX 419
4. Franking Credits
The Company’s payment of income tax generates franking credits that are available for future dividend
distributions.
20X2 20X1
$ $
Balance of dividend franking account 1 047 878 789 104

5. Income Tax
(a) Income tax expense
The major components of tax expense are as follows.
20X2 20X1
$ $
Current tax expense 417 153 615 307
Deferred tax expense/(income) related to the origination and reversal of
temporary differences 51 593 (57 665)
Total income tax expense in the statement of profit or loss and other
comprehensive income 468 746 557 642

(b) Reconciliation of the expected tax expense based on pre-tax accounting profit from operations
and the reported tax expense in profit or loss
20X2 20X1
$ $
Profit from continuing operations before income tax expense 1 296 377 1 794 280
Income tax calculated at 30% (20X1: 30%) 388 913 538 284
Add/(less): Non-deductible expenses 79 833 19 358
Income tax expense 468 746 557 642

The tax rate used in the above reconciliation is the corporate tax rate of 30% payable by Australian
corporate entities on taxable profits under Australian tax law. There has been no change in the corporate
tax rate when compared with the previous reporting period.
(c) Deferred tax assets/(liabilities)
Deferred taxes arising from temporary differences are summarised as follows.
Deferred tax assets/(liabilities) 20X2 20X1
$ $
Trade receivables 186 011 146 693
Property, plant and equipment (107 110) (1 230)
Capitalised computer software (68 482) (30 900)
Contract liability 346 783 298 567
Employee benefits liability 177 085 168 572
Other temporary differences 9 088 13 266
543 375 594 968

There are no unused tax losses and no unrecognised temporary differences.

6. Cash and Cash Equivalents
Cash and cash equivalents consist of the following.
20X2 20X1
$ $
Cash at bank and on hand
Term deposits

420 APPENDIX
 The effective interest rate on cash deposits was 5% (20X1: 5%); these deposits have no maturity date as
they are held in an interest-bearing cheque account.

7. Trade and Other Receivables

Trade and other receivables consist of the following.
20X2 20X1
$ $
Current
Trade receivables
Less: Allowance for credit losses

All amounts are short-term. The carrying amount of trade receivables is a reasonable approximation of
their fair value.
The closing balance of the loss allowance for trade and other receivables as at the end of the year
reconciles with the opening balance as follows.

20X2 20X1
$ $
Loss allowance as at 1 January 488 976 476 906
Add: Loss allowance recognised during the year 131 061 12 070
Less: Receivables written off during the year — —
Loss allowance as at 31 December 620 037 488 976

The expected credit loss for trade and other receivables as at 31 December 20X2 and 31 December 20X1
has been determined as follows.

More than More than More than

31 December 20X2 Current 30 days 60 days 90 days Total
$ $ $ $ $
Expected credit loss rate 4% 8% 20% 67%
Gross carrying amount 4 526 845 1 254 686 956 320 219 887 6 957 738
Lifetime expected credit loss 181 074 100 375 191 264 147 324 620 037

More than More than More than

31 December 20X1 Current 30 days 60 days 90 days Total
$ $ $ $ $
Expected credit loss rate 4% 8% 20% 67%
Gross carrying amount 4 858 661 1 252 684 696 077 82 387 6 889 809
Lifetime expected credit loss 194 346 100 215 139 215 55 199 488 976

8. Other Current Assets

Other current assets consist of the following.
20X2 20X1
$ $
Current
Prepayments

APPENDIX 421
9. Property, Plant and Equipment
Property, plant and equipment consists of the following.

Right-of- Right-of- Equipment,

use office use motor Motor furniture
20X2 buildings vehicles vehicles and fittings Total
$ $ $ $
Gross carrying amount
Balance at 1 January 20X2
Additions
Disposals
Balance at 31 December 20X2

Accumulated depreciation
Balance at 1 January 20X2
Depreciation expense
Disposals
Balance at 31 December 20X2

Net carrying amount

As at 31 December 20X2

Right-of- Right-of- Equipment,

use office use motor Motor furniture
20X1 buildings vehicles vehicles and fittings Total
$ $ $ $ $
Gross carrying amount
Balance at 1 January 20X1
Additions
Balance at 31 December 20X1

Accumulated depreciation
Balance at 1 January 20X1
Depreciation expense
Balance at 31 December 20X1

Net carrying amount

As at 31 December 20X1

The carrying value of leased property, plant and equipment at 31 December 20X2 is $1 254 161 (20X1:
$328 963). Additions during the year include $512 525 (20X1: $83 901) of leased plant and equipment.
Leased motor vehicles are pledged as security for the related lease liabilities.

10. Intangible Assets

Intangible assets consist of the following.
20X2 20X1
$ $
Computer software
Total intangible assets

The computer software is purchased as part of a system upgrade and is still under development. It is
expected to be completed by December 2020 and amortisation will commence during this period also. As
the asset was not in use during 20X1 and 20X2, the only movement has been additions.
An impairment test has been performed during the year and, based on the expected net cash inflows
from the software, there is no impairment loss. Sensitivity analysis on the assumptions used have shown
that there is no reasonably possible movement that would cause an impairment loss.

422 APPENDIX
11. Trade and Other Payables
Trade and other payables consist of the following.
20X2 20X1
$ $
Trade and other payables
Accrued expenses
Amounts payable to related parties

Trade creditors and other creditors are non–interest bearing liabilities. Trade creditor payments are
processed once they have reached 30 days from the date of invoice for electronic funds transfer payments
or cheque payment, or 30 days from the end of the month of invoice for other payments. No interest is
charged on trade payables.
All amounts are short term and the carrying values are a reasonable approximation of fair value.

12. Employee Benefits Liabilities

Employee benefits liabilities consist of the following.
20X2 20X1
$ $
Current
Annual leave
Long service leave

Non-current
Long service leave

Total

The current employee benefits liability includes $455 433 of annual leave and vested long service leave
entitlements accrued but not expected to be taken within 12 months (20X1: $406 334).
The Company makes contributions to employee superannuation schemes, which are defined contribution
plans. The amount recognised as an expense are disclosed at Note 3.

13. Borrowings
Borrowings consist of the following.
20X2 20X1
$ $
Current
Borrowings — overdraft

Bank Overdrafts
The bank overdraft facilities may be drawn at any time and may be terminated by the bank without notice.
The Company has granted a floating charge over its assets as security for the bank overdraft facilities. The
holder of the security does not have the right to sell or re-pledge the assets.
Fair Value Disclosures
The fair value of current borrowings approximates their carrying amount as the impact of discounting is
not significant. No fair value changes have been included in profit or loss for the period as financial
liabilities are carried at amortised cost in the statement of financial position.

APPENDIX 423
Financing Facilities Available

20X2 20X1
$ $
Total facilities
— Bank overdraft

Facilities used at reporting date

— Bank overdraft

Facilities unused at reporting date

— Bank overdraft

Total facilities
— Facilities used at reporting date
— Facilities unused at reporting date

14. Contract Liability

The contract liability consists of the following.

20X2 20X1
$ $
Current
Deferred services income

The deferred services income represents customer payments for consulting services received in advance
of performance. The amounts recognised will generally be utilised within the next reporting period.

15. Lease Liabilities

The Company has leases for its offices and motor vehicles. Each lease is reflected on the balance sheet as
a right-of-use asset and a lease liability. The Company classifies its right-of-use assets from the leases in
a manner consistent with its property, plant and equipment (refer Note 9).
Lease liabilities are presented in the statement of financial position as follows.

20X2 20X1
$ $
Current 258 724 57 113
Non-current 1 008 563 200 850
Total 1 267 287 257 963

Each lease generally imposes a restriction that the right-of-use asset can only be used by the Company.
Leases are either non-cancellable or may only be cancelled by incurring a substantive termination fee.
Motor vehicle leases generally contain an option to purchase the underlying leased asset outright at the
end of the lease. The Company is prohibited from selling the leased motor vehicles without the express
authority of the lessor. The Company must arrange insurance on leased assets and incur maintenance fees
on such items in accordance with the lease contracts.
The nature of the Company’s leases by right-of-use asset is shown below.

No. of No. of No. of

leases leases leases No. of
Range of Average with with with index leases
No. of remain- remain- exten- options linked with
Right-of-use assets ing lease ing lease sion to pur- variable termination
asset leased term term options chase payments options
Office buildings 3 4 years 4 0 0 0 0
Motor vehicles 20 1–5 years 3 0 10 0 0

424 APPENDIX
 The lease liabilities are secured by the related underlying assets. Future minimum lease payments at the
end of the year are as follows.

Within 1–2 2–3 3–4 4–5

1 year years years years years Total
$ $ $ $ $ $
31 December 20X2
Lease payments 325 027 322 063 311 840 308 431 186 544 1 453 905
Finance charges (66 303) (52 412) (37 853) (22 876) (7 174) (186 618)
Net present values 258 724 269 651 273 987 285 555 179 370 1 267 287

31 December 20X1
Lease payments 67 432 59 945 57 450 52 940 50 340 288 107
Finance charges (10 319) (8 034) (5 958) (3 898) (1 935) (30 144)
Net present values 57 113 51 911 51 492 49 042 48 405 257 963

The total cash outflow for leases for the year ended 31 December 20X2 was $340 755.

16. Issued Capital

The share capital of the Company consists only of fully paid ordinary shares. The Company does not have
a limited amount of authorised capital and issued shares do not have a par value.
(a) Fully paid up share capital
20X2 20X1
$ $
Fully paid ordinary shares
Total

(b) Issued ordinary shares

20X2 20X1
Balance at 1 January 2 042 367 2 042 367
Issue of/(redemption of) shares — —
Balance at 31 December 2 042 367 2 042 367

(c) Terms and conditions of issued capital

Ordinary shares have the right to receive dividends as declared and, in the event of winding up the
Company, to participate in the proceeds from the sale of all surplus assets in proportion to the number
of and amounts paid up on shares held.
Ordinary shares entitle their holder to one vote, either in person or by proxy, at a meeting of the
Company. None of the ordinary shares on issue are held in escrow.

17. Statement of Cash Flows

(a) Reconciliation of cash
In the statement of cash flows, the balance of cash and cash equivalents includes cash on hand, cash
deposits in banks, investments in money market instruments with terms of less than 90 days, and is net
of outstanding bank overdrafts.
Cash and cash equivalents at the end of the year as shown in the statement of cash flows is reconciled
to the related items in the statement of financial position as follows.
20X2 20X1
Notes $ $
Cash at bank and on hand 6
Bank overdraft 13

APPENDIX 425
(b) Reconciliation of net profit after income tax to net cash flows from operating activities
20X2 20X1
$ $
Net profit after income tax

Non-operating items
Interest revenue

Non-cash items
Depreciation expense
Loss on sale of non-current assets
Doubtful debts

Changes in assets and liabilities

(Increase)/decrease in assets
— Trade and other receivables
— Other assets
— Deferred tax assets

Increase/(decrease) in liabilities
— Trade and other payables
— Contract liability
— Income tax payable
— Employee benefits liability
Net cash flows from operations

18. Subsequent Events

Other than disclosed above and elsewhere in the financial statements of the Company, no other matter
or circumstances has arisen since the end of the financial year that has significantly affected or may
significantly affect the operations, results or state of the Company.

19. Contingent Liabilities

The Company has no contingent liabilities as at 31 December 20X2 (20X1: nil).

20. Financial Instruments

The Company is exposed to a variety of financial risks through its use of financial instruments. The
Company’s objectives, policies and processes for managing and measuring these risks are set out below.
(a) Risk management framework
The Company’s overall risk management plan seeks to minimise potential adverse effects due to the
unpredictability of financial markets.
(i) Significant financial risks
The Company does not actively engage in the trading of financial assets for speculative purposes
nor does it write options. The most significant financial risks which the Company is exposed to
are described below.
Risk management
framework Interest rate risk Credit risk Liquidity risk

Exposure arising Long-term borrowings at Cash and cash Borrowing and other
from variable rates equivalents; trade liabilities
and other receivables

Measurement Sensitivity analysis Ageing analysis; credit Credit limits and

ratings retention of title over
goods sold

Management Interest rate swaps (where Rolling cash flow Availability of committed
exposure exceeds pre- forecasts credit lines and
specified limit) borrowing facilities

These were not required in

the current or previous year

426 APPENDIX
 (ii) Objectives, policies and processes
The risk management policies of the Company seek to mitigate the above risks and reduce
volatility on the financial performance of the Company. Financial risk management is carried
out centrally by the Finance Department of the Company.
(iii) Capital risk management
The Company manages its capital to ensure that the Company will be able to continue as a going
concern while maximising the return to stakeholders through the optimisation of the debt and
equity balance.
In order to maintain or adjust the capital structure, the Company may pay dividends to
shareholders, return capital to shareholders, issue new shares or sell assets to reduce debt. None
of these, however, occurred during the years ended 31 December 20X1 or 20X2.
The Company’s Board of Directors reviews the capital structure on a quarterly basis, and as
part of this process the board considers the cost of capital and the risks associated with it. Based
on recommendations of the board, the Company will balance its overall capital structure through
the payment of dividends, new share issues and share buy-backs as well as the issue of new debt
or the redemption of existing debt.
The Company is not subject to any financial covenants.
(b) Interest rate risk
Interest rate risk refers to the risk that the value of a financial instrument or cash flows associated with
the instrument will fluctuate due to changes in market interest rates.
The Company’s borrowings, which have a variable interest rate attached, give rise to cash flow
interest rate risk. Interest rates are as follows.
20X2 20X1
Interest rate
From–to From–to
Australian dollar interest rates % %
Financial assets
Cash and cash equivalents

Financial liabilities
Borrowings

A sensitivity of 0.5% increase and 0.25% decrease in interest rates is considered reasonably possible
given current economic indicators. The impact on profitability of these changes would be as follows.
20X2 — impact on profit/equity
+0.5% –0.25%
Cash
Borrowings

In 20X2, there was no reasonably possible movement that would cause a material impact on profit.
Lease liabilities are subject to fixed interest rates.
(c) Credit risk
Credit risk refers to the risk that a counterparty will default on its contractual obligations resulting
in financial loss to the Company. The Company has a policy of only dealing with creditworthy
counterparties and obtaining collateral or other security where appropriate, as a means of mitigating
the risk of financial loss from defaults. The Company measures credit risk on a fair value basis. This
strategy is consistent with the prior year.
The Company does not have any significant credit risk exposure to any single counterparty or any
counterparties having similar characteristics, given the number and diversity of debtors. For trade
receivables, the Company has applied the simplified approach to measure the loss allowance at lifetime
expected credit losses.
The Company manages credit risk using procedures and policies which:
• assess each application on the merits of the customer
• implement prompt follow up when payment of an account is missed.
The maximum exposure to credit risk is the carrying value of trade receivables as disclosed in
Note 7.

APPENDIX 427
(d) Liquidity risk analysis
Liquidity risk arises from the Company’s management of working capital and the finance charges and
principal repayments on its debt instruments. It is the risk that the Company will encounter difficulty
in meeting its financial obligations as they fall due including the risk it:
• will not have the funds necessary to settle a transaction on the due date
• will be forced to sell financial assets at a value which is less than what they are worth
• may be unable to settle or recover a financial asset at all.
To help reduce these risks, the Company relies on operating cash flow and long-term financing
options, such as leases, to fund working capital and investment in non-current assets. The ratio of
current borrowings to current debtors is low. The Company’s strategy is consistent with the prior year.
Amounts presented below represent the future undiscounted principal and interest cash flows.
Interest
rate < 1 year 1–5 years > 5 years Total
20X2 % $ $ $ $
Financial liabilities
Borrowings 7
Trade and other
payables n/a
Lease liabilities 6
Total financial liabilities

Interest
rate < 1 year 1–5 years > 5 years Total
20X1 % $ $ $ $
Financial liabilities
Borrowings 7.5
Trade and other
payables n/a
Lease liabilities 6
Total financial liabilities

The above contractual maturities reflect the gross cash flows, which may differ to the carrying values
of the liabilities at the reporting date.
Liquidity risk associated with cash at bank and non–interest bearing receivables and payables is
represented by the carrying amounts as shown in the statement of financial position.

21. Auditor’s Remuneration

Auditor’s remuneration consists of the following.
20X2 20X1
$ $
Amounts received or due and receivable by the auditors for:
Auditing the financial statements of the Company
Total remuneration of auditor

22. Related Party Transactions

(a) Key management personnel remuneration
20X2 20X1
$ $
The key management personnel compensation included in
‘employee expenses’ are as follows.
Short-term employee benefits
Other long-term benefits
Post-employment benefits
Termination benefits
Share based payments

428 APPENDIX
(b) Loans to key management personnel
20X2 20X1
$ $
Loans made to key management personnel
Loans repaid by key management personnel
Loan balance outstanding at year end

Terms and conditions:

A short-term loan totalling $20 000 (20X1: $nil) was made to a member of the key management personnel
during the year. The loan was repaid in full prior to 31 December 20X2.
For all loans to key management that extend beyond 12 months, interest is payable at prevailing market
rates, currently 7% (20X1: n/a%). The principal amounts are generally repayable over 3–5 years. All loans
are secured by registered first mortgage over the borrower’s residences.
Interest received on the loans totalled $nil (20X1: $nil).
(c) Key management personnel equity holdings
None of the key management personnel hold any securities in the company.
(d) Other transactions with key management personnel
There were no other transactions with key management personnel or their related entities.
(e) Transactions with other related parties
Brookfield is a related party because it holds shares in the Company that give it significant influence.
Brookfield provides advertising services to the Company at market rates.
20X2 20X1
$ $
Expense during the year
Services purchased from Brookfield Ltd

Outstanding balance of payable at reporting date

Services purchased from Brookfield Ltd

23. Capital Expenditure Commitments

The Company is refurbishing its offices and has signed a contract at 31 December 20X2 for an external
firm to manage and perform the refurbishment works. The works are due to be completed over a two-year
period and instalments will be paid equally over this period. The total value of the contract is $200 000.

Suggested solution: Completed Financial

Statements — Techworks Ltd
Statement of profit or loss and other comprehensive income
for the year ended 31 December 20X2
20X2 20X1
Notes $ $
Income
Revenue from continuing operations 2 5 842 999 5 493 282
Interest revenue 60 000 31 250
5 902 999 5 524 532
Expenses from operating activities
Employee costs 3 (3 044 736) (2 516 331)
Advertising and marketing costs (553 154) (470 523)
Occupancy costs (29 875) (197 528)
Legal and professional costs (250 011) (247 109)
Administration and other (120 114) (122 833)
Impairment loss on trade receivables (131 061) (12 070)
Depreciation and amortisation 3 (253 484) (88 141)

APPENDIX 429
 20X2 20X1
Notes $ $
Loss on sale of non-current assets 3 (69 194) —
Finance costs 3 (154 993) (75 717)
Profit before income tax 1 296 377 1 794 280
Less: Income tax/(expense) 5 (468 746) (557 642)
Profit after tax from continuing operations 827 631 1 236 638
Other comprehensive income (net of tax) — —
827 631 1 236 638
Total comprehensive income for the period
attributable to members of Techworks Ltd 827 631 1 236 638

The statement of profit or loss and other comprehensive income is to be read in conjunction with the
attached notes.
Statement of financial position
as at 31 December 20X2
20X2 20X1
Notes $ $
ASSETS
Current assets
Cash and cash equivalents 6 1 468 699 683 659
Trade and other receivables 7 6 337 701 6 400 833
Other current assets 8 74 451 80 760
Total current assets 7 880 851 7 165 252

Non-current assets
Property, plant and equipment 9 1 862 114 939 798
Intangible assets 10 228 273 103 000
Deferred tax assets 5(c) 543 375 594 968
Total non-current assets 2 633 762 1 637 766
Total assets 10 514 613 8 803 018

LIABILITIES
Current liabilities
Trade and other payables 11 996 320 1 606 433
Borrowings 13 900 000 900 000
Lease liabilities 15 258 724 57 113
Contract liability 14 1 155 944 995 224
Current tax payable 559 771 241 967
Employee benefits 12 522 210 500 283
Total current liabilities 4 392 969 4 301 020
Non-current liabilities
Lease liabilities 15 1 008 563 200 850
Employee benefits 12 68 072 61 623
Total non-current liabilities 1 076 635 262 473
Total liabilities 5 469 604 4 563 493
Net assets 5 045 009 4 239 525

SHAREHOLDERS’ EQUITY
Issued capital 16 2 042 367 2 042 367
Retained earnings 3 002 642 2 197 158
Total shareholders’ equity 5 045 009 4 239 525

The statement of financial position is to be read in conjunction with the attached notes.

430 APPENDIX
 Statement of changes in equity
for the year ended 31 December 20X2
Attributable to equity holders of Techworks
Issued Retained
capital earnings Total
$ $ $
At 1 January 20X1 2 042 367 960 520 3 002 887
Total comprehensive income for the year — 1 236 638 1 236 638
Closing balance as at 31 December 20X1 2 042 367 2 197 158 4 239 525

At 1 January 20X2 2 042 367 2 197 158 4 239 525

Adjustment for initial application of IFRS 16 — (22 147) (22 147)
Total comprehensive income for the year — 827 631 827 631
Closing balance as at 31 December 20X2 2 042 367 3 002 642 5 045 009

The statement of changes in equity is to be read in conjunction with the attached notes.
Statement of cash flows
for the year ended 31 December 20X2
20X2 20X11
Notes $ $
Cash flows from operating activities
Cash receipts from customers 5 935 790
Cash paid to suppliers and employees (4 573 318)
Cash generated from operations 1 362 472
Interest paid (154 993)
Income taxes paid (99 349)
Net cash flows from operating activities 17(b) 1 108 130
Cash flows from investing activities
Proceeds from sale of property, plant and equipment 195 000
Proceeds on settlement of KMP loan 20 000
Purchase of intangible assets (125 273)
Purchase of property, plant and equipment (192 119)
Payment for origination of KMP loan (20 000)
Interest received 60 000
Net cash used in investing activities (62 392)

Cash flows from financing activities

Payment of lease liabilities (260 698)
Net cash used in financing activities (260 698)

Net increase in cash and cash equivalents held 785 040

Cash and cash equivalents at the beginning of the year 17(a) (216 341)

Cash and cash equivalents at end of the year 17(a) 568 699

1 Insufficient information is provided to complete the comparative statement of cash flows for 20X1.

The statement of cash flows is to be read in conjunction with the attached notes.

APPENDIX 431
Suggested Solution: Notes to the Financial Statements
Note Contents
1 Summary of significant accounting policies
2 Income
3 Expenses included in net profit from continuing operations
4 Franking credits*
5 Income tax
6 Cash and cash equivalents
7 Trade and other receivables
8 Other current assets
9 Property, plant and equipment
10 Intangible assets
11 Trade and other payables
12 Employee benefits liabilities
13 Borrowings
14 Contract liability
15 Lease liabilities
16 Issued capital
17 Statement of cash flows
18 Subsequent events
19 Contingent liabilities
20 Financial instruments
21 Auditor’s remuneration*
22 Related party disclosures
23 Capital expenditure commitments
* Australian specific terminology/disclosure note.

Notes to the financial statements

For the year ended 31 December 20X2
1. Summary of Significant Accounting Policies
(a) Nature of operations
Techworks is a for-profit entity. The principal activities of the Company are:
• consulting services for the design of information technology (IT) systems, telecommunication
systems strategies, and IT security
• IT outsourcing services including for payroll and accounts payable transaction processing.
The Company operates in Australia and provides its services primarily to small- and medium-sized
enterprises (SMEs).
(b) Statement of compliance
Techworks is a limited liability company incorporated and domiciled in Australia. The address of its
registered office and its principal place of business is Level 2, 635 Sedgefield Road, Acklam, Central
Australia, 9000.
The financial statements are general purpose financial statements that have been prepared in
accordance with the requirements of the Corporations Act 2001, Australian Accounting Standards
and other authoritative pronouncements of the Australian Accounting Standards Board (AASB).
The Company has elected to apply Tier 1 reporting requirements in preparing general purpose
financial statements in accordance with AASB 1053 Application of Tiers of Australian Accounting
Standards. The Company’s compliance with Australian Accounting Standards therefore results in full
compliance with the International Financial Reporting Standards (IFRSs) as issued by the International
Accounting Standards Board (IASB).
The financial statements were authorised for issue by the Board of Directors of Techworks at a
directors’ meeting on 4 April 20X3.
(c) Basis of preparation
(i) Presentation
The financial statements are presented in Australian dollars which is the company’s functional
currency. Amounts disclosed relate to the company unless otherwise stated. The financial
statements have been prepared on an accrual basis and under the historical cost convention.
When required by accounting standards, comparative figures have been adjusted to conform to
changes in presentation for the current financial year.

432 APPENDIX
(ii) New standards adopted
The Company adopted IFRS 16 ‘Leases’ effective 1 January 20X2. IFRS 16 Leases replaces
IAS 17 Leases together with three Interpretations: IFRIC Interpretation 4 Determining whether
an Arrangement contains a Lease; SIC Interpretation 15 Operating Leases — Incentives; and SIC
Interpretation 127 Evaluating the Substance of Transactions Involving the Legal Form of a Lease.
The adoption of IFRS 16 has resulted in the Company recognising right-to-use assets and
related lease liabilities in respect of office building leases formerly classified as operating leases.
IFRS 16 has been applied to the office building leases by recognising the cumulative effect of
applying the standard for the first time as an adjustment to the opening balance of retained earnings
for the current period. The prior period comparative has not been restated.
The Company elected not to include initial direct costs in the initial measurement of the right-
of-use asset for office building leases in existence at the date of initial application. The Company
also elected to measure the right-of-use assets at an amount equal to the lease liability adjusted
for any prepaid or accrued lease payments that existed at that date.
Instead of performing an impairment review on the right-of-use assets at the date of initial
application, the Company has relied on its historic assessment as to whether leases were onerous
immediately before the date of initial application of IFRS 16.
The right-of-use asset and lease liability for the Company’s motor vehicle leases, which were
previously classified as finance leases, has been measured at the date of initial application using
the same amounts as under IAS 17 immediately beforehand.
The weighted average incremental borrowing rate applied to office building lease liabilities
recognised on initial application of IFRS 16 was 6.5%.
The following is a reconciliation of the financial statement line items from IAS 17 to IFRS 16
at 1 January 20X2.
Property,
plant and Lease Retained
equipment liabilities earnings
$ $ $
Carrying amount at 31 December 20X1 939 798 257 963 2 197 158
Reclassification of office building leases 735 350 757 497 (22 147)
Carrying amount at 1 January 20X2 1 675 148 1 015 460 2 175 011

The following is a reconciliation of the total operating lease commitments for office buildings
at 31 December 20X1 to the lease liabilities for office buildings recognised at 1 January 20X2.
$
Total operating lease commitments for office buildings disclosed at 31 December 20X1 911 400
Discounted using the incremental borrowing rate (153 903)
Finance leases for motor vehicles at 31 December 20X1 257 963
Total lease liabilities recognised under IFRS 16 at 1 January 20X2 1 015 460

(iii) Amended standards adopted

The Company adopted revised accounting standards and amendments effective at the beginning
of the current year as follows.
• IFRIC Interpretation 23 Uncertainty over Income Tax Treatments
• IASB ‘Annual Improvements to IFRS Standards 2015–2017 Cycle’
These amended standards do not have a material impact on the financial statements.
(iv) Amended standards not yet effective and not adopted early
The Company has not early adopted revised accounting standards and amendments that are not
effective at the beginning of the current year as follows.
• IASB ‘Definition of a Business (Amendments to IFRS 3)’
• IASB ‘Definition of Material (Amendments to IAS 1 and IAS 8)’
• IASB ‘Amendments to References to the Conceptual Framework in IFRS Standards’
In the next financial year, these amendments will be adopted for the first time but are not
expected to have material impact on the financial statements.

APPENDIX 433
(d) Significant management judgements in applying accounting policies
When preparing the financial statements, management is required to make judgments, estimates and
assumptions about the recognition and measurement of assets, liabilities, income and expenses. The
estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting
estimates are recognised in the period in which the estimate is revised if the revision affects only
that period or in the period of the revision and future periods.
The management judgments and information about estimates and assumptions that may have the
most significant effect on the financial statements are set out below. The estimates and assumptions
are based on historical experience and various other factors that are believed to be reasonable under the
circumstance, the results of which form the basis of making the judgments. Actual results may differ
substantially from estimates.
(i) Recognition of consulting service revenues
Consulting service revenues are recognised over time and the amount of revenue recognised in the
reporting period depends on management judgment of the extent to which performance obligations
have been met.
(ii) Capitalisation of internally developed software
Management judgment is exercised to determine the research and development phases of a
customised software project and whether the recognition requirements for the capitalisation of
development costs are met. Management monitors whether the recognition requirements continue
to be met after capitalisation and whether there are any indicators that capitalised costs may
be impaired.
(iii) Recognition of deferred tax assets
The extent to which deferred tax assets are recognised is based on management’s assessment of
the probability that future taxable income will be available against which deductible temporary
differences and carried forward tax losses can be utilised.
(iv) Impairment of financial assets
Trade receivables include amounts receivable from debtors who have fallen outside their payment
terms. Trade receivables are measured after an allowance that reflects the management’s best
estimate of uncollectible debts. The measurement of the allowance is based on an ageing analysis
that incorporates the Company’s previous experience of the realisation of customer debts.
(v) Impairment of non-financial assets
When there is an indication of impairment, management estimates the recoverable amount of each
asset or cash-generating unit based on expected future cash flows and an appropriate risk-adjusted
discount rate. Assumptions about future operating results and the determination of discount rates
involve estimation uncertainty.
(vi) Useful lives of depreciable assets
Management reviews its estimate of the useful lives of depreciable assets at each reporting date,
based on the expected utility of the assets. Uncertainties in these estimates relate to technological
obsolescence that may change the utility of certain software and IT equipment.
(e) Significant accounting policies
The following significant accounting policies have been adopted in the preparation and presentation
of the financial statements. The accounting policies are consistent with those applied in the prior year,
except the accounting for leases.
(i) Revenue
Revenue arises from the provision of services, which are earned from providing software- and
hardware-related services, including consulting. In determining whether to recognise revenue, the
Company follows a 5-step process as follows.
• Step 1: Identifying the contract with a custom
• Step 2: Identifying the performance obligation
• Step 3: Determining the transaction price
• Step 4: Allocating the transaction price to the performance obligations
• Step 5: Recognising revenue when/as performance obligation(s) are satisfied
Revenue from the rendering of consulting services is recognised over time as the Company
satisfies the performance obligations by transferring the promised services to customers. The
Company invoices customers monthly as work progresses. Any amounts that remain unbilled to
consulting service customers at the end of the financial year are presented in the statement of

434 APPENDIX
 financial position as accounts receivable because performance obligations have been met and only
the passage of time is required before the receipt of amounts will be due.
The Company recognises contract liabilities for consideration received from consulting services
customers in respect of unsatisfied performance obligations and reports the amount outstanding at
financial year end in the statement of financial position.
The Company also generates revenue from providing IT outsourcing services to customers in
exchange for a fixed monthly fee. This revenue is recognised on a straight-line basis over the term
of each contract. As the amount of work required to perform under these contracts does not vary
significantly from month-to-month, the straight-line method presents a faithful depiction of the
transfer of the services.
(ii) Interest revenue
Interest revenue is recognised on an accrual basis using the effective interest method.
(iii) Operating expenses
Operating expenses are recognised in profit or loss upon utilisation of the service or at the date
of their origin. Employee costs include payroll tax and superannuation contributions made by the
Company to the employees’ nominated superannuation funds.
(iv) Borrowing costs
Borrowing costs that are directly attributable to the acquisition or production of a qualifying asset
are capitalised as part of the cost of that asset until such time that the asset is ready for its intended
use. All other borrowing costs are recognised as an expense in the period in which they are incurred
and reported as finance costs in the statement of profit or loss and other comprehensive income. The
Company treats the finance costs paid as operating cash flows.
(v) Income tax
Income tax expense is recognised in profit or loss and comprises the sum of current tax and deferred
tax not recognised in other comprehensive income or directly in equity.
Current tax is calculated by reference to the amount of income taxes payable or recoverable
in respect of the taxable profit or loss for the period, which differs from profit or loss in the
financial statements. Current tax is calculated using tax rates and tax laws that have been enacted or
substantively enacted by the end of the reporting period. The current tax liability represents those
obligations to the Australian Taxation Office (ATO) and other fiscal authorities relating to the current
or prior reporting periods that are unpaid at the reporting date.
Deferred tax is calculated using the liability method on temporary differences between the
carrying amounts of assets and liabilities and their tax bases. Changes in deferred tax assets or
liabilities are recognised as a component of tax income or expense in profit or loss, except where
they relate to items that are recognised in other comprehensive income or directly in equity, in
which case the related deferred tax is also recognised in other comprehensive income or equity,
respectively.
Deferred tax assets are recognised to the extent that it is probable that they will be able to be
utilised against future taxable income, based on the Company’s forecast of future operating results,
which is adjusted for significant non-taxable income and expenses and specific limits to the use of
any unused tax loss or credit.
Deferred tax assets and liabilities are calculated, without discounting, at tax rates that are expected
to apply to their respective period of realisation, provided they are enacted or substantively enacted
by the end of the reporting period.
Deferred tax assets and liabilities are offset only when the Company has a right and intention to
set off current tax assets and liabilities from the same taxation authority.
(vi) Cash and cash equivalents
Cash and cash equivalents comprise cash at bank and in hand and short-term deposits with an original
maturity of three months or less, which are convertible to known amounts of cash and are subject
to an insignificant risk of change in value. Bank overdrafts form an integral part of the Company’s
cash management function and are included as a component of cash and cash equivalents shown in
the statement of cash flows.
(vii) Trade receivables
Trade receivables are recognised when the Company satisfies performance obligations by
transferring promised services to customers. Trade receivables do not contain a significant
financing component and are initially measured at the transaction price in accordance with
IFRS 15 Revenue from Contracts with Customers. Trade receivables are subsequently measured

APPENDIX 435
 at amortised cost because they are held within a business model where the objective is to collect
the contractual cash flows. No interest is charged to trade receivables. The effect of discounting is
omitted because it is immaterial.
The Company uses a simplified approach in accounting for the loss allowance on trade receiv-
ables. The allowance is recorded at an amount equal to the expected lifetime credit losses based on
historical experience, external indicators and forward-looking information. The Company assesses
impairment of trade receivables on a collective basis as they possess credit risk characteristics based
on the days past due. The Company allows 2% for amounts that are 30 to 60 days past due, 4% for
amounts that are between 60 and 90 days past due, and 6% for amounts more than 90 days past due.
Trade receivables are written off when there is no reasonable expectation of recovery. In this
regard, the Company writes off any amounts that are more than 180 days past due if the customer
fails to engage on making alternative payment arrangements for their debt.
Adjustments made to the carrying amount of the allowance account for impairment are recognised
in profit or loss. When a trade receivable is deemed uncollectible, it is written off against the
allowance account. Subsequent recoveries of amounts previously written off are credited against
the allowance account. In a subsequent period, if the amount of the impairment loss decreases
and the decrease can be related objectively to an event occurring after the impairment was
recognised, the previously recognised impairment loss is reversed through profit or loss.
(viii) Internally developed software
Expenditure on the research phase of projects to develop new customised software for IT and
telecommunication systems is recognised as an expense as incurred.
Costs that are directly attributable to a project’s development phase are recognised as intangible
assets, provided they meet the following recognition requirements.
• The development costs can be measured reliably.
• The project is technically and commercially feasible.
• The Company intends to complete the project and has the resources to do so.
• The Company has the capability to use or sell the software.
• The software will generate probable future economic benefits.
Development costs not meeting the above criteria for capitalisation are expensed as incurred.
Directly attributable costs include employee costs incurred on software development together with
an appropriate portion of relevant overheads and borrowing costs.
Internally generated software recognised as an intangible asset that is in use is amortised over its
useful life ranging from 3–5 years. Internally generated software recognised as an intangible asset
that is not yet complete or ready for use is not amortised, but is subject to impairment testing as
described below.
(ix) Plant and equipment
The Company’s property, plant and equipment is comprised of IT equipment, fittings, furniture,
motor vehicles and of right-of-use assets for office buildings motor vehicles.
Items of property, plant and equipment are initially recognised at acquisition cost including any
costs directly attributable to bringing the assets to the location and condition necessary for them to
be capable of operating in the manner intended by management.
Items of property, plant and equipment are subsequently measured at cost less accumulated
depreciation and impairment losses.
Depreciation is recognised on a straight-line basis to write down the cost less estimated
residual value. The following depreciation rates are used in the calculation of depreciation of
plant and equipment.
• IT equipment: 2–5 years
• Fittings and furniture: 3–12 years
• Motor vehicles owned: 3–5 years
• Motor vehicles leased: 3–6 years
• Office buildings leased: 5 years
The estimated useful lives, residual values and depreciation method are reviewed at the end of
each reporting period.
An item of property, plant and equipment is derecognised upon disposal or when no further future
economic benefits are expected from its use or disposal. Gain or losses arising on the disposal of
property, plant and equipment are determined as the difference between the disposal proceeds and

436 APPENDIX
 the carrying amount of the assets. The gains or losses are recognised in profit or loss within other
income or expenses respectively.
(x) Right-of-use assets
The Company’s lease agreements for office buildings and motor vehicles qualify as leases as defined
in IFRS 16 because the:
• contracts contain an identified motor vehicle that is explicitly identified
• Company has the right to obtain substantially all the economic benefits from use of the identified
motor vehicle throughout the period of use.
• Company has the right to direct the use of the identified motor vehicle throughout the period
of use.
At the lease commencement date, the Company recognises a right-of-use asset and a lease liability
on the statement of financial position.
The right-of-use asset is measured at cost, which is made up of the initial measurement of the
lease liability, any initial direct costs incurred and any lease payments made in advance of the lease
commencement date (net of any incentives received).
The Company depreciates the right-of-use assets on a straight-line basis from the lease com-
mencement date to the end of the lease term.
At the commencement date, the Company measures the lease liability at the present value of the
lease payments unpaid at that date, discounted using the interest rate implicit in the lease.
Lease payments included in the measurement of the lease liability are made up of fixed payments,
amounts expected to be payable under a residual value guarantee and payments arising from options
reasonably certain to be exercised.
Subsequent to initial measurement, the liability is reduced for payments made and increased for
interest. It is remeasured to reflect any reassessment or modification, or if there are changes in in-
substance fixed payments.
When the lease liability is remeasured, the corresponding adjustment is reflected in the right-of-
use asset, or profit or loss if the right-of-use asset is already reduced to zero.
In the statement of financial position, right-of-use assets have been included in property, plant
and equipment and lease liabilities have been included in trade and other payables.
(xi) Impairment testing of non-financial assets
At the end of each reporting period, the Company reviews the carrying amounts of its tangible and
intangible assets, including right-of-use assets, to determine whether there is any indication that
those assets have suffered an impairment loss.
If any indication of impairment exists, the recoverable amount of the asset is estimated in order
to determine the extent of the impairment loss (if any). Where the asset does not generate cash
flows that are independent from other assets, the Company estimates the recoverable amount of the
cash-generating unit to which the asset belongs.
Intangible assets not yet available for use are tested for impairment annually and wherever there
is an indication that the assets may be impaired.
(xii) Trade and other payables
Trade and other payables are recognised when the Company becomes obliged to make future
payments resulting from the purchase of goods and services. The amounts are unsecured and are
usually paid within 30 days of recognition.
(xiii) Employee benefits liability
Short-term employee benefits are benefits, other than termination benefits, that are expected to be
settled wholly within 12 months after the end of the period in which the employees render the
related service. Examples of such benefits include wages and salaries, non-monetary benefits and
accumulating sick leave. Short-term employee benefits are measured at the undiscounted amounts
expected to be paid when the liabilities are settled.
Long-term employee benefits are benefits for annual leave and long service leave that are not
expected to be settled wholly within 12 months after the end of the period in which the employees
render the related service. They are measured at the present value of the expected future payments
to be made to employees. The expected future payments incorporate anticipated future wage and
salary levels, experience of employee departures and periods of service, and are discounted at
rates determined by reference to market yields at the end of the reporting period on high-quality
corporate bonds that have maturity dates that approximate the timing of the estimated future cash

APPENDIX 437
 outflows. Any re-measurements arising from experience adjustments and changes in assumptions
are recognised in profit or loss in the periods in which the changes occur.
The Company presents employee benefit obligations as current liabilities in the statement
of financial position if it does not have an unconditional right to defer settlement for at least
12 months after the reporting period, irrespective of when the actual settlement is expected to
take place.
(xiv) Borrowings
Borrowings are initially measured at fair value, net of transaction costs. Borrowings are subsequently
measured at amortised cost using the effective interest method, with interest expense recognised on
an effective yield basis.
(xv) Equity and reserves
Share capital is recognised at the fair value of the consideration received by the Company for
ordinary shares issued. Transaction costs arising on the issue of ordinary shares are recognised
directly in equity as a deduction from share capital net of any related income tax benefits.
Retained earnings includes all current and prior period profits less dividend distributions to
ordinary shareholders.
2. Income
(a) Revenue from services
Revenue from services consists of the following:
20X2 20X1
$ $
Consulting services transferred over time 5 094 595 4 955 449
Fixed monthly fees from IT outsourcing 748 404 537 833
Total services revenue 5 842 999 5 493 282

Consulting services revenue for 20X2 includes $943 127 (20X1: $687 724) that was recognised in
the contract liability balance at the beginning of the financial year.
The following aggregated amounts of transaction prices relate to performance obligations from
existing contracts that are unsatisfied or partially unsatisfied as at 31 December 20X2.
2021 2020 Total
$ $ $
Revenue expected to be recognised 121 110 458 120 579 230

(b) Finance income

Finance income consists of the following.
20X2 20X1
$ $
Interest revenue:
Financial instruments measured at amortised cost:
— Bank deposits 60 000 31 250
Total finance income 60 000 31 250

3. Expenses Included in Net Profit From Continuing Operations

20X2 20X1
$ $
Net profit before income tax includes the following specific expenses.

Employee benefits expense

Salary and wages expense 1 787 368 1 938 525
Contributed superannuation 691 521 446 461
Other employment costs 565 847 131 345
Total employment costs 3 044 736 2 516 331

438 APPENDIX
 Depreciation of plant and equipment
Right-of-use assets for office buildings 147 070 —
Right-of-use assets for motor vehicles 65 677 32 478
Motor vehicles owned 21 952 54 512
Equipment, fittings and furniture 18 785 1 151
Total depreciation 253 484 88 141

Occupancy costs
Rent — 171 041
Electricity 29 875 26 487
Total occupancy costs 29 875 197 528

Finance costs
Interest on bank overdrafts and loans* 74 936 68 939
Interest expense on lease liabilities 80 057 6 778
Total finance costs 154 993 75 717

(Gain)/loss on disposal of assets 69 194 —

* The weighted average interest rate on funds borrowed generally is 5.8% p.a. (20X1: 6.6% p.a.).

4. Franking Credits
The Company’s payment of income tax generates franking credits that are available for future dividend
distributions.
20X2 20X1
$ $
Balance of dividend franking account 1 047 878 789 104

5. Income Tax
(a) Income tax expense
The major components of tax expense are as follows.
20X2 20X1
$ $
Current tax expense 417 153 615 307
Deferred tax expense/(income) related to the origination and reversal of
temporary differences 51 593 (57 665)
Total income tax expense in the statement of profit or loss and other
comprehensive income 468 746 557 642

(b) Reconciliation of the expected tax expense based on pre-tax accounting profit from operations
and the reported tax expense in profit or loss
20X2 20X1
$ $
Profit from continuing operations before income tax expense 1 296 377 1 794 280
Income tax calculated at 30% (20X1: 30%) 388 913 538 284
Add/(less): Non-deductible expenses 79 833 19 358
Income tax expense 468 746 557 642

The tax rate used in the above reconciliation is the corporate tax rate of 30% payable by Australian
corporate entities on taxable profits under Australian tax law. There has been no change in the corporate
tax rate when compared with the previous reporting period.

APPENDIX 439
(c) Deferred tax assets/(liabilities)
Deferred taxes arising from temporary differences are summarised as follows.
Deferred tax assets/(liabilities) 20X2 20X1
$ $
Trade receivables 186 011 146 693
Property, plant and equipment (107 110) (1 230)
Capitalised computer software (68 482) (30 900)
Contract liability 346 783 298 567
Employee benefits liability 177 085 168 572
Other temporary differences 9 088 13 266
543 375 594 968

There are no unused tax losses and no unrecognised temporary differences.

6. Cash and Cash Equivalents

Cash and cash equivalents consist of the following.
20X2 20X1
$ $
Cash at bank and on hand 1 458 699 673 659
Term deposits 10 000 10 000
1 468 699 683 659

The effective interest rate on cash deposits was 5% (20X1: 5%); these deposits have no maturity date as
they are held in an interest-bearing cheque account.

7. Trade and Other Receivables

Trade and other receivables consist of the following.
20X2 20X1
$ $
Current
Trade receivables 6 957 738 6 889 809
Less: Allowance for credit losses (620 037) (488 976)
6 337 701 6 400 833

All amounts are short-term. The carrying amount of trade receivables is a reasonable approximation of
their fair value.
The closing balance of the loss allowance for trade and other receivables as at the end of the year
reconciles with the opening balance as follows.
20X2 20X1
$ $
Loss allowance as at 1 January 488 976 476 906
Add: Loss allowance recognised during the year 131 061 12 070
Less: Receivables written off during the year — —
Loss allowance as at 31 December 620 037 488 976

The expected credit loss for trade and other receivables as at 31 December 20X2 and 31 December 20X1
has been determined as follows.

More than More than More than

31 December 20X2 Current 30 days 60 days 90 days Total
$ $ $ $ $
Expected credit loss rate 4% 8% 20% 67%
Gross carrying amount 4 526 845 1 254 686 956 320 219 887 6 957 738
Lifetime expected credit loss 181 074 100 375 191 264 147 324 620 037

440 APPENDIX
 More than More than More than
31 December 20X1 Current 30 days 60 days 90 days Total
$ $ $ $ $
Expected credit loss rate 4% 8% 20% 67%
Gross carrying amount 4 858 661 1 252 684 696 077 82 387 6 889 809
Lifetime expected credit loss 194 346 100 215 139 215 55 199 488 976

8. Other Current Assets

Other current assets consist of the following.
20X2 20X1
$ $
Prepayments 74 451 80 760
74 451 80 760

9. Property, Plant and Equipment

Property, plant and equipment consists of the following.
Right-of- Right-of- Equipment,
use office use motor Motor furniture
20X2 buildings vehicles vehicles and fittings Total
$ $ $ $
Gross carrying amount
Balance at 1 January 20X2 735 350 386 888 598 583 72 185 1 793 006
Additions — 512 525 74 400 117 719 704 644
Disposals — (166 556) (182 926) — (349 482)
Balance at 31 December 20X2 735 350 732 857 490 057 189 904 2 148 168

Accumulated depreciation
Balance at 1 January 20X2 — 57 925 58 782 1 151 117 858
Depreciation expense 147 070 65 677 21 952 18 785 253 484
Disposals — (56 626) (28 662) — (85 288)
Balance at 31 December 20X2 147 070 66 976 52 072 19 936 286 054

Net carrying amount

As at 31 December 20X2 588 280 665 881 437 985 169 968 1 862 114

Right-of- Right-of- Furniture,

use office use motor Motor equipment
20X1 buildings vehicles vehicles and fittings Total
$ $ $ $ $
Gross carrying amount
Balance at 1 January 20X1 — 302 987 76 528 — 379 515
Additions — 83 901 522 055 72 185 678 141
Balance at 31 December 20X1 — 386 888 598 583 72 185 1 057 656

Accumulated depreciation
Balance at 1 January 20X1 — 25 447 4 270 — 29 717
Depreciation expense — 32 478 54 512 1 151 88 141
Balance at 31 December 20X1 — 57 925 58 782 1 151 117 858

Net carrying amount

As at 31 December 20X1 — 328 963 539 801 71 034 939 798

The carrying value of leased property, plant and equipment at 31 December 20X2 is $1 254 161 (20X1:
$328 963). Additions during the year include $512 525 (20X1: $83 901) of leased plant and equipment.
Leased motor vehicles are pledged as security for the related lease liabilities.

APPENDIX 441
10. Intangible Assets
Intangible assets consist of the following.
20X2 20X1
$ $
Computer software 228 273 103 000
Total intangible assets 228 273 103 000

The computer software is purchased as part of a system upgrade and is still under development. It is
expected to be completed by December 2020 and amortisation will commence during this period also. As
the asset was not in use during 20X1 and 20X2, the only movement has been additions.
An impairment test has been performed during the year and, based on the expected net cash inflows
from the software, there is no impairment loss. Sensitivity analysis on the assumptions used have shown
that there is no reasonably possible movement that would cause an impairment loss.

11. Trade and Other Payables

Trade and other payables consist of the following.
20X2 20X1
$ $
Trade and other payables 730 423 1 409 512
Accrued expenses 156 345 102 933
Amounts payable to related parties 109 552 93 988
996 320 1 606 433

Trade creditors and other creditors are non–interest bearing liabilities. Trade creditor payments are
processed once they have reached 30 days from the date of invoice for electronic funds transfer payments
or cheque payment, or 30 days from the end of the month of invoice for other payments. No interest is
charged on trade payables.
All amounts are short term and the carrying values are a reasonable approximation of fair value.

12. Employee Benefits Liabilities

Employee benefits liabilities consist of the following.
20X2 20X1
$ $
Current
Annual leave 509 811 489 295
Long service leave 12 399 10 988
522 210 500 283
Non-current
Long service leave 68 072 61 623

Total 590 282 561 906

The current employee benefits liability includes $455 433 of annual leave and vested long service leave
entitlements accrued but not expected to be taken within 12 months (20X1: $406 334).
The Company makes contributions to employee superannuation schemes, which are defined contribution
plans. The amount recognised as an expense are disclosed at Note 3.

13. Borrowings
Borrowings consist of the following.
20X2 20X1
$ $
Current
Borrowings — overdraft 900 000 900 000
900 000 900 000

442 APPENDIX
Bank Overdrafts
The bank overdraft facilities may be drawn at any time and may be terminated by the bank without notice.
The Company has granted a floating charge over its assets as security for the bank overdraft facilities. The
holder of the security does not have the right to sell or re-pledge the assets.
Fair Value Disclosures
The fair value of current borrowings approximates their carrying amount as the impact of discounting is
not significant. No fair value changes have been included in profit or loss for the period as financial
liabilities are carried at amortised cost in the statement of financial position.
Financing Facilities Available

20X2 20X1
$ $
Total facilities
— Bank overdraft 900 000 900 000
900 000 900 000
Facilities used at reporting date
— Bank overdraft 900 000 900 000
900 000 900 000
Facilities unused at reporting date
— Bank overdraft — —
— —
Total facilities
— Facilities used at reporting date 900 000 900 000
— Facilities unused at reporting date — —
900 000 900 000

Details of the Company’s risk exposure arising from borrowings is provided in Note 20.

14. Contract Liability

The contract liability consists of the following.
20X2 20X1
$ $
Current
Deferred services revenue 1 155 944 995 224

The deferred services income represents customer payments for consulting services received in advance
of performance. The amounts recognised will generally be utilised within the next reporting period.

15. Lease Liabilities

The Company has leases for its offices and motor vehicles. Each lease is reflected on the balance sheet as
a right-of-use asset and a lease liability. The Company classifies its right-of-use assets from the leases in
a manner consistent with its property, plant and equipment (refer Note 9).
Lease liabilities are presented in the statement of financial position as follows.
20X2 20X1
$ $
Current
Non-current 258 724 57 113
Total 1 008 563 200 850
1 267 287 257 963

Each lease generally imposes a restriction that the right-of-use asset can only be used by the Company.
Leases are either non-cancellable or may only be cancelled by incurring a substantive termination fee.
Motor vehicle leases generally contain an option to purchase the underlying leased asset outright at the
end of the lease. The Company is prohibited from selling the leased motor vehicles without the express
authority of the lessor. The Company must arrange insurance on leased assets and incur maintenance fees
on such items in accordance with the lease contracts.

APPENDIX 443
 The nature of the Company’s leases by right-of-use asset is shown below.
No. of No. of No. of
leases leases leases No. of
Range of Average with with with index leases
No. of remain- remain- exten- options linked with
Right-of-use assets ing lease ing lease sion to pur- variable termination
asset leased term term options chase payments options
Office buildings 3 4 years 4 0 0 0 0
Motor vehicles 20 1–5 years 3 0 10 0 0

The lease liabilities are secured by the related underlying assets. Future minimum lease payments at the
end of the year are as follows.
Within
1 year 1–2 years 2–3 years 3–4 years 4–5 years Total
$ $ $ $ $ $
31 December 20X2
Lease payments 325 027 322 063 311 840 308 431 186 544 1 453 905
Finance charges (66 303) (52 412) (37 853) (22 876) (7 174) (186 618)
Net present values 258 724 269 651 273 987 285 555 179 370 1 267 287

31 December 20X1
Lease payments 67 432 59 945 57 450 52 940 50 340 288 107
Finance charges (10 319) (8 034) (5 958) (3 898) (1 935) (30 144)
Net present values 57 113 51 911 51 492 49 042 48 405 257 963

The total cash outflow for leases for the year ended 31 December 20X2 was $340 755.
16. Issued Capital
The share capital of the Company consists only of fully paid ordinary shares. The Company does not have
a limited amount of authorised capital and issued shares do not have a par value.
(a) Fully paid up share capital
20X2 20X1
$ $
Fully paid ordinary shares 2 042 367 2 042 367
Total 2 042 367 2 042 367

(b) Issued ordinary shares

20X2 20X1
Balance at 1 January 2 042 367 2 042 367
Issue of/(redemption of) shares — —
Balance at 31 December 2 042 367 2 042 367

(c) Terms and conditions of issued capital

Ordinary shares have the right to receive dividends as declared and, in the event of winding up the
Company, to participate in the proceeds from the sale of all surplus assets in proportion to the number
of and amounts paid up on shares held.
Ordinary shares entitle their holder to one vote, either in person or by proxy, at a meeting of the
Company. None of the ordinary shares on issue are held in escrow.
17. Statement of Cash Flows
(a) Reconciliation of cash
In the statement of cash flows, the balance of cash and cash equivalents includes cash on hand, cash
deposits in banks, investments in money market instruments with terms of less than 90 days, and
outstanding bank overdrafts.

444 APPENDIX
 Cash and cash equivalents at the end of the year as shown in the statement of cash flows is reconciled
to the related items in the statement of financial position as follows.
20X2 20X1
Notes $ $
Cash at bank and on hand 6 1 468 699 683 659
Bank overdraft 13 (900 000) (900 000)
568 699 (216 341)

(b) Reconciliation of net profit after income tax to net cash flows from operating activities
20X2 20X1
$ $
Net profit after income tax 827 631

Non-operating items
Interest revenue (60 000)

Non-cash items
Depreciation expense 253 484
Loss on sale of non-current assets 69 194
Doubtful debts 131 061

Changes in assets and liabilities

(Increase)/decrease in assets
— Trade and other receivables (67 929)
— Other assets 6 309
— Deferred tax assets 51 593

Increase/(decrease) in liabilities
— Trade and other payables (610 113)
— Contract liability 160 720
— Income tax payable 317 804
— Employee benefits liability 28 376
Net cash flows from operating activities 1 108 130

18. Subsequent Events

Other than disclosed above and elsewhere in the financial statements of the Company, no other matter
or circumstances has arisen since the end of the financial year that has significantly affected or may
significantly affect the operations, results or state of the Company.

19. Contingent Liabilities

The Company has no contingent liabilities as at 31 December 20X2 (20X1: nil).

20. Financial Instruments

The Company is exposed to a variety of financial risks through its use of financial instruments. The
Company’s objectives, policies and processes for managing and measuring these risks are set out below.
(a) Risk management framework
The Company’s overall risk management plan seeks to minimise potential adverse effects due to the
unpredictability of financial markets.
(i) Significant financial risks
The Company does not actively engage in the trading of financial assets for speculative purposes
nor does it write options. The most significant financial risks which the Company is exposed to
are described below.

APPENDIX 445
 Risk
management
framework Interest rate risk Credit risk Liquidity risk

Exposure Long-term borrowings at Cash and cash Borrowing and other

arising from variable rates equivalents; trade and liabilities
other receivables

Measurement Sensitivity analysis Ageing analysis; credit Credit limits and retention
ratings of title over goods sold

Management Interest rate swaps (where Rolling cash flow Availability of committed
exposure exceeds pre- forecasts credit lines and borrowing
specified limit) facilities

These were not required

in the current or previous
year

(ii) Objectives, policies and processes

The risk management policies of the Company seek to mitigate the above risks and reduce
volatility on the financial performance of the Company. Financial risk management is carried
out centrally by the Finance Department of the Company.
(iii) Capital risk management
The Company manages its capital to ensure that the Company will be able to continue as a going
concern while maximising the return to stakeholders through the optimisation of the debt and
equity balance.
In order to maintain or adjust the capital structure, the Company may pay dividends to
shareholders, return capital to shareholders, issue new shares or sell assets to reduce debt. None
of these, however, occurred during the years ended 31 December 20X1 or 20X2.
The Company’s Board of Directors reviews the capital structure on a quarterly basis, and as
part of this process the board considers the cost of capital and the risks associated with it. Based
on recommendations of the board, the Company will balance its overall capital structure through
the payment of dividends, new share issues and share buy-backs as well as the issue of new debt
or the redemption of existing debt.
The Company is not subject to any financial covenants.
(b) Interest rate risk
Interest rate risk refers to the risk that the value of a financial instrument or cash flows associated with
the instrument will fluctuate due to changes in market interest rates.
The Company’s borrowings, which have a variable interest rate attached, give rise to cash flow
interest rate risk. Interest rates are as follows.
20X2 20X1
Interest rate
From–to From–to
Australian dollar interest rates % %
Financial assets
Cash and cash equivalents 2% 2.5%

Financial liabilities
Borrowings 7% 7.5%

A sensitivity of 0.5% increase and 0.25% decrease in interest rates is considered reasonably possible
given current economic indicators. The impact on profitability of these changes would be as follows:
20X2 — impact on profit/equity
+0.5% –0.25%
Cash $7 250 ($3 625)
Borrowings ($4 500) $2 250

In 20X2, there was no reasonably possible movement that would cause a material impact on profit.
Lease liabilities are subject to fixed interest rates.

446 APPENDIX
(c) Credit risk
Credit risk refers to the risk that a counterparty will default on its contractual obligations resulting
in financial loss to the Company. The Company has a policy of only dealing with creditworthy
counterparties and obtaining collateral or other security where appropriate, as a means of mitigating
the risk of financial loss from defaults. The Company measures credit risk on a fair value basis. This
strategy is consistent with the prior year.
The Company does not have any significant credit risk exposure to any single counterparty or any
counterparties having similar characteristics, given the number and diversity of debtors. For trade
receivables, the Company has applied the simplified approach to measure the loss allowance at lifetime
expected credit losses.
The Company manages credit risk using procedures and policies which:
• assess each application on the merits of the customer
• implement prompt follow up when payment of an account is missed.
The maximum exposure to credit risk is the carrying value of trade receivables as disclosed in
Note 7.
(d) Liquidity risk analysis
Liquidity risk arises from the Company’s management of working capital and the finance charges and
principal repayments on its debt instruments. It is the risk that the Company will encounter difficulty
in meeting its financial obligations as they fall due including the risk it:
• will not have the funds necessary to settle a transaction on the due date
• will be forced to sell financial assets at a value which is less than what they are worth
• may be unable to settle or recover a financial asset at all.
To help reduce these risks, the Company relies on operating cash flow and longer-term financing
options, such as leases, to fund working capital and investment in non-current assets. The ratio of
current borrowings to current debtors is low. The Company’s strategy is consistent with the prior year.
Amounts presented below represent the future undiscounted principal and interest cash flows.
Interest rate < 1 year 1–5 years > 5 years Total
20X2 % $ $ $ $
Financial liabilities
Borrowings 7 963 000 — — 963 000
Trade and other payables n/a 996 320 — — 996 320
Lease liabilities 6 325 027 1 128 878 — 1 453 905
Total financial liabilities 2 284 347 1 128 878 — 3 413 225

Interest rate < 1 year 1–5 years > 5 years Total

20X1 % $ $ $ $
Financial liabilities
Borrowings 7.5 967 500 — — 967 500
Trade and other payables n/a 1 606 433 — — 1 606 433
Lease liabilities 6 67 432 220 675 — 288 107
Total financial liabilities 2 641 365 220 675 — 2 862 040

The above contractual maturities reflect the gross cash flows, which may differ to the carrying values
of the liabilities at the reporting date.
Liquidity risk associated with cash at bank and non–interest bearing receivables and payables is
represented by the carrying amounts as shown in the statement of financial position.
(e) Fair value estimation
The carrying value less impairment provision of trade receivables and payables is a reasonable
approximation of their fair values due to the short-term nature of trade receivables.

21. Auditor’s Remuneration

20X2 20X1
$ $
Amounts received or due and receivable by the auditors for:
Auditing the financial statements of the Company 98 778 86 988
Total remuneration of auditors 98 778 86 988

APPENDIX 447
22. Related Party Disclosures
(a) Key management personnel remuneration
20X2 20X1
$ $
The key management personnel compensation included in ‘employee expenses’
are as follows.
Short-term employee benefits 202 000 256 000
Other long-term benefits 14 000 —
Post-employment benefits 10 000 10 000
Termination benefits 52 000 —
Share based payments 6 000 —
284 000 266 000

(b) Loans to key management personnel

20X2 20X1
$ $
Loans made to key management personnel 20 000 —
Loans repaid by key management personnel (20 000) —
Loan balance outstanding at year end — —

Terms and conditions:

A short-term loan totalling $20 000 (20X1: $nil) was made to a mem
ber of the key management personnel during the year. The loan was repaid in full prior to 31 December
20X2.
For all loans to key management that extend beyond 12 months, interest is payable at prevailing
market rates, currently 7% (20X1: n/a%). The principal amounts are generally repayable over 3–5
years. All loans are secured by registered first mortgage over the borrower’s residences.
Interest received on the loans totalled $nil (20X1: $nil).
(c) Key management personnel equity holdings
None of the key management personnel hold any securities in the company.
(d) Other transactions with key management personnel
There were no other transactions with key management personnel or their related entities.
(e) Transactions with other related parties
Brookfield is a related party because it holds shares in the Company that give it significant influence.
Brookfield provides advertising services to the Company at market rates.
20X2 20X1
$ $
Expense during the year
Services purchased from Brookfield Ltd 108 625 31 000

Outstanding balance of payable at reporting date

Services purchased from Brookfield Ltd 109 552 93 938

23. Capital Expenditure Commitments

The Company is refurbishing its offices and has signed a contract at 31 December 20X2 for an external
firm to manage and perform the refurbishment works. The works are due to be completed over a two-year
period and instalments will be paid equally over this period. The total value of the contract is $200 000.

Workings for Statement of Profit or Loss and OCI

Item Chart of accounts
Revenue from continuing operations [4405]
Interest revenue [4410]
Employment costs [5505, 5510, 5515, 5520, 5525, 5530, 5535]
Advertising and marketing costs [5540, 5605, 5610, 5630]
Occupancy costs [5570, 5615]
Legal and professional [5545, 5595]
Administration and other [5575, 5580, 5625, 5635, 5640, 5645]

448 APPENDIX
(continued)
Impairment loss on trade receivables [5565]
Depreciation and amortisation [5550, 5555, 5560, 5561]
Loss on sale of non-current assets [5600]
Finance costs [5585, 5590]
Income tax/(expense) [5650]

Workings for Statement of Financial Position

Item Chart of accounts
Cash and cash equivalents [1105, 1110, 1115, 1120]
Trade and other receivables [1125, 1130]
Other current assets [1145]
Property, plant and equipment [1148, 1149, 1150, 1155, 1160, 1165, 1170, 1175]
Intangible assets [1180]
Deferred tax assets [1140]
Trade and other payables [2205, 2220, 2230, 2235]
Borrowings [2225]
Lease liabilities — current [2210]
Contract liability [2240]
Current tax payable [2245]
Employee benefits liability — current [2255, 2260]
Lease liabilities — non-current [2215]
Employee benefits — non-current [2250]
Issued capital [3305]
Retained earnings [3310, 3311, profit after tax]

Workings for Statement of Cash Flows

Cash receipts from customers = 5 935 790 = 5 842 999 – 67 929 + 160 720
Service fee income [4405]
Less: Increase in Accounts receivable [1125]
Add: Increase in Contract liability [2240]

Cash paid to employees = 3 016 360 = 3 044 736 – 6 449 – 1 411 – 20 516
Employee costs [5505, 5510, 5515, 5520, 5525, 5530, 5535]
Less: Increase in Provision for long service leave – Non-Current [2250]
Less: Increase in Provision for long service leave – Current [2255]
Less: Increase in Provision for annual leave [2260]

Cash paid to suppliers and for other operating expenses = 1 556 958 = 553 154 + 250 011 + 29 875 +
120 114 – 6 309 + 679 089 – 15 564 – 55 412 + 2 000
Advertising and marketing costs [5540, 5605, 5610, 5630]
Add: Legal and professional costs [5545, 5595]
Add: Occupancy costs [5570, 5615]
Add: Administration and other costs [5575, 5580, 5625, 5635, 5640, 5645]
Less: Decrease in Prepayments [1145]
Add: Decrease in Accounts payable [2205]
Less: Increase in Intercompany payable [2220]
Less: Increase in Accrued expenses [2230]
Add: Decrease in Accrued Audit fees [2235]

APPENDIX 449
Cash paid to suppliers and employees = 4 573 318 = Cash paid to employees + Cash paid to suppliers
and for other operating expenses = 3 044 736 + 1 556 958
Interest paid = 154 993 = 80 057 + 74 936
Finance costs [5585, 5590]

Income taxes paid* = 99 349 = 468 746 – 317 804 – 51 593

Income tax expense [5650]
Less: Increase in Income tax payable [2245]
Less: Decrease in Deferred tax asset [1140]

* The general formula that should be used for this item when deferred tax assets/liabilities exist is
Opening balance of current tax payable + Income tax expense – Closing balance of current tax payable +
Closing balance of deferred tax asset – Opening balance of deferred tax asset – Closing balance of deferred
tax liability + Opening balance of deferred tax liability.
Proceeds from sale of PPE = 195 000 = 182 926 – 28 662 + 166 556 – 56 626 – 69 194
Book value of PPE disposed [per fixed assets register]
Less: Loss on sale of PPE [5600]

Proceeds on settlement of KMP loan = 20 000

Refer related party information regarding the loan to the CEO

Purchase of intangible assets = 125 273

Increase in Computer software costs capitalised [1180]

Purchase of PPE = 192 119 = 117 719 – 108 526 + 182 926
Increase in PPE – at cost [1150, 1170]
Add: Cost of PPE disposed [per fixed assets register]

Payment for origination of KMP loan = 20 000

Refer related party information regarding the loan to the CEO

Interest received = 60 000

Interest revenue [4410]

Payment of lease liabilities = 260 698 = 1 081 319 + 166 556 + 22 147 – 1 009 324
Increase in Leased assets (gross) [1148, 1160]
Add: Leased assets (gross) disposed [per fixed assets register]
Add: Adjustment on initial application of IFRS 16 [3311]
Less: Increase in Lease liability [2210, 2215]

Cash and cash equivalents at the beginning of the year = (216 341) = 683 659 – 900 000
Cash and cash equivalents in statement of financial position [1105, 1110, 1115, 1120]
Less: Bank overdraft [2225]

Cash and cash equivalents at end of the year = 568 699 = 1 468 699 – 900 000
Cash and cash equivalents in statement of financial position [1105, 1110, 1115, 1120]
Less: Bank overdraft [2225]

450 APPENDIX
Workings:
To determine the sensitivity of cash and cash equivalents:
Cash deposits
Interest revenue at $1 450 000 @ 2% = $29 000
Increase by 0.5% is $1 450 000 @ 2.5% = $36 250
Decrease by 0.25% is $1 450 000 @ 1.75% = $25 375

Bank borrowings
Interest expense at $900 000 @ 7% = $63 000
Increase by 0.5% is $900 000 @ 7.5% = $67 500
Decrease by 0.25% is $900 000 @ 6.75% = $60 750

APPENDIX 451
GLOSSARY
accounting policies The specific principles, bases, conventions, rules and practices applied by an entity
in preparing and presenting financial statements.
accrual basis Where assets, liabilities, equity, income and expenses are recognised when they satisfy the
definitions and recognition criteria in the Conceptual Framework.
acquiree The business over which the acquirer obtains control.
acquirer The business which acquires control over another business.
acquisition method Shows the financial impact of the business combination on the acquirer by
identifying what was acquired in exchange for the consideration transferred.
active market A market in which transactions for the asset or liability take place with sufficient
frequency and volume to provide pricing information on an ongoing basis.
adjusted market assessment approach An entity evaluates the market in which it sells goods or
services and estimates the price customers would be willing to pay for those goods or services,
whether provided by the entity or a competitor.
adjusting event An event that provides new or further evidence of conditions that existed at the end of
the reporting period.
amortised cost The amount at which the financial asset or financial liability is measured at initial
recognition minus the principal repayments, plus or minus the cumulative amortisation using the
effective interest method of any difference between that initial amount and the maturity amount, and,
for financial assets, adjusted for any loss allowance.
asset A present economic resource controlled by the entity as a result of past events. An economic
resource is a right that has the potential to produce economic benefits.
associate An entity over which the investor has significant influence.
business combination A transaction or other event in which an acquirer obtains control of one or more
businesses.
carrying amount The monetary amount recognised for an asset, liability or equity in the statement of
financial position. For an asset, this is the amount which is recognised after deducting any
accumulated depreciation and accumulated impairment losses.
cash and cash equivalents Cash comprises cash on hand and demand deposits. Cash equivalents are
short-term, highly liquid investments that are readily convertible to known amounts of cash and which
are subject to insignificant risk of changes in value.
cash-generating unit (CGU) The smallest identifiable group of assets that generates cash inflows that
are largely independent of the cash inflows from other assets or groups of assets.
cash-settled share-based payment transaction The entity acquires goods or services by incurring a
liability to transfer cash or other assets, the amount of which is based on the price of the entity’s equity
instruments.
comparability Financial information is more useful if it can be compared with similar information
about the same entity for another reporting period and with similar information about other entities.
compound financial instruments Consist of both liability and equity components.
comprehensive balance sheet method Focuses on balance sheet (or statement of financial position)
items (i.e. assets and liabilities) and requires consideration of the difference between the carrying
amounts of those items (as recognised in the statement of financial position) and their underlying tax
bases (as determined according to the tax rates and tax laws enacted in the relevant jurisdiction).
consolidated financial statements Presents the assets, liabilities, equity, income, expenses and cash
flows of the parent and its subsidiaries as those of a single economic entity.
contingent asset A possible asset that arises from past events and whose existence will be confirmed
only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the
control of the entity.
contingent liability A possible obligation that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly
within the control of the entity.
contract An agreement between two or more parties that creates enforceable rights and obligations.
contract modification A change in the scope or price (or both) of a contract that is approved by both
contracting parties.

452 GLOSSARY
corporate assets Assets, other than goodwill, that contribute to the future cash flows of multiple
cash-generating units at the same time.
cost of disposal Incremental costs directly attributable to the disposal of an asset or cash-generating
unit, excluding finance costs and income tax expense.
credit risk The risk that one party to a financial instrument will cause a financial loss for the other party
by failing to discharge an obligation.
cross-currency swap Involves the exchange of principal and interest payments for a loan in one
currency for principal and interest payments in another currency.
current assets Assets, held primarily for trading purposes, that the entity intends to sell or consume in
the entity’s normal operating cycle or within 12 months after the reporting period.
current cost (of a liability) The consideration that would be received for an equivalent liability at the
measurement date minus the transaction costs that would be incurred at that date.
current cost (of an asset) The cost of an equivalent asset at the measurement date, comprising the
consideration that would be paid at the measurement date plus the transaction costs that would be
incurred at that date.
current liabilities Liabilities, held primarily for trading purposes, that the entity expects to settle within
the entity’s normal operating cycle or within 12 months after the reporting period.
current tax Amount of income taxes payable (recoverable) in respect of taxable profit (tax loss) for the
period.
current tax asset The amount of tax already paid in respect of current and prior periods that exceeds the
amount due for those periods.
current tax liability The amount of tax payable to the taxation authorities for current and prior periods,
to the extent unpaid at the end of the financial year.
customer A party that has contracted with an entity to obtain goods or services that are an output of the
entity’s ordinary activities in exchange for consideration.
deductible temporary differences Temporary differences that will result in amounts that are deductible
in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or
liability is recovered or settled.
deferred tax Movement in deferred tax assets and liabilities for the period recognised in the profit
or loss.
deferred tax assets Amounts of income taxes recoverable in future periods in respect of:
(a) deductible temporary differences [which are future deductible amounts that will result from the
realisation of assets or the settlement of liabilities]
(b) the carry forward of unused tax losses, and
(c) the carry forward of unused tax credits.
deferred tax liabilities Amounts of income taxes payable in future periods in respect of taxable
temporary differences [which are future taxable amounts that will result from the realisation of assets
or the settlement of liabilities].
derivative financial instrument A financial instrument that has all three of the following
characteristics.
(a) Its value changes in response to the change in a specified interest rate, financial instrument price,
commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or
other variable, provided in the case of a non-financial variable that the variable is not specific to a
party to the contract (sometimes called the ‘underlying’).
(b) It requires no initial net investment or an initial net investment that is smaller than would be
required for other types of contracts that would be expected to have a similar response to changes
in market factors.
(c) It is settled at a future date.
direct acquisition Acquiring the assets and liabilities (i.e. net assets) of another business that does not
represent a separate legal entity or subsequently ceases to exist as a separate legal entity.
disclosures Provide additional information and explanations to assist users in understanding the
financial statements.
discount rate A current, market-determined, risk-adjusted rate of return that reflects the systematic risk
of the asset, or group of assets, concerned.
effective interest rate A discount rate that discounts all future cash flows to the amount of cash received
or paid at the present date.

GLOSSARY 453
embedded derivative A derivative that is embedded in financial assets or financial liabilities, as well as
non-financial contracts.
equity The residual interest in the assets of the entity after deducting all its liabilities.
equity instrument Any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities (e.g. shares issued on a securities exchange).
equity method Involves recognising the investor’s share of the post-acquisition change in net assets
(i.e. equity) of the associate.
equity-settled share-based payment transaction The entity acquires goods or services as
consideration for its own equity instruments, or it receives goods or services but has no obligation to
settle the transaction with the supplier.
executory contracts Are contracts under which neither party has performed any of its obligations or
both parties have partially performed their obligations to an equal extent.
expected cost plus a margin approach An entity forecasts its expected costs of satisfying a
performance obligation and then adds an appropriate margin for that good or service.
expenses Decreases in assets, or increases of liabilities, that result in decreases in equity, other than
those relating to distributions to holders of equity claims.
fair value The price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.
fair value less costs of disposal Is a variant of fair value used in some standards (e.g. IAS 36
Impairment of Assets).
faithful representation Requires that financial information faithfully represent the effects of
transactions and events that they purport to represent.
finance lease A lease that transfers substantially all the risks and rewards incidental to ownership of an
underlying asset.
financial asset An asset that is cash, an equity instrument of another entity, a contractual right, or a
contract that will, or may, be settled in the entity’s own equity instruments.
financial guarantee contracts Refers to a guarantee where the guarantor is now required to make
payments to the lender due to some form of default by the original borrower.
financial instrument Is any contract that gives rise to a financial asset for one entity and a financial
liability or equity instrument of another entity.
financial liability A liability that is a contractual obligation, or a contract that will, or may, be settled in
an entity’s own equity instruments.
financing activities Result in changes in the size and composition of the contributed equity and
borrowings of the entity.
forward contract Arises where two parties agree, at a point in time, to carry out the terms of the
contract at a specified time in the future.
fulfilment value The present value of the cash, or other economic resources, that an entity expects to be
obliged to transfer as it fulfils a liability.
futures contract A contract to buy or sell a stated quantity of a specified item, on a specified date in the
future, at a set price.
general purpose financial reporting The objective of general purpose financial reporting is to provide
financial information about the reporting entity that is useful to its primary users for making decisions
about providing resources to the entity.
going concern assumption The assumption that an entity will continue to operate for the foreseeable
future.
group A parent and its subsidiaries.
historical cost (of a liability) Value of the consideration received to incur or take on the liability minus
transaction costs.
historical cost (of an asset) Value of the costs incurred in acquiring or creating the asset, comprising the
consideration paid to acquire or create the asset plus transaction costs.
identifiable asset or liability An asset or liability capable of being individually identified and separately
recognised in the statement of financial position and must be part of the business combination
transaction, rather than a separate transaction.
income Increases in assets, or decreases of liabilities, that result in increases in equity, other than
those relating to contributions from holders of equity claims.
indirect acquisition Acquiring the shares of another separate legal entity in order to obtain control over
that entity, in which case a parent–subsidiary relationship arises.

454 GLOSSARY
input methods Recognise revenue based on the entity’s efforts or inputs towards satisfying a
performance obligation relative to the total expected inputs to satisfy the performance obligation.
intangible asset An identifiable non-monetary asset without physical substance.
interest rate swap Involves two parties swapping fixed- and floating-rate interest obligations based on
an underlying notional principal.
investing activities Relate to the acquisition and disposal of long-term assets and other investments not
included in cash and cash equivalents of the entity.
investment entity An entity that:
• acquires funds from investors for the purpose of providing investment management services to those
investors
• has an objective to invest funds for its investors to solely provide returns from investment income,
capital appreciation or both
• primarily measures and assesses performance of its investments on a fair value basis.
investment property Property (land or a building — or part of a building — or both) held (by the
owner or by the lessee as a right-of-use asset) to earn rentals or for capital appreciation or both, rather
than for:
(a) use in the production or supply of goods or services or for administrative purposes, or
(b) sale in the ordinary course of business.
joint arrangement Arrangement of which two or more parties have joint control.
joint control Arises when decisions relating to the relevant activities of the arrangement require the
unanimous consent of the parties who share control.
liability A present obligation of the entity to transfer an economic resource as a result of past events.
liquidity risk The risk that an entity will encounter difficulty in meeting obligations associated with
financial liabilities that are settled by delivering cash or another financial asset.
market risk The risk that the fair value or future cash flows of a financial instrument will fluctuate
because of changes in market prices. Market risk comprises currency risk, interest rate risk and other
price risk.
materiality Information is material if omitting, misstating or obscuring it could reasonably be expected
to influence decisions that the primary users of general purpose financial reports make on the basis of
those reports, which provide financial information about a specific reporting entity.
net realisable value The estimated selling price in the ordinary course of business less the estimated
costs of completion and the estimated costs necessary to make the sale.
non-adjusting event An event that reflects conditions that were not in existence at the end of the
reporting period, but which arose for the first time after the end of the reporting period.
non-controlling interest Equity in a subsidiary that is not attributable (either directly or indirectly) to
the parent’s equity in that subsidiary.
non-current assets Assets that are not classified as current. That is, those assets the entity intends to
hold or consume for a period greater than 12 months after the reporting period.
non-current liabilities Liabilities that do not satisfy the criteria to be classified as current. That is, those
liabilities the entity expects to settle over a period greater than 12 months after the reporting period.
obligation A duty or responsibility that an entity has no practical ability to avoid.
offsetting Combining the balances of assets and liabilities or income and expenses.
operating activities Relate to the principal revenue-producing activities of the entity and which are not
from investing or financing activities.
operating cycle The time between the acquisition of assets for processing and their realisation in cash or
cash equivalents.
operating lease A lease which does not transfer substantially all the risks and rewards incidental to
ownership of an underlying asset.
operating segments A component of the entity that undertakes business activities from which it may
generate revenues and incur expenses.
option contract Gives the holder of the contract the right, but not the obligation, to buy or sell an asset
from or to the issuer (commonly called the ‘writer’) of the contract on or before a specified date.
other comprehensive income Comprises items of income and expense not recognised in profit or loss.
other price risk The risk that the fair value or future cash flows of a financial instrument will fluctuate
because of changes in market prices (other than those arising from interest rate or currency risk),
whether those changes are caused by factors specific to the individual financial instrument or its issuer
or factors affecting all similar financial instruments traded in the market.

GLOSSARY 455
output methods Recognise revenue based on direct measurements of the value (to the customer) of
the goods or services transferred to date relative to the remaining goods or services promised under
the contract.
parent An entity that controls another entity.
performance obligation A contractual promise to deliver goods or services to the customer.
power The current ability to direct the ‘relevant activities’ that significantly affect the investee’s returns.
present value technique Involves discounting a series of expected cash flows using an appropriate
discount rate to control for the time value of money and risk.
professional judgment The ability to diagnose and solve complex, unstructured values-based problems
of the kind that arise in professional practice.
profit or loss The total of income less expenses and excludes the components of other comprehensive
income.
provision A liability of uncertain timing or amount.
recoverable amount The higher of an asset’s fair value less costs of disposal and its value in use.
relevance Information is relevant when it is capable of influencing the decisions of users.
relevant activities Include a range of operating and financial activities, such as selling and purchasing
goods and services, acquiring and disposing of assets, and determining a funding structure.
replacement cost Current cost of replacing an existing asset with an asset of equivalent productive
capacity or service potential.
reporting entity An entity that is required, or chooses, to prepare financial statements. A reporting
entity can be a single entity or a portion of an entity or can comprise more than one entity. A reporting
entity is not necessarily a legal entity.
reproduction cost Current cost of replacing an existing asset with an identical one.
residual approach An entity estimates the stand-alone selling price as the total transaction price less the
sum of the observable stand-alone selling prices of other goods or services promised in the contract.
short-term employee benefits Employee benefits (other than termination benefits) that are expected to
be settled wholly before twelve months after the end of the annual reporting period in which the
employees render the related service.
significant influence The power to participate in the financial and operating policy decisions of the
investee but is not control or joint control of those policies.
stand-alone selling price The price (at the time of entering into the contract) for which an entity would
sell the distinct good or service separately to a customer.
statement of cash flows Explains the movement in an entity’s cash and cash equivalents over the
reporting period.
statement of changes in equity Explains and reconciles the movement in the equity (net assets) of an
entity over a reporting period.
statement of financial position Presents the entity’s assets, liabilities and equity at a given point in
time. Often referred to as a ‘balance sheet’.
subsequent event A favourable or unfavourable event occurring between the end of the reporting period
and the date when the financial statements have been authorised for issue.
subsidiary An entity that is controlled by another entity (parent entity).
swap contract An arrangement whereby two parties contractually agree to swap or exchange one stream
of cash flows for another, over a period of time.
systematic risk Sometimes referred to as market risk or non-diversifiable risk. Systematic risk relates to
the extent that the variability of the return earned on an asset, or group of assets, is due to
economy-wide factors affecting all assets.
tax base of a liability Carrying amount less any amount that will be deductible for tax purposes in
respect of that liability in future periods. In the case of revenue which is received in advance, the tax
base of the resulting liability is its carrying amount less any amount of the revenue that will not be
taxable in future periods.
tax base of an asset The amount that will be deductible for tax purposes against any taxable economic
benefits that will flow to an entity when it recovers the carrying amount of the asset. If those economic
benefits will not be taxable, the tax base of the asset is equal to its carrying amount.
tax expense (tax income) Aggregate amount included in the determination of profit or loss for the
period in respect of current tax and deferred tax.

456 GLOSSARY
taxable temporary differences Temporary differences that will result in taxable amounts
in determining taxable profit (tax loss) of future periods when the carrying amount of the
asset or liability is recovered or settled.
temporary difference The difference between the carrying amount of an asset or liability in the
statement of financial position and its tax base.
timeliness Enhances the relevance of information in GPFSs. Undue delays in reporting information may
reduce the relevance of that information to users’ decision making.
total comprehensive income The change in equity during a period resulting from transactions and other
events, other than those changes resulting from transactions with owners in their capacity as owners.
transaction price The amount of consideration to which an entity expects to be entitled in exchange
for transferring promised goods or services to a customer, excluding amounts collected on behalf of
third parties.
understandability Requires the information in financial statements to be clearly and concisely
classified, characterised and presented.
unsystematic risk The risk that is specific to a particular asset due to that asset’s unique features.
value in use The present value of the cash flows, or other economic benefits, that an entity expects to
derive from the use of an asset and from its ultimate disposal.
verifiability Exists if knowledgeable and independent observers can reach a consensus that the
information is faithfully represented.

GLOSSARY 457
SUGGESTED ANSWERS
MODULE 1
QUESTION 1.1
According to paragraph 1.5 of the Conceptual Framework, the primary users of general purpose financial
reports are existing and potential investors, lenders and other creditors who do not have the ability to require
a reporting entity to provide information. As such, they rely on the general purpose financial reports for
information.
Other users may find the reports useful, but these reports are not specifically directed at them. This
includes management (who can obtain information internally), regulators and members of the general
public (Conceptual Framework, paras 1.9 and 1.10).

QUESTION 1.2
The focus of financial reporting is on the information needs of primary users, but this does not mean that
financial reports will be irrelevant to other users. Although the reports may not be specifically tailored to
meet their needs, other parties, such as regulators and members of the public, may find general purpose
financial reports useful (Conceptual Framework, para. 1.10).
One reason for this is that the information needs of primary users and other groups of users overlap.
For example, customers of a construction company may need information about cash flows, sources of
funds and risk to assess whether the company is likely to continue its operations. This may help them to
decide whether to trust the construction company with a long-term project. They would not wish to hire a
company to do a job that it could not complete. Similarly, investors and creditors need information about
cash flows, sources of funds and risk to assess the long-term viability of the construction company.

QUESTION 1.3
The decision-usefulness objective of financial reporting provides some guidance to standard setters
because it provides the underlying purpose that should be served in making deliberations about accounting
standards. That is, the standard setters should seek to determine what types of information are most useful
for decisions made by users of financial statements. However, the decision-usefulness objective fails to
provide unambiguous guidance in solving financial reporting problems, because any evaluation of the
usefulness of items of information to users is biased by their familiarity with the information. It is difficult
to find evidence of the usefulness of information that is not available. Also, decision-usefulness may vary
between users because they make different types of decisions, such as whether to sell their shares or
whether to extend credit. Even for similar decisions, users may use different decision-making models,
giving rise to different information needs. Finally, the decision-usefulness objective is capable of multiple
interpretations and has been used to support a variety of measurement approaches in accounting standards.

QUESTION 1.4
Alternative measures of profit of Tower Ltd for the first year of operations are as follows.

Cash basis Accrual basis

$ $
Sales 37 000 40 000
Cost of goods sold (50 000) (30 000)
Insurance expense (4 000) (1 000)
Profit (loss) for the year (17 000) 9 000

The accrual basis includes all of the sales revenue generated during the period, whereas under the cash
basis, revenue is recognised when cash is received. Thus, the uncollected credit sales of $3000 at the end of
the period are excluded. If the accounts receivable are collected in the following year, they will be included
in the sales revenue for that year under the cash basis.

458 SUGGESTED ANSWERS

 Another difference between the two measures of profit is that the accrual basis determines cost of sales
as the cost of inventory that has been consumed during the period. Accordingly, under the accrual basis
of accounting, cost of sales includes the cost of widgets to the extent that they have been sold, whereas
the widgets on hand at the end of the period are recognised as an asset. In contrast, all payments for the
acquisition of inventory are included as cost of sales using the cash basis.
Under the accrual basis of accounting, the expenditure on the insurance premium is recognised as an
expense to the extent that it relates to the current period. In this case, 25% of the insurance premium is
recognised as an expense because three months of the 12-month period covered by the insurance contract
have expired. The unexpired portion of the premium is 75% because there are nine months remaining of
the 12-month contract. The insurance premium is recognised as an asset (prepaid insurance) to the extent
that it relates to a period of insurance cover that remains unexpired at the end of the reporting period. In
contrast, under the cash basis of accounting, the entire insurance premium is recognised as an expense in
the period in which the payment is made.
The accrual basis provides more useful information about the performance of the entity because
it compares revenue with expenses incurred in the same period. Further, under the accrual basis of
accounting, assets are recognised when expenditure results in future economic benefits that are expected
to flow to the entity. For example, the accrual basis recognises that Tower Ltd has a resource, namely
inventory, from which it expects to obtain future cash inflows through sale. The prepaid insurance premium
represents future economic benefits because Tower Ltd will be covered for property losses arising from
fire or theft during the next nine months.
An understanding of accrual accounting and why the recognition of income and expenses does not
always coincide with the receipt and payment of cash is assumed knowledge in the Financial Reporting
subject. If you have found the calculations and reasoning in the answer to this question to be challenging,
it is recommended that you revise balance day adjustments and the basics of calculation of cash flows from
an introductory financial accounting textbook before attempting module 2 of this subject.

QUESTION 1.5
The purpose of this question is to help you to appreciate the role of professional judgment in applying
principles such as the fundamental qualitative characteristics. Answers may vary depending on what type
of information is suggested as being most relevant to users’ decision-making processes. The following
suggested answer should not be viewed as a unique solution to the problem.
(a) The market value of the emission trading allowances is tentatively suggested as the most relevant type
of information about the phenomenon.
(b) Market value might be assumed to be available and as being able to be represented faithfully. If this
is the case, it should be used. However, if it is assumed that the available market value is not from an
active market, it could be concluded that the market value cannot be represented faithfully. A reason
for this is that it might be necessary to make some adjustments to the most recently traded price to
estimate a current market value. Accordingly, an alternative type of information, such as the cost of
the emission trading allowances or their market value at the time they were acquired, might be used if
Coalite Ltd had received them as a government grant.

QUESTION 1.6
IFRS 13 applies comparability by establishing a single definition of fair value and hierarchy for its
measurement instead of having different definitions and measurement frameworks within the IFRSs.
The standard applies verifiability by identifying a quoted price, which is directly verifiable, as the pre-
ferred measurement (Level 1). Similarly, a Level 2 estimation model that has no significant unobservable
inputs is preferred over a Level 3 estimation model, which includes some significant unobservable inputs.
Some aspects of Level 3 measurements can be verified, including processes such as calculations used in
applying the model and any observable inputs.

QUESTION 1.7
Subsequent measurement of the Sydney Harbour Bridge at the AUD equivalent of its historical cost could
have implications for the decision-usefulness of the statement of financial position because the historical
cost of the bridge is merely a historical record of the financial sacrifice made to construct it. The historical
cost, particularly one incurred so long ago, is not a relevant measure of the future economic benefits
expected to be derived from using the bridge.

SUGGESTED ANSWERS 459

 There may also be implications for the comparability of financial statements that recognise this asset
because the financial statements may include costs relating to assets acquired at different times. The Sydney
Harbour Bridge, reported at its historical cost equivalent of AUD 13.5 million, could be recognised at a
lower value than other, more recently constructed assets and, in accounting terms, may be immaterial in
size. Further, ratios could be distorted by the comparison of current income with a historical cost, in the
light of changes in the purchasing power of currency since 1932.
In this regard, historical cost has been criticised on the grounds that it aggregates costs incurred at various
times as though they are equivalent in economic terms. However, allowing for the time value of money,
the presumption is open to criticism.
In summary, the question highlights one of the major deficiencies of historical cost — that is, with the
passage of time, historical costs become dated and, therefore, have limited relevance to decision making.

QUESTION 1.8
The measurement technique for the Alpha B shares uses Level 2 inputs because their measurement was
based on a similar security in an active market, the Alpha A shares. It is not Level 1 because the observed
price is not for an identical security. The Alpha B preference shares held by Stanley Ltd are unlisted and
have a different coupon rate.

QUESTION 1.9
Current cost could provide more decision-useful information because it is based on the amount of cash
or cash equivalents that would be required currently to acquire (or construct) the asset, which may be
considered more relevant than historical cost.
This information may also be considered to be more comparable because the financial statements that
include current cost relating to assets will be measured at the same time, rather than at different times. In
that way, the Sydney Harbour Bridge reported at a current cost would be recognised at a value that has the
same basis as any other bridge constructed at a later time.

QUESTION 1.10
The journal entries to be recorded by the lessee (B Ltd) throughout the term of the lease are as follows.
Year ended 30 June 20X4
30.06.X4
Dr Right-of-use vehicle 67 813
Cr Lease liability 49 813
Dr Prepaid executory costs† 1 800
Cr Cash 19 800
Initial recording of lease asset/liability.

† Prepaid costs: because the benefits of insurance and maintenance will not be received until following period.

Year ended 30 June 20X5

01.07.X4
Dr Executory costs 1 800
Cr Prepaid executory costs 1 800
Reversal of prepayment.

30.06.X5
Dr Lease liability 13 517
Dr Interest expense 4 483
Dr Prepaid executory costs 1 800
Cr Cash 19 800
Second lease payment.
Dr Depreciation expense 15 453
Cr Accumulated depreciation 15 453
Depreciation charge for the period ($67 813 – $6000)/4.

460 SUGGESTED ANSWERS

 Year ended 30 June 20X6

01.07.X5
Dr Executory costs 1 800
Cr Prepaid executory costs 1 800
Reversal of prepayment.
30.06.X6
Dr Lease liability 14 733
Dr Interest expense 3 267
Dr Prepaid executory costs 1 800
Cr Cash 19 800
Third lease payment.
Dr Depreciation expense 15 453
Cr Accumulated depreciation 15 453
Depreciation charge for the period.

Year ended 30 June 20X7

01.07.X6
Dr Executory costs 1 800
Cr Prepaid executory costs 1 800
Reversal of prepayment.
30.06.X7
Dr Lease liability 16 059
Dr Interest expense 1 941
Dr Prepaid executory costs 1 800
Cr Cash 19 800
Fourth lease payment.
Dr Depreciation expense 15 453
Cr Accumulated depreciation 15 453
Depreciation charge for the period.

Year ended 30 June 20X8

01.07.X7
Dr Executory costs 1 800
Cr Prepaid executory costs 1 800
Reversal of prepayment.
30.06.X8
Dr Lease liability 5 504
Dr Interest expense 496
Cr Right-of-use vehicle 6 000
Return of leased vehicle.
Dr Depreciation expense 15 454
Cr Accumulated depreciation 15 454
Depreciation charge for the period — rounding adjusted in final
year.
Dr Accumulated depreciation 61 813
Cr Right-of-use vehicle 61 813

QUESTION 1.11
The journal entries to be recorded by the lessor (A Ltd) throughout the term of the finance lease are
as follows.

Year ended 30 June 20X4

30.06.X4
Dr Motor vehicle 68 000
Cr Cash 68 000
Purchase of motor vehicle.

SUGGESTED ANSWERS 461

 (continued)
Year ended 30 June 20X4
Dr Lease receivable 68 000
Cr Motor vehicle 68 000
Lease of motor vehicle.
Dr Lease receivable 2 647
Cr Cash 2 647
Payment of initial direct costs.
Dr Cash 19 800
Cr Lease receivable 18 000
Cr Reimbursement in advance† 1 800
Receipt of 1st lease payment.

† Reimbursement of executory costs are carried over to the next period when they will be paid by the lessor.

Year ended 30 June 20X5

01.07.X4
Dr Reimbursement in advance 1 800
Cr Reimbursement revenue 1 800
Reversal of accrual.
30.06.X5
Dr Insurance and maintenance expenses 1 800
Cr Cash 1 800
Payment of costs on behalf of lessee.
Dr Cash 19 800
Cr Lease receivable 13 262
Cr Interest revenue 4 738
Cr Reimbursement in advance 1 800
Receipt of 2nd lease payment.

Year ended 30 June 20X6

01.07.X5
Dr Reimbursement in advance 1 800
Cr Reimbursement revenue 1 800
Reversal of accrual.
30.06.X6
Dr Insurance and maintenance expenses 1 800
Cr Cash 1 800
Payment of costs on behalf of lessee.
Dr Cash 19 800
Cr Lease receivable 14 455
Cr Interest revenue 3 545
Cr Reimbursement in advance 1 800
Receipt of third lease payment.

Year ended 30 June 20X7

01.07.X6
Dr Reimbursement in advance 1 800
Cr Reimbursement revenue 1 800
Reversal of accrual.
30.06.X7
Dr Insurance and maintenance expenses 1 800
Cr Cash 1 800
Payment of costs on behalf of lessee.
Dr Cash 19 800
Cr Lease receivable 15 756
Cr Interest revenue 2 244
Cr Reimbursement in advance 1 800
Receipt of third lease payment.

462 SUGGESTED ANSWERS

 Year ended 30 June 20X8
01.07.X7
Dr Reimbursement in advance 1 800
Cr Reimbursement revenue 1 800
Reversal of accrual.
30.06.X8
Dr Insurance and maintenance expenses 1 800
Cr Cash 1 800
Payment of costs on behalf of lessee.
Dr Motor vehicle 10 000
Cr Lease receivable 9 174
Cr Interest revenue 826
Return of vehicle at end of lease.

QUESTION 1.12
(a) At 30 June 20X6, 20% of the entity’s employees had taken their full entitlement of sick leave during
the year. The remaining 80% of employees have an average of 12 days accumulated sick leave. If the
provision for sick leave was based on the average number of accumulated days per employee then the
provision would be calculated using a total of 4800 days (500 employees × 80% × 12 days). However,
the provision for sick leave should be based on payments ‘expected’ to be paid to employees in the
short-term (IAS 19, paras 11–14). Therefore, the provision for sick leave should be calculated using
data on the past experience of employees taking accumulated sick leave. This is calculated as follows:

Number of employees Number of sick

expected to days expected to be Total number of sick
Total employees % take sick leave taken per employee leave days expected
500 50% 250 6 1 500
500 30% 150 2 300
1 800

Given an average annual salary per employee of $40 000 and a five-day working week, the payment
per sick day would be: $40 000/260 = $153.85 (5 days × 52 weeks = 260 working days per year).
Therefore, the amount of the provision for sick leave:
= Total expected number of days of sick leave × Payment per sick day
= 1800 × $153.85
= $276 930
(b) The expected timing of payments is important in determining how the liability should be measured.
The liability for sick leave that the entity expected to settle within 12 months after the reporting
period is measured at the nominal amount. Liabilities for compensated absences expected to be settled
beyond 12 months after the period are measured using PV techniques in accordance with IAS 19
Employee Benefits.

QUESTION 1.13
To determine the amount of LSL for Maynot Ltd, it is first necessary to determine those employees who
will become entitled to receive a payment as a result of services provided up to the reporting date. All
employees with ten or more years of service are currently entitled to a payment. Although Maynot Ltd
has 80 employees who are currently not entitled to LSL at 30 June 20X7, some will eventually be paid
LSL for services that they have already provided. Therefore, the second step is to assess is the probability
of those employees not currently entitled to LSL actually receiving a payment for LSL. This assessment
would be based on past data either for the whole entity or for groups of employees where, for example,
staff turnover rates may vary between different groups of employees. The third step is to determine the
amount and timing of future payments for services performed up to the end of the reporting period that will
be made to the employees who, as estimated in the second step, will receive LSL pay. The amount and the
timing of payment will depend on projected future wages and salaries, as well as experience with employee

SUGGESTED ANSWERS 463

departures and periods of service. The next step is to determine appropriate discount rates to measure the
estimated payments at their PV. These rates will be based on the rates of high-quality corporate bond with
terms to maturity that match the terms of the estimated cash payments. Finally, Maynot Ltd’s liability for
LSL will be calculated as the PV of the estimated cash payments needed to be made to employees that will
be entitled to LSL.
The detailed procedure, starting with determining the probability of Maynot Ltd’s employees actually
receiving a payment for LSL is described in example 1.8.

MODULE 2
QUESTION 2.1
(a) The accounting policies of Techworks Ltd comply with the requirements of IAS 1 such as:
• the accounting policies present information about the preparation of the financial statements and the
specific accounting policies adopted in the notes to the financial statements (para. 112(a))
• the basis of preparation of the financial statements (prepared in accordance with Australian
Accounting Standards as issued by the Australian Accounting Standards Board (AASB) and
the International Financial Reporting Standards (IFRSs) as issued by the International Financial
Accounting Standards Board (IASB) and the requirements of the Australian Corporations Act is
disclosed in the notes (para. 112(a))
• the measurement basis (historic cost, except for derivatives and certain financial assets measured at
fair value) has been identified that was used in preparing the financial statements (para. 117(a))
• in accordance with paragraph 117(b), the summary describes accounting policies relevant for a
proper understanding of the financial statements.
(b) The notes to the financial statements of Webprod Ltd would include the following initial Note:
1. Statement of significant accounting policies
(A) Basis of preparation
The general purpose financial statements of Webprod Ltd have been prepared in accordance
with the requirements of the Corporations Act 2001, Australian Accounting Standards and other
authoritative pronouncements of the Australian Accounting Standards Board (AASB). Compli-
ance with Australian Accounting Standards results in full compliance with the International
Financial Reporting Standards (IFRSs) as issued by the International Accounting Standards
Board (IASB). Webprod Ltd is a for-profit entity. The financial statements have been prepared
on accruals basis under the historical cost convention, except for land and factory buildings
which are measured on a fair value basis. An independent valuer determines fair value on
an annual basis. The accounting policies of Webprod Ltd are consistent with those of the
previous year.

QUESTION 2.2
(a) As detailed in Note 31(e) basis of accounting, the following Accounting Standards had been issued by
the AASB, but had not been adopted in the preparation of the 30 June 2018 financial statements:
• AASB 9 Financial Instruments (mandatory application date for financial years commencing on or
after 1 January 2018)
• AASB 15 Revenue from Contracts With Customers (mandatory application date for financial years
commencing on or after 1 January 2018)
• AASB 16 Leases (mandatory application date for financial years commencing on or after 1 January
2019).
The directors of JB Hi-Fi noted that they did not expect the financial effects of adopting AASB 9 and
AASB 15 to be material. The directors were still in the process of determining the financial effects of
adopting AASB 16. As at 30 June 2018, JB Hi-Fi had $684.4 million of non-cancellable operating lease
commitments that were not recognised as a right-to-use asset that potentially would come on-balance
sheet once AASB 16 was adopted.

(b) As detailed in the accounting policies note, Techworks has elected to early adopt IFRS 16 Leases.
Paragraph 19 of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors requires that
the change in accounting policy for leases be applied retrospectively (unless it is impracticable to do

464 SUGGESTED ANSWERS

 so) as IFRS 16 does not contain any specific transitional provisions. Paragraph 28 of IAS 8 requires
disclosure of the amount of the adjustment for each financial statement line item affected for the current
period and in the comparatives to the extent practicable.
(c) The notes to the financial statements of Webprod Ltd would include the following.
1. Statement of significant accounting policies
(B) Change in accounting policy
During the 20X7 reporting period, IAS 23 Borrowing Costs was issued. As a result, Webprod Ltd
changed its accounting policy on the treatment of borrowing costs. Previously all borrowing costs
were expensed as incurred. The transitional provisions of IAS 23 require borrowing costs that relate
to qualifying assets and that are incurred after the date the standard is applied to be capitalised. In
addition, no adjustments are to be made to the opening balances of the financial statements.
From 1 July 20X6, any borrowing costs relating to qualifying assets were capitalised during the
reporting periods in which construction of the asset took place. During the 20X7 reporting period,
Webprod Ltd included $10 146 of borrowing costs as part of factory, plant and equipment under
construction. This change in accounting policy is also expected to materially affect subsequent
reporting periods.

QUESTION 2.3
The events outlined in Note 36 of the BHP Billiton 2014 annual report relate to conditions that arose after
the end of the reporting period. The legislation to repeal the MRRT received support of both Houses of
Parliament on 2 September 2014. The event would be considered a non-adjusting event.

QUESTION 2.4
The first subsequent event is the loan renegotiation which meets the definition of a non-adjusting event, as
it is one that arises after the reporting date for the first time. In other words, this event did not relate to a
condition that existed at the reporting date. As such, paragraph 10 of IAS 10 requires that the entity shall
not adjust the financial statements in respect of these events. Instead, the event should be disclosed as a
note in the financial statements.
The loan renegotiation made after the reporting date, does not represent conditions that existed at the
reporting date; therefore, it would not change any loan amounts that had classified as current at that date
(IAS 1, para. 76).
The second subsequent event is the declaration of a final dividend by the directors. Paragraph 13 of
IAS 10 confirms that if an entity declares a dividend after the reporting period but before the financial
statements are authorised for issue, the dividends are not recognised as a liability at the end of the reporting
period because no obligation exists at that time. As such, the dividends should be disclosed in the notes to
the accounts.

QUESTION 2.5
(a) A major drop in the share price on 30 July is considered a non-adjusting event, as it relates to an event
that does not reflect conditions existing at the end of the reporting period. The information relevant at
30 June is the market price of the shares at that date, which was correct at that time. The drop in share
prices occurred after 30 June as a result of new information subsequent to reporting date. Therefore,
the investments will not be adjusted in the statement of financial position, but the nature of the event
and its financial effect should be disclosed in the notes to the financial statements (IAS 10, para. 8).
(b) A debtor who owed a significant sum of money at 30 June and is declared bankrupt on 18 August
is likely to be an adjusting event. If the debtor’s account was significantly overdue at 30 June, the
bankruptcy is probably just a confirmation that the debtor could not pay at reporting date. Here,
the event of bankruptcy simply confirms conditions at the end of the reporting period. Therefore,
the accounts receivable in the statement of financial position would be adjusted accordingly (IAS 10,
para. 8).
On the other hand, if the debtor experienced financial problems after 30 June — for example, where
a fire destroyed the debtor’s business in early July, causing extreme financial difficulties — then it
could be argued that the financial statements should not be adjusted. Instead, details of the bankruptcy
should be disclosed in the notes as this would constitute a non-adjusting event (IAS 10, para. 21).

SUGGESTED ANSWERS 465

 It is important to note that all circumstances must be taken into account, and professional judgment
is often required when dealing with events after the end of the reporting period.
(c) A major explosion on 20 July is a non-adjusting event as it relates to an event that does not reflect
conditions existing at the end of the reporting period. It should not result in adjustments of assets
and liabilities, but details of the nature and financial effect of the event should be disclosed (IAS 10,
para. 21). However, if the significant losses are uninsured and the company is thereby placed into an
insolvent financial position, then financial effects of removing the going concern assumption would be
recognised through a fundamental change in the basis of accounting (IAS 10, para.15).

QUESTION 2.6
Note: IAS 1 paragraph numbers are provided for your reference.
WEBPROD LTD
Statement of profit or loss and other comprehensive income
for the year ended 30 June 20X7
$ IAS 1
†
Revenue 20 794 434 82(a)
Interest revenue accounted for using the effective interest method 12 283
Other income 25 000‡
Expenses excluding finance costs (19 438 004)§
Operating profit 1 393 713
Finance costs (103 654) 82(b)
Profit before tax 1 290 059
Income tax expense (387 018)|| 82(d)
Profit for the year 903 041 81A(a)
Items that will not be reclassified to profit or loss
Other comprehensive income (net of tax):
Revaluation surplus 82A
Revaluation surplus — land (230 000)
Revaluation surplus — buildings 150 000
Other comprehensive income for the year, net of tax (80 000)# 81A(b)
Total comprehensive income for the year 823 041 81A(c)

Additional information:
1. Allocations between non-controlling interests and parent entity owners will not be dealt with until module 5 and have not been
incorporated into the ‘Case study data’.
2. Details of expenses classified by nature or function would have to be provided in the notes to the financial statements.

Calculations

† Calculation of revenue $
Sales 19 194 434
Telecommunications project revenue 600 000
Grant revenue 1 000 000
20 794 434
‡ Other income
Profit on sale of factory plant and equipment 25 000

§ Calculation of expenses excluding finance costs

Cost of sales 12 046 232
Loss on write-down of inventory 24 921
Under-applied overhead expense 87 500
Employee benefits expense retail 166 320
Doubtful debts expense 5 400
Amortisation expense 85 000
Depreciation expense 10 254
Damages expense 620 000
Warranty expense 12 300
Audit fees 25 000
Consulting fees — auditor 30 000
Advertising campaign — new product 380 000
Selling and marketing expenses 2 415 000
Other administrative expenses 3 530 077
19 438 004

466 SUGGESTED ANSWERS

 Balance as at
# Revaluation surplus 20X6 20X7 30 June 20X7
Land 400 000 (230 000) 170 000
Buildings 300 000 150 000 450 000
Total 700 000 (80 000) 620 000

Note: According to IAS 16 (para. 40), the revaluation decrease of land is recognised in P/L only if there is no existing credit balance
in the revaluation surplus in respect of that asset. If there is an existing credit balance, the decrease will be first adjusted to the
extent of the credit balance existing in the revaluation surplus account. If the revaluation decrease exceeds the credit balance in
the revaluation surplus account, the excess is recognised in P/L. As per Section 3.3 of the Case data, the 20X6 credit balance of the
revaluation surplus of the land was $400 000, hence, the entire revaluation decrease of $230 000 will be adjusted to the revaluation
surplus of the land, and recognised in the OCI.
According to IAS 16 (para. 39), the revaluation increase of buildings is to be recognised in OCI under ‘Revaluation
surplus — buildings’ in the statement of P/L and OCI.
For the purposes of this module, ignore any tax effects of revaluations as this topic is not dealt with until module 4. Therefore,
assume the $80 000 is net of tax.

QUESTION 2.7
(a) As outlined in paragraph 96 of IAS 1, reclassification adjustments do not arise on changes in revaluation
surplus made in accordance with either IAS 16 Property, Plant and Equipment or IAS 38 Intangible
Assets. While such items are included in OCI, they are not reclassified into the P/L in subsequent
periods. Changes in revaluation surplus may be transferred to retained earnings in subsequent periods
as the asset is used or when it is derecognised.
(b) The disposal of the foreign operation would require the following items to be recognised in the
determination of profit or loss and other comprehensive income for the reporting period during which
the disposal took place.

Profit or loss $
Exchange difference on translating foreign operation 10 000
Income tax expense 3 000
Net exchange difference recognised in profit or loss 7 000

Other comprehensive income $

†
Exchange difference on translating foreign operation (net of tax) 2 800
Reclassification adjustment (net of tax)‡ (7 000)
Net exchange difference recognised in other comprehensive income (4 200)

† Of the accumulated exchange difference gains of $7000, $2800 (pre-tax of $4000) relates to the current period. The exchange
difference arising up to the date of disposal of the foreign operation is initially included in other comprehensive income.
‡ The reclassification adjustment is for the accumulated exchange difference gains (net of tax) over the total period that the
foreign operation was in existence. As the foreign operation has been disposed of, this exchange difference gain can now be
recognised in profit or loss.

The impact on total comprehensive income for the current reporting period is net of tax $2800. The
disposal of the foreign operation gives rise to the realisation of an accumulated exchange difference gain
(net of tax) of $7000. Due to it being realised, it is to be recognised in profit or loss. Prior to the disposal,
however, the exchange difference gain in the current period was unrealised and, as a result, was recognised
in OCI. The unrealised exchange difference gain was spread over several reporting periods, with $2800
being recognised in the current reporting period in OCI (prior to it being realised) and the remaining $4200
recognised in OCI of prior periods. Due to the reclassification of the exchange difference gain from OCI
(when it was unrealised) to profit or loss (upon becoming realised) a reclassification adjustment net of tax
of $7000 is recognised in OCI. This occurs in the current reporting period when the realisation occurs. As
the exchange difference gain of $2800 remains recognised in OCI in the current reporting period, the net
exchange difference recognised in OCI in the current reporting period is ($4200) (being $2800 – $7000).
This amount offsets the exchange difference gain recognised in OCI of prior periods, so that the total
impact of the foreign operation on OCI is $nil.

SUGGESTED ANSWERS 467

 The following table illustrates what has been recognised in the statement of P/L and OCI of the reporting
entity over the life of the foreign operation.
Current Total impact
Prior periods period over life
($) ($) ($)
Profit or loss (after tax) — 7 000 7 000
Other comprehensive income
Exchange difference on translating foreign operation 4 200 2 800
Less: Reclassification adjustment (7 000)
Other comprehensive income 4 200 (4 200) —
Total comprehensive income 4 200 2 800 7 000

QUESTION 2.8
(a) Paragraph 97 of IAS 1 indicates that when an item of income or expense is material, its nature and
amount must be separately disclosed. That is, it is a material item because it could influence the decision
making of financial statement users. This depends on the size and nature of the item in the context of
circumstances involved.
The determination of such items is a matter of judgment. In the case of Webprod Ltd,the items
that could be considered for separate disclosure are the loss on write-down of inventory expense, the
underapplied overhead expense, the damages expense and the advertising campaign for new product.
The nature and size of damages expense is the item most likely to be relevant to users’ understanding of
the financial performance of Webprod Ltd. Material items can be disclosed separately in the statement
of P/L and OCI or in the notes to the financial statements. In practice, the composition of the balances
for selling expenses and administrative expenses would also be reviewed for any large and unusual
items that may warrant separate disclosure.
(b) WEBPROD LTD
Statement of profit or loss and other comprehensive income
for the year ended 30 June 20X7
Note $ Para./Std
Revenue 1 2 0 794 434) B87–89/IFRS 15
Cost of sales 5, 7 (12 046 232) 99/IAS 1
Gross profit 8 748 202 85/IAS 1
Interest revenue using the effective interest method 12 283 82(a)/IAS 1
Other income 1 25 000
8 785 485
Expenses
Retailing expenses 2, 5, 7 (2 971 574)(a) 99/IAS 1
Product expenses 3, 4, 5 (829 721)(b) 99/IAS 1
Administrative expenses 7 (3 585 077)(c) 99/IAS 1
Other expenses 6 (5 400)(d)
Finance expenses (103 654) 82(b)/IAS 1
Profit before income tax 1 290 059
Income tax expense (387 018) 82(d)/IAS 1
Profit for the year 903 041 81A(a)/IAS 1
Other comprehensive income (net of tax):
Revaluation surplus 82A/IAS 1
Revaluation surplus — land (230 000)
Revaluation surplus — buildings 150 000
Other comprehensive income for the year, net of tax (80 000) 81A(b)/IAS 1
Total comprehensive income for the year 823 041 81A(c)/IAS 1

Notes to the financial report

The following disclosure notes may include additional information regarding the nature of the item that was not provided
in the case study information. You are not expected to know this information — it has been included for illustrative
purposes only.

468 SUGGESTED ANSWERS

Note 1: Revenues and other income

(a) Revenue $ Para./Std

Sales revenue 19 194 434 B87–89/IFRS 15
Telecommunications project service revenue 600 000 B87–89/IFRS 15
Grant revenue 1 000 000
20 794 434
(b) Other income
Profit on sale of factory plant and equipment 25 000

Note 2: Advertising campaign — new product 97/IAS 1

Included in the retail expenses is $380 000 paid for an advertising campaign to launch Webprod Ltd’s new high-speed modem.

Note 3: Write-down of inventory 97/IAS 1

Because of rapid changes in the computer industry, two lines of software and one line of hardware will have to be sold at substantial
discounts. As a result, these inventory items have to be carried at net realisable value at 30 June. This has resulted in an inventory
write-down of $24 921.

Note 4: Damages — lawsuit 97/IAS 1

On 15 January 20X7, Webprod Ltd was sued for infringement of a patent right. On 20 August 20X7, Webprod Ltd settled the lawsuit
for $620 000. A liability for damages has been recognised in the statement of financial position.

Note 5: Depreciation and amortisation 104/IAS 1

Amortisation of patent rights 85 000

Depreciation of non-current assets 232 116†

† Depreciation of retail fixtures and fittings $10 254 + Depreciation of factory and plant $221 862 (see section 3.2 of ‘Case study data’).

Note 6: Bad and doubtful debts

During the 20X7 financial year, Webprod Ltd incurred a doubtful debt expense of $5400.
Note 7: Employee benefits 104/IAS 1
During the 20X7 financial year, Webprod Ltd incurred employee benefit expenses of $3 272 000 (see section 4 of ‘Case study data’).

Calculations $
(a) Retailing expenses
Employee benefits — retail 166 320
Depreciation expense — retail fixtures and fittings 10 254
Advertising campaign new product 380 000
Other selling expenses 2 415 000
2 971 574
(b) Product expenses
Write-down of inventory 24 921
Under-applied overhead 87 500
Amortisation of patent rights 85 000
Damages expense 620 000
Warranty expense 12 300
829 721
(c) Administrative expenses
Audit fees 25 000
Consulting services — auditor 30 000
Other administrative expenses 3 530 077
3 585 077
(d) Other expenses (from ordinary activities)
Doubtful debts 5 400

QUESTION 2.9
WEBPROD LTD
Statement of changes in equity
for the year ended 30 June 20X7

Share Revaluation Retained

capital surplus earnings Total
($) ($) ($) ($) IAS 1
† 1 050 000 700 000 843 240 2 593 240 106(d)
Balance 1 July 20X6
Profit for the year 903 041 903 041 106(a)
Other comprehensive income (80 000) (80 000) 106(a)

SUGGESTED ANSWERS 469

 Share Revaluation Retained
capital surplus earnings Total
($) ($) ($) ($) IAS 1
Comprehensive income‡ (80 000) 903 041 823 041 106(a)
Dividends paid or declared§ (450 000) (450 000) 106(d)(iii)
Balance 30 June 20X7 1 050 000 620 000 1 296 281 2 966 281 106(d)

† See ‘Case study data’ section 1 for the closing balance of shareholders’ equity for the prior reporting period (i.e. the opening
balance as at 1 July 20X6).

Shareholders’ equity as at 30 June 20X6

Share capital 1 050 000
Revaluation surplus 700 000
Retained earnings 843 240
Total shareholders’ equity 2 593 240

† Comprehensive income for 20X7 (see the suggested answer to question 2.6).

Comprehensive income items for the year ended 30 June 20X7

Profit for the year 903 041
Other comprehensive income (net of tax) (80 000)
Total comprehensive income 823 041

§ Dividends paid or declared (see ‘Case study data’ section 8).

Dividends paid or declared for the year ended 30 June 2017

Interim dividend 200 000
Final dividend 250 000
Total dividends paid or declared 450 000
Dividend per share $0.30 ($450 000/number of
ordinary shares, being 1 500 000
as per Case data Section 1)

QUESTION 2.10
WEBPROD LTD
Statement of financial position
as at 30 June 20X7
Note $ IAS 1
Current assets
Cash and cash equivalents 1 192 173 54(i)
Trade and other receivables 2 984 010 54(h)
Inventories 3 812 837 54(g)
Other current assets 4 63 350
Total current assets 2 052 370
Non-current assets
Trade and other receivables 2 50 000 54(h)
Financial assets 5 99 103 54(d)
Property, plant and equipment 6 4 099 730 54(a)
Intangible assets 7 465 000 54(c)
Total non-current assets 4 713 833
Total assets 6 766 203
Current liabilities
Trade and other payables 8 505 500 54(k)
Current tax payable 387 018 54(n)
Dividend payable 250 000
Borrowings 9 100 000 54(m)
Provisions 10 741 000 54(l)
Total current liabilities 1 983 518
Non-current liabilities
Borrowings 9 1 535 000 54(m)
Provisions 10 281 404 54(l)
Total non-current liabilities 1 816 404
Total liabilities 3 799 922
Net assets 2 966 281

470 SUGGESTED ANSWERS

 Shareholders’ equity
Issued capital 11 1 050 000 54(r)
Reserves 12 620 000 54(r)
Retained earnings 1 296 281 54(r)
Total shareholders’ equity 2 966 281

Note: As explained in the module notes, paragraph 77 requires further subclassification of the line items, presented in a manner
appropriate to the entity’s operations.

The following subclassifications illustrate the composition of the items in the statement of financial
position.

Extracts from notes to accounts

1. Cash and cash equivalent $
Cash at bank and on hand 192 173

2. Trade and other receivables $

Current
Trade receivables 723 210
Less: Allowance for doubtful debts (17 200)
706 010
Grant receivable 250 000
Secured loan to director 28 000
984 010
Non-current
Secured loan to director 50 000

3. Inventories $
Raw materials — at cost 53 820
Work in process — at cost 132 540
Manufactured finished goods — at cost 437 800
Retail inventory — at cost 213 598
Less: Allowance for inventory write-drown (24 921)
812 837

4. Other current assets $

Prepaid borrowing costs 4 550
Other prepayments 58 800
63 350

5. Financial assets $
Investment in debentures 100 000
Unamortised debenture discount (897)
99 103

6. Property, plant and equipment

Land and buildings $
Land — independent valuation 20X7 970 000
Factory buildings — independent valuation 20X7 1 650 000
2 620 000

Factory plant and equipment (at cost) 1 790 246

Accumulated depreciation (352 862)
1 437 384

Fixtures and fittings — retail outlets (at cost) 76 300

Accumulated depreciation (33 954)
42 346

Total property, plant and equipment 4 099 730

Webprod Ltd adopted a policy of revaluing both its land and factory buildings annually to fair value, in
accordance with the revaluation model under IAS 16.
I. Virgo, FAIV, an independent valuer, carried out the revaluation as at 30 June 20X7 on the basis of the fair
value of the land and buildings from their existing use (being the highest and best use under IFRS 13
Fair Value Measurement). Virgo determined that the value of the land and buildings was as follows.

SUGGESTED ANSWERS 471

 Land 970 000
Buildings 1 650 000
7. Intangibles $
Patent rights (at cost) 200 000
Accumulated amortisation (115 000)
85 000
Product development costs (R&D) 380 000
465 000

8. Trade and other payables $

Trade payables 342 500
Accruals 163 000
505 500
9. Borrowings
Current $
Bank loan — secured 100 000

Non-current
Bank loan — secured 800 000
Promissory notes 235 000
Loan — Finance Ltd 400 000
Preference shares 100 000
1 535 000

10. Provisions
Current $
Employee benefits 110 000
Warranties 11 000
Damages — lawsuit 620 000
741 000
Non-current
Employee benefits 243 404
Warranties 38 000
281 404

11. Issued capital $ IAS 1

Issued and fully paid capital
1 500 000 fully paid ordinary shares (no par value) 1 050 000 79(a)(ii)(iii)
The company had 1 500 000 ordinary shares outstanding at the beginning and end of the year ending 30 June
20X7 (79(a)(iv)).
12. Reserves $ IAS 1
Revaluation surplus† 620 000 79(b)
† See suggested answer to question 2.6.

QUESTION 2.11
CASH FLOWS FROM OPERATING ACTIVITIES
1. Cash received from customers: $19 535 264
In order to determine the amount of receipts from customers, the following formula may be used.

Opening balance of + Sales revenue − Bad debts − Closing balance of

trade receivables written off† trade receivables
† To determine the amount of bad debts written off, the following formula is relevant.

Opening balance of + Doubtful debts − Closing balance of

allowance for doubtful debts expense (from P/L) allowance for doubtful debts

472 SUGGESTED ANSWERS

 The amount of receipts from customers is calculated as follows.

$
Opening balance of trade receivables 467 840
Add: Sales revenue 19 194 434
Add: Telecommunications project revenue 600 000
20 262 274
Less: Bad debts written off (see calculation‡ ) (3 800)
20 258 474
Less: Closing balance of trade receivables (723 210)
Receipts from customers 19 535 264

‡ Bad debts written off are determined as follows.

Opening balance of allowance for doubtful debts 15 600

Add: Doubtful debts expense 5 400
21 000
Less: Closing balance of allowance for doubtful debts (17 200)
Bad debts written off 3 800

This represents a cash inflow from operating activities.

2. Cash received from grants: $750 000

In order to determine the amount of grants received, the following formula may be used.

Opening balance of + Grants revenue − Closing balance of

grants receivable grants receivable

The amount of receipts from grants is calculated as follows.

$
Opening balance of grants receivable —
Add: Grants revenue 1 000 000
1 000 000
Less: Closing balance of grants receivable (250 000)
Grants received 750 000

This represents a cash inflow from operating activities.

3. Cash paid to suppliers: $15 216 421

There are several steps in determining the amount of payment to suppliers and employees.
Step 1: Purchase of raw materials on credit
The first step involves determining the amount paid to purchase inventories — namely, raw materials —
on credit.
Section 2.2.1 of the ‘Case study data: Webprod Ltd’ indicates that the company purchased raw materials
totalling $5 423 500.
Alternatively, this amount may have been calculated using the following formula.

Closing balance of + Cost of raw materials − Opening balance of

raw materials allocated to work in process raw materials

SUGGESTED ANSWERS 473

 The amount of raw materials purchased is calculated as follows.

$
Closing balance of raw materials 53 820
Add: Raw materials allocated to work in process (given in question) 5 432 180
5 486 000
Less: Opening balance of raw materials (62 500)
Raw materials purchased 5 423 500

Step 2: Purchase of retail inventories on credit

The second step involves determining the amount paid to purchase inventories — namely, retail
inventories — on credit.
We are told in section 2.1 of the ‘Case study data’ that the company purchased retail inventories
totalling $2 563 200.
Alternatively, this amount may have been calculated with the following formula.

Closing balance of + COGS − Opening balance of

retail inventories retail inventories

The amount of retail inventories purchased is calculated as follows.

$
Closing balance of retail inventories at cost 213 598
Add: COGS (see Section 2 note 2.1) 2 544 602
2 758 200
Less: Opening balance of retail inventories (195 000)
Retail inventories purchased 2 563 200

Step 3: Determining the amount of cash paid to the suppliers of inventories

To determine the amount of inventories purchased for cash, it is necessary to adjust for the opening and
closing balances of trade payable. The case study has assumed that trade payable relates solely to the
suppliers of raw materials and retail inventories.
The following formula may be used.

Opening balance of + Inventories purchased on − Closing balance of

trade payable credit (from formula) trade payables

The amount of cash purchases of inventories is calculated as follows.

$
Opening balance of trade payables 340 000
Add: Inventories purchased on credit† 7 986 700
8 326 700
Less: Closing balance of trade payables (342 500)
Cash paid to the suppliers of inventories 7 984 200

† Inventories purchased are $7 986 700 (raw materials $5 423 500 + retail inventories $2 563 200).

Step 4: Determining the amount of operating expenses paid

The next step is to determine the amount of operating expenses paid during the current reporting period.
To do this is a two-step process.
First, exclude non-cash expenses and expenses relating to investing and financing activities that are
included in the statement of P/L and OCI.

474 SUGGESTED ANSWERS

 Non-cash expenses include the following.
$
Depreciation expense 10 254
Damages expense (provision) 620 000
Amortisation expense 85 000
Employee benefits — retail (provision) 166 320
Loss on inventory write-down 24 921
Under-applied overhead expense 87 500
Warranty expense (provision) 12 300
Total non-cash expenses 1 006 295

Borrowing costs (expenses relating to investing and

financing activities) 103 654

The remaining expenses include:

Audit fees 25 000
Consulting fees 30 000
Advertising campaign 380 000
Selling and marketing expenses 2 415 000
Other expenses 3 530 077
Total remaining expenses 6 380 077

Second, determine the amount of the remaining operating expenses for which cash has been paid; given
some of the operating expenses may have been incurred but have not been paid in full. To determine the
amount of operating expenses paid during the current reporting period, it is necessary to adjust for the
opening and closing balances of accruals.
The following formula may be used.

Opening balance + Operating expenses − Closing balance

of accruals incurred (from calculation provided) of accruals

The amount of cash expenses is calculated as follows.

$
Opening balance of accruals 124 000
Add: Operating expenses incurred (from calculation provided) 6 380 077
6 504 077
Less: Closing balance of accruals ($163 000 − $30 000)† (133 000)
Operating expenses paid 6 371 077

† We are told in the question that during the 20X7 reporting period, Webprod Ltd purchased $1 084 846 of factory
plant and equipment, of which $30 000 of this amount is included in the accruals liability.
Of the closing accruals balance of $163 000 shown in the statement of financial position, $30 000 relates to the
purchase of factory plant and equipment. This $30 000 accrual will be reflected in the cash flows from investing
section of the statement of cash flows. For this reason, the $30 000 accrual is excluded from the $163 000 closing
balance.
Step 5: Increase in prepayments
In some instances, an entity will also prepay operating expenses. This will be reflected in the prepayments
account in the current asset section in the statement of financial position. Examples include prepaid rent
and prepaid insurance. While they are reflected as current assets, these prepayments relate to payments of
operating expenses and, as such, need to be included as part of the payments to suppliers figure in the net
cash flows from operating activities in the statement of cash flows.
If the amount of prepayments increases during the reporting period, then the increase needs to be
reflected as an additional cash outflow in the statement of cash flows.
It will be observed that there was an increase in the prepayments balance in the statement of financial
position from $22 500 (see ‘Case study data’ section 1) to $58 800 (see ‘Case study data’ section 8). An
increase in prepayments indicates that the payments of operating expenses exceed the amount of operating
expenses incurred in the statement of P/L and OCI. This increase of $36 300 needs to be included in
determining the payments to suppliers.

SUGGESTED ANSWERS 475

Step 6: Determining under-applied overhead expense paid in cash
The final step is to determine the amount of cash paid in relation to under-applied overhead.
The amount of overhead allocated to work in process totalled $1 624 487 (see section 2.2.2 of ‘Case
study data’. The under-applied overhead expense as shown in ‘Case study data’ section 8 is $87 500. This
gives a sub-total of $1 711 987 ($1 624 487 + $87 500).
Those expenses included in this sub-total of overheads that were non-cash expenses must be excluded.
In this particular case study, there are two non-cash expenses that are included in overhead expenses that
must be excluded as follows.

$
Employee benefits (refer section 4 of ‘Case study data’) 665 281
Depreciation expense of factory and plant† 221 862
Total 887 143

† Refer to section 3.2 of ‘Case study data’ (depreciation of factory buildings $100 000 + depreciation
of factory plant and equipment $121 862).

Therefore, the total cash expenses related to under-applied overhead is $824 844 ($1 711 987 –
$887 143).
Putting it all together
The total amount of payments to suppliers of $15 216 421 comprises the following.

$
Cash paid to the suppliers of inventories 7 984 200†
Operating expenses paid 6 371 077‡
Increase in prepayments 36 300§
Under-applied overhead expense 824 844#
Total 15 216 421

† See step 3: Determining the amount of cash paid to the suppliers of inventories.
‡ See step 4: Determining the amount of operating expenses paid.
§ See step 5: Increase in prepayments.
# See step 6: Determining under-applied overhead expense paid in cash.

This represents a cash outflow from operating activities.

4. Cash paid to employees: $3 272 000

Refer to section 4 of the ‘Case study data’, which states that:
During the 20X7 financial year, the total payments for wages and salaries, including annual leave, totalled
$3 250 000. Long service leave paid during the same period amounted to $22 000. Therefore, total employee
benefits paid were $3 272 000.

This represents a cash outflow from operating activities.

5. Borrowing costs: $118 350

In determining the total cash paid for borrowing cost, apart from the amount noted in the expense item, it
is also important to take into consideration the items noted in the statement of financial position such as
the movement in prepaid borrowing costs and capitalised borrowing costs.
(a) Borrowing cost paid: $108 204
In order to determine the amount of borrowing costs paid, the following formula may be used.

Closing balance of + Borrowing cost − Opening balance of

prepaid borrowing costs expenses prepaid borrowing costs

476 SUGGESTED ANSWERS

 The amount of borrowing costs paid is calculated as follows.
$
Closing balance of prepaid borrowing costs† 4 550
Add: Borrowing cost expenses‡ 103 654
(108 204)
Less: Opening balance of prepaid borrowing costs —
Borrowing cost expenses paid 108 204

† See section 5 of the ‘Case study data’.

‡ See section 5 of the ‘Case study data’.

This represents a cash outflow from operating activities.

(b) Capitalised borrowing costs paid: $10 146
In addition to the borrowing cost payments identified in part (a) of this question, Webprod Ltd included
$10 146 (see section 5 of the ‘Case study data’) of borrowing costs as part of plant under construction
during the 20X7 reporting period. This represented a change in accounting policy.
This $10 146 capitalised borrowing costs paid is added to the borrowing cost paid of $108 204 calculated
in part (a) of this question to give total borrowing costs paid of $118 350.
This represents a cash outflow from operating activities.

6. Warranties paid: $8800

In order to determine the amount of warranties paid, the following formula may be used.
Opening balance of + Warranties − Closing balance of
provision for warranties expense provision for warranties
The amount of warranty payments is calculated as follows.
$
†
Opening balance of provision for warranties 45 500
Add: Warranty expense‡ 12 300
57 800
Less: Closing balance of provision for warranties§ (49 000)
Warranties paid 8 800

† Provision for warranties: current $10 500 and non-current $35 000 (see section 1 of ‘Case study data’).
‡ See section 8 of ‘Case study data’.
§ Provision for warranties: current $11 000 and non-current $38 000 (see section 8 of ‘Case study data’).

This represents a cash outflow from operating activities.

7. Income tax paid: $120 000

Where there are no temporary differences (i.e. no DTAs and/or DTLs), then the opening balance of current
tax payable is usually the amount of income tax paid during the current period.
In order to determine the amount of income tax paid, the following formula may be used.

Opening balance of + Income tax − Closing balance of

current tax payable expense current tax payable

The amount of income tax paid is calculated as follows.

$
Opening balance of current tax payable† 120 000
Add: Income tax expense‡ 387 018
507 018
Less: Closing balance of current tax payable§ (387 018)
Income tax paid 120 000

† See section 1 of ‘Case study data’.

‡ See section 8 of ‘Case study data’.

This represents a cash outflow from operating activities.

SUGGESTED ANSWERS 477

CASH FLOWS FROM INVESTING ACTIVITIES
8. Interest received: $11 467
In order to determine the amount of interest received, the following formula may be used.
Closing balance of + Interest revenue − Opening balance of
unamortised debenture unamortised debenture
discount discount
The amount of interest received is calculated as follows.

$
Closing balance of unamortised debenture discount 897
Add: Interest revenue 12 283
13 180
Less: Opening balance of unamortised debenture discount (1 713)
Interest received 11 467

This represents a cash inflow from investing activities.

9. Proceeds from sale of factory plant and equipment: $88 000

Refer to section 3.1 of the ‘Case study data’, which states that:
On 1 December 20X6, factory plant and equipment with a carrying amount of $63 000 (cost $160 000) was
sold for $88 000. The profit or loss on sale is based on the carrying amount of the plant at the start of the
reporting period.

The gain on the sale of $25 000 is shown in the statement of P/L and OCI. However, this is a non-cash
gain.
The proceeds from the sale of factory plant and equipment totalled $88 000. This represents a cash
inflow from investing activities.

10. Purchase of factory plant and equipment: $1 052 700

Refer to section 3.1 of the ‘Case study data’, which states that during the 20X7 financial year:
2. On 20 August 20X6, retail fixtures and fittings were purchased at a cost of $8000.
3. During the 20X7 reporting period, Webprod Ltd purchased $1 084 846 of factory plant and equipment;
$30 000 of this amount is included in the liability for accruals.

$ $
Purchase of factory plant and equipment
Retail fixtures and fittings† 8 000
Factory plant and equipment† 1 084 846
Subtotal 1 092 846
Less
Accruals† 30 000
Capitalised borrowing costs‡ 10 146
Cash payment for factory plant and equipment 1 052 700

† See section 3.1 of ‘Case study data’.

‡ See section 5 of ‘Case study data’.

Moreover, $10 146 worth of capitalised borrowing costs paid has already been included as an operating
cash outflow and, to avoid double counting, cannot be included as an investing cash outflow. This represents
a cash outflow from investing activities.

11. Loan to director: $6000

In order to determine the amount of the loan to the director, the following formula may be used.
Closing balance of − Opening balance of
director loan director loan
(asset) (asset)

478 SUGGESTED ANSWERS

 The amount of the loan to the director is calculated as follows.

$
Closing balance of director loan account (asset) 78 000
Less: Opening balance of director loan account (asset) (72 000)
Loan made to director 6 000

This represents a cash outflow from investing activities.

12. Cash paid for product development costs (R&D expenditure): $380 000
The product development costs of $380 000 that were capitalised as an intangible asset (that form part of
R&D expenditure. As per Note 7 of the 20X7 Trial Balance, $380 000 was paid already) in the statement
of financial position is shown separately as a cash outflow from investing activities.
In order to determine the amount of monies spent on capitalised product development costs, the
following formula may be used.

Closing balance of − Opening balance of

product development product development
costs costs

The amount of monies spent on capitalised product development costs is calculated as follows.

$
Closing balance of product development costs 380 000
Less: Opening balance of product development costs —
Payment for product development costs 380 000

This represents a cash outflow from investing activities.

CASH FLOWS FROM FINANCING ACTIVITIES

13. Proceeds from funds borrowed: $400 000
In order to determine the amount of funds borrowed, the following formula may be used.

Closing balance of − Opening balance of

loan − Finance Ltd loan − Finance Ltd

The amount of funds borrowed is calculated as follows.

$
Closing balance of loan — Finance Ltd 400 000
Less: Opening balance of loan — Finance Ltd —
Funds borrowed 400 000

This represents a cash inflow from financing activities.

14. Dividends paid: $260 000

In order to determine the amount of dividends paid, the following formula may be used.

Opening balance of + Interim + Final − Closing balance of

dividend dividend dividend dividend
payable (liability) payable (liability)

SUGGESTED ANSWERS 479

 The amount of dividends paid is calculated as follows.
$
Opening balance of dividend payable (liability)† 60 000
Add: Interim dividend‡ 200 000
Add: Final dividend‡ 250 000
510 000
Less: Closing balance of dividend payable (liability)‡ (250 000)
Dividends paid 260 000

† See section 1 of ‘Case study data’.

‡ Interim dividend $200 000, final dividend $250 000 and dividend payable $250 000 (see section 8 of
‘Case study data’).

This represents a cash outflow from financing activities.

15. Repayment of bank loan: $100 000
In order to determine the amount of the repayment of the bank loan, the following formula may be used.
Opening balance of − Closing balance of
bank loan − secured bank loan − secured
The amount of the repayment of the bank loan is calculated as follows.
$
†
Opening balance of bank loan 1 000 000
Less: Closing balance of bank loan‡ (900 000)
Payment of bank loan 100 000

† Opening balance of bank loan $1 000 000 (current liability $100 000 + non-current liability $900 000,
as per section 1 of ‘Case study data’)
‡ Closing balance of bank load loan $900 000 (current liability $100 000 + non-current liability
$800 000, as per section 8 of ‘Case study data’)

This represents a cash outflow from financing activities.

16. Payment of promissory notes: $65 000

In order to determine the amount of the repayment of promissory notes, the following formula may
be used.
Opening balance of − Closing balance of
promissory notes promissory notes
The amount of the repayment of promissory notes is calculated as follows.
$
Opening balance of promissory notes 300 000
Less: Closing balance of promissory notes (235 000)
Payment of promissory notes 65 000

This represents a cash outflow from financing activities.

WEBPROD LTD
Statement of cash flows
for the reporting period ended 30 June 20X7
$
Inflows
Note (Outflows)
Cash flows from operating activities (IAS 7, paras 10, 14, 18)
Cash received from customers 19 535 264
Cash received from grants 750 000
Cash paid to suppliers (15 216 421)
Cash paid to employees (3 272 000)
Borrowing costs paid (IAS 7, para. 31) (118 350)
Warranties paid (8 800)
Income tax paid (IAS 7, para. 35) (120 000)
Net cash flows from operating activities 4 1 549 693

480 SUGGESTED ANSWERS

 Inflows
Note (Outflows)
Cash flows used in investing activities (IAS 7, paras 10, 16, 21)
Interest received (IAS 7, para. 31) 11 467
Proceeds from sale of factory plant and equipment 88 000
Purchase of factory plant and retail fixtures and fittings (1 052 700)
Loan to director (6 000)
Cash paid for product development costs (380 000)
Net cash used in investing activities (1 339 233)

Cash flows from financing activities (IAS 7, paras 10, 17, 21)
Proceeds from funds borrowed 400 000
Dividends paid (IAS 7, para. 31) (260 000)
Payment of bank loan (100 000)
Payment of promissory notes (65 000)
Net cash flows used in financing activities 5 (25 000)

Net increase in cash and cash equivalents 185 460

Cash and cash equivalents at the beginning of the period 6 713
Cash and cash equivalents at the end of the period 1 192 173

Notes to the statement of cash flows:

1. Components of cash and cash equivalents (IAS 7, para. 45)
For the purpose of the statement of cash flows, cash includes cash on hand and at banks and short-term
deposits at call, net of outstanding bank overdrafts (IAS 7, para. 46). Cash and cash equivalents at the
end of the financial year, as shown in the statement of cash flows, are reconciled to the related items in
the statement of financial position as follows:
Cash at bank: $192 173
2. Non-cash financing and investing activities (IAS 7, para. 43)
There were no non-cash financing and investing activities during the current period.
3. Financing facilities (IAS 7, para. 50) (see notes at the end of section 1 of the ‘Case study data’)
Bank overdrafts
The company has access to bank overdrafts to a maximum of $200 000, which is secured by a first
mortgage over Webprod Ltd land and buildings. The bank overdraft has not been used by Webprod Ltd
during 20X7. The overdraft bears an interest rate of 8%.
Bank term loan
Webprod Ltd has a 10-year bank loan secured by a first mortgage over the land and buildings
of Webprod Ltd. The bank loan has an effective interest rate of 7%.
Credit standby arrangements
A bank standby facility of $200 000 is available to Webprod Ltd. This bank standby facility bears interest
at 9%.
4. Reconciliation of net profit for the period to the net cash provided by operating activities

$
Net profit after tax for the period 903 041

Non-cash adjustments
Amortisation expense 85 000
Depreciation expense 10 254
Depreciation included in overhead 221 862
Write-down of inventory 24 921
Profit — factory plant and equipment (25 000)

Non-operating activity adjustments

Interest revenue (12 283)
Borrowing costs capitalised (10 146)

Add/Less:
Increase in net trade receivables (255 370)
Increase in grant receivable (250 000)

SUGGESTED ANSWERS 481

 $
Increase in work in process (24 140)
Increase in finished goods (25 700)
Increase in retail inventory (18 598)
Increase in prepaid borrowing costs (4 550)
Increase in prepayments (36 300)
Increase in allowance for doubtful debts 1 600
Decrease in raw materials 8 680
Increase in trade payables 2 500
Increase in accruals 9 000†
Increase in employee benefits 54 404
Increase in warranty provision 3 500
Increase in provision for damages 620 000
Increase in tax payable 267 018
Net cash provided by operating activities 1 549 693

† Excludes increase in accruals from construction of factory plant $30 000 because this amount has also been excluded in the
calculation of operating expenses in Part 3, Item 4.

5. Reconciliation of liabilities arising from financing activities (IAS 7 44A–E)

(Note that you may want to refer to section 1 ‘Case study data’ for the closing balance of liabilities
related to financing activities as at 30 June 20X6, the cash flows from financing activities in answer to
question 2.11 and the solution to question 2.10 statement of financial position for Webprod Ltd as at
30 June 20X7.)
Reconciliation of liabilities arising from financing activities
Cash Non-cash
01.07.X6 flows changes 30.06.X7
Current liabilities — financing activities
Dividend payable 60 000 (260 000) 450 000 250 000
Bank loan — secured 100 000 (100 000) 100 000 100 000

Non-current liabilities — financing activities

Bank loan — secured 900 000 (100 000) 800 000
Promissory note 300 000 (65 000) 235 000
Loan — Finance Ltd — 400 000 400 000
Preference shares 100 000 — — 100 000
Total 1 460 000 (25 000) 450 000 1 885 000

6. Cash not available for use (IAS 7, para. 48)

There were no restrictions on use of cash held as at 30 June 20X7.

ASSUMED KNOWLEDGE REVIEW QUESTION 1

In both cases (a) and (b), the cash flow could be classified in more than one way.
(a) Interest paid and interest received
Interest paid (borrowing costs paid) is typically regarded as an operating cash outflow as per
paragraph 33 of IAS 7. In the illustrative example shown in Appendix A of IAS 7, interest paid is
classified as an operating cash outflow. However, the same paragraph goes on to state that an entity
may elect to show interest paid as a cash outflow from financing activities. The rationale behind this
is that interest represents a cost of obtaining financial resources.
Interest received is typically regarded as an investing cash inflow as per paragraph 31 of IAS 7. In the
illustrative example shown in Appendix A of the standard, interest received is classified as an investing
cash inflow. However, the same paragraph goes on to state that an entity may elect to show interest
received as a cash inflow from operating activities because they represent returns on investments.
This module uses the same approach as the illustrative examples in IAS 7.
(b) Income taxes paid
Because income tax is included as an expense in determining profit after tax, it is normally classified
as an operating cash outflow (IAS 7, para. 14) unless the cash flow can be identified with particular
investing or financing activities. For example, the income tax paid attributable to the sale of a large
parcel of land could be separately disclosed within investing activities. In this case, it is still necessary
to disclose the total amount of taxes paid in the notes to the financial statements (IAS 7, para. 36).

482 SUGGESTED ANSWERS

ASSUMED KNOWLEDGE REVIEW QUESTION 2
MANAGEMENT SERVICES LTD
Net cash flows from operating activities
for the year ended 30 June 20X3
Based on the data provided, net cash flows from operations would be reported using the direct
method, as follows. $
Receipts from customers 507 000
Payments to employees and suppliers (including prepaid expenses) (244 000)
Income tax paid (14 000)
Net cash flows from operating activities 249 000

These amounts have been calculated as described in the following.

Receipts from customers

To determine the amount of receipts from customers, the following calculation is necessary.
Opening balance of trade receivables 37 000
Add: Sales revenue 500 000
537 000
Less: Closing balance of trade receivables (30 000)
Receipts from customers 507 000
Payments to suppliers and employees
To determine the amount of payments to suppliers and employees, the following reconstruction is
necessary.
Opening balance of trade payables and accruals 6 000
Add: Expenses (excluding depreciation and interest) 277 000
Add: Increase in prepaid expenses 1 000
284 000
Less: Closing balance of trade payables and accruals (40 000)
Payments to suppliers and employees 244 000

If Management Services Ltd had held inventories, the opening and closing balances of inventories
would need to be taken into account in determining the amount of inventory purchased on credit. This
figure would flow through the provided calculation. However, this is not relevant in the current situation
as Management Services Ltd does not have any inventory on hand.

Income taxes paid

IAS 7 requires separate disclosure of income taxes paid in the statement of cash flows. Income taxes paid
forms part of the cash flows from operating activities. The amount of tax paid in the current financial year
largely depends on whether there are temporary differences (i.e. deferred tax asset (DTA) or deferred tax
liability (DTL), which are explained in module 4).
Management Services Ltd does not have any DTA or DTL. The amount of income tax paid in the current
year will simply be the opening balance of current tax payable at 30 June 20X2. This figure is $14 000.
This amount is disclosed in the statement of cash flows.
The amount of income tax expense in the current year (i.e. $60 000) is reflected in the current tax payable
liability account in the statement of financial position and will be paid to the taxation authorities in the
following financial year. That will form part of the following year’s statement of cash flows.
An alternative to the provided calculations would be to reconstruct the ledger accounts involved. If you
are unsure of the answers provided in this section, please reconstruct the relevant ledger accounts now.

ASSUMED KNOWLEDGE REVIEW QUESTION 3

To prepare a reconciliation between profit and net cash flows from operating activities, we start with profit
for the period and make adjustments for income and expense items that were not the result of operating
cash transactions during the reporting period. Such adjustments may arise from two sources:
1. non-cash income and expense items such as depreciation and profits and losses on the sale of plant and
equipment
2. changes in statement of financial position items that affected the determination of profit, such as net
changes in trade receivables, trade payables and inventories (i.e. movements in opening and closing
balances of current assets and current liabilities).

SUGGESTED ANSWERS 483

 Another adjustment that may be relevant to some entities is where an item is included in the profit or
loss, but the related cash flow is classified as an investing or financing activity. For example, some entities
may treat dividends received as a cash flow from investing activities.

Reconciliation of profit or loss to net cash from operating activities for the period
$
Net profit for the period 140 000
Non-cash adjustments
Add: Depreciation expense1 23 000

Add/Less:
Decrease in trade receivables2 7 000
Increase in prepaid expenses3 (1 000)
Increase in trade payables and accruals4 34 000
Increase in current income tax payable5 46 000
Net cash from operating activities 249 000

Notes on adjustments:
1. Depreciation expense is added back because the expense is a non-cash item; it does not reflect an outlay of cash made in the
current period.
2. A decrease in trade receivables implies that the amount of cash collected from customers in the current reporting period exceeds
the sum of credit and cash sales revenue recognised in that period. The lesser amount (sales revenue) has been credited to the
statement of P/L and OCI in measuring profit. The extra cash collected is allowed for by adding back to profit or loss the decrease
in trade receivables.
3. An increase in prepaid expenses implies that the amount of cash disbursed for prepayments exceeds the amount of prepayments
charged as expense (expired prepayments). The lesser amount, expired prepayments, has been deducted in the statement of P/L
and OCI in determining current period profit or loss. The larger cash outlay is allowed for by deducting the increase in prepaid
expenses from profit or loss.
4. An increase in trade payables and accruals implies that cash outlays for expenses are less than expenses. The larger amount of
expenses has been deducted in arriving at the profit in the statement of P/L and OCI, the lesser cash outlay is arrived at by adding
back to the profit or loss the increase in trade payables.
5. An increase in current income tax payable implies that the cash outflow for tax in the current period is less than the tax expense
of that period. (In the absence of deferred tax accounts, the amount by which the expense exceeds the cash flow is equal to the
increase in the current tax payable account.) The larger amount, tax expense, has been deducted in arriving at the profit in the
statement of P/L and OCI. The lesser cash outlay is arrived at by adding back to profit or loss the increase in current tax payable.
6. Another way to simplify the adjustments is to note the following rule:
– Any credit movements (i.e. where current assets decrease or where current liabilities increase) is a source of cash and results in
an addition in the reconciliation.
– Any debit movements (i.e. where current assets increase or where current liabilities decrease) is a use of cash and results in a
subtraction in the reconciliation.
In other words:

Decrease in asset Add

Increase in asset Less
Decrease in liability Less
Increase in liability Add

The presentation of the operating activities section of the statement of cash flows using the indirect
method is very similar to the reconciliation between profit and operating cash flows. However, if presenting
a statement of cash flows using the indirect method, we would need to add back interest expense and
income tax expense and present interest paid and income tax paid as separate line items to comply with
paragraph 31 of IAS 7.

ASSUMED KNOWLEDGE REVIEW QUESTION 4

Cash flows from investing activities
Investing activities relate to the purchase and sale of non-current assets during the reporting period. Most
investing cash inflows and outflows will come from analysing the movements in the non-current assets
accounts in the statement of financial position.
An inspection of the statement of financial position of Management Services Ltd reveals that land and
buildings have increased by $216 000 (from $34 000 to $250 000).

484 SUGGESTED ANSWERS

 It is possible that there were disposals of land and buildings during the period, or that land and buildings
were revalued. However, there is no evidence of asset disposals and no asset revaluation (revaluation surplus)
account shown in equity. Hence, it can be concluded that the entity acquired land and buildings during the
financial year totalling $216 000. The cash outflow from investing activities is therefore $216 000.
Cash flows from financing activities
Financing cash flows relate to changes in the financing activities of the entity (i.e. movements in debt and
equity). Cash flows from financing activities typically include proceeds from borrowings, repayment of
borrowings and the proceeds from the issue of shares.
An inspection of the statement of financial position of Management Services Ltd reveals that share
capital has not increased or decreased during 20X3. Hence, the company did not issue any shares or redeem
(or buy back) any of its share capital during the financial year.
However, the amount of debentures (a form of long-term liability) decreased from $15 000 to $Nil during
20X3. This means that the company redeemed its debentures, resulting in a cash outflow of $15 000.
The cash flows from the financing section of the statement of cash flows also record the amount of
dividends paid by the entity during the reporting period. The company’s net profit after tax (as per the
statement of P/L and OCI) was $140 000. This flows through into the retained earnings section in the
statement of financial position. However, the increase in the retained earnings balance between 20X2 and
20X3 was only $110 000. This means that the amount of dividends paid during the 20X3 financial year
totalled $30 000. Put another way:
Dividends paid = Net profit after tax − Increase in retained earnings
= $140 000 − $110 000
= $30 000
Alternatively, Dividends paid = Opening balance of Retained Earnings +
Net profit after tax for the current period –
Ending balance of retained earnings
= $40 000 + 140 000 – 150 000
= $30 000

The net cash flows used in financing activities were therefore $45 000.

$
Debenture repayment (15 000)
Dividends paid (30 000)
(45 000)

ASSUMED KNOWLEDGE REVIEW QUESTION 5

Management Services Ltd
Statement of cash flows
for the reporting period ended 30 June 20X3
Inflows Inflows
(Outflows) (Outflows)
Cash flows from operating activities
Receipts from customers 507 000
Payments to employees and suppliers (244 000)
Income taxes paid (14 000)
Net cash from operating activities 249 000
Cash flows from investing activities
Payment for land and buildings (216 000)
Cash flows from financing activities
Repayment of debenture liability (15 000)
Dividends paid (30 000)
Net cash used in financing activities (45 000)
Net decrease in cash and cash equivalents held (12 000)
Cash and cash equivalents at the beginning of the reporting period 49 000
Cash and cash equivalents at the end of the reporting period 37 000

SUGGESTED ANSWERS 485

MODULE 3
QUESTION 3.1
At the agreement’s inception, the construction company will apply the requirements of IFRS 15 to the
agreement to construct the shopping centre. This is because there is a contract (the threeyear agreement)
with a customer (the property developer) that appears to possess all the attributes outlined in paragraph 9
of IFRS 15.
After 12 months, however, there is a significant change in facts and circumstances. The property
developer is experiencing significant financial difficulties. This significant change in the customer’s
circumstances requires the construction company to reassess whether the agreement contains all the
attributes in paragraph 9 of IFRS 15. As it is no longer probable that the construction company will collect
the consideration, IFRS 15 no longer applies to the agreement. The construction company can continually
reassess the agreement to determine whether all attributes are present again.

QUESTION 3.2
First, because the software is delivered before the other goods and services, and it functions without the
updates and technical support, the customer can benefit from each of the goods and services on their own
or together with the other goods and services. As such, each of the goods and services satisfies the criterion
in paragraph 27(a) of IFRS 15.
Second, the promise to transfer each good and service to the customer is separately identifiable from each
of the other promises. As indicators of this, the entity is not providing a significant service of integrating
the software and services into a combined output, given the software functions without the updates and
technical support and each can be sold separately. Moreover, the promised goods or services do not
significantly modify or customise each other, as the installation service does not significantly modify the
software itself. Finally, the software and services are not highly interdependent or highly interrelated as
the software functions independently of the updates and technical support (see IFRS 15, para. 29). Thus,
each of the goods and services satisfies the criterion in paragraph 27(b) of IFRS 15.
As both paragraphs 27(a) and (b) are satisfied for each of the goods and services provided under the
contract, each constitutes a distinct good or service. Each distinct good or service gives rise to a separate
performance obligation. On this basis, the software developer would identify four performance obligations:
1. the software licence
2. installation service
3. software updates
4. technical support.

QUESTION 3.3
Contract for construction of office block
The consideration promised under this contract is a combination of both fixed and variable amounts.
The $1 500 000 represents fixed consideration, as the construction company is entitled to this amount
on completion of the office block independent of the timeliness of completion. The $350 000 is variable
consideration, as it is a performance bonus in accordance with paragraph 50 of IFRS 15. The construction
company is only entitled to the $350 000 if the office block is completed within 18 months. If not, the
construction company does not receive this amount. As such, whether the construction company receives
$350 000 varies according to the timeliness of completion.

Contract for construction of warehouse

The consideration promised under this contract is a combination of both fixed and variable amounts. The
amount of $450 000 ($500 000 – $50 000) is fixed, as the entity is entitled to this amount irrespective
of whether the penalty is imposed. The $50 000 arising from the penalty is variable in accordance with
paragraph 50 of IFRS 15, as it is dependent on whether construction is completed by 31 August 20X6.

QUESTION 3.4
In accordance with paragraph 91 of IFRS 15, the entity recognises an asset for $12 500 as the incremental
costs of obtaining the contract. This amount relates to the commissions to sales employees for obtaining
the contract, which would not have been incurred if the contract had not been obtained. Further, the entity

486 SUGGESTED ANSWERS

expects to recover those costs through future fees for the consulting services. As the contract is for three
years, the amortisation period is longer than one year.
The travel costs to deliver the proposal ($20 000) and the portion of legal fees payable irrespective of
the success of the tender ($10 000) are not incremental and cannot be recognised as an asset. In relation
to the $15 000 legal fees payable on the tender being successful, although incremental, the entity would
not expect to recover these costs either directly or indirectly. As such, these costs would be expensed as
incurred.

QUESTION 3.5
An obligation to repair or replace goods sold if they are determined
to be faulty
An obligation to repair or replace goods sold is likely to be a provision within the scope of IAS 37. As a
result of a past obligating event (i.e. the sale of the goods), this is a present obligation that is probable for
an uncertain portion of the goods returned.

A warranty provided for a television sold by a retailer

An obligation relating to a warranty provided on the sale of a television is likely to be a provision within
the scope of IAS 37. A warranty generally involves the retailer (or manufacturer) warranting to make good,
either by repair or replacement, any defects to the goods sold within a specified period. As a result of a
past obligating event (i.e. the sale of the television with the warranty), this is a present obligation that is
probable for an uncertain amount, depending on how many televisions require repair or replacement.

Annual leave
Annual leave payable to employees is an example of a liability covered by another standard and, therefore,
not within the scope of IAS 37. The requirements for recognising provisions for annual leave are dealt
with as a short-term compensated absence in IAS 19 Employee Benefits.

QUESTION 3.6
For a provision to be recognised, IAS 37 requires that:
(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required to settle the
obligation; and
(c) a reliable estimate can be made of the amount of the obligation (IAS 37, para. 14).

In this example, the manufacturer has a present legal obligation. The obligating event is the sale of the
product with a warranty.
IAS 37 outlines that the future sacrifice of economic benefits is probable when it is more likely than
less likely that the future sacrifice of economic benefits will be required. In this example, the probability
that settlement will be required will be determined by considering the class of obligation (warranties) as a
whole (IAS 37, para. 24). In accordance with paragraph 24, it is more likely than less likely that a future
sacrifice of economic benefits will be required to settle the class of obligations as a whole.
The final criterion in paragraph 14(c) of IAS 37 must be met before a provision can be recognised. If
a reliable estimate can be made, the provision can be measured reliably. Past data can provide reliable
measures, even if the data is not firm-specific but rather industry-based. Paragraph 25 of IAS 37 notes that
only in ‘extremely rare cases’ can a reliable measure of a provision not be obtained. Difficulty in estimating
the amount of a provision under conditions of significant uncertainty does not justify non-recognition of
the provision.

Conclusion
The manufacturer should recognise a provision based on the best estimate of the consideration required to
settle the present obligation as at the reporting date.

QUESTION 3.7
The expected value of the cost of repairs in accordance with IAS 37 is:
(80% × nil) + (15% × $2m) + (5% × $5m) = $300 000 + $250 000 = $550 000

SUGGESTED ANSWERS 487

QUESTION 3.8
Provision for warranties — Spring Valley Ltd’s compliance with IAS 37
Disclosure in Spring Valley Ltd’s 20X2 financial
IAS 37, para. 85 requirement statements (Note 14 ‘Provisions’)

A brief description of the nature of the obligation ‘Provision is made for estimated warranty claims in
respect of products sold which are still under warranty
at the end of the reporting period.’

The expected timing of any resulting outflows of ‘These claims are expected to be settled in the next
economic benefits financial year.’

An indication of the uncertainties about the amount
or timing of those outflows. Where necessary
to provide adequate information, an entity shall
disclose the major assumptions made concerning
future events, as addressed in paragraph 48 of
IAS 37
‘Management estimates the provision based on
historical warranty claim information and any recent
trends that may suggest future claims could differ from
historical amounts.’

The amount of any expected reimbursement, stating Spring Valley Ltd provides no disclosure in relation
the amount of any asset that has been recognised to any reimbursement. As such, it may be assumed
for that expected reimbursement that no such reimbursement is expected, or if any is
expected, it is immaterial to the financial statements.

QUESTION 3.9
Earnings management could be decreased due to the increased transparency of the movement in provisions.
As a result of the increased disclosure requirements, users are able to determine:
(a) the carrying amount of provisions at the beginning of the reporting period;
(b) additional provisions made during the reporting period; and
(c) amounts used (i.e. incurred and charged against the provision) during the period (IAS 37, para. 84).

Therefore, users are able to establish the increase and decrease in provisions, including the subsequent
write-back of provisions.

QUESTION 3.10
You could have included a range of examples of contingent assets from your own knowledge and
experience. One example is an application by the entity for damages or compensation in a court of law;
if successful, the entity will receive a cash payment. This would be a contingent asset because the future
economic benefit will be confirmed only by the decision of the court. Another example of a contingent
asset is when an entity is expecting to receive future economic benefits from an estate, but the amount to
be received is uncertain at the reporting date.
The reporting of contingent assets may have an effect on the decisions of equity investors or other finance
providers, who make their assessment based on the likelihood of a contingent asset becoming the entity’s
asset. If the asset does crystallise, it is likely to have an effect on performance ratios, such as leverage, and
may assist the entity in meeting its debt covenants.

MODULE 4
QUESTION 4.1
(a) The carrying amount of the inventory in the financial statements is $250, as provided in the facts to
the question. The future deductible amounts are equal to the tax cost of the inventory, $250. When the
inventory is sold, the tax cost of the inventory (as provided in the facts to the question) will be included
as a deduction against the taxable proceeds on sale of the inventory.

488 SUGGESTED ANSWERS

 This is an example of where an asset generates future taxable economic benefits. Therefore, the tax
base is the future deductible amounts of $250.
(b) The carrying amount of the accounts receivable in the financial statements is $250, as provided in the
facts to the question.
This is an example of where an asset does not generate future taxable economic benefits because
related revenue has already been included in taxable profit (tax loss). Therefore, the tax base is the
carrying amount of $250.

QUESTION 4.2
The first step is to determine whether the liability is either:
• a liability that is not revenue received in advance, or
• a liability that is revenue received in advance.
(a)
Tax base of a
Future
liability that is not Carrying
= – deductible
revenue received amount
amounts
in advance

nil = 100 – 100

The carrying amount of the employee benefits is $100.

The employee benefits will be deductible when paid; therefore, the future deductible amount is $100.
There are no future taxable amounts because there is no revenue associated with the payment of
employee benefits to be included in taxable profit (tax loss). Therefore, the tax base is $nil.

(b)

250 = 250 – nil + nil

The carrying amount of the loan is $250.

The loan repayment has no tax consequences; therefore, there are no future deductible or taxable
amounts. Therefore, the tax base is $250.

(c)
Tax base Amount of
of revenue Carrying revenue not
= –
received amount taxable
in advance in the future

nil = 400 – 400

SUGGESTED ANSWERS 489

 The carrying amount of the revenue received in advance is $400.
The revenue received in advance has already been taxed; therefore, the amount not taxable in the
future is $400. Therefore, the tax base is $nil.

QUESTION 4.3
(a) According to paragraph 10 of IAS 12, an entity shall, with certain limited exceptions, recognise a
deferred tax asset (liability) whenever recovery or settlement of the carrying amount of the asset
or liability will make future tax payments smaller (larger) than they would be if such recovery or
settlement were to have no tax consequences.
In this scenario, it is expected that only $80 of the trade receivable will be recovered (the remaining
$20 is doubtful). If only $80 is recovered, a tax deduction of $20 for the bad debt will arise. The
tax deduction will cause future tax payments to be smaller than they would have been in the absence
of the tax consequence. Therefore, in accordance with the fundamental principle in paragraph 10 of
IAS 12, a deferred tax asset arises.
(b) The amount of the deductible temporary difference implied by the answer to requirement (a) is $20.
That is the amount for which the entity will receive a tax benefit in the form of an allowable deduction.
(c) This modified example falls into cell 2 of table 4.6 since the relationship between the carrying amount
of the asset and the tax base is:

Carrying amount of asset < Tax base of asset

This confirms that the recovery of the receivable gives rise to a deferred tax asset.
Before leaving this modification to Example 3 of IAS 12, paragraph 7, it is helpful to note that
deferred tax assets are defined as amounts of income taxes recoverable in future periods. Recall that
the $100 of revenue has already been included in taxable income and tax on this amount has previously
been paid. The deferred tax asset of $6 is that portion of the tax previously paid that will be recovered
when the debt is written off and the $20 is deducted from taxable profit.

QUESTION 4.4
Part A
(a) The explanations are as follows.

Development costs
When the carrying amount of the development costs is recovered by using the asset, the entity will
generate assessable income. Since the whole of the development expenditure has already been deducted
for tax purposes, there will be no amount deductible against the assessable amount. Consequently, tax
will become payable on the revenue earned. Hence, the tax base is nil. Therefore, the entity should
recognise a deferred tax liability for the additional tax payable of $1000 × 30% = $300.

Prepaid expenses
The reasoning for this item is the same as that for development costs. To recover the carrying amount of
the asset, the entity generates taxable revenue of an amount equal to the carrying amount of the prepaid
expenses. However, there will be no amount deductible against the revenue earned, the amount already
having been deducted for tax purposes. Therefore, tax will be payable on the whole of the economic
benefits recovered. Hence, the tax base is nil. The entity should recognise a deferred tax liability for
the future tax payments of $1000 × 30% = $300.

490 SUGGESTED ANSWERS

 (b) The following formulas are applicable for both items.

Future
Tax base
= deductible
of an asset
amounts

0 = 0

Temporary Carrying
= – Tax base
difference amount

1000 = 1000 – 0

Taxable
Deferred tax
= temporary × Tax rate
liability
difference

300 = 1000 × 30%

For both items, taxable temporary differences need to be recognised as the tax bases are lower than their
carrying amounts and those differences generate deferred tax liabilities.

Part B
(a) When the liability is settled in a later period, an additional $20 will be required to purchase the foreign
currency needed to settle the liability. This extra amount will be deductible for tax purposes. When
the amount is deducted, taxable profit will be reduced by $20 and tax payments will be reduced by $6
($20 × 30%). Therefore, the entity recognises a deferred tax asset of $6.
(b) The amount of the deductible temporary difference implied by the answer to Part (a) of this question
is $20, which is the amount by which the carrying amount of the liability has been adjusted.
(c) The tax base for the liability after its remeasurement and the temporary difference created are calculated
as follows.

SUGGESTED ANSWERS 491

 Tax base of a
Future
liability that is not Carrying
= – deductible
revenue received amount
amount
in advance

100 = 120 – 20

Temporary Carrying
= – Tax base
difference amount

20 = 120 – 100

The temporary difference created in a deductible temporary difference as the carrying amount of the
liability is greater than the tax base.
(d) The temporary difference created on the remeasurement of the liability gives rise to a deferred tax asset
that is calculated as follows.

Deductible
Deferred tax
temporary × Tax rate =
asset
difference

20 × 30% = 6

QUESTION 4.5
(a) The analysis of the data for example 4.8 indicates that the entity should recognise the following deferred
tax balances that originated during 20X1.

Deferred tax asset $13 500 ($45 000 × 30%)

Deferred tax liability $30 000 ($100 000 × 30%)

There were no other transactions during 20X1, so these are the net movements in the deferred tax
balances for the period. Therefore, the related deferred tax expense and deferred tax income are as
follows.

Deferred tax income† $13 500

Deferred tax expense $30 000

† It is acceptable to recognise this as a reduction in the deferred tax expense account instead of an
increase in deferred tax income.

492 SUGGESTED ANSWERS

 Also note that taxable profit for the year ended 31 December 20X1 was $nil. Therefore, current tax
is $nil by definition (IAS 12, para. 5). Tax expense (income) is the aggregate of current tax expense
(income) and deferred tax expense (income) (IAS 12, para. 6). Hence, tax expense for the period is as
follows.
$ $
Current tax expense 0
Deferred tax expense 30 000
Less: Deferred tax income (13 500) 16 500
Tax expense 16 500

Therefore, the income tax journal entry is as follows.

31 December 20X1
Dr Deferred tax expense (net) 16 500
Dr Deferred tax asset 13 500
Cr Deferred tax liability 30 000

(b) Since the tax loss can be carried back for three years, the expected loss in 20X2 would be available
for offset against the taxable income of 20X1 and the two preceding years. Taxable income for 20X1
was $nil. Therefore, recognition of the balance of the deferred tax asset, $4500, is contingent on there
being sufficient taxable profit in the two years prior to 20X1.

QUESTION 4.6
(a) The tax bases of assets can be calculated based on the following formulas:

1. Future economic benefits are taxable Tax base = future deductible amount

2. Future economic benefits are not taxable Tax base = carrying amount

Using these formulas, and in some cases the fundamental principle of paragraph 10 from IAS 12,
the tax bases of the assets of Lowsales Ltd as at 30 June 20X1, presented together with the carrying
amounts are as follows.
Carrying amount Tax base
Asset $ $
Cash 97 000 97 000
Accounts receivable (net)† 234 000 245 000
Prepaid rent‡ 4 000 0
Inventory 228 000 228 000
Equipment (net)§ 48 000 40 000

† Revenue, which led to accounts receivable, is included in taxable profit in the same year, but the allowance for
doubtful debts will be deductible in the future when the debt becomes bad. Therefore, applying the fundamental
principle in paragraph 10 of IAS 12, there should be a deductible temporary difference for accounts receivable
for the amount of the allowance for doubtful debts. Tax base is then determined based on this amount of
deductible temporary difference and the carrying amount, knowing that the deductible temporary differences
for assets should reflect the excess of tax bases over carrying amounts.
‡ When the prepaid rent is recovered in the future, there will be a taxable amount of $4000. However, there
will be no future deductible amounts, as the prepaid rent has already been claimed as a deduction (i.e. when it
was paid). Therefore, applying the fundamental principle in paragraph 10 of IAS 12, there should be a taxable
temporary difference for the amount of the prepaid rent. Tax base is then determined based on this amount
of taxable temporary difference and the carrying amount, knowing that the taxable temporary differences for
assets should reflect the excess of carrying amounts over tax bases.
§ For equipment, applying the formula provided at the start of the question considering that the future economic
benefits are taxable, the tax base is equal to the future deductible amount. That amount for equipment will be
the cost of the equipment ($80 000) less tax accumulated depreciation as at 30 June 20X1 ($40 000).

SUGGESTED ANSWERS 493

 As mentioned in the question, there are no future tax consequences associated with cash and
inventory. As such, their tax bases should be equal to their carrying amounts.
The tax bases of liabilities can be calculated based on the following formulas.

Tax base of a
Future
liability that is not Carrying
= – deductible
revenue received amount
amounts
in advance

Amount of
Tax base of
Carrying revenue not
revenue received = –
amount taxable
in advance
in the future

Using these formulas and in some cases, the fundamental principle of paragraph 10 from IAS 12,
the tax bases of the liabilities of Lowsales Ltd as at 30 June 20X1, presented together with the carrying
amounts are as follows.

Liability Carrying amount Tax base

$ $
Accounts payable 67 000 67 000
Revenue received in advance† 18 000 0
Bank loan 100 000 100 000
Foreign currency loan payable‡ 32 000 33 000
Provision for employee benefits liability§ 65 000 0

† For the revenue received in advance, the tax base is equal to the carrying amount of the liability ($18 000)
less the amount already included in taxable profit and, therefore, non-taxable in the future ($18 000),
which equals $0.
‡ When the foreign currency liability is settled in a later period, $1000 less will be required to purchase the
foreign currency needed to settle the liability. This $1000 difference will be taxable. Therefore, applying
the fundamental principle in paragraph 10 of IAS 12, there should be a taxable temporary difference for the
loan payable in foreign currency. Tax base is then determined based on this amount of taxable temporary
difference and the carrying amount, knowing that the taxable temporary differences for liabilities should
reflect the excess of tax bases over carrying amounts.
‡ The settlement of the employee benefits liability will result in future tax deductions equal to the carrying
amount. Applying the formula, the tax base, calculated as the difference between carrying amount and
future deductible amounts is $0.

As mentioned in the question, there are no future tax consequences associated with accounts payable.
As such, their tax bases should be equal to their carrying amounts. Also, there are no future tax
consequences for the bank loan in national currency; therefore, its tax base is also equal to its carrying
amount.
(b) The format of the following deferred tax worksheet is an adaptation of the deferred tax worksheet in
the Illustrative Examples, ‘Illustrative computations and presentation’, of IAS 12.
Deferred tax worksheet for Lowsales Ltd as at 30 June 20X1 is as follows.

Taxable Deductible
temporary temporary
Carrying Tax base differences differences
amount $ $ $
Cash assets 97 000 97 000
Accounts receivable (net) 234 000 245 000 11 000
Prepaid rent 4 000 0 4 000
Inventory 228 000 228 000
Equipment (net) 48 000 40 000 8 000
Total assets 611 000 610 000

Accounts payable 67 000 67 000

Revenue received in advance 18 000 0 18 000
Bank loan 100 000 100 000

494 SUGGESTED ANSWERS

 Foreign currency loan payable 32 000 33 000 1 000
Employee benefits liability 65 000 0 65 000
Total liabilities 282 000 200 000
13 000 94 000
Deferred tax liability 3 900†
Deferred tax asset 28 200‡
Less: Opening deferred tax liability/asset§ (2 400) (16 200)
Movement in deferred tax liability/asset 1 500Cr 12 000Dr
Deferred tax expense 1 500Dr 12 000Cr

† Total taxable temporary difference $13 000 × 30%.

‡ Total deductible temporary difference $94 000 × 30%.
§ The movement in deferred tax liability is an increase of $1500, recognised as a credit to the liability account, together with
a debit to deferred tax expense. The movement in deferred tax asset is an increase of $12 000, recognised as a debit to the
asset account, together with a credit to deferred tax expense. It should be noted that as the deferred tax asset and liability are
likely to be offset against each other (refer to part D of the module for discussion of offsetting), the worksheet could have
also been prepared on a net deferred tax asset basis. In that case, there would be an opening net deferred tax asset of $13 800
($16 200 – $2400) and a closing deferred tax asset of $24 300 ($28 200 – $3900), resulting in a net increase of $10 500.

(c) The current tax is going to the recognised by applying the relevant tax rate to the taxable profit for the
current period (i.e. $331 000), giving rise to a current tax expense and a related current tax liability of
$99 300. Now that current deferred tax effects have been determined for Lowsales Ltd, the following
income tax journal entries would be prepared.

30 June 20X1
Dr Current tax expense 99 300
Cr Current tax payable 99 300§
Dr Deferred tax expense 1 500
Cr Deferred tax liability 1 500†
‡
Dr Deferred tax asset 12 000
Cr Deferred tax expense 12 000
Total tax expense is $99 300 – $12 000 + $1500 = $88 800.

† Calculated based on the taxable profit as $331 000 × 30% = $99 300. The taxable profit was provided in the facts of
the question.
‡ Movement in the deferred tax liability for the year (calculated in the deferred tax worksheet in (b)).
§ Movement in the deferred tax asset for the year (calculated in the deferred tax worksheet in (b)).

QUESTION 4.7
Year ended 30 June 20X9
Bayside Ltd incurred a tax loss of $7000 during the period ended 30 June 20X9. During the loss year,
the excess of tax depreciation over accounting depreciation was $1000, causing the related temporary
difference to increase by the same amount. This movement in the taxable temporary difference caused the
entity to recognise an increment in the deferred tax liability of $300, increasing the item from the opening
balance of $600 to $900.
The tax loss for the period was $7000, giving rise to a deferred tax asset of $2100. However, the probable
future taxable profit arising from the reversal of taxable temporary differences (via depreciation) at 30 June
20X9 was only $3000 (opening $2000 + additional tax depreciation $1000). As at 30 June 20X9, the entity
was unable to establish that it was probable there would be future taxable profits in excess of the reversal
of this taxable temporary difference of $3000. Therefore, the entity recognises only $900 of the total tax
deferred tax asset, using the benefit of only $3000 ($900/30%) of the total tax losses of $7000.
The journal entries are, therefore, now described.
The first entry recognises the $900 deferred tax asset that results from the tax losses that the entity
believes will be recovered from the reversal of taxable temporary differences.
30 June 20X9
Dr Deferred tax asset 900
Cr Current tax income 900

SUGGESTED ANSWERS 495

 The second entry relates to the increase in the deferred tax liability as a result of the additional tax
depreciation during the 20X9 financial year.
Dr Deferred tax expense 300
Cr Deferred tax liability 300

As at 30 June 20X9, tax losses for which no deferred tax income had been recognised were $4000.

Year ended 30 June 20Y0

During the year ended 30 June 20Y0, the excess of tax depreciation over accounting depreciation was
$800, causing the related taxable temporary difference to increase by the same amount. This movement
in the taxable temporary difference causes the entity to recognise an additional $240 to the deferred
tax liability.
Recognising an increase in the deferred tax liability implies that it is probable that there will be a further
$800 ($240/30%) of taxable profit against which an additional $800 of unrecognised tax losses can be
offset. As a consequence, the entity recognises an extra deferred tax asset of $240.
For the year ended 30 June 20Y0, the taxable profit before utilising tax losses was $2000. Therefore,
tax losses of $2000 may be recovered for this period. When tax losses are recovered, the benefit from the
recovery is first allocated to tax losses for which no deferred tax asset was previously recognised, and then
to tax losses for which a deferred tax asset was previously recognised.
Recall that, in the previous period, deferred tax assets were recognised with respect to only $3000 of
the tax losses arising during the year ended 30 June 20X9. Therefore, there were unrecognised benefits
associated with $4000 of tax losses (unrecognised tax losses) as at 30 June 20X9. A consequence of
recognising an additional $240 to the deferred tax asset is that unrecognised tax losses are reduced by
a further $800 ($240/30%), leaving a balance of unrecognised tax losses of $3200.
Therefore, the whole of the benefit of the $2000 of tax losses recovered during the year ended 30 June
20Y0 is attributed to tax losses for which no benefit was previously recognised. This reduces unrecognised
tax losses to $1200.
The applicable journal entry is as follows.
30 June 20Y0
Dr Deferred tax asset 240
Cr Current tax income 240
Dr Deferred tax expense 240
Cr Deferred tax liability 240
Recognition of additional deferred tax liability and deferred tax asset ($800 × 30%).

Dr Deferred tax expense 600

Cr Current tax income 600
Recovery of tax losses not previously recognised ($2000 × 30%).

Year ended 30 June 20Y1

During the year ended 30 June 20Y1, the excess of tax depreciation over accounting depreciation was
$700, causing the related taxable temporary difference to increase by the same amount. This movement
in the taxable temporary difference causes the entity to recognise an additional $210 to the deferred
tax liability.
During the previous reporting period, tax losses of $2000 were recovered, leaving a $5000 balance of
tax losses yet to be recovered. For the year ended 30 June 20Y1, taxable profit before using tax losses
was $7000. This is sufficient to absorb the balance of the unrecovered tax losses. The benefit of the losses
recovered is allocated in the order discussed earlier.
As at 30 June 20Y0, tax losses for which no deferred tax income had yet been recognised (unrecognised
tax losses) were $1200 and those for which a benefit had been recognised were $3800. Therefore, the
benefit of the first $1200 of tax losses recovered is allocated to the first category of tax losses. The
remainder is allocated to the $3800 of tax losses for which a deferred tax asset had been recognised.

496 SUGGESTED ANSWERS

 The journal entry is as follows.

30 June 20Y1
Dr Deferred tax expense 360
Cr Current tax income 360
Recovery of tax losses not previously recognised ($1200 × 30%).

Dr Deferred tax expense 1 140

Cr Deferred tax asset 1 140
Recovery of tax losses previously recognised: reversal of deferred tax asset that had
been created for $3800 of tax losses (20X9: $900; 20Y0: $240).

Dr Deferred tax expense 210

Cr Deferred tax liability 210
Deferred tax liability resulting from additional tax depreciation of $700.

Dr Current tax expense 600

Cr Current tax payable 600
Recognition of tax liability on taxable profit of $2000.

Unrecognised tax losses†

Year ended Year ended Year ended
30 June 20X9 30 June 20Y0 30 June 20Y1
$ $ $
(1) (2) (3)
1. Unrecognised tax losses at beginning — 4 000 1 200
2. Add tax losses incurred this period 7 000 — —
7 000 4 000 1 200
3. Tax losses for which deferred tax asset
recognised this period (3 000) (800) —
4. Unrecognised tax losses recovered
this period — (2 000) (1 200)
5. Unrecognised tax loss at end 4 000 1 200 —
6. Tax losses for which deferred tax asset
recognised at end 3 000 3 800 —
†
‘Unrecognised tax losses’ refers to tax losses for which no deferred tax asset has been previously recognised.

QUESTION 4.8
The adjusted balances of the deferred tax accounts under the new tax rate are as follows.
$
Deferred tax asset
Previously recognised as income $200 000 × 0.45 = 90 000

Deferred tax liability

Previously recognised as OCI $70 000 × 0.45 = 31 500
Previously recognised as expense $80 000 × 0.45 = 36 000
67 500

The net adjustment to deferred tax accounts is a reduction of $2500. This adjustment is a result of an
amount of $7500 that increases the deferred tax liability and $10 000 that increases the deferred tax asset.

SUGGESTED ANSWERS 497

 The amounts are calculated as follows.
Increase
(decrease)
Carrying amount Carrying amount in deferred
at 45% at 40% tax expense
$ $ $
Deferred tax asset
Previously recognised as income 90 000 80 000 (10 000)†
Deferred tax liability
Previously recognised as OCI 31 500 28 000 3 500‡
Previously recognised as expense 36 000 32 000 4 000§
67 500 60 000 7 500
Net adjustment (2 500)

Notes: $
† An alternative method of calculation is: $200 000 × (0.45 – 0.40) = 10 000
‡ An alternative method of calculation is: $70 000 × (0.45 – 0.40) = 3 500
§ An alternative method of calculation is: $80 000 × (0.45 – 0.40) = 4 000

The journal entry is as follows.

Dr Deferred tax asset 10 000
Cr Deferred tax expense 10 000
Dr Deferred tax expense 4 000
Cr Deferred tax liability 4 000
Dr OCI — revaluation surplus 3 500
Cr Deferred tax liability 3 500

The previous journal entries can be combined as follows.

Dr Deferred tax asset 10 000
Dr OCI — revaluation surplus 3 500
Cr Deferred tax expense† 6 000
Cr Deferred tax liability 7 500

$
† Increase in deferred tax liability previously recognised as expense 4 000
Less: Increase in deferred tax asset previously recognised as revenue 10 000
Net deferred tax expense (6 000)

QUESTION 4.9
The temporary difference after the revaluation is a taxable amount of $80 as illustrated as follows.
Before After
revaluation revaluation
$ $
Carrying amount 100 180
Tax base 100 100
Temporary difference Nil 80

In future periods when the entity recovers the $180 carrying amount of the asset by use or by sale, the
amount deductible in determining taxable profit is $100. Therefore, the net taxable amount is $80, giving
rise to a deferred tax liability of $24 ($80 × 30%).

498 SUGGESTED ANSWERS

QUESTION 4.10
(a) Carrying amount recovered by using the asset
Dr Other comprehensive income — revaluation surplus 21
Cr Deferred tax liability 21
To recognise additional deferred tax as an adjustment to OCI accumulated in the revaluation
surplus (i.e. $24 – $3).

(b) Carrying amount recovered by selling the asset

Dr Other comprehensive income — revaluation surplus 15
Cr Deferred tax liability 15
To recognise additional deferred tax as an adjustment to OCI accumulated in the revaluation
surplus (i.e. $18 – $3).

Note: Full details of the calculations are provided in example 4.14.

QUESTION 4.11
(a) Capital gains tax not applicable
In a regime in which there is no capital gains tax, if the asset is sold for the revalued amount of $45 000,
the capital gain of $5000 (the excess of the sale proceeds $45 000 over initial cost of $40 000) is exempt
from income tax. However, this is a depreciable asset and any tax depreciation recovered from the sale
of the asset is taxable. Tax depreciation recovered is equal to any remaining proceeds of sale, after
capital gains, in excess of the tax written-down amount of the asset.
Therefore, there is a taxable temporary difference of $30 000 associated with the recovery of the
asset, shown as follows.
Recovery by sale $ $
Sales proceeds 45 000
Less: Capital gain (5 000)
Cost (Balance of sale proceeds) 40 000
Less: Tax written-down cost
Cost 40 000
Tax depreciation (30 000) (10 000)
Taxable temporary difference 30 000

Because there is no capital gains tax applicable, the depreciation recovered is equal to the taxable
temporary difference. The deferred tax liability is $30 000 × 30% = $9000.
(b) Capital gains tax applicable
In a regime in which capital gains tax applies, if the asset is sold for the revalued amount of $45 000, the
capital gain of $5000 (the excess of the sale proceeds $45 000 over initial cost of $40 000) is taxable.
As noted above, in addition to the capital gain, because this is a depreciable asset, any tax depreciation
recovered from the sale of the asset is also taxable. Tax depreciation recovered is equal to any remaining
proceeds of sale, after capital gains, in excess of the tax written down amount of the asset.
There is a taxable temporary difference of $35 000 associated with the recovery of the asset.
The taxable temporary difference can be disaggregated between the $5000 capital gain and $30 000
recovery of depreciation, shown as follows.
Recovery by sale $ $
Sales proceeds (recovery of cost of
$40 000 plus $5000 capital gain) 45 000
Less: Tax written-down cost
Cost 40 000
Tax depreciation (30 000) (10 000)
Taxable temporary difference 35 000
The deferred tax liability is $35 000 × 30% = $10 500.

SUGGESTED ANSWERS 499

QUESTION 4.12
Part A
Deductible
Carrying Taxable temporary temporary
amount Tax base difference difference
20X1 $ $ $ $
Receivable 55 000 — 55 000
Inventory 2 000 2 000
Investments 33 000 33 000
Buildings 24 000 20 000 4 000
Plant and equipment 10 000 10 000
Warranty obligations 10 000 — 10 000
Goodwill 10 000 10 000
Accounts payable 500 500
Long-term debt 20 000 20 000
Total 59 000 10 000
Deferred tax liability (taxable temporary differences × 30% tax rate) 17 700
Deferred tax asset (deductible temporary differences × 30% tax rate) 3 000

Deductible
Carrying Taxable temporary temporary
amount Tax base difference difference
20X2 $ $ $ $
Receivable — —
Inventory 2 000 2 000
Investments 33 000 33 000
Buildings (refer to table 4.17) 36 000 10 000 26 000
Plant and equipment 10 000 10 000
Warranty obligations — —
Goodwill 10 000 10 000
Accounts payable 500 500
Long-term debt 20 000 20 000
Total 26 000 0
Deferred tax liability (taxable temporary differences × 30% tax rate) 17 800
Deferred tax asset (deductible temporary differences × 30% tax rate) 0

Part B
Current tax liabilities (assets) are to be recognised at each reporting date at the amounts that are expected
to be paid to (recovered from) the taxation authorities. The tax rates and tax laws to be applied are those
that have been enacted or substantively enacted by the end of the reporting period (IAS 12, para. 46).
Deferred tax assets and liabilities are to be measured at the tax rates expected to apply on realisation or
settlement of the deferred tax assets and deferred tax liabilities, respectively. The expected tax rates and the
tax laws to be applied are those that have been enacted or substantively enacted by the end of the reporting
period (IAS 12, para. 47).
Therefore, AAA Ltd should measure the deferred tax assets and deferred tax liabilities using the new
tax rate of 25%. The deferred tax liability would be $26 000 × 0.25 = $6500.

QUESTION 4.13
If an entity has a history of losses, special consideration should be given to establishing whether or not
sufficient taxable profit will be available against which the deductible temporary difference can be utilised.
In this case, IAS 12 requires that the guidance provided in paragraphs 35 and 36 be considered (IAS 12,
para. 31). This guidance requires that, when utilisation of a deferred tax asset is dependent on future taxable
profit in excess of the taxable profit arising from the reversal of existing taxable temporary differences,
the probability recognition criterion will be satisfied only if there is convincing other evidence that such
taxable profits will be available.

500 SUGGESTED ANSWERS

MODULE 5
QUESTION 5.1
Only situations (d) and (e) represent business combinations. Situations (a) and (b) represent acquisition of
individual assets that do not constitute a business. The regularity of those kinds of asset acquisitions has
no impact on this assessment. The asset acquisitions on a regular basis may indicate strong relationships
between the parties involved, but that does not necessarily indicate that one entity has control over the
other.
Situation (c) describes the acquisition of a bundle of assets that will not be used together to generate
output; as such, this bundle does not satisfy the definition of a business, and therefore the acquisition
cannot be recognised as a business combination. Situation (d), on the other hand, describes a business
combination, as the bundle of assets acquired represents a business.
Situation (e) is again a business combination, but the form is different from situation (d). While situation
(d) describes a direct acquisition, situation (e) represents an indirect acquisition. In both these cases, the
form of the transaction does not matter; it is the substance of acquiring control of other businesses that
makes them business combinations.

QUESTION 5.2
(a) A Ltd would be the acquirer in this combination. This conclusion is supported as follows.
– With 90% of the voting rights, A Ltd would have the power over the investee to affect the amount
of the returns it would receive from B Ltd as the holders of the other 10% of the voting rights would
not have the ability to out-vote A Ltd when decisions about relevant activities of B Ltd need to
be made.
– A Ltd would be able to appoint the directors of B Ltd, who could direct the activities of the company
to provide a return to A Ltd via its performance.
– A Ltd provided consideration as it gave up cash to acquire the ordinary shares of B Ltd (IFRS 3,
para. B14).
(b) D Ltd was formed to facilitate the business combination and issued shares in D Ltd for all of the shares
in A Ltd, B Ltd and C Ltd to their former owners/shareholders. In such situations, one of the combining
entities that existed before the combination is identified as the acquirer. One must determine whether
A Ltd, B Ltd or C Ltd is exposed, or has the rights, to variable returns from its involvement with the
other entities and has the ability to affect those returns through its power over the entities, that is, which
entity has control over the other entities in the combination.
In some circumstances, this may be an arbitrary decision. It is essential to focus on the substance
and not the form of the transaction. IFRS 3 indicates that it is important to consider factors such as
which entity initiated the combination, the relative size of the combining entities (IFRS 3, para. B17)
and those indicators listed in IFRS 3, paragraph B15. For example, the acquirer is likely to be the entity
that has a significantly greater fair value than the other entities, or the entity that has a management
that will dominate the selection of the combining entity’s management. Without further information
about the combining entities, it is difficult to nominate which one would be the acquirer.
(c) Even though A Ltd acquired the shares of B Ltd, the combination could be a reverse acquisition where
B Ltd is, in fact, the acquirer. After the combination, the original shareholders of B Ltd will hold
800 000 shares in the combined entity (via shares in A Ltd), while the original shareholders in A Ltd
will hold only 500 000 shares in the combined entity. Hence, the original shareholders in B Ltd may
now be able to replace (or appoint the majority of) the directors of A Ltd. In such circumstances,
B Ltd would have the rights to variable returns from A Ltd (via dividends) and the ability to affect
those returns through its power over A Ltd (IFRS 10, para. 6). Hence, B Ltd would be considered to
be the acquirer in the combination. As with all combinations, all of the circumstances involved would
have to be considered.

QUESTION 5.3
Goodwill represents the future economic benefits from unidentifiable assets. Identifiable assets are those
assets capable of being individually identified and recognised in the financial statements. IAS 38 defines an
intangible asset as identifiable if it meets either the separability criterion or the contractual–legal criterion.

SUGGESTED ANSWERS 501

If one criterion is satisfied, the identifiable intangible asset of the acquiree can be recognised if its fair
value is capable of reliable measurement (IAS 38, para. 35).
The question mentions three items:
1. brands
2. competitive position
3. market strength.
‘Competitive position’ and ‘market strength’ are typical of items not recognised as identifiable assets in
the statement of financial position. Such items do not satisfy the identifiability criteria in IAS 38, as they
cannot be separated from the entity and sold, rented, transferred, licensed or exchanged (the separability
criterion), nor do they arise from contractual or legal rights (the contractual–legal criterion). Even though
an acquirer would be willing to pay for such items, they would be regarded as unidentifiable assets and,
hence, form part of goodwill.
Many entities separately recognise their brand names as intangible assets. The illustrative examples in
IFRS 3 (IFRS Compilation Handbook) include ‘Examples of items acquired in a business combination
that meet the definition of an intangible asset’. IFRS 3, paragraphs IE19−21 deal with trademarks, trade
names and other intangibles that are often synonymous with brand names.
As trademarks are usually registered, IFRS 3 regards this as satisfying the contractual−legal criterion
of IAS 38 — that is, future benefits can be derived from legal rights. A trademark is also likely to satisfy
the separability criterion because it can be sold. Finally, where a brand name is regarded as an identifiable
intangible asset because it satisfies the criteria of IAS 38, it can be recognised and its fair value can be
reliably measured (IAS 38, para. 35).
In conclusion, even though there are three items mentioned by the managing director, only the brand
name could possibly be regarded as an identifiable asset. The other two items would be regarded as
components of goodwill.

QUESTION 5.4
No, some identifiable assets and liabilities may not have been recognised in the acquiree’s statement
of financial position prior to acquisition. As noted in IFRS 3, paragraph 13, the acquirer may obtain
control over identifiable assets and liabilities that were not previously included in the statement of
financial position of the acquiree (e.g. identifiable intangible assets generated internally, like brand names
and trademarks; or contingent assets and liabilities). This may be because the items did not satisfy the
applicable recognition criteria prior to acquisition.

QUESTION 5.5
Examples of unidentifiable assets that may form part of goodwill include market penetration, good indus-
trial relations, strategic location, superior management, good credit rating, excellent training programs,
specialised skills and community standing. Each of these would provide future economic benefits to the
entity, but would not be recognised because it would not be possible to reliably measure their fair value.
Also, they may not satisfy the identifiability criteria in IAS 38, as they normally cannot be separated from
the entity and sold, rented, transferred, licensed or exchanged (the separability criterion), nor do they arise
from contractual or legal rights (the contractual–legal criterion).

QUESTION 5.6
(a) No, the costs associated with running an acquisitions department would not be included in the cost
of a business combination. General administrative costs associated with maintaining an acquisitions
department for a particular business combination are not considered part of the cost of the business
combination and should be expensed as incurred. They may be acquisition-related costs, but the general
principle is that those costs are expensed in the periods in which they are incurred (IFRS 3, para. 53).
(b) (i) The consideration transferred should be determined as at the acquisition date, the date when the
risks and rights to future benefits associated with the investment pass to Investor. This is not
1 April 20X5, which is the date when the agreement was signed, but 30 June 20X5, which is when
the terms of the agreement were fulfilled.
The consideration transferred should be measured by reference to the fair value of what was given
up at the acquisition date (being 30 June 20X5, as discussed), not what was received. Investor gave

502 SUGGESTED ANSWERS

 up 100 000 shares and their fair value at 30 June 20X5 was $5.00 per share, making the fair value
of the total consideration transferred equal to $500 000.
Consulting fees cannot be included as part of the consideration transferred, as acquisition-related
costs are expensed in the periods in which the costs are incurred (IFRS 3, para. 53).
(ii) The pro forma journal entries prepared by Investor to account for the acquisition of the investment
and the payment of acquisition-related costs are as follows.

Dr Investment in Investee 500 000

Cr Issued capital 500 000
Issue of shares to acquire the investment.
Dr Consulting fees (expense) 10 000
Cr Bank 10 000
Acquisition costs recognised in P/L.

QUESTION 5.7
The fair value of the identifiable net assets in B is calculated as follows.

Fair value of total identifiable assets recorded by B $10 000 000

Add: Fair value of identifiable assets not previously recorded by B $1 000 000
Less: Fair value of total identifiable liabilities recorded in B ($5 000 000)
Less: Fair value of contingent liability not previously recorded in B ($1 000 000)
Fair value of total identifiable net assets of B $5 000 000

Therefore, the goodwill on acquisition is:

Fair value of consideration transferred by acquirer $8 000 000
Less: Fair value of identifiable net assets in B ($5 000 000)
Goodwill $3 000 000

The journal entry posted by A in its own records to recognise the acquisition of all the assets and liabilities
of B is as follows.

Dr Accounts receivable 400 000

Dr Inventory 600 000
Dr Plant and equipment 2 000 000
Dr Land and buildings 7 000 000
Dr Trademark 1 000 000
Dr Goodwill 3 000 000
Cr Accounts payable 500 000
Cr Bank loan 4 500 000
Cr Provision for damages 1 000 000
Cr Bank 8 000 000

QUESTION 5.8
In example 5.6, the acquirer acquired all the assets and liabilities of a business that it now fully owns. This
acquisition is a direct acquisition and, as such, the assets are transferred to the acquirer’s accounts, which
recognise them as assets of the entity, together with the previous assets it owned prior to the acquisition.
Liabilities are only directly transferred into the acquirer’s records.
On the other hand, in example 5.7, the acquirer acquired only the shares issued by the business that it
now fully owns, but the acquiree retains legal ownership of its assets and a legal responsibility to settle its
liabilities. As such, the treatment of this acquisition recognises that the acquirer purchases just one single
asset that it needs to recognise in its own accounts. Shareholders in the acquirer will not be able to easily
identify by looking at the financial statements of the acquirer what assets and liabilities were acquired
unless they are provided with a detailed description of the business combination.
To make it easier to understand the financial impact and the risks and opportunities facing the acquirer
as a result of this business combination via purchase of shares, IFRS 10 requires the acquirer in these
instances to prepare consolidated financial statements that will include the assets and liabilities of all the
entities within the group.

SUGGESTED ANSWERS 503

QUESTION 5.9
The pro forma journal entry at acquisition date to reflect the acquisition of Small’s assets and liabilities by
Large is as follows.
Dr Trade receivables 95 000
Dr Inventory 200 000
Dr Land and buildings 700 000
Dr Goodwill 60 000
Cr Bank overdraft 30 000
Cr Trade payables and loans 400 000
Cr Bank† 400 000
Cr Issued capital‡ 225 000
†
Payment of consideration in cash.
‡
Issue of shares as part of the consideration transferred.
Notes
1. The identifiable assets and liabilities acquired by Large are recorded at their fair values at acquisition
date in accordance with IFRS 3, paragraph 18. The amounts recorded for these assets and liabilities by
Small are not relevant to this type of business combination, which is structured as a direct acquisition.
2. There is no deferred tax asset or deferred tax liability recognised by Large as the assets and liabilities
acquired are of such a type that their amounts recorded by Large also establish their tax base.
3. The difference between the fair value of the consideration transferred (made out of cash and shares)
and the fair value of the identifiable assets and liabilities acquired is equal to the goodwill, which is
recognised as an asset in accordance with IFRS 3, paragraph 32.

QUESTION 5.10
The pro forma journal entry at acquisition date to reflect the acquisition of Low’s assets and liabilities by
High is as follows.
Dr Trade receivables 200 000
Dr Inventory 850 000
Dr Plant and equipment 2 600 000
Dr Deferred tax asset 90 000
Dr Goodwill 350 000
Cr Trade payables 100 000
Cr Loans 890 000
Cr Contingent liability 300 000
Cr Bank† 2 800 000
†
Payment of consideration in cash.

Notes
1. The identifiable assets and liabilities acquired by High are recorded at their fair values at acquisition
date in accordance with IFRS 3, paragraph 18. This includes the contingent liability because it is a
present obligation and its fair value can be reliably measured at acquisition date.
2. The recognition of the contingent liability has given rise to a deferred tax asset.
3. The difference between the fair value of consideration transferred and the fair value of the identifiable
assets and liabilities acquired is equal to the goodwill, which is recognised as an asset in accordance
with IFRS 3, paragraph 32.

QUESTION 5.11
(a) The degree of equity ownership is not the overriding consideration in determining the existence of
control, but the existence of voting rights attached to the shares that constitute the equity ownership
would be a factor (remember that not all classes of shares have voting rights attached). Whether Y is a
subsidiary of X will depend on whether X controls Y (IFRS 10, para. 5). X will only have control over
Y if all of the following criteria are satisfied.
– X has power over Y through having existing rights to direct Y’s relevant activities.
– X is exposed, or has rights, to variable returns from its involvement with Y.
– X has the ability to use its power over Y to affect the amount of its returns (IFRS 10, paras 6 and 7).

504 SUGGESTED ANSWERS

 Determination of whether X has control will rely on judgments being made based on the substance
of the case. Given no other relevant factors, and assuming that X has 60% of the voting rights in Y, it
would be expected that X has the power to direct the relevant activities of Y. This power would derive
from an ability to use its voting power to appoint the majority of directors of X who direct the relevant
activities of the company, including the operating (e.g. selling goods or services, buying assets) and
financing activities (e.g. obtaining funding) of the company (IFRS 10, paras B11 and B35).
X would also be exposed to, or have a right to, variable returns based on the performance of Y. As a
shareholder, X would expect to receive a return via dividends and changes in the value of its investment.
These returns could be positive or negative depending on Y’s profitability. It does not matter that the
other shareholders’ (who hold 40%) share in the returns of Y (IFRS 10, paras 15 and 16). X may also be
able to include a right to receive returns from factors such as securing a supply of services, economies
of scale or remuneration from providing services (IFRS 10, para. B57).
Finally, it would be expected that X could use its power over Y to affect the returns it received from
the company. That is, X could use its power to increase the returns it received from Y or reduce any
potential losses.
(b) Even though X does not hold the majority of shares in Y, it can still have control of Y. The critical
issue is whether X has the power to direct the relevant activities of Y. IFRS 10, paragraph B42 and
Example 4 of Appendix B both suggest that it is likely that X would satisfy the power criterion of
control. This stems from both X’s absolute and relative voting rights compared with other shareholders
(IFRS 10, para. B42(a)). To outvote X, other shareholders with a combined interest of a least 45% of the
shares need to act together. This would involve hundreds of shareholders. As few of these shareholders
attend annual meetings and there is no agreement between shareholders to make collective decisions,
this is highly unlikely.
In addition to X having the power to direct the relevant activities of Y, the company must also satisfy
the other criteria for control (IFRS 10, paras 6 and 7). As a shareholder in Y, X is exposed to returns
from the company, which will vary depending on the performance of Y. Finally, X can use its power to
affect the returns from Y. As the dominant shareholder, X would be able to influence the appointment
of Y’s directors and hence the financial and operating decisions of the company, which in turn will
impact on X’s returns from Y.
(c) As with Part (b), the critical criterion of control in this situation is whether X has power over
Y. In accordance with IFRS 10, paragraph B42(a) and the discussion in IFRS 10, Example 6 of
Appendix B, X would not satisfy the power criterion of control. The central factor preventing X from
having power over Y is that the two other shareholders have combined voting rights of 56%. Hence,
these two shareholders can work together to prevent X from directing the relevant activities of Y.
Therefore, in this case, X is not likely to control Y.
(d) IFRS 10, paragraphs B36 and B37 discuss the situation in which an investor can have the majority
of voting rights but no power. One example of where this could occur is when another entity has a
contractual right to direct the relevant activities of the investee and is not an agent of the investor. In
such a situation, the investor does not have power over the investee. Another example is where the
voting rights are not substantive as the investor does not have the practical ability to exercise their
rights (IFRS 10, para. B22). This could occur where the relevant activities of the investee are subject
to direction of other parties, such as the government, a court administrator or a liquidator.

QUESTION 5.12
(a) The fair value of the consideration transferred is the aggregate of the fair value of share capital issued
as consideration. The fair value of the shares issued by Holding, at 30 June 20X3, was $5.00 per share.
Hence, the fair value of consideration transferred is calculated as follows.
Fair value of shares issued (30 000 shares1 @ $5.00) = $150 000
(b) The pro forma journal entry for Holding to account for the acquisition of the Subsidiary’s shares is
as follows.
Dr Investment in Subsidiary 150 000
Cr Issued capital 150 000
Issue of shares to acquire shares in Subsidiary.

1 Subsidiary has an issued capital of 12 000 shares. Holding offered five of its shares for every two of Subsidiary and therefore issued
12 000/2 × 5 = 6000 × 5 = 30 000 shares as part of consideration.

SUGGESTED ANSWERS 505

(c) The recognition of the identifiable net assets of Subsidiary at fair value as part of the business
combination leads to the recognition of a deferred tax liability. The amount of the deferred tax liability
is calculated as follows.
$000
Fair value of identifiable net assets 125
Less: Tax base of identifiable net assets acquired (95)
Taxable temporary difference 30

Therefore, a deferred tax liability of $9000 ($30 000 × 30%) arises on acquisition.
Note: The deferred tax liability only arises in this situation due to the difference between the fair
value of the identifiable assets and their tax base.
The pro forma journal entry for the revaluation of Subsidiary’s non-current assets to fair value in the
consolidation worksheet is as follows.
Dr Non-current assets 20 000
Cr Deferred tax liability 6 000
Cr Revaluation surplus 14 000

The consolidation journal entry for the revaluation of the identifiable current assets of Subsidiary to
fair value on consolidation is as follows.
Dr Current assets 10 000
Cr Deferred tax liability 3 000
Cr Business combination reserve 7 000

(d) The group has purchased goodwill as the fair value of the consideration transferred is larger than the
fair value of the identifiable net assets acquired (IFRS 3, para. 32). As Holding acquired the entire
issued capital of Subsidiary, there is no non-controlling interest or previous equity interest.
The fair value of the identifiable net assets acquired by Holding is calculated as follows.
$000
Fair value of identifiable net assets before deferred tax liability 125
Less: Deferred tax liability arising on revaluation of identifiable net assets
to fair value (9)
Fair value of identifiable net assets acquired 116

Therefore, the goodwill to be recognised by the group is determined as follows.

$000
Fair value of consideration transferred (refer to Part (a)) 150
Less: Fair value of identifiable net assets acquired (116)
Goodwill 34

(e) The pre-acquisition elimination journal entry to account for the elimination of the investment in
Subsidiary is as follows.
Dr Goodwill 34 000
Dr Revaluation surplus 14 000
Dr Business combination reserve 7 000
Dr Issued capital 12 000
Dr Retained earnings 83 000
Cr Investment in Subsidiary 150 000

QUESTION 5.13
The pre-acquisition consolidation elimination entries as at the acquisition date should:
1. revalue the plant acquired to its fair value and recognise a business combination reserve (considered part
of pre-acquisition equity of Subsidiary) for the after-tax increase in value and a deferred tax liability
for the tax effect

506 SUGGESTED ANSWERS

2. eliminate the investment account appearing in the financial statements of Parent, together with the parent
entity’s share of the pre-acquisition equity of Subsidiary that includes the business combination reserve
recognised on revaluation of plant and recognise any goodwill.

1. Revaluation of plant
Remember that it is the group that has acquired the business (including goodwill) of the subsidiary.
Therefore, the requirements of IFRS 3 in terms of using the acquisition method for this business
combination are applicable in the consolidated financial statements. As such, as long as the plant wasn’t
revalued in the subsidiary’s accounts, it has to be recognised at fair value on consolidation, just like all the
other identifiable net assets.
At the acquisition date (1 July 20X0):
• the financial statements of Subsidiary recorded plant at cost of $100 000, less accumulated depreciation
of $40 000 (see point 3 of case study 5.1)
• Parent considered that the plant owned by Subsidiary had a fair value of $80 000. In accordance with
IFRS 3, the plant must be initially measured at $80 000 (i.e. fair value) in the consolidated financial
statements (see point 3 of case study 5.1).
Therefore, the consolidation worksheet entry must decrease the gross carrying value of the plant by
$20 000 (i.e. from $100 000 down to $80 000) and decrease accumulated depreciation by $40 000 (i.e.
from $40 000 down to $nil). This is reflected in the consolidation worksheet entry as a debit to accumulated
depreciation of $40 000 and a credit to the gross carrying value of plant of $20 000. After these adjustments,
the plant is valued at fair value (an increase of $20 000 over the old carrying amount in the records of
Subsidiary), but the tax base is not affected, and therefore, a taxable temporary difference is created, for
which a deferred tax liability of $6 000 (assuming a tax rate of 30%) needs to be recognised. Similar to
the case of the revaluation of plant in individual accounts, for the after-tax increase in value, a revaluation
reserve has to be recognised. In this module, the term used for the reserve created on the revaluation of
the subsidiary’s assets and liabilities to fair value in the consolidation worksheet entry is the ‘business
combination reserve’. This term is not specified by IFRS 3, and other names could be used.
The journal entry will be posted in the consolidation worksheet as follows.
Dr Accumulated depreciation 40 000
Cr Plant 20 000
Cr Deferred tax liability 6 000
Cr Business combination reserve 14 000

From the group’s perspective, the plant was acquired at a fair value of $80 000 and this is reflected in
this worksheet.
Note: Items of plant and equipment may be shown in a worksheet ‘net of accumulated depreciation’ and
hence the consolidation entry is a single adjustment to that line item. That is, for this example, if there was
no detail concerning accumulated depreciation, the $60 000 net of accumulated depreciation amount for
plant would be simply adjusted by a debit of $20 000 to arrive at the $80 000 consolidated amount net of
accumulated depreciation.

2. Elimination of the investment in the subsidiary and the pre-acquisition

equity and recognition of goodwill
Dr Issued capital 100 000
Dr Retained earnings 80 000
Dr Business combination reserve 14 000
Dr Goodwill 36 000
Cr Investment in Subsidiary 230 000

This entry relates to the elimination of the pre-acquisition equity and the investment in the subsidiary and
the recognition of goodwill. Business combination reserve is considered a part of pre-acquisition equity
of the subsidiary because it reflects the after-tax profit-making potential of the asset. In effect, these are
pre-acquisition benefits of the plant.

SUGGESTED ANSWERS 507

 The two preceding entries could be combined as follows.

Dr Issued capital 100 000

Dr Retained earnings 80 000
Dr Accumulated depreciation 40 000
Dr Goodwill 36 000
Cr Plant 20 000
Cr Deferred tax liability 6 000
Cr Investment in Subsidiary 230 000

As a result of these entries, the consolidated financial statements would then:

(i) include the net assets of Subsidiary recorded at fair value
(ii) recognise the deferred tax liability arising from the business combination in accordance with IAS 12
and IFRS 3
(iii) exclude the asset ‘Investment in Subsidiary’ because the group cannot have an investment in itself
(iv) have a shareholders’ equity that includes the issued capital of the parent (the issued capital of
Subsidiary is owned by Parent, not shareholders external to the group) and retained earnings of Parent
(the retained earnings of Subsidiary are obtained prior to the formation of the group and, therefore, do
not belong to the group and have been eliminated).

QUESTION 5.14
(a) For the year ended 30 June 20X2, Subsidiary would process the following depreciation entry.

Dr Depreciation expense 12 000

Cr Accumulated depreciation 12 000

As point 4 of case study 5.1 indicates, the remaining useful life of the plant as of 1 July 20X0 is
five years with a scrap value of $0. Given the carrying amount of the plant is $60 000 (see point 3 of
case study 5.1), depreciation expense per annum in the financial statements of Subsidiary is $12 000
(($60 000 – $0)/5 years). This amount is annual depreciation expense for each year subsequent to the
acquisition date, including the year ended 30 June 20X2.
As discussed in example 5.10, the statement of P/L and OCI of the group should include depreciation
expense for the plant of $16 000. This is because the plant had a fair value of $80 000 at the acquisition
date, giving rise to annual depreciation expense of $16 000 (($80 000 – $0)/5 years). A comparison
of the statement of financial position of Subsidiary with what should be reported in the statement of
financial position of the group would reveal the following information in relation to the plant.
Subsidiary Group
$ $
Plant 100 000 80 000
Less: Accumulated depreciation (64 000)† (32 000)‡
Carrying amount 36 000 48 000

†
Accumulated depreciation at acquisition date ($40 000) plus depreciation for the years ended
30 June 20X1 and 30 June 20X2 ($12 000 + $12 000) from the point of view of Subsidiary.
‡
Depreciation for the years ended 30 June 20X1 and 30 June 20X2 ($16 000 + $16 000) from the point
of view of the group.

Consolidation entries on 30 June 20X2

1. Revaluation of plant to fair value
Dr Accumulated depreciation 40 000
Cr Plant 20 000
Cr Deferred tax liability 6 000
Cr Business combination reserve 14 000

508 SUGGESTED ANSWERS

2. Depreciation entry and associated tax effect
Dr Retained earnings (opening balance — prior year adj.) 4 000
Dr Depreciation expense (current year adj.) 4 000
Cr Accumulated depreciation 8 000

Accumulated depreciation must be adjusted for two years’ depreciation adjustments (20X1 and
20X2) — hence, the credit of $8000 (2 × $4000), where the depreciation adjustment reflects the
difference in annual depreciation expense between the group and Subsidiary ($16 000 – $12 000 =
$4000). The debit to the retained earnings account of $4000 relates to increased depreciation in the
prior accounting period (i.e. 20X1). As an alternative explanation, the $4000 debit to the opening
retained earnings account could be considered from the point of view of the depreciation charges
made in the financial statements of the group in the preceding period. To illustrate, in the year ended
30 June 20X1, an additional $4000 of depreciation expense was recognised in the statement of P/L
and OCI of the group, as compared to that of Parent plus Subsidiary. These higher depreciation
charges would have reduced the profits and, in turn, the retained earnings of the group, as compared
to the profits and retained earnings reported in the financial statements of Parent plus Subsidiary.
As a result, in the 20X2 financial year, the opening retained earnings account of the group had to be
reduced by $4000.
Dr Deferred tax liability 2 400
Cr Income tax expense 1 200
Cr Retained earnings (opening balance) 1 200

The higher group depreciation expense in 20X1 reduces the group profit before tax, which requires
the 20X1 tax expense of the group to be reduced by $1200 ($4000 × 30%). This reduction in group
tax expense by $1200 is reflected in the credit entry to the opening retained earnings account, as it
relates to increased group profit after tax from a prior period. Hence, in the 20X2 financial year, the
opening retained earnings account of the group increased by $1200. The net effect of the impact
of the 20X1 depreciation adjustment net of tax was to reduce (debit) the opening retained earnings of
the group by $2800 ($4000 – $1200). The higher group depreciation expense in 20X2 also reduces
the group profit before tax, requiring the 20X2 tax expense of the group to also be reduced by $1200,
which is reflected in the credit entry to income tax expense.
The deferred tax liability of the group after the preceding entries is $3600 ($6000 – $2400),
as the temporary difference relating to the plant at 30 June 20X2 is $12 000. That is, at 30 June
20X2, the carrying amount of the plant for the group is $48 000 (see previous statement extract),
while its tax base is $36 000. The tax base corresponds with the carrying amount of the plant to
the Subsidiary because the plant was not revalued for tax purposes and the tax and accounting
depreciation calculations are consistent.
3. Pre-acquisition elimination entry
Dr Issued capital 100 000
Dr Retained earnings 80 000
Dr Business combination reserve 14 000
Dr Goodwill 36 000
Cr Investment in Subsidiary 230 000

The preceding three entries could be combined as follows.

Dr Issued capital 100 000
Dr Retained earnings (opening balance) 82 800
Dr Depreciation expense 4 000
Dr Accumulated depreciation 32 000
Dr Goodwill 36 000
Cr Plant 20 000
Cr Income tax expense 1 200
Cr Deferred tax liability 3 600
Cr Investment in Subsidiary 230 000

SUGGESTED ANSWERS 509

 Accumulated depreciation must be adjusted for two years’ depreciation adjustments (20X1 and
20X2) — hence, the debit of only $32 000 ($40 000 – (2 × $4000)), which reflects the combined
debit and credit entries to accumulated depreciation from consolidation entries 1 and 2. This entry to
accumulated depreciation for $32 000 can also be confirmed by referring to the statement of financial
position extract, which illustrates that Subsidiary would have recorded accumulated depreciation at
30 June 20X2 of $64 000, while the group should report accumulated depreciation of $32 000.
The other entry to be explained is the debit to the retained earnings account of $82 800. In
effect, this comprises two entries: the elimination of the original pre-acquisition earnings ($80 000);
and an entry relating to increased depreciation expense (net of tax) in the prior accounting period
($4000 – $1200 = $2800). The latter reflects the fact that the parent entity recognised the profit-
making potential of the asset and was prepared to pay $20 000 more than the carrying amount of
plant. In effect, these are pre-acquisition benefits of the plant. This is easier to see if one recalls that
the revaluation of the plant entry (entry (1)) has resulted in a credit to the business combination
reserve. Of course, this is clearly a component of the pre-acquisition equity acquired. As the
asset is used, this pre-acquisition equity is reflected over subsequent accounting periods via higher
depreciation charges and lower group profits.
(b) Point 5 of case study 5.1 states that the plant held by Subsidiary was sold on 1 July 20X2 to an
external party. Therefore, Subsidiary would not need to record any depreciation for the financial
year ending 30 June 20X3. Instead, at 1 July 20X2, Subsidiary would process the following entry
to account for the sale of plant.
Dr Bank 40 000
Dr Accumulated depreciation 64 000
Cr Plant 100 000
Cr Profit on sale of plant 4 000

Dr Issued capital 100 000

Dr Retained earnings (opening balance) 85 600
Dr Profit on sale of plant 12 000
Dr Goodwill 36 000
Cr Income tax expense 3 600
Cr Investment in Subsidiary 230 000
Consolidation pre-acquisition elimination entry on 30 June 20X3.

The debit to opening retained earnings of $85 600 has two components: the elimination of the
original pre-acquisition profit of $80 000; and an entry relating to the two prior years’ depreciation
adjustments net of tax (2 × $2800 = $5600). The rationale for the adjustment to opening retained
earnings for prior years depreciation adjustments was explained in Part (a).
Subsidiary has recorded a profit on the sale of the plant of $4000, being the difference between
the amount received for the plant ($40 000) and the carrying amount of the plant in Subsidiary’s
accounts ($100 000 – $64 000 = $36 000). From the group’s point of view, however, a loss of $8000
should be recorded for the sale of plant (sale price $40 000, less carrying amount $48 0002 ).
The debit to the Profit on sale of plant account for $12 000 in the statement of P/L and OCI
converts the ‘profit’ of $4000 (credit) recorded by Subsidiary to a ‘loss’ of $8000 (debit) for the
group in the consolidated statement of P/L and OCI.
Again, this reflects the fact that, at the acquisition date, the group treated the difference between
the book value and the fair value of the plant ($20 000) as pre-acquisition equity. The group has
already recognised $8000 of this amount in previous periods via depreciation charges (refer to the
debit to the retained earnings account — gross adjustment of $8000 less tax effect of $2400, giving
a net adjustment of $5600). The remaining $12 000 is treated as pre-acquisition equity on the sale
of the plant. Hence, the group will not recognise the $4000 profit in Subsidiary’s statement of P/L
and OCI, but an $8000 loss.
The reduction of the profit on the sale of the plant by the group by $12 000 compared with Parent
and Subsidiary requires the tax expense of the group to be reduced by $3600 ($12 000 × 30%). As
such, it is recorded entirely to income tax expense.

2 Refer to the statement of financial position extract in the answer to question 5.14, part (a).

510 SUGGESTED ANSWERS

 (c)
Dr Issued capital 100 000
Dr Retained earnings 94 000
Dr Goodwill 36 000
Cr Investment in Subsidiary 230 000

The $94 000 debit to retained earnings is made up two components: the elimination of the
original pre-acquisition earnings of $80 000; and the $14 000 reduction in retained earnings via
the depreciation and profit on sale adjustments, net of the tax effects of previous reporting periods.
That is, the 20X1 and 20X2 depreciation adjustments net of tax (2 × ($4000 – $1200) = $5600) plus
the adjustment for the sale of plant net of tax ($12 000 – $3600 = $8400).
The $14 000 also reflects the amount that was debited to the business combination reserve at the
acquisition date, as it involved pre-acquisition equity. This component of pre-acquisition equity is
now reflected in retained earnings, and its effects will be carried over to every subsequent reporting
period because retained earnings will always be $14 000 less than the sum of the retained earnings
of Parent and Subsidiary.

QUESTION 5.15
(a) Question 5.15(a) assumes that all of the inventory held by the subsidiary as at 30 June 20X3 was sold
in July 20X3 for $50 000 to parties external to the group.
The following pro forma consolidation worksheet entries would be processed.
Dr Retained earnings (opening balance) 10 000
Cr Cost of goods sold 10 000
Dr Income tax expense 3 000
Cr Retained earnings (opening balance) 3 000

Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Sales 50 50
Less: Cost of goods sold (40) 10 (30)
Gross profit 10 20

Profit before tax 10 20

Income tax expense (3) 3 (6)
Profit for the year 7 14
Retained earnings
(opening balance)† 7 10 3 —
†
Refer to ‘Profit for the year’ of Parent in the example 5.14 worksheet.

Group profit before tax for the year ended 30 June 20X3 (the prior year) was $10 000 less than
the sum of the profit before tax for individual entities in the group as the inventory transferred intra-
group on 1 June 20X3 was still on hand with the subsidiary, and therefore, the intra-group profit was
not yet realised from the group’s perspective. As that unrealised profit was not eliminated from the
parent’s accounts, the opening retained earnings at 1 July 20X3 of the parent includes that profit. On
consolidation, that has to be eliminated. Hence, the opening retained earnings for the financial year
ended 30 June 20X4 has to be reduced by $10 000 (a debit entry).
In the current financial year, the inventory has been sold to parties external to the group. Hence, the
profit on the sale should be recognised by the group. The sale would be included in the total sales of
the subsidiary, the reporting entity that held the inventory after the ‘internal’ sale. However, the cost
of goods recorded in the financial statements of the subsidiary would be overstated from the point
of view of the group as it is based on the inventory value recognised by the subsidiary — that was
overstated from the perspective of the group at 30 June 20X3 as it was recorded based on the price
paid intra-group that included the unrealised profit. Therefore, in the 20X4 financial year when the
inventory is sold the cost of goods sold has to be remeasured (reduced) to reflect the cost to the group.
The credit entry to the cost of goods sold achieves this reduction. After processing this worksheet entry,

SUGGESTED ANSWERS 511

 the consolidated profit before tax will be $10 000 greater than the combined profit before tax of the
parent and the subsidiary (refer to the consolidation worksheet extract to confirm this). In essence, the
profit recognised by the parent in the previous period is transferred to the current period when it should
be recognised by the group.
Thus, the profit on the sale of the inventory has been correctly included in the 20X4 financial year,
the period during which it was sold to parties external to the group. As the profit on the sale of the
inventory has now been recognised by the group, a corresponding increase in the income tax expense
of the group should be recognised — hence, the debit to the income tax expense.
In the 20X3 financial year, the income tax expense of the group was reduced by $3000 on the
elimination of $10 000 profit. The effect of this reduction in income tax expense ‘flowed through’ the
worksheet, resulting in an increase in the closing retained earnings of the group compared with that of
the parent entity plus subsidiary. Thus, the 20X4 opening balance of the retained earnings of the group
needs to be increased. This is achieved via a credit entry in the worksheet.
Another way of viewing the two entries that adjust the opening balance of retained earnings is that
in the 20X3 financial year, the unrealised profit after tax of the group was $7000. The elimination of
this unrealised profit after tax has resulted in a lower closing balance of retained earnings. Hence, to
obtain the same result, the 20X4 consolidated opening retained earnings has to be reduced by $7000
(the debit of $10 000 and the credit of $3000).
Finally, it should be noted that in the 20X3 consolidated financial statements, a deferred tax asset
of $3000 was recognised. During the 20X4 financial year, the profit on the sale of the inventory was
recognised in the consolidated financial statements. However, as the tax relating to this profit has
already been paid in 20X3 by the parent, no tax is payable on the recognition of this profit by the
group. In this instance, the 20X3 deferred tax asset has been used by the group in the 20X4 financial
year. Therefore, no accounting entries are required to reinstate the deferred tax asset account.
(b) Question 5.15(b) assumes that half of the inventory held by the subsidiary as at 30 June 20X3 was sold
by 30 June 20X4 for $25 000 to parties external to the group. The consolidation elimination entries at
30 June 20X4 would include the following.
Dr Retained earnings (opening balance) 10 000
Cr Cost of goods sold 5 000
Cr Inventory 5 000

Dr Income tax expense 1 500

Dr Deferred tax asset 1 500
Cr Retained earnings (opening balance) 3 000

Consolidation worksheet after the consolidation elimination entries

Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000

Sales 25 25
Less: Cost of goods sold (20) 5 (15)
Gross profit 5 10

Profit before tax 5 10

Income tax expense (1.5) 1.5 (3)
Profit for the year 3.5 7
Retained earnings
(opening balance)† 7 10 3
Statement of financial position
Inventory 20 5 15
Deferred tax asset 1.5 1.5
†
Refer to ‘Profit for the year’ of Parent in example 5.14 worksheet.

The rationale for the debit and credit entries to the retained earnings (opening balance) is the same
as the adjustments to the retained earnings (opening balance) explained in (a).
In the financial year ended 30 June 20X4, only half of the inventory that had previously been sold
within the group was sold for $25 000 to parties external to the group. Both the consolidated cost of
goods sold and consolidated asset ‘inventory’ should be recognised at $15 000. This amount represents

512 SUGGESTED ANSWERS

 half of the cost of the inventory to the group, which the parent purchased for $30 000. Therefore, the
cost of goods sold recognised by the subsidiary of $20 000 overstates the cost of goods sold of the
group by $5000 (half of the $10 000). The remaining half of the inventory on hand is still reflected in
the inventory of the subsidiary as $20 000, but its value is also overstated from the group’s perspective.
Both the cost of goods sold and the inventory remaining need to be remeasured (reduced) to reflect
only the effect of the external transactions of the group.
As the group has recognised half ($5000) of the intra-group profit previously eliminated (refer to
the consolidation worksheet extract to confirm this), the income tax expense of the group has to be
increased by $1500 (debit tax expense — 30% of $5000). However, given that the tax on the full intra-
group profit was already paid, this tax expense recognised for the group now essentially means that
the group has used half ($1500) of the deferred tax asset recognised in the 20X3 financial year. Hence,
the consolidated statement of financial position should only include the remaining deferred tax asset
of $1500 for the remaining unrealised intra-group profit.
(c) The entries processed by the subsidiary and parent for the year ended 30 June 20X3 would be as
follows.

Dr Bank 50 000
Dr Accumulated depreciation 60 000
Cr Plant 100 000
Cr Profit on sale of plant 10 000
For Subsidiary.
Dr Plant 50 000
Cr Bank 50 000
Dr Depreciation expense 10 000
Cr Accumulated depreciation 10 000
For Parent.

The following pro forma consolidation worksheet entries would be processed for the financial year
ended 30 June 20X3.

Dr Profit on sale of plant 10 000

Dr Deferred tax asset 3 000
Cr Plant 10 000
Cr Income tax expense 3 000

Dr Accumulated depreciation 2 000

Dr Income tax expense 600
Cr Depreciation expense 2 000
Cr Deferred tax asset 600

Notes
• Debit ‘Profit on sale of plant’ — $10 000
In the 20X3 financial year, the financial statements of the subsidiary would include $10 000 profit on the
sale of the plant to the parent entity. From the perspective of the group, this profit should be eliminated.
• Debit ‘Deferred tax asset’ and credit ‘Income tax expense’ — $3000
If the profit on the sale is eliminated, the income tax expense recognised by the subsidiary should also be
eliminated. A deferred tax asset also needs to be recognised by the group. In future accounting periods,
the group will recognise the profit on sale of the plant but will not pay tax because the subsidiary has
paid it in 20X3. Alternatively, the consolidated tax asset of $3000 can be explained by the fact that the
tax base of the plant ($50 000) is greater than its carrying amount to the group ($40 000) and, hence, the
group has a deductible temporary difference of $10 000 and therefore a deferred tax asset.
• Credit ‘Plant’ — $10 000
The Plant account has to be reduced, as it is overstated from the group’s point of view. It is measured in
the statement of financial position of the parent entity at $50 000. However, the carrying amount of the
plant to the group was $40 000.
• Debit ‘Accumulated depreciation’ and credit ‘Depreciation expense’ — $2000
The plant is being depreciated by the parent entity based on the cost to that entity ($50 000). In preparing
the consolidated financial statements, the depreciation should be measured using the cost to the group
($40 000). Both the parent entity and the group are depreciating the plant on a straight-line basis over the

SUGGESTED ANSWERS 513

 remaining useful life of the asset (five years). To relate the depreciation to the cost to the group requires
a decrease in depreciation expense of $2000 each financial year.
Note: The group should depreciate a depreciable non-current asset using the same depreciation
method and rate applied by the member of the group using the item. That is, the group is using up
the service potential of the depreciable item at the same rate as the member of the group that controls
it. In this case, when the plant was held by the subsidiary prior to 1 July 20X2, the group would have
used the reducing-balance method of depreciation. However, since the plant was sold to the parent, it
has been used in a different manner such that its service potential is being used up evenly. As a result,
both the parent and the group should use the straight-line basis of depreciation. The difference in the
amount of depreciation recorded by the parent entity versus the group derives from the different cost of
the plant to each entity, not from the depreciation rate being used.
• Debit ‘Income tax expense’, credit ‘Deferred tax asset’ — $600
This entry is the tax effect of the preceding entry. As the group uses the plant, the intra-group profit is
recognised via depreciation charges. Hence, the income tax expense of the group must be increased as
the deferred tax asset created in 20X3 is used. That is, the group is including the profit, but the tax has
already been paid by the subsidiary when the plant was sold to the parent entity.
After the preceding entries, the consolidated deferred tax asset is $2400. This reflects the fact that the
tax base of the plant to the group at 30 June 20X3 is $40 000 (carrying amount in financial statements of
parent entity), which is $8000 greater than its carrying amount of $32 000 in the consolidated financial
statements, and therefore a deductible temporary difference.

Dr Retained earnings (opening balance) 5 600

Dr Deferred tax asset 2 400
Dr Accumulated depreciation 2 000
Cr Plant 10 000

Dr Accumulated depreciation 2 000

Dr Income tax expense 600
Cr Depreciation expense 2 000
Cr Deferred tax asset 600
Pro forma consolidation worksheet entries for the financial year ended 30 June 20X4.

Notes: First entry

• Debit ‘Retained earnings’ — $5600
This entry reflects the net adjustment to the retained earnings account as a result of the eliminations at
30 June 20X3 of all the effects of the intra-group transaction from 1 July 20X2. Note that the retained
earnings account always recognises after-tax profit. The decrease in the retained earnings of $5600 needs
to be recognised because of the following.
$
Elimination of the after-tax profit from the intra-group transaction (7 000)
Recognition of after-tax profit realised via depreciation 1 400
Net effect on 20X3 closing consolidated retained earnings (5 600)

In essence, the net effect on 20X3 closing consolidated retained earnings is a decrease by the
remaining intra-group profit still unrealised from the group’s perspective at 30 June 20X3. As the
retained earnings account closing balance needs to be reduced by $5600 in 20X3, the opening balance
for 20X4 must be similarly reduced.
• Debit ‘Deferred tax asset’ — $2400
This entry is related to the prior adjustment to the retained earnings account in that it represents the tax
effect of considering that some intra-group profit is still unrealised as of 30 June 20X3, meaning that
there are still tax benefits to be enjoyed by the group as the tax of the remaining unrealised profit was
already paid.
• Debit ‘Accumulated depreciation’ — $2000
Reinstatement of reduction in 20X3 accumulated depreciation.
• Credit ‘Plant’ — $10 000
Remeasurement of plant to the cost to the group.

514 SUGGESTED ANSWERS

Notes: Second entry
• Debit ‘Accumulated depreciation’, credit ‘Depreciation expense’ — $2000
Remeasurement of the depreciation expense of the plant from that recorded in the parent entity to the
basis required in the consolidated financial statements.
• Debit ‘Income tax expense’, Credit ‘Deferred tax asset’ — $600
Tax effect of the preceding entry: as the group uses the plant, the profit on ‘Internal sale’ is recognised
via lower depreciation charges.

QUESTION 5.16
Eliminations &
adjustments
Non- Parent
controlling equity
Parent Subsidiary Dr Cr Consolidated interest interest
Accounts $000 $000 $000 $000 $000 $000 $000

Issued capital 300 100 70 330 30 300

Retained earnings 300 150 70 380 45 335
600 250 710 75 635

Other net assets 440 250 690

Investment in
Subsidiary 160 160 —
Goodwill 20 20
600 250 160 160 710

The increase in the consolidated net assets during the 20X3 financial year reflects the profits recorded
by Parent ($100 000) and Subsidiary ($50 000). Compared with example 5.15, the increase in the non-
controlling interest from $60 000 to $75 000 represents the noncontrolling interest in the profit earned by
Subsidiary during 20X3 (30% of $50 000) (IFRS 10, para. B94). Moreover, the increase in the parent
equity interest of $135 000 ($635 000 – $500 000) reflects the profit earned by Parent, $100 000, plus its
share of post acquisition profits of Subsidiary, $35 000 (70% of $50 000).
The items recorded in the adjustments column are the pre-acquisition elimination entries. Recall
from example 5.15 that 70% of the shares were purchased for $160 000. Therefore, the pre-acquisition
elimination entry eliminates the parent entity’s 70% share of the equity in the subsidiary at the acquisition
date. At the acquisition date, the issued capital of Subsidiary was $100 000 and retained earnings was
also $100 000. Therefore, the parent entity’s share to be eliminated is $70 000 from issued capital (70% ×
$100 000) and $70 000 from retained earnings (70% × $100 000), as recorded in the adjustments column.
As a result of the transaction giving rise to these pre-acquisition elimination entries, $20 000 goodwill was
recognised by the group. The pre-acquisition elimination entry is repeated each year that the consolidation
worksheet is prepared and every year it eliminates the parent’s share of the subsidiary’s pre acquisition
equity only. The profit earned by the subsidiary after acquisition date is post acquisition and, as such,
increases the consolidated equity. The parent’s share of these profits should not be eliminated as it reflects
the return earned by the group after the acquisition.

QUESTION 5.17
Non-controlling interest — 30 June 20X5:
Non-controlling interest in opening retained earnings account = $33 600 (according to non-controlling
interest in closing retained earnings calculation of previous year in example 5.16).
During the year ended 30 June 20X5, the inventory originally sold intra-group during the year ended
30 June 20X4 was on-sold to external parties. Hence, the group would recognise the previously unrealised
profit as part of the 20X5 consolidated profit. The non-controlling interest will be entitled to its share of
this profit after tax.
Non-controlling interest in the current profit:
= 30% of (Current after-tax profit in financial statements of Subsidiary – (+) Current period unrealised
after-tax profits (losses) made by Subsidiary + (–) Current period realised after-tax profits (losses) of
the group that were originally made by Subsidiary in a prior period)

SUGGESTED ANSWERS 515

= 30% of (Current after-tax profit in financial statements of Subsidiary + Current period realised profit on
sale of inventory – Tax effect on the current period realised profit)
= 30% of ($100 000 + $40 000 – $12 000)
= 30% of $128 000
= $38 400

Note that the profit of Subsidiary for both 20X4 and 20X5 totals $300 000 ($200 000 + $100 000).
The non-controlling interest’s share of this amount is $90 000 (30% of $300 000). The non-controlling
interest in the consolidated profit for 20X4 and 20X5 is also $90 000. This consists of the $51 600 from
example 5.16 and the $38 400 calculated in this question. However, it must be stressed that while the non-
controlling interest has received over the two years its share of the profits recorded by Subsidiary, it has
only received it when the profit was included in the consolidated statement of P/L and OCI.
In general, if the non-controlling interest is calculated over a number of periods during which intra-group
transactions take place followed by external transactions involving all the assets originally transferred intra-
group, the non-controlling interest in the profits over those periods can simply be calculated as its share of
Subsidiary’s profits. On the other hand, if the non-controlling interest is calculated over a number of periods
during which intra-group transactions take place followed by external transactions involving only some of
the assets originally transferred intra-group, the non-controlling interest in the profits over those periods is
calculated as its share of Subsidiary’s after-tax profits excluding the unrealised profits related to the assets
still on hand. If the retained earnings account is capturing those unrealised profits over a number of periods,
this discussion is relevant to the calculation of the non-controlling interest in the retained earnings.

In this question, the non-controlling interest in closing retained earnings account will be calculated
as follows:
= 30% of (Closing retained earnings account of Subsidiary – Unrealised after-tax profits of Subsidiary)
= 30% of Closing retained earnings account of Subsidiary†
= 30% of $190 000
= $57 000

An alternative way of reconciling the non-controlling interest in the closing retained earnings is by using
the individual items making up the balance:
= Non-controlling interest in opening retained earnings + Non-controlling interest in profit – Non-
controlling interest in dividends
= $33 600 + $38 400 – $15 000 (30% of $50 000)
= $57 000

Note that it is important to understand the principles involved in measuring the non-controlling interest
and not just learn a formula. The principles have to be applied to different circumstances.

QUESTION 5.18
(a) Completion of the consolidation worksheet
Eliminations &
adjustments
Non- Parent
controlling equity
Parent Subsidiary Dr Cr Consolidated interest interest
Accounts $000 $000 $000 $000 $000 $000 $000
(3a)
Sales 400 150 8 542
Less: Cost of goods sold (210) (70) 2(2a) (274)
4(3a)
Gross profit 190 80 268
Less: Expenses (88) (30) 2(7a) 4(4) (116)
102 50 152
Dividend income 14 — 14(8) —
Other income 4 — 4(4) —
Profit before tax 120 50 152

516 SUGGESTED ANSWERS

 Less: Income tax expense (36) (15) 0.6(2b) 0.6(7b) (49.8)
1.2(3b)
Profit for the year 84 35 102.2 9.24 92.96
Retained earnings
1 July 20X1 270 68 4(2a) 1.2(2b) 303 21.24 281.76
354 103 35(1) 4(6a) 405.2 30.48 374.72
1.2(6b)
Less:
Interim dividend (10) (10) 7(8) (13) (3) (10)
Final dividend (20) (10) 7(8) (23) (3) (20)
Transfer to general reserve (20) (10) 7(1) (23) (3) (20)
Retained earnings
30 June 20X2 304 73 346.2 21.48 324.72
Issued capital 400 100 70(1) 430 30 400
General reserve 20 10 7(1) 23 3 20
Total equity 724 183 799.2 54.48 744.72

Liabilities
Trade payables 25 15 1(5) 39
Final dividend payable 20 10 7(9) 23
Other 79 52 131
Deferred tax liability 0.6(7b) 1.2(6b) 0.6
Total equity and liabilities 848 260 992.8

Current assets
Dividend receivable 7 7(9)
Trade receivables 40 18 1(5) 57
Inventory 65 22 2(2a) 81
4(3a)
Other 171 60 231

Non-current assets
Plant (net) 230 90 4(6a) 2(7a) 322
Other 215 70 285
Investment in Subsidiary 120 120(1)
(1)
Goodwill 15 15
Deferred tax asset 0.6(2b) 1.8
1.2(3b)
Total assets 848 260 175.2 175.2 992.8

Entries:
1. Pre-acquisition elimination entries
The pre-acquisition elimination entries will be as follows.
Dr Goodwill 15 000
Dr Retained earnings (opening balance) 35 000
Dr Issued capital 70 000
Cr Investment in Subsidiary 120 000

This first entry is the same as the pre-acquisition elimination entry recorded in 20X1 (see pre-
acquisition elimination entry (1) in example 5.17).
The next entry is explained as follows. The directors of Subsidiary transferred $10 000 from pre-
acquisition retained earnings to a general reserve. As the transfer took place during 20X2, the effect
to the retained earnings is recognised as a movement during the year and does not affect the opening
balance. The journal entry posted by Subsidiary to recognise this transfer would be as follows.

SUGGESTED ANSWERS 517

 Dr Retained earnings — transfer to general reserve 10 000
Cr General reserve 10 000

Considering that this transfer is from pre-acquisition equity, it will impact on the pre-acquisition
elimination entries prepared on consolidation at 30 June 20X2 as some of the pre-acquisition equity
that needs to be eliminated is now recognised as general reserve and a movement in retained
earnings. Thus, an additional entry is required to ensure that Parent’s share of the entire pre-
acquisition equity of Subsidiary is eliminated. In essence, the following entry simply reverses the
entry processed in the accounting records of Subsidiary, but only for Parent’s share.
Dr General reserve 7 000
Cr Retained earnings — transfer to general reserve 7 000

2a. Inventory sold in previous year from Parent to Subsidiary

Half of the inventory remained on hand as at 30 June 20X2.
Dr Retained earnings (opening balance) 4 000
Cr Cost of goods sold 2 000
Cr Inventory 2 000

In the previous financial year, the profit made by Parent from the sale of inventory to Subsidiary
was regarded as unrealised from the group’s point of view and it was eliminated (see consolidation
elimination entry (2a) from example 5.17). The consolidation process in 20X2, however, starts
by adding together the amounts recognised in the individual statements of Parent and Subsidiary,
which are not affected by the previous consolidation adjustments. Hence, the elimination needs to
be repeated, but this time to the opening retained earnings balance for the 20X2 financial year to
reduce it by the unrealised profit of the previous year (20X1).
If we recall, Parent sold the inventory to Subsidiary in 20X1 for $9000. This amount ($9000)
will become the cost of goods sold for Subsidiary when all of this inventory is sold to external
parties. At 30 June 20X2, half has been sold, meaning cost of goods sold is $4500. From the group’s
perspective, when Subsidiary sold half of the inventory in 20X2, the cost of goods sold (i.e. $4500 =
half of $9000) included in the financial statements of that entity would be overstated by $2000. That
is, the group should record cost of goods sold upon selling half of the inventory to external parties
at $2500 (not $4500), which is half of the original cost to the group of $5000. Also, the remaining
inventory on hand at 30 June 20X2 is overstated by $2000 (recorded as $4500 by Subsidiary when
the cost to the group was $2500). The credit entries correct both the cost of goods sold and the
inventory to the cost to the group. The credit to cost of goods sold results in an increase in the
group’s profit for 20X2: in essence, the group recognises $2000 of unrealised intra-group profit
from 20X1 that is now realised due to the sale to external parties.
2b. Tax effect of preceding entry
Dr Income tax expense 600
Dr Deferred tax asset 600
Cr Retained earnings (opening balance) 1 200

The group’s $2000 of realised profit in 20X2 requires the related income tax expense to be
recognised. In addition, $2000 of profit is still unrealised given half of the inventory is still on
hand. As such, the group still has a deferred tax asset of $600 remaining. That is, in the future, the
group will recognise the profit when the inventory is sold to parties external to the group, but the tax
has already been paid by Parent in 20X1. An alternative explanation as to why there is a deferred
tax asset of $600 relates to the fact that while the inventory is recognised by the group at $2500,
it has a tax base of $4500 (the amount recorded in Subsidiary), and this gives rise to a deductible
temporary difference of $2000, which in turn generates the deferred tax asset.
In 20X1, the income tax expense of the group was reduced by $1200 as a result of the elimination
of unrealised profit (see consolidation elimination entry (2b) from example 5.17). This further
resulted in an increase in the closing retained earnings of the group as compared to Parent plus
Subsidiary. The credit entry in item 2b reflects the fact that the opening retained earnings of the
group in the 20X2 financial year must be increased by the same amount.

518 SUGGESTED ANSWERS

3a. Sale of inventory from Subsidiary to Parent
Subsidiary processed the following entry for the intra-group sale of the inventory.
Dr Bank 8 000
Dr Cost of goods sold 4 000
Cr Sales 8 000
Cr Inventory 4 000

Parent processed the following entry for the intra-group purchase of the inventory.
Dr Inventory 8 000
Cr Bank 8 000

From the group’s perspective, the intra-group sales revenue and cost of goods sold must be
eliminated (which will result in the elimination of the intra-group profit on the sale) and the inventory
must be remeasured to the cost to the group. Therefore, the following consolidation elimination entry
(3a) is processed.
Dr Sales 8 000
Cr Cost of goods sold 4 000
Cr Inventory 4 000

To explain each line of this entry, the debit to Sales eliminates the credit to Sales recorded by
Subsidiary upon the sale of inventory to Parent. Similarly, the credit to Cost of goods sold eliminates
the debit to Cost of goods sold previously recorded by Subsidiary at the time of sale. The credit to
Inventory of $4000 offsets the ‘net’ debit to Inventory recorded by both Parent and Subsidiary at the
time of sale (i.e. $8000 debit recorded by Parent minus $4000 credit recorded by Subsidiary equals
$4000 ‘net’ debit). No entry is required for Bank as the debit recorded by Subsidiary at the time of
sale has already been offset by the credit recorded by Parent.
3b. Tax effect of entry (3a)
The consolidation elimination entry for inventory requires the following tax effect entry (3b).
Dr Deferred tax asset 1 200
Cr Income tax expense 1 200

As the group has eliminated $4000 of unrealised profit (i.e. Sales of $8000 minus Cost of goods
sold of $4000, as recorded by Subsidiary), the income tax expense of the group must be reduced by
$1200 (30% of $4000). In addition, the group must recognise a deferred tax asset of $1200. That
is, while the carrying amount of the inventory for the group is $4000, it has a tax base of $8000
(based on the amount recognised by the holder of those assets intra-group) and this gives rise to a
deductible temporary difference of $4000.
4. & 5. Elimination of intra-group provision of services and intra-group debt resulting from the
provision of services
Parent processed the following entry for the services rendered.
Dr Trade receivables 1 000
Dr Bank 3 000
Cr Other income 4 000

Subsidiary processed the following entry for the services received.

Dr Expenses 4 000
Cr Bank 3 000
Cr Trade payables 1 000

From the group’s perspective, these entries relate to parties within the group and should be
eliminated. Therefore, the following consolidation elimination entries (4 and 5) must be processed.

Dr Other income 4 000

Cr Expenses 4 000
Consolidation elimination entry 4.

SUGGESTED ANSWERS 519

 Dr Trade payables 4 000
Cr Trade receivables 4 000
Consolidation elimination entry 5.

There won’t be any consolidation tax effect elimination entry as there is no net impact on the
profit recognised by the group. This is because the amount of Other income eliminated equals the
amount of Expenses eliminated, meaning that the effect of these elimination entries on consolidated
profit is nil. No entry is required for Bank as the debit recorded by Parent is already offset by the
credit recorded by Subsidiary.
6a. 20X2 adjustment for inter-company loss on sale of plant eliminated at 30 June 20X1
Recall that Subsidiary sold plant to Parent in the previous financial year (20X1) at a loss of
$4000. In 20X1, the loss made by Subsidiary was regarded as unrealised from the group’s point
of view and it was eliminated (see consolidation elimination entry (5a) from example 5.17). The
consolidation process in 20X2, however, starts by adding together the amounts recognised in the
individual statements of Parent and Subsidiary, which are not affected by the previous consolidation
adjustments. Hence, the elimination needs to be repeated, but this time to the opening retained
earnings balance for the 20X2 financial year to increase it by the unrealised loss of the previous
year (20X1). Therefore, the following consolidation elimination entry (6a) must be processed.
Dr Plant 4 000
Cr Retained earnings (opening balance) 4 000

6b. Tax effect of entry (6a)

During the 20X1 financial year, the elimination of the loss on the sale of the plant resulted in an
increase in the income tax expense of the group (see consolidation elimination entry (5b) from
example 5.17) and, consequently, a decrease in consolidated profit. The decrease in the 20X1
consolidated profit (due to the increase in income tax expense) had the effect of decreasing the
consolidated closing retained earnings at 30 June 20X1. As the elimination needs to be repeated,
consolidated retained earnings is to be decreased (debited), but this time to the 20X2 consolidated
opening retained earnings account. Therefore, the following consolidation elimination entry (6b)
must be processed.
Dr Retained earnings (opening balance) 1 200
Cr Deferred tax liability 1 200

7a. Correction of group depreciation relating to plant sold on 30 June 20X1

Recall that the carrying amount of the plant in Subsidiary’s financial statements in 20X1 is $20 000,
which is the amount reported in the consolidated financial statements. The group must, therefore,
depreciate the plant at $9000 per year (($20 000 – $2000)/2 years). Parent, however, depreciates the
plant based on the carrying amount of $16 000, resulting in depreciation expense of $7000 recorded
by Parent (($16 000 – $2000)/2 years). Therefore, the following consolidation elimination entry
(7a) must be processed in 20X2 to reflect the difference in annual depreciation recorded by Parent
($7000) and that which should be recorded by the group ($9000).
Dr Depreciation expense 2 000
Cr Accumulated depreciation 2 000

7b. Tax effect of entry (7a)

In the previous consolidation elimination entry, an increase in the depreciation expense was
recognised that decreases the group’s profit. In turn, this will result in a reduction in (credit to)
the income tax expense of the group that should be recognised on consolidation. However, Parent
pays additional tax (as it has more profit due to lower depreciation charges than the group) and,
hence, a part of the deferred tax liability recognised in consolidation elimination entry (6b) needs
to be reversed. The 30 June 20X2 consolidated deferred tax liability should only be $600 to reflect
the fact that the carrying amount of the plant to the group is $11 000 ($20 000 – $9000), while its
tax base, recognised based on the amount recorded by the holder of the asset, is $9000 ($16 000 –
$7000). The difference between the carrying amount and tax base gives rise to a taxable temporary
difference of $2000 and deferred tax liability of $600 ($2000 × 30%). At the time of consolidation
elimination entry 6b, deferred tax liability is $1200. As the consolidated deferred tax liability should

520 SUGGESTED ANSWERS

 be $600 (and not $1200), deferred tax liability is to be reduced (debited). Therefore, the following
consolidation elimination entry (7b) must be processed.
Dr Deferred tax liability 600
Cr Income tax expense 600

8. & 9. Elimination of intra-group dividends

Note that the parent is entitled to 70% of the interim (70% of $10 000) and final (70% of $10 000)
dividends (total = $14 000), while the remainder of the dividends is paid to the non-controlling
interest (a party external to the group). Therefore, the intra-group dividends amount to only 70%
of all dividends and the effects of those intra-group dividends will have to be eliminated on
consolidation. That includes:
– for interim dividends: 70% of the interim dividend recognised by Subsidiary and the related
dividend income recognised by Parent
– for final dividends: 70% of both the declared dividend and dividend payable recognised by
Subsidiary and both the related dividend income and dividend receivable recognised by Parent.
Therefore, the following consolidation elimination entries (8) and (9) must be processed.
Dr Final dividend payable 7 000
Dr Dividend income 14 000†
Cr Final dividend (retained earnings) 7 000
Cr Interim dividend (retained earnings) 7 000
Cr Dividend receivable 7 000
†
$7000 dividend income recognised by Parent in relation to interim dividend plus $7000 dividend income recognised
by Parent on the final dividend declared.

(b) Calculation of non-controlling interest

Note: The non-controlling interest is entitled to its share of Subsidiary’s equity, as reflected from the
group’s perspective. That means that unrealised profits from intra-group transactions that originate
from Subsidiary will need to be eliminated from Subsidiary’s equity before non-controlling interest is
allocated a part of it. The intra-group sales from Parent to Subsidiary are not relevant to non-controlling
interest calculations, as it is Parent that profits from these sales.
• Non-controlling interest in opening consolidated retained earnings:
= 30% of (Opening retained earnings balance in financial statements of Subsidiary – (+) Unrealised
after-tax profits (losses) made by Subsidiary in the previous period(s))
= 30% of (Opening retained earnings balance in financial statements of Subsidiary + Unrealised
after-tax loss on plant made by Subsidiary in the previous period)
= 30% of ($68 000 + ($4000 – $1200))
= 30% of ($68 000 + $2800)
= 30% of $70 800
= $21 240
This calculation is the same as the second approach used to calculate the non-controlling interest
in Subsidiary’s 20X1 closing retained earnings (see example 5.17). Refer to the relevant calculation
presented under the heading ‘Calculations of non-controlling interest’ in the comprehensive example
(example 5.17).
• Non-controlling interest in Subsidiary’s profit after tax (adjusted for profit or loss on intra-group
transactions):
= 30% of (Profit in financial statements of Subsidiary – (+) Unrealised after-tax profits (losses) made
by the Subsidiary + (–) Realised after-tax profits (losses) of the group that were originally made
by the Subsidiary)
= 30% of (Profit in financial statements of Subsidiary – Unrealised after-tax profit on sale of inventory
– Realised after-tax loss on plant (via depreciation))
= 30% of ($35 000 – ($4000 – $1200) – ($2000 – $600)
= 30% of ($35 000 – $2800 – $1400)
= 30% of $30 800
= $9240
To determine the non-controlling interest in the 20X2 consolidated profit, there are two
adjustments for unrealised profits or losses resulting from the sale of assets from Subsidiary
to Parent.

SUGGESTED ANSWERS 521

 First, during 20X2 Subsidiary sold inventory to Parent for $8000. This inventory had an original
cost of $4000, giving rise to an intra-group profit of $4000, which is unrealised from the group’s
perspective as all of the inventory is still on hand at year-end. This unrealised profit was eliminated
in consolidation elimination entry (3a), with the tax effect of this elimination being recognised
in consolidation elimination entry (3b). The profit on inventory ($4000) and associated tax effect
($1200) give rise to an unrealised profit after tax of $2800 ($4000 – $1200). As this has been included
in the profit after tax in the financial statements of Subsidiary, the non-controlling interest in the
consolidated profit of the group needs to be calculated after excluding this item from Subsidiary’s
profit.
Second, another adjustment to the non-controlling interest calculation stems from the 20X1
unrealised loss on the sale of plant from Subsidiary to Parent. During 20X2, part of this loss was
realised by the group through the plant being used and producing goods or services for sale to parties
external to the group. Therefore, the group recognised $2000 of the loss (via depreciation) and an
associated tax effect of $600. However, the 20X2 profit after-tax of Subsidiary ($35 000) does not
include the loss recognised by the group. Hence, the noncontrolling interest in the consolidated profit
of the group needs to consider Subsidiary’s profit adjusted for this loss (and the related tax effect).
• Non-controlling interest in Subsidiary’s closing retained earnings:
This figure can be calculated in two ways.
(i) Using the calculations of the individual items making up the closing balance of the retained
earnings account:
= Non-controlling interest in Subsidiary’s opening retained earnings (refer to prior calculation)
+ Non-controlling interest in Subsidiary’s profit after tax adjusted for profit or loss intra-group
transactions (refer to prior calculation) – Non-controlling interest in Subsidiary’s dividends
– Non-controlling interest in transfer by Subsidiary of retained earnings to general reserve
= $21 240 + $9240 – (30% of $20 000) – (30% of $10 000)
= $21 240 + $9240 – $6000 – $3000
= $21 480
(ii) Using the closing balance of retained earnings of the Subsidiary – (+) Any after-tax unrealised
profits (losses) made by the Subsidiary:
= 30% of ($73 000 – Unrealised after-tax profit on inventory ($4000 – $1200) + Remaining
unrealised after-tax loss on sale of plant ($2000 – $600))
= 30% of $71 600
= $21 480
The closing balance of the retained earnings of Subsidiary ($73 000) includes both the 20X2
after-tax profit from the sale of inventory to Parent and the 20X1 after-tax loss from the sale
of plant to Parent. Therefore, to determine the non-controlling interest in the closing retained
earnings of the group starting with the closing balance retained earnings of Subsidiary requires
adjustments for: the unrealised inventory profit and the loss on the plant yet to be realised by
the group at the end of the 20X2 financial year. By the end of 20X2, after one year of use, half of
the unrealised loss is still to be realised through the use of the asset. Both of these adjustments
incorporate the tax effects involved.
• Non-controlling interest in Subsidiary’s issued capital:
= 30% of $100 000
= $30 000
• Non-controlling interest in statement of financial position:
= Non-controlling interest in Subsidiary’s issued capital (refer to prior calculation) + Non-controlling
interest in Subsidiary’s closing retained earnings (refer to prior calculation) + Non-controlling
interest in Subsidiary’s reserves (refer to prior calculation)
= $30 000 + $21 480 + $3000
= $54 480

522 SUGGESTED ANSWERS

QUESTION 5.19
(a) Consolidated statement of profit or loss and other comprehensive income for the year ended
30 June 20X2
$
Revenue 542 000
Less: Cost of goods sold (274 000)
Gross profit 268 000
Less: Expenses (116 000)
Profit† before tax 152 000
Less: Income tax expense (49 800)
Profit for the year 102 200
Other comprehensive income (OCI) —
Total comprehensive income for the year 102 200
Profit attributable to:
Non-controlling interests 9 240
Owners of the parent 92 960
102 200

†
Refer to worksheet in question 5.18.

(b) Consolidated statement of changes in equity for the year ended 30 June 20X2
Equity attributable to owners of Parent
Issued General Retained Non-controlling Total
capital reserves earnings Total interest equity
$000 $000 $000 $000 $000 $000

Balance 30 June 20X1† 400 281.76 681.76 51.24 733

Total comprehensive
income for the year 92.96 92.96 9.24 102.2
Dividends (30) (30) (6) (36)
Transfers to general reserve 20 (20) — — —
Balance 30 June 20X2 400 20 324.72 744.72 54.48 799.2

†
Refer to worksheet in the comprehensive example (example 5.17).

(c) Consolidated statement of financial position as at 30 June 20X2

Equity $000 $000

Equity attributable to owners of the parent
Issued capital 400.0
Reserves 20.0
Retained earnings 324.72 744.72
Non-controlling interest 54.48
Total equity 799.2
Represented by:
Assets
Current assets
Trade receivables 57.0
Inventory 81.0
Other 231.0 369.0
Non-current assets
Plant (net) 322.0
Other 285.0
Deferred tax asset 1.8
Goodwill 15.0 623.8
Total assets 992.8
Less: Liabilities
Trade payables 39.0
Final dividend payable 23.0
Other liabilities 131.0
Deferred tax liability 0.6 193.6
Total net assets 799.2

SUGGESTED ANSWERS 523

QUESTION 5.20
Equity accounting is applied where an investor has significant influence over an investee. Significant
influence normally stems from voting power, not ownership interest, which may or may not reflect voting
power. Whether the accounting policy is valid depends on the voting rights attached to the securities, not
the wording of the accounting policy (which refers to a ‘shareholding between 20% and 50% of the issued
capital’). Neither the definition of ‘significant influence’ (IAS 28, para. 3) nor the discussion of significant
influence (IAS 28, paras 5–9) focuses on ownership interest.
The accounting policy focuses on the 20% quantitative test. While this test leads to a presumption
of significant influence, all prevailing circumstances should be considered before deciding an entity is
an associate. Presumably, in arriving at the conclusion that a company is an associate, the entity has
considered evidence apart from voting power, such as board representation, participation in policy making,
and interchange of managerial personnel (IAS 28, para. 6).

QUESTION 5.21
(a) Investor has the following ownership interest in Z (IAS 28, para. 27).
%
Direct interest held by investor/parent 5
Indirect interest
via subsidiary — X Ltd (80% of 25%) 20
25

In preparing equity-accounted information in the consolidated financial statements, the investor

(group) would use 25% to calculate its share of items such as the profit of the associate company
Z. In accordance with IAS 28, paragraph 27, the holdings of the investor’s other associate (Y) are
ignored. However, it should be noted that where an associate (Y) has an interest in an associate (Z),
the group’s share of Y’s profit will be based on a profit that includes a share of Z’s profit (IAS 28,
para. 27). Therefore, in essence, the group captures the indirect interest in Z through the associate Y.
(b) While voting power is important in determining whether significant influence exists (IAS 28,
paras 5–9), it is the investor’s ownership interest in the associate company that must be determined
when implementing the equity method (IAS 28, para. 27).
(c) If the percentages recognising the ownership interest are also denoting the voting power, then Investor,
directly and indirectly via a subsidiary, has enough voting power to claim that it is able to exercise
significant influence over Z (i.e. Investor controls voting power of 25%, that is 5% direct and 20%
through a subsidiary — this is larger than 20%, the cut-off considered as enough for significant
influence to exist).

QUESTION 5.22
(a) The goodwill of $10 000 (refer to example 5.19) will not be separately disclosed, but will remain part of
‘Investment in associate’, both in the financial statements of Investor and in any consolidated financial
statements that include the investment based on the equity method.
When applying the equity method in subsequent accounting periods, the goodwill remains part of the
investment and must not be amortised against the investor’s share of the associate’s profits or losses
(para. 32). In addition, when testing for impairment, the focus is the entire carrying amount of the
investor’s investment in the associate, not the goodwill determined at acquisition (para. 42).
(b) The revaluation by Investee does not affect Investor’s cost of investment. In subsequent reporting
periods, Investee’s depreciation expense relating to depreciable assets will be higher than in the absence
of revaluation. This will be reflected in Investee’s statement of P/L and OCI. In turn, this will flow
through to Investor’s ‘share of profits’ for equity accounting purposes. Therefore, this particular
revaluation of assets by Investee does not require Investor to make any adjustments (when equity
accounting).
If the associate did not revalue the assets in its own financial statements, its statement of P/L and OCI
would include depreciation based on original carrying amount. This would necessitate an adjustment
to the investor’s share of the associate’s profits (an equity-accounting adjustment) so that depreciation
is based on the fair value of the assets as assessed by the investor at the time of making the investment

524 SUGGESTED ANSWERS

 (IAS 28, para. 32). Similar consolidation adjustments were seen when the net assets of the subsidiary
were not recorded at fair value in the subsidiary’s financial statements.

QUESTION 5.23
After equity accounting for the investment, the following information would appear in the consolidated
financial statements of Investor:
INVESTOR
Abridged consolidated statement of profit or loss and other
comprehensive income
for the year ended 30 June 20X5
$000
Other income and expenses 300
Share of profit or loss of associate† 25.2
Profit before tax expense 325.2
Less: Income tax expense (90)
Profit for the year 235.2
Other comprehensive income (OCI) —
Total comprehensive income 235.2

†
IAS 1, para. 82(c)

INVESTOR
Consolidated statement of financial position
as at 30 June 20X5
$
Issued capital 600 000
Retained earnings† 195 200
Revaluation surplus 60 000
Liabilities 270 000
1 125 200
Investment in Investee Ltd‡ 65 200
Other assets 1 060 000
1 125 200

†
Retained earnings of Investor ($185 000) + Share of associate’s post-acquisition increase in retained
earnings ($10 200 = $25 200 – $15 000).
‡
IAS 1, para. 54(e).

QUESTION 5.24
(a) INVESTOR
Abridged consolidated statement of profit or loss and other comprehensive income
for the year ended 30 June 20X5
$000
Other income and expenses 300
Share of profit or loss of associate† 23.1
Profit before tax expense 323.1
Less: Income tax expense (90)
Profit for the year 233.1
Share of other comprehensive income (OCI) of associates‡ 6
Total comprehensive income 239.1

†
IAS 1, para. 82(c).
‡
IAS 1, para. 82A.

Note: The total comprehensive income includes the profit for the year, which would be included in
retained earnings, and the share of other comprehensive income (OCI), which is reflected in equity in
the revaluation surplus.
(b) The same elimination entry is used, no matter whether the transaction is ‘upstream’ or ‘downstream’.
Hence, the pro forma journal entry processed in example 5.21 would also be processed if the sale of
inventory was from Investee to Investor.

SUGGESTED ANSWERS 525

(c)
Net assets of Investee Ltd $204 000†
†
$184 000 according to example 5.20 + $20 000 for revaluation of land.

$
Investor Ltd’s share of carrying amount = 30% of $204 000 = 61 200
Less: Unrealised profit on inventory‡ (2 100)
Investor Ltd’s share of net assets 59 100
Add: Goodwill 10 000
Equity investment in Investee Ltd 69 100

‡
As outlined in example 5.21, the unrealised profit on inventory must be eliminated on a net basis.
That is, the only accounts affected are ‘Investment in Investee’ and ‘Share of profit or loss of
associates’. The elimination reflects the investor’s ownership interest (30%) in the unrealised profit
after tax of $7000 ($10 000 × (1 – .30)). Note: The elimination is not against the individual accounts
affected as would be the case with a consolidation adjustment for unrealised profits or losses.

QUESTION 5.25
The following consolidation worksheet entries would be processed to account for Investor’s share of profits
and losses.
30 June 20X7
Dr Share of profit or loss of associate 30 000†
Cr Investment in associate 30 000
†
The total share of the associate’s losses is 30% of $150 000 or $45 000. However, in accordance with IAS 28,
paragraph 39, the investment can only be written down to zero. Hence, before the investor’s share of subsequent
profits can be recognised, its share of losses not recognised ($15 000) must be offset (IAS 28, para. 39). That is, the
associate must earn a profit of $50 000 ($15 000/ 30%).

Note: In accordance with IFRS 12, paragraph 22(c), the notes to the financial statements of Investor should
disclose the amount of unrecognised losses, both for the period and cumulatively. The amount of the
unrecognised losses is $15 000.
30 June 20X8
Dr Investment in associate 9 000
Cr Share of profit or loss of associate 9 000‡
‡
The total share of the associate’s profits is 30% of $80 000 or $24 000. However, as the share of the associate’s losses
not recognised is $15 000, only $9000 of the investor’s share of profits will be recognised during the 20X8 financial
year.

After the preceding entry, the amount of the investment in the associate will be $9000. This amount can
be reconciled as follows.
$
Investment as at 1 July 20X6 30 000
Share of losses 20X7 (30% of $150 000) (45 000)
(15 000)
Share of profits 20X8 (30% of $80 000) 24 000
Investment as at 30 June 20X8 9 000

ASSUMED KNOWLEDGE REVIEW QUESTION 1

(a) Consolidation worksheet 30 June 20X3
Eliminations &
adjustments
Holding Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Issued capital 230† 12 12 230
Retained earnings 140 83 83 140
Revaluation surplus 21 21 —

526 SUGGESTED ANSWERS

 Deferred tax liability 9 9
Liabilities 50 25 75
420 150 454
Current assets 40 30 70
Investment in Subsidiary 150 150 —
Non-current assets 230 120 350
Goodwill 34‡ 34
420 150 150 150 454

†
Original issued capital ($80 000) plus shares issued at fair value to the shareholders of Subsidiary (30 000 @ $5.00 per
share = $150 000).
‡
Consideration transferred ($150 000) minus the fair value of identifiable net assets calculated based on the value of
equity after revaluation ($12 000 + $83 000 + $21 000).

Holding has acquired a single asset, ‘Investment in Subsidiary’, for $150 000. On the other hand,
the group has acquired the business of Subsidiary and this has two implications. First, the consolidated
financial statements of the group must recognise the identifiable assets and liabilities relating to the
combination at their fair values. Second, any goodwill arising from the business combination must be
recognised in the consolidated financial statements.
The assets of Subsidiary were revalued to fair value in Subsidiary’s financial statements (Non-current
assets increased by $30 000, a deferred tax liability of $9 000 was recognised and the revaluation surplus
increased by $21 000).
The worksheet illustrates that:
• the acquirer, Holding, includes its interest in the acquiree in its own financial statements as an asset
called ‘Investment in Subsidiary’
• the identifiable net assets of the subsidiary are recorded at their individual fair values (see non-current
assets = $90 000 + $30 000 revaluation increment)
• a deferred tax liability is recognised due to a temporary difference arising on the revaluation of the
non-current assets
• goodwill has been determined and brought to account in accordance with IFRS 3
• on acquisition of a subsidiary, goodwill has been treated as a consolidated adjustment as it is the
group that has acquired the business of the subsidiary.

(b) Consolidation worksheet 30 June 20X3

Eliminations &
adjustments
Holding Subsidiary Cr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Issued capital 230 12 12† 230
Retained earnings 140 83 83† 140
Business combination reserve 21† 21‡ —
Deferred tax liability 9‡ 9
Liabilities 50 25 75
420 120 454
Current assets 40 30 70
Investment in Subsidiary 150 150† —
Non-current assets 230 90 30‡ 350
Goodwill 34† 34
420 120 180 180 454

Entries:
†
Pre-acquisition elimination entry.
‡
Revaluation of non-current assets including tax effects.
Note: These entries could have been combined.

SUGGESTED ANSWERS 527

 In this part of the question, because Subsidiary has not revalued the non-current assets in its own
accounts, the undervalued assets must be revalued via the consolidation process. Hence, the consoli-
dation elimination entries include a debit of $30 000 to the ‘Noncurrent assets’, a credit of $9 000 to a
‘Deferred tax liability’ and a credit of $21 000 to a ‘Business combination reserve’.
Note: Compare this worksheet with that prepared under (a) and note the difference in the consolida-
tion elimination entry (and in the amount recognised by the subsidiary at acquisition date). However,
as would be expected, note that the resulting consolidated financial statements are identical.

ASSUMED KNOWLEDGE REVIEW QUESTION 2

(a) (i) The entry processed by the subsidiary for the sale of inventory to the parent would be as follows.
Dr Bank/trade receivables 20 000
Dr Cost of goods sold 10 000
Cr Sales 20 000
Cr Inventory 10 000

The entry processed by the parent for the purchase of the inventory would be as follows.
Dr Inventory 20 000
Cr Bank/trade payables 20 000

After these entries in the financial statements of the parent and the subsidiary, the impact on the
consolidation worksheet would be as follows.
Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Sales 20
Less: Cost of goods sold (10)
Gross profit 10
Inventory 20

From the group’s perspective, the sale should not be recognised as it is not to a party external to the
group and, hence, its effects should be eliminated in full. This involves the following adjustments:
• the sales revenue is eliminated as it wasn’t earned as a result of a transaction with an external
party
• the associated cost of goods sold is also eliminated and, as a consequence of this in combination
with eliminating the sales revenue as discussed above, it results in the elimination of the profit
from the transaction as it is considered unrealised
• the inventory is adjusted to the original cost to the group ($10 000) from the $20 000 recorded in
the statement of financial position of the parent.
Hence, the 20X3 consolidation adjustment entry would be as follows.
Dr Sales 20 000
Cr Cost of goods sold 10 000
Cr Inventory 10 000

After the consolidation elimination entry, the consolidation worksheet would be as follows.
Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Sales 20 20 —
Less: Cost of goods sold (10) 10 —
Gross profit 10 —
Inventory 20 10 10

528 SUGGESTED ANSWERS

(ii) The subsidiary would process the same entry as in Part (i). As the parent sold half of the inventory
for $16 000, the following entries would be processed by the parent for the purchase of the inventory
from the subsidiary and its subsequent sale.
Dr Inventory 20 000
Cr Bank/trade payables 20 000
Dr Cost of goods sold 10 000
Dr Bank/trade receivables 16 000
Cr Inventory 10 000
Cr Sales 16 000

The impact on the consolidation worksheet of the intra-group transaction and the subsequent sale
of half the inventory to parties external to the group would be as follows.
Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Sales 16 20
Less: Cost of goods sold (10) (10)
Gross profit 6 10
Inventory 10

From the group’s perspective, the sale recorded by the subsidiary is not to a party external to the
group and, hence, its effects should be eliminated. That involves the following adjustments:
• the sales revenue recorded by the subsidiary ($20 000) is eliminated as it wasn’t earned as a result
of a transaction with an external party
• the cost of goods sold recorded by the subsidiary ($10 000) must be eliminated because it relates
to an intra-group sale, and the cost of goods sold recorded by the parent needs to decrease by
$5 000, as it should reflect half of the original cost of the inventory to the group (50% of $10 000);
as a consequence, the consolidated cost of goods sold decreases by $15 000 ($10 000 + $5 000)
and, given that the consolidated sales revenue decreases by $20 000 as a result of the adjustment
discussed above, this will result in the elimination from the consolidated profit of the remaining
unrealised profit from the intra-group sale of inventory (i.e. the intra-group profit attributable to
the inventory that was not transferred to an external party)
• the inventory still on hand should be adjusted so that it is recorded at cost to the group, which is
$5 000 (50% of $10 000), not the $10 000 recorded in the statement of financial position of the
parent.
Hence, the consolidation elimination entry would be as follows.
Dr Sales 20 000
Cr Cost of goods sold 15 000
Cr Inventory 5 000

The impact on the consolidation worksheet after the elimination entry is illustrated as follows.
Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Sales 16 20 20 16
Less: Cost of goods sold (10) (10) 15 (5)
Gross profit 6 10 11
Inventory 10 5 5

It should be noted that the profit of the group is $5 000 less than the profit of the parent plus the
subsidiary as it excludes the remaining unrealised profit on the intra-group sale of inventory from
the subsidiary to the parent.

SUGGESTED ANSWERS 529

 (iii) As the other half of the inventory is sold during the year ended 30 June 20X4 for $16 000, the
following entry would be processed by the parent.
Dr Cost of goods sold 10 000
Dr Bank/trade receivables 16 000
Cr Inventory 10 000
Cr Sales 16 000

The consolidation worksheet prepared at 30 June 20X4 would initially include the following
effects from both internal and external transactions recognised by the individual entities.
Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Sales 16
Less: Cost of goods sold (10)
Gross profit 6
Opening retained earnings† 6 10
Inventory —
†
The balances of the opening retained earnings are equal to the profits recognised in the year ended 30 June 20X3 by the
two entities and include unrealised profit from the intragroup transaction.

From the group’s perspective, the following information should be reflected in the consolidated
financial statements.
• The sales revenue recognised by the parent is earned from a transaction with an external party
and should be included as revenue of the group.
• The cost of goods sold should be recorded at the cost to the group of the inventory sold during the
current period to an external party (50% of $10 000 = $5 000); therefore, the cost of goods sold
has to decrease by $5 000 (from $10 000 as recognised by the parent); given that sales revenue
is not adjusted, the result is that group profit increases by $5 000, essentially recognising that
the unrealised profit attributable to the inventory still on hand at the beginning of the period is
realised during the period as that inventory gets sold to an external party.
• The opening retained earnings of the group should reflect only profits recognised by the group
as of 30 June 20X3 and, hence, should be equal to the aggregated amount of opening retained
earnings of the parent and subsidiary, minus the unrealised profit as of 30 June 20X3.
Therefore, the consolidation elimination entry would be as follows.
Dr Retained earnings (opening balance) 5 000
Cr Cost of goods sold 5 000

After the consolidation elimination entry, the consolidation worksheet would be as follows.
Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Sales 16 16
Less: Cost of goods sold (10) 5 (5)
Gross profit 6 11
Opening retained earnings† 6 10 5 11
Closing retained earnings 12 10 22
Inventory —
†
The balances of the opening retained earnings are equal to the profits recognised in the year ended 30 June 20X3 by
the two entities and include unrealised profit from the intra-group transaction.

The group has recognised $5 000 of the previously unrealised profit. It should also be noted that,
by 30 June 20X4, the closing retained earnings of the group ($22 000) is the same as the profit of
the parent plus the subsidiary ($12 000 + $10 000) because all of the profit has been realised by the
group.

530 SUGGESTED ANSWERS

(b) The entry processed by the parent for the provision of management services to the subsidiary would
be as follows.
Dr Bank 20 000
Dr Trade receivables 5 000
Cr Revenue from services 25 000

The subsidiary would process the following entry for the receipt of management services from the
parent.
Dr Management services expense 25 000
Cr Trade payables 5 000
Cr Bank 20 000

The impact on the consolidation worksheet of the intra-group transaction would be as follows.
Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Revenue from services 25
Management services expense (25)
Trade receivables 5
Trade payables 5

From the group’s perspective, the management services revenue and expense should be eliminated
because they result from an intra-group transaction. Likewise, the group cannot have a debt to itself
and, hence, the intra-group receivable/payable should be eliminated. Therefore, the intra-group services
transaction would result in the following consolidation elimination entry.
Dr Management services revenue 25 000
Dr Trade payables 5 000
Cr Management services expense 25 000
Cr Trade receivables 5 000

After the consolidation elimination entry, the consolidation worksheet would be as follows.
Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Revenue from services 25 25 —
Management services expense (25) 25 —
Trade receivables 5 5 —
Trade payables 5 5 —

(c) The subsidiary would have processed the following entry to account for the declaration of the dividend.
Note: Please revise how to account for dividends if necessary. This is assumed knowledge for this
segment.
Dr Dividend declared 10 000
Cr Final dividend payable 10 000

The parent would have processed the following entry to account for the final dividend declared by
subsidiary.
Dr Dividend receivable 10 000
Cr Dividend income 10 000

SUGGESTED ANSWERS 531

 The impact on the consolidation worksheet of the intra-group transaction would be as follows.
Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Dividend income 10
Dividend declared (10)
Final dividend receivable 10
Final dividend payable 10

From the group’s perspective, there should be no recognition of the dividend declared, as this is
an intra-group transaction. Likewise, the group cannot have a debt to itself and, hence, the intra-
group dividend receivable/payable should be eliminated. The intragroup dividend would result in the
following consolidation adjustment entry.
Dr Dividend income 10 000
Dr Final dividend payable 10 000
Cr Dividend declared 10 000
Cr Final dividend receivable 10 000

After the consolidation elimination entry, the consolidation worksheet would be as follows.
Eliminations &
adjustments
Parent Subsidiary Dr Cr Consolidated
Accounts $000 $000 $000 $000 $000
Dividend income 10 10 —
Dividend declared (10) 10 —
Final dividend receivable 10 10 —
Final dividend payable 10 10 —

MODULE 6
QUESTION 6.1
(a) The instrument meets the definition of a financial instrument because it creates a financial asset for
Angel Investor Pty Ltd, and a financial liability (or equity instrument) of Easy Business Ltd.
(b) The instrument should be classified as an equity instrument because it meets the fixed-for-fixed test.
That test requires an instrument to be classified as equity if a fixed amount of cash is settled with
a fixed number of equity instruments. In this case, Angel Investor Pty Ltd is exposed to the share
price movements of those 10 000 shares because the total value of what it receives in settlement of
the instrument will depend on the market price of Easy Business Ltd shares. For example, if the share
price is $5, Angel Investor Pty Ltd will receive shares to the total value of $50 000 (10 000 × $5), but
if the share price is only $0.60, the value of shares received by Angel Investor Pty Ltd would be $6000
(10 000 × $0.60).

QUESTION 6.2
A forward contract requires an entity to pay a fixed amount of cash in exchange for cash or another asset.
When used to reduce price risk, the forward contract will usually be settled net in cash. The effect is that
the exposure is fixed at the amount agreed in the contract. The entity would not be able to participate in
any favourable price movements.
An option contract, on the other hand, provides the holder the right, but not the obligation, to settle
the contract at the agreed price. A singular option contract on its own can be used to limit an entity from
either favourable or unfavourable price movements. If an entity chooses to protect itself from unfavourable
price movements, it will be exposed to favourable price movements, and vice versa. For this reason, some
entities favour option contracts over forward contracts because the option contract allows the entity to

532 SUGGESTED ANSWERS

participate in favourable price movements but be protected from unfavourable movements. In contrast,
forward contracts protect the entity from all movements, both favourable and unfavourable.

QUESTION 6.3
Has MCL transferred substantially all the risks and rewards of ownership? The repurchase agreement is
part of the total transaction and it means, in substance, that MCL retains substantially all the risks and
rewards of ownership and should not treat the transaction as a sale.
Note: In this suggested answer the interest expense on the loan is recognised when the entity repurchases
the inventory due to the brief period of the loan. In practice, the entity would carry the loan at amortised
cost and recognise interest expense using the effective interest rate.
Therefore, MCL should record the transaction as follows.
Dr Cash 2 000 000
Cr Loan payable 2 000 000

The impact of the repurchase or repayment of the loan will result in an outflow of $2.4 million and the
removal of the loan.
Dr Loan payable 2 000 000
Dr Interest expense 400 000
Cr Cash 2 400 000

QUESTION 6.4
(a)
Dr Loan payable 235 000
Cr Paid-up capital 200 000
Cr Gain on settlement 35 000

(b) Paragraph B3.3.3 of IFRS 9 does not permit the derecognition of a financial liability simply because
funds have been transferred to a trust. There must be a legal release of the obligation for the debtor.
Therefore, the entry would be as follows.
Dr Receivables from trust 1 000 000
Cr Cash 1 000 000

QUESTION 6.5
(a) A bond that is convertible into shares of the issuer and the return on the bond is linked to the
return on the issuer’s shares
This is an example of an instrument that has leverage, as the return to the bond holder is not based on
contractual terms that give rise on specified dates to cash flows that are solely payments of principal
and interest on the principal amount. Hence this instrument would be classified at fair value.
(b) A variable rate loan where the rate is reset every three months based on movements in the CPI
index
This instrument is similar to instrument A in paragraph B4.1.13 in IFRS 9. The instrument does qualify
for amortised cost as the amounts payable on the loan are reset to the CPI index, which will adjust the
interest for movements in inflation and nothing more. If the reset of interest is linked to some other
measure, like the performance of the debtor, then it fails the test as there is no certainty about the
returns.

QUESTION 6.6
(a) Yes, the securities will no longer be managed based on contractual cash flows but will be managed by
Tadpole on a fair value basis and Jolly Frog will be required to apply the fair value measurement basis.

SUGGESTED ANSWERS 533

(b) The journal entry on 1 April 20X8 is as follows.
Dr Securities 15 000
Dr Allowance for impairment loss 10 000
Cr P/L 25 000

At the time of the reclassification and change to fair value, the carrying amount of the securities was
$90 000 because an impairment loss had been recognised to reduce the carrying amount from cost to
the recoverable amount. The provided journal entry reverses the allowance for impairment account and
increases the securities account. The gain of $25 000 is the increase from the former carrying amount
of $90 000 to the new carrying amount of $115 000.

QUESTION 6.7
(a) The contract to purchase goods is a firm commitment and would be a hedged item under IFRS 9.
(b) Unless the potential transaction is a highly probable forecast transaction, the transaction would not
qualify as a hedged item under IFRS 9, paragraph 6.3.3. A highly probable forecast transaction is an
acceptable hedge item that can be hedged. Therefore, if the sale to the customer in France was regarded
as highly probable, it would be a qualifying hedged item under IFRS 9.

QUESTION 6.8
The requirements in paragraph 28 of IFRS 7 are designed to ensure that entities do not exploit possible
differences between the fair value at the date of initial recognition and the amount that would be determined
using a valuation technique. At the very least, this difference must be reported, allowing users to assess its
impact on the entity’s performance for the period.

QUESTION 6.9
Transfers of financial assets that fail IFRS 9’s derecognition criteria are those that create new liabilities for
entities. Users of financial statements need to understand the relationship between the assets that continue
to be recognised and the newly recognised liabilities. These disclosures will allow users to understand the
cash flows of the entity and its financial position.

MODULE 7
QUESTION 7.1
(a) The asset has a history of profitable use within A Ltd’s operations and is currently profitable. However,
the evidence from internal reporting indicates the cash outflows are significantly higher than those
originally budgeted. According to paragraph 12(g) of IAS 36, this is an indication that the asset may
be impaired. Therefore, A Ltd should make a formal estimate of the recoverable amount of the asset.
(b) The announcement by one of B Ltd’s competitors that it had developed a new generation of computer
chips, which would result in a 15% reduction in the cost to manufacture the chips, constitutes a
significant adverse change in the technological environment in which B Ltd operates. According to
paragraph 12(b) of IAS 36, this is an indication that the assets of B Ltd may be impaired. Therefore,
B Ltd should make a formal estimate of the recoverable amount of the assets used to manufacture
computer chips for use in domestic appliances.
(c) C Ltd expects to be able to compensate for the loss of market share in the gaming industry by
diversifying into hospitality and entertainment activities. However, the assets of C Ltd that are
dedicated to gaming activities may potentially be impaired as a result of the recent government
regulations that will likely increase competition in the sector. According to paragraph 12(b) of
IAS 36, this is an indication that the assets of C Ltd may be impaired. Therefore, C Ltd should make
a formal estimate of the recoverable amount of the assets used in gaming activities.

534 SUGGESTED ANSWERS

(d) The market capitalisation (net worth) of D Ltd at its most recent reporting date ($50m) exceeds
the carrying amount of D Ltd’s net assets at this date ($47m). Therefore, on the basis of market
capitalisation, there is no need for D Ltd to make a formal estimate of the recoverable amount of
its assets.
(e) Although E Ltd was not directly affected by the natural disaster, many of its suppliers have ceased
operations indefinitely. As a result, E Ltd’s plant is operating at only half its capacity. This indicates
that the cash inflows from the use of the plant will be significantly lower than expected. The assets
of E Ltd may potentially be impaired as a result of this change in accordance with paragraph 12(g) of
IAS 36. Therefore, E Ltd should make a formal estimate of the recoverable amount of the assets in
Country X.

QUESTION 7.2
The IASC objections are described in the ‘Basis for Conclusions’ for IAS 36 included in the IFRS
Compilation Handbook.
The IASC primarily objected to the IAS 36 definition of ‘recoverable amount’ based on the sum of
undiscounted cash flows expected to be derived from an asset for the following reasons.
• It ignores the time value of money.
• Measurements that consider the time value of money are more relevant to resource allocation decisions
made by investors, other external users of financial statements and management.
• Discounting techniques are well understood by many entities.
• Discounting is already required for other financial statement items.
• Entities are better served if they are provided with timely information regarding whether their assets
will generate a return that at least compensates for the time value of money (IAS 36, para. BCZ13 in
the IFRS Compilation Handbook).
The IASC primarily objected to a definition of ‘recoverable amount’ based on the fair value of an asset
for the following reasons.
• It refers to the market’s expectations of the recoverable amount of an asset rather than to a reasonable
estimate made by the entity itself. For example, in some cases, an entity may have superior information
than the market about the future cash flows expected to be derived from an asset. Further, an entity may
intend to use an asset in a manner that differs from the best use of the asset that is assumed by the market.
• Market values, as a means to estimate fair value, presume that an entity is a willing seller. In some cases,
an entity may be unwilling to sell an asset because it believes that it can derive greater service potential
from the continuing use of the asset in the entity rather than from selling it.
• It does not reflect the principle that, when the recoverable amount of an asset is assessed, it is more
relevant to consider what an entity can expect to recover from an asset (IAS 36, para. BCZ17 in the
IFRS Compilation Handbook).
The IASC primarily objected to the IAS 36 definition of ‘recoverable amount’ based on the value in use
of the asset for the following reasons.
• If the net selling price (i.e. fair value less costs of disposal) is greater than the value in use, rational
management will dispose of the asset. The definition of ‘recoverable amount’ should reflect this
commercial reality.
• To the extent that the net selling price exceeds the value in use, and when management decides to retain
the asset, the additional loss falling on the entity (the difference between the net selling price and value
in use) should be allocated to future periods consistent with management’s decision to retain the asset
in each of those periods (IAS 36, para. BCZ22 in the IFRS Compilation Handbook).

QUESTION 7.3
Calculation of the value in use of the machine owned by East Ltd (East) includes a consideration of
the projected cash inflows (i.e. sales income) from the continued use of the machine, as well as the
projected cash outflows that are necessarily incurred to generate those cash inflows (i.e. cost of goods
sold). Additionally, projected cash inflows include $80 000 from the disposal of the asset in 20X9, while
cash outflows include routine capital expenditures of $50 000 in 20X7. Note cash flows do not include
financing interest (i.e. 10%), tax (i.e. 30%) and capital expenditures to which East has not yet committed
(i.e. $100 000); they also do not include any savings in cash outflows from these capital expenditures, as
required by IAS 36.

SUGGESTED ANSWERS 535

 The cash flows (inflows and outflows) are presented below in nominal terms. They include an increase
of 3% per annum to the forecast price per unit (B), in line with forecast inflation. The cash flows are
discounted by applying a discount rate (8%) that is also adjusted for inflation.
Value
Year ended 31.12.X5 31.12.X6 31.12.X7 31.12.X8 31.12.X9 in use
Quantity (A) 10 000 10 500 11 025 11 576 12 155
Price per unit (B) $200 $206 $212 $219 $225
Estimated cash inflows
(C = A × B) $2 000 000 $2 163 000 $2 337 300 $2 535 144 $2 734 875
Miscellaneous cash inflow: disposal
proceeds (D) $80 000
Total estimated cash inflows
(E = C + D) $2 000 000 $2 163 000 $2 337 300 $2 535 144 $2 814 875
Cost per unit (F) $160 $162 $165 $168 $171
Estimated cash outflows
(G = A × F) ($1 600 000) ($1 701 000) ($1 819 125) ($1 944 768) ($2 078 505)
Miscellaneous cash outflow:
maintenance costs (H) ($50 000)
Total estimated cash outflows
(I = G + H) ($1 600 000) ($1 701 000) ($1 869 125) ($1 944 768) ($2 078 505)
Net cash flows (J = E – I) $400 000 $462 000 $468 175 $590 376 $736 370
Discount factor 8% (K) (1/1.081 ) = (1/1.082 ) = (1/1.083 ) = (1/1.084 ) = (1/1.085 ) =
0.9259 0.8573 0.7938 0.7350 0.6806
Discounted future cash flows
(L = J × K) $370 360 $396 073 $371 637 $433 926 $501 173 $2 073 169

QUESTION 7.4
Suggested responses are based on Example 1 in the ‘Illustrative Examples’ section of IAS 36 from the
IFRS Compilation Handbook.
(a) In identifying whether Store X is a CGU, the following are considered.
i. Internal management reporting is organised to measure performance on a store-by-store basis.
ii. The business is run on a store-by-store profit basis or on a regional or city basis.
All M’s stores are in different neighbourhoods and probably have different customer bases. So,
although X is managed at a corporate level, X generates cash inflows that are largely independent of
those of M’s other stores. Therefore, it is likely that X is a CGU.
(b) Case 1
X could sell its products in an active market, thereby generating cash inflows that would be largely
independent of the cash inflows from Y. Therefore, it is likely that X is a separate CGU, although part
of its production is used by Y.
It is likely that Y is also a separate CGU. Y sells 80% of its products to customers outside the entity.
Therefore, its cash inflows can be regarded as largely independent.
Internal transfer prices do not reflect market prices for X’s output. Therefore, in determining the
values in use of both X and Y, the entity adjusts financial budgets and forecasts to reflect management’s
best estimate of future prices that could be achieved in arm’s length transactions for X’s products that
are used internally.
Case 2
It is likely that the recoverable amount of each plant cannot be assessed independently of the
recoverable amount of the other plant because:
(a) The majority of X’s production is used internally and cannot be sold in an active market. As such,
the cash inflows of X depend on the demand for Y’s products. Therefore, X cannot be considered
to generate cash inflows that are largely independent of those of Y.
(b) The two plants are managed together.
As a consequence, it is likely that plants X and Y form the smallest group of assets that generates
cash inflows that are largely independent.

536 SUGGESTED ANSWERS

QUESTION 7.5
Three members of the IASB dissented from the decision to issue IAS 36 because of their concerns about
the impairment test prescribed in IAS 36 for goodwill. Their concerns arose particularly in relation to the
merger of an acquired business with an acquirer’s pre-existing operations.
A key concern cited relates to the failure of the impairment test to distinguish between the benefits
provided by the acquirer’s pre-existing internally generated goodwill at the time of the acquisition and
the benefits provided by the purchased goodwill (paragraphs DO6–DO7 of ‘Dissenting Opinions’ on
IAS 36 included in the IFRS Compilation Handbook). As a result, the acquirer’s pre-existing internally
generated goodwill provides a ‘shield’ against impairment of the purchased goodwill. A further shield
against impairment is also provided by internally generated goodwill that is generated subsequent to the
acquisition. Interestingly, the dissenting members did not offer views as to how such internally generated
goodwill could be measured.
Another key concern cited relates to the failure of the impairment test to incorporate a subsequent cash
flow test (paragraphs DO8–D10 of ‘Dissenting Opinions’ on IAS 36 included in the IFRS Compilation
Handbook). Under such a test (discussed in paragraphs BC195–BC198 of the ‘Basis for Conclusions’ on
IAS 36 included in the IFRS Compilation Handbook), actual cash flows are required to be substituted for
estimated cash flows, which were estimated when a past impairment test occurred. An impairment loss
has to be recognised if the actual cash flows would have created an impairment loss for goodwill.

SUGGESTED ANSWERS 537

INDEX
AAA Ltd 208–16 presentation of 95–6 with multiple embedded derivatives
AASB standards (AASBs) 5 revaluation of 250–2 358
accounting associate 279 comprehensive consolidation 268
for leases 40 ASX see Australian Securities Exchange comprehensive income
policies 359 Australian Accounting Standards components of 83
professional judgment 51–2 Board (AASB) 5, 7–8 presentation of 82–3
profit 204–14 legislation 7–8 statement of 85–95
rules, special 353 public accountability 7 concept of control 243–8
for share-based payments 48–9 small and medium-sized entities exception to consolidation of
standards for financial instruments 10–11 subsidiaries 246–8
303 two-tier model of 8 exposure, or rights, to variable returns
for time value of options 353–9 AASB 1020 Income Taxes 166 from an investee 245
accounting estimates Australian dollars (AUD) 312 link between power and variable
changes in 72–3 Australian Securities and Investments returns 245
material errors, prior period 73–5 Commission (ASIC) 10 power over an investee 244–5
accounting policies 68 Australian Securities Exchange (ASX) Conceptual Framework 220, 313,
changes in 70–2 310 see also financial statements
consistency of 69 accrual basis 14–15
disclosure of 69–70 balance sheet method 158 Australian Accounting Standards
selection of 68–9 Basis for Conclusions (BC) 6 Board 11
accounting treatment, of different ‘Better Communication in Financial comparability 18–19
investment types 221 Reporting’ 11 cost constraint 20–1
accrual basis 14–15, 65 borrowing 314–16 fair value 32–3
acquiree 223 business combinations 222 faithful representation 17
acquirer 223 applying the acquisition method for Financial Reporting 12
identifying 224 233–5 going concern 15
acquisition analysis 248 deferred tax arising from 235–8 IFRSs 5
acquisition date 226 disclosures 238–41 international consistency of 26–7
acquisition method 222, 224–33 identifying 223–4 purpose and application of 12–13
applying to different forms of business business model 326 understandability 19–20
combinations 233–5 for managing financial assets 324 consideration, identifying and measuring
determining the acquisition 230–1
date 226 carrying amount 25, 164 consistency 67–8
direct acquisition 233–4 cash 305 consolidated financial statements 241
exceptions 228–9 cash and cash equivalents 100 consolidated statement of financial
identifying and measuring cash flow hedges 349–52 position 275
consideration 230–1 cash flows depreciation adjustments 252–4
identifying and measuring classification of 100–3 disclosures 275–9
non-controlling interest 231–3 financing 102–3 introduction to 242–3
identifying the acquirer 224 investing 101 non-controlling interest 262–75
indirect acquisition 234–5 net basis 104 notes including accounting policies,
measurement 228 operating 100–1 and explanatory notes 276–83
measurement and recording of statement of 102 parent with an equity interest in
goodwill 233 cash-generating units (CGUs) 392 subsidiary 249
recognising and measuring goodwill allocating corporate assets to 397 preparation of 246–75
or gain 229–33 allocating goodwill to 395–7 revaluation of assets 250–2
recognition 227–8 carrying amount of 394–404 transactions within the group
acquisition of multiple businesses 219 identifying 393–4, 396 254–62
adjusted market assessment approach impairment loss 399–401 consolidated statement
131 impairment testing for 398, 400 of cash flows 276
adjusting events 75–6 recoverable amount 392–406 of changes in equity 276
aggregation 65–6 reversal of impairment losses on 401 of financial position 275
Amcor Limited 2018 Annual Report timing of impairment tests for 398–9 of profit or loss and other
205, 206 cash-settled payment 49 comprehensive income 275–6
amortisation 137–8 cash-settled share-based payment contingent assets 151–2
amortised cost 30–2 transaction 48 contingent liabilities 152–4
reporting date 31 CGUs see cash-generating units contract 121, 343
amortised cost measurement, of financial collateral or credit enhancements 363 contract balances 138–9
liabilities 335 commercial substance 121 contract costs
appropriate discount rate 387–95 Companies Act 2016 (Malaysia) 9 amortisation and impairment 137–8
asset impairment 378 comparability 18–19 costs to fulfil a contract 137
assets 22 comparative information 67 incremental costs of obtaining a
current cost of 33 compound financial instruments contract 136–7
derecognition of 26 338–42 contract modification 123

538 INDEX
contracts to buy or sell non-financial
items 307–8
contractual cash flows test 326
contractual rights 305
corporate assets 397
Corporations Act 2001 5, 7, 10, 62
cost constraint, financial reporting
20–1
cost method vs. equity method 282
cost-based measurement, IASB
amortised cost 30–2
historical cost 28–9
costs of disposal 34, 380
credit exposure 359, 363
credit risk 338, 361–3
credit risk exposure 362
credit risk management 361
cross-currency swaps 311–13
current asset condition 386–7
current cost 33–4
current rates 37–8
current tax 161–3, 199–201
current tax assets 201
current tax expense 212–14
current tax liability 163
customer 121
customer relationship management
(CRM) 120
deductible temporary differences 165,
179–80
deferred tax
calculation 164, 165
carrying amount 164
current tax 199–201
description 163
liabilities 165–6
measurement, assets and liabilities
172–8
purchase of business from another
entity 237
related to assets and liabilities 235–6
related to tax losses 236–43
revaluation 193–9
tax base of asset and liability 164,
166–9
temporary differences 164–5,
169–72
deferred tax assets 165
deductible temporary differences
179–80
probable 180–3
reassessment of the carrying
amounts 190–4
recognition of the movement 183–4
unused tax losses and credits 184–9
deferred tax liabilities 165–6
IAS 12, para. 15(a) 178
IAS 12, para. 15(b) 179–83
reassessment of the carrying amounts
190–4
depreciation adjustments
related to revaluation of depreciable
assets 252–4
derivative financial instruments 308
cross-currency swaps 311–13
forward contracts 308–10
futures contract 310
interest rate swaps 311
option contract 310–11
swap contracts 311
derivative instruments 342
derivatives 308
direct acquisition 222, 233–4
disaggregation of revenue 138
disclosure 359–60
changes in equity 91–4
consistent approach to 53
contract costs 140–2
contracts with customers 138–40
criteria for 52–3
deficiencies 138
financial position statement 96–7
financial statement users 140
financial statements 52
material income 87
qualitative and quantitative
information 138
revenue from contracts with
customers 140
role and purpose of 52
scope and level of 356
single statement 84–5
two statements 85–95
Disclosure Initiative 11
discount cash flows 36
discount rates 36–8
discount, allocation of 132–3
disposal value, of asset 387
Dissenting Opinion (DO) 6
distinct 124–5
dividends paid by subsidiary 265
dividends provided by associate 287
Effective Date (ED) 6
effective interest rate 30, 331
embedded derivatives
definition of 327–8
examples of 329
identifying 328
separation of 328
employee benefits 43–8
long-term 45–8
performance bonuses 49
short-term 44–5
enhancing qualitative characteristics
application of 20
comparability 18–19
timeliness 19
understandability 19–20
verifiability 19
entity-specific value 35
entity’s performance 134–5
equity 23–4, 306–7
equity instrument 305
investments in 337
equity interest 306
equity method 279
application of 283–93
basic features 283–4
basis of 281–3
identifying share of associate 284–5
investor’s share of losses 292
recognising initial investment at
cost 285–7
recognising investor’s share the
associate 288–90
recognising the dividends provided by
associate 287
transactions between associate and
investor 291–2
use of 280–1
vs. cost method 282
equity-settled payment 49
equity-settled share-based payment
transaction 48
Ernst & Young (EY)’s Automated
Ledger Review Tool 207
exceptions 228–9
to consolidation of subsidiaries
246–8
executory contracts 142
expected cash flow approach 383
expected cost plus a margin
approach 131
expected future cash flows 381–7
expenses 24–5
External Reporting Board (XRB) of New
Zealand 8–9
fair value 32–3, 331, 359, 380
less costs, disposal 34
fair value hedges 346–7
fair value less costs of disposal
380–1
fair value option 347–9
faithful representation 17
finance lease 41
financial assets 304–6, 367
business model for managing 324
categories of 357
classification of 323–6
contractual cash flows 324–7
derecognition of 313–14, 319
at fair value through profit or loss
357
impairment of 332–4
initial measurement 331
not subject to impairment
requirements 362–3
reclassification 329–31, 334–42
recognition of 313
sale of 314–15
subsequent measurement of 331–4
transfers of 314–25, 365–8
financial information
enhancing qualitative characteristics
18–20
fundamental qualitative characteristics
15–18
multiple stakeholders 11
primary users 4–5
financial instruments 302, 304, 307
compound financial instruments
338–42
contracts to buy or sell non-financial
items 307–8
definition of 304–6
derivative financial instruments see
derivative financial instruments
financial assets 304–6
financial liabilities 306–8
liability 306–7
INDEX 539
 nature and extent of risks 360–1
significance of 356
financial liabilities 306–8
amortised cost measurement of 335
categories of 357
classification of 326–9
derecognition of 313–23
at fair value through profit or loss
327, 338, 357
embedded derivatives 327–32
initial measurement 331
modification of 321
recognition of 313
subsequent measurement of 335–6
Financial Markets Conduct Act
2013 (New Zealand) 9
financial position statement
analysis 97–9
disclosures 96–7
financial position, statement of 357–8
financial reporting
complexity of 9–12
Conceptual Framework 12–13
cost constraint on 20–1
general purpose of 13–14
IFRSs 5–6
importance of 3–5
interaction between 7–9
profit or loss statement 3
role of 2–3
statement of financial performance 3
technology advancements 11
Financial Reporting Act 2013 (New
Zealand) 9
Financial Reporting Council (UK) 11
financial statements
accrual basis 65
aggregation 65–6
assets 22
comparative information 67
complete set of 61–3
consistency 67–8
consolidated 105–9
criteria for recognising
elements 25–6
equity 23–4
expenses 24–5
going concern 65
income 24
liabilities 22–3
materiality 65–6
measurement of 27–38
offsetting 66
reporting frequency 66–7
segment reporting 63–4
statement of cash flows 99–100
technological advancements on
79–82
user decisions 3
valuation technique 36–8
financing cash flows 102–3
fixed-for-fixed test 305
fixed-to-floating interest rate swap 346
floating-to-fixed interest rate swap 349
for-profit entities 8
for-profit private sector entities 9
foreign currency cash flows 387
foreign currency contracts 342
540 INDEX
formula method 103
forward contracts 308–10
amortisation of forward element of
353
fulfilment value 35
full goodwill method 231
fundamental qualitative characteristics
application of 18
faithful representation 17
materiality 16–17
relevance 15–17
future cash flows 383–5
futures contract 310
general purpose financial statements
(GPFSs)
objective of 2
two tiers of 8
GFC see global financial crisis
global financial crisis (GFC) 303
going concern 15, 65
reporting period, after 78–84
goodwill 374, 392
recognising and measuring 229–33
GPFSs see general purpose financial
statements
group 242
concept of control 243–8
defined 243
transactions within 254–62
hedge accounting 342, 359
hedged items 343
hedges 342
purchase of inventory 350
types of 345–53
hedging instruments 342–5
hedging relationship 342–4
accounting for 344–53
assessment 353–4
discontinuing 354
hedged items 343
hedging instruments 342–5
increased disclosures 354–6
hedging risk components 343–5
historical cost 28–9
historical rates 37
IAS 1 Presentation of Financial
Statements 11, 60, 91–4, 199
IAS 11 (Construction Contracts) 120
IAS 12 Income Taxes 66, 142, 158
IAS 16 Property, Plant and Equipment
22, 28, 119, 137, 192, 389
IAS 18 Revenue 119
IAS 19 Employee Benefits 11, 37, 43,
142
IAS 2 Inventories 137
IAS 21 The Effects of Changes in
Foreign Exchange Rates 352
IAS 24 Related Party Disclosures 220
IAS 27 Separate Financial Statements
118, 220
IAS 28 Investments in Associates and
Joint Ventures 118, 220, 279, 280
IAS 30 Disclosures in the Financial
Statements of Banks and Similar
Financial Institutions 356
IAS 31 Interests in Joint Ventures 296
IAS 32 Financial Instruments:
Disclosure and Presentation 303,
338, 356
IAS 36 Impairment of Assets 37, 332,
369, 371, 373, 392, 404, 406
IAS 37 Provisions, Contingent
Liabilities and Contingent Assets
36, 37, 180, 386
contingencies and professional
judgment 154–6
contingent assets 151–2
contingent liabilities 152–4
liabilities vs. contingent liabilities
154
provisions 143, see also provisions,
IAS 37
scope of 142–3
IAS 38 Intangible Assets 119, 137, 374
IAS 39 Financial Instruments:
Recognition and Measurement
303
IAS 40 Investment Property 119
IAS 7 Statement of Cash Flows 99
IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors
135
IASB see International Accounting
Standards Board
IASs see International Accounting
Standards
identifiable asset or liability 227
IFRS see International Financial
Reporting Standards
IFRS 10 Consolidated Financial
Statements 118, 162, 220, 224,
241, 296
IFRS 11 Joint Arrangements 118, 220,
297
IFRS 12 Disclosure of Interests in Other
Entities 220, 241, 279
IFRS 13 Fair Value Measurement 11,
32
IFRS 15 Revenue from Contracts with
Customers 66
contract costs see contract costs
contract types and elements 118
contract(s) with the customer 121–3
disclosure see disclosure
financial reporting of revenue 118
five-step model 120
impact of 119–21
performance obligation(s) in the
contract 123–5
performance obligations 133–6
previous revenue standards 118
scope of 118–19
transaction price of the contract
125–31
transaction price to each performance
obligation 131–3
IFRS 16 Leases 6, 38, 142
IFRS 17 Insurance Contracts 118, 142
IFRS 3 Business Combinations 142,
178, 220, 222, 224, 225, 238
IFRS 5 Non-current Assets Held for Sale
and Discontinued Operations 34,
127, 180
IFRS 7 Financial Instruments:
Disclosure 303, 338, 356, 365
IFRS 9 Financial Instruments 30, 142,
220, 303, 314, 323, 339, 354
Illustrative Examples (IE) 6
impairment indicators 375–81
impairment loss
disclosures of 404–5
recognising and measuring 388–9
reversals of 389–92, 404
impairment of assets
basic principles of 371–3
identifying 373–8
important for users 372
key definitions 372–3
requirements 371
impairment of cash-generating units
392
identifying 393–4
recoverable amount 392–3
impairment of individual assets
fair value less costs of disposal
380–1
measurement of recoverable amount
378–80
recognising and measuring an
impairment loss 388–9
reversals of impairment losses
389–92
value in use 381–8
impairment test
for cash-generating units 398
requirements for 373–4
income 24
income taxes
current and future tax
consequences 159
current tax 161–3
deferred tax see deferred tax
financial statement extracts 159
financial statements 159
principle of IAS 12 176, 215
tax expense 160–1
tax losses 186–92
Incorporated Associations Act 8
indirect acquisition 222, 234–5
inflation 386
initial investment at cost, recognising
285–7
initial recognition 30
intangible asset 374
impairment testing for 401
interest rate, effective 30
interest rate swaps 311
International Accounting Standards
(IASs) 5
International Accounting Standards
Board (IASB) 5, 7
small and medium-sized entities 10
stakeholders 11
International Financial Reporting
Standards (IFRSs) 5–6, 220
cost-based measurement 27–35
disclosures 52–3
employee benefits 43–8
fair presentation and compliance with
64–5
investment property 49–51
leases 38–43
professional judgment 51–2
segment reporting 63–4
share-based payments 48–9
value-based measurement 27–35
intrinsic value 353
investing activities 101
investing cash flows 101
investment property 49–51
investments 218
in equity instrument 337
in equity securities 357
investments in associates 279
application of equity method 283–93
basis of equity method 281–3
disclosures for 293–6
identifying 279–80
use of equity method 280–1
investor relationships 219
investor—associate relationship 219
investor’s share of associate 288–90
investor’s share of losses 292
joint arrangements 219, 296–301
joint control 296
leases 38–43
accounting for 40
lessee 39–41
lessor 41–3
presentation and disclosure 43
lessee 39–41
lessor 41–3
liabilities 22–3, 306
current cost of 33
derecognition of 26
long service leave, entity 46
presentation of 95–6
link between power and variable
returns 245
liquidity risk 363
long service leave (LSL) 44–8
entity’s liability for 46
long-term employee benefits 45–8
Malaysian Private Entities Reporting
Standard (MPERS) 9
market risk 364–5
materiality 16–17, 65–6
multiple business models 324
multiple businesses, acquisition of 219
multiple stakeholders 11
net investment, in foreign entity 352
net realisable value 34–5
non-adjusting events 75–8
non-cash consideration 130
non-controlling interest 228, 262–75
calculation of 272
dividends paid by subsidiary 265
identifying and measuring 231–3
measurement of 265–75
pre-acquisition elimination entry
262–5
non-depreciable asset 197–201
obligation 144
offsetting 66
one-line consolidation method 279
operating activities 100
operating cash flows 100–1
operating lease 41
operating segment 63
option contract 310–11
option pricing 353
OTC see over-the-counter
other comprehensive income (OCI) 82,
358–68, 388
analysis 89–91
information presented with 87–8
statement of 84–5
total comprehensive income 83–4
vs. profit or loss statement 88–91
other price risk 364
over-the-counter (OTC) 311
own-use contracts 347
parent entity 243
parent with an equity interest, in
subsidiary 249
parent—subsidiary relationship 219
partial goodwill method 231
performance bonuses, employee 49
performance obligation 122
satisfied at a point in time 135–6
satisfied over time 134–5
transaction price 139–40
power 244
power over an investee 244–5
pre-acquisition elimination
entry 262–5
present value technique 36
current rates 37–8
discount rates 36–8
historical rates 37
professional judgment 51–2, 154–6
profit or loss (P/L), statement 82
analysis 89–91
expenses 86–7
information presented with 85–6
single statement 84–5
two statements 85–95
vs. other comprehensive income
88–91
provisions 143
provisions, IAS 37
and professional judgment 149–51
disclosure 147–9
economic benefits 144
measurement of 145–6
present obligation and past event
143–4
public accountability 7
public-benefit entities 8
qualitative characteristics
application of 21–2
enhancing 18–20
fundamental 15–18
realisation of profit or loss, by group
255–7
recognition 227–8
recoverable amount 34, 405–6
individual asset or cash-generating
unit 392–3
measurement of 378–80
INDEX 541
reduced disclosure requirements
(RDR) 8
relevance 15–17
relevant activities 244
replacement cost 33
reporting entity 242
reporting period, accounting
adjusting events 76
dividends declared after 78
going concern issues after 78–84
non-adjusting events 76–8
reproduction cost 33
residual approach 131
revaluation of assets 250–2
revalued amounts, assets
carried at 192–3
revalued assets 194–7
revenue recognition
five-step model 155
IFRS 15 116, 117
reversals of impairment loss 389–92
sale of financial assets 314–15
sale of inventory 258
segment reporting 63–4
settlement in entity’s own equity
instruments 305–6
SGX see Singapore Exchange
share of associate, identifying 284–5
share-based payments
accounting 48–9
arrangement 48
transactions 49
short-term employee benefits 44–5
significant influence 279
Singapore Exchange (SGX) 310
small and medium-sized entities (SMEs)
10–11
SMEs see small and medium-sized
entities (SMEs)
SPE see special purpose entity
special purpose entity (SPE) 338
special purpose financial statements
(SPFSs) 10
spreads 353
stand-alone selling price 131, 132
statement of cash flows 99
analysis 105–8
financial statements 99–100
formula method 103
542 INDEX
net basis, cash flows 104
statement of changes in equity 91
statement of financial position 94
format of 94–5
statement of profit or loss 358–68
subsequent accounting treatment 219
subsequent event 75
subsequent measurement
of financial assets 331–4
of financial liabilities 335–6
recognising gains and losses 336–7
subsidiary entity 243
swap contracts 311
systematic risk 36
tax balances 216
tax base of
assets 166–8
liabilities 168–9
recovery affects 174
temporary differences 169–72
tax credits 184–9
tax effects, of intra-group transactions
257–62
tax expense (tax income) 160–1
and accounting profit 203–5
components of 201–3
taxable profit (tax loss) 184–9, 192,
212–14
taxable temporary difference 164–5
temporary difference
deductible temporary difference 165
description 164–5
taxable temporary difference 164–5
types of 205–8
time value of option 353
accounting for 353–9
timeliness 19
Tokyo Stock Exchange (TSE) 310
total comprehensive income 83–4
transaction price 125
transactions between investor and
associate 291–2
transactions within the group 254–62
realisation of profit or loss by group
255–7
tax effects of intra-group transactions
257–62
transferred assets 318–19
transfers of financial assets 314–25,
365–8
with collateral 319–23
with derecognition 317
without derecognition 318
TSE see Tokyo Stock Exchange
understandability 19–20
unsystematic risk 36
unused tax credits 184–9
unused tax losses 184–9
US Financial Accounting Standards
Board (FASB) 10
US Generally Accepted Accounting
Principles (GAAP) 10, 118
US Securities and Exchange
Commission (SEC) 10
use of credit derivatives,
in hedging 347
value in use 381–8
determining an appropriate discount
rate 387–95
estimating expected future cash
flows 381–7
expected cash flow approach 383
factors to consider 382–3
value-based measurement, IASB
current cost 33–4
fair value 32–3
fair value less costs, disposal 34
fulfilment value 35
net realisable value 34–5
value in use 35
variable consideration 126–8
allocation of 133
verifiability 19
Webprod Ltd
accounting policy, changes 111
acquisitions and disposals 110
amortisation 110
borrowing costs 111
depreciation 110
land and buildings, revaluation
110–11
manufacturing inventory 109–10
non-current assets 110
prior reporting periods 108–9
retail inventory 109
revenue 111
wages and salaries 111
30 June 20X7 trial balance 111–14